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Intuitive Surgical, Inc. (NASDAQ:ISRG)

Q3 2009 Earnings Call

October 20, 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

James Francis – Morgan Stanley

Tycho Peterson – JP Morgan

Tao Levy - Deutsche Bank

Unidentified Analyst

Sameer Harish – Needham & Company

Sean Lavin – Lazard Capital Markets

Vincent Ricci – Wachovia

Operator

Welcome and thank you for standing by. At this time all participants are on a listen-only mode. (Operator Instructions). Now I would like to turn today's call over to Mr. Ben Gong, Vice President of Finance.

Benjamin Gong

Good afternoon and welcome to Intuitive Surgical's third 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 third 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 provide a review of our third quarter financial results. Aleks will discuss marketing and clinical highlights, and then I'll provide an update on 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. Despite the challenging and uncertain economic environment, patients, surgeons, and hospitals continue to recognize the value our products bring to surgery and surgical outcomes. Before reviewing our operating highlights for the third quarter, I’d like to remind you that we took a $20 million revenue deferral in the first quarter associated with our offer to customers who purchased the Da Vinci S system in the first quarter to upgrade to the new SI system. We recognized the remaining $6 million of that $20 million deferral this past quarter. I excluded the impact of the revenue deferral and reversal in my summaries of our first and second quarter financial performance, and will exclude the $6 million reversal in my summary of our third quarter performance.

With that background, operating highlights for the third quarter were as follows. Procedures grew approximately 49% over the third quarter of 2008. We sold 86 da Vinci surgical systems, down from 71 sold during the third quarter of last year. Fourteen of 86 systems were sold to international customers. We ended the third quarter with 1308 da Vinci systems installed worldwide. Total revenue grew to $274 million, up 16% from last year. Instrument and accessory revenue increased to 101 million, up 33%. Total recurring revenue grew to $144 million, up 31% from the prior year, comprising 53% of total revenue. We generated an operating profit of $123 million before non-cash stock option expense, up 16% from the third quarter of last year, and we ended the quarter with $1024 million in cash and investments, up $122 million from last quarter and up $203 million from this time last year after spending $150 million to repurchase stock earlier this year.

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

Gary S. Guthart

As a whole, Q3 has been a productive quarter for our organization with strong progress across a wide variety of activities. In the quarter, we generated $106 million in gross cash from operations which is 165% of our reported GAAP net income and $2.71 per fully diluted share as compared with GAAP net income of $1.64 per fully diluted share. Our significant cash outlays during the quarter totaled $5 million invested in property, plant, and equipment, and we benefited from $1 million change in working capital. In addition, we grew our global ISI team by 64 members in Q3 bringing our total employee count to 1188.

We have seen steady adoption of our SI system in regions in which it is approved, representing 81% of sales in these markets. The introduction of the SI has also catalyzed trade-in transactions for Da Vinci’s standard systems. Architectural improvements in the S and SI have led to procedure throughput increases on these platforms relative to the standard, and with the standard now at two generations behind current products, customers have been motivated to replace standard systems with SI units.

We continue to invest in manufacturing efficiencies with regard to our SI systems and are realizing improving SI system margins. Second consoles were included in 16% of SI sales, and early reports of training efficacy with SI second consoles are encouraging. Several of our customers are evaluating training pathways using the dual console with an eye towards analysis of efficiency and efficacy of training.

Our development teams continue to make progress across several fronts. In new instrumentation, we’re investing in robotic stapling and multi-function energy delivery instruments and in other instruments and accessories that facilitate teachable and repeatable procedures. We are currently piloting training technologies including distance mentoring using the internet as well as surgical simulation for Da Vinci as a way to shorten learning curves and standardize training pathways.

With respect to imaging, we’re working closely with our technology partners to bring to market real-time contrast based imaging capabilities to supplement the 3-D view. These imaging technologies will allow surgeons to highlight anatomic areas of interest within the console endoscopic view. Lastly, our teams are making progress in researching and commercializing mechanisms that will allow for single port robotic surgery.

We’re in discussion with regulatory agencies worldwide seeking approvals for new products and new indications for our Da Vinci system. We’ve seen some positive steps regarding approval in Japan, but we have much yet to accomplish before full commercialization can begin, including granting of approval and import licenses and establishing the payment pathway for relevant procedures. We believe Japan will be an important market for ISI in the medium and long-term and are therefore focused on the successful first approval and import licensing following by building well-trained and successful robotic programs with our early customers.

With that, I’ll turn the time over to Marshall for our financial review.

Marshall L. Mohr

As previously announced, 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. As a result, we deferred a total of $20.1 million of revenue in the first quarter comprised of $18 million os system revenue associated with system upgrade offers and $2.1 million of accessory revenue. In our second quarter, we recognized $13.8 million of the total $20.1 million originally deferred. In our third quarter, we recognized the remaining the first quarter deferred revenue of $6.3 million, as we completed the 13 remaining upgrades in the third quarter.

To provide listeners with comparable information, I will now walk you through our revenue results excluding the deferrals. Our third quarter revenue was $274 million, up 16% compared with $236 million for the third quarter 2008, and up 11% compared with $247 million for the second quarter of 2009. Quarter to quarter, revenue and procedure growth reflected a seasonal slowdown particularly outside the US.

Third quarter revenues by product category are as follows: Third quarter instrument and accessory revenue was $100 million, up 32% compared with $76 million for the third quarter of 2008 and up 6% compared with $94 million in the second quarter of 2009. The increase compared with the prior quarters is driven by procedure growth; specifically procedures have increased 49% compared to the third quarter of 2008. Also impacting instrument and accessory growth are both the number of initial stocking orders and the lower impact that initial stocking orders have on a higher base of instrument and accessory usage.

The amount of instrument and accessory revenue we realized per procedure including initial stocking orders was approximately $1920 per procedure, down approximately $250 per procedure compared to last year and up approximately $30 per procedure compared to the second quarter. The decline in revenue per procedure compared to the third quarter of 2008 reflects the lower impact that initial stocking orders have on an increased installed base and customer efficiency. The increase from last quarter reflects increased initial stocking orders.

Third quarter 2009 systems revenue of $130 million was $4 million higher than the $126 million of systems revenue for the third quarter of 2008 and $19 million higher than the $111 million of systems revenue for the second quarter. Despite the increase in systems revenue, we continue to feel the impact of curtailed hospital spending for capital equipment in the ongoing economic recession.

We sold 86 systems during the third quarter of 2009, compared with 91 systems last year and 76 systems last quarter. Seventy-two systems were sold in the US during the quarter, compared with 71 systems last year and 56 systems in the last quarter. Fourteen systems were sold outside the US, compared with 20 last quarter and 20 last year. Seventy of the 86, or 81% of the units sold in the quarter, were Da Vinci SI systems. Twenty of the systems sold in the quarter involved trade-ins of Da Vinci standard systems, compared to 5 in the third quarter of 2008 and 5 last quarter. We’ve encouraged trade-ins as we believe that the SI system provides clinical and user benefits over Da Vinci standard and increased system usage.

Third quarter system revenue also included $10 million of upgrade revenue compared to $1 million in the third quarter of 2008 and $2 million in the second quarter of 2009. $3 million of the upgrade revenue represented the incremental revenue on the 13 first quarter upgrade offers completed in the third quarter. The remainder of the upgrade revenue was primarily associated with 10 Da Vinci SI upgrades sold and installed in the quarter. Our third quarter average sales price per system including all Da Vinci models but excluding upgrades and the revenue deferral was $1,390,000, a decrease from $1,430,000 realized in the second quarter and an increase from the $1,370,000 realized in the third quarter of 2008. The decrease from the second quarter reflects credits provided to customers on the 20 trade-in transactions and the lower mix of European direct sales.

Service revenue increased to $44 million, up 30%, compared with $34 million last year and up 6% compared with $41 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 $144 million, up 31% compared with the third quarter of 2008 and up 6% compared with the second quarter of 2009. Recurring revenue represented 53% of total third quarter revenue compared with 46% in the third quarter of last year and 55% 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, all of the $13.8 million second quarter recognition, and all of the $6.3 million third quarter recognition had an equal impact on revenue, gross profit, operating income, and pretax income. Excluding the impact of the deferral activities, gross margin in the third quarter was 70.4%, compared with third quarter 2008 gross margin of 71.9% and second quarter 2009 gross margin of 71.5%. The decrease in gross margin reflects inventory reserves recorded to write down certain Da Vinci standard inventory as well as lower system ASPs.

Third quarter operating expenses of $95 million were up 12% compared with the third quarter of 2008 and up 4% compared with the second quarter. The quarter over quarter increase reflects commissions associated with higher revenue, costs associated with 64 employees added during the quarter, and increased R&D costs. In addition, patent amortization expenses increased to $3.6 million for the quarter, compared with $2.5 million during the third quarter of 2008 and $3.8 million last quarter.

Excluding the impact of deferral activities, third quarter 2009 operating income was $98 million or 36% of sales, compared with $85 million or 36% of sales for the third quarter of 2008 and $86 million or 35% of sales for the second quarter of 2009. Third quarter2009 operating income reflected $25 million of non-cash compensation expense compared with $21 million for the third quarter of 2008 and $25 million last quarter. Our third quarter 2009 other income of $4.4 million was approximately the same as the third quarter of 2008 and approximately $800,000 less than the second quarter of 2009. The sequential quarter decrease primarily reflects lower interest due to declining interest rates on investments.

Our effective tax rate for the third quarter of 40.7% was slightly higher than our anticipated rate of 40% due to higher state tax rates. Our effective tax rate for the third quarter of 2008 was 35.7% reflecting R&D credits recorded in the third quarter of 2008 relating to our 2007 tax return.

Our net income was $65 million or $1.64 per share, compared with $58 million or $1.44 per share for the third quarter of 2008 and $62 million or $1.62 per share for the second quarter of 2009. Excluding the impact of deferral activities, third quarter net income was $61 million or $1.55 per share, compared with $58 million or $1.44 for the third quarter of 2008 and $54 million or $1.40 per share last quarter.

Let me quickly summarize our results for the first nine months of 2009, and I’d like to point out that since all of the upgrades associated with Q1 offers were completed by September 30, 2009, the two periods are comparable. Procedures grew by 53% for the first 9 months of 2009 compared to 2008. Total revenue for the first nine months of 2009 was $729 million, up 13% compared with $643 million last year. This included recurring revenue growth of 33% and a decrease in systems revenue of 4%. The decrease in systems revenue reflects the impact of curtailed hospital spending for capital equipment. Operating income for the first 9 months of 2009 was $249 million, up 9%, compared with $228 million last year. Operating income included $72 million of stock-based compensation charges in the first 9 months of 2009 compared with $55 million in 2008. Net income for the first nine months of 2009 is $155 million or $3.97 per share, compared with $154 million or $3.84 per share last year.

Now moving to the balance sheet, we ended the third quarter of 2009 with cash and investments of $1024 million, up $122 million from both June 30, 2009, and December 31, 2008, amounts. The increase during the quarter reflects cash flow from operations and $22 million from the exercise of stock options, partially offset by $5 million of capital expenditures. Since December 31, 2009, cash flow from operations of $269 million and stock option exercises of $34 million was partially offset by IP purchases and capital expenditures of $46 million and the $150 million used to buy back and retire 1.4 million shares of common stock.

Our accounts receivable balance increased to $187 million at September 30, 2009, from $175 million at June 30, 2009. The increase in receivables reflects increased revenue. Our net inventory decreased to $57 million at September 30, 2009, from $59 million at June 30, 2009. Despite growth in revenues, our inventory declined during the third quarter, primarily due to the utilization of material built up to support the Da Vinci SI 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 third quarter, we sold 86 Da Vinci systems—72 in the US, 8 in Europe, and 6 into rest of world markets. We traded in 20 standard Da Vinci systems during the quarter. The net 66 additions to the installed based brings to 1308 the cumulative number of Da Vinci systems worldwide; 968 in the US, 229 in Europe, and 111 in rest of world markets. 37 of the 86 installed systems represented repeat system sales to existing customers which included a sixth system to Methodist Medical Center in Houston, a fifth system to Ohio State University Medical Center, a fourth system to Memorial Herman in Houston, and third systems to USC Medical Center, Johns Hopkins, and Baptist South Florida. Internationally, we placed three more Da Vinci systems into Germany.

Clinically, we had another strong quarter, in what is traditionally a slower procedure quarter. We had excellent sequential growth within several of our targeted procedures. Demand for Da Vinci hysterectomy, both for benign and malignant conditions, continues to lead the way. Also showing strong sequential growth were sacro-colpopexies, myomectomy, partial nephrectomy, thyroidectomy, and Da Vinci low rectal resections. In Q3, over 300 Da Vinci related clinical publications and abstracts were published within peer-reviewed journals—90 within the GYN specialty alone, which speaks volumes when you consider that for all of 2008 there were a total of 50 GYN publications.

In the traditionally slower third quarter, our participation within the various domestic and international medical conferences was abundant, and Q4 is off to a rapid start. During previous calls, I’ve highlighted the growing volume of literature that discusses the benefits of DVH for treatment of endometrial cancer, and this quarter, I will highlight Da Vinci’s growing role within cervical cancer. The results of a multicenter study examining the perioperative results of DVH for treating early stage cervical cancer was published in the journal Gynecologic Oncology.

The study emanated out of Northwestern University, The University of Tennessee, Chattanooga; the University of Wisconsin School of Medicine and Public Health; and the University of Tennessee Health Sciences Center in Memphis. Five GYN oncologists who at the time of their publication had documented the results under an IRB of 835 DVH procedures. From this set of patients, they identified 42 women who required type 2 radical hysterectomy for early stage cervical cancer. Ten of these patients had undergone a type 2 radical DVH, and 32 had undergone a type 3 radical DVH procedure. The results were impressive. The overall average blood loss was only 50 cc. Not a single patient received a blood transfusion. The medium lymph node yield was 25. The average operating time was 250 minutes, with only one patient being converted to a laparotomy. The average hospitalization for these complex radical hysterectomies was 1 day. The authors’ conclusion and I quote “robotic radical hysterectomy is associated with minimal blood loss, a shortened hospital stay, and few operative complications. Operative time and lymph node yields are acceptable. This data suggests that robotic radical hysterectomy may offer an alternative to traditional radical hysterectomy.”

As you know, our greatest market opportunity resides within the benign GYN patient segment, and last quarter the Journal of Robotic Surgery reported a collective series from a GYN group at Rochester General Hospital in Rochester, New York. The study is entitled Robotic Assisted Gynecologic Surgery in a Community Setting. The authors reviewed the outcomes of 110 GYN procedures. 74 patients underwent a DVH with bilateral salpingo-oophorectomy, 18 Da Vinci sacro-colpopexies, 15 da Vinci myomectomies, and 3 da Vinci oophorectomies. The patient group studies had undergone procedures between June 2005 and April 2008. All of the procedures were completed robotically without the need to convert to an open approach. The average procedure time was 135 minutes, with an average blood loss of 160 cc.

There was only one intraoperative complication which was repaired robotically, and the mean hospital stay was 1 day, with over half of the patients being discharged within a 24-hour time period. Postoperative pain levels ranged from 0 to 6 on a 10-point scale and was relieved by non-steroidal anti-inflammatory drugs. The overall complication rate for their hysterectomy patients including intraoperatively and postoperatively was 7%, which is very low when compared to the reported 26% and 22% complication rate for abdominal and laparoscopic hysterectomy respectively.

In their conclusions, the authors wrote and I quote, “Robotic assisted laparoscopy for benign surgical procedures are feasible techniques in a community setting. Robotic assisted laparoscopy has a promising future in minimally invasive surgery as it has proved beneficial for our patients who experience low complication rates and overall fast recovery when compared to other approaches.”

Da Vinci partial nephrectomy is rapidly emerging as an alternative to both open partial nephrectomy and laparoscopic partial nephrectomy. The largest multicenter experience to date comparing 129 consecutive Da Vinci partial nephrectomies to 118 consecutive laparoscopic partial nephrectomies was recently published in the Journal of Urology. The study represented the experiences from Washington University in St. Louis, the Vattikuti Institute at Henry Ford Hospital in Detroit, and NYU Medical Center. Comparison of the operative data revealed no significant differences in the overall operative time, collecting system entry, pathologic tumor size, and positive margin rates between the two cohorts. Intraoperative blood loss was less in the robotic cohort, as was the length of the hospital stay, but most importantly, warm ischemic times were significantly shorter in the Da Vinci series—19.7 minutes versus 28.4 minutes. Subset analysis based on complexity revealed that tumor complexity had no effect on operative time or estimated blood loss in the Da Vinci series, although complexity did affect these factors in the laparoscopic partial nephrectomies. There were no intraoperative complications in the Da Vinci group compared to one intraoperative complication in the laparoscopy group.

The authors concluded by saying and I quote, “Robotic assisted partial nephrectomy is a safe and viable alternative to laparoscopic partial nephrectomy, providing early equivalent oncologic outcomes and comparable morbidity to traditional laparoscopic approach. Moreover, robotic assisted partial nephrectomy appears to offer decreased hospitalization as well as significantly less intraoperative blood loss and shorter warm ischemic time, the latter which may help to provide maximum preservation of renal reserve. In addition, operative parameters for robotic-assisted partial nephrectomy appeared to be less effected by tumor complexity compared to laparoscopic nephrectomy. Interestingly, while the advantages of robotic surgery have historically believed to aid laparoscopic naïve surgeon, these data indicate that robotic-assisted partial nephrectomy may also benefit experienced laparoscope surgeons.”

Last week, JAMA published a study entitled Comparative Effectiveness of Minimally Invasive Prostatectomy Versus Open Radical Prostatectomy which claimed that minimally invasive radical prostatectomy was associated with higher rates of incontinence and erectile dysfunction than open radical prostatectomy. While we don’t take issue with the study’s data, it’s easy to question the study’s design, written conclusions, and the media’s interpretation of these conclusions.

To summarize, the study evaluated the results of 3 distinct surgical techniques—traditional laparoscopic prostatectomy which has a history of higher rates of incontinence and erectile dysfunction, robotic prostatectomy, and open retropubic prostatectomy between the years 2003 and the first part of 2006. Here is the challenge: Without differentiating between lap and robotic techniques, the study blended them into a single minimally invasive radical prostatectomy cohort and reported it as such. There was no way to determine the ratio between laparoscopic and robotic cases since at the time in question CPT code 55866 incorporated both lap and robotic techniques. Moreover, there was no baseline established for the patients’ pre or postoperative condition using any validated quality of life instrument since all the information was extracted from CPT data. When you consider the facts associated with the study, it is perplexing that someone could conclude that DVP was associated with more incontinence and erectile dysfunction than open prostatectomy.

Be that as it may, I suspect that the greater urologic community has recognized the inconsistencies and faults between the study design and its conclusion, but it is the patient in our opinion that has been done a great disservice by the media’s portrayal of this inconclusive JAMA report.

In any given quarter, peer-reviewed urological journals address this very topic, and last quarter was no different. In the British journal of urology, Dr. Vincenzo Ficarra and his team from the Department of Oncologic and Surgical Sciences at the University of Padova in Padova, Italy, published their results from a prospective nonrandomized trial comparing robotic-assisted radical prostatectomy to retropubic radical prostatectomy.

The study enrolled 208 men; 105 received an open retopubic radical prostatectomy, and 103 received da Vinci prostatectomy. When comparing blood loss and blood transfusions between the two cohorts, the da Vinci group experienced 40% less blood loss and 86% fewer transfusions than the open route. Complications and positive surgical margins were similar, but the most significant difference between the two groups was in the area of postsurgical incontinence and erectile function. For urinary continence, 41% of the open patients and 68% of the da Vinci patients were continent at catheter removal. The 12-month continence rates were 88% for open patients and 97% for the da Vinci group with a mean time to continence being 75 and 25 days respectively.

At the 12-month followup, 49% of the men having a bilateral nerve sparing open procedure and 81% of the men having a da Vinci bilateral nerve-sparing procedure had recovery of erectile function. The conclusion and I quote, “robotic-assisted radical prostatectomy offers better results than retropubic radical prostatectomy in terms of urinary incontinence and erectile function recovery with similar possible surgical margins.”

That concludes my remarks, and I will now turn the time over to Ben.

Benjamin Gong

I’ll be providing an update on our forecast for 2009 based on our results in Q3. Consistent with the previous two quarters, I’ll provide a forecast for procedure growth, but will not be providing specific guidance on system or total revenues. Procedures were strong in the third quarter, despite the seasonal slowdown we see every summer particularly in Europe. Procedures grew approximately 49% in the third quarter compared to last year. In our last earnings call, we forecasted procedures to grow more than 45% for the year. Given our current run rate, we should exceed 200,000 procedures for the year; that’s more than 47% higher than the 136,000 procedures we completed last year. This continues to drive significant growth in our total instrument and accessories revenue this year. However, as we have mentioned in our previous calls, variations in initial stocking orders and customer ordering patterns can cause our instrument and accessory revenues to fluctuate on a quarterly basis. In the longer term, instrument and accessory revenue growth should more closely match our growth and procedures.

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 $140,000 in service revenue per system per year. With regard to gross margin, we have been consistently at about 71% over the past two years. While margin could fluctuate quarter to quarter due to product and geography mix, we expect it to remain at about 71%.

Moving to operating expense, we are reiterating a forecast of growing our GAAP operating expense by approximately 19% in 2009. We are continuing to move higher resources in the field to drive procedure growth in the near-term, and we're continuing to invest new and existing R&D projects to drive growth in our long-term business. Other income, which is mainly comprised of interest income, has been decreasing slightly due to lower interest rates on our cash investments. We expect other income to remain at approximately $4 million for the fourth quarter.

With regard to income tax, we have recorded a tax rate of 41% year to date, and it is likely to remain at approximately this rate for 2009. We are working on setting up processes that would allow us to start reporting a lower tax rate sometime in 2010. Our share count for calculating EPS increased from Q2 to Q3 by approximately 700,000 shares, primarily due to the recent increase in our stock price. We ended the quarter with approximately 38.2 million shares outstanding, and approximately 1,000,000 shares were added to the diluted share count for calculating Q3 EPS. For the fourth quarter, we expect our share count for calculating EPS to be between 39.5 and 39.8 million shares.

Finally regarding our cash flows, we continue to generate significantly more cash than our reported net income. We generated $96 million cash from operations in Q3, compared with net income of $65 million. Year-to-date, we generated $269 million in cash flow from operations compared with our reported net income of $155 million over the same period. The largest contributor to this difference was a recording of approximately $72 million of non-cash stock compensation expense year-to-date, and as we mentioned last time, we expect to record another $25 million in the fourth quarter. As a result, our cash flows will continue to be significantly higher than our reported net income. That concludes our prepared remarks. We will now open the call to your questions.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of James Francis with Morgan Stanley.

James Francis – Morgan Stanley

It looks like the OUS results that you had were the weakest that we have seen in some time. What else can you tell us about the source of this sequential decline from Q2? Is there a specific country where orders did not materialize or are you seeing some seasonality in EU? Is the CapEx spending cycle bottoming out OUS maybe with a lag from the US cycle?

Lonnie M. Smith

James, I think a little of everything you said has probably affected our Q3 numbers. First off, Q3 is historically a slow quarter in Europe. There are a lot of vacations both from a patient’s side, although our procedures remain strong, just putting deals together is always more challenging, but I think on top of that, without question, there is some recessionary activity being felt in Europe, and I don't think it's the same in any country as evidenced by Germany having three systems for example this quarter while other countries did not contribute, so I think we really attribute it to nothing really structural other than some forces that work against us OUS in Q3.

James Francis – Morgan Stanley

Getting back to the JAMA study, if you think about the clinical data published on Da Vinci, it’s not been sponsored by the company and much of it tends to evaluate the single center experience. After the JAMA study came out last week, how much sense does it make for Intuitive to sponsor clinical work, particularly larger, more multi-center trials that can demonstrate the real value of technology?

Lonnie M. Smith

Our position has always been that the data will come, and it'll probably come in forms that people become accustomed to, meaning multi-centered trials and surgeons working together to put together multi-centered trials. In fact, we're seeing some of that and you saw some of that, and actually I referenced it in the GYN oncology site. One of the challenges of rapid multi-centered trial is going to be the source of information. For example, you could do a retrospective analysis and observational study using CPT codes, but the medical community doesn’t really look at that as really good solid evidence-based medicine, and so I think what you're asking for will happen, and perhaps there are some things we can do to help it, but I think it has always been our belief and remains our belief that staying out of good clinical evidence is probably not a bad position for us to take.

James Francis – Morgan Stanley

On the hysterectomy market, you mentioned that you have been seeing doctors that sometimes may start out doing their more complex cases on the robot and then gravitate towards using robot exclusively. Are you starting to think that maybe the initial market that you identified for hysterectomy, that is the 250,000 oncology and complex benign, might really be bigger or could it be closer to all practicing GYNs or operating GYNs?

Lonnie M. Smith

I think the way we have really looked at that and the way we have sized it is, you have heard us not waver our position where we talk about the surgeon value equation, and we know that the highest surgeon value equation that we can help contribute comes from those very complex cases, and that's where we are going to start. Does that mean that we can’t get to all of the hysterectomies? You know it really doesn't. There are non-complex cases that people have gravitated with Da Vinci, and I think that's great, but we feel very strongly about the patient value of that. They contribute to the open hysterectomies when we can convert them to minimally invasive, and we’ll see where it goes. It may turn out that we were wrong, and the market can be significantly larger, but I think it's early for us to say that.

Operator

The next question comes from the line of Tao Levy with Deutsche Bank Securities.

Tao Levy – Deutsche Bank Securities

On the upgrades that happened in the quarter, the 20 systems, can you maybe walk through the benefits for Intuitive of a hospital converting from a standard to an SI? Maybe you can walk us through the different segments within your P&L, the benefit on the system side, any impact on disposables, service, how do those metrics change?

Lonnie Smith

As Gary mentioned with the announcement of SI, those old standards are now two generations behind, and there is a dramatic difference between the first system that we came out with standard to the SI, and the ease of use is dramatically different in terms of changeover, the whole feature set, and what we have seen is as we track procedures for system, even going from standards to S’s, we see that S’s are more heavily used than standards, and we believe SI will follow that pattern, and so then as I look at it, I assume replacement market. US domestic, I assumed about an eight-year life, and that after 8 years those things will start to be turned in, and I think that is not far off. It is a little longer for international, and so we clearly would like to get, and hospitals want to standardize too, because they want to buy a second system, and so when they buy the second system, they prefer to have one consistent with the other so that surgeons can move from one to the other because the interface is a bit different, so in my personal view and I think our view as an organization is that this is a good thing for us and a good thing for the hospitals as they move to a more capable, easier to use system that is consistent from one OR to the next in terms of the metrics, in terms of disposables, or accessories. I don't think there is a lot of difference, but I’ll let Ben answer that.

Benjamin Gong

On a recurring revenue basis, on the instruments and accessories, they are very similar—the standard system and an SI—but as Lonnie mentioned, on average we think we are getting higher utilization in general on the newer technology than the other ones. There's a small increase in the service revenue on the SI’s versus the standard, so we are going to benefit from that, but it's not terribly a large amount, but it is beneficial.

Tao Levy – Deutsche Bank Securities

On Japan, is there anything else that you can tell us in terms of the next steps that you're waiting for before final approval, and also what is the process for import licensing that you're waiting for after approval?

Gary Guthart

We need a few things. We need to receive the Shonan which we think is in process, but has not been done yet. Then there are import license restrictions that you have to clear, so you have to get an import license. There are some supplier audits and other internal things that have to be completed before you can ship into the country, and then we are working on what the payment pathways are for various procedures, so those are really the big chunks that have to be done.

Tao Levy – Deutsche Bank Securities

How long is the import part?

Gary Guthart

I am not really able to give you an exact timeline in each of these steps. They are in months.

Tao Levy – Deutsche Bank Securities

Historically, when the dollar has been weak, Ben, is there any correlation with increases in international sales because theoretically you're getting a system for a little bit cheaper if you’re paying in foreign currencies?

Benjamin Gong

Remember when we are selling direct into Europe, we’re selling in the local currency, so from the customer’s standpoint, they may not see that much difference, but it's true when we're selling to distributors. We do sell in dollars, so it could help in some way with the distributors perhaps being more able to sell systems at a different price.

Operator

Our next question comes from the line of Tycho Peterson with J.P. Morgan.

Tycho Peterson – J.P. Morgan

Following up on the last questions on Japan, I understand that there are a lot of uncertainties in the near-term on the timelines. Can you just give us a sense longer term how you are thinking about the market opportunity? Is there any potential mix shift here? Would it be larger for dual console versus the US opportunity and also how you are thinking about pricing? Obviously, they tend to reimburse fewer devices but typically at a higher level, so how you’re thinking about the ASP opportunity over there?

Gary Guthart

Let me answer the first part, and then Ben can answer the next. The system is going through approval in Japan as the S, not the SI, and that just has to do with the timing of the whole process and how long it is taking to go through our approval process, so no dual consoles there. In terms of pricing in mix, I think Ben can speak to it more than I.

Benjamin Gong

As Gary mentioned, it is Da Vinci S that we’re slated to get approval on, so you might want to think in terms of that. The historical pricing that we have been getting on S is probably what we are going to be getting over there. The second part had to do with the market size?

Gary S. Guthart

Segmentation, and I think the way we are thinking about segmentation, again based on the earlier comments, there is not going to be a lot of system segmentation, but the procedures that you look at when you look at the Japanese market perhaps are a bit different than you’re used to seeing in the US. It has to do probably with more GI surgery including gastric cancers and a high esophageal and colorectal cancers, and probably fewer prostatectomies on a per capita basis since prostate cancer does not affect Asian men at the same level as it does Europeans and Americans, so it will be interesting to see how that all unfolds because it is going to be a little different than the United States market or the European market in terms of those patient targets. We think collectively it represents a big opportunity, and we will see how it unfolds and how we segment our resources.

Benjamin Gong

One thing I didn’t mention is we do plan on selling through a distributor in Japan, so again the pricing that we’ll be getting is going to be consistent with the distribution pricing that we’ve had in other places.

Tycho Peterson – J.P. Morgan

On the R&D priorities, I think, Gary, in your comments you talked a little about real-time imaging capabilities. I’m just wondering if you can elaborate a little bit more on that. Is there an effort to bring on more of a consumable stream into the mix with imaging agents, and then can you also just talk about some of the initiatives to move up and down the value chain? I think you talked about some hand-held instruments with the SurgiQuest deal earlier this year. I was just wondering if you could update on some of those partnerships.

Gary Guthart

On the imaging side, we don’t think there will be a substantial change in terms of the consumable mix with regard to imaging. We think it will give us better clinical outcomes by allowing surgeons to see through tissue planes that they can’t otherwise see through, things like vasculature, lymphatics, things like that, so it really is a value-add relative to the instrumentation that’s there already. With regard to SurgiQuest, we’re not getting into hand-held instrumentation. That isn’t part of our strategy, and so in all the partnership deals that we have been doing, it really has been about bringing into robotic surgery technologies that we think are complementary and lead to better outcomes or fast procedures, and so we continue to do that. I think our teams are working well with our technology partners, and those are complex programs, but I think they are high value.

Tycho Peterson – J.P. Morgan

Lastly on the inventory management issues, have we from your sense worked through the worst of it? Obviously, it looks like revenues per procedures are up this quarter and that’s reflective of inventories coming up a little bit, but what is your sense going forward as to where we are from a management perspective from your customers?

Benjamin Gong

That’s a hard one to tell. One thing that stood out to us was in Q1, there seemed to be some active inventory management among our customer base, and in

Q2 and Q3, it seemed to be less so, but I think that’s something that’s just going to be subject to fluctuation.

Operator

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

Unidentified Analyst

We recently had a very short survey that seemed to indicate a little bit more interest in upgrades, meaning the current S systems being upgraded to the SI, and certainly you do have some upgrades this quarter. Is this a real opportunity that we should think about, and is there a way to handicap that?

Benjamin Gong

I would say that we were pleasantly surprised with the number of upgrades we had. Again, to review of the 23 that we had, 13 of them pertain to the first quarter offers, but the other 10 were upgrades, and that was a pretty fair chunk of revenue. I think it’s hard for us right now to judge how many we’re going to get on a quarterly basis. We’ll probably want to monitor it a little bit more.

Lonnie M. Smith

I think the place where we’ll often see it is when somebody buys the new SI, and they have an S and they like to make it consistent for surgeon use and for the OR staff, and so that’s the ideal time to upgrade an S to an SI.

Benjamin Gong

Of those 10, a fair number of those were at the same time that an existing customer was buying another system, and they wanted to upgrade their existing system at the same time.

Unidentified Analyst

I know you are not ready to comment on the timeline in Japan, but is it feasible to think at this point that we’re going to see placements in Japan sometime in 2010 or is it more of a longer term opportunity?

Gary Guthart

We’re working it down. I don’t think you’ll see an explosion in 2010 but we are hopeful that we can get some systems in.

Unidentified Analyst

Maybe later in the year rather than earlier?

Lonnie M. Smith

Time will tell.

Unidentified Analyst

On JAMA study that just came out, I appreciate the feedback, and you can certainly question the methods and the conclusions for the study, but I am curious to know if you expect any impact on procedures. I know a lot of times it happens when patients read the paper that’s what they see and they don’t actually read the actual study or look at the actual data. Do you expect to see any impact on the volume of prostatectomies you currently get because of the study?

Aleks Cukic

I think you’re right. I think patients read headlines and make conclusions, but thankfully what we have found thus far is that the urologic community, which I think is ultimately the strongest source for these patients as they are conversing with their doctors and their physicians are aware of the faults if you will of the conclusions and I think as the data disseminates, I think it will ultimately help influence the patient’s decision. I’ll say that I don’t know exactly how to answer your question with a definitive position because it is forward looking, but our belief is and the people we have spoken to the clinicians did not put a lot of weight into that study, and I think their impact on the patient’s decision is going to be important.

Operator

Our next question comes from the line of Sameer Harish – Needham & Company

Sameer Harish – Needham & Company

Just want to followup a little bit on the investments you’re making in R&D and sales and marketing. Just in general terms can you talk a little bit about the longevity of these investments? Do you expect to continue to be increasing these as a percentage of revenue into next year or is this likely to be completed this year?

Lonnie Smith

I think on the R&D side, we will expect to continue to increase investments in revenue at a pace about what you’re seeing as a percentage of revenue, and we invest on multiple time horizons, from things we expect to be out in months to things we think will take many years to develop and come to fruition.

Benjamin Gong

On the SG&A side in particular with the field, we added 30 people into the field this past quarter, and we have not really slowed down in our hiring. Again, as we place more systems out there and we have this 49% procedure growth year over year, it requires us to have a lot more people out there in the field, so we plan to continue to hire people in the field at a pretty good pace.

Sameer Harish – Needham & Company

I don’t think you guys gave an update on the share buyback, but could you talk a little bit about use of cash going forward?

Lonnie Smith

It has not changed from what we have said in the past. The cash is there for growth opportunities and flexibility. We’re glad we got it, and to your question, we have not made a decision on what we are going to do with the remaining authorization we have gotten from the board, but we keep it in mind, and over time if we believe that the cash is excess to our needs, we’ll return it to shareholders similar to what we have done in the past.

Sameer Harish – Needham & Company

Is there more interest in licensing or acquisitions in the future, and if there is, could you talk about potential area?

Lonnie Smith

We continue to enjoy the flexibility that the cash gives to license things that we think are a good fit to us, and we’ll continue to do that. On the other hand, it’s not burning a hole in our pockets to go invest it when we are not ready to do so.

Gary Guthart

We don’t think it’s particularly useful to telecast the things we are looking at or interested in looking at.

Operator

Our next question comes from the line of Sean Lavin with Lazard Capital Markets.

Sean Lavin – Lazard Capital Markets

Just a couple of quick question with help with modeling, can you tell us what the average price was on the SI upgrades, what portion of these upgrades had a second console and how much of a discount do you give to hospitals trading in an old non-S system?

Benjamin Gong

Even though we don’t give you the specifics on that Sean, maybe I can help you a little bit. The $10 million we had in upgrade revenue, I think $3 million of that had to do with the 13 that were from Q1. The remaining $7 million was primarily the other 10 upgrades, but we also had some fourth arm and HD upgrades, something on the order of $1 million of that, and there were actually as you pointed out a couple of second consoles that people bought a la carte let’s say, all in that extra $7 million.

Sean Lavin – Lazard Capital Markets

Any help on what kind of discount you give to people trading in the old systems?

Benjamin Gong

We’re not specific on that. We do give them a credit, and you notice when you have a large number like 20 of them, that in combination with fewer direct sales into Europe caused our ASP to go down by about $40,000 from last quarter to this quarter.

Sean Lavin – Lazard Capital Markets

If you could quantify the inventory writedown that you talked affecting margins?

Benjamin Gong

It was a little less than $2 million.

Operator

Our next question comes from the line of Vincent Ricci – Wachovia.

Vincent Ricci – Wachovia

Generally speaking, the procedures you guys have been most successful for, these have been open procedures, you’re converting to minimally invasive such as prostatectomy or the oncological hysterectomies. You’re targeting colorectal and general surgery, you guys have talked about it on and off as being a good procedure for you guys, but also Covidien and Epicon have discussed these procedures as well. Maybe can you differentiate for us that these are different procedures that guys are looking at and if there is a different strategy attacking this area?

Aleks Cukic

I can’t comment on their strategy, but I would say this that if my history is right, the first laparoscopic colon procedures were reported on in the early ’90s. I recall when some of them were being done then, and here we are 16 years later, and there is a light penetration in overall colorectal procedures. For many reasons, the prostatectomy business had gone really unpenetrated with general laparoscopy. It’s difficult to do, and so what I think you see in today’s laparoscopic colorectal is you see a lot of right colons and perhaps some transverse, and you start getting less penetration as you go down the colon and get into the low rectal procedures. It’s not by coincidence that that’s probably one of our fastest areas of growth because it’s very difficult to do laparoscopically, and some of the early adoption in da Vinci is starting there, so that’s fairly similar is that we are starting in the more difficult places where I would say that laparoscopic is started in some of the easier places, so we’ll see where that ultimately goes. I think when you look at improving visualization, you can improve the necessary suturing, manage vascularity differently, and do more precise surgery which tends to come with robotics over laparoscopy and in Intuitive motion and motion scaling and everything else. You tend to put yourself in good position to get those procedures, so we know we need a few extra instruments, we’re working on those instruments, and we’ll see where that goes.

Vincent Ricci – Wachovia

As long as you’re talking about instruments, Gary, quickly mentioned the stapler? Can you guys talk a little bit about the progress there?

Gary Guthart

We’re working down the heart of the development pathway here, so we know what we want to do and we are in the middle of doing it, and that’s about what I can tell you right now. I think so far so good.

Vincent Ricci – Wachovia

Maybe just looking at this from slightly different standpoint of metrics that you guys have given in the past, could you possibly talk to us about kind of what your clip is on training doctors historically over the last couple of quarters?

Lonnie Smith

Training doctors has been pretty consistent. Generally pretty high.

Gary Guthart

I think you should think of our training initiatives as one big bucket, but within that bucket, there is going to be a mix. In other words, you can imagine that ’04, ’05, ’06 had a huge urology focus in that training whereas ’07, ’08, ’09 probably has more GYN, and so on and so forth. I think that will be the nature of our training programs as procedure targets change and procedure opportunities grow, you’ll see that change, but overall, training is very important to us. It’s very important to our customers, and we plan to do it as much as we can in the area of training.

Lonnie Smith

As I previously said while we focus on financial metrics such as revenues, profits, and cash flow during these conference calls, our organizational focus remains on increasing patient value by improving surgical outcomes and reducing surgical trauma. One of our metrics for patient satisfaction is a survey of patients who have contacted da Vinci surgeons through our physician locator. This is a blinded survey, so we don’t know the identity of the patients or their surgeons, but the patients who responded as having had a da Vinci procedure, 93.2% were extremely satisfied or very satisfied, and when asked if they would recommend the procedure to other people in the same situations as themselves, 100% of the GYN and general surgery patients and 98.1% of the prostate cancer patients responded, yes, they would recommend it to others. I hope that the following patient’s personal story will give you some sense of what this means in the lives of our patients.

I’ll start with John. John is a 65-year-old engineer from Mascot in the United Kingdom. He said he was shocked when he received his PSA score and set out to read everything he could about prostate cancer including Dr. Walsh’s book. Having looked at all the competing therapies including radiation, he came to the conclusion that having the cancer removed was the most definitive option, but was very concerned about urinary incontinence. He believed that finding the right surgeon was the key to minimizing potential risks. The result, even though the cancer was more widespread than originally thought, all postoperative tests have come back negative, and urinary control returned 8 days post operation. For John, the final benefit of his da Vinci prostatectomy was that he able to compete on one of his vintage motorcycles in an event 2-1/2 weeks after his surgery.

The second patient, Greg, required major surgery to treat pancreatic cancer surgery in which the pancreas, gallbladder, duodenum, and lower part of the stomach were removed followed by major reconstruction; it’s called the Whipple procedure. Greg chose to have his surgery at the Cleveland Clinic because they would perform it minimally invasively with the da Vinci Surgical System. A few weeks after surgery, Greg visited Detroit and met another patient who had had the same procedure with open surgery. He commented on the stark contrast of their individual experiences post-operation. Six months after the surgery, the other patient still had not returned to work. In contrast, Greg said, 2 weeks after his surgery, he was walking through a mall and visiting a bookstore. Patients like these are the strongest advocates for the surgery with the da Vinci system and are the very 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 surgery beyond the limits of the human hands. 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.

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Source: Intuitive Surgical, Inc. Q3 2009 Earnings Call Transcript

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