Seeking Alpha
Long/short equity, special situations, value
Profile| Send Message|
( followers)  

Shares of Stryker (NYSE:SYK) fell slightly after the company announced the acquisition of MAKO Surgical (NASDAQ:MAKO). As Stryker pays a 86% premium for the promising technology, investors are a little cautious given the significant premium being paid.

Yet I like the long term appeal of the deal as Stryker will acquire promising technologies in a growing market. Yet the true impact from the deal will take years to materialize.

Given the significant momentum in Stryker's shares so far this year and the "full" valuation at the moment, I remain on the sidelines.

The Deal

Stryker announced that it has entered into a definitive agreement to acquire MAKO Surgical. Under terms of the deal, Stryker will pay $30.00 per share in cash to holders of MAKO stock, valuing the company at $1.65 billion.

MAKO has been founded as recent as 2004, pioneering the advancement of robotic assisted surgery in orthopedics. The company is currently marketing the RIO Robotic Arm Interactive Orthopedic Systems and the RESTORIS implants which enable the Partial Knee Resurfacing procedure for early to mid-stage osteoarthritis.

CEO Kevin Lobo commented on the rationale behind the deal, "MAKO has established a compelling technology platform in robotic assisted surgery which we believe has considerable long term potential in joint reconstruction. The acquisition of MAKO combined with Stryker's strong history in joint reconstruction, capital equipment (operating room integration and surgical navigation) and surgical instruments will help further advance the growth of robotic assisted surgery."

For the calendar year of 2012, MAKO generated annual revenues of $102.7 million, on which the company reported a $32.5 million loss. The company ended its most recent quarter with some $60 million in cash and equivalents and operates without the assumption debt. As such, operating assets of the firm are valued around $1.59 billion, or 15.5 times last year's revenues.

The deal is subject to normal closing conditions. The deal is expected to be dilutive to Stryker's adjusted earnings per share by $0.10 - $0.12 per share in the first year following completion of the deal. Note that this excludes integration related charges. The deal should be neutral to accretive to earnings per share in the year's thereafter.

The deal is subject to normal closing conditions, including regulatory approval and approval by shareholders of MAKO.

Valuation

Stryker ended its second quarter with $4.65 billion in cash, equivalents and marketable securities. The company operates with $2.74 billion in total debt, for a net cash position of around $1.9 billion. As such, Stryker has sufficient liquidity to finance the deal with MAKO.

Revenues for the first six months of the year rose by 3.2% to $4.40 billion. Net earnings fell by 23.4% to $517 million in the meantime. Given the guidance of 4 to 5.5% revenue growth, annual revenues for the year are expected to come in around $9.1 billion. Full year adjusted earnings are seen around $1.6 billion.

Trading around $69 per share, the market values Stryker at $26 billion, or its operating assets around $24 billion. This values operating assets at 2.6 times annual revenues and 15 times adjusted earnings.

Stryker pays a quarterly dividend of $0.26 per share, for an annual dividend yield of 1.5%.

Some Historical Perspective

Long term holders in Stryker have seen modest returns. Shares rose from $40 in 2004 to highs of $75 in 2007. Shares fell to $30 in 2009 and have steadily risen to highs of $70 in recent weeks. Shares have already risen some 25% year to date.

Between the calendar year of 2009 and 2012, Stryker has grown its annual revenues by a cumulative 29% to $8.7 billion. Net earnings rose by 17% to $1.30 billion in the meantime. Note that earnings per share growth was a touch higher after the company retired roughly 5% of its shares outstanding over the time period.

Investment Thesis

Investors in Stryker are not too happy with the deal. Its shares fell some $1.50 halfway during the trading session, reducing the value of the company by almost $600 million.

Note that MAKO's shares which are trading with gains of 83%, have boosted the valuation of the company by some $625 million, making this pretty clear than the market judges this deal as a wealth transfer to MAKO's shareholders.

While the absolute amounts involved are large, the "premium" amounts to roughly 2% of Stryker's own market capitalization. In a response to the deal, shares of much larger competitor Intuitive Surgical (NASDAQ:ISRG), known from the da Vinci surgical robot, jumped up 1%. The medical conglomerate is valued around $14.6 billion, or 6.1 times last year's annual revenues when backing out the net cash position of the firm.

As such, I do not think that investors should not be too concerned about the valuation and the "premium" which has been paid by Stryker. Note that Stryker stands to benefit from significant revenue and cost synergies, yet this will take a long time to materialize.

Stryker can much better position the RIO robot through its much more elaborate distribution and marketing system. The technologies are furthermore complementary to its own offerings, while its larger sales force can push sales to drive up the low adoption levels.

So don't see this as a money wasted investment. Stryker is acquiring a technology which can be leveraged through its own much larger distribution network, expanding the target to a much broader range of surgical procedures.

For MAKO's shareholders this deal results in immediate value realization after shareholders receive a 86% premium, marking year to date returns of 130%. In fact, as recent as April of this year shares were trading as low as $10 per share. Despite the significant premium, shares are still down some 30% from highs in the spring of 2012, when shares peaked in their mid-forties.

While robotic arms have been under scrutiny given their much higher costs and debate about their usefulness versus manual surgery, the industry's long term future looks bright. It is inevitable that technology will play an increasingly more important role in the future, while the Affordable Care Act and an economic recovery should boost demand for discretionary procedures.

While I like the addition a lot, the immediate and medium term impact, are hardly making a dent in Stryker's operations given its size. After witnessing year to date returns of 26%, the valuation at roughly 20 times normalized earnings has gone a bit too far, to my opinion. This is especially true in combination with the modest 1.5% dividend yield.

Despite the nice addition, I remain in the sidelines given the overall valuation of Striker after a reasonably strong momentum this year. For MAKO's shareholders this provides a nice opportunity to monetize your investment with exception of those unlucky ones buying in the spring of 2012.

Source: Stryker - Strikes A Nice Strategic Deal By Acquiring MAKO Surgical