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Company: Stryker Corporation. Industry: Medical products. Ticker: SYK US ADV 3m: $233 million. Market cap: $76.8 billion. Float: 86.4%. Stock price: $205.17

Recent days have been rich in new elements around our Stryker thesis. In a week, Stryker investors have seen the release of disappointing quarterly earnings, its CEO abruptly selling more than a third of its stake, the announcement of another outsized acquisition at twice the market rate, the company dropping its margin growth outlook, and two credit rating agencies placing the name on negative watch.

On Tuesday 29-Oct-2019, Stryker reported after-hour its Q3 results (link), with topline growing 10% per annum but GAAP EPS missing Street estimates by -26%. Reported EPS came at 1.23/sh while the Street expected 1.662/sh.

No surprise to our readers, the GAAP-to-non-GAAP reconciliation showed that 24% of the non-GAAP EPS went into merger expenses (0.06/sh), legal settlements (0.11/sh), restructuring expenses (0.11/sh) and others including income tax charges (0.12/sh). As previously written, it is our opinion that Stryker actual profitability is structurally lower than the non-GAAP EPS attempts to display. Both equity investors and creditors fail to take into account this structural drag on profitability.

Missing in action too is an allegedly undisclosed ongoing SEC investigation. Probes Reporter reported on 10-Oct-2019 (link) that "on-going enforcement proceedings [were] confirmed on appeal two times since, most recently on 5-Sep-2019. This suggests there is another SEC investigation of the company that remains undisclosed.". "5-Sep-2019 Appeal Response Two-part appeal response: Existence of on-going SEC enforcement proceedings officially confirmed on appeal". Our reader may recall the "horrible record of disclosing SEC investigations" highlighted in our first piece.

Sell-side regularly praises management for merger execution skills to justify Stryker trading at a premium to peers. Yet, the K2M integration pace was disappointing. Analyst at Piper Jaffray Matt O'Brien noted that the "slower ramp up of K2M as the salesforce integration has been more challenging than expected". In a dramatic preview of Monday release, Bloomberg's Jason McGorman reiterated that "Stryker's ability to support organic growth through recent M&A [remains] underappreciated".

The 30-Oct-2019 earning call was uneventful. On Thursday 31-Oct-2019, a new SEC Form 4 (link) disclosed that CEO Kevin Lobo sold 19,286 shares of SYK for a market value of approximatively $4.1 million. The sale is a drastic reduction of nearly 40% of his stake. Kevin Lobo still controls 31,002 shares of the company as per the filing.

We won't speculate on the reason for the sale, and acknowledge they are generally for tax purpose. However, our reader may be familiar with CEO compensation structure discussed in previous post (link) and equity investors shall take note of the obvious increase in sensitivity of CEO to the top line growth at the detriment of his sensitivity to the share price.

With that in mind, our astute reader may not be surprised by Monday 4-Nov-2019 announcement. Pre-market, Stryker announced the acquisition of Wright Medicals (ticker: WMGI) for $30.75/sh in cash per share, a 50.6% premium to WMGI prior close. The deal sets WMGI at a $5.4b entreprise value and $4.7b equity value. For context, this sets WMGI at 48.8x transaction value / EBITDA or more than twice the comp median transaction value of at 17.3x. Stryker is paying 5.3x 2020 sales vs. a 4.7x average for similar deals — a comp metric already distorted by Stryker previous acquisition of Mako at 9.4x.

What have Stryker shareholders received for this $5.4b transaction ? $2.85b of Stryker market capitalization were erased on the announcement.

The deal will have a 10-cent dilutive EPS impact in fiscal 2021. Stryker expects the deal to be accretive after, but this optimistically assumes that "WMGI current salesforce disruptions in foot and ankle, where it has low-single-digit organic growth, are only short-term and will resolve fairly soon.".

During the call following announcement (link), Morgan Stanley's analyst David Ryan Lewis took note that "Wright struggled […] with both sales attrition as well as their Cartiva product". Sales synergies were not obvious either: "One of the things that happened right last quarter which is losing some sales people in lower extremities. And so now as you're combining these 2 companies, how do you prevent that from happening further, given the uncertainty now that this introduces into the business?"

Because of the WMGI acquisition, Stryker also dropped its goal of 30-50 bps of annual operating margin improvement. Quoting Stryker's CFO: "we don't expect that we will have 30 to 50 basis points of op margin expansion in 2020 or 2021". In the past, Stryker had always maintained this target despite other acquisitions.

The WMGI deal will likely face review from the Federal Trade Commission, and sell-side analysts now expect Stryker to be forced to divest for antitrust reason: Stryker and Wright both offer foot and ankle products, each having a 22% market share.

Three days later, analysts were far less enthusiastic about the underappreciation of Stryker merger skills.

Quoting Jason McGorman again: "Stryker's recent delays integrating its $1.3 billion acquisition of spinal-implant maker K2M may be a bit concerning, now that the company announced a $5.4 billion purchase of extremities-implant maker Wright Medical. Both deals come with the risk of salesforce defections to competitors, but the Wright acquisition could face a lengthy antitrust review and more sales disruptions than expected."

When WMGI announced it was considering a sale, Smith & Nephew (ticker: SN/ LN) appeared a more logical acquirer. But SN's incoming CEO Roland Diggelmann "may have a low appetite for such a rival bid, given a low long-term EPS boost and return on capital below 5%". Needham's analyst Michael Matson still believes in a competing bid.

We would not hold our breath, but an anxious reader may consider hedging Stryker short term upside risk of an unlikely competing bid by buying some WMGI. WMGI closed at 29.04/sh. or a 5.89% discount to Stryker offer of $30.75/sh.

JP Morgan and Guggenheim Capital are both acting as advisers for WMGI. Stryker's advisers are unknown. In our initiation piece, we had pointed how sell-side analysts were often reluctant to downgrade a serial acquirer. What happens to sell side recommendations when the prospect of advisory and structuring fees is drying out in the near future ? JP Morgan's analyst Robert Justin Marcus asked for all: "I was wondering how this deal impacts your M&A strategy going forward? Does this still leave you the opportunity to do continued deals here? Or is this set for the foreseeable future?". To all M&A departments disappointment, only small deals are on the table: "So with this deal, we still have the capacity to continue to do tuck-in deals even as we delever following the acquisition."

Which leads us to credit. Stryker CFO confirmed during the call that "the transaction will be financed with a combination of newly issued debt and some available cash that we have on the balance sheet.".

The mix between debt and cash is not yet known, but Kevin Lobo seems aware of credit rating pressure: "Obviously, there will be a majority of newly issued debt and some available cash that we'll use for the deal. In terms of deleveraging, we see that our debt-to-adjusted-EBITDA will probably peak at 3.0 in 2020, and then we'll have a plan to bring that down, and we're actively in discussions with the credit rating agencies for that to share that plan with them."

Our reader may recall the initiation report pointing to a higher leverage. Pre-deal, we wrote: "actual leverage of the company appears closer to 2.7x and there are substantial chances of an impending credit rating downgrade to A- or lower medium grade."

Yesterday 4-Nov, both S&P and Moody's placed Stryker on a negative watch.

Quoting S&P: "The incremental debt will drive leverage well over 2x in 2020 and 2021. We are placing our ratings on Stryker, including our 'A' issuer credit rating and 'A-1' commercial paper rating, on CreditWatch with negative implications. The CreditWatch placement reflects our view that the size and timing of the transaction may indicate a more aggressive financial policy than we expected. We will meet with Stryker's management to further clarify the company's acquisition strategy, leverage target, and debt reduction plans. Should we conclude that Stryker's financial policy has become more aggressive and the company is unlikely to maintain long-term leverage ratio below 2x, we may lower our ratings on the company, its debt, and its commercial paper."

And Moody's (link): "Moody's Investors Service ("Moody's") placed the Baa1 senior unsecured ratings of Stryker Corporation ("Stryker") under review for downgrade." "The review for downgrade reflects higher financial leverage resulting from the acquisition. Moody's estimates that pro forma debt/EBITDA will rise from approximately 2.3x to approximately 3.5 times based on financials for the twelve months ended September 30, 2019. The review for downgrade also reflects the potential for integration risk and the company's apparently increasing acquisition appetite. This transaction follows several other acquisitions over the past two years totaling more than $2.5 billion."

Since our 27-Aug initiation report, Stryker is down -5.88% while the S&P500 went up +7.64%, or a -13.52% underperformance.

We maintain our target price of 162/sh. (-21%), with a bull case at 227/sh. (+10%) and a bear case at 130/sh. (-36%).

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