Hospitals' CapEx Cautions May Be Limiting Intuitive Surgical Growth, For Now

Intuitive Surgical (ISRG), which makes robotic surgical devices, is not as exposed to hospitals’ credit market problems as other medical device makers, but concerns about hospitals’ total capital spending budgets in the face of the tight credit market and other factors coupled with the company’s slightly lower than expected revenues guidance for 2008 knocked $60 off the price of ISRG Friday. It closed at $288.50, down 17.2%, while the Dow Jones jumped 1.8% and the NASDAQ rallied 2.6%.

ISRG announced its first quarter results here. Although ISRG said that in 2008 its revenues will grow 42%, up from a previous forecast of 40%, analysts were expecting a 46% projection, according to Thomson Financial. I previously reported on ISRG on March 1. ISRG’s options and technicals are covered below.

A quick glance at ISRG’s key statistics shows that the market has compressed the company’s PE based on its earnings projections to 41.5, compared with its trailing 12 months PE of 77.9, which is down from an untenable 90-plus only a few days and weeks ago. The PEG ratio of 1.47 (PE/projected five-year growth rate) looks fairly cheap for such a fast-growing company. Despite its remarkable profit margins, ISRG’s return on assets of 15.2% and return on equity of 19.6% aren’t as outstanding compared with other companies, but they are still excellent. Note that the short interest on ISRG has increased over the last month to 6.7% of its float from 6.2% of 37.75 millions shares outstanding. Insiders hold 1.61% of the shares and institutions 72.6%. Surgeons who use ISRG’s products and their peers and colleagues probably are big holders as well.

Back on Feb. 26, 2004, The Wall Street Journal’s Bernard Wysocki, Jr., wrote an excellent article that explains how the da Vinci robot is used by surgeons. The robot allows surgeons to be more precise, although the Journal says some surgeons debate that advantage. It also requires more hospital staff during operations but because of quicker recoveries due to the less invasive nature of operations performed with the machine, post operative care is less expensive. Hospitals are paid the same for operations performed with the robot and when it’s not used, according to the Journal. That the less invasive nature of the operations allows a much quicker recovery and return to work is of little or no concern to most hospitals, physicians nor insurers. They’ve got to be shown the economic returns, including the reduction in mishaps and followup operations that the da Vinci probably allows. (Question, are there such benefits?) But self-insured employers and patients see the economic and personal comfort and the benefits of quick and returns to work. This Chicago Tribune article reports on the benefits as well as the reasons many surgeons still are reluctant to use the da Vinci for certain procedures. Some find it difficult to use, and it’s clear that it takes a lot of practice for surgeons to become skilled operators of the device.

Growing patient demand that their surgeons use the da Vinci machine is driving demand for the product. A key question is whether surgeons have financial incentives to demand that their hospitals buy the da Vinci and to use it. If insurers and employers can be shown that patients who are operated on by surgeons using the machine are less costly to treat in terms of claims filed for the total care of the patient, they should pay surgeons and hospitals more for operations where the da Vinci is used. If employers can be shown that employees are made productive more quickly and that da Vinci patients illnesses cost them less, they should give providers financial incentives to use the device. Whether ISRG and hospitals can sell or are selling large, self-insured employers on the concept is another question that needs to be asked. Medicare and Medicaid are unlikely to provide such incentives regardless. Their systems give hospitals financial incentives to do what’s most profitable for the providers, not for insurers nor patients. For more information about clinical efficacy and frequently asked questions, check out ISRG’s excellent media kit.

It doesn’t seem that hospitals or surgeons have the financial incentives to buy the da Vinci as quickly as hospitals and radiologists rushed to buy the first CT scanners back in the 1970s. Today, CT and MRI scanners are in every hospital an a lot of outpatient diagnostic centers, and 10 or 20 years from now, the da Vinci devices may be, too.

For a hospital CEO’s point of view and those of respondents to his blog questioning the economics and clinical benefits of buying a da Vinci, read Running A Hospital, a blog by Paul Levy, president and CEO of Beth Istrael Deaconess Medical Center in Boston. His blog clearly is hostile toward the da Vinci. Surgeons and patients who commented on his blog make some convincing arguments in favor of it. Read all of the comments.

During a conference call on April 17 with securities analysts, one of the analysts asked about the market’s concerns that hospitals may be cutting capital expenditures in the face of rising interest rates, a tight credit markets, recession, rising deductibles and inflationary fears. ISRG executives said they haven’t seen any evidence that their sales are being hurt by sharply higher interest costs many tax-exempt hospitals are experiencing in the auction rate bond markets. Only about 15% of the $1 million to $1.5 million machines sold by ISRG are financed, and installations are made without remodeling operating rooms or other facilities. In addition, ISRG contends, its machines are high-priorities on many hospitals’ capital expenditure budgets.

ISRG derives revenues of $1,500 to $2,000 per procedure, or more than $500,000 in procedure fees per installed machine “for established accounts” annually. Marshal L. Mohr, senior vice president and CFO, said:

Our average revenue per procedure including initial stocking orders has been gradually decreasing as the ratio of new systems to our install base declined and it is between $2,000 and $2,300 per procedure. Systems revenue of $99.1 million increased 76%, compared with $56.1 million last year, and decreased 9%, compared with $108.6 million last quarter.

Benjamin Gong, vice president of finance, told the analysts:

As regard to revenue, we expect our total 2008 to grow approximately 42% over 2007, which is up from our previous estimate of 40%. Instrument and accessory revenue which is specifically driven by procedures performed is on track to grow 55% this year. During Q1 procedures grew in line with our previous estimates and therefore we are maintaining our forecast for 55% growth in instrument and accessory revenues for the year. System revenues were modestly stronger than we expected in Q1 and we are increasing our forecast for the year. We are forecasting system revenue to grow 33% to 35% over 2007, which is up from our previous forecast of 30% growth. We expect this growth to come from an increase in unit shipments.

Therefore, in an effort to increase its procedure revenues, ISRG is investing in a bigger sales effort to get more surgeons to do more procedures on each machine. The more specialities that are using a machine, the more likely a hospital is to add another machine, ISRG said.

As for machine sales, the three- to six-month sales cycle in the U.S. and Europe hasn’t changed, ISRG said. The sales cycle is between six months and over a year in other parts of the world. ISRG sold 74 of its da Vinci Surgical Systems, up from 44 a year earlier but down from 78 in the fourth quarter of 2007. Of the first quarter sales, 27 were to existing customers and 20 were to international customers, up from 11 last year. The company didn’t announce its order backlog for the machines, and analysts didn’t ask about it.

Lonnie M. Smith, chairman and chief executive officer, told analysts:

We ended the first quarter with 867 da Vinci systems installed worldwide. That solid quarter-over-quarter procedure growth in all significant specialties led by GYN with strong growth in Urology, particularly in Europe. Procedure adoption continues to be procedure specific, patient driven and the primary growth factor are driver of our business. Total revenue grew to a $188 million, up 65% from last year. Instrument and accessory revenue increased to $62 million, up 54%, total recurring revenue, including service grew to $89 million, up 53% from prior year, comprising 47% of total revenue.

We generated an operating profit of $79 million, 42% of our revenue before non-cash 123R stock option expenses, up 87% from the first quarter of last year. GAAP net income grew to $45 million, 24% of revenue, up 88% from last year. We ended the quarter with $700 million in cash and investments, up $64 million from last quarter and up $315 million from last year. After subtracting $15 million in cash received from exercise of stock options and adding back $30 million, invested in fixed assets and working capital during the quarter, our gross operating cash flow in the first quarter amounted to 167% of our reported GAAP net income.

In its investor presentation prepared for its conference call after it announced its 2007 full year results, ISRG showed the potential markets for its products. The presentation and annual report are here.

Technically, ISRG, which had been rallying until last week, looks weak on its daily, weekly and point and figure charts. The latter indicates a bearish price objective of $272.

In the options markets, ISRG covered calls are offering very generous annualized returns of 46.9% on the 270 strike calls to 77.9% on the May 290 calls. These high yields show how risky the covered calls can be and how optimistic call buyers are that the stock will recover to between $300 and $314 before the options expire in 28 days. On the bearish put side, options traders are speculating the stock will touch $261.50 to $266.50 before the options expire. Covered call traders buy a stock and sell options for an equal number of calls. It’s generally a bad idea to trade covered calls when a stock is declining.

Long term (LEAPS) ISRG January 2010 290 (strike) calls show traders think the stock will touch $377 before the options expire. Bearish puts buyers are pricing the January 2010 290 puts in anticipation of a further price plunge to about $213. But the open interest on the January 2010 calls and puts is small. So take these price indications with a grain of salt. With historical volatility at .899 and implied volatility at .598, the LEAPs look cheap, but both are far above their 52-week lows. This means that the stock price could rise and the LEAPs could fall as the volatility falls back to the levels seen earlier this year. In other words, the January 2010 calls don’t look so cheap after all.

When I get more answers to my questions about the economics of the da Vinci, I’ll post them.

Disclosure: I don’t own ISRG, but my investment club does.

Comments

[Aijaz]

i think this comment needs further clarification.

"concerns about hospitals’ total capital spending budgets in the face of the tight credit market and other factors coupled with the company’s slightly lower than expected revenues guidance for 2008 knocked $60 off the price of ISRG Friday."

sales guidance on da vinci systems was increased on the latest conference call. 3 months ago an oppenheimer analyst assumed that sales would slow due to problems in the capital markets. it caused the stock to drop to $227. a few days later his assertion was emphatically rejected by management. since system purchases are a capital expense, it hardly makes sense that anyone is concerned about capital budgets when management is raising their guidance for system sales.

[Donald E.L. Johnson]

You might note that systems sales fell in the first quarter vs. the fourth. And the stock plunged 17% after the guidance disappointed the market. Wouldn't that have something to do with sales forecasts? And the revenue guidance was lower than the Street expected.

[Polaris]

My point a figure chart -even including the fall on friday is still showing a price target of 537 and has a strongly bullish trend line on all time frames. I am using the charting programme supplied by Updata Technical Analysisa a highly regarded European company used widely in London.

The company beat analysts forecasts on all metrics by a wide margin. AND what is more, contrary to the misinformation that has been widely spread around about this company the company did in fact increase its guidance for the next quarter and the year as a whole and this was in line with the average forecast of the analysts.

There was one problem however. If you look at the spread of forecasts for the next quarter by the analysts most clustered as expected around the mean. Only one rogue analysts produced a forecast that was clearly overly optimistic. The company's guidance this did fall short of the ridiculously high estimate by the one oddball analyst. Can't blame ISRG for that. The analyst got it wrong.

More to the point - if you take out the rogue forecast then the company guidance going forward beat the average for the analysts.

With a growth stock like this what is important is the forward P/Eand not the trailing P/E as well you know - look at the forecast P/E around 40 - not bad for this stock

As to your comments on the covered calls . I have been using calls on this stock for over three years to gear up my equity holding and as I see it the only change over last year is the increase in volatility but that has become a feature of the market as a whole.

The Ichimouku Kinhou-hyou chart looks very positive on all time frames.

I accept that you have done your best to put a negative spin on the company but I feel that this is totally unjustified by the company's performance and by a the share price volaltility that is still within the
range we have experienced over the last twelve months - even including the nfall created by the bear raid that has been engineered over the last few days.

[Polaris]

Mr Johnson your comments about the 1stQtr 2008 sales being below 4thQtr 2007 are grossly misleading

The company did forecast this in January - The 1stQtr is always the slowest Qtr of the year.

Surely a more realistic and valid comparison is with the 1stQtr of last year - a 65% increase - now that's growth in anyone's book.

You are just the last in a long line of analysts that has tried to bring this company down - these include Michael Matson of Wachovia who just prior to the Jan CC claimed that the credit squeeze had hit the company's sales - a claim strongly rejected at the CC then and again last week.


Then we had that numb skull Amit Hasan who claimed just prior to the Jan cc that GYN surgeons were slow to adopt the robot - again not true as we all knew from our contacts with the surgeons and the growing published list of GYN surgeon using the robot. The claim wasfirmly and quickly diosmissed by the company.

Hasan did not even have the guts to posit his question at the CC and used a stooge insted to ask the questions form.

The diriver for this product is not the insurance companies nor even the hospitals - it is the patients themselves. And bear in mind this -most of these patients( prostate and GYNB) are post middle age and usually very well heeled. Do they need medicare?- I think not.

Hospitals will have to adopt the robot if they are to compete in the field. AND a good many of them have more than one machine already.

Sorry laddie your arguments do not wash .

[Donald E.L. Johnson]

Thanks for the comments.

I think that if you read the whole piece you will see comments on both the pros and the cons, which look pretty well balanced to me, especially if you read all of the comments on the Running a Hospital link.

The charts and options markets are what they are, and the economics of hospitals and the credit markets are what they are.

What I see is a device that has great appeal to patients, but it doesn't provide anywhere the leaps forward that we saw with the intros of CTs and MRIs, and you see resistance on the part of surgeons, regardless of patient demand, which is very important, as the piece shows. I think patients will win, and if employers get smart as discussed in the article, patients and da Vinci will win even more. But there are other minimally invasive technologies competing for OR time, and they don't require the investments and retraining that the da Vinci does.

Thus, as I say in the article, I think that this device will work its way into most hospitals over time, but this doesn't look like a slam dunk to me. Acceptance will be gradual. It would be faster if the economics of the device and the over all economy looked stronger.

Hey, the company's growing incredibly fast. The long term outlook is bright, but the stock may have gotten ahead of itself, as fad stocks do. Morningstar as of this morning estimates the stock's fair value is $175. The M* analyst is re-evaluating that estimate but says that the new FV estimate will not be close to the current high price of the stock. The exact quote is, "we do not anticipate raising it anywhere close to recent share prices, which we think reflect overly optimistic assumptions."

Don't fall in love with any stock. Manage your holding, make decisions based on the facts. If you think ISRG is a good long-term holding and you can stand the volatility, hold on. I can't argue with that, because I think my article reflects a lot of positives for the stock. Note that the one-year PEG is only one, which makes the stock look cheap. The question is whether the company will achieve its sales goals. There are no certainties in this world. That's what speculating is all about, guessing. Good luck.

I approach all stocks objectively. I'm looking for investments. I have no skin in this stock except for my tiny part of my investment club's tiny holding, which is not material to me.

[Donald E.L. Johnson]

As of this morning, the daily charts are bearish, the weekly chart has just gone bearish and the point and figure price objective still is $272. stockcharts.com has one of the best charting services available.

[Random Walk]

60% of hospitals are not-for-profit. The credit crunch and problems in the auction rate securities markets do have an impact on these hospitals. On the margin, such hospitals would target big ticket items like capital equipment. Last I remember Intuitive Surgical revenues are comprised of such big ticket items. Given the multiple on the stock, should the recession persist longer than six months, why should you expect med cap equipment companies to trade at an even higher multiple than other companies during a bear market, given the financing issues of hospitals?

[Chuck]

Time will tell.
All I know is that (when) I need my prostrate removed, I want ISRG to do it.
I'm 60 now, and want to make it to see all my Grandkids graduate from college and getting married. They seem to be my best bet.

[Donald E.L. Johnson]

Here are some questions that ISRG needs to answer:

1. How many of your da Vinci machines are in hospitals owned by the publicly-owned hospital chains?

2. Does ISRG have multi-machine contracts with any of the investor-owned or tax-exempt multi hospital systems or the group purchasing organizations such as Premier, VHA, etc.? Any pending?

3. Will ISRG publish a list of American hospitals that have the machine?
Has anyone published such a list and kept it up to date?

4. Will ISRG publish an economic analysis of how having the da Vinci will help hospitals and physicians make money and insurers, patients and employers save money by having surgery done with the da Vinci?

5. Is there a study with recent data that shows of the economics of da Vinci minimally invasive surgery versus laparascopic minimally invasive surgery for the same procedures in the same institutions?

6. What are independent consultants and advisory firms such as the Healthcare Advisory Board recommending about the da Vinci?

7. Since some insurers are going to outcomes-based payment schemes, are any using outcomes such as length of stay, patient recovery times, infections and blood loss in ways that would make minimally invasive surgery more financially attractive to surgeons, hospitals and patients?

[Aijaz]

Thanks for the response, but I'm really surprised by what you've written.

Management has always informed investors of seasonality in their earnings. Q4 is the strongest quarter in the year. Q1 is typically weaker than the prior year's Q4 for system sales.
Guidance was raised to 42% sales growth for system sales. It's also meaningful to note that this "small" increase in system sales growth was on top of increased guidance the previous quarter. I'd recommend you listen to the past couple of conference calls to get the facts straight.

[robert miers]

One must catch a dose of prostate cancer and the fear of death (prostate generally spreads to the bone) and research all the available treatments, negative and positives and interview the professionals who treat the situations. Talk to experts only. Hire a oncologist, a gatekeeper, look outside your community. Research the true statistics about post operative problems. Go to the world famous institutions, Ford, Mayo,scripps. If you do, the obvious choice will be the DaVinchi.
The same surgeons who cut half a stomach out to get an ulcer will try to talk you into a major deep body intrusion because they have been doing the same for years. They are too old to learn and don't have the money for a machine. Ask them to explain why more than half of Radical Prosectomies are robot assisted in six short years. And lastly, check with the finest medical schools about up to date procedures on Urology, GYN, Cardo, and general surgery
DON"T TRUST your family doc....It is your life and your quality of life which is at stake...and bless you in your quest

[healthCareStrategist]

Very well written article!

Agree, unit sales will slow as nearly all major market hospital operators have a unit or two. Even second tier city's hospitals have units.

Most of the remaining US markets have lower rated NFP hospitals with a host of industry headwind related problems making expenditures for surgical robots a 'wish list' item, but not on the to do list. Bond disclosure documents reveal declines in EBITDA, operating margin and nearly all financial metrics.

The Public hospital companies only install the units in their leading market hospitals, again based on patient market analysis and for companies such as LifePoint, HMA CHS the number of units to total hospitals owned suggests smaller patient populations that do not support a surgical robot unit.

For both clases of hospitals, patients drive the 50-80 miles to larger healthcare facility with such capabilities.

[speculari]

Mr. Johnson's list of 7 questions brings to light the rudimentary ignorance he displays regarding a) the differences between simple laparoscopic procedures & the DaVinci machine and, b) the utter lack of time he has not invested with a visit to the ISRG website. In addition, the legendary & massive ego displayed by too many "older" surgeons is likely one of the few remaining impediments to the use of a truly marvelous device. I have watched the population of DaVinci machines go from one (1) to eight (8) in our small state from the time of my first long position on this stock @ $25 to the present time.