Health care investors have never been shy about rewarding innovation. Biotech companies continually sport nosebleed valuation based on assumptions that new, game-changing therapies will improve patient outcomes.
But biotech isn't the only health care industry reshaping patient treatment. Investors have bid up shares in genetic research equipment maker Illumina (NASDAQ:ILMN) and surgical robotics company Intuitive Surgical (NASDAQ:ISRG), too. Share prices in both companies have become less rich over the past few weeks, suggesting it's a good time to consider whether one is a better buy than the other.
Both companies are reimagining patient treatment. Illumina's gene sequencers are being used by commercial and non-profit research departments to identify intriguing new disease targets, while Intuitive's robotics are reshaping how doctors conduct complex surgery.
In order to see whether their technology warrants higher multiples, investors should consider each company's revenue trend. If the sales are growing quickly, it's more likely margin will expand as unit volume is leveraged against fixed costs.
Over at Intuitive, sales grew until 2013, but have since turned lower. Last week, Intuitive reported dismal preliminary first-quarter results showing that sales drooped 24% year over year because of sales of its da Vinci surgical system sliding 59%.
That may suggest that Intuitive has fully penetrated its target market. Or it may suggest buyers have been holding off on purchases in anticipation of Intuitive's latest product. The latter is possible given Intuitive announced earlier this month it is rolling out its latest generation system. The potential impact of this product was discussed by fellow Fools Michael Douglass and David Williamson in last week's Market Checkup.
While Intuitive's sales are struggling, Illumina's revenue has been steadily growing thanks to rebounding R&D spending.
After Illumina's sales paused in 2011 and 2012 because of government cuts to health care research, researchers' pent-up demand is boosting results as budgets loosen. As a result, Illumina's sales totaled $387 million in the fourth quarter, up 25% from last year, bringing full-year sales to $1.42 billion, up 24% from 2012.
While both companies should be applauded for growing their sales significantly since 2010, growth only matters if it eventually turns into profit.
Unfortunately, operating margin is retreating at both companies. Intuitive's margin has retreated from 40% to just shy of 38% because the company sold fewer systems, added headcount, and invested in its latest prototype.
Illumina's profit drop has been even more pronounced. The company is aggressively expanding its infrastructure in Asia to capitalize on China's growing research spend, and that's weighing on margins. Illumina believes those investments will pay off given China already accounts for 12% of its sales, and research spending in China is forecast to eclipse spending in the U.S. by 2022.
Since Illumina has been growing quickly this past year, investors are paying more for future earnings than at any point in the past five years. Despite investors paying less for sales than they were two months ago, Illumina's forward P/E ratio remains north of 65.
By comparison, Intuitive looks like a relative bargain at 30 times next year's earnings, especially since the measure was above 50 just a few years ago.
Since earnings can be affected by accounting charges, another way to value these companies is to consider price to free cash flow, which shows how much operating cash is being generated by selling the company's products.
Intuitive is trading at 23 times free cash, which may suggest there's an opportunity given this is at the low end of its five-year range. Illumina is trading at 63 times free cash, which is pretty pricey.
Fool-worthy final thoughts
Since growth stocks have a better chance of generating bigger-than-expected profit than more mature, slower growing companies, they deserve a premium. In this case, Illumina's growth appears to justify the premium more than Intuitive.
However, betting that Intuitive's new product cycle is about to kick off another move higher in sales could pay off, but it comes with risk. Intuitive recently settled lawsuits tied to earlier versions of the da Vinci system and has admitted that more suits could be coming. If they don't, then sales of Intutive's new system should help pricing, boosting its already high margin, and delivering bigger profit to its bottom line.
Todd Campbell has no position in any stocks mentioned. He owns E.B.Capital Markets, LLC, whose clients may or may not have positions in the companies mentioned. Todd also owns Gundalow Advisors, LLC, whose clients do not have positions in the companies mentioned. The Motley Fool recommends Illumina and Intuitive Surgical. The Motley Fool owns shares of Intuitive Surgical. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.