John Duncan posted this ISRG analysis on my facebook messages page and I thought it was rational so here it is:
The Robotic Surgery money machine
Phil, I would appreciate it if you could review my analysis of Intuitive Surgical (ISRG). I purchased this business (okay, not the whole thing, but quite a few shares of it) when it was definitely on sale and made a good profit. I recently sold it. Since then it has run up even more in value. Now I wonder if I made a mistake.
What is Intuitive Surgical?
ISRG is a manufacturer of a proprietary robotic surgical system - the "Da Vinci System." ISRG dominates this emerging industry in the medical field - surgical procedures done by robots acting as extensions of the surgeons hands - giving the surgeon the kind of hand eye control and precision humans could only dream about having. It, in essence turns the surgeon into a biotic man or woman! The systems offers hospitals enormous savings and it offers patients less intrusive procedures with much faster recovery times.
Although I have never had to undergo serious surgery, it was easy for me to find meaning in this company. If I was to ever need surgery, the first thing I would do is research to find out if the procedure was qualified to be done with the Da Vinci system and if it was, I would then seek out a hospital and surgeon who had this capability. It is easy to find overwhelming evidence of the benefits of using this equipment - much faster recovery times, less pain, lower risk of complications, and because of that - major cost savings for hospitals who employ Da Vinci. The Da Vinci systems offer surgical capabilities in urology, gynecology, cardio, transoral, and a few others . They continue R&D spending on new instruments to expand the capability into other specialties. ISRG's conference calls always end with a real testimonial from a patient. ISRG is what is right with American health care - innovation that makes life better for people, and will save the system money in the long run.
ISRG appears to have 3 moats - intellectual property, toll, and switching. I have done enough research to know that ISRG has a huge lead on competitive robotic systems. You want to compete? Good luck trying to develop something this sophisticated along with the FDA approvals necessary to commercialize a product like this. I believe there is a huge barrier to entry because of patent protection, but also, just how hard it would be to create an alternative system and get it approved? Intuitive continues to invest in R&D - they were just awarded FDA approval of the new instrument - the EndoWrist. ISRG's business model resembles the Gillette razor model - sell the expensive equipment into as many hospitals for a relatively reasonable price (a system might cost $1million), but the high margin part of the business is the selling of surgical tools, instruments, service, and training for the systems. Once a hospital has made the huge capital investment, it will be very difficult to drop the system or "switch" to another supplier. Each new machine represents years of training and service. Each time a surgery is done using Da Vinci, new sanitized instruments are needed. It's a snowball effect.
Red Flags - I have 3 big concerns with ISRG at this time. First, because their machine would be considered a major capital investment, for many hospitals, this probably involves financing. The crisis in Europe could trigger borrowing problems slowing growth in Europe. Europe is a big part of ISRG's growth strategy. If the credit crisis would spread, ISRG could be hit hard because of the nature and expense of its product. The other problem is around uncertainty. I don't have a good grasp of what the new health care law (Obamacare) might mean to high end products such as this one. From what I can tell, it appears the legislation really tries to hammer medical suppliers such as ISRG. I see this as really unfortunate. And 3rd, a major part of ISRG's method of retaining top engineers and talent is the use of stock options. The dilution of shares has been offset by share buy-backs. I need to understand if this cost is truly being accounted for in financial statements, so far, it appears to be okay.
Intuitive Surgical is led by Gary Guthart, Ph.D. He's been with the company since 1996. He became CEO in 2010. He was part of the core team that developed robotic surgery at the Stanford Research Institute - so he has the technical background from the infancy of the industry. His salary is $504K with stock options his total compensation is over $5 million. From what I can tell, the top management team and board of directors are very qualified individuals who have a passion for the product they are selling. I enjoy listening to the quarterly conference calls. It is all about how the use of their products in procedures benefit patients. I have found nothing negative in my research.
MARGIN OF SAFETY
ISRG has outstanding growth rates and return on capital that you would expect from a company in high growth mode.
ROIC: 5.8% (10 yr); 15.2% (5 yr); 18.1% (1 yr); Note: ISRG lost money during its start up years which lowers the 10 year average, however, the trend is good and they have consistently returned over 10% for the past 7 years.
BVPS: 31.9% (10 yr); 34.7% (5 yr)
EPS: 30.8% (10 yr); 49.6% (5 yr)
Sales: 44.3% (10 yr); 30.5% (5 yr)
Cash Flow: 38.7% (10 yr); 30.1% (5 yr)
I attempted to normalize the data for EPS and cash flow due to negative numbers 10 years ago during what I would consider a start up phase. Analysts estimates range from 19% - 21% growth rate. Their historical PE has been ~ 34
ISRG currently trades at $471 giving it a PE of 40. Based on what I hear in quarterly conference calls I felt comfortable pegging it's future growth rate at 22.5%, and I think it deserved a PE ratio of 36. The last 4 quarters of earnings were $11.58. This gives the business a sticker price of $784 so the MOS would be $392. The current payback time is 11.4 years - not good. I purchased ISRG around $275 and sold it at $425 simply because the payback time had gone up to 11 years. The stock has obviously continued to rise. Maybe I should have waited, but man I wish it would pull back to earth so I could buy it again!
Now go play.