Stryker Is Steady Eddy

Former Fool contributor Stephen Simpson had followed Stryker Corp. (NYSE: SYK  ) over the past several quarters and was impressed with its ability to manage consistent 20% earnings growth. Stryker is in the business of selling replacement hips and knees, surgical equipment, and hospital beds and stretchers. With third-quarter results posted, let's see whether the streak is alive. Drum roll . yes, it is!

It was the orthopedic segment that drove the results this quarter. As CEO Stephen MacMillan said in the conference call, "U.S. orthopedics is clearly now back on track." He goes on to further say that the results were largely driven across the board by general hard work, or in common management speak, "by blocking and tackling."

As for the results (all on a constant currency basis), revenues were up 9.8% for the quarter. All franchises within the orthopedic segment showed growth, including its flagging hip replacement business, which was up by a total of 3%. The MedSurg equipment business was also up 13.4%, which was helped by an increased international sales force. The physical therapies segment was the lone drag for the quarter and was down by 4.6%.

Net earnings for the quarter, adjusted for an apples-to-apples comparison, grew 23.9%. Earnings acceleration above revenue growth was again driven by gross margin expansion. Gross margins, which are now at record highs of 65.9%, have steadily expanded over the decade. Returns on shareholder's equity remain higher than 20%.

Stryker is expecting OP-1, its new orthobiologic or protein putty used to stimulate bone growth, to be approved by the FDA within 18 months. Management estimates that OP-1 could contribute to earnings by 2008. OP-1 would compete with companies like Medtronic (NYSE: MDT  ) and Biomet (Nasdaq: BMET  ) . Furthermore, Stryker should drive continued revenue gains from the recent purchases of Sightline, eTrauma, and PlasmaSol, which would bolster the MedSurg equipment business.

However, being the investing curmudgeon that I am, I wonder how long Stryker can maintain its Steady Eddy persona. Net earnings will decelerate when gross margins peak. Gross margins might also compress because of tougher pricing environments created by large customers such as HCA (NYSE: HCA  ) , or increased regulatory oversight as a result of the Department of Justice investigation. In either case, the end result would be lower earnings and lower forecasted cash flows -- both negatives in my valuation model. At these prices, the stock seems fairly valued, but I do see more risk than reward -- especially if we lose Steady Eddy's 20% earnings growth.

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Fool contributor Matthew Crews doesn't have a financial position in any of the companies mentioned. He welcomes your feedback -- really! The Fool has a disclosure policy.

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