Can Intuitive Surgical Drive Wider Adoption Fast Enough To Maintain Multiples?

Jul.20.12 | About: Intuitive Surgical, (ISRG)

Coming out of second quarter earnings, it's as clear as ever that surgical robot company Intuitive Surgical (NASDAQ:ISRG) does not have the luxury of being casual about driving wider adoption of its daVinci robotic surgical system. While the U.S. prostatectomy market is not going to disappear, the multiples on this stock leave almost no room for disappointment and declines in this long-time core market are starting to weigh on procedure volumes.

Procedure Volumes Come Up Short For Q2

While Intuitve's overall performance was very solid in the second quarter, procedure volume trends are going to dominate the story for the foreseeable future.

Revenue rose 26% and actually surpassed estimates, system revenues came in quite strong (up 23%) on 16% system placement growth. Procedure volume (instruments and accessories) grew 30% and actually beat most sell-side estimates, but due to a slightly larger increase than expected in per-procedure revenue (up 4%). Procedure growth was up 26% this quarter -- about 2% shy of most analysts, and down from 29% growth in the first quarter. Interestingly, U.S. growth held up relatively well (27% versus 29% in Q1), but Europe and Japan really fell off (21% versus 31%).

Intuitive continues to post phenomenal margins for a healthcare hardware company. Gross margin stayed steady at 72% -- a level that only a relatively small number of capex-centric companies can match or exceed. The company also continues to deliver good operating income leverage, growing 34% at this line for the quarter.

The Company's Prostate Trouble

While robot-assisted hysterectomies have become a significant procedure for Intuitive, this company largely built itself on the robot-assisted prostatectomy (or dvP), as the procedure offers shorter stays and better patient outcomes, despite longer times and higher costs. Unfortunately, the U.S. prostatectomy market is showing definite signs of a slowdown.

Intuitive doesn't give much per-procedure information, so there's a lot of guesswork involved in assessing the impact. Nevertheless, at about 16-20% of the company's procedure base, I'd estimate that Intuitive saw a 6-12% decline in U.S. dvP procedures -- which would explain the 2% or so sequential decline in U.S. procedure growth.

Multiple factors are playing into this situation. Higher insurance co-pays and deductibles may have some role, but so too does the move towards less PSA screening and decisions by more patients and doctors to go with active monitoring versus surgery. This situation could potentially get even worse in the years to come; the efficacy of Johnson & Johnson's (NYSE:JNJ) Zytiga and Medivation's (NASDAQ:MDVN) enzalutamide has been quite compelling and even if the label only suggests about 25% overlap with Intuitive's patient base, the possibility of off-label usage or expanded labeling cannot be ignored.

New Applications Are No Longer A Luxury

I would think that the prostatectomy market will stabilize over the next 9-18 months, but the impact on procedure growth (and, by extension, the stock) is such that Intuitive needs to step up adoption of other robot-assisted procedures. Analysts and physicians have been saying for years that the system could have broad applicability in thoracic, colorectal, and general surgery, and it's time to get that process moving. After all, as investors saw recently with MAKO Surgical's (NASDAQ:MAKO) unimpressive knee procedure volume trends, the Street cares a lot about this particular detail.

Intuitive is seeing good interest in its new Single Site instruments (for gall bladder removal), but the question is how quickly the company can develop instruments and move them through the FDA. At the same time, Covidien (COV) and Johnson & Johnson are also fighting hard to keep their respective surgical tools businesses growing and price competition/bundling is an option for them. There may even be a "you snooze, you lose" aspect here as well -- it could be argued that the success of transcatheter heart valves from Edwards Lifesciences (NYSE:EW) and Medtronic (NYSE:MDT) has reduced some of the need for Intuitive in cardiology (though there are many other procedures that TAVI does not replace).

What About Capex?

Given the strong system placement numbers, maybe there's not so much reason to worry about whether hospitals have room in their budgets for the $1.5 million daVinci robots. But Hologic (NASDAQ:HOLX) is trying to market its new 3D tomo system, Varian (NYSE:VAR) is pushing its image-guided radiation therapy offerings, and the new diagnostics platforms at Gen-Probe (NASDAQ:GPRO) (which is being acquired by Hologic) and Becton Dickinson (NYSE:BDX) run into the six digits.

There's only so much capital to go around at hospitals (as seen in the declining sales of patient beds at Stryker (NYSE:SYK) this quarter), so it really behooves Intuitive to make its robots as useful as possible, even if surgeon support for them is quite strong.

The Bottom Line

Even with the stock down about 15% since my last write-up, these shares still are not cheap. I'm willing to accept the potential for double-digit revenue growth out past 2020, and free cash flow margins sustainably in the 30's, and that points to free cash flow growth in the low 20% range for a decade. At that rate, Intuitive will be the next Stryker by 2016, but that still only supports a fair value below $500 even at a rock-bottom discount rate of 8%.

Accordingly, I'd still be inclined to stay on the sidelines with Intuitive Surgical stock, at least as pertains to a long-term investment option.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.