Why Stryker can Outperform Despite Q2 Miss
Ashish is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Last month, Stryker (NYSE: SYK) reported lower than expected 2Q results with sales of $2.11 billion (vs. consensus estimates of $2.14 billion) and adjusted EPS of $0.98 (a penny below the consensus). Also, management reiterated its commitment to 10% EPS growth in FY13 including a 7% EPS headwind from the device tax. Operating margins improved by 150 bps during 2Q as the company’s cost-containment and restructuring programs gained traction.
I believe that the combination of steady revenue growth and operating margins improvement will lead to double digit EPS growth. Stryker has several avenues for increasing per-share intrinsic value. While taking market share from rivals will be difficult, the entire industry should benefit from significant demographic tailwinds in coming years.
MedSurg Business (~37% of sales): In 2Q12, MedSurg margins decreased sequentially but improved YoY. I believe that hospitals slowed their pace of capital purchasing during 2Q, due to the Supreme Court’s decision on Affordable Care Act., which attributed to the lower than expected results in this segment. Instrument sales were strong and reported growth of 8.8% YoY, compensating for weaker numbers in endoscopy and beds. I expect growth in this business to accelerate with the recent introduction of new products like 1488 High definition camera.
Reconstructive Business (~44% of sales): In 2Q12 Reconstructive margins decreased both sequentially and YoY. I believe Stryker could continue to struggle in its Knee and Hip business segment during the coming quarters to defend its market share as several of its large competitors like Biomet, Johnson & Johnson (NYSE: JNJ) and Zimmer (NYSE: ZMH) are launching new products in this line. On the other hand, I believe that another segment of Stryker’s reconstructive business, Trauma and Extremities, provides a meaningful opportunity for Stryker in the coming quarter, as Johnson & Johnson’s recently completed acquisition of Synthes should result in some market share dislocation from the combined entity. I expect the company to capture new business as Stryker is the second largest producer of these products. Further, the Stryker acquisition of Memometal should allow it to participate in the fast-growing foot-and-ankle segment of the extremities market.
Neurotechnology and Spine Business (~19% of sales): The margins in this segment improved both sequentially and YoY in the last quarter. I expect that company’s interventional spine business will continue to perform well, largely due to the strong uptake of its vertebral augmentation balloon. Even though visibility into the performance of the various components of this business is limited, I believe growth was primarily attributed to elevated growth of the NeuroSpine ENT Interventional Spine and CMS platforms. Further, I believe the combination of the Orthovita biologics and interventional spine businesses may help accelerate growth within this segment of the business.
Strong Balance Sheet Opens Several Doors
Last quarter, Stryker generated roughly $457 million in cash from operations (up almost 200% year-over-year) and $406 million in free cash flow. The company maintains a very strong balance sheet (roughly $3.5 billion in cash vs. $1.8 billion in debt), it provides ample flexibility to opportunistically pursue strategic M&A, invest in R&D, and increase share repurchases/dividends. Over past few years, Stryker deployed large capital in M&A, but the company now appears inclined to pay more to shareholders before US cash generation becomes a constraint. Good dividend yield is another positive for Stryker’s investors.
Stryker is expected to grow its EPS by 10.21% in the current fiscal year and 8.7% in the next year, which is higher than expected EPS growth of Johnson & Johnson (1.4% this year, 7.7% next year). However, Stryker is currently trading at a 3% discount to Johnson & Johnson. Thus, on a relative basis Stryker seems undervalued given its attractive growth profile coupled with a well-diversified asset base. The company has done a good job of diversifying its asset base. The company's acquisitions seem to be bearing fruits, and I am optimistic about the company’s better overseas performance. I expect Stryker to achieve mid-single-digit revenue growth (with the equipment business poised to grow 6-7% on a sustainable basis) and produce mid-to-high single digit free cash flow growth over the next five years. I believe Stryker is well-positioned to deliver above-average sales and EPS growth given its market-leading portfolio, continued new product flow, strong balance sheet, and healthy "head start" adapting to an increasingly cost-aware and compliance-oriented era. Thus, I recommend it a buy.
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