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Knees And Hips -- And Now What?


When John Brown, 70, retires as CEO of Stryker Corp. (SYK) on Jan. 1, he will leave behind a powerhouse company built on weak knees. Over 27 years, Brown racked up average annual earnings growth of 22%. He transformed a $17 million hospital-bed company into a $4 billion provider of artificial joints, implants, and surgical instruments. That earned Stryker the No. 30 spot on last spring's BusinessWeek 50 -- the third year in a row it was recognized as a top-performing company.

With such success, though, come sky-high expectations -- and a steep penalty for slipping. On July 15, the Kalamazoo (Mich.) company reported another strong quarter: 42% higher profits. But sales growth, at 17%, was off a bit. Add to that some lingering nervousness about Brown's looming departure. Many investors, facing a price-earnings ratio of 43 on a stock that had nearly doubled in price in the past 17 months, to $57, figured it was a good time to cash out. In one day, Stryker's stock price fell $8.76, or 16%. In October, Stryker again spooked investors when costs from buying a spinal-device company and delays on a new artificial knee drove down third-quarter earnings by 87%. Today, Stryker shares trade near $44.

The job of filling Brown's shoes -- and calming those nervous investors -- falls to Stephen P. MacMillan. A former pharmaceuticals executive, MacMillan, 41, is betting he can create a new growth engine through biotechnology. He has high hopes for OP-1, a compound for promoting bone growth that Stryker has been developing for two decades. He also plans to continue Brown's strategy of adding products through judicious acquisitions. "To sustain revenues at the $4 billion to $5 billion level, we're going to need more innovation," MacMillan says.

NEW KNEES

Any way you slice it, though, Stryker's pace is certain to slow. It already faces heated competition -- unlike some health-care sectors that can count on high inflation, orthopedics makers rarely see price increases of more than 3% a year. That puts a heavy premium on coming up with new products. Stryker just launched the Triathlon knee, which is more stable and flexible. And it got a big boost starting in 2003 from its revolutionary Trident hip -- a ceramic and titanium joint, priced $300 to $400 above previous products, that could double the life of an implant to 30 years. But now rivals such as Johnson & Johnson's (JNJ) DePuy Inc. unit and Zimmer Holdings Inc. (ZMH) are piling in with their own versions. Stryker's move into biotech will only increase its exposure to powerful rivals. Earnings this year should still rise 27%, to $575 million, according to a Thomson First Call survey of analysts. But 2005 growth is expected to slow to 20%.

MacMillan knows what Stryker is up against. He arrived in June, 2003, from Pharmacia Corp., where he turned around a $2 billion unit that included such underperforming operations as consumer health care and diagnostics. Previously, Mac-Millan spent most of his career at Johnson & Johnson, where he marketed Tylenol and later ran European marketing. That background should come in handy as Stryker appeals more directly to consumers via newspaper and TV ads. It built a campaign for a new ceramic hip around golfer Jack Nicklaus, who got an artificial hip in 1999. "We haven't been taking full advantage of the Stryker brand," Brown says.

Stryker has come a long way from the company founded by a Kalamazoo surgeon in 1941. Dr. Homer Stryker started out selling a bed that made it easier for nurses to turn patients and avoid bedsores. Stryker heirs still hold a controlling 24% stake. Brown, a courtly man with a tinge of his native Tennessee in his voice, was hired in 1977 after the founder's son and president, Lee Stryker, died in a plane crash. Two years later, when Brown took Stryker public, bankers told him it would need at least 20% annual earnings gains to be considered a growth stock. Brown got there with a string of savvy acquisitions. The biggest: the $1.65 billion purchase of Howmedica from Pfizer Inc. (PFE) in 1998.

As Brown moved into each new area, he gave division heads plenty of autonomy -- and incentives. Half to two-thirds of officers' bonuses are tied to their results. "If you don't get your numbers, we may empathize and sympathize -- but you don't get paid," he says. The formula paid handsomely for investors, as Stryker stock returned 928% over the past 10 years, vs. 184% for the Standard & Poor's (MHP) 500-stock index. Brown's own stake is worth about $800 million.

To continue that streak, Stryker is counting on aging baby boomers. Their weekend escapades on basketball courts and ski slopes often result in damaged joints. And as Americans become increasingly obese, their weight strains hips and knees. Selling implants to boomers' parents and grandparents has already won Stryker a 24% share of artificial hips and a 19% share in knees.

Shortly after MacMillan signed on, he and Brown hammered out a transition plan at a pancake house. In 2003, Brown was in charge while MacMillan learned the business. This year, the new guy ran day-to-day operations with Brown's oversight. MacMillan immersed himself in learning the medical-devices business. It hasn't all been lab visits and sales calls. While weighing the purchase of SpineCore Inc., a maker of artificial spinal disks, he donned a surgical mask to observe a trial surgery.

MacMillan cinched that $120 million deal in July, with Brown's backing. MacMillan calls it a research and development investment -- SpineCore's two spine products are still in clinical trials and won't pay off until at least 2008. Stryker's real long-term gamble, though, is OP-1, the growth agent used on traumatic bone breaks that won't heal on their own. Figuring that such substances might one day make current orthopedic implants obsolete, Brown has plowed $300 million into research since 1985. OP-1 is being used in Europe and Asia. In the U.S., the Food & Drug Administration has approved it for limited "humanitarian" uses while trials continue. For now, Stryker's share of bone-growth agents and spinal products is small. Michael F. DeMane, president of Medtronic Inc.'s (MDT) spinal products unit -- which claims nearly half the market -- says Stryker has yet to prove that OP-1 works: "They don't have a product that is a barn burner."

When MacMillan signed up as Brown's successor, he was lured by a lock on the CEO job, of course. But he also has a chance to guide a smaller company to industry leadership. "I look at Stryker as the next J&J," MacMillan says. The trick, he admits, is balancing a vision for Stryker's future while delivering strong profits growth quarter after quarter. Only if he can pull off both will MacMillan deliver on Brown's legacy.

By Kathleen Kerwin in Kalamazoo, Mich., with Michael Arndt in Chicago


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