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Why Intuitive Surgical Is a Hold

Intuitive Surgical reported earnings ahead of expectations but a multiple on trailing earnings well above sustainable growth is a serious concern.

By Chris Bulkey, principal analyst at Technology Research Group



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Intuitive Surgical

(ISRG) - Get Intuitive Surgical, Inc. Report

reported revenue of $329 million (up 75% year on year) and earnings of $2.12 per share (up 194% year on year) for the first quarter of 2010 - both well ahead of expectations (TRG estimates - $293 million and $1.70 per share).

Margins were highly accretive and well above the prior year. Gross margin came in at 73.2% vs. 68.3% year on year. Operating margin improved to 39.5% from 23.9% year on year. The company generated a respectable return on equity of 19.3%, up sharply from 9.6% a year ago.

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Working capital was very well managed (DSOs = 49 days vs. 67 days year on year; inventory turns = 5.14 vs. 3.71 year on year). Profits were fully taxed (36.2% vs. 43.8% Y/Y). Deferred tax asset utilization won't be known until the 10-Q is filed (note: decline vs. year on year period no cause for concern given conservative deferrals in 2009 and relatively small amount on balance sheet). Units of da Vinci Surgical Systems sold increased nearly 60% over the prior year with growth largely organic in nature (goodwill minimal at 5.5% of total assets). Accounting is conservative, financial reporting is far from aggressive, and forecasts imply continued strong profit growth (i.e., 41% in 2010 and 21% in 2011).

Though we normally shy away from companies with pro forma-based earnings estimates, the shortfall from fully expensed numbers is minimal at roughly 2% (and thus a non-factor).

Valuation & Recommendation

Shares are up 26% year to date and valued at 49 times trailing earnings. Medical device manufacturer

St. Jude Medical


trades at 18 times. Both companies are profitable and generate solid returns on equity. A multiple on trailing earnings (49x) well above sustainable growth (ROE x Retention Rate = 19.3%) is our only serious concern and basis for a neutral stance. This disparity probably explains why short interest is a bit on the bearish side at nearly 6% of the float.

Companies with such clean financials are typically associated with negligible levels of short interest (i.e., no more than one or two percent of the float). We believe short sellers are betting on a valuation-based correction as opposed to a disappointing quarter, negative guidance revision, P&L restatement, or other harmful development. Because of this contingency, we are initiating coverage with a "Hold" rating.

Chris Bulkey is the principal analyst at Technology Research Group in Narberth, PA.