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Can This Robot Doctor Heal Itself?

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

Shares of surgical robot maker Intuitive Surgical (NASDAQ: ISRG) plunged 16% on July 9, after the Sunnyvale, Calif.-based company warned that its second quarter revenue would come in below analyst estimates when it reports earnings on July 18.

It’s been a chaotic year for Intuitive Surgical, which produces the da Vinci surgical robot that was once the darling of Wall Street. Despite rising 2,700% over the past decade, the da Vinci’s system’s real value has recently been questioned by several groups of doctors, who claim that it doesn’t offer any real advantages over traditional surgical methods.

Is Intuitive Surgical’s revenue warning a bleak signs of darker days ahead, or should investors buy the dip in hopes that the outlook for the da Vinci system will improve over the next few years?

Three main revenue streams

Intuitive Surgical generates its revenue from three main sources - sales of the da Vinci system, which costs $2 million, instruments and accessories for the system, and continual maintenance fees, which cost hospitals hundreds of thousands of dollars annually.

During the first quarter, instrument and accessory sales accounted for 43% of Intuitive Surgical’s top line. Sales of the da Vinci systems accounted for 42%, while service fees accounted for the remaining 15%. During the first quarter, sales of its accessories, systems and services rose 26%, 24% and 17%, respectively. In other words, the company was firing on all cylinders.

That’s the reason Intuitive Surgical’s preview of its second quarter revenue was so disappointing. The company now forecasts second quarter revenue to rise 7% year-on-year to $575 million, missing the Thomson Reuters’ consensus estimate of $629.6 million. Sales of da Vinci systems are expected to decline 6% to $215 million. However, sales of instruments and accessories, its largest segment, is forecast to rise 18% to $265 million. Net income is only expected to edge up 3.2% to $160 million.

The decline in demand for da Vinci’s core product raises serious concerns about the entire company’s business model and the sustainability of its accessories and services segments.

What does da Vinci do?

The da Vinci system allows surgeons to make microscopic incisions via robotically controlled arms that imitate a surgeon’s hand movements, making major operations more accurate and less invasive. Da Vinci is primarily used for urological and gynecological procedures, which account for 70% of its procedures. Doctors are currently experimenting with using the system in cardiothoracic and laparoscopic operations as well.

Although sales of the da Vinci robots declined during the quarter, total procedures using the system rose 18%, as usage in general surgeries offset a decline in gynecologic procedures. Gynecologic procedures declined due to insurers encouraging cheaper outpatient treatments. The overall effectiveness of the da Vinci system in hysterectomies has also been questioned by the Journal of the American Medical Association and the American Congress of Obstetricians and Gynecologists. The Journal noted that complication rates for robotic hysterectomies came in at 5.5%, slightly higher than the 5.3% rate for cheaper, traditional surgical methods.

Even though that report spooked many investors into believing that Intuitive Surgical’s core competency was now threatened, it’s important to note that the hospitals which own da Vinci systems installed are relying on them more than ever. This means that the company’s service and accessories revenue should continue to provide it with a steady cash flow.

Will the rise of the robots continue?

Intuitive Surgical enjoys a virtual monopoly in the market of robotic surgery. It successfully expanded out of a niche market and convinced healthcare providers that its technology could become mainstream in the future. However, the adoption of cutting-edge technologies faces a bumpy road ahead, as hospitals may hesitate to purchase high-priced systems in times of macroeconomic uncertainty. Let’s take a look at two other companies which may be affected by this trend.

Accuray (NASDAQ: ARAY), which manufactures image-guided, robotic-assisted radiosurgery devices, is considered an indirect competitor, although the company focuses more on the treatment of solid cancers. Like Intuitive Surgical, Accuray relies on a core, cutting-edge product, the CyberKnife Stereotactic Radiosurgery System, which is used to deliver precise, high doses of radiation to solid cancers.

Cyberknife uses real-time X-ray images during the treatment to see a tumor’s true position, rather than relying on pre-treatment images. Its "knife" can also maneuver around healthy tissues to treat a tumor from multiple angles. Cyberknife has proven to be a popular alternative to traditional chemotherapy, which targets all cells that divide rapidly, both healthy and infected. Despite the incredible potential of its technology, Cyberknife is currently unprofitable, and reported a 30.7% year-on-year decline in revenue last year. Its profit margin also comes in at -31.6%, which makes it a highly speculative play which lacks Intuitive Surgical’s established customer base. Shares of Accuray fell more than 5% after Intuitive Surgical’s revenue warning.

MAKO Surgical (NASDAQ: MAKO), which produces robotic prosthetics, is also exposed to the same headwinds that threaten Intuitive Surgical and Accuray. Mako’s MAKOPlasty procedure utilizes its RIO Robotic Arm Interactive Orthopedic System to treat patient specific, osteoarthritic diseases. RIO can be used to treat osteoarthritic knee and hip disease, and just like da Vinci, the robotic arm offers a more accurate, less invasive alternative to traditional surgical procedures.

Despite being a robotics business like Intuitive Surgical and Accuray, Mako can be considered a more conservative play that also sells regular joint-specific implants for orthopedic procedures. Although MAKO is also unprofitable, its losses have narrowed over the past five years, and its revenue has continued to rise, surging 26.3% year-on-year in the most recent quarter.

The Foolish Bottom Line

Even though Intuitive Surgical disappointed investors with its revenue warning, it remains one of the least speculative bets in the robotic surgery industry. The company is profitable, has shown robust revenue growth, and has no direct competitors to speak of.

Prospective investors should see if da Vinci can be used for a wider variety of procedures, to diversify away from the gynecological ones that have been scrutinized by some doctors. If it does so, and the macro environment remains stable, Intuitive Surgical’s core sales of da Vinci systems could pick up again, boosting revenue across its services and accessories segments. 

Therefore, I believe that Intuitive Surgical could be undervalued at current levels, since it now only trades at 21 times forward earnings - its lowest P/E valuation in four years and a substantial discount from the feverish P/E of 60 it traded at a mere three years ago. Yet that doesn't mean that there still isn't potential downside from these levels, and it might be prudent for investors to wait for its full earnings release for more information.

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Leo Sun 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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