Stryker Corp (SYK) SEC Quarterly Report (10-Q) for Q1 2016

NOTE 1 - BASIS OF PRESENTATION

General Information

These statements should be read in conjunction with our Annual Report on Form 10-K for 2015 . Management believes that the accompanying unaudited consolidated financial statements contain all adjustments, including normal recurring items, considered necessary for a fair presentation of the interim periods. However, the results of operations included in such consolidated financial statements may not necessarily be indicative of annual results. Certain prior year amounts on the balance sheet have been reclassified as a result of the adoption of ASU 2015-03, Interest - Imputation of Interest: Simplifying the Presentation of Debt Issuance Costs to conform with the current year presentation.

New Accounting Pronouncements Not Yet Adopted

In February 2016 the FASB issued ASU 2016-02, Leases (Topic 842). This update requires an entity to recognize assets and liabilities for leases with lease terms of more than 12 months on the balance sheet. We plan to adopt this standard on January 1, 2019. We are still evaluating the impact that this standard will have on our consolidated financial statements.

In March 2016 the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. This update simplifies the accounting for employee share-based payment transactions, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows. We plan to adopt this standard on January 1, 2017. We are still evaluating the impact that this standard will have on our consolidated financial statements.

In May 2014 the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606). This update outlines a single, comprehensive model for accounting for revenue from contracts with customers. We plan to adopt the standard on January 1, 2018. We are still evaluating the impact that this standard will have on our consolidated financial statements.

No other new accounting pronouncements were issued or became effective during the period that had, or are expected to have, a material impact on our consolidated financial statements.

NOTE 2 - SUBSEQUENT EVENTS

On April 1, 2016 we completed the acquisition of Sage Products Holdings II, LLC (Sage) for approximately $ 2,775 and the acquisition of Synergetics' neuro portfolio (Synergetics). On April 5, 2016 we completed the acquisition of Physio-Control International, Inc. (Physio) for approximately $ 1,280 . The results of operations for each of these acquisitions will be included in our consolidated financial statements beginning in the second quarter. Refer to Note 6 for further information.

NOTE 3 - ACCUMULATED OTHER COMPREHENSIVE INCOME (AOCI)

NOTE 4 - FAIR VALUE MEASUREMENTS

Financial assets and liabilities carried at fair value are classified and disclosed in one of the following three categories:

When applying the fair value principles in the valuation of assets and liabilities, we are required to maximize the use of quoted market prices and minimize the use of unobservable inputs. We calculate the fair value of our Level 1 and Level 2 instruments based on the exchange traded price of identical or similar instruments, where available, or based on other observable inputs taking into account our credit risk and that of our counterparties. Foreign currency exchange contracts and interest rate hedges are included in Level 2 as we use inputs other than quoted prices that are observable for the asset or liability. The Level 2 derivative instruments are primarily

valued using standard calculations and models that use readily observable market data as their basis.

Our Level 3 liabilities represent milestone payments for acquisitions. The fair value of the liabilities was estimated using a discounted cash flow technique. Significant unobservable inputs to this technique included our probability assessments of occurrence of triggering events, appropriately discounted considering the uncertainties associated with the obligation. We remeasure our assets and liabilities each reporting period and record the changes in fair value within selling, general and administrative expense and the changes in the time value of money within other income (expense), net.

There were no significant transfers into or out of any level between December 31, 2015 and March 31, 2016 .

Valuation of Assets and Liabilities Measured at Fair Value

Fair Value of Available for Sale Securities by Contractual Maturity

On March 31, 2016 the aggregate difference between the cost and fair value of available-for-sale marketable securities is nominal. Interest receivable of $ 3 related to our marketable securities portfolio was recorded in prepaid expenses and other current assets.The total of interest and marketable securities income was $ 5 and $ 6 in the three months 2016 and 2015 . The amounts are included in other income (expense), net.

Less than 1% of our investments in available-for-sale marketable securities have a credit quality rating of less than A2 (Moody's), A (Standard & Poor's) and A (Fitch). We do not intend to sell the investments and it is not more likely than not that we will be required to sell the investments before recovery of their amortized cost basis

which may be maturity. We do not consider these investments to be other-than-temporarily impaired on March 31, 2016 .

Securities in a Continuous Unrealized Loss Position

On March 31, 2016 substantially all our investments with unrealized losses that are not deemed to be other-than-temporarily impaired have been in a continuous unrealized loss position for less than twelve months, and the losses are nominal.

NOTE 5 - DERIVATIVE INSTRUMENTS

We use operational and economic hedges, foreign currency exchange forward contracts, net investment hedges and interest rate derivative instruments to manage the impact of currency exchange and interest rate fluctuations on earnings and cash flow. At inception the derivative is designated as a cash flow hedge, a fair value hedge or a free standing derivative. We do not enter into derivative instruments for speculative purposes. We have not changed our hedging strategies, accounting practices, or objectives from those disclosed in our Annual Report on Form 10-K for 2015 .

Designated Net Investment Hedges

We have designated certain long-term intercompany loans payable and forward exchange contracts as net investment hedges of our investments in certain international subsidiaries that use the Euro as their functional currency. The effective portion of derivatives designated as net investment hedges are reported as a component of AOCI. On March 31, 2016 the total after-tax amount in AOCI related to our designated net investment hedges was $ 5 . For derivative instruments that are designated and qualify as a net investment hedge, the effective portion of the derivative's gain or loss is recognized in OCI and reported as a component of AOCI.

We use the forward method to measure ineffectiveness. Under this method, for each reporting period the change in the carrying value of the Euro-denominated amounts due to remeasurement of the effective portion is reported as a component of AOCI and the remaining change in the carrying value of the ineffective portion, if any, is recognized in other income (expense), net. The gain or loss related to settled net investment hedges will be subsequently reclassified into net earnings when the hedged net investment is either sold or substantially liquidated. We evaluate the effectiveness of our net investment hedges quarterly and did not recognize any ineffectiveness in the three months 2016.

Designated and Non Designated Hedges

We are exposed to credit loss in the event of nonperformance by counterparties on our outstanding derivative instruments but do not anticipate nonperformance by any of our counterparties. Should a counterparty default our maximum exposure to loss is the asset balance of the instrument.

Net Currency Exchange Rate Gains (Losses)

On March 31, 2016 and December 31, 2015 pretax (losses) gains on derivatives designated as hedges of ($ 4 ) and $ 17 , which are reported in AOCI, are expected to be reclassified to earnings during the next 12 months. This reclassification is primarily due to the sale of inventory that includes previously hedged purchases. There have been no ineffective portions of derivatives that have resulted in gains or losses in any of the periods presented.

Interest Rate Risk on Future Debt Issuance

In the three months 2016 we terminated multiple designated interest rate cash flow hedges and recognized $ 7 in OCI related to hedges on our debt issuances and recognized a nominal amount of ineffectiveness in interest expense. The remaining amounts in AOCI will be reclassified to interest expense over the term of the debt. The cash flow effect of these hedges is recognized in cash flow from operations.

Fair Value Hedges

On  March 31, 2016 we had interest rate swaps with gross notional amounts of $500 designated as fair value hedges of underlying fixed rate obligations representing a portion of our $600 senior unsecured notes due in 2024. There was no hedge ineffectiveness recorded as a result of these fair value hedges.

NOTE 6 - ACQUISITIONS

2016 Acquisitions

In February 2016 we announced an agreement to acquire Sage for approximately $ 2,775 . Sage develops, manufactures and distributes disposable products targeted at reducing "Never Events," primarily in the intensive care unit.

In February 2016 we announced an agreement to acquire Physio for approximately $ 1,280 . Physio develops, manufactures and markets monitors/defibrillators, automated external defibrillators (AEDs) and CPR-assist devices along with data management and support services.

In February 2016 we announced an agreement to acquire all of the assets associated with Synergetics. The portfolio includes the Malis generator, Spetzler Malis disposable forceps, and our existing Sonopet tips and RF generator.

These acquisitions were completed in the second quarter of 2016 and enhance our product offerings within our MedSurg segment.

We have also completed various other acquisitions that are included in the 2016 column in the table below.

2015 Acquisitions

In January 2015 we acquired certain assets of CHG Hospital Beds, Inc. (CHG). CHG designs, manufactures and markets low-height hospital beds and related accessories. This acquisition enhances our product offerings within our MedSurg segment. Goodwill acquired with the CHG acquisition is deductible for tax purposes. The measurement period for CHG has been completed. Revisions to the original purchase price allocation were nominal.

The purchase price allocations for other 2015 acquisitions were based upon preliminary valuations, and our estimates and assumptions are subject to change within the measurement period.

Purchase Price Allocation of Acquired Net Assets

Estimated Amortization Expense

NOTE 7 - CONTINGENCIES AND COMMITMENTS

We are involved in various ongoing proceedings, legal actions and claims arising in the normal course of business, including proceedings related to product, labor, intellectual property and other matters that are more fully described below. The outcomes of these matters will generally not be known for prolonged periods of time. In certain of the legal proceedings, the claimants seek damages as well as other compensatory and equitable relief that could result in

the payment of significant claims and settlements and/or the imposition of injunctions or other equitable relief. For legal matters for which management has sufficient information to reasonably estimate our future obligations, a liability representing management's best estimate of the probable loss, or the minimum of the range of probable losses when a best estimate within the range is not known, is recorded. The estimates are based on consultation with legal counsel, previous settlement experience and settlement strategies. If actual outcomes are less favorable than those estimated by management, additional expense may be incurred, which could unfavorably affect future operating results. We are self-insured for product liability-related claims and expenses. The ultimate cost to us with respect to product liability claims could be materially different than the amount of the current estimates and accruals and could have a material adverse effect on our financial position, results of operations and cash flows.

In June 2012 we voluntarily recalled our Rejuvenate and ABG II Modular-Neck hip stems and terminated global distribution of these hip products. Product liability lawsuits relating to this voluntary recall have been filed against us. On November 3, 2014 we announced that we had entered into a settlement agreement to compensate eligible United States patients who had revision surgery to replace their Rejuvenate and/or ABG II Modular-Neck hip stem prior to that date. We continue to offer support for recall-related care and reimburse patients who are not eligible to enroll in the settlement program for testing and treatment services, including any necessary revision surgeries. In addition, some lawsuits will remain and we will continue to defend against them. Based on the information that has been received, the actuarially determined range of probable loss to resolve this matter globally is estimated to be approximately $ 1,843 ($ 2,075 before $ 232 of third-party insurance recoveries) to $ 2,414 .  In the three months 2016 we recognized additional charges to earnings of $ 19 representing the excess of the minimum of the range over the previously recorded reserves. We have made recall-related payments totaling $ 1,310 under the United States Rejuvenate and ABG II settlement agreement. The final outcome of this matter is dependent on many factors that are difficult to predict including the number of enrollees in the settlement program and the total awards to them, the number and costs of patients not eligible for the settlement program who seek testing and treatment services and require revision surgery and the number and actual costs to resolve the remaining lawsuits. Accordingly, the ultimate cost to resolve this entire matter globally may be materially different than the amount of the current estimate and accruals and could have a material adverse effect on our financial position, results of operations and cash flows.

In 2010 we filed a lawsuit in federal court against Zimmer Biomet Holdings, Inc. (Zimmer), alleging that a Zimmer product infringed three of our patents. In 2013 following a jury trial favorable to us, the trial judge entered a judgment that, among other things, awarded us damages of $ 76 and ordered Zimmer to pay us enhanced damages. Zimmer appealed this ruling. In December 2014 the Federal Circuit affirmed the damages awarded to us, reversed the order for enhanced damages and remanded the issue of attorney fees to the trial court. The Federal Circuit denied our petition for a rehearing en banc on the issue of enhanced damages. The United States Supreme Court agreed to hear our appeal on this issue and held oral arguments on February 23, 2016. In May 2015 the trial court entered a stipulated judgment that, among other things, required Zimmer to pay us the base amount of damages and interest, while the issues of enhanced damages and attorney fees continue to be pursued. In June 2015 we recorded a $ 54 gain, net of legal costs, which was recorded within selling, general and administrative expenses.

In April 2011 Hill-Rom Company, Inc. and affiliated entities (Hill-Rom) brought a lawsuit against us alleging infringement under United States patent laws with respect to nine patents related to electrical network communications for hospital beds. On March 31, 2015 the court granted the parties' joint motion to dismiss with prejudice the claims and counterclaims associated with three of these patents. The case has been stayed with respect to the remaining six patents, until reexamination proceedings at the United States Patent Office have concluded.  The ultimate resolution of this matter cannot be predicted and it is not possible at this time for us to estimate any probable loss or range of probable losses; however, the ultimate result could have a material adverse effect on our financial position, results of operations and cash flows.

NOTE 8 - DEBT AND CREDIT FACILITIES

In March 2016 we sold $3,500 of senior unsecured notes. Our commercial paper program allows us to have a maximum of $ 1,250 in commercial paper outstanding with maturities up to 397 days from the date of issuance. On March 31, 2016 there were no amounts outstanding under our commercial paper program.

Summary of Total Debt

We have lines of credit issued by various financial institutions that are available to fund our day-to-day operating needs. Certain of our credit facilities require us to comply with financial and other covenants. We were in compliance with all covenants on March 31, 2016 . On March 31, 2016 we had $ 1,305 of borrowing capacity available under all of our existing credit facilities.

On March 31, 2016 the total unamortized debt issuance costs incurred in connection with our outstanding notes were $ 50 . The fair value of long-term debt (excluding the interest rate hedges) on March 31, 2016 and December 31, 2015 was $ 7,702 and $ 4,009 based on the quoted interest rates for similar types and amounts of borrowings. Substantially all of our long-term debt is classified within Level 1 of the fair value hierarchy because the fair value of the debt is estimated based on rates with identical terms and maturities, using quoted active market prices and yields, taking into account the underlying terms of the debt instruments.

On January 1, 2016 we retrospectively adopted ASU 2015-03, Interest - Imputation of Interest: Simplifying the Presentation of Debt Issuance Costs. This standard update requires an entity to present debt issuance costs related to a recognized debt liability as a direct deduction from the carrying amount of that debt liability consistent with the treatment of debt discounts. The adoption of this standard resulted in the reclassification of $ 24 of unamortized debt issuance costs principally from other noncurrent assets to a reduction of long

term debt on our consolidated balance sheet on December 31, 2015.

NOTE 9 - CAPITAL STOCK

In February 2016 we declared a quarterly dividend of $ 0.38 per share payable on April 30, 2016 to shareholders of record at the close of business on March 31, 2016 .

In the three months 2016 we repurchased 135,000 shares at a cost of $ 13 under our authorized repurchase programs. The manner, timing and amount of repurchases is determined by management based on an evaluation of market conditions, stock price and other factors and is subject to regulatory considerations. Purchases are made from time-to-time in the open market, in privately negotiated transactions or otherwise. On March 31, 2016 the total dollar value of shares that could be purchased under our authorized repurchase programs was $ 1,870 .

NOTE 10 - INCOME TAXES

Our effective tax rates in the three months 2016 and 2015 were 16.4 % and 40.6 %. The decrease in our effective tax rate was primarily due to favorable audit settlements in 2016 and certain discrete items in 2015 related to the establishment of our European regional headquarters. In 2015 we retrospectively adopted ASU 2015-17, Income Taxes (Topic 740) Balance Sheet Classification of Deferred Taxes that amends the balance sheet classification of deferred taxes.

NOTE 11 - SEGMENT INFORMATION

There were no significant changes to total assets by segment from information provided in our Annual Report on Form 10-K for 2015 .

ABOUT STRYKER

Stryker Corporation is a global leader in medical technology with 2015 revenues of $9,946 and net earnings of $1,439. We offer a diverse array of innovative medical technologies including orthopaedic, medical and surgical, and neurotechnology and spine products to help people lead more active and satisfying lives.

We segregate our operations into three reportable business segments: Orthopaedics, MedSurg, and Neurotechnology and Spine. Orthopaedics products consist primarily of implants used in hip and knee joint replacements and trauma and extremities surgeries. MedSurg products include surgical equipment and surgical navigation systems (Instruments); endoscopic and communications systems (Endoscopy); patient handling and emergency medical equipment (Medical); and reprocessed and remanufactured medical devices (Sustainability) as well as other medical device products used in a variety of medical specialties. Neurotechnology and Spine products include both neurosurgical and neurovascular devices.

Overview of the Three Months 2016

In the three months 2016 we achieved sales growth of 4.9% and 6.1% in constant currency. We reported net earnings per diluted share of $1.07 in the three months 2016 and achieved an 11.7% growth in adjusted net earnings per diluted share (see page 11 for a reconciliation of reported net earnings per diluted share to adjusted net earnings per diluted share).

Recent Developments

In January 2016 we announced that William R. Jellison elected to retire from his role as Vice President, Chief Financial Officer effective April 1, 2016. Glenn S. Boehnlein, who previously served as our Group Vice President, Chief Financial Officer for MedSurg and Neurotechnology, has been promoted to Vice President, Chief Financial Officer effective April 1, 2016.

In February 2016 we announced an agreement to acquire Sage Products Holdings II, LLC (Sage) for approximately $2,775. Sage develops, manufactures and distributes disposable products targeted at reducing "Never Events," primarily in the intensive care unit.

In February 2016 we announced an agreement to acquire Physio-Control International, Inc. (Physio) for approximately $1,280. Physio develops, manufactures and markets monitors/defibrillators, automated external defibrillators (AEDs) and CPR-assist devices along with data management and support services.

In February 2016 we announced an agreement to acquire all of the assets associated with Synergetics' neuro portfolio (Synergetics). The portfolio includes the Malis generator, Spetzler Malis disposable forceps, and our existing Sonopet tips and RF generator.

These acquisitions closed in the second quarter of 2016 and enhance our product offerings within our MedSurg segment.

In March 2016 we sold $3,500 of senior unsecured notes. Refer to Note 8 in the notes to our consolidated financial statements for further information.

Consolidated Net Sales

Consolidated net sales of $2,495 increased 4.9% in the three months 2016 as reported and 6.1% in constant currency, as foreign currency exchange rates negatively impacted net sales by 1.3%. Acquisitions did not significantly impact net sales in the three months 2016. Net sales in constant currency increased by 7.5% from increased unit volume partially offset by 1.4% due to lower prices. The increase was led primarily by higher shipments of neurotechnology, instruments, knees and trauma and extremities products.

Orthopaedics Net Sales

Orthopaedics net sales of $1,057 increased 3.3% in the three months 2016 as reported and 4.6% in constant currency, as foreign currency exchange rates negatively impacted net sales by 1.4%. Net sales in constant currency increased by 6.3% from increased unit volume partially offset by 1.7% due to lower prices. The increase was led primarily by higher shipments of knees and trauma and extremities products.

MedSurg Net Sales

MedSurg net sales of $958 increased 3.4% in the three months 2016 as reported and 4.6% in constant currency, as foreign currency exchange rates negatively impacted net sales by 1.2%. Acquisitions did not significantly impact net sales in the three months. Net sales in constant currency increased by 5.0% from increased unit volume partially offset by 0.6% due to lower prices. The increase was led primarily by higher shipments of our instruments and medical products.

Neurotechnology and Spine Net Sales

Neurotechnology and Spine net sales of $480 increased 12.0% in the three months 2016 as reported and 13.1% in constant currency, as foreign currency exchange rates negatively impacted net sales by 1.1%. Net sales in constant currency increased by 15.5% from increased unit volume partially offset by 2.4% due to lower prices. The increase was led primarily by higher shipments of neurotechnology products.

Gross Profit

Gross profit in the three months 2016 increased to 67.9% from 65.3% in 2015 primarily due to favorable product mix and manufacturing productivity partially offset by decreases in the selling price of our products. In addition the two-year suspension of the United States medical device excise tax that became effective January 1, 2016 had a favorable impact on our gross profit in 2016. We expect this favorable impact to gross profit as a result of the suspension of the United States medical device excise tax for the next two years.

Gross Profit Adjustments