Over the past year or so, investors have come back to the med-tech space and pushed valuations back up to levels closer to historical norms. Although that means a lot of easy money is gone, many of these companies still hold worthwhile potential as long-term holdings. Among them, Stryker (SYK) may still be among the most interesting. Not only does this well-regarded med-tech stock have an improving ortho market to exploit, but the company is something of a free agent in terms of using M&A to further expand its long-term revenue possibilities.
Q4 Even Better Than Expected
While Stryker had previously given investors an early look at results, the final results were incrementally encouraging.
Revenue rose more than 5% this quarter, with organic growth of nearly 6%. Like Biomet and Johnson & Johnson (JNJ), Stryker benefited from a recovery in the recon space, as revenue rose more than 6% on solid hip and knee results and double-digit growth in trauma/extremities. MedSurg's performance was much less robust (up a bit more than 2%), while neuro/spine rose by about 10%.
I was pleased to see what Stryker accomplished on expenses. Gross margin improved by a point from last year, due in part to mix but also to cost reduction efforts. Operating income rose 11%, and Stryker tacked on another 20bp to the gross margin improvement to drive 120bp of improvement in operating margin - the best margin, I believe, in about two years.
Ortho May Be Back, But Stryker Has Work To Do
One of the big takeaways from this quarter is likely to be the recovery in the orthopedic space. Major companies like Biomet, Stryker, and Johnson & Johnson have been reported solid numbers, while smaller companies like Exactech (EXAC) and NuVasive (NUVA) have also been upgrading their guidance.
Stryker saw better than 5% growth in core hips and knees, which largely keeps it on track with what we've seen so far this quarter. It's worth noting, though, that Stryker continues to lag in Europe and fixing this is a major "must do" for 2013. It's also worth noting that while Smith & Nephew (SNN) and Zimmer (ZMH) are likely to be the laggards in recon this quarter, Zimmer has new product launches on the way and Stryker needs to be ready.
I was also impressed with the trauma/extremity results. While about a third of the trauma improvement came from a recall at Johnson & Johnson (a nail product from Synthes), the company posted very strong foot/ankle product sales in the U.S. - I'll be curious to see whether this is prelude to a good number from Wright Medical (WMGI), or whether Stryker is grabbing share.
Neuro/Spine Seems Back In Good Health
Along with the ortho market, investors have been waiting to get bullish on the spine care market again. I'm not sure investors can rest easy yet, but it looks like the market is getting stronger. While Medtronic's (MDT) November numbers were weak, and neither JNJ nor Biomet were particularly strong for the fourth quarter, the guidance from NuVasive and Stryker's fourth quarter numbers are encouraging. The big question will be whether this performance (up 7% against a down market overall) is sustainable or just a jump against easier comps.
MedSurg Has Good And Bad News
Between the reports of companies as varied as General Electric (GE), Varian (VAR), MAKO Surgical (MAKO), and Stryker, the best that can be said about the hospital capital equipment environment is that conditions are still difficult and unpredictable. While Hill-Rom (HRC) delivered 12% revenue growth this quarter and Intuitive Surgical seemed to have little trouble placing systems, Stryker saw its hospital equipment business (beds and the like) down more than 7% this quarter.
On a somewhat brighter now, better than 3% growth in instruments and 6% growth in endoscopy suggests good performance relative to JNJ and sets a bar for Covidien's (COV) upcoming release. As a reminder, Stryker has been active in developing and releasing new single-site tools as a way of growing its surgery business and offering alternatives to Intuitive Surgical's more expensive instruments.
A Growth Recovery, Better Efficiency, And More M&A
I've generally been consistently bullish on Stryker, and I'm not changing that view now. If the improvements in the U.S. ortho market are real/sustainable, that will make 2013 numbers easier to hit and will likely give management the room to really hone in on the European recon business and get that segment performing better. I also believe management could have at least another point (maybe two) to add to operating margin from its various efficiency initiatives - and that's including the impact of the medical excise tax this year.
Stryker's M&A plans are the bigger unknown at this point. The company just paid over $760 million for Trauson - a solid Chinese ortho company that not only expands the company's exposure to China, but also gives it a portfolio of value-priced orthopedic implants and tools that I believe could be invaluable in building a bigger/better emerging markets business (Stryker is relatively under-exposed to emerging markets).
I suppose a Trauson-like deal in areas like medical instruments or equipments could make sense. But I wouldn't lose sight of the fact that Stryker is a bit of a wildcard right now in med-tech. A lot of investors seem to forget that less than half of the company's business is ortho, and many were surprised when it bought Boston Scientific's (BSX) neurovascular business. To me, that means that Stryker could be looking at a variety of treatment categories, including peripheral vascular or cardiology, as well as incremental deals in the orthopedics space (including spine and extremities).
The Bottom Line
I believe Stryker will grow at the same basic rate that I see for most high-quality large interventional companies today - around 4% or so for the long term. I also see Stryker succeeding in its efforts to improve its operating efficiency, and I believe that the company could approach 20% free cash flow margins within five years. With that, I see free cash flow growth potential of close to 7% for the long term.
With that sort of growth (and excluding future M&A or large buybacks), I see fair value in the low-to-mid $70s today. That's not great potential I'll grant, but it's in line with the likes of JNJ, St. Jude Medical (STJ) and Covidien. I'd still be a willing buyer of Stryker today as there are worse things in life than buying a good company at a double-digit discount to fair value, but I would also look at names like Medtronic and NuVasive as part of a wider due diligence effort.