I last reviewed Intuitive Surgical (ISRG) in this October 19, 2022 post at which time I concluded that:
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.
Following the release of that post, ISRG's share price has fluctuated wildly. Most notably, ISRG's share price surged ~$29.30, or ~10.88%, on April 19, the day following the release of Q1 2023 results.
The share price at the time of my prior review was ~$211. As I compose this post, the share price is ~$298.60. Share price alone, however, is meaningless as it does not indicate whether shares are undervalued, overvalued, or reasonably valued.
In this brief post, I look at ISRG's valuation based on management's current outlook for the remainder of FY2023.
Please refer to the company's website and 'Item 1 - Business' in the FY2022 Form 10-K for a good overview of the company.
CEO and NEO Compensation
Of particular interest to me is a CEO's and Named Executive Officers' (NEO) compensation structure. I favour a structure where the compensation structure is aligned with the interests of long-term shareholders.
A comprehensive compensation overview commences on page 42 of the 2023 Proxy Statement.
In 2022, the majority of the CEO's and NEOs' total target direct compensation (base salary, target annual bonus, and the grant date fair value of equity awards) is long-term equity-based compensation. Linking most of the NEOs’ total target direct compensation to long-term equity emphasizes variable pay. This is consistent with ISRG's pay-for-performance philosophy.
The charts below illustrate the mix of their total target direct compensation.
ISRG's Q1 2023 Form 10-Q is currently unavailable. Form 8-K, however, provides a high-level overview of this past quarter's results. Supporting data is accessible here and some data is provided below for ease of reference.
Total revenue experienced ~14% YoY growth and average selling prices remained stable.
Some manufacturing and supply challenges in Q1 negatively impacted product margins.
ISRG had to incur charges related to its stapling line due to a raw material lot non-conformance that necessitated scrapping instruments.
Lower manufacturing yields were also the result of activating new production lines in high-volume production facilities to support multi-port accessory and Ion catheter growth. Customer availability was briefly impacted for stapling but has since recovered.
ISRG saw surprising strength in Q1 led by general surgery in the US and procedure growth beyond urology outside the US. On a procedure basis, cholecystectomy, bariatric surgery and hernia repair led the way.
All major regions, most notably India, Spain, the UK, Japan, Germany, and Italy, performed well. US performance was also significantly above trend. China is recovering from lows in Q4 although results do not yet meet the expected 2023 run rate.
The return of patients to healthcare providers and diagnostic pipelines post-pandemic continues. Evidence of this is an increased patient census and some diagnostic pipelines that are running above pre-pandemic levels.
ISRG is also seeing a commitment by its hospital customers to work through staffing constraints to maintain surgical volume.
Worldwide, ISRG placed 312 da Vinci systems and 55 Ion systems in Q1 compared with 311 da Vinci systems and 34 Ion systems in Q1 2022.
In the US, January and February were particularly strong relative to historical seasonality. March, however, returned to more normalized growth rates.
Outside the US, ~28% procedure growth was ahead of expectations across all major international markets. Non-urology procedures represented ~50% of the total outside the US procedures and grew 35% from Q1 2022.
The pro forma gross margin of 67.2% in Q1 was below expectations. This reflects a one-time adverse impact of ~100 bps relating to manufacturing-related issues and an increase in inventory reserves.
The one-time items that impacted gross margin are largely resolved. However, ISRG has identified opportunities to strengthen its manufacturing operations and improve product costs.
Headcount increased by ~330 in Q1 with ~50% being employees tasked to support revenue growth.
CAPEX of ~$0.197B was primarily comprised of infrastructure investments to expand ISRG's facilities footprint and increased manufacturing capacity; this includes the automation of certain production lines.
Free Cash Flow (FCF)
In FY2011 - FY2022, ISRG generated FCF (in millions of $) of 595, 700, 775, 560, 725, 1033, 953, 982, 1173, 1143, 1736, and 958.
The significant decline in ISRG's FCF in FY2022 relative to FY2021 is attributed to a few factors.
- ISRG is in the process of deploying capital to invest in infrastructure to expand its facilities' footprint, increase manufacturing capacity, and the automation of certain production lines.
- Supply chain issues led to ISRG carrying somewhat higher inventory levels to reduce the risk of running out of parts required for manufacturing.
- Hospitals are encountering significant financial pressures which have led to an increase in accounts receivable levels relative to prior years.
Despite this FCF decline, we can still expect ISRG to generate strong FCF in FY2023.
ISRG's FY2023 priorities are:
- increase the adoption of ISRG's priority procedures through training, commercial and market access execution;
- expand new platforms;
- focus on the continuity of supply, product quality and services provision; and
- increase productivity in ISRG's functions that benefit from scale.
When ISRG released FY2022 results, it forecast FY2023 procedure growth of 12% - 16%.
This forecast is now increased to 18% - 21%. This range continues to reflect the uncertainty associated with the course of the pandemic and macroeconomic risks. The low end of the range still assumes:
- continued choppiness with COVID hospitalizations;
- uncertainty with the timing of the capital quota in China for the remainder of the year;
- the macroeconomic challenges that could impact hospitals and patient spending; and
- moderation in procedures from elevated levels experienced in January and February 2023.
At the high end of the range, ISRG assumes COVID-related hospitalizations around the world continue to decline throughout 2023, a capital quota in China is available and macroeconomic challenges not impacting hospital procedure volumes.
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.
The FY2023 pro forma gross profit margin forecast is 68% - 69%. The actual gross profit margin, however, will vary quarter-to-quarter depending largely on product, regional and trade-in mix, and the impact of new product introductions.
The prior pro forma operating expense growth forecast was 9% - 13%. This is now amended to 11% - 15%. This increase reflects higher variable compensation and other costs related to higher procedure growth performance.
The FY2023 estimate for non-cash stock compensation expense is now ~$0.6B - ~$0.63B which is a decrease from the previous ~$0.61B - ~$0.64B estimate.
The projection for Other Income, comprised mostly of interest income, remains at ~$0.14B - ~$0.16B.
ISRG continues to forecast ~$0.8B - ~$1B in CAPEX for planned facility construction activities.
The estimate for the 2023 pro forma tax rate remains at ~22% - ~24% of pre-tax income.
No rating agency rates ISRG because it has no debt.
Dividend and Dividend Yield
ISRG does not distribute a dividend.
In FY2011 - FY2022, ISRG's weighted average number of outstanding shares (millions rounded) was 362, 370, 361, 339, 341, 354, 349, 356, 359, 361, 366, and 362. The weighted average number of outstanding shares in Q1 2023 was further reduced to 356.
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.
In FY2022, ISRG's valuation improved and management ramped up its share repurchases. ISRG repurchased ~$0.107B, ~$0.5B, ~$1B, and ~$1B in Q1 - Q4 2022 for a total of ~$2.607B.
In Q1 2023, ISRG spent $0.35B to repurchase 1.5 million shares at an average price of $230/share.
From the beginning of 2022 through the end of Q1 2023, ISRG has repurchased 12.6 million shares at an average price of $234/share.
There currently remains ~$1.1B under the current Board authorization to repurchase shares.
FY2011 - FY2022 PE ratios are 40.02, 30.69, 22.97, 46.20, 37.72, 34.17, 47.07, 72.02, 53.69, 93.18, 77.44, and 70.38.
Please refer to my October 19, 2022 post in which I provide ISRG's valuation at the time I wrote previous posts.
For ease of comparison, however, I provide ISRG's forward-adjusted diluted PE levels using the ~$211 October 18 closing share price and the forward-adjusted diluted earnings estimates from the brokers which cover ISRG.
- 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 share price is ~$298.60. Using this share price and the brokers' earnings estimates (which will likely change over the coming days), ISRG's valuation is:
- FY2023 - 23 brokers - mean of $5.42 and low/high of $5.03 - $5.60. Using the mean estimate, the forward adjusted diluted PE is ~55.
- FY2024 - 23 brokers - mean of $6.37 and low/high of $5.93 - $6.88. Using the mean estimate, the forward adjusted diluted PE is ~47.
- FY2025 - 16 brokers - mean of $7.43 and low/high of $6.87 - $8.29. Using the mean estimate, the forward adjusted diluted PE is ~40.
NOTE: These broker estimates are likely to be updated over the next few days.
I currently hold 450 shares in a 'Core' account in the FFJ Portfolio and continue to like ISRG's:
- long-term outlook;
- consistent track record of profitability and Free Cash Flow (FCF); and
- its impeccable Balance Sheet.
A few months ago it was relatively easy to find reasonably/attractively valued companies. Now, it appears irrational exuberance has once again reared its ugly head as evidenced by the ~$29 share price surge following the release of ISRG's Q1 2023 results and FY2023 outlook.
ISRG's share price can be volatile. Should we experience a broad market pullback, I expect a sizable share price pullback.
Were the valuation to retrace to a level in the mid-40s, a share price below $250ish (45 adjusted diluted PE x $5.42) is a level at which I would consider adding to my exposure.
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.