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Intuitive Surgical (ISRG) Investment Write Up

Intuitive Surgical (ISRG) Investment Write Up

ISRG is an excellent company demonstrated by its 92% market share in robotic assisted surgery, generating strong ROE’s over time, and with strong growth opportunities ahead. ISRG enjoys a first mover advantage in robotic surgery with more than 20 years of experience selling robotic surgery systems and backed by more than 22,000 peer reviewed articles supporting the clinical and economic benefits of robotic surgery compared to open surgery and minimally invasive surgery (MIS). Furthermore, the robotic surgery market is characterized by high customer switching costs and regulatory barriers. These switching costs are driven by the large capital cost for the robotic systems, and the substantial amount of training surgeons undergo to operate these machines. Furthermore, there are high regulatory barriers to entry, with regulatory approval required for new products to come to market.

ISRG also benefits from tremendous tailwinds in the robotic surgery market, as robotic surgery only has a 2% market share of applicable surgeries, and global robotic surgery revenue is expected to increase more than 4x by 2030. ISRG is well positioned to benefit from this secular growth given its dominant market share and substantial investments in research and development, as ISRG’s r&d budget has tripled over the past 5 years. As a result of ISRG’s first mover advantage and subsequent competitive advantages the company has generated an average ROE of 18% per year over the past decade.

In the near-term, ISRG’s business has been negatively impacted by COVID-19 due to lower healthcare utilization, however I expect utilization rates to normalize in 2021. The biggest risk ISRG faces is competition from other large medical device companies such as JNJ and MDT. Both companies have made acquisitions in the robotic surgery space but have experienced significant delays in launching a robotic surgery system. Furthermore, the FDA has set a high bar for new products coming to market, given how successful ISRG’s da Vinci robotic systems have been. As a result, I expect ISRG to maintain its strong competitive position over the next 5 years but expect the company to lose market share in the 2025-2030 time frame as competitors enter the market.

While ISRG is a phenomenal company, with a strong track record of innovation and substantial tailwinds for further growth, valuation for the company is currently unattractive. ISRG trades at 58x 2021 EPS and 64x 2021 FCF, and it will be challenging for ISRG to generate strong returns for investors over the next 5 years. As a result, I will continue to watch ISRG, and will hope for a better price point to make a purchase.

Key stats

Company Description: ISRG was founded in 1995 and designs and manufacturers robotic surgical systems as well as instruments and accessories that are utilized for robot assisted minimally invasive surgeries (MIS). ISRG launched its first da Vinci robotic system in 1999, which received FDA approval in 2000 for general laparoscopic surgery, as one of the first FDA cleared robotic-assisted surgical systems. The company is focused on improving patient outcomes through less invasive procedures and greater efficacy and lowering healthcare costs as a result of lower complication rates and reduced length of patient stay, providing value for hospitals and patients.

ISRG’s primary product line is the da Vinci surgical system, which is now on the 4th generation, the Xi. The da Vinci system includes a surgeon’s console, a patient-side care and a 3DHD vision system. The Surgeon Console is the control center of the Da Vinci which allows the surgeon to view the surgical field and control movement of the endoscopic instruments and endoscope. The Patient-Side Cart includes three or four articulated mechanical arms that support the instrument arms and camera arm during surgery. Additionally, the Electronic Cart contains supporting hardware and software components, such as the electrical surgical unit (ESU), and the light source for the endoscope. To date the da Vinci has primarily been used for gynecology (primarily hysterectomies), urology, and general surgery which includes hernia repair, colorectal surgery, and cholecystectomies (gall bladder removal).
birds eye viewSource: https://www.unitypoint.org/cedarrapids/services-how-does-it-work.aspx

ISRG generates revenue in three ways: through the initial sale or lease of a surgical system, instruments and accessories which are required for each surgical procedure, and through annual service contracts with hospitals. ISRG’s da Vinci system sells for $500K-$2.5mn per system, with an average selling price of $1.2mn per system in 2019. Additionally, each surgical procedure requires instruments and accessories ranging from $700-$3,500 per procedure, depending on the type and complexity. Furthermore, most hospitals enter a service contract with ISRG for $80K-$190K per year. Recurring revenue makes up roughly 72% of total revenue for ISRG, and consists of instrument and accessory revenue, service revenue, and operating lease revenue. The da Vinci systems typically last for 5-8 years depending on usage.

First mover advantage with strong clinical support

ISRG benefits from its first mover advantage with more than 20 years of experience and 22,000 peer reviewed publications supporting both the clinical benefits of ISRG’s equipment, and lower costs for hospitals. These peer revied publications are informed by more than 7.2 million lifetime procedures performed on ISRG surgical systems, with 1.2 million of those performed in 2019. For example, this paper compared the surgical outcomes of robotic surgery compared to conventional laparoscopic surgery for distal gastrectomy, finding higher surgical success with the robotic surgery, lower readmission rates, and less blood loss compared to conventional laparoscopic surgery. Another paper shows better patient outcomes for benign hysterectomies compared to laparoscopic or open surgery for one surgeon rom 2013-2015.

While these are just two examples out of more than 22,000 publications, ISRG also provides substantial clinical evidence supporting the benefits of robotic surgery across a variety of conditions and surgical categories including: hernia repair, lobectomy, Crohn’s disease, lung cancer, etc. Additionally, ISRG seeks out collaboration with researchers and offers grant opportunities to support research at non-profit academic institutions worldwide.

 

clinical evidenceSource: https://www.intuitive.com/en-us/about-us/company/clinical-evidence#

Importantly, ISRG has never had a Class 1 recall (the most serious classification) and has faced only minimal litigation associated with product quality and safety defects. As of FY19, ISRG had no product liability claims, and only $10.5mn as of FY18 and $12.8mn as of FY17. This is an impressive track record given the litigious environment companies operate in today.

Dominant market share with substantial barriers to entry driven by high switching costs

Driven by the company’s first mover advantage and strong product offerings, ISRG dominates the robotic surgery market with a 92% market share globally. This industry is characterized by substantial barriers to entry driven by high customer switching costs, and high regulatory barriers with regulatory approval required for new products to come to market. High customer switching costs are associated with both capital costs for the systems and the substantial amount of training surgeons undergo to operate these machines. As the da Vinci systems cost on average $1.2mn per system, these represent meaningful expenses for a hospital. ISRG’s lease option has become more popular over the past few years, making up 12.7% of all systems outstanding and 34% of all systems sold in 3Q20. It’s also noteworthy that hospital systems are highly fragmented, limiting their purchasing power.

ISRG’s surgical systems are now well integrated into hospitals with a massive installed base of 5,897 systems across more than 3,000 hospitals, with 63% in the U.S., and 37% international. ISRG has also experienced 400% growth in the past 5 years in the number of hospitals with 5 or more systems. Geographically, ISRG has demonstrated strong growth in Japan and Germany, and entered into a JV Fosun to enter the Chinese market in 2019.

Since inception more than 7.2 million procedures have been performed on ISRG systems, including more than 1.2 million procedures in 2019 alone. This has resulted in a substantial amount of clinical data as mentioned above. Notably, there are nearly 53,000 surgeons globally who have been trained on the da Vinci systems. ISRG offers substantial training for physicians including numerous global training centers, online instructional modules and videos, and on-site technology in-servicing. This results in a powerful feedback loop between ISRG and doctors, serving as a quasi-network effect, with ISRG incorporating the learnings from the millions of procedures done to improve existing products and inform new products and services. In this regard, ISRG has a material advantage over competitors, given its large installed base and the substantial number of procedures performed to date. Finally, ISRG is also considered the premier brand within the Medtech industry with a Net Promoter Score (NPS) of 70, compared to a Medtech average of 61, with any score above 50 is considered strong.

From a regulatory standpoint, ISRG has been issued or owns over 2,900 patents and has more than 1,900 active patent applications. Competing products would need to meet the quality standards of ISRG’s product offerings to be able to come to market. This represents a substantial hurdle for competitors, as ISRG continually improves its systems. Furthermore, competitors would need to be competitive on price, which would likely also be a challenge given the scale ISRG has achieved.

Massive growth opportunities

Over the past few years, ISRG has experienced substantial growth in the number of da Vinci systems sold and procedures performed with the systems on a global basis. While 2020 has been a challenging year for the company driven by reduced hospital utilization from COVID-19 (discussed in greater detail below), the company has substantial opportunities to increase the penetration rate of robotic surgery globally.

Procedure growth

Source: ISRG Investor presentation

On a global basis there are roughly 300 million surgeries performed every year. Goldman Sachs estimates 58 million of these procedures can be performed robotically, for economic and medical reasons. Currently the robotic market share is only 2% of the 58mn applicable procedures and the robotic market share is expected to increase to 14% by 2030, or 10.5 million robotic surgeries up from 1.1mn in 2018. As a result, GS forecasts the market to grow from $5.3bn in 2019 to $24bn in 2030.

Additionally, there are clearly substantial tailwinds for much higher growth well beyond 2030, as the below estimates show the robotic market share at only 14% in 2030. Furthermore, it is likely that new procedure categories will become available for robotic surgery. From a geographic perspective, ISRG is focused on expanding market share in Europe and Asia, and the company has seen substantial growth in both Japan and Germany.

robotic surgery market shareISRG continues to invest heavily in R&D and has seen its R&D budget triple over the past 5 years. The company recently launched ISRG’s first diagnostic tool, the ION, aimed at lung biopsies. The goal is to increase the accuracy of lung biopsies and decrease the time needed to diagnose lung cancer. The first 10 units of the ION were shipped in 2019, and I expect strong growth for the ION over the next few years.

Additionally, ISRG received FDA clearance for the IRIS augmented reality product to help surgeons by delivering a 3D image of patient anatomy for both pre and intra-operative settings.  Furthermore, ISRG is focused on driving down the cost of its higher volume products through economies of scale, by automating the production process for high-volume products. Lastly, ISRG is investing in big data capabilities and machine learning.

New products

Strong management and capital allocation policies

CEO Gary Guthart joined ISRG in 1996, a year after the company was founded, and became CEO in 2010. Gary Guthart has substantial skin in the game as he owns roughly 394K shares of ISRG, worth nearly $289 million. Since becoming CEO on 1/1/2010, ISRG’s stock has massively outperformed the S&P 500, generating a total return of 642% (20%/year) compared to the S&P 500 at 306% (13.7%/year). ISRG has grown revenue by 16% per year over that time frame,and has generated an average ROE of 18%/year during Guthart’s tenure. Guthart also has a 97% approval rating on Glassdoor (out of 427 ratings), and was ranked the 9th best overall CEO of large companies by Glassdoor in 2019.

ROE over time

From a capital allocation standpoint, ISRG has largely focused on r&d, strategic share repurchases, and the occasional bolt-on acquisition. ISRG has never paid a dividend and has focused largely on organic growth given the company’s substantial opportunity to increase the penetration rate of robotic surgery. In terms of R&D, ISRG has ramped up its R&D investment from $178mn in 2014 to $602mn over the LTM period. This also corresponds, with increased interest in robotic surgery from two of ISRG’s peers, JNJ and MDT.

ISRG has strategically bought back shares over time, $1.1bn in 2013, $1bn in 2014 and $2.3bn in 2017. ISRG has also made some small acquisitions over time, including the acquisition of the 3D robotics endoscope business from one of their suppliers in 2019 for $100mn, but has never pursued large scale M&A. ISRG has built up its cash balance over the past few years and now has $6.4bn in cash and investments as 3Q20. Given this large cash balance and no debt, I expect ISRG to start meaningfully repurchasing shares over the next few years. Additionally, I expect ISRG will continue pursuing bolt-on M&A. Finally, ISRG recently launched a $100mn venture fund to invest in early-stage companies across digital, medical device, therapeutic, and diagnostic domains.

Risks:

Near-term challenges related to COVID-19

COVID-19 presents a near-term challenge for ISRG due to the negative impact on elective procedures globally. Revenue was down 22% y/y in 2Q20 and down 4% y/y in 3Q20 due to a lower level of procedures and reduced system units sold. Additionally, operating income was down 78% y/y in 2Q20 and down 36% y/y in 3Q20 as gross margins declined and ISRG increased its r&d budget over this time frame. I expect the next couple of quarters will be weak for ISRG, but I view the impacts of COVID-19 as a near term challenge, as hospital utilization rates have improved over the past few months, and positive vaccine news signal a hopeful return to normalcy shortly. As a result, I expect earnings growth to accelerate in 2021 and beyond. The significant tailwinds described above and ISRG’s dominant market position will allow the company to thrive.

Competition from large peers

Over the long-term the biggest risk for ISRG is competition from two large healthcare companies: JNJ ($388bn market cap) and MDT ($147bn market cap). Both companies have strong positions in the traditional laparoscopic tool market, which ISRG’s surgical systems have taken market share from. As a result, both JNJ and MDT have acquired robotic surgery start-ups. MDT acquired Mazor Robotics for $1.7bn in 2019, which specialized in spinal surgery. JNJ acquired Auris Health in 2019 for $3.4bn plus up to $2.35bn in continent payments. Auris was founded by ISRG’s found Fred Moll, who left ISRG in 2003. Additionally, in 2019, JNJ acquired a remaining stake in Verb Surgical, which had been a JV with Google.

However, launches of new products have been delayed for several years, driven by a weak operating environment in 2020 with lower hospital utilization and delays in many elective procedures due to COVID-19. Additionally, there is an exceptionally high bar to hurdle for competitors to receive FDA approval. Competitor systems would need to be on par if not better than existing Da Vinci models. Without the clinical data ISRG has, it will be challenging for MDT/JNJ to compete on clinical outcomes. Competing on cost will also be challenging given the scale of ISRG’s operations, and its focus on further automating its production process.

In terms of competition, MDT announced the release of the Hugo system in 2019 to compete directly with the Da Vinci. Initially, the Hugo was expected to be released in the U.S. in the Fall of 2022 but has now been delayed, with no clear time table for a launch of the system. Furthermore, MDT’s Hugo system appears rudimentary compared to ISRG’s da Vinci. The system was launched on a prostatectomy, which was one of the first robotic surgical procedure to get approved and is not as sophisticated as the da Vinci.

JNJ also plans to enter the U.S. market, but doesn’t expect to enter clinical trials for its Ottava system until 2022, and it would likely be another couple years before JNJ could launch the system.

As shown below, GS estimates that ISRG’s robotic surgery market share will decline from 92% in 2019, to 71% in 2025 and 56% by 2030. MDT and JNJ are expected to take the majority of ISRG’s market share over that time frame. However, given ISRG’s substantial lead and the very high switching costs, I believe ISRG will be able to maintain a very high market share for a substantial period of time. Especially in light of the product delays from JNJ and MDT. Nevertheless, this competitive pressure is the greatest threat facing ISRG.

Market share over time

Financials
Financials

Valuation

From a valuation perspective ISRG trades at premium multiples given its wonderful business characteristics. Specifically, ISRG trades at 58x 21E EPS, and 47x 22 EPS. On a FCF basis, ISRG trades at 64x 21E FCF and 51x 22 FCF. Given these high starting multiples, substantial EPS growth over the next decade is needed to achieve a reasonable rate of return. The below charts show sensitivity analysis for 5Yr. and 10Yr. IRR’s for ISRG based on EPS growth rates and terminal multiples.

As shown below, prospective 5 year returns for ISRG are weak even assuming strong EPS growth and a high terminal multiple. ISRG has achieved 25% annual EPS growth over past 5 years, and 21% annual EPS growth over the past 10 years. However, it’s difficult to expect ISRG to grow at a faster rate than it has historically, as a larger company. Even over a 10-year time frame, 20+% annual EPS growth is needed to generate an attractive rate of return.

Given ISRG’s dominance in robotic surgery and the exceptionally low worldwide penetration of robotic surgery it’s certainly possible ISRG will grow earnings at an extremely high rate over the next decade. Additionally, it’s possible ISRG successfully expands beyond robotic surgery, into diagnostics and AI/machine learning for surgery. For now, I am not confident that ISRG will be able to grow earnings at 20+% for the next decade given how challenging a proposition that is, even for a dominant company. Especially since I expect competitors JNJ and MDT to enter the robotic surgery market by 2024/2025.

5yr IRR

10yr IRR

Disclaimer
This article is not to be taken as financial advice and is not recommending the purchase or sale of any particular securities. This information is meant merely for informational and discussion purposes only. Please do your own research or seek out a licensed financial professional for help with personal finance and investment decisions.

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