Earnings Report : MAKO Makes the Grade

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) 3rd quarter earnings report came out on Wednesday and it is, along with the subsequent conference call, chock full of valuable and detailed information. That's something I prize in CEO Maurice Ferré: He and his management team know what's important to MAKO's future, and they share a rich bounty of information on those topics.

As a prelude to this earnings announcement, I wrote an essay describing what a successful 3rd quarter would look like, which you can read here...

Now let's give MAKO's results the acid test against these criteria.

First & Foremost : Sales of RIO Surgical Robots

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

This is by far the most important of the criteria. If they aren't selling robots, they aren't getting the mainstream "Early Majority" customers onboard. No Early Majority, no future.

MAKO sold 15 RIOs this quarter! This superb result exceeds even my highside demand of 13 RIOs. It gets even better. I was looking for half of these sales to be to Integrated Delivery Networks, or IDNs, which are the big pragmatic hospital networks - the mainstay of the Early Majority. Of the 15 RIOs sold, 8 of them were to IDNs. This is an all-important first for MAKO.

Trends : Surgical Procedures Performed

(2) At least 2,785 procedures performed during the quarter

Second in importance, the number of procedures performed indicates the rate of adoption of the technology by surgeons trained on the system. It is also a large and growing portion of MAKO's revenues.

Only a disappointing 2,413 surgeries were performed resulting in a first time ever quarter-over-quarter reduction in surgeries. Worse still, it was on a 7% larger installed base of RIO robots than last quarter. The number of surgeries per installed robot declined from 7.2 per month, which has been at a steady high for awhile, down to 6.2 per month. That's a 14% decline - ouch!

Ferré elaborated at some length on the decline during the conference call. I am encouraged by his acknowledgement that the drop is important, with the details he provided on why the drop occurred, and with what October has produced. Together it indicates to me that the reduction is not indicative of a systemic decline. As to why the decline, Ferré noted that they had put so much more energy into shifting their marketing strategy and training their team, as well as releasing the latest version of both the knee and hip surgical software, that they had to ease up on their push on surgeons to use the system. Realize that surgeons have their way of doing things, and it takes constant pressure over a lengthy duration to migrate them to a new way of doing business.

In addition, hip procedures contributed to the decline because of an inventory shortfall; and lastly, Hurricane Sandy added its insult to the damage done to the East Coast by postponing many surgeries. The clincher for me in all the discussion is that they saw a resurgence of usage per RIO per month during October, the first month of the current quarter.

The software releases I just mentioned, version 2.5 for the knee and 2.0 for the hip, are critical pieces of the product development shift necessary to close deals with major IDN hospitals. This past year MAKO spent considerable field work assessing how to make the RIOs more acceptable to the surgeons. Surgeon feedback to the new software releases says it speeds up registration and improves ease of use. Streamlining the entire surgical process and reducing surgery times is crucial both to surgeon acceptance and to more surgeries per robot. MAKO is making progress here too.

Trends : Gross Margins and Operating Costs

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

Everything here looks on target except for the Procedures gross margin (GM). That latter, down 28 percentage points (28% pts), isn't a surprise with the reduction in number of procedures falling onto the shoulders of fixed costs. If October is any indication, this number should go back up next quarter (but let's keep an eagle's eye on it). RIO Systems GM declined 4% pts from the push to get the new software versions out the door, but is up 2% pts comparing the latest 3 quarters to 2011. Lastly, Service GM rose 7% pts.

The best news here is that the operating cost margins fell across the board (Selling, Research, and Depreciation) for both quarter over quarter and 9-month over 9-month. Total operating costs fell from 109% of sales last quarter to 91% of sales. In yet another first, Operating costs fell below sales and continue to trend downward towards eventual profitability.

Trends : International Sales

(4) Accelerating pace of international RIO sales.

There were no international sales. Though a bit disappointing, I'm not really surprised as this is a longer term trend to monitor over the coming quarters and years. The good news is that the search is on for a VP of Global Sales. Ferré believes they are ready to pursue the huge international market with more vigor.

Catalyst : New Procedures

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

I had not expected any news on this front for easily a year, so I was delighted to hear the surprise announcement that they are in partnership with Pipeline Biomedical Holdings for total knee replacement. Such a product greatly increases the size of their knee replacement market and puts them in head-to-head competition against the mainstream traditional surgical products companies who primarily support total knee replacement. It also further weans MAKO-trained surgeons from performing any traditional knee surgeries. This is BIG news, and MAKO ponied up $7 million in stock to close the deal. The battle is on!

The Competition

(6) Continued absence of a strong direct competitor in robotic surgery.

Here I'll repeat my prior description of MAKO's competition. All I will add is Ferré's comment in the conference call that he still doesn't see any direct competition. By that he means robotic challengers. The traditional surgical companies can still win if they have a "good enough" value proposition.

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. MAKO clearly plans to take them down with their new full-knee replacement product. 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. 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 choose to enter MAKO's robotic market and compete directly for the spoils, or even buy them outright.

The gold standard for robotic surgery is Intuitive Surgical (NASDAQ: ISRG). Their market so far is exclusively robotic surgery of organs; but 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. They too could simply buy out MAKO at the right price.

Shareholder Dilution

(7) Affirmation of no unplanned secondary public offerings (SPO).

Ferré and the CFO reiterated that cash levels continue to track the strategic plan which includes a secondary public offering in 2013. Thus there are no unplanned SPOs in the offing. The recent deal with Pipeline Biomedical included a $7 million issuance of MAKO stock, or about 1% of market cap. I view this as a valuable investment to expand their knee replacement market, to directly challenge the traditional knee replacement market, and to nip OmniLife Sciences in the bud.

A Green Light for Now

Though at first blush this earnings announcement looked like a mixed bag, on deeper inspection of the report and especially of the all-important conference call, this quarter looks like a major step across the "technology chasm" and into the green pastures of the large Early Majority market. I am very encouraged with their report and remain excited about MAKO Surgical's future.

They may yet become the next Intuitive Surgical.


Erik Eason owns shares of MAKO and ISRG, and a bull option position in JNJ. 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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