Shares of Stryker Corp (SYK Quick QuoteSYK - Free Report) fell 3.1% in after-hours trading following the company’s second-quarter 2016 results. The share price decline can be primarily attributed to the company’s soft third-quarter earnings guidance.

Stryker reported adjusted earnings of $1.39 per share, which comfortably beat the Zacks Consensus Estimate by 3 cents and improved 15.8% from the year-ago quarter.

The adjusted earnings figure was also better than management’s guided range. The upside was primarily driven by a 16.8% improvement in sales to almost $2.84 billion, which came in ahead of the Zacks Consensus Estimate of $2.80 billion.

At constant currency (cc), net sales improved 17% from the year-ago quarter, driven by improving volume (up 7.9%) and partially offset by pricing headwinds (down 1.3%). A strong U.S. dollar impacted overall sales by 0.2% in the quarter.
 

Segment Details

Organic sales growth was 6.6% at cc in the quarter, with the U.S. increasing 8.6%, while international posting growth of 2%. Overall, U.S. sales were up 19.2% year over year to $2.04 billion, driven by growth across all segments.

International sales increased 11.7% on a year-over-year basis to $794 million, primarily due to tough comparisons in the emerging markets, particularly in China. Europe reported mid-single-digit growth in the second quarter.

Stryker expects challenges in emerging markets to wane in the back half of 2016. Management expects good performance in Europe, Japan and Australia.

Orthopedic - Sales increased 4.8% at cc to $1.08 billion, driven by a 7.5% rise in Knees sales and 5.6% growth in Trauma & Extremities. Hips sales inched up 1.8% while other sales increased 1.4%.
 

In the U.S. sales increased 5.9%, driven by a 9.5% increase in Trauma and Extremities and a 6.8% growth in Knees. Sales growth was driven by strong performance of 3D printed Tritanium revision cones and cementless knee products. The U.S. Hips business posted low-single-digit growth due to softness in the revision market.

Stryker sold 17 MAKO robots globally during the quarter. The company noted that the order trend is encouraging, driven by expanded indications and the planned launch of the Total Knee system (expected in 2017). Robust procedure growth in both partial knees and hips using MAKO was also encouraging.

MedSurg - Sales surged 34.2% at cc to $1.26 billion. Excluding the impact of acquisitions, MedSurg posted organic growth of 8.5%. Medical, Endoscopy, Instruments and Sustainability sales improved 137.2%, 6.4%, 6.6% and 11.2%, respectively.

In the U.S., MedSurg reported organic growth of 11.1%. Instruments reported solid U.S. growth of 8% with strong performance in power tools business, highlighted by double-digit gains in the company’s Micro Power tools.

Endoscopy continued its momentum with sales growing 10.8% in the U.S., driven by continued success of the 1588 AIM video platform.

Excluding the impact of the Sage and Physio Control acquisitions, Medical reported sales growth of 16.9% in the U.S., driven by robust performance from Power cot products as well as solid performance of the company’s bed business.

Internationally, MedSurg organic sales were down 0.5% in the quarter, reflecting ongoing challenges in China, primarily related to distributor destocking.

Neurotechnology and Spine - Segment sales increased 9% at cc to $500 million, primarily owing to a 14.4% surge in Neurotechnology sales, which include neurovascular, CMF and NSE. Spine sales increased 1% on a year-over-year basis in the reported quarter.

In the U.S., Neurotech sales growth was robust at 15.6%, driven by continued strong demand for neurovascular products, the Trevo stent retriever and Target coil, neuropowered instruments and craniomaxillofacial fixation products.

The U.S. spine business grew 4.8% despite experiencing product supply issues. However, management noted solid demand for its newer 3D printed Tritanium products. Further, Spine's international growth was dampened by product supply issues and continued challenges in China.

Acquisitions Drove Sales

Management noted that the recently closed acquisitions of Sage Products LLC and Physio Control International contributed $240 million to sales in the quarter.    

Sage Products sales increased 9% in the quarter. Sage’s products are complementary to Stryker's portfolio of ICU and MedSurg products, with disposables targeted at reducing never events.

The acquisition also expands Stryker’s hospital product offerings and improves its product mix (single use versus capital products). Management at Stryker believes that Sage’s total addressable market in North America is currently worth $1.4 billion. The company expects double-digit revenue growth in the second half of 2016.

Stryker believes that a newly launched product like AirTap provides significant growth opportunity in the long haul. Management plans to expand manufacturing capacity beginning 2018 to support anticipated growth.

The other completed acquisition – Physio Control – has a dominant position in the development, manufacture and sale of defibrillators and monitors, automated external defibrillators (AEDs), and CPR-assist devices. Per management, on a global basis, Physio-Control's total addressable market is worth approximately $1.7 billion.

The Physio Control acquisition significantly improves Stryker’s product mix as it has an attractive mix of 60% capital and 40% recurring business. Notably, Stryker’s EMS business is almost 100% capital in nature.

Management believes that Physio Control’s expanding product portfolio and new product launches will drive strong sales growth in the long run.

Physio Control’s sales also grew roughly 9% in the quarter. The company now expects high-single-digit growth from the Physio Control business in the second half of 2016.

Margins

Adjusted gross margin contracted 10 basis points (bps) to 66.2%, primarily due to a favorable mix, foreign exchange rate and two-year suspension of medical device tax.

Research and development (R&D) expenses, as a percentage of sales, increased 10 bps to 6.4%.

On the other hand, adjusted selling, general and administrative (SG&A) expenses declined 120 bps to 34.9%, primarily due to leverage from recent acquisitions as well as improving sales mix and operating efficiencies.

Adjusted operating margin expanded 100 bps on a year-over-year basis to 24.8%, on the back of strong top-line growth, a favorable mix and lower SG&A expenses.

Liquidity

Stryker exited second-quarter 2016 with cash and cash equivalents of $3.66 billion as compared with $6.98 billion at the end of first-quarter 2016. Long-term debt (excluding current maturities) was $6.71 billion, flat with the first quarter.

Guidance

For the third quarter of 2016, Stryker expects adjusted earnings in the range of $1.33 to $1.38 per share. An unfavorable foreign exchange rate is expected to impact earnings by 3 cents per share, although it is forecast to have a neutral impact on quarterly sales.

Stryker expects organic sales growth of 6% to 6.5% (up from the earlier guided range of 5.5% to 6.5%) for full-year 2016. Unfavorable foreign exchange is expected to hurt sales by about 1% and have a negative impact of 10–12 cents on full-year 2016.

Moreover, gross margin is expected around 67% for the rest of 2016.

Adjusted net earnings are projected in the range of $5.70 to $5.80 per share compared with the earlier guidance of $5.65 to $5.80.

Stryker expects ongoing challenges in the MedSurg segment in China to continue throughout 2016 as the company strives to solve issues with distributors and drive end customer demand.

Management also expects the product supply headwind in the Spine business to continue affecting sales in the third quarter and start improving from the fourth quarter of 2016.

Our Take

We believe Stryker’s innovative product pipeline will be a key catalyst in the near term. Growing adoption of MAKO will drive sales in the orthopedic and reconstructive surgery market.

Moreover, the acquisitions of Sage Products and Physio Control have significant growth potential in our view. With Sage, the company has the opportunity to expand internationally in markets like Canada, Europe, Japan and Australia; although management believes that the process will take some time.

However, pricing pressure will continue to hurt sales. Moreover, China is expected to remain a challenging market for the company for the rest of 2016. Further, product supply issues are expected to impact the Spine business that can drag down top-line growth in the second half of 2016.

Moreover, intensifying competition is a major headwind. Management did not note any significant change in market share in the second quarter. However, we believe that the growing presence of its peers like Zimmer Biomet (ZBH Quick QuoteZBH - Free Report) and Johnson & Johnson (JNJ Quick QuoteJNJ - Free Report) will curb Stryker’s growth prospects in the near term.

Zacks Rank and Key Picks

Currently, Stryker carries a Zacks Rank #3 (Hold). A better-ranked stock in the medical sector is Boston Scientific (BSX Quick QuoteBSX - Free Report) , which sports a Zacks Rank #1 (Strong Buy).

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