On July 8, Intuitive Surgical issued preliminary Q2 results with a revenue of $575 million vs. the street consensus of $629.6 million. The warning sent the ISRG stock plunging nearly 20% the following day, ensuring several analyst downgrades. The revenue miss is due to the lower system sales and slightly slower procedure growth. While this performance is disappointing, this article attempts to analyze possible causes for the miss and their implications to the near and medium-term trading of ISRG.
We have recently analyzed ISRG's long-term growth prospect in this SA article. In light of several negative events surrounding the company in the past six months or so, we have argued that ISRG's fundamental remains intact. In particular, we see the da Vinci system developed into a nearly monopolistic technology platform for surgery and we see many years of super growth ahead for ISRG. In the near term, however, we believe that the negativity of these events has taken its toll on the ISRG business. In addition to the various reasons cited by the management for the shortfall, we believe that the concerted criticisms from some powerful sources in the medical community, namely the editorial remarks for the study published in the Journal of the American Medical Association (JAMA) and the subsequent American Congress of Obstetricians and Gynecologists (ACOG) statement, are probably most to blame for the present setback.
Given that the stock has reacted fairly strongly to those negative events as they occurred by trading down from $580, we would think their impact is to a large extent priced in. However, analysts have not lowered their expectations and when the company issued the warning, the stock got punished again. It would appear that the market has interpreted the quarterly miss as the inflection point for the ISRG growth story. We believe that the slowdown in the past two quarters is due to anxiety created by the recent negative events and the excessive negative press, none of which has shaken the fundamentals of the da Vinci technology that is built on its safety profile and value proposition. Once these negative stories have run their courses, the normal growth will return.
The bulk of the revenue shortfall is attributed to the lower da Vinci system sales in the quarter. The following table lists the number of systems sold in Q2 vs. prior quarters, breaking down by the geographical regions.
Q2 - 13
Q1 - 13
Q4 - 12
Q3 - 12
Q2 - 12
Q1 - 12
Q4 - 11
Q3 - 11
Q2 - 11
Q1 - 11
Table 1: number of quarterly da Vinci system sales
As shown on the table, the number of systems sold in Q2 is down substantially in the US while it grows robustly in other regions. There have been talks for quite some time now that the US system placements have reached the saturation level. If this were the case, it would have more likely occurred in a gradual fashion as opposed to an abrupt drop in this quarter. We think the concerted efforts from some powerful organizations to discredit the value of the da Vinci system for benign hysterectomy has affected the decision making of hospital administrators.
1. The number of da Vinci systems that the US hospitals need is ultimately determined by the number of procedures done. However, as most hospitals are at the point of purchasing their first systems, it is more determined by the number of hospitals that wish to be a full-service provider by installing state-of-the-art equipments. So, how many of such hospitals have yet to install a da Vinci system?
- As of the end of Q1, there are 1,957 da Vinci systems installed in 1,813 US hospitals according to a search on the da Vinci webpage.
- There are 4,973 community hospitals and 208 federal government hospitals in the US. To get a rough idea of the number of hospitals whose scale and breadth mandate installation of a da Vinci system, we consider the screening criteria used by the US News in their hospital ranking. Namely, a hospital eligible for their ranking must be a teaching hospital, or be affiliated with a medical school, or have at least 200 beds, or have at least 100 beds and offer at least four of eight specific medical technologies. There are 2,227 hospitals falling into this category. We believe that these are at minimum the hospitals that would install a da Vinci system. However, in many sparsely populated regions of the country, a smaller hospital may be the only hospital in a community and may have the need for a da Vinci system. So the actual addressable market for ISRG would be somewhat larger.
- Using 2,227 as a rough guide, the da Vinci installation base can grow at least 25% before reaching saturation. Even at the torrid system growth rate in 2012, this would take about 5 quarters before the installation reaches full saturation. (Note that only about 70% of quarterly system sales are new placements, the rest being upgrades.) However, we may be near that saturation point and as we get there, we expect the system sale to be leveling or even gradually declining, but the steep decline of the latest quarter does not feel like it.
2. When hospital administrators discuss about purchasing a da Vinci system, the recent JAMA editorial and the ACOG statement would certainly be brought up and cannot be ignored. Given the stature of the critics and given their potential impact on da Vinci hysterectomy procedures, it is not hard to imagine that some hospitals would opt for a wait-and-see strategy. We think this is the true reason behind the US system placement shortfall in Q2. Unfortunately, in our judgment, it is likely to continue for one or two more quarters; Q4 may be the turning point as the budget year ends. So, if we are right, some sales are merely delayed.
3. In the medium term, we do see US system sales reaching the saturation point in over a year or so, after which the US system placement will be driven by upgrades (accounting for about 30% already) and multiple installations. With the continued procedure adoption, we see multiple installations grow to a more meaningful level over time. In any case, we think the worldwide system sale should resume growth in a quarter or two as we expect the momentum in Japan and Europe to compensate any weakness in the US.
The procedure growth of 18% in Q2 is slightly below the expectation of about 20% guided in the last quarter call (for all 2013). The company attributes the shortfall to slower growth in benign gynecologic procedures even though general surgery procedures remains strong. We again believe the negative comments from JAMA and ACOG are probably the main reason behind the slowdown in benign gynecologic procedures (dvH).
- The overall procedure growth rate has been trending down throughout 2012; see Table 2 below for the procedure growth rate over the recent quarters. This is due to the steep decline (see the table) in the prostatectomy (dvP) procedures, which the company attributed to the U.S. Preventive Services Task Force recommendation against PSA testing and a change in treatment recommendations for low-risk prostate cancer away from definitive treatment. This appears to be the case as the dvP procedure count increases sequentially in Q1 2013. Note that the advantage of dvP over its alternative is unquestionable.
Q2 - 13
Q1 - 13
Q4 - 12
Q3 - 12
Q2 - 12
Q4 - 11
Q3 - 11
Q2 - 11
Q1 - 11
Table 2: Quarterly Procedure Growth Rate
- The growth in gynecologic procedures, consisting mainly of dvH, was strong throughout 2012. The growth has slowed in Q1-13 and the company had guided down the procedure growth rate for Q2. It is disappointing that the Q2 growth did not appear to meet the lowered guidance. To understand why, we first note that the slowdown in benign gynecologic procedures began in Q1, which coincides with the publication of the JAMA study and the ACOG statement in mid Q1. After that, this study and the ACOG statement would inevitably be discussed by surgeons with their potential dvH patients. As we have discussed in our previous SA article, the result of the JAOA study actually vindicate company's claim on the da Vinci advantages, but the negative spin of the editorial and the ACOG statement by focusing on the cost gave a false impression on the value of da Vinci to the patients. We do not believe they would deter adoption of da Vinci in the long run, but in the near term, it may have incrementally moved some patients away from dvH, which is what we believe happened in Q1 and Q2.
Looking out, the growth rate for dvH is slowing, but unlike dvP, the dvH procedures currently at 175,000 per year are far from reaching the 350,000 target (out of 500,000 hysterectomy procedures) set by the company and should continue to grow strongly when these unfair criticisms are better understood and fade away. In the meantime, the general surgery has replaced dvP and dvH as the new area of strong growth. Further out, we have confidence in the company to develop the next high growth procedure soon. Cardiology could be the next.
The present revenue outside US is a small percentage of the total revenue. If the number of system placements and the number of procedures outside US catch up to the present US levels, the total revenue would be almost doubled from here, even assuming absolutely no growth in US.
ISRG is a super growth stock that should be traded on its future growth potential. Instead, it has nearly become a value play where it is valued by accountants using various metrics. If you believe in these numbers, then you should at least take into account the very conservative accounting practice of the company and not be misled by some simplistic calculations.
ISRG earns $17.04/share (GAAP) in the past 4 quarters. At $400/share, the market cap is about $16 billion and the simple P/E is about 24. However, if we back out $3 billion of cash and investments, the enterprise value is about $13 billion. The company reports the GAAP earnings only but does provide the information on the stock-based compensation expenses after income tax effect, which amounts to about $2.60/share. Then the earnings excluding stock-based compensations - a standard accounting practice in the tech industry - is about $19.60, which gives an EV/E ratio of 16. We have not found another company with a product that truly improves people's life, with no competitor in sight, but yet trading at this valuation.
Thus, we believe ISRG is a compelling buy at $400 level. However, from the technical point of view, the stock appears weak, having traded past several supports. With probably some more anemic quarters ahead, the bears are on the upper hand at the moment. We think there is a chance that the stock may test the support at around $365.
Intuitive Surgical is an exemplar American business that brings innovation to the world in one of the most conservative sector of the healthcare business. It is unfortunately being attacked by the powers and bears, but in this free economy, we believe the choice of patients and surgeons will prevail.
If you agree that there are only a certain percentage of the population that could ever be trained as surgeons and if you agree that the demand for surgeons will rise due to Obamacare and expanding middle class in the world, then you have to believe that ISRG's technology will save the society from rationalizing surgical care and from skyrocketing surgical expenses in the long run, as there is no doubt that the da Vinci system makes an average surgeon a better one and it enables surgeons to prolong their professional life. A technology that has replaced almost all open prostatectomy surgery and is used for about 1/3 of the hysterectomy surgeries in the US must have done what it intends to do and there is no reason not to trust it to do the same for more.