The Inflection Point's  Instablog

Medical device maker, Intuitive Surgical Inc. (ISRG), produces the robotic da Vinci System used in urologic and gynecological surgeries. The da Vinci system has singlehandedly transformed the way urologists have approached prostrate surgery over the past 5 years. ISRG has recently made in-roads in additional modalities such as gynecological and cardiothoracic surgeries, positioning the company for continued growth in this competitive field. 

With all due respect towards its technology and prospects for long-term growth, TIP™ believes ISRG’s business is at a negative inflection point in the current market environment – one that will result in a lower stock price and valuation in the coming months. There are three primary reasons we believe ISRG is an attractive short here:

• Discretionary medical spending has taken a dive in the first six months of this year. As observed in this past week’s negative earnings pre-announcements by former stalwarts ILMN and MYGN, discretionary medical spending has taken a turn for the worse in the first half of 2009. Not only was Q2 weak for ILMN and MYGN, but Q3 also seems poised to continue this trend. Such an environment does not bode well for ISRG, a company heavily reliant on hospital spending.

In a poll taken by J.P. Morgan, 60% of respondents noted a slowdown in hospital capital spending over the last three months, with an average decline of 12.5%. Twenty of the 26 respondents remained pessimistic that cap-ex will improve anytime soon. In fact, most expected further reductions over the next 13-24 months. Particularly worrisome for ISRG is the expectation that robotic surgery is an area that will undergo the most significant spending cuts in the short term. 

It should be noted that J.P. Morgan has a $118 price target on ISRG, so there could be some conflicting interests in their research report.

• ISRG still trades at a very high valuation. For a company whose earnings are set to decline in 2009, a 35 PE is unwarranted. ISRG also trades for over 6x revenues, making the stock very pricey on a price-to-sales basis. With the stock priced for perfection, an earnings miss, slowdown in sales or negative guidance could be catastrophic for anyone caught long in the name.

• ISRG is showing technical weakness. As the Health Care Equipment sector falls out of favor, subtle signs of weakness can be observed in its 6-month chart. We have highlighted some areas of concern on the chart below:

ISRG 6-Month Chart
Source:  Stockcharts.com                                                                                                                  

Not only has ISRG’s volume been decreasing with each move higher, ISRG’s 20-day and 50-day SMAs are also showing signs of faltering in here. The 20-day SMA (blue line) has hit a short term plateau, moving sideways in the past few days. Should the stock weaken further, the 20-day seems poised to turn downward in the coming weeks, an ominous sign heading into ISRG’s July 22^nd earnings report.

To sum up our short thesis:  With no near-term sign of a recovery in discretionary hospital spending, a stock priced to perfection and signs of declining institutional support on the chart, we feel compelled to short ISRG. The rising short interest (20%) already in the name doesn’t hurt our case either.  

We entered this trade on Monday morning via the “in-the-money” August 170 puts for our accounts with options capability and by shorting the stock for the margin accounts we oversee. ISRG could go down to $120-130 on any type of earnings miss and less than stellar guidance. 

Disclosure: Short ISRG stock and long 170 August puts for the accounts we oversee.