ZBH - Intuitive Surgical: Valuation Hanging On By The $4 Billion Cash Thread

Summary

• Intuitive Surgical, Inc. is no doubt a nearly perfect company, although the investment is currently worrisome.
• With continued headwinds and a lofty valuation, a lot rides on what Intuitive Surgical will do with their $4 billion in cash.
• This article will summarize recent Intuitive Surgical, Inc. performance and developments, along with sharing my thoughts on key weak points.

Introduction

Intuitive Surgical, Inc. ( ISRG ) is a company with one of the largest moats in the world, and for almost 30 years. The company produces equipment, the Da Vinci system, that provides robotic-assistance for surgeons in the operating room. Over time, ISRG has focused on expanding the amount of procedures that can be completed with the equipment, primarily through the addition of new accessories and tools. And, in 2019, Intuitive Surgical released their first major new platform technology, Ion , for robot-assisted endoscopic lung biopsies (in partnership with Siemens Healthineers ( SMMNY )).

Due to the high barrier to entry, competition remains weak, although I will address some new disruptors that may become worry points. However, ISRG has invested millions into creating a sustainable ecosystem that makes it hard for surgeons to transfer to new platforms. This may be a defense mechanism that works to stall initial growth of competitors, but the risk will remain. There are also some indications in the company financials that there are issues arising. I believe that smart allocation of the current large pile of debt can be useful in combating certain issues. No product placement necessary.

Factors That Make ISRG Great

Most investors know that companies with moats in their sectors often outperform, or at least are financially stable. Intuitive Surgical offers one of the strongest moats in the market, and has generated strong returns and healthy financials. Over time, total procedures have been increasing at a fairly rapid clip, approximately 15% per year. Drivers for continued above economy/industry growth is due to a combination of factors, including organic growth of hardware sales (especially ex-U.S.), increased capabilities of the platforms, and increasing the efficiency of procedures (to allow more to occur in the same amount of time).

Unfortunately, the pandemic prevented many surgeries from occurring, leading to a slowdown in revenues over the past five years. However, the slowdown was temporary and the number of procedures performed has bounced back. There are still issues with hospital staffing and COVID that are continuing headwinds, but expect a return to a pre-pandemic growth environment in the coming quarters.

Revenues are fairly stable and grow mostly in line with procedures performed, with an addition of organic hardware sales added on top. This is due to the 75% or so recurring revenue percentage that is required for use of the Da Vinci and Ion systems. This includes servicing, accessory sales, and software. This is why overall revenue growth has performed worse than total procedures performed as hardware sales slowed but recurring revenues moved in-line with procedures. Management has stated that they would like recurring revenues to reach 80% of total revenues, and this will provide even more transparency and consistency to revenues in the future.

Considering that the healthcare industry is fairly constant, even in recessions, the pandemic is most likely one of the worst black swan events in terms of destruction of performance. As so, I expect a return to consistency moving forward that investors should enjoy. The problem is that as time passes, the former high barrier of competitive entry is surpassed, and the major headwind will turn into competition. This is why ISRG needs to invest the excessive cash balance into offensive and defensive strategies. But first, let's continue to look at the ISRG financial trends.

Historical Data Trends

Intuitive Surgical offers a strong historical revenue growth trend thanks to the organic expansion of their surgical robotics into hospitals around the world. However, the rate of growth is falling as the market is saturated. As of last quarter, the trailing 10-year revenue CAGR was 11.2%. Still a growth name, but the opportunity is far less than 20 years ago. I believe if ISRG can maintain growth at 10%, they are doing great, but don’t be surprised if the average falls below that mark. There has even been one period in the past where growth was negative, as reports questioning the cost-effectiveness, efficiency, and safety of the systems circulated. While temporary, and unlikely to occur after a further decade of independent research and analysis, even the best companies can have periods of weakness.

Along with slowing revenues growth, there is also a bad trend forming with earnings growth. While revenues have risen over 11% per year for the past decade, EBITDA, net income, and EPS have only risen by about 8% annually during the same time, each. The reason for this is both EBITDA and Net Income margins are below the 20-year mean as of the past few years. This may signal new inefficiencies in the business, competition, or higher component costs that can’t be passed to customers. While margins remain high, I fear they may fall as headwinds only increase.

Thankfully, Intuitive Surgical has strengthened their balance sheet over the past 10 years and total cash is at $4.3 billion, no debt. This also comes with no debt, so a leveraged buyout could also be on the table despite higher rates. There is also room for shares to be repurchased, and management has recently announced a $1 billion buyback of ~3.6 million shares, so cash on hand will fall next quarter. This will cause total shares to be reduced approximately 1%. I believe this is a waste of money, and I will now discuss investment opportunities.

All-In on Robot Assist

There is often too much of a good thing. ISRG has floated for 20 years on the back of Da Vinci, and has only recently launched a new product, Ion, to find new areas of organic growth. At the moment, investments are focused on expanding the number of instruments and accessories that can be used with Da Vinci. This has allowed the segment to grow approximately 3-4x that of the rest of the company, but it is a small portion of revenues. The impact to overall procedure growth has also been small, only maintaining organic growth at 10% or so. Thankfully, the Ion system seems to be growing rapidly, and may be a key area to focus on moving forward.

The problem is that ISRG is a $100 billion company and needs more than just Da Vinci and Ion. However, management seems intent on sticking to where they are comfortable. As discussed in their recent JPM Healthcare conference presentation transcript :

We want to continue to increase utilization and penetration in the target procedures we think are important. Those are by country, by specialty and we have strong tactical plans and investments to support those efforts. On our innovation fronts, we're expanding indications and launching our new platforms, SP, Ion.

A focus on quality of supply and reliability of supply as we emerge from pandemic stresses remains important. Our supply chain and logistics are not fully settled yet. We have an opportunity as we move to industrial scale to be more efficient inside our company and to drive both better quality out of our organization at lower cost and we're going to do that. So, we're making some automation investments inside the company, whether it's factory automation or workforce automation, some things that can help us.

While internal operational investments and a focus on Da Vinci are great, the scope is limited. ISRG needs something transformative and innovative once again. There is one way that ISRG seems has finally begun to drive outside innovation, and that is through the development of Intuitive Ventures :

With an inaugural $100 million fund, Intuitive Ventures has set out to build an international portfolio of players developing new digital tools and device platforms, as well as adjacent companies in diagnostics and therapeutics.

“The future of minimally invasive care spans the patient journey from early diagnosis to treatment and beyond,” said Intuitive Ventures President Julian Nikolchev, who also serves as senior vice president of corporate development and strategy at the elder Intuitive.

For ISRG, the $100 million is spare change, but the nurturing of partnerships across the innovation sector will provide boons down the road, certainly. So far, the fund invests in a few early stage companies developing a wide range of technologies: surgical AI, perioperative care, GI and metabolic devices, data management, AI-assisted imaging analysis, tumor resection technologies, robot-assisted dentistry, and cyber secure medical device manufacturing. In the future, these companies may be bolt-on acquisition targets to integrate or expand the ISRG ecosystem and it is good to see.

The venture fund is quite the change in ideology for ISRG, which has historically been focused on in-house innovation. I say this because the company has only performed 4 acquisitions in the past 20 years according to Crunchbase. This pales in comparison to the more diversified competition. For example, Medtronic plc (MDT) has made 7 acquisitions since the start of 2020 alone. Johnson & Johnson (JNJ) Medtech has taken the leap lately with the $20 billion acquisition of Abiomed ( ABMD ). However, the industry has been quite quiet in terms of acquisitions and mergers, reducing overall diversification. This has led to relatively poor performance, and Intuitive is included. I hope they break this pattern in the near term.

Competition is Weak, for Now

One key reason why ISRG must begin to undertake new innovations is due to the coming surge in competition. There has been some preparation, such as making the ecosystem hard to switch , but there will be pressure. However, the competitors are small and large, and approvals are beginning to roll out.

• Johnson & Johnson by 2026

• Medtronic’s Hugo is undergoing clinical trials .

• Asensus ( ASXC ) FDA cleared in 2017 , with advantages in automation.

• Vicarious ( RBOT ) FDA submission expected in 2024.

• CMR Surgical (Private) but with over 100 devices installed worldwide.

• Avatera approved and operational in Europe.

While those competitors are the most similar in torso-based robot-assisted surgery, there is also extensive competition across other parts of the body. This includes Stryker ( SYK ), Globus ( GMED ), and Zimmer Biomet ( ZBH ), who all compete in skeletal robotics. Will ISRG attempt to move into skeletal or other procedures? Will they continue to be the best at what they do despite new entrants arriving by the end of the decade? How will performance be affected either way? Those are the questions that remain lingering and will hurt investor sentiment and outlook, despite strong financials. For me, I believe that change is necessary, and ISRG needs to take additional steps to maintain their inertia, especially at current the valuation.

Valuation

Despite slowing growth and below average margins, ISRG continues to hold a high valuation. The profit issues are highlighted by the P/E vs P/S difference compared to historical values. Essentially, a lot of future expectations are baked in currently, as shown below.

• P/E is 37% above mean.

• EV/EBITDA is 31% above mean.

• P/S is 18% above mean.

This data suggests that investors expect profits to return over the coming quarters and this will help drop the P/E. However, there is no sign of increased profits for now, and this overvaluation will continue. We also have to consider that the current 18-30% above mean valuation cannot be supported due to relative performance alone. Therefore, further losses may be possible as the valuation resets below mean. Therefore, the ~$200 or 12.7x P/S mark remains a key area of support and I would only consider adding there.

Conclusion

While Intuitive Surgical, Inc. is a great standalone company, the current financial weakness, rise in competition, and high valuation are all detrimental factors to the investment. Therefore, investors must consider what plan works for them. Either: wait for shares to fall to fairer values, or slowly accumulate a long-term growth holding regardless of price. I believe that both options are viable, but waiting is best for those without shares, and accumulating is best for those holding and with a long-term mindset.

The issues I have discussed are slow-moving and not immediately disruptive. Therefore, there is plenty of chance for favorable improvement by Intuitive Surgical, Inc. over the next year, especially if margins don’t continue to fall. There is also the chance for Intuitive Surgical, Inc. to listen to my musings and take a chance on major platform additions through internal R&D or acquisition. The bolt-on strategy also works, especially if using company shares at current valuations. I do not see tremendous downside, but the risk is still there. For me, I will be waiting and updating if any major shifts occur down the road.

Thanks for reading. Feel free to share your thoughts below.

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