Summary
- Intuitive Surgical reported Q4 and FY2022 results that fell below expectations as hospitals continue to optimize CapEx in the face of challenging market conditions.
- Contrary to its customers, ISRG is in the midst of an up CapEx cycle as it prepares to launch next-generation robotic surgical systems.
- Our DCF model was constructed using optimistic assumptions, but it still indicates that the company's growth rate is capped somewhere in the mid-teens at best.
Investment Thesis
The development of Robotic-Assisted Surgery "RAS" could be the most significant advancement in surgical practice in the 21st century. Pioneered by Intuitive Surgical ( ISRG ) in 2000, the da Vinci Robotic Surgical System integrates technologies from robotics, medical imaging, artificial intelligence, and human-machine interaction into one coordinated platform, allowing surgeons to insert microsurgical instruments (blades, forceps, retractors, etc.) and high-definition cameras, into the body through tiny incisions to act as the surgeons' eyes and hands.
After a slow start, limited by a steep learning curve, and slow acceptance from the medical community, the da Vinci Robotic System is currently being used by thousands of surgeons worldwide for a variety of complex surgical procedures. In 2022, the company delivered 814 devices. For perspective, it took the company seven years since da Vince's 2000 debut to reach the same number of devices installed.
We initiate coverage of ISRG with a Hold rating and a $280 price target, representing a modest 15% upside potential from current price levels. Our rating and price target are conditional on the company's ability to deliver revenue growth and meaningful improvements in free cash flow. This is a high bar to meet, and the stock price already incorporates a significant growth premium, distorting the risk/reward balance of owning the stock.
Revenue Drivers
The Food and Drug Administration "FDA" has cleared the da Vinci system for use in a broad range of surgeries. The primary revenue driver is the medical community's adoption of the technology in preference to traditional surgical methods. To that end, ISRG is continuously working with key opinion leaders to find new applications for its instrument, highlighting the value it brings through academic research and publications.
Currently, the company focuses on five main areas.
- General Surgery
- Urologic Surgery
- Gynecologic Surgery
- Cardiothoracic Surgery
- Head and Neck Surgery
The company's growth strategy is simple: create value for patients, surgeons, and hospitals. For patients, ISRG aims at creating better outcomes with lower risk and invasiveness, defined in terms of pain and recovery time. For surgeons, the company provides easy-to-use surgical equipment to help them perform more complex and precise operations. Finally, for hospitals, there is always the marketing and advertising factor of using the most cutting-edge technology but also creating efficient and cost-effective solutions by using the right equipment at the right time to improve patient satisfaction by reducing complications.
For many, these factors justify the investment in the da Vinci device that comes with a $2.6 million price tag for the instrument and $2,600 operating cost per procedure spent on consumables and disposable accessories. One also can't ignore services, including maintenance and education, the latter costing $6,000 per surgeon.
How did this strategy fare over the past few years? Well, the growth rate was acceptable, at 15% annually in the past five years, even when excluding COVID disruptions in 2020 and the subsequent pent-up demand rebound in 2021.
Sales ($ Millions) | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 |
Consumables | $ 1,637 | $ 1,962 | $ 2,408 | $ 2,456 | $ 3,101 | $ 3,518 |
% change | 20% | 23% | 2% | 26% | 13% | |
Systems | $ 928 | $ 1,127 | $ 1,346 | $ 1,179 | $ 1,693 | $ 1,680 |
% change | 21% | 19% | -12% | 44% | -1% | |
Services | $ 573 | $ 635 | $ 724 | $ 724 | $ 916 | $ 1,024 |
% change | 11% | 14% | 0% | 27% | 12% | |
Total | $ 3,138 | $ 3,724 | $ 4,479 | $ 4,358 | $ 5,710 | $ 6,2 22 |
% change | 19% | 20% | -3% | 31% | 9% |
Recent results from Q4 demonstrated that ISRG is not immune to broader industry challenges, such as a shortage of hospital staff and rising operational and procurement costs. As typical with industry innovators, ISRG is bringing change to the market by changing the surgical workflow. Still, its tech is not pervasive enough for hospitals to feel compelled to adopt it instantaneously. Overall, market conditions and CapEx decisions of its end-users will ultimately determine ISRG's performance, as mirrored in its modest revenue growth last quarter. Seeking Alpha's Quant Rating (shown below) reflects these trends.
Profitability
Shareholders are yet to see meaningful signs of the economics of scale in ISRG. Despite a 100% growth in sales from $3.1 billion in 2017 to $6.2 billion in 2022, the gross margin was remarkably stable, fluctuating between 65% to 70% in the past decade.
Below is a table showing COGS per segment:
ISRG Cost of Goods Sold (Author's estimates based on company filings)
Whatever leverage ISRG gains from operating overhead is buried under chunky R&D expenses that fluctuate with hiring and capital needs related to the launch and development of new products. With these lines, Jamie Samath, company CFO notes:
We are planning for "balanced" growth in operating expenses in 2023 given the opportunity to advance our next-generation robotics capabilities and the relatively earlier stage of our investments in Ion, SP and digital. In 2023, we expect a significant increase in expenses related to clinical trials. Q4 2022 Earnings Call
R&D expenses (Author's estimates based on company filings)
R&D expense as a percentage of revenue increased above the historical average in the past few years as the company continues its efforts to bring the next-generation robotic systems to the market. Nonetheless, management made it clear that it will slow down hiring to allow time to absorb the new employee influx seen in the past few years. Thus, while we saw EBIT margins shrink to 25%, our 5-year forecast is built on the assumption that operating expenses will revert to the historical average, bringing EBIT margins up to a 30% ballpark. The following chart shows a proforma EBIT margin for the next five years, incorporating a correction of operating expenses to historical averages.
Profit margin forecast (Author's estimates based on company filings)
Although ISRG is experiencing an upward CapEx cycle, net Capital expenditure (defined as CapEx - Depreciation and Amortization) indicates that the company is investing less in growth and more in sustaining its competitive edge. Although ISRG is the market dominant in tissue robotic-assisted surgery, it is facing competition from robotic devices targeting other indications, namely orthopedics, such as Stryker's ( SYK ) hip replacement robotic arm, Mako, which, while it doesn't compete on sales, does compete in terms of Intellectual Property of various technologies incorporated in the devices.
The Mako Hip Replacement Device (Stryker)
Companies such as Johnson & Johnson ( JNJ ), Medtronic ( MDT ), and many others are also developing or have developed devices that directly compete with ISRG. For many hi-tech manufacturers with a rapidly changing landscape, R&D and CapEx are often critical to maintaining relevance in the market rather than increasing market share.
A Blueprint OTTAVA Robotic Surgical System. (Johnson & Johnson)
Incorporating these dynamics in our Discounted Cash Flow Model, we see modest upside potential for ISRF stock, as summarized below.
DCF Summary | |
Current Price | $245.00 |
Terminal Growth Rate | 2.00% |
Market Risk Premium | 6.00% |
WACC | 5.89% |
Risk-Free Rate | 4.50% |
Our model is predicated on strong revenue growth and terminal Free Cash Flow of $3.3 billion in 2027, compared to about $1 billion in 2022, which is hardly a conservative estimate.
Fair Value Per Share | $281.19 |
Upside Potential | 14.77% |
Summary
Robotic Surgical Systems are changing the way hospitals and surgeons conduct surgery and increasingly replacing traditional surgical procedures. There is no doubt that ISRG is bringing disruptive changes in the market. With its global reach and existing footprint in the U.S., ISRG provides a strategic advantage for its customers.
Q4 and FY 2022 results fell below expectations, impacted by lower sales volume than expected due to market weakness as hospitals optimize their CapEx in the face of tough economic conditions, manifested in labor shortage and inflation. ISRG's margins were also lower due to the same macroeconomic dynamics. Our DCF model is predicated on a rebound in FY 2023 and beyond. We assume a revenue growth rate of 15% annually for the next five years and moderation in operating costs but slightly higher CapEx to accommodate the deployment of new next-generation systems over the next few years. To be clear, our DCF model was constructed using somewhat optimistic assumptions, but it still indicates that the company's growth rate is capped somewhere in the mid-teens at best, underpinning our hold rating.
For further details see:
Intuitive Surgical Beyond Macroeconomic Challenges