Mail Bag: Stryker (SYK)

An Anonymous reader asked in a comment the following question,

“Since you’re in health care what do you think of Stryker…not a dividend monster by any means but maybe some upside soon?”

I actually talked a little about this company in some previous comments, but I can republish them here and go into a little more detail.

For those new to this stock Stryker (SYK) is a healthcare company that develops & manufactures specialty surgical and medical products. Specifically the company’s products are used for orthopaedic implants, bone cement, bone repair related to trauma, powered surgical instruments, endoscopic systems, craniomaxillofacial (jaw) fixation devices and they also provides some outpatient physical and occupational rehabilitation services.

It is a company I’m familiar with both professionally and as a prospective investor, but a stock that I have never owned.

The attraction of late towards this stock by some investors has been three-fold:

• The valuation of the company has fallen in the current market from $70 per share to $40
• The company has a strong history of raising dividends on a regular basis
• It has an established track record of growth in operations, product development & financial strength.

Recently the company has provided their earnings guidance for 2009 which I feel is a little on the ambitious side for a few reasons. I highlighted this as an area of caution in my public comments on the FWF and while I still expect the company to report a profitable 2009 growth is likely to be nearly stagnant considering the economic environment.

A big component of their earnings comes from orthopaedic products and in difficult economic times I look to this segment of the healthcare market as economically sensitive. Orthopedic surgeries are required if life threatening, but the majority are considered elective (non-urgent) and are either paid as out of pocket expenses or through insurance in the US.

A company that you could compare Stryker to in this current market environment might be National Dentex (NADX) which has experienced a more significant fall of their share price. NADX is a much different company since they provide denture products/services to patients as an elective product are not seen as an essential in an environment where budgets are tight. Individual patients who pay out of pocket for their surgery or pay sizeable deductibles may prolong their surgeries due to difficult times. A bad knee, despite the discomfort, may be financial unviable for someone who is on fairly stable financial ground, but is watching their investment portfolio, home value and job stability falling precipitously the past 24 months.

I don’t foresee a massive contraction in sales, but likely sales growth will slow considerably from what the company has achieved during the past 3-5 years. Medical supply/device companies I feel are in a much stronger position would be GE, JNJ, BAX & BDX. With BAX & BDX specifically an investor is getting a lot more secure revenue stream from sales in a depressed market because their products are most often single use items (IV’s, catheters, tubing) and used in significantly higher volumes. The valuations of the companies are not as cheap as other medical supply companies, but their products have what I consider to be perpetual demand in a market where few smaller firms have gained much traction. Elective surgeries, in my opinion, are something I anticipate people putting off for 6-18 months and this has the potential to negatively impact smaller medical device/supply companies over the interim. Stryker has a market capitalization far above smaller companies in its field so there is also the potential for consolidation in the industry as prices of firms with prized intellectual property or developing product streams remain at depressed levels. If you’re an investor who has a long investing horizon (5-10 years) Stryker has an excellent track record of performance, dividend growth and is situated with a market demographic that clearly will have increased demand in the future. I expect sales growth will be in the low single digits rather than the guidance provided by the company of 6-9%.

For almost any healthcare company I own or might consider owning I have a strict requirement: it has to pass a litmus test on the consumer. What I’ve found in my own research and experience is that healthcare companies exposed to markets with uncertain demand can get into a lot of trouble when you least expect it. Companies with a diversified portfolio of products that allow them to meet changing economic conditions are best suited when demand for elective category procedures dries up.

It does appear as if the company is building a base technically at its current valuation, but for the short-term investor I would likely steer clear of the company until the economic environment of 2009/2010 is clearer. I anticipate Stryker’s weaker competitors will come under increasing pressures over the next six months in both sales and costs. While this may impact the earnings of the industry Stryker is the best situated to tread water for the next year or so. There are other ortho-based healthcare companies an investor may want to look at that are more diversified in the elective care space, but the risk reward profile of a company in this market is much higher than I would assign to a larger, more diversified medical supply/device company.

One additional threat that has recently surfaced is the proposed legal action being taken against Stryker and a number of co-defendants.

As always an investor should perform their due diligence. As part of a diversified portfolio of healthcare companies I feel Stryker is a worthwhile addition, but my preference would remain on the larger companies in the space that have more stable access to patient care than expensive elective procedures.