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Intuitive Surgical, Inc. (NASDAQ:ISRG)

Q2 2014 Earnings Conference Call

July 22, 2014 4:30 PM ET

Executives

Calvin Darling – Senior Director, IR

Gary Guthart – President and CEO

Marshall Mohr – SVP and CFO

Patrick Clingan – Director, Finance

Analysts

Ben Andrew – William Blair

David Roman – Goldman Sachs

Robert Hopkins – Bank of America

David Lewis – Morgan Stanley

Tycho Peterson – JPMorgan

Tao Levy – Wedbush

Richard Newitter – Leerink

Operator

Ladies and gentlemen, thank you for standing by and welcome to Intuitive Surgical Q2 2014 Earnings Release Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. (Operator Instructions) And also as a reminder, today’s teleconference is being recorded.

And at this time, I will turn the conference call over to your host, Senior Director of Investor Relations, Mr. Calvin Darling. Please go ahead Sir.

Calvin Darling

Good afternoon, and welcome to Intuitive Surgical’s second quarter earnings conference call. With me today, we have Gary Guthart, our President and CEO; Marshall Mohr, our Chief Financial Officer; and Patrick Clingan, Director of Finance.

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, including our most recent Form 10-K filed on February 3, 2014 and 10-Q filed on April 25, 2014. These filings can be found through our website or at the SEC’s EDGAR database. 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 intuitivesurgical.com on the Audio Archive section under our Investor Relations page. In addition, today’s press release and supplementary financial data tables have 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.

Gary will present the quarter’s business and operational highlights. Marshall will provide a review of our second quarter financial results. Patrick will discuss procedures and clinical highlights, then I’ll provide our updated financial outlook for 2014. And finally, we will host a question-and-answer session.

With that, I will turn it over to Gary.

Gary Guthart

Thank you for joining us on the call today. I’m encouraged by several trends relative to the first quarter of the year. First, global procedures grew 8% on a sequential basis and 9% year-over-year. Our newest platform, the da Vinci Xi surgical system was launched in the quarter, and our customers’ reception for it has been very positive. Also during the quarter, we strengthened our direct presence in both Japan and Europe.

Turning to the United States, procedure growth improved over the first quarter led by growth in colorectal procedures, single-site, and early growth in hernia repair. Hernia repair is a broad category consisting of several procedure types and techniques for multiple underlying conditions. For some of these repairs, the da Vinci systems provide enhanced visualization and dexterity during the dissection and reconstruction phases of the procedure. We are very encouraged by this growth and we’ll pursue those opportunity in coming quarters.

Within our gynecology segment, negative trends in da Vinci use in US hysterectomy in the first quarter moderated in the second. That said, the macro environment around US hysterectomy appears unchanged and overall performance in hysterectomy is likely better understood by viewing the first half of 2014 as a whole versus a quarterly breakout. Overall, general surgery interest and utilization in United States is positive. Patrick will provide further procedure detail later in the call.

Capital placements in the United States grew sequentially from 45 in the first quarter to 61 in the second driven by the introduction of our da Vinci Xi system. Surgeon and institutional interest in da Vinci Xi has been strong with positive feedback from experienced users within many different specialties, as well as those new to da Vinci systems. The capital environment for robotic surgery remains constrained in the United States with customers evaluating their capital priorities broadly. With regard to our Xi system specifically, we anticipate increasing interest as additional clearances are obtained in experience with the product growth.

In Europe, procedure growth moderated relative to the first quarter. Growth rates in the quarter were balanced between urology, gynecology and general surgery. Some of the slowing growth may be attributed to fewer working days in the quarter compared with prior year. As expected, capital sales in Europe have been impacted in the near term by the introduction of da Vinci Xi. Capital sales cycles are typically longer in Europe, and the introduction of the new systems creates some delay as customers evaluate our new offering. Longer term we expect growing interest in our Xi system in Europe. We also expect continued interest in our Xi system for price sensitive customers. We continue to invest in our sales organization as well as scientific affairs to deepen our European capabilities.

Turning to Asia, procedure trends have been healthy with growth centered on cancer surgeries and urology, and general surgery. We are pleased to have completed a transaction with our Japanese distribution partner to enable Intuitive to interact more closely with customers in Japan and we welcome members of the adopted team to Intuitive. Direct interactions with customers, surgical societies and government agencies in Japan are essential to long-term growth of robotic surgery. And we look forward to serving the Japanese market meaningfully in coming years. As you know, we continue to work with multiple parties in pursuit of additional procedure reimbursement for da Vinci in Japan.

Capital sales in Asia were lower than prior quarters impacted by the introduction of da Vinci Xi in the U.S., as well as constrained procedural reimbursement in Japan. We have submitted applications for Xi clearance in Japan and Korea, and we’ll work with government bodies in subsequent quarters during the review process. As we have described in our earnings release, several non-cash charges make it valuable to understand our financial performance on a pro forma basis.

Taken together our operating performance in the quarter is as follows. Worldwide procedures grew 9% of the prior year. We sold 96 systems in the quarter, down from 143 in Q2 of 2013 and up from 87 in Q1. Total non-GAAP revenue in the quarter was $507 million, down from $579 million in Q2 of 2013 and up from $490 million in Q1 of 2014. Non-GAAP operating profit in the quarter was $196 million comprising 39% of non-GAAP revenue. Non-GAAP earnings per share were $3.70 compared with $4.60 in Q2 of 2013, and $3.50 in Q1.

Speaking of product contribution margins, we expect capital pressures on hospitals in most regions to continue. Given our new product introduction cycle for systems and broader market conditions, we expect capital margins to remain below prior year levels. However, overtime we expect recurring revenue margins to improve as new product volumes increase and we benefit from efficiencies in our supply chain services and product architectures.

Turning to new products, we’ve received FDA clearance for our Xi Vessel Sealer and are working through the clearance process with Xi Stapler and Xi Firefly in United States and other countries. These advanced technologies are an important step in filling in the Xi offering. Our Xi architecture simplifies implementation and improves performance for our advanced instruments, and we look forward to their introduction around the world. We have submitted our five 10-K application for our single-site wrist needle drivers, and are working through the clearance process. Pilot product performance for the wrist needle driver for single-site is compelling. We expect it will add significant capability and efficiencies for single-site surgeons.

Lastly, we continue to make progress in refining our SP platform. I’m excited and encouraged by the progress the technical teams are making. This will be a multi-core development that will be paced by technical and regulatory milestones. In summary, we are passionately pursuing the long-term opportunity to fundamentally improve surgery and are focused on the following. First, extending the benefits of minimally invasive surgery using da Vinci worldwide. Second, building da Vinci capability and supporting its use in general surgery. Third, disciplined execution in our new product launches. And finally continuing to invest in our capabilities in key international markets.

Now I’ll pass the time over to Marshall, our Chief Financial Officer.

Marshall Mohr

Thank you, Gary. I’ll be describing our results on a pro forma basis which excludes the impact of our Xi trade-in programs, legal claim accruals, stock-based compensation and intangible assets amortizations, and invested impairments. We’re providing pro forma information because we believe the business trends and operating results are easier to understand on a pro forma basis. I will also summarize our GAAP results later in my statements. We have posted reconciliations of our pro forma on GAAP results on our website so that there is no confusion.

Pro forma second quarter revenue was $507 million, down 12% compared with $579 million in the second quarter of 2013 and up 3% from last quarter. Procedures for the second quarter grew approximately 9% compared with second quarter of 2013, and were up approximately 8% compared with last quarter. Procedure highlights will be discussed by Patrick. Pro forma revenue excludes the impact of offers made to customers to trade-in their recently purchased Si products to newly introduced Xi products. At the time of announcing the da Vinci Xi surgical system, we offered our first grade of customers in the U.S. the ability to trade their recently purchased da Vinci Si surgical systems for da Vinci Xi surgical systems.

In the second quarter we obtained CE Mark in Europe in the similar trade-in offers to certain European customers that had recently purchased da Vinci Si systems. These trade-in programs often provide our customers with the opportunity to exchange certain recently purchased da Vinci Si instruments and accessories for da Vinci Xi instruments and accessories. As a result of these offers, we reserved $26 million of U.S. revenue in the first quarter, and reserved $6 million of European revenue in the second quarter. And these customers accept or decline their trade-in offers, we refine our estimates of the revenue reserves.

In the second quarter we reversed $10 million of the first quarter system revenue reserve, approximately reflecting more trade-outs completed and partially reflecting refinement of the number of customers that we expect to accept our offerings. As I’ve stated, pro forma results exclude the impact of these revenue reserves. Revenue highlights are as follows.

Pro forma instrument and accessory revenue of $262 million was down 1% compared with the second quarter of 2013, and was up 2% compared with the first quarter of 2014. The decrease relative to the second quarter of 2013 reflected lower stocking orders associated with newer system sales. The increase relative to the first quarter reflects increased procedures and number of stocking orders associated with higher systems partially offset by customer buying patterns and fewer sales of energy generator units in single-site starter kits. Keep in mind that the Xi incorporates are energy generator units.

Instrument and accessory revenue realized per procedure including initial stocking orders was approximately $1,830 per procedure compared with $2,020 in the second quarter of 2013 and $1,930 last quarter. The decrease relative to the prior year primarily reflects lower stocking order revenue, the decrease relative to the prior quarter reflects customer buying patterns and fewer energy units and single-sit starter kit sales.

Pro forma results or pro forma systems revenue of $138 million decreased 36% compared with the second quarter of 2013 and increased 6% compared with the first quarter of 2014. 96 systems were placed in the second quarter excluding the four Xi’s trade-in for Si’s. We saw more hospitals finance their da Vinci systems in the second quarter with 37% being financed compared to 11% in the first quarter, and 20% for all of 2013. We are participating in that trend financing 10 systems of which 3 were structured as operating leases. Enabling system placements will drive greater procedures of recurring revenue.

Globally, our systems ASP for the second quarter was $1.5 million, roughly equal to last year, and slightly higher than the $1.48 million last quarter. The increase compared to the last quarter was driven by product mix partially offset by geographic mix. 50 of the 96 systems placed during the second quarter were da Vinci Xi models. We sold 5 Si’s in the quarter compared with 13 last quarter. In U.S. we placed 61 systems in the first quarter compared with 90 systems in the second quarter of 2013, and 45 systems in the first quarter of 2014. The decline in U.S. system placements relative to last year reflects the impact of lower procedure growth, and ongoing macro factors that are impacting hospital capital decisions. The increase relative to the first quarter reflects seasonality and acceptance of our Xi system.

Outside the U.S., we sold 35 systems in the second quarter, including 19 into Europe and 5 into Japan, compared with 53 into international markets in the second quarter of 2013, which included 21 into Europe and 20 into Japan, and 42 systems into international markets last quarter which included 14 into Europe and 19 into Japan. Second quarter system sales also included five into France and three into Germany. Lower second quarter 2014 systems sales relative to last year and last quarter primarily reflect lower system unit sales in Japan but also reflect delays in purchasing as customers await local market approval of Xi. The decrease in system sales in Japan reflect the high installed base relative to only having one national reimbursement prostatectomy. The Xi product not yet being available as we work through regulatory approval process.

In June, we entered into new agreement to transition direct sales and marketing responsibilities in Japan from our distributor to our wholly owned subsidiary. The total transaction cost was expected to be approximately $70 million of which $50 million is a sign to goodwill and the remainder is a sign to intangibles that will amortize over varying periods. We expect that overtime the total cost associated with managing this direct channel and the costs of intangible amortization will be absorbed without a material impact in net income. As Gary indicated, the completion of the agreement enables direct interaction with our customers, surgical societies and government agencies.

Moving on to the remainder of the P&L. Pro forma gross margins was 69.2% in the second quarter of 2014 compared with 71.8% for the second quarter of 2013 and 70.2% for the first quarter of 2014. Our lower margin percentage reflects a higher mix of new product sales including the da Vinci Xi systems, and relative for last year, costs spread over lower production levels. Margins on newly launched products would typically be lower than our mature products reflecting vendor pricing on low volumes, temporary tooling costs and other start-up costs. However, overtime as volumes increase and we refine the manufacturing process and the product, we would expect to see improvement in the margins of these newer products although they may not ultimately reach the level of our matured products.

In the first quarter we recorded a pretax charge of $67 million to reflect the estimated costs of settling a number of product liability legal claims against the company. During the second quarter, we recorded an additional $10 million charge reflecting additional claims. These claims relate to alleged complications from surgeries performed with certain versions of monopolar cautery scissor or MCS instruments that included an MCS tip cover accessory that was the subject of a market withdrawal in 2012, and surgeries that were performed with MCS instruments that were the subject of a recall in 2013. Our estimate of the anticipated cost of settling these claims is based on negotiations with attorneys for patients who have participated in the mediation process that the company established in conjunction with the polling agreement. Our estimates will be refined as we proceed through the negotiation process.

Pro forma operating expenses which exclude reserves for legal claims, stock compensation expenses and amortization of intangibles were $155 million for the second quarter of 2014 compared with $152 million for the second quarter of 2013, and $155 million for the first quarter of 2014. The increase in pro forma operating expense in the second quarter relative to the first quarter reflects increased commissions associated with higher revenue and costs associated with new product launches. We expect the operating expenses to continue to ramp in the back half of the year primarily associated with international expansion, particularly in Japan and Europe, and new product launches.

In the quarter we recorded a $4 million charge to other income to write down an investment in early stage company. The investment originally enabled a license for technology, otherwise other income reflects interest on our cash and investments, our pro forma results exclude this charge. Our effective tax rate for the second quarter was 27.1% compared with 28.6% for the second quarter of 2013 and 26.8% last quarter. Our pro forma net income was $140 million or $3.73 per share, compared with $189 million or $4.63 per share for the second quarter of 2013, and $139 million or $3.54 per share for the first quarter of 2014. As I indicated earlier, pro forma income provides an easy comparison of our financial results in business trends. I will now summarize our GAAP results.

GAAP revenue was $512 million for the second quarter of 2014 compared with $579 million for the second quarter of 2013, and $465 million for the first quarter of 2014. GAAP net income was $104 million or $2.77 per share for the second quarter of 2014, compared with $159 million or $3.90 per share for the second quarter of 2013, and $44 million or $1.13 per share for the first quarter of 2014.

At the end of the quarter with cash and investments of $2 billion, down from $3 billion as of March 31, 2014, the decrease was primarily driven by $1 billion used during the second quarter for repurchase company stock on an accelerated basis and our acquisition of distribution rights in Japan, partially offset by cash generated from operations. The majority of the shares repurchased under our ASR program which amounts to approximately 2.5 million shares have been received and retired, the remaining shares if any under the program will be received and retired in early November although they could be received earlier if the ASR program is ended sooner. We do not plan to repurchase any additional shares until this ASR program is closed out.

And with that I’d like to turn it over to Patrick who will go over procedure and clinical highlights.

Patrick Clingan

Thanks, Marshall. Q2 year-over-year procedure growth was approximately 9%, with U.S. procedures growing 7% and international procedures growing 17%.

Stepping back and looking at the first half of 2014, U.S. procedures grew 5%. The softness in Q1 and the improvement in Q2 were impacted by a changing macro environment, including the implementation of the Affordable Care Act. We believe our U.S. procedure growth is best viewed by looking at the first half in aggregate. Q2 GYN procedure growth improved compared Q1 though we believe the low single-digit decline in procedure growth we experienced during the first half is likely representative of an overall rate of decline in benign gynecologic surgical volumes.

Since we do not sell power morcellators and they do not attach to our systems, we are unable to precisely measure the impact April’s FDA advisory specific to power morcellators may have had on our Q2 procedures. However, the advisory appears to be meaningfully impacting myomectomies while the effect on hysterectomies appear to have been muted. We believe that for many patients surgeons will not have to choose between minimally invasive surgery and morcellation. Alternatives for tissue extraction, including the use of da Vinci surgery exist. Similar to last quarter, single-site hysterectomy continues to be a source of growth in U.S. GYN procedures, though offer small base.

As we highlighted in a press release yesterday, a web-based patient satisfaction survey of over 6,000 hysterectomy patients sponsored by Intuitive in the Hyster Sisters patient support group recently published in the Interactive Journal of Medical Research found that robotic hysterectomy when compared to a abdominal, laparoscopic and vaginal hysterectomy was the only surgical modality that was an independent predictor of better patient experience, greater satisfaction, and willingness to recommended have the same procedure again.

Moving onto U.S. general surgery. Adoption continues to be strong across a broad number of procedures. Colorectal procedure adoption remains solid following the broad launch of our Xi Stapler earlier this year. In addition to driving procedure growth, with customers adoption Stapler and Vessel Sealer, I&A for colorectal procedure has been increasing over the past few quarters. Single-site cholecystectomy continues to grow with adoption being driven by cosmetically sensitive commercially insured patients. As people look at I&A for procedure among a large number of high volume customers suggests that achieving little to no difference in material operating costs compared to laparoscopic instruments is reproducible and sustainable.

Although there are additional general surgery procedures showing early signs of adoption, I want to take a moment to expand upon Gary’s comment about what we are seeing in hernia repair. Hernias occur in the abdomen pelvis, sometimes as a result of prior open surgical incisions. Open surgery remains the most common form of surgery for hernia repair. Looking specifically at ventral hernia’s that occur in the abdomen, [indiscernible] pain scores and difficulties associated with performing a laparoscopic repair has caused many surgeons to rely upon open surgery.

To perform minimally invasive ventral hernia repair, instruments much reach back towards the abdominal wall to repair the defect which can present a challenge even for professional laparoscopists. Early surgeon feedback on the use of da Vinci for ventral hernia repair has been encouraging. These surgeons find ease of suturing and enhanced vision enables a minimally invasive repair that is similar to open surgery. It is worth noting that some surgeons reduced or eliminate fixation instruments with robotic surgery resulting in material operating costs that are similar between robotic and laparoscopic ventral hernia repair.

International procedure growth of 17% continues to be lead by global adoption of DDP and other urologic procedures with solid early contributions from GYN, oncology and general surgery. Compared to Q1 procedure growth of 24%, a number of small factors impacted the growth rate during the quarter. Relative to Q1, Q2 international procedure growth compares to a more difficult prior year competitor as international procedures grew 23% in Q2 of 2013 compared to 14% in Q1 2013. International procedure growth was also impacted by the mixed polled days in Europe.

As we look forward, we expect an international procedure that maybe a bit lumpy quarter-to-quarter as adoption is not uniform across all procedures and geographies. We continue to expect international procedure adoption to be a driver or procedure growth as the opportunity for da Vinci surgery and cancer and complex open urologic, gynecology and colorectal procedures is substantial.

At the American Urological Association meeting in May, Dr. Murphy from Peter MacCallum Cancer Centre in Melbourne, Australia presented the results of an economic evaluation of robotic surgery sponsored by the Victorian Government. His evaluation included more than 5,000 patients from the state live database comparing outcomes and costs associated with open lap and robotic surgeries for prostate cancer. The analysis included direct costs associated with the surgery and post-operative care and concluded robotic assisted prostatectomy reduces heart stay [ph], blood transfusions and positive surgical margins in a public health system in Australia. In a case mix activity based funding model, the incremental cost of robotic assisted prostatectomy maybe offsets by reduced length of stay and blood transfusions when greater than 140 cases per year are performed.

Just finding it similar to the U.K. nice recommendation to consider robotic surgery in the treatment of localized prostate cancer they found robotic prostatectomy cost effective in centers performing at least 150 procedures per year.

In the debate over health spending, analysis of economic impacts of new technologies on specific procedures are an important tool. However, meaningful analysis requires a detailed understanding of clinical outcomes, patient populations, surgeon experience and skill variation, and actual costs to care for a patient across several alternative treatments. Studies that satisfy these criteria’s such as Dr. Murphy’s have been layered and those that overlook one or more of these elements do a dis-service to the healthcare community as a whole.

Recently we had seen an increase in both careful economic studies by investigators who understand the need to take a population based in direct cost approach to assessment, as well as those that inappropriately select subset in analysis as the basis to draw broad conclusions. We encourage the healthcare community to demand rigor in these analysis. Those that do derive the clearest picture of how new technologies impact lives and the economics of those who use them.

This concludes my remarks and I thank you for your time. I’ll now turn the call over to Calvin.

Calvin Darling

Thank you, Patrick. As Marshall describes, we are focusing our commentary towards non-GAAP pro forma results which exclude the impacts of significant non-cash expenses and certain non-recurring items. We believe that this enhances investor’s ability to asses our financial results. In order to provide historical context, we have posted summary leveled quarterly pro forma P&L metrics with GAAP reconciliation to the Investor Relations page of our website. I will be providing you with our updated financial outlook for 2014 in pro forma terms.

Starting with procedures. On our last call, we estimated full year 2014 procedure growth of between 2% and 8% above the approximately 523,000 procedures performed in 2013. Now based upon trends described earlier on the call, we are adjusting our 2014 procedure growth guidance to the higher end of this range, between 5% and 8%.

Moving to revenues. Several factors continue to make it difficult in the near term for us to predict systems sales volumes. And as a consequence total revenue, specifically. We are currently in the process of obtaining US FDA, an international regulatory clearances for the excise versions of our Stapler and Firefly products, and the Xi system is not available in Japan, Korea, and other international markets. Customers evaluation of the da Vinci Xi and the timing of their system purchasing decisions maybe impacted as we work to expand the product and geographic clearances for the platform.

Macro environmental issues impacting hospital, capital purchasing decision, the breadth and evolving nature of our procedure growth. Procedures are our primary driver, capital sales and the relationship between procedure growth rates and capital sales is highly sensitive, and likely variability in the timing of Japan system sails, given the timeline for obtaining other procedure reimbursement, beyond DPP, anticipated no sooner than 2016. Due to these factors affecting the capital side of our business, we will not be providing at this time.

Our Q2 2014 pro forma gross margin was roughly 69%, having declined about 100 basis points compared to last year, largely reflecting lower gross profit margins under da Vinci Xi systems launched in Q2. As we move forward in 2014, we expect our gross profit margin to move differentially lower based upon the impact of new products, product mix and market conditions. Our actual gross profit will vary quarter-to-quarter depending largely upon people mix and systems production volume.

We believe deeply in our ability to fundamentally improve surgery and are continuing to pursue plans to increase the use of da Vinci enabled MIS around the globe. As stated previously, 2014 will be a year of increased investment for Intuitive Surgical. Even during this period of capital sales uncertainty, we remain focused on building our international capabilities, investing in new product development and pursuing growth in multiple areas of our procedure business.

Last quarter we forecast full year operating expenses to grow between 12% and 15% above 2013 levels. We now expect to grow our operating expenses roughly 10% to 13% above the 2013 levels. We expect the 2014 non-cash stock compensation to be between $170 million and $180 million as compared to the $180 million to $190 million forecast on the previous call. We expect other income excluding the impact of the Q2 impairment charge to total between $13 million and $15 million.

With regard to income tax, on our last call we forecast our income tax rate to be between 25% and 28% of pretax income, depending primarily on the mix of U.S. and international profits. We are now refining this forecast to a range of between 26% and 28% of pretax income. This forecast does not assume the reinstatement of the R&D tax credit in 2014. Our share count for calculating diluted EPS in Q2 2014 was approximately 37.6 million shares. Going forward, based upon the full quarter impact of our Q2 buyback, we expect our Q3 shares count to be between 36.7 million and 36.9 million shares. We do not plan to repurchase any of our common stock in Q3.

That concludes our prepared comments. We will now open the call to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) And our first question will come from Ben Andrew with William Blair. Please go ahead.

Ben Andrew – William Blair

Gary, given the – thank you for the comments by the way. Given the view on sort of the international investments that you’re making in the refinement of the expense structure this year, can you give us some sense of what else you have to do as you look into 2015 and what we might think about as a longer term kind of margin trajectory for the company?

Gary Guthart

As we’ve said in the opening remarks, at the product side I think we’ll see capital margins come down a little bit relative to where we were in prior years but instruments and return revenue being strong. As we look at the spend profile, I think the next couple of years will be a set of investments, some of them around products, some of them around international expansion as we’ve been telling you as we go through. And I think it will take a couple of years for those investments to play out.

Ben Andrew – William Blair

Okay. And then as we look at kind of hernia opportunity that you’re highlighting here, can you size that for us a bit relative to maybe the colorectal – prostatectomy opportunity or general surgery, broadly. And how bigger contributor is that to the kind of the revision in the guidance and procedures that you gave today?

Gary Guthart

I think we’re too soon yet to break out all the segments in hernia. I guess I’d start by saying that hernia does have a fair number of segments, both in terms of where they are in the body and techniques that people use to approach them. We’re just working through now, what that looks like in terms of the value we bring to each one, so it’s a broad category, not a single procedure. We’re encouraged by it, I think that it’s growth rate has been real, it looks like there are real opportunities for us to bring value relative to alternative approaches, both clinical value and economic value, and that’s a good and powerful combination. So we’re not ready yet to break out the segment and size them for you, it looks to be a real opportunity, how big it ultimately will be, we’re going to have to work through the next couple of quarters before we publish that.

Ben Andrew – William Blair

Okay. And I guess, one another quick question for us [ph]. If you think about kind of the distribution, who is buying Xi’s very Si’s this quarter, particularly in the U.S., what might that help you understand in terms of people’s willingness to buy in advance of the additional instruments that are being reviewed by FDA and would that track with your expectations where people are moving more quickly, just maybe a little bit more flavor on what was going on in the quarter. Thank you.

Gary Guthart

Just in terms of basic response, we were pleased with the response of Xi. I think that surgeons in the markets that we had targeted for it, I think really appreciated it, understood the capabilities that were brought forward. Things like colorectal surgery and thoracic surgery, a lot of the kinds of features that we brought with things that they have been asking for or anticipating. I think I was positive surprised by some of the response of gynecologic oncology, some things that some features being brought forward that I think they’ll appreciate likewise in urology. So I think there was a broader positive reception than we had anticipated a surgical side. In terms of the splits of who is interested and who is buying from a commercial point of view. In the U.S. I’ll turn that to Marshall and just give a little color on, existing customers versus retails and so on.

Marshall Mohr

So within U.S. we saw [indiscernible] second systems – I think briefly I’ve just taken a little bit of longer that we’ll – resulting –

Ben Andrew – William Blair

Thank you.

Operator

Thank you very much. Our next question in queue will come from David Roman with Goldman Sachs. Please go ahead.

David Roman – Goldman Sachs

Thank you, and good evening. I wanted to maybe just start with a follow-up to Gary, your answer to the prior question regarding the next couple of years being a period of investment. As you kind of look forward in the evolution here of robotic surgery, globally why you want to visit to look like when you come at the other of that investment cycle. What would sort of be in your mind considered a successful trajectory for the company as we move beyond that investment period?

Gary Guthart

I think you’re asking around what is the financial profile or you’re asking around what is the ultimate like surgical vision?

David Roman – Goldman Sachs

Well, if you like to put it into growth rate terms, I – we generally take that but what operationally is actually going on in the business, and maybe anything you do to help frame it for us as this becomes standard of care across multiple category, do we see an inflection point in Europe, do we see multiple categories in Japan. Like what would you operationally want to see, come out of that.

Gary Guthart

Yes, so as we think about the opportunity looking forward I think there are a couple of big buckets. One of them in areas treating cancer and complex disease which are largely open surgical procedures, we see opportunity globally. In the U.S., we’re early in our experience in colorectal and thoracic; in Europe, we see opportunities in urology and gynecology for malignant conditions in colorectal and thoracic as well, likewise in Asia. So that sort of opportunities is one that we have been investing in, both on the product side as you know, things like Xi and stapling, and expanding and filling out the stapling line, as well as increasing our capabilities in terms of direct markets. And so, I think that opportunity is substantial, I think we’re still in the early innings of that – of exploring that opportunity and delivering those products and the consequences of those to those markets. So that’s one set that continues. A large part of our business is for gland [ph] surgery as well and you see things like the hernia opportunity we just discussed evolving pretty nicely. And as that happens, we will also look for products that optimize that opportunity, both clinically and economically. And I think those things are also translated cross borders. So we’re really working on both sets, we’re further ahead in adoption on the complex and cancer side, and so that’s where we’re starting in our U.S. markets for the most part. And that really informs the product pipeline in the go-to-market strategies that you’ve heard us talk about.

David Roman – Goldman Sachs

And then maybe just my follow-up on Japan, if you could go into perhaps a little bit more detail on the acquisition. I know in your prepared remarks you referenced a potentially closer to some of the medial societies, and my understanding in Japan is that the approval of indication does stem more for the medical society, that’s a little bit different from what we see in the rest of the world. Do you anticipate that this cultural relationship will provide you with access to helping – influence the adoption procedure rates, provide more clinical data. How can we see that play out in terms of gaining new applications in that country.

Gary Guthart

I think in general being closer to the user groups in the country helps us a lot in a bunch of different directions. One of them has made me sure we understand their needs and understand it in a very deep way. And in a broad setting so we are speaking to multi-specialties, that helps a lot. Number two is, as we say in Japan, the government interacts very closely with surgical societies to set guidance to understand data requirements and to help review issues and activities. And so having close relations with surgical societies, with keeping your leaders, and with our customers directly, those who already own our products. It help speed up the communication. It gets us more careful and deeper look into opportunities and issues to be resolved. And so we were pleased to do, it’s absolutely aligned with what we want to get done.

David Roman – Goldman Sachs

Okay, thank you very much.

Operator

Thank you. Our next question in queue that will come from Bob Hopkins with Bank of America. Please go ahead.

Robert Hopkins – Bank of America

Thank you, and good afternoon. So, the first question is on the procedure volume growth guidance that you provided. You grew 8% in the first half, you got easier comparisons in the back. And I just wanted to understand the 5% to 8%. Is there something specific that you guys are anticipating that would cause a lot bit of weakness despite the softer comps in the back half? And maybe specifically referring to hysterectomy there or is it just – it’s been kind of an interesting last year, and you want to remain conservative in your projections?

Gary Guthart

Looking at it there is not a specific thing that we think is looming and as we’ve said in the prepared remarks, I think there was some choppiness between Q1 and Q2 that had to do with quarter boundaries and some other things that may have been unique to Q1. And so if you look at the first half together rather than separating it on quarter boundaries, I think it gives a better picture of where we are. Going forward I think the determining factors will be continued strength in general surgery which we’ve been pleased with in the first half of the year. Offset by what happens next in gynecology in terms of stabilization, those are really underlying dynamics in the back half and that’s what Calvin has used to think through the back half range.

Calvin Darling

And there is other thing I’d point out Bob is, you talked about comparisons and when you get into the fourth quarter and seasonality of procedures complex benign procedures or simpler benign procedures, less complex, are more seasonal where you’d expect higher fourth quarter volumes. Now in the affordable care environment, you just don’t have a precedent for this with more people on high deductible plans and I think we’re learning as we go on that front and could some of these be deferred beyond a year, we’re just not sure. So it’s just another factor that we’ve considered.

Robert Hopkins – Bank of America

And then Gary, specifically on U.S. gain. I just wanted to kind of gauge your confidence that the trends we’re seeing in Q2 can remain at this type of level instead of getting worse. I noticed another article in JAM of today talking about morcellation. And I just wanted to kind of gauge your confidence specifically in U.S. gain and the stability of that kind of growth rate you’re experiencing today for the rest of the year?

Gary Guthart

Yes, I think that’s really interesting. On the clinical side and what da Vinci surgeons have been telling us, I think how the system works, what it can do for gynecology, it’s pretty stable and really won’t know. What’s hard to predict are any of the consequences of FDA guidance that – on tissue traction and things like that and part of that consequences that’s the range that Calvin has described to you. So I think as we look at that kind of the underlying dynamics of how our products are used, we feel like those are stable. I think as you look out what the environmental factors might do, that’s harder to predict and that accounts for the range [ph].

Robert Hopkins – Bank of America

Great. And just real quickly ask you why the expense guidance changed this quarter relative to what you gave at the beginning of the year?

Marshall Mohr

For half of the year we’ve obviously spent less than what we’ve have originally provided guidance for the year which was 12% to 15%, and so some of that had to deal with – I don’t think there is big difference but that had to do with the hiring patterns in – they will need to hire people quickly in Japan and places like that. So we’re little bit of to the favorable side but again, as I said earlier, we expect to ramp expenses as we do continue our international expansion in product development.

Gary Guthart

Yes, there is not a change there in our – what we believe is fundamentally important from an investment point of view. There are some things in the front half that are in a sense volume related cost that we didn’t have to incur and there are some things that are timing issues.

Robert Hopkins – Bank of America

Great, and congrats on the progress.

Marshall Mohr

Thank you.

Gary Guthart

Thank you.

Operator

Thank you. Our next question in queue will come from David Lewis with Morgan Stanley. Please go ahead.

David Lewis – Morgan Stanley

Good afternoon. Marshall, just a quick question on stock comp. It appears you want the street to value the company now excluding your stock compensation, just a couple of questions on that. I mean, I appreciate the non-cash charges but options are dilution for shareholders, so how does excluding that and still discipline how the company is going to issue equity awards [ph] and given it’s a form of compensation, why is it appropriate for us to evaluate Intuitive relative to peers who none of which back out stock comp?

Marshall Mohr

Sure, this isn’t a new thing, we always wanted to look at it without stock comp, we’ve previously provided you with a cash flow information that does include the impact of stock comp. I think in our particular stock – we’re pretty disciplined about how we issue equity. We maintain specific guidelines and I think are well within the industry parameters, 30% dilution on an annual basis. What [ph] is the valuation – I think Blackstone’s [ph] valuation has issues with it and one of those would be that it’s heavily reliant on volatility and other factors that go into the consultation. With our stock being a little bit more volatile, we unfavorably compare it to – with some of the peers like Johnson & Johnson, and so we think it’s better to look at us without it.

Gary Guthart

David, I think if you look broadly across larger cap, med-tech stock you’ll see that we range in stock based comp as a percent of revenue around 7% to 8% whereas most of the other companies range around 1%.

David Lewis – Morgan Stanley

But that’s just my point, it’s a form of compensation. So you need to be competitive against your peer group who are spending that compensation, you’re trying not to. That’s why I’m asking relative to your peer group call it sensible [ph]?

Gary Guthart

Short answer is we value equity, we understand completely dilution and we respect shareholders view of dilution. In terms of how our comp plans are absolutely built, we are building them so that we can be effectively for the talent that’s required to build this company and that’s relative to – sometimes med-tech but often our peer group is – in terms of talent is tech companies that share our location here in headquarters. And so, we’re careful about dilution, we don’t give it away without deep thought. It’s not in terms of what the expenses are, they are not in any way hidden, they are absolutely available, and when Marshall talks about pro forma he is really pointing out the economic engine of the company. So we understand and appreciate your remarks, we absolutely understand and respect to need to treat equity carefully.

David Lewis – Morgan Stanley

Let me just get a quick follow-up there, maybe to shift on the procedures because we’re probably going to agree or disagree on the prior topic but as you move over to main procedures, you gave us some nice color, Patrick did on DDH, just as you think relatively – can you give us any sense sequentially – it sounds like hernia did obviously much better but specifically as raised quality – whether quality [ph] progress sequentially low that was faster growth, slower growth or relatively the same quarter-on-quarter? Thank you.

Gary Guthart

Generally the dynamics we described last quarter in quality really stated about the same in terms of – it continues to grow, we see a segment of the market that values it, both in terms of patients and in terms of the surgeons and institutions that are providing it. Directionally I think in terms of rates, it was more or less in line with where we were before, perhaps a slight slow in volume as growth.

Operator

And we’ll take your next question in queue that will come from Tycho Peterson with JPMorgan. Please go ahead.

Tycho Peterson – JPMorgan

Thanks. Given the strong placement number this quarter, I am just wondering if you could talk a little bit about how that flows through the revenues, particularly around the trade-in’s, I had a number of people asked why it didn’t show more revenue upside, given both strong procedures and the trade-in. So maybe just talk a little bit about that and how you think about trade-in to long two and the back half of the year? And then to follow-on, can you talk about the leasing option, you talked about the current percentage but what percentage of the potential systems are potentially open to operating leases?

Gary Guthart

With regards to the systems Tycho, the ASPs we report, the $1.5 million, they do reflect the contractual revenue related to the sales agreement. This quarter we did happen to have three systems that were shipped under operating lease arrangements where the system revenues will be recognized over future periods and there were also other sales involving financing terms where revenue will be deferred over future periods which again is offset by the upgrade portion within the system category. So I think it’s – with this additional complexity it’s not as simple as it was, just multiply the ASP, times of number of units and get the systems revenue but we are absolutely focused on finding the customer solutions and adding to the installed base.

Tycho Peterson – JPMorgan

And then on the clinical data site, can you talk – it seems like the clinical data might be little bit higher in Europe. Can you talk about whether you have the appropriate dataset today as you go out to further penetrate that market? And then is there any data on clinical efficacy or cost to support hernia at this point?

Gary Guthart

On the first question of what are the data requirements in Europe, in general I think they tend to ask for data in local countries and particularly around local economics and so on. And so, a lot of what the emphasis has been there has been making sure the datasets make sense in the country. We have good indications and good capability studies and lot of work from around the world so that can help guide us. But ultimately it requires engaging those markets directly and the surgical societies directly. So that’s kind of – what the European picture looks like. One hernia, it’s always in the experience, our hernia data will start to be collected and analyzed more broadly but as usual, in these kind of procedures the early upticks proceed the large studies.

Tycho Peterson – JPMorgan

Now lastly on SP, can you just give us a sense as to whether you finalized self standalone versus the caught on to Xi and any chance if the port size may come down from 25 millimeters initially?

Gary Guthart

Let’s see, on the first one we are designing the product such that it can link up an existing Xi or you can configure it as a standalone, so it will be able to sell either as a standalone or as an option of into an Xi, that’s our product plan. There is nothing fundamental in SP long-term that keeps us from changing port size. The initial design and the initial instrumentation are of particular size, the architecture is actually quite flexible.

Tycho Peterson – JPMorgan

Okay, thank you.

Operator

Your next question in queue will come from Tao Levy with Wedbush. Please go ahead.

Tao Levy – Wedbush

Hey, good afternoon.

Gary Guthart

Good afternoon.

Tao Levy – Wedbush

I wanted to ask about the U.S. procedure growth which you touched on and I’m trying to figure out you don’t work with the areas that kind of improved off in the quarter. I’m surprised to hear you answer to one of the prior questions that coli [ph] rates maybe were a little bit lower than in the Q1. So I’m just wondering where did the incremental improvement in the rates specifically come from.

Gary Guthart

Tao I think if you look through the comments we’ve made, the stabilization in GYN and the improvement in Q2 is the largest factor between Q1 and Q2. But we think you should increasingly look at – particularly with all this being going on and the volatility around the elective benign procedures, look at the first half of the year in aggregate, when you think about those procedures, given everything has been going on around the macro landscape.

Tao Levy – Wedbush

Okay. And also the deferred revenue for the systems in the quarter – I think Marshall talked about how you were going to make some changes to that, maybe I missed it but what are some of the changes that you expect on that and why weren’t sort of more systems that were deferred turned into revenue in the quarter?

Marshall Mohr

Effectively we deferred revenue associated with the number of systems we expected that would be traded back in, so there was an estimate involved there. So when I say that we would modify – I said we would modify that estimate as we go through time and in fact at the end of Q1 we’ll get there, certain customers that we understand will not trade-in, so we reversed that the accrual for that. As far as why didn’t more take us up on our own – remember right now the Xi isn’t fully featured and there are other products that will go with it, that we’re still working on getting ready to floor with [ph]. And we think that some customers may have hesitated for that reason but we’ve extended these offers until September 30, so they have till September 30 for Xi.

Tao Levy – Wedbush

Okay, that’s helpful. Thanks. And just lastly, any progress on ready update on the single-site, the articulated needle driver, if that’s still kind of year-end potential approval?

Gary Guthart

So – a couple of things, I think from a product design and usability point of view in terms of internal testing, that’s very, very good, so I’m quite encouraged there. We’re in the process with FDA, I think the process is following a routine kind of exchange and so it’s always hard to predict what the final endpoint will be there but I don’t see big barriers to completing that work.

Tao Levy – Wedbush

Okay, great. Thanks a lot.

Gary Guthart

Thank you.

Operator

Your next question will come from Richard Newitter with Leerink. Please go ahead.

Richard Newitter – Leerink

Hi, thanks for taking the questions guys. I just – I wanted to ask a question, thanks for the color on some of the clinical advancements that you guys saw, you’ve published or talked about this quarter. But I just was hoping to get a better idea of what and when we can expect perhaps a more definitive, either company sponsored or industry – not industry but surge and multi-center kind of definitive study analyzing things like colorectal experience using the robot versus the traditional laparoscopic surgery. I know there is a study ongoing called Roller [ph], is this something that should be viewed as a proxy and saying that could be more kind of catalytic for your adoption rates in colorectal? And if not, is there something else and is there anything that is Intuitive can do to help kind of create or generate this type of data?

Gary Guthart

Yes, a couple of things. I think it’s really important to start with – understanding the concept that both clinical efficacy and value, economic value, have to be evaluated procedure-by-procedure across both, the population of patients and a population of surgeons. And so what that means is that looking for the one definitive study on dementia’s [ph] is unlikely, you’re going to have to take it, it’s just not possible, you’re going to have to take it case-by-case. As you look at case-by-case, there was actually quite a bit that has been done already and quite a bit that is in process, both company sponsored and sponsored by others. We pay attention to it, it’s important, really the strong elements that must be present for us to tell anything. Take colorectal as an example. The majority of colorectal surgeries done are open, some are done lap, and now robotics is coming in. And so a good study, one that’s going to look at that looks at all of the patient population that’s being done open, the patient population that’s minimal lap, patient population that can be done robotically, as well as the variance in certain skill from those who are skilled laparoscopically and those who are not. So those are broad suites. Some of the studies going on approach that but a lot of them look at subsets. And so the kinds of things that we’re interested in making sure happen and support and ones that were broadly enough. I think it’s a huge mistake as Patrick said in his remarks, to go look at it. Some population that is lap, some population of patients that [ph] and ignore a majority of population which is open. So the short answer to your question is, those things were developed in time, they go procedure-by-procedure, we ask our folks who are investigating to look broadly and compare against the majority modalities, some of which are sponsored by us, some of which are sponsored by government sponsorship or other approaches and they will develop in time and we’ll share them with you as they come up.

Richard Newitter – Leerink

Great, thanks. And then maybe if I could just ask one other one – you called our hernia this quarter as obviously as a general surgery procedure category that’s – maybe gaining accelerated attention and adoption. Can you give a little color on the types of hernia surgeons that are performing these procedures, mostly around the experience level? And then – are you getting kind of the sought leaders in the space who are kind of taking us on and we should potentially see kind of more talk at the podium from high level thought leaders about this procedure or is this kind of more – kind of – I don’t know the right terminology but everyday surgeons, so to speak, in the hernia category.

Gary Guthart

Yes Rich, I think it’s early and we’re encouraged by what we’re seeing. You’re seeing about the mixed bag of procedures that are being done as well as the types of surgeons and who is adopting. So it’s early for us to try to pitching it into any given sub-segment yet but we plan to look closely at it and report on it moving forward. Thanks.

Richard Newitter – Leerink

Thanks.

Gary Guthart

Thank you very much. That was our last question. As we have said previously, 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. The following are two responses to our new Xi surgical system from experienced customers.

From one of the most experienced robotic urologist, these are the best robot today, vision is nicer and clear, I can see structures very, very nicely. And from the patient side surgical assistant, docking process is easier and more efficient. Our second case was doc faster than our typical Si dockings, and we have done hundreds of those. We did not have a single external collision and there were almost no adjustments necessary. Usually on a bariatric procedure I’m adjusting the camera and instrument times frequently, but with the Xi it was not necessary.

We believe we have a unique opportunity to improve surgery. The quotes above speak to the care and diligence of our design, operations, training and field teams in meeting our customers’ needs. This concludes today’s call. We thank you for your participation and support on this extraordinary journey to improve surgery. And we look forward to talking with you again in three months.

Operator

Thank you very much. And ladies and gentlemen, that does conclude your conference call for today. We do thank you for your participation, and for using AT&T’s executive teleconference. You may now disconnect.

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Source: Intuitive Surgical's (ISRG) CEO Gary Guthart on Q2 2014 Results - Earnings Call Transcript

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