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What Is Missed on Intuitive Surgical's Big Miss

Dana is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Investors got little warning on Intuitive Surgical's (NASDAQ: ISRG) big second quarter miss. The first most heard about it might have been the company's own press release – the company doesn't officially report until next week.

In practical terms the miss isn't much – revenue of $575 million against an expected $630 million, and net income of $160 million instead of $177.7 million. But the stock, which was previously priced to perfection, fell out of bed anyway, dropping over 17% and shedding $2.87 billion in market cap overnight.

What's going on?

Sean Williams blames Obamacare, saying uncertainty over future payments is causing hospitals to stop buying. Dan Carroll suspects a series of FDA questions about the safety and efficacy of Intuitive's DaVinci system may be to blame, while Karl Thiel wants you to see an exclusive report on the matter.

Before all this, Intuitive was a big favorite here. Brian Stoffel had it on his ideal portfolio. The Fool was recommending it explicitly, and even its purchases were moving markets. 

The nature of a tech market

Having covered the medical device market since 2006, here is my take.

First, DaVinci robots are a miracle. They increase a surgeon's productivity, and they reduce mistakes when compared with doing operations by hand. Over time, they increase a surgery center's profitability and reduce its liability.

But this is a technology market. Just because you've got something that's cool doesn't mean you'll always be able to sell it at whatever price you set. Eventually the market moves through its demand curve, which means prices and margins must go down. As Jim Cramer noted last month, the price of Intuitive shares were overextended, on a technical basis. 

Also, just because Intuitive Surgical has lots of patent protection on how DaVinci works, this doesn't mean no one else can make a robotic surgeon. As Keith Speights wrote on July 2, there is now competition in this market. 

The competition is minor

Fortunately for Intuitive, and its shareholders while there are other companies in this market, they're generally small, specialized, and far more troubled than Intuitive is.

MAKO Surgical (NASDAQ: MAKO) has a robot that focuses on orthopedic procedures, which was used over 10,000 times last year. The company is not yet profitable, although sales are up 20% year-over-year, but it's debt-free, it had a great fourth quarter of 2012, which generated cash, and its RIO system could, over time, become directly competitive with Intuitive in other areas of surgery.

If I were to recommend any Intuitive competitor, it would be MAKO. But I won't. The company hasn't yet learned how to make money and its product line is limited. The company's ability to gain market share with a lower-priced, specialized device is key to success. But there's a natural ceiling to the orthopedic specialty, and its ability to penetrate other areas remains speculative. 

Accuray (NASDAQ: ARAY) has a robot called CyberKnife that does cancer surgery. The company looked like a winner at the start of 2012, but results since have been disappointing, with falling margins and lower sales.

The company raised substantial debt early this year to take another run at the market, becoming cash flow positive in the first quarter of the year. The biggest problem is a recall, in April, meant to “repair a defect” in the product.

I don't like recalls. I think Accuray's product line is too limited to compete in the long run, absent a buy-out by a large player trying to enter this market. Right now, it's fighting for its life. You can speculate on its success, but as with MAKO you're speculating. 

Margins will shrink

All of which means that the problem is a rather prosaic one. It isn't “ObamaCare,” or else Intuitive's press release would have emphasized strong results in international markets, and its sales problems would be limited to the U.S.

It's market saturation. Having developed the robotic surgery market, Intuitive Surgical now faces the normal problems of declining margins, replacement of older equipment, and the fact that the revolution has gone by. It's really no different from the problems at Apple or any other tech company that finds itself in a maturing market.

The fact that no one saw this coming, however, is troubling. If “ObamaCare” is really so bad for Intuitive, that's a feature and not a bug. At some point no one can keep raising prices. Efficiency must come. The percentage of GDP devoted to health care in the U.S. has to come down from its present level of 17%, or the economy will collapse of that weight.

My Foolish take

The recent fall in Intuitive shares have sent its Price/Earnings (PE) multiple down to 24. That's almost reasonable. It's below that of Google. When everyone else is panicking, that's a good time to buy stock in any company that is fundamentally sound.

Intuitive Surgical is fundamentally sound. It's no longer a speculation. When the hangover is over, when all the crazy-eyed bulls have run from this stock in terror, buy yourself a few shares. Your patience will be rewarded. 

Dana Blankenhorn has no position in any stocks mentioned. The Motley Fool recommends Intuitive Surgical and MAKO Surgical . The Motley Fool owns shares of Intuitive Surgical. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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