ISRG: Still Day 1 for the Intuitive Robot

Two months ago, I posted a 43-tweet-storm about my long thesis on Intuitive Surgical (Ticker: ISRG). In case you haven’t read the thread yet, I have copied the entire thread below. On the other hand, if you went through the thread before, you can quickly scroll down to see my thoughts on current quarter and valuation.

Typo: *I meant to say “The stock isn’t cheap. I think it’s close to be fairly valued than undervalued”

Thoughts on current quarter and valuation

I know it was a long thread, but let’s recap the three main thesis points here.

Thesis #1: Robotic MIS is still in the very early inning of a potentially long runway with worldwide adoption likely to increase from 2.5% in 2019 to ~15% in 2030.

Thesis #2: ISRG has the de-facto monopoly position in robotic MIS with pretty robust moats around its business.

Thesis #3: With a long reinvestment runway left, ISRG is in an enviable position with ~30% FCF margin (last 12-yr avg) that gets added to $6 Bn cash (~8% of current market cap) in the balance sheet to exploit this massive opportunity.

There are tons of questions some of which are difficult to answer. Let’s group these difficult questions thesis by thesis.

Questions related to thesis #1: If it took 20 years to have 2.5% penetration worldwide, is ~15% penetration in 10 years too bullish? What is the economics of Da Vinci systems from hospitals’ perspective? As adoption increases, will there be downward pressure on revenue per procedure? If yes, to what extent? Will increased volume compensate for the potential price reduction?

Questions related to thesis #2: With JNJ and MDT encroaching into robotic MIS, will we see a price war? Can increased competition lead to faster adoption? Can it permanently hurt the compelling economics i.e. ~30% FCF margin?

Questions related to thesis #3: Will we see an opportunistic share buyback with the massive cash in the balance sheet like we saw in 2017? Or is the cash war chest, in fact, required to finance hospitals for system purchases?

Did the questions scare you? Good. There is no free lunch, especially in the equity markets. There are paralyzing (often unsaid) questions in every bull thesis.

My opinions on some of these questions were answered in the original thread. Admittedly, I do not have a good handle on a few questions e.g. the economics of Da Vinci systems from hospitals’ perspective. And there are questions that are difficult to answer for anybody. But when it comes to revolutionary tech, I think it’s important not to miss the forest for the trees. In these cases, I think “Occam’s Razor” can be more helpful. Is ~10-15% penetration too high or too low for a tech such as robotic MIS? Looking at the forest (and not the trees), it does seem to be on the lower side.

In terms of the current quarter, I don’t want to make this a sell-side like update with all the numbers. If you are interested in that, just look at ISRG’s press release or any sell-side report following the quarter. There was, however, an interesting update from ISRG that I want to discuss.

ISRG management mentioned that if “extended use program” were in place, it would lead to ~7% drop in I&A revenues in 2019. The question is whether this price drop would lead to sufficient volume increase to make it gross margin neutral. ISRG seems to think it would be gross margin neutral, but also acknowledged the difficulty of volume increases timeline, especially given the uncertainty around Covid-19.

first question of do we think that it changes the volume of procedures that might be accessed by our technology, the answer to that is yes. I think the real question will be time line. A little bit hard to predict the time line in the near term, just because I think a lot of it will have to do with COVID and recovery, so that will kind of blur the speed with which it happens.

But if you look out over a couple of years, we clearly think that customers want to use our products. They want to use them broadly, broadly in different procedure domains, like general surgery, but also broadly regionally. And to the extent that we can help them with economics, we think they have a preference to use our products and we think that will help, and that’s why we did it.

As a shareholder of ISRG, I am not disappointed at the possibility of near-term revenue pressure because of this “Extended use program” as it clearly enhances the technology moat even further and in turn helps customers manage what is surely been a stressful time for them. One of the bear theses is impending competition coming from JNJ and MDT, and my response is it is difficult to overstate the technology lead ISRG has in this space. I think it is more likely that new entrants will find it difficult to match ISRG’s pace of innovation than the other way around. ISRG has a clear focus here. There is no innovator’s dilemma; ISRG IS the innovator in this space and the dilemma is in the competitors’ court.

Okay, let’s talk about valuation now. Since my original thread, the stock has been +20% in the last two months. The stock was trading at ~50x LTM P/E, and some people mentioned that it appears to be expensive. Of course, now it’s even more “expensive” at ~59x LTM P/E (~52x P/E on 2021 earnings).

It is tricky to comment on valuation. Like religion and politics, valuation has a very low barrier to entry to have an opinion. While valuation is certainly not science, most people tend to forget the math of value and growth.

P/E is a function of growth, return on incremental capital invested, and discount rate. Assuming a 7% discount rate (0.6% 10-year yield+6.4% Equity risk premium), we need 15% growth and 25% ROIIC assumptions for next 15 years to justify ~52x P/E. For context, ISRG had ~20% growth and >50% ROIC in the last 10 years. If it’s not clear yet, this is why an extremely long runway is required to deserve such rich multiples. And I think ISRG has it.

I am trying to follow (sometimes not successfully) Chuck Akre’s sell discipline. He gives three rationales for why he is so unwilling to sell quality businesses:

I. There may never be an opportunity to buy it back.

II. Great businesses are just too hard to replace.

III. The very best businesses tend to exceed expectations. What may seem like a high price today may be proven to be perfectly reasonable in hindsight.

Perhaps the most stupid rationale to sell a quality business is “oh it’s up by 20%/30% or 1000%”. Believe me, I have been there, and all I am trying is to be less stupid everyday.

If you enjoyed this piece, feel free to share it. It’s always encouraging to have an audience. Of course, I am always open to hear your thoughts as well.

Thank you for reading.