Recommendation: Hold Estimated Fair Value: $48 - $61

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1 Recommendation: Hold Estimated Fair Value: $48 - $61 1. Reasons For Recommendation In my opinion Stryker has received a hold recommendation because while the company and medical device industry as a whole show promise there are also several looming events that could possibly have a negative effect on Stryker s equity value. Stryker manufactures and sells reconstructive medical devices and surgical equipment. Stryker s primary business segment is their reconstructive division which accounts for 45% 1 of their current earnings. Generally elderly people over the age of 65 are the most likely clients of joint reconstructive products. The number of elderly people in America is expected to grow at 3.1% 2 annual compound growth from 2012 to 2017 compared to a compounded overall population growth of only.9%. 2 This along with the fact that the elderly population in the United States has been becoming more active bodes well for increased Reconstructive sales in the United States. Stryker maintains a large product mix offering many different products for many different treatment procedures. This large product mixed is enhanced generally through Stryker s acquisition of smaller healthcare business enterprises. In 2011 Stryker acquired the Neurovascular division of Boston Scientific Corp. and their sales in the Neurovascular field increased by 48.4% from $968 million to $1437 million. 1 I expect Stryker to continue their method of enhancing product mix by strategic acquisitions to boost their sales. By increasing product mix through acquisition, Stryker is able to remain competitive by acquiring proven technologies without the risk of using capital on research and development that proves to be unfruitful. With that being said from 2005 to 2011 Stryker spent on average $ million per year or 5.65% of their annual revenues. 1 The medical device manufacturing industry on average spends around 12% of their annual revenue on research and development. 2 As you can see Stryker spends significantly less than that percentage wise. Beginning in 2014 the Patient Protection and Affordable Care Act will go into effect increasing access to healthcare for millions of Americans. Physician visits are expected to increase by 2.49% compounding growth from 2012 to 2016 with a 6.82 projected growth rate in This increase in the number of insured customers will lead to increased medical procedures and increased product sales for Stryker. Stryker is currently involved in a number of current litigation or litigation that will very likely be forthcoming in the foreseeable future. In June 2012 Stryker recalled both their Rejuvenate and ABGII modular hip implants for metal on metal contact having adverse effects within patient s hip joints. Johnson and Johnson just settled a similar case stemming from a 2005 recall with individual settlements averaging about $250,000 per case. 3 There have been several lawsuits filed against Stryker so far and lawyers are still advertising to new clients affected by faulty hips before they move forward with their litigation. In August 2012 the FDA limited use of Stryker s Wingspan Brain Stent for causing adverse effects in certain stroke patients including new strokes and death. Also in June 2012 Stryker recalled three different Neptune Waste Management Systems after two patients were seriously harmed and one fatality. No litigation has been filed regarding the Wingspan Stent or the Neptune

2 Waste Management System but it is highly likely that civil suits will be filed in the near future seeking damages for liability. Stryker s European sales accounted for 16.64% of their total earnings in Many European countries have been affected by the negative outlook for the European Economy and the mounting debt being accumulated by certain member countries of the EU. This debt crisis I believe will lead to certain socialized healthcare systems being restricted and a decrease in medical device spending throughout Europe. Along with an increased population with health insurance in 2014 there will be a 2.1% 1 medical excise tax levied on all sales of medical devices in the United States. This tax will cut directly into Stryker s profits if there is no restructuring within the company in order to free up capital to pay the additional tax. 2. Company Analysis Stryker has a number of strengths which help them to remain among the market leaders in medical device technology. Stryker maintains a large portfolio of thousands of medical devices and surgical instruments. This enables them to cater to doctors preferences and allows doctors to choose from a wide array of options when doctors are dealing with specific procedures for their patients. Stryker is able to maintain a vertical business model by manufacturing and selling their own products and maintaining contracts with suppliers that ensure their supply of raw materials will not diminish. With Stryker s strengths there are certain weaknesses. On average from 2006 to the present Stryker s net capital expenditures have only been 3.26% 1 of revenue annually. The level of net capital expenditures is the result of Stryker spending on average $622 million or 9.62% of revenue per year on capital expenditures with $278 million or 4.29% of revenue per year on depreciation. 1 This could lead to a need for large future capital expenditures to ensure that Stryker s PP&E is competitive within the industry. Although Stryker s revenue has had supernormal growth within their Neurovascular division the growth in net income from that division is not reflective of the growth in revenue. Stryker must work on making their neurovascular division more efficient in order to maximize net income possible from said division. In a recent analyst meeting Stryker executives stated that they intend to pursue growing operations in China and India. While this is a very viable option to increase revenue and market share Stryker currently does not maintain a strong base of operations in either country. It is very likely that competitors have already set up shop and that may make it difficult for Stryker to gain a foothold in either of these two growing markets. In the upcoming years Stryker will run into many opportunities which must be capitalized on if they are to remain an industry leader. Stryker needs to continue strong sales within the United States especially when The Patient Protection and Affordable Care Act is enacted. The increasing senior population and number of people with healthcare will be able to access markets that were completely untapped by the medical device industry. As previously stated Stryker does not currently have a foot hold in either China or India. If Stryker were able to build operations in either country it would enhance their revenue stream for their Rest of the World segment which accounted for 19.93% of total sales in Both China and India are expected to have higher economic growth then

3 developed countries and with this growth will come increased healthcare for the countries respective populations. Stryker also has a number of obstacles and threats to overcome if they are to remain a viable company with in the medical device industry. As stated in section 1 Stryker is involved in a number of incidents involving recalls which will result in probable litigation. Stryker will also be subject to slowing growth rates in products sales throughout Europe and will also have to account for the Medical Excise tax starting in When examining the multiples for Stryker there are two conclusions that can be made. When looking at the median P/E ratio for the S&P based on Stryker s EPS on can see that from Stryker was significantly overpriced, but beginning in 2008 to the present the P/E multiple shows that Stryker is now only slightly overvalued when compared to the median S&P. On the other hand the segmented EV/ multiples indicate that Stryker is currently fairly valued when compared to its closest competitors on a segment level. 3. Industry Analysis The medical device industry deals in manufacturing and sales of orthopedic reconstructive devices such as hip, knee, and other joint replacements, spinal reconstruction products, neurovascular devices such and brain stents and synthetic dura membranes, medical products including hospital beds and stretchers, surgical instruments, and accessories necessary to perform orthopedic and surgical procedures. The industry is highly competitive as R&D is highly responsible for profits within a company. Companies must continue to remain innovative and maintain state of the art product mixes in order to remain competitive. New technology is being released to the market all the time and at any moment a company s products could become obsolete. This level of competition has led to an industry dominated by several large companies with a very large number of small enterprises looking for a piece of the pie. As with all industries generally these smaller companies are able to be much more innovative then the large corporations, but they lack the resources and market share to profit off of their innovations. This has led to a culture where large corporations while conducting their own R&D also rely on acquisitions of smaller companies and their patent portfolios to stay competitive with their own product mix. As stated earlier the industry as a whole is expected to benefit from The Patient Protection and Affordable Care Act in Revenues are projected to increase and more people in the U.S. are afforded healthcare. In addition to the growth from The Patient Protection and Affordable Care Act all companies within the medical device industry will be affected by the medical excise tax that comes with it. All major industry leaders within the medical device industry are Multinational Enterprises and will thus be exposed to declining sales growth in Europe as mentioned above; however, the affect that will have on a company to company basis will be dependent on the level of market share those respective companies maintain in Europe.

4 Appendix A: Inputs into Discounted Cash Flow Valuation Risk Free Rate 0.61% Default Spread 1.30% Cost of Debt 1.24% Bottom-up beta Bloomberg beta 0.89 Weighted Average MRP 6.60% Cost of Equity (bottom-up) 6.85% Cost of Equity (Bloomberg) 6.59% Weight of debt 80.87% Weight of Equity 91.91% WACC (bottom up) 6.10% WACC (Bloomberg) 6.06% Growth Rate 6.97% *All calculations generated from numbers obtained from Stryker 10-K reports and

5 Appendix B: Inputs Into Valuation Using Multiples Comparable Firms Reconstructive JNJ US Equity ZMH US Equity SN/ LN Equity MedSurg MDT US Equity COV US Equity BDX US Equity Neurovascular/Spinal COV US Equity MDT US Equity STJ US Equity *Source: Bloomberg Historic Multiples P/E multiple TTM SYK S&P *Source: Morningstar 1 Stryker 10-K 2 IBIS World Medical Device Manufacturing Industry Report 3 Settlement Info from Bloomberg.com