Intuitive Surgical: Great Technology, Tough Environment

Medical device maker, Intuitive Surgical Inc. (ISRG), produces the robotic da Vinci System used in urological and gynecological surgeries. The da Vinci system has single-handedly transformed the way urologists have approached prostrate surgery over the past 5 years. ISRG has recently made in-roads in additional modalities such as gynecological and cardiothoracic surgeries, positioning the company for continued growth in this competitive field.

With all due respect towards its technology and prospects for long-term growth, we believe that ISRG’s business is at a negative inflection point in the current market environment – one that will result in a lower stock price and valuation in the coming months. There are three primary reasons we believe ISRG is an attractive short here:

• Discretionary medical spending has taken a dive in the first six months of this year. As observed in this past week’s negative earnings pre-announcements by former stalwarts ILMN and MYGN, discretionary medical spending has taken a turn for the worse in the first half of 2009. Not only was Q2 weak for ILMN and MYGN, but Q3 also seems poised to continue this trend. Such an environment does not bode well for ISRG, a company heavily reliant on hospital spending.

In a poll taken by J.P. Morgan, 60% of respondents noted a slowdown in hospital capital spending over the last three months, with an average decline of 12.5%. Twenty of the 26 respondents remained pessimistic that cap-ex will improve anytime soon. In fact, most expected further reductions over the next 13-24 months. Particularly worrisome for ISRG is the expectation that robotic surgery is an area that will undergo the most significant spending cuts in the short term.

It should be noted that J.P. Morgan has a $118 price target on ISRG, so there could be some conflicting interests in their research report.

• ISRG still trades at a very high valuation. For a company whose earnings are set to decline in 2009, a 35 PE is unwarranted. ISRG also trades for over 6x revenues, making the stock very pricey on a price-to-sales basis. With the stock priced for perfection, an earnings miss, slowdown in sales or negative guidance could be catastrophic for anyone caught long in the name.

• ISRG is showing technical weakness. As the Health Care Equipment sector falls out of favor, subtle signs of weakness can be observed in its 6-month chart. We have highlighted some areas of concern on the chart below:

ISRG 6-Month Chart

Source: Stockcharts.com

Not only has ISRG’s volume been decreasing with each move higher, ISRG’s 20-day and 50-day SMAs are also showing signs of faltering in here. The 20-day SMA (blue line) has hit a short term plateau, moving sideways in the past few days. Should the stock weaken further, the 20-day seems poised to turn downward in the coming weeks, an ominous sign heading into ISRG’s July 22^nd earnings report.

To sum up our short thesis: With no near-term sign of a recovery in discretionary hospital spending, a stock priced to perfection and signs of declining institutional support on the chart, we feel compelled to short ISRG. The rising short interest (20%) already in the name doesn’t hurt our case either.

We entered this trade on Monday morning via the “in-the-money” August 170 puts for our accounts with options capability and by shorting the stock for the margin accounts we oversee. ISRG could go down to $120-130 on any type of earnings miss and less than stellar guidance.

Disclosure: Short ISRG stock and long 170 August puts for the accounts we oversee.

Comments

[Alan Brochs...:]

While I agree that ISRG remains somewhat expensive considering the environment and the chart is heavy, I take exception with your comparisons. ILMN's miss is very company specific, while MYGN seems to be related to fewer people going to the doctor due to insurance coverage issues and a lack of willingness to pay copays. I suppose you could argue that ultimately this same trend leads to people not getting diagnosed with cancer, but, until then, the ISRG consumable story is about share gains within existing procedures and the addition of newer procedures.

By the way, I have been surprised positively by the number of hospitals announcing upgrades or purchases of the new Si. I actually hope you are right in your prediction, as this is one I would like to buy again after selling out on the way up.

Jul 08 07:56 AM

[The Inflect...:]

Hi Alan, I agree that MYGN and ILMN are not the best comparisons for ISRG's business. However, one can make that the case that HNSN may be the better company to compare ISRG with and its negative pre-announcement does not bode well for ISRG. Although a company on a completely different level than ISRG, HNSN's revenue shortfall was eye-opening. With it being a stock priced to perfection, ISRG should go lower on any type of top-line weakness. Thanks for your comments. Much appreciated. Best, John

Jul 08 08:44 AM

[Marianne Rice:]

If I need gynecological or heart surgery, I'll go to a hospital with the da Vinci system. There's one in my home town. If they don't do the kind of surgery I need, there's a bigger da Vinci outfit in the metropolitan center 25 miles down the Interstate. I'm holding the stock I own and thinking about shorting some more during this beat-down.

Jul 08 01:11 PM

[Anthony B:]

I'm holding out for ISRG to get below $130, then selling a 6+ month put at around $100-$110. I agree it should go down, and agree with Alan that it's a good valuation at around $100. Who has been buying at $140 - $160?

Based on how much it moves seems like a bunch of day traders just go back and forth, back and forth, not realizing where the price has moved based on fundamental valuation. Earnings will reel them in.

Jul 08 06:15 PM

[The Inflect...:]

Hi Anthony, Assuming the 200 day gets broken on the heels of negative sales and earnings, next stop should be 100-110. Good luck to you on this trade. Stock is due for a short term bounce, however. Will use any pull-up back to 150 as a chance to add to this trade. best, John


On Jul 08 06:15 PM Anthony B wrote:

> I'm holding out for ISRG to get below $130, then selling a 6+ month
> put at around $100-$110. I agree it should go down, and agree with
> Alan that it's a good valuation at around $100. Who has been buying
> at $140 - $160?
>
> Based on how much it moves seems like a bunch of day traders just
> go back and forth, back and forth, not realizing where the price
> has moved based on fundamental valuation. Earnings will reel them
> in.

Jul 09 10:04 AM

[CuriousMonkey5:]

There are probably better stocks to short than this one, which is a great long term buy and hold. Great business with lots of upside (growing procedures per machine, more machines purchased eventually, international growth, more doctors trained on them, new types of machines being developed, etc).

Jul 10 03:47 AM

[The Inflect...:]

Covered ISRG in here. May go back into it for earnings trade right before the numbers. Weakness is too much to not monitor and possibly re-enter.

Jul 15 03:44 PM

[FoolishDanny:]

So what are your thoughts now that earnings are out and ISRG SPANKED estimates, beat on both top and bottom line! Not so much weakness there now....the shorts are getting roasted.

Jul 22 06:37 PM

[The Inflect...:]

As noted above, I covered ahead of earnings. Entering this short was a bad idea. Broke even on the trade, but got stopped out - thankfully!


On Jul 22 06:37 PM FoolishDanny wrote:

> So what are your thoughts now that earnings are out and ISRG SPANKED
> estimates, beat on both top and bottom line! Not so much weakness
> there now....the shorts are getting roasted.

Jul 23 07:38 PM