Stryker: Real Muscle in Orthopedics

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From Standard & Poor's Equity Research

We project 2006 and 2007 EPS, including stock option expense, of $2.02 and $2.43, respectively. Our stock option expense estimate is 10 cents in both years, and we note that the level of estimated stock option expense is modest relative to both the company's orthopedic device peers and our broader medical device coverage universe.

We think free cash flow will approximate $1.06 billion in 2007, rising to $1.22 billion in 2008, and expect that management will continue to pursue niche acquisitions, repurchase stock, and retire debt with some of this capital. Stryker recently boosted its annual cash dividend payment 100%, to 22 cents per share. We believe the company's acquisition strategy will focus on candidates in the $300 million to $500 million range, with a goal of broadening the product portfolio and extending the company's reach into emerging technologies within the reconstructive joint implant and surgical-equipment business areas.

Good Governance

During the third quarter of 2006, Stryker generated operating EPS of 46 cents, vs. 37 cents (including 3 cents for stock option expense) in the prior-year period, which matched Street consensus but was below our 48-cent forecast, largely reflecting weaker-than-expected sales growth within the physical therapy division. However, we were pleased with the performance in the core orthopedics implant segment, which expanded approximately 10% with solid growth across product categories, in our view. Heading into 2007, we think that more favorable unit pricing and opportunities to expand both gross and operating margins will help drive EPS growth of about 20%, above both peers and the S&P 500.

Our 12-month target price of $65 is based primarily on a price-to-earnings growth (PEG) multiple of 1.49 times, assuming three-year EPS growth of 18%, applied to our 2007 EPS estimate of $2.43. This PEG multiple target is a premium to the company's orthopedic-device peers within our analytical coverage universe, which we think is warranted by what we see as the company's higher sustainable reconstruction device growth rate relative to its peers and our belief that Stryker has greater margin expansion opportunities than peers. Our target price represents potential capital appreciation of 20% from recent levels.

In general, we view Stryker's corporate governance policies favorably and believe that the company compares well in this regard relative to its peers. On the positive side, a majority of the board of directors is controlled by independent outsiders, the compensation committee is comprised solely of independent outside directors, the full board of directors is elected annually, corporate governance guidelines are publicly disclosed on the company's Web site, a board-approved CEO succession plan is in place, no poison pill exists, and all stock-based incentive plans have been approved by shareholders. In addition, the company hasn't been the subject of an SEC enforcement action due to stock-option backdating.

Price Pressure

Conversely, some of the issues negatively impacting our view of the company's corporate governance are that Stryker doesn't use performance-based equity awards with specific performance criteria and hurdle rates disclosed, the board is authorized to change its size without shareholder approval, and there's no disclosure of a policy that limits the number of other boards on which directors may serve.

In our view, risks to our recommendation and target price include: lower unit pricing trends in the global reconstructive joint implant markets; an inability to successfully launch new products over the coming three years; increased regulatory scrutiny of product marketing practices within the orthopedic-device industry; and increased willingness among hospital customers to set ceilings on product pricing and to standardize pricing of orthopedic implants and other medical devices.

Gold is senior portfolio group analyst for Standard & Poor's Equity Research.