Intuitive Surgical – Keeping On Close Watch (NASDAQ:ISRG)


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Editor’s note: Seeking Alpha is proud to welcome Andrew Yeo as a new contributor. It’s easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA Premium. Click here to find out more »

Despite the recent pullback where Intuitive Surgical (NASDAQ: ISRG) fell as much as 16% from its peak on 2nd September 2020, DCF valuation analysis suggests that it is still currently slightly overvalued. Nevertheless, due to its attractive growth proposition as an industry leader, this is a stock to keep on close watch.

Companies which have a large market share within a growing industry are often valued very highly due to their first mover advantage and high projected growth, such as Nvidia (NASDAQ:NVDA) within the chip industry and Tesla (NASDAQ:TSLA) within the EV space. Intuitive Surgical finds itself in a similar dominant position in a niche segment, commanding 80% of the global robotic-assisted surgery systems industry. According to Medtech Insight, “the global market for robotic surgery systems is expected to reach $9.7bn by 2023”, which is almost double the market size for 2019, representing a rapid 20%-25% year-on-year growth.

To analyse its intrinsic value, we will identify growth factors and discuss a DCF approach to derive an implied share price for ISRG.

Growth Story

ISRG produces patented da Vinci robotic systems and its sales are mainly in the US market, although it has successfully reduced its reliance on the domestic US market, i.e. from 73% US sales to 69% US sales between 2017 and 2019 and is forecasted to continue this trend. This is due to its strategy of expanding its international portfolio (mainly focused on Japan, Korea, China and Germany). Non-US revenue growth has been strong at c.25% per annum.

How likely could we reasonably expect ISRG’s growth to continue? In this case, ISRG is well placed to continue its meteoric rise, as it has a strong moat due to its first-mover advantage and high barriers to entry. Its proprietary robotic system is patented and the industry is heavily regulated by the FDA in the US. Brand loyalty will likely be strong as there is a high switching cost for existing customers due to staff training involved and system compatibility issues with competitors.

Besides the regular selling arrangements, ISRG also leases machines to customers that could not afford the full capital outlay. Typically, the lease lasts for 4.5 years on average, with an option to purchase at the end of the lease. This gives Intuitive a steady recurring revenue and increases the earnings visibility for shareholders due to the simple nature of leasing contracts. Given the nature of the customers, i.e. private and government hospitals, defaults will unlikely be a case of concern.

Another recurring revenue stream is the maintenance and servicing of the machines. As the sole producer of the da Vinci system, customers are dependent on its expertise for upkeep. Services is currently at 16% of revenue and will likely to continue growing as more machines are deployed when the sector matures.

Recent scientific studies have also suggested that COVID-19 could bring long-term effects, mainly lungs and heart complications. In the long run, the ongoing pandemic could lead to an increase of demand for surgical procedures and will likely to have a positive knock-on effect to the market size for robotic surgical systems.

DCF Analysis

Due to the growth factors discussed in the above section, we can be confident that the high growth numbers could be sustained for at least the next 5 years. US revenues are forecasted based on 18% growth, which slowly tapers down to 4% in 2033 while non-US revenues are forecasted based on 24% growth, which tapers to 6% in 2033. Operating margins are forecasted to be 30%, which is roughly in line with historic margins of 32%. After adjusting for taxes, non-cash adjustments and capital expenditures, the unlevered free cash flow (FCF) is discounted at a WACC of 8.98% (Cost of equity of 9.10% and cost of debt of 1.63%).

Cost of equity is derived using risk-free rate of 0.66% (US 10-year treasury bonds) and equity risk premium of 6%. Levered beta is 1.759 and is derived from unlevering beta for comparables (Figure 1), then relevered to ISRG’s capital structure. We recognise that the comparables for ISRG tend to be smaller in size and nature so might not be the best representation, hence we have taken a 20% haircut and reduced beta to 1.407. Cost of equity = 9.10%.

US Corporate AAA Bonds yield (1.63%) is used as proxy for cost of debt due to ISRG’s low gearing ratio.

Figure 1 – Comparable companies’ beta

Source: Created by author using data from Yahoo Finance.

Terminal values are forecasted based on 3.2% terminal FCF growth, which is slightly above historic average US GDP growth of 3.0%. This is justified as ISRG is increasingly operating in emerging markets with higher GDP growth rates. Discount rates remain the same as WACC (8.98%) as above.

The implied Enterprise Value (EV) is the sum of the present value of the discounted unlevered FCF and the discounted terminal value. Based on our forecasts, the implied EV is $73.3bn (Figure 2).

To enable comparison with the current share price, we have moved from implied EV to implied Equity Value by adding back value of non-core operations and deducting debt. This gives us an implied Equity Value of $78.7bn. Taking into account diluted shares outstanding, the implied share price is $643.06, which represents a premium of 7.6% compared to share price as at 02/10/2020. Even though its growth paints an alluring picture, the DCF analysis suggests that it is currently slightly overvalued. As such, caution is needed when considering an entry point.

Figure 2 – Implied share price from DCF

Source: Created by author using data from Intuitive Surgical’s annual report.

ISRG implied share price

Risk

The key risk for ISRG is technological stagnation, causing it to lose its current competitive advantage. Given patents last for a maximum period of 20 years, there is a risk that sustained innovation is not achieved to further cement its position as a market leader. Having said that, ISRG spends an average (2017-2019) of 11% of total revenue on R&D and is expected to continue making substantial investments. ISRG’s continued commitment to R&D, coupled with its head start on competitors, makes it unlikely that competitors will surpass them in the near future. Nevertheless, if it does suffer from stagnation in the long run, this will impact its implied share price and further increase its current overvaluation.

Conclusion

Although ISRG will likely be a dominant force in the robotic surgical systems sector in the years to come, investors should carefully consider their entry point as current valuations indicate that there could be a further pullback.

Why did the robot go bankrupt? Because it lost all its cache.

Let’s not lose ours.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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