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Shares of Intuitive Surgical (ISRG) ended the final trading day of the week with losses of 6.2%. The losses followed up on a correction which started around lunch time on Thursday, as shares have lost a cumulative 10% in merely two days.

The company which is well-known for its da Vinci Surgical System, suffered as the American Congress of Obstetricians and Gynecologists questioned the added value of the robotic surgeon over the human surgeon. A negative research report from the Food and Drug Administration already sent shares downwards earlier in 2013.

Da Vinci Is Coming Under Scrutiny

On Thursday, The American Congress of Obstetricians and Gynecologists was critical about whether robotic surgeon offered any value above traditional means of performing hysterectomies.

Dr. James T. Breeden made a statement on the website of the association, "nor is it the most cost-efficient. It is important to separate the marketing hype from the reality when considering the best surgical approach for hysterectomies."

The doctor furthermore states that expertise with robotic hysterectomy is limited and varies wildly across hospitals and surgeons. He acknowledges that robotics have advantages in extensive surgeries, like cancer operations. At the same time, routine operations are not seeing improvements in terms of quality by using this expensive technology. As such, Dr. Breedan concludes that there is no data indicating that a robotic hysterectomy is as good or better than existing manual minimally invasive operations.

Investors were already scared off as there has been a rise in reports of problems with the da Vinci Machine. Intuitive Surgical counterattacks those claims, blaming the surge in the reports due to a revision in the reporting practices, which started in September of 2012. The company furthermore stressed that these malfunctions did not involve injuries or deaths. Intuitive Surgical acknowledges problems with cable breaks, which are most common and can be changed quickly.

So far the company has already lost 20% of its market capitalization from highs in February. On the final day of that month shares already fell some 11% after the Food and Drug Administration reported an increase in reported problems regarding the elaborate devices to conduct surgeries.

Valuation

Intuitive Surgical ended its fourth quarter of 2012 with $2.92 billion in cash, equivalents and short term investments. The company operates without any debt outstanding, for a comfortable net cash position.

The company generated full year revenues of $2.18 billion for the year of 2012, up 24% on the year before. The company reported a 33% increase in net income, coming in at $657 million.

After Friday's declines, the market values Intuitive Surgical around $18.4 billion. Excluding the net cash position, the market values operating assets around $15.5 billion. This values the firm's operating assets around 7.1 times annual revenues and 23-24 times annual earnings.

Despite the strong financial position, the company does not pay a dividend at the moment.

Some Historical Perspective

Long term investors have most certainly enjoyed their investment in the company. Shares have risen more than fifty-fold over the past decade. Shares steadily rose from $15 in 2004 towards $300 in 2008. Shares fell back towards $100 in 2009, and have steadily risen to all time highs around $600 at the start of the year. Shares have seen an almost 25% correction ever since, currently exchanging hands around $460 per share.

Between 2009 and 2012, the company has more than doubled its annual revenues to roughly $2.2 billion. Net income nearly tripled, increasing from $233 million in 2009, to $657 million over the past year.

Investment Thesis

The scrutiny from the FDA and now from the ACOG has hit shares of Intuitive Surgical hard, as the company has lost a quarter of its market capitalization from recent highs. The nervousness among investors is understandable as Intuitive's operations, and consequently its valuation, is entirely based on the fate of its da Vinci Systems.

The increased scrutiny started after an FDA research report indicated that an average robot assisted hysterectomy cost $2,189 more than a normal operation, based on some 265,000 operations. The agency furthermore concluded that the added expense might not be justified in some procedures. As a result, there is a risk that Intuitive Surgical might be forced to make adjustments, or even re-call its machines, if the reports about an increase in errors appear to be true.

The Da Vinci machine costs up to $1.5 million which excludes training, upgrades and a variable costs per operation which exceeds that of a manual surgery. The company justifies the increase in costs by pointing towards the benefits of robotic surgery. Intuitive Surgical claims that operations using robotics result in less pain and faster recovery times, a claim which is highly disputed in the medical world.

The stakes are high, according to the American Medical Association, all the US hysterectomy operations are costing the US health care systems some $5 billion a year. The agency also reports that the percentage of hysterectomy operations being performed by robots has increased from merely 0.5% to 10% over the past three years. The roughly $2,000 in extra costs per surgery appear to have no benefit compared to normal manual surgery, and could add $1-$2 billion in additional healthcare costs.

The timing of these reports is not good for Intuitive Surgical. A strained fiscal budget and ever expanding healthcare costs have put an increased scrutiny about higher expenses in the field. Despite these concerns, the long term prospects for robotic surgery appear to be good. The long term growth potential includes overseas opportunities as well as a transition from the hysterectomy market towards the gynaecological and "general" operations market, which are potentially many times larger than da Vinci's current focus area.

However these reports and remarks of the FDA and the ACOG will most likely have an impact. In a favorable scenario, the increase in usage of robots will merely temporarily slow down.

The long term trend towards robotic surgery seems unstoppable. Yet many short term risks have emerged which could slow this trend down as the cost-benefit analysis, which is heavily being marketed by companies like Intuitive Surgical, is coming under pressure. Costs are demonstrably increasing which is alright as long as there are other benefits including a higher percentage of successful operations, less pain or quicker recovery times. Unfortunately these benefits over manual surgery appear to be hardly existing, or hard to proof.

Not having a medical background, I find it hard to make up my mind on the matter. The fact is that the market sees the increasing scrutiny as a serious threat given the recent share price developments. While I do believe in the long term growth story of names like Intuitive Surgical, the recent decline does not come near enough my desired correction. At these levels the margin of safety is not large enough to pick up some shares for the long term.

I would not be surprised to see continued volatility and near term potential to the downside in the meantime.

For now I remain on the sidelines.

Source: Intuitive Surgical - Still No Margin Of Safety After The Recent Sell-Off