Stryker: A Strong Quarter

Profit growth was robust, but analysts are waiting to see if the orthopedic implant maker can put manufacturing problems to rest

by David Bogoslaw

Nobody will deny that 2007 was a standout year for Stryker Corp. (SYK) -- in terms of earnings growth and its increasing cash hoard -- but some analysts are waiting for two of the company's plants to pass regulatory inspection before turning gung-ho on the stock.

On Jan. 23, the Kalamazoo, Mich.-based manufacturer of orthopedic implants ands surgical equipment reported a nearly 22% increase in fourth-quarter earnings from continuing operations to $276 million, or 66 cents per share, from $228 million, or 55 cents per share, a year ago on an 18.6% jump in worldwide sales to $1.66 billion.

For the full year 2007, earnings from continuing operations rose nearly 28% to $986.7 million, or $2.37 per share, from $771.4 million, or $1.87 per share, in 2006.

Stryker shares traded 2.5% higher to close at $68.35 on Jan. 24.

Last year's profits included a $12.7 million intangible asset impairment recorded in the second quarter, while 2006 earnings included a $52.7 million charge to write off the cost of in-process research and development purchased, the company said in its release.

With an increase in cash of just over $1.0 billion, Stryker ended the year with $2.4 billion on its balance sheet.

"The fact that cash now exceeds $2.4 billion, o $5.72 per Stryker share, in an environment where many companies are leveraged to the hilt is very impressive," said Elliott Leo Schlang, an analyst at Great Lakes Review in Cleveland, Ohio. He has a gradual accumulate rating on the stock and owns shares of the company.

On a Jan. 23 conference call to discuss the latest results, the company said it will continue to be patient in deciding the best use of its cash.

Domestic sales were 17.4% higher in the fourth quarter and up 16.7% for the full year, while international sales rose by 20.2% in the fourth quarter and 16.3% for 2007 due to higher shipments in both of the company's segments. Foreign currency comparisons to the dollar added $55.9 million to international sales in the fourth quarter and $131.5 million to international sales for the full year.

Worldwide sales of orthopedic implants climbed 16.5% to $971.5 million in the fourth quarter and rose nearly 15% to $3.57 billion for the full year thanks to higher shipments of reconstructive hip, knee and shoulder implants, as well as trauma, spinal and craniomaxillofacial implants and bone cement.

In Stryker's MedSurg equipment segment, worldwide sales were up 21% to $686.6 million in the fourth quarter and up 19% to $2.43 billion for the full year. Driving the gains were on higher shipments of surgical equipment, surgical navigation systems, endoscopic, communications and digital imaging systems, as well as patient handling and emergency medical equipment.

Despite the potential for more pricing pressure in certain markets, Stryker expects net earnings from continuing operations to grow by 20% to roughly $2.88 per share in 2008. Net sales are projected to be 11% to 13% higher in constant currency terms as a result of higher shipments of orthopaedic implants and MedSurg equipment. If foreign currency exchange rates hold near current levels, Stryker expects them to boost net sales by 2.5% to 3% in the first quarter and by about 1% to 1.5% for all of 2008.

Acceleration of hip growth was likely powered by the launch of the Cormet Hip Resurfacing System, although Stryker didn't break out its contribution to revenue, analyst Mark Mullikin wrote in a Piper Jaffray & Co research note on Jan. 24.

"Even a modest contribution of $5 million from Cormet would imply that underlying hip replacement growth in the U.S. continues to lag the market in the mid-single digits," he wrote.

Mullikin, who has a neutral rating on the stock, predicts that the orthopedic knee implants will benefit from two product launches under the Triathlon brand in 2008, but said he expects the sales force to be stretched by efforts to roll out all three products at the same time. (Piper Jaffray does and seeks to do business with the companies covered in its research reports.)

During the conference call, CEO Stephen MacMillan said the company "will invest in and enhance our quality and compliance systems, which is likely to slow down the pace of gross margin expansion this year.

After receiving two warning letters last year from the U.S. Food & Drug Administration pointing out quality and safety violations at a manufacturing plant in New Jersey and another one in Ireland, Stryker said it has corrected the violations and is waiting for the FDA to reinspect the two sites.

To motivate management to work resolve quality control deficiencies and achieve world-class systems, Stryker will link 25% of each senior executive's and division president's annual bonus to this issue, MacMillan said on the conference call. He said he doesn't anticipate any further recalls any time soon.

But analyst Ed Shenkan at Needham & Co. said he remains cautious about the stock due to expected disruptions in its orthopedic business as the company takes a potential revenue hit from the hip recall and warning letters from the Food and Drug Administration. Shenkan believes knee revenues may also be hurt by the hip recall given that the same sales people sell hips and knees, he wrote in a Jan. 24 note. He said he expects the sales people to spend a disproportionate amount of time on hips addressing the recalls and warning letters with physicians until the issue is resolved.

Shenkan, who has a hold rating on the stock, warned that pricing pressure in the reconstructive implant market is likely to continue. Until recently, a positive reimbursement environment for the company's hip and knee implants has enabled Stryker to raise prices for many of its implants by 4% to 5% per year. But now that insurance companies have imposed cost reductions across orthopedic products, it may cause prices for orthopedic products to stay flat or to decline, the Needham note said.

Bogoslaw is a reporter for BusinessWeek's Investing channel .