Intuitive Surgical: Buy A ‘Little Slice’ Of The Future (NASDAQ:ISRG)

Moats and Monopolies

Here at Moats and Monopolies, we do things a little bit differently. We write exclusively about companies that we own in our publicly shared portfolio, which beat the S&P 500 by nearly 10% in 2023.

We take our time and write well researched and clearly explained articles that help investors determine whether one of the picks in our own portfolio might have a place in theirs.

We are long only, buy and hold, part owners of high quality assets from around the world. The companies we own have little debt, strong and consistent margins, high returns on capital, and are likely to compound and grow their intrinsic value for many years to come.

The most recent addition to the Moats and Monopolies Portfolio is the robot-assisted surgery market leader Intuitive Surgical (NASDAQ:ISRG). In this article, we’ll look at what the company does, how it created its dominant position in the large and expanding robotic surgery market, and why we believe it will beat the market over the long term.

The Business

Intuitive Surgical’s mission is: “We believe that minimally invasive care is life-enhancing care.” It has a couple of extra superfluous sentences, so we’ve taken the liberty of improving it by (surgically) removing the unnecessary bits. It’s a simple statement that resonates. If one needs to have surgery, it goes without saying that it is better to be as uninvasive as possible. It turns overnight hospital stays into outpatient procedures, speeds up recovery, and leaves less of a visible and permanent scar.

As we increasingly develop a symbiotic relationship with our technological advances in order to optimise how we work, the use of robotics to enhance the efficacy of human surgeons and operating teams is an inevitable and important step towards getting patients quickly and safely through their procedure and home again.

One example of this is within cardiology. In the past, any procedure on the heart was typically ‘open surgery’, meaning that the patient was literally opened up – cutting through the breast bone and opening up the ribcage. Today, robotic-assisted surgery is an increasingly common option whereby small holes are pierced into the body through which tools are inserted, with images projected via video camera and enhanced for the surgeon to see what they are doing. Below we can see a clear visual representation of this.

Intuitive Surgical is the market leader in the production of their robotic-assisted devices, which it calls da Vinci. These devices offer surgeons enhanced and zoomed in views of the operation in addition to instruments that act like like human hands but with greater motion, control and precision.

The company offers fully fledged devices as well as single purpose ones that are cheaper and act as gateways to the ecosystems for hospitals that are either reluctant to fully invest in more expensive models or currently unable to. Either way, once the company ‘lands’ in a hospital, they will start to profit from that relationship – having one of our favourite business models: the razor and blade. Intuitive sell their devices directly to hospitals at a price around a million dollars each. They then sell proprietary and essential instruments that are required to actually use the machines for surgery. A further, and increasingly lucrative part of the business model is the service contracts that they offer for hospitals looking to keep their machines well maintained and potentially extend the use life of their valuable assets.

Over time, this increases the amount of recurring revenue for the company as they rely less on the expensive production of their robotic devices and more on the consumables and service revenues that are needed to be able to use and maintain them once they are installed. The graph below shows that this pattern and that it will likely continue for a while. Companies with recurring revenue streams compound their sales over time and are exactly what we are looking for here.

The Moat and Opportunity

Intuitive has a first mover advantage that has allowed it to very quickly build what are potentially very long term relationships with hospitals. The visual below shows how this works: Hospitals purchase the da Vinci machines to improve patient outcomes and the high capital expenditure requires that surgeons and teams be trained to use them as much as possible. Training is increasingly valuable and builds a network effect where surgeons expect hospitals to use familiar machines and hospitals expect surgeons to know how to use them. This knowledge becomes standardised, think Microsoft (MSFT) Office or Adobe (ADBE) Creative products. As relationships are built between hospitals and Intuitive, more devices are installed and even more instruments purchased for use in each surgery. As the company scales up production, it increases either its gross margins or lowers its costs, which makes it more difficult for competitors to undercut them. Further, the company earns revenue from servicing older devices and any future upgrades further consolidate their relationship with hospitals.

Below we can see this in practice, as the number of hospitals and the proportion of hospitals that own at least 7 da Vinci systems is increasing exponentially over time; we do not expect this to slow down as Intuitive continues to expand in other major markets outside of the US.

Further, we can see that the total number of procedures using da Vinci systems continue to increase over time with an acceleration visible as post pandemic demand for elective surgeries (i.e. not immediately life threatening) returns. Remember, the recurring nature of the consumable instruments used in procedures means that the more the devices are used, the more we as shareholders get paid.

The article started with a basic thesis: robotic surgical assistance offers better results for patients and that this symbiosis of human and technological expertise is inevitable. We have already discussed how Intuitive has established its strong competitive advantage, but there’s no point in being top dog of a stagnant or dying industry. Rather, the global surgical robotics market has a very long runway of future growth that will probably last for decades – simply there is no unscrambling of the egg from here. Depending on the report that you read, it is estimated that the market wil grow at around a 15% CAGR for the next decade. We suspect that this will either continue steadily for a further decade or even accelerate due to the razor and blade model discussed and the exponential demand for accessories for surgery as well as servicing of devices.

The company’s first mover advantage and market leading position as well as the large recurring part of their revenue, mean that they have enviable margins, which we like here at Moats and Monopolies. The company is already able to produce a nearly 20% free cash flow margin that we believe will expand as the proportion of recurring revenue items to expensive device production increases into the future. These strong margins and compounding revenues have led to a wonderful balance sheet with over $7 billion dollars of cash and no debt whatsoever. This gives the company optionality for potential tuck in acquisitions as well as the chance to invest into itself in the research and design of further devices in the future.

The Risk

Intuitive is, in our view, a world class company that should be on the radar of every growth or quality investor that has at least a decade to hold the company. There is good reason for that as the stock is eyewateringly expensive with a PE that hovers between 60-70. Steady EPS growth of 15% over the next few years will still only bring that down to a valuation around double that of the market average. Valuation is a risk here and we would advise for patience – either for the company to grow into (and surpass) its valuation or to wait for dips as the market inevitably moves back to fear and investors sell of gains from the last few months of strong performance. Do not be surprised to see its stock price trend quite flat for a couple of years as earnings growth is counteracted by multiple contraction.

The other elephant in the room is competition with major threats from both Johnson and Johnson (JNJ) and Medtronic (MDT) as well as many smaller entrants into the space, all keen to get a piece of this lucrative international market for surgical robotics solutions. The nature of capitalism is that large opportunities are rarely left for one player to benefit from and there will be increased competition. However, we believe that a) developing these devices and getting them FDA as well as internationally approved is time consuming and incredibly expensive and b) the delay for competitors in getting products out there increases Intuitive’s stranglehold on existing hospitals as well as giving it more time to land into others. Whilst Johnson and Johnson are currently earmarking the end of this year for trials of its Ottava platform and an expectation that it will be at least a few years until approval, Intuitive will build upon its very high net promoter score as hospital management and surgery teams share positive stories of their use of da Vinci devices, which will lead to further increases to Intuitive’s already sizable head start.

The Chances of Beating the Market

The matrix below allows one to make their own forecasted annual return over the next 10 years. For a frame of reference:

Current TTM non-GAAP PE: 65

Red = 8% or less CAGR from the current share price

Orange = between 8% and 12% from current share price

Green = 12% or more from current share price.

Intuitive Surgical is undoubtably a top-tier company of which to be a part owner; however, it has an eye watering multiple attached to its earnings that has actually increased over the last 5 years and sits at time of writing this at 65.

The company’s EPS has been accelerating out of the pandemic and the full return of normal hospital services, including elective surgeries has seen its 3 year EPS CAGR hit nearly 20% – a doubling every 3 and a half years or so if it continues. We actually believe that the increased number of installations and procedures as well as the increasing recurring revenue from both accessories and services mean that these growth rates might either accelerate with scale or at least be maintained for the majority of the next decade. Futher, the company has recently started to reduce its share count, which will continue to increase EPS.

We haven’t discussed other potential growth drivers in this article, such as medical simulations, data utilisation and further optionality of its devices into different procedures, or even new devices such as the Ion that is being used for lung biopsies and currently selling very well.

These additional growth drivers make us feel quite good about our our assumptions here:

10 year future EPS CAGR: 17%

P/E in 2034: 40 – high, but an over 50% reduction from today’s multiple and the market for robotic devices is not getting any smaller any time soon. There will likely still be a lot of growth available for the company in 2034.

We do not expect a dividend payout during this time.

These assumptions are marked on the bold box below, feel free to check your own forecast to see whether the risk return works for you.

The Summary

We initiate our ‘buy’ rating along with confirmation that it is now a holding within the Moats and Monopolies portfolio. It is a recommendation only for those who are willing to wait patiently for a world class company to grow into its lofty valuation and have a long enough time horizon to watch it continue to dominate this huge market opportunity.

As always, thank you for kind and constructive comments below the line. We’ll meet you there!