Deep Dive – $ISRG Da Vinci Robots

by Enis January 16, 2014 7:13 am • Commentary

Intuitive Surgical is a very controversial medical device firm, with a number of controversies surrounding its robotic-surgery systems.  ISRG has been criticized at times by the medical community (whether its systems are effective, cause harmful side effects, marketing that leads to unnecessary procedures to increase revenues, etc.), by the financial community (Herb Greenberg investigated the firm in a documentary for CNBC about 9 months ago), and by the FDA itself.

The controversies have hit the company’s financial results and stopped the stock’s long-term advance.  Intuitive Surgical is one of the few S&P 500 companies that has negative performance since the start of 2012.  ISRG was actually a huge stock winner over the last decade, going from $6.00 in April 2001 to almost $600 in April 2012, an incredible return during a time when the overall stock market was stagnant:

ISRG monthly chart, Courtesy of Bloomberg
ISRG monthly chart, Courtesy of Bloomberg


However, ISRG stock has stumbled over the last two years as earnings did not grow in 2013 for the first time since 2006.

The company is a $15 billion market cap firm, focusing on its proprietary Surgical Systems.  Management’s description from the most recent quarterly release:

Intuitive designs, manufactures and markets da Vinci® Surgical Systems and related instruments and accessories, which taken together, are advanced surgical systems that the Company considers a new generation of surgery. This new generation of surgery, which the Company calls da Vinci surgery, combines the benefits of minimally invasive surgery (“MIS”) for patients with the ease of use, precision and dexterity of open surgery. A da Vinci Surgical System consists of a surgeon’s console, a patient-side cart and a high performance vision system. The da Vinci Surgical System translates a surgeon’s natural hand movements, which are performed on instrument controls at a console, into corresponding micro-movements of instruments positioned inside the patient through small incisions, or ports. The da Vinci Surgical System is designed to provide its operating surgeons with intuitive control, range of motion, fine tissue manipulation capability and Three Dimensional (“3-D”), High-Definition (“HD”) vision while simultaneously allowing surgeons to work through the small ports enabled by MIS procedures.

Detailed explanations and photos can be found at the company’s website, but this representation from the University of Louisville Hospital is a good all-encompassing view of the system:

Screen Shot 2014-01-16 at 6.20.30 AM

The first iteration of the da Vinci system was released in 1999, a second iteration in 2006, and the most recent iteration in 2009.  Sales grew from $90 million in 2003 to $2.2 billion in 2013.  The da Vinci systems have been most frequently used for the following procedures:

Gynecology is our largest U.S. surgical specialty. Overall U.S. gynecology procedure volume grew from approximately 123,000 cases in 2010 to approximately 170,000 in 2011 and to approximately 222,000 in 2012. The growth was driven by adoption of dVH (da Vinci Hysterectomy), our highest volume procedure, and other gynecologic procedures, including sacrocolpopexy, endometriosis resection, and myomectomy. U.S. dVH procedure volume grew from approximately 140,000 cases in 2011 to approximately 176,000 cases in 2012, of which approximately 38,000 were for the treatment of cancer and approximately 138,000 were related to benign conditions. We estimate the total annual U.S. addressable robotic hysterectomy market to consist of approximately 300,000 to 350,000 procedures previously performed in open surgery, of which approximately 50,000 are for cancer.

Urology is our second largest surgical specialty. U.S. urology procedure volume was approximately 88,000 in 2012, compared to approximately 93,000 in 2011 and 85,000 in 2010. We consider dVP (da Vinci Prostatectomy) to be the standard of care for the surgical treatment of prostate cancer in the U.S. About 62,000 dVPs were performed in 2012, compared to 73,000 in 2011 and 68,000 in 2010. The approximately 15% reduction in 2012 dVP procedures in the U.S. were caused by the U.S. Preventive Services Task Force recommendation against prostate-specific antigen (“PSA”) screening, as well as changes in treatment pattern for low risk prostate cancer away from definitive treatment.

However, over the past few years, patient lawsuits have climbed, with the company now facing more than 50 lawsuits from procedures performed by da Vinci systems:  

The Company is currently named as a defendant in about 50 individual product liability lawsuits filed in various state and federal courts by plaintiffs who allege that they underwent surgical procedures that utilized the da Vinci Surgical System and sustained a variety of personal injuries and, in some cases, death as a result of such surgery.

As a result of the layers of accusations, ISRG’s business over the last year has declined.  The dVP procedures have been hurt by the recommendation against PSA screening, while the dVH procedures are also showing signs of decline:

During the nine months ended September 30, 2013, we experienced lower growth rates in the category of U.S. benign gynecologic procedures than in prior years. Year-to-date 2013 benign gynecologic procedures grew at lower rates than the previous year. The slower 2013 growth rate in the category of U.S. benign gynecologic procedures reflected a number of factors including, but not limited to, apparent pressure on benign gynecology hospital admissions, negative media reports, and a trend by payers toward encouraging conservative disease management and treatment in outpatient settings.

Sales only grew 3% in 2013, and earnings were flat as the company’s margins declined a bit.  Management prevented an overall decline in earnings per share by rapidly buying back stock (bought back almost 10% of the float in 2013) and cutting certain expenses (like compensation and R&D).

Nevertheless, the negative commentary surrounding the company is a tall hill to climb, even though ISRG continues to stand by the integrity of its da Vinci systems.  Management has been trying to shift gears towards more international growth (international currently 20% of revenues) given the potential saturation of system sales in the U.S. (though the company still collects annual service revenues on each system).  After significantly reduced guidance in July due to weak U.S. demand, the stock fell almost 20%:

[caption id="attachment_34847" align="alignnone" width="600"]ISRG daily, 200 day ma in yellow, Courtesy of Bloomberg ISRG daily, 200 day ma in yellow, Courtesy of Bloomberg[/caption]

The price action this week has been a story in itself.  The stock jumped on Tuesday after management indicated that fourth quarter revenue was $576 million, vs. $549 million consensus (though, management has stated before that the 4th quarter is seasonally stronger due to patients electing for procedures once the deductibles have been filled).  However, management pointed to continued uncertainty surrounding hospital spending due to the Affordable Care Act, noting:

The uncertainties with regard to the implementation of the ACA, the number of new cases coming in with the new insurance coverage, and what the payment reforms will mean in terms of revenue have put some uncertainty, particularly into the capital acquisition cycle for our customers.”

Not surprisingly, management did try to draw attention to improved international sales.

With a controversial back story, I’m surprised that ISRG has kept a relatively full valuation.  It’s a 25 P/E name with 3-10% earnings growth expected over the next 2 years, and 5-15% earnings growth expected.  But the risks are numerous.  While ISRG’s business model of selling the $1-$2 million system up front, and collecting $100,000-$200,000 per year in service revenue off each system is a nice razor/blade model that improves with a greater installed base, the legal issues, questions about efficacy, potential U.S. saturation, and overall cost of the systems are all overhangs for the business.

Given all of that, I’m actually surprised the short interest is only 6% of float.  If the stock does make another run above $450, a fade the strength structure might make sense.