Stryker ( SYK - Get Report) shares slipped 3% after the orthopedic device maker posted a disappointing third quarter. The company saw third-quarter revenue jump by 14% to $1.17 billion and operating profit, excluding special items, climb 21% to $163 million, or 40 cents a share. Wall Street was looking for revenue of $1.19 billion and profits of 41 cents. Stryker also posted an 11% rise in orthopedic implant sales that fell short of some analyst expectations. The company pledged to deliver the 20% profit growth that Wall Street expects next year. However, the company confessed that a "much tougher price environment" for orthopedic implants -- with prices falling as much as 2% -- could make things tougher than usual. "Is it going to be harder? Yes," said CEO Stephen MacMillan. "It's going to stretch us and push us more." The company's stock, which jumped as much as 2.1% ahead of the report, dropped 3.2% to $45 in after-hours trading. By now, of course, investors have grown increasingly skittish about the orthopedic device group. They have seen five companies -- including Biomet ( BMET), Smith & Nephew ( SNN) and Wright Medical ( WMGI - Get Report) -- either release disappointing results or warn that they are coming. Moreover, they have listened to industry leader Zimmer ( ZMH) become more and more vocal about pricing pressures and slowing growth for the future. Leerink Swann analyst Jason Wittes suggested on Monday that the bad news would not necessarily end there. "Since our downgrade in early February of 2005, valuations and multiples have come down and are approaching our targets," said Wittes, who has a market-perform rating on the sector. "But we remain cautious on the orthopedic group ... particularly as we are still in the early innings of a changing environment and we expect revisions to 2006 earnings." In the meantime, Wittes felt that Stryker would fall slightly short of third-quarter expectations. He figured the company would need strong results from its MedSurg unit to offset weakness in its orthopedics division, just as it did one quarter earlier. The MedSurg unit did, in fact, come through with a powerful 21% jump in third-quarter sales. Baird analyst Suey Wong offered a similar forecast. In general, he said, Stryker's MedSurg division "continues to drive the company's overall business with solid results coming from all three of MedSurg's major segments." He predicted that Stryker would post an 18% jump in MedSurg sales compared to a smaller 13% increase in its orthopedics business. There, he was looking for a "generally healthy" knee market to drive solid midteens growth while expressing more caution about the tougher hip market for now.
Wong predicted stronger gains outside of Stryker's crucial orthopedics division. Specifically, he forecasted rapid growth from the company's endoscopy unit -- where sales have soared by at least 19% for eight quarters in a row -- and similar results from the medical unit despite the mature nature of the products that it sells. Stryker said Tuesday that endoscopy and medical division sales each jumped at least 20%. Regardless, both analysts remain heavily focused on challenges facing the orthopedics business instead. As a result, both remain generally cautious on the sector overall. During the second quarter, Wittes noted, signs of a slowdown in orthopedic pricing clearly began to surface. During the third quarter, he predicted, evidence should have become more pronounced. By now, he added, both Smith & Nephew and Wright Medical have specifically warned of slowdowns in their hip and knee businesses for the most recent period. In addition, he said, Zimmer has gone on to suggest that expectations for the company's top-line growth -- currently at 12% -- have got to come down. Wong highlighted some of those same developments when forecasting "less-than-stellar" third-quarter results and the potential for lowered guidance from the group. Already, he pointed out, both Stryker and Zimmer have seen domestic price increases for orthopedic implants fall to between 1% and 2% in recent quarters. For the third quarter, he suggested, both companies could report the same -- or even smaller -- gains. And looking ahead, he predicted, they will likely face continued pressure both inside and outside of the country. "All in all, it appears as if industry-wide pricing gains in the U.S. of approximately zero to 2% are the most likely scenario over coming quarters," Wong wrote. And "it appears as if Japan is once again planning to significantly cut medical device reimbursement rates for a two-year period beginning April 2006, so additional pricing pressures could impact our companies in Q2-06 and beyond."
Wong foresees other challenges as well. For one thing, he worries that "gain-sharing" -- which could lead surgeons to select cheaper orthopedic implants -- is gaining more congressional support. For another, he continues to voice concern about a sweeping government investigation of the industry. As a result, Wong finds himself willing to recommend only Wright Medical -- a stock that has really been hammered -- in the orthopedic space. "We believe most of the downside risk in this name has been removed ... (and) patient investors willing to act contrary to the current overwhelmingly negative sentiment in this name will be rewarded over the next 12 to 18 months," he explained. But "we still don't believe it's quite time yet to step in on most names" in the group.