Domo Arigato, Dr. Roboto

On November 12th, as an analyst from the Michael Price Student Investment Fund (MPSIF), I presented my findings on Intuitive Surgical Inc. (ISRG). ISRG is the founder and manufacturer of the da Vinci System pictured in Figure 1, a robotically-assisted, less-invasive surgery system that has been FDA approved for general laparoscopic surgery, thoracoscopic, urologic, cardiac and gynecologic applications. This edition features the research and analysis that led to the Growth Fund's decision to purchase ISRG.

Intuitive Surgical makes money in two ways; one-time revenue from the sale of the da Vinci system, and recurring revenue from Instrument Sales and Annual Service Agreements. ISRG da Vinci Systems sell for $1.3 million on average. With each system sale comes a service agreement. The service agreement lasts the life of the system (typically eight years) and results in $100,000 to $150,000 in annual revenue per machine. Because instruments wear out with use, ISRG earns approximately $1,500 to $2,000 in instrument sales per procedure performed. In 2007, each system performed approximately 135 cases. As can be seen in Figure 2, growth in the da Vinci installed base has been impressive, totaling 1032 units worldwide as of the third quarter.

The big question is, why has ISRG been so successful in the sale of this expensive piece of equipment? The da Vinci system provides a number of advantages compared to traditional, open, and less invasive surgical approaches. From a physician's point of view, the system provides improved comfort and visualization, while shortening the length of procedures and eliminating the effect of natural tremor found in the hands of surgeons. Many surgeons, as they age, develop tremor that can end their career; da Vinci is a way for those surgeons extend their career. From the insurance provider's perspective, the system reduces procedural trauma and shortens the hospital stay for the patient. For hospitals, shorter hospital stays leads to increased volume and, despite higher capital equipment costs, the robot leads to better per-procedure profitability. Most importantly, the patient benefits from less-invasive surgery which limits blood loss, scarring, and the hospitalization period.

The proof is in the pudding. As can be seen in Figure 3, these benefits have fueled rapid penetration into the system's targeted medical procedures.

In just a few short years, the da Vinci system has been able to garner a 67% share of all radical prostatectomy procedures within the United States, becoming a standard tool in this specific arena. Although the company performs a significant share of this procedure domestically, growth is clearly in its infant stages as da Vinci Prostatectomy (dVP) only accounts for 30% of worldwide radical prostatectomy cases. In 2007, 54,700 dVP procedures were performed worldwide.

Moreover, most of the future growth prospects are in Intuitive Surgical's ability to extend the use of its system to other practices, some with larger markets. In 2007, there were 180,000 worldwide radical prostatectomy procedures compared to 540,000 worldwide radical hysterectomy procedures. While the company has been performing radical prostatectomy (dVP) procedures for seven years, it only began to address the hysterectomy (dVH) market three years ago. Still, ISRG was able to conduct 14,000 dVH cases worldwide in 2007. Management forecasts dVP procedures to grow by 30% in 2008. dVH procedures, on the other hand, are expected to grow more than 150% over that same time period.

In addition to dVH and dVP procedures, other radical urological (nephrectomies, cystectomies, and pyeloplasties) and gynecologic (myomectomies and sacral colpopexies) procedures are being targeted. Cardiothoracic procedures such as mitral valve repair, cardiac revascularization and thoracoscopy will also contribute to growth. Among general surgeries, gastric bypass seems to be a key driver. Although already performing 30% of worldwide radical prostatectomy procedures, the company has only penetrated 3% of the market for radical hysterectomy, mitral valve and other general procedures, implying much room for continued rapid growth.

In addition, growth has also come from unexpected areas. Surgeons who have purchased the technology are beginning to use the system for much less invasive surgeries. Channel checks have indicated that surgeons are becoming extremely comfortable with the surgical results they can achieve with the robotic surgery and are using the tool for a broader range of cases. As the da Vinci continues to prove hospitals can profitably implement robotic surgery, we envision a path where da Vinci becomes the standard for surgical health care.

Granted, this stock definitely qualifies as a growth stock. But why buy now? Looking at the volatility of the markets, we see incredible highs and incredible lows. Clearly the market isn't valuing fundamentals much anymore, but running on emotion instead. The weakness in ISRG price per share appears to be related to the credit crunch and its effect on hospitals' capital budgets. Investors have leaped to the obvious conclusion; as hospitals lower their capital budgets, demand for expensive capital expenditures like the da Vinci system will decrease. The stock price has dropped from $350 earlier this year, to its current level of $132.53 as of November 31st. In our opinion, the weakness in price per share is unwarranted and provides an attractive entry point.

On the recent earnings call, despite the recent economic setting, management reiterated that there remains strong demand for the da Vinci systems and maintained guidance. The sales force has not observed any meaningful impact of the credit crunch on hospital budgets in terms of their ability to acquire da Vinci systems. Additionally, over the past several quarters, ISRG has continued to sell its robots at a rapid pace while maintaining its average sale price.