2023-10-25 08:30:00 ET
Summary
- Intuitive Surgical is arguably the most compelling medtech business on earth today, with a long runway for growth still ahead of it.
- It's an incredibly interesting, profitable, and dominant business that has fielded its product globally.
- I would say that most folks would agree with me in these respects.
- The issue, as I will demonstrate for you today, is that this is already known, and, as a result, has been priced into the valuation of Intuitive Surgical.
- In short, with $7.5B in cash, nearly no debt, 27.5%+ long run free cash flow and 35%+ operating margins, and a long runway for growth and evolution still ahead, I like Intuitive Surgical quite a bit. But I still, even after waiting to buy it for the last three years, cannot make its valuation make sense such that we can buy with a sufficient margin of safety.
Catching Up
Intuitive Surgical (ISRG) recently reported earnings, and, in light of its ~26% decline from its share price highs, I thought it would be a good time to revisit the business after taking a break from sharing research on it over the last three years or so.
Like so many of the businesses I've discussed with you over the last year, Intuitive Surgical is a company that I have monitored for the last few years but have not been purchasing due to valuation inflation created by the bubble precipitated by the U.S. 1.4x'ing its money supply over the last 3 years. I've sat patiently on the sidelines for years, waiting for the opportunity to buy Intuitive Surgical at an attractive price/valuation.
But while I've not been buying, I've been keeping track of the business' progress, and, based on my approximately half decade relationship with the business, I like it and its products quite a bit. In fact, I once visited and toured its headquarters with the help of a personal friend who was (and still is) an engineer at Intuitive in Sunnyvale, CA. You'll see some of the photos I took during my visit in my review of the business in the link below:
Notably, even at that time, while I liked the business, I was not smitten with the valuation.
I did, however, become smitten with the valuation when the stock fell during the March 2020 panic, and I articulated as much here:
So I know the business well. I like the business a lot, but its valuation has been the central issue for me, as has been the case for almost countless businesses within my coverage universe since the second half of 2020. With these ideas in mind, I'd like to begin this review of Intuitive with a valuation exercise, after which I will perform a deep dive into the company.
Valuing Intuitive Surgical
To a very high degree, Intuitive is a quantitative quandary. That said, the business has grown substantially since the above-shared research was published, and, to this end, I went into this review wondering if its business growth had finally caught up with its valuation.
Over the last three years, Intuitive has grown its sales from ~$4B to ~$7B as of my typing this in late October.
Further, it's grown its cash balance from $3.2B to $7.5B. These two data points represent a business that has made incredible progress in terms of financial performance and corresponding business growth in the last few years. Intuitive has performed incredibly well, though, quite notably, its stock price has essentially not budged during this period of exceptional business performance.
In addition to its sales and cash balance growth, Intuitive's business now offers three robotic surgical systems (Ion, da Vinci, and SP), as opposed to, essentially, just the one it offered in early 2020. It also offers a compelling software platform, as well as an entire vertically integrated ecosystem around its core hardware products. In the interest of brevity, I will explore this with you in future reviews of Intuitive that I plan to publish in the weeks/months ahead.
Due to ongoing aggressive reinvestment in the business, superficial valuation metrics have been more or less rendered useless. The current PE ratio or EV/FCF ratio are not representative of the business' true earnings power due to its aggressive reinvestment. In this vein, when I began assessing it more granularly over the last couple days, I noticed that its free cash flow margin had compressed substantially, while its capex soared (levered free cash flow = cash from ops less capex).
We can see this reality below:
Intuitive Surgical's Free Cash Flow Margin
Intuitive Surgical's Capex Spend
These two variables served to push upward on Intuitive's EV/FCF multiple, giving the illusion of a valuation that's vastly more expensive than it actually is on a trailing twelve month basis.
We can use this information to make a more informed decision as to the true attractiveness of the company today with a long term time horizon in mind. That is, we can, if you will, front run the expansion of Intuitive's margins, should the "fully expanded margin-version" of Intuitive's business be attractive to us from a valuation perspective (it still may not be, even using fully expanded long term margins!).
Of course, investing in this fashion, i.e., predicting long run margins and investing based on those margins, may not be for everyone, but I believe it's more than acceptable for businesses that have proven their earnings power in the past and that have dominant market positions.
As one example, this was the precise setup that I saw for Chipotle (CMG) following the ecolapocalypse, which temporarily compressed its margins in the mid-2010s. These temporarily compressed margins created an illusion of expensiveness for the casual observer, but, for those that examined its margin trends, it became exceedingly obvious that the business was vastly less expensive than superficial valuation metrics indicated.
Chipotle's Operating & Free Cash Flow Margin
Importantly, throughout this period, Chipotle's management communicated that restaurant-level operating margins would return to 27.5%+, with even more upside to be had with the advent of Chipotlanes and greater throughput.
And management delivered, restoring Chipotle's margins to their former levels prior to the aforementioned health scare (and Chipotle's margins might actually eclipse 30% on a restaurant basis via Chipotlanes and better throughput in the years ahead).
Similarly, Intuitive has experienced notably depressed operating and free cash flow margins recently, as can be seen in the chart below.
Intuitive Surgical's Operating & Free Cash Flow Margin
With these ideas in mind, we must ask the question, "Will Intuitive restore operating and free cash flow margins to their former levels?"
If the answer is "yes," then Intuitive's valuation is vastly less expensive than it appears at first blush today.
Of course, herein lies even the faintest thesis as of today, by which I mean that, if they cannot, there's absolutely no chance Intuitive is a buy as of today.
But, if they can, then Intuitive is perhaps a decent buy today. Let's explore what I mean in the next section.
Management's Margin Guidance
Management has, indeed, provided explicit guidance indicating that margins will eventually return to their former 25%+ free cash flow and 35%+ operating margin levels.
To wit:
Larry Biegelsen: Okay. So you have talked about, Jamie, top tier margins between 35% and 40% over time. How should we be thinking about the timeline to achieve those goals and expectation -- any expectations to return to pre-COVID levels?
Jamie Samath: Yeah. So framing last year we did about 35% op margin Q2 just past. We did 35% op margin, and we have said we don't have a management objective to be above 40%. So that's kind of the range that you referenced, Larry.
In the nearer term, we think op margin is choppy. We have a set of accumulated stresses from the pandemic that's kind of in our global operations impacting gross margin. We have some work to do with respect to the product cost structure in Ion gross margins there that are dilutive to corporate averages. So that set of activities within gross margin is impacting, obviously, operating margin and that will take us some time to work through.
We do have significant CapEx this year that will turn into depreciation next year. Those are longer term investments, particularly for facilities and manufacturing capacity . So they have a period of underutilization with respect to that depreciation expense.
We expect to leverage our enabling functions next year. We will start to see the benefit of the activities as we described in Q2, and we should see the benefit of that in the remainder of the year.
So we have an expectation that we can get to gross margins of 70% over time and then we can have operating margins above 35% over time. Not ready to put a timeline on it in part because of the environment we find ourselves in and the set of activities and actions that we have to execute, but we have a management commitment to at some point be above 35% [operating margin]."
Intuitive Surgical, Inc. ( ISRG ) Management Presents at 2023 Wells Fargo Healthcare Conference
Accounting for taxes, this comfortably puts us at a conservatively estimated 27.5% free cash flow margin. Notably, Intuitive has, in the past, achieved 30%+ free cash flow margins for extended periods of time, though it has struggled to restore this level of profitability in recent years due to covid principally.
With this data; namely, management's guidance and historical operating margins, for those that believe in the Intuitive business, which we will review in just a moment, we can create a valuation and determine reasonable to conservative future, projected returns.
Next, we will do just that.
L.A. Stevens Valuation Model Exercise
As a bit of context or preamble to the valuation exercise I will perform below, note that I used rather aggressive assumptions.
I've already run a variety of scenarios for the growth of free cash flow per share over the next decade, and I've come to realize that very aggressive expectations are still being priced into Intuitive. In essence, as of today, in order to achieve a 15% annualized return over the next decade, which I would say reflects true risk of the business (risk = return), we'd need:
- 30% free cash flow margin
- 16% annualized sales growth on average
- A 25% reduction in share count
I believe, in highlighting or conveying a bull case, it's worth using very conservative assumptions whereby I illustrate that, even in a worst case scenario, the business will produce solid returns. Conversely, I believe, in a conveying a bear case, it's worth using very aggressive assumptions whereby I illustrate that, even in a best case scenario, the business and the associated stock are unlikely to produce solid returns for investors.
In the former scenario, we have what's called a margin of safety, where a lot can go wrong for the company and/or the economy, and we'll still achieve our return objectives. In the latter scenario, we have no such margin of safety, and even if the business grows at extremely elevated rates, it's unlikely that we achieve our return objectives.
As one last piece of contextualizing data, here's Intuitive's quarterly revenue growth since it IPO'd:
Intuitive Has Grown at 20%+ Annually For Most Of The Last Two Decades
Let's now perform our valuation exercise:
Assumptions:
TTM 12-month revenue [A] | $7B million |
Potential Free Cash Flow Margin [B] | 27.5% |
Average diluted shares outstanding [C] | 357 million |
Free cash flow per share [ D = (A * B) / C ] | $5.31 |
Free cash flow per share growth rate | 15% |
Terminal growth rate | 3% |
Years of elevated growth | 10 |
Total years to stimulate | 100 |
Discount Rate (Our "Next Best Alternative") | 9.8% |
L.A. Stevens Valuation Model L.A. Stevens Valuation Model
Very notably, I assumed a share count reduction of 25%, which, again, is quite aggressive considering the company has no material track record of repurchasing shares at this rate, and it will have to buy back shares at ~50x EV/FCF, which will blunt its ability to reduce share count at a rate necessary to achieve a reduction in share count of 25% in 10 years.
Further, I used a 30x EV/FCF exit multiple, which, for a company that is already 25+ years old is quite aggressive, though certainly achievable (this depends on interest rates to a high degree by 2033, to be sure).
Were I to hold share count stable for the next 10 years and reduce the terminal multiple for the model to 25x, we'd only generate about 7% returns annually.
Lastly, 15% annualized growth equates to $27B in total sales by 2033, which, while certainly achievable likely accounts for no economic disruptions whatsoever. That said, as I will demonstrate in the next section, I do think it's achievable.
In short, after working through Intuitive's valuation once again, I still cannot make the math work such that it's an attractive buy today. I still cannot comfortably allocate capital here such that I am very confident we will beat the market in the five to ten years ahead, though, we certainly have an anchoring based on this review, and I would say about $175/share or lower would represent a very attractive entry point in my eyes.
Invariably, as has been the case for the last 3-4 years, which I believed would be the case, Intuitive will stagnate and/or experience a share price decline. I don't know how any big money could comfortably allocate capital here, unless they believe free cash flow margins will hit 35% and growth will sustain 15%+ annualized for the next decade. I think those are both possible outcomes, but they are also quite aggressive and making those assumptions entirely flouts value investing principles.
Let's now turn to an analysis of the business.
Intuitive Is An Incredible Business
And you can see the da Vinci system in one of the photos I took while touring the headquarters in Sunnyvale:
da Vinci System
Photo Taken By Author
When Intuitive first launched the da Vinci system, it was used in only a small number of procedures related to urology, such as hysterectomies.
At the time, of great note, laparoscopic hysterectomies were the prevailing methodology for performing this procedure, and doctors and medical professions were reluctant to adopt the da Vinci system. It was a controversy akin to the adoption of any new technology. This phobia of new technology is so pervasive, in fact, that there's an entire X profile devoted to it called Pessimist Archives, which documents the fear and, oftentimes, hysteria related to the advent and adoption of new technologies over the last couple thousand years.
Today, not only is the da Vinci system, i.e., robotic, minimally invasive surgery system, widely accepted as the method of choice for performing this procedure, but also it's now become surgical system for a broad array of procedures.
da Vinci Is Now Used In A Growing Number Of General Surgical Applications In The U.S.
J.P. Morgan Healthcare Conference 2022
Over time, I expect that surgical robotics will perform an even greater portion of procedures in the U.S. and around the world; likely moving beyond soft tissue over time. There is a high likelihood that robots perform these surgeries in their entirety at some point in the next few decades.
The adoption of robotic surgeries has resulted in the procedure growth depicted in the chart below:
Intuitive's Total Procedure Count Globally
Intuitive Surgical Q3 2023 Investor Presentation
As we can see, Intuitive's total procedure count has been growing rapidly in the last five years, reaching nearly 2M in 2022.
To give you context for what this means, Intuitive provided a total procedure TAM in its J.P. Morgan Investor Day in 2022.
J.P. Morgan Healthcare Conference 2022
Regarding my valuation, one could certainly create an algebraic proportion equation such that, at 1.8M procedures, Intuitive will generate about $7B in sales; so, at 6M procedures, it should generate about 3x that amount, resulting in about $23B in sales. Presently, this is what the market expects based on the valuation exercise I performed above, and the market certainly thinks Intuitive is good for it! Else we'd be offered more than about 12% returns in an optimistic scenario.
An Apple-Like Walled Garden Ecosystem
In the last decade or so, Intuitive has been transitioning its business model essentially away from "lifetime license models" to a "SaaS" business model, but, instead of "software," it's Robotics, or RaaS, if you will.
Instead of purchasing a da Vinci system or Ion system upfront, healthcare systems now de facto subscribe to the systems (technically lease) them.
Intuitive Surgical Q3 2023 Investor Presentation
In conjunction with the system itself, healthcare systems purchase a series of ecosystem products, such as software platforms like MyIntuit and advanced robotic accessories.
Similar to the Apple ecosystem, there's a central productivity tool (Macbook for Apple; da Vinci for Intuitive) around which Intuitive has created an ecosystem of software and hardware accessories that enhance the core productivity tool's experience.
Intuitive's Ecosystem Designed Around Robotic Surgical Systems, i.e., da Vinci and Ion
Intuitive Surgical Q3 2023 Investor Presentation
Intuitive's Comprehensive, Walled-Garden Ecosystem
Intuitive Surgical Q3 2023 Investor Presentation
To close this section, we now understand the da Vinci system itself as well as the ecosystem within which it operates. Notably, this ecosystem is a competitive advantage for Intuitive relative to its peers in the same way that Apple's ecosystem is a competitive advantage relative to its smartphone peers.
So we believe the ecosystem is the basis of competition and we think we have a wide moat with respect to the comprehensiveness and capability in our ecosystem.
Jamie Samath, CFO, J.P. Morgan Healthcare Conference 2022
Note The Woman Piloting One Of The da Vinci Systems
Photo Taken By Author
First, Second, and Third Foundational Investment Frameworks
As with many of our companies, Intuitive fits within a few of our foundational investment frameworks; namely the first, second, and third. Within Beating The Market, we employ these frameworks to decide what businesses we should buy/make new Top Ideas.
As a reminder, our first, second, and third foundational frameworks are highlighted below:
Author's Foundational Investment Frameworks
And I believe Intuitive fits perfectly within these three! Though, of course, its valuation suggests that I am not the only person who sees this reality and the corresponding quality nature of Intuitive.
The First
As we already explored today, Intuitive has built a vertically integrated platform, at the center of which is the da Vinci system.
This ecosystem serves as the company's moat in the same way that Apple's ecosystem serves as its moat, creating, most notably, an embedding/switching costs moat.
Intuitive started as just a hardware provider with its da Vinci system in the same way Apple started as just a hardware provider with its iPhone and computers, but, over time, Intuitive has gradually vertically integrated more components of the surgical procedure experience, ultimately creating an entire ecosystem.
Below, we can see this comprehensive, vertically integrated ecosystem:
Intuitive Surgical Q3 2023 Investor Presentation
And below we can see the targeted outcome from creating this integrated ecosystem:
J.P. Morgan Healthcare Conference 2022
J.P. Morgan Healthcare Conference 2022
The Second
Intuitive has begun repurchasing shares, though it has not had a strong track record of doing so, which makes sense considering it's still a fairly young business.
With 27.5% free cash flow margins and $7.5B in cash, it's likely that these share repurchases begin in earnest in the decade ahead, hence, Intuitive fits within the second foundational investment framework.
Intuitive's Hulking Cash Hoard, Which Currently Generates About $200M In Cash Per Year
That said, the market has already priced this in and then some, as I demonstrated for you earlier in assuming, in a best case scenario, that the business would reduce its share count by 25% in the decade ahead.
The Third
In the 2010s and 2020, I was not familiar with the Ion system, nor MyIntuitive, nor Intuitive's SP product.
Over the last few years, however, Intuitive has both launched new products and further vertically integrated its suite of products such that it's created the above-mentioned Walled Garden ecosystem.
Below, we can see the growth of its Ion system:
Intuitive Surgical Q3 2023 Investor Presentation
Additionally, while its SP (da Vinci Single Port) system has not gained as much adoption as its Ion system, it's been growing at a healthy rate as well.
Intuitive Surgical Q3 2023 Investor Presentation
Intuitive's Hardware Product Suite
Intuitive Surgical Q3 2023 Investor Presentation
Intuitive's clear commitment to launching new systems is heartening, and it demonstrates the company's ability to field new successful products, which is the key component of the third foundational investment framework that I shared with you just a moment ago.
Concluding Thoughts
To conclude this review, let's look at Intuitive through Beating The Market's Crucial Characteristics (a set of criteria we've used to evaluate new businesses).
Key Factors | Notes |
Zero to One Strategy | All businesses worth owning experience a Zero to One journey, and the concept is detailed in the book Zero to One. It's the idea of a company going from idea, which is effectively 0, to a defining business that is unrivaled, or a 1. Intuitive has pioneered surgical robotics and is the leading global brand. In some sense, Intuitive is synonymous with surgical robotics in the same way Kleenex is synonymous with tissues. Additionally, its strategy to further eliminate competition has been to create the above-mentioned Apple-like Walled Garden ecosystem. |
Why now? | Surgical robotics, and robotics of all kinds, are finally finding commercial application. Intuitive is building Star Wars-like surgical robotics, and Tesla is building Transformers-like vehicle robotics. It's an incredible time to be alive. Tesla is also now building androids, i.e., its Optimus product. |
Long Term Vision | I believe the very long term vision for Intuitive is to make its surgical systems more and more automated, akin to the Star Wars video I shared with you earlier. The launch of its software platform in 2021 is the first step along this journey: First, Intuitive must collect massive volumes of data that it can then feed into a fully autonomous robotic surgical system. |
Visionary Founder/CEO | Intuitive's visionary founder is no longer at the helm; however, CEO Gary Guthart has proven to be a quality CEO thus far. |
Quality Board of Directors | I believe Intuitive's board to be quality, and you may review it here: Intuitive Leadership |
Proprietary Tech | Intuitive is the pioneer of robotic surgical devices. It has developed quintessential proprietary technology. |
Product Roadmap And Evolution | Intuitive has demonstrated the ability to evolve its product set over the last decade or so, and I expect this culture of product evolution to continue, ultimately culminating in autonomous robotic surgeons. |
Network Effects ((MOAT)) | With the advent of Intuitive's software products, the more surgeons use the system within a hospital system, the more intelligent the entire hospital and its surgeons will become. Therefore, each additional user of the system will make the entire network of systems within a hospital or healthcare system more valuable. Each additional user of the network makes the network more valuable as a whole. This is the quintessential definition of a network effect, and we can see this playing out in the data below. Q3 2023 Investor Presentation |
Brand ((MOAT)) | Intuitive's brand is synonymous with surgical robotics. |
Scale ((MOAT)) | Intuitive is the largest surgical robotics company on earth presently (not the largest medtech to be sure). |
Embedding ((MOAT)) | Once a surgeon learns the da Vinci system and begins using its software, there's a very low chance they switch to another system. |
Net Promoter Score / Customer Satisfaction | Intuitive has a truly exceptional Net Promoter Score at 79. Q3 2023 Investor Presentation |
Powerful Secular Growth Trend | Surgical robotics are the future! Underpinned by software, cloud computing, AI, GPU-based parallel processing, etc. |
Total Addressable Market | Currently, Intuitive does about 1.8M procedures per year, and its leasing model is often structured on a usage-basis. There are 20M soft tissue procedures performed per year globally, and virtually all of these will be performed robotically at some point. |
Market Share | As of 2021, Intuitive possessed 80% market share of the global surgical robotics market. |
Competitive Differentiation | Intuitive is earth's leading surgical robotic manufacturer. These are highly complex systems that are genuinely life or death. Intuitive's brand and product consistency has given it its moat to a large degree thus far. That said, its creation of its Walled Garden ecosystem has become one of its key moats outside of brand. The specific moat that the Walled Garden ecosystem has created is embedding/switching costs. JNJ is one of Intuitive's primary competitors and my engineer friend who works at Intuitive recently shared with me: My Conversation With Engineer Friend |
Mergers & Acquisition Strategy | Intuitive has not been acquisitive; instead choosing to grow through organic product development. This is an attractive element of the company, though, at some point, my hope is that the company demonstrates its capital allocation acumen through value accretive acquisitions. |
International Expansion | International expansion remains one of the most compelling components of the Intuitive thesis. |
Sounds Financials | With 25%+ free cash flow margins, $7.5B in cash, effectively no long term debt, and 70%+ gross margins, Intuitive is as financially sound as a business can possibly be. |
Liquidity or Bankruptcy Risk | Intuitive has $7.5B in cash and ~$100M in long term debt. There's ~0% liquidity or bankruptcy risk. |
Shareholder Dilution Risk | To the contrary, Intuitive will likely repurchase a material percentage of its shares outstanding in the decade ahead. |
Risks
The central risk that Intuitive Surgical faces is valuation risk.
Competition is a risk, but I demonstrated that it has substantial moats, e.g., embedding and burgeoning network effects, to name a couple.
In short, my thesis is that Intuitive Surgical is a brilliant business with a series of moats, but its valuation is a bit too lofty.
Thank you for reading, and have a great day.
pre
For further details see:
Valuing Intuitive Surgical After 3 Years Of Share Price Stagnation