Intuitive Surgical (Nasdaq:ISRG) Why1. Intuitive Surgical is literally changing the way surgery is performed. It does this by improving the value of surgery for the patient in terms of improved surgical efficiency and reduced patient trauma. We are basically talking about 1-2 cm incisions vs the traditional method which is obviously much more severe.2. ISRG role in this advancement is to offer a product that “takes surgery beyond the limits of the human hand”. This is achieved through superior vision, improved precision, and reduced surgical time, through the use of robotic technology.3. As you can imagine the market is exploding due to reduced recovery costs and reduced patient suffering. Some of these procedural savings have totaled 40%. 4. Guess what? ISRG is really the only one offering this type of product and it owns all the patents.5. Hyper growth of procedures is pointing to increased adoption. #1 procedure up 65% in 07, #2 up 175%. Total procedures up 56%.6. Repeat purchases, like a Pringle customers can’t seem to buy just one daVinci. 110 customers have multiple units.7. I believe the Management team to be extremely transparent and whose primary mission is to deliver value to patients. They firmly believe if you take care of the patients and surgeons, the stock and take care of itself. Voracious readers. BusinessISRG designs, manufacturers, and markets the daVinci surgical system. By using this computer enhanced technology as a bridge between the surgeon and the patient, the system allows surgeons to perform MIS in ways never before imagined. The daVinci is a machine that controls 3 arms (with an optional 4th) that acts as the surgeons’ hands and endoscope. The 4th arm basically acts as a medical assistant. The system translates the surgeon’s natural hand movements on the instrument controls into corresponding micro-movements of the instruments positioned inside the patient through small “ports”/incisions. The competitive advantage of the daVinci is it provides the surgeon with intuitive control, an expanded range of motion, the ability to manipulate fine tissue, and the 3D vision of open surgery while still working in a small space. Key adoption metrics for this business include the total procedures performed up 56%, total units installed (946), year over year treated patients 85K. The financial levers include gross margins (70%), sales per system (800k-1M), service revenue per system $135K per year, and the amount of instrument and accessory revenue per procedure currently $1500-2000 per. Strategy1. Focus on key procedures, right now there are 4. As other procedures get FDA clearance they should be a catalyst for future growth.2. Focus on marketing to surgeons who are considered to be “thought leaders” in their fields.3. Focus on marketing to key institutions within the hospital as well as academic communities.4. Maintain market leadership by continuing to enhance and develop the technology.5. Continue to develop industry alliances, like those already established with Medtronic and Olympus.6. Increase patient awareness, take advantage of the trend that more patients are researching their own healthcare more than ever before. ManagementOwnership – While 5% holders own more than 11.5% of the company, insiders only own 1.6%. Still, Ceo Lonnie Smith has more than $90M of his personal fortune tied to the company.Allocation – With high returns on equity 21% and capital 19%, management effectively allocates capital. Tenure – Chairman and Ceo Lonnie Smith has been at the helm for over 10 years. He also has a BS in electrical engineering and an MBA from Harvard business school. I think he brings a nice blend of know how and business savy to ISRG.Stewardship – Lonnie Smith made only 830K or less than 1% of ISRG net income in 07. Unfortunately, stock based compensation came in at $36.3M over the same period of time. Still, most of that is going to the employees who own less than 5% of the company. As part of the compensation plan, employees are able to buy shares through a payroll deduction and a 15% discount to the markets price. Because ISRG is so early in its growth cycle it prefers to deploy capital back into its business as opposed to buybacks or paying out any sort of dividend. All this leads me to management’s candor and transparency. A good example is the hiring criteria as explained by Lonnie Smith. It all starts with Character, if you don’t have it you might as well stop there because nothing else matters. Next is Capacity, he explains this as the ability to find your way out of the forest with a buck-knife. Third is energy or the ability to go towards problems instead of running from them and lastly, is experience. The danger (per Mr Smith) is when you are in a high growth phase, the tendency is to invert these. Longer term, he realizes hiring in this way will kill a company. Competition and RisksIntuitive Surgical main competition is the continued use of open surgery and other forms of MIS. This is because the daVinci is unique in it’s space. Still, others dabble in robotics and the closest competitors include Hitachi and Toshiba while smaller niche players include Viking Systems and Prosurgical Limited. 1. The main risk is a sudden lack of continued market acceptance. daVinci procedures are far from saturating the market so any material slowing in the key metrics will flag a weakening of adoption. 2. These are expensive machines, so general economic weakness could cause a slowdown. Further, the purchase price is such that the product has to be approved by top line management and BOD.3. Like all tech, liability claims could cause havoc with the company if the machine does not work properly. This is magnified due to the space in which the daVinci operates. 4. At 40 times earnings and almost 12 times sales ISRG is not a cheap stock. If growth rates were to slow this stock would be beaten worse than most.ValuationWith a price to innovation ratio of around 35 and forward Pe around 32, the stock while still expensive is cheaper than its been in a long time. Assuming a 30% ST growth rate (reasonable considering the top line is growing at 66% and the bottom line is up almost 90% YTD) and 15% yrs 6-10 followed up by inflation, I value ISRG at around $265 yielding a 30% safety net. After reporting Q2 numbers, the stock spiked to $340 but has since been taken down to $190 for no other reason than general market volatility. I think today’s price is an excellent entry point for such a high quality business.
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