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Prologue

In the financial community there is always a group of glamor industries where the promise of growth in the years ahead is almost certain. Basically these companies are expensive (in terms of market ratios) because they earned the reputation of being the next Apple (NASDAQ:AAPL) or the next Microsoft (NASDAQ:MSFT). The problem lies in the fact that these companies are not yet consolidated in the market; usually, these kind of stocks are unpredictable, varying from expensive failures to rewarding investments.

Intuitive Surgical Simplified

Intuitive Surgical (NASDAQ:ISRG) designs, manufactures and markets da Vinci surgical systems and related instruments and accessories which together provide minimal invasive surgery (MIS) solutions for hospitals, surgeons and patients. The company's surgical system consists of a surgeon's console that controls a set of robotic arms placed on the patient's side. This system is designed to translate the surgeon's natural hand movements into correspondent movements of the instruments positioned near the patient. This system includes high definition 3-D vision, and precise, intuitive and tremor-free instruments' control.

The company's robot is used for urologic, gynecologic, cardiothoracic and general surgery. The business model consists of initially selling the da Vinci surgical systems. After this, the company generates recurring revenue from the sale of instruments used in surgeries. Finally the company enters into annual contracts to provide ongoing services to the hospitals. The recurring revenue has been increasing in the last couple of years and now represents around 57% of the company's total revenue (source: Intuitive Surgical 2012 Annual Report).

Basically, this consists of a model very similar to Gillette's razorblade. The company sells the main robot, but then keeps creating revenue through each procedure realized with the robot. The business fundamentals are very solid, since the company dominates the majority of the market, with a very solid technology.

Uncertainty arising

However, there are some problems affecting the company's stock price. One of the problems is the cost per surgery, another problem is the cost of the initial robot. There has been a lot of negative press suggesting that the robotic surgeries are more expensive than regular surgeries; this has been seen as extremely negative since it is widely accepted that the cost of robotic surgery should be lower than the cost of regular surgery. The price of the initial equipment, around 1.5 and 2.5 Million USD (Source: ISRG Annual Reports), has been source of delays in buying decisions of several hospitals. This point is related to the Affordable Care Act. Commonly known as ObamaCare, this program intends to lower health services costs, which is driving many hospitals to cut spending on capital expenditures such like Intuitive Surgical robots. Additionally, there have been reports of injuries in surgeries using the da Vinci robot. The FDA has open a investigation to those claims.

Investment Rationale

My premise as an investor is that problems sometimes spell opportunity. Therefore, I want to understand if the current stream of bad news surrounding the company is contributing to a decrease in stock price that might make the company attractive.

The basic question we have to ask ourselves is if this technology and this trend towards minimally invasive surgery is here to stay. I believe the answer is yes. The company was able to construct and to grow around a very solid technology, and at the same time, it has been able to gather lots of talented people.

If we look at this problem from a historical perspective we will realize that when Intuitive started, it was focused in cardiac surgery, it was almost by accident that the company entered the prostate surgery market. This is a script seen many times in innovative organizations, sometimes it is unpredictable from where the success is going to come. The point is that the company has to possess a valid technology and a spirit of ingenuity present in their staff to be able to bring their products and services to other markets that were not initially considered.

In my opinion the business model and the milestones achieved during the past decade give a clear indication that the company is on a good path. The resources, technology and skills are in place, it seems to me that more success will be a matter of time.

Let us now look at more tangible data (Source: Reuters):

Table 1 - Intuitive Surgical's Margins

(click to enlarge)

The company's margins are a good indication of what Intuitive was able to build in the last couple of years. It reflects the huge market that the company was able to create and operate almost alone. This almost justifies the current multiples at which the company is trading (PER around 25). The only metric that makes me wonder is the Price to Sales Ratio (PRS), currently at around 7. I have to admit that I have some problems in investing in a company with a PSR so high. However, the fact that the company operates almost alone in the market and the high margins obtained are a good justification for this. The main competition comes from Medtronic (NYSE:MDT) and Accuray (NASDAQ:ARAY).

Let us now look to Intuitive's balance sheet.

Table 2 - Intuitive Surgical's Balance Sheet Ratios

(click to enlarge)

Looking at the main balance sheet ratios, we can see a very conservative company in terms of financial management. In terms of short term liquidity, both the acid test and the current ratio show that the company is far from having problems. In the long term, the absence of debt is a good indicator, while the 1.13 leverage ratio is an assuring indicator that the company has plenty of room to increase debt in order to finance growth.

Wrap-up

Intuitive is a promising corporation with a solid structure that is already in place and achieving results. The main problem is that the company is dealing with confidence problems following a stream of bad press about allegations of malfunctions in some of the company's robots. Basically, the bad press surrounding the ISRG is the main reason why the company has seen a decrease in value around 33% since the high of $585.

At this point I am divided, I sense a good business behind the stock with lots of potential growth, but at the same time I see unrealistic valuation ratios, specifically the PSR. In the short term, I foresee that any bad news will throw the company down and any good news will make it soar.

More fundamentally, I believe that the most logic reasoning is that, in the next 6 months, the company will evidence a drag in its sales figures. The uncertainty surrounding the company's robots will take its toll on the moment any hospital decides to invest millions in a da Vinci robot. Additionally, the high PSR, makes me believe that there is more room to a short term deflation (based on short term sluggish growth) than for a short term recovery in the stock price.

Please note that I am not pessimist about this company, in the long term. I see good business fundamentals. I just think that, in the short term, a bad business momentum together with some unrealistic valuation ratios might hurt the stock.

Source: Intuitive Surgical: Good Underlying Business, Bad Momentum