In the last six months, the cost benefit concerns and a warning letter from the FDA, have taken a toll on the stock of Intuitive Surgical (NYSE:ISRG), the developer of robotic surgical system da Vinci. In Q2, the company reported dismal earnings as revenues grew by only 8%, significantly lower than the high-teen growth levels the company had achieved since 2008. (Read our note Intuitive Surgical Disappoints On All Fronts)
This was mainly attributed to U.S. hospitals’ reluctance to purchase the system as hysterectomies face pressure following the outcome of a comprehensive cost-benefit study by Columbia University (Read our note here for full details). Sales of the da Vinci system declined for the first time in the last three years. The situation is not expected to change in the near term as the management stated that overall revenues for 2013 are now expected to see growth in the range of 0% – 7%. Further, growth in the number of procedures should also settle around 15%-18%.
Owing to these recent developments and weak earnings, we have revised our price estimate for Intuitive Surgical to $450 from $600. Below we discuss the key changes made in our estimates.
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Concerns Weigh On Near Term Outlook
In February, the outcome of a detailed study conducted by the researchers at Columbia University showed that the cost-benefit ratio of using the da Vinci surgical system to perform hysterectomies is not particularly favorable. According to the study, hysterectomies through da Vinci cost a significant $2,189 more per procedure than laproscopic hysterectomies, even though the rate of complications and length of stay are statistically not significantly different than the latter.
Ever since the study became public, Intuitive Surgical is seeing a decline in hysterectomies being performed through the system. Health insurers are seemingly reluctant in approving hysterectomies procedures through the system. Since U.S. hysterectomies constitute nearly 30% of total procedures for da Vinci (~150,000 hysterectomies vs. ~450,000 total procedures in 2012), concerns have affected sales of the da Vinci system in the U.S. Continued procedure growth is required to make the system financially viable for them as the average initial cost of the system is a huge $1.5 million (ranges from $1 million to $2.3 million per system). The medical devices maker sold 90 da Vinci system in the second quarter, down from 124 in the same period last year.
Accordingly, we have lowered our sales forecast for the da Vinci system in our model. With the U.S. being the largest market for the da Vinci system, we now anticipate near term sales to decline as growth in the international markets may not be able to offset the full pressure. Additionally, the Patient Protection and Affordable Care Act (“PPACA”), which will come into full force beginning 2014, is expected to put further pressure on the number of procedures. As the act aims to reduce healthcare costs, the company may find it difficult to get reimbursement approvals. However, we expect sales to get back on the growth track beginning 2015 as Intuitive Surgical continues to focus on increasing its footprint in the international markets. International markets are not widely tapped and therefore present a significant opportunity for growth. Recently, Intuitive Surgical started selling its system in South Korea and addition of new markets will pave the way for continued growth, although at a slower pace. Growth in other procedures like gynecological and general surgery and addition of other procedures should also help in the longer term. Our earlier estimates projected yearly da Vinci system sales to near 1,000 by the end of our forecast period. However, with new revisions, we now expect the figure to cross 600.
However, there can be further downside to our estimates should the company fail to address the U.S. FDA’s demands. The FDA slapped the company with a warning letter in the last month and sought certain changes to be made in the system. The management has mentioned that these demands are addressable and is working on it. However, we will keep an eye on the development as it can make it harder for the company to sell the system.
We have also changed da Vinci’s average selling price (ASP) forecast in our model and we expect it to decline going forward and reach 2008 levels against our earlier expectations of a gradual increase. We expect the company to reduce the price of its system in order to revive growth momentum in the U.S. However, launch and adoption of the new upgraded system will offset some pressure. Further, as procedure growth slows down, the revenue growth from instruments and accessories will decline since demand for instruments and accessories is directly proportional to the number of procedures. These instruments and accessories have a limited life and need to be replaced periodically.
Consequently, we have also lowered our da Vinci system gross margins estimates as lower ASP will lead to lower gross margins going forward. According to our new estimates, gross margins should decline to around 64%.
While management had stated that it would compensate by taking cost-cutting measures to lend support to operating margins, we are cautious on the company’s aggression. The company is expanding in international markets and therefore will need to continue to invest in its sales force. Further, to offset pressure in key procedures, it would need to pump money in R&D to expand the scope of the system to other surgeries.
Structural Changes In Our Model
In addition to the aforementioned changes in key businesses, we have also incorporated certain structural changes in our model for the convenience of investors. We have introduced the flexibility to change the number of trade-in systems, which impacts the forecast of da Vinci’s installed base. Intuitive Surgical allows its customers to trade in their older systems for credit towards the purchase of a newer generation system. As part of a trade-in transaction, the customer receives a new generation system in exchange for its older used system. The refurbished systems are then sold to other customers at lower prices.
Trade-in as percentage of yearly system sales increased from around 16% in 2009 to near 27% in 2012. This was mainly due to an older installed base as existing customers chose to upgrade to new systems. Going forward, we expect the proportion of trade-ins to increase in 2013, before gradually declining to about 27% by the end of our forecast period. In 2013, lower da Vinci sales coupled with customers’ preference for refurbished system are expected to result in higher figure of trade-in as % of yearly system sales. However, as the company expands into new international markets, the figure should come down. A new market witnesses a lower number of trade-in in the initial years, which is evident from historical trends. As more new markets are added, there will be a higher proportion of new system sales.