Intuitive Surgical, Inc.'s Growing Pains Still Painful

There's a lot about the Intuitive Surgical (NASDAQ: ISRG  ) story that feels familiar. Whether you look at recent examples, like transcatheter heart valves and left ventricular assist devices, or more distant historical examples, like stents, Intuitive Surgical has followed that familiar pattern of "you don't get it ... this changes everything and valuations don't matter" to "oh no! It's not growing to infinity!"

I don't mean to flippant about what has surely been a harrowing couple of years for Intuitive Surgical shareholders. The good news is that clinical data continue to support the argument that robotic surgery deserves its place at the table and has value to offer alongside the minimally invasive tools and approaches advanced by Johnson & Johnson (NYSE: JNJ  ) and Covidien (NYSE: COV  ) . The bad news is that the stock gets whipsawed as short term-focused analysts and institutions obsess over the next year or the next quarter and cannot look at the longer term.  

Fourth quarter results remind us that details (and guidance) matter
Investors reacted with a great deal of relief when Intuitive Surgical gave an early peek at revenue, disclosing that fourth quarter revenue would be about 5% higher than analysts were expecting.

When the actual results (and guidance) arrived, though, the response wasn't as positive. Revenue fell 5% as the company guided, with system sales down 23% on a 46% decline in US system sales. Instrument revenue was up 6% on top of 12% underlying procedure growth, while service revenue rose 14%.

Gross margin fell almost three points (more than 150bp below expectation), while operating income declined 16%. Operating income actually exceeded expectations as the company spent less than expected on R&D and SG&A.

Vague Guidance Plays To The Street's Fears
Intuitive Surgical is in a pretty precarious position. Investors are nervous about the slowing trends in prostate and hysterectomy procedures, and worried that a seemingly constant drumbeat of "surgical robots aren't worth the money" in the media will hurt prospects for adoption in cholecystectomy and other general surgical procedures.

Management could have perhaps calmed things a bit with reassuring guidance, but instead said that conditions were too uncertain to give revenue or system sales guidance. The guidance for 9% to 12% procedure volume growth fit expectations, but the guidance for double-digit growth in operating expenses was a real surprise.

Playing Short Versus Long
Coming out of this quarter, it looks like the Street is really worried that Intuitive is going to have to spend more money on an ongoing basis to support the sales effort and improve reimbursement in markets around the world.

Analysts also seem to be worried about the impact of the Si-e system. This system carries a lower ASP (about 20% to 33% lower) and there is a fear that it will produce a less profitable mix of business (less complex cases). Herein is one of the big short-versus-long-term issues with this company – over the long term, I think it is a very good idea for Intuitive to target additional outpatient/ambulatory minimally invasive markets. These are areas where J&J and Covidien are already strong and it would be an important part of penetrating the company's overall addressable market, even if it has margin consequences in the short term.

The Bottom Line
Both JNJ and Covidien had solid quarters in their respective surgical businesses (JNJ up 4%, Covidien up 8% operationally), and Stryker also reported good growth in hospital demand for instruments and endoscopes. In other words, I think the underlying environment for less invasive surgery is healthy.

I likewise expect the current fuss over safety and cost-effectiveness to blow over – complications are rising as procedures increase, but the rate-per-procedure is improving. Likewise, while a few articles in JAMA attacking the economics of robotic surgery got a lot of attention, lesser-publicized articles have suggested that the economics for robotic surgery are positive for hospitals and payers.

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