With relatively positive news about the orthopedics market from Biomet and Johnson & Johnson (JNJ), investors were primed to hear more of the same from Stryker (SYK). Unfortunately, Stryker disappointed with numbers that showed real share loss outside the U.S. and ongoing difficulties in the hospital capital equipment market. While Stryker remains a quality GARP name to consider in healthcare, management's credibility is increasingly on the line.
"In-Line" Doesn't Really Capture The Story In Q2 Earnings
True, Stryker did more or less deliver as expected on both the top and bottom lines, but how it got there is an important story to understand.
Reported overall revenue grew about 3%, with organic constant currency revenue growth of 2.8% (made up of 4.4% positive volume and negative 1.6% price). More striking was the fact that U.S. sales were up nearly 8%, while international sales rose barely at all in constant currency terms.
Stryker did save itself some grief with better operational performance. Gross margin improved about half a point from both last year and last quarter. Likewise, operating income growth of 11% was slightly better than expected.
Creaky Joints In Europe And Japan
Stryker's roughly 4% overall growth in orthopedics actually wasn't bad, and compares reasonably well with both Biomet and JNJ, but again the details matter. Hips were quite weak (up less than 1%), as a solid 6% performance in the U.S. was offset by a nearly 4% decline in OUS markets. Likewise in knees - up 2% overall, but up 5% in the U.S. and down 3% OUS. Strong results in trauma and fixation (up 9%) helped save the day and remains an under-appreciated strength of Stryker - while the Synthes deal makes JNJ #1 by a long way, Stryker is well ahead of #3 in this fast-growing market.
So what's the problem? Unfortunately, it looks like execution may be the culprit in the company's overseas woes. We still have yet to hear from Zimmer (ZMH) or Smith & Nephew (SNN), but if Stryker's OUS performance is as much of an outlier as it appears, the company is going to have to address this and do so quickly (which likely won't help operating margins). At the same time, the U.S. ortho market remains challenged by higher co-pays/deductibles for patients and hospitals flexing their new-found muscle with pushbacks on price, but it looks as though conditions are in fact improving.
MedSurg Mixed, Neuro And Spine Pretty Strong
In Stryker's MedSurg ops, overall revenue growth of just 3% was disappointing, as was the widespread weakness. Instrument sales were up 11%, but more was expected, and endoscopy (up 2%) and medical (down 11%) were very soft. While JNJ's weak surgery performance does somewhat explain the weaker instrument result, investors in Hill-Rom (HRC) can't be feeling too good about Stryker's weak numbers in hospital beds (though these companies do not move in lock-step).
Like how trauma saved the day in ortho, neuro and spine basically saved the day for the overall revenue performance. This unit saw sales grow 12%, with both spine (up 9%) and neuro (up 16%) surprisingly strong. Although management talked about some pricing issues remaining in fixation, it looks like the company is doing well versus JNJ and Covidien (COV) (in neuro), and this could bode well for Nuvasive (NUVA).
The Bottom Line
If Zimmer and/or Smith & Nephew come through with strong hip and knee numbers, management is going to have to address its issues in Europe and Japan directly. Likewise, with management reiterating pretty aggressive growth goals for both 2012 and 2013, their credibility is on the line. That feels especially relevant given that Stryker has enjoyed a little bit of multiple expansion here of late.
I understand if investors are more attracted to "growthier" names like MAKO (MAKO) or Nuvasive, but for all of its problems I do believe Stryker is still a solid name to own in the med-tech space. The company's acquisitive habits in tools, spine, and neuro seem to be paying off nicely, and I still maintain confidence that the overseas joint issues are fixable.
Even with some modest downward revisions, I believe that Stryker can couple mid-single-digit revenue growth with improving cash flow generation and produce mid-to-high single digit free cash flow growth over the next ten years. That, in turn, supports a fair value of close to $70 and makes this a solid (if somewhat risky) GARP idea in healthcare.