Intuitive Surgical: Game Over Or Game Just Begun?

| About: Intuitive Surgical, (ISRG)

"Games are won by players who focus on the playing field, not by those whose eyes are glued to the scoreboard."

Do you recall that Warren Buffett maxim? It's never been more truer than when applied to robotic-surgical-equipment leader Intuitive Surgical Inc.'s (NASDAQ:ISRG) stock. Right now, the numbers on that company's scoreboard are almost inconsequential, compared to a stunning shift in the company's playing field.

There has always been controversy surrounding Intuitive Surgical, but if you had the audacity to climb aboard to when the company went public fourteen years ago, you would have experienced a climb of almost 2,000%. For more recent shareholders, unfortunately, the trajectory has been mostly downhill. The stock struggled mightily in 2013 over fears that the benefits of robotic surgery were overstated.

The fourth quarter earnings announcement on January 23 of this year wasn't good for Intuitive Surgical either. Intuitive Surgical sold 138 da Vinci Surgical Systems compared with sales of 175 systems during the same period the previous year. Revenue dropped year-over-year, with $576 million reported for the fourth quarter in 2013, down 5% compared to revenue in the fourth quarter of 2012.

There is no direct competitor for da Vinci Si, although there are surgical robots in development at the University of Washington. MAKO Surgical (NASDAQ:MAKO) also has a robot for orthopedic surgery. (MAKO was acquired last fall by Stryker (NYSE:SYK). Single-port surgical tools are available from Johnson & Johnson (NYSE:JNJ) and Covidien (COV). Perhaps most interesting is Accuray (NASDAQ:ARAY), which has a specialty surgical robot for the treatment of tumors.

These companies (and their robotic technologies) are at different places in their life-cycle, so the various performance expectations for their stocks should not be confused with Intuitive Surgical's. None of these companies, in fact, pose current threats to Intuitive Surgical, since none of their technology has the scope of the da Vinci Si.

With no current competition, some analysts claim Intuitive Surgical's stock issues are temporary. They're saying the tide has turned, the company will return to double-digit EPS growth in 2015, and to load up on dips. One recent analyst cited in the company's favor a study showing that patients who undergo hysterectomies using the da Vinci system are less likely to be readmitted to hospitals. He used it as his reason to suggest possibly buying the stock.

The report is good news, but it's a drop in a very large bucket. In fact, I'll stick my neck out and say he's got that call dead wrong.

It's certainly highly possible that Intuitive Surgical's stock could get pumped up by investors who obsess over the latest data offered in the new studies. After all, there's no doubt - with more than a million people in the United States having undergone robotic procedures ranging from cholecystectomy to mitral valve repair, there will be plenty of good data as well as bad.

The question is ISRG's long-term future.

While I'm all for taking calculated risks on emerging technologies, the risk has to be worth it. If Intuitive Surgical were still in control of its own destiny, they'd be a great bet. But they're not. At least, not in the United States.

American hospitals are facing an entirely new world under the Affordable Care Act, and it's a world that's likely to be very unforgiving to companies like Intuitive Surgical. The entire practice of medicine is changing. In particular, a new incentive structure will overturn the fortunes of many medtech companies nationwide, including, I believe, Intuitive Surgical.

Bear with me while I explain.

A key provision of the Affordable Care Act is being missed or misunderstood by many investors. That's partly because the thought of Obamacare sparks an emotional reaction in most people.

But if you want to continue to prosper in health care and medtech investing, you simply must understand at least one bombshell in the health care overhaul.

Remember the Oracle of Omaha's sage advice about keeping your eyes on the playing field? If you invest in health care, particularly health care technology these days, you can no longer afford to be the kind of investor who simply looks at the scoreboard.

So take a deep breath. Relax and turn off at least one of your eight flickering computer screens showing the latest stock quotes or whatever it is that fascinates you.

We're about to go in.

The Bombshell: Fee-for-Service Health Care is Dead

Up until recently, financial incentives for hospitals had everything to do with increasing the volume of surgeries and procedures.

That's the world in which Intuitive Surgical grew by 2000%. In that world, hospitals and medical centers enthusiastically purchased robotic surgical systems, and were willing to absorb the higher costs associated with robotic surgery.

While robotic surgery units are anything but cheap, from $1 million to $2.5 million for each unit, in the good old days that hardly mattered. Technological innovation has historically been one of the key drivers of hospital profit growth. Patients love "Star Wars" technology. When you work in health care consulting, it's stunning to see how quickly extremely costly acquisitions pay for themselves - as they expand the types and numbers of patients attracted to a medical center.

Hospitals like those belonging to South Nassau Community are typical. The center advertises the benefits of da Vinci "changing the experience of surgery." Specifically listed are "significantly less pain, less blood loss, less scarring, shorter recovery time, and in many cases, better clinical outcomes." Another link to a hospital system in Indiana. They proudly announce they were the first in Indiana to use da Vinci to remove a gallbladder. Another from a hospital in Madison County. Their claim? "We're the first and only hospital to offer robotic minimally invasive surgery."

Intuitive Surgical is no slouch at helping hospitals reach out and touch more patients either. It has advertised da Vinci Si on television, radio, YouTube and on billboards. As Dr. John Mulhall, an urologist at Memorial Sloan-Kettering Cancer Center in New York said, "If there was a Nobel Prize for marketing, it would go to Intuitive Surgical."

It was all worth it however, because hospital profit and hospital CEO bonuses (before Obamacare) rewarded volume and growth.

The Affordable Care Act changed all that. The 21st century challenge for American health care is to deliver quality care for less money.

This shift is being facilitated by the creation of Accountable Care Organizations. ACOs are third-party groups that oversee the cost and quality of care at hospitals. Today, an estimated 428 ACOs cover four million Medicare enrollees and millions more people with private insurance.

More Americans will be enrolled in these groups in the coming years. Whatever the eventual fate of some aspects of Obamacare, it's likely there's no road back from ACOs, the out-of-control costs of American health care mandate they continue to grow. "ACOs are coming, and it will change the way we pay for health care," said Dr. Michael Cryer, national medical director for employee benefits consultancy Aon Hewitt. "We're seeing the beginnings of a tsunami."

Under the new system, hospitals and providers are financially incentivized based on quality long-term patient outcomes, rather than the number and type of surgeries and services. ACOs' goal is to reduce hospital admissions, end unneeded surgeries, and shorten the length of stay in the hospitals and post-acute care centers. In other words, to provide less costly (but still quality) care.

There will be a transition phase, of course. Many health care leaders are still managing facilities paid mostly by fee-for-service arrangements. As Dr. Don Berwick, former head of CMS, described the situation in a spot on illustration: "They've got one foot on the dock and one foot on the boat and they're drifting apart. One foot is in fee-for-service, revenue-driven, grow the volume, do more and more, which is the dock, and the boat is, let's focus on what patients really need and decrease unnecessary care and the liability of harmable (sic) unnecessary care."

Has the Boat Sailed For Intuitive Surgical?

Let's overlap Obamacare's game-changing shift against Intuitive Surgical's future. While recurring revenues from service contracts and instruments are a significant percentage of total revenue, the company's future growth depends largely on its ability to sell new units and successfully expand the number of conditions that da Vinci is approved to treat.

Already, while the Affordable Care Act was looming, hospitals became more conservative about their capital purchases. Overhanging doubt about key provisions in the new law clipped Intuitive Surgical's sales, as well as the stock value.

And this is where it gets fuzzy. More than fuzzy, messy, complicated and even a little crazy.

It's clear that the overhaul of the health care requires robotic-assisted surgery to prove it is worth the extra cost because it provides significantly higher quality outcomes. And unfortunately, as of right now, whether or not robotic surgery succeeds at this depends almost entirely on whom you listen to.

I won't bore you with endless pro and con studies. An entire clinical library is available online. They range from studies published in the Journal of the American Medical Association to statements from the American Congress of Obstetricians and Gynecologists to reports on 66 oropharyngeal cancer patients by Dr. Eric Moore, at the Mayo Clinic in Rochester.

Here's the upshot.

As stated in a consensus document on robotic surgery prepared by the SAGES (Society of American Gastrointestinal and Endoscopic Surgeons) Robotic Surgery Group.

"Although robotic surgery has shown great promise across a broad range of surgical disciplines, no Level 1 data exists at this time to strongly support robotic surgery; conversely, no studies or anecdotal reports exist to suggest any increase in complication rates compared to conventional open or laparoscopic surgery."

In other words, are robotic surgeries significantly superior to conventional surgeries across a long list of possible procedures?

We don't know. At least, not yet.

Takeaway for Investors

One final visit to the Buffett rule for long-term investors.

"Games are won by players who focus on the playing field, not on the scoreboard."

Here's where you make your decision and place your bet.

Definitive evidence from well-designed, large-scale, multicenter trials of rigorous nonrandomized evaluations will need to appear. And if that evidence proves beyond doubt - across a large range of surgeries - the cost of using a robot-assisted procedure is justified by significantly better outcomes, then none of what I've written here will mean anything. Hospitals will be able to successfully use this information to respond to pressures from ACOs that robotic surgery costs are too high.

At that point, Intuitive Surgical and its stockholders will be able to swing for the fences again.

On January 23, according to Reuters, the company diverged from past practice by not providing a revenue forecast for the year.

In the conference call, Intuitive Chief Executive Gary Guthart said, "For 2014...we are focused on continuing to strengthen our capabilities in international markets, particularly Europe and Japan."

What do you think? I could be wrong, but it seems pretty clear Intuitive Surgical knows they're facing a brand new playing field. And they're not sure what happens next.

The game is not over for Intuitive Surgical. Not even close. Instead, a new game has kicked off. I'm booking a seat on the sidelines, that's a lot cheaper than the price of a bad bet. You can join me, or not - that's entirely your call.

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.