Stocks of medical device companies have been hot this year, with the iShares U.S. Medical Device ETF doubling the S&P 500's 7% return so far in 2017. Should investors buy the biggest name in this space, Medtronic (MDT 0.46%) or put money into the leader of robotic surgical systems, Intuitive Surgical (ISRG -1.46%)?
The case for Intuitive Surgical
Intuitive Surgical makes the da Vinci line of surgical robots and dominates that niche of the medical device industry. Intuitive's business is a razor-and-blades model, as it sells the robot systems for between $600,000 and $2.5 million and then makes most of its money selling the service on the units and the supplies that are required for each surgical procedure. The recurring revenue from service and supplies is a big attraction for investors because of the steadiness and predictability it brings, and in the most recent quarter, it amounted to 77% of the total business.
Driving much of the growth for Intuitive -- 13% in revenue and 20% in earnings per share in 2016 -- are new procedures for the machines. While urological and gynecological procedures were the big growth engines in past years, now general surgery, especially hernia repair, is creating the best growth in procedures in the U.S. An opportunity still ahead is thoracic surgery, which accounts for over 100,000 procedures per day in this country.
Outside the U.S., growth in utilization of the machines is even stronger, generating a 28% increase in procedure volume in the first quarter, compared with 18% procedure growth across all geographies.
Even as surgeons are using da Vinci robots for more kinds of surgeries, Intuitive continues to innovate and launch new platforms that will refresh system sales and open up new uses for them. The upcoming da Vinci X delivers the most sophisticated features at a more attractive price point, which should broaden the market. The da Vinci Sp, for single-port surgeries, should launch within a year and open up new procedures such as transoral surgery on the mouth and throat. Further out is a flexible catheter system that will be able to reach into parts of the body that are not accessible to robotic surgery today.
The case for Medtronic
Whereas Intuitive Surgical is the big dog in robotic surgery, Medtronic is huge across the whole medical device space, with 10 times the revenue of Intuitive. With products like pacemakers, heart valves, patient monitors, surgical staplers, and insulin pumps, the company is diversified across so many product lines that its business is very stable. As long as people are getting sick, Medtronic can continue to generate cash and pay a dividend.
The flip side of stability is growth, and Medtronic has been challenged to come up with much of that in recent years, particularly on the bottom line. GAAP earnings per share for the most recent four quarters stands at roughly the same as it was in 2011.
However, the company has been making changes that are likely to result in higher growth and better margins going forward. The 2015 merger with Covidien had the company called out for criticism by President Obama for the tax inversion aspect of it, but it did broaden the company's offerings significantly and added some growth areas. The company continues to take out cost "synergies," and the improving margins have started to rev up the bottom line. Earlier this month, Medtronic announced it was getting $6.1 billion from Cardinal Health for a group of businesses that actually declined in revenue last quarter. Nice move. Cardinal Health's stock plunged 11% on the news, but Medtronic said the transaction "is expected to result in an immediate positive impact to Medtronic's comparable, constant currency revenue growth rate and non-GAAP comparable, constant currency operating margin."
Company management is holding firm on its view that it can deliver mid-single-digit revenue growth and at least 10% EPS growth in 2017 and in years to come, despite some analysts questioning that in the last conference call. Growth is pretty evenly balanced between the four product groups and across geographies, with no real problem areas standing out. The company is big enough that no one new product will move the needle very much, but the $2 billion it spends on research and development every year is yielding promising new products such as the world's smallest pacemaker, an artificial pancreas, and new surgical stapling products. Medtronic is even partnering with Mazor Robotics to be able to offer its own surgery robots, but shipments of those products are likely to be small enough not to be a threat to Intuitive for many years, if ever.
The company is a standout dividend payer, yielding 2.1% and having raised its dividend for 39 straight years and grown it at a 12% compound annual rate over the last five years.
The better buy
This choice comes down to a big, steady company with a dependable dividend and a much smaller company that is dominating its niche with faster growth and a long runway ahead of it. As one might expect, Medtronic has a much more affordable valuation, with a forward price-to-earnings ratio of about half that of Intuitive Surgical's.
While Medtronic may very well be a better pick for some conservative investors who would shy away from Intuitive's forward P/E of 36 times, I will pick Intuitive Surgical. I think things are looking up for Medtronic investors, but management's ability to deliver double-digit earnings growth over many years and net of restructurings and acquisition costs is yet to be seen. Meanwhile, Intuitive Surgical's current growth, future opportunities, and dominant market share, along with the predictability that comes with recurring revenue from its "razor blades" make it more attractive to me. Patient investors may find a more favorable entry point, though.