MAKO Surgical: Burden of Proof Still on Management

MAKO Surgical’s (MAKO) first quarter results did little to inspire our confidence in this battered and bruised story, but for those that truly believe in the growth prospects, MAKO looks cheap relative to expectations. The main question that needs to be answered in order to justify ownership is: Are expectations (and guidance) achievable? MAKO, which released its quarterly earnings report after the close on Tuesday night, sold five RIO Systems in 1Q 2013 and announced that 2,988 MAKOplasty procedures were performed, generating revenue of $24.8M and a net loss of $0.21 per share. Revenue proved a slight beat compared to consensus estimates, while earnings were just shy of the $0.19 per share loss expected by analysts. Since its fall from graces last year, MAKO has been, and remains, a “show me” story, and we believe that management still needs to demonstrate at least 2 consecutive quarters of compelling results (solid meet or beat) to assuage investors’ fears that expectations for long-term performance will have to be, yet again, reset. With 27% of Mako’s float sold short, there’s a significant community of investors that believe numbers are still too high, and the results posted for 1Q aren’t likely to shake their belief, or bring new Long investors to the story. The burden of proof remains on management, and thus far, 2013 is off to a lackluster start. With little news flow until the next quarterly earnings report, we believe there will be continued pressure on MAKO and that potential investors will remain on the sidelines until performance improves. Furthermore, current shareholders are likely to step out in expectation of a re-entrance at lower prices, hence downside risk exists from here.

The focus is on company guidance and MAKO’s ability to measure up. Given MAKO’s history of overstating guidance and then revising significantly, investors are focused almost exclusively on MAKO’s ability to meet guidance for this year, which management reiterated alongside its quarterly results (45-48 RIO systems and 13,500-14,500 MAKOplasty procedures). The question then is whether the bar has been set appropriately, and whether quarterly results offer evidence that the company is on track to satisfy. With that in mind, Mako’s reported RIO system sales in the first quarter appear disappointing. Even considering that sales are generally back-end loaded throughout the year, the company didn’t come close to a run-rate that suggests reaching guidance. Mako reiterated 2013 guidance for 45-48 RIO system sales, but with only 5 new RIO placements in Q1, the company needs to average 14 RIO Systems quarterly for the next three quarters. It’s certainly within striking distance (MAKO sold 15 RIO Systems quarterly in the second half of 2012), but no shoe-in. The short’s argument against this precedent is that the low-hanging fruit (surgery centers that were more likely to purchase Mako’s systems) has already been picked. The company’s 2,988 MAKOplasty procedures performed in Q1 were a bit short of the 3,500 needed quarterly to meet guidance. Part of this, said management, was attributable to two fewer surgical days in the quarter. Again, MAKO expects MAKOplasty procedures to be a back-end loaded phenomenon (40/60 split, first half vs. second half) throughout the calendar year, although it’s important to note that 2012 was an anomaly to this expectation. If 2013 plays out similarly, the current run-rate won’t suffice.

Aside from meeting immediate guidance, we have three key concerns moving forward:

  • Practitioners that we spoke with still question the true medical need for a system like the RIO. Specialized surgeons indicated to us that they simply don’t need a robot in order to perform these procedures, and that the costs don’t make sense for their practices.
  • Along those lines, the high-volume centers that will be most lucrative to MAKO (higher procedure volume) and can afford a high-priced robotic system are the most experienced, hence, they’re the least likely to pick up a RIO System. Ironically, the lower-volume, less experienced surgeons are the ones that most need a RIO system, and affordability for many of these centers may be out of reach.
  • Finally, the RIO System is not interchangeable with other implants, which locks customers in and may be creating some buyer resistance. With other systems coming to the market that allow for interchangeability, Mako is likely to face additional headwinds. Management may be able to figure this out and push through, with a strong sales and marketing campaign, but investors are likely to demand the evidence first, given the past disappointments on expectations. The competitive threat is a component of the short thesis and a key reason for MAKO’s high short interest.

While we believe that Mako is within reach of its guidance for 2013, the first quarter didn’t instill the confidence needed for investors to jump in en masse. We believe the 1Q results reset the “show me” story for another couple of quarters; if the company demonstrates a second quarter similar to its first, particularly in terms of RIO sales, there’s more trouble on the horizon. Investors are enticed by the fact that MAKO traded at $44 in March of last year, and while the stock appears cheap relative to expectations for financial growth, the possibility that lowered expectations are still too high may keep investors away from the stock. A dip into the single digits, not out of the question, would, in our opinion, make MAKO a far more attractive come-back story, and those long the name may be wise exiting here and trying to find a better entry point in the future.