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It's Showtime for MAKO

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

MAKO Surgical's (NASDAQ: MAKO) earnings report is approaching, and much is riding on the results. Many eyes will read the report, and many ears will listen to the conference call. Let's be prepared so that we, as individual retail investors, can determine for ourselves whether MAKO is successfully navigating the difficult task of bringing mainstream customers onto their sales roster.

As each earnings season approaches I like to write down a concrete definition of what a successful quarter looks like for each of the largest holdings in my portfolio. I do this before the earnings are released so that the results themselves don't bias my assessment. It's only natural, after all, to bend our criteria towards making our favorite companies look good because we want them to succeed. Their success or failure, however, is totally independent of our perception; so it's important to set down tough success criteria and to dispassionately compare them to the results.

The "5 and 3" Technique

Lately I've taken to using a technique I first saw on The Motley Fool's "Stock Advisor" premier service. It's called "5 and 3" because you identify 5 positive developments to watch for and 3 adverse developments to be on guard against. I prefer to make them a mix of immediate results for the quarter, of long term trends which you want to see develop over the next few years, and any catalysts which would propel your company forward or, if adverse, could cripple it. Here is my 5 & 3 against which we can measure MAKO's upcoming quarterly report.

5 Positive Things to Look For

For this specific quarter :

(1) At least 10 RIO surgical robots sold during the quarter.

More specifically, I want to see sales to major hospital IDNs which represent the pragmatic mainstream customer base. During the last conference call, CEO Maurice Ferré reaffirmed their annual guidance for 42 to 48 RIOs sold. Given that they sold only 14 during the first two quarters, and that the 4th quarter gets the lion's share, that translates to about 10-13 RIOs sold this quarter and 18-21 sold next quarter. I also want half of these sales to be to the pragmatic IDN customers. These are the ones that MAKO must capture to successfully cross the technology chasm from the "early adopter" customers they have already reached, to the vast "early majority" of pragmatic customers.

Longtem trends :

(2) Stable or rising number of surgeries per RIO per month.

Last quarter there were 2,590 procedures performed, while the installed base of RIOs grew by 7.5%. I'm looking, therefore, for at least 2,785 procedures this quarter. This will indicate that surgeons continue to integrate them into their practices.

(3) Stable or rising gross margins and declining operating cost margins.

MAKO has shown remarkable success with their margin improvement. The CY 2011 gross margin was 68%, up from 14% in 2008; and its operating cost margin was 111%, down from 263% in 2008. I'd like to see CY 2012 deliver a 68% or better gross margin, and an operating cost margin below 100%; and each succeeding year improving on the operating cost margin.

(4) Accelerating pace of international RIO sales.

Only 3 RIOs have been sold internationally: one each to South Korea, Italy, and Hong Kong. I would like to see this double by year's end, and to accelerate in the years ahead.

Catalysts :

(5) New orthopedic procedures including shoulders, spine, and feet & ankles.

It's clear from the large R&D budget and comments from the CEO and within the annual report that MAKO has one or more major new orthopedic procedures in the pipeline. Any one of these would make the case for purchasing a RIO significantly more compelling. Given the rate that the hip surgery procedure has been adopted by current customers, 58% in the first three quarters of its availability, a new procedure built on the same robot could well break open the dam. I will be overjoyed if the next procedure debuts by this time next year.

3 Adverse Things to Watch For

For this specific quarter :

(1) Faltering of sales or margins from any of the three product categories.

MAKO makes money selling RIO robots, surgical products for each procedure conducted, and service warranties. If sales or gross margins of any of these three revenue sources declines, that will be a red warning flag that the business may be shifting into reverse.

Longterm trends :

(2) Rapid emergence of a strong direct competitor in robotic & computer assisted surgery.

Privately owned OmniLife Sciences is MAKO's only direct robotic competitor; but so far they are very small and have focused on total knee replacement, in contrast to MAKO’s focus on the partial knee replacement market. Other competitors hale from the traditional joint replacement market including privately held Biomet, DePuy Orthopedics (a subsidiary of Johnson & Johnson), Smith & Nephew (NYSE: SNN), Stryker (NYSE: SYK), and Zimmer Holdings (NYSE: ZMH). All five of them design, fabricate, and distribute medical implants and surgical devices for a wide variety of traditional medical procedures that partially overlap in an intriguing patchwork. These are large companies whose products span far beyond MAKO's current scope, supporting orthopedics of the spine, skull, jaw, hips, knees, shoulders, feet; and further afield into trauma, neurology, and endoscopy. They are the entrenched industry MAKO is attempting to overturn; but who could instead bar MAKO's continued intrusion, or even choose to enter MAKO's robotic market and compete directly for the spoils.

The gold standard for robotic surgery, of course, is Intuitive Surgical (NASDAQ: ISRG). Their market so far is exclusively robotic surgery of organs, but what if they decided that orthopedics showed such promise that it was worth the investment to expand their capabilities? They would be a tough opponent to any of the above companies, especially a young upstart like MAKO.

Catalysts :

(3) Confirmation or hints of additional secondary public offerings (SPO).

We've known for some time that MAKO will require raising funds via one more SPO in 2013 before they become cashflow positive. If their recent challenges linger on for quarter after difficult quarter; however, another may be needed. Not only would the serious share dilution hurt existing owners, but the loss of confidence in the company would further erode the share price, making for a double whammy.

Locked & Loaded

With the 5 & 3 at the ready, we are now prepared to make our own assessment of MAKO's earnings release, and we know what to listen attentively for on the conference call. Whether you are a current or prospective shareholder, or rooting for the competition, being informed before events unfold is paramount.

Now bring on that quarterly report.

Foolish Bottom Line

The recent market sell-off of MAKO Surgical shares has many wondering whether the potential growth prospects of the robotic surgery company make it a buy today or a stock to stay away from. Read The Motley Fool’s premium report to read up on the details of MAKO's story. Click here to access it now.   

Erik Eason owns shares of MAKO and ISRG, and a bull option position on JNJ. He would like to further acknowledge the Motley Fool for originating the "5 & 3" concept. The Motley Fool owns shares of Intuitive Surgical, MAKO Surgical , and Zimmer Holdings. Motley Fool newsletter services recommend Intuitive Surgical and MAKO 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.If you have questions about this post or the Fool’s blog network, click here for information.

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