Intuitive Surgical: When 20% Growth Isn't Enough

Oct.17.12 | About: Intuitive Surgical, (ISRG)

Intuitive Surgical (NASDAQ:ISRG) reported yet another strong quarter, its sixth straight quarter of 20% plus sales growth. Analysts had expected the company to produce sales of $535mm, and the company slightly exceeded the consensus, with $538mm in sales (+20%). Earnings per share were reported at $4.46, but they were exaggerated by a one-time reduction to the tax-rate. According to the company, had it not been for this one-time event, earnings would have been $3.54, just marginally above the consensus of $3.50 but still 16% above the year-ago level. This was the first time in three years that EPS grew slower than 20%.

ISRG is notorious for beating the consensus handily. Last quarter, for instance, sales came in 2.7% above the consensus with EPS beating expectations by more than 6%. In Q1, sales came in 6.5% above the consensus with EPS beating expectations by 11.5%. Notice a trend here?

I listened to the call live, but, for those who didn't and would like to review it, Seeking Alpha provided the transcript relatively quickly. You can find it here. Here are some of the main points:

  • Procedure growth was "only" 22%
  • The number one procedure in the U.S. for the company is declining
  • Europe is challenging
  • Japan is taking off

Let me hit each of these quickly. Procedure growth is ultimately the lifeblood of the company now that its installed base has proliferated to almost 2500 consoles worldwide. Investors hate when trends break, and this is a trend that has broken. The company's procedural growth, while still quite healthy, came in below expectations and has slowed from 26% in Q2, 29% in Q1 and 29% for all of 2011. Sales slightly exceeded the consensus due to strong sales in Japan (16 Da Vincis).

Prostate surgery has been the largest single procedure for the company. In the U.S., there has been a change in protocols, with less frequent PSA tests (so fewer diagnoses) and "watchful waiting" taking precedence over more immediate surgery for many patients. This is an issue that really accelerated this quarter, with procedures dropping 20% from a year ago. While it's not "news", the magnitude of the decline is likely to create concern.

Like many companies, ISRG is challenged in Europe. Placements of new Da Vincis were very weak, but procedures were also under pressure. The company cited macroeconomic factors, not surprisingly, but it also referred to "structural problems", which it clarified in the Q&A as being some internal sales allocation issues but also a trend towards per diem rather than per case reimbursement (which changes the economics adversely for ISRG, since it gets people out of the hospital quickly).

It wasn't all bad. My final main point was one of many positives, but it's the one that I think is most promising over the intermediate term. Japan only recently began to be a significant customer after approval last year, and it is now the second-largest market, with 70 systems. So far, only prostate is approved, but docs are apparently able to do some other procedures.

While I think that ISRG is one of the most exceptional companies I have ever encountered, one with a very bright future, it's a stock that trades somewhat expensively. At the 507 price it commanded in the after-hours, it trades at about 29X the 2013 consensus. Even stripping out the $2.7 billion in cash and investments, it trades at approximately 25X. With growth slowing, it seems likely that the PE is not going to rise substantially, suggesting that the stock price will track earnings growth. My target for the stock of 600 a year from now assumes perhaps slight PE expansion, but the near-term could be rough, perhaps dipping to 440-460 or so. To put that in perspective, here is the 5-year chart:

(click to enlarge)Click to enlarge

A move to 450 would be about a 25% correction from the recent all-time high and would not create a 52-week low, but it would eclipse the low of 467 in July.

One last point that I want to make is that 20% growth isn't as extreme as it sounds. If ISRG were the only company growing sales by 20%, perhaps investors would be more patient. The fact is that 64 companies in the S&P 500 with sales in excess of $1 billion per year have grown sales faster than 20% over the past year. I know, it sounds unbelievable, but that is what Baseline tells me. To be fair, some of these have grown through acquisitions, but many haven't.

My guess is that investors are more interested in companies growing above 20% that are on the way up rather on the way down (in terms of growth rate). Looking at the 64 companies, more than a handful have dramatically lower PE ratios.

I think ISRG is a great company. (I said so two years ago, when I also thought it was a great stock at $260.) This report doesn't lead me to change my view that ISRG is a great company, but it's not such a great stock. Unfortunately, 20% growth isn't enough!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.