Feb 11, 2012

Yes, my first position belongs to the '10 times revenue club' ... but is not Facebook

As my beloved readers know well, I have a 'value-soul' but it is not rare to find in my portfolio a good number of 'growthy' stocks, whose valuation are, well, all but cheap.
One of those stock is Intuitive Surgical, Inc. (ISRG) and it is now my first position (less than 15%).
The '10 times revenue club' I mention in the title is a reference (maybe, a tribute) to a great post written by William Gurley, general partner at Benchmark Capital, where he warns of the risk of re-playing the mentality in vogue during the 'dot.com' bubble in the late 90s: "(...) Calculating or qualifying potential valuation using the simplistic and crude tool of a revenue multiple (also known as the price/revenue or price/sales ratio) was quite trendy back during the Internet bubble of the late 1990s. Perhaps it is not peculiar that our good friend the price/revenue ratio is back in vogue. But investors and analysts beware; this is a remarkably dangerous technique, because all revenues are not created equal".
Just to contextualize the numbers, I have listed below the average values (here I have used ev/sales in order to correct the numerator, p, or market cap, for the net cash or debt position of each company) for sectors (GICS) represented in the S&P 500:
Consumer Discretionary 1.7, Consumer Staples 1.8, Energy 2.9, Financials 5.0, Health Care 2.3, Industrials 1.6, Information Technology 2.7, Materials 1.8, Telecommunication Services 2.3, Utilities 2.2 --> average value S&P 500 = 2.6
So, 'our' ISRG, with its 9.7, is a stock with an ev/sales of 9.7, more than 4 times the average of its sector (health care) and one of the most expensive stock in the entire S&P 500.

But now, before talking about valuation and explain why and if ISRG 'deserve' this kind of valuation, I'll go straight on the recently published 10-K that cover the fiscal year ended December 31, 2011, where I'll detail the most important lines in order to understand the business.

"Intuitive designs, manufactures and markets da Vinci Surgical Systems and related instruments and accessories (...). This new generation of surgery, which we call da Vinci Surgery, combines the benefits of minimally invasive surgery (MIS) for patients with the ease of use, precision and dexterity of open surgery. A da Vinci Surgical System consists of a surgeon’s console, a patient-side cart and a high performance vision system. The da Vinci Surgical System translates a surgeon’s natural hand movements, which are performed on instrument controls at a console, into corresponding micro-movements of instruments positioned inside the patient through small incisions, or ports (...)".
This is the list with features and benefits they tell they provide to surgeons:
- Immersive 3-D Visualization;
- Intuitive Instrument Movements "(...) in conventional MIS, the instrument tip moves in the opposite direction from the surgeon’s hand and surgeons must adjust their hand-eye coordination to translate their hand movements in this “backward” environment";
- EndoWrist Instruments;
- Scaled, Tremor Filtered Instrument Movement
- Improved Surgeon Ergonomics  "(...) is designed to allow surgeons to operate while seated, which may be clinically advantageous because of reduced surgeon fatigue". 
- Precise and Tremor-Free Endoscope Control;
da Vinci Surgical System:
- Surgeon’s Console;
- Patient-Side Cart;
- 3-D Vision System;
- Firefly Fluorescence Imaging;
- da Vinci Skills Simulator: "(...) the simulator is a practice tool which began shipping in early 2011 for the da Vinci Si Surgical System that gives a user the opportunity to practice his or her facility with the surgeon console controls". This is in my opinion a very interesting tool because it opens to a wider universe of surgeons the possibility to use this system so that hospitals can increase the number of procedures per system.
Instruments and Accessories
- EndoWrist Instruments;
- da Vinci Single-Site;
- EndoWrist One Vessel Sealer;
- Accessory Products.
Patient Value = Efficacy/Invasiveness
Surgeon Value = Patient value + repeatable, teachable, and reliable
Hospital Value = Patient value + surgeon value + economic benefit
These three equations (taken from p. 5, ISRG's Q1 2012 presentation) actually explain well that by reducing the trauma --> narrowing recovering times --> this solution add value both to the patient (less pain) and to the hospital (less costs and less complications after surgery).
As a result, ISRG is now trying to expand its business by converting a significant percentage of 'older' open procedures to da Vinci Surgery.

ISRG is focused on five surgical specialties even if over 90% of the procedures performed were in the urologic and gynecologic specialties.
Below is the list of procedures:
- Urologic Surgery: Prostatectomy, Partial Nephrectomy, Pyeloplasty.
- Gynecologic Surgery: Hysterectomy, Myomectomy, Sacral Colpopexy, Endometriosis Resection.
- Cardiothoracic Surgery: Mitral Valve Repair, Thoracic Surgery.
- General Surgery: Colorectal Surgery, Gastric Bypass.
- Head and Neck Surgery: Transoral Surgery, Thyroidectomy.
"As of December 31, 2011, we had an installed base of 2,132 da Vinci Surgical Systems. During the year ended December 31, 2011, we estimate that surgeons using our technology completed approximately 360,000 surgical procedures of various types in major hospitals throughout the world. Of those da Vinci procedures performed in 2011, we estimate that approximately 146,000 were da Vinci Hysterectomy (dVH) procedures and approximately 113,000 were da Vinci Prostatectomy (dVP) procedures". Just to give you an idea of the growth ahead, ISRG is estimating an addressable market of 2,000,000 procedures, of which, in U.S. only: Urology 150,000, Gynecology 500,000 (ISRG's Q1 2012 presentation, p. 17).

"No one customer accounted for more than 10% of revenue during the years ended December 31, 2011, 2010 and 2009. As of December 31, 2011, we had approximately 790 employees in our field sales and service organizations (...)".

R&D expenses:
2011: $140.2 million
2010: $116.0 million
2009: $95.1 million
Sunnyvale, California and Mexicali, Mexico

"Open surgery, conventional MIS in complex cases, drug therapies, radiation treatment and emerging interventional surgical approaches".

These are in my opinion two of the reasons ISRG has a 'wide economic moat': in fact, (1) they have more than 1,000 patents that are behind its system, (2) they are subject to regulation by FDA and other foreign body of international standards, so that a new entrant should not only spend a lot in R&D but it would have to wait (a lot) for accreditation.

Here reside one of the main risks. Whenever the procedures performed by hospitals and physicians are considered medically necessary, they are eligible for reimbursement from the government and insurance companies and so if there is more uncertainty relating to the amount reimbursed (particularly in this period of government budget constrains) this could represent a threat to ISRG's growth.

1,924 employees
1,057 marketing, sales, and administrative activities
609 manufacturing and service
258 R&D
And now, finally, is the time to talk about numbers.
Instruments and accessories
  $701.1  $528.8  $389.4  
  777.8  660.3  490.5  

Total product revenue
  1,478.9  1,189.1  879.9  
  278.4  223.9  172.3  

Total revenue
  $1,757.3  $1,413.0  $1,052.2  

Recurring revenue
  979.5  752.7  561.7  
% of total revenue
  1,378.7  1,126.0  827.0  
  378.6  287.0  225.2  

Total revenue
  1,757.3  1,413.0  1,052.2  

The revenue growth is impressive, around 30% YoY, and we have to consider the credit and the sovereign debt issues of the last years! But the very interesting fact is the recurring side of the revenue: looking at the higher growth from the recurring revenue, we can deduct that, at the limit, after establishing a da Vinci machine everywhere, what really will drive their future growth will be 'procedure growth'. In fact, converting a significant percentage of 'older' open procedures to da Vinci Surgery will mean that the customer is 'forced' to buy the instruments and accessories needed to perform a procedure --> the 'razor-blade' side of this razor-razor blade business model.
Now, how much I'm going to pay to be a shareholder in this business (@ price of 510$ and an EV of 18.8 bln $, 02/14/2012)? These are the last cash flow numbers (from Morningstar):

2011-12 2010-12 2009-12 2008-12 2007-12
Operating cash flow 678 528 385 278 206
Capital expenditure -83 -96 -53 -106 -24
Free cash flow 595 432 332 172 182

Ocf (YoY Gr.) 28,4% 37,1% 38,5% 35,0%
Fcf (YoY Gr.) 37,7% 30,1% 93,0% -5,5%

... well, exactly 30 times the last free cash flow number BUT for a growth of 30%!
Is this growth sustainable? Probably not, but for a 'wide moat' business that is establishing itself as a new standard for surgery I think that the probability it will be around in the next 10-20 years are high. As W. Buffett is quoted to have said in the Berkshire Hathaway 1999's meeting "(...) Our own emphasis is on trying to find businesses that are predictable in a general way as to where they'll be in 10 or 15 or 20 years. That means we look for businesses that in general aren't going to be susceptible to very much change. We view change as more of a threat investment-wise than an opportunity". In our case, the change is disruptive for the old procedure and seems to be good for Intuitive Surgical.

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