Intuitive Surgical: Great Company, Bargain Price

I have followed Intutive Surgical (ISRG) for 4 1/2 years, owning it for a nice run in 2005 but missing the big move last year. I recently repurchased the stock when they reported Q4 results, took profits on the bounce and have now bought it again below 90. In a bear market, we are afforded the opportunity to buy great companies at bargain prices (and not so great companies at lower prices too). I firmly believe that ISRG is a great company and find the current price of about 90 to be a very good if not great price.

I am assuming that the reader is familiar with the company, so I will be brief in background and spend more time detailing why I like the stock here. The company markets a $1.5mm dollar system to hospitals to aid surgeons in complex surgeries (radical prostatectomies and other urological procedures, complex gynecological surgeries, certain cardiac procedures, gastric bypass and many others). These systems have been sold primarily in the U.S., but international growth has been stronger lately. The company also sells maintenance plans as well as consumables used in procedures. The revenues from the razors (systems) and the blades (service and products) is about equal. Importantly, the company operates as a monopoly, and it is difficult to imagine anyone supplanting them given their broad patent portfolio and the very large installed base.

The company is run by a fantastic management team that clearly balances the needs of investors, employees, customers and patients. I have never heard the company be anything but conservative in their outlook in all regards. Despite its monopoly status, the company continues to invest heavily in R&D (9% compared to a peer group average of 6% for device companies with market caps in excess of $1 billion).

It is very clear from their actions that they intend to grow the adoption of their technology by investing heavily in adjacent and complementary technologies. The company also invests heavily in SG&A (marketing). Despite almost quadrupling sales over the past 3 years, EBITDA margins have increased from 35% to just 41% (1/2 from GM, 1/2 from OpEx). While some may feel that this margin isn't sustainable, remember it is a monopoly. Microsoft (MSFT) has a slightly higher EBITDA margin, and there are other limited competition areas where companies enjoy higher margins such as HPA semis (LLTC, ADI, MXIM). Gilead Sciences (GILD), which has a huge AIDS franchise, as well asMerk (MRK), have higher OMs, while many Healthcare companies have OMs in excess of 30%, including device makers Zimmer Holdings (ZMH) and Stryker (SYK).

Something that really sets apart ISRG from other companies is the strength of the balance sheet: No debt, $900mm in cash/investments on a $3.5 billion market cap ($22 per share), minimal intangibles ($167mm). Another way to look at the company is that its tangible book value of $1.1 billion is almost all cash, and there are total liabilities of just $208mm. I do note that Inventory growth was stronger than the torrid sales growth in 2008 and suggests that the company could see a small amount of margin pressure as it clears its inventory.

As you can see in the chart above (click to enlarge), despite strong reported numbers, the stock has collapsed. There are several simple reasons for this:

• The stock was way too expensive
• The outlook has diminished
• It's a stock

I won't spend any time on the first or last observation, but the outlook bears discussion. The company matched my expectations when it announced essentially flat systems placement expectations for 2009 and much lower consumables growth (though still very strong). The consensus is now for flat EPS for the year after 92% growth in 2006 and 41% last year. So, it looks like the momentum and growth investors have departed. Here are the big questions (and my answers):

• Is the outlook conservative enough?
• Is the stock cheap enough?

The real answer is that I don't know, but I believe that the answers are pretty close to yes. On the outlook, there is no doubt that their customers are hurting, with budget pressures as well as hits to charitable contributions that have helped fund the purchases historically. International penetration is much lower than the U.S., but even in the U.S. there is plenty of growth in terms of new placements in regions not yet penetrated or even within hospitals that are experiencing the need for additional systems. Years ago, the company suggested that 3 would be the max per hospital, but there are several 5-unit owners. The consumables growth is based upon the companies placement forecast as well as the procedural growth in the installed base, and I believe that the company has been conservative on this front. While perhaps the environment is worse than the company envisions, I believe that the longer-term prospects are stronger than ever.

Valuation is the trickier part. If it is cheap enough, perhaps the stock can absorb some disappointment on its operating metrics this year if that transpires. In a market where 10PE seems to be the norm, should we pay 17X 2009 projected EPS for ISRG? As you can see in the chart above, the PE is way off the charts for the company. Recall that it is a monopoly as well. Consider, though, that there are two big differences in the quoted PE today than over the past few years:

• So much cash per share now - one needs to consider the PE 13
• Options expense has been in the numbers for the past 3 years, making the PE historically even higher

3X book value for a monopoly sounds good. An income statement that has some capacity to allow the company to adjust spending in a negative scenario due to its high variable cost model sounds good. I also like that the company not only announced that it is authorizing a share repurchase, but that it is actually doing it in short order. One of the reasons that I bought the stock after it plunged on the disappointing Q4 and outlook is that for the first time they announced that they were considering a share repurchase. This $300mm purchase (8% of the company) is accretive and a good use of significant excess cash. Kudos to the company for NEVER repurchasing stock prior to today. They resisted the bankers who kept pushing them.

I have always believed that one shouldn't fall in love with stocks, and that is why I didn't participate in the parabolic move last year. I admit that I truly admire this company, so I hope that I am not blinded here. I haven't unearthed anything in 4+ years that has made me question management, their products, their accounting or any aspect of the company. It's not the undiscovered gem that it used to be, but it is clearly out of favor and attractive in terms of how I look at things. While I see technical downside to 74 (18% or so), I envision a return to 125 by the end of the year (20X 2010). I added the stock yesterday to my Top 20 Model Portfolio.

Disclosure: Long ISRG

Comments

[speculari:]

Alan:
Excellent article & overall analysis! I have watched ISRG from the time that they had only 1 unit in one hospital in CT(& made my 1st buy @$25) , they are now in 11 locations in CT with the 1st location now in the process of their 3rd unit installation. They have also racked up somewhere in the range of 28 or 30 consecutive Quarters of positive growth in both sales & earnings.

Mar 07 07:24 PM

[Fueled By R...:]

Y, I think ISRG will also benefit from secular trends in healthcare. Aging of populations in many countries means increasing number of surgeries will be performed. Pressure to reduce health care costs will also benefit ISRG; the machines are a large capital outlay initially but reduce costs over the long term by reducing recovery times and simplifying many procedures. Gotta love all that cash and, as you say, it's a monopoly!

Mar 07 07:58 PM

[EconoMarcus:]

I would agree that ISRG is a great company. Yes, I even bought an initial position just below 90 after I had been waiting so long till it finally got back down to this support level.

BUT: I sold it again on Friday. Reality check: Look at the chart and look at the real world. Why would you buy a stock in a downtrend in times when the worldwide economy is more or less in free fall (although China pretends its exports are growing again - I just wonder where they're exporting to...) which is also reflected in about every relevant stock market index? It's still downwards everywhere.

Pretty hard to believe that ISRG alone can buck the overall trend, don't you think? I hope you'll be lucky to catch a counter trend rally on Monday, maybe even for a few days. I preferred to play it safe. Good luck!

Mar 07 08:25 PM

[Alan Brochs...:]

I empathize strongly with your view - that is why I flipped my position so quickly right after they reported and I made a quick 15% or so. I wasn't there for all the JNJ takeout rumors. Maybe they get that rumor going again...


On Mar 07 08:25 PM EconoMarcus wrote:

> I would agree that ISRG is a great company. Yes, I even bought an
> initial position just below 90 after I had been waiting so long till
> it finally got back down to this support level.
>
> BUT: I sold it again on Friday. Reality check: Look at the chart
> and look at the real world. Why would you buy a stock in a downtrend
> in times when the worldwide economy is more or less in free fall
> (although China pretends its exports are growing again - I just wonder
> where they're exporting to...) which is also reflected in about every
> relevant stock market index? It's still downwards everywhere.
>
> Pretty hard to believe that ISRG alone can buck the overall trend,
> don't you think? I hope you'll be lucky to catch a counter trend
> rally on Monday, maybe even for a few days. I preferred to play it
> safe. Good luck!

Mar 07 09:10 PM

[BigOlDave:]

Alan,

Another nice analysis. It's important for us to know why NOT to buy a stock as when we should. ISRG has an excellent product and management, but it takes on the appearance of a "story" stock until analyses like yours disclose some of the warts.

I've owned and made money selling my ISRG. I'd like another opportunity to buy it, if there wasn't so much other great buys out there!

Dave

Mar 08 06:06 PM

[Barry Bazzell:]

I am an ISRG fan also. Other than VMW, I can't think of a small company w/a brighter future. For the time being, ISRG doesn't face the competitive landscape that VMW does. I love Silicon Valley growth stocks!

Mar 09 04:31 AM

[speculari:]

For all our fond hopes as well as the terrific performance we have seen with this stock - it is not likely to have a strong upside move until we see an increase in volume via increased participation by the FUNDS. The % of fund ownership has been around the 22-24% mark for a while, but the # of funds has declined from last year to this year from a high of around 355 to about 306. They will report earnings again in late April.

Mar 09 08:48 AM

[Alan Brochs...:]

Despite a couple of negative reports from brokers who are fearful due to general hospital spending weakness, the stock has finally caught a bid. From the time I shared this view, the stock has really been a market performer at best, moving in line with the overall market but certainly much better than the typical healthcare stock.

Why the surge from as low as 95 on Wednesday to above 112 on Thursday? I believe that folks have figured out that with earnings to be reported next Thursday and no pre-announcement, the results aren't likely to be dire. They might not be pretty, but they most likely aren't so ugly that a pre-announcement would have been necessary.

Fundamentally, it's easy to be afraid of hospital equipment stocks. I believe that a lot of it is factored into the price. While the company will show less cash due to the repurchase, going on year-end numbers and not including the cash they will generate this quarter, ISRG at 112 has an enterprise value now of $3.5 billion and no debt ($89 per share is the price net of cash). Their projected EPS of $5 this year includes large non-cash options expense of $1.60 per share. So, even if the estimates are too high, if we go with $6 per share excluding options, we are talking about 15X this year's cash earnings. So, it would seem that the stock could weather a modest cut to earnings, perhaps even rally a bit. I don't believe that the .08 of accretion I calculate from the share repurchase is in the numbers, so that's a cushion. If the number's hold up as they currently are projected, I could see the stock rising to $140. The math on this is 18 multiple on 6.50 eps excluding options + 25 in cash (note that the cash may go down from the share repurchase, but then the eps should go up).

My best guess is that the numbers will be a little softer and the stock should end up in the 110-120 range, but it's a tough call. I know that if they had a really bad quarter despite their failure to pre-announce, the stock could visit the low 80s.

While this is a lot of short-term thinking, more importantly the stock should be much higher in several years. In an environment where growth will probably be scarce over the next few years, a solid company like ISRG should ultimately command a big premium to the market.

Apr 10 07:28 AM

[ISRG Fan:]

Excellent analysis!! Best way to play is to buy a May call option spread 130/150. Yes, the stock can go lower but a lot would also depend how the sentiments are because most next week a crucial earnings week including GS, JPM, C, GOOG.


On Apr 10 07:28 AM Alan Brochstein wrote:

> Despite a couple of negative reports from brokers who are fearful
> due to general hospital spending weakness, the stock has finally
> caught a bid. From the time I shared this view, the stock has really
> been a market performer at best, moving in line with the overall
> market but certainly much better than the typical healthcare stock.
>
>
> Why the surge from as low as 95 on Wednesday to above 112 on Thursday?
> I believe that folks have figured out that with earnings to be reported
> next Thursday and no pre-announcement, the results aren't likely
> to be dire. They might not be pretty, but they most likely aren't
> so ugly that a pre-announcement would have been necessary.
>
> Fundamentally, it's easy to be afraid of hospital equipment stocks.
> I believe that a lot of it is factored into the price. While the
> company will show less cash due to the repurchase, going on year-end
> numbers and not including the cash they will generate this quarter,
> ISRG at 112 has an enterprise value now of $3.5 billion and no debt
> ($89 per share is the price net of cash). Their projected EPS of
> $5 this year includes large non-cash options expense of $1.60 per
> share. So, even if the estimates are too high, if we go with $6
> per share excluding options, we are talking about 15X this year's
> cash earnings. So, it would seem that the stock could weather a
> modest cut to earnings, perhaps even rally a bit. I don't believe
> that the .08 of accretion I calculate from the share repurchase is
> in the numbers, so that's a cushion. If the number's hold up as
> they currently are projected, I could see the stock rising to $140.
> The math on this is 18 multiple on 6.50 eps excluding options + 25
> in cash (note that the cash may go down from the share repurchase,
> but then the eps should go up).
>
> My best guess is that the numbers will be a little softer and the
> stock should end up in the 110-120 range, but it's a tough call.
> I know that if they had a really bad quarter despite their failure
> to pre-announce, the stock could visit the low 80s.
>
> While this is a lot of short-term thinking, more importantly the
> stock should be much higher in several years. In an environment
> where growth will probably be scarce over the next few years, a solid
> company like ISRG should ultimately command a big premium to the
> market.

Apr 11 05:34 PM

[ISRG Fan:]

Excellent analysis!! Best way to play is to buy a May call option spread 130/150. Yes, the stock can go lower but a lot would also depend how the sentiments are because most next week a crucial earnings week including GS, JPM, C, GOOG.


On Apr 10 07:28 AM Alan Brochstein wrote:

> Despite a couple of negative reports from brokers who are fearful
> due to general hospital spending weakness, the stock has finally
> caught a bid. From the time I shared this view, the stock has really
> been a market performer at best, moving in line with the overall
> market but certainly much better than the typical healthcare stock.
>
>
> Why the surge from as low as 95 on Wednesday to above 112 on Thursday?
> I believe that folks have figured out that with earnings to be reported
> next Thursday and no pre-announcement, the results aren't likely
> to be dire. They might not be pretty, but they most likely aren't
> so ugly that a pre-announcement would have been necessary.
>
> Fundamentally, it's easy to be afraid of hospital equipment stocks.
> I believe that a lot of it is factored into the price. While the
> company will show less cash due to the repurchase, going on year-end
> numbers and not including the cash they will generate this quarter,
> ISRG at 112 has an enterprise value now of $3.5 billion and no debt
> ($89 per share is the price net of cash). Their projected EPS of
> $5 this year includes large non-cash options expense of $1.60 per
> share. So, even if the estimates are too high, if we go with $6
> per share excluding options, we are talking about 15X this year's
> cash earnings. So, it would seem that the stock could weather a
> modest cut to earnings, perhaps even rally a bit. I don't believe
> that the .08 of accretion I calculate from the share repurchase is
> in the numbers, so that's a cushion. If the number's hold up as
> they currently are projected, I could see the stock rising to $140.
> The math on this is 18 multiple on 6.50 eps excluding options + 25
> in cash (note that the cash may go down from the share repurchase,
> but then the eps should go up).
>
> My best guess is that the numbers will be a little softer and the
> stock should end up in the 110-120 range, but it's a tough call.
> I know that if they had a really bad quarter despite their failure
> to pre-announce, the stock could visit the low 80s.
>
> While this is a lot of short-term thinking, more importantly the
> stock should be much higher in several years. In an environment
> where growth will probably be scarce over the next few years, a solid
> company like ISRG should ultimately command a big premium to the
> market.

Apr 11 05:34 PM