Stryker Corporation (SYK) Q1 2016 Earnings Report, Transcript and Summary

Welcome to the First Quarter 2016 Stryker Earnings Call. My name is Liz and I will be your operator for today's call. [Operator Instructions]. Before we begin, I would like to remind you that the discussions during this conference call will include forward-looking statements. Factors that could cause actual results to differ materially are discussed in the Company's most recent filings with the SEC. Also, the discussions will include certain non-GAAP financial measures. Reconciliations to the most directly comparable GAAP financial measures can be found in today's press release that is an exhibit to Stryker's current report on Form 8-K filed today with SEC. I will now turn the call over to Mr. Kevin Lobo, Chairman and Chief Executive Officer. You may proceed, sir.

Welcome to Stryker's first quarter earnings call. Joining me today are Glenn Boehnlein, who assumed the role of CFO effective April 1, and Katherine Owen, VP of Strategy and Investor Relations. For today's call, I will provide opening comments, followed by an M&A update from Katherine. Glenn will then provide additional details regarding our quarterly results before we open the call to Q&A. We're pleased with our start to the year, as Q1 organic sales growth of 6.1% came in above our expectations, with strong performances across all three segments: Orthopedics, MedSurg and neurotechnology and spine. The performance was led by continued new product introductions and strong sales and marketing execution. Geographically, Q1 was powered by ongoing momentum in the U.S., with sales growth of 8.9%. As expected, growth was challenged outside the U.S., given the tough year-over-year comparisons in emerging markets, where growth started to slow in the second quarter of last year. Challenges still exist in emerging markets, although the year-over-year impact should ease in the back half of the year. We continue to have good performance in Europe, Japan and Australia. Our strategy of business unit specialization with dedicated sales forces, marketing and R&D continue to be a differentiating factor in the sustainability of our above-market growth. Consistent R&D investment has generated strong internal product pipelines across the Company and we continue to augment them with acquisitions. We're thrilled to welcome Sage, Physio-Control and Synergistics to Stryker and believe that the addition of these companies will further strengthen our businesses. Looking at the P&L, we're building on 2015's success and delivered solid adjusted earnings growth of 11.7%, despite modest foreign currency headwinds. This improvement stemmed from the strong top-line and year-over-year gross margin expansion. Importantly, we continue to invest heavily in R&D in both absolute dollars and as a percent of sales. Our cost transformation for growth efforts are in the early stages and are multiyear nature and we're starting to realize benefits. Overall, we're confident in our stated goal of achieving sales at the high end of medtech, with ongoing earnings leverage and believe our Q1 results position us well for 2016. I will now turn the call over to Katherine.

Thanks, Kevin. My comments today will focus on providing an update on MAKO along with the two larger M&A deals we recently closed on, Sage and Physio-Control. With respect to MAKO, we sold seven robots during the quarter globally which is in line with the same period a year ago. As many of you know, capital sales tend to be the strongest in the fourth quarter and also can fluctuate from quarter to quarter. We're highly encouraged by order trends which reinforces the growing interest and demand for the MAKO robotic system, fueled by the expanded indications and planned launch of the Total Knee system, where we continue to target full commercial rollout in 2017. There is no change to our launch plans for the Total Knee which will focus throughout 2016 on working with key opinion leaders to optimize the training protocol and gather observational data that will help to frame the anticipated benefits, all of which will ensure a strong podium presence at key orthopedic meetings as we move throughout 2017. In Q1, we're also encouraged by the robust procedure growth in both partial knees and hips using MAKO. Turning to the recent M&A activity, in early April, we closed on both Sage and Physio-Control which will be integrated into our medical division. Starting with Sage, our focus will be to ensure the continuation of strong double-digit top-line growth that the Company has had a long history of achieving. With their market-leading product portfolio, focus on clinically supported innovation, product ease-of-use and strong sales support, we believe Sage can continue to drive both market expansion and share gain in the prevention of hospital-acquired conditions. Given our existing global footprint which includes strong and broad sales and marketing support, we believe that over time, Stryker can help drive adoption of the Sage portfolio outside the U.S., where revenue to date is limited as the Company had historically focused its investment in the U.S. market. Regarding Physio-Control, we believe we have significant opportunities over time to drive both sales and earning synergies, given our combined presence in the pre-hospital setting. In the near term, both businesses will operate largely independently, with a focus on their respective 2016 target and planned key new product launches. Importantly for both Sage and Physio-Control, we have identified and put in place a highly experienced integration team which, given our BD history, should help ensure a smooth integration. As we move through the first 12 months post closing of both Sage and Physio-Control, we will provide you with the pro forma quarterly growth rates for each to help provide visibility regarding our execution and their top-line contribution. There is no change to our previously announced expected accretion from both these transactions to adjusted EPS in 2016 and 2017 of $0.07 and $0.15 to $0.18, respectively. With that, I will now turn the call over to Glenn.

Thanks, Katherine. My comments on today's call will focus on the financial results and key drivers of our first quarter performance. Our detailed financial results have been provided in the various schedules included in today's press release. As to our overall performance, our constant currency organic sales growth of 6.1% exceeded the high end of our full-year expectations and came in better than our expectations at the start of the quarter. The growth, based on the same number of selling days, reflected strong U.S. volume and mix of 10.2%, marginally offset by pricing which was slightly negative, at 1.3%. Adjusted EPS of $1.24 increased 11.7% from 2015, primarily driven by our strong top-line growth and favorable margin performance. Foreign exchange unfavorably impacted EPS by $0.02 per share, roughly in line with our guidance. Looking at our segment highlights orthopedics' constant currency growth was 4.6% which was led by U.S. orthopedics growth of 7.9%, reflecting continued strong sales in our trauma and extremity business which grew 11% and a 9% increase in knees, reflecting continued momentum from our last quarter and the success of our Triathlon products, driven by our Tritanium revision cones, our cementless knee products, as well as new customer adoption of our MAKO [indiscernible] platform. We're now seeing an acceleration in our revision implant sales, where previously our market share lagged our overall total knee share. Partly offsetting the strong U.S. orthopedic performance was the continued challenging markets in China and Brazil which contributed to the negative 1.4% constant currency decline in international. Overall, our first quarter results continue to reflect strong momentum across our orthopedics portfolio. Our MedSurg segment, with constant currency growth of 4.6%, also demonstrated strong momentum, with U.S. growth of 7.6%. Instruments had solid U.S. growth of 10.2%, with good performance in their waste management products. Endoscopy's new 1588 camera which features enhanced visualization that broadens the applicable surgical applications, was a primary driver for the division's solid performance and will continue to be a growth engine in 2016. Lastly, medicals growth which was up against a tough year-over-year comparable, benefited from strong demand for its market-leading stretcher and ambulance cot products which underscored the strength of its portfolio and the overall health and stability of hospital capital budgets that we're seeing in the market. As with orthopedics, MedSurg also experienced challenges in emerging markets, primarily China. We expect this to continue as we work through our distributors to drive demand and reduce the buildup of their inventories, recognizing comparisons will also ease as we move through 2016. All in all, our MedSurg businesses saw healthy order growth in the first quarter and should be well positioned to continue their momentum. Turning to neurotechnology and spine, the impressive year-end momentum achieved by this group continued in the first quarter, with 13.1% constant currency growth. Neurotechnology's 21% growth was highlighted by the developing market for device-based treatment of ischemic stroke. While there's still considerable market development required, we're highly encouraged by the potential for this segment and our Trevo stent retriever technology. As one of two major stent retrievers on the market, combined with compelling clinical data underscoring the efficacy of these devices, such as the MR CLEAN study, Stryker is well positioned for growth in neurovascular. We also continue to see excellent performance in our neuro-powered instruments business, led by strong growth in their signature drill products released last year. We also are encouraged by the solid showing up for spine, up 5.8% in the U.S. as new product launches, including a limiting launch of our 3D-printed interbody device, are clearly having an impact. Neurotechnology and spine continue to benefit from a new product pipeline resulting from robust R&D investment over the past few years. I will now focus on our first quarter operating highlights, starting with gross margin which on an adjusted basis increased 240 basis points to 68%. Of this improvement, roughly a quarter relates to the two-year suspension of the medical device tax, while the remainder reflects a favorable mix and favorable foreign exchange, partly offset by negative pricing. As for our operating expenses, we continue to focus on internal innovation, with R&D at 6.4% of sales which is in line with our overall target spend. On an adjusted basis, SG&A increased to 37.4% of sales versus 35.9% in the prior period which was driven by increased selling activity, anticipated spending related to our new ERP deployment efforts and reinvestment of the medical device tax. Looking ahead, we expect SG&A on a full-year basis to be comparable to 2015. Overall, our operating margin increased 90 basis points, reflecting solid top-line growth and favorable mix and gross margins, offset slightly by higher SG&A for the quarter. Lastly, some financial highlights on the other income and expense. Other expenses increased due to higher net interest expense related to increased borrowings during the quarter, primarily to fund our recently completed Sage and Physio-Control acquisitions. Net interest expense will continue to be higher than Q1, as our borrowing incurred at the end of Q1. Our first quarter adjusted effective tax rate of 17.4% reflects the benefits of our global tax structure and the permanent renewal of certain tax extenders which was included in our guidance. Moving onto the balance sheet, we continue to maintain a strong balance sheet, with $7.5 billion of cash and marketable securities, of which approximately 17.2% was held in the U.S. This balance reflects $3.5 billion of proceeds related to our previously mentioned debt offering which is included in the $7.5 billion of debt on the balance sheet at the end of the quarter. Subsequent to the end of the quarter, $4.1 billion of cash was used to fund the Sage and Physio-Control acquisitions. Turning to cash flow, our cash flow from operations for 2015 was $2 billion compared to $4 billion last year, as we made $0.1 billion of payments associated with our rejuvenated and AVG II recall. Approximately 50% of the funding for the Rejuvenate liability is being sourced from O-U.S. cash. Finally, as we have previously announced, we have suspended our share repurchases for the remainder of the year. With that, I will move on to our guidance. Based on our first quarter performance, we now expect our full-year organic sales growth to be in the range of 5.5% to 6.5% for 2016. If foreign currency exchange rates hold near current levels, we anticipate net sales will be negatively impacted by approximately 1% for 2016. We also expect continued unfavorable price reductions in the range of 1.5% to 2%, consistent with the pricing environment we experienced in 2015. Finally, our guidance for adjusted net earnings per diluted share in 2016 now stands in the range of $5.65 to $5.80 for the full year and $1.33 to $1.38 for the second quarter. Now I will open up the call for Q&A.

[Operator Instructions]. Your first call comes from the line of David Lewis with Morgan Stanley. You may proceed.

So a couple of questions, Kevin just first off, just talk about the guidance. Obviously, the quarter was strong and it's a little early in the year, obviously, to raising your organic sales estimate, so obviously you have some conviction in the back half. As I think about the back half of the year, obviously medical comparables are going to get a little easier, emerging markets pressure should also ease. Is there anything else that you see in the business broadly across Stryker that is giving you the confidence in the raise to the organic sales guidance heading into the back half of the year?

I would say that I feel very good about the strength of our entire business portfolio. So if you look at MedSurg, you look at neurotechnology and even orthopedics, I really feel like we have balanced strength across our portfolio and that balanced strength is what gives us the confidence, even after the first quarter, to raise our organic sales guidance. So we had indicated previously that the first quarter would likely be closer to the 5% range and we exceeded that. And obviously, the emerging market comps will also ease as we get into the back half. So we're feeling very good about our position as we exit the first quarter and obviously feel confident about raising our organic sales guidance.

Okay. Maybe just two quick follow-ups, maybe, for Katherine, one, I know obviously the neuro number was very strong in the quarter. There's a lot of focus on stent retriever, but can you just give us a sense, Katherine, where you stand on pipeline opportunities within neuro, specifically interventional neuro? And secondarily, is there any reason to believe MAKO capital sales get harder into the full knee launch that could be sort of a delayed effect until people see the full evidence and software in the back half of the year? Or based on order patterns, you remain pretty comfortable? Thank you.

Yes. So within neuro tech, the bulk of the revenue is still from the hemorrhagic side and we continue to launch next generation of the coils, different sizes, different shapes and continue to launch into additional geographies. And we're the market leader in that segment of the market. We do have a flow diverter on the market outside the U.S. It's in clinical in the U.S. We're probably still a year or two before U.S. market launch of that product, but that will clearly be an important product launch, given that they have captured a portion of the coil market where they are applicable. And then continuing to invest in ischemic stroke, although candidly a lot of what's going to have to happen over the next few years in the ischemic segment has more to do with market development, as Glenn mentioned in his comments. On MAKO, nothing that I would bring up to suggest that placements will get harder and if anything, the economic and value proposition associated with the robot as we move toward full commercial launch of the Total Knee indication only gets greater. So we expect to see continued strong demand. As we've talked about, this year is really focused on training. So that's going to be to ensure an optimal rollout and to make sure the initial user experience is as positive as it can be, but we would assume continued momentum. And as I mentioned, we're really pleased with incoming order trends.

Your next call comes from the line of Mike Weinstein with JPMorgan. You may proceed.

A couple quick questions, there were two things that probably surprised us in the quarter. One would have obviously been the gross margin which was well above expectations and recent trends. And I was hoping you could spend a minute on why that was. And then second is just the sustainability of the growth we're seeing in the neurovascular business. We showed no signs of slowing at the U.S. international this quarter. And rather than same development trends from 2015 on the back of the data and the guideline changes, anything else you could add would be helpful.

Sure. Mike, I will start off with the neurovascular and then I will turn it over to Glenn for the gross margin. So certainly, the ischemic market, it's a new market and there obviously are many strokes that hadn't been treated prior. I kind of think this a little bit like the foot and ankle market, you are creating a new market. And when you create a new market, it's difficult to predict the pace of growth, but there's no doubt that the growth will be very significant and that was clearly the biggest contributor to the strong performance in neurovascular but equally pleased with the performance of our neuro-powered instruments which are having fantastic growth. Very strong double-digit growth with our signature drills which compete with one of the other major players. And we're taking significant market share with those products as well as our Sonopet product. So very strong performance, both in neurovascular as well as the neuro-powered instruments and even our craniomaxillofacial business, the third of our neuro businesses, is enjoying double-digit growth. So across the neuro portfolio, we're really performing very well. I will turn it to Glenn for gross margin.

Yes, I think if you look at our gross margin, we really benefited from a positive mix relative to U.S. and international. And then even relative to newer products over some of our older products, if you look at the 1588 and the signature drills that were sold, those sell at largely premiums. And then finally, we also continue to see sort of our stalwart product, knees, trauma, our ischemic stroke and coil products continue to sell fairly robustly, too which help lift the overall margin up.

And price was also more moderate than we've seen in the past.

Right. Glenn, it also looked like your inventories were up a lot this quarter from the end of the year. Any expectation on those trending down? So what I'm asking is any of the uptick in gross margin here one time or do you want us to view it as sustainable?

No, I think the inventories up were just -- it's reflecting what we're planning for the rest of the year in making sure that we're able to satisfy customers. And as far as the gross margin goes, we expect that we will continue to see this kind of trend throughout the year.

Your next call comes from the line of Bob Hopkins with Bank of America. You may proceed.

So the first question I wanted to ask is on the business outside the United States. Specifically, could you comment a little bit on the performance of your knee business outside the United States which was the one slightly weak spot within the ortho business? And then also, Kevin, I was wondering if you could just comment on Europe broadly from a capital equipment perspective because we've seen some other healthcare companies that sell capital equipment into Europe talk about a tough environment. I was wondering if you could just offer a broad comment on Europe from a capital equipment perspective and then also on the O-U.S. knee business. Thank you.

Sure, Bob. So on both businesses, I would tell you we don't have significant businesses, as you probably know. In capital equipment in Europe, our market share is quite low. And even for knees, if you look at last year, we had a pretty good comp. We had a plus-5% in knee. And quarter to quarter, given that we don't have very large businesses for both capital equipment in Europe and knees, we do tend to see fluctuations. So I would call this sort of the normal fluctuations that we get quarter to quarter. And we're not really seeing a lot of difficulty with capital equipment. That market for us in Europe, given that the bulk of our capital is not the large capital, we're not really seeing any new pressures. And we see the Europe market as being fairly healthy, at least for our businesses. Keep in mind, though, that we do have very low market shares and we have significant room to grow within both Europe as well as O-U.S. knees.

And then on emerging markets, I think the last couple of quarters, the business has been, as you expected, down about mid-single digits. Was that the same sort of growth rate that you saw this particular quarter? And can you just give us a little more color on the math and rationale for the expectation that perhaps in the back half, things get a little bit better?

So Bob, the emerging markets actually was -- the decrease was even more pronounced in the first quarter, so it was negative high-single digits in the first quarter. And that didn't surprise us because we had a very strong first quarter last year. Things really started to tail off starting in the second quarter last year. So that really contributed to the softness in our international sales was the negative growth in emerging markets and we do see that starting to taper and obviously the comps will ease as well. Inventory bleeds will eventually bleed out. It's hard to predict exactly when, but as I stated I think on our last call, we expect around midyear would be sort of the bottoming out period and we should start to see improvements in the second half of the year.

Your next call comes from the line of Rick Wise with Stifel. You may proceed.

Kevin, you've been very pointed in focusing us on the potential for more operating leverage in the P&L. We saw it this quarter with 90 basis points of positive leverage. When I look back at the last couple of years, you've had a couple of quarters where we have seen 100 basis points year-over-year improvement, but then it's not sustained. How do we think about this performance in the first quarter? Is it sustainable, is there more to come and is that the right way to think about the 2016, 2017 direction in terms of driving leverage?

I would tell you that if you look at our earnings guidance, it's pretty clear that we're driving leverage. So we've updated both our top-line guidance. We've also updated our bottom-line guidance. And this is the third time since the beginning of the year that we've raised our earnings guidance and we won't be able to deliver that type of earning guidance unless we drive operating leverage. So I'm not going to promise that is going to be 90 basis points every single quarter, but we're committed to driving leverage at the operating income level. And you will see that this year and you'll see that when we provide guidance for you in 2017.

And just following up on the knee performance which was really excellent clearly, I know there are multiple pieces here, Triathlon is doing well, revision. Maybe remind us of your current mix of revision versus primary knee, that mix. How does it differ from industry averages or aspirational norms? And is the story in knees, at least in part, the new products you showed us at AOS are going to drive us toward those norms? Or how should we think about it? Thank you.

Sure, yes. There are multiple factors that contribute to the knee performance. We had a great fourth quarter, with around 9% growth in the U.S. and another 9% in the first quarter. And certainly revision is part of it. And we've launched these new 3D-printed cones in the middle of last year and cones are a very important part of the procedure. They don't generate huge revenue by themselves, but you get the pull-through of the implant when you use the cones. Our market share was roughly 6 share points below what it was in primary knees and revision. So we did sell in the revision market, but we didn't maintain the same level of market share that we do with our primary knees, roughly 6 points. So we're really excited about being able to gain those 6 points back and then potentially even grow beyond that. Because we really believe we now have the best-in-class cones for revision procedures. We also have cementless knees which is growing and that is through a launch of our 3D-printed Tritanium baseplate. The baseplate portion of our knee system, that's a second factor. A third factor is really great sales force execution. Marketing programs and sales force execution. So it's hard for me to describe which of those three is the greater. I would say all three contributed to a very strong showing in knees and it's the second quarter in a row. And I really believe we're building momentum and that will continue to perform well in knees through the course of the year.

Your next call comes from the line of David Roman with Goldman Sachs. You may proceed.

I was hoping you could talk about the trauma business in the U.S. and Kevin, that's a franchise that you have mentioned in a couple different public settings that you weren't convinced that you could necessarily outgrow the market to the extent to which you have over the past several quarters. But that does look like it is continuing here, especially in the U.S. Can you maybe just help us think through some of the drivers that are supporting the sustainability of growth in that franchise? And how we should evaluate that on a go-forward basis?

Look, I'm thrilled with the performance of our trauma business and it's been a multiyear success story. We posted this plus-11% against a comp of plus-18% in the prior period, so we really are clicking on all cylinders within our trauma portfolio. It took us years to build out our portfolio, frankly, on the plating side of the business. We've always been strong in nails and then of course the launching of our foot and ankle business was tremendous a few years ago and that continues to grow above the overall trauma growth rate. It was midteens growth again this quarter. And very strong performance from the STAR Ankle as well, so I would say it's rounding out our portfolio and then terrific sales force execution. And again, it's been a three-year story. My only caution on trauma is really being able to maintain 15%, 16% growth quarter after quarter for years is just challenging. The law of numbers at some point you would think would start to catch up with you and just moderate the growth rate. But I have every confidence we will continue to grow above market and we demonstrated that most likely in the first quarter. Of course, not everybody has reported yet, but we feel that's a very strong showing.

Maybe just a follow-up on the cash flow side for Glenn, if I look at the operating cash flow and free cash flow numbers that you've disclosed for the quarter, it looks like quite a bit of capital deployed toward operating items and you are not converting all that much of your net income to free cash flow. Are there any one-time factors that may have negatively influenced Q1 that would reverse themselves through the balance of the year, whereby you can start growing cash flow in line with adjusted net income?

Yes, the biggest thing that we really we can't necessarily control the timing of is really the Rejuvenate payments that we made related to the recall. So we made a payment of $0.1 billion in Q1 and don't expect that based on what we've seen in the past that that could necessarily repeat itself throughout the year.

Your next call comes from the line of Richard Newitter with Leerink Partners. You may proceed.

I was hoping start off with spine. Kevin, can you give us any color on -- you've had two quarters now or three quarters of improving growth there above the market. I know you have some new product launches and a nice pipeline and that is I'm sure helping. Can you break out for us at all is the acceleration that carried over into the first quarter volume related, mix related? Are you getting share or is it just purely you have new products and you are getting premium pricing?

I would say it's mostly volume. There is obviously some mix when you launch innovative products. We just had a limited launch of our 3D-printed interbody device and we're getting fantastic feedback on that. And that obviously sells at a price premium. So there is a mix of components as well, but I would say it's mostly volume. And it is volume coming from the products that most of which we launched last year. We launched a slew of new products and those are being well adopted in the marketplace. I would say price continues to be pressured. Spine is the most pressured pricing division within Stryker and we believe that our price is roughly in line with the market. So the fact that we're growing above market now I think is four quarters in a row is really driven by a renewed focus on launching products and having great sales force execution. So I believe we will have another strong year just like we did last year in spine in 2016.

Okay. And then just one more on bundled payments. It's officially kicked off now that we're in April. Just wondering if you had any updates on ways or areas where you are working with or partnering with hospitals or how you are leveraging something that is unique about what Stryker can do in terms of partnering? Is there anything that you are doing more aggressively or hearing from customers that is resonating or allowing you to potentially differentiate and gain share with this new dynamic that's playing out in the market? Thanks.

Sure. So we have a division within Stryker called Stryker Performance Solution which has consulted with over 100 hospitals the past three years to improve service line performance, including areas directly impacted by bundled payments. So through these engagements, we've developed deep insight into the profitability and opportunities that hospitals have within orthopedics. We were also granted convener status by CMS last year as part of the bundled payment BPCI program. And we're actively taking risk with five institutions across multiple hospitals on the payment bundling, managing over $55 million in episode spend. With CJR, third parties like us are not allowed to operate as a convener anymore with the Medicare program. But our Stryker Performance Solution is still providing consulting services to hospitals to help them address the challenges of managing the bundle. So we have a lot of experience. We're continuing to help and consult with our customers. And what I tell you is the initial focus is really much more on the post-acute care. That's where the majority of the cost of the procedure is and the biggest opportunity in the short term is addressing post-acute care. But having this division which is headquartered in Chicago, has been a key asset for us. We have a lot of insights into the economics of the orthopedic service line and how to help our customers address this new world.

Your next call comes from the line of Matt Taylor with Barclays. You may proceed.

I was wondering in the last couple quarters, you've actually had better pricing or less declines. Has there been any change in the market where you would really call a trend, whether it is consolidation or new products broadly that have helped on price?

Yes, I would say obviously pricing is still negative. It is modestly less negative coming in at 1.3%, but we're still very close to the 1.5% to 2% range. So we wouldn't call out anything significant that is indicative of a change in the overall pricing dynamic. Typically consolidation helps, but again it's still negative. We have seen it vary quarter to quarter. Sometimes it's trended above. Fortunately, more recently, it's been trending on the lower end. I would say the outlook seems very stable and really no new dynamics that we see putting further pressure on pricing.

The other thing people talk about with CCJR is just more procedures moving to outpatient or just getting people out in the hospital quicker or moving to lower acuity settings. So I guess you mentioned your consulting division, but how else are you positioning yourself or is your product portfolio positioned to capture that trend or be competitors in that kind of vector?

I really think the way we're best positioned to help our customers is going to be through some of the insights that we've had, having this division now for a number of years within Stryker and understanding the economics. And the focus on post-acute care, given that eats up the bulk of the cost when you are looking at an episode of care. So we're able to work with them in that regard. But I wouldn't say there is a unique product offering that facilitates or is advantageous in the post-acute setting, if I'm understanding the question correctly.

Your next call comes from the line of Matthew O'Brien with Piper Jaffray. You may proceed.

Just to follow up a little bit on Matt's question on the CJR, I am curious if there's been any kind of either disruption from that program going into place earlier this month, be it with MAKO. Or potentially here in Q2, maybe seeing a little less volume as a result or if maybe some hospitals as they were preparing for it started to do more cases in Q1 and there was a benefit, specifically in Q1, in anticipation of that program going into place.

No, I wouldn't describe any of the change in Q1 to the CJR. Keep in mind that CJR is not impacting a large portion of the procedures, at least in the short term. It doesn't include Medicare Advantage, it doesn't include Medicaid, it doesn't include commercial payers, it doesn't include the hospitals that were already signed up for the BPCI program. So it's obviously certain MSAs that are required to participate, but it's very small and there aren't any penalties in the short term. So I wouldn't get overly concerned about this. It's not a new thing. Bundled payments have been around for a while. They are not brand-new. It's now mandatory in certain MSAs, but I don't really see that as a catalyst to changing behavior in any meaningful way, at least not in the short term.

Okay. And just to follow-up on that, Kevin, was there any slowdown potentially on the MAKO system side that was I think down year over year, just in anticipation of CJR? Hospitals trying to figure out how that program is going to play out. Maybe some of those facilities deciding just to pause on it?

No, I would say no. I think our order book is really strong for robot sales and our procedure growth was very robust, both in UKnees and in hips. And that's not new, the hip procedure growth was very strong in the back half of last year. So no, I would not say that there was some kind of change in behavior. We're really seeing continued growth and I am very bullish on our MAKO business.

Okay. And then as my follow-up, just on the domestic performance again, this quarter was extremely strong. I am just wondering with Q1 typically being a seasonally soft quarter and the strength that we're seeing here, obviously comping on ACA, it just seems interesting to me how strong everything has been. Can you just talk about volume price, mix, share taking, what's driving all that strength domestically? And then should we think about things in the U.S. slowing down in the back half, with OU.S. picking up and then exiting into 2017 hopefully with both of those segments starting to realize more normalized type growth?

I think we're going to continue to see strong performance in the U.S. Obviously, this was a very big quarter, but the real genesis of this is fantastic product pipelines. We have across our businesses, very, very good condition of our pipeline with many new launches that are just starting, launches that started in middle of last year. So having healthy product pipeline is always great and that leverages our best asset which is our sales forces of Stryker which really know how to execute. And we have health across our divisions. And that wasn't the case a few years ago. We had a few divisions that were a little bit softer. We now have strength in our endoscopy with our new camera. We have strength within our neuro-powered instruments. We have the human stroke market taking off, we have a strong pipeline within spine. You are seeing the 3D-printed implants taking off. So really across our portfolio, we have very strong pipelines. So that isn't a one quarter thing. I think we will continue to see strong performance through the course of the year. And we continue to spend very robustly in R&D, so we have a cadence of new products that will continue. And so I really believe this is sustainable. We will continue to perform very well in the U.S. It's not a one quarter thing.

Your next call comes from the line of Mike Matson with Needham & Company. You may proceed.

I guess, Katherine, I just wanted to ask about the Sage and Physio-Control acquisitions. Should we expect the growth rates to continue this year at the historical levels, so sort of double-digits at Sage and mid-single digits at Physio-Control? Or is there a risk that the growth tapers off a little bit while you are integrating those companies?

Recognizing there's always integration that has to happen, so I don't want my comments to be construed as exact targets for every quarter. But overall, Sage has a long history of sustaining very strong double-digit growth. And our goal, as I mentioned, is to make sure we do everything to continue to support them and over time unlock more of the opportunity outside the U.S. Physio-Control is embarking this year on a hefty new product launch cycle that will go for the next two years. So I think your estimations are a good place to be thinking about and again, we will be very transparent. We're going to give pro forma revenue performance for each business, respectively, for the first 12 months. So you will be able to see very clearly how they are growing relative to the prior-year base.

And then just with regard to the emerging markets and I guess China more specifically, can you just talk about the differences in what you're seeing with regard to the implant markets and the procedurally driven products versus the capital equipment markets? Do you have any sense as to whether or not the actual end markets for procedure volumes have slowed down? Or is that just steady and there's just some destocking going on at the distributors?

So I break it into three categories. I would say that the slowest impact and the greatest negative impact to us has been in the capital equipment. Then next would be spine and trauma which is -- a lot of that is tendered type of business where we've seen the distributors really had loaded up and are bleeding their inventory. And then the least negatively impacted would be in the hip and knee category which has a lot more cash pay and so the cash pay market is the least impacted. So I put it in those three buckets and obviously, it's all negative with varying degrees. With capital being the most negative, spine trauma second and then hips and knees last.

Your next call comes from the line of Larry Biegelsen with Wells Fargo. You may proceed.

First, I wanted to ask about trauma and extremities and then I had one on M&A. So Kevin, trauma and extremities has obviously been a stellar performer for you guys for a long time, but the two growth areas that you are not participating in are relatively small and are shoulder and cervical disc. So could you give us an update? I know you launched your shoulders a year or two ago. Give us an update there on what you're seeing and the outlook. And then second, how attractive is the cervical disc market to you and how important is it to have a cervical disc market? And I had one follow-up.

Sure. So shoulder, you are right. We're a relatively small player, but we're very pleased with the launch of our primary shoulder and our reverse shoulder which we launched just over a year ago. That has very nice growth, albeit from a small base, so we really believe we have the right products to be able to win in the market. It's going to take time. This isn't like foot and ankle, where we're approaching new surgeons. We have to be able to take share. But I was very encouraged by the growth the last two quarters in our shoulder business. It doesn't really make a big impact in our overall business, just given the size, but I feel that we now have a very good portfolio and shoulder will become a growth area for us going forward. What is the second question?

On cervical disc, how important it is to have a cervical disc.

We would normally report that if we had a cervical disc which we don't right now. That would be reported in our spine business, not in our trauma and extremities business. And right now, our spine business is doing really well. We're launching many, many products. We don't feel that we have to have a cervical disc at the moment to be able to drive growth. It's something we will look at, but at the current time, we don't see that as an impediment to having strong growth in our spine business.

And my apology for wrapping that into trauma and extremities, sorry about that. So Kevin, you spent $4 billion on two recent deals. So my question is how does that impact your ability or willingness to do more deals right until you integrate those two? Thanks for taking the questions.

Sure. We still have significant capacity to do extra deals. So we had a one-notch downgrade from both S&P and Moody's and if you look at S&P, we went from an A plus to A rating. We're committed to maintaining investment grade, but there's obviously a large gap between A rating and the low end of investment grade. Keep in mind that the vast majority of the deals we do are small tuck-in deals. That will continue to be the case for Stryker. That is where we drive the most value and we find great technologies that we can give to our fabulous sales forces to drive. So you will continue to see -- those will be the majority of deals, but we still have significant capacity to do more M&A and I would say all of our businesses have embedded BD people. We have not told them to slow down at all, so they are continuing to scour the market to look for opportunities that will add value. And we won't hesitate to pull the trigger on new deals if we believe they will be value-creating for Stryker.

Your next call comes from the line of Matt Keeler with Credit Suisse. You may proceed.

I guess just to start on Sage, you highlighted the potential to build that in Western Europe. And I was wondering if you could help us think about that market opportunity. Is that a market similar in size in Western Europe to the U.S. and Sage just has a smaller market share or is that a market that you will be building from scratch?

This will be much more building the market, much the way Sage did in the U.S. They really were -- is a driving force behind the innovations that allowed solutions to many of these hospital-acquired infections. These very elegant, easy-to-use solutions with demonstrated clinical data that shows when they are routinely used and they can significantly limit the occurrence -- the same conditions, hospital-acquired pneumonia infections, are prevalent around the world. It just was not an area they focused on, given their initial investment in the U.S. market. So this will be market development. It will be using the sales force as they do to help drive that, but it's -- very much the same conditions exist, but it will be much more about market expansion which is why we say over time, this is the value we look to unlock and it's not something that's going to occur suddenly in 2016. This will be a multiyear process to really start to drive awareness and adoption.

And my follow-up, last quarter, you shared some margin targets for the year. Just wondering if you will give us an update on what those will look like with Sage and Physio-Control.

So we provide top-line and earnings guidance. We don't provide specific margin guidance, although as Glenn noted on the call, while the magnitude of the year-over-year increase in gross margin won't continue, we should continue to be at the Q1 levels for 2016. But we haven't given specific guidance. We do expect margin expansion that is inclusive of the deals as they closed in early April, but beyond that and the -- upward to the targets today, there is nothing additional.

Your next call comes from the line of Glenn Novarro with RBC Capital Markets. You may proceed.

Two questions, one, U.S. knees and hips for Stryker came in better. Yesterday, J&J also reported a much stronger U.S. and knee/hip number. So the market is likely coming in better. But Kevin, I just wanted to see what your view is on the competitive dynamics. Zimmer and Biomet sales forces have combined as of last year. But I'm just wondering, are you still possibly seeing disruption in the marketplace associated with Zimmer and Biomet? And could that be helping your results as well as J&J's results yesterday? Then I have a follow-up.

So we're really pleased with our result, particularly our U.S. performance, in both hips and knees. At this point, with the largest player having not yet reported along with other competitors in the market, it's very difficult to make any kind of call with conviction around market growth. So clearly, we will have a much better sense as additional numbers roll in where the overall market growth is, but we feel very comfortable in the U.S. that we grew at the high end, if not above the market, but we will have to wait to see how numbers come in to get a general sense of whether there's been any type of acceleration. Keep in mind in recon, you really have to look at rolling four quarter trends because growth rates can vary quarter to quarter. So I wouldn't want to read too much into an uptick in growth to the degree we see one in the first quarter, because it may not be indicative of a trend line.

Okay. And then one last follow-up on CJR, one, of the pushback that we get is there is a thought out there that surgeons will start cherry-picking patients, that they may not do the more challenging cases and then they may fall through the system. Our due diligence does not suggest that will happen, but I just wanted to hear your opinion.

Yes, this is obviously gotten a lot of focus of late. I would tell you we do not believe that CMS's intent is to reduce utilization. It's really rather to ensure that each patient has access to their most appropriate care. There has been the speculation, but of some type of step-function reduction in volumes as higher-risk patients are increasingly denied surgeries. We believe that it's unlikely. We do think based on all the work we've done through SPS and obviously our presence in recon that surgeons are going to continue to look to optimize treatment for higher-risk patients. They do that today and this will include managing their post-acute care which can vary. So they have and are going to continue to treat all types of patients. The data clearly shows hip and knee surgery has a very high long term success rate and significantly improves quality of life. And that's for all patients, not just the healthiest ones. So we're not expecting some type of significant change, but rather we do believe they are going to look to find the optimum ways to treat these patients, including the post-acute care regimen.

Your next call comes from the line of Kaila Krum with William Blair. You may proceed.

So a follow-up on Rich's earlier question on spine. Just to dig in a bit further, you mentioned that you are seeing an increase in volume. Can you give us a sense for where you believe that increase in volume is coming from? Is it more market-related or do you think that you are taking share? And if it is the latter, I'm curious as to whether or not that share taking is coming from the bigger players in that segment or from some of the smaller pure plays.

Yes, we think overall, the market might be modestly improving. But again, it is very difficult today because we're one of the earlier companies to report results. So we will have to see how all the numbers come in and it is also is going to vary by company which segment of the market more of your products are weighted towards. So overall, we've been launching a number of new products, we've talked about the investments we've made over the last couple years in the R&D pipeline and we think this is mostly indicative of us gaining more market share back.

Yes, we've seen in the spine market, whether it is small players or larger players, innovation drives growth. And innovation is what takes market share. And our innovation engine is alive and well in our spine business and that's what's caused us to grow above the market.

Okay. And then I'm just curious if you guys had any differences in terms of selling days in the quarter that may have impacted growth in the quarter? And if so, that estimated impact. Thank you.

Yes, no. Selling days are equal between last year and this year.

Your next call comes from the line of Kyle Rose with Canaccord Genuity. You may proceed.

Just had one question on MAKO, you've talked a lot about refining the processes in the workflow over the course of 2016 to prepare for the launch in 2017. When you think about that, how do you think about the optimal time of a procedure and the trade-off of being potentially time additive? And I guess the real question is when you come to market with the MAKO Total Knee, what percentage of that market from a volume basis do you think the system will be time neutral to your high-volume or to your medium-volume search? What is the real market segment that the MAKO is really targeting here?

Sure. So much of the data you are looking for, we're going to be able to track once we go into full commercial launch. And it is going to vary by surgeon. A really high-volume surgeon doing hundreds of knee replacements a year is going to -- this is going to be time additive. For the lower-volume surgeon, they are going to get much closer to time neutral. But it's also why we wanted to spend our time on the training protocol to really look at ways that we can optimize this with this first-generation product. The other key is this is not just about time. We believe we're going to truly improve the patient experience. We're going to have a more reproducible surgery, because there tends to be tremendous variation, particularly with lower-volume surgeons. We think we can improve muscle disruption and things that add to the fact that close to 30% of knee patients are dissatisfied with the procedure. So it's really not just about time, it is truly about having an experience that is better for the surgeon, better for the patient and over time, we believe the outcomes data will support that.

And then just another question on the robotic side, we've heard a lot of thoughts and rumblings about robotics in the spine market. In particular, more of a play on navigated pedicle screw placement. Just your general thoughts on that, given your overlap in the spine, as well as presence from a capital equipment side and navigation and then how does, if any is the MAKO -- your robot play a factor in those plans moving forward.

So certainly, we have a terrific navigation business unit. That is within our instruments business and so we're very well aware of how that procedure gets done, whether it's with navigation or not. That continues to be a growth area for us, both the neuro and spine market. But we're in the next few years really focused on hip and knees with MAKO. We have a lot of work to do to get the Total Knee. We think that is a killer procedure. I think if you look down the road, five-plus years, certainly spine could be an area of interest. Hip arthroscopy could be an area of interest. Shoulder could be an area of interest. So there are many areas -- I think robotics will be a growth area for many, many years to come. But first things first, we really have to focus on hips and knees and that's where our attention will be for the next few years.

Your next call comes from the line of Amit Hazan with Citi. You may proceed.

Maybe just start on hip and knee side, U.S. volumes. I want to maybe take a big picture market view for a moment. When we look and analyze the market models, some of your competitors' data, it seems pretty clear that hip width and volumes have been really strong for a couple years now, maybe up in the 6%, 7%, 8% range for the market as a whole in the U.S. That would be well above the 10-year plus average for volumes. So I'm wondering what you think has been the driver of that over these last couple years. And perhaps more importantly, the extent to which you think that is sustainable on the volume side.

Yes, no, we're seeing a very stable market. Just look at demographics, every day in the 10,000 people over 65, more and more people are talking to friends that have had hip and knee replacement. The results are fabulous. People want to be active. So actually, we're seeing a lot -- certainly we see this with the UKnee with MAKO. We see a lot of young people going in for surgery, that wasn't happening before. You are seeing unemployment is a great proxy. When we see unemployment come down, we tend to see a lot more joint replacement, specifically knees. So hips really hurt, even when you lie down at night. Knees, you can defer and so we see that as a very good proxy. That is much more of a proxy than anything to do with ACA. So we really believe we've got a stable market that will continue to be stable for not just the next quarter, but for the next year or two years. And demographics is a key part, patient awareness is a key part and people wanting to be active. A lot of people want to be active and so we don't really see -- from a demand or volume standpoint, we don't see any headwinds right now. And frankly, the lower unemployment is a little bit of tailwind.

And then kind of back to MAKO and bundled payments, maybe just kind of asking a question in a different way to throw it out to you guys. What is the sales pitch for MAKO in a bundled payment environment? Essentially, how does MAKO fit into a 90-day [indiscernible] care better -- in a better way than what's being done here traditionally, such that it would have added value to the hospital?

So we really believe MAKO is going to improve outcomes. If you have consistent, reproducible product placement, less soft tissue damage, you need less rehab for your patient, they are more satisfied -- that's going to win in the market. So it's irrespective of the type of payment, whether it's a single-payer system, like in France, a two-tier system like in the UK or whether we're now -- it's a bundled payment system. So the method of payment is less interesting to us, frankly. If we deliver value and prove that value, we will win in the marketplace. And frankly, when you look at a bundle, again, the implant price and even with the robot, if you factor in the robot. And that is still not the majority of the procedure cost. So there's a lot of room to optimize beyond just the implant and we really believe if we deliver that excellent experience and they have better outcomes that we will be able to win in the marketplace.

Your next call comes from the line of Jeff Johnson with Robert W Baird. You may proceed.

Katherine, now that we're into April, on the MHLW price reset, can you just confirm now it's probably going to be, what, no more than 20 basis points, 25 basis point impact to your Company-wide pricing?

Yes, that's a good approximation.

And then Kevin, I guess a question for you. I heard the comments on the ankle performance in the quarter. It sounds like that was strong. When ITPS proposals came out the other night, the question -- I hadn't really thought of it until just staring at some of the rates the other night. But with us not getting a carveout on a total ankle replacement code which I don't think anybody really expected that we would again this year. But as you look at the episode of care cost on ankles being higher than hips and knees, but being reimbursed at those same rates and as we go into this bundled payment environment, you think there's any bias or any kind of skew away from ankles that hospitals would maybe take, just as their costs are higher, but reimbursement is the same with -- being paid under those hip and knee codes?

So first of all, we're just starting with hip and knee in bundled payments. And I think Medicare is going to be looking at high-volume procedures and moving them into the bundle. Total ankle is a very small part of the total market. Fusion is still the standard of care. Ankles are growing very fast, but from a very small base. So I really don't see this hitting the radar screen, at least not for few years for Medicaid. They've got a lot of other procedures they are going to focus on. I do believe bundled care and bundled payments will increase. It's a good thing for the overall healthcare system, it will address a lot of costs that need to be reduced. Frankly, in the case of hip and knee procedure, there is an over-prescription today on the post-acute. There's a lot of costs and we've seen when we work with hospitals on their service line profitability, that is the area that we tend to focus on the most. So I think we're a long way away from bundled payments having a big impact on total ankle. And frankly, it's a better outcome. So fusion is -- was standard of care in some of the joint replacements a long time ago and that's been replaced by total prosthesis and total ankle will be a better outcome. Of course, like everything in healthcare, finding payments and getting procedures reimbursed always goes through its ups and downs, but if you have a better outcome, eventually, it will get paid. So I don't really see a headwind for that, at least not in the next few years.

Your next call comes from the line of Josh Jennings with Cowen and Company.

I just was hoping you could clarify -- it looks like there is a step-up in CapEx in Q1 from the normal run rate. And just the driver behind that. And just linked to that question is any major product launches across the major divisions that you would call out that are going to help with this 5.5% to 6.5% organic growth trajectory? Thanks a lot.

Yes, in Q1, we started some of the spending that is going to be required for our deployment of our new ERP system. And so that is the big thing that kind of stuck out in the cash flow.

Yes. And as it relates to product launches -- so we have a number of products that we've talked about, like the signature line of neuro-powered drills that haven't had a full-year impact. But we do have our -- a Neptune 3 launch that is upcoming which is the main waste management product within instruments. That is coming in the middle of the year. That will be a contributor to growth, but I would say it's just a continuation. The camera launch was December. It really was mid-December of last year, the 1588. We're getting great customer feedback, so that will continue going into this year. Sports medicine is launching a number of products. Spine -- the 3D-printed implant -- the interbody device, great feedback, but a very small number of surgeons put those in in the first quarter. So we will expand that launch over the course of the year. So I wouldn't point to one single product. It is just typical of Stryker. We tend to have our growth spread across a wide variety of products, but there are a number of products that will contribute to the growth rate. And obviously raising after one quarter, we have confidence that we will be able to sustain this level of growth.

There are no further questions at this time. I would now turn the conference over to Mr. Kevin Lobo for any closing remarks.

So thank you all for joining our call. Our conference call for the second quarter 2016 results will be held on July 21. Thank you.

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.