Long investment thesis for Mako Surgical (MAKO).
Shares of Mako Surgical (MAKO) were market darlings as they surged from just $10 in the fall of 2010 all the way past $40 earlier this year. But two disappointing quarters so far in 2012 chased out the momentum players and brought in the short sellers.
Insiders bet solidly on an eventual recovery for MAKO as it plunged, however. We followed them in last month, betting that these fallen shares can again trade back to the mid to high $20 area in the next 12 months. So far so good on that call.
Mako Surgical makes a robotics system that assists surgeons in replacing knees and hips. The company’s system represents a high upfront cost (of about $1 million) for healthcare providers, but it can be justified by the lower cost per procedure it generates. Mako’s system (called RIO) only works with the knee and hip joints made by Mako. That generates recurring revenue for the company once a RIO system is placed. Higher margin recurring revenue represented 56% of total sales so far in 2012.
Insiders were heavy net sellers of MAKO as the stock went on its tear starting in the fall of 2010. But insiders selling into a stock’s strength is very common, and it’s difficult to tell just when a high-flyer with insider selling is going to break. That said, the insider selling combined with the way-too-high valuation on the shares of this still unprofitable firm certainly made MAKO a stock to avoid from our perspective during its previously suspect run.
The reversal of opinion from insiders after MAKO fell back to earth was quite notable, however. After Q1 results disappointed in early May, the stock nearly halved from $41 to $21. Three insiders accumulated 26,000 shares of MAKO shortly thereafter, either via open-market purchases or opting into the stock as it traded in the mid $20 area.
Director Frederick Moll was one of the May buyers. He had smartly purchased shares of MAKO back in late 2009, and again in late 2011 when this stock’s momentum run was interrupted for a quarter. Interestingly, Mr. Moll is also a director at Hansen Medical (HNSN), another robotics firm whose fortunes have sunk. Mr. Moll was selling shares of Hansen earlier this year after they had already tumbled. That shows that Mr. Moll is not one to reflexively buy the dip in his stocks, and was making a consciously bullish bet in MAKO.
A second director chose last May’s gap down to make his first open-market purchase of MAKO since joining the board back in 2008. And the third accumulator after the Q1 plunge was a vice president who had been happy to flip his incentive options for a risk-free profit when the stock was at $40 back in March, but who only sold a small portion of his options in June to cover his exercise costs. This insider’s “opting in” activity (as we call it) nearly doubled the holdings he is letting vacillate with the vagaries of this market.
So the reversal of insiders opinion on MAKO was already significant in May/June. Tellingly, however, one insider still elected to sell a large options grant into MAKO’s decline in May. And, sure enough, one bad quarter did beget another at the firm. The stock gapped down again in July to an eventual low of $12.
Into this second plunge entered a different quartet of insider buyers—with no lingering sellers to add doubt. Two directors since 2008 chose this second gap down to make their first open-market purchases. The chairman and yet another director decided to accumulate using the “opting in” technique. Perhaps most notable was that one of the directors that opted into MAKO in August was Christopher Dewey--the same one who smartly sold his previous options grant completely in May after the stock’s first gap down.
So the significance and an unanimity of MAKO’s insider behavior was finally clear in August. But identifying a stock as having significant insider behavior is only the first step in the investment approach at InsiderInsights. We’re fundamental analysts at heart and by training. And insider buying doesn’t change the fact that Mako Surgical is still an unprofitable firm—and likely to be so for the near future. That fundamental truth makes any bet on MAKO a high-risk one, despite it trading for a fraction of the price it fetched just four months ago.
Fact is, the robotic surgery business has produced both winners like Intuitive Surgical (ISRG), and losers such as Stereotaxis (STXS) and the aforementioned Hansen Medical. A technically proven product alone does not guarantee success. Overall cost saving are at least as important for some potential customers as better outcomes. A surgeon may also merely prefer not to use a robot.
The attraction of a robot depends highly on the type of procedure it is automating. Intuitive Surgical’s da Vinci system has found success by virtue of being applicable across numerous soft tissue procedures. The more procedures a robot can automate, the easier it is for a customer to justify the high initial capital expenditure. Intuitive is the only one of the four robotics firms mentioned that is actually profitable. Hansen’s robots, which assist with catheter-based procedures, and Sterotaxis’ cardiology instrument control system have largely disappointed—especially from an investor point of view.
Price/sales ratios may be interesting as indications of value in some sectors, but for robot makers they are best used as a measure of investor sentiment on specific shares. Successful ISRG garners a high-end trailing 12-month price/sales ratio of 10, while lagging HNSN goes for 5. Downright depressed STXS trades for a fraction of its sales. MAKO is in the middle, with a price/sales metric now nearing 8. But it did dip to around 5 times sales at its nadir this year.
“I think 5-6 times trailing sales is likely the base for MAKO,” says Piper Jaffray’s Matt Miksic. “keeping a 7 times multiple makes this a $28 stock” based on his 2013 revenue estimate. But after being cheered on by sell-side analysts when it was more than double its present price, most on Wall Street lowered MAKO to a Hold after it slumped. Michael Matson at Mizuho Securities offers the more cautious take on MAKO that the sell side is currently leaning towards. “I’m a little worried that growth is going to slow and Mako’s system will end up a niche product,” he offers. Mr. Matson also reminds that, though there aren’t competing robots for knee and hip surgery, competing technologies like creating custom instruments to assist with more traditional surgery techniques are a threat.
While customer utilization of Mako’s installed RIO systems appears firm, placing new robots has indeed become the company’s major challenge. Sales goals for RIO this year have been knocked down by 10 units, to a range of 42-48. But that hardly represents stagnation considering that the current installed base is just 126 RIO systems. Management is also now expecting 11,000 to 12,000 procedures to be undertaken this year—up nicely from just shy of 7,000 last year. To meet these targets, Mako is actively addressing issues with its sales force, and also expects to launch new software and implants for its newer hip business in the second half of this year.
A low bar to clear
By entering MAKO in August, we have bet that the company has finally lowered expectations enough to not disappoint investors in Q3. That will be an important event to start building back the investor enthusiasm that got so ahead of itself earlier this year.
The significant insider bullishness has certainly helped us feel comfortable making this bet. More importantly, we note that, even with all of Mako’s disappointments so far in 2012, sales growth of around 30% is still expected for this year and next. Just meeting those expectations should allow MAKO to support its current price/sales multiple, and generate a similar capital gain. Any big payoff in MAKO from here would require the firm to start beating expectations again, which would allow the exuberance that seems to follow this industry to again be felt in an expanding price/sales multiple for MAKO.
While it can’t be dismissed that Mako could go the way of other disappointing robotics firms like Stereotaxis and Hansen, downside targets from even the negative sell side analysts are “only” several dollars below MAKO’s current price. No one seems to expect Mako’s RIO systems to suddenly become wastes of space in their client’s facilities. To the contrary, guidance indicates to us that Mako remains firmly in high-growth mode.
We’ve been here before in similarly beaten-down stocks. After a loved name plummets in price, sell side analysts downgrade a stock, which generates even more selling pressure. Insiders buy into the plunge, and the sell side ends up upgrading the stock again only after it surges in the wake of again meeting or beating expectations. The time to place your bet is when a stock like MAKO still drips with disappointment. Judging by the this stock’s 35% short interest relative to its float, we’d say that disappointment still rules investor mindset in this name.
In the very short term, our major concern was that MAKO had already met technical resistance at its 50-day moving average at the end of August. It’s a good sign that the stock was recently able to break through that resistance in the absence of company specific news. In the medium term, we also admit concern about Mako’s cash burn. This seems to be a firm that needs to raise money in the next six months, and it would be a big negative if they had to do so at present price levels.
The real event we’re investing ahead of, however, is Mako’s Q3 earnings report. And, again, just meeting expectations should be enough to keep our investment thesis in tact. But let’s not kid ourselves: if Mako disappoints yet again, its shares could revisit yearly lows quickly. And though identifying significant insider behavior is a first screen that absolutely puts the odds in one’s favor when entering a risky situation like Mako’s, the odds of success are never 100%.