The stock market is a funny place, and it’s not all that uncommon for an analyst or investor to find himself defending a company/stock he once was not all that interested in owning. That’s where I’m at these days with Intuitive Surgical (NSDQ:ISRG), as although I’m accustomed by habit to lamenting Wall Street’s excessive enthusiasm for the company and the "everything is awesome" blue-sky feedback from docs during due diligence calls, sentiment has shifted quite a bit over the past few months.
Certainly there are real challenges for Intuitive now. Getting excluded from additional reimbursement in Japan for 2014 was a disappointment, and the company logged a sizable 2nd-quarter miss as lower procedure volume and lower utilization translated into lower machine orders. What’s more, another study has come out attacking the cost-benefit validating of robot-assisted hysterectomies. Although I do think Intuitive is looking at a turbulent period of adjustment, the long-term arguments for increased use of the da Vinci platform in a variety of surgeries remain in place. With that, patient and risk-tolerant investors have an opportunity here.
New study, familiar conclusions
Matters for Intuitive Surgical were not helped by a recent publication in Obstetrics & Gynecology of a paper from the University of Texas Southwestern Medical Center concerning hysterectomies. In this paper, 16,000 procedures were compared and used to support a conclusion that da Vinci robot-assisted surgeries offer almost identical complication rates at a meaningful additional cost to the hospital/healthcare system.
Honestly, I don’t know how much these papers really matter any more, as they always seem to have the same conclusions and the same omissions. To wit, the issue of patient comfort and pain was not addressed. Likewise, it remains debatable whether comparing robot-assisted surgeries to minimally-invasive surgeries is wholly appropriate.
The argument for robot-assisted surgery is supposed to be that it allows procedures to be done on a minimally-invasive basis that would otherwise have to be done as open procedures. I’m not claiming that doctors don’t use it as a straight-up alternative to minimally invasive procedures, nor that the company doesn’t encourage or abet it, but papers like this seem to generate more heat than light.
Eventually sentiment matters
What concerns me more, frankly, is an earlier study from Johns Hopkins that suggests that complications from robot-assisted surgeries are much more common than reports to the FDA would suggest. In particular, the study referenced a prior survey where over half of surgeons (57%) anonymously surveyed said they had experienced an irrecoverable malfunction during a robot-assisted procedure that required a conversion to a laparoscopic or open surgery.
At the end of the day, if the da Vinci doesn’t make a surgeon’s life easier (and the patient’s life better), it has no purpose. Yes, hospitals come under a lot of pressure to offer and use it because many patients have been sold on the "gee whiz" advantages of it, but complication rates are what come back squarely to bite surgeons and hospitals in the rear end.
Likewise, concerns that the company has been over-selling the advantages of the system could weigh on its attempts to grow procedure volume in various segments of general surgery. Between the declines in prostatectomy and hysterectomy (whether they are from decreasing overall procedure volumes or share loss for da Vinci), expansion into areas like gall bladder removal, gastric bypass and so on is definitely key to the company maintaining double-digit revenue growth and hitting various sell-side performance targets.
Can system growth reignite?
You can bet that analysts and investors are going to be paying keen attention to Intuitive’s system placements for the next few quarters, as so many were struck flat-footed by the 5% decline in placements in the 2nd quarter. In particular, it’s worth wondering whether this is a by-product of a shift towards less time-consuming procedures or an overall cooling towards the approach – if it’s the former, system demand should pick up as excess capacity gets absorbed with higher procedure volumes.
I also expect to see and hear more buzz and speculation about a new da Vinci system. Management has been pretty cagey about what they’re doing here, but if the sentiment really starts building that a new launch is imminent and that the new platform offers meaningful advancements, you could see hospitals hold off on orders prior to the launch.
The bottom line
I’m still willing to go with a baseline assumption that Intuitive Surgical can grow revenue at nearly a 9% rate over the next decade, with over 10% free cash flow growth. Such a growth rate doesn’t preclude more growth for Covidien (NYSE:COV) or Johnson & Johnson (NYSE:JNJ) in minimally invasive surgery, as there are still many procedures that can be converted from open to minimally invasive with the use of new tools and systems.
At the same time, it does assume that Intuitive can do a better job of addressing these worries about complication rates and the cost-benefit analysis of robot-assisted surgery. While I do expect that there will always be a backdrop of skepticism about da Vinci procedures (it happened with prostatectomy, it’s happening with hysterectomy and it’s only a matter of time before it starts happening with cholecystectomy (gall bladder removal)), eventually there will be a make-or-break point where the skeptics are either vindicated or ignored thereafter.
For now, I’m comfortable with a fair value target of $425 on ISRG shares. With that, it’s actually 1 of the more interesting values in medical devices today, which is something I never really imagined myself saying. While there are certainly higher-than-average risks here, a more aggressive move by management to grow the business in general surgery and/or answer criticisms about complication rates could go a long way toward restoring confidence in the name.
Stephen Simpson CFA is a former sell-side and buy-side analyst who focuses most of his professional attention on financial and investment writing. In addition to a decade of work as an analyst, Mr. Simpson has worked as a wet-bench biomedical researcher and a consultant in the med-tech industry, as well as writing on a freelance basis for over 10 years. He can be reached via email at firstname.lastname@example.org.