Why did net income decline sharply in 2005 despite higher sales?

Net income fell to $628 million from $1,062 million mainly because of a $780 million pre-tax litigation charge, most of it the $750 million cash payment and $24 million write-off in the September 2005 Medinol settlement. The company also recorded $276 million of purchased R&D from acquisitions, along with a higher effective tax rate of 29.5%. Excluding these items, operating performance was considerably stronger.

How dependent is Boston Scientific on its TAXUS drug-eluting stent?

Highly dependent. TAXUS sales were $2,556 million in 2005, about 41% of net sales, and coronary stents overall were about 43% of revenue. U.S. TAXUS sales growth stalled in the second half of 2005 due to share loss and pricing pressure. Management expects further pressure as Medtronic's Endeavor, Guidant's XIENCE V (via Abbott), and Conor's CoStar enter the market.

What is the FDA warning letter and how could it affect the business?

On January 26, 2006 the FDA issued a corporate warning letter citing serious quality-system problems at three facilities and finding the company's corrective action plan inadequate. Until deficiencies are corrected, the FDA will not issue export certificates or approve PMAs for related class III devices. Management believes it can remediate quickly and does not expect a delay to the planned U.S. TAXUS Liberté launch, but the FDA could still seize inventory, seek injunctions, or assess civil penalties.

What will the Guidant acquisition mean for the company's financial profile?

The $27 billion transaction is expected to add substantial cardiac rhythm management exposure and a second drug-eluting stent program. Financially, it will require about $8 billion of cash borrowings (including a $900 million loan from Abbott), trigger credit downgrades, and significantly dilute 2006 EPS. Weighted diluted shares are expected to rise to roughly 1.4 billion from about 840 million. Closing remains subject to HSR and EU clearances and shareholder approvals, and it faces legal challenges from shareholders seeking injunctions.

Does Boston Scientific pay dividends, and how is it returning capital to shareholders?

No cash dividends were paid in the past two years, and management does not currently intend to pay them, prioritizing debt repayment and growth. The company repurchased about 25 million shares for $734 million in 2005, and roughly 37 million shares remain under existing authorizations. However, no repurchases occurred in Q4 2005, and the pending Guidant transaction, which involves issuing shares and increasing authorized shares to 2 billion, will shift capital allocation toward deleveraging.

BSX 10-K FY2005 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed March 1, 2006. Cited figures are marked; the original filing is the authoritative source.

Boston Scientific's FY2005 10-K shows a company at an inflection point.

Net sales rose 12% to $6,283 million^a, and gross margin improved to 77.9%, driven largely by TAXUS drug-eluting stent sales of $2,556 million (about 41% of revenue). However, reported net income fell 41% to $628 million ($0.75 per diluted share) from $1,062 million, primarily because of a $780 million pre-tax litigation charge tied to the $750 million Medinol settlement, along with $276 million of purchased R&D from acquisitions. Operating cash flow dropped to $903 million from $1,804 million, and net debt rose to $1,172 million from $727 million.

The central risk for investors is the U.S. drug-eluting stent franchise. Management reported that U.S. TAXUS share declined sequentially through the first three quarters of 2005 before stabilizing in Q4, and pricing pressure is increasing. Competitors are entering internationally now and are expected in the U.S. in the second half of 2007.

The company also received an FDA corporate warning letter on January 26, 2006, citing quality-system deficiencies at three facilities, which could affect exports and class III premarket approvals, including the planned U.S. launch of TAXUS Liberté in the second half of 2006. The filing is dominated by the pending $27 billion^b acquisition of Guidant Corporation, expected the week of April 3, 2006, with Abbott acquiring Guidant's vascular businesses and sharing a second drug-eluting stent program. The deal requires roughly $8 billion of new cash borrowings and will be followed by a credit downgrade, an interest-rate step-up on certain senior notes, and significant EPS dilution.

Weighted diluted shares are expected to rise from about 840 million to about 1.4 billion. Investors should weigh the diversification into cardiac rhythm management against higher leverage, integration risk, and Guidant's product-recall and government-investigation overhang.

02—Key points

Key Highlights

Revenue growth: Net sales increased 12% to $6.28 billion in 2005, with gross margin rising to 77.9% from 77.0%, reflecting a shift toward higher-margin drug-eluting stents.
Earnings pressure: Net income fell to $628 million ($0.75 diluted EPS) from $1.06 billion ($1.24) as $780 million of litigation charges (mainly the $750 million Medinol settlement) and $276 million of purchased R&D weighed on results.
Stent concentration and share loss: TAXUS generated about 41% of 2005 sales ($2.56 billion), but U.S. market share declined through Q3 2005 and stabilized in Q4 amid pricing pressure; competition is arriving internationally now and in the U.S. in 2H 2007.
Regulatory risk: A January 26, 2006 FDA corporate warning letter cites quality-system problems at three facilities, and the FDA will not grant export certificates or approve class III PMAs related to the deficiencies until corrected.
Guidant acquisition: A $27 billion deal (about $80 per Guidant share in cash and stock) expected to close the week of April 3, 2006, which would add cardiac rhythm management and provide access to a second drug-eluting stent program via Abbott.
Leverage and dilution: Management expects about $8 billion of incremental cash borrowings, a credit rating downgrade (possibly toward or below investment grade), a potential 0.75% coupon step-up on the 2015 and 2035 notes, and roughly 1.4 billion diluted shares post-closing versus about 840 million in 2005.
Cash flow and balance sheet: Operating cash flow fell to $903 million (including $750 million for Medinol), cash and marketable securities declined to $848 million, and gross debt was $2.02 billion, leaving net debt of $1.17 billion.

03—Questions

Frequently Asked Questions

Why did net income decline sharply in 2005 despite higher sales?
Net income fell to $628 million from $1,062 million mainly because of a $780 million pre-tax litigation charge, most of it the $750 million cash payment and $24 million write-off in the September 2005 Medinol settlement. The company also recorded $276 million of purchased R&D from acquisitions, along with a higher effective tax rate of 29.5%. Excluding these items, operating performance was considerably stronger.
How dependent is Boston Scientific on its TAXUS drug-eluting stent?
Highly dependent. TAXUS sales were $2,556 million in 2005, about 41% of net sales, and coronary stents overall were about 43% of revenue. U.S. TAXUS sales growth stalled in the second half of 2005 due to share loss and pricing pressure. Management expects further pressure as Medtronic's Endeavor, Guidant's XIENCE V (via Abbott), and Conor's CoStar enter the market.
What is the FDA warning letter and how could it affect the business?
On January 26, 2006 the FDA issued a corporate warning letter citing serious quality-system problems at three facilities and finding the company's corrective action plan inadequate. Until deficiencies are corrected, the FDA will not issue export certificates or approve PMAs for related class III devices. Management believes it can remediate quickly and does not expect a delay to the planned U.S. TAXUS Liberté launch, but the FDA could still seize inventory, seek injunctions, or assess civil penalties.
What will the Guidant acquisition mean for the company's financial profile?
The $27 billion transaction is expected to add substantial cardiac rhythm management exposure and a second drug-eluting stent program. Financially, it will require about $8 billion of cash borrowings (including a $900 million loan from Abbott), trigger credit downgrades, and significantly dilute 2006 EPS. Weighted diluted shares are expected to rise to roughly 1.4 billion from about 840 million. Closing remains subject to HSR and EU clearances and shareholder approvals, and it faces legal challenges from shareholders seeking injunctions.
Does Boston Scientific pay dividends, and how is it returning capital to shareholders?
No cash dividends were paid in the past two years, and management does not currently intend to pay them, prioritizing debt repayment and growth. The company repurchased about 25 million shares for $734 million in 2005, and roughly 37 million shares remain under existing authorizations. However, no repurchases occurred in Q4 2005, and the pending Guidant transaction, which involves issuing shares and increasing authorized shares to 2 billion, will shift capital allocation toward deleveraging.

04—Continue

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