Surgical robotics leader Intuitive Surgical (Nasdaq:ISRG) consistently posted exceptionally strong growth for a long period of time, gaining an out-of-this world valuation from the Street in the process. Now investors having to re-learn a familiar med-tech lesson all over again – if something looks to good to continue, it probably won't. Although I'm still bullish on the underlying thesis that Intuitive Surgical will continue to see growing adoption and procedure counts, investors are seeing a harsh reassessment of the company's growth prospects and the “fair” price to pay for those prospects. I believe that Intuitive Surgical shares are too cheap at these levels, but investors considering the stock ought to remember that the bias of the Street will likely be against the shares for a couple of quarters.
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The Worst Results In Quite A While...
Intuitive warned investors about two weeks ago that the second quarter results were going to be substantially weaker than expected. Making matters worse, though, were a big a cut to guidance and a warning that growth in Japan may well be on hold for two years.
Revenue rose 8%, which even despite the warning led to a small miss versus the average sell-side target. System revenue declined 6% on a 5% decline in placements, with particular weakness in the U.S.. Instrument revenue rose 18%, with a 1% increase in revenue per procedure. Service revenue rose 18% for the quarter.
The weakness in Intuitive's margins would also suggest that the shortfall in system placements hit the company flat-footed. Gross margin declined two points from last year, missing the average estimate by more than a point. Operating income was down 3% for the quarter (and about 7% below expectation), and the operating margin contracted by more than four points. I think it's also worth pointing out that inventory jumped almost 25% on a sequential basis, as I would assume the company found itself with more systems in inventory than it had planned.
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… And Bad Guidance Only Makes It Worse
Although these numbers were bad, they were largely expected. What was another negative surprise was management's cut to guidance for the remainder of the year. Where they were once looking for growth in 2013 to be “on the higher end of 16-19%”, now the forecast is looking more like flat to 7% growth.
What's even worse, though, is the news that management does not expect to see additional procedures receive reimbursement in Japan under the biannual 2014 review. Japan has emerged as a meaningful growth market for Intuitve, and the lack of new procedures until the 2016 review will be a definite blow to the company's near-term growth prospects.
Is The Business Fundamentally Shifting Beneath The Company?
It seems pretty clear that there is a real trend underway to steer patients away from prostatectomy or hysterectomy and towards more conservative approaches. That's bad news for Intuitive as robot-assisted prostatectomy (dvP) and hysterectomy (dvH) constitute a major portion of the procedures done with the daVinci system. With fewer procedures, there is not only pressure on instrument revenue growth, but also system placements. It also isn't helping that recent earnings updates from Johnson & Johnson (NYSE:JNJ) and Stryker (NYSE:SYK) aren't exactly pointing to a robust environment for procedure growth in general.
It could actually be a little worse than that, though. It is true that Intuitive Surgical is seeing a very strong ramp for robot-assisted gall bladder removal (helped by imaging systems provided by Novadaq (Nasdaq:NVDQ)), and there are many additional general surgical procedures (over 1M/year total) where the daVinci could play a worthwhile role. What's troubling, though, is that many of these general surgery procedures take less time than dvP or dvH, meaning that hospitals can drive much higher utilization before needing to buy additional systems. While Intuitive should benefit from the growth of higher-margin instruments and tools, it could nevertheless create concern about the pace of new system placements.
The Bottom Line
I've seen a lot of med-tech growth stories rise and fall over the years, and so there are a lot of familiar attributes to what is going on with Intuitive right now. Not unlike Edwards Lifesciences (NYSE:EW), Intuitive got ahead of its valuation and investors are now trying to figure out how to value a slower growth trajectory than previously expected.
As I said, I still believe in the long-term potential of Intuitive, particularly given the lack of competition in the sector. I'm also a little relieved that I no longer have to project major share gains for the daVinici robot in order to make the numbers work. Revenue growth in the neighborhood of 9% and free cash flow growth of about 10% is sufficient to generate a target above $450 (though cash is about 15% of that figure) and that seems like a more reasonable level. Intuitive clearly has some issues to work through, including concerns about safety, the adequacy of training, and an FDA warning letter, but I do believe the shares have been beaten up to a point where they are worth considering again.