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Orthopedic devices major Stryker Corporation (NYSE:SYK) posted second-quarter fiscal 2011 adjusted earnings per share of 90 cents, meeting the Zacks Consensus Estimate while transcending the year-ago earnings of 80 cents.

Adjusted net income jumped 10.4% year over year to $352 million. The adjusted earnings exclude $43 million in charges associated with the company’s recent buyout of its rival Orthovita and the $1.5 billion acquisition of Boston Scientific's (NYSE:BSX) Neurovascular business.

However, profit (as reported) skid 3.1% to $309 million (or 79 cents a share) on account of the sizable acquisition-related charges. Stryker is on an acquisition binge to spur growth as it faces sustained pricing and procedure volume pressure in its core replacement hips and knees businesses. However, costs associated with such transactions have weighed on its bottom line.

The Kalamazoo, Michigan-based company’s shares fell $1.16 (or 1.96%) to $58 in after-hours trading on July 19, dampened by lower profit. Stryker, however, re-affirmed its fiscal 2011 revenues and adjusted earnings outlook.

Revenue Analysis

Revenues leapt 16.3% year over year to $2,045.5 million, above the Zacks Consensus Estimate of $2,007 million. Sustained double-digit growth at the company’s surgical equipment unit (“MedSurg”) once again catalyzed top line growth, offsetting the lingering challenges in the orthopedic business.

Volume and mix, acquisitions, and favorable foreign currency exchange translation contributed 7.2%, 6.2% and 4.4%, respectively, to the growth, partly neutralized by unfavorable pricing impact. Domestic and international revenues surged 10.7% and 27.3%, respectively, in the quarter.

Results by Segment

Revenues from the company’s Reconstructive unit, offering replacement hip, knees and extremities products, climbed 7.4% year over year to $916 million. However, barring the impact of foreign exchange swings, reconstructive sales grew a mere 1.8% in the quarter. Growth in the hips, trauma and extremities segment was, in part, marred by a somewhat weak knee business.

Domestic and international hip sales rose 11% and 18%, respectively, thanks to the favorable traction of new hip systems, ADM Restoration and MDM X3. Trauma and extremities business had a healthy quarter with sales climbing 11% and 17% in the U.S. and international markets, respectively.

However, Stryker’s knee business remains challenged given a soft market. Domestic knee sales grew 4% (down 1% in constant currency) in the quarter. The recently approved OtisMed pre-op surgical cutting guides are expected to rekindle growth in this business in the second half.

Implant pricing and elective procedure volume still remains headwinds for Stryker. The company stated that its selling prices fell 1.5% globally in the quarter. Moreover, continued patient deferral of elective procedures, impacted by a host of macro issues including high unemployment rate and expiry of health insurance, led to weak demand for hip and knee implants.

Revenues from Stryker’s MedSurg unit spiked 15% (up 11.9% in constant currency) year over year to $773 million, buoyed by strong sales of the company’s bed and stretcher offerings. Acquisitions contributed 1.9% to the growth. The division is benefiting from a recovery in capital spending by hospitals as they replace their worn-out equipment.

Neurotechnology and Spine products sales catapulted 52.6% (up 49% on constant currency basis) year over year to $356 million, boosted by higher shipments of neurotechnology products and the acquisition of the Neurovascular asset. However, the spine implant business continues to be impinged by pricing and volume pressure.

Margin Trends

Gross margin contracted to 65.2% from 69.3% a year-ago. Operating margins declined to 19.6% from 25.5% in the year-ago quarter. Margins were hit by the hefty acquisition-related charges (including inventory step-up and acquisition integration costs). Research, development and engineering expenses as a percentage of sales rose to 5.6% from 5.4% a year ago. Selling, general and administrative expenses (as a percentage of sales) increased to 38.4% from 37.6%.

Financial Condition

Stryker ended the second quarter with cash and cash equivalents and marketable securities of $2,675 million, a year over year decline of roughly 34%, on account of cash spent on the Neurovascular unit and Orthovita acquisitions. Long-term debt remained essentially flat year over year at $996.7 million.

Stryker generated $156 million of cash from operations during the quarter, down 52% year over year, with free cash flows of $106 million. The company did not repurchase any shares in the quarter.

Outlook and Recommendation

Stryker has maintained its forecasted revenue growth of 11%-13% (in constant currency) for fiscal 2011. Excluding foreign exchange translation impact and acquisitions, sales are expected to grow in the band of 5%-7%.

Growth is expected to be fueled by higher shipments of Reconstructive, MedSurg, and Neurotechnology and Spine products coupled with acquisitions. The company envisions foreign currency (assuming current exchange rates) to favorably impact sales by roughly 2.5%-3.5% in third-quarter 2011 and 2%-3% in fiscal 2011.

Adjusted earnings target for fiscal 2011 remains in the range of $3.65 to $3.73 per share, a 10%-12% year over year growth. The company now expects charges associated with acquisitions to trim its 2011 earnings per share by roughly 33-35 cents versus its earlier forecast of 28-30 cents. The current Zacks Consensus Estimate for fiscal 2011 is $3.71.

We believe that Stryker remains well placed for growth driven by new products, acquisitions and a stable-to-improving hospital capital spending environment. However, it contends in a soft and highly competitive orthopedic industry and faces tough challenges from its peers such as Zimmer Holdings (NYSE:ZMH), Johnson & Johnson's (NYSE:JNJ), DePuy, Smith & Nephew (NYSE:SNN), CONMED Corp (NASDAQ:CNMD) and privately-held Biomet.

Moreover, the company still remains exposed to pricing/volume pressure on its hip, knee and spine products. We are currently Neutral on Stryker, which is in line with a short-term Zacks #3 Rank (Hold).

Source: Weak Knees Hurt Stryker's Financial Footing