Intuitive Surgical Remains Hyper Focused On Capital Allocation

I last reviewed Intuitive Surgical (ISRG) in my April 23, 2022 post at which time it had just released Q1 2022 results.

Following the July 21 market close, ISRG released Q2 results. It continues to experience headwinds from:

  • COVID-driven lockdowns in China, ISRG's 2nd largest market;
  • supply chain disruptions with semiconductor component delays impacting the timing of system builds; and
  • continued pressure in hospital capital spending.

My underlying thesis for investing in this company, however, is intact. This is a high-quality growth company with a great reputation in the medical field. Its financial position (no debt) permits it to invest in R&D and weather the headwinds without being at the mercy of creditors.

Its valuation has improved considerably over the past several months. Based on my analysis, I think long-term investors are being presented with a window of opportunity to acquire shares; I acquired additional shares on July 22 at ~$210.24.

Financials

As I compose this post, ISRG's Q2 2022 Form 10-Q is not yet available. Form 8-K, however, provides a high-level overview of Q2 results.

At the end of Q2 2022, ~60% of ISRG's ~$13.705B Total Assets consisted of ~$8.175B in cash, cash equivalents, and investments; this is down from ~$8.4B, or ~61.4%, of ISRG's $13.678B Total Assets at the end of Q1 2022. This ~$0.225B reduction was primarily driven by:

  • share repurchases of $0.5B;
  • CAPEX; and
  • unrealized losses on interest-bearing debt securities classified as available for sale

with a partial offset from cash generated from operations.

On the Liabilities side of the Balance Sheet, ISRG had ~$1.623B of Total Liabilities at the end of Q2 versus ~$1.522B at the end of Q1. Of these Total Liabilities, ~$0.414B was Deferred Revenue in Q2 versus ~$0.409B in Q1.

Deferred Revenue represents funds ISRG has received from customers in advance of providing services. Once a service is provided, ISRG reflects the appropriate amount as Revenue.

The supply chain environment continues to be a challenge. During Q2, delays in the supply of certain semiconductor components led to delays in the manufacturing output of da Vinci systems. This led to several systems expected to be placed in the latter part of June to be shipped and installed in July (Q3 2022).

In Q1 and Q2, there has been some softening in the US sales pipeline. Hospitals are experiencing financial pressures given higher inflation, increasing interest rates, supply chain challenges, and continued staffing shortages. Some of the larger Integrated Delivery Networks (IDNs), or health systems, indicate that as a consequence of these financial pressures, they are lowering their capital investment plans and tightening operational budgets; IDNs are organizations responsible for managing one or more healthcare facilities within a defined geographic area.

This demand for capital, particularly in the US, is expected to continue while macro conditions remain a challenge.

Despite these challenges, the installed base of da Vinci systems grew ~13% YoY.

Q2 2022 revenue of $1.52B was a ~4% increase from Q2 2021. On a constant currency basis, however, Q2 2022 revenue grew ~6% over Q2 2021. Recurring revenue grew 14% YoY to $1.24B representing 81% of total revenue.

ISRG's Q2 2022 gross margin was 69.2% versus 71.7% in Q2 2021 and 69.8% in Q1 2022. The lower gross margin is primarily the result of the stronger U.S. dollar, higher logistics costs, increased component pricing and increased fixed costs relative to revenue.

ISRG continues to invest in infrastructure and manufacturing capacity to serve its long-term needs. Operating expenses increased ~23% compared with Q2 2021. This increase reflects a higher headcount, higher R&D-related project costs, and higher travel costs, including the impact of inflation.

ISRG's sales pipeline historically benefits from the trade-in of older generation systems to newer generation systems; trade-ins recently represented as much as 50% of all systems sold in the US. A relatively new development, however, is that ISRG only has a few hundred 3rd generation systems remaining in the field and the 5th generation systems are some time away from being ready for sale. As a result, the opportunity for trade-ins has materially diminished. Systems utilization, however, is strong which is a testament to ISRG's ongoing strength in the uptake of robotic surgery across all surgical areas.

As noted earlier, financial pressures on hospitals and IDNs have increased. Given this, many of ISRG's customers and prospects might not be in a rush to replace their existing ISRG equipment. This will benefit ISRG in that it can continue to develop its 5th generation equipment so that it will be available for sale once economic conditions improve.

Free Cash Flow (FCF)

In FY2011 - FY2021, ISRG generated FCF (in millions of $) of 595, 700, 775, 560, 725, 1033, 953, 982, 1173, 1143, and 1736. Q1 2022 FCF amounted to only ~$0.128B. Its FCF, however, can exhibit wild swings from quarter to quarter.

The midterm priority for the use of capital is to reinvest in global expansion, innovation initiatives and business infrastructure.

Q1 and Q2 2022 CAPEX amounted to $95 million and $131 million, respectively. This was primarily comprised of infrastructure investments to expand ISRG's facilities' footprint, increase manufacturing capacity, and the automation of certain production lines.

FY2022 Outlook

On the Q2 2022 earnings call, management provided its outlook for the remainder of FY2022.

In the prior quarter, the forecast was for FY2022 procedure growth of 12% - 16% versus 11% - 15% provided at FYE2021. The growth forecast is now 14% - 16.5%. This range continues to reflect the uncertainty associated with the course of the pandemic. The low end of the range assumes increasing COVID hospitalization and staffing pressure at hospitals for the remainder of the year. The high end of the range assumes COVID-19-related hospitalizations worldwide continue to decline throughout the remainder of 2022 with no additional significant impacts from further resurgences. The range does not reflect significant material supply chain disruptions or hospital capacity constraints similar to those at the start of the pandemic.

As noted earlier, trade-in opportunities have declined relative to historical levels. The core demand for procedures, however, continues to be healthy and system utilization is increasing; the 3-year compound annual growth rate in procedures is ~16% from Q2 2019 to Q2 2022 and the compound annual growth rate in installed base growth is ~11% over the same timeframe.

On the FYE2021 earnings call, the FY2022 gross profit margin forecast was 69.5% - 70.5%. On the Q1 2022 earnings call, this was amended to 69% - 70.5%. This estimate is now 69% - 70% of net revenue. With the ongoing impact of higher input costs related to the supply chain and the impact of a stronger U.S. dollar, management expects ISRG's gross profit margin will most likely be toward the lower end of the new range.

ISRG's actual gross profit margin, however, will vary quarter-to-quarter depending largely on product, regional and trading mix, fluctuations in foreign currency rates and the impact of new product introductions.

On the Q1 2022 earnings call, the FY2022 operating expenses growth forecast was 23% - 27% versus 21% - 27% provided at FYE2021. The forecast is now 23% - 25%.

The FY2022 noncash stock compensation expense was previously $0.51B - $0.55B. The outlook is now $0.52B - $0.54B.

The Other Income forecast (mostly interest income) was previously $50 - $60 million for FY2022. With the increase in interest rates, the outlook is now $60 - $70 million.

With the release of FY2021 results, ISRG forecast FY2022 CAPEX of $0.7 - $1B. In Q1, this was amended to $0.7B - $0.9B based primarily on the current timing of planned facility construction activities. This is now further refined to $0.7B - $0.8B.

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.

Dividends and Share Repurchases

Dividend and Dividend Yield

ISRG does not distribute a dividend.

Share Repurchases

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.

In Q1, ISRG repurchased 398,000 shares at an average price of $268/share for a total expenditure of $0.107B. In Q2, ISRG repurchased 2.2 million shares at an average price of $224/share for a total expenditure of $0.5B.

Since March 2009, ISRG has had an active stock repurchase program for which there is no expiry date. As of FYE2021, the Board had authorized an aggregate amount of up to $7.5B for stock repurchases, of which the most recent authorization occurred in January 2019, when the Board increased the authorized amount available under the share repurchase program to $2B. At FYE2021, there remained $1.6B available for repurchase under the authorized repurchase program. Concurrent with the release of Q2 results, ISRG's Board has approved an increase to the share repurchase authorization to $3.5B.

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.

When I initiated my ISRG position, the October 19, 2021 closing share price was ~$336. The two online trading platforms I use reflected the following adjusted diluted EPS estimates from the brokers which cover ISRG:

  • FY2021 - 18 brokers - mean of $4.89 and low/high of $4.50 - $5.06. Using the mean estimate, the forward adjusted diluted PE is ~68.7 and ~66.4 if I use $5.06.
  • FY2022 - 18 brokers - mean of $5.52 and low/high of $5.17 - $5.74. Using the mean estimate, the forward adjusted diluted PE is ~60.9 and ~58.5 if I use $5.74.
  • FY2023 - 18 brokers - mean of $6.40 and low/high of $5.69 - $6.91. Using the mean estimate, the forward adjusted diluted PE is ~52.5 and ~48.6 if I use $6.91.

At the time of my January 21, 2022 post, shares were trading at ~$270 and adjusted diluted FY2021 EPS amounted to $4.96 thus resulting in an adjusted diluted PE of ~55.

Guidance, which I anticipated would be amended over the coming weeks, and the current share price gave us the following forward adjusted diluted PE levels:

  • FY2022 - 16 brokers - mean of $5.12 and low/high of $4.63 - $5.80. Using the mean estimate, the forward adjusted diluted PE is ~53 and ~47 if I use $5.80.
  • FY2023 - 16 brokers - mean of $5.92 and low/high of $4.53 - $7.08. Using the mean estimate, the forward adjusted diluted PE is ~46 and ~38 if I use $7.08.

Despite the drop in ISRG's share price, shares were still a bit rich. However, I stated I was willing to pay a premium given ISRG's growth potential and strong financial position.

When I reviewed ISRG on April 22, 2022, the share price had dropped further to ~$252. Adjusted diluted EPS guidance and 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 ~50.4 and ~46.3 if I use $5.44.
  • 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 ~42.6 and ~40 if I use $6.30.
  • 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 ~36.8 and ~35 if I use $7.19.

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 are:

  • 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.

We must consider this is a high-growth company...when we do not experience the current global headwinds. We should not, therefore, expect ISRG's valuation to resemble that of low/marginal growth companies.

Final Thoughts

As noted earlier, ISRG remains hyper-focused on its capital allocation priorities. They are:

  • organically invest in the business given the significant opportunities to develop differentiated technology and drive adoption of ISRG products;
  • acquire external technology that creates value for customers and/or accelerates development timelines or acquisitions that accelerate growth; and
  • the efficient return of excess cash to shareholders.

ISRG's YTD results are weaker than I anticipated. However, I envision an improvement once the headwinds abate. Fortunately, ISRG is in an exceptionally strong financial position and is not at the mercy of creditors.

Although ISRG encounters more competition than a decade ago, it has an excellent reputation. Once medical practitioners become very familiar with ISRG's equipment, switching to equipment from another vendor becomes increasingly difficult.

My thesis for investing in ISRG remains intact and view the weakness in ISRG's share price as a window of opportunity. I acquired additional shares on July 22 at ~$210.24 and now hold 450 shares in a 'Core' account in the FFJ Portfolio. This is an increase from the 350 shares I held at the time of my April 23, 2022 post.

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.