MAKO Surgical - Rebuilding Credibility, But They Need To Rebuild More Knees

When I last wrote on MAKO Surgical (MAKO), I thought investors would be well-served by slowly building a multi-part position. With the stock up 38% since that piece (and 43% over the last three months), I'm feeling relatively good about that call. What's more, MAKO management has helped itself and rebuilt some credibility with the Street when it comes to guidance and financial performance. With the shares back in the mid-teens, it's going to take better utilization numbers for me to get more excited about the shares, and the trend there is not nearly so positive.

Doing What It Needed To In Q2

MAKO's fiscal second quarter was what I'd call "workmanlike" - the company's procedure count and system placement guidance were enough to cheer the Street immediately afterwards, and the company's cash burn seems to be on a reasonable trajectory.

Revenue rose 19% as reported, with system revenue basically flat (about 30% of the total) and procedure revenue up 26%. Although these numbers were below the average estimates, it wasn't a particularly large miss.

On the margin side, gross margin fell about 14 points as reported, but an inventory charge tied to the company's hip business was largely responsible. Net of the charge, gross margin would have been around 74%, slightly higher than a year ago. Although the company posted a larger operating loss for the quarter, it looks like here too the company would have been flat if not for the impact of the excise tax and inventory write-down. I'm normally pretty harsh with companies that indulge in a lot of "well, if you exclude, this, this, and that..." massaging, but in this case I think it's relevant as the company actually is doing a pretty good job of controlling underlying voluntary expenses.

But Utilization Is Still Troubling...

The financials are as far as I go in making excuses for MAKO, as I think the company's utilization experience is still worrisome.

MAKO saw 26% more procedures than last ! year and 10% more than in the first quarter, which absolutely blows away the "flat to up a little" growth reported by major ortho recon companies like Biomet, Stryker (SYK), Johnson & Johnson (JNJ), and Zimmer (ZMH). Unfortunately, utilization was still down year-on-year, and that continues a troubling trend.

By my calculations (which are different than the company's reported numbers, but directionally similar), overall utilization declined 9% from last year and rose 5% sequentially. Knee utilization continues to decline, dropping another 14% and marking six straight negative/non-positive quarters. On a brighter note, hip procedures more than doubled from the year-ago period (and rose almost one-quarter sequentially), with utilization jumping about 50%.

All told, my calculations suggest that MAKO's system is used less than seven times per month per user (MAKO's own numbers say 7.0 times per month). Clearly that's not enough utilization to drive additional system sales to existing clients, something that has very definitely benefited Intuitive Surgical (ISRG) over the years. Moreover, my due diligence with docs suggests that there's still a significant "feast or famine" lumpiness to the utilization - some facilities/docs use it often, others use it only in cases where the doctor believes that there are other factors in play that would make a partial knee replacement or hip procedure too risky without the system.

… Despite Good Data

What makes the MAKO experience more frustrating is that the data on the system are good for both knees and hips. The "MAKO vs. Oxford" study showed statistically significant improvements in accuracy, alignment, and post-op pain, as well as a significant increase in the number of patients achieving a functional score of 160 or better (57% versus 31%). Given that the inclusion criteria for the study didn't seem all that unusual, it's disappointing that MAKO's own installed base doesn't use the system more than they! do.

In any case, the data are good for both knees and hips, as a recent hip study showed the outcome benefits for avoiding cup misalignment in hip procedures. The key now is marketing that data and selling the physicians on it. Although hospitals have been pushing back hard on implant and instrument prices, MAKO's per-procedure cost is not uncompetitive, so it really should come down to simply convincing doctors that the procedure is worth doing.

That's not necessarily the simplest task when companies like Zimmer, Biomet, JNJ, and Stryker (SYK)

continue to push hard with their own tools and cutting guides (which are, for the most part, more familiar to docs and less challenging to their egos). What's more, many orthos prefer to stick with the hip and knee implants that they're familiar with, and that can be an obstacle to adoption. Likewise, unicondylar knee implants are still a "niche" procedure for many facilities and physicians.

Absent Better Usage, This Is Far Enough For Now

MAKO's performance since January has led me to raise my fair value estimate, but not by a very significant amount. I'm still looking for 18-19% long-term revenue growth, which is a bit below the implied growth (21%) if MAKO can get 20% share of its addressable markets. Likewise, I still look for MAKO to deliver a mid-teens free cash flow margin in 2017 and move into the low 20%'s a few years after that.

All told, and including the full impact of options in the sharecount, I think MAKO's fair value is a bit above $14 today. Likewise, the company's 4.6x multiple to 2014 revenue is already in the range that growth med-tech stories get these days, though clearly names like Heartware (HTWR) and Novadaq (NVDQ) show that there's plenty of upside there if MAKO can reach that next level of growth.

The Bottom Line

At this point, I'm not too worried about competitors like BlueBelt's Navio, though I can see how/why that company's open system (which allows doctors to use the implant of their ! choice) w! ould unnerve some investors. Instead, I think there's still work to be done in convincing doctors (and marketing to patients) that partial knee replacements and robot-assisted hip procedures are worthwhile.

Given the rebound in the shares already seen so far, I'm not inclined to jump in here, but I wouldn't rule out a run into the high teens if those knee utilization figures can beat estimates and turn around over the next few quarters.

Source: MAKO Surgical - Rebuilding Credibility, But They Need To Rebuild More Knees

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)