Intuitive Surgical (ISRG) manufactures and develops robotic-assisted products, most notably the da Vinci surgical system and related instruments and accessories, to improve clinical outcomes of patients through minimally invasive surgery.
Its products include da Vinci and Ion. The company was founded in 1995 and is headquartered in Sunnyvale, California. Although the company is very innovative, profitable, and has Wall Street’s backing, we are neutral on the stock because we believe that current price targets may be too optimistic.
Intuitive Surgical’s Competitive Advantage
As we often mention in our articles, there are a couple of ways to quantify a company’s competitive advantage using just its income statement. The first approach involves calculating a company’s earnings power value (EPV).
Earnings power value is measured as adjusted EBIT after tax, divided by the weighted average cost of capital. The next step is to find the company’s reproduction value, which can be measured using its total asset value. If the earnings power value is higher than the reproduction value, then a company is considered to have a competitive advantage.
For ISRG stock, the calculation is as follows:
EPV = EPV adjusted earnings / WACC
$26.7 billion = $1.87 billion / 0.07
Since Intuitive Surgical has a total asset value of $13.6 billion, we can say that it does have a competitive advantage. In other words, assuming no growth for Intuitive Surgical, it would require $13.6 billion of assets to generate $26.7 billion in value over time.
The second method to determine a competitive advantage is by looking at a company’s gross margin because it represents the premium that consumers are willing to pay over the cost of a product or service.
An expanding gross margin indicates that a sustainable competitive advantage is present. If an existing company has no edge, then new entrants would eventually take away market share, leading to a decreasing gross margin as pricing wars ensue to remain competitive.
Taking a look at Intuitive Surgical, we can see that its gross margin has remained relatively flat in the past several years. This indicates that a competitive advantage is present in this regard as well.
Profitability
Many investors appear to be obsessed with earnings. This is especially true for institutional investors who tend to overreact to slight earnings misses. However, these paper profits have the potential to be very misleading, which is why we prefer to focus on free cash flow.
In the last 12 months, Intuitive Surgical has recorded $1.74 billion in free cash flow, making it profitable by our definition. This indicates that the company doesn’t have to rely on equity raises to continue funding its growth.
Also, its free cash flow has been uptrending in the past few years. Its free cash flow was just $982 million in 2018. To us, this means that the company’s free cash flows are reasonably predictable.
Risks
To measure Intuitive Surgical’s risk, we will first check whether financial leverage is an issue. We do this by comparing its debt-to-free cash flow. Currently, this number stands at 0.05.
This is very low and is the benefit of being able to fund growth with its own free cash flow. As a result, debt is definitely not an issue that investors should be worried about.
However, there are other risks associated with the company. According to Tipranks’ Risk Analysis, Intuitive Surgical disclosed 46 risks in its most recent earnings report. The highest amount of risk came from the Legal & Regulatory category.
Overall, the company appears to have fewer risk factors than its sector average, meaning it is relatively less risky than its peers.
Valuation
Intuitive Surgical is undoubtedly a great business with a great future ahead of it. However, its current valuation is definitely not cheap. Its current price-to-free-cash-flow ratio is approximately 58x.
Assuming no change in stock price, this number is actually expected to rise in 2022 because free cash flow is expected to fall relative to 2021 before picking up again in 2023.
This is higher than its 10-year average of 45.6x, which is distorted to the upside because of the multiples it saw in the past two years during rock-bottom interest rates. As a result, this leaves the company more vulnerable during the current rate hike cycle.
Wall Street’s Take
Turning to Wall Street, Intuitive Surgical has a Moderate Buy consensus rating based on 13 Buys, six Holds, and one Sell rating assigned in the past three months. The average Intuitive Surgical price target of $330.11 implies 18% upside potential.
Analyst price targets range from a low of $230 per share to a high of $370 per share.
Final Thoughts
Intuitive Surgical is definitely a great company that has a track record of successful innovation. In addition, it is very profitable with low debt while maintaining a measurable competitive advantage.
Although it has the backing of Wall Street, which expects it to see more upside from here, the valuation appears to be too high for the current market conditions. This leaves the company prone to larger drawdowns as interest rates rise in an attempt to lower inflation.
As a result, analysts might be too optimistic at the moment, which is why we remain neutral on the stock.
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