Analysis

UAFRS focuses on operating profits, even “non-operating” operating expenses, leading us to understand this credit better than the market

May 13, 2020

Special items give companies a chance to separate one-off and unusual items from operating performance, but sometimes their recurring nature makes this view unwarranted.

This firm’s consistent litigation settlements made its operating profitability seem much safer than was accurate. However, once new management was able to mitigate the impact of the past administration’s mistakes, the firm’s cash flows strengthened and its credit risk subsided.

Below, we show how Uniform Accounting restates financials for a clear credit profile to confirm this counterintuitive view.

We also provide an equity tearsheet showing Uniform Accounting-based Performance and Valuation analysis of the company.

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When analyzing a company’s equity or credit, it is important to focus on a company’s operating profitability, as it often is more representative of a firm’s real cash flows, and can help form a clearer picture of a firm’s future cash flows and obligations.

A firm’s bottom-line can be full of distortions, as CFOs can utilize accounting choices inherent to GAAP to skew results. For example, one-off or unusual items can make a firm’s operations seem significantly more volatile than may be accurate.

However, sometimes a company may have these “one-off” items recur annually, likely associated with the same event. In any case, if they become a serial strategy for management to abuse, these special items can not be accurately accounted for as “unusual” or “one-off” anymore.

Boston Scientific (BSX) is a great example of a firm whose special items needed to be taken into account as part of its operating profitability.

For some time after the company acquired Guidant in 2006, after beating Johnson & Johnson in a bidding war, the firm had serial issues with lawsuits.

As management rushed out products to the market, some had defects or side-effects that dramatically impacted the health of its patients. Most recently, the firm has had to settle multiple suits surrounding its women’s pelvic mesh devices.

Even a major management change in 2012, as CEO Michael Mahoney took charge, was not enough to dispel the firm’s problems. Mahoney and his administration still dealt with the issues initiated by past management, as repercussions of the Guidant acquisition and management’s poor product decisions remained.

Litigation kept coming in, and Boston Scientific kept having to pay out cash to settle the claims.

This consistent cash payout suggests that real operating cash flows are materially lower than they would appear by just looking at traditional profit metrics.

We recognized the need for this adjustment for Boston Scientific over a decade ago, which also led us to conclude that the firm’s credit risk was understated in 2010.

The market eventually caught on, with the firm’s credit default swaps (CDS), a proxy for credit risk, rising significantly from only 56bps to start the year to almost 200bps by July.

However, since then, although some issues linger, management has made significant progress in clearing a large portion of the Guidant burden, with litigations occurring somewhat less frequently and at far lesser magnitudes.

As a result, those issues cast a much smaller shadow on the firm’s cash flows and credit risk. Although these recurring special items remain a minor headwind to the firm’s profitability, the firm’s operating profit, which was always much more robust if you could believe the company could put the litigation and restructuring charges behind it, show a much safer company.

Thus, the tightening of the firm’s CDS spreads have been warranted, with CDS currently sitting at only 25bps, signaling that the firm is an extremely safe credit. Once investors account for the misleading nature of recurring special items, a firm’s true credit profile becomes clearer.

Robust cash flows and a sizeable market capitalization suggest cash bond markets are overstating credit risk

CDS markets are accurately stating BSX’s credit risk with a CDS of 25bps relative to an iCDS of 33bps, while cash bond markets are overstating risk with a YTW of 1.664% relative to an Intrinsic YTW of 0.704%.

Meanwhile, Moody’s is accurately stating BSX’s fundamental credit risk, with its Baa2 rating in line with Valens’ IG4 (Baa2) credit rating.

Fundamental analysis highlights that BSX’s cash flows should comfortably exceed operating obligations in each year going forward. Moreover, the firm’s cash flows alone should be able to service all obligations, including debt maturities, through 2025.

In addition, despite a moderate 70% recovery rate on unsecured debt, the firm’s sizeable market capitalization and history of successful refinancing should allow it to access credit markets to refinance, if necessary.

Incentives Dictate Behavior™ analysis highlights mixed signals for credit holders. BSX’s management compensation framework should drive them to focus on top-line growth and margins, which should lead to ROA expansion.

In addition, most management members are material owners of BSX equity relative to their annual compensation, indicating they may be well-aligned with shareholders for long-term value creation.

However, a lack of asset efficiency or leverage metrics may drive management to overspend on assets and overleverage the balance sheet in order to finance growth.

Furthermore, management has significant change-in-control compensation, indicating they are likely to seek or accept a buyout or takeover of the firm, increasing event risk for credit holders.

Earnings Call Forensics™ analysis of the firm’s Q4 2019 earnings call (2/5) highlights that management is confident they had broad-based operational revenue growth, they remain bullish on their pain and brain modulation portfolio, and that their Vertiflex acquisition complements their RF ablation and SCS portfolio.

Moreover, they are confident WATCHMAN FLX has improved their share-taking capabilities in Europe and is set to launch in the United States in the second half of the year.

In addition, management is confident their organic growth revenue range of 6.5%-8.5% includes their ability to recapture some lost procedure volume in China.

However, they are also confident COVID-19 impacts a broad-based portion of the firm’s portfolio. Furthermore, they are confident high-growth products are initially dilutive to gross margin, and that they expect the defibrillator market to grow to -2%.

Additionally, management may be exaggerating their ability to hold share in the defibrillator market, meet EPS guidance, and execute their plan to achieve a debt leverage ratio of 2.6x EBITDA by the end of 2020.

Finally, they may be concerned about missing organic revenue guidance and the launch of their implantable cardiac monitor LUX-DX.

Robust cash flows and a sizeable market capitalization suggest cash bond markets are overstating BSX’s fundamental credit risk. As a result, a tightening of bond spreads is likely going forward.

SUMMARY and Boston Scientific Corporation Tearsheet

As the Uniform Accounting tearsheet for Boston Scientific Corporation (BSX:USA) highlights, the company trades at a 31.7x Uniform P/E, which is well above global corporate average valuation levels, but around its historical average valuations.

High P/E’s require high EPS growth to sustain them. That said, in the case of Boston Scientific, the company has recently shown a -27% Uniform EPS growth.

Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Boston Scientific’s Wall Street analyst-driven forecast projects a 24% shrinkage in earnings in 2020, followed by 113% growth in 2021.

Based on current stock market valuations, we can back into the required earnings growth rate that would justify $38 per share. These are often referred to as market embedded expectations. In order to meet current expectations for Boston Scientific, the company would need to have Uniform earnings grow by 10% or more each year over the next three years.

Wall Street analysts’ expectations for Boston Scientific’s earnings growth are above what the current stock market valuation requires.

Meanwhile, Boston Scientific’s Uniform earnings growth is below peer average levels, but the company is trading around peer valuations.

In addition, the company’s earnings power is 5x corporate averages. As a result, total obligations, including debt maturities, maintenance capex, and dividends, are above total cash flows, signaling a low risk to its dividend or operations.

To summarize, Boston Scientific is expected to see below average Uniform earnings growth in 2020, which is expected to grow in 2021, where it will exceed market expectations. Furthermore, the company is trading around peer valuations, with earnings growth below peers.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research