2023-04-13 05:01:41 ET
Summary
- Intuitive Surgical has a strong ecosystem that generates more associated revenue than the systems it sells alone.
- The company's high operating expenses mostly attributed to its R&D expenses, with the company set out to grow more in digital services while maintaining core competitiveness.
- It is in a strong position to sustain near-term growth without having to resort to borrowing, but its margins could be further pressured.
Investment Thesis
Intuitive Surgical ( ISRG ) builds a strong ecosystem, investing heavily in its R&D to fuel innovation and development, and continues to pursue industrial production to scale up. However, the higher costs and expenses have started to erode its margins. With a challenging macro environment ahead, the company will have difficult decisions to make. Although it is in a strong liquidity position to sustain near-term growth plans, the current stock price nonetheless overvalued the company.
Company Overview
Intuitive Surgery is a leader in providing robotic-assisted, minimally invasive instruments in surgical and medical care. The company was founded in 1995 and is headquartered in Sunnyvale, California. Its business operates as one segment, evolving around its main product called " da Vinci Surgical System," which has several models and generations of systems that focuses on general surgery, urologic, gynecologic, cardiothoracic, and head and neck specialties, providing high-definition vision, magnified view, and robotic and computer assistance during surgeries. It also has a range of instruments, accessories, and training services as part of its ecosystem of products and offerings.
Strength
Even though Intuitive Surgical reports as one segment, we can still review earnings breakdowns according to the clinical application of its systems. The worldwide earnings trend by procedure shows that, in General Surgery, it has the largest share and fastest growth. "The 2022 U.S. da Vinci procedure growth was approximately 16%, driven by strong growth in general surgery procedures, most notably hernia repair, cholecystectomy, and bariatric procedures, as well as moderate growth in the more mature gynecologic and urologic procedure categories", according to its 2022 10-K .
Compared with the regional growth, the Outside-of-US non-urology struck similar growth momentum to the US General Surgery field for 2022. These two are the main drivers of the overall 18% growth YoY. "The 2022 OUS da Vinci procedure growth was approximately 22%, driven by continued growth in urologic procedures, including prostatectomies and partial nephrectomies, and earlier stage growth in general surgery (particularly colorectal), gynecologic, and thoracic procedures", the company also stated.
The company's financials also reflect this overall strong growth. Both its topline revenue and gross profits have grown to the highest level in history.
The reason for not dividing the business units into segments certainly has roots in the nature of medical procedures, but the overall advantageous implications to business are also significant. The company is keen to develop an ecosystem around every da Vinci system it sells by providing accessories, supportive instruments, training, and analytical services.
The company stated that each of its da Vinci Systems is sold for between $0.5 million to $2.5 million, varied by the models and customization. It had sold 7500+ of them globally by early 2023. Its annual revenue in 2022 was $6.22 billion. So in a rough estimate, each da Vinci system, on average, generated $0.83 million in revenue for the company, and a unit EBITDA of $0.21 million, without differentiating by models or whether it's recurring spending. Building the ecosystem helps drives the organic growth of the company. This explains why its recurring revenue was so high as a portion of the total revenue, reaching 79% in 2022 by its own estimates.
This kind of growth is both highly profitable and organic. Customers who order more than one da Vinci System have seen increasing at double digits.
Therefore, for every da Vinci system sold, Intuitive Surgical stands to benefit from building a vibrant ecosystem. The revenue that its systems generated is growing about 11.75% per year in the past ten years, but the instruments and accessories sold to accompany the systems grew twice as fast. 10 years ago, they generated almost the same amount of revenue. By 2022, the revenue from instruments and accessories was twice as much as the revenue from selling the systems alone. And the services revenue alone also sees its value triple in the same time frame. This is a prime example of how much this value-added ecosystem helps the company's topline growth.
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Intuitive Surgical's organic growth can also be seen from its very low debt level. Through its high growth, the company has never been a big borrower or racking up debt, and lately, its debt-to-equity ratio has even dropped to its minimum, with almost no long-term debt. Its growth is funded by the cash generated from its own operation. It is advantageous to maintain growth without being disrupted in a higher interest rate environment, which is helpful for it to pursue long-term strategic growth.
Combined with the low debt level with its current ratio of 4.4x as of Q4, Intuitive Surgical is in a solid liquidity position. As of the end of the most recent quarter, the company had cash, cash equivalents, and investments of over $1.58 billion. The company has the ability to meet its short-term obligations and has the financial flexibility to pursue future growth opportunities.
With demand going strong and each da Vinci surgical system bringing about 20% EBITDA, ramping up production while maintaining its high quality is key for Intuitive Surgical to capture more growth. The company has been pushing to become productive at an industrial scale, and this has been working. Its average yearly unit placement in total is 1182 for the past three years. This number is at the ballpark of what it currently can produce annually at the current time. This number is more than double what it was ten years ago. In particular, its new placement growth in the US is the fastest, with Outside-of-the-US catching up quickly.
ISRG
However, due to the specialized and complex nature of its products, the industrial production scale can be limited at times. For example, its da Vinci Instruments, which provides EndoWrist technology with wristed joints for natural dexterity, most of its tips are customized for various surgical procedures with precise measurements. The capacity to be able to customize its robotic devices with high precision and complexity is both crucial for its success, as it could mean life or death in surgery and differentiate it from its competitors, as well as a challenge to produce at scale.
While boosting production, the company intends to continue driving its "innovative edge". This can be seen in its research and development efforts. Its R&D spending as a percentage of operating expenses has been consistent throughout the years, with the past five years staying at a similarly high level.
Weakness/Risks
In contrast with its strong revenue growth, both its free cash flow and net income have dropped in recent quarters, almost down to their pre-pandemic levels. These are still fairly healthy levels but the downward momentum needs to be halted to preserve its margins.
The company's decreasing free cash flow came from both lower operating cash flow and higher capital expenditure. It stated CAPEX would be significantly expanded in 2023 to $800 million to $1 billion, funded by the cash generated from operations. Most of it will be spent on building out imaging capacity and pipeline, accessories technologies, and digital/software services. The free cash flow will be further pressured if operating cash flow stays at or below current levels.
The operating expenses have become too high with respect to the bottom line. In absolute value terms, they have risen to their highest level. The operating expenses in 2022 were 50% more than in 2020, while earnings from operation have fallen back down to the 2020's level. The deviation between the two shows that the increase in operating expenses has exceeded gross profit growth. Its R&D expenses currently are more than 5x what it was in 2013, while its admin and selling expenses are a bit more than 3x compared to their value in 2013. Currently, the admin and selling expenses are about 1.9x of R&D expenses, while in 2013, that ratio was 3.4x. So the company is getting more efficient in managing while continuing to ramp up the core R&D investment. The higher operating expenses are still mainly due to the growth of R&D expenses.
In addition, its operating margin has fallen to one of its lowest levels, almost approaching the sharp drop in 2014. Overall, other than its gross margin, most of its margins have fallen to their lower historical levels. In particular, the EBITDA margin and free cash flow margin have fallen to about half of where they were in 2020.
Since Intuitive Surgical doesn't pay dividends, has just done one of its largest share repurchases, and has almost no debt obligation to meet, going forward, the focus of its cash flow deployment would be reinvestment into the business. The company is largely immune from tightening credit cycles due to its minimal debt level. Its increased expenses can be seen as driven by endogenous factors (such as the speed of innovation and development, or administrative and marketing costs), and the growth cycles that pertain to the medical industry. The almost halved net margin, EBITDA margin, and free cash flow margin in 2022 compared to 2021 do not bode well with yet broader macro challenges ahead. Although they are still firmly within their historical range, the company might need to dial back some of its growth plans or resort to cost-cutting measures. It could either slow its industrial production pace, innovation, or both. Or, simply shrinking its cash on hand to sustain the development pace. The question on our mind is how the company will navigate through the near-term headwinds and if any compromises would have to be made. We will explore that in our valuation process.
Financial Overview
Valuation
We consider all the analysis above and use our proprietary models to assess Intuitive Surgical's fair value by projecting its growth prospects ten years ahead. With its current growth in industrial production, the company is likely to double its annual output of new units in 6-7 years' time. And if it can continue at the current pace of innovation and development, the company could add 14% of marginal value to each unit's revenue generated annually, by the estimate of our own models. We used a cost of equity of 7.28% and WACC of 7.27%. In our bullish case, Intuitive Surgical is flat in its margin growth for 2023 with a comeback and a surge in the next few years with mostly double-digit growth till the end of the ten-year horizon; it was valued at $191.93. In our bearish case, the company has negative growth in '23, flat in '24, and a strong recovery afterward but has some volatility; it was valued at $162.34. In our base case, the company's growth was negative in '23 and flat in '24, followed by surging growth with less volatility; it was valued at $173.39. The current price is much higher than our bullish scenario. It seems the market has given it a lot of premium for its "innovative edge".
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Conclusion
Overall, we see Intuitive Surgical as a company with a keen focus on innovation and development, and the market has been rewarding ISRG stock for this effort. The company has made great progress in industrial production to scale up its growth, and this effort is solidly reflected in its increasing topline. However, its rapid expansion and development, including what it's planning to spend this year, are eroding its margin, even though the funding source is its own cash flow from operation. Innovations don't come cheap, and investors need to factor that in. We don't necessarily think the company should slow down the investment for its long-term growth, even by paying the price of a lower margin in the near term, but we do feel the current stock price is overly optimistic and factored in an expectation that is too high even with annual double-digit growth for the next ten years. In our opinion, a gradual re-adjustment of the price is inevitable, as the stock is overvalued. We understand the market tends to assign an "innovation premium" to the stock and would recommend staying on the sidelines and a hold instead of a sell.
For further details see:
Intuitive Surgical: Highly Valuable Ecosystem With Innovation That Doesn't Come Cheap