Intuitive Surgical, Inc. (ISRG)

Here's a Fool.com piece I wrote about ISRG:

http://www.fool.com/investing/high-growth/2009/04/21/wonderful-company-but-is-the-price-fair.aspx

Wonderful Company, but Is the Price Fair?
Brian Richards
April 21, 2009

Years from now, when we think back to the Great Stock Market Implosion of '08-'09, we'll remember the epic falls from grace at Bear Stearns, Lehman Brothers, Fannie Mae and Freddie Mac, Intuitive Surgical (Nasdaq: ISRG), AIG, Citigroup, et al.

… Wait, Intuitive Surgical?

How has a company with a four-year annualized earnings growth rate of 72% ended up among the hardest-hit victims of the credit crunch and bear market? Since Jan. 1, 2008, Intuitive Surgical has lost 61% of its value (at one point it was down 74%!); by comparison, the bailed-out disaster that is Bank of America (NYSE: BAC) is down 78% over that same time period.

A crucial difference
While the stock charts of Intuitive Surgical and B of A trend the same direction, the comparisons stop there. Whereas the banks, homebuilders, and insurers have been hurt because of deep-rooted problems in their businesses and industries, Rule Breakers pick Intuitive Surgical is down for only one reason: its formerly sky-high valuation.

At the end of 2007, Intuitive sported a price-to-earnings ratio of 104.9. The Triple-Digit P/E Alarm never sounded, leaving investors battered as a result.

The underlying business, though, was and remains excellent. In fact, as I was contemplating the business models of some of the juggernauts of American capitalism, I kept coming back to this $4.8 billion surgical robot maker from California. It boasts:

*A product that disrupts and revolutionizes a dull industry. Shining example: Amazon.com (Nasdaq: AMZN) and bookselling.
*A market with high barriers to entry. Shining example: Amgen (Nasdaq: AMGN) in a biotechnology market that requires heavy R&D and patent protection.
*A near monopoly in its niche. Shining example: Microsoft (Nasdaq: MSFT) in software.
*Macro tailwinds in its industry. Shining example: ExxonMobil (NYSE: XOM) over the past hundred years, as the world industrialized and Americans took to their automobiles.
*Predictable, recurring revenue from a "razor blade" model. Shining example: Gillette (now a unit of Procter & Gamble (NYSE: PG)) and its, er, razor blade model -- sell the razor, and keep 'em buying the blades.

Imagine those traits combined in a single company:

*Disruptive product: The da Vinci robot benefits patients, doctors, hospitals, and insurers -- a rare win-win-win-win.
*High barriers: Intuitive owns or has use of more than 600 U.S. and foreign patents, as well as FDA approvals.
*Near monopoly: Intuitive acquired its closest competitor several years ago. At the end of 2008, the company had more than $200 million in free cash flow, but as my colleague Devon Rackle recently wrote, management indicated that "there was no other company it could acquire that would provide any strategic advantage." Intuitive's the only game in town for robot-assisted surgeries.
*Macro tailwinds: Americans spent $2.3 trillion on health care in 2007 -- 16% of GDP! The trend ever higher is clear, as 78 million baby boomers approach (or are in) retirement. Moreover, President Obama has made health care a priority for his administration, so the industry has full governmental support.
*Predictable revenue: Innovating, manufacturing, and selling the da Vinci systems is not inexpensive. But the beauty of Intuitive Surgical's business is that only about half its revenue comes from the one-time system sales. "Instruments and accessories" -- i.e., the razor blades -- accounted for a third of 2008 sales, while the fat-margin "service agreements" made up another 15%. Most importantly, these two segments were predicted to grow between 25% and 35% in 2009, while systems sales stay flat (not bad in this economy).

Apologies for all the bullet points
Fast growth in a strong industry ... with predictable, wide-margin recurring revenue. This business is simple -- you could draw the model on the back of an envelope -- yet dominant.

So it's easy to get excited about the company, as fellow Fool Anders Bylund did in January: "Intuitive Surgical's moat isn't just wide. It's filled with triflic acid and mutant carnivorous plesiosaurs, surrounded by electrified razor wire, and patrolled 24/7 by veterans of the French Foreign Legion. … This business fears no competitor and has no peers."

The right side of the SWOT ledger
Now it's time for a dash of cold water: There are weaknesses and threats to Intuitive Surgical's model. (And we can't afford to overlook that half of the SWOT -- strengths, weaknesses, opportunities, and threats -- model.)

Fools shouldn't overlook its position in an intensely regulated industry, where it must seek governmental approval from the FDA and protection for its patents. Intuitive also carries a big reputational risk: If one of its robots should ever prove defective, the company could not only face legal liabilities, but also suffer permanent damage to its brand and sterling reputation.

There's also the concern of outsiders entering the space: Deep-pocketed health-care conglomerates, upstart Rule Breakers taking aim at the market leader, or even lower-cost medicines that could achieve what only surgery can today.

The Foolish bottom line
Even with these potential threats, Intuitive Surgical has a wonderful business model and lots of room to run.

Warren Buffett has famously said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

I believe Intuitive is a wonderful company. Prospective investors will have to decide whether 24.6 times earnings -- its current multiple -- constitutes a "fair price."