There has always been controversy around Intuitive Surgical (Nasdaq:ISRG) and its daVinci robotic surgical system. In recent months this controversy has reignited over allegations that device malfunctions/adverse events are increasing and that the system is little more than an expensive, unnecessary toy in procedures like minimally invasive hysterectomy. Making matters worse, this has long been an expensive stock where success has been predicated on double-digit growth in minimally invasive surgery and Intuitive's share in the market.
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First Quarter Results Strong, But Not Where They Count Most
Intuitive Surgical's first quarter is a pretty good example of why or how simply looking at a company's income statement and comparing it to First Call estimates may not give an investor the full picture of what's going on. While Intuitive's financials were quite strong, there were non-financial data points that were more troubling.
Revenue rose more than 23% this quarter, as system sales increased 24% on a 17% increase in units sold and an increase in per-robot selling prices. Instrument and accessory revenue rose almost 26% on a nearly 20% adjusted increase in procedures and a 6% higher average selling price. Service revenue was the only weak area, but I'd use the word “weak” advisedly given the 17% increase in revenue.
Intuitive continues to run a very profitable business. Gross margin did decline nearly one point on an annual and sequential comparison, but this was largely as expected. Operating income increased 30%, though, and came in well ahead of expectation due to both higher-than-expected revenue and lower-than-expected SG&A spending.
SEE: Understanding The Income Statement
Procedure Volumes On A Roller Coaster
The key driver for investor sentiment in Intuitive (and fellow, but different, robot player MAKO Surgical (Nasdaq:MAKO)) is procedure volume. While the reported 18% growth in procedures (and 20% on an adjusted basis) looks good, it was lower than most analysts and investors were expecting and investors won't like the acknowledgment from Intuitive management that the controversy about robot-assisted hysterectomy (“dvH”) seems to be impacting procedure growth.
On a positive note, procedure volume increased 18% despite an 11% decline in U.S. prostatectomy procedures (“dvP”) as the company continues to absorb the impact of a change in treatment protocols. What's more, international procedure volume increased 14% even despite the much-discussed reimbursement pressures that are hitting multiple overseas markets.
From where I sit, I think Intuitive investors need to accept a certain degree of “predictable unpredictability” when it comes to quarter to quarter procedure volume numbers. While I do think there is some competitive risk that single-port surgical tools from Johnson & Johnson (NYSE:JNJ), Covidien (NYSE:COV), and Stryker (NYSE:SYK) could capture some share (particularly since they're about 30% cheaper), most of Intuitive's volume is in procedures that the large majority of users believe cannot be performed without the robot.
I also think investors will see a repeat of the dvP and dvH controversies over and over again. Intuitive is still early in its launch of tools targeting gall bladder removal (a large market), but I suspect there will eventually be papers out decrying the expense of daVinci-assisted cholecystectomy and the similar of results with other minimally invasive procedures – just as we've seen in dvP and dvP procedures. Ultimately, though, I do believe that there is a legitimate use for this device in helping surgeons perform procedures on a minimally invasive basis that would otherwise be too difficult or dangerous, and that benefit is worth a premium price (though perhaps not as much of a premium as Intuitive currently charges).
The Bottom Line
The controversy and worry over Intuitive has put the stock in an unusual place – it actually looks cheap for once relative to my expectations. To be sure, my growth rates are aggressive as I am looking for long-term revenue growth of 12% and free cash flow growth of 13% to 14%. That sort of growth would appear to be worth about $550 per share, and it's worth noting that it was only a short time ago that the market was discounting a much higher (and likely too aggressive) rate of growth.
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It is probably unfair to say that the daVinci system is a two-trick pony, but the reality is that the company has really concentrated on building the business around dvP and dvH thus far. That leaves a pretty promising runway of growth if and when management can develop the devices and support the training efforts to push adoption in the numerous other procedures where the robot could be useful. That said, investors need to appreciate what they're getting into – Intuitive Surgical looks undervalued today and appears to have a strong future ahead of it, but quarterly volatility in procedure growth and never-ending controversy about the utility (and cost-benefit) of the system will keep these shares swinging within a wider-than-normal range.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.