Do Not Confuse a Great Company With a Great Invesment

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Intuitive Surgical (NASDAQ: ISRG), appears to be amongst todays best examples of  how to separate a great company from a great investment. These two can be very different.

Intuitive Surgical is a $22 billion company in the “Medical Instruments in Suppliers” industry, and  a market leader in the field of robotics-assisted minimally invasive surgery.  This technique has advantages of lesser tissue damage, fewer complications, and shorter recovery times. First mover advantage and a large installed base of its da Vinci system provides Intuitive Surgical with a wide economic moat and barriers to entry

 Allowing growth while preserving pricing power:  

With initial applications in prostatectomy, new growth areas include hysterectomy as well as urological and gynecological procedures. Going forward the large installed base will generate continued instrument sales and service revenue while providing the clinical case history sought by surgeons and hospital administrators

Competition would require a substantial technology or price advantage to gain entry into this niche, which are currently not visible on the horizon.

Demonstrated strong financials:

With free cash flows being >30% of revenue and RoIC in excess of 20%. The company has a strong balance sheet with no debt and nearly $2.0 billion in cash and liquid investments – adequate to fund future growth and investment.

In comparison with the industry it may be appropriate to look at  competitors in both Medical Equipment and Supplies Industries – Baxter International (NYSE: BAX), Covidien (NYSE: COV), Varisan Medical Systems (NYSE: MDT) – as well as the Medical Devices industry: Medtronic (NYSE: MDT). At the same time while GE (NYSE: GE) maybe a direct competitor, review across financial metrics may not be comparable given the conglomerate nature of its business.

  • Cash flow as % of sales: Intuitive, at 30%, is 2x the ratios for all competitors
  • RoIC: Intuitive, at  20%+, is higher than large competitors in both the Medical Equipment and Supplies and Medical devices industry as well as comparable to the higher ratios of mid sized companies.

 

<table> <tbody> <tr> <td> <p><strong>Company</strong></p> </td> <td> <p><strong>Ticker</strong></p> </td> <td> <p><strong>Free cash flow</strong></p> <p><strong> % Sales</strong></p> </td> <td> <p><strong>RoIC</strong></p> </td> </tr> <tr> <td> <p><strong>Intuitive Surgical Inc</strong></p> </td> <td> <p><strong>ISRG</strong></p> </td> <td> <p><strong>30 – 35%</strong></p> </td> <td> <p><strong>20%+</strong></p> </td> </tr> <tr> <td> <p>Baxter International</p> </td> <td> <p>BAX</p> </td> <td> <p>12 – 15%</p> </td> <td> <p>17 – 20%</p> </td> </tr> <tr> <td> <p>Covidien plc</p> </td> <td> <p>COV</p> </td> <td> <p>15%</p> </td> <td> <p>10 – 12%</p> </td> </tr> <tr> <td> <p>Varian Medical Systems</p> </td> <td> <p>VAR</p> </td> <td> <p>15%</p> </td> <td> <p>25 – 30%</p> </td> </tr> <tr> <td> <p>Medtronic Inc</p> </td> <td> <p>MDT</p> </td> <td> <p>20 – 22%</p> </td> <td> <p>10 – 12%</p> </td> </tr> <tr> <td> <p>GE</p> </td> <td> <p>GE</p> </td> <td> <p>10 – 15%</p> </td> <td> <p>< 1%</p> </td> </tr> </tbody> </table>

 

But current Valuation is very steep:  

At the current price of $583, ISRG appears to be at a very high valuation on both intrinsic and relative bases.

  • Intrinsic value: Based on Morninstar analysis – Intuitive currently trades at a significant multiple of its fair value (165% vs competitors being around 80%).
  • Relative value: Similarly it trades at a forward PE of 26.5x, nearly double the multiples for competitors.

 

<table> <tbody> <tr> <td> <p><strong>Company</strong></p> </td> <td> <p><strong>Ticker</strong></p> </td> <td> <p><strong>Price / </strong></p> <p><strong>Fair Value </strong></p> </td> <td> <p><strong>Forward </strong></p> <p><strong>PE</strong></p> </td> <td> <p><strong>PEG </strong></p> <p><strong>ratio</strong></p> </td> <td> <p><strong>PEG </strong></p> <p><strong>Payback</strong></p> </td> </tr> <tr> <td> <p><strong>Intuitive Surgical Inc</strong></p> </td> <td> <p><strong>ISRG</strong></p> </td> <td> <p><strong>$ 575/ 343</strong></p> <p><strong>= 165%</strong></p> </td> <td> <p><strong>26.5x</strong></p> </td> <td> <p><strong>1.2x</strong></p> </td> <td> <p><strong>8.8 yrs</strong></p> </td> </tr> <tr> <td> <p>Baxter International</p> </td> <td> <p>BAX</p> </td> <td> <p>$ 67 / 65</p> <p>= 105%</p> </td> <td> <p>12.8x</p> </td> <td> <p>1.4x</p> </td> <td> <p>7.8 yrs</p> </td> </tr> <tr> <td> <p>Covidien plc</p> </td> <td> <p>COV</p> </td> <td> <p>$ 62 / 76</p> <p>= 80%</p> </td> <td> <p>12.1x</p> </td> <td> <p>1.6x</p> </td> <td> <p>7.8 yrs</p> </td> </tr> <tr> <td> <p>Varian Medical Systems</p> </td> <td> <p>VAR</p> </td> <td> <p>$ 70 / 84</p> <p>=80%</p> </td> <td> <p>14.5x</p> </td> <td> <p>1.3x</p> </td> <td> <p>8.1 yrs</p> </td> </tr> <tr> <td> <p>Medtronic Inc</p> </td> <td> <p>MDT</p> </td> <td> <p>$ 46 / 48</p> <p>= 95%</p> </td> <td> <p>11.7x</p> </td> <td> <p>2.7x</p> </td> <td> <p>8.7 yrs</p> </td> </tr> <tr> <td> <p>GE</p> </td> <td> <p>GE</p> </td> <td> <p>$ 22 / 25</p> <p>= 85%</p> </td> <td> <p>11.4x</p> </td> <td> <p>1.1x</p> </td> <td> <p>6.9 yrs</p> </td> </tr> </tbody> </table>

(*) Fair Value using Morninstar estimates.

Conclusion

As Warren Buffett famously said on the rules for investing: Rule #1: Never lose money. Rule #2: Never forget Rule #1.  Always have a “margin of safety.”

ISRG is market leader with a wide economic moat in an attractive industry allowing growth while preserving pricing power – with healthy free cash flows and strong RoIC. Analysts expect 20% growth over the next 5 years.

But the valuation is very steep and does not allow for (a.) strong protection against downside risk, nor (b.) a good chance at earning high returns

Investment 101: Avoid the mistake of confusing a great company with a great investment – the two can be very different. 

<table> <tbody> <tr> <td> <p><strong>High Free Cash Flow/ Low RoIC</strong></p> <p><strong> </strong></p> <p><strong> </strong></p> </td> <td> <p><strong>High Free Cash Flow/ High RoIC</strong></p> <p><strong> </strong></p> <p>Less Risky Companies</p> <p>(<em>BUT Stocks maybe Risky if Valuations High)</em></p> <p><strong> </strong></p> <p><strong> </strong></p> </td> </tr> <tr> <td> <p><strong>Low Free Cash Flow/ Low RoIC</strong></p> <p><strong> </strong></p> <p>More Risky Companies</p> <p>(<em>speculative</em>)</p> <p><strong> </strong></p> <p><strong> </strong></p> </td> <td> <p><strong>Low Free Cash Flow/ High RoIC</strong></p> <p><strong> </strong></p> <p><strong> </strong></p> </td> </tr> </tbody> </table>

 

 


yourrule72 has no position in any stocks mentioned. The Motley Fool recommends Covidien and Intuitive Surgical. The Motley Fool owns shares of General Electric Company, Intuitive Surgical, and Medtronic. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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