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
