If I were to mention “virtual duopolies,” your mind probably would immediately jump to the twin dividend towers of AT&T (NYSE:T) and Verizon (NYSE:VZ).
But there’s a lesser-known one — consisting of Volcano Corp. (NASDAQ:VOLC) and St. Jude Medical (NYSE:STJ) — that looks pretty darn attractive, too.
Volcano and St. Jude are the primary players in the niche arena of fractional flow reserve (FFR) single-procedure disposables — tests used to determine whether a heart stent is required. But niche as it might be, it has the potential to be pretty lucrative. VOLC, for instance, reported record fourth-quarter earnings Jan. 7 thanks to a 45% increase (constant currency basis) in its disposables. VOLC expects total revenues for this product to have reached $95 million in 2012 alone, and CEO Scott Huennekens suggests the FFR market is a $2 billion industry.
Given this potential, both stocks are enticing. But which is the better buy? Well, we need to look at a few things: Why the opportunity is so great, how important FFRs are to each company’s business, and whether failure to capture this $2 billion opportunity would be fatal to either company.
The Role of FFR Tests
Most of us probably know at least one person who has had a stent inserted into a clogged artery to keep the blood flowing to the heart, thus preventing heart attacks. BCC Research says the global market for coronary stents was $7.1 billion in 2011 and is estimated to hit $10.6 billion by 2016.
In recent years, though, the use of stenting has declined modestly as less-costly drug therapies were found to be just as effective at extending one’s life. And that’s where FFR-guided percutaneous coronary intervention (PCI) comes in.
In January 2006, several physicians and scientists brought together 1,005 patients suffering from multi-vessel coronary artery disease in both the U.S. and Europe. They then divided the group into two relatively equal parts — one underwent angiography-guided PCI, and the other FFR-guided PCI. In each case, the point was to stent lesions that were causing artery blockage.
However, drug-eluting stents are expensive; therefore, it’s critical that stenting only be carried out where necessary. So, the study attempted to find out whether FFR combined with angiography does a better job dealing with the most problematic of lesions than by angiography alone.
The conclusions were industry-changing. Out of a total of 2,415 stents placed, 1,541 were from the angiography-only group. FFR had reduced the use of stents by 43% without any additional health problems one year later.
Most importantly, FFR did so while reducing the cost of patient care. That’s a win/win situation.
Importance to Business
Volcano’s total revenue in 2012 is expected to be $382 million; its FFR products will be responsible for 25% of overall sales, up from 19% in 2011 and 9% in 2007. It’s clearly becoming a bigger piece of the Volcano pie.
Over at St. Jude, I estimate FFR revenue in 2012 of approximately $105 million, which I’ve based on the Volcano CEO’s $200 million projection for FFR in the past year. St. Jude’s total revenue in 2012 is expected to be $5.5 billion, which puts FFR at 2% of its overall revenue.
The $2 billion addressable market that Huennekens refers to assumes FFR tests could be used in arteries throughout the body rather than those immediately leading to the heart. If the duopoly were to stay in place through 2017 and both companies were able to utilize FFR tests throughout the body, a $1 billion addition to Volcano’s revenues would translate into a 2017 top line of $1.7 billion with operating income of $136 million (8% operating margin vs. 6% in 2012) and earnings per share of $1.64.
Any way you slice it, the upside potential is far more attractive for Volcano than St. Jude.
If the market for FFR tests continues along its existing path and combined FFR revenues for both companies hits $400 million by 2017, Volcano should have $855 million in overall revenues and $71 million in operating profit and earn 86 cents per share. While not nearly as frothy as its best-case scenario, it’s still pretty darn good.
For St. Jude’s, the worst-case scenario might mean selling its FFR business to someone like Medtronic (NYSE:MDT) or one of the other leading stent makers, strangely similar to the situation Volcano finds itself at present. (Huennekens says the company isn’t for sale, but with no controlling shareholder, the prospect of deal is very real.)
Here we have two interesting companies — one small (VOLC) and one large (STJ). Both seem to be growing, although St. Jude’s growth appears to be from its Atrial Fibrillation and Neuromodulation products, while Volcano’s is from its FFR single-procedure disposables. Thus, VOLC is a much riskier play.
It’s also more expensive. Given the different stages of their businesses, it’s difficult to use any of the typical valuation metrics except price-to-sales, where St. Jude is trading at 2 times sales compared to almost 4 times sales for Volcano … though even that doesn’t seem out of line given the growth of its FFR segment.
But the best stock isn’t always the biggest or the cheapest. While St. Jude’s is a sturdy company, Volcano — with or without the $2 billion addressable market — has a much better chance of putting up some serious returns.
As of this writing, Will Ashworth did not own a position in any of the stocks named here.