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Shares of Intuitive Surgical (ISRG) sold off hard in after-hours trading on Thursday. The technology leader in robot-assisted minimally invasive surgery, known from the da Vinci robot, reported a disappointing set of third quarter results.

Third Quarter Results

Intuitive Surgical generated third quarter revenues of $499 million, down 7.2% on the year before, and far below consensus estimates of $526 million.

Net earnings fell by 14.2% to $157 million. As Intuitive Surgical has been repurchasing shares in recent times the fall in earnings per share was a bit more limited.

Earnings per share came in at $3.99 per share, down 10.5% on the year before. Earnings came in far ahead of consensus estimates of $3.40 per share.

CEO Gary Guthart commented on the third quarter performance, "Our third quarter results were impacted by the same pressures we faced in the first half of the year - namely, moderating growth in benign gynecology, combined with changing hospital capital spending priorities associated with the implementation of the Affordable Care Act."

Looking Into The Results

The real shocker was the large fall in system sales. In the third quarter, Intuitive sold 101 da Vinci surgical systems, down from 155 last year. System revenues fell some 31.5% to $159 million as a result, although average selling prices increased slightly to $1.57 million.

Revenues from instruments and accessories rose by some 10% to $239 million, being driven by a 16% increase in the number of surgical procedures being performed by the robots. Service revenues rose by 15% to $101 million as the installed base of da Vince systems kept increasing.

Operating income fell by 17.5% to $174 million. Note that despite the bad results, Intuitive boosted stock-based compensation by three million to $50 million over the past quarter.

Despite the poor results, notably on a sequential basis, gross margins came in at 71.5%, up 150 basis points compared to the second quarter, driven by higher average selling prices.

Valuation

Intuitive Surgical ended the third quarter with $2.53 billion in cash, equivalents and investments. The company operates without the assumption of debt for a solid net cash position.

Revenues for the first nine months of the year came in at $1.69 billion, up 7.6% on the year before. Net earnings rose by 4.8% to $504.8 million. At this pace, full year revenues could come in around $2.2-$2.3 billion as earnings are seen around $650 million.

Factoring in losses of 7% in after-hours trading, with shares exchanging hands at $370 per share, the market values Intuitive Surgical at around $14.8 billion. This values operating assets of the firm at $12.3 billion, at roughly 5.5 times annual revenues and 18-19 times annual earnings.

Intuitive Surgical does not pay a dividend at the moment.

Some Historical Perspective

Despite a very difficult year so far, long term shareholders in Intuitive Surgical have seen insane returns. Remind you that shares of the company traded at just $15 in 2004 and they steadily rose towards highs of $580 at the start of 2012, and even this year. Ever since, shares have lost more than a third of their value, trading around $370 per share.

Between 2009 and 2012, Intuitive Surgical more than doubled its annual revenues towards $2.18 billion. Net earnings roughly tripled to $657 million in the meantime.

Investment Thesis

Intuitive's problems are far from over. It all started this year when the FDA was surveying surgeons about the devices after reports indicated that possibly 70 deaths have been related to the use of the da Vince since 2009. In July, the company received a warning letter from the FDA saying that the company had not kept track of device correction and adverse patients outcomes administration in some cases.

Besides these immediate and serious issues, the company has received some scrutiny for a longer time. Besides questioning the safety, some are also wondering how cost effective the robots are. All this newsflow reflected rapidly impacted the company's operations, showing weak second and third quarter results.

Back in July, the company guided for unchanged to 7% full year revenue growth, but this will now come into the low end of the range. Besides all these issues, the implementation of Obamacare is also leading to a uncertainty in hospital budgets. Note that the company still sees 16-17% procedure growth, compared to the base of 450,000 procedures performed in 2012.

Luckily for investors, Intuitive Surgical has a highly flexible business with fat profit margins. Note that revenues fell some 13.7% compared to the second quarter, which is quite sizable. In the meantime, net earnings fell from merely $159.1 million to $156.8 million as earnings per share rose on the back of sizable share repurchases over the past quarter. Note that Intuitive bought back 1.74 million shares for an average of $399 per share over the past quarter, still having $1 billion in buybacks being authorized by the board.

Still investors are not impressed. The true shocker is the system sales which fell by 31% on the year before, while system sales only fell by 6% in the second quarter. The impact on overall revenues is still being mitigated by service and accessories revenues, but lower system sales does not bode well for total revenues in the medium term.

While the company remains really upbeat and stresses the safety, efficacy and cost-effectiveness of the da Vinci robot, the market is disagreeing triggering the significant sell-offs lately.

Back in July, when Intuitive reported its second quarter results, I last took a look at the company's prospects. I concluded that insurers are becoming more cost-aware, possibly driven by still uncertainly regarding the implementation of the Affordable Care Act. I stressed the importance of system sales which drive accessories and service sales, making up the majority of Intuitive's revenues. Even so, variable costs per procedure under the da Vinci robot are higher compared to traditional operations.

I concluded that investors are hit by a double whammy, seeing both lower earnings growth as well as a lower valuation multiple attached to that. The continued pressure from the FDA is rapidly impacting system sales which might have a serious effect on revenues in the medium term if weakness continues and intensify.

I remain extremely cautious, not having spotted any reason yet to pick up some shares.

Source: Intuitive Surgical - Uncertainty Remains As System Sales Plunge