Intuitive Surgical (ISRG) Gary S. Guthart on Q1 2016 Results - Earnings Call Transcript

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Intuitive Surgical, Inc. (NASDAQ:ISRG) Q1 2016 Earnings Call April 19, 2016 4:30 PM ET

Executives

Calvin Darling - Senior Director-Finance, Investor Relations

Gary S. Guthart - President, Chief Executive Officer & Director

Marshall L. Mohr - Chief Financial Officer & Senior Vice President

Patrick Clingan - Finance Director

Analysts

Robert Adam Hopkins - Bank of America Merrill Lynch

Tycho W. Peterson - JPMorgan Securities LLC

David R. Lewis - Morgan Stanley & Co. LLC

David Harrison Roman - Goldman Sachs & Co.

Ben C. Andrew - William Blair & Co. LLC

Rick Wise - Stifel, Nicolaus & Co., Inc.

Matt O'Brien - Piper Jaffray & Co. (Broker)

Lawrence Keusch - Raymond James & Associates, Inc.

Jason R. Mills - Canaccord Genuity, Inc.

Vijay Kumar - Evercore ISI

Tao L. Levy - Wedbush Securities, Inc.

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Intuitive Surgical Q1 2016 Earnings Release Call. At this time, everyone joining is in a listen-only or muted mode, and later we will have a question-and-answer session and instructions will be given at that time. As a reminder, the conference is being recorded.

And I'll now turn the meeting over to our host, Senior Director of Finance, Investor Relations, Calvin Darling. Please go ahead.

Calvin Darling - Senior Director-Finance, Investor Relations

Thank you. Good afternoon, and welcome to Intuitive Surgical's first quarter earnings conference call. With me today we have Gary Guthart, our President and CEO; Marshall Mohr, our Chief Financial Officer; and Patrick Clingan, Senior 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 2, 2016. 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 first 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 first quarter financial results, Patrick will discuss marketing and clinical highlights, and I will provide our updated financial outlook for 2016. And finally, we will host the question-and-answer session.

With that, I'll turn it over to Gary.

Gary S. Guthart - President, Chief Executive Officer & Director

Good afternoon and thank you for joining us on the call today. Our first quarter company performance was strong with excellent global procedure growth, solid capital placements, improving product margins and important new product launches.

Turning first to procedures, global procedure growth for the quarter was nearly 17%, led by growth in general surgery, growth in the use of da Vinci Surgical Systems outside the United States, continued growth in U.S. urology and modest growth in U.S. gynecology.

Trends in U.S. general surgery growth continued with strong growth in inguinal hernia repair and ventral hernia repair followed by continued growth in colorectal surgery. Customer feedback and commitment to the use of da Vinci in performing inguinal hernia repair for complex conditions has been encouraging in the quarter, increasing our confidence in its long-term acceptance.

Procedure growth was variable by country in Europe, with solid performance in the United Kingdom and Germany offsetting slower growth in the Nordic countries. Performance in the quarter was helped by an extra procedure day in some regions relative to Q1 of 2015. Patrick will review procedure trends in greater detail later in the call.

We placed 110 da Vinci Systems in the quarter, up from 99 in Q1 of 2015. Customers continue to purchase our Xi Systems over less expensive and less capable Si models by a factor of approximately three to one. Capital performance was strong in United States, offsetting capital softness in Europe and the exploration of our quota in China.

Lastly, customer leasing and lease to own arrangements are making up a greater percentage of new system placements. Marshall will take you through our finances in more detail later in the call.

Our operations teams remained focused on optimizing our manufacturing, design and supply chains for our newer products. Our teams continued to execute against their goals with steady improvements in reducing product costs for our new systems, advanced instruments in the quarter.

Product cost reductions exceeded our expectations, and we expect them to continue to improve in 2016 and 2017. Our offerings make up an ecosystem designed to meet our customers' needs in building and running outstanding robotic surgery programs.

This ecosystem includes systems and instruments and accessories, training technologies and peer-to-peer course work, service offerings, and program optimization and analytic support. As a result of the set of products and services that surround our systems, recurring revenue in the quarter comprised 75% of total company revenue.

Highlights of the first quarter operating results are as follows. Procedures grew nearly 17% over the first quarter of last year. We shipped 110 da Vinci Surgical Systems, up from 99 in the first quarter of 2015. Revenue for the quarter was $595 million, up 12% over the prior year. Pro forma gross profit margin was 70% compared to 65.6% in the first quarter of last year.

Instrument and accessory revenue increased to $322 million, up 16%. Total recurring revenue in the quarter was $447 million, representing 75% of total revenue. We generated a pro forma operating profit of $229 million in the quarter, up 24% from the first quarter of last year, and pro forma net income was $170 million, up 27% from Q1 of 2015.

We continue to enable our Xi platform with new product launches. Our launch of intraoperative Table Motion is proceeding well with order flow that has met our expectations and with strong customer feedback on its utility, particularly in general surgery. In the quarter, we also launched our 30-millimeter Xi stapler designed to facilitate stapling in thoracic procedures and our Xi Single-Site instrument and accessory kit. Both are 30-millimeter stapler, and our Xi Single-Site instruments have started clinical use with positive feedback on their utility. Our Sp program remains on track.

As our business has strengthened, we have increased our mid- and long-term investments in research and development. We have been increasing our investments in imaging, analytics and new product architectures based on our belief that substantial opportunity exists to enable better outcomes and to expand our access to our technologies globally. Calvin will take you through our projected spending later in the call.

As we move forward in 2016, we're focused on the following: first, expanding the use of da Vinci in general and thoracic surgery, particularly colorectal surgery and hernia repair; second, advancing our ecosystem including expanding our Xi line and taking our Sp product into initial clinical use; third, driving our organizational capabilities end markets in Europe and Asia; and finally, assisting our customers in their efforts to maximize the comprehensive value of their programs.

I'll now turn the call over to Marshall who will review financial highlights.

Marshall L. Mohr - Chief Financial Officer & Senior Vice President

Thank you, Gary. I will be describing our results on a non-GAAP or pro forma basis which excludes legal settlements and claim accruals, stock-based compensation, and amortization of purchased IP. We provide 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 script. We have posted reconciliations of our pro forma results to our GAAP results on our website so that there's no confusion.

First quarter revenue was $595 million, an increase of 12% compared with $532 million for the first quarter of 2015 and a decrease of 12% compared with the seasonally stronger fourth quarter of $677 million.

First quarter 2016 procedures of approximately 176,000 increased nearly 17% compared with the first quarter of 2015 and decreased slightly compared with the fourth quarter procedures of approximately 177,000. Year-over-year procedure growth was driven by general surgery procedures in the U.S., in urology worldwide and otherwise likely benefited from an additional calendar day associated with leap year.

Revenue highlights are as follows. Instrument and accessory revenue of $322 million increased 16% compared with last year and decreased 1% compared with the fourth quarter of 2015. These changes generally reflect changes in procedures. Instrument and accessory revenue realized per procedure, including initial staffing orders, was approximately $1,830 per procedure. This metric continues to fluctuate in a tight range from approximately $1,830 and $1,840 per procedure. Relative to the first quarter of 2015, the current quarter reflects higher sales of advanced instruments, offset by the impact of customer buying patterns and foreign exchange.

System revenue of $148 million increased 5% compared with last year and decreased 36% compared with last quarter. The increase relative to the prior year primarily reflects increased revenue associated with operating lease activities and slightly higher average system selling prices. The decrease relative to the fourth quarter primarily reflects seasonally lower unit sales and slightly lower ASPs, partially offset by increased revenue associated with operating lease activities.

110 systems were placed in the first quarter compared with 99 systems in the first quarter of 2015 and 158 systems last quarter. Approximately 77% of the systems shipped in the quarter were Xi's, which is comparable to prior quarters.

Hospitals financed approximately 37% of the systems placed in the first quarter, up from 17% last quarter. We directly financed 31 systems, including 19 operating leases. As of the end of the first quarter, there were 62 systems out in the field under operating leases.

We generated approximately $4 million of revenue associated with operating leases in the quarter compared with $1 million in the first quarter of 2015 and $3 million in the fourth quarter. We also generated approximately $6 million of revenue during the quarter from lease buyouts compared with $2 million of revenue in the fourth quarter and no lease buyout revenue in the first quarter of last year.

We excluded the impact of operating leases from our system ASP calculations. Globally, our average system price of $1.500 million was approximately $30,000 higher than the first quarter of 2015 ASP and approximately $50,000 lower than the ASP last quarter. Relative to the prior year, the increase reflects a proportionately lower trade-in volume and favorable geographic mix, partially offset by an unfavorable product mix. The decrease relative to the fourth quarter reflects proportionately higher trade-in volume and lower mix of Xi dual consoles, partially offset by favorable geographic mix.

Service revenue of $125 million increased 9% year over year and increased approximately 4% compared with the fourth quarter of 2015. The year-over-year and quarter-over-quarter increases reflect growth in our installed base of da Vinci Systems.

Outside of the U.S., results were as follows. First quarter revenue outside of the U.S. of $164 million increased 9% compared with $150 million for the first quarter of 2015 and decreased 25% compared with a seasonally stronger fourth quarter of $219 million. The increase compared with the previous year is comprised of a 14% growth in recurring revenue, which is driven by procedure growth of 22%, and increased systems revenue of 2%. The decrease compared to the fourth quarter reflects seasonally strong fourth quarter systems placements, partially offset by a 5% growth in recurring revenue.

Outside the U.S., we placed 36 systems in the first quarter compared with 36 in the first quarter of 2015 and 75 last quarter. Current quarter system sales included five into China and eight into Japan. System placements outside of the U.S. will continue to be lumpy, as some of these markets are in their early stages of adoption. Some markets are highly seasonal, reflecting budget cycles or vacation patterns, and sales into some markets are constrained by government regulation.

Moving on to the remainder of the P&L, the pro forma gross margin for the first quarter was 70% compared with 65.6% for the first quarter of 2015 and 69.6% for the fourth quarter of 2015. Compared with the first quarter of 2015, the higher gross margin reflects reduction of product and product repair costs, improved manufacturing operations efficiencies, the elimination of the medical device tax, lower costs associated with product field actions and related inventory charges, and a higher mix of instrument and accessory revenue.

The medical device tax has been suspended for the next two years and reduced our 2015 gross margin by approximately 70 basis points. Future margins will fluctuate based on the mix of our newer products, our ability to further reduce product costs, manufacturing efficiency, costs associated with product field actions, and in the long-term, the potential reinstatement of the medical device tax.

Pro forma operating expenses, which exclude legal settlements and accruals for legal claims, stock compensation expense and amortization of purchased IP increased 14% compared with the first quarter of 2015 and increased 5% compared with last quarter. The increases over prior periods reflect increased investments in advanced imaging, advanced instrumentation and next-generation robotics, increased head count, and higher payroll taxes associated with stock option exercises.

Our pro forma effective tax rate for the first quarter was 27.4% compared with an effective tax rate of 28.9% for the first quarter of 2015 and 24.9% last quarter. In late December 2015, Congress retroactively approved the 2015 federal research and development credit and made the R&D tax credit permanent going forward. The entire 2015 R&D tax credit was included in the fourth quarter, while no benefit was reflected in the first quarter of 2015 and a proportional benefit is reflected in the first quarter of 2016.

Other than the impact of the R&D credit, fluctuations in our tax rate between this quarter and the first and fourth quarters of 2015 primarily reflect changes in the mix of U.S. and OUS income.

Our first quarter 2016 pro forma net income was $170 million or $4.42 per share compared with $135 million or $3.57 per share for the first quarter of 2015 and $224 million or $5.89 per share for the fourth quarter of 2015.

Note that fully diluted shares outstanding increased by approximately 400,000 shares relative to the fourth quarter resulting primarily from the increase in our share price. As I indicated earlier, pro forma income provides an easier comparison of our financial results and business trends.

I will now summarize our GAAP results. GAAP revenue was $595 million for the first quarter of 2016 compared with $532 million for the first quarter of 2015 and $677 million for the fourth quarter of 2015.

GAAP net income was $136 million or $3.54 per share for the first quarter of 2016 compared with $97 million or $2.57 per share for the first quarter of 2015 and $190 million or $4.99 per share for the fourth quarter of 2015.

We ended the year with cash and investments of $3.8 billion, up from $3.3 billion as of December 31, 2015. The increase was primarily driven by proceeds from stock option exercises and cash generated from operations. As our cash builds, we will continue to evaluate our approach to capital allocation.

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

Patrick Clingan - Finance Director

Thanks, Marshall. Of our first quarter procedure growth of nearly 17%, U.S. procedures grew approximately 15% and OUS procedures grew approximately 22%.

In the U.S., even though growth benefited from favorable operating days in the quarter, procedure growth outpaced our expectations. First quarter growth in our mature procedures continued at levels similar to the second half of 2015 generating majority of the procedure outperformance relative to our expectation. General surgery procedure growth also exceeded our expectations.

In U.S. urology, first quarter growth in da Vinci Prostatectomy and kidney procedures continued at similar rates at the second half of 2015. We continue to believe that our U.S. prostatectomy volumes have been tracking to the broader prostate surgery market, and we expect the prostatectomy group to return to levels similar to prostate cancer incident rates over time.

In U.S. gynecology, first quarter procedures grew modestly year-over-year, with growth led by malignant and complex hysterectomy. Continuing the trend from 2015, we estimate a larger proportion of da Vinci Hysterectomy procedures were performed by gynecologic oncologists during the first quarter. Similar to the fourth quarter, U.S. Single-Site gynecology procedure growth declined compared to the first quarter of 2015.

First quarter growth in U.S. general surgery procedure adoption remains strong, led by a robust growth in hernia repair and continued adoption of colorectal procedures. Cholecystectomy procedures were roughly flat in the quarter, with growth in multi-port procedures offsetting declines in Single-Site procedures.

Q1 was another quarter with a large number of clinical publications evaluating da Vinci Surgery. Of these, I have selected a couple studies that you may find interesting. With the launch of our 30-millimeter stapler, surgeon interest in the use of da Vinci for thoracic surgery is growing. A new study comparing open video-assisted thoracic surgery, or VATS, and da Vinci Surgery for pulmonary lobectomy was published by Dr. Yang and colleagues from Memorial Sloan Kettering Cancer Center in the Annals of Surgery.

Using a prospective database including 2,400 surgeries to treat stage 1 non-small cell lung cancer patients, the officers' propensity matched 470 patients across da Vinci, VATS and open surgery. The study found that da Vinci and minimally invasive VATS approaches enabled a shorter chest tube duration and length of hospital stay compared to open surgery.

Da Vinci Surgery was also credited with improved lymph node yields as compared to both open surgery and VATS, an important clinical outcome for determining next steps in the patient's treatment pathway.

As related to the expansion of da Vinci lung resections, the authors highlighted that nearly 57% of pulmonary lobectomies in the U.S. are treated with open surgery, and they see promise in expanding patient access to minimally invasive surgery through da Vinci technology.

Turning abroad, procedure growth outside of the United States was approximately 22% in the first quarter, led by the global adoption of da Vinci Prostatectomy with solid contributions from kidney procedures and colorectal resection. Compared to the second half of 2015, procedure growth slowed in both Europe and Asia during the quarter, in part due to the timing of the Easter holiday. Historically, our OUS procedure growth rates have been lumpy and less predictable in the short-term. We are focused on improving our OUS procedure performance.

In Japan, there were positive developments relating to reimbursement in the quarter. The MHLW approved for reimbursement of partial nephrectomy at a premium rate relative to open surgery and also approved clinical trial enrollment to begin supporting a sensionary OB (20:42) submission for da Vinci malignant hysterectomy.

A recent study funded by Intuitive and published in BJU International by Professor Hughes and colleagues from University of Chester collected data from the United Kingdom health episode statistics database, including more than 20,000 prostatectomy patients and 2,000 partial nephrectomy patients, to assess health resource utilization and cost, following da Vinci, open and laparoscopic procedures. The database showed that from 2008 to 2013, the use of da Vinci Surgery increased from 15% to 50% of prostatectomies and 1% to 22% of partial nephrectomies by displacing open surgery.

During the first year after the operation, da Vinci Surgery was shown to reduce inpatient admission, hospital bed days and total costs for both prostatectomy and partial nephrectomy compared to open surgery. At three years, post operation, the study showed similar outcomes for prostatectomy and was insufficient to draw conclusions for partial nephrectomy.

Laparoscopic surgery outcomes were at the approximate midpoint between da Vinci and open surgery on resource utilization and costs for both procedures. The authors concluded "our analysis suggests that there are substantial savings associated with robotic-assisted surgery when compared with open and laparoscopic interventions."

This concludes my remarks. I'll now turn the call over to Calvin.

Calvin Darling - Senior Director-Finance, Investor Relations

Thank you, Patrick. I will be providing you with our updated financial outlook for 2016. Starting with procedures, on our last call, we estimated full-year 2016 procedure growth of 9% to 12% above the approximately 652,000 procedures performed in 2015. Now, based upon favorable U.S. dVP and gynecology macro trends, and U.S. general surgery growth, we are increasing our estimate for 2016. We now anticipate full-year 2016 procedure growth within a range of 12% to 14%.

Turning to gross profit. On our last call, we forecast 2016 pro forma gross profit margin to be within a range of between 68% and 69.5% of net revenue. We are now increasing our estimate. We now expect full-year 2016 pro forma gross profit to be within a range of between 69% and 70% of net revenue.

Turning to operating expenses. As we have described, we will be increasing our investments in key areas that will enable and drive the future of robotic-assisted surgery. On our last call, we forecast to grow pro forma 2016 operating expenses between 9% and 13% above 2015 levels. We are now increasing our estimate for operating expenses to a range of between 12% and 15% above 2015.

Consistent with our last call, we expect our noncash stock compensation expense to range between $170 million and $180 million in 2016 compared to $168 million in 2015. We expect our 2016 other income, which is comprised mostly of interest income, to be in the upper end of the $20 million to $25 million range forecast on our last call.

With regard to income tax, we continue to expect our 2016 pro forma income tax rate to be between 26.5% and 28.5% of pre-tax income, depending primarily on the mix of U.S. and OUS profits.

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

Question-and-Answer Session

Operator

We have a question from Bob Hopkins with Bank of America. Please go ahead.

Robert Adam Hopkins - Bank of America Merrill Lynch

Okay. Thank you. Two questions. But first of all, congrats on the great momentum in the business. I have a question on U.S. procedure volume growth and then on your comments on OpEx spend. First, on procedure volume growth, one, can you give us a sense of what you think you grew in the quarter on a same day selling basis? But then much more importantly, just give us a sense as to specifically which surgery types accelerated in the U.S. And what drove the growth? What caused the acceleration? Why did things get better?

Patrick Clingan - Finance Director

Hey, Bob, thanks for the question. From a same day selling perspective, estimating the impact of operating days is anything but an exact science. From a tailwind at leap year, that benefited the quarter and some modest benefit from the timing of new year's being on a Friday rather than a Thursday. And from a headwind perspective, you had the timing of Easter which moved from the second quarter into the first quarter. But that has more of an impact on the OUS geographies.

From what accelerated, the mature procedures sustained pretty strong growth in the quarter, as they saw throughout 2015, which was a little bit of a surprise to us relative to our initial expectations. And general surgery continues to be strong and growing off of a larger base which has more impact on the U.S. procedure growth number.

Robert Adam Hopkins - Bank of America Merrill Lynch

Okay. And then, well, for the follow-up, I wanted to ask Gary a question on OpEx spend because I think it's an important comment from you guys. Your spending in the quarter was high exactly as you said it would be. And now, you're raising that spend level even further. So can you just talk about where the incremental spend is going. What kind of new incremental technology announcements could that lead to? You mentioned a couple on the call, but I'm just really curious as to where the spending is going and when we could expect to get more visibility on the output from that spending.

Gary S. Guthart - President, Chief Executive Officer & Director

Sure. So on the spend, I think the acceleration is really borne of confidence, confidence in the long-term viability of some of the markets and some of the things we're pursuing. You'll see it really cut into a couple of buckets. Some of it is investments in OUS markets where we think that we can do more by investing more, and we've been talking to you about that. The other side is on R&D.

And in terms of categories, we've talked about it before, but we believe in them deeply: advanced imagining, the ability to see beyond what you can just see with your naked eye; new robotic architectures that allow surgeons to get into and out of the body in different ways and to different places than they could reach prior; as well as analytics and over-the-shoulder guidance, all things that we have been investing in, some things that we're accelerating.

So we won't do product announcements on this call. As we get deeper into those things and are ready to share them more broadly with you, of course we will.

Robert Adam Hopkins - Bank of America Merrill Lynch

And then lastly, just to get a sense, I thought I heard something about positive hysterectomy in Japan. It went by pretty quickly. Is there some positive momentum on hysterectomy in Japan from a reimbursement perspective?

Patrick Clingan - Finance Director

Yeah, Bob, the MHLW approved for a clinical trial to begin enrollment supporting malignant hysterectomy under the sensionary OB (28:17) process.

Robert Adam Hopkins - Bank of America Merrill Lynch

Perfect. Thank you.

Operator

Thank you. And ladies and gentlemen, it's been requested if you can limit yourself to one question and one follow-up question, and we'll take additional questions as time permits. Our next question from Tycho Peterson, JPMorgan. Please go ahead.

Tycho W. Peterson - JPMorgan Securities LLC

Okay, thanks. I'm just wondering if you could talk a little bit about Table Motion, how many systems are installed that are capable, what percentage of systems I guess have the option included, and if you could just talk a little bit about how it flows through to gross margins as well. It's mainly a software upgrade from your perspective, right?

Marshall L. Mohr - Chief Financial Officer & Senior Vice President

Yeah, we're pretty pleased with the level of adoption for Table Motion, where the information we're getting back from surgeons is they're pleased with its usage and its performance. We're not going to be disclosing every quarter just how many tables we've delivered, so I won't go there. I'll just tell you that, again, we're pretty pleased with the level of adoption.

Gary S. Guthart - President, Chief Executive Officer & Director

Obviously, the revenue and the margin side.

Marshall L. Mohr - Chief Financial Officer & Senior Vice President

Yeah, the margins – so what we're providing is a software update to the Xi that enables the Table Motion. The table itself is being purchased from Trumpf.

Unknown Speaker

(29:37).

Marshall L. Mohr - Chief Financial Officer & Senior Vice President

(29:39). And so, our billing is 100% margin.

Tycho W. Peterson - JPMorgan Securities LLC

And I guess maybe what I was getting at is the degree to which this is going to drive a bolus of demand for Xi now that you have that, plus the full instrument set. Could you maybe just talk a little bit about how you see that flowing through to Xi demand?

Gary S. Guthart - President, Chief Executive Officer & Director

Yeah, I think that it – each one of these steps, the 30-millimeter Xi stapler, the integrated Table Motion now, the Xi instrument kit is rounding out that Xi platform. And we have some more to do. It's not all complete, but it's definitely becoming a much fuller and richer ecosystem. We think that helps. It's very hard to forecast how much it is, how many people sit and wait until the next step, but we think those things add clinical value.

For sure, a 30 millimeter stapler in thoracic procedures is a big win, likewise Table Motion for a lot of the more complex procedures. So we think that's strong. And there are a group of hospitals that use Si with Single-Site that if they're a single system hospital, they only own just one and they have a robust Single-Site program. This allows them to consider Xi as an upgrade. So it's hard to quantify, but we think directionally it's really strong.

Tycho W. Peterson - JPMorgan Securities LLC

Okay. And then a follow-up. Can you just comment on Europe? It looked like that was a little soft. Maybe just talk about the outlook there for the year.

Gary S. Guthart - President, Chief Executive Officer & Director

Yeah. Europe was definitely variable, both in procedures and in systems. On the procedure side, we had some strength in some countries where they're moving along, and we think there's opportunity to do that and better. There are some other countries where it's going a little slower. Sometimes, it's a local economy issue. Sometimes, it's more where we are in maturity. In some of these countries, we're pretty well adopted in the mature procedures and they're really at the beginnings of emerging procedures. So it depends country-by-country.

On the capital side, I think there's two things going on. A little bit of environment is one, and a little bit of wait-and-see on competitive offerings as they come out, and we're navigating that pretty well. In terms of head-to-head comparisons with our technology, our systems are coming out great. But it can put a delay in the pipeline, and we're seeing a little bit of that in Europe.

Marshall L. Mohr - Chief Financial Officer & Senior Vice President

The only other thing I'd add is that Europe has become very seasonal. And so if you look at Q4, it was extremely strong relative to the previous couple of quarters, and Q1 is more comparable to the previous year Q1.

Tycho W. Peterson - JPMorgan Securities LLC

Okay. Thank you.

Operator

Our next question from David Lewis with Morgan Stanley. Please go ahead.

David R. Lewis - Morgan Stanley & Co. LLC

Good afternoon. Just two quick ones here. Marshall, just coming back to gross margin guidance, so GMs have been stronger for five consecutive quarters, and the guidance sort of implies no improvement throughout the year which seems, I guess, less likely to us, just given the cost improvements you've already discussed. So can we just talk through gross margin progression throughout the balance of the year and why you think 70% here in the first quarter is the high water mark?

Marshall L. Mohr - Chief Financial Officer & Senior Vice President

Sure. So one of the biggest factors we see going forward is product mix. So know that we have higher margins on instruments and accessories than we do on systems. And Q1 tends to be seasonally a lower quarter for capital. And also, we see growth in the new product, particularly energy product, stapling and vessel sealing going forward. And those also have lower margins than the base. So I think just based on product mix alone, we don't expect to sustain 70%.

David R. Lewis - Morgan Stanley & Co. LLC

Okay. And then Gary, obviously, people have asked about spending already. And I note that the R&D spend is the highest we've seen in four years. So you're obviously clearly going to continue to invest. I've no expectations you're going to talk to us about future instrumentation and system announcements, but I think the enigma for most shareholders actually is advanced imaging, because that's sort of more future looking. Is there any chance we get incremental updates or at least even any update on the strategy for advanced imaging this year? Thank you.

Gary S. Guthart - President, Chief Executive Officer & Director

Yeah. It's a fair question. In general, we have been making early investments in advanced imaging. And what I'd tell you there is it's not one thing. As you know, we have Firefly which is a molecular imaging based product. We also have invested in raw imaging hardware capabilities which we'll continue to do. What we like to do is, as we have milestones that make sense, whether it's talking to regulatory bodies or engaging in clinical work, those tend to be good anchors to discuss with you. And as those arrive, then we'll share with you what we're thinking.

David R. Lewis - Morgan Stanley & Co. LLC

And could those arrive potentially in 2016 for advanced imaging or unlikely?

Gary S. Guthart - President, Chief Executive Officer & Director

I think when we get there, we'll let you know.

David R. Lewis - Morgan Stanley & Co. LLC

Okay, sir. Thank you.

Operator

And we'll go next to David Roman with Goldman Sachs. Please go ahead.

David Harrison Roman - Goldman Sachs & Co.

Thank you and good afternoon, everyone. I wanted, Gary, just to come back to some of the early part of your prepared remarks where you discussed the continued momentum that you're seeing in hernia. And it seemed like at stages this year, there was sort of a positive, I would say, tipping point but just incremental enthusiasm from the position community around this procedure. Can you maybe sort of talk about what you think specifically is stimulating that demand and why you're confident in that continuing on a go-forward basis?

Gary S. Guthart - President, Chief Executive Officer & Director

There's two ways that our confidence has been building. One of them is around the clinical outcomes and anecdotes that we hear. And that comes to, as we've talked about before, inguinal hernia particularly is a segmented market. Not all patients are suffering the same level of disease and in the more complex cases, if it's bilateral or prior abdominal surgery, obese patients, a large herniated sac. The raw clinical capability of our products is being touted as and supported by surgeons as being important to them, a better quality of intervention, consumable costs in line with what their expectations are. So there, I think that we're feeling pretty good.

The second thing we can do is analyze kind of the reorder rates from surgeons as they go forward. So as you get through the trial periods, seeing kind of where as they learn it and get deeper and deeper into it, where do they apply it and how often do they keep buying our products. And that has been supportive as well. So as those two things come together, we start feeling better about it. And that's what's behind that set of comments.

David Harrison Roman - Goldman Sachs & Co.

That's helpful. Thank you. Then just for my follow-up on the operating lease side, it looks like this is sort of a higher quarter for percentage of total coming from operating leases. So I guess, A, can you just talk sort of through some of the dynamics underpinning that? And then, B, based on your disclosures, it looks like people are buying out these operating leases relatively quickly. Maybe help us understand is that true and why that's the case.

Marshall L. Mohr - Chief Financial Officer & Senior Vice President

Sure. So, the operating leases is our way of being able to be flexible with the customer and meet the customers' needs in terms of financing. Some of the leases are shorter term and basically bridge their ability to get to a capital approval process, and those are a couple of the ones you've seen bought out in this quarter. Most of the operating leases are longer term being four- and five-year terms. And we'll drive a recurring revenue going forward. Like we said, this quarter was around $4 million.

David Harrison Roman - Goldman Sachs & Co.

Okay. Got it. Thank you.

Operator

Thanks. Our next question from Ben Andrew with William Blair. Please go ahead.

Ben C. Andrew - William Blair & Co. LLC

Gary, a question on the ecosystem. One of the most material competitive advantages you guys have is kind of the embedding of the technology and your training and all the other things throughout the healthcare system. What investments can you guys make? And are you planning to make it different than what you've done before to try to lever that because you did specifically call that out?

Gary S. Guthart - President, Chief Executive Officer & Director

Yeah. Thinking a great robotic surgery program is really the integration of all of those things, and there are multiyear efforts to build that set of programs from peer-to-peer networks that do advanced course work and teaching to validated learning pathways and simulation. Those validations are multiyear efforts to get right to the full instrument kit from vessel sealing to stapling and so on.

And so, we're pretty thoughtful about balancing that set of investments. The thing that has gotten really stronger and interesting in the last couple of years have been our ability to analyze data, look at national benchmarking, look at regional-based benchmarking, and share that information with our customers so that they can make good decisions.

Sometimes, those decisions are good for them and not great for Intuitive in the near term. If they optimize their program, we may get revenue per procedure in the near term. But we think long term, it's better for everybody. And so, we've been making those analytics in those investments and then communicating with hospitals. So we really have been plugging in in each of those settings. And I do think it makes for an ecosystem that creates a lot of value for the customer and builds our relationship with them.

Ben C. Andrew - William Blair & Co. LLC

Thank you. And Patrick, a quick one for you. Can we think about the extra selling day as maybe 1.5 percentage points of procedure growth? I know there's some offsets with Easter, et cetera. But is it in that range of what the bump was net?

Patrick Clingan - Finance Director

Yeah, Ben, I'll let you kind of do your math on the specific percentage. But as it relates to the benefit, it really is just think of it more as in the U.S. because the favorability of leap year and new year gets mostly washed out by Easter, particularly in Europe.

Ben C. Andrew - William Blair & Co. LLC

Got it. Thank you.

Operator

And we have a question from Rick Wise with Stifel. Please go ahead.

Rick Wise - Stifel, Nicolaus & Co., Inc.

Good afternoon, Gary. Good afternoon, everybody. I wanted to talk a little bit more about U.S. urology and U.S. gynecology. I was really intrigued with the modest growth on the gynecology side. I mean that's a significant turnaround from the headwind you faced over the last couple of years; also urology acting better. Have we worked through some of the challenges in each? And are we actually going to return to more sustainable growth in U.S. gynecology after a year or more or two of training and education, et cetera?

Gary S. Guthart - President, Chief Executive Officer & Director

Let me speak to a couple other factors, and then I'll let Patrick take it from there. As we look at urology, you've got it right, three main procedures in urology: prostatectomy, partial nephrectomy and cystectomy; the biggest one being prostatectomy. We know there was a bolus of patients that went into watchful waiting, some of whom will have disease progression and come back to definitive treatment. How long that bolus lasts is a little bit hard for us to predict.

The second thing are the possibility of share changes between some of the treatment modalities, surgery versus radiation, versus watchful waiting. That data tends to lag. It's hard to get it in real-time. There may be some share change, although if there is, it's probably modest. And then there's just demographics. As demographics changes, you have more folks getting diagnosed with prostate cancer over time. So those are the three things that are rolling through, and sort of projecting how they balance out is what the challenge is.

On the gynecology side, the thing that we're seeing in our experience is that you're seeing more surgery being done by high volume gynecologists in general, not just robotic surgery but laparoscopy and others. We're seeing a consolidation in the marketplace into folks who are either GY (41:53) oncologists or more routine surgeons. We think that's good for the world, and we think that's good for Intuitive.

Those more dedicated surgeons tend to be our customers. We see them tackling more procedures in concentrated fashions, and so that's kind of what's happening in gynecology. Likewise, I think there's a demographic element here that's likely to find the bottom and then start to drift up. The unknown is nonsurgical approaches and in-office approaches. Those are kind of the factors at play.

Patrick, I'll let you go from there.

Patrick Clingan - Finance Director

Yeah. No, I think you described the urology situation well. The other thing to bear in mind in the GYN market is while Single-Site procedures have been declining, some of the other benign procedures have been stabilizing and are creating less of a headwind to us on a year-over-year comparison basis, things like myomectomy.

Rick Wise - Stifel, Nicolaus & Co., Inc.

And I guess my follow-up question, and it might have been you, Patrick, who mentioned it, I think somebody described OUS procedure growth as it can be lumpy and "we're working to improve the performance there." Can you talk a little about how you're going about that? What kind of initiatives are underway? And what you would hope or we should expect might come from those initiatives? Thank you.

Gary S. Guthart - President, Chief Executive Officer & Director

Yeah, I'll take that one, Rick. The opportunity in Europe tends to be country by country. So, where we're looking to do something different or better, it tends to be making sure that we have staff that is supporting local efforts and local needs that they're working in local language, that they understand the healthcare systems in intimate ways that are specific to that country. And so where we see opportunity, we'll invest there and build that out; we have been. Where we've made investments, we've seen growth. And so, where we see some areas of opportunity, we think we have a playbook. Now, we have to go execute against that playbook. That's been our perspective there.

Rick Wise - Stifel, Nicolaus & Co., Inc.

Thank you.

Operator

And we have a question from Matt O'Brien with Piper Jaffray. Please go ahead.

Matt O'Brien - Piper Jaffray & Co. (Broker)

Good afternoon. Thanks so much for taking the questions. I was hoping to start on the general surgery side. And it sounds like again very good quarter, but I'm just curious if either of the various ventral – or I'm sorry, the various hernia cases are really leading the charge in some of that growth. Are you seeing any kind of divergence or inflection in either ventral or inguinal? And are those procedures at this point getting sizable enough to start to sway hospital decision making as to adding additional systems in order to meet that demand?

Patrick Clingan - Finance Director

Hey, Matt. Thanks for the question. Certainly, both ventral and inguinal hernia procedures continue to exhibit robust growth. Inguinal hernia is just a bigger overall procedure category. It's just more commonly performed. But the rates of adoption that we're seeing in both procedures is encouraging, and the surgeon populations that are performing them are continuing to increase the volumes of procedures that they're doing. So it looks promising.

And certainly, from an overall volume perspective, it had some influence because just the numbers are getting to the point where it matters to create access for these surgeons to be able to continue to perform procedures that they are absorbing systems worth of activity at some of their institutions.

Matt O'Brien - Piper Jaffray & Co. (Broker)

Okay. That's very helpful. And then, Gary, your commentary about the delays that we saw in Europe as hospitals are evaluating some competitive systems that are hitting those markets is curious to me. Do you think that's something that will linger here throughout 2016 as those systems are fully rolled out? Or do you think it'll be a fairly quick process of kind of taking a peak, and maybe they're doing that now and we could see a snap-back in terms of the number of systems placed? I mean specifically, did you see 10, 15 hospitals kind of delay as they were evaluating both systems, and then out of those 10 hospitals, 9 of them ended up buying da Vinci either late last quarter or even early his quarter?

Gary S. Guthart - President, Chief Executive Officer & Director

Yeah. I think that it's a little bit hard to predict how fast it will go through. I guess our anecdotal experience has been, some have been quick looks, and make an evaluation and come sign up with us, and others are going through a little bit longer process. So with regard to a "snap-back," I wouldn't bake that in. I think it will play out a little longer than that.

Having said that, the response of our customers after they have evaluated the other offerings and come back to talk to us has been fantastic. So our confidence that we have good offerings and we can meet these customers' needs is very high. They'll go through that process. And I think as new and different technologies come to market, not just the ones that are there today, I think this will be part of the new normal a little bit for Europe, is people cross shopping and making decisions. And our goal is to make sure that they find our products to be a very high value. So far, so good.

Matt O'Brien - Piper Jaffray & Co. (Broker)

Got it. Very helpful. Thank you.

Operator

And we have a question from Larry Keusch, Raymond James. Please go ahead.

Lawrence Keusch - Raymond James & Associates, Inc.

Thanks. Good afternoon. I wondered if we could just, first question, start with the trade-ins. I think there were 42 as you mentioned this quarter, and I think the prior quarters it's been sort of averaging closer to 30. So I'm just trying to understand perhaps what is driving the higher trade-in. And then what's the ultimate opportunity to drive trade-ins in your older system base?

Marshall L. Mohr - Chief Financial Officer & Senior Vice President

There's nothing specific about this quarter that I would call out as it relates to trade-ins. I think you have the numbers right. It came off of our – the detail we provided with the press release. I wouldn't call anything out specifically. I think last quarter, it was around – in the high 30s, and it's been there for a little while. I don't know that – it'll probably fluctuate in that range. So I don't have any specific comments on it.

Lawrence Keusch - Raymond James & Associates, Inc.

Okay. And then for Gary, maybe just an update on SB (48:01). You mentioned some in your prepared comments. But where are we in getting those evaluations going? And is it conceivable that we could see commercial units perhaps by the end of the year?

Gary S. Guthart - President, Chief Executive Officer & Director

So we are in discussions with FDA on a trial type and end points, and we have clinical sites that are getting prepped; the product from the engineering and design and validation point of view is right on track. It looks really good. We're not expecting anything of substance in terms of revenue this year. We do expect them in clinical use in the second half, and that's what we're working towards.

Lawrence Keusch - Raymond James & Associates, Inc.

Perfect. Thank you.

Operator

And we have a question from Jason Mills with Canaccord Genuity. Please go ahead.

Jason R. Mills - Canaccord Genuity, Inc.

Great. Thanks, guys, for taking the question. Congrats on a great quarter. My first question has to do with just trying to understand better your dogma as it relates to managing the P&L. So what obviously we're getting here is higher procedural volume guidance and higher operating expense guidance. What we seem to be seeing is some leverage to the operating line. But I'm just curious, Gary, if you could talk about – Marshall, talk about your dogma over the next couple of years. And sort of are you looking for operating margin expansion? Is that what your objective is? Are you managing the business to top-line growth and trying to manage expenses the best you can to get there? Could you just talk about your dogma as it relates to managing the P&L?

Gary S. Guthart - President, Chief Executive Officer & Director

Yeah. So my first statement is kind of a caution of, beware of averages. So there are places in the business where we're seeking high operational efficiency and leverage. You see that in product cost reductions and some of the things we're doing in manufacturing. There are other places in the operation where we think we can find leverage. At the same time, we want to turn around and reinvest those savings in opportunity. And we see a lot of opportunity. And I think that that opportunity should be pursued.

So it'll be a little bit lumpy. We're trying to be balanced. I wouldn't say that our approach is hard over one or hard over the other. It's not revenue above all else, and it's not profit above all else. We're trying to be balanced in that approach. And it may be a little bit lumpy. I think opportunities happen when they happen. You can be overly cautious and miss them, and so we'll maintain a fiscal discipline. That's been part of our history and we'll keep it. Having said that, we want to make sure that we reinvest some of the benefits that the company has gained into expanding the opportunity we see in front of us.

Jason R. Mills - Canaccord Genuity, Inc.

That's helpful. My second and final question, having to do with your cash balance and use of cash, you've been very proficient at buying back stock in the past. Given where the share price is juxtaposed to a significantly expanding cash balance, would it be fair to assume that you'll do maybe modest to moderate share repurchases going forward? Or will we see maybe less over the next two years than we saw in the last two years? Thanks.

Gary S. Guthart - President, Chief Executive Officer & Director

In terms of just how we think about capital allocation, we are thoughtful and serious about it, as you'd expect. We think buybacks are one leg or one tool in capital allocation. We really start with, can we reinvest in the business and drive long-term growth and opportunity, buybacks if – there are times we've been typically patient and opportunistic. And we think because of the volatility of our stock, there are times that that makes a lot of sense for us.

And in conversations with shareholders, where we are thoughtful and listen, then we have considered dividends, and we will consider them in the future. So, we look at those three things and try to trade them off. And we think for the long term; when we're thinking about capital allocation, we're not trying to do signaling or messaging. We're trying to build value for the business and for the shareholders in the long term.

Jason R. Mills - Canaccord Genuity, Inc.

Thank you, guys.

Operator

And we have a question from Vijay Kumar with Evercore. Please go ahead.

Vijay Kumar - Evercore ISI

Hey, guys. Thanks for taking my question. So maybe one on the OUS placements. I know China, I think on the last quarter, you said they had about eight systems. Can we expect sort of renewed, I guess, a contract from the government, right (52:46)? How should we think about OUS from a systems perspective given that China, they're probably at the end of the amount of systems that they can import?

Marshall L. Mohr - Chief Financial Officer & Senior Vice President

Yeah. So, I'll speak to China first and then to other locations next. As far as China goes, when we left last quarter, there were about six systems left on the quota. We sold five this quarter. There's still one out there. I don't know if it'll happen. And we're going to have to go through a tender process, and that tender process had to have already begun.

As far as additional quotas, it's a part of the overall budget, government budget process in China. And so when that gets completed – and I don't have a magic ball that tells me when it will be completed – then we'll know whether we're still under the quota system and we'll know, if we are under the quota system, how many will be awarded. And there's no way to predict that in advance.

As far as the rest of the world goes, in my remarks, I mentioned that the fourth quarter is a seasonally strong quarter. If you look at where we came out for this quarter, it was pretty comparable to last year for the first quarter. But it's going to be lumpy market-by-market depending on the circumstances.

Vijay Kumar - Evercore ISI

Great. And then maybe one follow-up for Gary. I know that clinical trial – I mean R&D expenses were up 25% in the Q. Does that number include any clinical trial expenses, because I'm just trying to get a sense for – and as you talked about Japan, starting clinical trials, sort of any potential impact on that number?

Marshall L. Mohr - Chief Financial Officer & Senior Vice President

Yeah. There's some – we've said before, we're in the middle of gathering data or evidence for gastrectomy in Japan. That doesn't go into R&D. That's actually in our SG&A numbers. And if we were doing – I mean, as far as other clinical trials, we'll tell you about them when we think it's appropriate.

Vijay Kumar - Evercore ISI

Thanks, guys. Congrats on a strong quarter.

Gary S. Guthart - President, Chief Executive Officer & Director

Thank you.

Operator

And our next question from Tao Levy with Wedbush. Please go ahead.

Tao L. Levy - Wedbush Securities, Inc.

Yeah, hi. Good afternoon.

Gary S. Guthart - President, Chief Executive Officer & Director

Hey, Tao.

Tao L. Levy - Wedbush Securities, Inc.

So, we've talked a lot about the sort of hernia colorectal surgery, but you mentioned a couple times thoracic surgery and the benefit that, particularly, the Xi might bring to that procedure. Can you sort of maybe summarize some of the key opportunities within thoracic? Should we think of it as colorectal type opportunity where it's moving in the right direction, but it's a little bit slower? Or could it potentially be more like a hernia or hysterectomy opportunity?

Gary S. Guthart - President, Chief Executive Officer & Director

Yeah. Just I'll start, and I'll ask Patrick to join in. Just from the starting place, these are typically cancer procedures and typically complex, mediastinal cancers, lung cancers. The product set that we have, Xi moves us in the right direction. Some of the instrumentation we're bringing along moves us in the right direction in terms of providing surgeons with the tools they are looking for for efficient procedures. And I think we're at the beginnings of that.

The way to think about the market is there are some minimally invasive surgery done manually, video-assisted thoracic surgery. Some institutions do a lot of it with good results. Others do very little of it. If you look at national averages rather than institutional numbers, you see a lot of open surgery done, and we think that that's the opportunity.

I'll let Patrick characterize it sort of.

Patrick Clingan - Finance Director

Yeah, Tao. It's still pretty early days. We're in the foundation. We've got a small team in the U.S. focused on it, but our focus continues to be on driving general surgery growth and hernia and colorectal resections. And internationally, we're still highly focused on driving dVP adoption and some emerging procedures in countries where urology is deeply penetrated. And when you look around internationally, it is a cancer that is very common in Asia and other parts. So it's very big opportunity for us, so perhaps a little bit around the corner from what we're currently focused on.

Tao L. Levy - Wedbush Securities, Inc.

Okay, great. And as my follow-up, you mentioned focusing on urology internationally. And I understand that it's still relatively under penetrated, but it is just the same procedure that you keep on going after internationally. Should we be worried that some of the other procedures that are catching on here in the U.S. over the last few years aren't moving the needle yet internationally? Thanks.

Gary S. Guthart - President, Chief Executive Officer & Director

Thanks, Tao. That'll be our last question. I'll answer that, and then we'll move on. I think it depends by country. So we see, for example, nice adoption of thoracic surgery in China. We see a pretty different mix of procedures in Korea than we see in the United States. So you have to answer it country-by-country. I don't think there's a systemic worry here that somehow we're stuck at prostatectomy and won't be able to move any further. I do think that it's important for folks on the phone to realize that the profile of procedures at each country is going to differ based on disease state, based on how the reimbursement system works and the relative priorities of their healthcare system. So we see that reflected. We do see multiple procedure adoptions in different countries. It just differs on what they're after.

Tao L. Levy - Wedbush Securities, Inc.

Thank you.

Gary S. Guthart - President, Chief Executive Officer & Director

Thanks, Tao.

Gary S. Guthart - President, Chief Executive Officer & Director

That was our last question. As we've said previously, while we focus on financial metrics such as revenues, profits and cash flows during these conference calls, our organizational focus remains on increasing value by enabling surgeons to improve surgical outcomes and reduce surgical trauma. We've built our company to take surgery beyond the limits of the human hand, and I assure you we remain committed to driving the vital few things that truly make a difference.

This concludes today's call. Thank you for your participation and support on this extraordinary journey to improve surgery, and I look forward to speaking with you again in three months.

Operator

Thank you. And ladies and gentlemen, we thank you for using AT&T Executive Teleconference Service, and you may now disconnect.

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