Cancer Blaster vs. Surgical Robot?

The stock market is presenting all kinds of buying opportunities that are making me interested this week, but the one dynamic that stands out most today is the dramatic difference between the performance of two companies in my portfolio that sell high tech products that both do essentially the same thing ... though in very different ways.

Accuray (ARAY) is the maker of the Cyberknife, a targeted radiation machine for cancer treatments that has been called the "Cancer Blaster" by newsletter touts who enthusiastically recommend the stock. Though useful for all kinds of radiation treatments, the argument for this more advanced machine is that it can track moving tumors and spare nearby tissue -- making it particularly popular for prostate and lung cancers (since the lungs, you know, move, and the prostate is in, shall we say, a very delicate area of the body).

Intuitive Surgical (ISRG) is the maker of the da Vinci surgical robot, whose core market is prostate surgery (though other surgeries, including mitral valve heart surgery and gynecological applications, are growing fast). The strongest rationale for fast growth in the use of this robot a couple years ago was that prostate surgery with the da Vinci spared those same "delicate areas" near the prostate in a way that open surgery often did not ... though it certainly also has other advantages over open surgery, and, depending on the surgeon (and who you ask) over traditional laparoscopic surgery.

Accuray is up close to 10% today, Intuitive Surgical is down about 8% as of my last check. Why is that?

Well, it's certainly true that ISRG is much more steeply valued, being one of the top performers on the Nasdaq for all of last year, and there are huge numbers of shareholders, myself included, who have a cost basis several hundred percent below the current price -- that makes these shares a target for profit taking when shareholders start to panic that we're entering a recession and/or a prolonged bear market. Even the most enthusiastic shareholder would have a hard time arguing that ISRG is a bargain, even down $70 from its high, with a forward PE of about 60.

And Accuray is, on the face of it, much cheaper -- this much newer public company (IPOd over the summer last year) has much lighter penetration in the marketplace, and has some competitors who offer somewhat similar products (as opposed to the da Vinci, which has the multipurpose surgical robot space more or less to itself). And it trades at a forward PE of about 20, though there's no track record to encourage investors to believe that those analyst estimates are anywhere near accurate (earnings have fluctuated widely, as has the stock for its brief history).

ISRG got a downgrade today from Wachovia, which noted that hospital capital spending might be at some risk this year and that expectations for this highflier are quite optimistic. That's probably the most immediate reason for the price cut today, though general analyst concern and valuation jitters are probably the reason for the overall price cut from the high of $350 back in December to today's price around $280. ISRG still depends on sales of new systems for much of its revenue, though their recurring revenues from parts and services are growing faster and will be the future engine of the company -- so if they have a bad quarter and sell fewer systems than predicted, it would not be at all surprising if the shares fell dramatically, it has happened several times before.

And I'm not sure about any specific impetus for the ARAY move, though I do know that at least one newsletter is still actively pushing it, and the CEO did speak at the big JP Morgan conference in LA this morning (that conference has been moving stocks right and left, as usual, so that's probably the main move -- I haven't been watching, but perhaps they got a mention on CNBC). Add to that the general urge of investors to move to healthcare as a defensive move, and I guess ARAY is riding the trend.

I'm holding shares in both of these companies because companies that fight cancer will be facing a huge secular tailwind with the aging population over the next thirty years, and devices that are more advanced are popular with hospitals even when they cost millions of dollars -- I've seen the da Vinci advertised by hospitals for years by proud owner hospitals, which has clearly pressured their competitors to pick up the robot, too, and more recently I'm also seeing some ads for the Cyberknife from hospitals around the country. At this stage in their growth, with a more expensive machine that is in many fewer hospitals, I presume that Accuray is likely to get more of a boost from the fact that the Cyberknife still truly gives hospitals a dramatic competitive advantage in drawing oncologists and cancer patients.

So I still like both firms -- ISRG seems to me to be the company with a more dominant presence, though they don't compete directly, and they have a much steadier potential earnings stream due to the importance of "disposable" attachments and accessories for the da Vinci that must be replaced frequently, and they're priced accordingly. ARAY seems to me to have a higher growth potential because, if the value of the Cyberknife continues to be borne out through more studies, they have a huge green field of hospitals who will need to buy it -- but they're cheaper because they have more direct competition, they're newer, and the rely almost entirely on device revenue and have far less hope of a strong recurring income stream from accessories and attachments (though there is some).

Indeed, the newsletter touts talk about ARAY as the "next ISRG," and in some ways that argument is compelling -- ARAY is, by some measures, where ISRG was a few years ago. Whether it will ever get to where ISRG is today is another matter, but I've got a bet in place that both will do very well over the coming decade.

full disclosure: In case it's not obvious, I do own shares of both ARAY and ISRG and do not intend to trade in either in the next week.

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A Bigger Market for Prostate Surgery? (ISRG)

An interesting study was released this week in the Journal of the American Medical Association that might mean the market for prostate surgery is going to get bigger -- which would mean good things for the makers of the da Vinci surgical robot, Intuitive Surgical (ISRG).

The Washington Post ran a good story about the study today, and the basic findings were that treatment may be a good option for prostate cancer sufferers even in the later years of life.

This is significant, because although aggressive treatment (radiation or surgery) has for some time been the agreed-upon standard for younger men with prostate cancer diagnoses, for the most part elderly men (60 and over) have been advised to "wait and see" because prostate cancer generally moves so slowly that many of these men will die of something else before the cancer becomes dangerous.

Now that "wait and see" policy is in some dispute, thanks in part to this new study -- men who received treatment even at more advanced ages had a 30% chance of a longer life, and that is a dramatically significant number.

The study is in some dispute, because it was conducted using patient records instead of actually examining patients -- so it's certainly possible that other factors came into play (though the authors said they tried to correct for other health problems that might have skewed the results).

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But regardless, this is potentially important news for Intuitive Surgical going forward. I have owned ISRG for well over a year now, buying both above and below today's price (my cost basis is about $99). While the markets for the da Vinci are continually expanding, particularly in mitral valve repair and in gynecology, the lions share of da Vinci surgeries are da Vinci prostatectomies, and this is the first robotic surgery that is really being accepted as significantly better than its laparoscopic or open counterparts.

ISRG is shooting for roughly a 35% market share in prostatectomies this year, last time I checked, a share that has increased very rapidly over the last few years.

So if their share of prostatectomies continues to climb ...

and the number of prostatectomies performed continues to climb (not only because of this study, but also because the baby boomers are entering their prostate trouble years) ...

The overall number of da Vinci prostatectomies that are performed should climb almost exponentially.

And with procedure growth being a key component to ISRG's growth prospects moving forward (they need high utilization rates to encourage hospitals to buy multiple robots, and they make money with every surgery thanks to service and accessory sales), this can't help but be good news.

There are lots of moving parts in this equation -- if drugs to fight prostate cancer prove to eventually be better than surgery, that's bad news for ISRG ... then again, if they take hold in hysterectomies the same way they have in prostatectomies, the sky's the limit (I looked at the da Vinci volume drivers here). I'm just pleased to see that the potential market for people who can be helped by the da Vinci's minimally invasive solution is growing.

full disclosure: I do own Intuitive Surgical shares as of this writing, I last wrote about the company in detail after their last quarter's conference call.

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Intuitive Rollercoaster (ISRG)

Here's what I think was the most important quote from the Intuitive Surgical conference call last week, from the CFO: "Growth in procedures masked what is otherwise a seasonally slow quarter."

Intuitive Surgical (ISRG), maker of the da Vinci surgical robot, had a wild ride over the 24 hours surrounding their earnings release last week -- they released market-beating earnings after the market close on Thursday, which brought an immediate bump up by about 20%, then Friday morning the shares fell from the previous closing by about 10% after an analyst downgrade -- a swing from about $112 at closing yesterday, up over $120 in the after hours, then back down to about $100 ... and they opened lower today, hovering just under a hundred dollars a share.

This isn't that new for ISRG -- system sales can be quite lumpy from quarter to quarter, and management has a history of issuing pretty conservative guidance and then beating it, so each time they issue fairly tepid guidance the shares collapse a little, only to (usually) climb again by the time the next quarter is released.

So what was the bad news in the conference call that brought the shares down? The analyst who cut his rating to hold argued that the shares are now fully valued given their growth rate, and that's certainly a defensible position to hold (even if it's not mine).

I continue to believe that Intuitive is a few years away from having a truly spectacular ongoing revenue stream, with or without massive growth in the sale of new systems ... and that as long as I can focus on the longer term (not quarter to quarter), I'll be very pleased with the growth of the installed base of systems as well.

So far, system sales (the sale of the actual da Vinci surgical robots) still make up the majority of revenue -- about 55% -- but utilization is growing so quickly that the installed base is beginning to require a significant number of new instruments and significantly more doctor training ... and instrument and accessory sales are already growing slightly faster than system sales.

There were 42 new da Vinci surgical robots added to the worldwide installed base in this last quarter, three more than in the quarter before -- so there are now 509 systems installed worldwide (there were also four "trade-ins", so you may see totals of 46 for the quarter in some places, but those also removed four older machines from the market). It seems likely that their ability to forecast system sales is going to suffer further, as the sales cycle is getting a bit shorter. Their cycle is down to six months or even less in some cases, and some sales have less than a quarter lead time.

Each procedure done with a da Vinci generates somewhere between $1,500 and $2,000 in sales, primarily for instruments that are only usable for a limited number of procedures (and that doesn't count the instrument and accessory sales that accompany new installations). And while there is a huge range of utilization rates across different hospitals, procedure growth continues to be dramatic, and more and more hospitals are adding second, third or (in one case) fourth robots (12 of the sales this quarter were to hospitals with multiple machines) -- which leads me to believe that this recurring revenue stream should soon eclipse the systems sale revenue.

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But it really seems to me that investors are conditioned to focus only on the "units sold" number and on sequential growth ... and in that light, Intuitive didn't look that spectacular this quarter. They sold 39 robots last quarter, and 40 in the fourth quarter last year, so the 42 sold this quarter don't jump out as a dramatic growth indicator. Since the summer quarter is a pretty soft one for sales, according to management, and year over year growth was dramatic, I don't see anything significant to be concerned with at this time -- that strong and steady procedure growth noted by the CFO is much more significant than the quarter to quarter system sales.

Here are a few of the other things I thought were notable in the conference call:

Gross profit margin declined to 66% from 69.2% as a result of writeoff of inventory, and increased overhead with manufacturing expansion. They expect margins to improve by 100 basis points in the fourth quarter, which is promising. The expansion of their manufacturing capacity is complete, and they're now expanding engineering and product development space.

Non-cash stock options expenses are still pretty high, 7 million this quarter -- much of that is credited to their sales force, which has been expanded over the past year, and as long as they're in hyper growth mode and pushing sales of the systems to expand their footprint, I'll consider that to be reasonable. Right now, stock options reduce their gross margin by about one percentage point (still in the high 60s, so it doesn't bite too much yet).

52 hospitals now have multiple robots -- the biggest news this quarter was that Penn purchased 2nd, third and fourth systems to bethe first hospital with four robots as they build out a "center of excellence" in robotic surgery. Nine other customers now have three systems. (As I've written before, the goal is to have three robots each in all 1,500 of the largest US hospitals, which would bring the installed total to roughly ten times today's number ... and make a lot of people very rich.)

Clinically, they're seeing solid sequential procedure growth. Gynecology had the largest sequential percentage growth (though from a small base), followed by urology. New robotic surgical societies, publications, and conferences continue to sprout up and spread new techniques and procedures.

Results of clinical studies continue to show that cancer control and physical recovery are much better for da Vinci prostatectomies than for open prostatectomies -- after following this story for a couple years, it now seems to me that traditional open prostatectomies are almost never appropriate for standard cases (I'm not a doctor, that's just my impression).

In the key gynecology market (key for future growth, anyway), the da Vinci hysterectomy run rate will exceed 2% this year (5,000 of a projected 250,000 target market). This will continue to place demand on hospitals to increase their capacity to perform these surgeries, as one can only imagine the competition between urologists and gynecologists for the available machine time. Three papers were published on the da Vinci hysterectomy this quarter, but there has not yet been a big, influential, data-driven study published that might push the envelope on these procedures. Several such studies are underway, however.

For comparison purposes, ISRG exited 2002 at 1% and 2003 at a 3% run rate for prostatectomies -- and for 2006 they'll be at 2% for hysterectomies (prostatectomies should be near 35%). There are some significant differences between the specialties, but it's encouraging that gynecology is doing well out of the gate so far, since the hysterectomy market is so much larger.

Still, every procedure has a different adoption curve ... typically, cervical cancer is more urgent than prostate cancer and doesn't necessarily provide the time for consideration of many options, which leaves less time for shopping around and finding out about the da Vinci hysterectomy. And hysterectomy patients are likely to have a close provider relationship with a primary gynecological caregiver, so that doctor will strongly influence what they do -- most men don't have a urologist as a primary doctor, so and prostate cancer generally provides more of a lead time for action, so they are more comfortable with shopping around to find out about alternative procedures if their urologist doesn't offer the da Vinci prostatectomy.

Heart surgery is growing well, too -- at least one surgeon is reporting dramatically better mitral valve repair results (95% success versus 50% success in traditional mitral valve repair), and lots of new clinical interest in da Vinci for revascularization

One analyst asked what kind of utilization rate would force hospitals to upgrade to a second machine, and there was no precise answer -- but management's sense is that once a machine starts getting used for one surgery per operating day that begins to put pressure on the system -- so once 250 or so procedures are done a year, the pressure will grow to get additional machines. That threshold may be lower if the machine is shared across several specialties, which is getting more common.

All this leads me to be just as confident in this company as before -- and perhaps a little tempted to add to my position again now that the shares are hovering right around my average cost per share. And to ice the cake, they also improved their outlook -- ISRG had expected 50-55% sales growth, now projecting 58-60% overall sales growth, with all segments growing. 62-64% expected growth for instrument revenue leads the pack, as procedure growth continues to build this recurring revenue stream.

They could easily sell 50 systems and post blowout numbers in the fourth quarter and see their share price rocket ... or they might sell 35 systems, miss the numbers, and see the price halved. In the long run, though, I think their monopoly position in their niche and their growing installed base will drive them to many years of strong growth.

Full disclosure: As of this writing I own shares of ISRG, purchased at $112, $109, $90, and $70.

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What are the da Vinci volume drivers? (ISRG)

Intuitive Surgical's (ISRG) primary business is the manufacture, sales and service of the da Vinci surgical robot. The da Vinci is the only widely capable surgical robot approved by the FDA, and essentially enjoys a monopoly position in its niche.

Robot-assisted surgery stands every chance of becoming the standard for several different types of surgeries, in my opinion, and is already making inroads in several areas. There are a few key things that will impact ISRG's development, including insurance reimbursement rates, FDA approvals, encroaching competition (eventually), and the health of hospital capital budgets.

But the key for ISRG is going to be new surgery approvals, patient awareness, and physician adoption.

Surgery volume and patient demand is by far the most important driver of the economic success of the da Vinci system -- the machines cost well over a million dollars and require the ongoing purchase of regular maintenance contracts and proprietary accessories, so it is important to have both growth in the number of machines sold, and in the number of procedures performed. The lumpy earnings the company has experienced over the last year or two (though mostly they've reported blowout earnings) have related to the uneven timing of purchases of da Vinci robots by hospitals. Moving forward, the installation income will become less and less significant and the ongoing instrument and service income will become the core of ISRG's earnings.

And the only way to get instrument sales up is to build a bigger network of the machines and the doctors who are trained to use them, and to build public awareness among both doctors and patients about the virtues of the system to keep the utilization rates high.

So far, that has really already happened with prostatectomies -- da Vinci has steadily been taking market share in these surgeries, to the point that they expect to see the da Vinci used in 35% of all prostatectomies performed this year, roughly twice as many as last year. In many ways, prostatectomies have been an easier sell than some surgeries might be, since in addition to the benefits conferred by all minimally invasive surgeries (less blood loss, less chance of infection, shorter hospital stay, less pain), da Vinci Prostatectomies have been shown to have fewer complications and a good chance of regaining urinary function and sexual function faster than with traditional prostatectomies. That has led to men actively seeking out and demanding the da Vinci, and I expect the market share will continue to grow ... as will the market size, since the baby boomers are just now entering their prime prostatectomy years.

But I think Intuitive Surgical really needs more procedure growth in additional areas -- and while use is growing for mitral valve repair and other heart surgeries, and for gastric bypass surgery, I expect the next key market share move will be in gynecological surgery, specifically in hysterectomies. Hysterectomies are relatively complex surgeries, I've been told, and they are fairly standardized and extremely common (about five times as many hysterectomies are performed each year as prostatectomies), which makes them well suited for minimally invasive robot-assisted surgery and a great growth market for Intuitive Surgical.

The benefits, for those unfamiliar with robotic surgery, are laid out nicely in this table, borrowed from the da Vinci explanation at Women's Specialty Health Centers, P.C.:

	Gynecologic Surgery with the da Vinci Surgical System1	Open Abdominal Surgery
Incisions	5 1-inch incisions	1 8 to10-inch incision
Surgery Time	2-3 hours	1-2 hours
Hospital Stay	1-2 days	3-5 days
Recovery Time	1-2 weeks	4-6 weeks
Pain Medication	Motrin/Darvocet	Vicodin/Percocet

So what has been going on with gynecological surgery and the da Vinci since I last did some "channel checks" in April?

Well, there have been plenty more machines written about in the press, and plenty of hospitals advertising their robots for hysterectomies ...

For example, here's a UNC page advertising their "high precision" robotic surgery options for women in cervical cancer, for hysterectomies, and other applications.

And one from St. Johns Mercy Hospital in St. Louis.

And Sarasota Memorial.

And Lankenau in suburban Philadelphia.

There have been stories about surgeons doing gynecologic surgery using the da Vinci for the first time in hospitals around the country, like this one from Memphis.

And if you're not too squeamish, you can watch a da Vinci hysterectomy here. The market machine is in full swing.

But what I've been thinking about lately is the advance of research, and whether the volume of research studies has any predictive power vis a vis the adoption of the da Vinci. According to the company, it took about two years of intensive research study and publication to make the benefits of the robot clear, to make physicians aware, and to therefore build the da Vinci's market share in prostatectomies.

So I thought I'd look at the number of research reports involving the da Vinci in prostatectomies over the last several years, and in hysterectomies more recently, and see if the information is at all valuable.

Here's what I found:

The FDA approved the da Vinci for laparoscopic prostate surgery in June 2001 (just about a year after the first approvals came through for the da Vinci in other applications), and for laparascopic gynecological surgery in April of 2005.

I used the Medline database to analyze the number of articles that mentioned either prostatectomies or hysterectomies (broadly defined) and mentioned the da Vinci system, Intuitive Surgical, or robotic surgery in each of the past several years.

Prostatectomy
1999 -- 7 articles
2000 -- 11
2001 -- 13
2002 -- 13
2003 -- 29
2004 -- 47
2005 -- 77
2006 -- 84 so far

Hysterectomy
2002 -- 3 articles
2003 -- 4
2004 -- 3
2005 -- 10
2006 -- 4 so far

That's a pretty underwhelming comparison, and my guess is that it's going to take another couple years of positive research studies (I've seen nothing negative about the da Vinci in gynecological surgery yet, aside from cost issues) before hysterectomies can take off in the way that prostatectomies have for Intuitive Surgical.

That's too bad, but with new indications for the robot coming along every day I think we can afford to be patient with gynecology -- it took the da Vinci Prostatectomy five years to get a 30%+ market share ... if the da Vinci Hysterectomy can get even a third of that (10% of the hysterectomy market) within its first five years (that would be mid-2009), that would be another huge growth driver ... though unless studies give a clear preference for the da Vinci hysterectomy over other laparascopic, vaginal or open surgeries (as studies in the past couple years have done for the da Vinci Prostatectomy), it's possible that 10% might even be too optimistic a target.

I'll be keeping an eye on the performance of the company, their sales of new systems, and their instrument income ... but what I'll really be looking for, and the company is great about covering these details in their conference calls, are additional inroads into gynecological and other non-urological procedures.

It's always possible that keeping an eye out for other procedures will cause us to lose sight of the critical near-term driver of da Vinci usage, however. I need to remind myself that the da Vinci has come to prominence and proven its supremacy at possibly an ideal time, just before what may be a perfect storm in the world of prostatectomies: The cusp of the baby boomers are just entering their early 60s with good general health and an interest in maintaining a high quality of life (of which peeing and having sex are some key elements); the average prostate cancer diagnosis is now made in the late 60s (and declining); and prostatectomies have more than quadrupled in number in the last 20 years as diagnosis and treatments have improved.

I did some analysis of the valuation of ISRG last December, when the price was quite close to where it is now -- I thought it was reasonably priced then in relation to its growth, and I think it's even more reasonable now. For full disclosure, I do own shares of Intuitive Surgical, bought over the last year or so at $112, $109, $90, and $70, and my average cost per share now stands just a hair under one hundred dollars.

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One up for every one down (FORM, CKCM, AKAM, ISRG)

Many of my holdings have been moving in almost perfect mirror trajectories over the past couple of days, following earnings reports that either disappointed or encouraged investors.

Akamai (AKAM) did much better than I had expected -- and even though it showed accelerating growth, which is the holy grail for investors, I was shocked to see it climb back to within a hair of it's 52 week high. I thought the shares were already priced for some pretty dramatic outperformance, but clearly the wave of analyst upgrades following their earnings did their job as the shares zoomed higher by better than 20% yesterday. A nice surprise.

On the flip side, Intuitive Surgical (ISRG) shareholders reacted to strong growth and forecasts with much more anger -- we've gotten spoiled with ISRG, as with AKAM, and expect blowout growth every single quarter, so merely great growth isn't going to cut it if you're carrying a high multiple. Intuitive had very strong recurring revenue growth from their sales of instruments, which means procedure growth is very good. I think that's the most important thing to see, that surgeries using the da Vinci are continuing to grow, but clearly a lot of investors were looking for much more dramatic growth in system sales.

ISRG surprised everyone to the upside in the first quarter with 35 systems sold, many of them the newer, more expensive da Vinci S system, but even a 50% rise in systems sold year over year to 39 in this quarter was inadequate for many, even with a small-scale beat on earnings. I think folks expected a dramatic sequential climb in installations and didn't get it, but the growth there is still continuing and the second quarter can be pretty soft for big ticket purchases, so I'm not worried. I still think the key for ISRG will be procedure growth in Hysterectomies now that they have proven that they can build a dominant position in Prostatectomies, but it's early days still for the da Vinci in gynecological surgery.

And because my ISRG position is roughly twice as large as my AKAM position, they completely cancelled each other out yesterday.

The same thing happened today with two more volatile stocks -- Click Commerce (CKCM) disappointed due to a much higher tax rate and some slowing sales growth, and Formfactor (FORM) surprised with greater than expected growth in both earnings and sales.

I was a little disappointed with CKCM's performance, but not enough to sell my shares -- and frankly, given their low multiple, I think the shellacking the shares have taken this morning is quite overdone. Even if they were not growing very robustly, which they are even though taxes have taken a big bite out of earnings this quarter for the first time, they're being valued at a PE of about 9 on both forward and TTM earnings. That's just silly, and it implies an assumption that investors are assuming that their investments in R&D and in marketing will not allow them to build the business. They're priced for no growth now, but I expect good growth that will, within a couple quarters, come down to the bottom line. I am tempted to buy more but already have a large position, so I'll have to think about it a bit.

Formfactor, on the other hand, continues to delight. As I wrote a few weeks ago, the competition and innovation in the semiconductor industry is mother's milk for FORM as it allows them to sell a greater variety of testing probe cards, in higher volume. I don't see a significant downside even with overall semi volatility, given the remarkable diversity of customers and end user semiconductor applications that they serve. They managed sequential sales growth of 14% and YOY growth of 77% ... no complaints there, even though the year ago quarter was a low point. And more impressively, they turned that 14% sales growth into better than 20% sequential earnings growth. Unlike CKCM, FORM is priced now for significant ongoing growth, but I still like their chances. FORM is actually a relatively small position for me because I was never wise enough to double down last summer when the price was very enticing -- if it was one of my larger holdings I'd be tempted to take a small portion of my profits off the table given their high multiple, but as the situation stands it makes more sense to just hold and watch.

Formfactor's industry colleague MEMC Electronic Materials (WFR), by the way, is clearly confusing investors on a very fundamental level. They soundly beat the earnings estimates AND significantly increased their guidance for this year's earnings, and the shares actually went down. They're poised to invest in capacity to serve the solar power industry, thanks to an agreement with Suntech Power, and they continue to supply scarce wafers to the semiconductor fabricators at very nice margins. Given the average market multiple and their dramatica decline already over the course of this year (from $48 to below $28), I can only imagine that the reason WFR is falling is that everyone is terrified of the Intel/AMD problems. That's close to irrelevant for WFR, in my opinion, as long as chips continue to be required to run everything from laptops to cell phones to cars.

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Earnings Season Thoughts (GOOG, WFR, AKAM, ISRG, VRTX)

This is very likely the biggest single day for me in earnings season -- several of my strongest performing stocks like MEMC Electronic Materials (WFR), Akamai (AKAM), Intuitive Surgical (ISRG), and Vertex Pharmaceuticals (VRTX) are releasing earnings after the close today.

So this seemed an apt time to check up on the earnings releases that I haven't yet mentioned.

Yesterday, Cemex (CX) released their earnings -- and no one was particularly happy with them. The stock split recently, but that didn't have any real impact -- no, the impact was from declining US sales. Cemex had great sales increases in every other major area, including Mexico and Spain, but US sales dipped significantly. I found this very surprising, given the continuing cement shortage in this country, but I expect commercial and infrastructure construction to continue growing over the long term here at home, and with the rest of their markets performing very well right now I'm not terribly worried about a blip in the US. In fact, the news out today that GM was buoyed by its Latin American division gives me a bit of hope that consumption is increasing in that region, and any increase in automobile sales should help push demand for improved road infrastructure. That's a bit of a stretch, but at least it's a stretch on the positive side.

And Google (GOOG), another of my larger positions that has already released earnings, surprised me a little bit as well -- not because they continued to beat estimates handily (beat by more than 12% this time), but because it brought in virtually none of the volatility we've come to expect from GOOG earnings.

Google's now trading at less than a 40PE on current year's earnings (reported and estimated) -- that's about as cheap as it's ever been, though it's certainly not cheap in relation to the rest of the market. I sold about 40% of my Google holdings earlier this year at close to a 100% gain and will be holding these, but I think investors are now so afraid of growth stocks and technology stocks that GOOG is getting attractive again -- over the past two years they have steadily increased earnings, kept their noses clean, innovated with new products that may be monetized eventually, and, most importantly, continued to take market share from all of their competitors around the world.

And Gol Linhas Aereas Inteligentes (GOL), another of my bigger holdings, is managing to maintain very solid margins and increase market share even while they grow their fleet considerably and grow earnings by about 50% -- they're subject to oil prices just like all the other airlines (though Brazilian prices are a lot friendlier than US for jet fuel, in general), but they are growing very quickly without sacrificing profitability. The ADRs have been subject to the strength of the Real, and more significantly the shares have been on a rollercoaster as Varig's restructuring has played out ... but I don't see anything happening to Varig that will hurt GOL significantly, and I think the only thing that will bring trouble to the company is a recession in Brazil that curbs demand for tickets.

Looking forward, we've got AKAM, ISRG, VRTX and WFR all reporting today.

WFR is a company I've written about quite a bit recently -- the collapse of their deal with Motech was disappointing, but the cessation of their supply agreement with Evergreen Solar (ESLR) was an indicator of the upward trend in their market, and the signing of a deal with Suntech Power (STP) today to supply solar silicon wafers for ten years in exchange for an up-front payment and a warrant for STP shares came earlier than expected but is also a strong positive.

And today, WFR will release its earnings after the close -- and they've beaten estimates the last two times out, if not by all that much. Analysts are expecting something in the low-40 cent range for EPS, which would be close to twice their year-ago earnings (a year ago is roughly when the company began turning things around and their shares began climbing). WFR has been much higher than this, at around $48 before the bottom fell out of the market, and is priced at close to a market multiple -- for this kind of growth, that seems a more than fair price to pay.

VRTX should be insignificant -- their earnings don't mean much, because no one is buying this company for their current royalties on a few antiviral drugs that are in production now. No, people are buying Vertex for VX-950, their anti-hepatitis compound that has show remarkable results in early clinical trials. Vertex has made some solid partnership agreements in the last few months and is very well financed to complete these trials, so unless there is news about VX-950 or VX-702 (and I don't believe there will be), I don't think we'll learn much from the earnings release.

AKAM is feeling the pain of growth stocks everywhere -- it has gone up so much that it is hard to consider it cheap even on forward earnings. Add in the fact that now many folks are getting worried about Limewire, which has replaced Bittorrent and Google as Akamai's boogeymen, and I expect that the folks who are sitting on huge returns in this one have itchy trigger fingers. Limewire is actually a real competitor, with a similar business plan to Akamai's, but AKAM is so entrenched with their customers and has such a strong portfolio of clients that I think fearing the upstart is a bit premature right now. Still, any disappointment on earnings release this evening -- any worsening of margins that might bring in the specter of price cutting due to competition, or anything less than a big uptick due to heavy World Cup traffic, could bring another wave of selling. With the demand for faster commercial delivery of audiovisual files continuing to increase dramatically, I still think Akamai is a good place to be in the long run ... even if they get some competition in the space they have owned since they acquired Speedera. But it's not a slam dunk, and the shares aren't cheap right now in my opinion.

Intuitive Surgical has been actually fairly quiet lately. In the last few months it has recovered from the beating it took when they lowballed their first quarter sales numbers (especially since they then beat those lowballed estimates handily), but folks will certainly be watching very closely to see how many of the new Da Vinci S machines they sell, and what kind of penetration they're getting into the prostatectomy field (where they're shooting for 35% of the market by the end of this year) and, perhaps more importantly, into hysterectomies, where they are trying to build a presence in a much larger market. I looked into those with some channel checks in the Spring, but haven't followed up yet in any detail since the last earnings release eased a lot of my concerns. This company has the potential to revolutionize all kinds of surgeries in the years to come, but with hospitals generally hurting I'd be happy to see them just keep up with the sales they had in the first quarter -- in the long run, this will be a cash cow with lucrative instrument sales driving returns as more and more surgeries are performed, but in the short run the shares should bump up and down on the numbers of machines sold.

Should be an interesting day -- the next six hours will go a long way to determining whether or not my portfolio will shortly recover from the beating it has taken in the last two months, but so far I've heard nothing terribly disturbing from the companies I own, and I remain quite optimistic about their long term prospects.

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Intuitive Channel Checks (ISRG)

I've spend a fair amount of time lately trying to keep up on the news for Intuitive Surgical (Nasdaq:ISRG) -- this should be a pivotal year for them as their new system (the da Vinci S) gains customers and they expand the breadth of surgeries for which the da Vinci is commonly used. They'll be reporting their first quarter results two weeks from today, but with the price declining (perhaps thanks to Cramer once again jumping out?) and my constant temptation to buy more of this one, I hate to wait for the company to tell me how the marketplace is accepting their products.

It's hard to keep track of the number of new Da Vinci S systems Intuitive Surgical is selling, in large part because lots of newspaper and PR editors seem to think the S is a typo -- generally, you can guess that any ISRG robot purchased for more than $1.3 million this year is an S type, but unless they specify I can't be certain.

Thankfully, owning these robots is usually a competitive advantage for hospitals, and they like to brag about it. I've included links where they were available, but I pulled a lot of these articles from non-free web sources. I think these quotes and news items call attention to the demand for ISRG products, and the advantages of robotic surgery:

"Robert Carey, a urologist and robotic surgery expert at the University of Miami, is joining a local practice in part to use the newly upgraded robotic system, considered the most advanced on the market" -- Sarasota Memorial's newly purchased Da Vinci S, March 21.

"Between the demand and opportunity for heart surgery and lung surgery and what (the urologists) can do with prostate surgery, we had a backlog of cases waiting for the robot," Dr. J. Michael Smith said about Cincinnatti Good Samaritan purchasing the S as their second robot, on March 17.

Evanston Northwestern Healthcare got a da Vinci S as their first robot -- “My preference in the pelvic area and the prostate is to use the robot, because the area is a very small working area,” Johnston said. “We are looking where we are going as opposed to just feeling. We are doing a lot finer surgery and our whole goal with this is sparing the nerves,” according to Dr. William Johnston.

Spectrum Health in Grand Rapids, MI is the first in that city with the S -- “With this technology, Spectrum Health surgeons will raise the bar on performing complex procedures in a more timely, precise manner,” executive Matthew VanVranken said. “For example, cardiac surgery including bypass and valve surgery can be performed with smaller incisions and less pain. This less invasive approach means patients have less risk of infection, recover faster and return to normal daily activities more quickly.”

Pinnacle HealthSystem in Harrisburg got a system at the end of February -- "This is my next step in my striving to make things easier for the patients," Dr. Christine McCarty said. She plans to use the system initially on about 20 percent of her bypass patients, according to a Patriot-News article.

And Burbank has the new system, too, as of the March 12 LA Daily News: "With four arms wielding graspers, scissors and forceps, the new robotic surgeon at Providence Saint Joseph Medical Center could be the sidekick for Doc Ock, the evil, tentacled cyborg from the 'Spider-Man' comics. But this $1.5 million machine will try to save lives. 'We're the good guys. We'll be helping Spider-Man,' said Dr. Raymond Schaerf, a thoracic and cardiovascular surgeon who next month will be the first the medical center to perform a surgery using the machine on a cancer patient. 'This will be another episode in how we're advancing. ... We're going to be able to do a better job. We're all excited.'

"The medical center recently became the first hospital west of Texas to purchase the second generation da Vinci Surgical System, according to its creators, Sunnyvale-based Intuitive Surgical Inc."

It's great to see these machines moving out the door, and it's true that ISRG will need to sell many more machines to reach their goal of 4,500 machines in operation worldwide (they're about 10% of the way there now).

But beyond just selling the machines, both the original and the S, we need to see the types of procedures grow. Cardiac surgery was the first intended area for da Vinci and Prostate the first real area where da Vinci gained dramatic market share (20% and growing quickly) ... but new areas are needed to continue this growth. I've been looking for evidence of this expanded breadth of surgeries lately, too -- some of those above specify non-prostate applications, which is great. Here are some more:

Ochsner Medical Center, formerly Summit Hospital, is now offering robotic-assisted surgery and is the first to do so in Baton Rouge -- they're offering only gynecological surgery at this point, according to the Baton Rouge Advocate.

(Gynecological surgery might be the real bombshell financially -- it's a dramatically larger market than prostate surgery, largely because it was approved by the FDA less than two years ago, and is just now coming into it's own for ISRG)

On April 2, according to a Press Release, "The West Clinic Center for Gynecologic Oncology announced that gynecologic oncologists M. Patrick Lowe, MD, and Todd D. Tillmanns, MD, recently performed the first robotic-assisted hysterectomy and pelvic lymphadenectomy (lymph node dissection) for the treatment of endometrial cancer in the mid-South."

According to another Press Release, "George DeNoto, MD, chief of laparoscopic surgery at North Shore University Hospital (NSUH) in Manhasset, has carefully perfected a surgical technique on robotic colon surgery that has mystified other U.S. surgeons for years. Through the use of the da Vinci surgical robot, Dr. DeNoto is the first surgeon in this country to successfully perform a totally robotic sigmoid colon resection using this technique."

Or this snippet from the March 14, 2006 Press-Enterprise, which reported on the fact that people were so excited about Loma Linda's da Vinci that they had a naming contest for children (they named it "Billy"): "Initially, the da Vinci was used exclusively by Loma Linda urologists for performing minimally invasive laparoscopic prostate surgery. Since then, applications have expanded to include hysterectomies and kidney repair, with programs developing for colorectal cancer and heart valve, pediatric and general surgery. Surgeons at some hospitals already are employing it for esophageal and lung cancer procedures, as well as closed-chest coronary bypass and gastric bypass operations.

" 'In the last year, we've been able to get our robotic surgery program off the ground and have done 71 patients,' said Dr. Herbert Ruckle, chief of urology and professor of surgery."

The Chicago Daily Herald reported on kidney removal in a four year old boy at Advocate Lutheran General Hospital in Park Ridge: "'Since he hears us talking about it all the time, he just says he had robots in his stomach,' his mother, Veronica, said at a news conference Thursday. 'I expected him to be in bed for two weeks, but he was up and running around in three days. Now, he has more energy than before.' Lutheran General is one of about a dozen Chicago-area hospitals that use the $1.5 million da Vinci ... The hospital has had the machine for nine months, and doctors sometimes decide to use it for minimally invasive adult surgeries, including gynecological or colorectal procedures."

From the Winston-Salem Journal in North Carolina, "The da Vinci system is typically used for urological and cardiothoracic surgeries. Dr. Lawrence Nycum said that the hospital performed one of the first gynecological surgeries in the state using the device in January. 'It's the sort of thing where you have to lead, follow or get out of the way,' he said."

And the third thing to watch for Intuitive, in my opinion, is reimbursement rates. I think patient demand will continue to drive hospitals to buy the systems, and great results will drive them to continue expanding the types of surgeries they perform using the system (along with, of course, more trained doctors demanding it, and more need to increase surgical volume to justify the robot purchases in some cases).

On that front, I think things will work out well in the end if insurance companies are rational -- and there's some evidence that progress is being made. I read a Modern Healthcare article that mentions City of Hope, a heavy da Vinci user, and makes note of the way they're making money using the expensive robotic system.d I hope this is the way that other hospitals are trending in their negotiations with insurance companies:

"Chief Executive Officer and Chief Medical Officer James Miser, a pediatric oncologist, saw that if he stuck with the per diem compensation offered by most of his payers, he'd either lose money on each procedure or have to keep patients much longer than was good for them. 'Most of our costs-about $15,000-are incurred on the first day' for robotic procedures, he says. With a per diem, the hospital wouldn't usually break even until the seventh day. Instead, he's persuaded most of his payers to front-load their payments so that they always cover the surgical costs if the hospital commits to getting the patients home in a couple of days. 'We had to work hard to sell that particular carve-out, but it's good for the patients and the payers and for us,'' Miser says. ' We make money on most of the patients with most of the payers.' "

So that's the ticket for Intuitive Surgical:

• Patient and doctor demand drives more installations.
• Dramatic success in prostate surgery is followed by advances in cardiac, gynecological, gastric bypass and other major surgical areas, which drives surgical volume and increases recurring revenue from instruments and training.
• And Insurance companies begin to better reward hospitals for using these devices, thanks to lower post-surgery costs associated with shorter hospital stay, less chance of infection, and much less of a need for blood transfusions.

That adds up to what I continue to be believe will be a spectacular long term investment ... every time we have a little downturn, as we're seeing today, I'm tempted to buy more as I've done several times on ISRG's way up.

I think it's probably wiser to wait for their earnings release, since we know taxes will have more of an impact this year and we expect the sales to slow briefly while hospitals decide between the da Vinci and the more advanced and expensive da Vinci S -- but I'm not sure how patient I'll be, and I'm still mindful about the fact that this past earnings announcement was the only time the stock has gone down after earnings in the last year (thanks to their conservative guidance). If it turns out over the next six months that they were lowballing the guidance, which is how it looks to me, there's no telling where the price will go.

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Intuitive Recovers (ISRG)

I've been very pleased with Intuitive Surgical's (NASDAQ: ISRG) recovery in the market over the last month or so ... after bottoming out in the weeks following their great earnings release (and the unexpectedly low first half guidance for 2006), the shares have now bounced back to well above my highest buy price.

For those who didn't follow my relentless chasing of ISRG as it climbed up the chart, I made purchases at $69, $89 and $109, and later bought on the earnings dip at $112 ... my average cost per share is now just about $99, so I was a bit underwater as the shares swooned last month.

ISRG may be in a brief hiccup period while their new Da Vinci S system gets rolled out and starts to get some orders and as hospitals take longer to decide which system to buy ... but I think once that possible sales lull shakes itself out we should see continuing significant advances in recurring revenue (instrument/disposable) sales as well as a ramping up of new installations.

The rollout has clearly already begun. I wrote a while back about the growth of systems and the incredible surge of hospital press releases that was beginning to make any hospital without a Da Vinci look bush league, and I think that may be just beginning for the next generation Da Vinci S machines.

As of the earnings announcement, there were a few Da Vinci S robots in hospitals, I think the first one tested was in Atlanta, and press releases about new ones are starting to trickle out -- Dr. Savatta wrote in his great robotic surgery blog about his eagerness to use the first Da Vinci S at Newark Beth Israel when it's ready for him in April, a hospital in Illinois recently became the first to use the S system in that state, and in Oregon a hospital recently got exclusive area rights to the S system for six months, and I've seen announcements in the last month that hospitals in California, Texas and Florida have also placed orders for or installed the Da Vinci S (sorry, don't have links for those -- I think Burbank and Sarasota hospitals both have the S system on order, don't remember the Texas one) ... so anecdotally it sounds to me like the ISRG team is out selling pretty hard.

There could well be a disappointment in the next quarterly release if the results aren't as strong as in the past, even with the lower guidance, but I'd treat any short term sales blips as buying opportunities (as I treated the dip on their last earnings as a buying opportunity, though I bought a little too early at $112 and kicked myself as it dipped to the $80s).

As I've said before, I think what will drive the growth in Da Vinci systems is not only the penetration in prostatectomies -- in which they aim to hit a 25% market share in this year, from 20% last -- but the expansion into gaining significant market share in other surgeries, with mitral valve and gastric bypass looking like big areas for possible expansion, and hysterectomies and other gynecological surgeries looking like a massive market if they can achieve the same results over the coming year as they got in early urological applications. I'll be watching their growth in these other areas, particulary in gynecological surgery, to see if they can really open up (pardon the pun) these largely untapped markets to Da Vinci utilization.

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Buy on the dip -- Intuitive Surgical (ISRG)

This was too good an opportunity to pass up, in my opinion. I decided yesterday as I read the earnings releases and listened to the call that I would put in a lowball limit order just in case the market overreacted (in my opinion) to the somewhat conservative guidance and incoming tax issues.

Taxes were already known to be a new issue for ISRG in 2006 and 2007, and they also gave conservative guidance to begin 2005 (and we all know how that worked out, with the shares roughly tripling last year), so I considered both of those to be non-critical issues in light of the long term prospects for this business.

So I put in a limit order for Intuitive Surgical (isrg -- click to register for free RT streaming quote) at $112, just a few dollars higher than my last purchase at $109 in November. I was actually a little surprised that it dipped that low almost as the market opened and I received the shares, but I'm happy to have them. In the short term, it may well dip further below this point, but I expect to hold these for dramatic growth over many years.

I have written many times about Intuitive Surgical since I first bought shares -- most extensively when I looked at growth and the extent to which hospitals are advertising their robotic capabillities, and when I pondered the valuation and decided I thought it was reasonable.

Here's what I learned from the call :

They sold 40 systems in the fourth quarter, 9 of them overseas. 3 Da Vinci S systems have been placed in training centers. There are now 394 systems worldwide, and 31 hospitals now have multiple systems. They expect 1500 hospitals to be their market, and 3 machines per hospital to be a reasonable target. 150 robots overall were sold in 2005.

Growth continued to be dramatic -- revenue was up 60%, high-margin recurring revenue was up more than 70% (and is now 45% of revenue). They generally realize between $1,500 and $2,000 per procedure in instruments sales, so the growth (expected perhaps to be 70,000 operations this year, double last year) should continue apace in the recurring revenues space.

They have a great balance sheet -- $203 million cash, even after they bought a new building from HP (which tripled space for manufacturing and operations, I consider that to be very optimistic)

Several new studies were released this year indicating continued improvements in cancer control, continence and sexual function for robotic prostatectomies -- 20% of prostatectomies are already performed with the da Vinci, and I think patient demand should continue to drive that much higher (their goal is hitting 25% this year, which I think is conservative). The only argument against da Vinci prostatectomies is now the high up front cost. It's definitely worth listening to the call (archived on their website) just for the clinical update.

My opinion on the cost issue: In most cases hospitals can't charge more for the robotic procedures than for open procedures, but in the future this might change with the clear benefits to insurers of much shorter hospital stays and better results.

Mitral valve repair, gastric bypass, and "da vinci hysterectomy" can all be significant drivers of procedure growth if the good results we've so far seen continue. The huge gynecological market is just beginning to be tapped and may show growth that compares to prostatectomies in the coming years (but for a much larger market). It took about two years of study before the prostate surgery took off for ISRG, so the gynecological growth may be a year or two from hitting its stride.

Definitely worth listening to the conference call if only for the detailed review of the medical studies and literature -- the momentum in both increasing depth and breadth of procedures should continue without moderation given the consistently excellent results.

Then there were the guidance issues, which were what brougth the share price down to my buying level:

There is continued growth in demand. Total revenue growth of 25-30%. Instrument/accessory 45-55%, service 35-57%. Systems growth was lowballed at 15-25% given new system -- they're concerned that the ramp-up of the da Vinci S might delay some purchasing decisions as hospitals decide which machine to go with.

Gross margins should decrease near term due to low volume of Da Vinci S, then steadily increase by end of year to roughly current levels as the get volumes up.

Options expensing is going to be an issue for ISRG this year as well, again as expected. 2006 options expense should be between $21-28 million. Dilution could be as much as 10% or so depending on share price.

What everyone was talking about was the "tax event" that dramatically increased (almost doubled) 4Q earnings. Net taxes were negative in 2005, and guidance is impacted by the fact that they anticipate a 36-42% tax rate going forward that will impact reported earnings dramatically, but it is important to note that the majority of those taxes will not actually be paid in cash due to their remainign carryforwards that will get them through much of the year without any taxes due.

Robotic surgery continues to advance, and though it's always risky to be invested in a company with this kind of growth expectation I genuinely believe that they're underestimating the potential growth of robotic surgery ... and they remain the monopoly owner of the only meaningful and FDA approved surgical robot in the world. I would not be shocked if the price was cut dramatically at some point if their installations dip for a quarter or two, but I'm convinced that over the next five years this is going to be a spectacular investment.

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Annual Checkup -- ISRG

I last wrote about Intuitive Surgical (ISRG -- free RT quote) about a month ago when I asked "is the valuation intuitive?", and nothing significant has changed in that time -- even the share price today is roughly where it was then, which is saying something for a skyrocket like ISRG. I have been buying on the way up at roughly $70, $90, and $110 and don't have an overall huge return on paper at this point (with an average cost of $87/share, I'm sitting on about a 40% return at this afternoon's price), but this is certainly one of the few extremely fast growers in my portfolio, right in league with Google and Vertex this year even if I didn't get in early enough to see all that gain. So when does it stop going up? Or does it? I am certainly expecting that at some point in the next few quarters ISRG is going to miss its numbers -- they have clobbered the numbers on the positive side with every release this past year, but with earnings relying so much on a relatively small number of units sold as they build out the installed base of Da Vinci systems, there are bound to be quarters when they sell fewer units than we expect. There will also be a point next year when taxes start to get factored into their earnings, as they are expected to pay taxes for the first time in 2006, though certainly all serious ISRG investors are already expecting this. As soon as any big dip happens, the naysayers will finally be right, and they will crow about the fact that ISRG has reached a saturation point with their surgical robots. I think that's Nonsense. This technology is here to stay and is already dominant in one type of surgery (prostate) and growing in several others -- this is the beginning of robotic surgery, which I expect to revolutionize operating rooms around the country. Check out Dr. Domenico Savatta's blog to see what he's doing with the da Vinci and follow the clinical experience of a trailblazer. When I did my back-of-the-envelope calculations last month I figured we're good for at least a several hundred percent return from here to roughly a $15 billion market cap if the company meets it's intended installed base of 4,500 machines ... but the caveat, beyond the fact that management might be too optimistic, is that I don't know whether that will be in two or three years, or in ten. I already have overweighted in ISRG so I don't plan to add any more shares this year unless the price falls dramatically, but I think ISRG management is actually lowballing the number of installations they might be able to do before they saturate the market, and I think the long term future is extremely bright. I've seen estimated that 2004 saw 24,000 robotic surgeries and 2005 had about 36,000, and experts are predicting that in 2006 that number will double to 70,000. It would take something drastic to get me to sell.

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Is the valuation Intuitive? (ISRG)

I've been thinking a little more about Intuitive Surgical (ISRG -- free real time quote from ADVFN)lately, as it continues to eke out small gains after the last two big jumps up on earnings releases. I'm excited to be an owner of this company and I think they're doing great things and will continue to grow very quickly, but the stock is incredibly richly valued right now -- do we have anything to worry about?

I bought ISRG three times this year and own what I consider to be a full position -- though I'm sometimes tempted to add more. If you want to read my prior writeups you can see them here, here, and here.

If you want an overview of where the company stands now, you might check out the Investor Presentation (PPT file) they released last month on their website, it has great information about their progress in various kinds of surgeries, their growth rate, and their goals for building the company. Also, if you have time, listen to the audio of CEO Lonnie Smith's presentation to the Stanford Entrepreneurial Though Leaders series (other talks from some interesting people are available through their podcast if you're interested). He talks from a presentation that migth be the same as the PPT file, but adds in a lot more detail.

One tidbit I picked up in that speech which I hadn't noticed before is that the recurring revenue stream is more predictable than I at first thought -- they design it to be that way, by selling instruments for the da Vinci that include chips that will prevent them from working after they've been used in 10 surgeries. I had thought that the instruments just gradually wore out or had to be replaced after a certain number of sterilizations, but it's interesting that the company builds specific obsolescence periods into the tools.

I think the main current issue that might be of concern for Intuitive Surgical owners, aside from the simple fact that the shares have risen so fast that they could fall equally quickly, is that insiders have engaged in quite a bit of selling over the past month.

In the main, this has been due to a few options exercises by the CEO and a couple directors, but there was one very large insider sale that has gathered some attention. Susan Barnes, the CFO, has sold off more than half of her very substantial holdings (she is still the second largest individual shareholder, with roughly 100,000 shares according to recent filings). I'm not too worried about that -- I assume that her sale is due to the fact that she was leaving the company, which was announced back on August 31st (apparently she has now left, since the announcement said she would leave in November).

And frankly, though I prefer to see lots of steadfast holdings by company leaders, I'm not that worried about the options exercises of CEO Lonnie Smith and some of the board members, either. Those of us who look at this company today as relatively new investors see incredible growth potential, and a pretty dramatic climb from $50 or so in the Spring to well over $100 now. Imagine if your frame of reference was the $15-20 range that the stock bounced around in for five years prior to this breakout -- I can see how the company insiders who saw the stock discounted for a variety of reasons for several years would want to get some of their hard-earned appreciation away from the vagaries of Wall Street.

If Intuitive Surgical is able to reach it's goal of placing da Vincis in 1,500 hospitals, with an average of three machines at each hospital, and the increased surgical volume that we assume would come with that and the high margin service and instrument income that follow, the company's size could be several times what it is today in a matter of, I think, several years.

ISRG's operating margin so far this year is 29%, even though we'd have to think that they are at the low end of their potential economies of scale. Their current market cap at today's price is about $4 billion. The eventual potential of the recurring revenue market if they've achieved their 4500 systems would be about $2.5billion annually, according to the company presentation.

I tried to look at a couple companies for comparison to see if we could make any guesses at proper valuation given those expected sales volumes and margins. Medtronic has a $67 billion market cap off about 11 billion in sales, and an operating margin of 33%. I think estimating that ISRG's operating margins would improve to at least that level is pretty conservative.

If we assume that the operating margin remains comparable and apply the same Price/sales ratio of 6 to ISRG, we'd have a market cap of $15 billion, almost 400% above where it is today.

Zimmer Holdings, for another comparison, has about the same operating margin right now of 33%, and about $3.5billion in sales from a $17 billion market cap, or roughly a 5X price/sales ratio. Given that same ratio ISRG would reach a 12.5 Billion market cap, roughly a 300% increase from today's level.

And that, of course, does not take into account the vast income ISRG would receive along the way to reaching it's goal of 4,500 installed systems and the ways in which they might reinvest that income into the company -- and while that growth in system sales doesn't come with quite the same great margins as the recurring revenue, it does bring much higher sales numbers at a little more than $1 million per system sold with their current pricing.

I also can't guess at the timeframe for reaching this "mature" level, or even whether ISRG will in fact make it to that point in it's current configuration (who knows, maybe GE will buy them next year -- somethings are totally unpredictable). The key variation for me is time -- if they are able to achieve this theoretical 300-400 percent return in five years, I'll be thrilled. Given the risks of the current high PE ratio that would be a more than fair return on investment of well over 30% a year. And maybe it's just my irrational exuberance for ISRG talking, but I think they might beat those goals by a significant amount by achieving significantly higher margins as a mature company servicing their massive installed of robots. Then again, it might take them ten years or longer to get there, which would mean current owners are not being nearly as well compensated.

It should be an interesting ride -- there obviously aren't any good comparisons for ISRG out there if you look at their business and the product and service they deliver. I just brought up Zimmer and Medtronic as some pretty stable, fairly valued medical device companies that might be valued somewhat similarly to a mature ISRG. That might not be a reasonable guess.

It's also certainly possible that Intuitive Surgical won't ever reach their goals of installing 4,500 systems, though as first movers and current monopoly holders in this segment I'd guess that to be a conservative goal, given the success of the systems in the limited scope of surgeries they have completed so far. After all, the baby boomers are just now moving into their prostate years -- and ISRG has just a 20% market share of prostatectomies. If their success over conventional surgeries continues to be this dramatic there will be few people willing to settle for a non-daVinci prostatectomy.

The population of the world is growing rapidly and the populations of our richest countries are aging rapidly -- medical care in general is a huge growth area, and I think robotic surgery is a star within that area.

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Can't resist the robot (ISRG)

Well, as we close out a very successful week in the markets, it turns out that I can no longer resist the siren song of Intuitive Surgical (ISRG). I've been researching them in some detail since buying my first two positions in recent months, and the information I find leads me to the same answer I had when it was at $70 ... then at $90. $109 is a lot of money, but it's still a reasonable price to pay for this kind of growth potential. I don't expect to keep buying it at $20 increments all the way up, though ... for me, this is a full position for now and I'll sit back and watch.

But I did buy some more today. Purchased Intuitive Surgical (ISRG) on November 18 for $109.02.

You can read my earlier writeups on Intuitive Surgical -- my first buy, and second -- if you're interested in all I've got to say. I was first turned on to them by a Fool newsletter, and I have now gotten over my initial fear of paying too much for these shares.

There are a few caveats: It's still not cheap, and this is betting against the analysts to some extent -- they're predicting pretty flat sales and taxes due in 2006 for a forward PE of around 70 according to Yahoo Finance, which I think is extremely pessimistic. But they're probably smarter than I am, so buyer beware -- because as long as I maintain faith in management and the long term potential of this business, I'm not selling even if the analysts are right.

Patients are looking for this kind of minimally invasive surgery now, and we appear to be at a tipping point where it is prevalent enough (about 300 systems installed) that patients may begin to demand or expect it. And for all intents and purposes, they've got not only first-mover status in this area, but a monopoly.

Even so, Intuitive thinks they've hit less than 10% of their addressable market. And add to that the fact that those 300 or so systems are spread around about 230 hospitals in the US and maybe 30 or so elsewhere in the world (they just sold their first in China .. but even Australia only has two, and the UK one), and you can see that there's also ample room for selling multiple systems to the larger hospitals who perform the lion's share of major surgeries.

Hospital centers everywhere are releasing press releases or web pages that brag about their experience in robotic surgery ...

like Penn ...

or Shawnee Mission in Kansas ...

or the Henry Ford Health System in Michigan...

or Swedish Medical Center in Seattle ...

And it's showing up in regular advertising -- like this commercial from the DC Urology center at GWU (video).

There's even a robotic surgery blog from a doctor in New Jersey -- and he's predicting an almost exponential increase in the number of da Vinci surgeries he will perform.

If you don't know much about the field, a class at Brown University did an interesting looking report that has a lot of details -- it's slightly out of date, but well worth reviewing. Also a little out of date, a Business Week article from March provides a nice overview.

The success of the da Vinci system with prostatectomies is, I believe, just the first wave. That was the first major type of surgery for which FDA approval was granted and the first to reach a critical mass of trained surgeons and happy patients. Intuitive Surgical even has a special website just for patient information on the da Vinci prostatectomy.

But there are other types of surgeries performed every day in the US that could benefit from these minimally invasive techniques -- heck, those with strong stomachs could have watched a live heart valve surgery using the da Vinci back in January. And In March, doctors discovered that the da Vinci can be very effective in treating Oral cancer and doing other otolaryngological surgeries.

To sum up my investment philosophy for ISRG, and why I think the growth will continue (even if not at quite this same rate):

The growing BREADTH of hospitals and doctors who own and are trained on this machine is the first huge growth engine, but the growing DEPTH of procedures for which the machine is commonly used should be the second.

And don't forget, maintenance costs about $100,000 a year on these machines, and you can easily spend that much in accessories and replacement parts ... and doctor training can run a quarter of a million dollars, though I understand it's usually included in the purchase price. That $100,000 of high-margin income for ISRG will grow as each machine performs a larger number of surgeries of different types, and the overall steady income from this source will grow significantly as each new system is brought online.

I intend to hold these shares for many years and enjoy the ride, though I fully expect that this rapid growth will come with some hiccups along the way (and sometime over the next few months I'll probably regret that I didn't wait to fill out my position).

And remember -- my purchase today probably means it will drop on Monday, as I've recently seen with Shanda (SNDA) and Cryo-Cell (CCEL), so keep your eyes open for a great buying opportunity.

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Still Surging -- bought more ISRG

I've decided to build out my position in Intuitive Surgical (ISRG get free real time quote from ADVFN) by a little bit this morning, bought some more at $89.71.

There is certainly some risk that I am succumbing to irrational exuberance here, as ISRG is certainly not a cheap company at this point -- but it wasn't cheap when it was at $40 in the Spring or at $70 a few weeks ago for my first purchase, either (my initial writeup on ISRG with my first purchase is here). Sometimes companies with this growth potential never look cheap. I was hoping for a weaker quarter and a pullback, but after seeing this earnings release and reading up some more on the company my best guess is that we're not going to see one of those for a while. I am reserving the right to make another buy if they have a tough quarter or some temporary bad news, but at this point I don't expect it.

There are a few things I like about this that I haven't noted in any of my earlier postings on ISRG over the past couple of weeks. Of course they are growing extremely rapidly, but it is important to look at the way they are growing.

They're starting to sell more overseas, which is a major and almost untapped market, and they are getting higher than expected growth on the revenue streams that we expect will be more stable -- training, service, and tools and accessories. Their success in selling more machines this quarter (30) than expected really bumped the earnings number up, but it is the fact that the installed base is now over 350 that will really drive earnings moving forward. The more machines there are out there and the more doctors there are trained, the more surgeries will be done and the more recurring revenue ISRG will see. And the more difficult it will be for any competitors to gain a foothold.

The success this year in placing more and more machines in hospitals should mean great success on the bottom line for years down the road -- and of course, the more doctors there are who get trained on these and like them and the more patients who prefer these easier-recovery surgeries, the more demand for Da Vincis.

And that doesn't even approach the real reason Intuitive Surgical might become dramatically larger in the years to come -- which is that they are only really making a dent in a few specialized surgical areas, with a very strong position in urological surgeries. If they can add on that to do more gynecological procedures and further expand their repertoire around the body in all the places where a less invasive laparoscopic robot could improve results, the market size grows dramatically and no hospital will be able to get by with only one Da Vinci.

And finally, I like that most of the analysts who cover ISRG -- and there are only a few -- are well behind the growth curve (as we have all been, it's fair to say) and are almost all rating it as "neutral", "hold", or "underperform". That could create pent up demand for the shares as well, and is another risk for waiting to buy -- with ISRG's track record for increasing sales and developing a recurring revenue stream, I have to believe that a few of these analysts (or some others that might decide to open coverage) will have to upgrade ISRG and admit that they've underestimated them. According to the Yahoo Finance tallies, the average target price is still below $70 ... not for long, I imagine.

So I'm not willing to wait for more good news. Have bought some more and we'll see how it plays out, I expect I'll be very happy with my Intuitive Surgical holdings in 2008, and perhaps will have some chances in the interim to add more to my position.

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Biotech earnings updates -- ISRG, MYGN, VRTX, CVTX

Lots of releases on my biotech companies yesterday and today, some great, some a little bit bad, most just the kind of non-news one often expects from an earnings release from a early stage biotech.

First, Intuitive Surgical -- some might not call this biotech as it's in the medical devices area, but I think of the whole next generation of health care companies as biotech so mabye I'm a bit broader than most. ISRG (get free real time quote from ADVFN) absolutely blew away estimates, again, and took off by 25%, again. In retrospect, of course, I wish I had bought some more yesterday while I was thinking about it ... but I still think my ideas had merit. It's true that their earnings are likely to be lumpy as long as sales of new robots is the major part of their earnings, but it so happened that these last two quarter have been really, really big lumps. My loss, I'll have to think about whether I'm willing to add to my position now at $90 -- this is really a bit of a crap shoot, long term I expect a lot of great growth so I should probably just buy, but short term I can't believe that this won't pull back at some point and give me a better price. We'll see which angel of my nature I follow this time.

Next, Myriad Genetics. They beat the analyst estimates by a bit, which isn't quite as dramatic for them as it is for ISRG since their earnings growth isn't necessarily what everyone's looking for just now -- and it didn't move the share price at all. MYGN's (get free real time quote from ADVFN) earnings from testing services did grow substantially more than predicted, which is great, and I think this part of their business is perhaps a little bit underestimated. But what we're all waiting for are their drugs -- and not even necessarily their top-line drug, the Flurizan for alzheimer's that is their farthest along. The news from that particular drug has been particularly so-so all along, as it is for most Alzheimer's compounds, so it seems likely that actual approval or solid sales would be a good lift for the company. But what we're really waiting on are their early stage drugs -- they show promise, but no news of significance just now so we'll just sit and wait and watch the testing business grow to soak up those drug development costs.

And finally, Vertex and CV Therapeutics.

CV Therapeutics had some surprisingly bad news yesterday in that they need to pull back one of their new drug candidates in Europe for additional research. That definitely hurt the shares, much more than any news about marginally bad losses in the balance sheet. No particular news on ACEON yet, which is what I was hoping to see, just that in their brief selling window before the end of the quarter they didnt' reach the milestones that require royalty payments yet. The real bad news was on ronalizine (Ranexa), which was rejected by European regulators and which will require another trial and resubmission. This sends a message that perhaps this flagship drug will have some trouble and require additional trials in the US as well given the current FDA climate ... so the stock tumbled a bit. CVTX needs Ranexa, but there is no reason that I've seen to suggest that it might not be approved -- hopefully it will just take a little longer, I'll definitely be keeping an eye on this one. According to an AP story, "CV said it plans to conduct one or more additional trials in order to satisfy regulators, but said it does not expect a large or lengthy trial to be necessary."

And Vertex is plugging right along -- they had a big charge this quarter which may have spooked a few folks, but that should have been expected from the retirement of convertible debt. The big news for VRTX (get free real time quote from ADVFN) will be the progress of their clinical trials, and on that front they appear to be on track. The CEO reiterated that they remain on schedule, and that phase 1b for VX-950 is underway and phase II shoudl begin in the fourth quarter, and phase II for VX-702 is fully enrolled. Those are the two real flagships of the pipeline, so good news that there are no announced hiccups just yet. New is going to come hot and heavy from Vertex over the coming year, so I expect lots of volatility -- hopefully much of the news will be good from their trials and reinforce everyone's hopes that VX-950, at least, might reach blockbuster status and be the first actual cure for HCV. After many years of disappointment Vertex really seems to have a few possibly hits on their hands -- let's hope it remains that way.

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Intuitive Surgical, Wish List Graduate (ISRG)

Well, I've now purchased the first stock that I had previously written about in my wish lists (as I watched ISRG and its meteoric rise from the sidelines following their last earnings report). I have been continuing to follow them, and read up on the stock with hopes that it would drop so I could feel comfortable buying in.

Well, it didn't drop much, but it did dip below $70 for the first time in a while and I had some cash, so into the portfolio it goes (as with my other recent purchase, it of course dropped a bit more after I bought in ... c'est la vie).

Bought Intuitive Surgical (ISRG) at $69.54 on September 22, 2005.

Intuitive Surgical sells Da Vinci robots, which are the super-expensive high-precision robots that hospitals are using more and more for delicate surgery. Robotic surgical gear like this allows for the surgery to be a bit more precise, which can often mean better results and easier recovery (there's lots of debate about this, so it's certainly not a home run for all kinds of surgery).

And Intuitive sells not just the super-expensive machines themselves, but the necessary accessories and service that go along with such a high-end medical device -- just like in the rest of the medical and surgical world, lots of the tools and Da Vinci attachments are disposable and the more durable ones that can be sterilized still only last through a limited number of surgeries.
So like Imax with movie theaters, the more big-dollar installations the company does (and makes big up-front profits from), the more installed operations there are that require service, maintenance and supplies that they can leverage to maintain an ongoing and growing revenue stream (whether those supplies are surgical attachments and equipment, or Hollywood movies). Like Imax, ISRG owns the technology and will supply all of the necessary goodies at a nice price.

Intuitive is definitely a risk. As I noted when I put it on my wish list, it's pretty freakin' expensive, and became more so when that earnings release sent them up from the $50 range to above $70. But I think we pretty much have to pay up if we want this kind of earnings growth and potential -- sales up almost 100% year over year, earnings growing faster than that, and the installed base of machines continuing to ramp up significantly. We run some significant risks in paying for this kind of growth -- but I think they're short term risks if you believe in the potential of the business. Paying up for growth is nothing new for my portfolio, just see Chico's if you want a recent example.

If ISRG has a bad quarter this time around or the growth stalls or even slows somewhat, the stock price is likely to drop nearly as fast as it climbed. But they think they've not yet even reached 10% of their potential installed base, and they are the market leaders in an emerging technology with real benefits (not to mention the fact that they are only approved for a few narrow varieties of surgery so far, and I bet that breadth will grow significantly over time) -- so over the next several years, the surprises are much more likely to be on the high side.

I expect to hold ISRG for many years, and if we do see some hiccups in the growth pattern I'll be seriously considering buying additional shares. For now, it's a pretty small position and I'm looking forward to learning more about the company.

I've committed a pretty significant portion of my speculative portfolio to biotech with MYGN, PDLI, VRTX, CVTX, EXEL and now, with the addition of ISRG, medical devices. ISRG is a pretty small company, just like the biotechs I'm invested in. Is investing too much in that sector a risk? Probably so, but I think of these as all on the speculative edge of an industry, health care, that is relatively untethered from the arc of the general economy -- these companies could all fail, though I don't believe they will, but it won't be because their industry is hurt by a tepid economy, and therefore this part of my portfolio shouldn't be hurt by the same things that might hurt my other holdings that rely more on consumer spending or other economic factors.

Or at least that's the theory. I guess we'll find out, eh?

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