Will Reform Weigh on Medical Device Firms?

Kobayashi-Solomon: So, it sounds like there's a big training component. In other words, for a surgeon to get comfortable with the techniques and with the equipment, is that right?

Stralow: Definitely. It takes a long time to become an expert in those procedures. And when you're considering switching some of those variables, that would take a lot of time out of your practice, maybe. A lot of surgeons aren't willing to shut that stream off and learn a different tool set.

So, it's a very sticky relationship once you get proficient in a particular supplier's tools set.

Kobayashi-Solomon: But one of the things that I'm worried about is recently hospital capex [capital expenditures] has been falling. Some of the hospital companies, like Tenet THC, have been really struggling to make ends meet. I think they've been cutting back on capital expenditures. We talked about this a little bit with Intuitive Surgical ISRG.

How large of a threat do you think this slowdown in capex spending on the hospital side is to a main beneficiary of this capital spending, which is Stryker?

Stralow: If people aren't aware, Stryker gets about 40% of its sales from a segment other than orthopedic implants. They are orthopedic surgical tools and endoscopic tools and also some medical beds and stretchers. So, that is a big part of their business.

A lot of it is related to orthopedic procedures, but some of it's not. And when you talk about capex spending especially, they haven't seen a lot of delays in, for example, the stretcher business and in the medical bed business. That's really been slowing down a lot of Stryker's sales in the first half of the year.

The nice thing that we've been seeing is that the slowdown in capital spending has really come to maybe a stabilization point.

Kobayashi-Solomon: Kind of a bottoming out.

Stralow: Kind of bottoming. I hate to say that it's absolutely the bottom, because you never know what's going to happen in the next few months. But it seems like we're getting to the point where some momentum might shift in the other direction. At the end of this year, we're going to have some pretty easy comparables. And in the beginning of 2010, the same thing.

So, if they can get some growth re-ignition in those businesses, things might look a lot better for Stryker's top-line growth. We think there's actually some catalysts our there in the hospital spending front.

So, yes, it's been painful, the past half a year since the end of '08, but I think that can actually provide an opportunity for long-term investors.

Kobayashi-Solomon: The other big risk that I see in Stryker, and that I talk about in the piece, is the present administration's new health-care plans, and a lot of the uncertainty about this.

Let's just perform a thought experiment.

Stralow: OK. [laughs]

Kobayashi-Solomon: Monday morning, we wake up and suddenly the U.S. health-care system looks like Sweden's, and the government mandates what charges medical providers can make, controls every aspect of the medical provision industry. What happens to Stryker in this worst-case scenario?

Stralow: Right now, Medicare is heavily involved in paying for orthopedic procedures, but there is a very profitable chunk that is provided by private payers. It is more profitable for hospitals to do a private paid insurance procedure than a Medicare procedure.

So if, for example, a public health insurance option came into effect, and all those people who are on private insurance plans moved over to the public plan, you've got to think that the Medicare pricing for these procedures would probably come into effect more than they have been in the past.

Kobayashi-Solomon: So, you might see a drop in profitability.

Stralow: For the hospitals, sure. And I do think if that happens, there would be some pushback on suppliers like Stryker. So, the profitability of the procedures goes down, and they might want to have, say, a bigger discount on the devices. So, I think that is actually the biggest concern that I have.

While I think volume growth will remain strong, there could be some pricing pressure. So far, pricing pressure has been alleviated by new product introduction and mixed benefits. But, in a reform scenario, our worst case scenario is that stops and that pricing actually becomes a major detriment to these companies.

However, we've done some scenario analysis, and we've looked at these worst case scenarios. And even in those worst case scenarios, they're higher than where Stryker's price is trading at right now.

So, we really think that long-term investors, if they can get over this uncertainty, could make a great return on investment with Stryker shares.

Kobayashi-Solomon: Julie, thanks very much for coming in and chatting with us today about this.

Stralow: No, problem, Erik. It's a pleasure.

Kobayashi-Solomon: And thank you all for watching today. I'm Erik Kobayashi-Solomon, co-editor of Morningstar OptionInvestor. Please stop by the OptionInvestor site, where we publish regular option investment strategies based on Morningstar's fundamental research.