Intuitive Surgical (NASDAQ: ISRG) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Intuitive Surgical shares for the portfolio in September 2016 at a price of US$237 and then again in April 2017 at US$255. I’ve not sold any of the shares I’ve bought.
The purchases have performed very well for my family’s portfolio, with Intuitive Surgical’s share price being around US$593 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Intuitive Surgical shares.
Company description
In recent years, there have been news articles on the da Vinci robotic surgical systems being used in some of Singapore’s major hospitals. The da Vinci systems are the handiwork of the US-based Intuitive Surgical.
Founded in 1995, Intuitive Surgical is a pioneer in robotic surgical systems. Today, the company primarily manufactures and sells its da Vinci family of robot systems and related instruments and accessories. The robots are used by surgeons around the world to perform minimally invasive surgical procedures across a variety of surgical disciplines, including general surgery, urology, gynecology, thoracic, and trans-oral surgery.
The da Vinci system, which costs between US$500,000 and US$2.5 million each depending on the model and geography, acts as an extension of a surgeon’s hands – surgeons operate the system through a console that is situated near a robot. But it is more than just an extension. The da Vinci system is tremor free, has a range of motion analogous to the human wrist, and has the ability to move at smaller length-scales with greater precision.
The US is currently Intuitive Surgical’s largest geographical market, accounting for 71% of the company’s US$3.2 billion in total revenue in the first nine months of 2019.
Investment thesis
I had previously laid out my six-criteria investment framework in The Good Investors. I will use the same framework to describe my investment thesis for Intuitive Surgical.
1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market
Intuitive Surgical is a great example of a company with revenue that is large in a fast-growing market. In 2018, the company’s revenue was US$3.7 billion, which accounted for a significant share of the global surgical robot market; according to Mordor Intelligence, the market was US$4.1 billion then. Mordor Intelligence also expects the market to compound at nearly 22% per year between 2019 and 2024.
I believe the projection for high growth in the global robotic surgical market is sound for two key reasons.
Firstly, minimally invasive surgeries lead to better patient outcomes as compared to open surgery, such as lesser pain, faster post-surgery recovery, and lesser scarring. The da Vinci system is used to perform minimally invasive surgeries. Furthermore, the system “combines the benefits of minimally invasive surgery for patients with the ease of use, precision, and dexterity of open surgery.” I think these traits are likely to lead to long-term growth in demand for surgical robot systems from both patients and surgeon. As of 2018, there were over 18,000 peer-reviewed medical research papers published on Intuitive Surgical’s robotic surgery systems.
Secondly, just 2% of surgeries worldwide are conducted with robots today, according to medical device company Medtronic. Even in the US, which is Intuitive Surgical’s main market, only 10% of surgical procedures are performed with robots currently. These data suggest that robots have yet to make their way into the vast majority of surgical theatres across the globe.
2. A strong balance sheet with minimal or a reasonable amount of debt
Intuitive Surgical has a formidable balance sheet, with US$5.4 billion in cash, short-term investments, and long-term investments against zero debt (as of 30 September 2019).
Another big plus-point is that the company has been stellar at producing free cash flow over the years. I’ll discuss this soon.
3. A management team with integrity, capability, and an innovative mindset
On integrity
Intuitive Surgical is led by CEO Gary Guthart, Ph.D., who is currently 53. In 2018, his total compensation was US$6.4 million, which is less than 1% of the company’s profit of US$1.1 billion in the same year. There are two other big positives about the compensation structure for Guthart and the other key leaders of Intuitive Surgical.
Firstly, the majority – 75% – of Guthart’s total compensation in 2018 came from restricted stock units (RSUs) and stock options that vest over periods of 3.5 years to 4 years. It’s a similar story with other members of Intuitive Surgical’s senior management team – 78% of their total compensation in 2018 was directly tied to the long-term growth in the company’s share price through the use of RSUs and stock options that vest over multi-year periods. I typically frown upon compensation plans that are linked to a company’s stock price. But in the case of Intuitive Surgical, the compensation for its key leaders is tethered to multi-year changes in its stock price, which in turn is driven by the company’s business performance. So I think this aligns my interests as an Intuitive Surgical shareholder with the company’s leaders.
Staying on the topic of alignment of interests, I think it’s also worth pointing out that as of 31 December 2018, Guthart directly controlled nearly 339,000 Intuitive Surgical shares (not counting options that he could exercise shortly after end-2018) that are worth around US$200 million at the company’s current stock price. This is a large ownership stake that likely also puts Guthart in the same boat as other Intuitive Surgical shareholders.
Secondly, the chart below shows that the growth in Guthart’s total compensation from 2014 to 2018 has closely tracked the changes in Intuitive Surgical’s stock price over the same period.
On capability and innovation
Over the years, Intuitive Surgical’s management has done a tremendous job in growing the installed base of the da Vinci systems as well as the number of surgical procedures that have been conducted with the systems. These are two very important numbers for me when assessing the level of demand for Intuitive Surgical’s robots.
Management has also been innovative in expanding the range of surgical procedures that Intuitive Surgical’s systems can reach – see the chart below for how quickly the number of the company’s general surgery procedures around the world has expanded from 2012 to 2018 even as growth in gynecology and urology procedures have decelerated.
Staying with the theme of innovation, Intuitive Surgical has already commercialised four generations of its da Vinci family of surgical robots, so it has a strong history of improving its flagship product. There are also some interesting developments in the pipeline:
- Intuitive Surgical is in the first phase of the rollout of the da Vinci Sp system. The new system is already used in urology, gynecology, general, and head and neck surgical procedures in South Korea. But it was only cleared by US regulators in recent months for use in urologic and transoral surgical cases in the country. At the end of 2019’s third quarter, the total installed base of the da Vinci Sp was just 38. Intuitive Surgical’s management also said in the quarter’s earnings conference call that “customer response and early clinical results using Sp remain encouraging.”
- The Ion platform, Intuitive Surgical’s flexible robotics system for performing lung biopsies to detect and diagnose lung cancers, received 510(k) FDA (Food & Drug Administrattion) clearance in the US in 2019’s first quarter. “Hundreds” of procedures have been performed with the Ion platform as of 2019’s third quarter, and the initial rollout has met management’s expectations and received “strong” user feedback. Lung cancer is one of the most common forms of cancer in the world. If the Ion platform is successful, it could open a previously untapped market for Intuitive Surgical.
- The company recently acquired an existing supplier of 3D robotic endoscopes, Schölly Fiberoptic. The acquisition boosts Intuitive Surgical’s capabilities in the areas of imaging manufacturing, design, and processing, which are important for surgeries of the future, according to the company’s management.
- Intuitive Surgical received 510(k) FDA clearance for its Iris product in 2019’s first quarter too. Iris is the company’s augmented reality software which allows 3D pre-operative images to be naturally displayed in a surgeon’s da Vinci console for use in real-time during an actual surgery.
- As recently as October 2019, Intuitive Surgical was looking to hire software engineers who have skills in artificial intelligence for its imaging and intelligence group. I see this as a sign that the company is working with AI to improve its product features.
I think we should note that Guthart joined Intuitive Surgical in 1996 and became COO (Chief Operating Officer) in 2006. In 2010, he became CEO. In other words, much of Intuitive Surgical’s excellent track record in growing its installed base and procedure-count that I mentioned earlier had occurred under Guthart’s watch.
Many of Intuitive Surgical’s other key leaders have also been with the company for years and I appreciate their long tenures. Some last words from me on Intuitive Surgical’s management: It’s a positive sign for me on the company’s culture to see it promote from within, as has happened with many of the C-suite roles, including Guthart’s case.
4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour
You may be surprised to know that the one-time sale of robotic surgical systems accounts for only a small portion of Intuitive Surgical’s revenue despite their high price tag – just 29% of total revenue of US$3.2 billion in the first nine months of 2019 came from systems sales.
That’s because the robots bring with them recurring revenues through a classic razor-and-blades business model. Each surgery using the da Vinci robot results in US$700 to US$3,500 in sales of surgical instruments and accessories for Intuitive Surgical. Moreover, the robots also each generate between US$80,000 and US$190,000 in annual maintenance revenue for the company. The table below shows the breakdown of Intuitive Surgical’s revenue in the first nine months of 2019 according to recurring and non-recurring sources:
There is also an important and positive development at Intuitive Surgical in recent years: The proportion of the company’s robots that are sold on leases has been increasing. For 2019’s third quarter, 33.5% of new system placements by Intuitive Surgical were based on operating leases that include usage-based models, up from 25.1% a year ago. For more context, operating lease revenue at Intuitive Surgical has more than tripled from US$16.6 million in 2016 to US$51.4 million in 2018, and more than doubled from US$35.0 million in the first nine months of 2018 to US$72.9 million in the first nine months of 2019.
Intuitive Surgical’s management believes that providing leasing – an alternative to outright purchases of the da Vinci systems – accelerates market adoption of the company’s surgical robots by lowering the initial capital outlay for customers. I agree, and I think the introduction of leasing – which started in 2013 – is another sign of management’s capability.
Leasing also boosts recurring revenue for Intuitive Surgical, leading to more stable financial results. If leasing revenue was included, 73% of Intuitive Surgical’s total revenue in the first nine months of 2019 was recurring in nature.
5. A proven ability to grow
The aforementioned growth in the adoption of da Vinci robots by surgeons over time has led to a healthy financial picture for Intuitive Surgical. The table below the company’s important financial figures from 2006 to 2018:
A few key points about Intuitive Surgical’s financials:
- Revenue has compounded impressively at 21% per year from 2006 to 2018; over the last five years from 2013 to 2018, the company’s annual topline growth was slower, at just 10.5%. But growth has picked up in more recent years, coming in at 15.9% in 2017, 18.7% in 2018, and 19.5% in the first nine months of 2019.
- The company also managed to produce strong revenue growth of 45.6% in 2008 and 20.3% in 2009; those were the years when the global economy was rocked by the Great Financial Crisis.
- Recurring revenue (excluding leasing) grew in each year from 2006 to 2018, and had climbed from 44.8% of total revenue in 2006 to 70% in 2018. As I mentioned earlier, recurring revenue (again excluding leasing revenue) was 71% in the first nine months of 2019.
- Net profit has jumped by nearly 26% per year from 2006 to 2018. Although growth has slowed to ‘merely’ 10.9% over the past five years (2013 to 2018), it has accelerated in the first nine months of 2019 with a 22% jump.
- Operating cash flow has increased markedly from 2006 to 2018, with annual growth of 22.8%. The growth rate from 2013 to 2018 was considerably slower at just 6%, but things appear to be picking up again: Operating cash flow was up by 25.7% in the first nine months of 2019.
- Free cash flow, net of acquisitions, has consistently been positive and has also stepped up significantly from 2006 to 2018. The growth in free cash flow has grounded to a halt in recent years, but I’m not worried. The absolute amount of free cash flow is still robust, and in the first nine months of 2019, free cash flow was up 14.2% from a year ago to US$730.1 million.
- The net-cash position on the balance sheet was positive in every year from 2006 to 2018, and has also increased significantly. In fact, Intuitive Surgical has consistently had zero debt.
- Dilution has also been negligible for Intuitive Surgical’s shareholders from 2006 to 2018 with the diluted share count barely rising in that period. It’s the same story in the first nine months of 2019, with the diluted share count inching up by just 0.6% from a year ago.
6. A high likelihood of generating a strong and growing stream of free cash flow in the future
There are two reasons why I think Intuitive Surgical excels in this criterion.
Firstly, the company has done very well in producing free cash flow from its business for a long time. Its free cash flow margin (free cash flow as a percentage of revenue) was in a healthy range of 19.7% to 38.2% from 2006 to 2018, and it came in at 22.8% in the first nine months of 2019.
Secondly, there’s still tremendous room to grow for Intuitive Surgical. This should lead to a higher installed base of surgical robots for the company over time. It’s also reasonable to assume that the utilisation of the robots (procedures performed per installed robot) will climb steadily in the years ahead; it has increased in every year from 2007 to 2018, as shown earlier. These assumptions mean that Intuitive Surgical should see robust growth in its recurring revenues (instruments & accessories; services; and leasing) – and the company’s recurring revenue streams likely come with high margins.
Valuation
I like to keep things simple in the valuation process. Since Intuitive Surgical has a long history of producing solid and growing streams of profit and free cash flow, I think both the price-to-earnings (P/E) ratio and price-to-free cash flow (P/FCF) ratio are suitable gauges for the company’s value.
Intuitive Surgical’s valuation ratios at its current share price may give you sticker shock: The P/E ratio is around 54 while the P/FCF ratio is around 70. The chart below illustrates the two ratios (purple for the P/E ratio and orange for the P/FCF ratio) over the past five years, and they are clearly near five-year highs.
But Intuitive Surgical’s high levels of recurring revenue also lead to relatively predictable streams of earnings and cash flows, something which I think is very valuable. This, along with the company’s excellent track record and huge growth opportunities ahead, justifies its premium valuation, in my view.
I think it’s worth noting too that Intuitive Surgical has, in my eyes, built a strong competitive position because of its first-mover advantage in the surgical robot market. Hospitals and doctors need to invest time and resources in order to use the da Vinci robots. The more da Vinci systems that are installed in hospitals, the harder it is for competitors to unseat Intuitive Surgical – so it’s good to know that there are more than 5,000 da Vinci systems installed worldwide today.
The risks involved
There are two key risks with Intuitive Surgical that I’m watching.
The first is any future changes in healthcare regulations. Intuitive Surgical’s revenue-growth slowed dramatically in 2013 (up just 4%, compared to a 24% increase in 2012); revenue even declined in 2014. Back then, uncertainties related to the Affordable Care Act (ACA) – the US’s national health insurance scheme set up by then-US president Barack Obama – caused hospitals in the US to pull back spending.
Current US president, Donald Trump, made changes to the ACA as early as 2017. Trump’s meddling with the ACA has so far not dented Intuitive Surgical’s growth. But if healthcare regulations in the US and other countries Intuitive Surgical is active in (such as Germany, China, Japan, and South Korea) were to change in the future, the company’s business could be hurt.
The second key risk is competition. Intuitive Surgical name-dropped 16 competitors in its latest 2018 annual report, including corporate heavyweights with deep pockets such as Johnson & Johnson and Samsung Corporation. Although Intuitive Surgical is currently the runaway leader in the field of robotic surgery systems, there’s always a risk that someone else could come up with a more advanced and more cost-effective surgical robot.
Medtronic, one of the competitors named by Intuitive Surgical, will be launching its own suite of surgical robots in the near future – the company earned nearly US$31 billion in revenue over the last 12 months. Meanwhile, Johnson & Johnson has been busy in this space. It acquired Auris Healthcare (another of Intuitive Surgical’s named competitors) in 2019 for at least US$3.4 billion, and recently announced the full acquisition of Verb Surgical (yet another named competitor of Intuitive Surgical). Verb Surgical was previously a joint venture between Johnson & Johnson and Alphabet, the parent company of Google.
I mentioned earlier that Intuitive Surgical has already carved out a strong competitive position for itself, so I’m not worried about the competition heating up. Moreover, I think the real battle is not between Intuitive Surgical and other makers of robotic surgical systems. Instead, it is between robotic surgery and traditional forms of surgery. As I had already mentioned, only 2% of surgeries worldwide are conducted with robots today, so there’s likely plenty of room for more than one winner among makers of surgical robots. Nonetheless, I’ll still be keeping an eye on competitive forces in Intuitive Surgical’s market – I’ll be worried if I see a prolonged deceleration in growth or decline in the number of surgical procedures that the da Vinci robots are used in.
It’s worth noting too that Intuitive Surgical is not sitting still in the face of upcoming competition. At the end of 2018, the company had over 3,000 patents and 2,000 patent applications around the world, up from over 1,300 and 1,100, respectively, in 2012.
The Good Investors’ conclusion
Intuitive Surgical shines when seen through the lens of my investment framework:
- It is a leader in the fast-growing surgical robot market.
- Its balance sheet is debt-free and has billions in cash and investments.
- The management team is sensibly incentivised. They also have excellent track records in innovation and growing the key business metrics of the company (such as the installed base of the da Vinci robots and the number of procedures conducted with the robots).
- The company has an attractive razor-and-blades business model that generates high levels of recurring revenues with strong profit margins.
- Intuitive Surgical has a robust long-term history of growth – its revenue, profit, and free cash flow even managed to soar during the Great Financial Crisis.
- It has historically been adept at generating free cash flow, and likely can continue doing so in the years ahead.
Intuitive Surgical carries pricey P/E and P/FCF ratios right now, but I think the high valuations currently could prove to be short-term expensive but long-term cheap. Firstly, the company’s recurring revenues provide a stability to the business that I think the market values. Secondly, there are significant growth opportunities for the company.
There are important risks to watch, as it is with any other investment. In Intuitive Surgical’s case, the key risks for me are future changes in healthcare regulations and an increasingly competitive business landscape.
In all, after weighing the risks and potential rewards, I’m happy to have Intuitive Surgical shares continue to be in my family’s investment portfolio.
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