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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

Jerry McNamara – Senior Vice President of Sales and Marketing

Analysts

Tao Levy - Deutsche Bank

Ben Andrew – William Blair

David Lewis - Morgan Stanley

Unidentified Analyst

Sameer Harish – Needham & Company

Tycho Peterson – JP Morgan

Vincent Ricci – Wells Fargo Securities

Intuitive Surgical, Inc. (ISRG) Q2 2009 Earnings Call July 22, 2009 4:30 PM ET

Operator

Welcome and thank you for standing by. At this time, all participants are in a listen-only mode until the question-and-answer session of today’s conference. (Operator Instructions). I would now like to introduce your host for today's call Mr. Ben Gong.

Benjamin Gong

Good afternoon and welcome to Intuitive Surgical's second 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; and Jerry McNamara, our Senior Vice President of Sales and Marketing.

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 second quarter results, 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. Gary will follow with operational highlights. Marshall will follow with a review of our second quarter financial results. 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. It has been an interesting 6 months. Despite the challenging economic environment, patients, surgeons, and hospitals continue to recognize the value our products bring to surgery and surgical outcomes. During the first six months, procedures grew by 56%, which compares well with the 50% in the first half of last year. Revenue grew by 12% excluding the revenue deferrals and reversals that will wash out by year end. While this is not the 60% growth we enjoyed in the first half of last year, I consider our ability to remain in positive growth territory during the worst worldwide economic downturn since the Great Depression a significant accomplishment and our team’s operational execution exceptional.

Pro forma operating income year to date before revenue deferrals and non-cash stock option expense grew by 12%. We repurchased $150 billion in stock at an average price just under $107 per share, invested $40 million in capital and intellectual property, reduced working capital by $21 million, and ended the first half with $902 million in cash and investments--equal with year end 2008 and $162 million than this time last year.

As most of you know, we took a $20 million revenue deferral in the first quarter, associated with our offer to customers who purchased Da Vanci S systems in the first quarter to upgrade to the new SI system. We recognized $14 million of that deferral in the second quarter.

I excluded the impact of the revenue deferral in my summary of our first quarter financial performance and will exclude the reversal of deferred revenues in my summary of the second quarter. With that background, operating highlights for the second quarter excluding the $14 million in deferred revenue during the quarter were as follows: Procedures grew approximately 52% over the second quarter of 2008. We sold 76 Da Vinci Surgical Systems, down from 85 in the second quarter of last year. Our international team contributed 20 of the 76 systems sold. We ended the second quarter with 1242 Da Vinci systems installed worldwide. Total revenue was $247 million, up from 13% from last year. Instrument and accessory revenue increased to $94 million, up 28%, and total recurring revenue grew $136 million, up 32% from prior year, comprising 55% of total revenue.

We generated an operating profit of $110 million, before revenue deferral and non-cash 123R stock option expense, up 13% from the second quarter of last year. We ended the quarter with $902 million in cash and investments, up $80 million from last quarter. Significant cash outlays during the quarter include $13 million invested in intellectual property and property, plant, and equipment. Excluding the impact of this outlay, $6 million in cash for stock proceeds and $7 million change in working capital, we generated $80 million in gross cash from operations, $2.07 per fully diluted share and 128% of our GAAP reported net income in the second quarter.

With that, I’ll pass the time over to Gary Guthart, our President and Chief Operating Officer.

Gary S. Guthart

During our last earnings call, we announced the introduction of our new Da Vinci SI surgical system, and during Q2, we had the opportunity to showcase the SI system at several major conferences, which included the American Urology Association, the American College of Obstetrics and Gynecology, the World Robotic Gynecologic Symposium, the American Association of Thoracic Surgery, and American Society of Colon and Rectal Surgery to name a few, with an excellent customer response. Evidence of this response can be seen in the proportion of the SI system sales within our Q2 results, achieving 62% of system sales in the quarter. The improved vision system, enhanced user interface, and dual console capability which expands the surgical training paradigm have been well received in both academic and community medical centers. We will continue to extend the SI product offering to other international markets during the subsequent quarters.

Speaking of the new SI, Dr. Jay Michael Smith, a leading cardiac surgeon at Good Samaritan Hospital in Cincinnati, remarked, “The SI dual console will bring a huge opportunity for robotic surgery in complex procedures, both in the ability to train surgeons in advanced technique and in the ability to work collaboratively during a case. It takes the fourth arm from a static retractor to a dynamic instruments that exceeds the capability of a bedside assistant by giving them articulation and 3-D vision.” Of the new Vision system, Dr. Tim Wilson, an experienced laparoscopic and robotic urologic surgeon at City of Hope Medical Center in Los Angeles reported, “I think this is the best image I’ve ever seen in any laparoscopic surgery.”

For the systems installed to date, the SI has been used in approximately 1000 cases. The SI’s clinical performance and dependability have exceeded our expectations. As always, we remain committed to developing significant products that deliver clinical value to patients, are easy to use, and facilitate repeatable and teachable procedures. We continue to invest in developing novel instruments for our Da Vinci platform and improving and expanding our imaging capabilities and developing new patient side mechanism and in creating surgical networking and training technologies. Our development teams are focused on bringing high clinical value products to the market quickly while our manufacturing organization is relentless in the pursuit of quality, efficiency, cost reduction, and inventory management.

With that, I will turn the call over to Marshall for a review of financial highlights.

Marshall L. Mohr

As reported last quarter, we offered certain first quarter customers the opportunity to upgrade their Da Vinci S systems to Da Vinci SI systems at a discount to the otherwise list price for such an upgrade. We also offered those customers the opportunity to return Da Vinci S accessories in exchange for Da Vinci SI accessories. As a result, we deferred a total of $20.1 million in revenue in the first quarter comprising of $18 million of system revenue associated with the system upgrade offer and $2.1 million of accessory revenue. These customers were given until June 30th to accept our offers.

In our second quarter of 2009, we recognized $13.8 million of the total $20.1 million originally deferred. Nineteen of the 45 system upgrade offers were accepted. $12.4 million of the $13.8 million related to 26 declined system upgrade offers and six completed system upgrades. $1.4 million of the $13.8 million related to accessory exchange offers declined or completed. We expect the remaining first quarter deferred revenue of $6.3 million associated with 13 accepted upgrade offers to be recognized by the end of 2009.

To provide listeners with comparable information, I will now walk you through our revenue results excluding the first quarter deferral of $20.1 million and the second quarter recognition of $13.8 million. Our second quarter revenue was $247 million, up 13%, compared with $219 million for the second quarter 2008, and up 18% compared with $208 million for the first quarter of 2009.

Second quarter revenues by product category are as follows: Second quarter instrument and accessory revenue was $94 million, up 28% compared with $74 million for the second quarter of 2008, and up 16% compared with $82 million in the first quarter of 2009. The change compared with the second quarter of last year was driven by procedure growth of 52%. The change compared with the first quarter reflects increased procedure volume and customer buying patterns.

The amount of instrument and accessory we realized per procedure including initial staffing orders was approximately $1880 per procedure, down approximately $360 per procedure compared to last year and up $90 per procedure compared to the first quarter. The decline in revenue per procedure compared to the second quarter of 2008 reflects lower stocking orders, procedure efficiency as certain customers are using less instruments per procedure, and customer buying patterns. The increase from last quarter primarily reflects customer buying patterns.

Second quarter 2009 systems revenue of $114 million was $5 million lower than the $116 million of systems revenue for the second quarter of 2008 and $24 million higher than the $87 million of systems revenue for the first quarter. We sold 76 systems in the second quarter of 2009, compared with 85 systems last year and 66 systems last quarter. We continue to feel the impact of curtailed hospital spending for capital equipment in the ongoing economic recession, particularly in the US. Fifty-six systems were sold in the US during the quarter, compared with 66 systems last year and 44 systems last quarter. Twenty systems were sold outside of the US, compared with 19 last year and 22 last quarter. Forty-seven of the 76 or 62% of the units in the quarter were Da Vinci SI systems.

Our first quarter average sales price per system including all Da Vinci models but excluding upgrades and the revenue deferral was $1.43 million, and increase from the $1.33 million realized in the first quarter reflecting the 62% mix of Da Vinci SI systems of which five were sold with second consoles.

Service revenue increased to $41 million, up 40% compared with $29 million last year and up 5% compared with $39 million last quarter. The growth in service revenue is primarily driven by a larger system installed base.

Total second quarter recurring revenue comprised of instrument, accessory, and service revenue increased to $136 million, up 32% compared with the second quarter of 2007 and up 12% compared with the first quarter of 2009. Recurring revenue represented 55% of total second quarter revenue compared with 47% in the second quarter last year and 58% last quarter.

Moving on to gross margins, there were no costs deferred in conjunction with the $20.1 million revenue deferral, and therefore, all of the $20.1 million first quarter deferral and the $13.8 million second quarter recognition had an equal impact on revenue, gross profit, operating income, and pretax income. Excluding the impact of the deferral activities, gross margins were approximately equal in the first and second quarters of 2009 at about 71.5% and slightly better than the 71.2% realized in the second quarter of 2008.

Second quarter 2009 operating expenses of $91 million were up 16% compared with second quarter 2008 and up 8% compared with the first quarter. The quarter over quarter increase reflects commissions associated with higher revenue, costs associated with 34 employees added during the quarter, higher non-cash 123R compensation, and increased R&D costs. In addition, patent amortization expense increased to $3.8 million for the quarter compared with $2.2 million during the second quarter of 2008 and $3.5 million last quarter.

Second quarter 2009 operating income was $100 million or 38% of sales compared with $78 million or 36% of sales for the second quarter of 2008 and $45 million or 24% of sales for the first quarter of 2009. Excluding the first quarter deferral and the second quarter recognition, second quarter 2009 operating income was $86 million or 35% of sales, compared with $78 million or 36% of sales for the second quarter of 2008 and $65 million or 31% of sales for the first quarter of 2009.

Second quarter 2009 operating income reflected $25 million of non-cash stock compensation expense, compared with $20 million for the second quarter of 2008 and $23 million last quarter. The increase in 123R expense primarily reflects the impact of our annual option grant made on February 17th.

Our second quarter 2008 other non-operating income of $5.2 million was approximately the same as the first quarter of 2009 and approximately $500,000 less than the second quarter off 2008. Our effective tax rate for the second quarter of 40.4% was slightly higher than our anticipated rate of 40% due primarily to higher state taxes.

Our net income was $62 million or $1.62 per share, compared with $51 million or $1.28 per share for the second quarter of 2008 and $28 million or $0.72 per share for the first quarter of 2009. Excluding the first quarter deferral and the second quarter recognition, our net income was $54 million or $1.40 per share compared with $51 million or $1.28 per share for the second quarter of 2008 and $40 million or $1.02 per share last quarter.

Now moving to the balance sheet, we ended the second quarter of 2009 with cash and investments of $902 million, up $80 million from March 31, 2009, and approximately the same as December 31, 2008. The increase in the current quarter reflects cash flow from operations and $7 million from the exercise of stock options, partially offset by $13 million of capital expenditures. Since December 31st cash flow from operations of $173 million and stock option exercises of $12 million net of capital expenditures of $40 million were entirely offset by $150 million used to buy back and retire 1.4 million shares of common stock.

Our accounts receivable balance increased to $175 million at June 30th, from $139 million at March 31st. The increase in receivables reflects increased revenue. Our net inventory decreased to $59 million at June 30th from $64 million at March 31st. Our inventory declined during the second quarter primarily due to the utilization of material built up to support the Da Vinci product launch.

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

Aleks Cukic

During the second quarter, we sold 76 da Vinci systems, 56 in the United States, 12 in Europe, and 8 into rest of world markets. A total of 5 systems were part of trade-in transactions. The net 71 additions to the installed base brings to 1242 the cumulative number of da Vinci systems worldwide, 916 in the United States, 221 in Europe, and 105 in rest of world markets. Sixteen of the 76 systems installed represented repeat system sales to existing customers, which included a fifth system to Good Samaritan Hospital in Cincinnati and third system to Florida Hospital in Celebration, Florida, and Florida Hospital in Orlando, Florida, and Strong Memorial in Rochester, NY. This brings to 152 the total number of customers who own two or more da Vinci systems. Internationally, we placed 4 da Vinci systems into Germany, 3 into the UK, and 2 into both France and Qatar.

Clinically, we had an excellent quarter. For the third quarter in a row, we had double digit sequential procedure growth, both domestic and internationally. Demand for da Vinci hysterectomy, both for benign and malignant conditions, sacral colpopexy, myomectomy, partial nephrectomy, cystectomy, and da Vinci prostatectomy were most notable. We also experienced early international demand for a number of our general surgery procedures, specifically Da Vinci colon and rectal procedures and Da Vinci thyroidectomy, most of which is emanating from Asia.

In Q2, well over 200 da Vinci related clinical publications and abstracts were published within peer reviewed journals, and as Gary mentioned, our participation within various medical conferences corresponding with the Da Vinci SI launch was very strong.

Over the past several quarters, the management of endometrial and cervical cancer has been one of our largest and fastest growing areas of focus. The clinical value of converting these predominantly open high invasive operations to a minimally invasive da Vinci procedure has become widely accepted. The surgeons at Northwestern University Medical Center in Chicago reported the impact this shift was having on fellowship training at their university. Dr. Anna Hogstra and team authored a paper entitled, “Robotic Surgery in GYN Oncology: The Impact on Fellowship Training” which was published in the May edition of the Journal of Gynecologic Oncology. Prior to the adoption of da Vinci hysterectomy for both endometrial and cervical cancer,

Northwestern’s fellows predominantly participated in open surgery which represented 94.4% of their surgical oncologic training. This percentage corresponded with the level of open cancer surgery within their practice, but three months post da Vinci implementation, the fellows participated in robotic procedures was up to 45%. After six months, 72%; and after 12 months, it was up to 92%. The author summary was as follows, and I quote, “Fellows surgical training underwent a dramatic change with the introduction of robotic surgery program. The management of endometrial and cervical cancer was impacted the most by robotics. Robotic surgery broadened fellowship surgical training, but balanced surgical training and standardized fellow training modules remain challenges for fellowship programs.”

The transition from open surgical oncologic management toward Da Vinci is not limited to US borders. In the May edition of the Journal of Minimally Invasive Gynecology, Dr. Magioni and Piretti from the European Institute of Oncology, a teaching hospital in Milan, Italy, published a paper which outlined their significant shift toward the robotic approach to endometrial and cervical cancer surgery. The authors reviewed patient data from 80 consecutive da Vinci hysterectomies for endometrial carcinoma. Data collected included BMI, operating time, histology, blood loss, conversions and postop pain management. Rather than run through all the numbers and statistics associated with their findings, I’ll sum it up with their conclusion which I believe says enough, and I quote, “Over a relatively short time using the Da Vinci surgical system, we observed a substantial change in our surgical activity. For endometrial cancer, open surgical procedures decreased fro 78% to 35%. Moreover, our preliminary data confirmed that surgical robotic staging for early stage endometrial cancer is feasible and safe. Age, obesity, and previous surgery do not seem to be contraindications.”

The incorporation of Da Vinci into residency and fellowship training programs has become increasingly popular, which we believe represents a meaningful and potentially powerful shift in the training pathway of future attending surgeons, in both the US and abroad.

We’ve not commented much on our cardiac business during the past few calls, but we did see a nice increase in both Da Vinci mitral valve repair and Da Vinci revascularization procedures during the quarter. We’ve always believed that patients evaluate their surgical treatment options using an equation that balances efficacy and invasiveness. There is perhaps no clear example of a more favorable score than that associated with a Da Vinci cardiac procedure. Even though the growth of cardiac category has not mirrored urology or gynecology, the relief from postoperative pain and suffering probably exceeds them both.

In the April edition of the journal Cardiology, Dr. Bonatti and team from Innsbruck Medical University in Innsbruck, Austria, and the University of Maryland in Baltimore set out to evaluate postsurgical quality of life at 3, 6, and 12 months, comparing open revascularization to da Vinci revascularization. The study included 120 patients split pretty evenly between open sternotomy and Da Vinci’s endoscopic approach. Nine patients were converted from an endoscopic approach to a sternotomy which were also assessed postoperatively. The comprehensive analysis evaluated several factors, including but not limited to hospitalization, operating time, postsurgical pain and discomfort, time to resuming normal activities such as taking shower, gardening, riding a bicycle, driving a car, and shopping. The result of the comparisons was pretty dramatic.

Hospitalization for the da Vinci patients was approximately half as long when compared to the open patients. The time to take a shower was reduced from 9.8 days for an open approach to 3.7 days for the da Vinci approach. Gardening was reduced from 54.2 days to 22.2 days, driving a car from 35.5 days to 16.4 days, walking outdoors from 15.5 days to 6.2 days, and riding a bicycle was shortened from 67.2 days to 28.2 days. I think you get the picture. Virtually all quality of life metrics improve significantly incorporating the da Vinci approach. In their conclusion, the authors remarked, and I quote, “TCAB using robotic technology leads to improved physical health, shorter hospital stay, and more rapid restoration of daily activity. Conversion from TCAD to sternotomy does not lead to a quality of life impairment as compared with primary sternotomy.”

Regarding our urology business, we continue to see a tremendous adoption of da Vinci prostatectomy, nephrectomy, and partial nephrectomy, pyeloplasty, and da Vinci cystectomy taking place on a worldwide basis. The agenda at this year’s AUA Conference held in Chicago was a Da Vinci testimonial in and of itself. Presentations, clinical abstracts, live surgeries, postgraduate robotic courses, and booth presentations dominated this year’s conference. The mass global appeal of da Vinci-based procedures within the specialty of urology is truly material. During the 4-day conference, we registered over 1000 urologists at our booth, representing nearly 40 countries. The most popular area of inquiry remained DVP; however, Da Vinci partial nephrectomy, cystectomy, and pyeloplasty are all procedures that are being rapidly adopted.

Among the more interesting abstracts at this year’s AUA pertained to prostate cancer mortality rates following radical prostatectomy, external beam radiation, and primary androgen deprivation therapy. A large multicenter series was derived from the CAPTURE Registry which accrues patients from 31 practice sites prospectively and follows then under a uniform protocol regardless of treatment and follows them through death or withdrawal from the study. 8321 men with localized disease at the time of the diagnosis with at least 6 months followup after radical prostatectomy, EBRT, or PADT were analyzed. The study was authored by Dr. Matthew Cooperberg and the Urologic Oncology Group from the University of California at San Francisco. The study used CAPRA scoring which is cancer of the prostate risk assessment which is a well-validated instrument incorporating PSA, Gleason score, age, percentage of biopsy cores positive, and caner stage. A parametric survival model was constructed to compare outcomes among different treatments adjusting for CAPRA score and age.

It was a very comprehensive and statistically relevant approach toward assessment the various treatment methods. The results: 261 men died of prostate cancer at a median 6.4 years followup. Adjusting for age and risk, the hazard ratio for cancer specific mortality was twice as high for an external beam radiation therapy than for radical prostatectomy and 2.3 times as high for primary androgen deprivation therapy versus radical prostatectomy. The author’s conclusion, and I quote, “Surgery for localized prostate cancer is associated with a significant and substantial reduction in cancer-specific mortality relative to EBRT and PADT. Although not a randomized study, the analysis was adjusted for clinical risk and age, and it is unlikely that the unmeasured cofounders would account for the large observed difference in survival.”

Our strong belief has always been that the removal of the cancerous prostate through surgery is the most effective treatment for patients with localized prostate cancer, especially so when taking into account long-term survival. As patients are diagnosed earlier in life and better informed on their treatment options, we would expect our DVT opportunity to further expand.

This concludes my summary, and I now will turn the time over to Ben.

Benjamin Gong

I’ll be providing an update on our forecast for 2009 based on our results in Q2. First and foremost, procedure growth which is the primary driver of our total revenues continues to be strong. Procedures grew approximately 52% in the second quarter. In our last earning call, we forecasted procedures to grow more than 40% for the year. We are increasing our forecast on procedures to grow more than 45% for the year. This will continue to drive significant growth in our instrument and accessory revenues; however, as we have mentioned previously, variations in initial stocking orders and customer ordering patterns can cause our instrument and accessory revenues to fluctuate and difficult to forecast on a quarterly basis. Therefore, we will not be reinstating guidance for instrument and accessory revenues at this time.

Likewise, while strong procedure growth continues to drive high demand for system sales, the general slowdown in hospital capital spending makes it difficult for us to accurately forecast how many systems we will be selling in the near term. Therefore, we also will not be reinstating guidance on system revenues at this time.

Our service revenue model has been very consistent, and we expect it to remain as it has in the past. We’re generating an average of about $148,000 in service revenue per system per year. Since our revenue is driven largely by the installed base, we continue to expect service revenue to grow approximately 35% this year.

With regard to gross margin, excluding the one-impact of the $20 million revenue deferral in Q1 and the release of a portion of that deferral in Q2, our gross margins have been very consistent with that of previous quarters. Since the balance of Q1 revenue deferral will be recognized the end of the year, the deferral should have no net impact on gross margin in 2009. In our last earnings call, we forecasted our gross margin for the year to come in between 70% and 71%. Based on our gross margins to date, we estimate that gross margin for the year will be approximately 71%.

With regard to operating expense, last quarter we provided a forecast of growing our GAAP operating expense by approximately 17% in 2009. We are increasing our estimate to 18% to 20% growth in operating expense based on two factors. First, we estimate our stock compensation charge for the year to be approximately $98 million compared with our previous estimate of $95 million. Secondly, we’re hiring more field personnel to drive continued procedure growth, and we’re increasing our investments in new and existing R&D projects to drive growth in our long-term business.

With regard to income tax, we continue to expect to report a GAAP tax rate of approximately 40% for the balance of the year. For calculating earnings per share, we ended the quarter with approximately 37.9 million shares outstanding, and approximately 700,000 shares were added to the diluted share count for calculating EPS in Q2. For the balance of the year, assuming we do not repurchase any additional stock, we expect our share count for calculating EPS to be between 38.6 million and 39 million shares. Finally, regarding our cash flows, we continue to generate significantly more cash than our reported net income. For the first six months of 2009, we generated $173 million in cash flow from operations, compared with our reported net income of $90 million over the same periods. The largest contributor of this difference was our recording of approximately $47 million of FAS123R stock compensation expense year to date, and we expect to record an additional $51 million in stock compensation expense in the second half of this year. As a result, our cash flow should continue to be significantly higher than our reported net income.

That concludes our prepared remarks. Before we open the call to questions, we ask that you limit your inquiry to a couple of questions, and for any followup questions, please get back onto the queue. We will 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

On the gross margin side, you’ve given the number of SI that you sold and also your procedure growth. I would have thought maybe you would have seen some sequential improvement, excluding the deferrals, instead of just staying at 71.5%. Is there any scrap material related to the S or anything going on there?

Benjamin Gong

No, really there is not. Even though you have a higher ASP due to the higher price of the SI, the cost of producing an SI system is actually higher than it is for the S, and that’s why the gross margin was very similar even though you have a mix of SIs in the sales mix.

Tao Levy - Deutsche Bank

Aleks, you talked about the paper on prostate caner and long-term survival, have you looked at an analysis on the cost difference between the different therapies, and a question that kind of ties into that maybe for Lonnie because I’m sure he’s got a perspective on it, any thoughts on what’s going on with healthcare reform, the thoughts of comparative effectiveness, maybe having robotics a part of that?

Lonnie M. Smith

Clearly, we have. It’s interesting to me. Proton beam reimburses about $72,000 if you assume 40 treatments which is about the average, and IMRT reimburses, and these are CMS reimbursements, just under $40,000. Brachytherapy around $29,000; and surgery assuming comorbidities and complications is about $10,000. All of those include both the facility fees as well as the surgeon or the physician, and Aleks pointed out those numbers. Actually, there was a longitudinal study of a little over 3000 patients at Henry Ford and found that life expectancy over what you call conservative treatment which will be hormonal treatment or watchful waiting was 4.6 more years of life, and this is age adjusted, disease stage adjusted for radiation therapy, and 8.6 more years of life for surgery. Now, if you do a simple calculation, I’m a simple minded guy, I divide the cost by the number of years of additional expected life, and for proton beam, assuming it’s the same as other radiation therapies is about $16,000 per year of additional year of life, about $9000 for IMRT, about $6000 for seeds, and less than $1000 for surgery. So, in terms of comparative effectiveness and things like that, we’re big proponents of it, especially if it’s a level playing field, and people go into without a preset agenda. So we have some interesting days ahead, but I really do think that comparative effectiveness can lead us to a better place with healthcare both in terms of cost and outcomes.

Operator

Your next question comes from the line of Ben Andrew – William Blair.

Ben Andrew – William Blair

You talked about, I think, a relatively high percentage of de novo systems coming in this quarter in particular. Can you speak a little bit more about what you were hearing from customers and what you think was driving that mix shift?

Marshall L. Mohr

It’s hard to say in a single answer that drove each of them, but what would like to say is if you think about the customers that do not have a da Vinci system and the pressures that they face, for example, radical prostatectomy has moved to what is widely accepted now as standard of care through Da Vinci, if you are not participating in that, you have that impact on your radical prostatectomy program. If you look at the hysterectomy consolidation that is going on both for benign and malignant conditions, if you again have not participated in a robotics program, you have missed that and potentially will miss quite a few going forward, so if you put yourself in a position of a customer that has a system, your participating in it, and now you’re looking at your capacity and what you can do with that system or that second system or third system. If you do not have a system, you’re viewing it a little bit differently, and so I believe that customers are looking at that a little bit closer with really some pain that they are feeling on lost procedures.

Ben Andrew – William Blair

Aleks, did you see anything relative to not as many people adding capacity or are they just working harder to take advantage of the capacity out of the existing system before buying a new one or was there something unusual there?

Aleks Cukic

I can’t answer that, but perhaps Jerry can give you some color on that.

Jerome McNamara

Over the last three quarters as we have gone into this change in the economic environment, we’ve seen customers try to extend the available slots per surgery per day, so they are really looking at their efficiencies and maximizing the number of surgeries before they buy a second system, so we have seen a shift in the buying pattern.

Ben Andrew – William Blair

As you look at the international rollout opportunity for the SI, what percentage of your available market if you will has access to that product and when would you get to broader rollout?

Gary S. Guthart

I guess the areas that we don’t have regulatory approval right now include Asian countries like Korea, China, and of course Japan where we don’t have any approval for any type of system, and then in other parts of the world, Canada, we are still waiting for approval there, and registration in some parts of South America. By and large, we have Europe pretty well covered, and we did sell SI systems in Europe this quarter.

Operator

The next question comes from the line of David Lewis with Morgan Stanley.

David Lewis – Morgan Stanley

Just thinking about revenue per procedure, I know you are not giving obviously a significant new guidance; obviously the procedure numbers were up, but your reversal in revenue per procedure was interesting. Does this indicate signal to that the relative level of destocking pressures have ceded or that the relative mix between hysterectomy and prostatectomy has ceded, so should we expect flat revenue per procedure going forward?

Marshall Mohr

You are right. We are not providing guidance. The amount of instrument and accessory revenue per procedure is going to vary from quarter to quarter based on the number of stocking orders or new system sales and stocking orders associated with it, and customer buying patterns will also have a big influence over it, and we are not ready to predict what those customer buying patterns are going to be for the next few quarters.

David Lewis – Morgan Stanley

Marshall, was there a reason that this quarter would have seen a reversal in that trend, and why that may not be repeatable in a forward quarter?

Marshall Mohr

We believe we have seen in the first quarter particularly and at the end of even Q4 we saw hospitals managing their inventories and their costs very closely, and so we believe they managed them down more so in the first quarter. It’s just not possible for us to predict how much more they need to manage them or will manage them going forward.

David Lewis – Morgan Stanley

In terms of new system placements, the de novo placements in the US market place, can you give us a sense of those? It sounds like 40 new system placements or new version placements. What was the average size of the hospital in terms beds that those systems were placed into?

Marshall Mohr

I don’t know that we have that breakout at this stage. Perhaps later we can give you that information, but I don’t have that available. I can say that we sold to large academic medical centers, and I’m aware of even small hospitals. In fact, even some fairly small hospitals that purchased dual console systems, so I don’t think there is anything remarkable about this quarter versus historical past in terms of size of hospitals.

Jerry McNamara

I don’t know that there is a differentiation on the size of the hospital and a correlation between that and the de novo system purchases. If you want some steps, there are three steps that people typically want. The large hospitals, there are 457 sites with 614 systems. The medium-sized hospitals, 176 sites with 190 systems, and the small hospitals, 100 sites with 112 systems, totaling 733 sites in the US with 916 systems.

David Lewis – Morgan Stanley

You are obviously expanding R&D it sounds like here in the back half of the year, but if you think about a series of deals the company did, some externally and some internally as it relates to attacking single port procedures or better visualization, when can we start seeing some of the significant product launches associated with what seem to a pretty substantial internal focus on this area starting middle of last year?

Gary Guthart

As we’ve said before, we don’t announce timelines for them before they are ready to be launched. In general, our investments are really focused on long term, so a lot of these things are all looking out into the future, both in IP acquisitions and in technology developments that will give us growth into the future.

David Lewis – Morgan Stanley

Let me ask you just one different way. One of your quasi-competitors in the instrument space is thinking of rolling out better articulating instruments in the back half of 2010. Do you think the marketplace as you see it is ready for single port procedures and articulating instruments in back half of 2010?

Gary Guthart

I think we’ve seen in the marketplace already several companies who are looking at single port and articulation. We think that the robotics will have a role to play in single port surgery, so we’ll have to see how they rollout, and we’ll see how we enter the market.

Operator

The next question comes from the line of Rick Wise with Leerink Swann.

Unidentified Analyst

I’m curious to hear how you guys view the mix of the SI versus the standard model systems going forward. Obviously, you have pretty impressive performance for the SI in the first quarter post launch. I’m just wondering does this have to do with teaching institutions purchasing more systems early on, or would you expect this kind of a mix to continue based on the benefits of the system?

Ben Gong

Historically we have seen that a lot of customers like to have the most capable system that we offer, and that happened when launched da Vinci S in 2006, and we see it happening again with the launch of da Vinci SI, so we think the majority of the systems that we sell going forward will probably be da Vinci SI, although we are continuing to sell da Vinci S systems.

Unidentified Analyst

In terms of upgrades of your current installed base, did you see any upgrades in the quarter? Can you help us handicap that opportunity?

Ben Gong

Yes. We made those offers to those Q1 customers which as Marshall mentioned 19 of those 45 offers were taken, and we were capable of installing 6 of those in the quarter, and we will install the other 13 in the latter part. Think of that as a concentrated number of upgrades. Other than that, we’ll probably see some upgrades from the existing customer base that purchased prior to Q1, but it’s probably not going to be a large number each quarter.

Unidentified Analyst

Obviously, you’re increasing investments in R&D and in clinical investments again. I’m just curious as to your thoughts about the environment. Do you feel a little bit more comfortable with the environment in terms of hospital capital spending and economic environment at this point that are you’re taking these actions or has anything changed? Obviously, you’re not updating guidance. Has anything changed in your mind now as of the end of the second quarter versus where you stood in the first quarter of ’09 when you withdrew the guidance?

Lonnie M. Smith

We don’t manage the business or our R&D on a quarter to quarter basis. We really believe that robotics will play a significant role in healthcare and surgery for decades, and we are investing with that kind of mindset, so we aren’t going to pull back because this quarter might be a little bit weaker or something else. We’re investing for the long term. We have been building this business from the beginning that way. We’ll continue to do so. We have high confidence in the long term, and that’s where we are investing for.

Operator

The next question comes from the line of Sameer Harish with Needham & Company.

Sameer Harish – Needham & Company

Did I hear correctly that you sold 5 second consoles in the quarter?

Marshall Mohr

That’s correct.

Sameer Harish – Needham & Company

Do you have an idea or can you talk a little about what you are expecting as far as salesforce expansion in numbers?

Jerry McNamara

We don’t provide the specifics on that. We did add 20 people to the field organization this past quarter, and that was on top of 25 people that we added in the first quarter, and that continues to comprise a large portion of the total headcount we add. That 20 in Q2 was out of a total of 34 people in the company, so we definitely are continuing to hire in the field.

Sameer Harish – Needham & Company

If we look at that international versus US, what do you think is the level of investment that you feel will be necessary for international growth in 2009?

Jerry McNamara

Part of the people that we are hiring are for the direct business in Europe, and we are again continuing to look at various ways of expanding through our distribution channels as well, so we’re investing not just through hiring in our direct business but hopefully investing with our distribution partners as well.

Sameer Harish – Needham & Company

I guess if you look at it as a change from what your expectations were last quarter, is most of that increase directed towards international or is it split pretty evenly?

Lonnie M. Smith

It’s consistent with the metrics that by which we measure the business in the past, so we add clinical heads as per a number of systems that are placed, so we’re sticking to the same metrics that we managed the business last year, the same metrics this year.

Sameer Harish – Needham & Company

Just to switch over to R&D. Again, as we look at it incremental versus last quarter, are you looking to invest more on product development or clinical work to expand indications?

Gary S. Guthart

We really invest in all of those things. We invest in clinical side, we invest in research and in development as well as some IP acquisitions, so you see it in all those buckets. There is not a radical change in which buckets these things go into.

Operator

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

Tycho Peterson – JP Morgan

On the utilization of the SI, is there any change in mix? In other words, are you seeing adoption per procedures beyond what you saw with the traditional S system, and can you also comment on whether you’re seeing any interest, I know it’s early, for the dual console outside the teaching hospitals?

Marshall Mohr

As far as the first question, I don’t think there is enough data at this stage for us to make any or really expect that there is going to be much of a difference in terms of the uptake. I think there are a lot of variables that go into the success and the early success of a program depending on the commitment from the hospital and other factors. The system is certainly designed to improve ease of use and some of factors, but it’s early for us to say that it’s had a material impact on the rate of adoption yet. As far as your second question on the dual console, there were hospitals that were outside of the, call it, traditional larger academic medical centers that did purchase second systems. I should say they purchased dual console systems, and again these took place during the quarter, and we will be able to comment on it more as they become more familiar with a quarter’s worth of usage in the future, but there is definitely interest both within academic medical centers as well as outside within community-based, non-academic medical centers.

Jerry McNamara

But again, it’s really too early for us to give you a call on what percentage our sales are going to include dual consoles.

Tycho Peterson – JP Morgan

Just a followup on the prostate market; obviously with the New England Journal article this spring, there’s been some noise that the number of prostatectomies could be impacted with potential declines in PSA testing overall as well. Can you just comment on whether that’s something that you’re picking up on still or are you still expecting the prostate market to grow significantly in the near term?

Lonnie M. Smith

It’s interesting. During the quarter, there was an AUA gathering of 15,000 urologists from around the world, and I can say that as long as I have been associated with this business, this debate has been going on, and certainly even longer than that, and I think it will continue for sometime in the future. There were some really spirited discussions on it. In our view as we look at it, we don’t look at it as something that is going to materially impact our business one direction or the other at this point.

Gary S. Guthart

The European portion of that study showed that there was improved survival rate, significant survival rate, with PSA testing, and the other part of the study was inconsistent in terms of the consistency of the testing, so at least for me, I’ll be tested.

Operator

The next question comes from the line of Vincent Ricci with Wells Fargo Securities.

Vincent Ricci – Wells Fargo Securities

Aleks, you guys mentioned increased adoption in general surgery, particularly lower anterior rectal surgery in Asia, and I’m just curious, has some of your ability to increase adoption there been around any kind of instrumentation you been working on? You called out some instrumentation that seems to be linked to that.

Aleks Cukic

No. There isn’t anything that the Asian community is getting that is not available in the US market or anywhere else for that matter, and you might be referring to something like a surgical stapler which we talked about developing. There is nothing that’s driving it there. I would say that the growth in the Asian businesses is certainly large, but there is also solid growth in the US business in colorectal surgery. Thyroidectomy on the other hand is largely driven out of Asia, but in terms of the colon and rectal surgery, sort of equal set of instruments globally and good growth going on globally, more so outside of the United States and Asia.

Vincent Ricci – Wells Fargo Securities

Is there any specific dynamic that makes thyroidectomy a good procedure in Asia or is that just more of a cultural thing?

Aleks Cukic

It’s something that they are certainly more sensitive about. They are more sensitive about the scaring that goes on with the operation in a traditional operation which is an incision in the neck, and again it is early for us to really draw a lot of conclusions other than the fact that it is growing very rapidly, and it is growing very rapidly in the Asian countries.

Vincent Ricci – Wells Fargo Securities

Marshall, there has been a lot of talk about tax reform. You guys clearly don’t have a lot of the problems that some companies that might be impacted would have, but you guys have also been talking about longer term tax planning initiatives. Can you just walk us through what we should be thinking about not only in the near term but also 2-3 years out?

Marshall Mohr

A caveat in that is I don’t think the administration is done in their attempts to modify the tax code, so I can only speak to what we have seen so far, and based on what we have seen so far, our previous plans that were laid out are still okay, I guess, is the way to put it, and that means that sometime probably next year you’ll start to see some improvement in our tax rate, and we’re hopeful that we can get it down to like the mid 30s over time.

Vincent Ricci – Wells Fargo Securities

You guys have largely been on a run rate in the mid-teens for repeat placements, and I’m just curious, is there is a certain dynamic that helps drive that consistency there?

Gary S. Guthart

The dynamic that drives the second system placement is really hospital adoption in running out of capacity with their first, second, or third or whatever it might be. I don’t think there is anything that sort of stops it from being more in the mid teens or less than, so I think that’s probably coincidental.

Lonnie M. Smith

That was our last question. As I have said previously while we focus on the financial metrics such as revenues, profit, and cash flow during these conference calls, our organizational focus remains on increasing patient value by improving surgical outcomes and reducing surgical trauma. I hope the following patients’ personal stories in their own words give you some sense of what that means in the lives of our patients. The first is Christie’s story. She says, “On December 15, 2008, I got the devastating news I had cancer. In a whirlwind, I was referred to an oncologist who determined I needed surgery which I had on January 22, 2009. At 2 p.m., my gynecologic oncologist and I had decided to use the da Vinci surgical system because we felt it was the safest and the most likely to provide satisfactory results. I went to sleep, and when I woke up my worst postoperative issue was nausea from the anesthesia. Around 8:30 a.m., my doctor happily discharged with simple but important instructions. Days 1 through 3 postop were spent mostly in bed, except fro a few important walks. By day 7, I no longer was taking even the mild pain pills I was prescribed, and on day 9, with my doctor’s permission, I was back on my treadmill, starting slowly of course. My surgery was an amazing success on several fronts, first because my surgeon had the freedom of movement and visibility, he was able to be sure that he removed all the cancer. I went from having stage 1b grade 3 endometrial cancer to no evidence of disease. By mid February, I formed a cancer advocacy research company. We provide research grants to medical students in our area. I speak to about 2000 people each month, less than 4 months after surgery, about cancer prevention, screening awareness, and about the da Vinci robotic system. It not only saved my life; it saved my quality of life.”

The second is Beth’s story. “I am 30 years old. I was diagnosed with mitral valve prolapse at the age of 14. I went through my teenage years and a portion of my adult life before it needed to be repaired. When I began seeing my current cardiologist, Dr. Michael Bach, years ago, he made me aware that surgery would more than likely be in my future. My regurgitation was moderate to severe. I was as much prepared as I could be. My husband and I were married in October 2008, and the news came less than 2 months after our nuptials. The timing was difficult, but I kept my eye on the picture. My health was most important. We also want children, and my condition at the time would not have allowed it. Dr. Bach referred me to Dr. Douglas Murphy, and I’m forever grateful that he did. The procedure amazed me, and the overall experience was a positive one. There is pain and discomfort with any surgery, but overall it could have been much worse had it not been for the miracle hands of Dr. Murphy and the da Vinci surgery. Three and a half weeks later, I’m already feeling better than ever. My scarring is minimal, which was something that was important to me personally. I can’t say enough about this procedure and the experience I had. I feel so blessed in so many ways.”

Patients like these are the strongest advocates for surgery with the Da Vinci system and are the foundation of our operating performance.

In closing, I assure you that we remain committed to focusing on the vital few things that truly make a difference as we strive to take beyond the limits of the human hand. That concludes today’s call. We thank you for your participation and support on this extraordinary journey. We look forward to talking to you again.

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Source: Intuitive Surgical, Inc. Q2 2009 Earnings Call Transcript
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