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Growth may be starting to pick up in the med-tech world, but Stryker (NYSE: SYK ) is still finding a way to stand out from the crowd. Stryker had a surprisingly strong quarter in its reconstructive products business, and the long-term outlook for instruments, endoscopy, and neuro/spine are all appealing. Add in upside from the MAKO Surgical acquisition and, while Stryker may not be a bargain-basement stock anymore, it still holds some appeal for long-term investors.
A solid end to the year
Stryker came out of 2013 with some solid momentum in the business. Total revenue increased a little less than 6% as reported, and close to 6% on an organic basis. The reconstructive products division was surprisingly strong with 8% constant currency growth, as hip sales rose 8% and knee sales rose almost 5%. Those hip numbers compare very well with the results from Johnson & Johnson (NYSE: JNJ ) and Biomet (mid-single digits, each). While knee growth lagged Jonson & Johnson & Biomet (both around 8%), there was no expectation that Stryker was going to outperform them. Trauma and extremities were slightly weak at 12% growth.
The medical and surgical products division saw nearly 7% growth, as unexpected strength in endoscopy (up 10%) and instruments (up more than 7%) offset softness in medical (up 2%). It's difficult to tease out the comparables to companies like Johnson & Johnson and Covidien (NYSE: COV ) here, but I'd say Stryker is seeing share growth on top of a generally healthy market for surgery-related instruments. Neuro/spine was up more than 7%, with nearly 10% growth in neuro offsetting more sluggish 5% growth in spine.
While Stryker lags both Johnson & Johnson and Medtronic pretty significantly in spine, Stryker seems to be taking advantage of weakness at these larger rivals to gain some share (Johnson & Johnson's spine sales were down 2% this past quarter). On the neurotechnology side it looks as though Stryker continues to gain share from Covidien.
As has been the case for other device companies this quarter, margins were mixed. Stryker saw gross margin decline two points and miss estimates by nearly the same amount, due in large part to foreign exchange and the geographic mix of sales. Management was able to pare back spending more than expected, though, and the operating income growth of more than 5% led to a nearly in-line result for operating margin.
Making the most of MAKO
Stryker isn't wasting time trying to maximize its new surgical robotics asset. Stryker will be starting a clinical trial of the MAKO system in total knee replacement in the first half of this year, and management also made some relatively non-specific comments about designing a new generation of implants to take advantage of the robotic approach.
I remain bullish on the potential of the MAKO asset in Stryker's hands. MAKO's RIO System doesn't really improve outcomes for top orthopedic surgeons, but it can help less skilled surgeons achieve similar outcomes in difficult procedures. Assuming that Stryker can build on MAKO's clinical work demonstrating benefits in outcomes and economics, the combination of MAKO's robotic approach and Stryker's sales capabilities (as well as future implant designs) should be a powerful one and a true threat to the reconstructive businesses of Biomet, JNJ, and Zimmer. As a reminder, Stryker is #3 in both hips and knees and close enough that the addition of an asset like MAKO could lead to share gains.
MedSurg an underappreciated asset
Ortho gets a lot of attention from Stryker analysts because it is the historical core of the business and has long been one of the major sub-markets of medical devices. Neuro and spine get attention because of their higher growth rates (though it has been a while since spine has been a real growth industry). With that, I feel like the medical and surgical products unit is often an afterthought.
Stryker is the leader in instruments like power tools, and doesn't really have a close rival. Competition is stronger in areas like endoscopy and medical equipment like beds and stretchers (Hill-Rom is the market leader), but this is a solid business where Stryker has shown meaningful innovation over the years. What's more, it's a market that gives Stryker better exposure to growth in emerging markets as power tools and scopes are fundamental necessities.
This is also a business where Stryker is still looking to grow. The company recently acquired Patient Safety Technologies for its barcoded sponges, towels, and monitoring system, and the FDA reclearance of Neptune should allow the company to regain business lost to Zimmer while this fluid waste management system was off the market.
The bottom line
I'm looking for Stryker to grow revenue at a long-term rate of between 4% and 5% and couple that with ongoing improvements in margins and free cash flow generation. My estimate of roughly 7% free cash flow grow leads to a DCF-based fair value of nearly $80. Although that does not make Stryker a screaming buy in my book, it suggests the potential for annual returns of around 8% to 11% by my estimation, and I think that's a respectable return for a company of Stryker's quality and upside potential.
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