Intuitive Surgical Shows Signs of Improvement Even as Q2 Earnings Decline

Intuitive Surgical (NASDAQ:ISRG) surprised the market with better-than-expected Q2 2014 results on Tuesday, although both the top and bottom line continued to decline. Net income dropped about 35% year-over-year (y-o-y) from $159 million in Q2 2013 to $104 million in Q2 2014. However, this was an improvement of about 136% over the income reported in the first quarter ($44 million). Total revenue for the second quarter was about $512 million, down 11% on a year-over-year basis but up 10% sequentially. This was also about 2% over the analyst consensus compiled by Thomson Reuters. The spike in revenue and earnings on a sequential basis can be attributed to the greater-than-expected rise in total procedures, which increased 9% y-o-y and 8% over the first quarter. ((Intuitive Surgical’s CEO Discusses Q2 2014 Results – Earnings Call Transcript, Seeking Alpha, July 22 2014 )) ((Press Release, Intuitive Surgical, July 22 2014))

Reflecting the rise in procedure volumes, sales of the company’s da Vinci systems improved about 35% over the previous quarter to about $144 million. Instruments and Accessories revenues were almost flat y-o-y at $262 million while Service revenues grew in high single-digits over the prior year quarter to about $107 million. On the cost side, the company’s gross margin in Q2 2014 was 67.2% compared to 70% in the same period last year. This decline was attributed to a higher proportion of new products (which have slightly lower margins) in the total sales mix and higher costs due to overall lower production. The company expects its gross margin to decline further in the near term as it focuses on new products such as the da Vinci Xi. However, it expects margins to improve in the long run as production volumes increase and its products gain more acceptance.

We currently have a price estimate of $455 for Intuitive Surgical, which is about 15% ahead of the market price.

See our full analysis for Intuitive Surgical

Market Concerns Impacting Sales

The company’s performance has been negatively impacted in the last few quarters by a number of factors, such as concerns over the efficacy and cost effectiveness of its da Vinci systems, as well as changed institutional capital-spending priorities because of the Affordable Care Act in the U.S. and in anticipation of a new da Vinci system by healthcare institutions. Owing to such uncertainties, the company again did not provide any revenue guidance for the remainder of the year. However, it revised its guidance for yearly growth in operating expenses for full year 2014 from 12-15% to 10-13% . Going forward, we expect the company to benefit from sales of its new products and growth in number of procedures.

Procedure Volumes Show Sustained Growth

Intuitive Surgical reported a 9% increase in procedures driven by consistent growth in general surgery, urology and colorectal procedures, partially offset by declining gynecology procedures in the U.S. A greater number of procedures generally means a greater number of instruments and accessories, as well as a shorter replacement cycle. Therefore, the number of procedures directly impacts the company’s revenue.

We expect procedures to increase going forward as the company focuses on promoting the use of da Vinci systems in gynecology and urology procedures worldwide. A focus on rolling out the low cost Single-Site kit of instruments and accessories and expansion of the da Vinci Stapler in the U.S. could also positively impact procedure volumes for the company in the coming quarters. Looking at the improvement in procedure volumes this quarter, Intuitive Surgical adjusted its procedure growth forecast from 2-8% to 5-8% for full-year 2014. The total number of procedures performed  in 2013 was 523,000.

New Products Drive System Sales

The company received FDA clearance for two new surgical systems in the last quarter- da Vinci Xi and da Vinci Sp. The da Vinci Xi system is aimed at multi-port procedures with better mobility and ease-of-use. It also boasts a better imaging system with 3D and high-definition visuals. In its earnings call, the company reported that out of the 96 da Vinci systems sold in the second quarter this year, 50 were da Vinci Xi models.

On the other hand, the da Vinci Sp surgical system is designed specifically for single-port surgeries such as urology procedures. It is relatively smaller in size and is aimed at faster and cost-effective procedures using a high-definition camera and a few instruments. The company stated in its Q1 earnings call that it does not intend to commercialize the da Vinci Sp system and that it will be sold as part of the da Vinci Xi system. The Sp could be an important addition to Xi in improving the da Vinci surgical system sales going forward.

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