Although it wasn't all that long ago that Stryker (SYK +1.46%) traded at a pretty meaningful discount to fair value, Wall Street has come back around to the enduring value of one of the better-run names in the sector. Helping matters greatly is a recovery in major joint reconstruction and early success with margin improvement initiatives. These shares are no longer a tremendous bargain, but they're still priced to generate decent long-term returns for long-term shareholders.
A largely solid third quarter
Stryker reported 6% organic constant currency growth this quarter, fueled by one of the best performances in Recon in some time. Revenue from the Recon business rose more than 9% this quarter (despite price erosion of almost 2%), as hips grew over 9%, trauma/extremities grew more than 18%, and knees rose 2%. MedSurg was less impressive, growing more than 2% as an 8% gain in endoscopy was weighed down by declines in both instruments and medical. Last and not least, neuro/spine rose 10% as neuro grew nearly 14% and spine grew more than 5%.
Margin performance was a little more mixed. Gross margin jumped 60 basis points on an adjusted basis, but the number is likely to weaken into the fourth quarter. SG&A spending was a little higher than expected due to some turnover in distributors abroad, and that limited operating income growth to about 4%.
Not many aches in these joints
Investors have been waiting for good news from the major joint reconstruction companies, and they're finally getting it. Although Zimmer (NYSE: ZMH) has not yet reported, the space has been strong this quarter. Biomet reported 4% and 5% growth in hips and knees, respectively, while Johnson & Johnson (JNJ 0.15%) reported 6% and 3% respective growth (both on an operating basis). Reimbursement/pricing pressure remains an issue, but volumes are recovering -- likely due at least in part to patients reaching a point where they no longer can (or wish to) put off their surgeries. As a reminder, both J&J and Zimmer have been focusing more attention on new knee platforms, while Stryker and Biomet have been placing more emphasis on ligament-sparing and soft tissue preservation.
Stryker is also showing quite a bit of strength in spine, trauma, and extremities. While J&J's spine business actually declined 2% on an operating basis, Stryker likely gained share with that 5% revenue growth number. Medtronic and Johnson & Johnson still dominate the spine space (with what I estimate to be about two-thirds share), and Stryker would likely be better served with an acquisition to grow its scale/share, but it is showing that it can grow on its own.
It's also worth noting Stryker's recent agreement to acquire MAKO Surgical. This deal won't change much for Stryker in the first few years, but Stryker management has made it clear that they believe robotics can increase procedure volume and that the MAKO platform can be taken beyond partial knee procedures. Zimmer and Johnson & Johnson have been more skeptical about the influence/potential of robotics in orthopedics, but the combination of MAKO's RIO platform with Stryker's marketing and R&D capabilities could be powerful down the road, and I'm not sure J&J, Zimmer, or Biomet can offset it just with better cutting guides and tools.
Still waiting on MedSurg
While two of the three businesses at Stryker are strong, I don't think investors should expect a quick turnaround in MedSurg. Although Johnson & Johnson had a pretty good quarter in surgical tools, Stryker is more skewed to higher-ASP capital equipment and hospitals are still being relative cautious and slow with their spending. Long term, I think this is still a good business but investors shouldn't expect a quick turnaround (though it can be a lumpy business on a quarter-to-quarter basis).
The bottom line
I've been bullish on Stryker for a while and I still am, though not to the same table-pounding extent. I expect Stryker to grow its revenue at a better than 4% rate long term, and I am looking for 7% free cash flow growth as the company's margin improvement efforts make a lasting difference. Discounted back, that suggests a fair value in the mid-$70's today.
A mid-$70s price target doesn't suggest exciting undervaluation for Stryker, but even at today's level I believe the shares are priced to possibly generate high single-digit returns in the coming years. With a better-than-average risk profile, I would argue that Stryker is still a very strong "hold" and maybe a stock to consider for investors looking for long-term positions.
