Last week, surgical robot maker Intuitive Surgical (ISRG) reported its fiscal third quarter earnings report. The company beat on both the top and bottom line, something ISRG investors are used to. However, this was not as large a beat as many have been used to. Procedure growth slowed down, as the company noted some tough times in Europe. That's not a surprise. Going forward, the company said it expected to face some significant headwinds. There have been those that have questioned this name in the past, stating that Intuitive's valuation is just too high. However, this is a market leader that has no competition, is extremely profitable, and has a pristine balance sheet. Today, I'll discuss Intuitive's third quarter results, and show why the stock is still a buy.
Third Quarter Results:
For the third quarter, Intuitive reported revenues of $538 million, which beat analyst estimates by $3 million. Product revenues were up 20.03% to $450 million, while service revenues were up 22.28% to $88 million. Overall, revenues rose by 20.39% over the prior year period, despite tough conditions in Europe.
On the bottom line, the company reported earnings of $3.54, which beat by 4 cents. This was the smallest earnings beat in a while, but it was still a beat. If you include a one-time tax benefit, earnings per share came in at $4.46. Obviously, you should exclude the $38 million benefit when looking at results, but still, that's money saved.
To fully analyze the results, I will provide a margin chart, then discuss how those numbers were produced.
*Excluding tax benefit, 2012 profit margin would have been 27.09%.
Bears will come out and say that product gross margins declining is a huge red flag. The company noted in its 10-Q filing that the decline in product margins was due to newly launched products, that tend to have lower margins at introduction and see an increase in margins as their product cycle matures.
But despite the 85 basis point decline in product margins, gross margins only lost 33 basis points. Service gross margins improved by nearly 250 basis points. Now, product sales represent 83.67% of the quarter's total, down from 83.93% in last year's period. A higher percentage of sales from the lower margin service business did not really affect margins that much. As service margins continue to improve, these gross margin numbers will hold up more. I trust the company when they said that the decline was due to new products. They've earned some credibility.
Overall, gross margin dollars for the period increased by 19.85% to $390 million. However, because revenues rose at a slightly higher rate, you saw the above mentioned decline in gross margins.
When it comes to operating expenses, selling and general expenses only rose by 16% year over year, slower than the rise in revenues and gross margin. However, R&D expenses rose by 40%, due to a large increase in stock based compensation and higher prototype costs. Those prototype costs can be uneven throughout the year, so they were a bit higher this quarter. In fact, during Q2, total R&D expenses rose at a rate slower than revenues. Q3 just happened to have larger R&D spending. Overall, operating expenses rose by 21.9%, which led to a 74 basis point decline in operating margins.
The company did announce a higher amount of interest income, which partially helped to offset a slightly higher tax rate (excluding the benefit). Overall, net margins fell by 31 points, which is better than the decline in operating margins. This company is still producing more than 27 cents of earnings for every dollar in revenues. That is a highly profitable company.
The beautiful balance sheet:
Intuitive's balance sheet continues to get better and better. I don't hear many bears talking about the balance sheet, because it is that good. The following table shows the balance sheet over the past two years, including the numbers at the end of this year's Q2.
Let me just highlight some very important numbers when it comes to the financial health of Intuitive Surgical:
- The cash and investment pile increased by $70 million, and that includes the fact that the company spent $170 million to buy back over 340,000 shares.
- Working capital decreased because the company shifted funds from cash and short term investments to long term investments. Cash and short term investments decreased by $70 million, while the long term investment account balance increased by $140 million.
- Current liabilities increased by $18 million, and total liabilities decreased by $5 million. Total assets increased by $106 million.
- The company now has more than $8.50 of assets for every dollar of liabilities. You should read that sentence again. You won't find many companies that have this few liabilities.
Even though the current ratio and working capital numbers declined, it was just due to a shift in assets and liabilities. Overall, the company's cash position increased, liabilities decreased, and the debt (liabilities to assets) ratio is under 12%. That is amazing.
Like I said, the company bought back $170 million in shares during the quarter. Intuitive does not pay a dividend currently, but they could if they wanted to. Instead, they are buying back shares. They obviously have the financial flexibility to buy back a lot more shares, and they will continue to do so. At the end of Q3, $383 million remained on their current buyback plan. That will certainly help earnings per share numbers, which will bring down the valuation (more on that later).
Intuitive guided that 2012 revenues would come in at the high end of its 20% to 23% growth range. Current, analysts expect 22.5% growth. Since the company has given fairly conservative guidance in the past, I think that they will probably beat, or at least meet, revenue expectations for the year. If they can manage to get any improvement from Europe we could see a nice beat.
Looking forward, analysts currently expect Q4 revenues to rise by 17.7% to nearly $585 million. Earnings per share are expected to rise from $3.75 to $4.05, or 8%.
There lies the opportunity for Intuitive. Earnings per share growth is expected to be half that of revenue growth. Part of that has to do with the fact that the diluted share count rose 2% from last year's Q4 to this year's Q3. However, like I mentioned above, the company is buying back shares, and the share count is down from Q2. Depending on how many shares the company buys back, earnings per share could see a nice benefit. It appears analysts also see margins coming down a little.
But let's go back to Q3. Earnings per share rose by 16.1%, compared to the 20.4% rise in revenues. That includes margins coming down a bit, and a 2.5% rise in the share count.
So to me, analysts look a little bearish when it comes to Q4 earnings for ISRG. I think estimates will probably come up a little. Even if the company only increases earnings at 12%, compared to a nearly 18% rise in revenues (expected), that gets you $4.20 in earnings. A 10% rise in earnings gets you $4.125. Current estimates call for $4.05. There is some nice room for a beat here.
Valuation / Targets:
Intuitive has been criticized for carrying a very high valuation. I can't say that this hasn't been the truth. The following table shows the high and low price to earnings range for the stock in recent years. This is based on the year's actual earnings, as well as that years' high and low prices during the year.
Now based on Monday's close, the stock is currently trading at 37.1 times this year's expected earnings of $14.86, and 31.4 times 2013's expected $17.57. But remember, that is based on current expectations. Remember my discussion above about Q4? What if the company does beat by a dime, or a quarter, or more? The valuation will get pushed down even further.
After the company's Q2 results, I called the stock a tremendous buying opportunity at $475. Those that listened to that call have fared extremely well. At that time, analysts were expecting $17.46 in earnings for 2013. We've come up 11 cents since then, and I think estimates will continue to rise, especially as the company buys back more stock. Plus, we haven't even finished 2012 yet. If they continue to beat, those estimates for 2013 will go higher and higher.
Conclusion - ISRG can still be a buy:
I've stated in the past that I thought ISRG could easily do $18 to $20 in earnings next year. Even at $18, which wouldn't even be the current high estimate on the street, you're getting a stock for about 30 times next year's earnings. While that may seem expensive, you are talking about a company with no competition, sky high margins, a fair amount of growth potential, a stock buyback, and an amazing balance sheet. Sometimes, you have to pay a little extra for a market leader, and investors have been willing to do that in the past.
The current analyst price target is about $589, implying $40 of upside from here. But I'm guessing most analysts haven't fully analyzed Q3 yet, which means I think the average price target goes higher. One analyst even has a $670 target on the name. Now, ISRG may not get to $700 as fast as I thought, but even if it gets to $650 in the next year or so, that's plenty of upside. I do understand why some may question the valuation, so if investors want to wait for a pullback, that is certainly a viable option. You could also consider something like selling puts, where you collect a premium if the stock stays flat or goes up, but could enter the stock at a lower level if the options are exercised. For example, selling the April 2013 $550 put gets you $44, an 8% return by April or in around $506.