Wait For The Next Shoe To Drop Before Buying Intuitive Surgical

| About: Intuitive Surgical, (ISRG)

Intuitive Surgical (NASDAQ:ISRG), the dominant manufacturer of robotic surgical devices, has had a difficult 2013 and its troubles may continue. Despite theories that this weakness is related to Obamacare implementation concerns or reductions to hospital budgets, ISRG's woes are directly and almost exclusively due to the Food and Drug Administration ("FDA") warning letter and the related investigation into the efficacy, safety and use of the company's "da Vinci" surgical robot, which the company disclosed last quarter. Further, despite theories that the company's recent weakness is probably over, it probably is not.

What investors must now recognize is that government investigations are generally slow and that ISRG's troubles here are bound to continue for the duration of it. Intuitive Surgical was priced for substantial growth, and though it is still growing, the company's development shall be stunted until the conclusion of FDA scrutiny. Hospitals will refrain from purchasing new da Vinci robots, whether or not they want or can afford them, while this overhanging regulatory concern persists.

Hospital administrators are effectively handcuffed, which will restrict ISRG's near-term growth rates. As this incontrovertible predicament continues, Intuitive Surgical will have no choice but to continue reducing its forward guidance. Similarly, analysts will have to reduce their estimates, but most will only do so after the company reports and revises its own guidance. Intuitive Surgical is scheduled to report its third quarter results on October 17, and so it is reasonable to expect that near term growth estimate reductions will occur later this month.

The staring price for a da Vinci robot is roughly $1.5 million. The da Vinci surgical system and related accessories generated about $2.2 billion in revenue for Intuitive Surgical in 2012. Last quarter, the company noted that though sales of instruments and accessories increased 18 percent during the second quarter, revenue from sales of the actual robot declined by six percent. Prior to reporting Q2 results, Intuitive Surgical disclosed that sales of the da Vinci robot system had declined compared to a year earlier. Intuitive Surgical also reduced its sales growth estimates for 2013 to a seven percent increase, while at the start of 2013, the company forecast annual sales growth of 16 to 19 percent.

The safety and cost-effectiveness of the da Vinci robot has been under scrutiny for a while. Regulators were investigating an apparent increase in adverse event reports relating to da Vinci procedures. According to ISRG's Chief Executive Officer, Gary Guthart, the company received an FDA warning letter that indicated inspections performed in April and May found certain reporting deficiencies, including that ISRG did not adequately report device corrections and patient adverse events.

The possible causes behind the adverse events that the FDA is investigating include device defects and a less trained/skilled group of surgeons now using the device, as well as many other possible causes. The da Vinci robot is approved for hysterectomies, cancerous tumor growth and gall bladder removals, but is expected to be approved for an expanded list of surgeries over time. This approval expalnsio will also be delayed by this investigation.

Beyond safety concerns, hospital administrators have debated for years as to whether several da Vinci assisted surgeries are really worth the extra cost to the hospital for the device, and to the patient for the procedure. In February, the Journal of the American Medical Association ("JAMA") published an analysis of data on hysterectomies performed between 2007 and 2010, and concluded that "robotically assisted and laparoscopic hysterectomy had similar morbidity profiles, but the use of robotic technology resulted in substantially more costs." The JAMA-published study may have been a motivating force behind the recent FDA scrutiny, though it is also possible that the decision to probe Intuitive Surgical was wholly based upon its own survey data.

The study, which reviewed data from 264,758 procedures at 441 U.S. hospitals, found that the average cost for a robot-assisted hysterectomy for benign circumstances was $2,189 more expensive than a hysterectomy without robot assistance. The study's cost-benefit analysis solely considered the cost of the actual procedures, and not potential external costs that are commonly associated with procedures, such as the value of a shorter recovery time, or expenses incurred during potentially longer recovery times.

Many proponents of the da Vinci system tout that robot-assisted procedures have quicker recovery times, and also that the benefit from this is significant enough to warrant a higher price, including potential reductions to pain and scarring. The present FDA probe and the related question regarding possible lax reporting by ISRG tarnishes claims regarding better general outcomes and improved recovery times, but that does not mean they are not true (we just have to wait and see). The FDA and healthcare providers must now discover whether the apparent recent rise in incident reports is a true reflection of problems with the robots or the result of some other issue(s).

The adverse event reports sent to the FDA include serious complications, like uterine injuries during gynecological surgeries, burns and pieces of the robotic arm breaking off and falling into patients. Problems will always exist, mistakes will always occur and machines will always break, so the existence of issues does not mean anything other than that the device exists in reality. Many of the above-mentioned occurrences are easily and rapidly resolvable, and often during the same surgery, but incidents are frequent and concerning enough to substantiate a probe. Other issues involve whether the machines are being properly sanitized, including whether any possible sanitization deficiency is due to a design defect and/or improper instructions. Improper santizing could be due to lax hospital standards, or lax employees, but it also could be because the complicated machine has nooks, crannies and joints that are simply difficult to effectively clean.

The da Vinci robots are designed with redundancies aimed at minimizing injuries, indicating that safety is clearly an important issue to Intuitive Surgical, but redundancies come at a price. Even with the safety measures taken by the designers, questions remain and leave some wondering if they are safe enough. Further, the JAMA-published hysterectomy study indicates that the added expense might not generate a superior safety profile, though that study does not appear comprehensive enough upon which to solely base any conclusions.

A significant reason that da Vinci usage has increased so dramatically over the last several years is not because of some government or peer reviewed study, but rather because patients are seeking out and in many cases demanding the robots. Hospitals are clearly encouraging this patient demand. See examples of billboards for medical facilities that are touting their ownership of a da Vinci robot:

This consumer demand is at least partially fueled by facilities marketing their robot ownership, and the demand also compels many facilities to acquire the machines in order to stay competitive. Facilities have become almost obligated to obtain the machines in order to compete for business, and especially at the higher end, where patients have the income to choose more expensive options and the ability to go to the facility that has the staff they desire, whether that staff be man or machine.

Demand for robotic systems is strong enough to support not only ISRG's dominant technology, but also some competitors and/or peers. For example Mako Surgical (NASDAQ:MAKO), offers a product named RIO, which is a robotic arm for use in knee and hip replacement surgeries, among other robotic medical technologies. Robotic devices like da Vinci and RIO will grow in use and also expand into other and further applications over time, and patients are likely to continue demanding their contribution.To this end, Stryker Corporation (NYSE:SYK) recently announced its intention to acquire Mako, which it likely shall.

It is also probable than several other robotic technologies will grow in use, and that the owners will become takeover targets. For example, last quarter, the FDA approved a magnetically navigated catheter system made by Stereotaxis (NASDAQ:STXS) for certain cardiology applications. This is yet another example of a new and complex device that targets a completely different medical issue, but with the same goal of enhanced precision through machine manipulation of instruments placed inside of patients. Most individuls will prefer the more precise method, as will most surgeons.

As da Vinci robots proliferate, their usage becomes more standardized and commonplace. Nonetheless, the earliest adopters were more profitable and high tech facilities that also generally have above average doctors and safety records. As a result, it could have been that the initial safety metrics regarding da Vinci procedures would have been better than average regardless of the robot's usage, simply because the human element was one that would generally perform above average. To the extent that this may be the case, as the number of facilities and surgeons who use the robot expands, the safety profile for robotically assisted procedures revert towards the norm. Such a reversion would not necessarily mean that the device is not worth using, but only that the preliminary data is not.

There are certainly reasons why and situations where a robot should be helpful. A robot should be more precise and steady with a scalpel and have superior vision than a human, and such abilities would not be diminished by daily fatigue, as they would be on a person. Nonetheless, for every advantage, there is going to be some limitation. One notable limitation is that the device will lack the ability to feel around, probe and sense for non-visible issues in a manner that a trained surgeon might.

Though the usage of the da Vinci robot and other robots in surgical procedures is likely to continue increasing over time, the near term speed at which usage grows has already hit a speed bump and may continue to slow due to this regulatory headwind. The ongoing government scrutiny of the da Vinci robot has and will undoubtedly continue to prompt many hospital administrators to refrain from purchasing the expensive device until the investigation is completed.

Individuals arguing that ISRG is better priced now than it has been since 2009 may be right, but that does not mean shares cannot decline further due to continued sales weakness on the back of this issue. To that end, on the other side of the probable further reduction to 2013 estimates and a corresponding continued estimate reduction for 2014, shares may be even better valued, presuming this investigation ends favorably for Intuitive Surgical.

IRSG shares are likely to remain volatile, yet with minimal upside potential, until the FDA investigation is resolved. Government investigations are generally slow, and so it is relatively unlikely that this one will be concluded within 2013. Despite this near-term uncertainty, the continued proliferation of robotic technology into operating rooms is inevitable, as is the continued expansion of approved procedures and related applications. Patient investors are likely to find a more advantageous long-term price in the coming weeks, at which point ISRG may represent an opportunity not to be missed.

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.