Robot Future Is Near ( Barrons )

By B ALPERT

Prostate cancer put our man up close and personal with a surgical robot made by Intuitive. But does a terrific technology justify the stock's valuation?

WHEN HE TOLD ME I HAD PROSTATE CANCER, my doctor's tone was sympathetic and vigilant -- as if ready to catch me should I collapse. He needn't have worried. I instantly reverted to reporting mode, grilling him about treatments and outcomes. Diving into the research, I could escape my angst, just as I've always done. All the better, then, when it turned out the best treatment would be surgery with a robot from Intuitive Surgical . I knew it was one of the hottest growth stocks of our time. I was elated to find a way to turn my sickness into a work assignment. There were stacks of medical journals to read, doctors to interview.

I still can't tell you how I feel about the cancer. But I can tell you about Intuitive. Its stock jumped more than 50 bucks Wednesday, after the Sunnyvale, Calif., company reported better than 50% growth in June-quarter sales and once again beat earnings estimates. At 322 each, the shares now go for more than 75 times trailing 12-month earnings, giving Intuitive one of the handsomest multiples in the Standard & Poor's 500. That multiple reflects the alacrity with which surgeons have adopted the company's da Vinci robot, a four-armed marvel the doctor controls from an operating-room console. Patients have less bleeding and scarring, and can get back on their feet without a long, expensive hospital stay.

But Intuitive's volatile and pricey shares also bespeak the desperation of investors mobbing a quality growth story in a lousy economy and stock market. That momentum mob seems heedless of how suddenly this expensive stock could become a victim of the robot's success.

You can gauge the market for robotic surgery better than you can for some other new technologies...like Google's, for example. About 40% of the country's large hospitals already have at least one da Vinci robot. When Intuitive (ticker: ISRG) finishes placing its robots, it will see a falloff in the systems sales that have contributed more than half of its revenue.

Sales of disposable instruments and accessories for each operation will continue, but the growth rate of those revenues will also decline once the da Vinci gets its share of the relatively fixed number of surgical procedures performed each year.

In its report last week, Intuitive allowed that procedure growth has slowed for the kind of robotic prostate surgery that I had last fall. The robot took seven years to garner the majority of the 90,000 prostate procedures conducted annually.

Robotics is gaining share more quickly in the rather larger market for hysterectomies and other surgeries performed by gynecologists.

But after that, there are only a handful of remaining high-volume procedures in the U.S. and abroad. Each of these additional kinds of procedures will contribute, perhaps, a buck a share in earnings from ongoing sales of instruments. That would just about offset the earnings hole from slowing sales of systems, leaving Intuitive with maybe the same $8 or $9 a share in annual earnings that Wall Street predicts for the next couple of years.

What stock multiple investors would put on such steady-state earnings is harder to predict. Shares of profitable medical-device makers that saturated their markets, like coronary-stent maker Boston Scientific (BSX), have settled into earnings multiples in the high teens. Even if that earnings arithmetic proves too stingy, Intuitive shares could fall by at least 25% once most people get their surgery robotically, as I did. The volatile stock has fallen as much twice this year already, as it changes among momentum investors' fickle hands.

The company and its fans say growth is far from slacking. "We don't think we are anywhere near saturation in anything," says Intuitive's vice president of finance, Benjamin Gong.

MY BIOPSY FOUND CANCER, BUT THE DISEASE probably hadn't spread beyond the prostate. That made me a lucky cancer patient. By having the prostate cut out completely, I could probably get rid of the cancer. As with other surgeries, studies show that the doctors who do the most prostate procedures have the best success. So I began looking for a high-volume surgeon in the New York area. It's exactly this sort of active search by patients that has driven market share to da Vinci procedures.

I found my way to Ash Tewari, the cheerful director of the robotic prostatectomy program at Weill Cornell Medical Center. Tewari does more than 600 prostate surgeries a year. Unlike other da Vinci surgeons I've interviewed, Tewari owns no Intuitive stock. "I want to keep my life simple," he says.

He trained at Henry Ford Hospital in Detroit, where doctors perfected the prostate operation that put Intuitive on the road to success. Engineers had long tinkered with surgical robotics for NASA and the military, but it wasn't until 1999 that Intuitive introduced a really useful system -- the da Vinci.

Other minimally invasive tools can require that the surgeon stand and move awkwardly, lowering his hands to raise the instrument.

The da Vinci instruments have wrists, allowing the surgeon to work the controls more intuitively, while sitting comfortably at a console that gives a 12-times magnified, 3-D view of the surgical field. Hand tremors can be filtered out and movements scaled down. "It boils down to two things," says Tewari. "I can see things better, and I can go into very narrow corners."

Prostate surgery suits the robot. In a narrow area, the doctor must do a lot of precision work to avoid rendering the patient incontinent and impotent. Those possibilities scare guys into shopping around for the very best surgery. And the evidence so far shows that da Vinci prostate surgery is as good or better than the traditional approach.

I have only four small scars from my operation instead of a big gash. My recovery was quick. Tewari made me walk a mile in the hospital corridor before going home the day after surgery. He had me walk three miles a day thereafter. In a week, I was ready to go back to work.

Urologists rate prostate surgeries in terms of what they call the Trifecta: potency, continence and cancer control. Studies show that after da Vinci surgery, success rates are comparable to traditional open surgery for the first two measures. Cancer control takes longer to prove because prostate cancer develops slowly. It can take seven years to know if one kind of prostate-cancer treatment is failing more often than another, and the da Vinci has been in wide use for only a few years.

The early signs are good, however, with blood tests taken five years after surgery showing no evidence of recurrence in about 84% of da Vinci patients (whose cancers were caught when still confined in the prostate, like mine) -- which is comparable to open surgery. Tewari says the most important factors in a successful outcome are the stage of the cancer and the skills of the surgeon, regardless of whether the surgeon uses the robot.

AS GUYS HAVE CLAMORED TO HAVE A ROBOT CUT out their prostates, da Vinci procedures have burgeoned. About 55,000 fellows around the world went under the da Vinci in 2007. With other kinds of da Vinci surgeries, there were a total of 85,000 robotic operations last year, an increase from 2006 of almost 75%.

That demand drives hospitals to invest in robot systems. The worldwide installed base of da Vinci robots grew 42% last year, to almost 800, with about 600 of those in North America. A system sells for more than $1.3 million. The hospital pays another $135,000 a year for service and support. Each procedure consumes $1,500 to $2,000 in disposable instruments and accessories.


Intuitive Surgical
While sitting and operating the da Vinci, surgeons can see well and navigate narrow areas.
Intuitive became profitable within a couple of years of its $9-a-share initial public offering in 2000. Revenue grew 61% in 2007, to $600 million. Of that revenue total, about 54% came from system sales, and the remainder was the recurring revenue from instruments and service.

Chief Executive Lonnie Smith has run a thrifty business. Gross margins on both systems and consumables are 70%. Operating margins are almost 35%, and if you add back noncash charges for stock options, cash margins from operations approach 45%. Net income in 2007 was about $140 million, or $3.70 a share.

Last week, when Intuitive reported its excellent financial results for the June quarter, the company raised its guidance for the current year. Revenues could grow 45% to 47%, to reach $871 million to $883 million. Investors received the news cheerfully, boosting the shares 18% to as high as 331. Analysts boosted their price targets. Tao Levy of Deutsche Bank increased his target from 360 to 365, arguing that the stock should trade at 46 times his estimate for the next 12 months' earnings of about $7.90 a share.

Others are even more bullish. Lazard Capital Markets analyst Sean Lavin thinks Intuitive deserves a multiple of 60 times his 2009 earnings estimate of $7.05, yielding a price target of $420.

To get the stock to such levels, Intuitive has to sell a lot more da Vinci systems and doctors have to perform a lot more procedures. At investor meetings, Intuitive executives sketch out the number of systems they think they can sell.

The thousand largest hospitals in the U.S. (those with more than 325 beds) should be good for three systems each, says the company. The next thousand hospitals could have one da Vinci apiece. Hospitals in the rest of the world could buy 2,000 more, Intuitive says, for a worldwide total of 6,000 robots. Through June, the company had sold 946 da Vincis worldwide, so Intuitive thinks it has penetrated only 15% of the hospital market.

THE COMPANY'S MEASURE OF THE MARKET FOR ROBOTS may be far too optimistic. Jose J. Haresco, an analyst at Merriman Curhan Ford in San Francisco, thinks there's room for about 1,800 da Vinci robots in the U.S. and 600 more abroad. Intuitive's dream of three robots in every big hospital isn't yet supported by the evidence. One hospital near me, in Hackensack, N.J., has five da Vincis. But the average among large hospitals so far is 1.3 robots each.

Early-adopter hospitals and surgeons have been able to keep their da Vincis pretty busy. My surgeon, Ash Tewari, for example, works two machines to capacity almost single-handedly.

In San Antonio, gynecologist Vincenzo Sabella and his associates have done hundreds of procedures with the two da Vincis at St. Luke's Baptist Hospital. That hospital had an exclusive concession on San Antonio from Intuitive until just recently, says Sabella. All the other hospitals in town are now getting robots. As their exclusives expire, will Intuitive's early adopters -- and everyone else -- keep as busy? For every high-volume program like Tewari's in New York, there is a hospital that uses its robot only a few times a month.

The company, in its financial presentations, suggests that the world could keep 6,000 robots busy. Intuitive figures that consumables and service contracts could bring in $573,000 a year per system, resulting in $3.4 billion in annual recurring revenue. At today's rate of $135,000 for annual service and the consumables average of $1,750 per procedure, those numbers imply five procedures a week per robot -- which well exceeds today's average of about three procedures.

Taking the company's numbers and projecting a decline in research and selling expenses once the hospital market for robots is saturated, you'd have a profit of perhaps half that $3.4 billion a year. That generous calculus might justify today's $13 billion market cap.

But those numbers imply that da Vinci surgeons would be carrying out 1.5 million procedures a year, worldwide It's hard to get to such numbers using a bottom-up model of available surgical procedures. That kind of analysis points to only about one million procedures a year.

Consider some numbers from last Tuesday's earnings call. While Intuitive raised its guidance for this year's growth in total procedures from 55% to between 57% and 58%, it tempered its forecast for growth in prostate procedures -- the company's leading market -- from 40% to between 35% and 39%. "No surprises here," said CEO Lonnie Smith. "It's just a matter of moving through the adoption curve." The modified growth rate is still strong, but it suggests the da Vinci's share gains in prostate surgery are slowing after reaching about two-thirds of the 90,000 in annual U.S. procedures.

Finance V.P. Ben Gong, and bulls like Deutsche Bank's Tao Levy, are quick to change the subject to hysterectomies. There are an estimated 600,000 performed in the U.S. each year. Many of these procedures already qualify as minimally invasive; gynecologists pioneered surgery through laparoscopic key-hole incisions. Yet Intuitive thinks surgeons could use the da Vinci for about 250,000 complex hysterectomies currently done with open incisions.

"The learning curve is much more simple for the gynecological surgeon than for the urologist," says Jeanne Hassebroek-Johnson, whose practice in Sioux Falls, S.D., has become known for its da Vinci surgery.

Gynecologists who don't want to take time to become proficient with the da Vinci have argued that their long relationships with their patients will keep the patients from deserting them. Thomas Payne, with a busy da Vinci practice in Baton Rouge, La., scoffs at that argument: When women hear about the quick recovery that robotic surgery allows, they forget their loyalty to their gynecologist.

Intuitive predicts that the number of da Vinci hysterectomies performed this year will increase by 150% over last year's 13,000. "We're in the early stages of a very steep curve," says Gong.


Middle table: Intuitive suggests that it has tapped only 15% of the potential market for surgical robots. But a more realistic look at the potential market indicates that the company is closer to saturation. Bottom table: Intuitive shares go for more than 75 times trailing-year earnings and 45 times bullish estimates for 2009. That's hard to justify with realistic forecasts for robotic surgeries, like those in the tables above.

Gynecologists are starting to use the robot for other operations, too. The company hopes to get a fair share of the 60,000 annual surgeries for vaginal prolapse and the 55,000 operations for removing uterine fibroids. Outside of gynecology, the robot is seeing action in some of the 50,000 kidney-cancer surgeries and the 20,000 repairs of the heart's mitral valve. The company won't itemize these da Vinci procedures, but subtracting Intuitive's 2008 forecast for prostatectomies worldwide (75,000) and hysterectomies (33,000) from the forecast total (135,000) suggests that all other da Vinci procedures could amount to 27,000.

Adding up the various kinds of procedures that Intuitive is currently targeting in the U.S., a very generous total might come to half a million da Vinci surgeries a year (see nearby table, The Limits of Innovation). That's far below the 1.5 million implied by the bullish model.

INTUITIVE'S CHIEF FINANCIAL OFFICER, MARSHALL MOHR, urged me not to overlook the robot's opportunities abroad. International sales have so far contributed a bit more than 20% of revenue, so there's certainly upside. The system was approved just this month in China, and has yet to be approved in Japan. "We're very early in the adoption cycle overseas," Mohr says.

Many analysts predict that the international market for da Vinci procedures will prove slightly larger than that in the U.S. That would bring the worldwide opportunity above a million annual procedures, still well below 1.5 million.

Don't allow my ungrateful scrutiny of Intuitive's stock price to blind you to the terrific benefits that the company delivered to patients like me: less surgical trauma; a shorter and cheaper hospital stay; a quicker return to my supposedly productive work.

But those who buy the stock at these levels may find themselves abandoned by momentum investors .

I like this play if u can stay around for a long term play , this is the future of surgey , baby boomers will be needing more surgey in the near future !