The reality is that virtual reality (VR), augmented reality (AR), and other riffs on these digital interfaces have not lived up to the hype. The latest hype cycle got underway around 2015-16. That’s when the vaunted Oculus Rift headset hit stores and Magic Leap came out of stealth mode. The former failed to launch the VR gaming revolution and the latter pretty much failed to launch to expectations. This translates to few opportunities for retail investors. Just two AR/VR stocks can be found in our Nanalyze Disruptive Tech Portfolio that are pick-and-shovel plays on the theme, and both are largely predicated on the success of the metaverse, which appears to be spinning nowhere, like the blue wheel of death on the computer screen. Still, if any of those market reports out of Mumbai are to be believed, the current VR/AR market is not inconsequential.
Unfortunately, the above chart does not break down the numbers between consumer and enterprise markets. We suspect more of the growth is happening on the enterprise side. Applications range from virtual collaboration to construction and engineering to healthcare. Use cases around medical virtual and augmented reality are particularly intriguing. These technologies address everything from pain management to medical training. We recently came across a pure-play medical technology stock, Surgical Science Sweden (SUS.ST), which develops VR hardware and software for education and training. The company more than doubled revenues last year and is pushing hard into the robotic surgery market.
About Surgical Science Stock
As you might guess from the company’s full name, Surgical Science is based in Sweden. Founded in 1999, the company is a self-proclaimed “world leader in the development of virtual reality simulators for evidence-based training.” Its core proprietary software and hardware technologies simulate interactions between instruments and anatomy to train surgeons and other medical specialists. Since 2017, Surgical Science has also been working on simulation solutions for medical device companies, particularly in robot-assisted surgery. The company splits its business between its core Education market and the emerging Industry/OEM market.
Before 2021, annual revenues were modest at about $10 million. Then revenues more than tripled to about $33 million in 2021 and then more than doubled in 2022 to $72 million. The sudden burst in revenues can be largely attributed to three acquisitions. In 2019, Surgical Science acquired a fellow Sweden-based medical simulator software developer, SenseGraphics, for $32 million. The company went on a bigger buying spree in 2021. It acquired U.S.-based Mimic Technologies, with expertise in robotic surgery simulation and training, for $18 million. It then spent $305 million in cash and stock to acquire Simbionix, a sizable competitor that principally operates out of Tel Aviv, Israel. You can see the big bump in revenue from the combined company beginning in Q3-2021.
Like Surgical Science, Simbionix generates income partly from its proprietary simulators across medical procedures, including areas such as general surgery, endoscopy, urology, and others. It also licenses simulation software to robotic surgery companies, including Intuitive (ISRG) and Medtronic (MDT), which acquired Mazor Robotics about five years ago. Both were also customers of Surgical Science prior to the acquisition of Simbionix, which had nearly $41 in revenue in 2020, though that was down from more than $45 million in 2019. No doubt the Rona was to blame, but based on Q1-2021 results of $9.7 million, Simbionix was on pace for flat or slightly lower revenues before it was absorbed by Surgical Science. It’s highly unlikely we’ll see revenue double again in 2023 as the dust settles on those acquisitions (more on future outlook below).
The Robotic Surgery Market for VR Simulation Training
While the lion’s share of revenue currently comes from Education products, Surgical Science believes its “strongest future growth” will come from the Industry/OEM segment where it can leverage its past R&D to easily (i.e., more profitably with bigger gross margins) integrate product-specific simulations into clinical medical products. The VR company is particularly bullish on robotic surgery, which it calls the “key customer group for the business area.” The principal business model involves a development fee for customizing or integrating with a customer’s products, along with a software license fee based on each unit, the installed base, or on usage. Sounds like maybe they’re still working out which approach works best.
Surgical Science currently claims to have 10 to 15 robotic-surgery customers, which probably represents a sizable portion of the existing industry. Intuitive is far and away the biggest, with an estimated 80% of the current market with $6.2 billion in revenues last year and 7,500 installed machines. That begs the question: Just how big is the opportunity here for Surgical Science, especially if Intuitive is already a customer that represents more than 10% of revenue? The company argues (and our own research shows) that robotic surgery is still in its infancy, with a global penetration across all medical procedures of just 3% to 4%. In addition, a number of Intuitive patents expire in 2017, potentially opening the gates to more competitors.
However, it’s unclear how much headway the small-cap robotic surgery companies are making. The best is probably a company called Accuray (ARAY), which is a robotics platform that delivers radiosurgery treatments to cancer tumors, with about $450 million in 2022 revenues. Behemoth medical device company Stryker (SYK) and its Mako Robotic-Arm Assisted Surgical System is probably the biggest revenue maker after Intuitive, with some estimates suggesting more than $1 billion in annual revenue from sales and service contracts. But the expense of these robotic surgery platforms, along with the costs of consumables and services, would seem to limit upside and long-term market penetration.
Should You Buy Surgical Science Stock?
The best measure of how well Surgical Science is growing is license revenue within Industry/OEM, which it only started tracking last year. Fortunately, the company is providing more granularity into its two main revenue streams, and we can indeed see the growth story is alive and well in the first half of 2023 (all numbers are in Swedish krona, with $1 USD = 11 SEK):
And, yes, license revenues are up about 55% this year compared to the first half of 2022, while overall net revenues have increased 22% through the first six months of 2023 versus last year. Those numbers could inch higher, especially in the Education segment, as the fourth quarter of the year is generally the company’s strongest. That’s because most Education customers are hospitals, which usually hold off on purchases until they can see what funds remain in the budget towards the end of the year. That also means these customers see VR training as a nice-to-have rather than a necessity, which can disrupt the bottom line when budgets are tight. Triple-digit growth is already a distant memory.
Surgical Science management claims the company is still on track to reach $135 million in annual sales with an adjusted profit margin of at least 40% by 2026. While the form seems achievable, the latter would require the company to significantly boost its current profit margin of 23% based on a gross margin of 66%. That’s where those licensing revenues will play a big part.
If you somehow had the foresight to buy a little-known Surgical Science stock when the VR simulation company IPO’d back in June 2017, you would be up nearly +900% on your investment compared to about +100% for the Nasdaq. At the height of the pandemic tech boom in 2021, Surgical Science stock was up by more than +2,700%. That’s some serious volatility for a company only very recently realizing significant revenues, mostly based on very recent acquisitions.
The volatility and short history of revenue growth are enough to give us pause. The company’s current market cap of about $570 million makes it pretty small potatoes. A simple valuation ratio of about 6 (market cap/annualized revenue) suggests that Surgical Science stock is fairly valued and is right in line with the average of our Nanalyze Disruptive Tech Portfolio. Those with a high-risk tolerance associated with small-cap stocks like Surgical Science stock and interested in investing in VR could do a lot worse.
Conclusion
As risk-averse investors, we will continue to watch Surgical Science stock and see if it can grow recurring license revenues and hit its financial goals. Key for us will be breaking the $1 billion market cap threshold at a fair valuation. The options for investing in a quality virtual reality company have been nearly nonexistent. However, we are not going to invest in VR just for the sake of investing in VR.
