March 17, 2015 Intuitive Surgical Inc. Current Recommendation Prior Recommendation SUMMARY DATA NEUTRAL Outperform Date of Last Change 03/21/2013 Current Price (03/16/15) $506.82 Target Price $532.00 52-Week High $540.63 52-Week Low $352.35 One-Year Return (%) 18.80 Beta 0.75 Average Daily Volume (sh) 193,941 Shares Outstanding (mil) 37 Market Capitalization ($mil) $18,669 Short Interest Ratio (days) 4.32 Institutional Ownership (%) 91 Insider Ownership (%) 4 Annual Cash Dividend $0.00 Dividend Yield (%) 0.00 5-Yr. Historical Growth Rates Sales (%) 14.0 Earnings Per Share (%) 15.2 Dividend (%) N/A using TTM EPS 38.6 using 2015 Estimate 35.0 using 2016 Estimate 29.1 Zacks Rank *: Short Term 1 3 months outlook * Definition / Disclosure on last page 5 - Strong Sell (ISRG-NASDAQ) SUMMARY Intuitive Surgical crushed the Zacks Consensus Estimate for both earnings and revenues in the fourth quarter of 2014. However, EPS of $4.18 declined 4.1% from the year-ago quarter primarily due to contraction in gross and operating margins, despite a 4.3% increase in revenues. A tight hospital spending environment, unfavorable product mix, headcount additions and higher incentive expenses negatively impacted profitability. Management expects unfavorable product mix and a strong U.S. dollar to continue to hurt gross margins. Operating expenses are also expected to increase owing to continued investments in product development. Nevertheless, growing adoption of the Da Vinci system among physicians for general surgery, oncology, urology and gynecology procedures is a key growth catalyst in our view. The recent contract win from the department of defense is also a major positive. Moreover, increasing International procedure volumes presents significant growth opportunity. Further, we believe that the upcoming Xi compatible Da Vinci SP product launch will expand the company s product portfolio. Risk Level * Type of Stock Low, Large-Growth Industry Med Instruments Zacks Industry Rank * 150 out of 267 ZACKS CONSENSUS ESTIMATES Revenue Estimates (In millions of $) Q1 Q2 Q3 Q4 Year (Mar) (Jun) (Sep) (Dec) (Dec) 2013 611 A 579 A 499 A 576 A 2,265 A 2014 465 A 512 A 550 A 605 A 2,132 A 2015 536 E 578 E 577 E 650 E 2,341 E 2016 2,586 E Earnings Per Share Estimates (EPS is operating earnings before non-recurring items, but including employee stock options expenses) Q1 Q2 Q3 Q4 Year (Mar) (Jun) (Sep) (Dec) (Dec) 2013 $4.56 A $3.99 A $3.99 A $4.28 A $16.82 A 2014 $2.67 A $2.77 A $3.24 A $4.18 A $13.12 A 2015 $2.93 E $3.55 E $3.59 E $4.43 E $14.50 E 2016 $17.41 E Projected EPS Growth - Next 5 Years % 9.2 2015 Zacks Investment Research, All Rights reserved. www.zacks.com 10 S. Riverside Plaza, Chicago IL 60606
OVERVIEW Intuitive Surgical Inc (ISRG) designs, manufactures and markets the da Vinci surgical system and related instruments and accessories, which is an advanced robot-assisted surgical system. The surgical system comprises a surgeon s console, patient-side cart, 3-D vision system, da Vinci Skills Simulator and Firefly Fluorescence Imaging. The da Vinci surgical system translates a surgeon s natural hand movements on instrument controls at a console into corresponding micro-movements of instruments positioned inside the patient through small puncture incisions, or ports. The system enhances a surgeon s intuitive control, wrist movements and fine tissue manipulation capability. The system provides 3-D High Definition vision, which helps surgeons gain superior visual clarity of target tissue and anatomy. To date, the company has commercialized four generations of da Vinci surgical systems, namely, da Vinci standard (1999), da Vinci S (2006), da Vinci Si (2009) and da Vinci Xi (Apr 2014). Accessories available with da Vinci surgical systems are EndoWrist Instruments, da Vinci Single-Site, Single-Site needle driver product, EndoWrist One Vessel Sealer, EndoWrist Stapler 45 Instrument and Accessory products. In 2014, the company s revenues declined 5.9% year over year to $2.13 billion. REASONS TO BUY Intuitive Surgical s da Vinci surgical system enables minimally invasive surgery that helps overcome the trauma faced by patients in open surgery. Minimally invasive surgery is becoming increasingly popular as it helps patients recover faster, thereby reducing hospitalization costs. Although high price of the da Vinci system may hinder its widespread adoption, we believe that the overwhelming benefits of minimally invasive surgery will compel surgeons and patients to use the system. This will drive the company s system sales thereby improving top-line growth in the long run. Intuitive Surgical keeps innovating new technologies for its surgical systems. The latest da Vinci Xi robotic surgical system has longer instrument shafts enabling greater reach for surgery. The robotic arms of the system are also smaller and thinner and have a new joint design that improves their range of motion. The system also includes an overhead instrument arm design providing surgeons anatomical access from most of the positions. We believe that the upgraded system will drive penetration into the minimally invasive surgery market over the long term. Intuitive Surgical s business model ensures that it continues to generate revenues following the initial sale of the da Vinci surgical system. Recurring revenues, as a proportion of total revenues (70% in 2014 versus 63% in 2013) continue to grow at a much higher rate as compared with system sales. This ensures a regular stream of income even in testing times. Moreover, Intuitive Surgical operates in a niche market with no direct competition, which is a major positive in our view. Of late, Intuitive Surgical has been receiving a number of clearances for advanced technologies that enhanced the capabilities of the da Vinci system. In Jun 2014, the company received the U.S. Food and Drug Administration (FDA) approval for the EndoWrist One Vessel Sealer instrument of the da Vinci Xi System. The EndoWrist Sealer is a fully wristed instrument than can be used for sealing and cutting vessels up to 7 mm in diameter and tissue bundles that fit in the jaws of the instrument. In July, the company received FDA approval for the EndoWrist Stapler 45 and Stapler white, blue and green reloads, which can be used with the da Vinci Xi. Following this, in August, the company Equity Research ISRG Page 2
received FDA clearance for using Firefly as an optional feature in da Vinci Xi. The go-ahead will help surgeons identify blood flowing in vessels and tissue during minimally invasive surgical procedures. In Sep, 2014, the company received FDA clearance for Single-Site Wristed Needle Driver for use in single-incision surgery with the company s da Vinci Si system. REASONS TO SELL Intuitive Surgical faces the risk of adoption of its procedures. Adoption growth takes time, as each procedure needs to gain credibility. Furthermore, broad use of Intuitive Surgical s products requires training of surgical teams. Market acceptance could be delayed by the time required to complete such training. The da Vinci Surgical System has a long sale and purchase order cycle as it is a major capital investment for hospitals that requires the approval of senior management at purchasing institutions. The time lag may act against the interests of the company. Intuitive Surgical faces the risk of lower capital spending by hospitals particularly during the current changes emanating from healthcare reform in the U.S. and austerity measures in Europe. Thus, a major source of risk is pricing pressure. Austerity measures in Europe have targeted hospital capital expenditure as a source of cost savings. In the U.K., the budget has shifted the focus from capital expenditures to operations in order to protect health benefits. European customers are therefore expected to gravitate toward low-end systems. Further, healthcare reform-oriented reimbursement pressure would negatively affect Intuitive Surgical. The implementation of the medical device excise tax of 2.3% on U.S. sales of medical products from Jan 2013 has increased Intuitive Surgical s operating expenses and is hindering the company s profitability. The new law or any future legislation can reduce medical procedure volumes, lower reimbursement, and impact the demand or price of the company s products. RECENT NEWS Intuitive Surgical Q4 Highlights Intuitive Surgical reported fourth-quarter 2014 adjusted EPS (including stock-based compensation) of $4.18, which steered past the Zacks Consensus Estimate by $0.75. However, EPS declined 4.1% from the year-ago quarter primarily owing to contraction in gross and operating margins. Revenues Revenues (including the impact of the Xi trade-out program) increased 4.3% year over year to $600.8 million, which was much better than the Zacks Consensus Estimate of $585 million. The year-over-year growth was attributable to robust performance across all the business segments. Instruments and Accessories revenues grew 4.5% to $280 million in the quarter. Global da Vinci procedures grew approximately 10% on a year-over-year basis driven by higher general surgery procedures (up 33%) and worldwide urologic procedures (21%). Equity Research ISRG Page 3
Revenues realized per procedure were approximately $1,830, down from $1,930 in the year-ago quarter. The decline can be primarily attributed to unfavorable customer buying pattern (fewer stocking orders) and temporary withdrawal of the da Vinci Si Stapler systems from the market. The withdrawal resulted from three intraoperative instrument failures, which have however been solved by Intuitive Surgical in the quarter. Systems revenues increased almost 3% to $211 million. Intuitive Surgical shipped 137 da Vinci Surgical Systems, one less than the number shipped in the year-ago quarter. Sales of da Vinci Xi System moved up to 97 units from 59 units in the previous quarter. Globally, system average selling price (ASP) increased to $1,550,000, primarily on favorable product mix (higher number of Xi s). Hospital financed approximately 15% of the systems, down from 27% in the third quarter. Intuitive Surgical directly financed 12 systems of which 5 were structured as operating leases. Through the fourth quarter of 2014, the company entered into 14 operating leases. Intuitive Surgical placed 71 systems in the U.S. during the quarter compared with 72 systems in the yearago quarter. Outside the U.S., the company placed 66 systems. The same number of systems was placed in the year-ago quarter. Among the fourth quarter 2014 lot, 39 systems were placed into Europe, up from 28 in the year-ago quarter. The company also placed 9 systems in Italy, 7 in Turkey and 5 into the Nordic countries. However, placements declined in Japan from 21 to 6, which reflected customers awaiting Xi clearance and reimbursement issues. Services revenues were up 6.4% to $110 million. The improvement reflected growth in the installed base of da Vinci Surgical Systems. Margins Adjusted gross margin contracted 370 basis points (bps) to 65.7% in the quarter, primarily due to unfavorable product mix. Selling, General & Administrative (SG&A) expenses, as percentage of revenues, increased 100 bps on a year-over-year basis owing to headcount additions and higher incentive compensation. Research & Development expenses, as percentage of revenues, increased 60 bps from the year-ago quarter. Adjusted operating margin declined 440 bps to 32.6% on a year-over-year basis, primarily owing to a lower gross margin base and higher operating expenses. Product Updates During the quarter, Intuitive Surgical re-launched da Vinci Si Stapler and started shipping the product early in the first quarter of 2015. The company also initiated the shipment of Xi Stapler in the first quarter. In the fourth quarter, Intuitive Surgical launched its Wristed Needle Driver instrument for use with Single Site surgery. In 2015, Intuitive Surgical plans to submit a 510 (k) for software that allows coordinated table motion with the Xi and 510 (k) for a Xi compatible version of its Single Site instrument. Equity Research ISRG Page 4
Balance Sheet Intuitive Surgical had cash, cash equivalents and investments of $2.5 billion as of Dec 31, 2014 as compared with $2.26 billion as of Sep 30. Notably, during 2014, Intuitive Surgical bought 2.5 million shares for $1 billion. Guidance Intuitive Surgical forecasts 2015 procedural volumes in the range of 7% to 10%. The company also apprehends foreign exchange headwinds from the strengthening of the U.S. dollar. Management expects 2015 gross margin to be more or less in line with the fourth-quarter figure owing to unfavorable product mix and foreign exchange headwinds. Management forecasts operating expense increase in the range of 7% to 10% for full-year 2015, taking into account continued investments being made by the company. Recent News On Feb 2, 2015, Intuitive Surgical announced a new share buyback program worth $1 billion. Management plans to fund the new program through cash and investments, which amounted to $2.5 billion at the end of 2014. We believe that the new share buyback program will boost the company s bottom line in 2015. On Mar 2, 2015, the U.S. Department of Defense (DOD) announced that Intuitive Surgical was awarded a contract (worth a maximum of $430 million) to supply da vinci surgical systems to the Defense Logistics Agency. The devices will be used in government hospitals by Army, Navy, Air Force, Marine Corps, and federal civilian agencies. Equity Research ISRG Page 5
VALUATION Intuitive Surgical shares are currently trading at 38.6X TTM earnings, a discount to the peer group average of 45.6X but at a premium as compared with S&P 500 average of 18.2X. The stock is trading slightly above the mid-point of the historical range of 22.2X to 49.2X TTM earnings. The stock is trading at 35X, a 71.9% discount based on our 2015 forward estimates. Key Indicators F1 F2 Est. 5-Yr EPS Gr% P/CF 5-Yr High 5-Yr Low Intuitive Surgical, Inc. (ISRG) 35.0 29.1 9.2 32.3 38.6 49.2 22.2 Industry Average 124.6 32.9 18.4 31.0 45.6 160.4 32.0 S&P 500 16.6 15.4 10.7 14.5 18.2 18.4 12.0 Edwards Lifesciences Corp. (EW) 35.4 31.5 15.1 35.5 42.5 47.0 20.8 HOLOGIC INC (HOLX) 20.8 19.1 8.1 9.6 20.8 20.8 12.0 Teleflex Incorporated (TFX) 19.2 16.8 11.2 13.1 21.0 21.2 12.3 Elekta AB (EKTAY) 18.0 15.9 9.0 14.9 24.4 31.5 25.1 TTM is trailing 12 months; F1 is 2015 and F2 is 2016, CF is operating cash flow Intuitive Surgical, Inc. (ISRG) P/B Last Qtr. P/B 5-Yr High P/B 5-Yr Low ROE D/E Last Qtr. Div Yield Last Qtr. EV/EBITDA 5.4 7.9 3.8 15.0 0.0 0.0 28.0 Industry Average 5.9 5.9 5.9-773.9 0.1 0.0-763.3 S&P 500 6.2 9.8 3.2 25.4 N/A 2.0 N/A Equity Research ISRG Page 6
Earnings Surprise and Estimate Revision History Equity Research ISRG Page 7
DISCLOSURES & DEFINITIONS The analysts contributing to this report do not hold any shares of ISRG. The EPS and revenue forecasts are the Zacks Consensus estimates. Additionally, the analysts contributing to this report certify that the views expressed herein accurately reflect the analysts personal views as to the subject securities and issuers. Zacks certifies that no part of the analysts compensation was, is, or will be, directly or indirectly, related to the specific recommendation or views expressed by the analyst in the report. Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Because of individual objectives, the report should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions expressed herein are subject to change. This report is not to be construed as an offer or the solicitation of an offer to buy or sell the securities herein mentioned. Zacks or its officers, employees or customers may have a position long or short in the securities mentioned and buy or sell the securities from time to time. Zacks uses the following rating system for the securities it covers. Outperform- Zacks expects that the subject company will outperform the broader U.S. equity market over the next six to twelve months. Neutral- Zacks expects that the company will perform in line with the broader U.S. equity market over the next six to twelve months. Underperform- Zacks expects the company will under perform the broader U.S. Equity market over the next six to twelve months. The current distribution of Zacks Ratings is as follows on the 1130 companies covered: Outperform - 15.1%, Neutral - 75.0%, Underperform 9.0%. Data is as of midnight on the business day immediately prior to this publication. Our recommendation for each stock is closely linked to the Zacks Rank, which results from a proprietary quantitative model using trends in earnings estimate revisions. This model is proven most effective for judging the timeliness of a stock over the next 1 to 3 months. The model assigns each stock a rank from 1 through 5. Zacks Rank 1 = Strong Buy. Zacks Rank 2 = Buy. Zacks Rank 3 = Hold. Zacks Rank 4 = Sell. Zacks Rank 5 = Strong Sell. We also provide a Zacks Industry Rank for each company which provides an idea of the near-term attractiveness of a company s industry group. We have 264 industry groups in total. Thus, the Zacks Industry Rank is a number between 1 and 264. In terms of investment attractiveness, the higher the rank the better. Historically, the top half of the industries has outperformed the general market. In determining Risk Level, we rely on a proprietary quantitative model that divides the entire universe of stocks into five groups, based on each stock s historical price volatility. The first group has stocks with the lowest values and are deemed Low Risk, while the 5 th group has the highest values and are designated High Risk. Designations of Below-Average Risk, Average Risk, and Above-Average Risk correspond to the second, third, and fourth groups of stocks, respectively. Equity Research ISRG Page 8