Intuitive Surgical: Even the Widest Moat Can Be Overpriced

We believe the market is overestimating  Intuitive Surgical's (ISRG) long-term revenue and earnings growth potential. Our valuation model and company report incorporate optimistic expectations for emerging procedures even as growth moderates in core procedures. But we also expect that post-reform, U.S. hospitals operating in a tight reimbursement environment will be increasingly motivated to maximize returns on their investments, which will be reflected in slowing growth of da Vinci system sales. While we don't think that the European spending environment will remain constrained permanently, we do believe Intuitive will generally face a tougher road ahead in Europe, where providers are more hesitant to adopt new-generation technology than their U.S. counterparts. We are cognizant that Intuitive has long been a Wall Street darling, and rightfully so, given the performance of its business and shares. However, we think the market continues to extrapolate past growth forward, as evidenced by the overwhelming bullish sentiment despite the 28 forward earnings multiple and tougher comps ahead. Our $420 fair value estimate implies a 23 multiple to our 2013 earnings per share forecast, and we believe the stock is currently moderately overvalued.

We have to separate our belief in the durability of the company's competitive advantages from our take on its valuation. In our opinion, Intuitive's wide economic moat continues to stand out as one of the most durable in the sector. The company probably won't be enjoying its monopolistic position for much longer, as we estimate competitive platforms to enter the market in 2016-17, but we don't believe Intuitive will cede meaningful market share, given its plethora of clinical data and massive installed base. Enormous switching costs and a meaningful recurring revenue stream shield the firm's position and its returns on invested capital. We forecast adjusted ROICs in the 50%-plus range throughout the decade.

One of the challenges in figuring out Intuitive's growth trajectory is that historical growth was three-pronged: System placements, disposable instrument sales, and service revenue have all contributed significantly to the firm's five-year overall revenue compound annual growth rate of 30%. The initial adoption of robotic surgery was driven by box placements, as hospitals--lured by the appeal of robotic surgery and incremental pull of profitable consumers--were willing to invest in $1.3 million-plus systems without having a sufficient idea of how to utilize them. However, as is typical with early-stage adoption of new technology, the deployment rate of da Vinci has stayed well below its targeted rate. Many hospitals that had da Vincis simply didn't have enough procedures (or interest) to deploy them.

In the long run, we think focusing on procedure growth will give us the clearest picture of likely demand for da Vinci systems and services; our forecast for this dictates our estimates for system sales as well as instrument and service revenue. Our systems growth revenue looks very modest relative to historical growth rates, but we think the systems' novelty and shrewd marketing that led to initial high growth rates in da Vinci placements are not sustainable.

Core Procedures Maturing, but Emerging Surgeries Will Drive Future Growth
On the basis of our procedure-by-procedure analysis, we believe the company will be able to sustain its high procedure growth rate, with maturing growth from procedures such as da Vinci prostatectomy and da Vinci hysterectomy offset by emerging procedures such as partial nephrectomy, sacral colpopexy, colorectal, and so on. Our base-case forecast calls for a 12% 10-year procedure compound annual growth rate, with growing 19% on average outside the United States.

We believe the total number of da Vinci procedures will more than triple over this decade. That said, as Intuitive encroaches on the territory of laparoscopic surgery, its value proposition will be increasingly questioned. Most head-to-head clinical data in the company's possession compare da Vinci with open surgery, and the company will be hard-pressed to produce more cost-benefit analysis versus minimally invasive surgery for indications where its incremental value is more muted. Reimbursement is generally the same regardless of whether a procedure uses robotic or manual MIS, so while offering a robotic option can lure patients, robotic procedures carry higher fixed and variable costs, resulting in a lower profit margin for a hospital. Thus, we think hospitals are bound to become more selective with the type of surgery they steer toward da Vinci.

The main challenge in valuing Intuitive is figuring out the size of the robotic marketplace. The technology itself is in a relative nascence, so its true potential is hard to handicap. In theory, a big chunk of all 48 million surgical procedures performed in the U.S. annually alone could switch to a robot, but we think the real number is likely to be much smaller. Our model incorporates our assessment of what we know--procedures currently approved and likely to receive near-term clearance--but we also give Intuitive credit for creating its own market. Da Vinci hysterectomy went from zero to 184,000 procedures in seven years, and with the majority of procedures still performed in an open setting, it is fathomable that Intuitive could have success in procedures that aren't even on our radar yet. Our model assumes that roughly one fourth (350,000) of all da Vinci procedures by 2022 will be of "other" varieties, but if this number goes to 600,000, our fair value estimate increases 15%.

Slowdown in System Sales as Market Penetration Decelerates
Each da Vinci system costs $1.3 million-$2.2 million, which is a major investment for any hospital besides the elite facilities such as the Cleveland or Mayo clinics. However, over the past decade Intuitive was extremely successful in penetrating not just the high-volume facilities, but also smaller rural hospitals.

We think that much of the low-hanging fruit in terms of systems placements has been picked, and while the hospital penetration rate in theory leaves room for more hospitals to put the cart before the horse, we believe procedure volume will dictate purchasing decisions going forward. We believe systems growth will depend on the ability and willingness of hospitals to maximize utilization rates, as the return on investment on an idle (or underutilized) system isn't that attractive, given the high initial sticker and incremental increase in a per-procedure variable cost for robotic surgeries. As a result, we believe that da Vinci economics, assuming no major changes to the pricing model, will preclude the company from making further inroads into the virtually unpenetrated small-hospital marketplace.

On the flip side, we believe patients will gravitate to large facilities, which also tend to attract top specialists; this will give large hospitals the incentive to increase their installed bases. The percentage of greenfield placements has steadily declined over the past few years (59% of all systems sold in 2012 versus 74% of all systems sold in 2009), a trend that is unlikely to reverse. We also believe the U.S. utilization rate will continue to increase, with more procedures performed on existing instruments before an upgrade (in part skewed by high-volume hospitals accounting for a larger portion of total installations). Our base-case expectation for the U.S. installed base is 3,600 robots by 2022, from 1,878 currently, and that incorporates a meaningful deceleration in system revenue growth (we are holding average selling prices relatively flat, even as we believe the company will be under pressure to reassess its pricing model).

The situation is moderately better in Europe and the rest of the world. We anticipate placements outside the U.S. will drive system revenue growth, and our forecast calls for the installed base to more than quadruple to 2,900 units by 2022. This implies a 12% unit placement compound annual growth rate despite the generally more skeptical attitude toward health-care innovations outside the U.S. Our base forecast for both the U.S. and overseas incorporates a 75% replacement rate every five years.

Three key variables affect our instrument sales forecast: procedure volume, instrument mix, and the pricing environment. The impact of mix is least understood by the marketplace, in our opinion. One of Intuitive's key product launches in the past few years was a single-port instrumentation suite that allows the company to shield some of its existing positions and add to its procedure repertoire. The company has several clearances for single-site, most importantly in cholecystectomy and benign hysterectomy. While the addition of single-site will probably result in the continuing expansion of da Vinci hysterectomy in benign hysterectomy and drive general surgery procedures, instrumentation on average is priced at a 15%-20% discount to the traditional multiport. With our forecast calling for nearly 50% of all benign hysterectomies going to single-port in 2016, in addition to virtually all cholecystectomies and a small number of other procedures, the mix shift alone will be responsible for 1%-2% annual ASP declines for the next three to four years.

A bigger threat to Intuitive's pricing is the general belief that Intuitive's monopolistic position and hospitals' price insensitivity have driven ASPs beyond what the market will be willing to bear in the post-reform environment. With reimbursement generally not distinguishing between robotic surgery versus manual MIS, hospitals will have to weigh factors such as surgeon comfort, the cost of extra training to achieve proficiency in laparoscopy, incremental improvements in blood loss and post-op recovery time achieved with a robot, and so on. We sense the math will become increasingly less favorable for Intuitive, particularly in areas where Intuitive is squaring off not only against open surgery but also manual MIS.

Finally, we do expect competition to emerge in the next few years. Intuitive's first-mover advantage and a corresponding massive installed base and robust clinical data have provided a daunting comparison for new entrants. We think medical professional inertia is also a factor; once comfortable with one technology, surgeons tend to stick with it, and with more residents training on da Vinci robots, the stickiness grows. However, Intuitive is increasingly targeting specialties outside its core urology and gynecology areas, and considering these are relatively new markets for the company, surgeon loyalty is less pronounced. Further, Intuitive's technology is arguably not best suited for specialties such as cardiothoracic and head and neck surgery and somewhat cost-prohibitive in general surgery.

Still Room for Margin Expansion, but Downside Risk Exists
Intuitive's amazing revenue growth has been accompanied by equally amazing operating margin performance. Intuitive has gross and operating margins among the highest in the industry, despite generating a significant portion of its sales from capital equipment (which tends to carry lower margins across the device and instrument industry) and service (which tends to have even lower margins). The difference is the monopolistic environment where Intuitive operates and hospitals' willingness to be price-takers because of the perceived value of robotic surgery. It is hard for us to envision a scenario where the company's 70%-plus gross margins on products do not come under pressure over a 10-year forecast. Even if competition remains nonexistent, we believe hospitals will increasingly balk at the system and instrumentation costs, and with a shift toward lower-price procedures, the company's procedure mix will provide downward pressure on gross margins. Our base-case forecast sees a modest product gross margin decline, largely offset by continuous gains on the service side.

Operating margins also have more room for improvement as the company continues to drive higher revenue per employee. Intuitive stands to gain substantially on the margin side from each incremental procedure shifted to a robot, and with its emphasis on clinical sales reps (versus sales reps focused on box placements), revenue adjusted for head count should still rise even as box placements slow. Leveraging overhead and research and development brings us to a 43% margin in our base-case forecast by 2022.

The upside is limited, however, as too many factors could threaten margins. Pricing, slowing box placements, and stabilization of service margins all are reasonable risk factors. Further, Intuitive has so far effectively applied its platform without many modifications across most specialties. However, one of da Vinci's criticisms is its urology focus, and for certain specialties Intuitive needs to continue to innovate in order to penetrate them effectively. With competition specifically aiming at future growth targets (general surgery, ENT), Intuitive will be hard-pressed to maintain its R&D investments.

Organic Earnings Growth to Slow, with Buybacks Likely to Accelerate
With revenue slowing and the ability to expand margins diminishing, Intuitive is likely to increasingly rely on share buybacks to drive earnings per share growth. The firm just announced a round of share buybacks, and with free cash flow rates north of 20% and steady, Intuitive has ample capital to fund even greater repurchases going forward. Historically, the company has been disciplined with its buybacks, slowing (or even stopping) the activity when it thought it didn't represent an attractive use of capital, but we think Intuitive may be pressured to step up its repurchases if growth rates further decelerate. Investment opportunities are somewhat rare, given the lack of robotic alternatives, and the company may be tempted to leverage its existing R&D and sales infrastructure to also drive earnings growth. Our forecast calls for a 12% 10-year EPS compound annual growth rate, with buybacks accounting for about 200 basis points.

While a Risk, We Don't Consider the FDA Probe a Meaningful Concern at This Time
The Food and Drug Administration recently launched an investigation into the safety of Intuitive's robots following several reports highlighting the increasing number of injuries related to da Vinci. We accessed the Manufacturer and User Facility Device Experience database that tracks all the surgical injuries, and while we note the increasing number of injuries during robotic surgery, (a) there are many more da Vinci surgeries now than even five years ago, (b) there is no clear indication that the prevalence of patient injuries stemming from robot usage is higher than the alternative treatment, and (c) most injuries reported are listed in a "user error" category. While it is possible that da Vinci surgeries are being performed by less-experienced surgeons, there is no concrete evidence that robotic malfunctions are the source of injuries. If anything, da Vinci affords more precision versus laparoscopy, and for particularly challenging laparoscopic procedures, the da Vinci learning curve is actually not as steep as manual MIS. We're also aware of a number of lawsuits recently filed against the company for the alleged injuries caused by robotic surgery. This issue, which is tied to an FDA probe, is a risk for Intuitive, but it shouldn't be the key reason for avoiding or shorting the stock at this point.

We Acknowledge Intuitive's Potential Upside, but Buyer Beware
Our forecast is drastically different than Intuitive's prior growth rates, and given the company's monopolistic status and a virtually unlimited number of procedures, it is easy to come up with scenarios where the shares could be worth double what they are now. However, many things have to go right for the company to continue increasing its procedure rates and system placements at double-digit rates every year for the next decade.

Our bullish scenario, while possible, tends to ignore the realities of the U.S. health-care system. With more emphasis on comparative and cost effectiveness, the firm will be pressured to deliver real clinical and cost benefit to supplant laparoscopy in addition to open surgery. We believe it has the ability to do so, but we think it faces a more challenging environment. We're still very bullish on robotic surgery expansion, but we think it is procedure growth, not system placements, that will be the key performer over the next decade.