Intuitive Surgical, Inc. Q4 2008 Earnings Call Transcript

| About: Intuitive Surgical, (ISRG)

Intuitive Surgical, Inc., (NASDAQ:ISRG)

Q4 2008 Earnings Call

January 22, 2009 4:30 pm ET

Executives

Benjamin Gong – Vice President of Finance

Lonnie M. Smith – Chairman and Chief Executive Officer

Gary S. Guthart – President and Chief Operating Officer

Marshall L. Mohr – Chief Financial Officer

Aleks Cukic – Vice President, Strategic Planning

Analysts

David Lewis - Morgan Stanley

Frederick A. Wise - Leerink Swann

Tycho Peterson – JP Morgan

Amit Hazan - Oppenheimer

Tao Levy - Deutsche Bank

Mimi Pham - JMP Securities

Vincent Ricci – Wachovia

Operator

Welcome and thank you for standing by. At this time all participants are on a listen-only mode. After the presentation, we will conduct a question-and-answer session. (Operator Instructions). Now I would like to introduce your host for today's call Mr. Ben Gong, Vice President of Finance.

Benjamin Gong

Good afternoon and welcome to Intuitive Surgical's fourth quarter conference call. With me today, we have Lonnie Smith, our Chairman and CEO; Gary Guthart, our President and Chief Operating Officer; Marshall Mohr, our Chief Financial Officer; Aleks Cukic, our Vice President of Strategic Planning.

Before we begin, I would like to inform you that comments mentioned on today's call may be deemed to contain forward-looking statements. Actual results may differ materially from those expressed or implied as a result of certain risks and uncertainties. These risks and uncertainties are described in detail in the company's Securities and Exchange Commission filings. Prospective investors are cautioned not to place undue reliance on such forward-looking statements.

Please note that this conference call will be available for audio replay on our website at www.intuitivesurgical.com on the audio archives section under our Investor Relations page. In addition, today's press release has been posted to our website. Today's format will consist of providing you with highlights of our fourth quarter, as described in our press release announced earlier today, followed by a question-and-answer session.

First, Lonnie will present the quarter's business highlights. Marshall will follow with a review of our fourth quarter and annual financial results. Next, Aleks will discuss sales and marketing highlights, then I'll provide our financial forecast for 2009 and finally, we will host a question-and-answer session.

With that, I'd like to introduce Lonnie Smith, our Chairman and CEO.

Lonnie M. Smith

Thank you for joining us today. Operating highlights for the fourth quarter are as follows. Procedures grew 61% over the fourth quarter of 2007. We sold 85 da Vinci surgical systems, up from 78 during the fourth quarter of last year. Our international team had an excellent quarter contributing 30 of the 85 systems sold. We ended the fourth quarter with 1111 da Vinci systems installed worldwide. Total revenue for the quarter was up 22% from last year. Instrument and accessory revenue increased to 82 million, up 45%. Total reoccurring revenue including service grew to $118 million, up 46% from the prior year, comprising 51% of total revenue. We generated an operating profit of $104 million before non-cash 123R stock option expense, up 25% from the fourth quarter of last year, and GAAP net income grew to $51 million, up 3% from last year.

During the full year 2008, procedures grew by 60% over 2007. We sold 335 da Vinci surgical systems, up 39% from prior year. Total revenue grew to $875 million, up 46%. Reoccurring revenue grew to 420 million, up 52%, comprising 48% of total revenue. We generated $387 million in operating profit before non-cash 123R stock option expense, up 59% from last year, and GAAP net income grew to $204 million, up 41%.

We ended the year with $902 million in cash and investments, up $80 million from last quarter, and $266 million from last year. Excluding $45 million in cash received from the exercise of stock options and adding back $116 million invested in intellectual property, working capital, and property, plant, and equipment during the year, we generated $338 million in cash from operations before operating investments of $8.46 per fully diluted share and 165% of our reported GAAP net income for the year. This is a reflection of significant non-cash stock option and statutory tax expenses reflected in our GAAP net income and is the reason we continue to believe that operating profit before non-cash 123R stock option expense remains the best measure of our actual financial performance.

Adoption of surgical robotics is procedure specific and patient driven. We continue to drive the adoption curve for robotically assisted surgery procedure by procedure. Some of our highest growth procedures of 2008 defined as greater than 100% year over year growth include nephrectomy, partial nephrectomy, gastrectomy, radial cystectomy, hysterectomy, sacral colpopexy, thyroidectomy, and colon and rectal resections. I should note that our gastrectomy and thyroidectomy procedures are concentrated in Asia. While some of these procedures are measured off a relatively small number in the prior year, we have learned from past experience that these are usually stages of new adoption curves.

We continue to make significant progress in terms of innovation and efficiency in every area of our business. Some 2008 data points you might find of interest include we added 285 new employees during the year, ending the year with 1049 employees. Revenue per employee grew to $965,000 in 2008 compared with $905,000 in 2007, and instrument and accessory revenue per system was up 6.6% to $322,000 from $302,000 in 2007.

With that, I’ll pass the time over to Marshall Mohr, our Chief Financial Officer.

Marshall L. Mohr

As previously announced, total fourth quarter revenue of $232 million increased 22% compared with $189 million for the fourth quarter 2007, and decreased 2% compared with $236 million for the third quarter of 2008. Procedures for the fourth quarter increased 61%, compared with the fourth quarter of 2007 and 15% sequentially. DVP and DVH growth was as expected.

Fourth quarter revenues by product category were as follows: Instrument and accessory revenue increased to $82 million, up 45% compared with $56 million last year and up 7% compared with $76 million last quarter. The growth rate in instruments and accessories is the direct result of our procedure growth rates. Procedure growth rates increased more than instrument and accessory revenue reflecting lower stocking orders associated with fewer systems placed, procedure mix, strengthening of the dollar and surgery efficiency. The amount of instrument and accessory revenue we realized per procedure including initial stocking orders was approximately $2000 per procedures.

Systems revenue of $114 million increased 5% compared with $108 million last year and decreased 10% compared with $126 million last quarter. The decrease in systems revenue compared with the third quarter of 2008 reflects decreased unit sales, as well as a decrease in the average revenue per system.

Fourth quarter da Vinci Surgical Systems revenue reflects the sale of 85 systems compared with 78 systems sold in during the fourth quarter of last year, and 91 systems sold in the third quarter. The decrease in systems sold reflects reduced hospital capital spending as a result of the economic and financial market issues. 66 of the systems sold during the quarter were our latest S model incorporating high definition vision capabilities. 10 were four-arm S models incorporating standard vision capabilities.

Four were three-arm S models, and five were refurbished standard systems. Six of the systems in the quarter involved trade-ins.

Our fourth quarter average revenue per system, including all da Vinci models but excluding upgrades, was $1.32 million which is 50,000 less than the average revenue per system in the third quarter of 2008. The lower average revenue per system primarily reflects changes in product and geographical mix and the strengthening of the dollar.

Service revenue increased to $36 million, up 46% compared with $25 million last year and up 7% compared with $34 million last quarter. The growth in service revenue is primarily driven by a larger system installed base.

Total third quarter recurring revenue comprised of instrument, accessory and service revenue, increased to $118 million, up 46% compared with the fourth quarter of 2007 and up 6% compared with the third quarter of 2008. Recurring revenue represented 51% of total revenue in the fourth quarter compared with 46% in the third quarter of 2008.

Revenue outside the United States represented 27% of total fourth quarter revenue compared with 19% of total third quarter revenue. International procedures and revenue increased from a seasonally low third quarter. We sold 30 systems outside of the US this quarter compared with 20 in the third quarter, a 50% increase despite the global economic downturn.

Our fourth quarter 2008 gross margin of 71.4% was similar to the 71.9% realized in the third quarter. Lower average selling prices for systems and effects of the strengthening dollar were partially offset by lower operating costs and material cost reductions.

We opened our Mexico facility in July which is now responsible for nearly half of our instrument volume. Although we incur lower labor costs in Mexico, the overall savings in 2008 was mostly offset by manufacturing startup costs.

Total operating expenses for the fourth quarter of 2008 were $83 million compared with $85 million in the third quarter of 2008. The sequential operating expense decrease of $2 million reflects decreased commissions associated with lower system sales, strengthening of the US dollar, decreases in outside services, and overall decreases in spending partially offset by increase headcount. In the fourth quarter, we purchased an additional facility in Sunnyvale which will be used for shipping and logistics beginning in February. We also postponed the construction of the new facility next our main campus for at least one year. These net changes will result in lower costs in 2009 than we otherwise would have incurred but did not impact the fourth quarter.

We added 36 employees during the fourth quarter ending the period with 1049 regular employees. The majority of these additions were to our worldwide clinical sales and engineering teams.

Fourth quarter 2008 operating income was $83 million or 36% of sales, compared with $85 million or 36% of sales for the third quarter of 2008. We would like to point out that operating income includes 123R stock compensation and amortization charges associated with purchased IP. Both the third quarter and fourth quarter included $21 million of 123R stock compensation expenses. In the fourth quarter, it included $4 million of amortization of purchased IP compared to approximately $3 million in the third quarter.

Our fourth quarter 2008 other income was $6 million, up $1 million from the third quarter, reflecting reduced exchange losses on euro accounts and higher interest on our increased investment balances. Given the recent volatility of the euro exchange rate, in January, we went into foreign exchange contracts to hedge our euro balances at December 31, 2008, and a portion of our expected revenue for the first 6 months of 2009.

Our effective tax rate for the fourth quarter was 42.5% which is higher than the 37.8% recorded for the first nine months of the year. The increase in our rate reflects certain non-deductible costs partially offset by federal 2008 R&D credits. The non-deductible costs reflected in the fourth quarter rate included adjustments related to 2007 and the first nine months of 2008. The rate for all of 2008 was 39%.

We continue to utilize carry forward tax benefits and employee stock related tax benefits in 2008, and expect out cash outlay for income taxes will be approximately 22% of pretax income for 2008. Our cash outlay estimate is slightly greater than our previous estimates given lower employee stock option exercises in the fourth quarter.

As a result of the delay in the IRS’s issuance of new regulations, we have postponed expenditures to implement the remainder of our tax structure. As a result, the GAAP benefits of our international tax structure will be delayed 1 year. However, in the meantime our cash outlays for tax will continue to benefit from the international structure.

Net income of $51 million or $1.27 per share increased 3% compared with $49 million or $1.24 per share for the fourth quarter of 2007 and decreased 12% compared with $58 million or $1.44 per share for the third quarter of 2008.

Let me quickly summarize our results for 2008. Total procedures grew 60% to approximately 136,000. Total systems sales grew 39% to 335 systems. Total revenue for 2008 was $878 million, up 46% compared with $601 million last year. Operating income for 2008 was $311 million, up 50% compared with $207 million last year. Operating income for 2008 was $311 million, up 50% compared with $207 million last year. Operating income included $77 million of stock base compensation changes and $10 million of IP amortization in 2008 compared with $36 million of stock-based compensation changes and $1 million of IP amortization in 2007. Net income for 2008 was $204 million or $5.12 per share, up 41% compared with $145 million or $3.70 per share last year. Cash and investments grew $266 million for the year to $902 million on December 31st.

Now turning our attention to the balance sheet. We ended the year with cash and investments of $902 million, up $80 million from September 30, 2008. Cash generated from employee stock activities was $3 million for the quarter. The remaining cash generated is primarily related to operating activities. Capital expenditures of $23 million for the fourth quarter included $17 million associated with the purchase of a building and land in Sunnyvale and expenditures associated with facilities and information technology infrastructure to support our growth.

Our accounts receivable balance decreased to $170 million at December 31st, compared with $174 million at September 30, 2008. Despite the economic environment, collections have remained strong. Our net inventory increased to $63 million at December 31st compared with $52 million at September 30, 2008. The increase in inventory reflects lower than expected systems revenue.

With that, I would like to turn it over to Aleks, who will go over our sales, marketing, and clinical highlights.

Aleks Cukic

During the third quarter, we sold 85 da Vinci systems, 55 in the United States, 23 in Europe, and 7 in rest of world markets. A total of six system sales were part of trade-up transactions. The net 79 new system installations brings to 1111 the cumulative number of da Vinci systems worldwide, 825 in the United States, 194 in Europe, and 92 in rest of world markets. Fourteen of the 79 net system installs during the quarter represented repeats systems to existing customers, which included fourth systems to both the Cleveland Clinic and Hartford Hospital and third systems to Cornell medical Center, Memorial Sloan-Kettering, Scottsdale Healthcare, and Methodist Hospital in Rochester, Minnesoa. This brings to 131 the total number of customers which own two or more da Vinci systems.

International sales were particularly strong and included 5 da Vinci placements into Germany and three into the countries of France, Italy, Korea, and Russia.

Clinically, we had an excellent quarter, with strong sequential procedure growth within our targeted surgical specialties, both domestic and internationally. Growth of da Vinci hysterectomy, both for benign and malignant conditions, sacral colpopexy, nephrectomy and partial nephrectomy and da Vinci prostatectomy were most notable.

In Q4 along, there were over 200 da Vinci related clinical publications within various peer reviewed journals, and the medical conference season was back in full swing. Case studies and serious presentations were plentiful during the quarter, but I will limit my review to only a few.

At this year’s Association of Advanced Gynecologic Laparoscopy Conference or AAGL, the agenda included robotic postgraduate courses, robotic satellite symposia, and a very well attended robotic symposium. As you might suspect, clinical procedure discussions feature da Vinci hysterectomy for both benign and malignant conditions, da Vinci sacral colpopexy and da Vinci myomectomy. Consistent with GYN meeting reviews, surgeon’s report of lower blood loss, lower complications, shorter hospitalization, shorter learning curves versus laparoscopy, quicker returns to normal activity, and increased patient satisfaction were common themes. What resonates with me at this point in our GYN evolution is the positive impact that da Vinci is making in surgeon practice patterns and more specifically how da Vinci has helped to expand minimally invasive surgery treatment within a surgical specialty that is already believed to have a high penetration of minimally invasive surgery.

Dr. Gary Donovitz, a GYN surgeon practicing at USMD Hospital in Arlington, Texas delivered a presentation that compared his benign hysterectomy practice before and after his switch to da Vinci. Dr. Donovitz began performing DVH in early 2006, and he compared his pre-DVH practice of 2004 or 2005 to his post-DVH practice of 2006 and 2007. His pre-DVH statistics were as follows: Out of 175 overall hysterectomies, 11 were performed as total vaginal hysterectomies, 115 were total laparoscopic hysterectomies, and 49 were total abdominal hysterectomies.

As a highly skilled laparoscopist, his 28% abdominal incision rate was less than half the US average. In 2006 and 2007, post da Vinci, he performed a total of 188 hysterectomies, 4 were vaginal, 180 were DVH, and most importantly only 4 required the total abdominal approach. His already low 28% abdominal hysterectomy rate was reduced to 2%, meaning that after incorporating da Vinci into his practice, 98% of the women requiring a hysterectomy left the hospital without an abdominal incision, and 96% of these women received a da Vinci hysterectomy.

Similarly, Dr. Angelo Maggioni, an accomplished GYN oncologist from Milan, Italy, delivered a presentation on 80 of his da Vinci endometrial cancer procedures at the International Gynecologic Oncology Robotic Symposium or IGRS where he stated, “we have experienced an 85% increase in minimally invasive surgical procedures in our practice due to robotics.” These examples not only speak to the changing GYN practice but more importantly they speak to the increased patient value that da Vinci is providing throughout the specialty of GYN surgery.

Over the past few quarters, we’ve discussed the uptake in da Vinci’s use within renal or kidney cancer surgery. As Lonnie mentioned earlier, the growth within da Vinci nephrectomy and partial nephrectomy globally was strong throughout the year. The renal surgery community has truly embraced to need to preserve as much healthy tissue as possible in patients suffering from renal cancers. Da Vinci’s contribution to performing minimally invasive partial nephrectomy is becoming widely known and for good reason.

Earlier this month, the International Urologic Robotic Society convened their annual meeting in Las Vegas. Over 500 surgeons representing 21 countries were in attendance. Prostate, renal, and bladder cancer along with benign reconstructive procedures were the primary topics of this year’s meeting. As you might expect, the volume of DVP material presented was abundance to say the least, but what really caught our attention was both the number and quality of the da Vinci renal surgery procedure presentations and most notably da Vinci partial nephrectomy.

Dr. Eric Weise, Director of Robotic Surgery at Lutheran Hospital in Fort Wayne, Indiana, presented his comprehensive da Vinci partial nephrectomy data. Dr. Weise, a leader in this field, began incorporating da Vinci in his renal surgery practice in 2005, and he has tracked outcomes in a diligent manner. What Dr. Weise showed was that the indications for da Vinci partial nephrectomy expanded significantly through his learning curve. In his analysis, he compared both the percentage of da Vinci partial nephrectomies performed as a subset of all renal tumor patients as well as the measured size of the tumor. He stratified five groups into independent 6-month intervals and compared them to one another. His results were impressive.

In his first 60 patients, he was able to perform 10 da Vinci partial nephrectomies or 17%, and median tumor size was 1.9 cm, and the maximum size of 3.3 cm. In his second group, he performed 9 da Vinci partial nephrectomies out of 23 candidates or 39%, with a median tumor size of 3 cm and a maximum size of 5 cm. In his third group, he performed 24 da Vinci partial nephrectomies out of 49 candidates or 49% with median tumors of 2.9 cm and a maximum of 5.4 cm. In the fourth group, 30 out of 44 candidates or 68% median tumor growing to 3.2% and the largest being 7 cm, and fifth and final sixth month group, he performed a da Vinci partial nephrectomy, and 22 out of a possible 25 candidates, 88% with a median tumor size of 3.8 cm and the largest being 10.6 cm in size.

In just over three years, he has expanded da Vinci partial nephrectomy in his patients suffering from renal tumors from 17% to 88% while the average tumor size within that period doubled. The theme of expanding indications through one’s experience is consistent with what we saw in da Vinci prostatectomy, da Vinci hysterectomy, and da Vinci mitral valve repair, and as a theme we would expect to continue with in all our targeted procedures.

In closing, I’ll call your attention to some interesting statistics associated with the recent World Congress of Endourology Meeting that took place in Shanghai. This year’s meeting speaks volumes to how far we have come within the specialty of urology. The World Congress of Endourology Meeting is a form where anything and everything associated with urologic disorders is discussed and presented. The list of topics is enormous and includes everything from pharmacology to radical surgery.

The global number of da Vinci-related abstracts and presentations at this year’s conference was rich. For the entire conference, 2120 papers and abstracts were submitted, and 1847 were accepted. Out of these, 158 or 9% were related to da Vinci surgery. While da Vinci prostatectomy topics contributed have of these accepted abstracts, da Vinci nephrectomy, partial nephrectomy, cystectomy, pyeloplasty, urogynecologic procedures, and da Vinci pediatric procedures contributed the rest.

The accepted abstracts were offered in a variety of countries which included United States, France, the UK, Korea, Turkey, Australia, China, Italy, Venezuela, and India. It was not that long ago when we would have been pleased to have any da Vinci-related abstracts accepted at this prestigious meeting, so to have 9% of all excepted abstracts relate to da Vinci surgery, and having them originate from nearly a dozen countries is truly exceptional.

That concludes my summary, and then I’ll turn the time over to Ben.

Benjamin Gong

I’ll be providing our 2009 financial forecast from revenue to earnings per share on a GAAP reporting basis. I will also provide estimates of certain non-cash expenses to provide you with visibility of our expected future cash flows. Starting with procedures, as Aleks mentioned, we are continuing to see strong growth driven by DVP and DVH as well as other urology procedures such as nephrectomies and partial nephrectomies and other gynecology procedures such as sacral colpopexies.

In 2009, we expect total procedures to grow 35 to 40% from approximately 136,000 procedures performed in 2008. Our instrument and accessory revenues are driven by procedures performed. However, we expect these revenues to grow at a slower rate than procedures in 2009. While procedures are expected to grow 35 to 40% this year, we are forecasting our instrument and accessory revenues to grow to 25 to 30%. There are three main factors that causing a downward trend in our revenue per procedure.

First, initial stocking orders continue to comprise of lower proportion of total instrument accessory revenues as our installed base continues to grow. Secondly, as customers increase their utilization rates, they become more efficient in their use of consumable supplies, and finally, we are seeing a higher growth in benign GYN procedures that require fewer instruments. As our procedure counts grow in to the hundreds of thousands per year, we naturally expect efficiencies to gradually bring down the revenues we generate on each procedure. System revenues are more difficult for us to project.

In the current hospital spending environment, our ability to sell systems in the short term is less certain, and we would caution you not to place undue reliance on our forecast for system revenues. Nevertheless, based on our projected procedure growth, we believe that customers will purchase a similar number of systems in 2009 as we saw in 2008. Therefore, we expect system revenues in 2009 to be relatively flat compared with 2008. Based on flat system sales for 2009 and consistent pricing on service contracts, we expect service revenues in 2009 to grow approximately 35% from 2008.

In summary, estimate our topline revenue growth in 2009 to be approximately 15%. With regard to gross profit margin, we averaged approximately 71% for all of 2008. For 2009, we expect our gross margins to slightly lower to between 70 and 71% based on the expected higher mix of service revenue and the US dollar’s recent strength against foreign currencies. With regard to operating expense, we expect total operating expense to grow approximately 20% in 2009. Included in this estimate are some significant increases in non-cash expenses.

First with regard to FAS123R, in 2008, we recorded $77 million in stock compensation expense. In 2009, assuming our stock price remains at approximately $100 per share, we expect stock compensation expense to increase 22% to approximately $93 million, and secondly with regard to IP amortization charges, we scheduled to record to $14 million in the R&D expense line for 2009, up 40% from the $10 million we recorded in 2008.

We plan to manage our fixed cost closely as we demonstrated in Q4, but we will continue to add resources in the sales and R&D functions as we view these as important investments to continue driving growth in the near term and the long term. We expect operating income to grow 7 to 8% for the year.

With regard to income tax, we reported a GAAP tax rate of approximately 39% for all of 2008 while our effective cash tax rate was approximately 22%. For 2009, we expect to report a GAAP tax rate of approximately 40%. Our effective cash tax rate is largely dependent on employee stock option exercises during the year. Given the recent drop in our stock price, we expect a significantly smaller benefit than we have seen in recent years, and therefore, our effective cash tax rate could reach as high as 40%. We expect earnings per share to come in between $5.30 and $5.40, representing approximately 5% growth from 2008 to 2009.

That concludes our prepared remarks. We’ll now open the call to your questions.

Question and Answer Session

Operator

(Operator instructions) The first question comes from the line of Tao Levy from Deutsche Bank

Tao Levy - Deutsche Bank

The strength in the quarter internationally, it seems like you get blocks of systems from countries, like 5 in Germany. Are these government tenders or how does that process work or is it is just coincidence? Also if you can just comment on what you see developing internationally just given the economic issues that they are also facing right now.

Benjamin Gong

You are right. We had for example 5 different sales in Germany. That was not part of one system sale for a government. They were actually five different individuals, but to your point selling three systems in Korea, and we do have probably a headwind with the exchange rate in Korea being much weaker against the dollar, and what you saw in Q4 was certainly a strong quarter, but as we saw in Q1 of last year, international system sales sequentially in Q1 are likely to be lower than what we saw in Q4.

Tao Levy - Deutsche Bank

In general, the international environment, what you’re getting from sales force, has that changed just as much as you’ve seen here in the US?

Marshall L. Mohr

When we look at the things that we can see, and the most important thing we can see are procedures, and Q4 procedures, both US and OUS were really strong, exceptionally strong OUS, so when we take the temperature of the individual salespeople and people focused on procedures, it seems really strong in DVP. We are starting see a little bit of nice uptake in DVH, which we have talked about in the past as has lagging. The cancer procedures around nephrectomy and partial nephrectomy, and as Lonnie mentioned in his summary, even some procedures that we don’t see being performed in the United States in great numbers are being performed in places like Asia, mainly thyroidectomy, gastrectomy, and some of the colon procedures, so I would say in general as we have said in the past, international is made up of multiple markets, but if I were to assess it globally, I would say that it was very strong in Q4. Individual systems, as we talked about in years past or quarters past, for example, when we see a spike in Belgium or in Korea, that’s going to vary from quarter to quarter, country to country.

Benjamin Gong

In terms of visibility, the sales force in Europe seems relatively positive, but visibility from where we sit with all the news that keeps coming is uncertain, and I wish I could give you an answer, but it’s kind of one of those things time will tell. We will continue to drive hard. Procedures will be key to driving new systems sales, and just like the rest of the world, we are going to have to take this a step at a time as this evolves and hopefully we will start to come out of this economic disaster.

Tao Levy - Deutsche Bank

You’ve announced over the last few months some R&D alliances. You haven’t spent too much time going through what those alliances bring to the table in terms of advancing robotic surgery. If you can maybe spend just a couple of points on why it’s important, why you did them, why you are spending their, and again the benefits of that.

Gary S. Guthart

As we look at the technology acquisitions we’ve done, there have been few that I will call out. You have seen recently SurgiQuest and Novadaq. We have PMI also, and I guess what I will tell you about the grouping as a whole is that in each of these we are looking for component technologies that when added to robotics give us better clinical outcomes, and we think those examples do that in the case of stapling, it will give us access to a different set of procedures. In the case of Novadaq, that’s fluorescence imaging, we think that will drive clinical benefits in a variety of procedures, so that’s what we are looking to do, and when we see those opportunities, we pursue them, and we have done that aggressively this last year, and we will continue as opportunities present themselves.

Tao Levy - Deutsche Bank

Is there any timing you can provide as to when we could see some of these, maybe 5 years down the road, 12 months, 2 years?

Gary S. Guthart

We are working aggressively, but we are not ready to tell you any specific timeline.

Benjamin Gong

Tao, it’s something I said over and over again, and I will continue to say it. We truly believe that robotic surgery is going to displace a very significant part of traditional open surgery, and this is a long-term play, and so we are trying in these kinds of investments to look out and anticipate where it’s going and make sure that we have a pre-emptive position as we drive adoption of surgical robotics on a very broad scale both in this country and worldwide.

Operator

The next question comes from Mimi Pham with JMP Securities.

Mimi Pham – JMP Securities

Can you provide some more color on the fourth quarter system shortfall in the US? Were these likely postponements or flat-out cancellations?

Benjamin Gong

We went into even December with quite a few customers in the United States who were indicating that they wanted to purchase systems, and in the end they ultimately didn’t. We think these are all credible customers, and they all would like to either get their first da Vinci system or an additional da Vinci system, so they are most likely postponements. Is that a postponement to next quarter or next year? I think that remains to be seen.

Mimi Pham – JMP Securities

Do you get a census if the reasons why for the postponements also, like have you talked to them in depth? Are they just waiting maybe for the new budget, financing? Has that been an issue for any of the placements, being able to get financing?

Benjamin Gong

It was pretty broad. There was not any particular, I’d say, one segment that we can point out, existing customer or new customer or big hospital or small hospital. I guess the overriding theme that they didn’t want to spend money or did not have money to spend at this particular time.

Lonnie M. Smith

Mimi, I think there were several systems where given the economy, hospitals were pressing for very significant discounts, and many of those we just walked away from because that gets to be a slippery slope, and people see an opportunity, and I’m sure some of the suppliers they are talking to get a little desperate, and we not going to do that.

Benjamin Gong

Also related to your question, Mimi, is we often get asked how many systems are financed. In Q4, it was between 15 and 20%, so it was not materially different than we saw in Q2 or Q3. There were certainly a lot of people who were interested in that, and those folks who were interested and wanted to follow through were able to obtain financing. I would also point out that there were five different leasing companies out there who provided financing for da Vinci purchases during the quarter, so there generally is financing available.

Mimi Pham – JMP Securities

I know your guidance for systems is based on your procedure growth, but can you at least comment on your systems pipeline heading into 2009 relative to the absolute number heading into 2008 to give us some more color? Is it substantially higher or a little bit higher or around the same level?

Benjamin Gong

Well, we go through our bottoms-up forecast in a similar manner every year, and we do take a look at that pipeline, and when we came up with our forecast for flat systems for next year, it was in light of what we saw in that pipeline, but even though there is a pretty healthy pipeline, it’s not certain as to when any of these particular systems are going to actually close, and nowadays it is less certain than it ever has been.

Mimi Pham – JMP Securities

Can you at least provide some color? Is it in absolute terms of bigger than what you had entering 2008?

Lonnie M. Smith


We didn’t make that comparison, so we are not prepared to say.

Mimi Pham – JMP Securities

Your sales strategy in terms of systems and driving utilization, are you changing anything given the more challenging environment, does that change in any way in terms of the sale force and how they go into the accounts?

Marshall L. Mohr

I think the recipe we have for growing procedures is pretty well baked, and I think it has been pretty successful, so we’re certainly not going to get away from our strength. Now the question of allocating resources, certainly that is something that we look at and decide how we are going to spend and where we are going to spend it, but the process of awareness and driving through education and proctoring and training, etc., is a good established process, and there is no reason to get away from that.

Operator

The next question comes from Vincent Ricci from Wachovia.

Vincent Ricci – Wachovia

From listening to yourself and some other companies, it sounds like in the middle to late half of December things got very ugly. I was just wondering if you guys could maybe shed some light unto us as to what changed in those two months that may have not been around in November when the hospitals were setting their budgets.

Marshall L. Mohr

Unfortunately the third month of every quarter is always the heaviest month for selling systems, and so March, June, September, and December all are pretty big months for us, so going into December it didn’t seem any particularly different than a March or September, but as that month progressed, and certainly toward the end there, there were a number of people who decided they weren’t going to by.

Benjamin Gong

I would say also Vincent if you were look at the activity that the sales force goes through in closing a system, our sales force was as busy in the fourth quarter as they were at any other time. What was different is that the signatures didn’t come when you wanted the signatures to come, but the demand and people that we’re looking at getting involved in robotic surgery or getting second and third systems, and the activities supporting that was very high, so it isn’t that it just got ugly and changed materially.

Lonnie M. Smith

As said, we were very active. At the operational level, people were ready to buy. They clearly see the benefits and are supportive of it, and that’s the reason we saw all that kind of activity. We don’t sit in the broad meetings of all these hospitals, so we are really not privy to it, but the people we have talked to or I have talked to would tell you that that when capital decisions in general came up to the board level, with the media and everything that’s happening in the economy, some of these boards just decided to postpone the capital expenditure or cut their capital budgets significantly, so I don’t think it is anything different than what has happened across the economy. When it reached that level, I think people have gotten very conservative and fearful and therefore have postponed purchases that they might have planned when they made their capital budgets. The world has changed since people made their capital budgets over a year ago.

Vincent Ricci – Wachovia

Could you explain a little bit better the hedging plan that you guys are putting in place?

Benjamin Gong

Again, we are entering in an environment where as you’ve probably watched, the euro-dollar relationship changes dramatically day to day, and in order not to be the victim of those fluctuations on a P&L basis, we took out some hedges on our balance sheet position at the end of year, and as you know we sold 30 systems and a number of those in euro, so we hedged our balances at the end of the year, and we’ll evaluate each month and may take out additional hedges as the original hedges lapse, and based on what we’ve got in the way of euro. We also wanted to again for planning purposes lock in better what we would wind up realizing in the way of revenue, and so we did take out couple of hedges to deal with revenue during the first 6 months of this year.

Vincent Ricci – Wachovia

A couple of other medical device companies have commented over the last couple of days that for them being that they are in a strong financial position which you guys have been due to your prudent use of cash, this has presented a once in a lifetime opportunity for them to go out there and make strategic acquisitions. For you guys, you’ve largely done a lot of partnerships and licensing agreements. I’m just wondering are there any assets out there in the private markets, public markets that you think that can help bolster your platform and get you into newer markets that you might not have been able to get into without that technology. Anything you see interesting?

Lonnie M. Smith

I think the answer is since we are on the forefront of robotic surgery, there is nothing out there that we would buy a company that would provide significant near-term or long-term capability. The things that we are looking at are the things that Gary mentioned earlier, technologies that we can develop so that it would either be an adjunct or support entry into new surgical procedures or surgical segments or just enhancements of the surgical capability of the system, but we are not going to go out and buy a suture company or some manual surgical device company because that takes us exactly the opposite direction that we are trying to take the markets.

Operator

The next question comes from David Lewis with Morgan Stanley.

David Lewis - Morgan Stanley

I appreciate the 15% and your prudent comments about boxes and box guidance. You are guiding a 15% topline and 5% bottomline. Am I hearing you say that you are committed to that 5% EPS number regardless of how the macro environment changes or should we assume, or if the topline changes, the bottomline could change as well?

Benjamin Gong


Certainly.

Marshall L. Mohr

We are committed to continuing to invest in our future, and so that’s why that disparity could occur.

David Lewis - Morgan Stanley

Okay, Marshall, so you are going to continue to spend through this. You are not making commitments though. We will not be flat year over year.

Marshall L. Mohr

The fact is that we truly believe that we have started this new technology. We are well into the process, and there’s enormous growth ahead. Now, we’re going through a business cycle that may cause a pause, but we’re going to continue to invest in the technologies and product enhancements and everything else that when we come out of this we will be in a position to continue to grow and to drive the adoption of robotics in surgery.

Lonnie M. Smith

Having said that, we do endeavor to control expenses to the best of our ability where they are controllable and they don’t affect our future.

Benjamin Gong

As an example, Marshall pointed out a couple of things. We’ve postponed building a building. We’ve put that on hold for a while. We cut back on some outside services even during the fourth quarter. You saw that operating expenses actually in the fourth quarter were down sequentially from Q3, so we’re trying to be prudent about those that we are spending money on.

David Lewis - Morgan Stanley

So maybe earnings won’t change as fast as revenue, but if revenue changes, earnings can change.

Benjamin Gong

Correct.

David Lewis - Morgan Stanley

On revenue per procedure, I think I understood the nature of optimization of procedure as well as mix. What did you forecast though, Ben, for 2009 in terms of how prevalent or pervasive this mix shift issue happens? In other words, what did you assume for revenue per procedure for 2009?

Benjamin Gong

We are forecasting a continued reduction, and we took that into account in that roughly speaking a 10% differential in the growth rate. You have a 35-40% growth rate in procedures versus a 25-30% growth rate in the revenues, and so what that turns into is a gradual decrease of that revenue per procedure over time driven by those three factors, and I think what you’re alluding to is do we expect more benign dVH growth as a percentage of the total, and the answer is yes.

David Lewis - Morgan Stanley

You feel that assumes some trajectory on benign hysterectomy and assumes some optimization in prostatectomy, and you’re fairly confident that number is unlikely to worsen more than 10%?

Benjamin Gong

We gave a forecast of that 35-40% procedure growth. We feel pretty confident in that procedure growth rate, and in order to get there, those big procedures like dVH and dVP have to grow.

David Lewis - Morgan Stanley

Lastly, Lonnie, you made comments about not wanting to discount on price, which obviously we think is the right strategy. You also have been sort of averse to taking risk to your balance sheet. You have a very large balance sheet. Would you consider taking capital risk and balance sheet risk to promote the revenue line this year?

Lonnie M. Smith

I’m not sure what you mean.

David Lewis - Morgan Stanley

Extending financing, doing sales-type lease terms with your customers.

Lonnie M. Smith

Well, we’ve looked at that, and right now we have lenders who are quite ready to provide that service. We’ve had no problem with it. If it came to that, then we certainly would consider it. I think it certainly is an option. We have, as you say, a large asset on the balance sheet. It’s not giving us a very attractive return. On the other hand, it gives us enormous flexibility, and in this market, as it was mentioned earlier, there are opportunities that we want to be in a position to take if and when they come, but it is an asset that doesn’t give us very good return, and if there are better ways to utilize that asset, we will do so.

David Lewis - Morgan Stanley

With 22% to 25% of your market cap in cash, is there any point at which share buybacks become a useful return on capital?

Lonnie M. Smith

We do manage the business for long term, and with that said, I didn’t think we’d be asking this question either. It’s a board decision and not a management decision. It’s something we would have to bring to the board, but at the current prices, I would certainly consider that as a possible use of a portion of the cash.

Operator

Your next question comes from the line of Frederick A. Wise from Leerink Swann

Frederick A. Wise - Leerink Swann

I’m just trying to assess the near to medium term risk and outlook here. Is it possible or does it seem realistic as we think about gauging the quarters, metering the quarters throughout the year that first half of 2009 is a lot tougher than the second half or the fourth quarter of ’08 or a lot weaker than the second half of ’09, and so this sort of basically flat outlook, we’re going to have to wait until we get to the fourth quarter of ’09 to really see that all play out, if you see where I’m going Ben.

Benjamin Gong

A lot depends on the general market conditions, and I think that’s the broader economy that Lonnie is referring to. If we are in this situation in terms of capital spending for a long period of time, then we’re just going to be in this period of uncertainly for that long. I don’t know that you could say that we’re going to have more clarity in the second half of the year versus the first half of the year, other than it’s closer to the end, so are you going to be able to predict the finish a little bit better? I guess so.

Frederick A. Wise - Leerink Swann

I know you’re not planning to give quarterly guidance, but it seems to me that in the first quarter, I just don’t know what would change from this sort of tone and mindset of the hospitals that you saw in December.

Benjamin Gong

I see. What I should say is our guidance assumes the same or similar seasonality as we’ve seen in the past, meaning sequentially down in Q1 from Q4. So what’s the metric? I think in Q1 of 2008, we had revenues of about $188 million. We had 74 systems that were sold, so the comparisons that we’re going to be making are against that first quarter, and not against the fourth quarter.

Frederick A. Wise - Leerink Swann

Can you give us any color or could this be an exceptionally weak or the weakest quarter of the year in a profound way than the normal usual seasonal pattern?

Benjamin Gong

We don’t have a lot of clarity in the pipeline, Rick. It’s really hard to predict at this point in time, and I think what Ben told you is the probably the best we can do at this point, which is to just point out that we will see seasonality.

Frederick A. Wise - Leerink Swann

If it turns out as we proceed through the year that 2009 is materially worse than the flat outlook, how would you manage the business differently appreciating that you have this desire to and an appropriate one to invest in the long term development of robitics? How quickly and where could you adjust?

Lonnie M. Smith

We look at cost very carefully, and we’re very prudent about where we spend money. However, as we said earlier to an earlier question, we will continue to invest in our future.

Lonnie M. Smith

In this environment we will focus our resources on those things where we think we can get the greatest leverage, and in the sales organization, probably we will invest more heavily on the clinical side driving procedures. This is going to be something you manage literally on a very tight timer depending upon how things start to evolve. You pick up the Financial Times every morning and just look at what’s on and the announcements today are Microsoft, Intel….This is something we will manage on a short leash. Now, in terms of procedures, we won’t cut out things that we think are fundamental to driving adoption, but we will focus our resources on those things, and some other things we may have to postpone. Depending upon how it rolls out, we will continue to adjust and move. One other thing about being in unexplored territory is that we’ve had to be from the beginning pretty agile. There’s lots of new information coming. There’s not a tried and proven path that everybody goes down. This is new territory, and so I think we’re well equipped to be responsive to the uncertainties of the financial markets that we haven’t had because we’ve been dealing with the same kinds of things with adoption and the technology. If anybody could predict what the end of 2009 is going to look like or 2010, and we can run a lot of different scenarios, one thing we know is we’ve got a strong cash position, cash and investments, so we’re financially in a good position to endure that, and in this market, there are a lot of companies that are not. We tend to be fairly conservative and prudent about those things that we believe are fundamental to our long-term strategy of driving this adoption, but you’re going to have to ride alongside of us. We’re in this together, and we will respond to the market as it comes, and if all of a sudden we start to see it’s coming out of it, we will move resources to do it. If it tends to move down, we will adjust resources within to adjust to that as well.

Frederick A. Wise - Leerink Swann

Mexico you talked about, Marshall, that the initial cost savings were offset by the startup cost. Can you give us any flavor for what kind of incremental annual savings in any shape or form you want to describe it that that could benefit ’09 and be an offsetting counterbalance to some of the things that are going on?

Marshall L. Mohr

Where you save money in Mexico is on labor. The material costs which frankly is the majority of the cost of our instruments is the same whether you’re operating in Mexico or here because the suppliers are the same, so you basically look at the labor content which is not a significant portion of the overall cost, and then you have to think about instruments, and instruments is only a portion of our overall revenues. So from an impact on gross margin standpoint, it is not going to be very impactful, it’s certainly worth a while.

Frederick A. Wise - Leerink Swann

The weakness that you saw in December, is it possible to make any generalizations about it, large hospital versus small hospital, urology more deferred or gynecology?

Benjamin Gong

It really wasn’t any particular segment, if you will, that was seemingly impacted.

Operator

Our next question comes from the line of Tycho Peterson from JP Morgan.

Tycho Peterson – JP Morgan

I have a question on pricing and what you’re assuming in terms of ASP. You talked a little bit about the pricing drop you saw this quarter, and I guess you commented it was a combination of geographic mix and then people migrating maybe toward lower-priced systems. Can you give us a sense as to what you are assuming for ASPs for ’09?

Benjamin Gong

Similar to ’08, and there was a range for all of ’08, and quite coincidentally it came out to be on average about the same as ’07. As exchange rates and different mixes changed during the year, you saw it go up and down, but in the end, it turned out to be about the same.

Tycho Peterson – JP Morgan

On the margin issue, can you remind us what the relative margins are between the three? You gave overall margin guidance for the year, but just give us a little bit granularity on the three pieces?

Benjamin Gong

The gross margins on systems are similar to that of instruments and accessories. The gross margins on service are a little bit lower, and service is going to be growing, let’s say, faster than for example systems. Therefore, that could cause the overall gross margin to be a little bit lower, but not much, for next year.

Operator

Our final question comes from Amit Hazan from Oppenheimer.

Amit Hazan - Oppenheimer

On the procedure side, I just want to get a confirmation that hysterectomy actually grew 150% and that prostatectomy actually grew above 30%. Is that correct?

Benjamin Gong

It is, and roughly speaking we ended up with about 73,000 prostatectomies and something around 34,000 hysterectomies in the year.

Amit Hazan - Oppenheimer

In terms of hysterectomy, are you modeling or expecting or thinking about or have you seen yet any sensitivity to the economy in that procedure in particular?

Benjamin Gong

Interestingly all the procedures grew pretty strongly throughout the fourth quarter. We ended up with 60% year over year growth, 61% Q4 to Q4, and benign versus malignant hysterectomies, again, both of them grew at a very good rate with benign growing faster. Both of them have remainder on our curves, so we have not seen at this point in time, but we do so see some quarter to quarter deviation on and off the curve, but the curves have a very high correlation, so it’s not been significant enough other than noise.

Amit Hazan - Oppenheimer

Is it fair to say in terms of the guidance that you’re modeling along that curve and not expecting any economic issues to hysterectomy?

Benjamin Gong

We are watching it and taking it a month, a day, or a quarter at a time, but so far we have not seen a significant shift.

Lonnie M. Smith

I think what surprised a lot of people throughout the year is that the actual rate and the size growth of benign over malignant was greater.

Amit Hazan - Oppenheimer

On followup on gross margin, and I’m trying to get to your guidance. I’m thinking the mix probably shifts to OUS in 2009 a little bit like we saw in the fourth quarter, and as you said, you have the service component. 70 to 71, like you said, is not far off from what you did in ’08. With that mix shift to OUS, am I missing something? Is there something else that you’re counting on, or do the OUS gross margins actually come pretty close to the US? How do you get there, or is that shift not going to happen? Am I wrong on that?

Benjamin Gong

When we sell through distributors, it’s a lower gross margin. When we sell direct, it’s a little bit higher, so there’s mix shift even within the international. We’re taking, I think, a reasonable estimate as to what that mix is going to be, but we even saw for a example a product mix in Q4 that was a little bit less strong than what you saw in Q3, so there’s definitely going to be some fluctuations in there, and we’d probably be fooling you if we said we could call it any closer than what we just said.

Lonnie M. Smith

As I have said previously, we focus on financial metrics such as revenues, profits, and cash flow during these conference calls, but our organizational focus remains on increasing patient value by improving surgical outcomes and reducing surgical trauma. Two brief examples of what this means in the lives of our patients, the first is a patient of Thomas Randalls, a GYN oncologist at the University of Pennsylvania. This woman was brought to the office by her daughter for treatment for recurrent uterine cancer. One year earlier, she had undergone radiation therapy to the pelvis following an open hysterectomy with bilateral oophorectomy for treatment of uterine cancer involving the vagina. Prior to her visit, she had seen two other GYN oncologists, and the first had recommended further chemotherapy, although this had only about a 20% chance of working, and the second recommended a total pelvic sweep or surgical removal of the entire vagina, bladder, and rectum because after radiotherapy it become virtually impossible to dissect the vagina free from the surrounding structures using traditional surgical techniques. With the da Vinci system, Dr. Randall was able to perform a complete removal of the vagina including the recurrent tumor without injury to the bladder, uterus, or rectum. Surgical margins were negative for cancer, and 4 months later, she is without evidence of recurrence nor of surgical complication. So this is a pretty significant improvement from what her life would have been like if she had not had a surgery with a da Vinci system.

The second patient is a sister of one of our clinical sales managers, and I’d like to read a message that she sent to me. She says Stephanie is 36 years old, married with three children, and the youngest is 2 years old. Her husband is a fireman, and she works part time as a hospice nurse. She has struggled with pelvic pain and abnormal bleeding most of her adult life. After having children, Stephanie’s OB/GYN recommended a hysterectomy, but after performing an exam and completing an ultrasound, was not sure he could perform the procedure minimal invasively. Because of prior open abdominal surgery to remove one of her ovaries when was 16 years old, Stephanie feared having a hysterectomy because she vividly remembered the pain, discomfort, and downtime from her previous experience. Daily care requirements of her three children and the financial implications of an extended recovery period were also serious considerations.

As part-time employee, she didn’t qualify for compensation during her medical leave. She scheduled the surgery with the OB/GYN because she trusted his opinion. She goes on to say after hearing my sister’s situation, I immediately called Dr. Cohen at Ohio State. He shared with her the advantages of robotic surgery and why he would be able to overcome the limitations that may cause other surgeons to perform a total abdominal hysterectomy. He performed the robotic procedure two weeks later. The result: Stephanie was out of the hospital within 23 hours, Christmas shopping four days later, and did 20 minutes on an elliptical trainer one week post-op, and then she goes on to say, P.S., my mother had a TAH 20 years ago and was in the hospital for 7 days.

We are making a difference. Patients like these are our strongest advocates for surgery with the da Vinci system and are the very foundation of our operating performance. In closing, I assure you we will remain committed to focusing on the vital few things that truly make a difference as we strive to take surgery beyond the limits of human hand.

That concludes today’s call. We thank you for your participation and support in this extraordinary journey. We look forward to talking with you again in 3 months.

Operator

The call has ended. Please disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!