Will Bad Press Outweigh Strong Earnings for This Medical Device Pioneer?

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

Rising earnings estimates and strong third quarter results, including a 28.2% positive earnings surprise, helped Intuitive Surgical (NASDAQ: ISRG) achieve a Zacks #1 Rank (Strong Buy) on Jan. 1. This pioneer of robotic surgery has delivered a positive earnings surprise in each of the last five quarters with an average of 13.7%.

Looking Ahead

Zacks expects that a number of procedures currently performed either in an open surgical manner or with laparoscopy will be eventually replaced by da Vinci surgery, as robotic surgery becomes the standard of care.  The company has a virtual monopoly in robotic surgery with little significant competition. The company's revenue stream continues to be robust. Recurring revenues continue to grow as a proportion of total sales. They grew by 24% year-over-year in the third quarter, making up 57% of revenues. However, until the global economy fully recovers, the company could face potential problems from macroeconomic uncertainty impairing the commitment of hospitals towards investment in high-cost robotic systems. In the meantime, the installed base continues to grow as hospitals are forced to upgrade their systems. The company has a strong financial position with substantial cash holdings and no debt.

The company tweaked its guidance for revenues and operating income for 2012 along with its third quarter results. For 2012, revenues are expected to grow in the range of 21.5% to 23%, compared with the earlier guidance of 20% to 23%. Operating income is expected to be about 40% of net sales, compared to approximately 39% to 40% earlier. The company lowered its procedure growth at 24% (earlier in the band of 25% and 27%) for 2012. The Zacks Consensus Estimate for 2012 increased to $14.85 per share, and the current estimate implies year-over-year growth of over 20%.

Negative Analyst Outlook

Citron has produced a report titled "Has the Halo Been Broken on Intuitive Surgical?" Citron believes the medical device company, which currently trades at more than 30 times earnings, is headed toward $250 per share, a far cry from its current price of around $498. The report cites excessive and unjustified marketing, lack of clinical evidence, and legal liability arising out of some patient outcomes. Investors should realize that Citron is a notorious short seller.

Citron has been accurate in cases such as Questcor (NASDAQ: QCOR) and Vivus (NASDAQ: VVUS), both of which have lost value. Questcor fell nearly 50% on Sept. 19, 2012 after Aetna announced that it would stop coverage of Acthar for certain conditions. Vivus lost substantial value in November and has been crawling higher. Investors seem to be skeptical about the sales of its weight loss drug Qsymia. Health risks associated with Qsymia and obesity drugs in general are also a concern for physicians. A report filed by Vivus shows side effects of Qsymia include birth defects in pregnant women and increased heart-rate and metabolic acidosis.

Citron points out an increasing number of lawsuits, which it claims are credible, against the company. Lawsuits are nothing new for a medical device company, but for the da Vinci Surgical System's biggest use, hysterectomies, there have been a few new lawsuits because of negative outcomes. Hysterectomies are relatively straightforward surgeries to perform manually, so this presents a credibility problem for the pricey da Vinci robotic surgery systems, which can cost anywhere between $1 million and $2 million. Citron cites 10 different lawsuits filed in 2012 related to hysterectomies, with two of them involving the death of the patient. Citron also says that Intuitive chairman Lonnie Smith sold $50 million worth of his options in the company. While there may be perfectly legitimate reasons for this, it does send out the wrong message.

Reaction to the Citron Report

Raymond James analyst Lawrence Keusch said that after reviewing the Citron report they would not consider it to have any meaningful new information. With over 1 million procedures performed with the da Vinci Surgical System, its safety record is solid. There will always be some surgical outcomes that are not ideal and lawsuits could be filed, but this should be expected in the medical device industry. The firm reiterated an "Outperform" rating and $620 price target on Intuitive Surgical. Lazard Capital Market's Sean Lavin disagreed with much of what Citron said, but not all. Citron Research has a very strong track record of successfully picking shorts, but normally goes after small cap companies that it believes are fraudulent. In this case, no fraud is being claimed. The firm maintains a "Neutral" rating on Intuitive Surgical.

Industry Outlook

Growing health care costs have not yet affected the company, but with hospital budgets getting tighter, it is only a matter of time before hospital administrators will question whether a million dollar machine is worth the money. Europe hit Intuitive and its peers hard this year. The ongoing financial crisis in the euro zone has negatively affected the entire industry. Intuitive's international revenues have seen slower growth as a result.  International revenues now constitute less of the company's total, and declining from 22% to 20% of total sales.

Europe has also affected medical companies like Stryker (NYSE: SYK) and Boston Scientific (NYSE: BSX), both of which experienced declines in the organic growth outside the U.S. Europe's widespread fiscal tightening and unfavorable exchange rates have exacerbated the problem. Stryker is fighting back as the medical device stock has jumped more than 8% since early January and recently announced that it had offered $764 million in cash for Chinese orthopedics maker Trauson HoldingsMeanwhile, Boston Scientific announced that it has successfully treated the first patient in its ZERO AF clinical trial. This study is aimed at evaluating the performance of the company's Blazer Open-Irrigated Temperature Ablation Catheter in patients with symptomatic, drug refractory paroxysmal atrial fibrillation.

In the robotic surgery field, Intuitive has looked outstanding when you consider that MAKO Surgical, which considers itself a clone of Intuitive, has had a bad 2012, with full-year sales guidance of RIO surgical systems lowered in July and share prices taking a beating. Less prominent Hansen Medical has also seen shares prices fall significantly, losing more than 20% last year.

Conclusion

Based on current market conditions, Intuitive appears overvalued at the moment. I am placing a "Hold" rating on the stock. 


jordobivona has no position in any stocks mentioned. The Motley Fool recommends Intuitive 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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