Stryker Corporation – Stock Analysis

In my November 10, 2019, Stryker Corporation stock analysis I discuss SYK's agreement to acquire Wright Medical and disclose that I initiated a position in one of the 'Core' accounts within the FFJ Portfolio and in an account for which I do not disclose details.

I followed up this post with another on November 15, 2019, in which I disclose the sale of January 2021 'put' contracts with a $165 strike price; this trade provided the buyer with the right to sell me shares at $165/share up until January 15, 2021. I received $7.60/share and since each option contract represents 100 shares, I received $760 for every contract I wrote (less nominal commission).

SYK's share price never dropped to $165 or lower before expiry so I retained 100% of the option premium. The share price did, however, plunge to ~$138 in mid-March 2020. In hindsight, I should have added to my SYK position at such time but I deployed money toward other purchases.

On October 28, 2021, SYK released its Q3 and YTD2021 results and FY2021 guidance and on November 18, it held its 2021 Investor Day.

I now provide the following update and disclose the purchase of additional shares.

Stryker - Stock Analysis - Business Overview

SYK is one of the world's leading medical technology companies. Its operations are segregated into 3 reportable business segments:

• Orthopaedics;
• MedSurg; and
• Neurotechnology and Spine.

SYK's products are sold in over 75 countries through company-owned subsidiaries and branches, as well as third-party dealers and distributors. Its products include:

• implants used in joint replacement and trauma surgeries;
• Mako Robotic-Arm Assisted technology;
• surgical equipment and surgical navigation systems;
• endoscopic and communications systems;
• patient handling, emergency medical equipment and intensive care disposable products;
• neurosurgical, neurovascular and spinal devices; and
• other products used in a variety of medical specialties.

Roughly 73% of SYK's total annual revenue is derived from within the US where it markets its products directly to doctors, hospitals and other healthcare facilities. SYK, however, is expanding in international markets.

Its website and Section 1 of the FY2020 10-K contain a wealth of additional information including the names of key competitors in its 3 reportable business segments.

Acquisitions

In addition to SYK's organic growth, it has completed several acquisitions to bolster its product offering. The most recent large acquisition was Wright Medical; this was completed on November 11, 2020.

The following reflects the extent to which SYK's sales, margins, and earnings grew from 2015 - 2019 before the transformative Wright Medical acquisition.

On the Q3 2021 earnings call, management indicated that SYK is always actively looking at acquisitions. Even after the Wright Medical acquisition, SYK has completed the following small acquisitions:

• OrthoSensor, Inc., a leader in the digital evolution of musculoskeletal care and sensor technology for total joint replacement. This is now part of SYK's Orthopaedics business.
• Gauss Surgical, Inc., a medical device company that has developed Triton, an artificial intelligence-enabled platform for real-time monitoring of blood loss during surgery. Gauss is part of the Instruments business within MedSurg.

The focus after the Wright Medical acquisition has been debt reduction so recent acquisitions have been 'tuck-in'; the aggregate purchase price of acquisitions, net of cash acquired was $267 million and $26 million in the nine months 2021 and 2020.

SYK's strong cash flow performance and debt reduction, however, has now positioned management to start looking at slightly larger tuck-in acquisitions in conjunction with ongoing debt reduction.

Despite valuations being very high overall, management has indicated there are still a lot of target companies. It remains confident that it will continue to find value-creating acquisition opportunities.

Stryker - Stock Analysis - Financials

Q3 and YTD 2021 Results

I reference SYK's Q3 and YTD results found in the Q3 2021 8-K and Q3 2021 10-Q and 2021 Investor Day Presentation.

In addition to sales growth analysis versus 2020, SYK has provided sales growth versus 2019. The reason for this is that provides a more normal baseline for comparison given the
variability caused by the COVID-19 pandemic throughout 2020.

SYK's MedSurg and Neurotech businesses continue to experience double-digit growth in both segments. The Orthopaedics and Spine businesses, however, have been adversely impacted by increases in COVID-19 related hospitalization rates starting in early August, especially in the US as a result of the Delta variant.

In Q3, US organic sales increased 7.1%, reflecting the continued strong demand for Mako, instruments, medical and neurovascular products.

International organic sales experienced ~12% growth resulting from positive sales momentum in Europe, Australia, Canada and emerging markets.

Adjusted quarterly EPS of $2.20 increased 15.2% from 2019, reflecting sales growth, gross margin expansion and a lower quarterly adjusted effective tax rate of 14%, partially offset by the impact of business mix and higher interest charges resulting from the Wright acquisition.

SYK's YTD effective tax rate is 14.8% and management expects an adjusted effective tax rate of 15% to 15.5% for FY2021.

SYK ended Q3 with ~$2.6B of cash and marketable securities and long-term debt (excluding current maturities) of $12.7B (refer to Note 8 - Debt and Credit Facilities in the Q3 2021 10-Q).

In October, after the end of Q3, SYK entered into a new revolving credit agreement that replaces the previous agreement dated August 19, 2016. The primary changes were to:

• increase the aggregate principal amount of the facility by $0.75B to $2.25B;
• extend the maturity date to October 26, 2026;
• increase the leverage ratio to 3.75; and
• provide LIBOR replacement language.

On the Q3 earnings call, management indicated that concerning the implant-related procedures, the last 18 months have not been normal from a volume perspective. Some quarters have been strong and others have been weak but a backlog still exists.

COVID-19 has impacted regions of the US differently with hospitals in the southern states experiencing higher COVID-19 related challenges because of lower vaccination rates.

SYK believes that once COVID-19 cases become more controlled, the backlog will begin to decline. This will result in improved sales growth rates but investors should not expect a large outsized growth rate in any one particular quarter.

From raw material and supply chain perspectives, SYK is experiencing challenges like everyone else (ie. tight labour market, shortages in electronics or resins). To date, however, SYK has been able to meet all of its customer needs.

Free Cash Flow (FCF)

YTD cash from operations was $2.263B and FCF was $2.131B

On the Q3 earnings call, management stressed the heightened focus on working capital management.

FY2021 Guidance

On January 27, 2021, when SYK released FY2020 results, management expected FY2021 adjusted diluted EPS of $8.80 - $9.20.

Guidance was then amended to $9.05 - $9.30 when Q1 2021 results were released on April 27, 2021.

This was amended to $9.25 - $9.40 when Q2 2021 results were released on July 27, 2021.

Based on SYK's YTD results as at the end of Q3 2021, the continued volatility experienced as a result of COVID-19, procedural delays in hospital staffing shortages as well as uncertainty around the pace of recovery in Q4, FY2021 organic net sales growth is expected to be 7% - 8% and Adjusted diluted EPS guidance is now $9.08 - $9.15.

Stryker - Stock Analysis - Credit Ratings

SYK's domestic senior unsecured long-term debt ratings are as follows with a stable outlook.

• Baa1 (Moody’s) is the top tier within the lower-medium grade category;
• A- (S&P) is the lowest tier within the upper-medium grade category.

The Baa1 rating defines SYK as having an ADEQUATE capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments.

The A- rating (one notch above the Baa1 rating) defines SYK as having a STRONG capacity to meet its financial commitments. It is, however, somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.

These ratings are satisfactory for my purposes.

Stryker - Stock Analysis - Dividends and Share Repurchases

Dividend and Dividend Yield

While SYK has a track record of increasing dividends, capital deployment has been primarily toward mergers and acquisitions to drive sales growth in core and adjacent markets.

On October 29, 2021, SYK distributed its 4th quarterly $0.63/share dividend. Within the next couple of weeks, I anticipate SYK will announce a dividend increase. Given SYK's strong YTD financial results and positive outlook I expect a ~$0.04 - $0.06/share quarterly dividend increase.

With shares trading at ~$264, the forward dividend yield, based on my assumption, will likely be ~1%.

Stock Splits and Share Repurchases

SYK has had 5 stock splits over the years. In 1989 it had a 3 for 2 stock split and in each of 1991, 1996, 2000, and 2004 it had a 2 for 1 stock split.

Since FY2011, SYK has repurchased ~$2.7B of issued and outstanding shares. The weighted-average diluted shares outstanding (in millions) in FY2011 - FY2020, however, is 390, 383, 382, 383, 381, 379, 380, 380, 380, and 380 because of share-based compensation. Share count for the 9 months ending September 30, 2021, has risen to 382.3.

Furthermore, SYK discontinued the repurchase of outstanding shares in 2019 when it announced its intent to acquire Wright Medical.

Based on SYK's share repurchase track record, I do not envision share repurchases suddenly becoming a key priority when it comes to deploying capital.

Stryker - Stock Analysis - Valuation

When I initiated a position on November 10, 2019, SYK was at ~$200/share. Based on management's FY2019 adjusted diluted EPS $8.20 - $8.25 guidance, the forward adjusted diluted PE was ~24.32 (using the $8.225 mid-point).

At the end of Q3 2019, SYK had generated $3.58 in diluted EPS. I estimated that SYK would generate ~$1.20 (~1/3 of YTD diluted EPS) in diluted EPS in Q4 thus resulting in ~$4.78 in FY2019. Using the ~$200 share price, I arrived at a forward diluted PE of ~41.84. As it turns out, SYK generated FY2019 diluted EPS of $5.48 so my valuation estimate was over the actual ~36.5.

SYK is now trading at ~$264 and it has generated $3.48 in diluted EPS. If it generates ~$1.15 in Q4 then FY2021 diluted EPS should be ~$4.63 giving us a forward diluted PE of ~57.

Investors need to consider that earnings are negatively impacted by the Amortization of Intangible Assets; SYK has reported $0.474B YTD2021 versus $0.417B, $0.464B, and $0.472B in FY2018 - FY20220. As a result, the PE ratio is distorted by this non-cash expense.

This distortion is partially offset by the Annual Depreciation figures that are lower than Annual CAPEX; the purchases of property, plant and equipment exceed depreciation by $0.266B, $0.335B, and $0.147B in FY2018 - FY2020 and by $0.041B YTD2021.

Looking at SYK's valuation based on adjusted diluted earnings, we see in the FY2021 Guidance section of this post that guidance has been amended a few times this year.

Using the stock price on the date earnings were announced this year and the mid-point of the previous adjusted diluted EPS guidance, we get the following adjusted diluted PE levels.

• January 27, 2021: $9 mid-point, ~$231, forward adjusted diluted PE ~25.7
• April 27, 2021: $9.175 mid-point, ~$265, forward adjusted diluted PE ~28.9
• August 27, 2021: $9.325 mid-point, ~$273, forward adjusted diluted PE ~29.3

For comparison purposes, SYK's adjusted diluted PE levels based on FY2015 - FY2020 adjusted diluted earnings are:

• FY2020: $7.43, ~$231, adjusted diluted PE ~31.1
• FY2019: $8.26, ~$214.90, adjusted diluted PE ~26
• FY2018: $7.31, ~$161, adjusted diluted PE ~22
• FY2017: $6.49, ~$168.75, adjusted diluted PE ~26
• FY2016: $5.80, ~$121.50, adjusted diluted PE ~21
• FY2015: $5.12, ~$96, adjusted diluted PE ~18.75

YTD adjusted diluted EPS is $6.38. Management's FY2021 adjusted diluted EPS guidance is $9.08 to $9.15 ($9.115 mid-point) giving us a forward adjusted valuation of ~29 based on the current ~$264 share price.

In addition, the following are the projected adjusted diluted PE levels based on current FY2021 - FY2023 broker guidance:

• FY2021 - 25 brokers - mean of $9.12 and low/high of $9.08 - $9.20. Using the mean, the forward adjusted diluted PE was ~29.
• FY2022 - 25 brokers - mean of $10.21 and low/high of $9.75 - $10.95. Using the mean, the forward adjusted diluted PE was ~26.
• FY2023 - 20 brokers - mean of $11.32 and low/high of $10.93 - $12.26. Using the mean, the forward adjusted diluted PE was ~23.3.

SYK's valuation on an adjusted basis is not as attractive as in some prior years. This is not surprising given current market conditions.

Stryker - Stock Analysis - Final Thoughts

SYK's business is generally not seasonal. The number of orthopaedic implant surgeries, however, is typically lower in the summer months and sales of capital equipment are generally higher in Q4. In addition, many medical procedures for which SYK products are used are elective (eg. hip, knee and spine) in nature. As a result, its business has been negatively impacted by COVID-19; some medical procedures have not necessarily been cancelled but rather have been postponed until the hospitals have the appropriate resources to perform these procedures.

The current addressable market is more than $70B and is growing mid-single digits; SYK's FY2021 revenue will likely end up at ~$16B so it has ample growth opportunity.

SYK is generating strong FCF and looking at the summary of total debt as of September 30, 2021 (for which a link is provided earlier in this post), it should have no problems meeting these obligations and financing acquisitions to fuel growth.

Despite these 'upsides', current market conditions are such that many companies that appeal to me now have valuations beyond what I consider reasonable; SYK is one such company.

I considered writing $240 January 2022 'put' contracts but decided I do not want to tie up money ($240 x 100 shares x # of put contracts) in the likelihood I have to purchase the shares if the option contracts are exercised; I want to be able to deploy funds as I see fit if we do get a broad market correction.

At this point, I am opting to patiently wait for SYK's FY2021 forward-adjusted diluted PE to retrace to a level below 27. Based on management's guidance, this would result in a share price below $246.

I wish you much success on your journey to financial freedom!

Note: Please send any feedback, corrections, or questions to [email protected].

Disclosure: I am long SYK.

Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.

I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with any company mentioned in this article.