As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. Though we think Intuitive Surgical (ISRG) is worth about $549 per share, the upper end of our fair value range suggests a much higher price tag, nearly $700 per share.
For some background, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (click here for an in-depth presentation on our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best. In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:
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If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Intuitive Surgical posts a VBI score of 5 on our scale, reflecting our 'fairly valued' DCF assessment of the firm (on the basis of our fair value range), its unattractive relative valuation versus peers, and neutral techinicals. We prefer firms that have scores of 9 and 10, as it has been shown that a cohort of stocks with both attractive value and momentum qualities have great potential for outperformance. Our white paper outlining this conclusion can be downloaded here. Still, for companies like Intuitive Surgical, reaching the low end of our fair value estimate range may be a bit of stretch. We use Medtronic (MDT), Varian Medical Systems (VAR), Zimmer (ZMH), and Waters (WAT) for our peer group analysis.
Our Report on Intuitive Surgical
In the spirit of transparency, our report on Intuitive Surgical and hundreds of other companies can be found here.
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Most Recent Quarterly Results
Intuitive Surgical , one of the more well-known momentum firms on the market today, reported excellent first-quarter earnings. We're sticking with our fair value estimate for Intuitive Surgical at this time. The robotic medical-equipment firm, best known for its da Vinci Surgical System (click here), reported first-quarter 2012 revenue of $495 million, which advanced an impressive 28% from the same period a year ago (consensus was at $477 million). The key drivers continue to be higher robotic procedure adoption and higher da Vinci Surgical System sales. First-quarter instruments and accessories revenue jumped 32%, while systems revenue increased 24%. The firm's da Vinci systems continue to gain traction in the health-care community, with the firm selling 140 systems in the period versus 120 systems in the same quarter a year ago (up 16%). We continue to expect explosive growth in da Vinci sales.
The firm did a fantastic job translating its top-line growth into profit expansion, with operating income jumping over 30% during the period. Intuitive Surgical's net income per diluted share expanded to $3.50 (consensus expectations were at $3.14 per share), up more than 35% from the year-ago quarter. Looking ahead, investors should expect continued strong fundamental performance from Intuitive Surgical and strong adoption of its innovative da Vinci system.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Intuitive Surgical's 3-year historical return on invested capital (without goodwill) is 135%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Intuitive Surgical's free cash flow margin has averaged about 32% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Intuitive Surgical, cash flow from operations increased about 76% from levels registered two years ago, while capital expenditures expanded about 55% over the same time period.
Our discounted cash flow model indicates that Intuitive Surgical's shares are worth between $412.00 - $686.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $549 per share represents a price-to-earnings (P/E) ratio of about 44.6 times last year's earnings and an implied EV/EBITDA multiple of about 28.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 18.2% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 26.2%. Our model reflects a 5-year projected average operating margin of 40.5%, which is above Intuitive Surgical's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 8.8% for the next 15 years and 3% in perpetuity. For Intuitive Surgical, we use a 10.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $549 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Intuitive Surgical. We think the firm is attractive below $412 per share (the green line), but quite expensive above $686 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Intuitive Surgical's fair value at this point in time to be about $549 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Intuitive Surgical's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $747 per share in Year 3 represents our existing fair value per share of $549 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
Additional disclosure: ISRG is included in the portfolio of our Best Ideas Newsletter.