Stryker Strikes Again, But Quality Does Not Come Cheap

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About: Stryker Corporation (SYK), Includes: NVDQ
by: The Value Investor
Summary

Stryker continues to deliver on solid organic growth while announcing bolt-on deals.

The company has made roughly 25 deals at a cost of $10 billion since 2010, as investors like this growth strategy.

Continued solid topline sales growth and modest leverage warrants a premium to the market, which makes me a buyer if shares re-test market valuation multiples.

Stryker (SYK) has made another bolt-on acquisition, as this strategy of dealmaking has served the business and its shareholders well in the past decade. Unfortunately investors have recognized the dealmaking capabilities of the company and its management team as well, which combined with mid-single digit organic growth warrants a premium multiple compared to the overall market.

If shares hit market-equivalent multiples again, translating to an entry target of $110-$120 per share, you can count on me as an eager buyer in what is a quality long tem growth play, both organically and through M&A.

Adding Novadaq

Stryker has reached an agreement to acquire Novadaq Technologies (NASDAQ:NVDQ) in a deal which values the company at $654 million net of cash, valuing shares at $11.75 per share.

With the purchase, Stryker buys a leading developer of so-called fluorescence imaging technology, allowing visualization of blood in vessels as well as tissue perfusion in cardiac, cardiovascular and various other procedures.

Investors of Novadaq welcome the deal, which comes at a near 100% premium. While this premium looks impressive, shares have been under a lot of pressure in recent years.

The Canadian-based company has grown its sales rather aggressively over the past years, as revenues hit $80 million on a trailing basis. Topline sales growth of 25% and high gross margins look impressive, but so are the losses as Novadaq posted a fat loss of $60 million last year. This has put pressure on the cash holdings of the firm and caused severe dilution for equity holders as well.

The innovative technology has caught the attention of Stryker as it can reduce post-procedure complication rates and thereby costs of care as well. The company sees dilution to the tune of $0.03-$0.05 per share on an adjusted basis in 2017, although the deal is expected to be neutral to earnings next year.

The near 100% premium, equivalent to little over $300 million in actual dollar terms, did not really bother investors in Stryker in a big way. Shares were down half a percent in response to the deal which actually equates to the premium paid, but the modest price reaction in terms of percentage moves indicates that the market is not really reacting to the bolt-on deal.

Adding To A Diversified MedTech Leader

With the latest addition, Stryker continues to expand its leadership in the medical world. The company classifies its activities under three segments being the NeuroTech & Spine, Orthopaedics and Medsurg segment, in which it operates in various subsegments. These include knees, hips, trauma, instruments, endoscopy, spine and neurovascular solutions, among others.

Total sales reached $11.3 billion in 2016, which means that Novadaq will boost pro-forma sales by 0.7%, but more importantly add another growth driver to the business. This comes as Novadaq is growing its sales by roughly 25% pre annum, as leverage of Stryker´s sales force could even accelerate growth and result in real synergies. This is necessary as the company guides for a flat impact to 2018 earnings.

This deal fits right within the core strategy of the company which is dealmaking. Since 2010 the company has made roughly 25 deals which combined with organic growth has allowed sales to rise some 60% from $7.3 billion to nearly $12 billion on a trailing basis. These deals came at a combined cost of roughly $10 billion according to the cash flow statements over this period of time. The company has managed to grow and finance these deals, while it managed to repurchase 5% of is shares as well.

It is not that Stryker simply buys company for the sake of growth as the quality of the acquired businesses are fairly good. For 2017, Stryker sees organic growth of 6% plus or minus half a percent, with adjusted earnings seen at $6.40 per share, plus or minus five cents. GAAP earnings are seen nearly a dollar lower at around $5.57 per share with the vast majority of the discrepancy resulting from non-cash amortization charges. While I am not a big fan if blindly trusting adjusted earnings metrics, in this case the adjusted earnings number closely mimics the cash flow being generated.

With shares trading near the highs at $141, shares now trade at 22 times adjusted earnings. With first quarter adjusted EBITDA coming in at $777 million, full year adjusted EBITDA probably comes in around $3.3 billion. As Stryker has $3.3 billion in cash, financing this and other deals is no issue, as net debt stands at ¨just¨ $3.9 billion. That means that leverage stands at 1.2 times ahead of the deal, as the pro-forma leverage might increase to 1.4 times given the lack of acquired earnings in the latest dealmaking episode.

Quality Is Recognized By The Market

As Stryker has made many small but solid deals, its sales have doubled over the past decade, without causing any dilution to shareholders, in fact the company has net bought back shares.

This growth translates into a decent 7-8% revenue CAGR as the quality of the business is solid with organic growth coming in at the single digits, as bolt-on dealmaking supports these revenue numbers. With shares trading at 22 times earnings, Stryker trades at a roughly 20% premium to the market but this can be rationalized by the great track record, very solid growth and modest leverage ratio employed.

While medical device companies do not tend to be cyclical, Stryker is still somewhat exposed to the economic cycle. This can be seen in 2009, as actual sales were flattish during the recession while its shares fell from $70 in 2007 to the low thirties in 2009, before starting on the multi-year run to current highs in the $140s. Does that mean that shares are an obvious buy at these levels, probably not.

Yet Stryker remains an excellent business to hold onto and add, or initiate a position if it trades at market multiples. With current earnings power that translates into an entry/addition target of $110-$120 per share. While this sounds like a far reach from today's levels, realize that we have actually seen it at the end of 2016.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.