Intuitive Surgical, Inc. (ISRG) Q1 2015 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. And welcome to the Intuitive Surgical First Quarter Earnings Release Call. At this time, all lines are in a listen-only mode. Later, there will an opportunity for your questions, and instructions will be given at that time. [Operator Instructions] And as a reminder, this conference is being recorded. I will now turn the conference over to Senior Director of Investor Relations for Intuitive Surgical, Calvin Darling. Please go ahead, sir.

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, Director of Finance. Before we begin, I would like to inform you that comments mentioned on today's call maybe deemed to contain forward-looking statements [Audio Gap] including our most recent Form 10-K filed on February 5, 2015. 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 www.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. Then I'll provide our updated financial outlook for 2015. And finally, we will host a question-and-answer session. With that, I'll turn it over to Gary.

Thank you for joining us on the call today. In the first, we experienced solid growth in procedures, modest system sales growth and increase pressure on product margins. Starting with procedures, year-over-year growth in the first quarter was approximately 13%. Growth was led by general surgery, particularly hernia repair and colon and rectal resections. Early response by surgeons to the use of da Vinci and early datasets in these procedures are very encouraging. Urology also continued to show growth, maintaining growth rate seen in the fourth quarter. Year-over-year performance in gynecology grew modestly over Q1 of 2014. Procedure outperformance was broad based and included U.S., Europe and key markets in Asia. Patrick will review procedure trends in greater detail later in the call. Looking at trends in capital sales for the year, we placed 99 systems in the quarter compared to 87 in the first quarter of 2014. da Vinci Xi continues to draw significant interest from our customers. Sales in Europe are historically lumpy and Q1 sales were lower than Q4 due primarily to seasonality. System placements and distributor markets were solid in the quarter. In Japan da Vinci Xi was cleared for sale at the end of Q1. We placed one Si system in Japan in Q1 as customers waited to evaluate Xi. We have remained focused on supporting Japanese customers and pursuing reimbursement and continue to make progress in daily collection and analysis. Turning to costs, margins decreased relative to prior quarters as a result of three main drivers. First, manufacturing cost as a percentage of revenue for our new system and advanced instruments remained higher than our more matured products. As these new products make up a greater percentage of our sales, our aggregated product margins have declined. Second, service costs for our Xi Imaging system have remained higher than we would like, as we work new technologies into our supply chain. We are addressing both manufacturing and service costs, and we will pursue the reduction diligently over the next several quarters. Finally the strength of the dollar was a negative in margins. In the first quarter, financial and operational hedges have offset some of the impact of exchange rates, although, we expect the impact of exchange rates to increase through the year. Marshall will take you through this and other financial performance in greater detail later in the call. In summary, our operating performance for the first quarter is as follows. Procedures grew 13% over the first quarter of last year. We placed 99 da Vinci Surgical Systems up from 87 in the first quarter of 2014. Total pro forma revenue for the quarter was $532 million, up 9% from prior year and up 11% year-over-year on a constant currency basis. Total pro forma instrument and accessory revenue increased to $277 million, up 8% over prior year. We generated a pro forma operating profit of $185 million in the quarter compared with $189 million in the first quarter of 2014 and pro forma net income was $135 million compared to $139 in Q4 -- in Q1 of 2014. In product development, we are rounding out our Xi system offering by launching additional EndoWrist Instruments, developing Single-Site for our Xi system and integrating table motion on to the Xi platform. We expect to submit our 510(k) for software that enables table motion with our Xi system in the third quarter and the 510(k) for Xi Single-Site Instruments in the second half of the year. For da Vinci Sp, our dedicated single point of entry architecture, development remains on track with system integration and laboratory testing in process. I will now turn the call over to Marshall who will review our financial performance.

Thank you, Gary. I'll be describing our results on a non-GAAP or pro forma basis which excludes the impact of our Xi training program, legal claim accruals, stock-based compensation, amortization of purchased IP, and investment impairment. We are providing pro forma information because we believe that business trends and operating results are easier to understand on a pro forma basis. I'll also summarizer our GAAP results later in my script. We've posted reconciliation of our pro forma result to our GAAP results on our website. Pro forma first quarter revenue was $532 million, an increase of 9%, compared with $490 million for the first quarter of 2014, and down 11% from last quarter. On a constant currency basis, pro forma first quarter revenue increased 11% over the prior year. First quarter 2014 pro forma revenue includes revenue for systems where we subsequently offer a trade out -- to trade out Si product for Xi product. This trade out offers were either fulfilled or lapsed in 2014. Revenue highlights are as follows, pro forma instrument and accessory revenue grew 8% compared with the first quarter of 2014 and declined 1% compared with the fourth quarter of 2014. The increase relative to the prior year reflects procedure growth, partially offset by lower instrument and accessory revenue per procedure. The decrease from prior quarter primarily reflects procedure seasonality. Instrument and accessory revenue realized per procedure, including initial stocking orders was approximately $1,840 per procedure, compared with $1,930 in the first quarter of 2014 and $1,820 last quarter. The decrease prior -- relative to the prior year reflects the impact of foreign exchange, lower Si Vessel Sealer generators and Firefly kits, lower instrument usage per case as surgeons become more efficient in their instrument usage, partially offset by increasing stocking orders. The increase relative to the previous quarter primarily reflects increase stocking order and customer buying pattern, partially offset by the impact of foreign exchange. Pro forma system revenue of $141 million increased 9%, compared with the first quarter of 2014 and decreased 33% compared with the fourth quarter of 2014. The increase relative to the prior year reflects increase unit sales, partially offset by the impact of foreign exchange. The decrease in systems revenue compared with the fourth quarter primarily reflects seasonality of system sales than lower system sales in Japan as customers’ anticipated Xi approval. 99 systems replaced in the first quarter compared with 87 systems in the first quarter of 2015 to 137 systems last quarter. 76% of the systems placed in the first quarter were Xi, compared with 71% in the fourth quarter. Xi was launched in April of 2014. Globally, our system ASP of $1,480,000 was approximately the same as the first quarter of last year and decreased relative to last quarter ASP of $1,550,000. Relative to the first quarter 2014, system ASPs were higher due to the introduction of Xi, which was offset by geographic mix, a higher Si trading credit mix in foreign exchange. The decrease in ASPs relative to last quarter reflects higher trading credits and foreign exchange, partially offset by an increased mix of Xi product, including Xi dual-consoles. Hospital financed approximately 14% of the systems placed in the first quarter, down from 15% last quarter. We directly financed 11 systems of which 9 were structured as operating leases. Through the first quarter of 2015, we've entered into 23 operating leases. In the U.S., we placed 63 systems in the first quarter, compared with 45 systems in the first quarter of 2014 and 71 systems in the fourth quarter of 2014. The increase compared with the prior years reflects market acceptance of the Xi and procedure growth. The decrease compared with the fourth quarter reflects seasonality and system sales. Outside of the U.S., we placed 36 systems in the first quarter compared with 42 in the first quarter of 2014 and 66 systems last quarter. The reduction in year-over-year system placements includes a reduction in Japan system placement, one system this quarter compared with 19 systems last quarter as customers anticipated the Xi approval. We received Xi approval in Japan in late March. Europe systems placements grew from 14 systems in 2014 to $18 systems in the first quarter of 2015. We also placed eight systems in China this year, compared with zero in the first quarter of 2014. The reduction in systems placements relative to the prior quarter reflects seasonality. International revenue results were as follows. First quarter pro forma revenue outside the U.S. was $150 million, compared with $155 million for the first quarter of 2014 than $197 million last quarter. The decrease compared with the previous year reflects lower Japan system revenue of over $30 million and the impact of foreign exchange, partially offset by higher instrument and accessory revenue, reflecting procedure growth and higher system placements in the Europe and rest of world markets. Our lower sequential international revenue primarily reflects seasonality. Firs quarter 2015 o-US procedure volume was approximately 22% higher than the first quarter of 2014 and 12% higher than the fourth quarter of 2014. Procedure growth was led by DDP that also reflected strong growth in gynecology and general surgery. Before moving onto the remainder of the P&L, I’d like to outline the impact of the strengthening of the dollar has had on our results. We generally hedge a portion of our expected revenue for six months period at the beginning of January and July. In addition, we purchase system components from suppliers in euros and pay our sales force in local currencies, providing for national hedges. The pre-tax impact of currency movement, net of hedges relative to the fourth quarter was less than a $1 million. However, relative to the first quarter of 2014, currency movement had the impact of lowering our revenue to 9% versus 11% on a constant currency basis. Note that approximately 17% of our first quarter 2015 revenue was transacted in other than U.S. dollar, primarily in euro and yen. And natural hedges only partially offset the impact of currency movements on revenues. The impact of the past year’s currency changes will have a more pronounced impact going forward, particularly after our January as hedges expire in July. Moving to the remainder of the P&L, pro forma gross margins for the first quarter of 2015 was 65.6%, compared with 70.2% in the first quarter of 2014 and 67.1% for the fourth quarter of 2014. Our lower margin percentage relative to prior quarters primarily reflects a high mix of Xi systems, which have a lower margin than our mature Si products, as well as costs associated with our direct and scope recalls. New products like Xi and stapling have lower gross margins earlier in their life cycle than our mature products. We believe our efforts to reduce the cost of these products will begin to deliver limited improvements in our gross margins by the end of this year and greater improvement in fiscal 2016. The costs associated with the direct and scope recall, product recalls are not expected to continue. In the first quarter of 2014, we recorded a pretax charge of $67 million to reflect the estimated costs of settling a number of product liability legal claims under a tolling agreement. In the second and fourth quarters of 2014, we recorded another $15 million of charges reflecting additional claims. In the first quarter of 2015, we refined our estimate of the overall cost of settling claims and recorded $7 million of additional reserves. We will continue to refine our estimates as we proceed through the negotiation process. Pro forma operating expenses, which excludes the reserves for legal claims, stock compensation expense and amortization of purchases IP were up 6%, compared with the first quarter of 2014 and were down 1% compared with last quarter. Our first quarter 2015 pro forma operating expense compared to the first quarter of 2014 reflects headcount additions and higher incentive compensation. Our pro forma effective tax rate for the first quarter was 28.9%, compared with an effective tax rate of 27% for all of 2014. The pro forma effective tax rate for 2014 benefited from the release of reserves specific to tax years where we have completed our IRS audit or jurisdictions where statute of limitations has now expired. In addition, the 2014 rate benefited from the reinstatement of the federal research and development credit. Our tax rate will fluctuate with changes in the mix of o-US and U.S. income and will not reflect a federal research and development credit unless such credit is reinstated. Our pro forma net income was $135 million or $3.57 per share, compared with $139 million or $3.54 per share for the first quarter of 2014 and $184 million or $4.92 per share for the fourth quarter of 2014. 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 $532 million for the first quarter of 2015, compared with $465 million for the first quarter of 2014 and $605 million for the fourth quarter of 2014. GAAP net income was $97 million or $2.57 per share for the first quarter of 2015, compared with $44 million and a $1.13 per share for the first quarter of 2014 and $147 million or $3.94 per share for the fourth quarter of 2014. We ended the quarter with cash and investments of $2.7 billion, up from $2.5 billion as of December 31, 2014. The increase was primarily driven by cash generated from operations and proceeds from stock option exercise, partially offset by stock buybacks. During the quarter, we repurchased 30,000 shares for $15 million at an average price of $495 per share. And with that, I’d like to turn it over to Patrick, who will go over sales, marketing and clinical highlights.

Thanks, Marshall. As mentioned earlier, total first quarter year-over-year procedures grew approximately 13%, with U.S. procedures growing approximately 11% and international procedures growing approximately 22%. The meaningful uptick in U.S. procedure growth rates during the first quarter was largely due to a return to more normal Q4 to Q1 transition relative to what we experienced during the first quarter of 2014. U.S. da Vinci Prostatectomy procedure growth experienced in the second half of 2014 continued through the first half of 2015. Given our high rate of penetration in the U.S. prostatectomy market, our dVP volumes are likely to attract overall U.S. prostatectomy volumes, which had improved over the past three quarters. Kidney cancer procedures continued to be a solid contributor to our U.S. urology procedure growth during the first quarter. In U.S. gynecology, modest growth returned in Q1 led by benign and malignant hysterectomies. We believe that the modest increase in da Vinci benign hysterectomy volume during the first quarter has more to do with the return to normal seasonality than change in the trajectory of the total market for benign hysterectomies. We continue to believe that our procedure volumes are likely to attract to the overall benign hysterectomy market estimated to be declining at a low-single-digit rate. Despite high levels of da Vinci penetration for malignant hysterectomy, growth remains consistent with cancer procedures. Moving onto U.S. general surgery. Adoption continues to be solid across a broad number of procedures. Colorectal and hernia adoption remains a source of strength, while cholecystectomies continued to decline in the quarter. During the quarter, there were positive developments supporting the adoption of da Vinci surgery in colorectal resections and hernia repair. The colorectal resections, return of our Si Stapler and launch of our Si Stapler were positively received by surgeons. With our stapler, surgeons are reporting that the improved articulation and stability of the platform enables use deep in the pelvis for rectal resections while improved dexterity is supporting involving technique of intracorporeal anastomosis and right hemicolectomies. For hernia, the momentum behind adoption of da Vinci surgery and ventral and inguinal hernia repair continues to build. At the Society of American Gastrointestinal and Endoscopic Surgeons annual meeting and the Global Symposium on Robotic-assisted and Minimally Invasive Hernia Repair, surgeons shared case series that showed da Vinci surgery contributed to improve clinical outcomes within their practice and may serve as a tool to expand minimally invasive surgery to a larger population of patients. A number of surgeons have reported that the material operating costs associated with their da Vinci procedures is similar to the cost of laparoscopic procedures, as da Vinci technique enables substitution of high cost instruments such as tacks and balloons. Looking abroad, first quarter international procedure growth was approximately 22% continue to be led by global adoption of dVP and other urologic procedures with solid early contributions from gynecology and general surgery. In Asia, dVP adoption in Japan remained the source of strength in the first quarter. The clinical trial to support a reimbursement submission for partial nephrectomy completed enrollment and we continue to explore reimbursement pathways for additional procedures. In China, strong initial utilization of the systems sold in the second half of 2014 contributed to international procedure growth. In Europe, dVP adoption continues to be the primary driver of procedure growth in the first quarter with solid contributions from gynecologic oncology and colorectal procedures. During the quarter Dr. Ind and colleagues from The Royal Marsden hospital within the United Kingdom National Health Service published on the impact da Vinci surgery has had on the gynecologic oncology service in the Journal of Medical Robotics and Computer Assisted Surgery. In a study of 196 radical hysterectomies, the rate of laparotomy decreased from 60% pre da Vinci to 26% following the adoption of da Vinci surgery. Clinical outcomes improved as complications and blood loss were reduced and length of stay decreased by two days and average cost per patient decreased by about 1400 pounds or about 1200 pounds when system depreciation was modeled, though the author noted that the hospital’s existing system had capacity not being consumed by their urologists. In a detailed cost analysis, da Vinci surgery was found to be least the expensive method reported at 7900 pounds versus 12500 pounds growth in surgery and 10,000 pounds for laparoscopic surgery with the da Vinci surgery cost remaining low at 8500 pounds when model depreciation was included. This is also similar to papers from the U.S., Canada and Sweden that report clinical advantages and cost effectiveness of da Vinci surgery for gynecologic oncology. During the quarter there were several large scale database studies published supporting the role of da Vinci surgery. Two studies of interest pertains benign hysterectomy and partial nephrectomy. The first study used premier database at nearly 300,000 benign hysterectomies from 156 hospitals that adopted da Vinci following FDA clearance for gynecologic surgery in 2005. Published by Luciano and colleagues from the hospital of central Connecticut which supported from Intuitive. The study determined that the rate of minimal invasive surgery increased from 40% to 67% from 2005 to 2010. The increase of minimally invasive surgery came from both the adoption of da Vinci surgery and the expansion of laparoscopy. The profile of the da Vinci patient cohort was similar to the open cohort with higher comorbidities, larger uteri and a greater rate of morbid obesity than the laparoscopic and vaginal cohorts. Despite this more complex patient mix, da Vinci surgery experienced a lower complication rate than open, lap or vaginal procedure. This oral complication rate was also true during the initial 25 case series of a new adopting surgeon compared to mature rates of laparo open surgery. Conversion rates were also lower in da Vinci surgery arm compared to the laparoscopic arm. While the da Vinci procedures took longer than the other three modalities, experienced surgeons were able to achieve similar operative times to laparoscopy. There have been earlier studies published from the premier database that compared da Vinci surgery to laparoscopic procedures within the narrower patient population that is a minimal to laparoscopy, but this study showed da Vinci patient populations were closer in profile orphan surgery patients and that Vinci surgery improved clinical outcomes. The second study analyze the kidney cancer from within the Medicare surveillance, epidemiology and end results database to assess whether access to da Vinci systems enabled greater adherence to surgical society guidelines for partial nephrectomy and that clinical and economic da Vinci surgery has had on kidney cancer populations. A team of health economists led by Dr. Chandra from Harbor stuied over 27,000 kidney cancer patients treated with partial and total nephrectomies from 1995 to 2010 and published and help prepares. The office found the communities that had access to a da Vinci system were consistently more likely to have a higher rate partial nephrectomies compared to total nephrectomies and then those communities that did not have da Vinci system with an average 52% increase in the rate of partial nephrectomy penetration. Patients in this communities experienced lower rates of mortality and renal failure, These improved outcomes such as 5-year net benefit in quality adjusted life years of about $100,000 per patient. The author has concluded that the benefits of da Vinci surgery outweighed the cost by a ratio of 5:1 from a payer and patient perspective Intuitive provided financial support to the study. This concludes my remarks. And thank you for your time. I'll now turn the call over to Calvin.

Thank you, Patrick. I will be providing you with our updated financial outlook for 2015. Starting with procedures. On our last call we estimated full year 2015 procedures growth of 7% to 10% above the approximately 570,000 procedures performed in 2014. Now based upon continued strength in U.S. general surgery procedures, particularly hernia repair, favorable dVP macro trends and solid international procedure growth we are increasing our estimate for 2015. We now anticipate full year 2015 procedure growth within the range of 8% to 11%. Turning to gross profit. Our full year 2015 pro forma gross profit margin was 68.4% of revenue and at today’s exchange rate, we expect the stronger U.S. dollar will reduce gross profit by about 200 basis points for the year. Excluding this exchange impact, we anticipate our full year 2015 gross profit margin will be roughly flat with 2014 on a constant currency basis. We expect gross margin to increase by quarter in 2015 as the positive impacts of our product cost reductions take effect. Our actual gross profit margin will vary quarter to quarter depending largely upon product mix, systems production volume and foreign exchange rates. Turning to operating expenses. On our last call, we forecasted to grow pro forma 2015 operating expenses between 7% and 10% above 2014 levels. We now expect to grow our operating expenses towards the lower end of this range. We now expect our non-cash stock compensation expense to range between $170 million and $180 million in 2015, compared to $180 million to $185 million forecasted on our last call and $169 million in 2014. We continue to expect other income which is comprised mostly of interest income to total between $14 million and $16 million in 2015. With regard to income tax, we continue to expect our 2015 pro forma income tax rate to be between 28% and 30% of pretax income depending primarily upon the mix of U.S. and international profits. This forecast does not assume the reinstatement of the R&D tax credit in 2015. That concludes our prepared comments. We will now open the call to your questions. Operator?

[Operator Instructions] And our first question will come from Tycho Peterson with JP Morgan. Go ahead, please.

Thanks guys. I just want to start with your view on sustainability of some of the trends you are seeing in hernia. How much do you think is trailing right now if you kind of go back and compare in contrast to early experience with coli. How do you think about the trajectory going forward on hernia specifically?

Yeah. Thanks for the question. As I look at ventral hernia, I think that you are seeing pretty nice response, the early response from surgeons and the data looks, looks quite good. I think long term there that’s moving in a positive direction for us, how big that total market is, still little bit hard to estimate. But the early returns there look like surgeons are finding value pretty quickly. When you look at inguinal hernia, there are some sub segments in that. And so that one -- that picture is little more complicated or little more nuanced. There are clearly some cases that are more complex even because the disease is more advanced or because the patient has comorbidities in which da Vinci really is delivering value. We’re getting a lot of great feedback and there are some other procedures that are little simpler and a little different where it’s used maybe a little bit more optional. I think we’re going to have to let that play out. So I think on the renal side, there is clearly a segment that matters and there are some other segments that maybe less so and we won’t know for sure until we see few quarters pass.

Okay. And then as follow-up, since it is the first call, since we saw the United policy. Can you maybe just talk around preauthorization and what your discussions with docs are like and how you see that playing out both with United and other private payers?

Really speaking to the -- too soon to make any commentary really in the second quarters. Speaking to the first quarter, it really -- that said of preauthorizations and conversation is the continuation of a trend. We didn’t feel the nature of those conversations really change with our customers. We are attracting it in Q2 and that’s something that we can give you more detail on our next call.

Okay. And then just one last one on dVP, are you seeing any kind of bounce back around watchful waiting as some of the older patients drop out?

One of the underlying drivers we think for return of some strength in dVP. In the U.S. is that we’re seeing some patients come back into surgical options as falling out of watchful waiting. And you see some patients being diagnosed later as a result of less PSA screening. So it’s little bit of both of those things, I think, are contributing to growth. You’ve seen that stability now for a few quarters in a row. It seems to be evident.

Okay. Thank you.

Thank you. We’ll go next to Bob Hopkins with Bank of America. Go ahead please.

Hi. Thanks for taking the question. Just wanted to ask a financial question of Marshall on the gross margin side because there are more of the things that stuck out to me in the quarter. I think in the last quarterly call, you suggested that the gross margin for 2015 excluding stock option would be kind of similar to the low 67 levels that you saw exiting 2014. And I know you gave some updated guidance here but I was just curious if you could talk about for 2015, what’s your new guidance implies relative to the old guidance of the low 67s for the full year?

So to be clear, going from last quarter, you’re right, it was at 67.1 and this quarter we undershot that debt. Couple of factors there, one is foreign exchange changed since the time that we gave our original estimates back in January and that has a negative impact on us. Second thing is as we had some -- in the quarter we had some higher mix of Xi systems. And in Xi systems as we’ve said before it has lower margins than our Si systems. And then finally we had some of the product recall costs that we don’t expect to continue but they reduced our margin this quarter. As we go forward into the year, what our guidance is really predicting is that we are working hard towards reduction of cost associated with our newer products. And it will start to see some benefit from that. Having said that, it takes time and the majority of the benefit from those efforts will really be realized in 2016.

And just kind of running through the guidance one more time, Bob. So we kind of took a look at the full year 2014 gross profit margin on a pro forma basis, it was 68.4%. Now when you kind of look at the exchange impact at today’s exchange rate, we think impact is roughly 200 basis points. It gets you back to a constant currency scenario. So excluding that, you get something like 66.4 as the full year rate as Marshall mentioned making improvements by quarter as the year goes on as we are implementing some of these cost reduction improvements.

Okay. All right. So for the full year, you think you’d be somewhere around that 66.4 roughly. On the manufacturing cost for Xi, originally when you launched it, you told us it was lower margin product but then you said overtime you saw that the margin on Xi could get up and approach some of the Si levels. I’m just wondering if you can update us on how long you think that will take and then lastly for me is I was just wondering here if you can comment on different subject which is just your confidence in reimbursement for Japan in 2016. Any updates there would be appreciated? Thank you.

Going back to the comments on Xi, what we’ve said in the past is that our margins on our newer products and we typically talked about Xi stapling and vessel sealing, we’re lower in -- we'll be lower in the early stages of introduction and that will work to reduce those cost every time. We have always provided the caveat that it doesn’t necessarily mean you’ll get to the same level as our mature products. They are highly complex products. And so -- and they have added features to them. And so we never committed that we would get back there. Having said that, I think that they had room to improve from where we are and we are working hard on those improvements.

That’s right. Just turning to Japan, we continue to be in full conversation with multiple parties in Japan and supporting them as they pursue reimbursement. We’re generally pleased with the direction that the conversations are taking. We have not received assurance from the surgical societies or from the government that those methods will produce reimbursements in the 2016 timeframe, so that remains uncertain. Having said that I think, the work that’s been done in the pace of work been done is appropriate. And we feel like we’re doing the right thing.

Great. Thank you very much.

Thank you. Our next question comes from Ben Andrew with William Blair. Please go ahead.

Good afternoon, guys. Thanks for taking the questions. Few things, first off, Gary, talk a little bit about your confidence and the procedure growth? And what dynamics push you towards the higher end of the newly raised range?

So you’re asking a kind of hypothetically what would we see happen that would move it toward the top end?

Yes.

Yeah. So I think, we’re seeing strengthened in the U.S. general surgeries. So we would expect that to continue to strength there is centered on hernia and colorectal. Colorectal recessions, the data looks really good. There is a lot of data that started to come out. We expect that that will be a big risk conversation but the early results we’re seeing particularly as a result -- as it relates to the large population of patients were getting open surgeries looks great. I think that hernia would continue on its growth rate. It’s on the fast growth rate. I think as surgeons find value as those publications come out. I think that would support the higher end. Urology has had some macro environment positives but we would have to see those continue to be at the high end. And then gynecology has stabilized in this quarter. Although we think as Patrick has described in his prepared remarks that hysterectomy, the fundamentals around hysterectomy are likely staying about the same environment and we think that we’re really just looking at Q1 over Q1 changes here. So to be on the high end, I think you have to see positive support there and a stabilization of the coli business. And just to kind to add -- sorry Ben, to add the other end of it, what would be the assumptions to get to the low end? Probably you would be assuming a higher degree of payer push back on some of the benign gynecologic procedures.

Okay. And then Gary, just one other thing extending out there, what do you think the bottleneck is in general surgery penetration right now, is it Xi availability? Is its surgeon kind of training? And obviously, working hard on both of those but what do you think the bottle neck is?

Yeah. I don’t think its so much of product availability problem. I think it’s you can do a lot of certainly the introductory work on Si systems. For sure, Xi makes a difference in much quadrant and so that’s something we’re working on. Part of it is excess to training although I think honestly more of it is going to be surgeon education, surgeon interacting with their peers and looking at the data and the potential benefits. So some of its just pure adoption dynamics, peer to peer interaction.

Okay. Great. And then maybe a quick one for Marshall, you gave us some good insights on the gross margin trajectory. Where do you think you exit ‘15 on a gross margin standpoint excluding currency impacts? Thank you.

So I think, Calvin has given you a sort of the expectation for the year. And of course, given the commentary around that we believe that will be able to reduce cost as I expect that the latter part of the year will be better than the earlier part of the year.

Great. Thanks, guys.

Thank you. We now have a question from David Roman with Goldman Sachs. Please go ahead.

Hey guys. It’s actually Chris Hammond in for David here. Thank you for taking the questions. So my first question, I wanted to circle back to the gross margin conversation. And I understand that there are a number of puts and takes in the quarter whether that’s FX or recall cost and et cetera. But I was hoping that we could just kind of take a step back and talk about what your assessment is of the long-term trajectory for the gross margin of the business is. And primarily, I think that at least in my view, the biggest lever is probably around the ASP, both on instruments and for the systems. If I look at this over several years, they tend to be declining. And the argument that Xi is a greater percentage of mix. That seems to be the way of the future I guess, in where systems are going. So I just don’t understand how we can get back to where that all run rate was and any more color there will be very helpful?

So when you talk about the old run rate, I’m not sure which period you’re speaking about. I think that as we go forward, -- again not to sound like a broker record. But we’ll continue to look on cost associated with the newer products. I think that there are numerous dynamics on a long-term basis. So we haven’t put out any guidance beyond this year. And the numerous dynamics include over time. We’ll see some pressure on capital. We’ll defend what we have in terms of instrument and accessory and recurring revenue margins. We will and we’ll -- as we expand into products like stapling and vessel sealing will be taken a greater share of the overall wallet but likely at a lower margin. So there is things going for us and then they are saying several push back on it.

Okay. That’s helpful. And then just on the o-US side, I know there you talked about customers waiting in Japan ahead of the exciting approval but now that we’re moving past there. Is there any incremental call that you could talk about and what the customer reaction has been so far? Is there a more trailing period that has to go on or demo period that would make a more meaningful uptick in Japan, to be pushed out till little later in the year. Is that something that we might could expect in the second quarter?

The two dynamics going on with regard to the capital side in Japan. One of them is folks really coming into valuate Xi. The -- that's not in hospital that’s looking at the product and understanding its differences vis-à-vis Si. Now that’s happening now, the interest in it is quite high. What that looks like in terms of translating that interest into sales, we’ll see in the quarters. Our longer term in terms of building new programs, that really is going to be dependent on the reimbursement conversations that we’ve been having in this call and prior calls.

Okay. Great. Thanks, guys.

Thank you. Our next question comes from David Lewis with Morgan Stanley. Go ahead please.

Good afternoon.

Hi, David.

Gary, just a couple of questions here. I guess, first off, on hiring. Looks like the hiring in this particular quarter was the strongest we’ve seen or the highest we’ve seen in two years. I wonder if you just could, A, if that’s accurate, but it’s not accurate, how should that we know that would be an embarrassing question? But just in terms of where the hiring is happening? Is this U.S. hiring? Is this OUS hiring? And specifically, if it’s U.S. which particular procedures is this hiring going to support?

Yeah. Just functionally, where the adds remain, you’re right, it was 140 new employees added. We added in the quarter with 3,118 employees. I think majority of the add this quarter were in the product operations area, specifically in manufacturing, product developments and quality groups, and secondarily continuing to invest in our international organizations, including Japan and to a much lesser extent the U.S. commercial side.

Okay. Very helpful. And then, another question, I think, I asked a couple of quarter go was about the broader capital environments. I think the question in was based on what we’re seeing U.S. versus OUS. Have you reached the point where it’s more obvious that future capital growth or net placement growth is going to come outside the U.S. versus U.S. I think at the time, I think, Gary mentioned, it wasn’t clear, where we see -- as you take this four or two quarters and a couple of things this quarter, is it now beginning to become clear that net placement growth is really going to be materially driven outside the U.S. versus the U.S.? And this particular quarter, that placement growth was a little lighter. And was that just simply driven by Japan and China, specifically, was there any particular region you could call out that would explain the net placement differentials, so those two pieces would be great if you give some color on? Thank you.

Yeah. On the capital side, I think, there are a couple of things in the quarter that were a little more specific to us. On the U.S. side we see hospital systems, particularly corporate ownership optimizing their capital portfolio, it actually makes perfect sense. And so what they are doing is looking at where they want their systems both within hospitals and between hospitals that they own. We support them in doing that. And that’s, I think, will drive capacity consumption. And so on those bigger customers, they are doing that and we see that, that's not new for the quarter we’ve seen that for the last few, but I expect that trend to continue. For sure you saw a difference in Japan. I think a year ago in Japan, Marshall, the number was 19 down to 1. So that has to do with the things we had talked about prior about Japan both reimbursement and timing of Xi. I think that's the real question becomes, the answer of your question is going to come down to available capacity on systems and existing customers. How hard can they push capacity utilization before they need additional systems. We have a pretty good read on that for single hospitals. What changes the dynamic is our corporate-owned hospital groups, where they are willing to either move doctors, move patients or move systems to get higher utilization and that part is not yet clear where that will settle.

Okay. Thank you so much.

Thank you. Our next question is from Tao Levy with Wedbush. Go ahead please.

Great. Thanks. So quick question on the gross margin side, so you, I understand you brought in-house some manufacturing that you were outsourcing before? Does that -- did they have any impact -- sort of a negative near-term impact on the Xi manufacturing costs and you expect that to improve as you get better experience at some of that?

What, a couple of things there, one is, we’ve periodically both in-source and outsourced, I wouldn’t tag one particular thing as the general trend here. In terms of Xi cost reductions, the work that we are doing tends to be a fair number of little things. It’s not a one big activity that does the trick. It’s really optimizing both component manufacturing, looking at manufacturing yields in various parts of the line and working with suppliers who have better processes. So it’s a lot of little work and I wouldn’t tag it to one thing in particular. On the service side, some of it is really getting to utilization of our products and what service costs are both in terms of building out the field replaceable units in the field, so there’s some investments to make that happen, as well as optimizing kind of the ruggedness of some products in some environments. And so we are -- those -- that's the main focus on that product side. As Marshall said, we expect the instruments and accessory side to recover our margin quickly. We think the system side will be a little slower.

Okay. And sort of on the hysterectomy front, any update on the uptake of Single-Site hysterectomy with the wristed articulation and also just to tag onto that and you said, year-over-year the comps were easy in hysterectomy? What about quarter-over-quarter anything there like might give you some comfort that hysterectomy might be a little bit better than you alluding to?

Yeah. Thanks for the question, Tao. When you look at the Single-Site it's been the Wristed Needle Driver has been well received by the gynecologic surgery community. Reinstalling a risk on the single site platform enables them to do more of the reconstruction that they used to when they do a lot for da Vinci hysterectomy. So it’s been more received, it’s still early days and we’ll see where it goes from here, specific to -- sorry what was your other question?

Looking at hysterectomy quarter-over-quarter instead of year-over-year with the comps?

Yes. I think when you look at GYN space and some of the other benign procedures, this quarter looked a lot more like traditional Q4 to Q1 transitions relative to what we experienced in 2014.

Okay. Great. And then just lastly, any reason why you're seeing lower Vessel Sealer usage, I would’ve assumed that would have gone up?

Just a point of clarity -- Calvin go ahead.

No. I think in general, we are seeing increased Vessel Sealer utilization in the field. What you're seeing less of there is initial orders of the Vessel Sealers and the generator products that are part of that initial sale. A bolus of hospitals had now made those investments and that had run through our accessory line. Also the -- that's right.

The generator is integrated into the Xi, so they have to do separate purchase.

Okay. Perfect. Great. Thank you.

Thank you. Our next question is from Larry Keusch with Raymond James. Please go ahead.

Good afternoon. Thanks. Garry or any of the team, I am wondering if you could speak a little bit to call as you -- you did indicate that that again you saw those procedures decline. I think in the past you sort of talked about surgeons making decisions on what procedures should be done in as coli falls to the bottom when you are looking at other general surgical procedures. So just wanted to see if you got any further insights into why that procedures set appears to be declining?

I think our commentary is similar to what we had talked about last quarter. Given the choice for competitive block time on one of our systems, if they can trade it off between a hernia procedure or colorectal procedure or prostatectomy, quality tends to be a lower priority. We see surgeons and patients who are delighted with the results and who are committed to it. And we see some folks who -- if they have a barrier else we’ll switch to a different approach and if there is a barrier having to do with machine access or so there is barrier with OR times or other approaches. So how big that market ultimately is and what it does as capacity settles out with remains to be same.

Okay. But you are not seeing any specific issues with the procedure itself, I take it?

No, we haven’t seen anything that would indicate that clinically there is something going on and that's changing folks’ view.

Okay. And then I am wondering Gary if you could talk a little bit about China, which is just a market that you started to speak to in the last couple quarters. Maybe help us understand sort of where we are within that market, what needs to happen to further develop it and maybe how we should think about the potential adoption of this technology over there?

Sure. Clearly, we are in early innings here in China. The response we are seeing both in terms of capital and then the utilization really has to do with the release of a government quota a few quarters ago and now the replacement of those systems is there meeting that quota. Capital sales are still paced in terms of the civilian market through a quote system and so that’ll be a limiting step on growth over time. Having said that once they are placed the utilization is coming up and the level of excitement and interest on the part of surgeons is high. We are currently partnered with the distributor in China. I think that as we look at long-term and years not quarters, clearly there is an opportunity there. And there will be some build-out of organizational strength required on both sides for that market to really reach its full potential and it’s something of course that we’re thinking about.

And then lastly there for Marshall or Calvin, Calvin, in your guidance you indicated on operating expense. If I got this correctly that you now anticipate those expenses to grow at the lower end of the 7% to 10% range. It wasn’t clear to me why those expenses now are anticipated to go slower than they had been a quarter ago.

Yes. I mean, there is certain element of timing in terms of new hires and programs. But I think it really the exchange impact that we’ve been talking about in terms of its impact on revenue and margin as an effect of reducing the expenses in U.S. dollar terms and it’s largely that that you’re seeing.

But no holding back on number?

No.

Okay. Thank you.

Thank you. We now have a question from Imron Zafar with Jefferies. Go ahead please.

Hi. Good afternoon. Thank you for taking my question. I wanted to ask you about where penetrations stands in some of the developed market like Western Europe and maybe Korea, in dVP. And I guess also dVH just in terms of where penetration is and what the -- how much runways lies ahead in terms of growth opportunity going forward?

We think about as you look out at Europe, take it country by country, generally we’re at healthy penetration but below half in most of the big markets in Europe. So Germany, Italy, France are probably highest in Nordics and then in U.K. So we think there is a significant room both in dVP and partial nephrectomy. Hysterectomy will really be anchored on hysterectomy for malignant conditions. I think we’re just in the beginnings of hysterectomy for malignant conditions in Europe. We are seeing some nice really uptake and some nice really work, but you’re probably still on single digits for the most part.

And like the Nordic countries and growing quickly in the U.K.?

Korea is a similar I think picture. dVP again in the double digits probably not quite half, and likewise really early days in dVH for malignant conditions or partial nephrectomy in between those two.

Yeah. And one thing that was interesting, Imron. Last year for 2014, we did about 60,000 prostatectomies in the United States. If you look at the international market all-in, it was 65,000 with a lot of room to grow as was described.

And then lastly, I was wondering if you had any more updates on the Sp in terms of timing, where you are vis-à-vis instrumentation and things like that?

Yeah. So we recall -- we are working through two things. One is making computational platform and the software compatible with Xi and we are on track doing that. And the second thing is being getting the supply chain and costs in line for the instrumentation on the technical side and that’s also on track. As those things come together then we start doing laboratory testing, some in-house customer evaluation and the beginnings of laboratory testing and the building of those dossiers, which is really what’s set for the back half of the year. So far, we are pleased with where we are.

Okay. And not to beat the gross margin, that was even more but the Sp launch plan that is all factored into your commentary about potential improvement gross margin next year?

We haven’t tagged a launch date on Sp, nor we tag pricing yet. So we’re really -- the commentary is really ex-Sp without income.

Okay. Great. Thank you very much.

Thank you. We now have a question from Richard Newitter with Leerink Swann. Go ahead, please.

Hi. Thanks for squeezing me in. Just to follow-up on that last question on the gross margin in Sp. When Sp does actually come to market, is that something where we should maybe expect kind of an incremental gross margin drag and so you get up to kind of economies of scale on that?

Yeah. Generally speaking, just sort of some context on system gross margins, this systems when they come out relative to industrial products are very low volume compared to anything you used to in your day-to-day life compare to cars or cell phones or anything like that. These are really low volumes. So part of the reason that you go through the process of optimization over a couple of years is that it takes that long to get through the volume. The volume changes that you need to make and also to do some of the manufacturing optimization. It’s not possible to do it on variable volumes at a time. So it is generally expected that you’ll have a margin hit, when one of the new pieces of capital come in. And so we would expect some now. We’ll manage that both with the work, pre-work we do and how we price when Sp comes out but a little premature for that in the forecast.

Okay. And then just one more on gross margin. You’re saying, all else equal, improvement in 2016, is that improvement off of the 2015 level that you kind of alluded to in that 66.4% range, is that the right kind of benchmark to think of improvement also?

Yes. That’s exactly what the guidance was.

Okay. Thank you. And then Gary just one last one. Now that we are a few quarters into the Xi launch, I was just wondering where you are seeing Xi being used in the field, are you surprised by kind of the types of procedure that’s being used in? Or is there anything worth calling out or telling us with respect to kind of where it’s been used and maybe when expected to be used in? Are certain types of physicians gravitating towards it for the certain types of procedure?

In the places that we designed it for, I think we are really feeling like it’s meeting our expectations. It looks really good. Our multi-quadrant surgery, colorectal surgery -- we expected it to set up really well for thoracic surgery and it is. If we’ve been surprised, it’s being positive surprises. We’ve seen urologists appreciate what it can do. Folks doing ventral hernia find the flexibility of its setup is helpful for them. And GYN oncologists find the range of motion helpful. So that has been a pleasant surprise is their interest in using it and the benefit that it brings them. Well, thank you. That was our last question. As we've said previously, while we focus on financial metrics such as revenues, profits and cash flow during this conference call, our organizational focus remains on increasing patient value by improving surgical outcomes and reducing surgical trauma through products that our surgeons use. We have built our company to take surgery beyond the limits of the human hand and I assure that we remain committed to driving the vital few things that truly make a difference. 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.