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Summary

  • Many investors may be interested in investing in ISRG as a Turnaround.
  • The company suffered definite setbacks in its US business in 2013.
  • On the other hand, the company has a very healthy international business that is growing.
  • Based on my IRR valuation model, the current price of $435 yields an IRR of only 7%.
  • Investors need to wait for price to drop OR for the company's US business to recover.

Introduction

Intuitive Surgical (NASDAQ: ISRG) has been the darling of Wall Street in medical technology. Since its IPO in 2000, its stock price has appreciated as much as 3100% to peak at $586 in April 2012, making it a 31-bagger for early investors. Since then, the company has faced significant headwinds in the form of patient lawsuits, negative reports from Citron as well as a statement from the American Congress of OB/GYN about high cost and lack of clinical efficacy of performing hysterectomy using the DaVinci robot. The stock has at one point dropped to as low as $350, -40% from the peak.

For current and future investors of ISRG, it is important to assess the impact of these headwinds on ISRG's business. I myself have been an investor in ISRG since 2007 and have worked in the field of medical robotics. As a result, I have developed an intimate understanding of the medical robotics companies from both a business and an investing perspective. As mentioned in my first article, I will be writing three articles on ISRG and medical robotics:

  • Article 1 described ISRG's three revenue streams and provided three simple key metrics to help investors gain advanced insights into the company's business in light of the current headwinds.
  • Article 2 (This Article) will dive deeper into ISRG's key driver of future growth - geographic expansion - to provide the basis for 5-year forward modeling
  • Article 3 (To be written) will apply ISRG's analysis onto other publicly traded medical equipment with similar multiple revenue streams. This will allow investors to assess if these other companies can replicate or exceed the success of ISRG.

Structure of this article

A full one year has transpired since my first article dated April 2013, giving us one whole year of financial results to fully assess the impacts of the negative headwinds mentioned above on ISRG's business. In this article, I will:

  1. Perform a recap of ISRG's financial results up to 2013, and assess the damage done thus far.
  2. Break down ISRG's US and international business lines, establishing the thesis that international expansion may be key to ISRG's future growth.
  3. Perform a 5-year forward projection of ISRG's business based on the premise of a growing international installed base and a stabilizing US installed base.

The main purposes of this article are two-fold: (1) to allow savvy investors determine whether to invest in ISRG as a turnaround, and (2) at what price will this investment make economic sense.

Recap of the Damage Done

As stated in the Bottom Line of my first article, negative publicity and resistance from the American Congress of OB/GYN have created a higher level of uncertainty in ISRG's future. The greatest threat to ISRG's business is that negative publicity will result in (1) female patients shying away from robotic hysterectomy, (2) hospitals holding off purchase of new systems, and (3) doctors stop learning and performing robotic surgery.

My article also stated that symptoms of these negative impacts will show up in 3 key metrics even as ISRG's revenue and profit continue to grow:

  1. New systems sold
  2. Average selling price
  3. Procedure/Unit Growth Rate

To draw an analog of ISRG's business to the chain restaurant business, new systems sold is similar to the number of new restaurant units added, and Procedure/Unit Growth Rate is similar to comparable store sales growth rate.

So with the FY2013 results out, what has actually transpired?

  • On a global basis, new systems sold dropped 12%, from 620 units in 2012 to 546 units in 2013.
  • Average selling price of these system sales increased from $1.5M in 2012 to $1.53M in 2013.
  • Procedure/Unit Growth Rate continues its decline from 20% in 2007 to 1% in 2013.

2007

2008

2009

2010

2011

2012

2013

Units Sold

241

335

338

441

534

620

546

Growth rate

39%

1%

30%

21%

16%

-12%

ASP ($M)

$1.35

$1.36

$1.45

$1.50

$1.46

$1.50

$1.53

System revenue ($M)

$324.40

$455.30

$490.50

$660.30

$777.80

$932.90

$834.90

Installed Base

795

1,111

1,395

1,752

2,132

2,585

2966

service/unit ($K)

$106.54

$113.95

$123.51

$127.80

$130.58

$132.53

$133.95

Service revenue ($M)

$84.70

$126.60

$172.30

$223.90

$278.40

$342.60

$397.30

Procedures/unit

122

147

159

169

174

176

Procedures/unit Growth Rate

20%

8%

6%

3%

1%

Toll/procedure ($)

$2,154

$1,900

$1,902

$1,948

$2,007

$1,975

Consumable revenue ($M)

$191.7

$293.0

$389.4

$528.8

$701.1

$903.3

$1,032.9

Revenue ($M)

$600.8

$874.9

$1,052.2

$1,413.0

$1,757.3

$2,178.8

$2,265.1

Net Margin

24%

23%

22%

27%

28%

30%

30%

Net Income ($M)

$145.0

$204.0

$232.6

$381.8

$495.1

$656.6

$671.0

(click to enlarge)

The obvious damage to ISRG's business is the significant drop in new system sales and the subsequent drop off in system revenue. But the more troubling development is the continuous decline in Procedure/Unit Growth Rate. At 176 procedures per installed system, this is equivalent to 3.5 robotic surgical procedures per week, pointing to excess capacity in the worldwide installed base.

This is analogous to a chain restaurant business that has slowed down its new restaurant rollout while comparable store growth continues its steady decline towards zero percent. The key questions for investors of that restaurant chain should be:

(1) Will the comparable store growth soon drop to negative growth?

(2) Why is the comparable store growth steadily declining even when the number of customers served per restaurant appears low?

ISRG's US and International Businesses

To gain a better understanding of ISRG's business performance, we need to split out ISRG's US and international business lines and analyze them separately. Using the same techniques I have outlined in my first article on ISRG, we can break down ISRG's US and international businesses into their separate system, service and consumable revenue streams.

These are some key observations about ISRG's US business:

  • System sales dropped off severely from 476 units to 342 units (-28%) in 2013
  • Procedures/Unit Growth Rate actually went negative (-1%) in 2013

These results reflect the negative impacts of the patient lawsuits and the American Congress of OB/GYN statement on the company's US business. We currently have no way of knowing when ISRG's US business will finally turn around.

2007

2008

2009

2010

2011

2012

2013

Units Sold

174

246

252

335

400

476

342

Growth in Units Sold

41%

2%

33%

19%

19%

-28%

ASP ($M)

$1.35

$1.36

$1.45

$1.50

$1.46

$1.50

$1.53

System revenue

$234.21

$334.34

$365.70

$501.59

$582.62

$716.23

$522.96

Installed Base

825

1,028

1,285

1,548

1,878

2,083

service/unit ($K)

$106.54

$113.95

$123.51

$127.80

$130.58

$132.53

$133.95

Service revenue

$94.01

$126.97

$164.22

$202.14

$248.90

$279.02

Procedures/unit

142

171

188

197

202

200

Growth Rate

21%

10%

5%

3%

-1%

Toll/procedure

$2,154

$1,900

$1,902

$1,948

$2,007

$1,975

Consumable revenue

$234.7

$251.7

$334.3

$460.2

$593.9

$761.8

$823.9

Total US Revenue

$468.9

$680.0

$827.0

$1,126.0

$1,378.7

$1,726.9

$1,625.9

(click to enlarge)

On the other hand, the company's international business appeared to be accelerating in 2013:

  1. System sales increased 42% from 144 units to 204 units
  2. Procedures/Unit Growth Rate increased 20% from 100 to 120 procedures per site. Note that procedure volume of an international DaVinci system is only ½ that of a US DaVinci system

These results clearly indicate that the negative headwinds' impact is confined to the company's US business. Also, the company's management is aggressively driving its international business to compensate for its deteriorating US business.

2007

2008

2009

2010

2011

2012

2013

Units Sold

67

89

86

106

134

144

204

Growth in Units Sold

33%

-3%

23%

26%

7%

42%

ASP ($M)

$1.35

$1.36

$1.45

$1.50

$1.46

$1.50

$1.53

System revenue

$90.19

$120.96

$124.80

$158.71

$195.18

$216.67

$311.94

Installed Base

286

367

467

584

707

883

service/unit ($K)

$106.54

$113.95

$123.51

$127.80

$130.58

$132.53

$133.95

Service revenue

$32.59

$45.33

$59.68

$76.26

$93.70

$118.28

Procedures/unit

67

79

77

94

100

120

Growth Rate

17%

-2%

22%

6%

20%

Toll/procedure

$2,154

$1,900

$1,902

$1,948

$2,007

$1,975

Consumable revenue

$41.9

$41.4

$55.1

$68.6

$107.2

$141.5

$209.0

Total Intl Revenue

$132.1

$195.0

$225.2

$287.0

$378.6

$451.9

$639.2

(click to enlarge)

ISRG as Turnaround Investing

Whether to invest in ISRG as a turnaround depends on qualitative assessment, which cannot really be modeled. For me personally, it comes down to the following:

  1. Can the company redevelop the DaVinci robot into a platform that can help hospitals improve clinical efficacy and patient safety so as to justify the additional cost added to a robotic procedure?
  2. Will the company learn from its current setback to restructure its field organization to emphasize surgeon proficiency and patient safety, rather than simply achieving sales quotas and profit targets?

I think each investor should make his or her own decision about whether ISRG should be invested as a turnaround. For those who think ISRG is a potential turnaround investment, I have put together a valuation model to help them decide on the right price to accumulate the shares.

ISRG's Valuation Model

I have constructed a 5-year projection of the company's business based on the following assumptions on the company's system, service and consumable sales:

(1) System Sales Assumptions:

· US system sales decline by 15% in 2014, then recover to 5% growth in 2015-2018

· International system sales grow at 20% in 2014, eventually slowing down to 15% in 2018

· Average selling price for both US and international systems remains constant at $1.5M

2012

2013

2014

2015

2016

2017

2018

Units - US

476

342

291

306

321

337

354

Unit sales growth (%)

19%

-28%

-15%

5%

5%

5%

5%

Units - Int'l

144

204

245

294

347

403

463

Unit sales growth (%)

7%

42%

20%

20%

18%

16%

15%

Units

620

546

536

600

668

740

817

ASP ($M)

$1.50

$1.53

$1.50

$1.50

$1.50

$1.50

$1.50

System revenue

$933.2

$834.5

$803.8

$900.1

$1,002.1

$1,110.1

$1,225.6

(2) Service Revenue Assumptions:

· New installs as a percentage of total system sales in the US decline from 60% in 2013 to 35% in 2018, as the company increasingly rely on upgrade sales to existing customers instead of new system sales to new customers.

· New installs as a percentage of total system sales in the international market remain high at 85%, as the company continues its geographical expansion selling new systems to new hospitals.

· The DaVinci installed base increased from 2967 systems in 2013 to 5170 systems in 2018, consisting of 2372 International systems and 2798 US systems.

· Service contract remains stable at $135K per installed system.

2012

2013

2014

2015

2016

2017

2018

Units - US

476

342

291

306

321

337

354

Units - Int'l

144

204

245

294

347

403

463

Installed Base - US

1,878

2,083

2243

2396

2540

2675

2798

New Install % - US

69%

60%

55%

50%

45%

40%

35%

Installed Base - Int'l

707

883

1091

1341

1636

1979

2372

New Install % - US

85%

86%

85%

85%

85%

85%

85%

Installed Base

2,586

2,967

3334

3737

4176

4653

5170

service/unit ($K)

$133

$134

$135

$135

$135

$135

$135

Service revenue

$342.6

$397.3

$450.1

$504.5

$563.8

$628.2

$698.0

(3) Consumable Sales Assumptions:

· US procedure per site declines another 1% in 2014, then recovers to 3% growth in 2015-2018. Growth will be driven by increase in general surgery, offset by reduction in urologic and gynecologic surgeries.

· International procedure per site continues to grow at 10% per year

· Combined US and international procedures grows from 523K in 2013 to 1.08M in 2018

· Consumable revenue per procedure stays constant at $1975

2012

2013

2014

2015

2016

2017

2018

Installed Base - US

1,878

2,083

2243

2396

2540

2675

2798

Procedures/unit - US

202

200

198

204

210

217

223

Growth Rate

3%

-1%

-1%

3%

3%

3%

3%

Installed Base - Int'l

707

883

1091

1341

1636

1979

2372

Procedures/unit - Int'l

100

120

132

145

160

175

193

Growth Rate

6%

20%

10%

10%

10%

10%

10%

Total Procedures

450,121

523,106

588,562

683,734

795,250

926,639

1,082,298

Total Procedure Growth

25%

16%

13%

16%

16%

17%

17%

Toll/procedure

$2,007

$1,975

$1,975

$1,975

$1,975

$1,975

$1,975

Consumable revenue

$903.3

$1,032.9

$1,162.4

$1,350.3

$1,570.6

$1,830.1

$2,137.5

The assumptions made above are based on a moderately optimistic outlook on ISRG's business. It assumes that the negative impact to ISRG's business is localized in the US and will last only one more year. It also assumes the company will be successful in expanding its international installed base and growing procedure volume per site close to US level.

Under this base line scenario and assuming the company will be valued at a P/E of 18 in 2018, if we were to buy ISRG at $435 now, it will generate an IRR (internal rate of return) of only 7%.

In ($M)

2012

2013

2014

2015

2016

2017

2018

System revenue

$933.2

$834.5

$803.8

$900.1

$1,002.1

$1,110.1

$1,225.6

Service revenue

$342.6

$397.3

$450.1

$504.5

$563.8

$628.2

$698.0

Consumable revenue

$903.3

$1,032.9

$1,162.4

$1,350.3

$1,570.6

$1,830.1

$2,137.5

Revenue

$2,179.09

$2,264.67

$2,416.26

$2,754.89

$3,136.42

$3,568.33

$4,061.07

Net Margin

30%

30%

30%

30%

30%

30%

30%

Net Income

$656.6

$671.0

$724.9

$826.5

$940.9

$1,070.5

$1,218.3

Revenue Growth

24%

4%

7%

14%

14%

14%

14%

Income Growth

33%

2%

8%

14%

14%

14%

14%

P/E

18

18

18

18

18

Market Cap

$ 13,048

$ 14,876

$ 16,937

$ 19,269

$ 21,930

Num Shares

41.1

40.1

39.7

39.3

38.9

38.5

38.1

Fair Value

$ 328.67

$ 378.52

$ 435.29

$ 500.23

$ 575.06

IRR

7%

$ (435.00)

$ -

$ -

$ -

$ 575.06

The Bottom Line

For investors who believe that ISRG is able to reposition its robotic system into a technology platform that can help hospitals improve clinical efficacy and patient safety, so that it compensates for the added cost of robotic surgery, the company may be a good candidate for turnaround investing.

Digging deeper into the company's financial performance, we discover that the company is facing challenges primarily in its US business while its international business continues to experience healthy growth.

I have therefore created a 5-year IRR valuation model, which is based on a moderately optimistic outlook on ISRG's business. It assumes that the negative impact to ISRG's business will be localized in the US and last only one more year until 2015. It also assumes the company will be able to expand its international installed base and grow Procedure/Unit close to the US level.

At the current stock price of around $435, the model yields a relatively low IRR of 7%. This is not a screaming buy under the scenario proposed above, as the investor is not given a high enough margin of safety. In fact, only when the stock price drops to $330 will the current model yield a decent IRR of 15%.

I believe investors can take a monitoring position at the current price and not suffer significant capital loss in a 5-year time frame. On the other hand, unless there is a stronger recovery of the company's US business, with corresponding increase in system sales and procedures performed per site, it is prudent not to aggressively invest at current pricing.

Source: Valuing Intuitive Surgical For Turnaround Investing