2017 was an amazing year for long-term holders of Intuitive Surgical Inc. (ISRG, Financial). Long a close companion of the S&P 500, last year saw it break away to the upside, gaining more than 77%. But expectations are shifting, so seekers of great companies should shift to wait-and-watch mode.
Intuitive is a medical instruments company. According to its 10-K for 2017, its key product is a set of surgical instruments and accessories. Called daVinci Surgery, the set comprises three main tools:
- Surgeon's console.
- Patient-side cart.
- High-performance vision system.
A surgeon sits comfortably at a console while viewing a 3-D and HD image of the operating tool and the field of operation. The surgeon manipulates the instrument in what's called a "natural manner" -- the technology is said to make operating instruments analogous to the motions of the human wrist. In addition, the technology and tools eliminate the natural tremors inherent in a surgeon's hand. Overall, the system aims to reduce the amount of variability in surgery and to provide less invasive surgery.
The company says its business strategy is to deliver patient value, surgeon value and hospital value. It had 4,409 daVinci-enabled operating rooms worldwide at the end of 2017.
Intuitive makes its money through one-time and recurring revenue:
- Initial capital sales of daVinci systems, as well as follow-up sales of instruments, accessories and service. There are some 80 types of systems sold, at prices ranging from $0.5 million to $2.5 million. Service contracts attached to these sales vary from $80,000 to $170,000 per year.
- Recurring revenue takes in additional instrument and accessory sales, service revenue and operating lease revenue.
This table shows revenues (in millions of dollars) for the past two years:
In something of a razor blade model, the company sells more consumables than initial systems. In this case, each system sale opens a new door, a captive opportunity to sell replacements and accessories.
The company’s Beta is 1.06, indicating it should follow the S&P 500, thus its share price will be determined by broader market forces as well as its own fortunes.
Note that the two parted ways in late 2016, and Intuitive left the S&P 500 well behind in 2017 with share price appreciation of 77.5%.
While that performance last year was exceptional, could this be considered a potentially great company (subject to further due diligence)? The Macpherson model provides a set of data that provides an initial assessment (data below from the Intuitive page at GuruFocus):
Regarding the moat, the operating margin is a healthy 33.71% in 2017, and it has been quite consistently in the 30s since 2006. Net margin: For 2017, it was 21.09%. Over the past 10 years, it has ranged from 19.65% to 29.62%.
These tables show that Intuitive passes all the hurdles and gets a tentative “great companies” designation. It has a moat, which means it has a competitive advantage and pricing power, which will help maintain its healthy margins. It also has financial strength and is profitable.
A second table looks at the stock’s valuation, based on two types of Discounted Cash Flow (DCF). If the stock price is above the DCF, as is the case here, then there is no intrinsic value or margin of safety:
Obviously, Intuitive’s pricing got ahead of at least some of its fundamentals when the share price roared wildly up in 2017, gaining more than 77%.
Other key financial data:
- Ebitda slipped in 2013, and took a plunge in 2014. Since the beginning of 2015, though, it has been back on track.
- The company does not pay a dividend and does not buy back shares.
Turning to ownership, at the end of 2017, 12 of the GuruFocus gurus owned shares of the name. The biggest five holdings belonged to Jim Simons (Trades, Portfolio), Vanguard Health Care Fund (Trades, Portfolio), Manning & Napier Advisors Inc., Eaton Vance Worldwide Health Services Fund and Pioneer Investments (Trades, Portfolio). Simons was the only one who held more than a million shares (he owned nearly 1.5 million, giving him 1.25% of shares outstanding).
Intuitive has been embraced by institutional investors, who currently own 91.64% of the company. Insiders own just under 1%, with a director and the CEO having the largest holdings among that group. These two groups of shareholders thus control 92.5% of all shares.
While the stock price soared in 2017, investors (or traders) have been less bullish this year, after the company announced a $318 million expense due to changing tax laws and adjusted the guidance for 2018 downward.
The company has hedged its outlook in guidance, but in a presentation to the JPMorgan Healthcare Conference 2018, it pointed to strong operational growth this year:
For the longer term, Intuitive enjoys some secular trends:
- Aging populations in much of the developed world.
- Preference for less invasive surgery among patients, surgeons and health care organizations.
- Decreased variability in surgical procedures, which means better results from all surgeons, especially those who are less-gifted.
Intuitive has numerous prospects in its pipeline, including variations on its daVinci system and new products like this one:
Conclusion
Intuitive Surgical Inc. has the trappings of a great company (subject to further due diligence), with its competitive moat, financial strength, profitability and growth.
What it does not have is a great price. Both free cash flow-based and earnings-based Discounted Cash Flow numbers are well below the current price, resulting in a negative margin of safety.
However, the company does appear to have promise for value investors who are willing to wait. With a beta of 1.06, the price may come crashing back down or revert to the mean. Once back to “normal” valuation, investors can wait for either a full-market pullback or a company-specific pullback.
Disclosure: I do not own shares in any companies listed and do not expect to buy any in the next 72 hours.
