Intuitive Surgical (NASDAQ:ISRG) announced its third quarter earnings on Thursday, October 17th and, despite radically lowered guidance from the company and Wall Street analysts in recent months, the results were not good. Revenues were down seven percent compared to the third quarter of 2012. This makes two straight substandard quarters for the once high-flying company. Not surprisingly, its stock has dropped significantly from an all time peak of almost $600 at the beginning of this year to the $400 range today. Despite the recent selloff, I don't intend to cover my short position in ISRG in the near future. Its stock is still overvalued by at least 25 percent, in my opinion, and I believe it will continue its downward trajectory for at least the rest of the year, and perhaps a good deal longer. By Christmas, I expect it to be close to or below $300.
As I have written previously, most of the fifty shorts in my hedge fund's portfolio are in what I like to call "dead-companies-walking," businesses on their way to bankruptcy. Let me say up front that Intuitive Surgical does not even remotely fit into this category. I have studied the company's history and fundamentals and visited its headquarters in Sunnyvale, California. It's a solid business with scalpel-sharp leadership. Moreover, I don't share the opinion that Intuitive's troubles have much to do with recent legal proceedings or government investigations. Lawyers love to sue medical device companies and regulatory headaches are also part of doing business in that industry.
Intuitive's main problem is not lawsuits or bureaucrats, it's plain old stock market gravity. For years, ISRG shot up like a rocket on the company's phenomenal earnings growth. But that growth has stalled now, perhaps permanently. There's simply no more fuel left in the tank to propel the stock's climb and it's got nowhere to go but down.
In the June 2013 quarter, for the first time in its history, Intuitive sold fewer of its da Vinci robotic surgery devices to hospitals and surgical facilities than it had in the same quarter the previous year: 143 in 2Q 2013 versus 150 in 2Q 2012. It continued this negative sales trend in the most recent quarter, selling only 101 da Vincis versus 155 in 3Q 2012. All told, its revenues shrank from $538m in last year's third quarter to $499m this year. While many investors sold off ISRG following its disappointing results in the June quarter and many more will likely do so in the days and weeks to come, the market has yet to price in just how disastrous these figures are for the company. Analysts have been predicting earnings of more than $15 a share for the full year, roughly the same as 2012. But even if the company achieves that number, its recent results do not come close to justifying its current stock price. Applying a very conservative 15x earnings multiple values ISRG at a mere $225--and even that might be too high.
Intuitive's sales slump is not a temporary glitch, or short-term challenge. Nearly half of its total revenues come from selling new da Vinci devices, which cost about $1.5 million apiece, and medical trends show that future sales are unlikely to rebound in any meaningful way. Surgeons employ da Vincis almost exclusively for two procedures: hysterectomies and prostatectomies. Roughly half of all hysterectomies are for so-called "benign" indications, and fewer and fewer women are electing to undergo the radical procedure in those cases. A study published in the August 2013 edition of the Journal of Obstetrics and Gynecology showed that the rate of hysterectomies dropped by 40 percent from 2002-2010. As for prostatectomies, Intuitive's own most recent annual 10-k reported a 15 percent decline in da Vinci-assisted procedures from 2011 to 2012 and blamed the drop on, "pressures from reduced levels of PSA testing and increased use of non-surgical disease management." On top of these clearly ominous numbers, nagging cost-benefit questions about da Vinci versus conventional surgeries still persist.
To recap: Intuitive makes almost half of its money by selling an expensive product which may or may not be worth the price for procedures that fewer patients seem to want or need. (Another 40 percent of its revenue comes from selling one time accessories for those same procedures.) That is not exactly a sterling business model going forward, at least at the company's current valuation. I visited Intuitive's corporate offices recently and its sales materials show that the company's management is keenly aware of these challenges. Glossy brochures in the lobby advertise da Vinci-assisted surgeries for a host of additional diseases, including lung and colorectal cancers. But non-urological and gynecological procedures account for a fraction of the company's revenues, and it's hard to believe they will ever drive sales high enough to bring ISRG back to its former apexes.
Intuitive bulls can point to several positive developments or possible turnarounds, but none of them will fuel another sustained ISRG rally. While it's true that overseas markets have accounted for a larger portion of da Vinci sales in recent quarters, they still haven't come close to bringing the company back to its previously brisk revenue growth. Similarly, even though Intuitive's impressive marketing campaigns have persuaded more patients to select da Vinci-assisted instead of conventional surgeries, a larger share of a shrinking market cannot possibly produce the kind of growth rate that justifies a $400 stock. At the same time, Intuitive's still-elevated stock price should snuff out any hopes of it being acquired. ISRG rallied briefly in September after a smaller competitor, Mako (NASDAQ:MAKO), was bought out by Stryker (NYSE:SYK). But comparing Mako to Intuitive is like comparing a guppy to a Beluga whale. Even if ISRG does fall significantly in the coming months, as I expect it will, no company is going to be able to swallow its $12-15 billion market cap.
Again, I believe Intuitive is a solid, even great company. I am not one of those short-sellers claiming that da Vinci-assisted surgeries are unsafe, or that the company has failed to train physicians adequately in its use. Da Vinci is a worthwhile, perhaps even life-saving device and it will continue to produce decent earnings, both in sales, accessories and maintenance fees. But as a stock, ISRG is a classic growth-driven winner whose growth has flamed out.