We are initiating Stryker (NYSE:SYK) with a hold rating. This is a high-quality company with a solid history of growth, high margins, and stable returns. However, we believe the company is slightly overvalued, and better opportunities exist elsewhere.
We recently wrote about other healthcare companies that seem to be offering better value. Bio-Rad (BIO) offers some stability because of its investment in Sartorius. Thermo Fisher Scientific (TMO) is an equally high-quality company with higher growth but is going through a slump after a post-pandemic increase in revenues.
We will demonstrate why SYK is slightly overvalued, but given its quality measures it does not warrant a sell rating.
Returns on Cash Generating Assets, our take on Cash Flow Returns on Investment have been stable and persistently above its cost of capital. The company is also expected to maintain its growth, margins, and returns going forward.
With a market cap of over $100bn, SYK is a major player in medical technologies. In FY22, 58% of revenues were derived from MedSurg & Neurotechnology, its division that provides caregiving and surgical equipment, and neurotechnology implant products. The remaining 42% of revenues came from its Orthopaedics and Spine segments, and this consists of joint replacement implants.
With 74% of revenues within the US, SYK is less exposed to foreign exchange risk, but we think foreign exchange risk can only be transitory, can go both ways, and will not affect the long-term prospects. If these products are manufactured or raw materials are imported, there are short-term FX risks to the costs of revenue. Additionally, higher labor cost inflation will add to SG&A. A lower pass-through rate will have a negative impact on the margins and profitability.
Over its history, SYK has demonstrated high growth while maintaining margins. Revenues grew 7.8% CAGR over 15 years, while net income over the same period grew by 8.9%.
Not all of this growth has been organic, as the company has been making multiple bolt-on acquisitions along the way. Just over the last five years, it has spent over $10bn, including the acquisition of K2M, Wright Medical Group, and Vocera.
Regardless, the revenue per share has grown from 2008’s $16.5 to $48.8 per share in 2023, about 7.5% CAGR. Shares outstanding have gone down over the same period from 408m to 380m, indicating its acquisitions are cash-financed.
The company’s structure has changed from net cash to net debt position, with EBITDA of 2.37x in FY22. As of 30 June 2023, net debt stood at $11.5bn, a negligible change from FY22. We can take comfort that the interest cover is a very comfortable 13x in 2022.
SYK revenues continued to grow at 11.2% for the second quarter of 2023 to $5.0bn. During and post-pandemic, many companies within this sector saw revenues increase and subsequently stall. The macroeconomic environment remains challenging, and most businesses remain cautious and unwilling to spend until they have more clarity. However, a handful of companies, including SYK have managed to avoid the slump and continue growing. Both segments saw double-digit growth in revenues and are also expected to continue for the remainder of FY23. MedSurg and Neurotechnology net sales grew to $2.9 billion, an increase of 12.2%, and Orthopaedics and Spine net sales came in at $2.1 billion, an increase of 9.9%. Consensus estimates revenue to continue growing at 9.8% for FY23 and 7.2% for FY24, and EPS to grow at 10% per year over the same period.
The Value Drivers
We will now try and identify the value drivers, similar to a DuPont-like breakdown.
Return on Equity = Net Income / Stockholders Equity
This can be broken down further:
ROE = (profit margins) X (asset turnover) X (equity multiplier)
ROE = (net income/revenue) X (revenue/assets) X (assets/equity)
We need to go one step further and add growth to this mix to show how they would interact to create value.
We have already looked at the revenue growth and this leads us to asset turnover. Asset turnover is the ratio of assets required to generate revenues.
We see that asset turnover is falling, indicating that more and more units of assets are required to generate the same amount of revenue. Alternately, the growth in assets is greater than the growth in revenues.
As mentioned earlier, margins are stable. The next step in our assessment process involves combining these together to calculate the Returns On Cash Generating Assets (ROCGA), an equivalent measure of Cash Flow Returns on Investments (CFROI).
Returns On Cash Generating Assets have fallen over the years, mainly due to its acquisitions. However, if we exclude goodwill, Returns On Cash Generating Assets excluding goodwill (ROCGA-X) have remained more stable.
More information on how ROCGA is calculated including gross assets, gross cash, and Cash Flow Returns on Investments can be found in Bartley Madden’s paper “The CFROI Life Cycle“. Bartley Madden has been a significant contributor to the Cash Flow Returns on Investment methodology.
Price to sales and price to earnings have risen significantly over the past few years. We know the company has aspirations to be a larger player in its space. It has doubled revenues over the last 10 years. Some of that growth has been organic, and some via bolt-on acquisitions, all the while keeping margins stable. Growth has been stable (see SYK Financial Report Summary figure above) and that does not seem to be the reason for the valuation ratios creeping up. The company is trading significantly above its historical averages as well as the industry averages on all valuation matrices.
Using forecast FY23, the PE clocks in at 26.8x and PS at 5.2x. These are significantly high and SKY is looking overvalued with too much growth baked into its valuation.
Cash Flow Returns On Investments Valuation
To value a company, we use our affiliate ROCGA Research’s quantitative and systematic Cash Flow Returns On Investments based DCF valuation and modeling tools. The first step involves modeling the company, back-testing the valuation for correlation with the historical share prices, and using that same model to forecast forward.
Value is a function of returns and growth in cash-generating assets. The total value of the company takes into account the present value of existing assets and the present value of growth. The blue band above represents the share price highs and lows for the year, and the orange line is the DCF model-driven historic valuation. The green line is the forecast warranted value derived using the same model along with consensus earnings and default self-sustainable organic growth.
The model shows SYK as being undervalued for the first half and then over the last 8 or so years, the warranted value falls within the share price range. Given the current share price, SYK looks a little too expensive if we project forward to FY23 and FY24.
For the warrant DCF valuation to be close to the current share price of $278, we need to increase growth by an additional 2.3%, from the default of 10.2% to 12.5%. To see any meaningful upside, we need to increase growth to 15%, in our opinion, a little beyond the scope of SYK.
The company is looking overvalued using conventional and systematic Cash Flow Returns On Investments based DCF valuation. However, SYK is a high-quality company with a proven history of strong growth and returns, and the company will generate value over time. Given the company’s strengths, we assign a HOLD rating.