Calvin Darling - Senior Director-Finance, Investor Relations Gary S. Guthart - President, Chief Executive Officer & Director Marshall L. Mohr - Chief Financial Officer & Senior Vice President Patrick Clingan - Finance Director.

Ben C. Andrew - William Blair & Co. LLC Tycho W. Peterson - JPMorgan Securities LLC David Ryan Lewis - Morgan Stanley & Co. LLC Robert Adam Hopkins - Bank of America Merrill Lynch Lawrence S. Keusch - Raymond James & Associates, Inc. Brandon Henry - RBC Capital Markets LLC Rick Wise - Stifel, Nicolaus & Co., Inc. Tao L. Levy - Wedbush Securities, Inc.

Rich S. Newitter - Leerink Partners LLC.

Ladies and gentlemen, thank you for standing by, and welcome to the Intuitive Surgical Q2 2016 Earnings Release Call. At this time, all participants are in a listen-only. Later there will be an opportunity for questions. As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Calvin Darling, Senior Director of Finance, Investor Relations of Intuitive Surgical. Please go ahead, sir..

Thank you. Good afternoon, and welcome to Intuitive Surgical's second quarter earnings conference call. With me today we have Gary Guthart, our President and CEO; Marshall Mohr, our Chief Financial Officer; and Patrick Clingan, Vice President 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 2, 2016, and 10-Q filed on April 19, 2016. These filings can be found through our website or at the SEC's EDGAR database.

Prospective investors are cautioned not to place undue reliance on such forward-looking statements. Please note that this conference call will be available for audio replay on our website at intuitivesurgical.com on the Audio Archive section under our Investor Relations page.

In addition, today's press release and supplementary financial data tables have been posted to our website. Today's format will consist of providing you with highlights of our second quarter results as described in our press release announced earlier today followed by a question-and-answer session.

Gary will present the quarter's business and operational highlights, Marshall will provide a review of our second quarter financial results, Patrick will discuss marketing and clinical highlights, then I will provide our updated financial outlook for 2016. And finally, we will host a question-and-answer session. With that, I'll turn it over to Gary..

Good afternoon and thank you for joining us on the call today. In the second quarter our company performance was strong, highlighted by sustained procedure growth across multiple geographies, improved margins and continued customer preference for our new products.

Turning first to procedures, global procedure growth for the quarter was nearly 16% with prior quarter trends continuing. Drivers of growth included U.S. general surgery, growth in the use of da Vinci surgical systems outside the United States and modest growth in U.S. urology and gynecology.

Inguinal hernia repair and ventral hernia repair growth remains strong, and growth in colorectal surgery was solid. Procedure growth was variable by country in Europe, with accelerating growth in Germany. Both the Nordics and France experienced modest improvement relative to Q1 growth rates. In the U.K., growth decelerated slightly from Q1.

In Asia, procedure growth in Japan was solid again in the quarter while growth in Korea was robust and accelerated over Q1 growth rate. Growth in procedures in China was also strong. Patrick will review procedure trends in greater detail later in the call. We placed 130 da Vinci systems in the quarter, up from 118 in Q2 of 2015.

Our most capable model, da Vinci Xi, represented roughly three quarters of new capital placements. System placement orders included an increase in dual consoles and the addition of integrated Table Motion, leading to higher feature content on average than Q1. Placements in Europe and Asia increased over Q1, while U.S.

placements were up slightly up relative to last quarter. Marshall will take you through our finances in more detail later in the call. Our operations teams have performed well over the past several quarters and remain focused on optimizing our manufacturing design and supply chains.

Q2 was another strong quarter of operations efficiency and cost reduction performance. We plan to continue these optimization efforts as they provide significant financial flexibility for us in coming years. Turning to highlights of our second quarter operating results, procedures grew nearly 16% over the second quarter of last year.

We shipped 130 da Vinci surgical systems, up from 118 in the second quarter of 2015. Revenue for the quarter was $670 million, up 14% from the prior year. Pro forma gross profit margin was 71.9% compared to 68% in the second quarter of last year. Instrument and accessory revenue increased to $339 million, up 14%.

Total recurring revenue in the quarter was $467 million, representing 70% of total revenue. We generated a pro forma operating profit of $297 million in the quarter, up 30% from the second quarter of last year, and pro forma net income was $220 million, up 28% from Q2 of 2015.

Recent launches of Xi products, including Xi intraoperative Table Motion, have been well received, as has expansion of advanced instrument lines, including our stapling products. We are continuing to invest in these line extensions to increase the value and utility of our Xi offering.

We have also increased investment in advanced imaging, including significant refinements in our intraoperative 3D endoscopes, image processing for real-time and preoperative images and near infrared fluorescence imaging. Our single port, or Sp, program is progressing to plan.

As Sp approaches clinical readiness, we are conducting in-house validations and initiating work with clinical trial sites and regulatory agencies. We expect first markets to include head and neck surgery, urology and colorectal surgery. Over time, I expect this list of applications to evolve.

As our business has strengthened, we have increased our mid and long-term investments in research and development. We have been increasing our investments in imaging, analytics and new product architectures based on our belief that a substantial opportunity exists to enable better outcomes and to expand access to our technologies globally.

We expect quarter-to-quarter variation in spending and increased fixed expenses in the back half of this year. Calvin will take you through our projected spending later in the call. As we move forward in 2016, we remain focused on the following.

First, expanding the use of da Vinci in general surgery and thoracic surgery, particularly colorectal surgery and hernia repair. Second, advancing our ecosystem, including expanding our Xi line and taking our Sp product into initial clinical use. Third, driving our organizational capabilities in markets in Europe and Asia.

And finally, assisting our customers in their efforts to maximize the comprehensive value of their programs. I'll now turn the call over to Marshall who will review financial highlights..

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

Second quarter 2016 revenue was $670 million, an increase of 14% compared with $586 million for the second quarter of 2015 and an increase of 13% compared with first quarter revenue of $595 million. Second quarter of 2016 procedures increased nearly 16% compared with the second quarter of 2015, and increased 7% compared with last quarter.

Procedure growth has been driven by general surgery in the U.S. and urology worldwide. Revenue highlights are as follows. Instrument and accessory revenue of $339 million increased 14% compared with the last year, and increased 5% compared with the first quarter of 2016. Growth in instruments and accessory revenue generally reflect procedure growth.

Instrument and accessory revenue realized per procedure, including stocking orders, was approximately $1,810 per procedure. This metric has fluctuated in a tight range over the past couple of years.

The slight decrease in the second quarter relative to the second quarter of 2015 and the first quarter of 2016 primarily reflects the impact of customer buying patterns, partially offset by increased usage of our stapling and vessel sealer products.

While instrument and accessory usage per procedure has been relatively constant, customer buying patterns fluctuate in the short term. System revenue of $203 million increased 15% compared with the second quarter of 2015, and increased 37% compared with last quarter.

These increases primarily reflect higher average system selling prices, higher system placements, and revenue associated with lease buyout transactions. 130 systems were placed in the second quarter compared with 118 systems in the second quarter of 2015 and 110 systems last quarter.

15 systems were placed under operating lease transactions in the current quarter, compared with 19 last quarter, and 5 systems in the second quarter of 2015. As a reminder, revenue on operating lease transactions is recognized ratably over the life of the lease.

As of the end of the second quarter, there were 66 systems out in the field under operating leases. We generated approximately $4 million of revenue associated with operating leases in the quarter, compared with $1 million in second quarter of 2015, and $4 million in the last quarter.

We also generated approximately $13 million of revenue during the quarter from lease buyouts compared with $6 million in the first quarter, and $4 million in the second quarter of last year. We exclude the impact of operating leases and lease buyouts from our system ASP calculations.

Globally, our average system selling price of $1.56 million was approximately $60,000 higher than both the second quarter of 2015 and last quarter. The increase compared with prior quarters reflect a higher mix of dual console systems and sales of Table Motion.

We introduced intraoperative Table Motion in Europe in the third quarter of 2015, and early this year in the U.S. During the first and second quarters, we recognize $1 million and $6 million of Table Motion software, respectively. Both the mix of dual consoles and number of Table Motion placements will fluctuate quarter-to-quarter.

Service revenue of $128 million increased 13% year-over-year, and increased approximately 3% compared with the first quarter of 2016. The year-over-year and quarter-over-quarter increases reflect growth in our installed base of da Vinci systems. Outside of the U.S., results were as follows. Second quarter revenue outside of the U.S.

of $185 million increased 10% compared with $168 million for the second quarter of 2015, and increased 13% compared with the first quarter of $164 million. The increase compared with the previous year is comprised of 16% growth in recurring revenue, which is driven by procedure growth of 25%, and increased systems revenue of 2%.

The increase compared to the first quarter reflects systems revenue growth of 30% and recurring revenue growth of 4%. Outside the U.S., we placed 51 systems in the second quarter, compared with 46 systems in the second quarter of 2015, and 36 systems last quarter. Current quarter systems sales included 22 into Europe, 4 into China, and 13 into Japan.

System placements outside the U.S. will continue to be lumpy, as some of these markets are in the early stages of adoption. Some markets are highly seasonal, reflecting budget cycles or vacation patterns and sales into some markets are constrained by government regulations. Moving on to the remainder of the P&L.

The pro forma gross margin for the second quarter of 2016 was 71.9%, compared with 68% for the second quarter of 2015, and 70% for the first quarter of 2016.

Compared with the first quarter of 2016, the higher gross margin reflects reduction in product costs, favorable costs associated with our scope exchange program, manufacturing efficiencies, and higher dual console mix, lease buyouts and Table Motion sales.

Future margins will fluctuate based on the mix of our newer products, the mix of systems and instrument accessory revenue, costs associated with our scope exchange program, our ability to further reduce product costs, improve manufacturing efficiency and, in the long term, the potential reinstatement of the medical device tax.

Pro forma operating expenses increased 9% compared with the second quarter of 2015, and decreased nearly $2 million compared with last quarter. The increase over the second quarter of 2015 reflects increased investments in advanced imaging, advanced instrumentation, and next-generation robotics, and increased head count.

The decrease compared with the prior quarter reflects lower payroll taxes, partially offset by increased head count – head count costs particularly in our product operations areas. Our pro forma effective tax rate for the second quarter was 27.8%, compared with an effective tax rate of 25.6% for the second quarter of 2015, and 27.4% last quarter.

The increase in the tax rate compared with 2015 reflects one-time benefits reflected in 2015. Our second quarter 2016 pro forma net income was $220 million or $5.62 per share compared with $173 million or $4.57 per share for the second quarter of 2015, and $170 million or $4.42 per share for the first quarter of 2016.

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 net income was $185 million or $4.71 per share for the second quarter of 2016, compared with $135 million or $3.56 per share for the second quarter of 2015, and $136 million or $3.54 per share for the first quarter of 2016. We ended the quarter with cash and investments of $4.2 billion, up from $3.8 billion as of March 31, 2016.

The increase was primarily driven by cash generated from operations and proceeds from stock option exercises. As our cash builds, we'll continue to evaluate our approach to capital allocation. And with that, I'd like to turn it over to Patrick, who will go over our procedure and clinical highlights..

Thanks, Marshall. Of our second quarter procedure growth of nearly 16%, U.S. procedures grew approximately 13% and OUS procedures grew approximately 25%. During the first half of 2016, global procedure growth increased to approximately 16%, compared to approximately 15% in the second half of 2015, and approximately 13% in the first half of 2015.

We expect our procedure growth rate to moderate in the second half of 2016. In the United States, second quarter procedure growth continued to outpace our expectations. Second quarter growth in our mature procedures slowed modestly compared to the first quarter. General and thoracic procedure growth remained robust. In U.S.

urology, second quarter growth in da Vinci prostatectomy and kidney procedures slowed modestly compared to the first quarter of 2016. We continue to believe that our U.S. prostatectomy volumes have been tracking to the broader prostate surgery market and we expect prostatectomy growth to return to levels similar to prostate cancer diagnoses over time.

In U.S. gynecology, second quarter procedures grew modestly year-over-year, growth led by malignant and complex benign hysterectomy. Continuing the recent trend, we estimate a larger proportion of da Vinci hysterectomy procedures were performed by gynecologic oncologists during the second quarter. Similar to the first quarter, U.S.

single-site gynecology procedures declined compared to the second quarter of 2015. In the U.S., procedures for benign gynecologic conditions slightly grew during the first half of 2016, exceeding our expectations. Second quarter U.S.

general surgery procedure adoption remained strong, led by robust growth in hernia repair and continued adoption of colorectal procedures. Hernia repair continues to contribute the largest volume of new procedures in general surgery, and surgeon retention and expansion remains encouraging.

Cholecystectomy procedures slightly declined in the quarter, with growth in multi-port procedures nearly offsetting declines in single-site procedures. Second quarter was another quarter with a large number of clinical publications and presentations evaluating da Vinci surgery. Of these, I have selected a few studies that you may find interesting.

Intuitive is among the founding partners for the American Hernia Society Quality Collaborative initiative, or the AHSQC, and this quarter, two preliminary analyses comparing da Vinci to open or laparoscopic complex ventral hernia repair were brought forward. The first was a podium presentation at the American Hernia Society annual meeting by Dr.

Poulose from Vanderbilt, comparing da Vinci to open retromuscular hernia repair. This patient matched analysis involving data from multiple institutions found that da Vinci reduced hospital length of stay by three days without significant differences in surgical site infections, readmissions, or reoperations.

In addition, a paper was published in Surgical Endoscopy by Dr. Warren and colleagues from the University of South Carolina. The authors used their institution's submissions to AHSQC to compare da Vinci to laparoscopic retromuscular hernia repair.

Their study found that with a longer operative time, da Vinci reduced the hospital length of stay by one day and also enabled a greater percentage of patients to receive fascial closure and extraperitoneal placement of mesh, to which the authors attribute a reduced likelihood of hernia recurrence or bowel adhesions Next, as Marshall mentioned earlier, sales of our intraoperative Table Motion technology were strong in the quarter.

During the quarter, the first clinical publication reviewing this technology was published in the international journal of colorectal disease by Dr. Morelli and colleagues from the University of Pisa.

In a small case series of colorectal resections, surgeons used Table Motion to reposition the patient in an average of three to four times per procedure.

The authors suggested that the technology may improve patient safety by reducing the amount of time in extreme patient positions and stated, "the da Vinci Xi plus the new operating table gives the potential to optimize gravity exposure, and provides a quick access to different surgical objectives that is important in colorectal surgery." Turning abroad, procedure growth outside of the United States was approximately 25% in the second quarter, led by the global adoption of da Vinci prostatectomy, with solid contributions from kidney procedures and colorectal resections.

Compared to the first quarter of 2016, second quarter procedure growth improved in Europe and was similar to the first quarter in Asia. Outside of the U.S., second quarter procedure performance varied by country, with strong growth in Germany, China and South Korea.

In certain countries where our urology business has become more mature, such as the United Kingdom and Nordic countries, procedures continue to grow at a slower rate.

Emerging procedures are in an early stage in these markets, and we are engaged with a broad range of stakeholders working to enable procedure adoption into gynecologic and general surgery. In Japan, partial Nephrectomy growth accelerated in the first quarter following approval of national reimbursement.

During the quarter, a meta-analysis sponsored by the South Korean National Evidence-based healthcare Collaborating Agency, or NECA, was published in The Annals of Surgical Treatment and Research. It reviewed da Vinci and laparoscopic colon cancer resection.

The meta-analysis included nearly 700 patients and found that with a longer operative time, da Vinci surgery resulted in a more rapid return of normal diet and bowel function, lower blood loss, and a shorter hospital stay.

This government-sponsored health technology assessment adds to the number of HCAs has have evaluated da Vinci surgery and a broad range of procedures over the years. I will conclude my remarks by highlighting one of the largest population base studies on the impact of da Vinci prostatectomy published in the Journal of Urology by Dr.

Pearson and colleagues from the University of Chicago. Using data from the national cancer database, this study includes nearly 100,000 prostatectomy patients treated with either da Vinci or open surgery.

After matching the patient populations for risk factors, da Vinci surgery was shown to reduce positive surgical margins across low, medium, and high risk cohorts, as well as reduce use of radiation therapy, 30-day readmissions and 30-day mortality compared to open surgery. Dr.

Koch from Indiana University published a letter alongside the study titled Robotic versus Open Prostatectomy, End of Controversy, in which he stated that any debate over robotic prostatectomy should be put to rest. This concludes my remarks. I will now turn the call over to Calvin..

Thank you, Patrick. I will be providing you with our updated financial outlook for 2016. Starting with procedures. On our last call, we estimated full-year 2016 procedure growth of 12% to 14% above the approximately 652,000 procedures performed in 2015. We are increasing our estimate for 2016.

We now anticipate full year 2016 procedure growth within a range of 14% to 15%. In regards to certain forward-looking metrics, we have the following expectations. We anticipate fewer lease buyouts and lower upgrade and other system revenue in Q3 and Q4 than we saw in Q2.

Second half 2016 system ASPs will likely be lower than Q2 driven by product and channel mix. We expect a directionally higher proportion of our system placements in Q3 and Q4 to come from operating leases than we saw in Q2. Turning to gross profit.

On our last call, we forecast 2016 pro forma gross profit margin to be within a range of between 69% and 70% of net revenue. We are now increasing our estimate. We now expect full year 2016 pro forma gross profit to be within a range of between 70% and 71% of net revenue. Turning to operating expenses.

Based upon investments we are making in key areas of the business, we expect expense growth will accelerate in the second half of 2016. We continue to forecast pro forma 2016 operating expenses to grow between 12% and 15% above 2015 levels.

Consistent with our last call, we expect our noncash stock compensation expense to range between $170 million and $180 million in 2016, compared to $168 million in 2015. We expect other income to total approximately $30 million in 2016, higher than the $20 million to $25 million forecast on our last call, due primarily to higher interest income.

With regard to income tax, we continue to expect our 2016 pro forma income tax rate to be between 26.5% and 28.5% of pre-tax income, depending primarily on the mix of U.S. and international profits. That concludes our prepared comments. We will now open the call to your questions..

Certainly. [Operation Instructions] One moment, please. Okay. And our first question comes from the line of Ben Andrew of William Blair. Please go ahead..

Good afternoon. Thanks for taking the question. Gary, maybe just start out by talking about the increased investments in OpEx in the back half. Obviously, you guys have always been looking for opportunities there, but talk a bit more granularly about where those investments are coming and when we may see some payoffs.

I recall it took about a year for the European investments to kick in..

Sure. As we've said before, I think the messaging here has been pretty consistent. Some of the investments are in technology, things like Sp starting to move into field-based investment and scale rather than just the upfront D. So you're seeing some growth in that. We have some other technology investments that are a little broader.

We've talked about imaging, and that's kind of a multistep process. Some of it is on the acquisition side, new kinds of endoscopes, some of it's on the software side, and some of it is in the ability to enhance our florescence imaging portfolio. Some of those things will become commercial in future quarters.

Some of them are a little longer, multiyear types of investments. With regard to investments outside of R&D, you know we've been growing our investments in regions around the world where we think there's real opportunity from Japan to Germany and France and others. That'll continue. I think that be some of those investments are doing well for us.

We have opportunity to perform better than we have thus far. And so the right kinds of investments there are sometimes in clinical data and clinical trials, sometimes in other market development efforts, sometimes in our resources and head count.

And, again, those things can be effective from a couple of quarters out to multiyears out, depending on what the activity is..

Okay. And then two more quick ones for me, please. In Europe, you talked about some of the investments in emerging procedures.

Is that a protracted multiyear process to move beyond urology and the initial GYN procedures that you've kind of started to mature in certain geographies?.

I think that you can see early success sooner than years, but I think broad adoption in many of these places is a multiyear process. It starts with leading surgeons and key opinion leaders and surgical society endorsement and goes from there. In some cases, we need interactions with payers and reimbursement.

So I don't think have you to wait years to see the early indicators but full penetration is often more than a year process..

Great. And then finally, in the Sp, you did say head and neck. Can you be more precise? Would that be sleep apnea or is this more thyroidectomy? Do you have some initial thoughts on where specifically, please? Thank you..

Yeah, so I think in the beginning it's really starting in the markets we're already participating in, so transoral more than, for example, thyroidectomy. I think this is more around surgery in the throat. And for sure there's cancer indications for that. There may be benign indications.

Part of what we're talking to regulatory bodies about are clinical requirements for them to make some of those assessments and varies from what happens in Europe to what happens in the U.S. to what happens in Asia. So that will play out in time. But think of head and neck starting point as TORS. It may have other applications in neck surgery over time.

I think that Sp is a pretty powerful platform, and where we start and where it evolves to will differ as surgeons get a chance to experience it for themselves..

Okay. Thank you. And the next question is from Tycho Peterson of JPMorgan. Please go ahead.

Hey, thanks. First question, Gary, can you maybe just provide a little bit more clarity on Sp timelines? I understand you're lining up the initial sites now. It sounds like from some of the discussions, you're really not expecting that to be much of a revenue contributor in 2017.

So can you maybe just talk a little bit about how we should think about the rollout next year?.

Sure. So, first step here is clearances and some clinical data to support that clearance. 2017 will be really focused on data generation. While I expect some revenue, I don't think it will be a material revenue contributor in 2017.

A lot of that will be building the foundation, the evidence foundation, some of the clinical work, and then I think 2018, it starts to become more of a material contributor for us. And as we get our clearances and start to solidify that timeline, we'll color that (30:45) up more for you..

Okay. And then switching over to hernia, I think you talked in the past about doing some initial trial work.

Can you maybe talk a little bit about where that stands in terms of any patient enrollment and how we should think about timelines around the trial for 30-day, one-year, and two-year follow-up?.

I'll turn that to Patrick..

Yeah. So, we have a number of different initiatives ongoing as it relates to sponsoring evidence development in hernia repair.

The two presentation and publication that I mentioned on the call from the AHSQC is among the investments we've made in helping support surgeons bring forward the outcomes that they're getting with da Vinci compared to the alternatives..

Okay. And then just last one. You had noted some delays in Europe around tenders from competitive bake off (31:38).

Just anything changed from your perspective this quarter?.

No, nothing new to note. I think that tender offers in competitive interaction is the new normal. I think our teams are doing great. I think their performance has been effective. I think we're communicating well. We have a broad portfolio that allows us to engage the customer at different levels depending on what their needs are.

So nothing new to report..

Okay. Thanks..

Thank you. And the next question from the line of David Lewis of Morgan Stanley. Please go ahead..

Good afternoon. Just a couple of quick questions from me. Gary, one for you and then kind of a clarifying financial question. So, Gary, I appreciate the incrementally more detail you gave us in the pipeline this quarter. So two pieces. First is analytics.

Can you just give us a broader sense of what the word analytics means to you in Intuitive? And then on imaging, is the next disclosure we're likely to see in advanced imaging an approval or simply an announcement of an imaging clinical study? And then I had a quick financial follow-up..

I think analytics has multiple components in it. As you may know, the majority of our systems are real-time connected to the Internet today. I think over 90% of systems are online. They report back information to us mostly around the system performance itself, what it is itself is doing, rather than, say, patient information.

That data can be turned into insights for the company and for our customers and we have been doing that for some time now. So there's that type of analytics. Going forward, I think that as our computational structures get more powerful, we can bring some of that intelligence more real-time.

So rather than offline insights, you can start generating real-time insights. That's a multi-year pathway. I think it's interesting and challenging. I think there's long-term potential in it.

But we're moving down that pathway, making sure that we have good access and fast access and low latency access to our devices in the field, and then bringing to bear information that can help surgeons as they're performing the procedure.

And you'll see from us in future years a series of products that come out using that set of kind of digital pipeline. Turning to imaging, there are a couple of different things. We are releasing endoscopes at a fairly regular clip and improving that set of technologies.

We made a technology change in the type of imaging we use when we switched to Xi that has allowed for faster iteration for us in the kinds of imaging we do. So there's that kind of thing that's going on at kind of a regular heartbeat. Our customers are pretty well aware of where those things are.

There are other things that we've talked about, other indications for fluorescence. We're more likely to talk to you about what's happening clinically there than to announce a launch, so you'll have some warning prior to launch..

Okay. That's helpful. And then just, Calvin or Marshall, just thinking about the systems guidance into the back half of the year, a couple of components.

I note this quarter that operating leases were down for the first time in several quarters, yet I think you said operating leases will pick back up in the back half of the year, so sort of what's the driver there? And then just on mix or ASPs going lower for systems in the back half, I'm assuming that's tied to your view of different geographies, less Xis or less consoles, dual consoles.

Just give us some flavor on sort of those two dynamics, why you're so confident operating leases tick back up and ASPs tick down? Thank you..

Sure. So philosophically, first of all, we provide our customers leases to provide some flexibility in how they get into robotics, and it's proven out to be – to work out pretty well for both them and us. This last quarter, we just saw a fewer number than the previous quarter. The previous quarter, if you recall, was 19 (35:40).

We would expect it to be more like Q1 than it was Q2, so that's the increase that Calvin was referring to. As far as ASPs go, seasonally, systems revenue is stronger in Q4. Systems drive a slightly lower gross margin than do instruments and accessories, so that mix alone will cause margins to go down.

We also would expect a little bit better performance, again, due to seasonal factors in the non-U.S. markets, or the outside of the U.S., and so that mix also will drive revenues down a little. And then we expect to continue to see growth in stapling and vessel sealing in our newer technology products and those also drive slightly lower margins.

So a lot of the mix will cause margins to go down in the next couple of quarters..

Marshall, none of these things seem to me to be new dynamics. These seem to be ordinary operating dynamics for Intuitive.

Is that sort of how you see it?.

For the most part, the seasonal things are. I think the new thing is as we drive the new product revenue, that's increases over previous quarters..

And, David, if we're talking about margins, the one thing that was kind of different in the second quarter was on the service side. You saw a pretty marked increase in the service gross profit in the second quarter. And during the quarter we were able to utilize more refurbished scopes for our scope replacement program with customers.

We're going to be expanding the program as the base builds out in the second half and it's going to require a much higher proportion of new scopes at higher cost and lower margin to replenish, so that's something that will be a headwind in the second half..

Okay. Thank you very much..

Thank you. And the next question is from the line of Bob Hopkins of Bank of America. Please go ahead..

Thanks.

Can you hear me okay?.

We can..

Great. Good afternoon. So, Marshall, just to continue on this conversation around margins, you know, because last quarter you commented on mix on how you didn't think you'd be able to sustain 70% and now the guidance is going up on gross margin. And I understand there's a lot of moving pieces here.

So just from a top-down perspective, from where you sit today, when you look forward at the business, should we be thinking about low 70%s gross margin as something that can be sustained over time? Just give us a sense of what you've just been learning here in the first half of this year as it relates to a more sustainable outlook for gross margins longer term..

Yeah, I think we've given you the guidance for the remainder of the year. We think that that's the best crystal ball that we have at this point. There are a lot of moving parts and it's hard to predict exactly where each one will come out. And so I'll leave it at that. I don't want to get into where we think it will go long term.

Long term, those same moving parts will cause us to not have high confidence in exactly where they'll come out, although know that we'll manage things very diligently.

As you know, last year we put in some programs to reduce the costs of Xi and Xi related product, and those have been successful, and that's part of what we're seeing here in the year to year improvement..

But I mean, in terms of thinking about the biggest moving pieces, what are the things that you have us focus on as we think a little bit longer term when we try to consider what a sustainable gross margin would look like for the rest of the company?.

Yeah, I don't think we've put a stake in the ground and I don't think that I'm prepared to do that right now..

Okay. Well, no, anyway, we could take it offline. But thank you for that. And then, Gary, one other thing I wanted to ask about – two quick things.

One, on just the eye-popping number of $4.2 billion now in cash on the balance sheet, and you get the question quite frequently, but I'm just curious now with this almost 20% of the market cap in cash, are there sizable M&A targets out there that you're considering and that's why there hasn't been anything incremental done with the cash? Just would love to get be an updated view there.

And then you mentioned on the topic of advanced imaging and timelines for future products, you said some of these approvals could come in future quarters. I was just curious.

When you made that comment, were you talking about advanced imaging specifically?.

Well, let's speak to cash and then we'll go to the organic side. We look at the cash and think we're at an interesting point in the company's evolution here. On the one hand, I think that customer acceptance of our products has been really high. We're seeing, I think, great momentum on the clinical side in terms of clinical acceptance.

We have a couple of things going on. We have some new platforms we want to bring to the market that, I think, are outstanding, are very well done and well-conceived. That will take some investment for us to do. The other thing is that we see proliferation of folks who want to enter the market with competitive offerings.

And that's both an opportunity for us and a requirement for some diligence. And the opportunity is some of those technologies are interesting and may be interesting to us. Other ones are things where we may want to speed up or adjust our strategy as the market evolves.

As we think about the cash broadly, our first thought is can we use the cash productively to drive future growth organically? Our second thought is are there M&A opportunities that for the long term are good for the company? The answer to both of those are there opportunities? The third are, are there other ways we can deploy capital with a long-term view for the benefit of shareholders? And that might be in buybacks or dividends or other things.

So we're disciplined about thinking about capital allocation. I think this is a special time in the company's history and we're walking through how we think about cash with a fair amount of discipline and diligence. You had asked a question on product releases. Why don't you ask it again just to make sure I hit it..

Sure. You made a comment about the timing of new product releases and you said some will take many of these years and some of those approvals could come in future quarters. And I was just curious as to whether that was a broad comment or whether you were specifically speaking to advanced imaging..

A broad comment. There are some imaging things that are kind of nearer product things that look a lot like what we have today and there are some long-term imaging investments. And so the submission pipeline and our regulatory interactions are a pretty full pipeline..

Thank you very much..

Okay. Thank you. And the next question is from the line of Larry Keusch of Raymond James. Please go ahead..

Thank you. Gary, just wanted to pick up on your last answer on the imaging.

If you were to sort of think about all the efforts in analytics and imaging that the company is working on and you were to take this out several years, what would be the benefits to the surgeon at that time with these technologies embedded versus what's available today in Xi?.

Yep. It's a good question. There's a couple of things that I think drive some of the variability that you see in surgery. So it's really interesting.

If you ask the question and there's some research out there – surgery, in general, not just Intuitive, how much better in terms of outcomes and lower complications is the top 10th percentile surgeon versus the average surgery surgeon? And the spread is quite big as you look at that. There's a lot of variability in surgical performance.

And so you ask the question, what drives that variability? Why? And some of it, not all of it, but some of it is that what you're looking for in visual images is subtle.

Where are nerves? Where are cancer boundaries? Where are ureters? What's the right tissue to section plane? Those things are subtle and take a long time for people to internalize, and the best do it better. And so what we're trying to do here is find technologies that make it easier for other surgeons to be as good as the best.

And we think that matters. Imaging will play a large role in it. So going forward a decade, what you'd really like to be able to do is mark tissues of interest in real time. Paint for the surgeon what the elements and boundaries are that allow for a good dissection or the proper resection or the best margin performance.

And that's what's really directing our investments..

Okay. That's really helpful. And then for Marshall, I guess, two quick ones. The per procedure revenue certainly was at a lower level than we've seen in some time. You definitely mentioned some customer buying patterns in there. So if you could just help us understand what that means. And then on China you did a number of systems in the quarter.

Just wanted to figure out where we were with the quota.

Are those kind of one-offs now in any given quarter?.

So as it relates to my comments on customer buying patterns, we're able to measure or look at what happens with instrument accessory usage. And from that, what we've determined is that the usage really hasn't changed a lot surgery by surgery.

And so when we see fluctuations and what they're buying versus what they're using, there are times when they use more than they buy and times when they buy more than they use. And it just happens that – and it's going to fluctuate quarter to quarter, and that was my comment on the short term.

And so what we saw this quarter was they used more than they purchased. And so I don't have a great explanation for it beyond that. That's just what we see. On the other hand, we have do have distributors that buy in bulk because they're holding inventory to sell to their end customers, and we do see fluctuations in those numbers as well.

So the combination of the two, direct hospitals that we sell to as well as distributors, we can actually measure or identify what is customer buying pattern. I don't think – we don't see anything there that alarms us in one way or another..

Okay.

And China?.

China, China we sold four systems this quarter. Those systems were sold to military hospitals. The quota that we were selling to and couple of past years expired at the end of December. And we're awaiting for the government to approve a new quota. We don't have great information as to when that will occur..

Might describe the differences between military hospitals and non-military hospitals and vis-à-vis quotas..

Yeah. The quota system that we had was for public hospitals, and there is a process by which we're classified as high technology and there's a quota established by the government. It's in conjunction with their normal budget process.

Their normal budget process this year has been delayed, so that's why we're not sure exactly when they'll approve that and then when we'll get a quota for it. Military hospitals buy independent of those public hospitals, and we've been selling to military hospitals all along, frankly, and have a number of placements at them..

Okay. Great. Very helpful. Thank you..

Yep..

Okay. Thank you. Next question from the line of Brandon Henry of RBC Capital Markets. Please go ahead..

Yeah. Thanks for taking my question. Obviously, Intuitive has posted better than expected gross margins in the first half of the year. And I think we're all trying to figure out how sustainable that is.

So could you help us try to quantify or maybe bucket into several categories, what were the drivers of the year-over-year increase in gross margins in the first half of the year for 2016 versus the first half of the year in 2015?.

Yeah. I'm not sure we can list out item by item a specific contribution, but we have been focusing obviously on reducing costs for quite some time and managing our fixed costs, and we're really pleased with the progress.

We look at where we sit, six months into the year we're at 71% on a year-to-date basis, and that coincides with the upper end of the 70% to 71% guidance range. But Q2 was an exceptionally strong quarter for gross margin. And I think we wanted to leave some specific comments there.

Specifically on the product side, we would expect a higher proportion of sales of newer products, as was described in lower proportion of dual console sales, and probably more sales through distributors at lower pricing and lower margins.

And I think I already mentioned previously, on the service side, we had some real benefits on the scope exchange in the second quarter, which are unlikely to continue in the second half..

Okay. And then separately – I think you guys mentioned some slight slowing in prostatectomy growth in 2Q. Can you give us some more details on this comment and kind of discuss what's implied for prostatectomy growth in the updated guidance range? Are we now through the bolus of patients that previously deferred treatment? Thanks..

Hey, Brandon. It's tough to know where exactly you are with the patient population that may have deferred treatment. What we saw in the quarter was just a slight slowing of growth from what we saw in the first quarter and the second half of 2015, or frankly all throughout 2015.

How much of that is associated with having worked through any potential bolus that may be out there is difficult to predict, though, I think as you've heard us say a few times in the past, over time we do expect that prostatectomy volumes are likely to return towards the rate of diagnoses, and our recent history and the recent growth rates we've seen in 2015 or the first half of 2016, we believe, exceed that growth rate..

Okay. Thank you..

Okay. Thank you. And the next question from the line of Rick Wise of Stifel Nicolaus. Please go ahead..

Good afternoon, everybody. Let me start off with procedures again. I just wanted to make sure I understood the comment about the second half procedure growth slowing. Yes, I see that comps are modestly tougher.

Is it something about OUS? Is it the urology sort of recovery, if you will, slowing? Can you just help us better understand your thinking there?.

Hey, Rick. Yeah, you mentioned the growth rate comparisons get a little harder in the second half of the year. The mature procedure contributions that we saw in the first half of the year we don't think will be as strong in the second half of the year. We continue to expect and we'll continue to drive growth in U.S.

general surgery and in our overseas markets in urology and early stage of urgent procedures..

Okay. Back on gross margin. Clearly, it sounds from your comments that Table Motion adoption, which has been, in your words, well received, has been one factor helping margins.

Where are we in sort of the penetration of the installed base, I mean, 3% converted? 50%? And, is this a tailwind now – leaving aside all of the other moving factors, is this a positive tailwind now for a year or two or three?.

Yeah, I don't think I want to get into specific units on this. We're really pleased with the progress we're making and the strong market response from the customers. I think Marshall mentioned in his script we had $6 million of revenue attributable to Table Motion. It was roughly split 50/50 between new installations and systems in the field.

So, again, it was a strong quarter, but I think we'll see how it heads..

The history of selling back into the installed base rather than new installs is that you have a few quarters of strong performance and then it tends to tail off. Folks who are going to be interested in it tend to move forward quickly.

And then mostly it will be a go forward, so you can look at the history to sort of give you a guide as to how much that is..

Yeah. And we do have roughly around 750 or so da Vinci Xis out in the world at this point in time, and we've made some progress on that. There's still some more out there..

Got you. And just one last one for you, Gary, if I could.

At SAGES this year, it was very clear that Intuitive's messaging around looking at total procedure cost in the hospital for robotics and how much economic sense it made – robotics makes, when I listen to the looming competition from Medtronic at their Analyst Day and your friends at Verb, they're very focused on lowering per procedure robotic costs to, it seems like, in their words, laparoscopic levels.

How do you react, how do you deal, how do you compete with that approach given their entrenched instrument capabilities and will your new platforms address that per procedure cost aspect of positioning you to better address some of these factors? Thanks so much..

Sure.

I think the first thing of some of the messaging coming out around opportunities on price, on per procedure price, I think there's a big challenge for new entrants there, which is what benefit do you bring at which price point? So I think you're going to have to show benefit over laparoscopy, what can be done that lap can't do? And that's going to require some innovation and some technology, and that technology is going to have to be paid for.

So I think over time, folks are going to have to come out and show what it is that they plan to do to make that happen. As we look at it, I do think there are opportunities for Intuitive to manage different price pints. We have already in terms of our capital line, and it's also true in our instrument line and we can continue to do that.

So I think customers will have choice, and the choice will be at what price point do they want to enter and what benefit and value do they find at that price point. Intuitive will offer multiple price points. We will give them that opportunity. We have already and we will continue to. And what value they find at what price point will be their decision.

And there's so far been really just one or two companies who have been out there having those conversations and driving it. I think we understand it reasonably well..

Appreciate the (54:51) perspective, Gary..

Next question, please..

One moment. And the next question is from the line of Tao Levy of Wedbush Securities. Please go ahead..

Great. Thanks. Good afternoon. Your utilization per system in the U.S. keeps on hitting new highs.

And so I'm just wondering, where is the increase in capacity that the hospitals are finding? Where is that coming from? Are they utilizing the workweek schedules a little bit more effectively versus in prior years?.

Hey, Tao..

Hey..

I think it's more than one thing for me. One is we're seeing health systems, integrated delivery networks, optimizing the placement of their products and optimizing the flow of patients and surgeons around that product.

And so that's kind of an operational efficiency at the hospital level or health system level that has been driving it, and I think it's great. It's been great for our customers and we support it.

I think that the second thing is that some of the new procedure categories we're coming into allow for higher volume of procedures and sign up single sites, so more repeatable, shorter durations give you higher utilization, just kind of the nature of the mix of product that's coming in.

And lastly, I think in some of the markets we're seeing referral consolidations. So low-volume surgeons are referring to higher-volume surgeons, essentially passing patients to those who do more, and that also drives up utilization. So there are kind of multiple factors there that have supported the growth. I don't know that it goes on forever.

I don't think there's infinite growth in utilization possible, but so far, so good..

Got you.

And then just lastly, the percent of your applicable procedures that are currently using the robotic vessel sealer or stapler, do you have sort of a rough metric of where that stands today that you can share?.

Yeah. Hey, Tao. Certainly, we have seen growth in our vessel sealer and stapler adoption each quarter over the past few years and particularly in procedures where there's a high value associated with using those, whether it be in colorectal resections, even in some gynecologic procedures with vessel sealers. There's still a lot of runway left.

And in particular, as you think about the wide reloads that are only available on our Xi, and as the Xi installed base becomes larger, opening up more opportunities for those to be used in thoracic procedures, there's going to be plenty of runway ahead as the installed base continues to move towards our newest technology..

You don't have like a procedure – I'm sorry, a percent that you can share just to get a sense of how long that runway is?.

Not at this time..

Okay..

Operator, we'll take one more question from one more questioner and....

Okay. Thank you. Okay. And the next question is from the line of Richard Newitter of Leerink Partners. Please go ahead..

Hi. Thanks for squeezing me in. I just had a quick one, a follow-up on your Table Motion.

It sounds like that product is certainly graining traction, and I was just curious to know, is this feature being used in the way that you would have expected it to? And what I'd really like to know is do you think, or can you tell us what procedures or new incremental procedures does this potentially open for you or could you begin to see it open up where you aren't already being used today? Thank you..

Yeah. I think that early experience has been that it's well received, particularly by multi-quadrant general surgeons, which is really where Xi was positioned and one of the big motivations for Table Motion.

As frequently happens in this space, something that's a fundamental capability that's good in one place tends to have application in others, and I suspect we'll see that. And as we get more data on it, we're happy to share it with you..

That was our last question. As we said previously, while we focus on financial metrics such as revenues, profits and cash flows during these conference calls, our organizational focus remains on increasing value by enabling surgeons to improve surgical outcomes and reduce surgical trauma.

We have built our company to take surgery beyond the limits of the human hand, and I assure you that we remain committed to driving the vital few things that truly make a difference. This concludes today's call. I 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. Thank you..

Okay. Thank you. That concludes our conference for today. Thank you for your participation and for using AT&T Executive TeleConference Service. You may now disconnect..