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Intuitive Surgical (ISRG) has been the darling of Wall Street in medical technology. Since its IPO in 2000, its stock price has appreciated 2600%, making it a 26-bagger for early investors. Recently, the company started facing significant headwinds in the form of patient lawsuits, negative reports from Citron as well as a statement from the American Congress of OB/GYN about high cost and lack of clinical efficacy of performing hysterectomy using the DaVinci robot.

For current and future investors of ISRG, it is of paramount importance to assess the impact of these headwinds on ISRG's business. I myself have been an investor in ISRG since 2007 and had worked in the field of medical robotics. As a result, I have developed an intimate understanding of these companies from a business and an investing perspective.

I will be writing three articles on ISRG and medical robotic:

  • Article 1 (this article) will describe ISRG's three revenue streams and provide three simple key metrics to help investors gain advanced insights into the company's business in light of the current headwinds.
  • Article 2 will go deeper into ISRG's key drivers of future growth - geographic expansion and surgical category extension. This provides the basis for 5 year forward modeling, which allows savvy investors to know how much to pay ahead for future growth.
  • Article 3 will apply ISRG's analysis onto other publically traded medical robotic companies, such as Hansen Medical (HNSN) and Mako Surgical (MAKO). This allows investors to assess if these companies can replicate the success of ISRG.

ISRG's Triple Revenue Streams

Intuitive Surgical is the manufacturer of the DaVinci robotic surgical system. The surgical system is general purposed and can be used by surgeons to perform many types of surgeries. Right now, DaVinci is the gold standard for prostatectomy, which is performed by urologists. And it is in the process of gaining acceptance in hysterectomy, which is performed by gynecologists.

For investors, ISRG's business model is extremely attractive because the company has a total of three revenue streams, making it even more attractive than a convention razor-razor blade business, which only has two.

For each Da Vinci robotic surgical system sold, the company gets:

(1) $1.5M in system revenue on the day of installation

(2) For the life of the system (which may last 10-15 years) $130K in service revenue per year

(3) For the life of the system, annual consumable revenue that is based on the number of procedures performed on the system that year (at around $2000 per procedure)

To give an example, if ISRG were to sells a DaVinci system to a hospital and the hospital were to keep the robot for 10 years performing 150 procedures per year with the system. ISRG will receive a total of $5.8 million in total from that hospital - $1.5 million on Day 1, and $4.3 million over the next 10 years. Of that $4.3 million, $1.3 million will be service revenue and $3 million will be consumable revenue.

Install Date

Annual Revenue after Install

10 Year Total Revenue

System Revenue

$ 1,500,000

Service Revenue

$ 130,000

$ 1,300,000

Procedure per year

150

1500

Consumable Revenue

$ 300,000

$ 3,000,000

Lifetime Revenue

$ 5,800,000

ISRG's Revenue Breakdown

Over the years, as ISRG sells more and more DaVinci systems into hospitals, its install base (total number of systems installed) progressively increased to around 2,600 systems by 2012. This huge install base generates significant amount of both service and consumable revenue for ISRG.

($ Millions)

2007

2008

2009

2010

2011

2012

System revenue

$ 324.4

$ 455.3

$ 490.5

$ 660.3

$ 777.8

$ 932.9

Service revenue

$ 84.7

$ 126.6

$ 172.3

$ 223.9

$ 278.4

$ 342.6

Consumable revenue

$ 191.7

$ 293.0

$ 389.4

$ 528.8

$ 701.1

$ 903.3

Revenue

$ 600.8

$ 874.9

$ 1,052.2

$ 1,413.0

$ 1,757.3

$ 2,178.8

Net Margin

24%

23%

22%

27%

28%

30%

Net Income

$ 145.0

$ 204.0

$ 232.6

$ 381.8

$ 495.1

$ 656.6

2009 is a pivotal year for ISRG. This is when the company started to derive more of its revenue from the service and consumable revenue from its install base than from system revenue generated by new system sales. It renders the ISRG's revenue and profit much more stable than a typical medical device or capital equipment company.

(click to enlarge)

On the flip side, it also becomes harder for an average investor to detect problems in ISRG's underlying business by simply looking at traditional investment metrics like revenue and earnings growth rates. I will discuss this later in this article.

Characteristics of Each Revenue Stream

I will use the following table to summarize the characteristics of the three revenue stream. The discussion afterward will involve mathematic formulae, so readers can skip those discussions if they do not like mathematics and go straight to "The Bottom Line."

Characteristics

System Revenue

- Depend on how effective the sales force is.

- Driven by number of unit sold and the average selling price of the units

- Susceptible to hospital capital equipment funding cycles. In many countries besides the US, the funding is primarily controlled by government policies and/or budgets.

Service Revenue

- Depend on whether the hospital is using the system

- Driven by total number of active units in the install base

- ISRG has significant pricing power on service contract because there is no second source for its parts

Consumable Revenue

- Depend on how frequently the hospital is using the system

- Driven by total number of active units in the install base and the average procedure performed per system

- ISRG has significant pricing power on consumables because there is no second source

System Revenue

System revenue is the most volatile of the three revenue stream. In modeling, the revenue has two main dependencies we can track: (1) average selling price ASP, and (2) numbers of systems sold.

System revenue = ASP * number of systems sold

ISRG provides investors with System Revenue, as well as number of systems sold. We can therefore derive ASP by:

ASP = System revenue / number of systems sold

2007

2008

2009

2010

2011

2012

System revenue ($M)

$ 324.4

$ 455.3

$ 490.5

$ 660.3

$ 777.8

$ 932.9

Units Sold

241

335

338

441

534

620

ASP ($M)

$ 1.35

$ 1.36

$ 1.45

$ 1.50

$ 1.46

$ 1.50

A review of ISRG's business performance from 2007 to 2012 tells us that ISRG has been very successful in selling new systems. It almost tripled its system revenue from 2007 to 2012, by simultaneously increase the number of systems sold while slightly increasing ASP.

With all the negative news we have been getting about ISRG, what we need to monitor closely are system units sold and ASP. What we want to find out from these numbers is whether the hospitals are deferring or holding off adding DaVinci systems because of the negative publicity.

Service Revenue

Of the three revenues, service revenue is the most stable. In modeling, the revenue has two main dependencies we can track: (1) average service contract price, and (2) number of systems installed.

Service revenue = Average service contract * average number of systems installed

Since ISRG provides investors with (1) Service Revenue, and (2) total number of systems installed at the end of each year, we can easily calculate average service contract price:

Average Service Contract Price = Service Revenue / average number of systems installed

Average number of systems installed = (Number of system installed at the end of this year + Number of system installed at the end of last year)/2

A review of the table below indicates that ISRG has been growing its service revenue by (1) tripling its install base, and (2) steadily increasing its service contract price.

2007

2008

2009

2010

2011

2012

Installed Base

795

1111

1395

1752

2,132

2,585

service/unit ($K)

$133

$138

$142

$143

$145

Service revenue

$ 84.7

$ 126.6

$ 172.3

$ 223.9

$ 278.4

$ 342.6

Consumable Revenue

Consumable revenue is the most complex revenue stream to model, but it is also the most important item to track. This is because it provides investors with insights about how frequently the DaVinci systems are utilized by the hospitals.

For example, if the DaVinci system at a hospital is already under-utilized, that hospital will certainly not buy an additional system in the near future. If the system is not utilized at all, the hospital may end up not even extending the service contract. In addition, the presence of an under-utilized system tends to depress new system sales in the surrounding areas. This is because there is less competitive pressure for the other hospitals in the surrounding areas to provide robotic surgical procedures.

In modeling, the consumable revenue has three main dependencies: (1) number of systems installed, (2) average procedure performed per system, and (3) instrument cost per procedure.

Consumable Revenue = number of systems installed

* procedures performed per system

* Instrument cost per procedure

ISRG provides investors only with total number of systems installed at the end of each year in their annual report, so investors will need to calculate the other two metrics on their own. But do not worry, they are very simple calculations.

Let's first tackle instrument cost per procedure. ISRG provides investors with (1) Consumable Revenue, and (2) Total DaVinci Procedures Performed. Instrument cost per procedure can be calculated in the following way:

Instrument cost per procedure = Consumable Revenue / total number of procedures performed

My next table demonstrates that ISRG has been successful at maintaining instrument cost per procedure at around $2000. So it has been growing its consumable revenue primarily by driving the total number of procedures performed on the DaVinci robots.

2007

2008

2009

2010

2011

2012

Consumable revenue ($M)

$ 191.7

$ 293.0

$ 389.4

$ 528.8

$ 701.1

$ 903.3

Total procedures

136,000

205,000

278,000

360,000

450,000

Instrument Cost/procedure

$ 2,154

$ 1,900

$ 1,902

$ 1,948

$ 2,007

Next we tackle procedures performed per system. This is the most important performance metric investors need to track. It is conceptually equivalent to the comparable store sales in the chain restaurant and retail business. Since ISRG does not provide comparable system utilization statistics, we need to estimate it based on other information ISRG provides.

ISRG provides investors with (1) total number of systems installed at the end of each year, and (2) total DaVinci procedures performed. Procedures performed per system is simply:

Procedures performed per system = Total number of procedures performed / average number of systems installed

Average number of systems installed = (Number of system installed at the end of this year + Number of system installed at the end of last year)/2

The table below shows us that ISRG has been growing its procedure volume by primarily adding new units to the installed base. It was growing its procedure performed per installed system (think comparable store sales) rapidly in 2008-2009, but growth has flattened out in 2011 and 2012.

2007

2008

2009

2010

2011

2012

Total procedures

136,000

205,000

278,000

360,000

450,000

Installed Base

795

1111

1395

1752

2,132

2,585

Procedures/unit

143

164

177

185

191

Procedure/unit growth

15%

8%

5%

3%

Let's put the whole picture together for ISRG's consumable revenue. In a nutshell, ISRG has quadrupled its consumable revenue by (1) tripling its installed base, (2) growing its procedure/system from 143 to 191, and (3) maintaining instrument cost per procedure at around $2000.

2007

2008

2009

2010

2011

2012

Units

241

335

338

441

534

620

Installed Base

795

1111

1395

1752

2,132

2,585

Total procedures

136,000

205,000

278,000

360,000

450,000

Procedures/unit

143

164

177

185

191

Procedure/unit Growth Rate

15%

8%

5%

3%

Toll/procedure

$ 2,154

$ 1,900

$ 1,902

$ 1,948

$ 2,007

Consumable revenue

$ 191.7

$ 293.0

$ 389.4

$ 528.8

$ 701.1

$ 903.3

With all the negative publicity around ISRG, the key statistics we need to keep an eye on is Procedure/Unit Growth Rate. We want to know if the negative publicity will accelerate the slowdown in Procedure/Unit Growth Rate, or even turn it negative.

The Bottom Line

Negative publicity and resistance from the American Congress of OB/GYN has created a higher level of uncertainty in the ISRG's future business. Investors may decide to remain bullish and hold onto their existing shares, or sell and re-accumulate later. Whatever is your strategy, you need to stay one step ahead of the analysts and develop a more advanced insight into the business of ISRG. You can only accomplish this by more advanced modeling.

There are three specific parameters that need to be tracked:

  1. New systems sold
  2. Average selling price
  3. Procedure/Unit Growth Rate

To draw an analog to the chain restaurant business, new system sold is similar to the number of new restaurant units added, and procedure performed per system growth rate is similar to comparable store sales growth rate.

The greatest threat to ISRG's future is that the negative publicity results in (1) patients shying away from robotic hysterectomy, (2) hospitals holding off purchase of new systems, and (3) doctors stop learning and performing robotic surgery. Symptoms of these will show up in the above 3 metrics even as ISRG's revenue and profit continue to grow.

Source: Modeling Intuitive Surgical's Triple Revenue Stream

Additional disclosure: I have been trimming my position in ISRG since the Citron Reports.