This Company's Management Has No Reason to Break Bad Habits

Boston Scientific (BSX) looked like a great buy in the early 2000s...

From 2001 through early 2004, the stock soared roughly 545%. Nobody would have blamed you for wanting in on the action back then.

It looked like nothing could stop Boston Scientific's ascent. This was clearly a blue-chip medical device stock... And then it went into freefall.

From its peak in March 2004 to its low in November 2012, the stock plunged 88%. Anyone holding shares in 2004 waited a decade and a half just to get back to where they were.

In 2006, the company bought cardiovascular-technology maker Guidant in a bid to improve its financials. It fought hard, even beating biopharmaceutical giant Johnson & Johnson (JNJ). But the acquisition didn't turn out the way it hoped...

Boston Scientific stock is up just 68% since January of that year. In contrast, the broad health care sector – as measured by the Health Care Select Sector SPDR Fund (XLV) – is up 297%, despite recent volatility.

This lackluster performance is at least partially due to allegations of shoddy quality control. These claims have been plaguing Boston Scientific for more than a decade.

In 2011, the company had to pay $30 million for a problem with Guidant's heart stents. Guidant allegedly rushed the product to clients without proper testing between 2002 and 2005.

In 2012, the company appointed Mike Mahoney as the new CEO. As the former chairman of Johnson & Johnson's medical-devices unit, Mahoney knew how to run a business. Johnson & Johnson had a reputation for prioritizing quality control.

But it wasn't enough. Many of Boston Scientific's issues remained even after Mahoney joined.

Between 2006 and 2016, the company averaged $600 million per year in legal reserves or settlement payouts. That's $6 billion over a 10-year period... roughly half of total operating income during that time.

Mahoney was elected chairman of the board in 2016. Since then, legal payments have dropped dramatically. They're down to an annual average of $200 million.

But it doesn't look like Boston Scientific's days of notoriety are behind it. Last year, the U.S. Food and Drug Administration ("FDA") recalled 48,000 of the company's Ingenio pacemakers, which were manufactured between 2011 and 2018.

And a whistleblower lawsuit recently claimed that Boston Scientific devices were being used in unnecessary medical procedures... and that the company ignored employee concerns.

Of course, we're in no position to know the accuracy of these claims. But if the allegations pan out, it seems like Boston Scientific's problems might run deeper than who is in charge.

Management will do what it's paid to do...

It might seem counterintuitive that management would be OK with spending hundreds of millions of dollars each year on litigation. That's especially true when many of these lawsuits could likely be avoided through better quality control.

It's not that management wants costly lawsuits year in, year out. Rather, it has no reason to prevent these problems.

Regular readers know that one of our favorite mantras is "incentives dictate behavior." That means people will do what they're motivated to do based on promised rewards.

In terms of Boston Scientific, a look at management's compensation plan may explain why it hasn't done more to prevent quality-control lawsuits.

Executives' short-term compensation is awarded based on revenue growth and adjusted earnings per share ("EPS"). Long-term compensation is tied to incentives like stock performance versus peers and adjusted free cash flow ("FCF").

At first glance, these metrics are reasonable. Legal issues would hurt EPS and FCF, so management should have plenty of incentive to prevent them.

The answer lies in the fine print...

You see, this compensation is awarded based on adjusted metrics.

(That's not the same thing as our adjusted Uniform Accounting metrics. Companies can create their own adjusted metrics when paying management. The board of directors has a compensation committee that decides which metrics matter.)

Boston Scientific's compensation breakdown conveniently doesn't punish management for incurring legal costs. The adjusted metrics exclude any gains – and more importantly, any losses from litigation.

Management is encouraged to focus on chasing revenue growth and profits without worrying about legal costs. That could be a big reason why these lawsuits continue despite personnel changes at the top.

This isn't a unique case, either. Plenty of seemingly strong companies fall victim to misguided management compensation... and the results can be disastrous. On Friday, my colleague and Altimetry founder Joel Litman will dive deeper into what to look for. 

It's true that Boston Scientific stock is up more than 700% since that 2012 low. It seems like investors are more than happy to give the company the benefit of the doubt... for now.

But as long as management's compensation structure fails to take legal costs into consideration, we'd steer clear.

Remember that investors can only take so much pain. More lawsuits could prove dangerous for Boston Scientific in today's uncertain market.

Regards,

Rob Spivey
October 19, 2022