Intuitive Surgical (ISRG), maker of the da Vinci surgical robot, had a wild ride over the 24 hours surrounding their earnings release last week. They released market-beating earnings after the market close on Thursday, which brought an immediate bump up by about 20%. Then Friday morning the shares fell from the previous closing by about 10% after an analyst downgrade -- a swing from about $112 at closing yesterday, up over $120 in the after hours, then back down to about $100 ... and they opened lower today, hovering just under a hundred dollars a share.
This isn't that new for ISRG. System sales can be quite lumpy from quarter to quarter, and management has a history of issuing pretty conservative guidance and then beating it, so each time they issue fairly tepid guidance the shares collapse a little, only to (usually) climb again by the time the next quarter is released.
So what was the bad news in the conference call that brought the shares down? The analyst who cut his rating to hold argued that the shares are now fully valued given their growth rate, and that's certainly a defensible position to hold (even if it's not mine).
I continue to believe that Intuitive is a few years away from having a truly spectacular ongoing revenue stream, with or without massive growth in the sale of new systems. As long as I can focus on the longer term (not quarter to quarter), I'll be very pleased with the growth of the installed base of systems as well.
Long Term da Vinci Growth
So far, system sales (the sale of the actual da Vinci surgical robots) still make up the majority of revenue -- about 55% -- but utilization is growing so quickly that the installed base is beginning to require a significant number of new instruments and significantly more doctor training. Instrument and accessory sales are already growing slightly faster than system sales.
There were 42 new da Vinci surgical robots added to the worldwide installed base in this last quarter, three more than in the quarter before. So there are now 509 systems installed worldwide (there were also four "trade-ins", so you may see totals of 46 for the quarter in some places, but those also removed four older machines from the market). It seems likely that their ability to forecast system sales is going to suffer further, as the sales cycle is getting a bit shorter. Their cycle is down to six months or even less in some cases, and some sales have less than a quarter lead time.
Each procedure done with a da Vinci generates somewhere between $1,500 and $2,000 in sales, primarily for instruments that are only usable for a limited number of procedures (and that doesn't count the instrument and accessory sales that accompany new installations). And while there is a huge range of utilization rates across different hospitals, procedure growth continues to be dramatic, and more and more hospitals are adding second, third or (in one case) fourth robots (12 of the sales this quarter were to hospitals with multiple machines) -- which leads me to believe that this recurring revenue stream should soon eclipse the systems sale revenue.
But it really seems to me that investors are conditioned to focus only on the "units sold" number and on sequential growth. In that light, Intuitive didn't look that spectacular this quarter. They sold 39 robots last quarter, and 40 in the fourth quarter last year, so the 42 sold this quarter don't jump out as a dramatic growth indicator. Since the summer quarter is a pretty soft one for sales, according to management, and year over year growth was dramatic, I don't see anything significant to be concerned with at this time. That strong and steady procedure growth noted by the CFO is much more significant than the quarter to quarter system sales.
Here are a few of the other things I thought were notable in the conference call:
Gross profit margin declined to 66% from 69.2% as a result of writeoff of inventory, and increased overhead with manufacturing expansion. They expect margins to improve by 100 basis points in the fourth quarter, which is promising. The expansion of their manufacturing capacity is complete, and they're now expanding engineering and product development space.
Non-cash stock options expenses are still pretty high, 7 million this quarter -- much of that is credited to their sales force, which has been expanded over the past year, and as long as they're in hyper growth mode and pushing sales of the systems to expand their footprint, I'll consider that to be reasonable. Right now, stock options reduce their gross margin by about one percentage point (still in the high 60s, so it doesn't bite too much yet).
52 hospitals now have multiple robots -- the biggest news this quarter was that Penn purchased three new systems, in addition to their first, to be the first hospital with four robots as they build out a "center of excellence" in robotic surgery. Nine other customers now have three systems. (As I've written before, the goal is to have three robots each in all 1,500 of the largest US hospitals, which would bring the installed total to roughly ten times today's number ... and make a lot of people very rich.)
Growth in Gynecology and Urology Procedures
Clinically, they're seeing solid sequential procedure growth. Gynecology had the largest sequential percentage growth (though from a small base), followed by urology. New robotic surgical societies, publications, and conferences continue to sprout up and spread new techniques and procedures.
Results of clinical studies continue to show that cancer control and physical recovery are much better for da Vinci prostatectomies than for open prostatectomies -- after following this story for a couple years, it now seems to me that traditional open prostatectomies are almost never appropriate for standard cases (I'm not a doctor, that's just my impression).
In the key gynecology market (key for future growth, anyway), the da Vinci hysterectomy run rate will exceed 2% this year (5,000 of a projected 250,000 target market). This will continue to place demand on hospitals to increase their capacity to perform these surgeries, as one can only imagine the competition between urologists and gynecologists for the available machine time. Three papers were published on the da Vinci hysterectomy this quarter, but there has not yet been a big, influential, data-driven study published that might push the envelope on these procedures. Several such studies are underway, however.
For comparison purposes, ISRG exited 2002 at 1% and 2003 at a 3% run rate for prostatectomies -- and for 2006 they'll be at 2% for hysterectomies (prostatectomies should be near 35%). There are some significant differences between the specialties, but it's encouraging that gynecology is doing well out of the gate so far, since the hysterectomy market is so much larger.
Still, every procedure has a different adoption curve. Typically, cervical cancer is more urgent than prostate cancer and doesn't necessarily provide the time for consideration of many options, which leaves less time for shopping around and finding out about the da Vinci hysterectomy. And hysterectomy patients are likely to have a close provider relationship with a primary gynecological caregiver, so that doctor will strongly influence what they do.
Most men don't have a urologist as a primary doctor, and prostate cancer generally provides more of a lead time for action, so they are more comfortable with shopping around to find out about alternative procedures if their urologist doesn't offer the da Vinci prostatectomy.
Heart surgery is growing well, too -- at least one surgeon is reporting dramatically better mitral valve repair results (95% success versus 50% success in traditional mitral valve repair), and lots of new clinical interest in da Vinci for revascularization
One analyst asked what kind of utilization rate would force hospitals to upgrade to a second machine, and there was no precise answer -- but management's sense is that once a machine starts getting used for one surgery per operating day that begins to put pressure on the system. So once 250 or so procedures are done a year, the pressure will grow to get additional machines. That threshold may be lower if the machine is shared across several specialties, which is getting more common.
All this leads me to be just as confident in this company as before -- and perhaps a little tempted to add to my position again now that the shares are hovering right around my average cost per share. And to ice the cake, they also improved their outlook -- ISRG had expected 50-55% sales growth, now projecting 58-60% overall sales growth, with all segments growing. 62-64% expected growth for instrument revenue leads the pack, as procedure growth continues to build this recurring revenue stream.
They could easily sell 50 systems and post blowout numbers in the fourth quarter and see their share price rocket ... or they might sell 35 systems, miss the numbers, and see the price halved. In the long run, though, I think their monopoly position in their niche and their growing installed base will drive them to many years of strong growth.
ISRG 1-yr chart: