It's hard to call the current state of the med-tech world healthy, but some companies are definitely starting to do better. Prominent among them is Stryker (NYSE:SYK), which seems to be past its problems in joint reconstruction and back to building for the future. While I have hopes for the company's ongoing cost reduction initiatives and its plans for further M&A, I wouldn't ignore the challenges facing the U.S. orthopedics market. On balance, absent a new major growth driver, I think Stryker is more or less fairly valued today, albeit still a high-quality option in the healthcare space.
Growth Appears To Be Back
One of the more striking parts of the quarter was that the company seems to be outgrowing its markets again. As that's often a key factor in how institutions value these stocks, that's a definite positive.
Revenue rose 5% as reported, or a bit more than 4% on an organic “same day” basis. Orthopedics revenue rose nearly 8%, as hip and knee revenue were both up mid single-digits (better than Johnson & Johnson (NYSE:JNJ) or Biomet) and trauma/extremities grew another 17%.
The MedSurg equipment business was more sedate at 5% growth, but endoscopy and medical were both up better than the market (up about 5% and 9%, respectively), and the 1% growth in instruments was in part a byproduct of a significant product recall (Neptune). Last and not least is the neuro/spine business, which grew more than 7% this quarter, as Stryker continues to take share in embolization coils from Covidien (NYSE:COV) (neuro revenue was up almost 10%).

SEE: Intuitive Surgical Burning Up On Re-Entry
Margin performance was pretty good too. Gross margin did decline about a half-point from the year-ago period, but was more or less as expected. Operating income rose less than 2%, though, and was slightly below expectation as Stryker bumped up its spending on R&D.
Leverage Isn't Nice To Have, It's Essential
One of the more significant ongoing projects for Stryker is a comprehensive series of steps designed to reduce costs and improve both gross and operating margins. This isn't just a “nice to have” way of boosting operating leverage, though. I believe it's going to be essential for the company.
While Stryker's ortho business looked good this quarter, this market is getting more and more difficult. Hospitals are continuing to push for deeper price cuts in hip and knee implants, as well as pushing more bundled pricing and unwinding physician preference programs. Stryker reported pricing pressure of more than 3% in major joints this quarter, and I expect that it will get worse.
Volume growth could also be emerging as a threat again, just as the sector seemed to be getting back on its feet. Hip and knee procedures were added to pilot readmission reduction program for next year, meaning that hospitals who have unacceptably high readmission rates for certain procedures (four, including hip/knee replacement) will see a 3% reduction across the board in reimbursement. With that, hospitals may be disinclined to go forward with procedures for high-risk patients and that could reduce volume.
SEE: A Look At Corporate Profit Margins

Managing The Present And Building For The Future
Stryker hasn't exactly been quiet about its intentions to seek further growth through M&A, and it sounds like the company is getting closer to pulling the trigger. I will be very interested to see where Stryker goes with this.
On one hand, I'd like to see the company pick up a new growth-oriented business segment like it did when it acquired Boston Scientific's (NYSE:BSX) neuro business. On the other hand, Stryker has made overseas (particularly emerging market) growth a priority, so I wouldn't be surprised to see a deal for a foreign company with attractive low-cost devices, good manufacturing, and extensive distribution capabilities. Then again, Stryker being Stryker, they'll probably surprise me with a synergistic tuck-in deal for something like orthobiologics or surgical tools.
In the meantime, I do see a fairly balanced risk-reward profile for Stryker's capex businesses. Hospitals are still generally hesitant about making large purchases, but the ongoing move towards minimally invasive surgery ought to help the company's MedSurg business overall.
The Bottom Line
Up about 34% over the past year, Stryker isn't much of a bargain today even with its improving performance in orthopedics. I'm continuing to look for revenue growth of 4% and free cash flow growth of nearly 7% for the long term, growth rates that lead to a fair value of $72 today. There are definitely worse decisions than buying Stryker at or near fair value, so I still like the stock even if I no longer expect outsized gains in the short term.

Related Articles
  1. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  2. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  3. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  4. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
  5. Investing News

    Chipotle Served with Criminal Probe

    Chipotle's beat muted expectations and got a clear bill from the CDC, but it now appears that an investigation into its E.coli breakout has expanded.
  6. Stock Analysis

    Analyzing Sprint Corp's Return on Equity (ROE) (S)

    Learn about Sprint's return on equity. Find out why its ROE is negative and how asset turnover and financial leverage impact ROE relative to Sprint's peers.
  7. Stock Analysis

    Why Alphabet is the Best of the 'FANGs' for 2016

    Alphabet just impressed the street, but is it the best FANG stock?
  8. Investing News

    A 2016 Outlook: What January 2009 Can Teach Us

    January 2009 and January 2016 were similar from an investment standpoint, but from a forward-looking perspective, they were very different.
  9. Mutual Funds & ETFs

    3 Vanguard Equity Fund Underperformers

    Discover three funds from Vanguard Group that consistently underperform their indexes. Learn how consistent most Vanguard low-fee funds are at matching their indexes.
  10. Investing News

    Alphabet Earnings Beat Expectations (GOOGL, AAPL)

    Alphabet's earnings crush analysts' expectations; now bigger than Apple?
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
Trading Center