Stryker Should Benefit From Continued Robust Procedure Volume

Senior Equity Analyst

Debbie Wang

Revenue segments as reported by the company.

MedSurg and Neurotechnology

Orthopaedics and Spine

Orthopaedics

MedSurg

Neurotechnology and Spine

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Stryker remains a top-tier competitor in a number of attractive medical markets, including orthopedic implants, surgical instruments, endoscopy, and neurovascular devices. It enjoys a long record of innovation in its key markets, and we anticipate the pattern will continue, allowing the wide-moat company to earn attractive economic profits. 

In contrast to rival Zimmer Biomet, Stryker has diversified itself and eased its earlier reliance on large joint reconstruction. The benefit of this strategy became clear as the Great Recession pushed the orthopedic market into slow-growth mode, demonstrating that the historically recession-resistant business was indeed vulnerable when many uneasy patients deferred elective procedures. Stryker is also relatively less vulnerable to the increased pricing pressure on hips and knees. We have always liked Stryker's presence in the medical-surgical equipment area, as it offers a measure of stabilization and diminishes the impact of periodic economic downturns. The varied product lines also mean Stryker has more opportunities to engineer meaningful innovation, which is critical to gaining pricing advantages. Stryker continues to pursue its strategy of augmenting internal innovation with acquisitions of specific technology, including Patient Safety Technologies, Sage, Mako, and Vocera. This fits into the firm's larger goal of partnering more closely with its hospital customers across multiple device and equipment categories.

While we see few opportunities for optimizing synergistic innovation across Stryker's divergent business segments, the extensive breadth of products should, nonetheless, serve Stryker well as hospital customers seek to consolidate suppliers in order to take advantage of volume discounts. Moreover, Stryker management has demonstrated an acute understanding of new opportunities for medtech competitors that have arisen thanks to the shift toward value-based reimbursement that has put pressure on providers. We anticipate Stryker will continue to make strategic acquisitions of technology and products that aim to avoid complications or reduce costs.

Business Strategy & Outlook

Stryker enjoys a wide economic moat thanks to its competitive advantages across its key businesses. We think the orthopedic segment remains Stryker's moatiest division because of significant switching costs for surgeons, who are still influential decision-makers for implant brand choice. Because the extensive tools used to prepare bones and install implants are not standardized and differ by company, there is a long learning curve to become proficient in using a company's instrumentation. Moreover, relative to other specialists, an orthopedic surgeon's skill and experience can play an outsize role in the clinical outcome for the patient. These factors leave surgeons reluctant to train and master multiple instrumentation systems, especially if procedure volume is too low to maintain high surgical facility with more than one system. Surgeons' preferences for certain vendors can stretch back to their days in residency training. Research has found that surgeons stick with their preferred vendors and sales reps beyond 15 years and use that vendor for approximately 95% of their orthopedic procedures during that time. Switching to another instrumentation system would require taking time out for training, developing a relationship with a new sales rep, and working less efficiently during the early period of mastering another vendor's tools, possibly raising clinical risks for the patient and reducing the number of procedures (and income for the surgeon). This dynamic explains why market share among the four top orthopedic implant makers has remained remarkably steady. Over the past decade, Stryker's market share in knee implants has hovered around 24%, and Zimmer Biomet and DePuy have held share at 33% and 20%, respectively, by our estimates. The most common avenue to significant and durable share gain has been through acquisition. 

The relationship between Stryker sales rep and surgeon is an intangible asset that contributes to the firm's maintainable competitive advantage. More so than with any other medical device or equipment, orthopedic sales reps play a critical role for the surgeons. The sales rep is present for every procedure, teaches the surgeon how to use each tool in the kit, and prepares selection of instrumentation in all the right sizes and sequence for the procedure. For most orthopedic surgeons, who may perform 30-40 hip replacements and 60-70 knee replacements in a year, sales reps provide a valuable service. For the small group of high-volume surgeons, who may be performing five knee replacements in a day, there is less need for any training by the sales rep and the surgeon may wish to hire a nurse who can handle the procedure preparation. However, these high-volume surgeons remain a minority. 

While Stryker's other businesses are not quite as moaty as orthopedics, the firm does enjoy maintainable advantages there too. In particular, Stryker's intellectual property keeps new entrants out and competitors at bay. The firm owns roughly 5,800 patents around the globe and acts assertively to enforce them. Following changes to patent law introduced in 2012, the U.S. has switched to a first-inventor-to-file system from what had been a first-to-invent system. We think this change favors the moats of the larger competitors such as Stryker. The new system rewards those companies that file in the most timely manner, with the most comprehensive understanding of the future application of such technology, and those with deep pockets to oppose newly granted patents to rivals. In the end, we think the legal changes will translate into more challenges to patents. Firms like Stryker, which can support a large legal team, will be in a better position to take advantage of the new law. Conversely, the new law erects hurdles that keep emerging upstart firms from becoming serious threats to Stryker and its peers.

In terms of environmental, social, and governance issues, Sustainalytics pegs Stryker as high risk, driven primarily by product governance and quality risk. While we agree that there is a modest level of ongoing exposure to defective products and associated legal settlements can be somewhat material, we have yet to see any recall or product defects permanently impair Stryker's competitive advantage or return on invested capital.

For example, Stryker's recall of its metal-on-metal hips remains the firm's largest-scale recall and cost an estimated $1.7 billion in expenses spread over several years to provide medical care and settle with patients. First, the cost of this debacle barely put a dent in Stryker's returns on invested capital, which remained more than 3 times the weighted average cost of capital during that period. Second, that episode did nothing to turn orthopedic surgeons away from Stryker's other products. As the recall unfolded, Stryker saw a low-single-digit decline in its hip revenue for one single year. In other years since 2012, the firm has maintained positive growth that, over the long term, has generally matched the hip market. We think this historical instance underscores the strength of the switching costs that supports Stryker's wide economic moat. Surgeons trained on Stryker instrumentation are extremely reluctant to switch. Additionally, the product cycles are fast enough that Stryker can make relatively easy adjustments to the product or simply pivot to a previous generation of technology that has already been proved on the quality front.

Wide

Economic Moat

Stryker

MAKO was a publicly traded medical device company based in Florida. On September 25, 2013, the Board of Directors of Mako Surgical accepted a deal to be acquired by Stryker for $1.65B. The deal closed in December 2013. The company manufactures and markets surgical robotic arm assistance platforms, most notably the RIO as well as orthopedic implants used by orthopedic surgeons for use in partial knee and total hip arthroplasty. They are known for their intellectual property of devices and have over 300 U.S. and foreign patents and patent applications.

MAKO Surgical Corp

Stryker Corp. is a medical technology company, which engages in the provision of products and services that help improve patient and healthcare outcomes. It operates under the MedSurg and Neurotechnology, and Orthopaedics and Spine segments. The MedSurg and Neurotechnology segment includes surgical equipment and navigation systems, endoscopic and communications systems, patient handling, emergency medical equipment, intensive care disposable products, clinical communication, workflow solutions, products for the treatment of acute ischemic and hemorrhagic stroke, traditional brain, and open skull based surgical procedures, orthobiologic, and biosurgery. The Orthopaedics and Spine segment focuses on implants used in hip and knee joint replacements and trauma and extremity surgeries, and cervical, thoracolumbar, and interbody systems used in spinal injury, deformity, and degenerative therapies. The company was founded by Homer H. Stryker in 1941 and is headquartered in Portage, MI.

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