Is the valuation Intuitive? (ISRG)

I've been thinking a little more about Intuitive Surgical (ISRG -- free real time quote from ADVFN)lately, as it continues to eke out small gains after the last two big jumps up on earnings releases. I'm excited to be an owner of this company and I think they're doing great things and will continue to grow very quickly, but the stock is incredibly richly valued right now -- do we have anything to worry about?

I bought ISRG three times this year and own what I consider to be a full position -- though I'm sometimes tempted to add more. If you want to read my prior writeups you can see them here, here, and here.

If you want an overview of where the company stands now, you might check out the Investor Presentation (PPT file) they released last month on their website, it has great information about their progress in various kinds of surgeries, their growth rate, and their goals for building the company. Also, if you have time, listen to the audio of CEO Lonnie Smith's presentation to the Stanford Entrepreneurial Though Leaders series (other talks from some interesting people are available through their podcast if you're interested). He talks from a presentation that migth be the same as the PPT file, but adds in a lot more detail.

One tidbit I picked up in that speech which I hadn't noticed before is that the recurring revenue stream is more predictable than I at first thought -- they design it to be that way, by selling instruments for the da Vinci that include chips that will prevent them from working after they've been used in 10 surgeries. I had thought that the instruments just gradually wore out or had to be replaced after a certain number of sterilizations, but it's interesting that the company builds specific obsolescence periods into the tools.

I think the main current issue that might be of concern for Intuitive Surgical owners, aside from the simple fact that the shares have risen so fast that they could fall equally quickly, is that insiders have engaged in quite a bit of selling over the past month.

In the main, this has been due to a few options exercises by the CEO and a couple directors, but there was one very large insider sale that has gathered some attention. Susan Barnes, the CFO, has sold off more than half of her very substantial holdings (she is still the second largest individual shareholder, with roughly 100,000 shares according to recent filings). I'm not too worried about that -- I assume that her sale is due to the fact that she was leaving the company, which was announced back on August 31st (apparently she has now left, since the announcement said she would leave in November).

And frankly, though I prefer to see lots of steadfast holdings by company leaders, I'm not that worried about the options exercises of CEO Lonnie Smith and some of the board members, either. Those of us who look at this company today as relatively new investors see incredible growth potential, and a pretty dramatic climb from $50 or so in the Spring to well over $100 now. Imagine if your frame of reference was the $15-20 range that the stock bounced around in for five years prior to this breakout -- I can see how the company insiders who saw the stock discounted for a variety of reasons for several years would want to get some of their hard-earned appreciation away from the vagaries of Wall Street.

If Intuitive Surgical is able to reach it's goal of placing da Vincis in 1,500 hospitals, with an average of three machines at each hospital, and the increased surgical volume that we assume would come with that and the high margin service and instrument income that follow, the company's size could be several times what it is today in a matter of, I think, several years.

ISRG's operating margin so far this year is 29%, even though we'd have to think that they are at the low end of their potential economies of scale. Their current market cap at today's price is about $4 billion. The eventual potential of the recurring revenue market if they've achieved their 4500 systems would be about $2.5billion annually, according to the company presentation.

I tried to look at a couple companies for comparison to see if we could make any guesses at proper valuation given those expected sales volumes and margins. Medtronic has a $67 billion market cap off about 11 billion in sales, and an operating margin of 33%. I think estimating that ISRG's operating margins would improve to at least that level is pretty conservative.

If we assume that the operating margin remains comparable and apply the same Price/sales ratio of 6 to ISRG, we'd have a market cap of $15 billion, almost 400% above where it is today.

Zimmer Holdings, for another comparison, has about the same operating margin right now of 33%, and about $3.5billion in sales from a $17 billion market cap, or roughly a 5X price/sales ratio. Given that same ratio ISRG would reach a 12.5 Billion market cap, roughly a 300% increase from today's level.

And that, of course, does not take into account the vast income ISRG would receive along the way to reaching it's goal of 4,500 installed systems and the ways in which they might reinvest that income into the company -- and while that growth in system sales doesn't come with quite the same great margins as the recurring revenue, it does bring much higher sales numbers at a little more than $1 million per system sold with their current pricing.

I also can't guess at the timeframe for reaching this "mature" level, or even whether ISRG will in fact make it to that point in it's current configuration (who knows, maybe GE will buy them next year -- somethings are totally unpredictable). The key variation for me is time -- if they are able to achieve this theoretical 300-400 percent return in five years, I'll be thrilled. Given the risks of the current high PE ratio that would be a more than fair return on investment of well over 30% a year. And maybe it's just my irrational exuberance for ISRG talking, but I think they might beat those goals by a significant amount by achieving significantly higher margins as a mature company servicing their massive installed of robots. Then again, it might take them ten years or longer to get there, which would mean current owners are not being nearly as well compensated.

It should be an interesting ride -- there obviously aren't any good comparisons for ISRG out there if you look at their business and the product and service they deliver. I just brought up Zimmer and Medtronic as some pretty stable, fairly valued medical device companies that might be valued somewhat similarly to a mature ISRG. That might not be a reasonable guess.

It's also certainly possible that Intuitive Surgical won't ever reach their goals of installing 4,500 systems, though as first movers and current monopoly holders in this segment I'd guess that to be a conservative goal, given the success of the systems in the limited scope of surgeries they have completed so far. After all, the baby boomers are just now moving into their prostate years -- and ISRG has just a 20% market share of prostatectomies. If their success over conventional surgeries continues to be this dramatic there will be few people willing to settle for a non-daVinci prostatectomy.

The population of the world is growing rapidly and the populations of our richest countries are aging rapidly -- medical care in general is a huge growth area, and I think robotic surgery is a star within that area.

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FARO in the doghouse

I've been an owner of FARO since January, with an average purchase price of about $27. Needless to say it hasn't been terribly pleasant watching this once highflying stock fall into disrepair this past Spring and Summer. I was a lot more optimistic about them in July, as I wrote about maybe trying to catch a falling knife, but things didn't turn around as I thought they might and I'm a little more concerned today.

This was a stock that came to my attention courtesy of Hidden Gems over at the Fool, though I no longer subscribe to that newsletter and am not privy to their current thoughts on it. Another Fool writer just wrote an interesting piece about selling FARO today, which brought it back out from the back of my brain where it had been stewing. I'm not necessarily giving up on Simon Raab and his cohort, but there's definitely concern in the air.

From outside, this looks like a situation where the founding science guys of a technology company had trouble with the business and competition side of things -- and especially with the job of managing market expectations. I don't know if that's a fair assessment, it's just my impression. Everything I've read tells me that the FARO arm is a significant tool with a great market and with a market leadership position in both sales and technology. And hey, Boeing just ordered a bunch more of them and they have a very deep and wide installed base of users and broad potential applications. That's the good news.

But everything I read lately tells me that this management is worrisome. Read the Fool piece above for a better take on this, but the basic gist is that Raab planned to ease out of his ownership position through a scheduled selling plan -- which is fine. But before it started to appear to outside investors that the wheels were coming off the bus, he accelerated that plan significantly and was able to sell at much better prices than we're seeing today.

I'm willing to give him some benefit of the doubt. I don't mind when founders and major insiders sell some of their holdings -- that's why you go public, after all, to make your fortune from the company you built. But given the fact that FARO was until their last earnings announcement still holding to an unrealistic earnings forecast for this year, It stinks of management propping up the stock price just long enough to get their own shares sold.

I certainly don't know that that's what they were doing -- but it definitely looks bad.

Just as I buy in chunks -- usually taking two or three purchases to build up a full position in a company -- so I often prefer to sell in chunks, too, and I'm going to look into FARO in much more detail to see whether it makes sense to sell a portion of my FARO holdings before the end of the year to offset some of my taxable gains. I'll let you know what I decide -- and if you're a FARO owner, too, let me know what you think.

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Shanda giving it away? (SNDA)

Shanda Interactive Entertainment has taken another clobbering today -- down another 13% as I type this note. Their online gaming competitors, Netease (NTES) are having a rough day, too, but in NTES' case it seems directly related to the changeover at the top of the company. NTES has brought the founder back in to serve as CEO, and apparently some investors don't approve.

I've written about Shanda and Netease a few times before, and while my NTES position is still in the black I bought SNDA at significantly higher prices than we're seeing right now -- my two positions were purchased at around $32 and $28, so I'm well under water with this one today.

There are two significant trends that seem to be moving Shanda down over the past few months -- fear of Chinese regulation, and fear that the Shanda pipeline won't replace the declining earnings of their headline games.

In the short term, I'd say that both of those things are certainly fears -- but of all the many gaming companies in China Shanda is arguably the closest to the government, so I'm not too worried about the government negatively impacting them in any significant way.

Much more at issue is whether Shanda's new licensed games from Actoz and the new Dungeons and Dragons MMPORPG will help to make up for the declining revelue from Mir II, the game that made Shanda but which is getting very old in the tooth. I'm certainly willing to wait to see how that plays out, especially given the other two big developments for Shanda recently.

It seems that the analysts are all quite afraid of Shanda's new strategy to be an entertainment and education platform in the Chinese home. Their new "EZ" strategy, which encompasses a set-top box and a handheld computer, both running on Intel architecture and developed by subcontractors, is designed to allow Shanda to provide fee-based entertainment, including games, music and television, and educational materials to Chinese homes. It's certainly a risky gamble -- it's going to take significant marketing to make it work, and it's going to start out as an upper class toy, given the prices the hardware suppliers are charging ... at least at first.

But if it works, this can help Shanda become much more central to the Chinese internet experience than any pure gaming company -- even if their games continue to be very successful, as we hope they will be. The "media center" PC hasn't been much of a hit in the US, but perhaps in a country with little cable TV and few home computers the computer can begin its service in the living room, instead of making the long and treacherous trek there from the den.

And on the gaming side the news today, the catalyst for sending the shares down so quickly, stands out as a very interesting experiment on which are riding the short-term revenues of the company. Shanda is taking advantage of declining competitiveness of some of its larger games to offer them for free and adopt a different business strategy. Instead of selling game playing time, which will now be given away for free, they will sell special features, special experiences, tools or toys for use in the game. This has been huge for some games -- notably the Kart Racer game in Korea -- and it might well work in China, I have no way of knowing.

But it is certainly going to make the earnings less predictable in the near future, and the company seems to think that it's very likely to reduce fourth quarter earnings.

For anyone who didn't listen to the last Shanda earnings conference call, the folks over at China Stock Blog have done a great service by putting the call and Q&A transcripts up online -- they're both worth a read. My impression of Chen Tiangtiao is still good, and I like the aggressive moves by the company to change the pricing structure even as they're moving to a much more diversified product offering and trying to take over the Chinese living room. They are clearly not motivated by the need to hit quarterly earnings numbers or achieve short-term results, but they do seem to have a solid long term plan for building a great company. Whether it will work is anyone's guess, but I'm willing to give them a long leash.

I won't be making any more buys or sells in Shanda until there is a lot more clarity in their prospects -- and that means I want to see a few quarters of this new pricing plan for their games, and the initial response to their EZ products and services. Until then, I'll hold my underwater shares and watch.

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