Dissecting Stryker’s Long-Term Opportunities
Health care has been volatile since August, with concerns ranging from heightened FTC scrutiny of managed care deals to intensified pricing pressure for specialty pharmaceutical drugs. This environment favors companies with multiple organic growth drivers and opportunities for margin expansion independent of pricing. We believe Stryker Corporation (SYK), a medical device company, is poised for strong results based on its research and development (R&D) pipeline, improving foreign sales, and unlevered balance sheet that can be utilized for attractive acquisitions.
Stryker was founded by Dr. Homer Stryker in 1946 as the Orthopedic Frame Company and is headquartered in Kalamazoo, Michigan. Nearly 70 years later, Stryker is still primarily focused on orthopedic implants, but has also branched into complementary areas such as operating room equipment.
Source: Company Fact Sheet, August 2015
The company’s revenue trajectory has been remarkably steady for over a decade, with tuck-in acquisitions supplementing organic growth. For 2015, revenues are anticipated to grow organically between 5.5% and 6.5% in constant currency terms. We believe growth could accelerate in 2016 and through the end of the decade based on new product introductions in Orthopedics, Spine and Neurology.
Orthopedics is the largest segment and Stryker occupies the number three position in hip and knee implants. Market share is sticky in the large joint space, as surgeons typically train on a particular brand and establish long-standing relationships with sales representatives. The latter play an important role with joint replacement surgeries, often acting as consultants to ensure optimal product selection. It is also customary for device manufacturers to include various free instrument sets. Consequently, sales expenses represent more than 35% of revenues. The challenge is to move share in a sticky market while maintaining or expanding margins.
Stryker purchased MAKO Surgical in late 2013 as a solution to these challenges. MAKO’s Robotic Arm Interaction System (RIO) is a robot-assisted virtual cutting guide and arm, which replaces the traditional system of blocks and jigs. The system is especially attractive for younger patients due to its tissue-sparing capabilities. While MAKO’s clinical data suggested statistically better patient outcomes, the company’s reliance on its own relatively unknown brand of implants limited its adoption outside of partial knee replacements.
Stryker recently received approval for the use of its total knee and hip implants on RIO, which marries the platform to a trusted brand. We believe the combined offering will lead to material share gains beginning in 2017. RIO also requires less sales representative involvement in the operating room, which may translate into margin improvement. Investor pushback on RIO primarily focuses on the necessity of a pre-operative CT scan, which adds time and expense. This concern seems misguided because scans will be more common as implants become increasingly customized. Additionally, Stryker’s R&D team is improving the interface to deliver surgical times equivalent to traditional procedures. Stryker appears to have a multi-year lead in the robotic joint replacement space, and we expect the robustness of its system to appeal to major practices.
Within Orthopedics, Stryker’s Trauma and Extremities sales are up 12% year-over-year on a combination of successful tuck-in acquisitions and share-taking from the disruption caused by the merger of Wright Medical Group and Tornier. We expect Trauma and Extremities to remain a strong contributor to top-line growth due to a secular shift favoring joint replacement over bone fusion. Longer term, Stryker’s investments in robotics could also open new opportunities for previously inoperable small joints.
Beyond Orthopedics, we see underappreciated growth opportunities for Spine and Neurology. Spine sales have lagged Stryker’s broader portfolio due to pricing pressure, industry-wide questions about efficacy, and pure-play competition. The company introduced 10 new products at the 2015 North American Spine Society conference in October. Key additions include an expanded minimally invasive line, SpineMask navigation system, and a 3D printed implant. Spine sales have improved to 3% constant-currency growth, but we see a pathway towards company-average growth over the next five years.
Neurology revenues have grown 14% over 2014 on the back of compelling clinical evidence for the company’s Trevo stent retrievers for use in ischemic stroke. We believe the potential ischemic stroke market for retrievers could grow from an estimated $150 million in 2015 to more than half a billion by 2020. Neurology tends to be more insulated from pricing pressure than other areas, and we expect the division’s outpaced growth will contribute to gross margin expansion.
Stryker has meaningful opportunities for growth beyond product introductions. Domestic sales comprise 68% of the business and have outpaced the market, but the company has struggled to produce the same results abroad. Management has re-aligned the European sales force to improve oversight and bring foreign sales more in line with the domestic business. Additionally, European Union headquarters were relocated to Amsterdam, which produced a permanent tax benefit this year of more than 2%. The company reinvested half of the first year’s savings in infrastructure, but will gradually recognize the full impact. Coupled with efficiency initiatives, we believe Stryker can realize approximately 40 to 50 basis points in operating margin expansion each year through 2018 without layoffs. These actions point to a management team firmly committed to the long haul.
Tuck-in acquisitions are the preferred use of capital. Management uses a three-year 12.5% return hurdle, and generally targets smaller companies with strong clinical results but lacking scale and international sales teams. As of September 30, 2015, Stryker had $3.3 billion in cash against $2.5 billion of debt. If asset prices fall, Stryker has plenty of dry powder to take full advantage.
Source: Company Fact Sheet, August 2015
Daily headlines reflect what may be a tougher road ahead for health care, but it is precisely this type of environment Stryker was built to withstand. The company has the ability to drive diversified organic growth and margin expansion through a combination of new products and a reinvigorated international sales force. Coupled with a fortress balance sheet and the patience to deploy it intelligently, we are very comfortable with the company’s prospects. At present, we believe the market is under-appreciating the diversity of Stryker’s portfolio, potential for margin expansion, and opportunities for capital deployment.
Originally published on November 18, 2015
The views expressed are those of the research analyst as of November 2015, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.