Intuitive Surgical Market Saturation Could Be Brief

| About: Intuitive Surgical, (ISRG)

Intuitive Surgical (NASDAQ:ISRG) makes surgical robots. In early 2009, during the panic, it dropped briefly below $90 per share. Before that it had been above $290 per share for most of the last quarter of 2007 through the third quarter of 2008. I passed on ISRG in early 2009, concerned about possible saturation of hospitals' needs and ability to pay for new robots, but ISRG rocketed above $500 in early 2012.

On September 3, Intuitive closed at $385.17. Its 52-week high was $585.67 on February 1, while its 52-week low was $357.02 on July 19. Is this a buying opportunity like the kind I missed in 2009? Or was ISRG over $500 per share an example of a one-stock bubble, a mere cautionary tale?

Intuitive Surgical reported Q2 2013 results on July 18, identified some problem areas, and reduced full-year-2013 guidance. Revenue was $578.5 million, down 5% sequentially from $611.4 million but up 8% from $536.5 million in the year-earlier quarter. Guidance for full 2013 revenue was from flat to up 7% vs. 2012. In other words, the worst is yet to come, but the worst is a flattening, not a nosedive.

Intuitive reports three revenue segments, all related to the da Vinci surgical robot. System (actual robot unit) sales revenue was down 16% sequentially and 6% y/y. 143 robots were sold, down from 150 in Q2 2012. Servicing the robots brought in revenue that was up 4% sequentially and up 18% y/y. That is because there were substantially more robots in the field to service than there were year-earlier (total systems in field ended the quarter near 2,800). Instruments and accessories revenue, mainly parts that are used once then disposed after a surgery, did fine, up 18% y/y. In fact the disposables sales generated more revenue than the robot system sales generated.

Strangely, my worry of 2009 was what slowed robot sales in Q2 2013. Many of the larger hospitals now have more than one da Vinci system. They look at the demand for robotic procedures and plan to add a new robot when the older ones are near capacity. Overall da Vinci procedures grew 18% y/y, but typically many of the robots in place are underutilized. One very high use surgical procedure is hysterectomies. The rate of increase in demand for robotic hysterectomies in the U.S. decreased. So some hospitals looked at their capacity and decided they did not need to hurry to get a new system installed. The decreased rate of hysterectomies in turn seems to stem from insurance companies pushing for conservative (and less expensive) medical management, and likely women increasingly resisting the idea that hysterectomies are as necessary as some doctors pitch them to be.

The "mad robot" publicity did not likely help, but the effects were hard to quantify. In case you forgot, even though robotic surgery statistically goes better than non-robotic surgery, at times things go wrong, including occasional robot malfunctions. A set of medical malpractice lawsuits resulted, and publicity is good for the legal business, since it encourages people to sign up to litigate and creates an atmosphere in which juries favor plaintiffs. Surgery is scary, and few people have not seen a science fiction movie featuring a berserk robot. Intuitive's robots, however, are not AI creatures that operate on their own. They are systems designed to give surgeons increased control and visibility during operations.

It would be a good idea, however, to watch for legal expenses, settlements, and jury awards that could impact Intuitive Surgical's bottom line.

The key point here is that revenue growth is flattening, but not falling off the cliff. The reason ISRG ended today 34% off the 52-week high is that back then ISRG had a high P/E, in line with future expectations of rapid profit growth.

I think the $585.67 52-week high was wrong, but not a true bubble. It is a cautionary tale about high-P/E stocks. To retain the high P/E, they have to retain high growth rates. If growth flattens but the P/E continues to grow as investors refuse to notice the new reality, that would be a bubble.

GAAP trailing P/E at today's price is just 22.4, high if ISRG has really hit a wall, but low compared to its glory days. All in all it seems like a reasonable P/E given the situation. If ISRG returns to stronger growth, it should re-inflate.

What do I see going forward? The main trend in 2014 and 2015 will be increased internationalization. Most systems that have sold outside the U.S. so far have been to Europe or Japan. Right now Europe is still iffy, and Japan's bureaucrats are taking some time to reformulate reimbursement policies. I expect China will eventually seem to be a source of almost unlimited demand, and other nations in Asia and South America with large classes of people who can afford quality medical care will also get on the robotic surgery bandwagon. International saturation is a long, long way off.

As we have seen in other tech growth industries, the over capacity problem in the U.S. will likely resolve itself within a few quarters. The number of procedures will continue to grow, which means continually increasing service and parts revenue even if units shipped stalls. One source of procedure growth will continue to be new types of operations that are shifting from manual surgery to robotic surgery.

I think ISRG is very attractive at this price, if you can hold for 2 or more years. More bad news could drive the stock lower in the short run. On the other hand, if Q2 was an anomaly, if the sales lost in Q2 simply make for a rich Q3, ISRG might even see a substantial boost as early as October, when Q3 results are released.

I am adding Intuitive Surgical to my list of biotechnology stocks to watch closely, but will also be looking at smaller companies that may have even better potential for growth and stock appreciation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.