Much has been bantered about Intuitive Surgical's (NASDAQ:ISRG) recent revenue and earnings weakness and the reason for a dramatic fall off in system sales. We first would like to stress that we do not believe management's explanation that this is primarily about the Affordable Care Act. You cannot have it both ways. The one aspect of AFA that is not in question is that costs will rise and, hospitals have to look to all areas where they can reduce operating costs. If Intuitive Surgical can demonstrate to hospitals that using da Vinci can meaningfully reduce costs, why has it been such a hard sell in recent quarters? Isn't that what administrators want? So that argument is suspect at best.
We believe the most likely culprit is the mounting evidence that there have been many botched surgeries with long-term health consequences for patients and many of those patients are starting to come out of the woodwork as the popular press has gotten a hold of this story. Whether the culprit is the machine itself or lack of training it is almost immaterial at this point. The Manufacturer and User Device Experience database (MAUDE) will continue to grow and there is no quick fix here.
Consider both possibilities. We do not believe that the system itself is fundamentally flawed. However, if there are design flaws in the systems themselves the system could be pulled from the market until they are repaired. Lack of extensive training among surgeons using the system is the more likely culprit; although it is possible the problems stem from some of each. There are no standards for surgeon training and, it is our understanding, from contacts within the medical community that most surgeons opt for very little training. After all, da Vinci is supposed to provide a system that is more precise and procedure friendly.
Many Challenges Remain
The company still faces the following challenges:
- Mounting evidence of much more litigation to come. Surgeons only have to voluntarily report problems to the FDA. Hospitals are required, but often do not. This means that once this is investigated many more problem cases could be found.
- Patients who had surgeries several years ago are beginning to come forward and report their experiences.
- The weak system sales in the recent past do no bode well for the recurring disposable revenue in the immediate or intermediate future
- It is likely that due to the litigation surgeons and hospital administrators will seek to reduce the number of procedures at least until answers are found as to why this has occurred.
- The appetite for technologically advanced equipment is abating. Formerly seeking to be "state of the art" to attract patients, hospitals have shifted to devices and equipment that can clearly reduce costs. Even if Intuitive Surgical can demonstrate significant cost savings, the potential malpractice liability may outweigh the provided cost savings.
Valuation and Stock Price
So what does all this mean to the stock price in 2014? ISRG is down 23% and 35% year to date and from its high, respectively. Yet, even with systems sales down one third in the third quarter and operating income falling 17.5% the stock still sports a forward PE of 23 and a price to sales of over 6, both of which seems excessive given the risk to revenue growth of further litigation. The saving grace so far has been instrument and accessory growth, up 10% in Q3 on 16% procedure growth. The recent severe reduction in system sales does not bode well for instrument and accessory growth in the intermediate future. And, as evidence mounts of more past problems caused by lack of training or system issues it is likely to begin crimping procedural growth in the near future.
We believe it is highly likely that further disappointing quarters are in the offing over the course of 2014 and there is little that could reignite forward momentum in revenue. We are early in this inquiry. A resolution will take time which leaves a cloud of uncertainty. Hospital administrators do not so easily defer to surgeons as they once did and are beginning to step in where they believe high risk leads to high costs and increased liability. Even if they are unable to reduce procedural volumes on current da Vinci systems, they do have the power to stop new purchases. Until there is more clarity on if and what the benefits of da Vinci are it is likely that administrators will be reticent.
A more appropriate forward multiple would be mid-to-high teens. Our analysis demonstrates that given the uncertainty a generous forward PE ration would be 15x which equals a stock price of $253, a 51% downside from current levels. Even if the PE is too low, there is a substantial opportunity for downward estimate revisions over the course of 2014. If systems sales begin to stabilize within the next two quarters, while procedure volumes at least remain steady there could be modest PE expansion to 25x leading to a price of $436, or 15%.
We believe that robotic surgery is the surgery of the future. That it will enable the potential for better patient care and cost reduction. However, even if the da Vinci system ultimately achieves a clean bill of health, there is much for the company to go through to prove it over the next 12-24 months. We recommend shorting ISRG at current levels given the potential for 50% gain with a limited loss potential.