Why the Market Is Wrong About Intuitive Surgical Stock

Investors were hoping for a good quarter from Intuitive Surgical (NASDAQ: ISRG  ) , so much so that I'm a little surprised to see such a positive market reaction to what was largely an in-line quarter and ongoing murkiness in the market outlook. Strong shipments of the Xi system are encouraging, as was the better-than-expected procedure growth, but utilization is still challenging and Johnson & Johnson (NYSE: JNJ  ) and Covidien (NYSE: COV  ) continue to highlight their own efforts to drive non-robotic minimally invasive procedures with their tools and instruments.

Better than expected, but not perfect
Revenue fell more than 11% this quarter, but was still about 2% better than the sell-side expected. Systems led the relative outperformance, as the company placed 96 robots and saw a 33% decline in sales (an 8% better result than expected). Shipments of the new Xi were particularly strong at 50 units.

Instrument and accessory revenue fell 1%, coming in slightly below expected (a 2% miss). On the positive side, procedure volume growth increased 9% yoy and 8% sequentially, not only better than the average expectation of 5.5% growth, but the first sequential increase in the yoy growth rate in about two years. U.S. procedures rose 5%, while international procedure volume climbed 17%. On the negative side, revenue per procedure dropped more than 9% and utilization declined again.

Service revenue rose 9% for the quarter, matching expectations.

On the profit side, gross margin fell almost three points from the year-ago level and missed expectations by about a point. It's not as much of a surprise given the trends in system sales and instrument/system utilization. Operating income declined 35%, but did eke out a small beat (1.5%) relative to Street expectations.

Hospitals still cautious, utilization sluggish
Intuitive Surgical continues to look at a hospital capital equipment market that is stubbornly slow. There is still money out there, and a willingness to take advantage of low interest rates and financing options, but administrators are being careful with their spending. Likewise, overall health care utilization has yet to pick up as expected in the wake of Obamacare implementation. I don't frankly expect this to be a major driver for Intuitive Surgical; those who were previously uninsured and have taken advantage of the ACA to get insured have skewed younger and aren't likely candidates for the sort of urology, gynecology, or general surgical procedures that make up the bulk of the company's procedure volume base.

Japan an opportunity, competition still a threat
Investors should expect to hear more and more about Japan in the coming quarters as the sell-side has really starting focus on this as the next major growth market for Intuitive. First approved about four years ago, Intuitive has been making meaningful investments in Japan for a number of years and recently announced a transition to a direct sales effort. Intuitive had about 160 robots in Japan at the end of 2013 and while reimbursement is presently limited to dVP procedures at this point, reimbursement for dvH and general surgical procedures could come into play in 2016. Japan already reimburses dvP pretty favorably (a $6,000 procedure premium) and this is a sizable surgical market for Intuitive Surgical.

On the competitive side, Johnson & Johnson announced at its recent MDD Analyst Day that it was developing a robotic surgical system that it intended to be smaller and more mobile. Presumably Johnson & Johnson views this as a way to keep its surgical and energy tools relevant in the evolving surgical market and while competing with Intuitive is easier said than done, Johnson & Johnson at a minimum has ample resources to dedicate to this case. Should Johnson & Johnson make headway with its robotic efforts, I would expect to see Covidien consider joining the race as well. Medtronic, which is attempting to acquire Covidien, has never been shy about committing significant R&D or M&A resources to maintain long-term competitiveness in key markets and developing a surgical robotics platform may ultimately be necessary to preserve the company's surgical and energy tools business.

The bottom line
I view Intuitive Surgical's second quarter results as much-needed stabilization, but not a definitive reacceleration of the business. Management was cagey with guidance and there are still significant uncertainties on system placements and procedure growth for 2014. Along similar lines, it is not as though the shares are trading at low multiples or expectations.

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