Does Intuitive Surgical's Valuation Make Sense? (ISRG)

Includes: ISRG, MDT, ZBH
by: Travis Johnson

I've been thinking a little more about Intuitive Surgical (NASDAQ:ISRG) lately, as it continues to eke out small gains after the last two big jumps up on earnings releases. I'm excited to be an owner of this company and I think they're doing great things and will continue to grow very quickly, but the stock is incredibly richly valued right now -- do we have anything to worry about?

I bought ISRG three times this year and own what I consider to be a full position -- though I'm sometimes tempted to add more. If you want to read my prior writeups you can see them here, here, and here.

If you want an overview of where the company stands now, you might check out the Investor Presentation (PPT file) they released last month on their website, it has great information about their progress in various kinds of surgeries, their growth rate, and their goals for building the company. Also, if you have time, listen to the audio of CEO Lonnie Smith's presentation to the Stanford Entrepreneurial Though Leaders series (other talks from some interesting people are available through their podcast if you're interested). He talks from a presentation that migth be the same as the PPT file, but adds in a lot more detail.

One tidbit I picked up in that speech which I hadn't noticed before is that the recurring revenue stream is more predictable than I at first thought -- they design it to be that way, by selling instruments for the da Vinci that include chips that will prevent them from working after they've been used in 10 surgeries. I had thought that the instruments just gradually wore out or had to be replaced after a certain number of sterilizations, but it's interesting that the company builds specific obsolescence periods into the tools.

I think the main current issue that might be of concern for Intuitive Surgical owners, aside from the simple fact that the shares have risen so fast that they could fall equally quickly, is that insiders have engaged in quite a bit of selling over the past month.

In the main, this has been due to a few options exercises by the CEO and a couple directors, but there was one very large insider sale that has gathered some attention. Susan Barnes, the CFO, has sold off more than half of her very substantial holdings (she is still the second largest individual shareholder, with roughly 100,000 shares according to recent filings). I'm not too worried about that -- I assume that her sale is due to the fact that she was leaving the company, which was announced back on August 31st (apparently she has now left, since the announcement said she would leave in November).

And frankly, though I prefer to see lots of steadfast holdings by company leaders, I'm not that worried about the options exercises of CEO Lonnie Smith and some of the board members, either. Those of us who look at this company today as relatively new investors see incredible growth potential, and a pretty dramatic climb from $50 or so in the Spring to well over $100 now. Imagine if your frame of reference was the $15-20 range that the stock bounced around in for five years prior to this breakout -- I can see how the company insiders who saw the stock discounted for a variety of reasons for several years would want to get some of their hard-earned appreciation away from the vagaries of Wall Street.

If Intuitive Surgical is able to reach it's goal of placing da Vincis in 1,500 hospitals, with an average of three machines at each hospital, and the increased surgical volume that we assume would come with that and the high margin service and instrument income that follow, the company's size could be several times what it is today in a matter of, I think, several years.

ISRG's operating margin so far this year is 29%, even though we'd have to think that they are at the low end of their potential economies of scale. Their current market cap at today's price is about $4 billion. The eventual potential of the recurring revenue market if they've achieved their 4500 systems would be about $2.5billion annually, according to the company presentation.

I tried to look at a couple companies for comparison to see if we could make any guesses at proper valuation given those expected sales volumes and margins. Medtronic (NYSE:MDT) has a $67 billion market cap off about 11 billion in sales, and an operating margin of 33%. I think estimating that ISRG's operating margins would improve to at least that level is pretty conservative.

If we assume that the operating margin remains comparable and apply the same Price/sales ratio of 6 to ISRG, we'd have a market cap of $15 billion, almost 400% above where it is today.

Zimmer Holdings (ZMH), for another comparison, has about the same operating margin right now of 33%, and about $3.5 billion in sales from a $17 billion market cap, or roughly a 5X price/sales ratio. Given that same ratio ISRG would reach a 12.5 Billion market cap, roughly a 300% increase from today's level.

And that, of course, does not take into account the vast income ISRG would receive along the way to reaching its goal of 4,500 installed systems and the ways in which they might reinvest that income into the company -- and while that growth in system sales doesn't come with quite the same great margins as the recurring revenue, it does bring much higher sales numbers at a little more than $1 million per system sold with their current pricing.

I also can't guess at the timeframe for reaching this "mature" level, or even whether ISRG will in fact make it to that point in it's current configuration (who knows, maybe GE will buy them next year -- somethings are totally unpredictable). The key variation for me is time -- if they are able to achieve this theoretical 300-400 percent return in five years, I'll be thrilled.

Given the risks of the current high PE ratio that would be a more than fair return on investment of well over 30% a year. And maybe it's just my irrational exuberance for ISRG talking, but I think they might beat those goals by a significant amount by achieving significantly higher margins as a mature company servicing their massive installed of robots. Then again, it might take them ten years or longer to get there, which would mean current owners are not being nearly as well compensated.

It should be an interesting ride -- there obviously aren't any good comparisons for ISRG out there if you look at their business and the product and service they deliver. I just brought up Zimmer and Medtronic as some pretty stable, fairly valued medical device companies that might be valued somewhat similarly to a mature ISRG. That might not be a reasonable guess.

It's also certainly possible that Intuitive Surgical won't ever reach their goals of installing 4,500 systems, though as first movers and current monopoly holders in this segment I'd guess that to be a conservative goal, given the success of the systems in the limited scope of surgeries they have completed so far. After all, the baby boomers are just now moving into their prostate years -- and ISRG has just a 20% market share of prostatectomies. If their success over conventional surgeries continues to be this dramatic there will be few people willing to settle for a non-daVinci prostatectomy.

The population of the world is growing rapidly and the populations of our richest countries are aging rapidly -- medical care in general is a huge growth area, and I think robotic surgery is a star within that area.