Intuitive Surgical, a manufacturer with almost no tangible assets?

Intuitive Surgical (NASDAQ:ISRG) is a prime example of how robotics is similar to other IP intensive industries like software, biotech, and entertainment.

In December my colleagues and I produced a valuation of Intuitive Surgical.  Below is a representation of our model of the asset structure of Intuitive Surgical in our forecast.  Whether you agree with our estimate of a 31% return on economic assets or not (though the stock market roughly seems to), this chart is very instructive to look at what the economic assets of a successful robotics firm are.

And hey, guess what?!  Intuitive looks more like a software company than a traditional manufacturer.  Strike another blow for the case that robotics companies–at least successful ones–are capital efficient!

Moreover, if I was critiquing the model in the valuation I would say that we hadn’t adequately valued the intangible assets of Intuitive Surgical.  The intangible assets of the firm probably have a market value of 2-8 times what we estimate.  Even with our conservatism, look at what you’re buying into when you buy a share of Intuitive:  A $2Bn stack of cash, a multi-billion dollar IP portfolio, and a smallish medical device manufacturing company.

Assumptions of FCF forecast through an economic view
[How to read this chart:  Black is our estimate of “R&D assets” in $K so starting balance is just shy of $2Bn.  Red is GAAP non-financial assets, otherwise know as real stuff, like buildings, inventory, and accounts receivable.  Grey is our estimate of financial assets with the current dividend policy–this model posits that Intuitive will be sitting on $4Bn in cash or the like in 2016 and an IP portfolio equally as large and valuable.
Return on economic assets was estimated using our income forecast over capitalized R&D spending in the R&D account plus assets less cash and securities.  The model has a depreciation factor for R&D each year to account for obsolescence and expiration.  We went back several years to estimate an appropriate R&D account starting balance for the projection.]

The stock market assigns a $20Bn valuation to Intuitive.  It recognizes that Intuitive’s control of  intangible assets is very valuable. The graph of the model here only scratches the surface of intangible assets.  We assumed that the only off balance sheet economic asset was an R&D account.  Clearly, this is not the case as Intuitive Surgical also has unique and valuable organizational processes, sales relationships, and employment relationships with talented employees but those are much harder to find information about in SEC disclosures.    Similarly, we also marked R&D at cost–with a portfolio as valuable as Intuitive’s the market is probably going to value the R&D output at more than Intuitive paid to develop the R&D assets.

Even with all this, Intuitive Surgical looks like lean, mean, capital efficient, IP intensive, knowledge economy company.  Can anyone tell me why we let people talk about robotics like it is capital intensive?

I’d like to gratefully acknowledge my co-authors of this report who have given me permission to publish it: Avinash Belur, Naohiro Furuta, Masayuki Minato, Kohei Mutoh, & Dashampreet Sidhu.  Analysis available by request.

 

ExOne IPO Successful: Shareholders Contribute Random Passers-by

Before I start bashing bankers, I’d like to congratulate the ExOne Company on a successful initial public offering (IPO).  I haven’t seen much about ExOne [NASDAQ:XONE] on the robotics sites, but if we’re calling Stratasys [NASDAQ:SSYS] a robotics company, we should call ExOne a robotics company as well.  It is really good to see another public company in our sector.  Hopefully, this will encourage more investment of both capital and entrepreneurial energy in our industry.

Last time I checked 26 is a lot more than 18.

Last time I checked 26 is a lot more than 18.

By the criteria of the market commentators, the ExOne IPO was a huge success.  You can Google things like “3D printing red hot.”  The IPO was priced at the top of the range $16-18, it opened around $26 before shooting up over $33.  Almost a week later it is trading roughly at its opening price.

Now this is all fine and dandy as far as it goes, unless you were an ExOne shareholder.  Who, by the way were the ones selling in the IPO.  One shareholder sold 300,000 shares in the IPO.  This means that this one shareholder transferred a gain of $2.4M to some connections of the underwriters.  This shareholder is taking $5.4M, less fees and discounts, call it $5M from of the IPO, so $2.4 is not exactly a rounding error.  Presumably, this shareholder is also more inclined to build companies with the capital than whatever speculators are hovering over the IPO.  Similarly, the company lost out on $40M of capital that could be invested in projects.  Think about that.  The company is worth less than $350M and the IPO mis-pricing cost it $40M of cash.  Cash!  Cash that could be sitting on the balance sheet scaring off competition and waiting for the next expansion opportunity.

It is hard to explain an IPO price that is so far below the fair market value of the company.  I know that there are a lot reasons why bankers try to justify under pricing an IPO, but giving-up over 10% of the firm’s market value in a single transaction seems really hard to justify no matter what.  I’m not sure what part of the economic gains from listing publicly should be given to financial intermediaries and incoming investors to get a deal done, but over 10% of the company seems quite excessive.  These new shareholders have no restrictions on ownership and quite likely to flip their shares instead of taking an active roll in growing the company, which seems to further erode any claim they might have to extraordinary gains.

I’m not familiar with the track records of FBR, BB&T, and Stephens, the underwriters for the ExOne IPO, but I’d think twice or three times about hiring them if I was going to do an IPO.  They seem to have not only underpriced the IPO, but also floated too much of the company, almost 40%.  Underpricing the IPO might be tolerable if the bankers had only floated 5-10% of the company.  The company could have done a secondary offering later once the offering had an established market price, instead of getting ripped off during the IPO.  The large offering certainly did do one good thing for the bankers: it increased the underwriting fee.

If my company ever goes public, I hope I’ll have the good sense to hire Morgan Stanley–unless an underwriter is involved in litigation for overpricing an IPO, how can you be sure they’re any good?  Heck, they even give discounts–what’s not to like!

Cognex [NASDAQ:CGNX]: Economic Valuation of A Robotics Company

I prepared this valuation for Prof. Joel Stern.

If you would like to see a chart or table with a white background, click through it twice.  Use the back button to return to the article.

Executive of Summary

Cognex is correctly valued in the market.

A aiagram from a machine vision patent assigned to Cognex

A diagram from a machine vision patent assigned to Cognex

Overview of Cognex

Cognex is a machine vision systems corporation—they focus on computers which can see—particularly in industrial automation applications.  Originally an MIT spin-out, whose name stood for Cognition Experts, they are headquartered in Natick, Massachusetts—though one of their two main divisions is in the Bay Area like a respectable technology company should be.  They have been public since 1989 and have been paying an extremely modest dividend since 2003.

CGNX Share Price Chart

Figure 1 – Source:  Google Finance

As of close on December 7th, Cognex stock was trading at $36.62 a share with 42,961,000 shares outstanding and a market capitalization of $1.573 billion.   Their revenues are well diversified with 66% coming from outside the United States and the top five customers only account for 7% of revenue.  Like most robotics companies, Cognex has no debt and exhibits the cash anomaly of the knowledge economy.  For tax reasons, Cognex is planning to pay a large 4th quarter dividend, but before paying the dividend, Cognex will have over $400 million in cash and securities on its balance sheet.  Cognex’s non-financial, GAAP capital, net of operating liabilities was only about $200 million and of that $80 million was goodwill.  Contrary to popular wisdom, it does not take a lot capital to build robots.

Cognex is a classic, mid-sized, public robotics company if there if ever was one.  Financially, it looks very similar to other successful robotics companies like Brooks Automation (BRKS), iRobot (IRBT), Aerovironment (AVAV), and to a lesser extent Intuitive Surgical (ISRG)—although none of these companies are direct competitors.

Cognex has unique technologies, a portfolio of successful and related products, and a habit of expanding its business with both organic growth and prudent, related acquisitions.  The macroeconomic trends of the coming decades probably favor Cognex.  The growth of on-shoring, higher labor and environmental standards, rising third-world wages, continued growth of the global middle class, and the increased pace and automation of supply chains all favor the growth of Cognex’s business.  There is some threat of emerging competition or economic disruption from start-up companies like ReThink Robotics, but Cognex’s cash and industry relationships make it equally likely that they are the distribution and exit strategy for such start-ups.

Valuation Process

The valuation process relies on data gathered from market reporting and the SEC’s EDGAR database.  Historical returns allowed me to compute the cost of capital.  Following this, I made adjustments to discover Cognex’s historical assets and economic returns to assets.  I assumed that the 7 year historical return, approximately one economic cycle, would be a good guide to future returns as this is not Cognex’s first economic cycle.  This means that we are assuming that Cognex returns 21.3% on its economic assets every year.

I used a somewhat roundabout way to get investment.  First, I assumed that the GAAP assets required to produce these sales would remain unchanged and so depreciation would exactly equal GAAP investment.  Compared to other robotics and tech companies Cognex has too many GAAP assets, see Figure 2.  To estimate future R&D spending, I observed Cognex has been remarkably consistent in spending 14% of gross revenue on R&D, so I backed into gross revenue from the economic return on assets by assuming a fixed ratio from historical data.  From there, I took 14% of gross revenue and added it to capitalized R&D.  From this capitalized R&D figure, I removed 1/12 annually for obsolescence, to arrive at a capitalized R&D figure.  This figure was added to GAAP non-financial assets to get the economic assets of the firm.

Reader, my apology for overuse of this chart

Reader, my apology for overuse of this chart

Figure 2 – Source: 2011/2012 10-Ks on EDGAR as of July 2012

From this forecast of the company growth, I used three valuation methods.  First, I estimated a free cash flow, which is the economic return of the assets of the company less the addition to capitalized R&D.  Because they have no debt and no GAAP investment beyond depreciation, this is equal to Cognex’s operating profit.  Next, I calculated the economic value added, this is the spread on the total economic assets employed by the company in any given year.  I calculated both of these methods for the next 20 years, with a perpetuity value beyond the forecast period.  Finally, I calculated a long form economic value driver model of the firm.  For this, I ran the calculation two ways.  One way, the forecast period is 20 years, the other has an investment period of 10 years.  The ten year period brought the value in line with the other methods.  This may be a consequence of the way that I dealt with the changing investment amounts.  However, the long form is mostly intended to talk about the sources of value in the stock price, not accurately predict what the price should be.

Cost of Capital

To estimate the cost of capital for Cognex, I regressed the monthly returns to Cognex over the ten year treasury return for the last five years against the equity premium of the Russell 3000.  The result is below in table 1.  The alpha is not significant—and even if it was, this alpha could not be expected to be permanent—however forcing it to zero does not yield a significantly different beta, so I used a beta of ~1.38.

Cost of Capital Regression

Table 1 – Regression of Cognex Premium Returns to Russel 3000 Premium Returns

This beta times a future equity risk premium of 6% and on top of a ten year risk free rate of 1.626% results in cost of capital 9.89%.  Since Cognex has no debt, this is the weighted average cost of capital as well.  The ten year bond may not be a perfectly appropriate choice given our forecast period of twenty years, but it should be an adequate estimator for our purposes.  Using the 30-year yield would raise the cost of capital by about 1% to be almost 11% instead of just under 10%.  Given the economic spread that Cognex returns, this would change the valuation by about 10-15%, but it probably wouldn’t change many of the company’s investment decisions.

Free Cash Flow Valuation

Using the method above, I prepared a forecast of the free cash flows Cognex can be expected to produce.   The table below shows the forecast with the intervening years truncated.  Of course this forecast does not adequately capture the cyclicality of Cognex’s business selling industrial equipment.  However, it gets very close to the share price in the market.

FCF Valuation

Table 2 – Free Cash Flow Valuation of Cognex [Entries 2018-2031 Omitted for Clarity]

Discounted Economic Value Added Valuation

R&D should be capitalized in the firm.  This is the key asset which Cognex derives its revenues from.  Robotics factories tend to be singularly unimpressive and largely undifferentiated affairs.  The basis of the 21.3% return the Cognex has historically earned on its economic assets is largely the R&D.  As pointed out above, Cognex is probably not very efficient at managing its real GAAP assets.  My R&D capitalization schedule relies on assumptions, but I think reasonable ones based on my experience in the robotics industry.  These assumptions, along with the spread on employed economic capital, drive the value in the discounted economic value added method.  The spread that I used has to be pretty close to a fair estimate given the R&D depreciation method that I used, which assumes that R&D useful life is a random exponentially distributed variable with a mean of 12 years.

Discounted EVA Valuation

Table 3 – Discounted EVA Valuation of Cognex [Entries 2018-2031 Omitted for Clarity]

Long Form Economic Valuation

The long form model of the firm show in table 3 looks at the drivers of value.  As investment is variable over the period, I used the starting value of economic investment to .  This will likely understate the long form value of the firm slightly.  However, the long form appears to overstate the value of the firm compared to the other methods.  If an investment period of 10 years is used, the long form comes much more into harmony with current prices and the other methods.

Long Form Economic Value Drivers Model Table 4 – Long Form Valuation of Cognex

Conclusion

I’m not very enamored of public equity investing so I’m a little foggy on what the analyst terms mean.  In recent periods it has seemed like analyst terms like, “strong buy” and “buy,” mean things quite contrary to their common meaning—perhaps closer to “Be careful” and “Call your broker with a sell order ASAP.”  Going by conservative assumptions derived from historical data of the last economic cycle, I got prices that were very close to, and bracketed, the market price of the stock.  Cognex would be reasonable to hold in a portfolio if you expect earn the market cost of capital on your portfolio.  There is upside potential, but there are also risks the current price.  All in all, it looks set to return the cost of capital for the foreseeable future.

There is power in being able to say what amount of economic capital you are employing—regardless of where the accountants hid it.  It also allows you to look at any company like it is a bank.  The firm takes in capital from whatever sources, and using it for purposes that earn a spread over the cost of capital, then returning the capital and pocketing the spread for the owners.  This uniformity of treatment, really gets at the heart of what is creating value in the firm.

However, I’m not sure that any of the methods of valuation adequately speak to what the real risk of this company is—which is that it needs its research to match the needs of its customers.  The dogs might not eat the dog food, or they might unexpectedly ask for seconds.  These changes in customer demand are going drive immense fluctuations in all the assumptions that financial forecasts make.  It is a messy and localized business, but fundamentally, this is what really creates the value.  Just doing R&D is not going to necessarily create value, true of any asset, but the matching problems are much more severe in R&D and the rate of economic return incorporates a lot implicit assumptions about how management will make the assets perform.

Appendix

Data and Estimates

Data and Estimates

Table 5–Data and Estimates

Full Calculation

Table 6 — Printable Full Discount Calculations

The Knowledge Economy Cash Anomaly: Part 1

This is part 1 in a three part series about why technology companies hold so much cash on their balance sheets.  Here are Part 2 and Part 3.

The academics disclaim knowledge of a definitive answer as to why companies in the knowledge economy hoard a such a disproportionate amount of cash.   The problem is that the chart below has two branches where our classical understanding would only expect one.

Robotics (Blue) is firmly in the knowledge economy, using very few real assets, but a disproportionate amount of financial assets, to finance the company.

Robotics (Blue) is firmly in the knowledge economy, using very few real assets, but a disproportionate amount of financial assets on the company’s balance sheet–just like software companies.

The Expectation

The companies that form a cluster heading up close to the Y-axis are the traditional economy companies.  They are everything from utilities to content companies to retailers–some of them quite high-tech.  Basically, they have the real assets that they need to their business and a little bit of cash and securities to get them through the shocks of the next couple of months.

This is what financial economists expect companies to look like:  orderly, well managed institutions that collect cash from operations and distribute the operating profits out to shareholders and debt holders.  Since these companies have access to relatively liquid and efficient capital markets, they have no need to hold onto cash.  Good investment projects can simply be financed through issuing new securities or retaining more future earnings.

Tech Companies

Robotics companies and tech companies on the other hand horde massive amounts of cash–spreading out along the X-axis in the chart above.  Many of these companies, already profitable, could forego revenues for over a year.  And, oddly enough, the most profitable and most successful of these companies hold the most financial assets.  Nobody quite understands why companies do this.  The previous discussion, Is a Dollar Worth a Dollar on a Tech Company’s Balance Sheet?, reviewed some of the arguments for and against the value of cash on a company’s balance sheet.

Holding Cash Is Usually Bad

Most investors feel that excess cash in the company is a temptation to value destroying misadventures by management.  Particularly if management has incentives to grow gross profit, management can grow gross profit by deploying the company’s cash in less than profitable ways.  The classic example of this overpriced acquisitions.  Say you were the CEO of HP and you wanted to grow profits.  You might have heard about this company called Autonomy.   So you decide to buy it at market price plus a huge control premium.  Your profits go up, because you have HP + Autonomy’s profits together.  You get a bonus.  But your shareholders get hosed.

If the shareholders wanted to buy Autonomy, they could have owned it without paying the control premium.  Unless these so-called synergies show-up (and synergies are what go up the banker’s chimney after Santa Claus comes down–see I learned something in business school),  there is no reason to pay the control premium.   The control premium just gets pocketed by the previous owners and the bankers with all that value lost to the shareholders of the acquirer–those are your shareholders.

Conversely, if the company disgorges the cash, and you and your management team go to the market to raise new debt or equity to finance the purchase of Autonomy, Instagram, or any of another thousand bad acquisitions–the financial market has a chance to tell you that this is a really bad idea.  But if it is a good acquisition, the market will easily provide you with the money.  So all in all, investors tend to discount cash on the balance sheet and reward paying it out where they can reinvest it.  So why would companies hold all this cash?

Concentrated Ownership

Many tech companies are owned or controlled largely by single individuals or small groups.  The company represents a substantial portion–if not substantially all–of the wealth of the these founders.  Since they control the company, they are willing to take steps to decrease the risk to the company that are not economically maximal to diversified shareholders.

Consider this hypothetical:  Google and Apple are locked in winner take all product war for a small market that is worth $2Bn in market capitalization to Google now, but will go entirely to Apple in year unless Google spends $3Bn.  If all of your wealth is in Google and you couldn’t easilty get it out, you might be willing to have Google spend $3Bn to save $2Bn in wealth.  Your loss is now $1Bn instead of $2Bn.  However, if you are a diversified investor and own both Google and Apple, you want Google to let the business go and refund you the $3Bn.  You still have your share of the $2Bn in your portfolio and the chance to invest your share of the $3Bn somewhere else to earn a return.

Founder Payout Diversified Common Shareholder Payout
Spend money to protect Failing Business -1 -1
Do Not Spend Money to Protect Failing Business and Payout Cash -2 +3Bn

Less sinister, the company may just be conducting tax free diversification on behalf of the founder.  The effective corporate tax rate is below the individual tax rate, especially on capital gains.  While this is tax efficient for a founder, it may not be tax efficient for other investors.  The harm is probably not as stark as the example above, but it does raise the question about who the firm is being run for and rubs our Anglo-Saxon sensibilities about the primacy of the shareholders the wrong way.

Defense

The story here is that only Apple or Microsoft would ever even think about entering search knowing that Google has the largest market share, the best technology, and is sitting on $45Bn in cash.  If you want to take search from Google, you are playing a long game and an extremely expensive game.  It will fight hard and it has the resources to do this.  Potential competition is scared off, increasing the ability of the company to earn rents in on its primary operations.   While closely related to concentrated ownership story, this is actually favorable to the common shareholder if this is true.   Services like Siri, Wolfram Alpha, and IBM’s Watson cast some doubt on this story, but perhaps at least in the example of general consumer search it is mostly true.

The defensive effect need not be 100% effective to be worthwhile.  This effect is an extra return on the cash that shows up in operations, not financing, because of accounting rules.   Additionally, the company always has the cash, so there is option value.  In our example, if Bing every really started to rule search, Google could decide not to fight, and either sell or wind down search operations.  They still  have $45Bn to distribute even if the value of operations falls to zero, but the option to fight is inherently valuable.  With the cash to execute this option, it becomes more valuable, or credible.

to be continued…   Next up, option value of IP and distress costs

Jump to Part 2

We need horizontal migration for robotics

Despite the tremendous potential for robotics to transform people’s lives, robotics is not nearly as widespread as information technology.   Traditionally this has been ascribed to the high capital costs of starting a robotics company, but this explanation does not bear scrutiny[i].  More realistic explanations for the lack of proliferation of robotics are that management in most robotics companies cannot effectively match customer development and product development cycles, and robotic solutions are not easily ported from one industry to another.

The lack of synchronization between product and customer development leads to a much slower and more expensive development cycle than in software based businesses. This is not an inherent problem of robotics, but a product of the management practices employed in robotics versus software businesses.  Better management is already leading to falling iteration cycle times.  Many of the leading robotics firms on the West Coast have cycle times that are within a factor of 2 or 3 of software best practice.

The more fundamental problem in robotics is that robotic solutions are not easily ported from one industry to another.  Solutions tend not to be universal but rather quite tailored to specific industries.  As a result, successful robotics firms tend to think of themselves as serving specific industries and being participants in that industry rather than having a core technological competence.

Take the example of Automated Healthcare, one of the first substantial out-of-factory robotics acquisitions.  In the 1990s, it developed a solution for automating pharmacy operations at hospitals to reduce labor and more importantly theft and errors in the pharmacy.  Although, their solutions was loosely based on handling of computer tape media, they did not view themselves as a material handling and storage provider, they came to view themselves as providers of drug distribution solutions—while this is certainly a valid business direction—the acquisition by McKesson ensured that their great success in drug distribution would likely stay in that industry.  I’m not suggesting that McKesson took a technology that was ready to jump industries and didn’t take it across industries.  However, once a technology finds a home in a giant healthcare company it is going to developed to serve the interests of the parent company, not the interests of the robotics community at large.

Contrast this with solution providers for information technology.  Ten years prior to the start of Automated Healthcare, Oracle was being started as a relational database company.  Oracle did not stay fixed on any particular industrial niche, but rather became a database solutions provider to practically every industry that uses databases.  This portability allowed Oracle to grow to a thousand times the size of Automated Healthcare, even though material handling probably generates as much revenue as do relational databases.   The sad part is that the acquisition of Kiva Systems by Amazon indicates that this trend robotics material handling solutions being aligned to particular industries is likely to continue.

ReThink’s Baxter may point at a broadening of robotics to serve several sub-segments of manufacturing.  I hope that Baxter can also become the mail clerk in an office and serve lunch in the cafeteria.  Once we get to that point, our industry will really start to take off.  My suspicion is that there are enabling technologies and infrastructure that we haven’t developed yet to do this.  A truly universal dispatching system and some other key enabling technologies are likely to have to fall in place before this happens.  I hope to devote a future post to what those key enabling technologies and infrastructure pieces are.

Guess that’s not happening…

So I wonder how the EADS shareholders feel about taking a hit for a merger that never happened.  Oddly enough, it seems like the German government is actually looking out for shareholders in blocking the deal.  Most analysts couldn’t figure out why they were trying to do this.   EADS / Airbus does well enough on its own when not making blunders like the A380.  BAE does well on its own because it has access to the U.S. defense market in a way that a partially government owned continental firm would never have (see: tanker competition; see also: special alliance).  I’m still puzzled by the logic of this.

There are great mergers out there in our field.  Pittsburgh robotics firm RedZone has gone on acquisition kick and bought up companies that provide software and solutions for larger diameter pipes to build a complete sewer solution.  iRobot has bought Evolution Robotics when it seems like someone else’s mousetrap had some cool features.  Both of these create value for the company and have clear economic rationales underlying them.

Let’s hope that robotics can keep our business combinations on the path to having economic rationale.

Speaking of management destroying value: EADS & BAE

Might be getting a little out of my wheelhouse today, but BAE and EADS are both unmanned aircraft manufacturers, if relatively small time players thus far.  News of their merger is HUGE in the defense world.  But take a look at what their stock prices are doing (EPA:EAD) and (LON:BA).

With almost a day to digest the announcement, it looks like BAE’s stock price has settled about 2-3% higher (or almost within the range of previous variation) after some initial shenanigans, but EADS’s stock is down about 15%.   The market does not look favorably on this merger.  This is a reasonably common pattern to see the acquiring company’s stock tank, but still I think that it provides a strong comment to those wringing their hands about America’s so-called decline in aerospace.

It appears that the A380 has been a commercial disaster and that being a Western defense contractor without reliable access to the U.S. market (however unjustified the tanker competition rules may be) is not a good idea.  I’m not sure that tying up with BAE will magically fix these problems–though if they really can eliminate €1B / year in overhead, there might be something to do.

However, it seems that the real shortage for creating value is management attention.  I’m not sure how becoming bigger and cutting more overhead is really going to change things at the new B/EADS.  Maybe if they focused on opening European airspace to unmanned aircraft faster than the U.S. is doing and came out with cheap and innovative products with broad military and commercial applicability…  nevermind.