Stryker Humming Along, But Seems To Be Straining The Sell-Side

by

Summary

However you feel about the valuation, I don’t know how you don’t admire the money-making machine that is Stryker (SYK), and this excellent med-tech company continues to execute at a high level that most other med-techs (if not most other companies in general) could only aspire to reach. The “but” is that once you reach such a high level, feeding the Street’s insatiable appetite for “more” gets harder and harder.

Although transitioning to the next year in my model does boost my fair value assumptions for Stryker, it’s not enough to bring the shares into the realm of “cheap”. It’ll probably take a significant market washout or a real misstep from the company to drive significant derating, though a suppose it’s plausible that just a general “it’s gone as far as it can go” malaise could come into play. Whatever the case, it’s a must-follow if you care about med-tech, but it’s hard to get excited about what looks like a mid-single-digit prospective return, particularly with Stryker likely to be more on the sidelines with growth-driving M&A in the near future.

A Curiously Mixed Fourth Quarter

While there’s nothing operationally wrong with Stryker, I think expectations are frankly a greater opponent for the company than its in-market rivals. I say that because there’s not much Stryker really did wrong, and yet the revenue and operating income beats were pretty modest … in a quarter where several well-established businesses posted double-digit growth.

Revenue rose 8% in organic terms, beating expectations by less than 1%. Gross margin improved 60bp yoy in adjusted terms, beating by about 10bp. Operating income rose 12%, with 80bp of margin expansion, which barely beat expectations (and margin was a 10bp miss).

The “mixed” part comes into play with the individual units. Ortho and Neuro/Spine both managed modest beats (1% and 3%, respectively), and MedSurg was a 1% miss. By sub-category, of the 10 that Stryker breaks out, six beat and four missed. Again, there was no problem area standing out this quarter, but I think analysts have been pushing their models in an attempt to justify/rationalize higher target prices, and I think this quarter’s results relative to expectations show some of the strain.

Mako Gliding Through Ortho

Stryker’s orthopedics business saw better than 7% organic growth this quarter, a strong performance relative to the one rival that has reported (Johnson & Johnson (JNJ) ) and underlying growth across the market. Knees were the star, growing more than 10% in the quarter both in the U.S. and abroad. Unless Smith & Nephew (SNN) and Zimmer Biomet (ZBH) post radically different quarters than expected, it looks like Stryker gained about two more points of market share in the U.S. knee market.

Mako continues to be a major driver of that growth, with the company adding another 63 placements in the U.S. (against 36 last year), bringing the installed base close to 700. Mako procedures were up 50% in the period, with 59% growth in Mako-assisted total knee replacements. With Chinese approval for total knees expected later this year, that’s another long-term growth opportunity to watch.

At this point, Zimmer’s competing robotics platform doesn’t seem to be slowing Stryker’s momentum with Mako, and management indicated that over half of Mako placements are still in competitive accounts. One impact Zimmer has had is in disclosure, with Stryker management indicating that it will no longer provide the details on placements and so on.

Hips were also stronger than expected this quarter, with 6% overall strong and slightly better performance outside the U.S.. Although Stryker isn’t building share at quite the same pace here as in knees, the company is outperforming JNJ and gaining share. Mako is also a longer-term driver here; I don’t think Mako will ever be as much of a driver for hips as for knees, but Mako-assisted hip procedures were up 40% in 2019.

Other ortho categories were mixed. Trauma and extremities was up 4%, below expectations, while “Other” (which incudes Mako capital equipment sales) was up almost 11%.

MedSurg Lagged A Bit

Stryker was up against a tough comp (up 10% a year ago), but MedSurg was the one business that lagged some relative to expectations. Nearly 7% organic growth is hardly bad, though, and all of the units posted growth. Instruments grew more than 7%, but growth was sluggish in the U.S. (up around 4%) and I didn’t hear a good explanation of why that business was relatively weak (literally, if management addressed it, I missed it). Endo was far stronger, with 10% constant currency growth and mid-teens growth in the U.S.. Medical and Sustainability (reprocessing) were both up around 6%.

Stryker will be launching a new bed in 2020, but I don’t expect that to move the needle much. Likewise with another year into the launch of the 1688 imaging platform.

Neuro And Spine Still Generating Good Growth

While Neuro/Spine did well overall (up more than 12% organic), spine was once again a little shy of expectations (with nearly 19% reported growth, including the K2M acquisition). This deal has been a harder one for Stryker to integrate, but I’m still bullish on what this business can do for Stryker’s spine efforts over the long term.

The Neuro business was stronger than expected (by 5%), with around 18% overall growth and over 16% growth in the U.S.. This has long been a strong business for Stryker, and the launch of a new larger-bore aspirator in the first half of 2020 should boost it further. That’s a competitive threat for Penumbra (PEN) (as well as Medtronic (MDT) ), and I’ll be curious to see if this new product is any better received – while Stryker has a strong marketing effort, their product development in aspiration has been lacking so far.

The Outlook

This is absolutely a subjective assessment on my part, but it felt like at least a few of the sell-side participants on the Stryker call were trying to coax management into bolder guidance for 2020 than the roughly 7% organic revenue growth guide they got. Like I said, I get it – clients get excited about higher price targets and higher price targets need higher underlying growth estimates.

Very little changes in my model. The transition to a new year shaves a little off the long-term revenue growth based on my year-by-year assumptions (still between 6% and 7%), but I’m still looking for double-digit FCF growth as FCF margins move toward the 20%’s. The Street now takes it as a given that Stryker will seamlessly transition to consistently high FCF generation, but the company hasn’t managed back-to-back high-teens FCF margins in about a decade.

The Bottom Line

With a DCF-based prospective return in the mid-single-digits and the shares above what the market has historically paid for similar combinations of growth and margins, I still can’t recommend buying Stryker. Given the high level of expectations, this is a name to watch for disappointments, and it’s definitely a good name to own at the right entry price.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any 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.