Stryker Is One Stock Worth Overpaying For

Summary

• Stryker has raised its dividend for the past 25 years.
• Second-quarter earnings showed robust organic growth, something the company knows a lot about.
• Hip and knee replacement surgeries are expected to increase drastically over the next decade and a half.
• Stryker, with its Mako robot, is in a prime position to capitalize on this.

After making 16 purchases in the first half of 2018 in the March to Freedom Fund, my wife and I managed just one purchase in July. We added Stryker (NYSE:SYK) to our portfolio at the end of July. We’ve spent the last year or so attempting to build up positions instead of adding new ones. Stryker is just the second new position we’ve opened this year.

Why add Stryker now?

I’ve long wanted to own this medical device maker because it is an earnings growth machine. Stryker suffered just a $0.01 decline in earnings from 2008 to 2009, a time when most companies were suffering double-digit drops in EPS. From 2008 through 2017, Stryker had a compound annual growth rate of 14%.

Recent quarterly results showed that the company continues to grow. The company announced 2^nd quarter earnings on July 24^th. Earnings per share were $1.76 in the quarter, $0.03 above estimates and 15% higher year over year. Stryker grew sales 10% to $3.32 billion, which came in $10 million ahead of expectations.

Organic growth company-wide was almost 8% during Q2, led by a 12% organic growth figure for Neurotechnology and Spine. MedSurg saw strong demand for its power tools, helping the division improve 7% organically.

While each division of Stryker had solid organic growth, it was Orthopedics that stood out to me. This division posted 7% organic growth, with hip and knee procedures growing 4.3% and 8.5%, respectively. Competitor Johnson & Johnson (JNJ) had growth of just 1.2% in hip procedures and saw a 2.2% drop in knee procedures. This has occurred several times in the last couple of quarters.

Hip and knee procedures are growing industry wide, with 7 million Americans already having received at least one of these operations. Hip replacement surgeries are expected to grow 174% through 2030, with knee replacement increasing 673% during this time. The cost of just these two procedures is expected to reach $35 billion. Stryker is seeing robust increases in the number of hip and knee operations it is performing at a time when its major competitor is seeing sluggish growth or declines. This means Stryker is taking market share.

What is allowing Stryker to take market share? The company’s Mako robot continues to grow in popularity amongst surgeons and hospitals. There are now more than 550 robots installed around the world. The company installed 39 in the 2^nd quarter, up from 26 last year. Many of these robots were installed in hospitals where Stryker had below-average market share or no presence at all. A little more than 10% of hospitals that Stryker sells products to currently have a Mako robot installed. There will be clinical data released next April that will help determine if robotic procedures can improve patient outcomes compared to human operations. If this data comes back positive for Mako, then Stryker could see the percentage of penetration increase even higher.

Stryker is accustomed to having the best technology in its industry.

Source: Slide Show Presentation from the 36^th Annual J.P. Morgan Healthcare Conference

Over the past few years, Stryker’s medical devices have seriously outpaced the rest of the industry in terms of organic growth. A portion of this organic growth comes from businesses that Stryker purchases. Stryker has made more than 20 acquisitions since 2013. Some acquisitions add to the company’s already existing competencies, while others help Stryker enter new markets. For example, Stryker added Entellus Medical at the end of 2017. This company specializes in products for use by doctors who specialize in the areas of Ears, Nose and Throat. With this one purchase, Stryker now has access to a whole new set of doctors and patients. This is how a company outperforms its competitors.

Dividend History

In addition to being an impressive earnings machine, Stryker has an equally remarkable dividend growth history. Stryker is a Dividend Champion (thank you David Fish, may you rest in peace), having increased its dividend for the past 25 years.

Source: YCharts

The dividend increase has averaged better than 10% for the better part of a decade:

3-year average increase: 11.7%; 5-year average increase: 14.9%; 10-year average increase: 22.7%

The last increase was announced on December 27^th and resulted in a 10.6% rise in the company’s dividend. Even after double-digit increases for more than a decade, Stryker’s payout ratio is rather low.

Source: YChart

While the ratio did spike at the end of 2017, Stryker has posted robust organic sales growth in recent quarters. That should lead to the earnings increases needed to fuel dividend growth.

The current yield of 1.1% might not excite some investors, but the dividend growth, when coupled with earnings growth, is very enticing.

My Valuation for Stryker

I’ve wanted Stryker for some time now, as I feel that it is the best company in the medical device industry. The company’s history of organic growth is well above the industry average. The market knows this and that is why Stryker has traded at a premium multiple (above a P/E of 25 for the past 5 years) in recent times.

If you’re not familiar with how I value stocks, I take the current price and compare it to fair values and price targets from a number of different sources. This helps me determine a fair value for a stock. For a Dividend Champion like Stryker, I am willing to pay 5% above fair value as I see this slight overpayment as the cost of doing business with an excellent company.

We added Stryker to our portfolio at $169.11 on July 25^th. F.A.S.T. Graphs said that the current price to earnings multiple was 24.6. Compared to the 5-year average P/E of 19.6, Stryker was 20.3% overvalued when we purchased our shares. Morningstar assigned a fair value of $142, meaning the stock was trading at a 16% premium to its fair value. CFRA had a one-year price target of $188, 8% upside from our purchase price. Normally, I use its fair value assessment as well, but it didn’t offer one at the time of purchase. Value Engine had a one-year price target of $182.61, offering us 8% of upside potential. Its fair value was $141.47, 16% below our purchase price. Averaged out, my system for valuing stocks showed that we overpaid for Stryker by 6.7%. This is actually the lowest overvaluation I’ve had for Stryker in at least a year.

Normally I would choose to wait for a better valuation for Stryker, but I want to assemble a portfolio of companies which are the best of breed and show a commitment to paying and increasing their dividends. Stryker’s strength in the medical device industry, a robust earnings growth history and potential growth in hip and knee replacements surgeries combined with a stellar dividend history make the stock a compelling buy to me. For these reasons, I was willing to pay more than I would normally for Stryker.

What are your thoughts on this purchase? Is there a medical device company you prefer? Feel free to leave a comment.

Analyst’s Disclosure: I am/we are long SYK, JNJ. 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.