Tuesday, May 14, 2013

Dithering woman speaks - On Intuitive Surgical (Ticker ISRG)

Now and then my husband asks me for a call on our investments. My thoughts on the Intuitive Surgical Story have run away with me.

Intuitive Surgical is a US based company that makes robotic surgical systems. There is a surgeon who sits on a computer console from where he directs the robot to perform laparoscopic surgery.  

Laparoscopic surgery means surgery where the surgeon has no direct visual access to the surgical field. He sees through the laparoscope. The laparoscope is a tube attached with video cameras, and it is inserted into the patient through a smaller incision. Using the image from the endoscope, the surgeon traditionally uses long handled instruments to perform the surgery. This is also called Minimal Invasive Surgery – MIS for short.

Suppose you dropped your ring in the trashcan. You could wade in and get your hands dirty or you could shine a torch and look carefully before picking it up with a pair of long handled forceps. The second option requires more skill. What you do is key when that trashcan happens to be a human body. Surgeons receive special training for laparoscopic surgery.

The Intuitive Surgical Robot is called ‘da Vinci’. It has 4 arms and it can be moved around the operating table. 2 arms have surgical tools like scissors scalpels etc. 1 arm has electrocautery instruments, 1 arm has the endoscope with two lenses.

Using the console the surgeon maneuvers with his two hands the two tool arms of the robot. With his left foot he manipulates the lever that controls the robot’s endoscopic 3rd arm that gives stereoscopic visual access to the surgical field. With the right foot he controls the AC current flow to the 4th electrosurgical arm for cutting/blood coagulation/ cauterizing purposes.

So you’re not struggling with those long forceps, you have your own friendly robot, wristed and all, capable of listening to your remote control commands to pick that ring up. An expensive but probably the better solution, right?

Makes sense, and the operational and financial success of Intuitive Surgical attests to it. It has helped that the company has pursued an aggressive and concerted marketing strategy, managing to make inroads in the medical sector, selling the robots in greater and greater numbers. How did they do this? By going directly to the customers to explain the advantages of robotic surgery so that patient demand drove hospital purchases. The sales team is linked into the use of the machines in the hospitals and is looking at all times to increase applications.

Intuitive Surgical has shown great results. It is trading at USD 500, with a Price to Earnings ratio (exactly what it means -  Price of the share divided by the Earnings per share; Earnings per share is again what it means Net profit of the Company divided by the Number of shares of the company) of 29; Net Income at USD 657 mio has exceeded expectations. And the market for revolutionary surgery techniques should only grow.

However some questions have been raised. Apparently evidence that robotic surgery delivers much benefit when compared to other MIS (minimally invasive surgery) is scarce. Since it is much more expensive this puts a question mark on insurance funding. Then there is the matter of lawsuits that allege that system malfunction has resulted in adverse surgical results, which would definitely be a negative. An FDA investigation has seen people scurrying to the MAUDE (Manufacturer and User facility Device Experience) database to make sense of what is going on. The product replacement initiated last week by Intuitive Surgical I feel is very key although the market has not responded to it.

The naysayers like Citron say that the P/E multiple should be in line with that of the medical devices industry while the yaysayers like Motley Fool contend that the numbers look good, it is the technology of the future and what more do we need.

So buy or sell?

I was very ambivalent about rat dissection in school. I was never starry-eyed about cutting up a rat and labeling its innards, I was clear I did not want to be a doctor. But Biology came easy to me, as a good middle class Indian I did not want to close a door to professional success, just like that. But I was bad at the cutting pasting, knotting and sewing kind of craft. The dissection started with one delicately pinching and pulling outward the chest skin of the rat with forceps, then making a tiny incision with the scissors. The technique now was to maneuver the scissors into this incision and through that split open the rib cage without cutting the heart. I could not do it.

I remained nonplussed until tired of my own hesitation I grabbed the rib cage with my hands and split it apart. It was neat and it worked. My dissection looked the same as everyone else but had been performed by touch rather than sight. My teacher commented as she walked by, “She will be a doctor!” I have no idea what she meant, but I wonder how many doctors depend on tactile feel for completing their surgery. Now the ones who perform traditional laparoscopy are obviously the superior craftsmen, so how about the ones who are not, who are being co-opted into new age techniques that rely on optics rather than haptics (communication by touch)? How many of them are being coerced into jumping on the new age bandwagon? Nothing wrong with that, but only some of them will be able to do it. Who is monitoring that?

It reminds me of the derivative business of banks. Derivatives have great value. They monetize risks, parcel out value and cut across market inefficiencies. But in the hands of fools and rogues it can become dangerous. More fools than rogues they.

What are derivatives? Let me give you an example. You want to buy your rented house but not at current levels. At some point the market starts to move down, down, down until at last you feel it is time to buy. But now you have a new problem; your landlord also feels that the property market cannot go any lower, or he is in the middle of a messy divorce and has no time to look at your bid. What do you do? You curse your luck of course. But what if you buy a different apartment? As and when the landlord decides he needs to sell to pay off his alimony, you could sell the apartment you had bought and buy the house. If the property market had risen like you thought, you would still make the gain on the sale of the purchased apartment, which would offset the higher costs of the house. If the reverse happened, well, you were going to buy your house at a higher price anyway.

What if you have an agent who sells apartments whose value corresponds to the house that you are trying to buy? The apartment is a derivative asset, standing in for your intended house, and the agent is your derivative salesman. But the more transactions you do, the greater are your transaction costs, and the cost of unwinding your arrangements if circumstances change. There is also the risk that the linkage between your derivative asset and the underlying asset starts to unravel. But your agents' commissions increase all the time. If apartment prices collapsed while bungalow prices skyrocketed- the agent is fine, you are the one with the big hole in your pocket. So here is a high value, high involvement, agent-intensive product, which does not reward the agent for alignment with your needs but for turnover. And if you disregard this basic fact, at some point, the sh—t will hit the fan. If a business imagines that a high involvement and high-risk product should be a revenue stream, then that business is a high-risk business.

That is what I think is happening to Intuitive. It is a high-involvement product that requires high-end practitioners and regulatory oversight, both of which are missing now. Another story where the marketing is overreaching itself. Further the product design is not being driven by the practitioner, but by the manufacturer. And for every doctor who embraces the da Vinci Robot enthusiastically, there is one who is taking it doubtfully perhaps fearfully, but the learning curve they say is steep and soon everyone is jollying alone. Until the sh—t hits the fan. This is not the iPod or the Tesla car, with its hyper perfectionist sexy bosses but a regular nuts and bolts operation, with an aggressive marketing department. I will not give it a different P/E multiple than the rest of the medical devices industry.

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