Stryker: A Q3 Earnings Hiccup In A Broader Bullish Trend

Summary

• SYK's investment-grade credit rating mirrors its cash generative ability, successful M&A expansion strategy, and leading industry position.
• Q3 results came below expectations because of challenging trends related to Chinese pricing regulations, combined with COVID-variants disruptions.
• I believe that the company will generate above-average returns in the mid-single digits above the market in the coming 12 to 18 months.

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Investment Thesis

Stryker Corp (NYSE:SYK) stands out in the medical equipment market with a hawkish approach utilizing a proven M&A expansion strategy, creating cross-selling opportunities and organic and top-line revenue growth. This unique position is highlighted by SYK's competitors' operational, strategic, and market positioning challenges manifested in flat revenues, loss of market share, and moat. For example, Zimmer Biomet (ZBH), SYK's closest competitor in the orthopedic market, lacks the resources to keep up with a changing market environment, focusing on enhancing its financial position as it clenches to the edge of a Baa3 credit rating. ZBH's lagged entry into the robotics market is one example of a shrinking moat for the once-leading orthopedic company. Johnson & Johnson's (JNJ) medical equipment sales remained flat this year, compared to 2019, and so did Smith & Nephew (SNN), while SYK generated 8% organic growth and ~15% total growth.

I see the Q3 results as a hiccup, exaggerated by the market. Companies with solid, reliable and growing cash flows are rare, and SYK's recipe for success generates lucrative returns to investors as demonstrated in its share price performance compared to the market index. Despite generating below-than-expected returns, the fundamentals for the long-term bullish thesis remain intact.

Revenue Trends

SYK's praiseworthy performance is highlighted by challenging industry trends around pricing, competition, and the more recent COVID-variant disruptions. This year, China adopted volume-based procurement "VBP" programs to reduce healthcare costs, subjecting medical equipment companies to competitive bidding. China's new VBP program affected multiple product lines within SYK, including knee, hip, and spine segments, leading to asset impairment which caught retail investors by surprise, perhaps because management has only been communicating the VBP risks for a few quarters, not enough time for the news to seep into the retail investors' community psychic. The non-cash expense mirrors the lower expected future cash flow from the impaired assets. Shares decreased +4% on the news before pairing most of its losses, closing 0.9% in the red.

In the US, the Center for Medicare & Medicaid Services "CMS" has been implementing competitive bidding programs for medical devices since 2003. The 2010 Affordable Care Act " ACA" provisions were designed to create a gradual change that continues today. Since its introduction, SYK's product prices have decreased more than 15% on a cumulative average basis, as shown below. This trend will continue, and I won't be surprised if the company recorded another impairment in light of the significant intangible assets subject to periodic revisions and valuation under US accounting rules and guidelines.

Source: Author's estimates based on SYK annual reports

The COVID pandemic disrupted multiple product lines within SYK, as authorities halted elective procedures to alleviate pressure on hospitals dealing with COVID cases. Now that social distancing rules are easing, elective procedures, such as hip and knee replacements, are resuming, gradually lifting demand back to normal. We still see pockets of continued COIVD-related disturbances due to the emergence of virus variants, suppressing SYK's sales in Q3. To some extent, the company's diversified portfolio has been softening these disruptions. For example, its Medical segment, which includes emergency medical equipment and intensive care products, which generate approximately $6.5 billion, remained stable during the pandemic.

Nonetheless, because of the 2020 revenue irregularities, comparing 2021 results with 2019 is more informative of the company's broader revenue trends. In the first half of this year, SYK achieved 17% revenue growth, compared to 2019, fueled partly by the Wright Medical Acquisition in the fourth quarter of 2020. I don't remember a year that SYK hasn't made an M&A. It is part of its strategy and has achieved impressive results, leading to cross-selling opportunities historically. Wright Medical manifests a continued successful integration trend seen in previous M&A deals. This year's first and second quarters, SYK delivered 4.7% and 9.3% organic growth compared to 2019.

Last week, the company reported Q3 results that came below investors' expectations. A $100 million impairment charge related to China's VBP program contributed to EPS miss. SYK's Trauma and Extremities segment, which holds the majority of newly acquired Wright Medical, yielded disappointing results, raising fears over the deal's economic value. The company attributed the disappointing performance, to COVID-variant disruptions, pushing management to lower 2021 organic growth guidance's upper bound by 1%.

Is Stryker Corporation a Buy, Hold or Sell After Q3 Results?

The phrase "past results are not indicative of future performance" remains a working principle, but at the same time, there is nothing in the Q3 report that indicates a reversal of the trend. SYK has historically generated above-average returns, fuelled by a long-tested M&A expansion strategy that generated organic growth through cross-selling opportunities. Pricing pressure that led to the EPS miss is nothing new and has impacted SYK and its peers for years. Despite this trend, SYK has been able to generate lucrative returns to investors.

Second, the third quarter is usually the softest. It is too early to judge the Wright Acquisition from one quarter, especially given management's history in picking winning M&A deals. Finally, although Q3 results were below expectations, they still constitute ~8% organic growth compared to 2019, not a bad result given all industry headwinds discussed above.

Financial Position

Critics of SYK point to its increasing debt accumulated throughout the years to fund its M&A transactions. The company's cash generation assuages some of these concerns, as demonstrated in Moody's outlook upgraded from negative to stable earlier this year. The rating agency assigns SYK's $14.2 billion debt a Baa2 investment-grade rating.

Data by YCharts

In recent quarters, SYK suspended its share buybacks and channeled cash to pay down debt, a similar strategy to its closest peer ZBH, but from a much favorable position. SYK's leverage is about half of that of ZBH, and its FCF is more than double its peer, not to mention ZBH's defensive strategy, compared to SYK's long record of organic growth.

Data by YCharts

Is Stryker Overvalued or Undervalued?

SYK isn't exactly cheap compared to the healthcare sector or its peers. Conservative investors might want to wait for a pullback but risk missing an opportunity given the bullish tailwinds mentioned above. The company is growing and has a favorable position compared to its peers. Still, investors should note that at current prices, SYK trades above its historical averages, as shown in the table below:

Ratio	Current Rate	5-Year Avg.	% Difference from Avg.
P/E	39.8	31.19	27.61%
EV / Sales	6.49	5.32	21.93%
EV / EBITDA	22.79	19.3	18.11%
EV / EBIT	24.88	21.11	17.86%
Price / Sales	5.86	4.89	19.91%
Price / Book	6.69	5.47	22.29%

Click to enlarge

Source: Seeking Alpha Quant Score Ratings

Summary

SYK's bullish trade is supported by lucrative FCF, operating cash flow, and a proven growth strategy that makes it stand out in light of unaccommodating industry trends manifested in pricing pressure, increasingly stringent regulations, and competition. Despite these challenges, SYK has generated lucrative returns and growth, demonstrating management acumen and a successful M&A expansion strategy.

The company has historically outperformed the market, and despite Q3 results coming below expectations, there are no signs that the trend is reversing, at least from a fundamental perspective. The company remains strong, and its business segments have generated strong results during the quarter, equating to an 8.5% organic growth compared to 2019. For these reasons, I believe that SYK will generate above-average returns in the coming 12 to 18 months.

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.