Why I Don't Invest In Stryker, Even Though It Could Cost Me Returns

Summary

• Those who had hoped for a setback in the Stryker share price in recent months were disappointed. The share knows only one direction and that is upwards.
• The management has an incredibly good track record and a great instinct for acquisitions, so I won't rule out that Stryker's past performance will also be possible in the future.
• Nevertheless, there are some caveats.

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Those who had hoped for a setback in the Stryker (NYSE:SYK) share price in recent months were disappointed. The share knows only one direction, and that is upwards. Yet, the company is not one of the pandemic profiteers. Revenue declined last year for the first time in 40 years as it fell from $14.88 billion in 2019 to $14.35 billion.

But despite this rather lousy year, this development didn't harm the share price development. Since Stryker's low during the pandemic in March 2020, the share price has almost doubled. This gives long-term investors in Sktryker a decent return. Over the last 20 years, the share price has risen by nearly 1,000 percent, corresponding to a return of over 10 percent per year.

I do not rule out that this performance will also be possible in the future. The management has an excellent track record and a great instinct for acquisitions. Nevertheless, there are some caveats.

A good fundamental basis for future growth

Stryker operates through three business units. 35 percent of Stryker's revenue comes from the "Orthopaedics" segment. It includes implants for the replacement of the knee and hip joints and devices and technologies for operations.

The largest segment, which contributes 44 percent of revenue, is "MedSurg". It also includes sub-segments such as surgical equipment and navigation systems, endoscopy and communication systems, emergency medical equipment and disposables, and remanufactured medical devices.

The third segment is "Neurotechnology and Spine". Here Stryker offers neurosurgical and neurovascular products as well as spinal implants. This product portfolio has grown enormously through acquisitions. Nevertheless, Stryker has been very successful with this strategy. Despite the decline in revenue last year, revenue increased from $2 billion in 1999 to $14.35 billion.

The fundamental outlook is also great as the company benefits from an aging population. In particular, unhealthy lifestyles in the office and everyday life are causing wear and tear on the joints. Stryker is one of the leading companies in its business areas and is therefore well-positioned to benefit from this trend.

Great quarterly results

It all looks like last year was just an exception in Stryker's otherwise impeccable growth story. Revenue increased 51.8 percent compared to 2020, with organic revenue rising 42.9 percent. Of course, these numbers are distorted due to the pandemic since Stryker, like other healthcare companies, suffered severely from the restrictions. These resulted in surgeries and other non-essential operations being postponed, so demand for Stryker's products fell. But already, in January 2021, management announced plans to grow by 8-10 percent over 2019.

And yes, management delivered. Compared to 2019, revenue grew by a robust 16 percent in the last quarter. Organic growth was 9 percent. All three business units were able to contribute to the growth.

Source: Stryker, investor relations

EPS also rose from -$0.22 in 2020 to $1.55. A commendable element of the quarterly results is the increase in the gross margin. There had been a decline here for several years. Admittedly, the decline was minimal. In the long term, however, such developments are detrimental and can affect the ability to increase dividends continuously.

Data by YCharts

There are some caveats

Nevertheless, there are some caveats that investors should at least be aware of and then have to decide for themselves how to weigh them. Only part of Stryker's growth is truly organic. A significant portion of the growth has been the more than 30 acquisitions since 2011. Such an approach is perfectly okay. However, it shows that the market does not offer comparable organic growth.

Secondly, such a strategy contains risk on several levels. Even if it has worked well for Stryker in the past, failures due to future acquisition failures cannot be ruled out. The increased risk of a write-off in the case of bad acquisitions is the flip side of accelerated growth through acquisitions. The goodwill accumulated at Stryker over the years demonstrates this risk quite well. Goodwill now stands at almost $13 billion. In 2011, it was only $2 billion.

Data by YCharts

This growth strategy becomes critical in bad deals mainly because it burns massive amounts of money - be it in the form of equity or debt. Stryker's debts have also continued to rise. Interest-bearing debt was $7.2 billion in 2017. Today, it has almost doubled and currently stands at $13.15 billion. Most recently, Stryker was able to calm investors' nerves somewhat because, in 2020, the interest-bearing debt was as high as $14.4 billion. In this respect, the debt ratio, measured in terms of interest-bearing debt, has fallen from 42 percent last year to the current 39 percent. Nevertheless, I think the debt is still too high.

Lastly, I consider the fundamental situation to be critical, as the share is already somewhat inflated. Yes, Stryker is growing very fast. Nevertheless, despite the great growth story, the adjusted P/E ratio has averaged 21 over the last 20 years. Currently, however, it is 29. The P/C ratio of 30 is also far above the historical average of 23. So while the market sees a lot of potential in Stryker, there is also a high degree of optimism that the growth story, which is based on timely and reasonable acquisitions, will continue.

What's left for investors besides dividends

Undoubtedly, the dividend yield below 1 percent is not exceptionally high, but it is safe as Stryker only distributes 35 percent of its free cash flow.

Source: Seeking Alpha, dividend safety grade

So investors can at least expect continuously rising distributions. Growth has been quite respectable in recent years. The last increase in May was almost 10 percent. This puts Stryker in line with the average of the previous few years. Here, the average growth of the last 3 and 5 years was about 10 percent.

But the fundamental view of the multiples above already shows that the market has priced in a lot of future growth. Of course, these price levels influence the risk/reward ratio to the detriment of the rewards. A DCF analysis also supports this idea. Such an analysis always depends on the data, of course, but it is also a piece of the puzzle that fits well into the overall picture. To use a somewhat more conservative approach, I like to use a discount rate of 7 percent but feel free to calculate with a rate of 8, 9, or even higher.

Source: Discount rate for Stryker

For the DCF analysis, I have already assumed a current growth of 15 percent and then 10 percent annually, which is perhaps a little too conservative. On the other side, however, to grow 10 percent in the medical technology market is already a challenge that a company first has to pass. In addition, considering the analysts (source: FactSet), I have assumed an increase in the operating margin from the current level of just over 17 percent to over 20 percent.

Source: alphaspread.com/estimates by author and FactSet

So, based on these numbers, Stryker seems to be highly overvalued right now.

Source: alphaspread.com/estimates by author and FactSet

If this downside scenario materializes, Stryker's share price would also fall back to its historical multiples. As I said, this kind of analysis always depends on the numbers entered. Nevertheless, much suggests that the share price is driven more by future hopes than by the current business.

Conclusion

Stryker is an excellent company with great management. In retrospect, the company was a worthy investment, and Stryker may continue to offer strong performance. From my point of view, I remain on the sidelines for the reasons mentioned above. I don't need to chase after everything that sparkles. And so it is now with Stryker.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.