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I last reviewed Intuitive Surgical (ISRG) in my July 23, 2022 post at which time it had just released Q2 2022 results. In that post, I disclosed the purchase of additional shares on July 22 at ~$210.24. Following that purchase, ISRG got caught up in the broad market sell-off. This gave investors a wonderful opportunity to acquire attractively valued ISRG shares (the $180s).
As mentioned in my October 18 Lockheed Martin post, I had set aside liquidity on the expectation of a broad market pullback. Circumstances changed, however, and I must now deploy this liquidity toward the purchase of a second home (November 2 closing date); we are not selling our current principal residence so I can not rely on proceeds from the sale of our current home.
Despite being unable to meaningfully add to existing positions, several of my holdings are releasing earnings over the coming weeks. I am unable to allocate the time I would like to analyze these results. However, I want to delve into the numbers when I see a significant share price change to determine the impact on a company's valuation.
After the October 18 market close when the share price settled at $193.73, ISRG released its Q3 and YTD results. On October 19, the share price surged to ~$221. By the end of the day, however, the share price had retraced to ~$211.
I now revisit ISRG to gauge its valuation.
Overview
I recommend you consider investing in Intuitive Surgical to benefit from the global adoption of robotic surgery. While it faces greater competition from larger and well-established companies, such as Johnson & Johnson (JNJ) and Medtronic plc (MDT), both these companies are struggling to get their competing platforms to the market. Up until now, neither company is in a position to alter the industry landscape, significantly disrupt ISRG’s operations, or erode ISRG's returns on capital.
The list of competitors reflected in ISRG's FY2021 Form 10-K (page 15 of 146) includes foreign companies (eg. Shandong Weigao Group Medical Polymer Company Limited, meerecompany Incorporated, MicroPort Scientific Corporation), privately owned companies, and small-cap companies (Titan Medical Inc., Asensus Surgical, Inc.). Hospital administrators need to look beyond the numbers when selecting from whom they are going to purchase/lease millions of dollars of highly sensitive equipment!
Investors should consider ISRG's intellectual property and growing instrumentation base. The ever-growing clinical database presents the biggest challenge for a new entrant. New competitors are faced with the challenge of having to convince enough hospitals to purchase or trial their instrumentation for an extensive period, train robot-naive or da Vinci-trained surgeons, and recruit willing patients.
There are companies other than JNJ and MDT with substantial experience in industrial robotics that could potentially expand into the field of surgical robotics and become a competitor. The ISRG da Vinci system, however, has demonstrated that it can assist multiple types of surgeries across numerous specialties. This allows hospitals to drive more procedures through the same platform. This diverse user base also insulates ISRG from potentially specialized rival devices.
In addition, I think surgeons are hesitant to risk their reputation/career by switching from ISRG’s systems to which they are accustomed.
Although hospital budgets factor into the decision-making process, very compelling differences between ISRG's products and those of its competitors would be required to convince hospitals to switch from existing platforms. I can not envision a hospital switching from ISRG's system to a competitor's system solely because the competitor's system might be slightly less expensive.
Financials
ISRG's Q3 2022 Form 10-Q is currently unavailable. Form 8-K, however, provides a high-level overview of Q3 results. Supporting data is accessible here.
At the end of Q3 2022, ~55.7% of ISRG's ~$13.261B Total Assets consisted of ~$7.392B in cash, cash equivalents, and investments. This is down from:
- ~$8.175B, or ~60%, of ISRG's ~$13.705B Total Assets at the end of Q2;
- ~$8.4B, or ~61.4%, of ISRG's $13.678B Total Assets at the end of Q1.
Investors need to account for the repurchase of ~$1B of issued and outstanding shares in Q3.
On the Liabilities side of the Balance Sheet, ISRG had $1.687B of Total Liabilities at the end of Q3 of which ~$0.396B was Deferred Revenue. In comparison, ISRG had:
- ~$1.623B of Total Liabilities of which ~$0.414B was Deferred Revenue at the end of Q2;
- ~$1.522B of Total Liabilities of which ~$0.409B was Deferred Revenue at the end of Q1.
ISRG's business fundamentals strengthened in Q3 with 20% procedure growth in da Vinci procedures compared with Q3 2021. The company also reported solid performance in all the global regions in which it operates; growth in procedures, the installed base of da Vinci systems, and average system utilization were healthy in Q3.
ISRG experienced headwinds from the strong U.S. dollar, lingering supply chain issues, and inflation. Supply chain challenges, while still present, are abating from their pandemic peaks.
Procedures experienced 20% growth versus 14% in Q2 2022 and the 3-year compound annual growth rate of 16% during the pandemic.
General surgery, ISRG's largest procedure category, is growing at the fastest rate of any category. This is fueled by bariatric surgery, cholecystectomy, hernia repair, and other foregut procedures in the United States. In Europe, several countries are growing with diversified use beyond urology.
Germany, the U.K. and Ireland, Italy, and Spain stood out in Q3. In Asia, Japanese procedure growth accelerated relative to Q2, and Korean growth remained solid. Procedures in Japan and Korea are also diversifying beyond urology.
In China, procedure growth was just above the global average but was hampered in part by regional rolling lockdowns that continue to impact procedures and utilization.
ISRG placed 305 da Vinci systems in Q3 compared with 336 in Q3 2022 and 279 in Q2 2022.
Ion placements grew to 50 in Q3 versus 28 in Q3 2021 and 41 in Q2 2022. Overall, ISRG's customers are acquiring systems where there is an opportunity for procedure growth.
On the expense front, the ~23.5% increase in Operating Expenses relative to Q3 2021, was driven by:
- increased headcount;
- higher R&D-related project costs; and
- higher travel costs.
Growth in operating expenses has been primarily in support of ISRG's Ion platform, next-generation robotics capabilities, digital capabilities, and infrastructure expansion to allow the company to effectively scale.
ISRG is also reporting higher regulatory costs as a result of increased regulatory requirements globally and the expansion of its new platforms outside the US market.
In Q3, ISRG moderated headcount growth to focus on deeply integrating employees who joined the company in the past several quarters. It added ~530 employees - well below the 700+ employees added per quarter in the last 3 quarters.
Free Cash Flow (FCF)
In Q1, Q2, and Q3 2022 CAPEX amounted to $95 million, $131 million, and $153 million.
The midterm priority for the use of capital is to invest in infrastructure to expand ISRG's facilities' footprint, increase manufacturing capacity, and the automation of certain production lines.
In FY2011 - FY2021, ISRG generated FCF (in millions of $) of 595, 700, 775, 560, 725, 1033, 953, 982, 1173, 1143, and 1736. In the first half of FY2022, ISRG's FCF amounted to only ~$0.44B. FCF, however, can exhibit wild swings from quarter to quarter.
Outlook
Expectations are for a slowdown in the rate of fixed expense growth in FY2023. The slowing growth rate of operating expenses reflects the completion of some of ISRG's infrastructure and business process improvement investments.
As part of its planning process, a review of ISRG's capital expenditure priorities is being undertaken. The next quarterly earnings call is to include an update as to the outcome of this review.
On the Q2 earnings call, management forecasted 14% - 16.5% FY2022 procedure growth. The forecast is now 17% - 18%. This revised forecast continues to reflect the uncertainty associated with the course of the COVID pandemic.
The low end of the range still assumes increasing COVID hospitalizations, regional lockdowns, and staffing pressure at hospitals for the remainder of the year.
At the high end of the range, it is assumed COVID-19-related hospitalizations around the world continue to decline throughout the remainder of 2022, and there are no additional significant impacts from further resurgence.
The range does not reflect significant material supply chain disruptions or hospital capacity constraints similar to what ISRG experienced at the start of the pandemic.
Turning to gross profit. ISRG previously forecast an FY2022 gross profit margin of 69% - 70.5% with the expectation that results would be toward the lower end of the range. This forecast is now 69% - 69.5% of net revenue. This revision reflects the ongoing impact of higher input costs related to the supply chain and the impact of a stronger US dollar. ISRG's actual gross profit margin, however, will vary quarter to quarter depending largely on products, regional and trade-in mix, fluctuations in foreign currency rates, and the impact of new product introductions.
Operating expenses were previously forecast to grow 23% - 25%. This is now 21% - 23%.
The estimate for ISRG's FY2022 noncash stock compensation expense is $0.52B - $0.53B.
The estimate for other income (mostly interest income) has now been lowered to $40 -$50 million from the previous $60 - $70 million. The decrease primarily reflects lower interest income because of the disbursement of cash used to repurchase shares. In addition, this lower estimate also reflects the net impact of certain foreign exchange gains and losses.
ISRG has incurred YTD CAPEX of ~$0.379B. The prior FY2022 CAPEX forecast was $0.7B - $0.8B. The estimate is now $0.6B - $0.7B.
On last quarter's call, ISRG forecasted $700 million - $800 million in FY2022 CAPEX. This is now $600 million - $700 million.
There is no change to the FY2022 tax rate of 22% - 24% of pre-tax income.
Credit Ratings
No rating agency rates ISRG because it has no debt.
Dividend and Dividend Yield
ISRG does not distribute a dividend.
In FY2011 - FY2021, ISRG's weighted average number of outstanding shares (millions rounded) was 362, 370, 361, 339, 341, 354, 349, 356, 359, 361, and 366.
ISRG is hyper-focused on capital allocation. This is borne out by the limited number of share repurchases when they were richly valued; ISRG repurchased ~$0.27B in FY2019, ~$0.134B in FY2020, and no shares in FY2021.
With the share price decline in 2022, ISRG has taken the opportunity to reduce the weighted average diluted shares outstanding to 360.5 million. In Q3, ISRG completed a $1B accelerated share repurchase. This repurchase is in addition to the $0.607B of shares repurchased in the first half of FY2022. Since the end of 2021, ISRG's diluted share count has decreased by ~6.5 million shares or ~2%, and it has a remaining authorization to repurchase $2.5B of shares.
Valuation
FY2011 - FY2020 PE ratios are: 40.02, 30.69, 22.97, 46.20, 37.72, 34.17, 47.07, 72.02, 53.69, 93.18, and 77.44.
In my July 23, 2022 post, I compare ISRG's valuation at the various times when I acquired shares. I, however, provide a condensed list below.
On June 1, 2022, I acquired additional shares at $214.32. Using the Adjusted diluted EPS guidance available at the time of my April 22, 2022 post, the forward adjusted diluted PE levels were:
- FY2022 - 19 brokers - mean of $5.00 and low/high of $4.65 - $5.44. Using the mean estimate, the forward adjusted diluted PE is ~42.9.
- FY2023 - 19 brokers - mean of $5.91 and low/high of $5.48 - $6.30. Using the mean estimate, the forward adjusted diluted PE is ~36.3.
- FY2024 - 13 brokers - mean of $6.85 and low/high of $6.29 - $7.19. Using the mean estimate, the forward adjusted diluted PE is ~31.3.
On July 22, I acquired additional shares at ~$210.24. Using the current adjusted diluted EPS guidance from the brokers which cover ISRG, the forward adjusted diluted PE levels were:
- FY2022 - 20 brokers - mean of $4.87 and low/high of $4.64 - $5.15. Using the mean estimate, the forward adjusted diluted PE is ~43.2.
- FY2023 - 20 brokers - mean of $5.73 and low/high of $5.27 - $6.10. Using the mean estimate, the forward adjusted diluted PE is ~36.7.
- FY2024 - 15 brokers - mean of $6.67 and low/high of $6.10 - $7.15. Using the mean estimate, the forward adjusted diluted PE is ~31.5.
An investor who acquired ISRG shares as recently as October 14 when the share price was ~$184 would have fared extremely well. Using the earnings estimates available at the time of my July 22 purchase, the forward adjusted diluted PE levels would have been:
- FY2022 - 20 brokers - mean of $4.87 and low/high of $4.64 - $5.15. Using the mean estimate, the forward adjusted diluted PE is ~37.8.
- FY2023 - 20 brokers - mean of $5.73 and low/high of $5.27 - $6.10. Using the mean estimate, the forward adjusted diluted PE is ~32.1.
- FY2024 - 15 brokers - mean of $6.67 and low/high of $6.10 - $7.15. Using the mean estimate, the forward adjusted diluted PE is ~27.6.
ISRG released Q3 and YTD results following the October 18 market close and I expect very slight changes in earnings estimates from the analysts who cover ISRG over the coming days. However, using currently available estimates and ~$211 share price, the following are ISRG's forward adjusted diluted PE levels.
- FY2022 - 22 brokers - mean of $4.72 and low/high of $4.59 - $4.83. Using the mean estimate, the forward adjusted diluted PE is ~44.7.
- FY2023 - 22 brokers - mean of $5.45 and low/high of $4.99 - $6.10. Using the mean estimate, the forward adjusted diluted PE is ~38.7.
- FY2024 - 19 brokers - mean of $6.43 and low/high of $6.01 - $7.02. Using the mean estimate, the forward adjusted diluted PE is ~32.8.
ISRG's current valuation is just slightly higher than at the time of my most 2 recent purchases and considerably higher than just a few days ago.
Final Thoughts
In addition to ISRG's competitive advantages noted earlier in this post, I have invested in ISRG because of my desire to benefit from the global adoption of robotic surgery. In addition, I like its consistent track record of profitability and Free Cash Flow (FCF) and its impeccable Balance Sheet!
A drawback with ISRG is that its valuation is rarely attractive. While its current valuation appears high, this is a high-growth company (~$2.2B of annual revenue in FY2012 versus ~$4.6B in the first 3 quarters of FY2022). Investors should not, therefore, compare ISRG's valuation to that of mature companies.
Another drawback is that ISRG's share price can exhibit wild variances.
Despite these drawbacks, I like ISRG's long-term total investment return potential.
I currently hold 450 shares in a 'Core' account in the FFJ Portfolio. If I had sufficient liquidity to add to my ISRG exposure, I would hold off on buying shares. Despite ISRG's fair valuation, I think there is a very strong probability of a challenging economic environment in 2023. Further broad market pullbacks are not out of the realm of possibility and investors may be able to acquire more attractively valued shares in the coming months.
I wish you much success on your journey to financial freedom!
Note: Please send any feedback, corrections, or questions to [email protected].
Disclosure: I am long ISRG.
Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your own research and due diligence. Consult your financial advisor about your specific situation.
I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with any company mentioned in this article.
