Spruce Point Capital Management Announces Investment Opinion: Releases Report and Strong Sell Research Opinion on Stryker Corp. (NYSE: SYK)
NOTE TO EDITORS: The Following Is an Investment Opinion Issued by
Highlights Evidence That
Evidence Suggests That Stryker Is Caught in a Massive Margin and Cash Flow Squeeze, as a Result of Its Product Portfolio Falling in Deflationary Categories, Cost Inflation Pressures and a Multi-Year Failure to Rationalize Its Supply Chain, Manufacturing and Operational Footprint
Highlights Growing Competitive Pressures Resulting in Steep Price Concessions and Financial Reporting Anomalies with Stryker's Once-Flourishing Mako Robotics Franchise
Finds Evidence That Stryker Has Failed to Disclose Inventory Accounting Challenges and Made Various Changes to Accounting Policies Designed to Flatter Its Performance, Using Greater Non-GAAP Adjustments to Portray Margin Stability and Earnings Growth
Spruce Point Report Overview
Founded in 1946 by Dr.
Despite growing reputational issues at the Company, Stryker’s shareholders have enjoyed an impressive ride through a debt-fueled acquisition binge since the Great Financial Crisis. Since 2009, Stryker's shares are up ~550%, not including reinvested dividends. In 2009, Stryker had just
Stryker has a history of overpaying for subpar acquisitions, which see growth targets stall and delayed cost integrations. Spruce Point interviewed a former Stryker M&A professional and learned that Stryker’s acquisition spree is now working against it. The opinions we heard include: “I believe we overpay,” “target prices tend to go up when they hear Stryker is looking at them,” and “we’ve experienced some challenges where we significantly overpaid, which caused a negative mark on our report card.” Based on our review, we believe Stryker’s most recent billion-dollar closed deals such as
Wright Medical Group("Wright") and K2M Group("K2M") have had materially lower growth than initially projected by Stryker. Stryker claimed it would postpone large acquisitions for a period after closing the Wright deal, but then closed Vocera Communicationsfor $3.2 billion. Spruce Point finds significant issues with many of Stryker's recent large and “tuck-in” acquisitions, including issues such as revenue misreporting, suspect inventory step-up accounting and a failure to continue reporting deal ROIC expectations. We note that Stryker revalued Wright's inventory five times, and a “Critical Audit Matter” was issued related to management’s judgement for Wright’s profit margins. In relation to K2M, Stryker’s own auditor issued a qualified opinion related to $30 millionof K2M’s acquired foreign inventory. Notably, K2M’s management had been involved in a prior accounting scandal related to inventory accounting weaknesses at inPhonic Inc.
Years of bloated costs and failure to rationalize operations has led to a current margin and cash flow squeeze. Spruce Point has learned that Stryker was challenged by inventory accounting and excess inventory issues pre-COVID-19. Stryker did not preemptively warn investors that 50% of its sales were tied to elective procedures and it was hit particularly hard during COVID-19. Stryker worked down inventory and claims its inventory turns have improved. However, based on our analysis, which adjusts for reclassified loaner equipment, we see no improvements. Stryker has made subtle changes to its inventory accounting method, which we believe is likely boosting margins. As a whole, Stryker has been reporting growth in Non-GAAP earnings and stability in margins. However, Non-GAAP results are diverging at a greater rate from GAAP results. Stryker’s operating cash flow is not growing, it has suspended stock repurchases to conserve cash, and deferred capital spending to boost short-term free cash flow. We expect free cash flow to remain pressured as cost inflation and mismanaged supply chains hit margins. Stryker failed to properly unite more than 40 technology systems through an impaired
$500 millionERP project. As one former employee told us, the ERP has to be completed or “there's no way the company can survive.”
Stryker has severely downplayed competitive threats to Mako Surgical ("Mako"), a rare growth spot in its portfolio. Stryker was an early mover in robotic-assisted knee surgeries with its
$1.6 billionacquisition of Mako in 2013. After early integration challenges, Stryker experienced a growth period from 2017-2019 with total knee surgeries. After 2019, Stryker ceased providing quarterly information on Mako and never provided clear revenue or margin reporting with the business. We now find historical anomalies with Mako unit reporting. Based on discussions with former Mako employees, we estimate the business generates up to $1.2 billionof revenue for Stryker. However, we learned that with the emergence of new competitors such as Zimmer Biomet ("Zimmer") (2019) and J&J VELYS (2021), the dynamics have markedly changed. Zimmer offers “placement deals” for its ROSA® robotic system at no upfront cost in exchange for long-term commitments to purchase joints. To compete, Stryker has responded with a Joint Value program containing substantial discounts to Mako’s list value. We also learned that pressures are continuing, as evidenced by Mako cutting prices by up to 30% in 2022.
- A growing misalignment between insiders and shareholders. Despite overwhelming evidence that Stryker is systematically overpaying for acquisitions and failing to achieve stated targets while experiencing growing financial pressures, management’s compensation appears immune. In 2020, Stryker executives received an arbitrary 55% “upward adjustment” to their bonus calculation, reaping a payout 75% of target. Although COVID-19 threw a curveball at the overall business, management was still rewarded for things we believe it could control and objectively failed at. Notably, “functional goals” included successful integration of acquisitions and leadership toward the Company's cost transformation plan. We have strong evidence management failed to integrate Mobius Imaging according to plan, and its impairment of the ERP was a major step back toward cost transformation. Stryker’s Compensation Committee Chair failed to stand for re-election in 2021, and Stryker hired a new compensation consultant for the first time in five years. Management earned record compensation in 2021 and some members including the CFO even received “off cycle” Restricted Stock Units ("RSUs") for “retention purposes.” Is the CFO at greater risk of departing? It appears that even the Stryker family may not believe in the Company's prospects. Throughout the years, the Stryker family has been a consistent seller of stock. The family’s total stock sales increased by 33% in 2021.
We conservatively estimate 35% - 75% downside risk to Stryker’s share price. Stryker commands the highest valuation in the medical products industry, but we believe its multiple should compress as its size and leverage now inhibits its acquisition strategy where 60%+ of its capital is deployed. We highlight that during its
November 2021Analyst Day, Stryker modified its written “Long-term sustainable financial growth” to qualify for “adjusted” EPS growth and weakened its wording of EBIT improvement over the next five years. Stryker’s product portfolio is deflationary, and the Company is exposed to inflationary input costs that are forcing gross margin pressures. Stryker can no longer ignore these issues. We believe investors should penalize Stryker for its delays in right-sizing its operational footprint which are amplifying its problems. We believe Stryker is more levered and expensive than it appears. We discount Stryker’s dubious “Non-GAAP” add-backs to EBITDA such as acquisition, integration and product recall costs. These are real costs attributable to Stryker’s roll-up strategy and management’s blunders. Furthermore, taking into account the recent Vocera Communicationsdeal, and adjusting for other “hidden” forms of debt such as tax interest penalties and unfunded employee compensation programs, we estimate Stryker is levered at total debt to EBITDA of 4.9x. Sell-side analysts are resoundingly bullish on Stryker, but with an average analyst price target of $282, we view the implied 5% upside as a poor risk / reward. We value Stryker at 6.5x, 35x, and 43x 2022E sales, EBITDA and operating cash flow, but if it traded at multiples closer to industry peers, we believe its share price would be more fairly valued at $67.00- $174.50per share or 35% to 75% downside.
Please note that the items summarized in this press release are expanded upon and supported with data, public filings and records, and images in Spruce Point’s full report. As a reminder, our full report, along with its investment disclaimers, can be downloaded and viewed at www.SprucePointCap.com.
As disclosed, Spruce Point has a short position in
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