Stryker's Stock Is En Route to Recovery

THE THIGH BONE'S connected to the hip bone, and the hip bone's connected to the backbone. The connections, however, wear out with age, which is bad news for baby boomers but big business for Stryker , a leading maker of hip, knee, spine and other joint replacements, and a likely beneficiary of a coming wave of surgeries in the U.S. and abroad.

The recession has knocked Stryker (SYK: 40.85, -0.31, -0.75%) out of joint, curbing its historic double-digit rate of sales and profit growth. Patients have delayed costly elective surgery, hurting the orthopedic-implant business, while hospitals have reined in spending on beds and stretchers, denting the company's Med Surg Equipment unit. As a result, investors have the opportunity to snap up shares for $40 apiece, nearly 50% below the stock's 2008 high of $75.

Stryker's business -- and its shares -- could rebound sharply in 2010, as the economy recovers and employment perks up. Analysts expect the Kalamazoo, Mich., company to earn $1.2 billion, or $2.96 a share, this year, up just 5% from last year's $2.83. But earnings could rise 12% next year, to $1.3 billion, or $3.31 a share, on sales of $7 billion.

Help could come from any increase in hospital spending, which is likely to be flat to up 5% in 2010, after falling more than 20% this year, according to some analysts. Also, foreign-currency exchange could turn from a headwind to a tailwind toward the end of '09 if the dollar stays weak. Overseas markets account for 35% of Stryker's sales, and the company is pushing to expand in Japan, Africa, the Middle East and other regions.

"As the economic situation stabilizes, a favorable exchange rate and increased health-care spending will be significant upside catalysts for Stryker's growth," says Ronnie Moas, president of Standpoint Research in New York. Moas thinks the stock could trade between 50 and 55 next year.

Founded in 1941 by Dr. Homer Stryker, an orthopedic surgeon, Stryker is the tenth-largest medical-device company in the U.S., and a prominent player in the $38 billion orthopedic-implant market, where it competes with Johnson & Johnson (JNJ: 56.60, +0.33, +0.58%), Zimmer Holdings (ZMH: 43.10, +0.18, +0.41%), Medtronic (MDT: 34.97, +0.25, +0.72%) and others. Last year the orthopedic-implants business contributed 59% of total sales of $6.7 billion, while the Med Surg unit chipped in 41%.

With $2.2 billion of cash and only $20 million of debt, Stryker has one of the strongest balance sheets in the health-care sector. It has generated return on equity of at least 19% for nine straight years, and produces more than $1 billion a year of cash flow. The company has used its cash to buy back stock and pay a dividend -- now 40 cents a share, for a yield of 1%. It also has made small acquisitions and is rolling out new products, including a titanium hip cup and a wireless HDTV operating-room monitor.

Worries that health-care reform will crimp profits are obscuring Stryker's long-term prospects, as are concerns the slowdown in domestic hospital spending could go global. "An [international] capital-equipment slowdown may be the next leg down for Stryker," says Needham analyst Ed Shenkan, who has a Hold rating on the shares.

Moreover, the company has received four "warning letters" from the Food and Drug Administration in the past two years that led in some cases to voluntary product recalls. The letters, the latest received in May, alleged, among other things, improper quality and compliance issues at company facilities, including the sale of products without marketing approval. Stryker also is fending off regulatory investigations into its promotion of a bone-growth protein, and the sale of medical devices overseas.

The company is in the early stages of a three-year plan to spend $200 million to upgrade its quality controls and compliance system. At an analyst meeting in May, Chief Executive Stephen MacMillan, a J&J veteran, said management is making "tremendous progress" in improving quality, but conceded "regulatory overhang in the next 12 months" is the biggest risk facing the company. Stryker officials weren't available to comment.

Stryker's stock could fall to 35 or so in coming quarters if the market loses steam. But investors' concerns largely are baked into the price. Morningstar analyst Julie Stralow says a $40 stock assumes that sales increase only 4%, compounded, through 2013, and that operating margins fall to 18% from 23% now. "The current share price reflects a dire scenario" that is unlikely, says Stralow, who pegs fair value at $72 a share.

Stryker sells for 12 times 2010 estimates, slightly above peers. Back out its $5-plus per share in net cash, and the price/earnings ratio falls to 10. For a company with Stryker's healthy prospects, it doesn't get more out of joint than that.

The Bottom Line
Stryker's stock has fallen 47%, to $40, from its peak. It could rise to the mid-$50s as health-care spending rebounds. Morningstar pegs fair value at $72.

THE THIGH BONE'S connected to the hip bone, and the hip bone's connected to the backbone. The connections, however, wear out with age, which is bad news for baby boomers but big business for Stryker , a leading maker of hip, knee, spine and other joint replacements, and a likely beneficiary of a coming wave of surgeries in the U.S. and abroad.

The recession has knocked Stryker (SYK: 40.85, -0.31, -0.75%) out of joint, curbing its historic double-digit rate of sales and profit growth. Patients have delayed costly elective surgery, hurting the orthopedic-implant business, while hospitals have reined in spending on beds and stretchers, denting the company's Med Surg Equipment unit. As a result, investors have the opportunity to snap up shares for $40 apiece, nearly 50% below the stock's 2008 high of $75.

Stryker's business -- and its shares -- could rebound sharply in 2010, as the economy recovers and employment perks up. Analysts expect the Kalamazoo, Mich., company to earn $1.2 billion, or $2.96 a share, this year, up just 5% from last year's $2.83. But earnings could rise 12% next year, to $1.3 billion, or $3.31 a share, on sales of $7 billion.

Help could come from any increase in hospital spending, which is likely to be flat to up 5% in 2010, after falling more than 20% this year, according to some analysts. Also, foreign-currency exchange could turn from a headwind to a tailwind toward the end of '09 if the dollar stays weak. Overseas markets account for 35% of Stryker's sales, and the company is pushing to expand in Japan, Africa, the Middle East and other regions.

"As the economic situation stabilizes, a favorable exchange rate and increased health-care spending will be significant upside catalysts for Stryker's growth," says Ronnie Moas, president of Standpoint Research in New York. Moas thinks the stock could trade between 50 and 55 next year.

Founded in 1941 by Dr. Homer Stryker, an orthopedic surgeon, Stryker is the tenth-largest medical-device company in the U.S., and a prominent player in the $38 billion orthopedic-implant market, where it competes with Johnson & Johnson (JNJ: 56.60, +0.33, +0.58%), Zimmer Holdings (ZMH: 43.10, +0.18, +0.41%), Medtronic (MDT: 34.97, +0.25, +0.72%) and others. Last year the orthopedic-implants business contributed 59% of total sales of $6.7 billion, while the Med Surg unit chipped in 41%.

With $2.2 billion of cash and only $20 million of debt, Stryker has one of the strongest balance sheets in the health-care sector. It has generated return on equity of at least 19% for nine straight years, and produces more than $1 billion a year of cash flow. The company has used its cash to buy back stock and pay a dividend -- now 40 cents a share, for a yield of 1%. It also has made small acquisitions and is rolling out new products, including a titanium hip cup and a wireless HDTV operating-room monitor.

Worries that health-care reform will crimp profits are obscuring Stryker's long-term prospects, as are concerns the slowdown in domestic hospital spending could go global. "An [international] capital-equipment slowdown may be the next leg down for Stryker," says Needham analyst Ed Shenkan, who has a Hold rating on the shares.

Moreover, the company has received four "warning letters" from the Food and Drug Administration in the past two years that led in some cases to voluntary product recalls. The letters, the latest received in May, alleged, among other things, improper quality and compliance issues at company facilities, including the sale of products without marketing approval. Stryker also is fending off regulatory investigations into its promotion of a bone-growth protein, and the sale of medical devices overseas.

The company is in the early stages of a three-year plan to spend $200 million to upgrade its quality controls and compliance system. At an analyst meeting in May, Chief Executive Stephen MacMillan, a J&J veteran, said management is making "tremendous progress" in improving quality, but conceded "regulatory overhang in the next 12 months" is the biggest risk facing the company. Stryker officials weren't available to comment.

Stryker's stock could fall to 35 or so in coming quarters if the market loses steam. But investors' concerns largely are baked into the price. Morningstar analyst Julie Stralow says a $40 stock assumes that sales increase only 4%, compounded, through 2013, and that operating margins fall to 18% from 23% now. "The current share price reflects a dire scenario" that is unlikely, says Stralow, who pegs fair value at $72 a share.

Stryker sells for 12 times 2010 estimates, slightly above peers. Back out its $5-plus per share in net cash, and the price/earnings ratio falls to 10. For a company with Stryker's healthy prospects, it doesn't get more out of joint than that.

The Bottom Line
Stryker's stock has fallen 47%, to $40, from its peak. It could rise to the mid-$50s as health-care spending rebounds. Morningstar pegs fair value at $72.