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%).
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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.
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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.
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