Intuitive Surgical: China, $2 Billion Buyback And Growth Scenarios

| About: Intuitive Surgical, (ISRG)

Summary

Intuitive stock surged after the buyback announcement.

Is this buyback of a high P/E stock rational?

China presents both opportunity and danger.

Higher growth rate possible, but not guaranteed.

Intuitive Surgical (NASDAQ:ISRG) is the world's leading maker of surgical robots. Its da Vinci systems allow surgeons to perform many types of operations with less risk to patients. With little competition so far, Intuitive enjoys strong profit margins.

Q4 2016 results announced on January 24, 2017, showed solid growth, but Intuitive stock could be considered pricey, with a high P/E (price to earnings) ratio of 37. Also announced was a $2 billion stock buyback, which is likely why the stock surged over 4% the following day.

I am cautious about buying stocks with high P/E ratios (anything over 20), which can be due to unwarranted investor enthusiasm. In a rational market, stocks are priced solely according to realistic expectations of future profits. In this article I will examine Q4 results, the buyback and related capital allocation issues, and Intuitive's future in China. But first I will review the basics, in case you missed them.

Intuitive Surgical Q4 2016 results

Revenue was $757 million, up 11% sequentially and up 12% from Q4 2015. That is a solid growth rate, but it masks some weaknesses (and strengths). You can ignore the seemingly spectacular jump in revenue from Q3 to Q4, because it is within typical seasonality, as hospitals finish using their annual capital budgets. Q1 will be down sequentially, which is no reason to panic, the data to look for is y/y changes.

Overall, Intuitive's revenue grew rapidly from the launch of its commercial systems until 2008-2009. As the recession ended, growth resumed but at a slower clip. Mostly this was because it is easier to grow rapidly on a small base than on a large one. Here are recent annual figures:

Intuitive Surgical annual revenue, $ millions

2011

1,757

2012

2,179

2013

2,265

2014

2,132

2015

2,384

2016

2,704

Qualitatively, revenue growth has been lumpy. Following the decline in 2014, revenue in 2015 was only 5% above 2013 revenue. That is not a growth rate that high P/E ratio stocks are normally made of. True, I cherry picked the worst two-year period since 2009 to make my caveat.

Intuitive breaks out revenue into 3 segments. One segment consists of the initial robotic system sales. Here there is genuine cause for concern about the growth rate. In Q4 2016 163 systems were sold, up only 3% from 158 year-earlier. Revenue from that segment was $236 million, up just 2% y/y.

The reason Intuitive showed a 12% y/y overall revenue growth rate was that procedures (surgeries) performed on the systems were up 15% y/y. Just looking at procedure growth, it is easy to rationalize a relatively high P/E ratio. Intuitive supplies the disposable parts needed for each procedure. This instrument and accessories segment had revenue of $386 million, up 20% from the year-earlier quarter. Note this segment produced more revenue than the sale of the systems themselves; it is a razor and blade revenue model. Intuitive reported that revenue per procedure was $1,900.

Given the large installed base, it is easier to grow instrument revenue than system revenue. Typically when a hospital buys a robotic surgery system it cannot immediately use it at full capacity. Utilization grows over time. In the U.S., where many hospitals already have systems, there is room to continue to increase the instrument revenue even if system sales fall substantially.

Finally, services revenue was $135 million, up 12% y/y. This is primarily repairs and maintenance of the systems.

An analyst could make either a bearish or a bullish case based on these figures. But there are other variables to consider (aside from the macroeconomy or the possible termination of the ACA): potential for growth in systems sales outside the U.S. and potential expansion of types of systems to be sold. But first, capital allocation.

Intuitive Surgical da Vinci robot

Image Source: Intuitive Surgical

Cash and Capital Allocation

Short term, the price of a stock usually rises when a major buyback plan is announced. Intuitive has about 39 million shares outstanding. Before the announcement, at a price of $666.05, Intuitive's market capitalization was about $26 billion. Buying $2 billion of stock back at that price would have eliminated 7.7% of the outstanding stock. That would, in turn, boost EPS. If the stock price remains higher, the number of shares retired will decrease.

Intuitive ended Q4 with $4.8 billion in cash and no debt. So using $2 billion to buy back stock is certainly no danger to the operations of the company. Unlike companies that borrow money to pursue stock buybacks, or are already in debt, there is no need to worry about how much interest is being paid.

We should, however, consider alternative uses of the money.

The baseline is what future earnings the $2 billion is buying. We only can ballpark here, so I will start with 2016 full-year earnings, which were $18.73 per diluted share (GAAP). Intuitive ended the week, on Friday January 27, at $691.29. Instead of thinking in terms of buying shares, consider how much is being bought in earnings.

$691.29 buys $18.73 in annual earnings (more if you want to use non-GAAP EPS). That is a return of 2.7%. Not very much better than 10-year Treasuries, which were at 2.46% at close of trade Friday. But a lot better than 6-month Treasuries, that currently pay 0.51%.

There is reason to believe that Intuitive Surgical will continue to grow revenue and earnings. If so, over time, the return would exceed 2.7%.

There is also at least a slight danger that revenue and earnings might drop, as in 2008 and 2014, possibly taking the rate of return below 10-year Treasuries. Also, if interest rates keep rising, by the end of 2017 you might be able to get a return on 10-years of 3.25%, but that will depend on Federal Reserve Board decisions.

There are two other alternatives: paying a dividend, either regular or special and making an acquisition. The stock buyback does not exclude either. Even if the entire buyback were done immediately, Intuitive would still have $2.8 billion in cash. Cash flow in Q4 was not stated, it should be in the 10-Q when filed, but would probably be near $277 million, the sequential increase in cash. So there is plenty of money to make an acquisition, if a smaller robotics company could be found that is worth acquiring.

A one-time dividend with $2 billion would give stockholders about $51.61 per share. That would be the most direct way to convert Intuitive cash to shareholder cash. The main disadvantage for shareholders is that a dividend is taxable in the year it is issued, whereas capital gains taxes are delayed until the year the shares are sold.

Cash had through a dividend or stock sale could be used to buy a more attractive stock, but that is always the case.

Executives tend to favor buybacks of their own company's stock because they are judged by the stock price. They also tend to be optimistic about their company's prospects. This results in errors when stock prices are high and then fall after the buyback, which is more likely when a stock has a high P/E than when its P/E is moderate.

I can find no major fault with Intuitive's board regarding this buyback. There is no debt and the cash flow looks unlikely to stop. Aside from unlikely future disaster scenarios, the main effect will be to reduce the share count and increase EPS in the future. There is plenty of money to invest in R&D, and enough to buy out a small competitor if that seems advantageous. The return on cash is not immediately attractive to me, but it should be for many investors.

The only questionable point is whether Intuitive can maintain its current P/E ratio. That will depend on investor sentiment, which is unpredictable, and the rate of earnings growth.

China

One big question mark for Intuitive is China. Lately, the growth rate in the U.S. market has been slowing. Growth is being driven primarily by the relatively untapped European market, despite system sales being weak in 2016. The biggest potential growth market is China, with a population larger than the U.S. and Europe combined, and increasingly able to pay for high end medical services.

The bottleneck for Intuitive is currently the Chinese government, which sets a national annual budget for healthcare that recently has included a quota for surgical robots. However, as of the Q4 results conference, the 2016 quotas had been used and no 2017 quotas had been announced. The 2017 budget had been approved, but it is not a public document. Management had no visibility as to whether the quota would go up, stay stable, or go down.

China has not yet approved the current most advanced system, da Vinci Xi, and while management does not know of any impediment to approval, they also have no visibility as to timing.

While China is a huge opportunity, it also has its hazardous side. In the U.S., Intuitive is protected by patents and trade secrets, the relatively large cost of developing competing systems, and the difficulty of entering a specialized market. In China the robots could be reverse engineered, subsidized by the government, and massively deployed, creating a new global competitor. There is no evidence of that yet, but given past behavior, it should not be a surprise outcome. Or the Chinese government could demand that systems sold in China be built in China.

So, back to growth rates, which determine in the long run whether the $2 billion stock buyback is a good investment. If China and Japan open their markets to mass deployment of Intuitive robots, not buying Intuitive at today's price will look like a major opportunity missed. If European growth is strong for a few more years, the market there will start to saturate and the base will be bigger, so growth rates will likely decline, unless Asia kicks in.

With higher growth rates P/E ratios tend to rise, with lower growth rates they tend to fall. Right now, China, Japan and many other nations are clearly underserved. My first guestimate is that, barring a global recession, future growth rates will depend on the ability of the sales team to show that da Vinci systems are a good investment for government-run health systems. In the U.S. model, sales target surgeons, who then lobby their hospital administrators. In most countries the important people to lobby are high up in government healthcare bureaucracies.

The installed base was 3919 systems at the end of 2016. The larger the installed base becomes, the better the accessory sales, but the harder it is to grow quickly.

The other possible growth engines are new products, including new accessories for existing systems.

Future products and 2017 guidance

Intuitive is constantly developing new products, both improvements to the main system and accessories that help with the many specific kinds of operations surgeons want to perform. This includes systems to help visualize the surgery. The level of development can be gauged by the R&D expense line, which was $69 million (GAAP) in Q4 2016.

The next major system upgrade is designated da Vinci Sp. "Our current da Vinci Sp system met its development goals in the fourth quarter and we initiated its first clinical feasibility studies … We plan first markets to include head and neck surgery, urology and colorectal surgery. Sp is a platform technology that allows high dexterity access with great 3D vision to confined surgical spaces. Early surgeon response to Sp in the trials has been very positive." [Intuitive Surgical earnings call transcript]

Intuitive is also working on systems that use robotic catheters, which are more flexible than the current instruments and allow for a number of new diagnostic and corrective surgeries. Although the development of this system is advanced, no product revenue is expected in 2017.

For 2017 guidance is for growth, but not as strong a growth as occurred in 2016.

Surgical procedures using da Vinci systems in 2017 are expected to rise between 9% and 12% over 2016. No revenue estimate was given, but in Q4 2016 revenue growth trailed procedure growth by 3%. No estimate of profits was given, but you can make your own guess based on the following guidance. Gross profit margin 69% to 71%, non-GAAP. Operating expenses up 15% to 18% y/y. $190 to $200 million non-cash compensation. $25 to $30 million other expense. Tax rate (non-GAAP) 26.5% to 28.5%.

Price, P/E, and Conclusion

As described above, predicted growth in 2017 probably does not quite justify the current P/E ratio of 37 (trailing 12-month GAAP). Therefore it does not justify the stock buyback, short-run. But the opportunities for faster growth in the long run are abundant, which could justify the ratio and buyback.

Talking to individual investors, I have found that throughout its history Intuitive Surgical has been a Silicon Valley favorite. In other words, its investors are more likely to also hold Tesla (NASDAQ:TSLA), Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and Apple (NASDAQ:AAPL) rather than Gilead (NASDAQ:GILD), Celgene (NASDAQ:CELG) and Amgen (NASDAQ:AMGN). If that is true, it is a robotics play more than a healthcare play. Hence the appetite to gamble on the future, without it being clear where the increases in earnings will come from.

The returning of cash to shareholders, in some form, should be a goal of every company listed in the stock market. When a stock is undervalued, I think stock buybacks are the best way to return cash. I think Intuitive's management has done a good job running the company and accumulating the cash that will be used in the buyback. But the argument for a dividend instead of a buyback is strong, from my point of view, at the current stock price.

If you disagree, feel free to say so and state your reasons in the feedback section.

Disclosure: I/we 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.

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