Intuitive Surgical: Buying into robotics

Pay a visit to any automotive manufacturing facility and you will be amazed at the amount of robotic devices that cut, assemble, finish and then paint the finished product.

At a recent visit to the new BMW factory in Munich, I observed 3 Series sedans virtually built in their entirety by these clever machines. Industrial robots have become commonplace on factory floors over the past 20 years and are poised to proliferate in the developing world. Observing a motorcycle assembly line in Hero Honda's Delhi factory last year, I watched the entire bike literally assembled by hand. This is where robotics will go next.

There are literally hundreds of industrial robotics manufacturers in the world and over the years there have been some good investment opportunities in pure plays such as German-based Kuka AG and Japanese robotic giant, Fanuc. Going forward, however, in spite of the emerging economies demand and replacement cycles from a large installed base, these companies will really be a play on global industrial production and gross domestic product.

As technically adept as these machines are, the investment potential and economic impact lies in robotics that can think, mimic and replace human labour to the extent they are almost human or even superior to a human. Recent advances in AI (artificial intelligence), sensors, machine vision, drive motors, electronics, and hydraulics will give rise to new generations of robots that will substantially raise productivity, have significant economic impact and greatly improve human life.

A robotic surgery pioneer

Healthcare is an area where robotic surgery and advanced prosthetics in the form of intelligent powered exoskeletons or specialised “smart” prostheses will have a significant impact on the quality of life, not to mention healthcare spending. This also is the area where I see an investable opportunity—Intuitive Surgical (ISRG US), a US-based pioneer in the design and manufacture of robotic surgery systems.

Intuitive Surgical has had a virtual monopoly in the robotic surgery space since it was founded in 1995. The company went public in 2000 and has had an incredible record of growth. It was a “market darling” until early 2013 when a combination of short-seller attacks (Citron Research), negative articles in the financial press, a full-blown prime time “60 Minutes” expose, slowing procedure growth, a flurry of lawsuits, and concerns that hospital capital expenditure budgets were under pressure diminished the company's stellar investment performance. The final straw was media concern regarding the overall safety record of robotic surgery. As a result the stock got hammered. Having hit a record high of $US600 in 2012 the shares plummeted to the mid-$US300s, where it languished throughout 2013, seriously underperforming in a strong market.  

Recently there have been some positive developments for Intuitive in the form of some well received new products and a good quarterly earnings report.

That being said, it is and will remain a controversial stock in spite of its past success and future potential and the shares will be driven as much by news flow as reported fundamentals. I do, however, think we MAY be at an inflection point where new products and a broadening of procedures beyond the abdominal area may begin to restore Intuitive to its former glory. First a bit of background:

Intuitive Surgical's technology

Intuitive Surgical basically invented robotic surgery for complex procedures. Its main product is called the “da Vinci system” (named after the legendary Italian inventor). This consists of a surgeon's console, a side cart for the patient and a vision system. The operating surgeon controls arms which have endoscopic instruments on the end that perform all surgical tasks such as cutting, cauterising, stitching etc. The da Vinci system essentially replicates the hand and wrist movements used during surgery.

The system performs what is known as minimally invasive surgery, which results in less trauma, blood loss, and pain for the patient, significantly shorter hospital stays, and requires fewer operating room staff. It can also boost the hospital's bottom line. Surgeons can perform more procedures in a day, as the system reduces fatigue where surgeons are standing for hours on end and craning their necks to maintain a proper visual perspective. Advanced 3D visualisation provides an almost perfect and magnified view of the affected area in the patient, so mistakes should be almost non-existent. As you can see in the video, it is the surgeon that controls the machine, so the level and quality of training is paramount. That being said, when I visited the company in 2011 I was allowed to “operate” on a capsicum and miraculously it survived! Given I am more at home with a chainsaw than a scalpel, the way that the machine translated my untrained hand movements was quite incredible.

Historically, the company has enjoyed an incredible run of growth as hospitals in the US and around the world bought da Vinci systems. The installed base now has over 2100 systems in the US with 480 in Europe, some 300 in Asia, and 35 in Australia and New Zealand. The systems are not cheap, costing over $US1.2 million each and are not the only revenue generator for the company. The specialised cutting devices on the ends of the arms must be replaced after each surgery and the machines must be serviced regularly, throwing off a another recurring revenue stream. For example, in 2013 system sales generated $US835 million, instruments and accessories $US1.03 billion, and service agreements $US397 million.

Procedures that have been commonly and successfully undertaken by doctors using the da Vinci system include prostate surgery, hysterectomy, gall bladder, kidney and other lower abdominal surgeries. In 2013 there were over 500,000 procedures undertaken globally using the da Vinci system. The company also believes there are many more opportunities in general surgery, cardiac / thoracic procedures and complex head and neck surgeries.

New developments

Early this year the company introduced two new products to the market – the da Vinci Xi and the da Vinci SP. The Xi is a fourth-generation system, with a number of improvements including slimmer robotic arms, laser targeting with voice activated set-up, and self-calibrating endoscopes. The SP is a new one-armed patient side cart dedicated to single port surgery, and has already been approved by the FDA for urology procedures.

The company reported its 2Q 2014 results on July 22 and they were much better than expected. Not only did procedure growth pick up to 9%-plus but the company shipped 50 of the new da Vinci Xi systems (the market expected 15) and 96 systems in total. Management guidance was cautious, however, still seeing capital constraints in most markets but noted that Xi demand remains very high. They also raised guidance for 2014 procedure growth from 2-8% to 5-8%, the narrowing of the range reflecting confidence in the new systems which will be a driver of procedure growth going forward. The stock rallied 20% on the news.

Growth prospects and surgical risks

So we have a world-class company with no competition that is trading at the lower end of its 10-year range by any metric; P.E., EV/ EBITDA, EV/ sales etc. If you back out stock option compensation and $US50 per share in cash, the company is actually trading on 15x 2015 earnings. New product take-up is brisk and set to continue, with 2015 setting up to be a pretty good year for the company. Low overall penetration globally is a huge opportunity as procedure growth overseas continues to grow at twice that of the US. For example, in Japan, gastric cancer procedures (a disease that occurs 5-10x higher than the US) are a real opportunity and reimbursements are set to start in 2016.

While other surgical categories will take time, it will happen driven in part by some of Intuitive's complementary products for stapling (EndoWrist ) and fluorescence imaging (Firefly). This is a stock I want to own for the long term, as robotic surgery is here to stay, Intuitive has undisputed market leadership, procedures will eventually broaden out to other parts of the body, and I suspect the company will eventually develop smaller, cheaper and smarter products.

Before pulling the trigger, however, we have to consider the negatives. Two of Intuitive's engines of growth – prostate surgery and benign hysterectomies – are declining. Prostatectomies are being put off by a number of men adopting a  “watchful waiting” approach, based on the New England Journal of Medicine's PIVOT study that suggested that there were alternatives to surgery. Hospitals have realised that robotic surgery provides no better outcomes for benign hysterectomies than using a laparoscope, so that category (and one of the historical growth drivers) is in decline. 

Given the recent controversies and reports of botched surgeries (not the machine's fault, I might add), hospitals may well insist on longer training periods for surgeons. That would delay sales. Ongoing lawsuits and negative press will continue to be a factor, although medical device makers have long been a target for US-based litigators.

Market valuations

For what it's worth, Wall Street is divided on the stock, with 12 buys and 12 holds / sells. Intuitive Surgical's latest quarterly results spurred some upward revision to earnings, and a few analysts put “buys” on the stock. Valuing the stock has always been difficult as it has always traded at a large premium to the medical device makers (its only near peers).

Using discounted cash flow models (DCF) some analysts have price targets in the $US550 range. If the stock could trade at the mid- point of its 10-year  EV / Sales multiple of 8.5x (it was trading at 10.2x before de-rating in 2012) that would equate to a stock price of $US650, or 38 % above today's close, so if things go right there is still reasonable upside.

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Competition and risks

Eventually there will be competitors. Large companies like Johnson & Johnson and Covidien already operate in the laparoscope and medical device market and have expressed interest in robotic surgery. One analyst has even suggested that they might be interested in Intuitive as an acquisition. There are some smaller emerging companies such as MedRobotics, SOFAR S.p.A. and Transenerix that could eventually “disrupt” Intuitive Surgical's almost unassailable market position, although this is probably five years away and with smaller single site machines.

Risks are mostly headline in nature and will affect the stock price and sentiment in the near term only. Although litigation makes big news, the chances of a big settlement are remote given a long and continuous history of safe procedures and FDA approval and oversight. Hospital budgets will continue to get squeezed in the US and abroad. The company needs to more forcefully demonstrate the economic benefits of their systems in a low-growth world.

Conclusion and Recommendation

This is a stock for patient, long-term investors. Robotic surgery is here to stay and Intuitive Surgical should maintain its market dominance for years to come. Given that the stock has had a 20% pop, I would recommend accumulating Intuitive Surgical now and using the volatility of the market and any negative news flow to build a position over time. It's pretty unlikely it will return to its 2014 low of $US353, but you might get some in the low $US400s.