Intuitive Surgical: Operating Well Even During Challenging Times

I reviewed Intuitive Surgical (ISRG), one of my favorite companies, in early March, suggesting that it could move from the $90 price at the time to $125 by year-end. Well, with a lot of help from the market and what I believe was stellar execution in a very tough environment during Q1, the stock closed at $130 on Friday. As I incorporate the new information into my view regarding the current valuation, I find the stock probably stretched near-term but capable of rising as the year progresses if they are able to exceed current expectations or if the market continues to be more forward-looking than it has been up until recently.

Having followed the company for almost 5 years now, I have to say that Thursday was one of the strangest days ever. First, the company accidentally filed its 8-K early, and the stock plunged initially on what was clearly a headline miss. It traded as low as 106 in the pre-market. As it became clear that there was a special situation impacting reported numbers, the stock rallied sharply and then traded above 130 (still in pre-market!). During the day, it traded between 113 and 127, closing almost unchanged at 118. During the call, as the company announced it was "suspending" certain key elements of its full-year guidance, the stock plunged below 105 briefly before ending the after-hours session near 110. The range on Friday was 114-132, closing at 130 and leaving the stock now up year-to-date. Wow!

I suggest reading the transcript if you are interested in the company. It was very clear that the long-term story is intact, with procedural growth up 60% year-over-year. The deferral, which the company described as "complex" (a word I like to see only when used to describe the surgical procedures!), fully explains the "miss". Clearly there are several challenges as well, including lower unit demand for new systems and pressure on instrument sales due to the lower initial stocking as well as better inventory management by customers. On the other hand, I found the high international percentage despite currency challenges, the pricing holding up, the compelling features of the new technology and the clinical data to more than make-up for the short-term dampening of demand.

I believe that the stock might run into trouble at 140 or so, if not earlier, but I am even more confident that it will be substantially higher in a few years. As you can see in the chart below (click to enlarge), the valuations are relatively low for a high-growth monopoly.

I believe that 90 is very solid entry level should it pull back, but I would buy some in front of that level as well (105-110). I have to confess to making a trading blunder, having sold my position at 114-120 early last week with the hope of repurchasing after they reported or even before if the stock dropped enough. I missed while I was on the call, but I was concerned that the "guidance suspension" could force the stock below 100 briefly. The good news is that it is a large position in my Top 20 model portfolio (which is now up 17% YTD), though I expect to take some off the table there Monday.

I continue to believe that no matter how bad this economy is or becomes, ISRG will continue to enjoy the proliferation of its technology. The part that challenges me is how cheap investors may allow the stock to become between now and then. In a "best-case" scenario, I wouldn't be surprised to see the stock trade to 175 by year-end, as this would represent a 25PE on 2010 projected pre-options earnings. In this market, though, best-case scenarios haven't been materializing, so I will be cautious for now.

Disclosure: No position

Comments

[richjoy403]

I too have high (long-term) hopes for ISRG . I the near term however, I would expect the stock to suffer if DiVenci installations lag -- which is likely if the worldwide recession continues to pressure hospital budgets (which I expect to lag an economic recovery).

2009 Apr 19 09:42 AM

[mmm309]

I agree, DaVinci is a great system and
I would opt for robotic surgery if I needed
surgery. That said, I think their growth
will be subdued for a while.

EPS decreased 35% YOY and guidance
suspended is bad.

I don't agree that the deferred revenue
explains the miss. On the conference
call they fumbled all over this. The 10Q indicated that the customers have not acepted the offer of an upgrade yet; so how
is it deferred revenue if a sale has not been consumated? (see 10Q quote below) Customers have until June 30 to accept or decline the offer. Given medicare cuts that are coming it's doubtful
all will accept the offer even it it is at a substantial discount. And since it will be at a substantial discounts, they won't make their margins on those that do accept.
margins.

Management indicated that they plan to expand staff
in sales and R&D. 41 new FTEs. Seems like a lot.
If hospitals havn't bought DaVinci yet, why do it during
a recession. And as for multiple systems at existing
hospitals, it's more likely hospitals will focus on improved
scheduling or will run the existing systems more shifts before buying another.

Regarding their international sales, a strong dollar
will not help them and CHDX has the right to sell
DaVinci in China so that will hit their margins as
well.

The withdrawal of guidance coupled with sale by GS
of 1.4M shares at $106. makes me think, ISRG the stk,
may not be the growth story it was. Expect analysts
to lower EPS estimates for 09 and 2010.

Finally, I tried to go back and listen to the QA again but
couldn't. It cut off on multiple sites.

SEC 10Q Filed 4/17/09 "In April 2009,
we offered certain of our customers who purchased
da Vinci S Surgical Systems in the first quarter,
the opportunity to upgrade their recently purchased
da Vinci S Surgical Systems to a da Vinci Si Surgical
System. The upgrade is being offered at a
discount to its fair value. These customers
have been given until June 30, 2009 to accept
our offer.

Position - puts

2009 Apr 19 08:00 PM

[Alan Brochstein]

I think I can explain the deferred sales. They had to clarify in Q&A, but it seemed as if everyone was on the same page at that point (hence 130 and not 100).

The way I understand it is that the customers paid the regular price for the Da Vinci S. The Si has a $600K higher price I believe, but the company offered it at $150K to 44 customers. The company had to thus take that $450K difference and "defer" the sales. If you check the math, 44*450 accounts for that $20mm. IF the customer turns it down, THEN the company realizes the deferred portion. But, IF the customer does the upgrade, the company will actually receive an extra $150K in cash and recognize that portion in revenues.

Isn't that pretty clear?

2009 Apr 19 08:23 PM

[ksmithdc]

Interesting read, thanks.

2009 Apr 19 08:26 PM

[mmm309]

Thank you for the reply. I don't want to belabor the pt but I am
disturbed by what I think is a slight of hand.

I understand the 20m but not sure about how it will look in q2 and beyond. For simplity, lets say all 44 accts accept the offer to upgrade. ISRG will take in 6.6m in rev and cash and have to take a promo expense or marketing exp of 13.4m (I think).

Also, since this was q1 09 ending March 31 and the offer to upgrade was made in April, seems disingenuous at best to say that
they had a rev increase (incl the deferred rev) of 11% in q1.
I guess we'll see.
Megan

On Apr 19 08:23 PM Alan Brochstein wrote:

> I think I can explain the deferred sales. They had to clarify in
> Q&A, but it seemed as if everyone was on the same page at that
> point (hence 130 and not 100).
>
> The way I understand it is that the customers paid the regular price
> for the Da Vinci S. The Si has a $600K higher price I believe, but
> the company offered it at $150K to 44 customers. The company had
> to thus take that $450K difference and "defer" the sales. If you
> check the math, 44*450 accounts for that $20mm. IF the customer turns
> it down, THEN the company realizes the deferred portion. But, IF
> the customer does the upgrade, the company will actually receive
> an extra $150K in cash and recognize that portion in revenues. <br/>
>
> Isn't that pretty clear?

2009 Apr 20 06:14 PM

[Alan Brochstein]

My understanding, Megan, is that the expenses were absorbed. I have been following this company for quite some time. They are extreme straight-shooters. As I disclosed, I have no current position, so I can't be talking my position! You have puts. I actually hope that you do well with them, as I would like to repurchase the stock. I have shifted towards healthcare rather dramatically over the past couple of weeks, and ISRG is just the kind of balance-sheet strong company I like these days.

2009 Apr 20 07:23 PM