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Stryker Corporation (SYK - Analyst Report) reported adjusted earnings per share of 98 cents in the third quarter of 2013, up 1.0% year over year. However, it missed the Zacks Consensus Estimate by a penny. Adjusted EPS included costs associated with the Medical Device Excise Tax amounting to 3 cents per share. Adjusted net income increased 0.8% to $373 million in the quarter.

However, the Mich.-based orthopedic device major’s reported net income plunged more than 70% to $103 million or 27 cents a share from $353 million or 92 cents per share. This is mainly due to the negative impact of the company’s various product recalls such as the Rejuvenate and ABG II modular-neck hip stems and the Neptune Waste Management System.

Stryker’s third-quarter revenues grew 4.8% to $2,151 million, slightly missing the Zacks Consensus Estimate of $2,158 million. Volume and product mix contributed 7.1% to sales growth while acquisitions contributed 0.7%. This was partly neutralized by unfavorable pricing impact and foreign currency exchange translation of 0.9% and 2.0%, respectively.

On an organic basis (excluding the impact of acquisitions), net revenues grew 6.1% at constant exchange rate (CER), reflecting solid growth across all the business segments. Revenues in the U.S. climbed 6.5% to $1,449 million, while international revenues inched up 1.5% to $702 million and improved 7.5% at CER.

Adjusted gross margin in the third quarter was 68.8% versus 68.2% in the prior-year quarter. Management asserts that the company’s 5-year plan to drive greater operational efficiencies has led to the improvement in margin.

Selling, general and administrative (SG&A) expenses spiked 43.6% to $1,136 million, mainly due to product recalls. On an adjusted basis, SG&A was 38.0% of sales compared with 38.2% in the year-ago quarter. This decline was on account of a distributor transition in Asia. Research, development and engineering expenses also grew 19.3% to $136 million due to increased investment in additional R&D projects and innovation activities.

Adjusted operating margin of 22.8% declined 20 basis points (bps) from the prior-year quarter. This was mainly due to the medical device tax, pricing pressure and higher R&D spending, partially offset by operational efficiency and favorable product mix.

Segments Analysis

Revenues from Stryker’s core Reconstructive unit grew 6.5% (9.2% at CER) to $949 million in the third quarter. In terms of constant currency, hip sales climbed 9.3%, while the knee business inched up 2.1%. The trauma and extremities business continues to post strong results, with revenues soaring 20.4% at CER, led by robust sales of Foot & Ankle offerings along with contributions from new products and sales force expansion.

Revenues from Stryker’s MedSurg segment increased 1.5% (2.6% at CER) to $792 million, boosted by the Endoscopy and Sustainability Solutions franchises. Within MedSurg, Instrument sales dropped 5.5% in the U.S. due to the Neptune recall and difficult year-over-year comparisons, while the same grew 8.3% overseas. Endoscopy sales were up 8.4% at CER whereas Medical revenues inched up only 0.2% in the quarter under review.

Stryker’s Neurotechnology and Spine segment continued its solid growth streak with revenues increasing 7.7% (up 10.0% at CER) to $410 million. Growth was led by Stryker’s IVS and Neurotechnology businesses. Revenues from the Neurotechnology sub-segment climbed 13.9% at CER, while spinal implant sales improved 5.5% in the quarter.

Financial Health

Stryker ended the third quarter with cash and cash equivalents and marketable securities of $5,138 million, up roughly 19.9% from $4,285 million at the end of 2012. Long-term debt jumped 57.1% to $2,743 million as of Sep 30, 2013, from $1,746 million at the end of 2012.

For the first nine months of 2013, SYK generated solid cash from operations of $1,214 million, 14.4% higher than $1,061 million generated in the first nine months of 2012. The company repurchased shares worth $252 million in the first nine months of 2013 under the company’s share repurchase program. Shares worth approximately $750 million are still available for repurchase.

Outlook

Stryker raised its revenue guidance for 2013 driven by solid sales in the first nine months of the year as well as the prevailing market conditions. Constant currency sales growth guidance, excluding acquisitions, has been raised to the range of 4.5% to 5.5% from the earlier band of 4.0% to 5.5%. The company expects foreign currency to hurt sales by roughly 1.5% to 2.0% in the fourth quarter as well as full year 2013.

However, SYK reiterated its projection for adjusted earnings in the range of $4.20 to $4.26 a share for 2013. The current Zacks Consensus Estimate of $4.23 for 2013 lies within the guided range.

Our Take

Stryker’s share price increased 1.4% to $72.55 on Oct 17, following the announcement of the third quarter results. We are encouraged by the recent stability in SYK’s businesses, especially the core reconstructive business.  Moreover, the company’s raised revenue guidance for 2013 reflects management confidence to drive top line growth on the back of a well-diversified product portfolio, increasing footprint in emerging markets and strategic acquisitions.

The company continues to expand its base through acquisitions such as the recently announced decision to takeover MAKO Surgical Corp. . Although expensive, the acquisition of MAKO’s advanced robotic arm technology is expected to benefit Stryker over the long term.

Despite solid top-line growth reported in the third quarter, we are concerned about Stryker’s increasing expenses, largely related to product recalls, which are hampering the company’s margins. The company needs to address these internal issues to avoid additional expenses. Moreover, the company remains challenged by adverse foreign exchange swings, pricing pressure and a stringent hospital capital budget environment.

Stryker currently carries a Zacks Rank #3 (Hold). While we choose to remain on the sidelines regarding SYK, medical products companies such as Resmed, Inc. (RMD - Analyst Report) and Bio-Rad Laboratories, Inc. (BIO - Snapshot Report) are expected to do well. Both these stocks carry a Zacks Rank #1 (Strong Buy).
 

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