Intuitive Surgical Surges Ahead: New Robotic Platform Broadens Its Reach

 Intuitive Surgical's (ISRG) April 1 announcement of Food and Drug Administration clearance of its new robotic surgical platform, da Vinci Xi, was well-received by the marketplace, with the shares up significantly on the news. We understand investors' enthusiasm regarding this approval, as the new system builds on the existing portfolio of da Vinci products and should allow robotic surgery to make inroads into a number of underpenetrated surgical areas. We anticipate that this platform will be well-received by several surgical specialties, particularly general and cardiovascular surgeons, and has the potential to reverse the recent trend of the significant growth deceleration in system placements.

The Xi rollout also reinforces our wide moat rating and positive moat trend, which are predicated largely on Intuitive extending its technological superiority, penetrating markets previously untapped, and maintaining its monopolistic competitive positioning. However, we're not making any changes to Intuitive's valuation on the news, as our long-term growth trajectory implies growth in procedures that presented a challenge for Intuitive's da Vinci Si platform. To deliver double-digit growth in procedures for the next five to 10 years, as we forecast, Intuitive had to offer a meaningful upgrade from the Si to the surgical community, and considering that the company has a habit of rolling out new platforms every three to five years, the Xi's launch shouldn't come as a particular surprise.

Refocusing on Complex Open Surgery
To the company’s great credit, it didn't sit idly as its core markets--urology and gynecology--exhibited significant deceleration over the past years, and its emphasis on general surgery as a growth engine has proved prudent. Even as the Si platform wasn't viewed initially as a particularly useful system for general surgery, Intuitive launched a number of instruments over the past two years to equip general surgeons with tools they had to have to advance robotic surgery in this area. The company even launched a three-arm Si-e version and a single-port suite of tools to offer general surgeons a "budget" alternative to manual laparoscopy, well suited for more basic procedures such as cholecystectomy and bariatric surgery. With the Xi launch, Intuitive is going in the opposite direction--instead of fighting a more challenging battle against manual lap, the company returns to its roots by going after complex open surgery. The new system features should make the platform more compelling in complex procedures and could allow Intuitive to finally make inroads in the cardiovascular area, long proved to be rather impenetrable for robotic surgery (the company's penetration in this area and a relative weight of cardiovascular procedures in the overall volume are in low-single digits). Targeting open surgery also allows the company to escape the mounting criticism over both the clinical and economical value of robotic surgery. The uptake is likely to be slow, but as clinical evidence accumulates and cost-benefit analysis for hospitals shows to be favorable (as has been the case in other procedures), Xi's ultimate success is very likely.

Potential for Robotic Surgery Is Virtually Limitless
After a decade of explosive growth, Intuitive Surgical is becoming a victim of its own success, with tougher comps and challenges in its key procedures slowing its trajectory. So, with declines in dVP, a slowdown in dVH, and questions surrounding the cost of the robot, why do we still expect the total number of procedures to more than triple over the next decade? The answer is that the ceiling is virtually unlimited, with existing applications of robotic surgery only scratching the surface of all possible procedures that could migrate to the robot over the next decade. Urology, gynecology, general surgery, ENT, and cardiothoracic all still offer sizable un- and under-penetrated opportunities, in the United States and more importantly outside the United States. While Western Europe faces similar constraints as the U.S., robotic surgery's penetration in Europe is significantly lower, and when including significantly underpenetrated markets such as Japan, robotic surgery still has ample room to grow. In the absence of formidable competitors, the firm will continue to dominate the robotic surgery arena, and even in cost-conscious environments in the U.S. and Europe, the adoption of robotic surgery will remain robust.

However, we are cognizant of decelerating growth rates, with litigation and the FDA warning letter providing additional risk factors. The company clearly has a target on its back, and its aggressive marketing campaigns and recent product recalls haven't helped its cause. While we don't expect product liability claims to severely hamper the company over the long term or provide material downside to our valuation, its effect on near-term sales or investor confidence will linger for a while. That said, we believe Intuitive's competitive positioning remains superb and while system sales will likely never reach growth rates of the past, we are still confident in our forecast of overall double-digit growth over the next decade.

Our Fair Value Estimate Is $440 per Share
We recently raised our fair value estimate to $440 per share from $400. Most of our increase was due to incorporating cash flows realized recently, but we also modeled recovery in Intuitive's growth in late 2014 and early 2015.

One of the challenges to figuring out the proper growth trajectory (and valuation) is that historical growth has been three-pronged: System placements, disposable instrument sales, and service revenue all have contributed significantly to the five-year overall revenue compound annual growth rate of 30%. Now, as system placements will be increasingly driven by the procedure volume, utilization rates are likely to expand and new system installations to slow.

Very High Switching Costs Support Intuitive's Wide Moat
With its expanding installed base of more than 2,500 da Vinci robotic surgical systems and its impressive clinical history, we think Intuitive Surgical has dug a wide moat around its business. Healthy system and instrument pricing reflects the firm's monopoly status in its niche, allowing Intuitive Surgical to achieve profitability rarely enjoyed by medical equipment makers, with operating margins around 40%. In fact, gross margins on Intuitive's systems are comparable to its instruments (consumable component) profitability, which is unique in an industry where consumables typically command a much higher gross margin.

Rarely does such an attractive and rapidly growing market as robotic surgery stay impenetrable by competition for as long as it has, and the firm's monopoly will sooner or later cease to exist. There are several emerging competitors, but none have the potential to significantly disrupt the firm's operations or erode its extraordinary returns on capital. Intuitive's intellectual property on its system and growing instrumentation base create a sizable barrier, but it is the ever-growing clinical database that presents the biggest challenge for a new entrant. To amass the body of data that Intuitive possesses, new competitors (which are still a few years away from U.S. or European approval) will have to convince enough hospitals to purchase or trial their instrumentation for an extensive period, train robot-naive or da Vinci-trained surgeons, and recruit willing patients. We are, however, certain that competing instruments--if priced attractively--may make inroads into procedures/specialties currently underpenetrated by Intuitive, particularly in hospitals that have balked at da Vinci's cost. But if anything, this would expand the overall market, which could serve to Intuitive's advantage, given its ubiquitous brand and already-robust installed base.

Once a hospital purchases Intuitive's system, switching costs become exorbitant as the average system price around $1.4 million represents a large portion of a typical hospital's annual capital-expenditure budget. Customers would need a very compelling technology or price difference to switch before their machines wear out naturally (the upgrade cycle is somewhere around five years). Given the need to purchase new instruments with each procedure, installed systems should provide a relatively dependable stream of revenue per procedure, as long as surgeons continue to use installed systems.

The biggest threat to Intuitive's moat is the future of robotic surgery in general. It is plausible that cash-strapped hospitals that receive no additional reimbursement for robot usage may opt for a plodding yet cheaper alternative of manual laparoscopy, particularly if the clinical body of work supporting robotic surgery over traditional MIS is lacking.