Revising Ests on Hold-Rated Stryker

In February 2008, Stryker Corporation (SYK) announced a $750 million share buyback program that reflects its strong cash position, offsetting some share dilution while also suggesting lack of solid acquisition targets. Stryker's strength is its diversification. Core hips and knees are about one-third of total revenues, making Stryker the least directly exposed to the reconstructive implant market of any of the major orthopedic manufacturers, but the company has several related growth drivers in its MedSurg segment.

Domestic pricing has been modestly positive, and the outlook remains moderately stable. International pricing will continue to be weak, particularly in Japan, but this is factored into management's outlook.

Stryker initiated a voluntary recall of its Trident PSL and Hemispherical Acetabular Cups, prompted by the receipt of two FDA warning letters in 2007 due to certain manufacturing issues in its Cork and Mahwah facilities. However, management is making efforts to remediate this, as it believes there are no patient safety issues, and expects no major supply issues.

SYK also disclosed it had received a Department of Justice subpoena related to the previously announced informal SEC inquiry into possible violations of the Foreign Corrupt Practices Act. Although we expect little additional news in the near-term, the issue does create a near-term overhang for the company and the entire ortho group.

Stryker trades at roughly 22x our 2008 estimate of $2.88, or at a 1.2x 2008 P/E/G, slightly below the comparables average 1.3x 2008 P/E/G. Our revised $71 target is based on a 1.3x 2008 P/E/G, or roughly 25x our 2008 earnings per share estimate. 

Positives for BJ's Priced-In

BJ's Wholesale Club, Inc. (BJ) reported strong results for the fourth quarter. Its earnings per share were $0.04 above our forecast and $0.07 above consensus. The upside was due to operating cost controls and continued share repurchases.

The company's efforts to improve its merchandise and increase store traffic continue to drive steady sales growth. We think this positive momentum can continue for the next few quarters.

Nevertheless, we remain concerned with BJ's competitive position in the wholesale club market, lack of geographic diversity, and inability to substantially expand its profit margins from current levels. Despite its lower growth rates, BJ's Wholesale Club's shares trade at a slight premium to the industry mean.

We think this valuation reflects the company's improving business prospects as well as the potential for the company being acquired. The stock currently trades at 17.8x our fiscal year 2008 EPS estimate and 16.1x our fiscal year 2009 EPS estimate. The stock should perform in-line with the overall market, in our view.

We maintain our Hold rating. Our target price is $36, or about 18x our fiscal year 2008 EPS estimate.

A Close Look at "Fat Fannies"

Fannie Mae (FNM) just released its underwriting guidelines for buying/insuring the Jumbo loans that it was authorized to start working with in the recent stimulus package.  These new conforming jumbos, or as I like to call them, 'Fat Fannies,' are the result of raising the limit on conforming loans from $417,000 to as much as $730,000 in some high-cost (read: California) areas of the country. 

The aim is to stabilize the housing market in the most overpriced areas that are currently experiencing some of the worst problems with delinquencies and foreclosures.  It is also an indirect subsidy of some of the wealthiest homeowners in the country.  Given that Fannie  -- and Freddie Mac (FRE); it is likely that those guidelines are similar -- are severely capital-constrained after the two of them lost a combined $6 billion in the fourth quarter, there is also a very high probability that they will continue to lose significant amounts this year. 

Expanding their balance sheets strikes me as downright dangerous.  The implicit government guarantee of their debt could be tested shortly.  This is the key reason that the spread on the yield on Fannie paper over the 10-year T-note widened yesterday to its highest point since 1986.  I would also note that the yield on T-notes was a heck of a lot higher back then than it is today, so the ratio of the two yields is simply off the charts.

The good news, however, is that Fannie has decided to underwrite these loans in such a way that it is unlikely that they will actually buy many of them.  I have not had a lot of good things to say about the managements of major financial institutions lately, but my hat is off to the management of Fannie here. 

Among the key underwriting standards are a maximum combined loan to value (LTV) for fixed-rate loans of 90%, based on current appraisals, for purchase and a 75% LTV and 95% combined loan to value (CLTV) on re-fis.  The new appraisals must include an interior inspection (no 'drive-bys').   For ARM's,  it is an 80% LTV on purchase and 75%/90% LTV/CLTV.  Cash-out refis are not allowed. 

The minimum FICO score is 660 for any loan and 700 for LTV's greater than 80%.  Existing second mortgages must resubordinated and cannot be cashed out by the new loan on a refi.  All loans must be fully documented (i.e., no NINJA loans).  For refis, there cannot have been any late payments in the last 12 months.

The good news is that these guidelines will limit the risk to the GSEs since they will actually buy very few of them.  The vast majority of the troubled homeowners will simply not be able to qualify.  The bad news is that raising the conforming limits will not make mortgages more available for expensive homes, since very few of them will be bought by Fannie.  I would still avoid both Fannie and Freddie as they cannot escape major damage from the mortgage mess being right at ground zero.  However, it is refreshing to see that management is not crazy.

Dean Foods Poised for Gains

Management of Dean Foods Company (DF) has taken definitive actions to improve shareholder value from the spin-off of TreeHouse Foods, Inc. (THS) in 2005 to a $15 per share special dividend in 2007. Management has focused on the branded products business, reduced SKUs, and integrated strategic acquisitions in the Dairy Group.

However, 2007 was challenging due to increased dairy costs. Though costs are expected to be volatile in 2008, the decline in the stock's price has provided a buying opportunity, since any relief from high dairy costs will dramatically accelerate earnings growth. The stock of Dean Foods Company has traded in a P/E multiple range of 11 to 22 over the last five years.

The stock is currently trading at 17.6 times trailing 12-month EPS. Despite the increased debt-to-capitalization ratio from the decision to spin-off TreeHouse Foods without any debt and the additional debt incurred to pay a $15 special dividend, management's actions should create faster growing, higher margin company once the higher dairy costs abate. The six-month target price of $27 is based on a 22 P/E multiple on next year's (still depressed) earnings estimate. The rating is a Buy. 

Wait & See on CombinatoRx

CombinatoRx, Inc. (CRXX) is engaged in the discovery, development and commercialization of novel therapeutics that are combinations of approved drugs. CombinatoRx has identified seven product candidates which target multiple diseases like immuno-inflammatory diseases, chronic pain, topical dermatoses, metabolic disease and oncology.

We expect significant news flow on the pipeline candidates in 2008. At this time, we would like to see more clinical data before recommending the name.