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Summary

  • Struggling companies often retain elevated valuations for surprisingly long intervals before falling rapidly.
  • Intuitive Surgical is a clear example of this tendency.
  • Even after its recent sell-off, Intuitive's stock is still overvalued.

Last October, I wrote about my short position in Intuitive Surgical (NASDAQ:ISRG). I predicted that its stock, which was trading for around $400 at the time, would fall to $300 by Christmas. That turned out to be a bit premature. The stock dipped below $360 in December but, as so often happens with troubled companies, investors were willing to believe better days were coming and ISRG rallied strongly again, peaking above $500 a few weeks ago.

People in the investment world and business media routinely vilify short sellers, and ascribe all sorts of sinister powers to them. Many seem to believe that short sellers can single-handedly bring down a stock. But my experience with Intuitive shows how perilous short selling can be.

As I'm writing about in my book, which is due out later this year, companies with clearly eroding fundamentals often retain unrealistically high stock prices for long periods of time. Investors, by and large, are simply too optimistic. They hope for the best, especially when it comes to companies that produce beneficial products. ISRG has been a clear example of this tendency over the past year. I believe it will soon become an example of another tendency I've witnessed repeatedly in my three decades as a money manager: when investors finally shed their optimism and admit the truth about a business's declining fortunes, its stock price drops far more rapidly than it rose.

Last week we saw the first signs of just such a reality-check on Intuitive. On Wednesday, the company announced another disappointing quarter and its stock plummeted 11 percent in a single day to $374. In my opinion, this selloff was only the beginning of the pain for ISRG. I stand by my earlier prediction. This is, at best, a $300 stock, and I believe it will fall to that level sooner than later.

I was expecting Intuitive to have a subpar first quarter. Its management recently warned investors that "system revenue" would be down, as the company sold only 87 of its da Vinci surgical robots compared to 164 last year. But even with this negative news, last week's results were far worse than I imagined they would be. Revenues shrank 24 percent year-over-year to $465M, and first quarter earnings-per-share were $1.13 versus $4.56 last year. Net income was a disappointing $44m. While it's true that the company had a onetime litigation accrual last quarter, even after adding that back, EPS fell over 50 percent YoY.

Plenty of companies have rotten quarters, even rotten years, and make a strong recovery. And, to be sure, Intuitive faces some short-term headwinds, like reduced healthcare spending due to the Affordable Care Act. But its troubles do not look like they are going to abate anytime soon.

As I wrote about in my first article on Intuitive, even if more surgeons begin to use da Vinci devices, fewer women are undergoing hysterectomies. Those procedures, along with prostatectomies, account for the vast majority of da Vinci-assisted surgeries. Moreover, the company is facing thousands of lawsuits, and the FDA recently issued a warning that devices used in many robot-assisted surgeries might actually spread cancer. Not surprisingly given these challenges, Intuitive lowered its guidance on growth for 2014 procedures on existing da Vinci machines to 2-8 percent from its previous prediction of 9-12 percent. Year-over-year equipment sales will probably be negative for 2014, and this decline will barely be offset by growing instrument and accessory revenue and a ten percent increase in service revenue.

Let me be clear: I do not believe Intuitive Surgical is on its way to ruin. Unlike most of my fund's 50 short investments, Intuitive is not a "dead company walking," a business heading toward bankruptcy. Despite its legal issues, and the FDA warning, its products are extremely well regarded, as is its management. But slowing growth (or no growth) means that the price-earnings ratio for Intuitive's stock will inevitably shrink, probably to the current 16x price earnings ratio on the S&P 500.

Wall Street estimates for Intuitive's 2014 earnings are hovering around $14 a share. 16x $14 equals a $224 stock. That seems low to me. Intuitive has as buyback in place, which will slow the decline in its share price. But the math is clear: ISRG is headed below $300. I will most likely cover my short at that point. Who knows, if the company's fundamentals stabilize, I might even turn around and buy the stock.

Source: To The Bone: There Is More Pain Ahead For Intuitive Surgical