Intuitive Surgical, Inc. (ISRG) Q3 2015 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. And welcome to the Intuitive Surgical Q3 2015 Earnings Release Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session; instructions will be given at that time. [Operator Instructions] And also as a reminder, today’s teleconference is being recorded. And at this time, I will turn the conference call over to your host, Senior Director of Finance, Investor Relations for Intuitive Surgical, Mr. Calvin Darling. Please go ahead sir

Thank you. Good afternoon and welcome to Intuitive Surgical's third 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 and sales operations. 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 5th, 2015, and 10-Q, filed on July 22nd, 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 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 third-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 third-quarter financial results; Patrick will discuss marketing and clinical highlights and I will provide our updated financial outlook for 2015. And finally we will host a question-and-answer session. With that, I will turn it over to Gary.

Thank you for joining us on the call today. Overall, company performance in the quarter was solid with robust procedure growth, solid capital performance and improved operating margins. Starting with procedures, year-over-year growth in the third quarter accelerated to 15% compared with Q3 2014. Procedure performance mirrored our experience in the first half of the year with strength in hernia repair, colon and rectal resections, solid growth in prostatectomy, and stable trends in hysterectomy. Internationally growth trends in the first half of the year continued in the third quarter. Growth in Europe, China and Korea was multi-disciplinary with particular strength in neurology. Patrick will review procedure trends in greater detail later in the call. Turning to capital sales, we placed 117 systems in the quarter compared to 111 in the third quarter of 2014. Capital placements in The United States accounted for most of the growth in system placements year-over-year. Customers are preferring our most capable products and Xi systems and dual console configurations represented a larger proportion of placements in the quarter relative to a year ago. In Japan, procedure growth was solid and driven by growth in neurology. As we’ve said on prior calls, the growth of the market in Japan will be paced by continued progress on reimbursement. Clinical investigators are submitting their partial nephrectomy data to MHLW for review, and ISI continues to work with key stakeholders in the reimbursement for additional procedures. While we have no assurance of additional procedure reimbursement at this time Japanese authorities will review reimbursement submission for partial nephrectomy for inclusion in 2016 national coverage. Conversations regarding reimbursement for other procedures are ongoing, however inclusion of other procedures and full reimbursement guidelines in 2016 are unlikely. Turning to operating performance, our product operations teams have been focused on reducing cost for our new products and we have been managing our fixed expenses carefully. This quarter was another step in the right direction on gross margin, helped by product mix and some costs coming in at the lower end of their expected ranges. We will continue to focus on improvements in direct product cost over the next several quarters. As we look at long term financial position of our products we anticipate making targeted capital investments over the next few quarter and programs that we believe will facilitate better long term product and operating margins. Marshall will take you through this and other financial performance in greater detail later in the call. In summary, our operating performance for the third quarter is as follows. Procedures grew approximately 15% over the third quarter of last year. We placed 117 da Vinci Surgical Systems, up from 111 in the third quarter of 2014. Total pro forma revenue for the quarter was $590 million, up 10% from the prior year, and up 14% year-over-year on a constant currency basis. Total pro forma instrument and accessory revenue increased to $298 million, up 10% over prior year. We generated pro forma operating profit of $240 million in the quarter compared with $197 million in the third quarter of last year. And pro forma net income was $199 million compared to $145 million in Q3 of 2014. We are deeply committed to advancing our technologies and offerings to benefit surgeons, their patients and hospitals. We have launched integrated table motion for Xi in Europe this October and have submitted our U.S. 510(k) application. Table motion allow surgeons to interactively use gravity for retraction and eases patient management during da Vinci Xi surgical cases. As many of you saw at the American College of Surgeons meeting earlier this month, initial customer feedback has been strong. We also submitted our 510(k) for our single site instrument kit for Xi in the third quarter with the intent of bringing our single-incision tools to the Xi platform. In addition, we submitted a 510(k) application for a 30 millimetre stapler for Xi in the third quarter. This instrument has particular utility in thoracic surgery and includes a multi staple sizes including green, blue, white and grey reloads. Regarding our next generation single-port technology, our technical teams continue to meet their development milestones for da Vinci Sp, having completed the build of our first 10 Xi compatible systems, five of which were slated for human clinical use. We anticipate increased clinical evaluations of da Vinci Sp in 2016 particularly in transoral and transabdominal applications. Lastly, da Vinci systems are sophisticated network computing systems. The availability of these computational resources allows for both real time analytics that can provide surgeons relevant information for example the smart plant feature implemented in our stapler as well as anonymized utilization data that administration can use to help optimize robotic surgery programs. We are developing increased computational capability in both real time and program level applications along with the field force of work flow experts; this analytic capability allows us to aid our customers both during surgery and in optimizing their robotic surgery programs. As we’ve discussed on prior calls for 2015 we remain focused on expanding the application of da Vinci and general surgery, particularly colorectal surgery and hernia repair filling out our product line for da Vinci Xi and launching in key markets globally, developing our organizational capabilities in markets in Europe and Asia, advancing our technologies to improve surgery and lowering our direct product cost. I’ll now turn the call over to Marshall who will review our financial performance.

Thank you, Gary. I will be describing our results on a non-GAAP or pro forma basis, which excludes the impact of our prior year Xi trade-in programs, legal claim accruals, stock-based compensation, amortization of purchased IP, and investment impairments. We provide pro forma information because we believe that 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've posted reconciliations of our pro forma results to our GAAP results on our website so that there's no confusion. Pro forma third quarter revenue was $590 million, an increase of 10% compared with $534 million for the third quarter of 2014, and an increase of 1% compared with last quarter. Pro forma revenue for the third quarter of 2014 excludes net revenue associated with the offers made in 2014 to trade out Si product for Xi product. All trade out offers were either fulfilled or lapsed in 2014. Third quarter 2015 procedures of approximately 162,000 grew approximately 15% compared with the third quarter of 2014 and were approximately equal to the second quarter of 2015. Revenue highlights are as follows. Pro forma instrument, and accessory revenue grew 10% compared with the third quarter of 2014 and was approximately equal to the second quarter of 2015. The increase relative to the prior year reflects procedure growth, partially offset by foreign exchange and customer buying patterns. Instrument and accessory revenue realized per procedure including stocking orders was approximately $1,840 per procedure. This metric has now been trending in a tight range between $1,830 and $1,840 per procedure over the past four quarters with recent quarters reflecting higher sales of new instruments and the impact of foreign exchange. Pro forma system revenue of $174 million increased 13% compared with last year and decreased 1% compared with last quarter. The increase relative to the prior year reflects increased unit sales, and higher average system selling prices. The decrease relative to the second quarter reflects a higher number of operating leases partially offset by higher average systems sales prices. 117 systems were placed in the third quarter compared with 111 systems in the third quarter of 2014 and 118 systems last quarter. 77% of the systems placed this quarter were Xis compared with 53% in the third quarter of 2014, and 64% in the second quarter of 2015. We expect the mix of Xi to Si product to fluctuate quarter-to-quarter. Globally, our average systems price of $1.6 million increased compared with $1.45 million in the third quarter of 2014 and $1.5 million last quarter. Our third quarter 2015 ASP was our highest to date, reflecting an unusually high mix of dual consoles, including a high number of shipments to academic centers. We shipped 29 dual console Xis in the third quarter of 2015 compared with 13 last year and 18 last quarter. We expect to return to our historical mix of dual consoles and therefore expect our future ASP to be lower than this quarter. ASPs fluctuate quarter-to-quarter based on geographic and product mix trade-in volume and changes in foreign exchange rates. Hospitals financed approximately 25% of the systems placed in the third quarter, up from 21% last quarter. We directly financed 20 systems; including placing the most operating leases 13 since we began our direct leasing program in the second quarter of 2014. As of the end of the quarter there were 36 systems out in the field under operating leases. Revenue from operating leases was less than 2 million in the third quarter. We expect the impacts of operating leases from our system if we exclude the impacts of operating leases from our system ASP calculations. The number of systems placed under operating leases will vary quarter-to-quarter. Service revenue of $170 million increased 8% year-over-year and increased approximately 4% compared with the second quarter of 2015. The year-over-year and quarter-over-quarter increases reflect the increase in our installed base of da Vinci systems. Outside of the U.S., results were as follows; third quarter pro forma revenue outside of the U.S. of $151 million decreased 1% compared with $153 million for the third quarter of 2014, and decreased 10% compared with $168 million last quarter. The decrease compared with the previous year reflects lower system sales into China and the impact of foreign exchange partially offset by higher recurring revenue driven by approximately 28% higher procedure volume. The decrease compared with the last quarter was driven by lower system unit sales and timing of customer instrument and accessory sales. Outside the U.S., we placed 37 systems in the third quarter compared with 50 in the third quarter of 2014 and 46 systems last quarter o-US system placements included 9 systems into Japan compared with seven last year and 13 last quarters. 19 systems in Europe compared with 25 last year and 22 last quarter and no systems into China this quarter compared with 10 last year and none last quarter. System placements will continue to fluctuate quarter to quarter. Moving on to the remainder of the P&L, the pro forma gross margin for the third quarter of 2015 was 69.3% compared with 67.2% for the third quarter of 2014 and 68% for the second quarter of 2015. Compared with both the second quarter of 2015 and the third quarter of 2014 the higher third quarter of 2015 gross margin reflects higher systems ASPs, improved efficiencies, lower inventory charges among other factors. The increase in gross margins relative to the third quarter of 2014 also reflects charges to cost and sales related to the Si staple recall in 2014. In 2014, we recorded pre tax charges of approximately $82 million, representing the estimated cost of settling a number of product liability legal claims under a tolling agreement. During 2015, we have refined our estimate of the overall cost of settling claims and recorded additional charges of approximately $14 million in the first half of the year. There were no charges in the third quarter of 2015. Charges made related to this agreement are excluded from our pro forma results and are included in our GAAP results. At the end of the third quarter, $30 million remained accrued on our balance sheet as a significant portion of the estimated cost have been paid. Pro forma operating cost, which excludes the reserves for legal claims, stock compensation expense, and the amortization of purchased IP, increased 4% compared with the third quarter of 2014 and were less 1% less than last quarter. The year-over-year increase in pro forma operating expenses primarily reflects headcount additions and higher incentive compensation. Our pro forma effective tax rate for the third quarter was 18.4% compared with an effective tax rate of 27.2% for the third quarter of 2014 and 25.6% last quarter. The effective tax rate for the third quarter of 2015 included tax benefits of $29 million, or $0.77 per share related to a recent favorable tax court ruling involving an independent third party. 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 third quarter 2015 pro forma income was $199 million or $5.24 per share compared with $145 million or $3.92 per share for the third quarter of 2014 and $173 million or $4.57 per share for the second quarter of 2015. Excluding the prior period tax benefits our third quarter 2015 pro forma net income was $170 million or $4.47 per share. 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 $590 million for the third quarter of 2015 compared with $550 million for the third quarter of 2014 and $586 million for the second quarter of 2015. GAAP net income was $167 million or $4.40 per share for the third quarter of 2015, compared with $124 million or $3.35 per share for the third quarter of 2014 and $135 million or $3.56 per share for the second quarter of 2015. We ended the quarter with cash and investments of $3.1 billion, up from $2.9 billion as of June 30, 2015. The increase was primarily driven by cash generated from operations and proceeds from stock option exercises, partially offset by stock buybacks. During the quarter we repurchased approximately 70,000 shares for $36 million and average purchase price of $509 per share. This brings our total stock repurchases to approximately $100 million for the year. And with that, I would like to turn it over to Patrick who will go over our procedure and clinical highlights.

Thanks Marshall. As mentioned earlier, total third quarter year-over-year procedures grew approximately 15% with U.S. procedures growing approximately 12% and international procedures growing approximately 28%. In the U.S. third quarter procedure growth were approximately 12% accelerated modestly from first half growth of approximately 10% driven by an uptick in the growth of general surgery procedures with solid contribution coming from mature procedures despite already high levels of market penetration, remains uncertain how sustainable, the year to-date growth in these mature procedures will be in future periods. In urology trends observed during the first half of the year continued through the third quarter. Growth in da Vinci prostatectomy and kidney cancer procedures continued at similar rate as the first half of 2015 with da Vinci prostatectomy again exceeding our expectation. We continue to believe that our U.S. prostatectomy volumes have been tracking to the broader prostate surgery market. In gynecology, third quarter procedures grew modestly year-over-year with growth in malignant and complex hysterectomy partially offset by declines in benign procedures. Similar to the first half of the year, increased proportion of total hysterectomy procedures have been performed by gynecologic oncologists. Third quarter growth in general surgery increased compared to the first half of the year with robust growth in hernia repair and an uptick in colorectal procedures, being partially offset by continued declines in cholecystectomies. Hernia repair continued to drive the majority of growth in general surgery procedures during the quarter. Earlier this month at the American College of Surgeons meeting several presentations highlighted the emerging role of da Vinci surgery in ventral and inguinal hernia repair. Surgeons commented on the advantages of da Vinci surgery which include precise dissection, improved visualization, secure closure of the primary defect, application casing of the abdominal wall, suture fixation of mesh and a reduction in postoperative pain for patients. Specific ventral hernia repair Doctor Ballacer from the Banner Health Network compared 180 da Vinci hernia repairs to over 60,000 lap and open hernia repairs from the ACS National Surgery Quality Improvement Program database and found that reduction in hospital length of stay and complication saved approximately $550 per case compared laparoscopy and over $700 per case compared to open surgery. We are encouraged by these early clinical and economic validations around the use of da Vinci surgery in hernia repair. Regarding our Single-Site cholecystectomy business as we've stated over the past four quarters, our total cholecystectomy procedures decline through the rate -- though the rate of decline moderated in the third quarter. As growth in multiport cholecystectomies offset much of the decline in Single-Site cholecystectomy, as our belief that customer are finding added value in a more complex patient population, therefore gravitating to the traditional da Vinci multiport approach. Firefly technology was used in approximately 40% of da Vinci cholecystectomies in the quarter. Looking abroad during the third quarter, the approximate 28% international procedure growth was led by global adoption of da Vinic prostatectomy, with solid contributions from kidney procedures, malignant hysterectomies, colorectal resections. Procedure growth in Europe remains steady through the first nine months of the year, while the acceleration in procedure growth in Asia that began during the first half of the year continued into the third quarter. During the quarter the global evidence supporting the cost effectiveness of da Vinic prostatectomy in international markets continue to build. Our recent economic analysis from the Peter Maccullum Cancer Centre in Australia published in BJU International reviewed nearly 6,000 Prostatectomies from the Victorian Admitted Episode Dataset. Their analysis found da Vinci Prostatectomy to be cost equivalent open Prostatectomy where 140 da Vinic procedures per year were performed on the system well below the global third quarter annualized average of approximately 190 procedures per system. During the study period from 2010 to 2013, the rate of open Prostatectomies decline from approximately 73% to 47% among publish hospital in Victoria due to an increase in the adoption of da Vinci Prostatectomy. This concludes my remarks and I thank you for your time. I will 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 procedure growth between 11% and 13% above the approximately 570,000 procedures performed in 2014. We are now increasing our procedure estimate for 2015. We now anticipate full year 2015 procedure growth of between 13% and 14%. Turning to gross profit, our outlook for gross profit margin has again modestly improved compared to last quarter. We expect our fourth quarter 2015 pro forma gross profit margin to be within a range of 67.5% to 68.5 % of revenue. Note that this range is a bit lower than our third quarter gross margin as Q3 benefited from favorable product mix and other factors which we expect to return to more typical patterns in Q4. Our actual gross profit margin will vary quarter-to-quarter depending largely on product and regional mix, system's production volume and foreign exchange rates. Turning to operating expenses, consistent with our last call, we continue to expect to grow pro forma 2015 operating expenses towards the lower end of a range of between 7% and 10% above 2014 levels. Also consistent with our last call we expect our 2015 non-cash stock compensation expense to come in towards the lower end of 170 million to 180 million range, roughly flat compared to 169 million in 2014. We continue to expect other income, which is comprised mostly of interest income to total between $16 million and $18 million in 2015. With regard to income tax, for Q4 we expect our pro forma income tax rate to be between 28% and 30% of pre-tax income consistent with our previous estimate. 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.

Thank you very much. [Operator Instructions] We'll take our first question from Ben Andrew with William Blair. Please go ahead.

Good afternoon, guys. Thank you for taking the questions. I guess two things for us. If you look at the legacy U.S. procedures, Gary, we talked in August about some of the hospital systems looking more carefully at cost benefit analysis. Do you think that's supporting the complex dVH and dVP and are you getting more evidence that that's the case?

Yes. We've seen, I can speak to anecdotes. Anecdotally, the dVPs and some of the more complex procedures we've seen have been well supported by analysis done at the IDN level. They are getting more sophisticated in those analyses and I think they are getting more confident in them.

Okay. And then, as far as the kind of international procedure growth, that was an exceptional acceleration. How durable is that as we look at 2016 with Europe kind of steady growth, U.S. obviously a little bit above plan, but that Asian piece, it really sort of sticks out?

Yes. It depends on the country. So, if you go country by country in Asia I think Korea has been building nicely. I don't see radical changes one way or the other. Japan we've talked about, I think that there's a lot of interest and a lot of organic activity, but major penetration is going to require reimbursement. China, we saw a lot of acceleration. And the pacing there will be in part driven by capital placements and as you know well, there's a quota system in China, so there are some systems remaining on the quota that can be placed. There's a point at which you need a new quota to keep going. So we can get some growth in the existing installed base, although to really accelerate quickly you need additional systems and that something that Calvin can take you through little later in the Q&A.

Sure. And just last thing is the China zero last quarter, zero this quarter, anything to read there as it kind of a bolus effect in the year end? And obviously the quota being the quota, but how do we think about that from a consistency perspective over time? Thanks.

Yes. This is Marshall. There's a process behind it. The quota was provided year and a half ago, two years ago. There are 18 systems that remained on the quota, but there's a tender process that each of the hospitals have to undertake and the tender process is unpredictable in terms of when it will complete. It turns out that they've been completing in boluses, as you suggested. But the fact that none were completed in the last – no systems were shipped in the last two quarters, I don't necessarily believe is indicative of whether we'll ship more or less in the next couple of quarters. So, we'll see how the tenders play out and we'll see what we wind up with.

Great. Thank you very much.

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

Thank you and good afternoon everybody. I wanted just to start with the overall procedure volume environment, and understandably some of your comments, Patrick regarding the sustainability of some of the mature procedures may make sense. But if I look at the overall procedure volumes in the quarter, they were flat sequentially. I can't remember when in the third quarter you did not see a sequential decline, whether that was related to seasonality or some of the other factors that were influencing your business. So could you maybe just talk about what's going on in the overall environment and whether what we are seeing now is the impact of sun-setting some of the concerns that surfaced to couple of years ago, and maybe what maybe materialized in the third quarter that might have made for the outsized performance?

I'll speak to a couple of things, and Patrick, you can jump in. At the dVP level in the U.S. we really think that's the flow back into treatment of some folks who had set out in watchful waiting and then had disease progression. How long that persist is a little bit hard to predict based on some of the changes in PSA diagnostics. On the hysterectomy market we're seeing rotation of patients away from some of the lower volume surgeons in general and into higher volume and dedicated surgeons, so, GYN oncologists. That appears to be particular durable. I think that that trend makes sense and I think the activity is likely to continue. We're a large part of the dVH market and so I think the macro trend will go as the macro dVH market grows in the United States.

The one thing to bear in mind is that for the past handful of years the number of benign hysterectomy in total has been declining, and so that will continue to counter balance the hysterectomy market.

On the upside I think we're in the beginnings of our experience in a lot of our markets. In Europe we're still in the meaty part of adoption, in many of the countries that were in. We're really excited about what can happen in Asia and the various markets that we talked about. And general surgery I think we're more at the beginning of some of the adoption that we see in colon, rectal, and hernia. So I think as you think about the future it’s a little bit of the puts and takes there of how fast do mature markets moderate and how quickly do our emerging markets grow.

Okay. That's helpful. And then I just want to make sure I understand what you're saying explicitly about Japan for next year, obviously you have the dVP reimbursing. You talked about the society submitting on partial nephrectomy. What are the next steps in gaining additional reimbursement in Japan and how will we – how will that be disseminated?

Yes. There are multiple conversations from multiple stakeholders in Japan. Surgical societies play a role as well as government societies, in deciding what data is required and kind of in what sequence they want to address those different procedures, so from thoracic surgery to general surgery, things in the colon and others are - and gynecology, are of interest to Japanese surgeons and are in active discussion. To get into the national reimbursement, there are a couple of different pathways, wherein one of them called Senshin Iryo B for the process that we're in for partial nephrectomy. The government has asked to see that data and is going to review it. So we're not guaranteed what and when, but it’s part of the formal process. Other ones are not yet in that formal process. The government can choose to send it down a different reimbursement process. If that happens and we have some assurance that that is likely then we'll report that out to you. So, I think in terms of the near term and national coverage partial nephrectomy is the one to keep your eye on. I am not generally upset about progress. I think that there is a fair amount of interest. I think the conversations are active and it just continuing to push forward.

And then maybe lastly Gary, as you kind of reflect on the business and look at the progress that you've made over the past call it, 18 months, you kind of put all the moving parts together with macro and one thing you’re designated as the “unintended consequence” of the Affordable Care Act or economic pressures in Europe or the state of your business. How would you just compare your view of the forward outlook today versus how you might have felt a year ago and your level of confidence?

I think that we're seeing a lot of validation for our products in the hands of our customers. I am pleased with the response from general surgeons, the level of engagement they have with the company, the interest and satisfaction they have with the products and their interest in demand for new and different things that I think we can provide. In European markets we've been investing in both capability of our own organization and getting closer to those customers. Again, I think customer demand is really strong and that looks -- that bodes really well for us. I think we can do better in terms of some of our own team and processes and we're working on it. I think that the company is growing and is focused on those efforts and I expect to see greater capability in the next several quarters.

Okay. Thank you for all the detail.

Thanks, David.

Thank you. The next question in queue will come from Bob Hopkins with Bank of America. Your line is open.

Hi. Thanks for taking the question and congrats on a really good quarter. Two things, first I just wanted to start out for Marshall on the OpEx growth in the quarter. It was one thing that kind of surprised us. It looks like the operating expense growth in Q3 was a lot lower than we would have thought. So I was just wondering if you could kind of highlight that and it sounds like things will kind of pick back up in Q4. But is 7% to 8% still the right way to think about OpEx growth longer term and just again what happened in Q3 with the lower growth in OpEx?

Well, certainly for rest of this year, Calvin given you guidance in the lower end of the 7% to 110% range and more like to 7%, but I think that we're focused on controlling cost and watching it carefully. There are some costs that kind of happen – when they happened and that includes a prototypes in the engineering group and some of those didn't happened this quarter and will happen next quarter and so that's why you get some of the fluctuation between quarters, but overall I think we're managing to the bottom line.

Okay. And then just back on, Gary, back on Japan. I just want to be clear on the message there, because on the Q2 call you talked about partial nephrectomy, but then also four additional procedures. And it sounds like you're not as optimistic on those four additional procedures. So, I was wondering if you give some color on what's happened there and kind of we look to Japan as a source of real incremental procedure volume growth in 2016 or is that not the case given what you're articulating here?

Yes. I think in terms of partial nephrectomy, that's moving forward with a formal process into review for the national coverage. The conversations and the work being done on other procedures is on going, but its not yet at that level of rigor for the 2016 review and as a result I don't think its likely that they will be included in the 2016 book. We're not ready yet to give you the 2016 procedure guidance and we're working through that and rolling that up and that something we'll talk about in general in the next call. And you can anticipate that additional reimbursements accelerate in Japan and lack of it will put more pressure on procedures and they'll be part of the conversation as we go through our forecasting.

And then any quick update on Sp in terms of timing, I heard the comments you may have a call here, but just what is the year where you think you could start to generate revenues from Sp?

Yes. We're making good progress in terms of our technology and customer valuations of the product in lab are encouraging, quite exciting. In terms of when we expect real revenue? We're not ready to tell you exactly where the revenue launch will be. We're definitely looking forward to human clinical interactions in 2016 and we'll color that up more as we go forward in future calls.

Great. Thanks for taking the questions.

Thank you. Our next question in queue will comes from Rick Wise with Stifel. Please go ahead.

Thank you. Good afternoon everybody. Let me start with hernia. Gary, anecdotally talking to general surgeons about Xi adoption, it sounds like a lot of the folks we have talked to start with a ventral procedure because of the suturing benefits and then seem to move quickly to inguinal as they get comfortable. Are you seeing that kind of progression, maybe to what extent, and is this process what's driving the solid hernia adoption?

We see different pathways actually, as you know as you talk to different general surgeons, I wouldn't characterize the one that you've described as the most common or the only path that folks take. It's certainly a path. No doubt that's ventral hernia is something that benefits from precise control, great visualization suturing, the ability to close the primary defect directly with suture as well as supporting [Indiscernible]. So there are some advantages there. As general surgeons get comfortable then they start to explore other things that they can do with the tool and sometimes it goes ventral, then inguinal, sometime the reverse and from there it can take them into more complex cases or cases where there is an acute called cholecystectomy that they might want to try. So there are different pathways that can happen. I wouldn't characterize one as the only.

Okay. And coming back to procedures one more time, I feel like I have to ask. If I am looking at the numbers correctly, procedures, you've had a really strong year, procedure growth through the nine months, up 14%, in the third quarter, up 15%. And yet, Marshall, you're guiding us to -- if I'm understanding all these numbers correctly, 13% to 14% for the year, which suggests a softer fourth quarter against a similar comp to the third quarter. I think you grew 10% or so in both the third and fourth quarters last year. Can you help us just understand your thinking? And just given the mature procedures seem to be stable to improving and the growing stuff is still growing, what do we need to understand about the fourth quarter?

Yes, Rick. This is Calvin. And absolutely overall we're pleased with our procedure growth trends and this is actually the third quarter in a row that we've increased our guidance for procedures and the revise procedure growth assumptions generally reflect the continuation of the trends that we've seen through three quarters with growth coming from U.S general surgery and international procedures as I described. In our updated view 13% to 14%, it's lower than 15% in Q3, we're certainly at 14% on a year to-date basis. And the fact is in Q4, the comps get more difficult for those mature categories the dVPs in the United States and other mature categories whereas as Patrick described, I think maintaining the rate that you saw in the first nine months will become more challenging in the fourth quarter.

Thanks very much.

Thank you. Our next question in queue will come from Tycho Peterson with JP Morgan. Please go ahead.

Thanks. First one, maybe a bit of a subtlety, but Gary, in your comments you talked more about the network effect and then in the press you commented on the technology ecosystem, can you maybe just elaborate on that a little bit. Are you directing additional resources to software and informatics, you need a customer is asking for more?

We have over the last few years increased our capabilities in real time software and kind of guidance tools for the surgeon as well as kind of offline Informatics. So that's not an immediate thing, it's actually been a rising trend. When you think about the ecosystems sort of stepping back as a whole, one of these products is the robot itself, the imaging system, sometimes with molecules like Firefly, instrumentation everything from needle drivers to staplers and vessel sealers, training technologies like stimulators and dual console. And then there is another piece which is Informatics. Informatics has been power force. At the surgeon level what data can you give me in real time that helps surgeon make a decision, at the institutional level it comes down to what kind of instruments you're using, how long are you on the system, what is that look like relative to national norms. And they've been interested in that data and we've been supplying that data now for over a year and those conversations been really healthy and I think it will only grow.

And then I guess that's helping them to figure out the cost side of the equation as well?

It let them understand the couple of things, it let's than model their cost really carefully and really get the value right. The big thing in any of these conversations is total cost to treat, not price and so that helps them really understand total cost to treat. And its -- we found it to be an extremely productive and rich conversation with customer base. So, they like that. And it also gives them some sense of variation amongst different procedures and different surgeons, so they get a sense of how much variability they see within their institutions.

Okay. And then on margins, you talked about reengineering some of the newer products, I know last quarter you talk little bit about longer term gross margins. Should we expect to see an impact from some of the reengineering programs in next couple of quarters, how do we think about the potential there?

So, yes, we've talked about the facts, when we introduced new products the margins are lower than mature products and lower than they'll be ultimately once that products been around for while both because we are able to drag down the cost of venders through volume as well as be able to redesign the products and we've undertaken some redesigns as well as increasing volume. I think what we've said before is that those efforts are well underway. We're happy with where they are going. They won't drive a lot of benefit this quarter, more of the benefit will be in 2016 and even more in 2017.

Okay. And then you had more operating leases this quarter, can you maybe just talk about that and your willingness to use that as a lever to place more system placements in particular maybe outside U.S.?

Yes. I think what we are trying to do is to be flexible with our customers and our customers they are looking for flexibility and once we get a system installed obviously it drive procedures and instrument and accessory volumes. So, it’s a win, win, win all the way around. We did 13 this quarter. We have 36 outstanding operating leases outstanding. We're also doing capital leases. We have a number of capital leases out there. I think on the operating lease side, some of these have turned into purchases where the customers ultimately bought the product and so it again it feels like a real win situation for us to leverage our balance sheet and provide our customer flexibility to get into robotics.

They have been generally satisfied with it and we have, too.

Okay. Great. And then just lastly on hernia, are you comfortable with kind of the sustainability of the trends here for both ventral and inguinal?

I think on both sides there are sub-segments in those markets and so getting to total available market and those is little bit hard to forecast. There are definitely segments in both where we think there is good long term sustainable value. How big those segments become, I think its going to be hard to predict, we just going to have to work through it.

Okay. Thank you.

Thanks.

Thank you. The next question in queue will come from Tao Levy with Wedbush. Please go ahead.

Great. Thanks. So first question, I was wondering if maybe you can explain if there is any difference between the Xi Single-Site instruments and what’s available with the Si? And I guess, again, I scratched my head as to why someone would want to use a Xi Single-Site and just -- for chole.

Yes. Fair question. So, in terms of functionally they are functionally equivalent. So there are some small technical differences, but from in terms of what our surgeon can do, they are pretty similar. Xi has opposite couple of advantages having to do with the way the arms work. But I think for the most part you can think of them as equivalent. The reason people have a interest in them or certain number of hospitals have really room in their program for a single robotic system, if they want that mix to include Single-Site and they want to be able to operate the Xi technology, this gives them that option. So for those one system sites that let them do the full portfolio of the things they want to do.

In terms of utilization of Firefly in chole, I think you mentioned about 40%. What about in other areas, like colorectal surgeries? Are you seeing any adoption of Firefly in those areas?

I will look to Patrick. I don't have the numbers at my finger tips in terms of colorectal perfusion.

Yes. We have been seeing just use of the technology across the broad section of procedures and it’s ramped nicely over time.

So just following up on that in my last question, at the ACS conference the company talked a lot about imaging being one of the biggest areas of investment for the company. So maybe if you could expand on that a little bit. What areas are you guys working on that is going to really improve patient outcomes specifically around imaging and the benefits that bring either the patients or surgeon comfort?

As we spoken before there are few things that I think are coming together that can really benefit surgeons. One of them is that sensor technology has been advancing rapidly around the world having to do with technology development for other things like cell phones. We can take advantage of that for application in surgical applications by developing sensors and products that are specific to what surgeons want to do and see, that's one dimension. The other dimension is to use other types of imaging modality, sometimes other frequency bands, sometimes molecules to allow surgeons to see things that are not visible with the naked eye. So highlight structures or highlight anatomical organisms that a surgeon wants to see during the surgery. And that since Firefly is really a platform idea not just a single molecule. And so overtime we think there are things that we can bring to market that will allow surgeons to see more and to customize their vision for the typical A procedure they want to be in.

Is this five years out or two years over…

Some of them are long conference and some of them are a little thinner, so it’s really a mixture there and now ready to go into detail with you on this call is to each of the sequences but the investments we’ve made in this distal chip imaging, the step into Xi is a set of investments that we think gives us a long runway in terms of the variety of endoscopes we can deliver and the kinds of technologies we can deliver on that platform.

All right, thank you.

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

Good afternoon. Gary, just two quick questions, I guess the first is we think it’s pretty early to be getting excited about the competitive systems that no one on earth has seen it to put it mildly. But if you were to comment on one element of the high level I wonder and that’s the theme emerging from some of these your competitors one day is that they are talking about a smaller capital footprint which seems to be lower priced systems and I guess, do you see lower priced capital systems be more important going forward or can you continue to price the value and keep system ASPs high and a quick follow up.

I think on that first one really that’s a question that’s going to be determined by the customer and we understand that technology pretty well and have been thoughtful about it in terms of what we’ve developed. As you refer to in your question and I completely agree it’s about value not price and the question is what are the outcomes that are going to be derived by these kinds of systems and what’s the price point at which you can offer them. We have a wide range from Xi down to Si-es and Si research and that range is very large and what we find is that the majority of our customers buy capability. I think in this last quarter you can look at what the Xi to Si exchange, what that mix flows. We explore and we think about where there are other positions and price points that make sense. Certainly we hear the same kinds of customer commentary that you hear and others hear. And I think the real question is not which is shown on the shop floor, it’s what do these systems do in surgery, and that’s going to come down to what can they deliver, what kind of outcome can they deliver and that’s how we think about it.

Okay. Very helpful and then just a follow up on Tycho’s questions on margins. So if I take commentary from you and Marshall last couple of quarters and there is two data points that come out, it feels like gross margins above 68% and EBIT margins about 40% are going to be challenging, but then based on this quarter, it’s very clear you certainly have the ability to surpass into those two margin objectives. So Gary I think about 68% growth and 40% margin, I mean do these goal post reflect the reality and investments you are going to have to make the next several years or things about product mix or any system to reflect conservative outlook.

Yes I’m not quite sure I understood the question. I think just stepping in, I’ll tell you what we care about and where we are heading. I think that in these technologies there as we said before, there are complex mixtures of robotics and imaging and instrumentation and there is a certain amount of investment that’s required to put them in position that they are cost effective for the company and that gives us the opportunity to have them be cost effective for the customer. Those are good things to invest in. There is a point at which we believe we are early in the adoption of robotic surgery globally. And so, some of that gross margin is around the cost and some of it is around price. And what we want to be able to do is lower the price -- the cost point to us and that gives us flexibility with regard to the price point and so that’s what -- and that’s what we are focused on. Where we’ll go long term will depend a lot on we think both what we can do in terms of our supply chain and our design and where we think the customer value inflation is. But in the quarter the two points that you are referencing were more a result of product mix and alignment of positives that as I said in my script we don’t expect to recur.

Okay. Thank you very much.

Thanks, David.

Thank you. The next question in queue that will come from Richard Newitter with Leerink Partners. Please go ahead.

Hi, thanks for taking the questions. Marshall, maybe just a continuation of the last question on margins. Can you give us just broad strokes kind of view the puts and the takes that we should be thinking of going forward even into next year on the margin side and then also the gross margin that is and then if you could just tell us or remind us how you guys view operating leverage materializing in the business model going forward?

From a margin perspective there are a number of different influences. One is a product mix and the products the margins on I&A are greater than they are on systems. So to the extent that we have systems doing well or not doing well the network swing in the margin and also a geographic mix where we sell in the United States and dollars obviously we sell to our distributors at a discount to that we sell to in certain markets in foreign currencies and depending on foreign exchange that can have some impact on the amount of revenue that have. And then we have expanding opportunities at in our newer product, and those newer products happen to have lower margins. And so to the extent that we are successful in let’s say stapling and vessel sealing, it’s a positives for the company because you are taking greater share of wallet, but in terms of the gross margin percentage it will push down the gross margin percentage because the margins on those products are not as high as our mature products. So there is a number of different things that can affect gross margin. As far as leverage, we manage the company wisely. We try to improve margin, we have a number of programs like we said in place to reduce the cost of products, but we are also as Gary said, we are new in a lot of markets and we will expand, we will sacrifice a point of margin for expansion of market. The way we think about it is you have opportunities for scale and leverage in things like instruments and accessories to some degree and imaging and then mature procedures, the commercial part. But you have opportunities for investment and that’s in new products, cost reductions and new geographies. And we are balancing those two. So we think about both.

Great, and then just one last one. Si-e sales looked like they were zero this quarter, first time since, I think, you launched that product. Gary, can you just comment on what you are seeing in the marketplace as far as demand goes for the lower price point in the context of more complex and the systems like the Xi that you're launching and the steam that might be building behind that? What does this mean, if anything, for demand trends for Si-e or the lower -- the low end of the spectrum?

We are happy to provide the customer a system that meets their needs as to where they want to go and partly due to robotics programs. And I think the results speak for themselves. I think that Xi is being well adopted I think as we finish the product set and complete the product set that has made it more attractive to those who may be waiting for that completion. We still sell Si refurbs and Si-e and I think the difference between an Si-e and a four [ph] arm is value people I see -- I think that while there are a lot of procedures you can do through arm people really enjoy that or value that fourth arm and so you see fewer Si-es I think it’s simple as that.

Thank you.

Operator, we have time for just one more question here, please.

Thank you sir and that will come from Vijay Kumar with Evercore. Please go ahead.

Hey guys, thanks for squeezing me in and congrats on a nice quarter. Maybe one on the margins here. I know that you sort of mentioned mix right and when you think about mix you had a higher proportion of Xi and if I remember correctly on the last call you said Xi you are still scaling up margins was lower but Xi was higher, but then offsetting that you had a higher proportion of system sales coming in from the U.S. I’m just trying to think how those two trade off and how they benefit your gross margins?

Yes I think this quarter specifically we benefitted from the product mix and that there was a high proportion of the dual console Xi and when you look at the product cost side the extra surgeon console us the mature technology with the lower cost on that and then you get the extra price to run through margin. So that helped us out as Marshall said there were negligible inventory charges in the quarter and other costs, other charges to cost of sales were pretty minor. So lot of things lined up pretty well for us in the fourth quarter -- in the third quarter, in the fourth quarter we think it was probably a more typical pattern in terms of the product mix and some of the other costs and a seasonally stronger capital quarter we have more system sales those that carry a little margins than the recurring revenue side and we’ll have more definite comments about 16 on the next call.

Great. And one follow up. Marshall, on that cap allocation sort of just wondering sort of what your priorities are and buyback was a little anaemic in the quarter. I was just wondering sort of what the moving parts were?

Yes there is no change in our philosophy. We will continue to purchase shares when at the right opportunity. Keep in mind that the stock has been depressed over the last 30, 40 days and yet that’s a period in which we cannot be in the market because it’s a blackout period for the company. And so anyway we’ll continue that philosophy and you’ve seen us purchase, repurchase over $2.5 billion worth of stock over the last couple of years and we think at rare prices.

That was helpful. Thanks guys.

Thanks, Vijay. That was our last question. As we’ve said previously while we focus on financial metrics such as revenues, profits and cash flow during these conference calls, our organizational focus remains on helping surgeons increase patient value by improving surgical outcomes and reducing surgical trauma. The following quote by Dr. Parekh, an experienced neurologist at the University of Miami sheds light on how our customers view our systems. The latest version of the da Vinci system Xi allows us to offer more minimally invasive surgical options to more patients. Hard-to-reach tumors or those encompassing more than one organ can potentially now be approached with this more agile and visually enhanced device. We’ve built our company to take surgery beyond the limits of the human hand and I assure you that we remain committed to driving the volatility of things that truly make a difference. This concludes today’s call. We thank you for your participation and support on the zest for ordinary journey to improve surgery and we look forward to talking with you again in three months.