Once a medical device lands in a hospital, it can be a lucrative business. While the device itself is usually sold for a thin margin, the consumable parts needed for ongoing operations and maintenance are what really brings money in.
That’s the basic business model behind the two companies in today’s match-up: surgical robot maker Intuitive Surgical (NASDAQ: ISRG) and medical device maker Medtronic (NYSE: MDT). If you’re interested in investing in this field, the question becomes: Which is the better stock to buy at today’s prices?
Obviously, there’s no way to know exactly where the two companies will stand five years from now. But by putting each under the microscope of three different lenses, we can get a better idea of what we’re getting when we buy shares. Here’s how they stack up.
Sustainable competitive advantages
There’s nothing more important for long-term investors to research than a company’s sustainable competitive advantage — or its moat. For both of these companies, the primary moat comes in the form of high switching costs. We’ll start with Intuitive Surgical.
The company currently has an installed base of 4,500 surgical robots throughout the world. . Though prices vary depending on the model of the machine, each of these costs over $1 million. Not only is that a significant investment for a hospital, but doctors log hundreds of hours getting trained and practicing on the machine.
As more and more procedures are found to benefit from the daVinci surgical systems — and procedure growth has far exceeded expectations for over two years now — the machines become more and more ingrained in a hospital’s DNA. Because the machines are only used (en masse) for operations where patient outcomes have a track record of improvement, this sets up a win-win-win for patients, doctors, and the company: Patients spend less time in recovery, doctors can perform procedures at a slightly higher volume, and the company’s instrument revenue — the high-margin parts that need to be ordered and replaced with each procedure — booms.
Medtronic is a bit tougher to tackle, given the wide breadth of its product offerings. Last fiscal year, the company’s cardiac and vascular group and its minimally invasive therapies division accounted for nearly 70% of sales. The former consists of pacemakers, defibrillators and monitoring devices while the latter focuses on surgical tools.
While I don’t see the same high switching costs facing doctors who use Medtronic’s devices as those who spend hours (and hospitals that spend millions) on a daVinci robot, Medtronic’s economies of scale — as the world’s largest device maker — mean that it can pour more into research and development, and cut down on development and distribution costs as a percentage of sales more than the competition. For the time being — until its size is challenged — that means good-enough products have attractive prices for hospitals.
In the end, these two are different enough that I don’t think a clear-cut winner emerges.
Winner = Tie
The way that I approach financial fortitude is as follows: If there were a major economic crisis that started today, or if the company stumbled upon unexpected, company-specific difficulties — how would this investment’s prospects — for 10 years from now — change?
You can group the answers to that question in three buckets: the fragile (the business would be hurt by the downturn), the robust (it would stay the same), and the antifragile (it would actually benefit). You can read more about how that would play out here.
Keeping in mind that Medtronic’s market cap — at $117 billion — is over twice the size of Intuitive Surgical, here’s how the two stack up.
|Company||Cash||Debt||Free Cash Flow|
|Intuitive Surgical||$4.1 billion||$0||$1 billion|
|Medtronic||$14.4 billion||$25.9 billion||$4.3 billion|
There’s no denying that Medtronic’s free cash flow is impressive. But Intuitive Surgical is no slouch either. The true differentiator here is the fact that Intuitive Surgical has a net cash position of $4.1 billion while Medtronic has chosen to use debt — giving it a net cash position of negative $11.5 billion.
Should no macro or company-specific crises arise, the use of that debt may very well benefit investors. For instance, Medtronic has used that debt in the past to make acquisitioons — like the 2014 acquisition of Covidien. But for the time being, Intuitive Surgical definitely stands a greater chance to benefit from an economic downturn — by repurchasing shares, acquiring rivals, or simply grabbing more and more market share.
Winner = Intuitive Surgical
Finally, we want to determine how expensive a company’s shares are. Here are five different metrics we can use to build out a fuller picture of what we’re paying for.
|Company||P/E||P/FCF||PEG Ratio||Dividend||FCF Payout|
On literally every metric, even the one (PEG ratio) that takes Intuitive’s headier growth into account, Medtronic is the cheaper stock. And not only that, it offers a modest 2.1% dividend to boot that — given its fairly low payout ratio — is both sustainable and has room for future growth.
It’s not so much that Medtronic is “cheap” right now, but Intuitive Surgical is very richly priced. The stock has quadrupled in the past four years, and investors clearly believe that procedure growth will continue to grow by leaps and bounds.
Winner = Medtronic
And my winner is…
So there you have it — a tie. While Intuitive benefits from very high switching costs, and Medtronic’s switching costs are buoyed by its economies of scale, Intuitive has the stronger balance sheet and Medtronic appears cheaper. When this is the case, my nod usually goes to the company with the wider moat. I have found, since I began investing a decade ago, that companies with the widest moats tend to benefit from the magic of compounding. They retain their customers for longer, and can grow their earnings uninterrupted more often.
Again, we have a tie. I’m going to side with Intuitive Surgical, a stock I personally own. One of the great things about the company — which I didn’t cover it above — is that it benefits from the fact that thousands of doctors are experimenting with the daVinci system for evermore procedures — meaning the growth runway is perhaps uncapped. As time goes on, I expect more and more procedures to benefit from a minimally evasive, robotic approach. I can’t say that the same type of trial-and-error optionality exists for Medtronic, tipping the scales ever-so-slightly in Intuitive’s favor.
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