The following analysis is a valuation of Stryker Corp (SYK), a healthcare equipment company according to S&P's Global Industry Classification Standard using an economic profit model, a primer on which can be found here. To begin, the company’s operating segments are detailed while also analyzing recent operating performance. Next, the company’s adjusted financial accounts and market capitalization are presented, leading to a reference valuation scenario. A number of alternate scenarios are considered given variations in assumptions about growth, profitability and liabilities. After integrating a forward looking view of the company’s position, an investment conclusion is formed.
The following table shows the three business segments Stryker operates in as well as their sizes and cumulative growth including acquisitions since 2009:
The reconstructive business segment is Stryker’s largest and also the slowest growing portion of the business. However, what growth there is has come organically and the company remains a market leader in the segment. The MedSurg segment is nearly the same size as reconstructive and has grown more strongly although some of that has come from acquisitions. From 1H10 to 1H11, growth net of acquisitions has been about 10%. Recently acquired (but already over a year old) high-growth businesses are driving a portion of that growth. The neurotechnology and spine segment, the company’s smallest, has been growing the fastest but the vast majority of that growth is due to acquisitions. From 1H10 to 1H11, the segment has grown at 7% in constant currency terms net of acquisitions.
The following figure show the contribution to segment revenue from various product groupings:
Hip and knee placement products comprise about 74% of the reconstructive segment’s $3.6 billion of trailing twelve month (TTM) revenue while trauma-oriented products represent about 26%. Trauma products are primarily related to fixation, either external or internal and include rods, screws and external frames. Stryker has experienced a slight decline in the knee business due to its products falling behind competitors, although the company is expected to rectify this situation with the release of a new knee product known as OstiMed in the later part of 2011.
Stryker reports three product categories within the MedSurg segment: surgical equipment and surgical navigation systems, endoscopic and communication systems and patient handling and emergency medical equipment. Total revenue was $3 billion on a TTM basis with patient handling being the smallest, but also growing the fastest due to hospital bed and related products sales. Management has been hesitant to call the trend of growth in this portion of the business stable after heavy questioning by analysts and there is some fear that growth may slow back to historical levels in the coming quarters.
Within the neurotechnology and spine segments there are two product groupings sharing the same names which comprise 47% and 53% of $1.2 billion total segment revenue, respectively. The spine business is growing at 4% in constant currency terms driven largely by interventional (minimally invasive) spine product sales. Over half the neurotechnology business was acquired from Boston Scientific (BXP) in January 2011, which is a major driver of the growth in the overall segment.
Stryker’s overall growth is typically not influenced by individual products to a great degree as evidenced by the comment by Katherine Owens' (VP of Strategy and Investor Relations for Stryker) comment on the second quarter conference call that the company’s portfolio of products is primarily “singles and doubles,” to use an analogy from baseball. While this lowers the risk from having a single product run into trouble, it does make it more difficult see into the company’s future and it makes it more unlikely that a single product will come along to really ignite growth. With this in mind it does not appear that Stryker has much in the way of noteworthy new products in the pipeline with the possible exception of OstiMed mentioned above or at least those product opportunities are not being highlighted by management.
The table below shows the current financial structure of the company, with the equity trading at $47.88:
Stryker is majority capitalized by equity and carries no net debt (gross debt minus cash). The company does have large amounts of deferred tax liabilities which are offset by various deferred tax assets. Those deferred tax assets associated with inventory ($540 million) have not been offset against deferred tax liabilities in the model and rather have been considered a permanent investment as part of invested capital. This deferred tax asset essentially represents the difference between actual taxes paid and those reported on the financial statements.
Other liabilities consist of tax items under dispute with various tax authorities and other unspecified liabilities of about $430 million of which half have been included in financial structure.
Adjusted Financial Accounts
The following table shows gross income assumptions for the base valuation scenario:
The base period for the valuation is the twelve months starting 1Q11 through 4Q11. Net income of $1,370 million excluding investment income conforms to actual adjusted results for 1Q11 and 2Q11 and First Call estimates for 3Q11 and 4Q11 ($0.89 and $1.02, respectively) with small adjustments made to account for diluted versus basic shares and stock buybacks.
In addition, net income has been reduced by $56 million reflecting the 2013 implementation of a 2.3% medical device excise tax on U.S. sales as part of H.R. 4872 [111th]: Health Care and Education Reconciliation Act of 2010. It is contemplated in the model that the company will able to recover one-third of the increased excise tax through pricing and that the tax is deductible for income tax purposes.
As the table below shows, the company’s largest portion of invested capital is in fixed assets, research and development, intangibles and other assets:
The capitalization period for research and development, marketing and advertising are six, three and eight years respectively. The growth rate of research and development over the last six years has been 6.1%. To reflect increased capital intensity in research and development due to more regulation and other factors, a small asset life adjustment has been made to better reflect replacement costs.
Advertising spend has been estimated based Schonfeld & Associates data for 2010 reporting that medical device companies spent 0.6% of sales on advertising. Marketing spend is estimated arbitrarily at 5% of selling, general and administrative expense.
An important asset for Stryker is instrumentation, which is loaner equipment exchanged for customer equipment under repair or possibly for trials. This asset category has grown very quickly at about 12% per year over the past 5 years.
The largest asset on Stryker’s balance sheet is intangibles comprised primarily of developed technology, customer relationships and patents. Because these assets were originally developed using research and development and marketing dollars and are supported by these expenses currently, an adjustment has been made in order to internally recapitalize these assets using such expenses. The net impact of this is to reduce the amount of such expenses capitalized under their respective headings and increase the net asset value of intangibles. If this adjustment were not carried out, it is likely that the calculated invested capital would be biased too high.
Other assets are primarily net working capital, including inventories and accounts receivable which are major items for Stryker with very little accounts payable to balance these two out. Other current assets (including certain deferred tax assets) and liabilities are a net liability of about $290 million.
Valuation and Scenario Analysis
The following table details the internal rate of return (IRR) calculation used to determine the company’s returns on capital:
The company’s IRR is 20.9% with a reinvestment rate of 12.8% which assumes about 47% of the company’s gross cash flow can be reinvested at the IRR. The balance is assumed to be invested at the cost of capital, leading to a modified IRR (MIRR) of 16.8%.
Given a real (inflation-adjusted) cost of capital of 5.6%, the company currently earns three times the cost of capital. Sustaining this level of returns is only possible through continuous innovation, although barriers to entry in this industry should provide some protection from returns falling too far. At the same time, competition and a concentrated pool of buyers for the company’s products are risks to sustaining this level of returns.
On a one-year forward basis, the company’s returns on capital are projected to remain about the same based on invested capital and gross income projections.
The following table summarizes Stryker’s valuation:
The valuation is broken into two parts, “existing business” which is the value of the existing amount of gross income given constant invested capital and the value of growth, both in invested capital and gross income.
The value of the existing business is $51.40 per share. Turning to growth, at a 2% rate of gross income and asset growth, the value of that growth if maintained for 5 years is $4.20 per share. In reality the 2% figure will serve as an average over that period due to the inherent volatility in growth and the likelihood of growth trailing off as time passes. For reference, the company is expected to grow invested capital as defined in the model at a 4.5% rate over the next year.
At the bottom of the table, sensitivities around the growth rate and longevity are given. These sensitivities are accurate around the baseline but at multiples of 3-4x, for example adding 3-4% growth, they start to lag the real impact due to compounding.
Adding the existing and growth values together, we get an equity valuation of $55.60. The market is pricing the stock at about $47.88 which implies a valuation gap of $7.72. However, the 200 day moving average for Stryker’s stock is $55.60 which happens to be spot on the valuation. At the 47.88 level, the market is implying a fall in returns on capital of 1.2 percentage points and no future growth. To manifest this change in returns on capital through net income, a 15% decline would be necessary.
The table below outlines the impact of two alternative valuation scenarios which are not part of the valuation:
Two alternative scenarios are contemplated, a repeal of the medical device excise tax and the addition of a product liability contingency. The repeal of the device tax would entail a significant rework of healthcare reform and would likely require significant political change in next year’s election. The impact would be on the order of $1.70 a share.
The second scenario involves a product liability contingency although to be clear there are no specific legal issues at Stryker currently which drive this scenario. However, the medical device industry is highly litigious – anything from patent issues to faulty products can create large legal liabilities. If there is a 20% chance of seeing a $1.5 billion legal issue at the company over a period of years, that would imply a $300 million liability on an expected value basis which translates into 80 cents per share.
One valuation factor not addressed quantitatively is the company’s outstanding dispute with the IRS regarding its cost sharing arrangements. Such arrangements are used to effectively transfer a greater portion of profitability to low tax areas. As Stryker states in its second quarter 10-Q “Ultimate resolution … could have a material impact on the Company’s income tax expense, results of operations and cash flows in future periods.” A percentage point move in tax rate will impact earnings by a little over $15 million translating into 50 cents a share of value. At this point it is impossible to tell what impact if any the ongoing dispute will have, but for now it does temper the valuation somewhat.
Only a small portion of the company’s valuation is driven by growth but the nature of the industry demands continual product innovation because returns will decline on existing products over time. In this area, I believe Stryker falls behind some of its peers from a qualitative standpoint if not in reality then at least in its ability to communicate its growth prospects. As an investor, it is hard to give much credit for growth when management cannot lay out its prospects.
Coupled with very slow revenue growth in certain core businesses such as reconstructive and the cyclical nature of other businesses such as hospital beds I find it hard to get comfortable with the company’s product pipeline. Most of this viewpoint is embedded in the very low growth rate of 2% embedded in the valuation, but I would like to see a stronger pipeline nonetheless to get comfortable with existing business valuation. Along the same lines, another factor to consider is that reconstructive products have some sensitivity to the economy due to the semi-elective nature of many of these procedures.
Given these factors and wanting to build in some conservatism to account for seemingly recurring, albeit small “one-time” costs in the company’s recent history, I would be comfortable holding the stock at a little under $50 per share. At the same time, there are other med-tech companies that appear relatively cheaper according to my valuation methodology and which in my opinion have more defensible product lines vis-à-vis Stryker’s reconstructive segment in the long-term not to mention, better growth stories. Investors more comfortable with the growth story at Stryker could easily attribute at least $5 of additional value to the company. The good news is that the company does not need to grow to justify the current valuation.