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Mako Surgical Analysis



May 18, 2011 – Comments (2) | RELATED TICKERS: MAKO.DL

Board: Value Hounds

Author: LeKitKat

Mako was an IPO February 2008.

Shares of MAKO Surgical Corp. (MAKO) fell almost 10% on Thursday, their first day of trading, after the company priced its initial public offering of 5.1 million shares at $10 per share. All of the shares were offered by the company.

The company raised about $51 million with the offering.

Mako cut the expected price range of the IPO of 5.1 million shares to between $10 and $11 per share prior the offering. The company originally filed to price between $14 and $16 per share.

J.P. Morgan and Morgan Stanley were the lead managers for the offering, and Cowen & Co and Wachovia Capital were acting as co-lead managers for the offering.

The company makes robotic devices and implants for minimally invasive orthopedic knee procedures.

The shares ended the week at $9.72 a share, down 2.8% from the offering price.

Mako surgical has developed a proprietary robotic arm that guides a surgeon’s hand in knee surgery and the implants that are used in the surgery.

Knee surgery can be a total replacement that is a brutal opening up of the entire joint, removal of the native joint and hammering and screwing into place a total implant. It is a revision of the long thigh bone or femur and the lower leg tibia and replacement of the ends of both bones with the implant device. The recovery is long and painful.

When the entire joint is ruined by arthritis, there is no other choice, but if the knee has localized areas of wear and tear, a partial knee can be done

All of the big ortho companies have minimally invasive surgery [MIS} for partial knees that allows the surgeon to make a smaller incision and work on only the affected portion of the joint.

Mako believes that the MIS currently used does not allow the visualization needed to optimize the outcome. The Mako device offers better visualization and gives the surgeon precise control of the knee surface that is repeatable procedure after procedure and less prone to cutting and shaping error. Surgeons gain better tactile feedback and a margin of safety from the arm, finer control of instruments, and better visualization.

In addition to the robotic arm, they have their own line of implants that can be used. The system does not allow use of other brands of orthopedic implants.

At present Mako only has the capacity to do knee surgery. They expect to launch partial hip implants the back of 2011.

We believe that the tissue sparing and bone conserving techniques enabled with knee MAKOplasty can offer substantial advantages to patients, surgeons and healthcare providers. Because of the minimally invasive nature of the procedure, smaller incisions are possible, which lead to less tissue damage and faster recoveries, thereby reducing the overall costs of rehabilitation, medication and hospitalization.

In addition, because more of the patient’s natural anatomy is preserved and less trauma is inflicted on the knee, we believe that patients who undergo knee MAKOplasty have the potential to experience better functionality and more natural knee movements, thereby achieving an improved post-operative quality of life. Our RESTORIS family of implants for use in single and bicompartmental knee resurfacing procedures provides the ability to address a broad range of the patient population suffering from early to mid-stage knee osteoarthritis.

Finally, because our RIO system is easy to use, we believe that our knee MAKOplasty solution makes knee resurfacing procedures accessible to orthopedic surgeons with varied levels of training and skills and has the potential to lead to greater adoption of knee resurfacing solutions for early to mid-stage osteoarthritis of the knee.

Knee implants have been a slowing segment of joint replacement overall in the last two years. Zimmer, Stryker and DePuy have all had disappointing sales in knees and the latest quarter was no exception. Growth has been especially sluggish in the US

The knee surgery slowdown is concerning because no one seems to be sure if this is a developing trend or whether it’s temporary and due mainly to macro-economic pressures.

One trend that has been notable is that younger patients opt for joint replacement than has been the historic norm. That would auger well for Mako as this patient population is more likely to get a partial knee and demand a faster rehab. This is also the population that has private insurance and may have lost that insurance along with jobs that has added to fewer knees sold in the last few years.

Recent key milestones in the development of the business from the 10K:

• During the year ended December 31, 2010, we sold 33 RIO systems, including two to international distributors, increasing our commercial installed base to 67 RIO systems.

• During the year ended December 31, 2010, a total of 3,485 MAKOplasty procedures were performed, representing a 118% increase over the same period in 2009.

• In February 2010, we received 510(k) marketing clearance from the FDA for our hip MAKOplasty application, which assists a surgeon in performing all components of a total hip arthroplasty using the RIO system. We believe this represents achievement of a necessary milestone towards what we anticipate will be our continuing development and future commercialization of a hip MAKOplasty application.

• The RIO System and our classic RESTORIS onlay unicompartmental knee implant system were approved for European Union CE marking in December 2009 and January 2010, respectively, which is a legal requirement for medical devices intended for sale in Europe. Our RESTORIS MCK onlay unicompartmental implant system was approved for CE marking in April 2010 and our RESTORIS MCK onlay patellofemoral and bicompartmental implant systems were approved for CE marking in January 2011

• During the second quarter of 2010, we launched a clinical research study in partnership with Glasgow Royal Infirmary, Strathclyde University and National Health Services in Glasgow, Scotland. In connection with the clinical research study, we placed a RIO system at the Glasgow Royal Infirmary. The system is being utilized in a three-year randomized prospective clinical trial with the objective of demonstrating the clinical, functional and ultimately, economic benefits of knee MAKOplasty. Glasgow Royal Infirmary reported that 23 procedures were performed at its site during the year ended December 31, 2010.

• In October 2010, the first hip MAKOplasty procedure was completed as part of our surgeon preference evaluation process, designed to solicit user feedback in advance of MAKO’s full commercial release of our hip MAKOplasty application, currently expected in the second half of 2011. As of December 31, 2010, 23 hip MAKOplasty procedures were performed as part of our surgeon preference evaluation process.

Mako has not had a profitable year in its history. In 2006, revenue was $60,000 and that has increased to $44.3 million in 2010. As revenue has climbed so has the stock price.October 2010 Mako was around $10. It would appear that the 2010 revenue increase to $44 million had a beneficial effect and it is now at $25. This is the largest price increase in Mako’s history and I am not quite sure what the catalyst was that took it up so far so fast. That makes it difficult to know what expectations are priced in and what the next event will be taking it up

2010 results

Revenue was $44.3 million in 2010, compared to $34.2 million in 2009. The increase was 29%--far smaller than the 10X increase in revenue 2008-2009. It was due to a $10.2 million, or 69%, increase in RIO system revenue and a $10.1 million, or 133%, increase in procedure revenue

There was $24.9 million in revenue from 33 unit sales of RIO system, including 31 domestic commercial sales and two international demonstration systems compared to $14.7 million of revenue from 19 unit sales in 2009. Unit sales doubled and perhaps that was the catalyst. More units placed ensures that more implants will be sold since the RIO does not work with any other branded product.

The $10.1 million increase in procedure revenue was due to an increase in MAKOplasty procedures---3,485 were done compared to 1,602 in 2009. Again, substantial growth.

They have a little over $1 million in deferred revenue that will be recognized in service revenue over the 2011 twelve-month period

Cost of revenue was down and gross margins increased to 59% from 37% in 2009. The decrease was primarily due to the recognition of $8.8 million during 2009 from 17 previously deferred unit sales. In other words, costs had to match sales even though the revenue was deferred. The bottom line is, the improved gross may not be sustainable, relying on timing of revenue recognition vs recognition of costs.

Mako also benefited from a warranty reserve reversal as inventory was written down.

SG&A expenses have been high as a percentage of revenue since the IPO. The 2010 expense was $47.0 million compared to $32.1 million last year. The 47% increase was primarily due to an increase in sales, marketing and operations costs associated with the production and commercialization, The total number of employees increased from 232 to 291 and of the 59 employee increase, 35 were in Sales and Marketing.

SG&A included $5.4 million in options expense compared to $3.3 million in 2009.

R&D has been another area of high spending. R&D was $15.0 million in 2010 compared to $13.1 million in 2009. The increase of $1.9 million, or 14%, was primarily due to an increase in research and development activities associated with on-going development of the RIO system, MAKO implant systems and potential future products, including the hip MAKOplasty application and associated implant systems.

Mako has no debt and has short-term investments as well as cash. Interest and other income was $317,000

No federal income taxes were recognized for 2010 and 2009, due to net operating losses in each period.

None of these results is unexpected for a medical device company in the initial stages of starting up and introducing new products that do not have a previously installed base. Attempting to penetrate an established market with a preferred way of doing things is difficult. Intuitive Surgical is of course a similar story. For that reason, I looked at ISRG from its first year of profitability and compared that to how Mako is progressing. There are some interesting differences and that is certainly due to the difference between orthopedic and prostate [initially and now many other applications] surgery.

Orthopedic surgeons appear to develop a high level of comfort and preference for particular procedures and brands that is difficult to penetrate. Prostate surgery was simply surgery with no attached implant product required for adoption. Once a surgeon was comfortable with the DaVinci, other applications naturally followed. Some do involve medical devices but surgeons can choose their preferred product line. Mako not only has to sell the robotic device but has to sell their knees too. That may be more difficult and could possibly account for the differences in growth and the time to profitability.

Intuitive Surgical and Mako comparisons

I looked at revenue, revenue growth, margins and operating expenses as a percentage of revenue across the two companies. Intuitive Surgical has been a faster and more resounding success story thus far. Especially notable were the differences in SG&A as a percent of revenue and research and development expenses. ISRG has had much lower expenses during its history allowing faster advancement to profitability.

[See Post for Tables]

ISRG was profitable starting in 2004 and made 70¢ per share. Gross margins have been consistently high and increasing. SG&A and R&D were high initially and by 2005 were definitely moving down.

I would not expect Mako to look like ISRG given the differences in markets and surgeons.

Revenue growth at Mako has been stratospheric, but expenses have been equally so. It is clear why the company has not turned a profit in spite of the revenue growth---expenses are greater than 100% of revenue by a substantial amount. The good news is that they do seem to be decreasing in 2010. SG&A is still coming in at more than 100% of revenue and according to the management discussion, it was largely due to increased headcount in marketing. It would seem their penetration into the market is far more difficult and costly than ISRG’s. As more units are placed I would hope this moderates—word of mouth and multiple units per surgical center/hospital would be a big help. It is a metric that bears close watching.

R&D is critical and you hope to see continued investment. It is coming down to more sustainable levels quickly.

Mako may be picking a bad time to enter the hip/knee implant market. Procedures and implant sales are down. Sales have decreased from norms in the high teen increases yearly to low single-digits the last two years. Knees have been especially bad and growth has stalled across the major orthopedic device makers—Zimmer, Stryker, DePuy and Smith & Nephew. Mako’s rapid share price increase is swimming against the tide in this respect and that makes me wonder what investors are building in to the current high price. I would be looking for better performance from the company if the implant market begins to grow again and would expect if it stays stalled, Mako may see some correction due to macro-forces in the market for implants. Can it defy the trends in pricing other device and implant makers are suffering through with subsequent lowering of share prices over the years? A catalyst will be increased demand for knees, especially from younger patients looking for partial procedures and quicker recoveries. The other catalyst will be their entry into hips.

Capital and dilution and options

Since we are looking at a company that burns cash rather than creates cash flow, it is always good to see where the cash is coming from since it does not come from operations Essentially, Mako issues shares when it needs cash. At current highs this would be a great time to fill up the bank account. The ability to sell shares is the driving force behind many IPOs. Mako became publicly traded in 2008

Here is the statement of financing since the IPO:

[See Post for Tables]

The share dilution over 3 years is 100%. This is not necessarily bad since the company has to raise capital to stay in business during the development of product. They have not taken on any debt. They say in the 10K that future capital needs will be met by debt or equity or both. Since it appears they are quite a distance from self-sustaining cash flow, I would guess more dilution is in shareholder’s futures.

Options awards have been high to the CEO over three years as has total compensation considering his company has not shown profits and may be a year or two out from being profitable:

[See Post for tables]

I am not sure if the level of compensation for the CEO is warranted, and am inclined to like to see compensation tied to returns to shareholders.It may be that the company cannot run without him—I haven’t done enough research to tell. If he is critical to this company’s success ultimately, then he may deserve this compensation. Would like to hear other opinions.

Not to keep comparing to ISRG but it is the only comp I know:

The CEO of ISRG took 60,000, 70,000 and 65,000 options for 2003-2006 as the company went profitable. His salary was $397,000 in 2006. The salaries are comparable and not out of line. The options trouble me a tad especially in view of the dilution that is necessary from raising capital. Just a small point. Not necessarily a deal breaker. ISRG share dilution since becoming profitable in 2004 is at 15%. They also have no debt.

These are two different markets for robotics. The adoption of DaVinci by surgeons did not require that a surgeon be separated from his favorite implant system. It was also not introduced during a lull in the market for the procedures. Mako has to convince surgeons to abandon a level of comfort with a successful product and not only use a new implant but use it with a new procedure. It will be a more difficult sell. They are also facing a slowing demand for the procedures they are targeting—knees first and foremost and hips.

The market for partial implants through small surgical incisions that allows a very rapid recovery looks good for the future. Mako has some short-term difficulties and unfortunately is selling at a price that reflects unclouded optimism. It is a little inexplicable. It is possible the market is being very forward looking anticipating success that seems likely in the future. I would like to see a recovery of implant business. I closely follow Zimmer, Stryker and JNJ and have not seen any return of growth. Most are in single-digit growth and that does not look like a promising environment for introduction of a relatively pricey new system.

The other big concern I have is the incredible spending on SG&A The need for marketing is a given, but it is consuming any potential profits and I have to wonder if this is such a hard sale now, whether all the spend is returning any value at present.

I think Mako has a reasonably good chance to be a good investment and that the rapid increase in placement of RIO units last year in spite of a difficult macro-environment for implants convinces me there is a market out there. The introduction of hip procedures in the back half of 2011 will provide a catalyst. It may even be enough to tip them into profitability in 2012.

As with all companies I find intriguing for investment there are things I love and things that are less likeable. Probably need to spend a few more quarters with this before deciding on an investment strategy. I have not lived with them quite long enough.

2 Comments – Post Your Own

#1) On May 18, 2011 at 1:31 PM, Evlampius (< 20) wrote:

can you add an executive summary to that please?  Buy or Sell?  who has time to read these 200 pages?

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#2) On June 06, 2011 at 6:00 PM, leemajors (< 20) wrote:

It seems to me that the likely main reason for the slowing/difficult implant market, at least in relation to the knee, is that short of a total knee replacement, knee implants have been an undesirable option- significant invasiveness, long rehab and recovery times, imperfect placements leading to mediocre results, etc. As a result, osteoarthritis sufferers have elected to live with the disease and pain for many years until it progresses to the point that a total knee replacement is finally waranted (where there is disease in at least 2 or all 3 of the compartments of the knee) - and even then this is a radical surgery that entails even greater invasiveness and even longer rehab and recovery times.

The whole point of MAKO is that changes all of that - providing minimal invasiveness, short rehab and recovery times and precision installation! This gives those with the disease in 1 and 2 compartments an option instead of waiting and living for years with the pain. And on top of this, its the only co that is able to offer this approach!!

Indeed, there are an estimated 15 million osteoarthritis of the knee sufferers in the US, but only 650K of them elected a partial or total knee implant in 2009. This leaves a potential market of 14,350,000 sufferers who are presumably holding out because of the above-referenced issues associated with the current implant procedures, and this 15 million is only in the US and is growing every year!  It is these facts, I think, that are driving the optimism about MAKO, and presumably in part what lead Goldman Sachs to deem it a storng buy w a $35 price target, which they revised up to $40 a few days later.

And soon there will be the hip - where again a similar analysis applies and again MAKO will be the only co that offers this approach!

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