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Mako Surgical (MAKO) is a medical device company that provides advanced robotic solution and orthopedic implants for minimally invasive orthopedic knee procedures.  The company makes a specialty product that consists of a robotic arm and computer navigation system for orthopedic  surgeons to implant unicompartmental knee replacements.   They also sell the implants which are implanted during the procedure. I believe the stock to be grossly overvalued at current levels and am short the name.

The potential market for unicompartmental joint replacements is much smaller than the street is realizing.  The vast majority of patients that present to an Orthopedic Surgeon with advanced arthritis have disease in more than one compartment and are candidates for a Total or Traditional Knee Replacement that replaces all three compartment of the knee.  One of the busier joint surgeons I work with estimates that only 5% of people he sees in his office are even candidates for a unicompartmental joint replacement.  When your knee becomes arthritic it is usually in more than one compartment.  There were 45,000 unicompartmental knees implanted in 2005 in the United States.  This is in contrast to 581,000 Total Knees Replacement implants per year in the United States.

The most popular unicompartmental knee replacement system is the Oxford by Biomet.  This knee has a considerable amount of history and numerous studies behind it and it has been on the market for over 20 years.   Biomet is one of the larger orthopedic companies and has a very large sales force and offers many classes for Orthopedic Surgeons to be trained to implant the Oxford.  The Oxford does not require a computer to implant and is the “go to” unicompartment knee implant for the vast majority of Orthopedic Surgeons.

The costs associated with a Mako system are very large.  The machine sells for $ 850,000.  This is a tremendous upfront cost for a niche market and I anticipate it is a very small number of hospitals willing to make that kind of capital expenditure in the coming age of Obamacare for what is a very specialized procedure.  Additionally a Makoplasty requires a preoperative CT or MRI scan so that the computer can map the cartilage and bone that needs to be removed for the replacement.  It is doubtful that these CTs or MRIs will be covered by Medicare or other insurers unless they are proven to be cost effective.  To date there are no studies in the orthopedic literature to suggest that a “navigated” knee replacement will last longer.  The hospital where I trained purchased a navigation system for 300,000 dollars from Stryker for Total Knee Replacements.  It was used somewhat at first—now it collects dust in the supply room.  The navigation added at least 20 minutes to each case and the navigated cases do not pay more.  At a recent International Orthopaedic meeting a prominent total joint surgeon presented a series of several thousand knee replacements.  Unless they were put in grossly out of alignment they all lasted about the same.  In other words an implant perfectly placed with a computer has yet to be shown to last longer.   

Mako recently reported third quarter revenue of 6.7 million dollars and a loss of 33 cents a share.  The majority of the revenue was from the sale of the machines and not from implant sales.  On average each site that has a machine is only doing 4-5 Mako procedures a month.   This is a testament to the number of people who are actually candidates for this procedure. Multiple analysts on the street have buy ratings on this stock.  I have no doubt they are intrigued by the technology and precision that Mako offers.  Unfortunately, Mako continues to burn through significant amounts of cash including $28 million last quarter.   They recently exercised a secondary offering diluting current shareholders and have $53 million in cash as of the close last quarter.  The company has 26 million in trailing annual revenue and analysts are calling for an increase in sales by almost 50% YOY to 46 million for the 2010 period.  This will be extremely challenging given the current environment in orthopedics and healthcare overall.  Most Orthopedic Surgeons I work with are 20% less busy then there were when the economy was strong.  People are putting off any elective procedures they can.  This has been reflected in Stryker and Zimmer’s relatively flat sales YOY.  Additionally, one analyst on Mako’s latest conference call went so far as to say he was uncomfortable with next year’s numbers and asked for any guidance for 2010 which the company declined to give.  The upfront costs of the system will prohibit all but the largest of Orthopaedic hospitals from making the initial investment.    Sales of the Mako machine are going to get much harder to come by.  It is one thing for the Hospital for Special Surgery or the Cleveland Clinic to fork over 850,000 dollars for a machine that is used for a less common knee procedure.  It is another thing to convince a smaller hospital to make that kind of investment.

In summary, we have a cash flow negative company that sells a very expensive machine for what right now is a very niche product.   I have a 5 dollar price target on the stock and see the only risk to a short position to be a takeover.    Many fast growing companies trade at high Price to Sales multiples as a reflection of future growth potential.  Mako trades at a Price to Sales of 11.  I believe this to be way too high given the difficulty in selling future systems in this environment. Mako does hold many patents regarding navigation.  It should also be noted that all of the large orthopedic companies including Zimmer, Stryker, and Biomet already sell their own navigation systems for total knees. 

I recommend the stock as a short candidate.

Disclosure: The author holds a short position in MAKO