Stryker Corporation. Recommendation. Company Profile SELL. Ticker: SYK Sector: Healthcare Services Industry: Medical Appliances & Equipment

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1 Ticker: SYK Sector: Healthcare Services Industry: Medical Appliances & Equipment Recommendation: SELL Pricing Closing Price $47.93 (09/23/10) 52-wk High $59.72 (03/26/10) 52-wk Low $42.74 (10/06/09) Market Data Market Cap $19.01B Total Assets $4.94B Trading Vol. 2.60M Valuation EPS (ttm) $2.94 P/E (ttm) PEG 1.00 Div Yield 0.90% Profitability & Effectiveness (ttm) ROA 13.08% ROE 18.37% Profit Margin 16.60% Oper Margin 24.41% Gross Margin 68.02% Nicholas Schaefer Stryker Corporation Recommendation SELL Stryker Corporation is an industry leader in the design, manufacture, and sale of medical equipment in the United States and worldwide. With its operations in global markets the firm is also well positioned to capture growth in emerging markets. However, recent regulatory actions and uncertainty regarding healthcare reform in the United States have negatively impacted operations and reduced the firm s outlook going forward. The fund currently holds 700 shares of Stryker equity securities, totaling approximately 3.34 percent of the total portfolio. It is my recommendation that the fund SELL a portion of its position in Stryker, as I feel that the security is overvalued at its current market price of $47.93 per share with a calculated intrinsic value of $ However, due to the aforementioned uncertainty inherent in these predictions, Stryker s strong positive forces for growth, and other professional analysts recommendations, I believe that the fund should continue to hold at least part of its position. Company Profile Founded in 1946 and headquartered in Kalamazoo, Michigan, Stryker Corporation is a leading developer, manufacturer, and marketer of medical equipment. The firm provides a broad range of products, including medical implants, surgical and imaging technologies, and patient handling and emergency medical equipment. Stryker is widely recognized as the industry leader in orthopedic implant technology, with the widest range of orthopedic products available in the world. 1 1 Morningstar

2 Stryker distributes its products on a global scale, servicing markets in over 100 countries through local dealers as well as its 4,100 direct sales personnel. International business accounted for approximately 36 percent of total net sales in fiscal year In late 2009, Stryker completed its acquisitions of OtisMed Corporation, a software technology firm, and Ascent Healthcare Solutions, Inc., a reprocessor of medical devices. 2 Figure 1. Stryker Net Sales by Market Figure 2. Stryker 2009 Net Sales by Market Operating Segments 3 Orthopedic Implants Stryker s orthopedic implant segment offers a wide range of products for use in joint replacement, trauma, craniomaxillofacial, and spinal surgeries. These include surgical implants, bone cement, and bone growth factor. Stryker specializes in products that facilitate minimally invasive procedures, minimize soft-tissue damage and patient discomfort while also significantly 2 Stryker K Annual Report 3 Stryker K Annual Report

3 shortening the recovery period. Implant Systems Stryker s implant sub-segment provides implant products for hip, knee, shoulder, elbow, spinal, and facial surgery. This includes artificial joints for patients who require joint replacement due to arthritis, osteoporosis, other disease, or injury, as well as bearings, pins, liners, resurfacing tools, and plates. Bone Cement Stryker s bone cement sub-segment provides Simplex bone cement, a binding agent used to secure implants and mend fractures. The firm produces a number of Simplex varieties for specialized applications and it remains the most widely used cement in the industry. Bone Growth Factor Stryker s bone growth factor sub-segment provides implants that promote bone and cartilage growth in patients suffering from degenerative skeletal disorders. Medsurg Equipment The Medsurg Equipment segment supplies surgical equipment and navigation systems, endoscopic and communication systems, and patient handling and emergency medical equipment for use in surgical environments. Surgical Equipment and Navigation Systems Stryker s surgical equipment and navigation systems sub-segment provides a wide mix of equipment used in the surgical drilling, burring, rasping, or cutting of bone, wiring or pinning fractures, and preparing hip or knee surfaces for implants. It also provides attachments and cutting accessories. Endoscopic and Communications Systems Stryker s endoscopic and communications systems sub-segment provides medical video-imaging and communications equipment as well as instruments for arthroscopy, general surgery, and urology. This includes video cameras, digital image software, and communication systems to link on and off-site medical professionals. Patient Handling and Emergency Medical Equipment Stryker s patient handling and emergency medical equipment sub-segment provides patient handling equipment such as stretchers, beds and accessories, ambulance cots, and cot-to-ambulance fastening systems used in the transport of patients to and from surgical facilities. In fiscal year 2009, the Orthopedic Implant operating segment accounted for 61 percent of net sales with the remaining 39 percent attributed to the Medsurg Equipment segment.

4 Figure 3. Stryker 2009 Net Sales by Operating Segment Financial Performance 456 Stryker Corporation experienced significant growth over the previous five years, with revenues increasing at an average annual rate of 8.5 percent. Additionally, 2009 gross, operating, and net margins represent increases of 2.7, 3.2, and 2.6 percent, respectively, over those reported in 2005, indicating increasing operational efficiency. The small decrease in return on assets and return on equity over this five year period may be attributed to the company s deleveraging, the onset of a global recession, and uncertainty related to healthcare reform in the key US market. Figure 6. Stryker Annual Financial Results 4 Stryker K Annual Report 5 Stryker 2010 Quarter 2 10 Q Quarterly Report 6 Morningstar

5 Figure 7. Stryker Annual Financial Results Going into fiscal year 2010, Stryker s growth remained low due to the aforementioned factors. Although net income decreased by approximately $3 million in the second quarter of 2010, gross, operating, and net margins increased by 1.65,.69, and.31 percent, respectively, over the first quarter and are up year-over-year. While return on assets and return on equity remained essentially unchanged, the downward pattern of financial leverage was reversed, with an increase of.18 over the five-quarter period. Earnings per share experienced a small decline in quarter two 2010, but remains well above that of the second quarter of the previous year. Figure 4. Stryker Quarterly Financial Results

6 Figure 5. Stryker Quarterly Financial Results Though both the Orthopedic Implant and Medsurg Equipment operating segments saw growth from 2007 to 2009, Medsurg underperformed in 2009, posting a decrease in net sales from the previous year. This was offset by a larger increase in net sales by Orthopedic Implant segment in this same period. Figure 8. Stryker Annual Net Sales by Operating Segment In comparison to its closest competitors, Stryker Corporation has shown middling performance. Styrker is relatively large, with $19.01 in market capitalization and $7.05 billion in revenue, and eclipsed in size only by Medtronic Incorporated. Stryker s gross and operating margins are somewhat low relative to other large cap competitors, but its net margin remains competitive. Similarly, Stryker s return on assets and return on equity ratios fall near the middle when compared to several larger competitors. Overall, it would appear that Medtronic is the industry leader in financial performance. The fact that Stryker and other large firms are able to maintain higher than industry average margins, return on equity, and return on assets indicates that economies of scale likely exist in the medical appliance and equipment industry.

7 Figure 9. Stryker Industry Financial Comparison SYK = Stryker Corporation ZMH = Zimmer Holdings, Inc. SNN = Smith & Nephew PLC ADR MDT = Medtronic, Inc. STJ = St. Jude Medical, Inc. Stock Performance Year-to-date, Stryker stock has realized significant losses of around 10 percent. Despite this poor performance, Stryker managed to outperform its closest competitors with the exception of St. Jude Medical. Relative to the S&P 500, Stryker stock has underperformed since mid-july, though it previously led the index. Stryker has, year-to-date, tracked closely with the Dow Jones US Medical Equipment Industry Index. 7 Figure 10. Stryker 2010 Stock Performance (SYK vs MDT & SNN & ZMH & STJ) 7 Bigcharts.com

8 Figure 11. Stryker 2010 Stock Performance (SYK vs S&P 500 & DJ Industry Index) Stryker Corporation s equity securities currently trade at price/earnings, price/book, price/sales, and price/cash flow multiples that are near the industry average as well as near those of their closest competitors. However, all multiples now fall well below their five-year mean. Such a pattern suggests that the stock could have been previously overvalued and that the subsequent correction brought prices back to more realistic levels. Morningstar places Stryker in the largegrowth style category. 8 Figure 12. Stryker Ratio Comparison 8 Morningstar

9 Figure Morningstar Investment Style: Stryker Positive Forces For Growth 910 High Level of Liquidity and Low Debt Stryker's balance sheet shows that the firm has maintained strong cash reserves, currently $2.96 billion, and a low level of debt. Current, quick, and debt to equity ratios of 5.33, 3.97, and.15, respectively, in the second quarter of 2010 demonstrate that the firm should have no difficulty covering its obligations, both short and long term. This position reduces risk and will allow Stryker to continue its pattern of successful acquisitions, another strength. Growth In Emerging Markets International operations now account for approximately 36 percent of Stryker s net sales. While continuing economic difficulties in developed markets could slow growth in key markets, such as the United States, the firm could utilize its experience and business relationships in emerging markets to benefit from growth in developing economies. Strong Product Pipeline Stryker invests a significant portion of its resources into the development of new medical technologies. In fiscal year 2009, research and development spending totaled $336.2 million, a number bested by only two competitors, Medtronic and St. Jude. In particular, Stryker s development of hip (ADM X3 and Rejuvenate) and knee (OtisMed's customization system) technologies shows promise. Successful Acquisitions Stryker has demonstrated its ability to successfully acquire and integrate smaller companies with potentially profitable patents and research. With its large amount of capital, Stryker has the resources necessary to bring these products to market. Stryker s recent acquisition of Ascent, a leading reprocessor of single use medical instruments, the company aims to provide a way for hospital administrators to lower costs, an important consideration in an increasingly cost conscious health care environment. 9 Morningstar 10 Stryker K Annual Report

10 Negative Forces For Growth 11 Impact of Healthcare Reform A high degree of uncertainty remains regarding the effects of health care reform in the key US market, which accounted for 64% of the firm's net sales in A number of Stryker s major customers, including Medicare and Medicaid, face mounting pressure to implement additional cost containment measures, which will increase price competition. Specifically, the capping of rate reimbursement has the potential to negatively impact suppliers of medical equipment. Regulatory Action The orthopedic medical equipment industry was the target of recent action by the U.S. Department of Justice, which alleged that five leading orthopedic implant manufacturers, including Stryker Corporation, participated in illegal kickback schemes. After settling the cases, the Department of Justice levied large fines and increased monitoring. 12 Additionally, Stryker has received several warning letters from the Food and Drug Administration, since resolved, that pointed to deficiencies in Stryker s manufacturing operations. Although all of these issues have since been settled, increased monitoring by regulatory agencies could increase compliance costs and result in future actions. 13 Valuation To approximate Stryker s intrinsic value per share, the discounted cash flow model was used. RNVS = 3.74% (10.59% %) = 10.04% Utilizing the Capital Asset Pricing Model above, a discount rate of percent was calculated. The risk free rate of 3.74 percent is the mean annual interest rate of US treasury bills going back to 1928, 14 while the market return rate of percent is the average growth rate of the S&P 500 index since While these numbers may fluctuate in the short-term, (S&P 500 and Treasury bill rates are currently depressed) these averages will likely be maintained in the long run. The Beta of.92 represents the average of estimates from Bloomberg, Reuters, Yahoo Finance, Google Finance, AOL Money, and MSN Money. Net income, depreciation, and amortization figures were gathered from the 2009 Stryker 10-K annual report. Average increase in working capital and average capital expenditures represent the mean of these figures for the previous 5 years listed in the 10-K. These averages appear representative, as there are no outliers within the data. 11 Morningstar 12 us attorneys.html 13 Stryker K Annual Report

11 Morningstar analysts forecast average annual growth rates of 12.7, 11, and percent over the next five years while Yahoo Finance forecast an percent growth rate for the same period The average of these projections, 11.8 percent, was utilized in the initial five-year period, with the growth rate lowered by one percent in each subsequent year until reaching a second stage growth rate of 3.42 percent, the historic mean rate of inflation in the US. 18 As a large firm, the growth rate of Stryker s free cash flow should eventually decrease to the rate of inflation as its potential for future growth is diminished due to increasing competition and the maturation of developing markets. The discounted cash flow Model reports an intrinsic value of $41.91 per share. The table below summarizes the sensitivity of this calculation to changes in the discount rate and estimated first and second stage growth rates. At the end of the trading day, Thursday, September 23, 2010, Stryker was priced at $47.93 per share. Based on this model, Stryker Corporation is overvalued at its current price. Figure SYK DCF Valuation Sensitivity Analysis On average, analysts place an outperform recommendation on this equity security and the analyst consensus target price is $57.69 per share. 19 Figure Morningstar Compiled Analyst Opinions Morningstar inflation rates/ Morningstar

12 Appendix A Valuation Calculations

13 Appendix B Stryker 2009 Annual Consolidated Financial Statements Stryker K Annual Report

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