MDT - Edwards Lifesciences: Sector Derating A Bigger Threat Than Competition Or Slowing Markets

2023-10-26 17:21:03 ET

Summary

• Third quarter results from Edwards Lifesciences don't really add much to the bull or bear case, with a small miss (but double-digit growth) in TAVR, and guidance for double-digit growth.
• Recent presentations from the annual TCT meeting may not look great for Edwards at first glance, but underlying analysis suggests little clinical difference between SAPIEN 3 and Medtronic's Evolut.
• Expectations for revenue growth and margin performance seem a lot more reasonable now, and Edwards still has many years of strong growth ahead (particularly if asymptomatic labeling comes through).
• On their own, these shares look undervalued, but medical device stocks have come under a lot of pressure lately, and it may be a little too early to step up and buy.

What, exactly, is going on in the med-tech space right now is anybody's guess, as the sector has seen a significant selloff over the last three months. While hype around GLP-1 drugs could perhaps explain concerns in some sub-sectors (lower obesity rates reducing long-term demand for some devices/procedures), I don't dismiss the possibility that the sector is simply derating back to more normal valuation parameters after a multiyear expansion.

Turning specifically to Edwards Lifesciences ( EW ), there are a lot of moving parts here. Recent presentations at the annual TCT meeting may be generating some headline risk, and there are longer-range challenges like increased competition and slowing market growth to consider, but derating could also explain a lot of the weak recent performance, though not the underperformance since my last update on this company (that, I believe, has more to do with what I saw as inflated expectations back then).

I have mixed feelings about Edwards at this point. Clearly the Street is down on this name, and quite possibly unfairly so. If high single-digit revenue growth and mid-teens FCF growth are attainable long-term expectations, these shares are well worth considering, but I think it's important to note that the Street has historically over-estimated both the revenue growth and margin expansion here, and further derating in the med-tech sector could drive more pain from here.

Q3 Results And Guidance Aren't Helpful, But Also Aren't Thesis-Changing

If you liked Edwards going into third quarter results, you probably still do now. Likewise, if you didn't like Edwards, there was nothing in the results that I would expect to change your mind. Guidance toward the lower end of management's prior revenue growth range was not a welcome development in an already nervous market, but I won't call it a thesis-changing revision.

Revenue rose 12% as reported, or about 11% in constant currency, which was basically in line with expectations. Revenue from the transcatheter aortic valve replacement (or TAVR) business rose 10%, missing by close to 1% despite improved hospital staffing levels and better results in Japan. US and OUS growth was similar in the TAVR business.

In Edwards' other lines, the Transcatheter Mitral and Tricuspid Therapies (or TMTT) business grew 65%, but is still a small contributor (<5% of revenue). Surgical Structural Heart revenue rose 11% and Critical Care rose 6%. Both TMTT and Structural beat expectations, while Critical Care came in a few million light.

Gross margin declined 460bp to 76.4%, barely missing expectations. My version of adjusted operating income (which keeps amortization but excludes one-time items) saw 7% growth, with margin down six points to 28.4%. By the more standard adjusted approach (which excludes amortization), Edwards met expectations at the operating margin line.

Pricing in TAVR was stable this quarter, and management's guidance was unchanged at 10% to 13% revenue growth, but did suggest the lower end of the range was more likely, and sell-side numbers have come down a little as a result.

Data Presentations At TCT Aren't As Troubling As They May Seem; Status Quo Seems Likely

This year's TCT meeting saw two trial presentations relevant to the TAVR space (one from Edwards, one from Medtronic ( MDT )), but I don't think either will change practices or behaviors much over the long term.

The PARTNER 3 study sponsored by Edwards showed 5-year results for the company's SAPIEN 3 offering versus surgical repair (or SAVR) in low-risk patients. The study was designed as a non-inferiority study, and statistically the study was a success. At first look, I imagine there was some alarm that the rate of all-cause mortality in the SAPIEN 3 arm was higher than in the SAVR group (10% vs. 8.2%), but it seems as though COVID-19 drove disproportionate deaths in the TAVR arm; the rate of cardiac death differed by only 40bp (5.5% vs. 5.1%), and TAVR showed lower rates of disabling stroke (5.8% vs. 6.4%) and lower rates of re-hospitalization (13.7% vs. 17.4%), as well as lower rates of other post-op issues like new-onset atrial fibrillation.

Looking at Medtronic's Evolut Low-Risk study, it was a strong set of numbers for Medtronic's Evolut valve. All-cause mortality and disabling stroke occurred less often in the Evolut group than in the surgical group (10.7% vs. 14.1%) and the difference grew over time.

This sounds like a potential clear win for Medtronic, but I'd be careful about rushing to that conclusion. Comparing across studies is always tricky, but looking at four-year data in PARTNER 3 suggests little to concern Edwards. If you look at all-cause mortality, stroke, and re-hospitalization at Year 4, the rates between SAPIEN 3 and Evolut were practically identical (18% vs. 18.1%), and all-cause mortality actually favored SAPIEN 3 (7.2% vs. 9%). I would note, though, that the rates of negative outcomes (including death) in the surgical group for the Evolut study were much higher than in the PARTNER 3 study; that is an added complication to these comparisons, and I'm not sure why the results would be so different.

Looking at these read-outs, I don't see much changing in the market. There are certain advantages to the Evolut design - it was designed for greater durability (better for younger recipients), and its design offers a higher effective orifice area and lower gradients. On the other hand, it's harder to implant (though the Evolut FX has been designed to address some of these issues), and the balloon-expanded design of Sapien (Evolut is self-expanding) provides for better subsequent coronary access (again, more relevant for younger patients who may need coronary interventions in the future).

The Outlook

There are a lot of moving parts to the Edwards story now. Within TAVR, I think the company's dominant position in high-risk and medium-risk TAVR is solid and unlikely to shift much in the coming years, but the market is likely to only grow at a mid-single-digit rate. In low-risk, I see more risk that Medtronic and Boston Scientific ( BSX ) (whose upcoming Accurate Neo2 is similar in design to Evolut) gain some share in this segment, and with mid-teens growth, that's important.

Longer term, I do see future opportunities like label expansion for asymptomatic patients once again expanding the market and preserving/extending Edwards' growth, and I think balloon-expandable will again be a preferred approach among this generally younger patient subset. As for tricuspid and mitral valves, I think Abbott Laboratories ( ABT ) will be tough to dislodge in mitral valve repair, but I do still see some potential upside in mitral valve replacement if the EVOQUE study really impresses.

Looking at how Edwards has performed since my last update, the intervening time saw the company meet my 2020 expectations, exceed my 2021 expectations by 3%, and then miss my 2022 expectations by more than 7%. Margin performance was likewise mixed, and I'd also note that Street expectations for margins are lower now than they were a few years ago.

I like the fact that expectations have come down to more reasonable levels, and I think Edwards can generate long-term revenue growth in the high single-digits from here (around 9%). I also do still expect improved margin performance, with EBITDA margin recovering back to the mid-30%'s over the next three to four years and then still growing beyond that. I believe free cash flow margins in the high-20%'s are still possible in around five years, with longer-term upside close to 30%, driving mid-teens FCF growth.

Discounting those cash flows back, I believe Edwards is undervalued below the mid-$70s, and it's quite common for quality med-tech to trade well above "fair" discounted cash flow. Using my growth and margin-driven EV/revenue models is where things get trickier. If you value Edwards by the standards that have prevailed over the last few years, a 7x multiple to revenue and a $78.50 fair value is the result. If you look at the longer-term standards, the fair multiple falls to 5x-5.5x and the fair value to $57-$62.

The Bottom Line

This is a tough time to try to call bottoms among medical device stocks, as investors seem to be bailing out of the space almost irrespective of the long-term outlooks for individual stocks. If that continues, it will be tough for Edwards to outperform. I believe in the long-term value of the business, though, and while GLP-1 drugs could perhaps reduce the long-term future supply of patients (obesity contributes to valve disease/damage), I don't think it's likely to have a noticeable effect for a long time.

I find today's price to be pretty interesting, but I'm not too eager to fight this negative trend in the market. With that, this is a name to watch closely and consider buying as the market settles down, but I'm personally not willing to take the risk of reaching out for a falling knife right now.

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