Intuitive Surgical in the Penalty Box

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Surgical robot manufacturer Intuitive Surgical  (NASDAQ: ISRG  ) has committed the cardinal sin for high-multiple growth stocks -- the growth has stopped. Investors need only pull up a chart of Heartware or Edwards Lifesciences to see what happens when the music stops and growth investors can't find enough chairs. Intuitive is going to need to show convincing improvements in system placements and procedure volumes to regain the Street's love. Unfortunately, I think that will take a few quarters at a minimum.

I feel like I am in a strange place with Intuitive. Above $450 a share, where the stock has spent most of the past two years, I thought the shares were overvalued and that almost everything had to go right for the stock to work from those levels. Although I wouldn't go as far as to say that Intuitive has been beaten into a value stock, I do believe that robot-assisted procedures are here to stay and that Intuitive has a major lead on any prospective rivals. Moreover, with growth harder to come by in the device world these days, maybe Intuitive could actually find itself in play if the stock languishes further.

Another stark example of new realities
Intuitive Surgical had a pretty rough third quarter. Even though sell-side analysts were expecting a year-on-year decline in revenue (something that I don't believe has happened in the last 10 years), the reported decline of 7% was still worse than expected. The decline was driven by the one-third drop in system sales, as placements declined 35% overall and more than 40% in the U.S.

Instrument and accessory sales (which have exceeded system sales for a little while now) were up 10%, but procedure growth slowed to 16%, down from 22% growth in the year-ago quarter. Service and training revenues were up 16% for the quarter.

With the weaker system sales came weaker margins. Gross margin fell a point, while operating income declined 18% on a nearly four and a half point retreat in operating margin. Total operating expenses rose 2% from last year, as the company grew SG&A spending well ahead of revenue.

Are bad press and reimbursement taking their toll?
There has been ample bad press on Intuitive Surgical lately, with multiple journal papers, articles, and sell-side reports questioning the value and safety of robot-assisted surgical procedures, as well as the company's adverse event reporting policies.

The impact of those may be debatable, but the ongoing pressures in reimbursement are less debatable. Just as Edwards has seen pushback on the cost of its cathether-based valves in the U.S., insurers are pushing back on surgical interventions for prostate cancer and benign hysterectomies, which is hurting da Vinci utilization rates at Intuitive Surgical client hospitals.

While growth in choly procedures (gall bladder removal) and colorectal resection lends some credence to the idea that Intuitive can extend da Vinci use past its cornerstone prostate and hysterectomy franchises, slowing procedure growth is certainly having an impact on hospitals' perceived need for additional robot systems. I'd also speculate, though, that some hospitals may be holding off on new system purchases ahead of greater clarity on when a new system may become available.

Competition may be more of a threat
It's also worth noting that Johnson & Johnson (NYSE: JNJ  )  and Covidien  (UNKNOWN: COV.DL  ) both continue to roll out new products for the minimally invasive surgical market, particularly the single-site market. Both companies have been introducing new fixation, energy, and sealing devices, and the reality is that minimally invasive procedures done with J&J or Covidien tools are typically faster and cheaper than those done with Intuitive's da Vinci system.

Intuitive bulls will argue that this is an unfair comparison and that da Vinci results need to be compared to open surgical procedures (where J&J and Covidien also compete). The on-the-ground reality is that Intuitive often markets and competes against existing minimally invasive approaches, as well as more conventional open procedures. While Covidien has yet to report as of this writing, J&J's solid results in specialty surgery in the third quarter (up about 7%) do suggest that Intuitive may have some risk here, particularly as Covidien and J&J's tool franchises are much less dependent on particular individual procedures.

The bottom line
If investors are looking for a growth play tied to surgical procedures, I'm much more comfortable recommending Novadaq than Intuitive; Novadaq is expensive, but I believe this surgical imaging company could see growth inflect upwards as it hits a critical mass of awareness and continues to build its marketing infrastructure.

With Intuitive, I do believe the stock has likely been "over-punished," but it is going to take a couple of solid quarters to reverse sentiment. I'm currently looking for long-term revenue growth in the high single-digits and free cash flow in the low double-digits, and that can support a fair value around $400. Still, the reimbursement environment is not a favorable one right now and growth investors have a way of punishing former darlings that don't live up to their growth expectations.

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