Intuitive Surgical, Inc.

Ladies and gentlemen, thank you for standing by. Welcome to the Intuitive Surgical Q2 2019 earnings release call. At this time, all participants are in listen-only mode. Later, we will conduct a question and answer session. Instructions will be given at that time. If you should require assistance during the call, please press star and zero. As a reminder, this conference is being recorded. I would now like to turn the conference over to our host, Mr. Calvin Darling, Senior Director of Finance Investor Relations. Please go ahead.

Thank you. Good afternoon and welcome to Intuitive's second quarter earnings conference call. With me today, we have Gary Guthart, our CEO, and Marshall Moore, our Chief Financial Officer. 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 4, 2019, and 10-Q filed on April 19, 2019. Our SEC filings can be found through our website or at the SEC's website. 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 intuitive.com on the latest events 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 that I will discuss procedures and clinical highlights and provide our updated financial outlook for 2019. And finally, we will host a question and answer session. With that, I will turn it over to Gary.

Thank you for joining us today. This second quarter of 2019 was a solid one for intuitive with healthy customer interest and demand for our products. Overall, procedure growth met our expectations while capital placement succeeded them. Global procedure growth was approximately 17 percent in the second quarter of 2019. Growth again centered on general surgery in the United States with positive contributions to the global growth rate from Germany, France and Japan. In China, we are pleased with procedure performance given the recent release of systems under the new quota. Turning to the United States, -over-year growth in the quarter was 16 percent. General surgery growth again accounted for the largest increase -over-year accompanied by expected moderation of growth in US urology and gynecology. Underlying this performance, we saw continued strength in bariatrics and cholecystectomy with modest tempering of growth rate in hernia and colon resection. Given the different types of procedures being performed by general surgeons, we see additional demands on system access and accounts as well as increased demands on our representatives' time to support different procedure types. We believe system placement strength in the US is driven in part by the desire of general surgeons for increased access. We have efforts ongoing to manage these issues. Calvin will take you through global procedure dynamics in more detail later in the call. With regard to our install base, placement of new systems in the quarter was strong with growth in total placements rising 24 percent from Q2 of 2018. Out of trade-ins and retirements, our DaVinci install base again grew 13 percent over Q2 2018 to approximately 5,270. The mix of system placements this quarter moved towards our flagship XI system while both sales of X systems and trade-ins remained healthy. The proportions of systems placed under operating leases was 32 percent this quarter compared with 33 percent last quarter. We do not anticipate this -to-quarter variance is indicative of a larger trend in leasing. With regard to capital average sales price, the mix of systems and trade-ins in geographies last quarter resulted in a lower ASP when compared to historical trends. The second quarter saw a reversal of mixed dynamics with more fully featured system sales and a greater proportion of system placements in direct markets resulting in an ASP that is higher than recent quarterly averages. As we said last quarter, this variance in ASP -to-quarter is the result of system and regional mix, not a fundamental change in our philosophy. Turning to expenses, we continue to invest as we launch new platforms, strengthen our computational capabilities and execute projects that support future scale and provide leverage opportunities as we grow. Our spending met our expectations, falling within the range of projections we shared with you last quarter and supported by solid procedure growth and capital placements. Financial highlights of our second quarter results are as follows. Procedures grew approximately 17 percent over the second quarter of last year. We placed 273 DaVinci surgical systems up from 220 in the second quarter of 2018. Our install base again grew at 13 percent from a year ago. Revenue for the quarter was approximately $1.1 billion, up 21 percent. Pro-forma gross profit margin was 71.3 percent compared to 71.1 percent in the second quarter last year. Instrument and accessory revenue increased to $579 million, up 22 percent. Total recurring revenue in the quarter was $780 million, growing 21 percent over Q2 of 2018 and representing 71 percent of total revenue. We generated a pro-forma operating profit of $455 million in the quarter, up 17 percent from the second quarter of last year and pro-forma net income was $388 million, up 18 percent. As you know, we measure our efforts by their ability to positively impact the quadruple lane. Better outcomes, better patient experience, better care team experience and lower total cost to treat per patient episode. We believe intelligent surgery takes the integration of three elements. First, a deep understanding of human interactions that inform holistic system design. Second, the development of high quality smart and cloud connected robotic imaging and instrument systems and lastly, informatics and AI to deliver relevant validated insights. For our customer, surgery has been digitized for the past 20 years. While we've made significant progress over our history, we believe continuous improvement is required and we have deployed our investment toward these aims. We design instruments and accessories to enable repeatable high quality surgeries that are efficient and cost effective relating to total cost to treat. Taking one example of our advanced instrument platforms, our second generation SureForm staplers are now in the market at both 60 millimeter and 45 millimeter instrument lengths and represent product families. Our 60 millimeter stapler has four staple lengths available and is sold in the US, Europe, Korea, Australia and now Japan. Our 45 millimeter SureForm stapler has five different staple length cartridges as well as a straight tip and curved tip instrument and is available in initial launch in the United States and our direct EU markets. Measured through Q2, surgeons have fired intuitive staplers clinically over a million times cumulatively since our stapling launch. Turning to systems, we're in the first phase launch of DaVinci SP. We installed 13 systems in Q2 to bring our clinical install base of SP to 34. Our teams have done a nice job resolving the manufacturing variances that SloatR installs in Q1. The highest per system utilization of SP is occurring in Korea where regulatory clearances support the access to a large range of clinical applications. The Korean experience with SP is encouraging with regard to the broad possibilities for our platform. In Korea, procedures in urology, gynecology, general surgery and head and neck surgery are being performed. In the United States, we have two cleared indications for SP, urologic and transoral surgery. As you know, we're pursuing additional clinical indications for SP and have engaged regulatory agencies regarding their requirements. These requirements are in discussion which implies projected timelines for additional indications are not yet available. Our pipeline of interested SP customers is healthy and the combination of additional indications for SP and our readiness for deployment at larger scale pace the speed of our SP commercial expansion. In flexible diagnostics, our ION platform is focused on the need for accurate family biopsies to support definitive early diagnosis of suspicious lung cancers, lesions for lung cancer. ION received FDA clearance in the first quarter. With 510K clearance, we have initiated our next phase focused on clinical use, customer feedback and product production optimization. First cases on the cleared system were performed at the end of Q1 and we plan a measured rollout this year. Placements to date are at hospital sites collecting data. So far, three have been initiated and over 50 procedures have been performed so far. We're pleased with early clinical results and look forward to our customers continued progress. We expect commercial placements commence in the next few months along with the initiation of additional clinical collection sites. We do not anticipate material revenue from ION in 2019. Turning to imaging and analytics, this week we announced the acquisition of the 3D robotic endoscope business from our long time supplier, Shirley Piper Optic. The transaction is subject to closing conditions and thereafter, we look forward to welcoming their employees to the intuitive team. Leading visualization has been a core pillar of our offerings and we believe it is essential to the future of intelligent surgery. This acquisition strengthens our design and supply chain capabilities and increases our manufacturing capacity for imaging products. For the balance of the year, our focus remains in completing the tasks we set for ourselves. First, supporting adoption of DaVinci in general surgery and in key procedures in global markets, second, launching our SP and ION platforms, third, driving intelligent surgery innovation and finally, supporting additional clinical and economic validation in our focus procedures and countries. Before I turn the call over to Marcel, I'd like to take a moment to acknowledge our Chief Operating Officer, Mr. Sal Bronia, who announced his intention to step back from day to day operations after 20 years at intuitive. Sal has made enormous contributions to building our product line, our capabilities and in the past few years, our leadership team. I extend my personal thanks and that of the company for his efforts over these past two decades. We anticipate working with Sal post transition on projects of mutual interest. I'll now turn the call over to Marcel who will review financial highlights.

Good afternoon. I will describe the highlights of our performance on a non-GAAP performance basis. I will also summarize our GAAP performance later in my prepared remarks. A reconciliation between our pro forma and GAAP results is posted on our website. Key business metrics for the second quarter are where it follows. Second quarter 2019 procedures increased approximately 17% compared with the second quarter of 2018 and increased approximately 7% compared with last quarter. Procedure growth continues to be driven by general surgery in the US and urology worldwide. Calvin will review details of procedure growth later in this call. Second quarter system placements of 273 systems increased 24% compared with 220 systems last year and increased 16% compared with 235 systems last quarter. We expanded our install base of DaVinci systems by 17% to approximately 5,270 systems. This growth is consistent with last quarter and slightly higher than the .5% increase last year. Utilization of clinical systems in the field measured by procedures per system grew approximately .5% which is slightly lower. Then last quarter growth of approximately 4% and below the 5% growth last year. Our revenue overview is as follows. Second quarter 2019 revenue was 1.1 billion, an increase of 21% compared with 909 million for the second quarter of 2018 and an increase of 13% compared with 974 million last quarter. Instrument and accessory revenue of 579 million increased 22% compared with last year which is higher than procedure growth primarily reflecting customer buying patterns and increased usage of our advanced instruments. Instrument and accessory revenue realized per procedure was approximately $1,920, an increase of 4% compared with the second quarter of 2018 and a decrease of 2% compared with last quarter. Systems revenue for the second quarter of 2019 was 344 million, an increase of 24% compared with the second quarter of 2018 and an increase of 39% compared with last quarter. Systems revenue in the quarter reflected higher system placements, higher ASPs and higher lease related revenue. We completed 88 operating lease transactions representing 32% of total placements compared with 44 or 20% of total placements in the second quarter of 2018 and 78 or 33% of total placements last quarter. As of June 30th, we have 486 operating leases outstanding and realized approximately 25 million of revenue related to these arrangements in the quarter compared with 12 million last year and 20 million last quarter. Operating leases create a future source of recurring revenue and reduce the volatility of system revenue. While the increased number of operating leases placed in the quarter dampens short-term revenue growth for the quarter in which they're placed. Operating leases included usage-based financing that we provide to certain experienced hospitals. We believe that our lease financing alternatives align with customer objectives and have enabled faster market adoption. Related to systems purchased over the lease period, we earn a small premium reflecting the time value of money and in the case of usage-based arrangements, the risk that those systems may not achieve the anticipated usage levels. The proportion of these types of arrangements could increase long-term and will vary quarter to quarter. We recognize 27 million of lease buyout revenue in the quarter compared with 12 million last quarter and 13 million last year. Lease buyout revenue has varied significantly from quarter to quarter and will likely to do so. We do not expect the second quarter of buyout revenue, level of buyout revenue to repeat. Thirty-eight percent of the current quarter system placements involve trade-ins reflecting customer desire to access or standardize on fourth generation technology. This is an increase in the proportion of trade-ins compared to 34 percent in the second quarter of 2018 and 36 percent last quarter. Seventy-four percent of the systems placed in the quarter were DaVinci XIs and 20 percent were DaVinci X system compared with 67 percent DaVinci XIs and 25 percent DaVinci Xs last quarter. Thirteen percent of the systems placed were SP systems, our rollout of the SP surgical systems measure, putting systems in the hands of experienced DaVinci users while we optimize training pathways in our supply chain. Globally, our average selling price, which excludes the impact of operating leases and lease buyouts, was approximately 1.54 million compared with 1.42 million last year and 1.31 million last quarter. Our mix of systems and customers in the second quarter of 2019 was very favorable relative to prior periods. We had a high mix of XI versus X and SI systems. We also had a low mix of distributor versus direct sales. In the second quarter of 2019, we also had fewer multi-system arrangements where we provided volume discounts. The mix of systems, customers, and size of arrangements will vary over time. We expect system ASPs to be in the range of the midpoint of the first two quarters. Outside of the US, results were as follows. OUS procedures grew approximately 20 percent compared with the second quarter of 2018 and increased four percent compared with last quarter. Second quarter revenue outside of the US of 314 million increased 19 percent compared with the second quarter of 2018 and increased 11 percent compared with last quarter. The increase compared with the prior year reflects increased instruments and accessory revenue of 34 million or 29 percent growth. The increase in instrument accessory revenue was primarily driven by procedure growth and customer buying patterns. Outside of the US, we placed 80 systems in the second quarter compared with 82 in the second quarter of 2018 and 81 systems last quarter. Current quarter system placements included 30 into Europe, 24 into Japan, and 8 into China. 61 percent of the systems placed in the quarter were DaVinci XIs and 33 percent were DaVinci X systems compared with 38 percent DaVinci XIs and 44 percent DaVinci Xs last quarter. Twelve of the system placements were operating leases compared with six last year and 11 last quarter. Placements outside of the US will continue to vary as some of the OUS 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 limitations. Moving on to gross margin and operating expenses. Pro Pharma gross margin for the second quarter of 2019 was 71.3 percent compared with 71.1 percent for the second quarter of 2018 and 71.2 percent last quarter. The increase compared with the second quarter of 2018 and last quarter primarily reflects higher system ASPs. Future margins will fluctuate based on the mix of our new products, the mix of systems and accessory revenue, system ASPs and our ability to further reduce product costs and improve manufacturing efficiency. Pro Pharma operating expenses increased 27 percent compared with the second quarter of 2018 and decreased one percent compared with last quarter. Spending is consistent with our plan and includes an order of magnitude of increase, costs associated with the expansion of our OUS markets, spending on our informatics capabilities and investment in our infrastructure in order to scale the business. Our pro pharma tax rate for the second quarter was 20 percent and within our expectations of 19 to 20 percent. Our tax rates will fluctuate with changes in the mix of US and OUS income, changes in taxation made by local authorities and with the impact of one time items. Our 2020 tax rate will increase with the return of the medical device tax. Our second quarter 2019 pro pharma net income was 388 million or three dollars and 25 cents per share compared with 327 million or two dollars and 76 cents per share for the second quarter of 2018 and 312 million or two dollars and 61 cents per share for the for last quarter. I will now summarize our gap results. Gap net income was 318 million or two dollars and 67 cents per share for the second quarter 2019 compared with gap net income of 255 million or two dollars and 15 cents per share for the second quarter of 2018 and gap net income of 307 million or two dollars and 56 cents per share for last quarter. The adjustments between pro pharma and gap net income are outlined and quantified on our website and include excess tax benefits associated with employee stock awards, employee equity and IP charges, amortization of intangibles and acquisition related items and legal settlements. We ended the quarter with cash and investments of 5.1 billion, approximately the same as March 31st, 2019. Cash generated from operations was offset by stock repurchases and investments in working capital and infrastructure during the quarter. We repurchased approximately 400,000 shares for 200 million and an average purchase price of 477 dollars per share. In the quarter, we grew inventory by 45 million to 513 million, representing approximately 140 days of inventory. We continue to build inventory to address the growth in the business as well as mitigate risks of disruption that could arise from trade, supply or other matters. With the growth in the business and our focus on efficiency and scale, we expect our capital expenditures will increase to over 250 million in 2019. And with that, I'd like to turn it over to Calvin, who will go over procedure performance and our outlook for 2019.

Thank you, Marshall. Our overall second quarter procedure growth was 17 percent compared to 18 percent during the second quarter of 2018 and last quarter. Our Q2 procedure growth was driven by 16 percent growth in US procedures and 20 percent growth in OUS markets. In the US, Q2 procedure results were generally consistent with recent trends. Q2 growth was again driven by growth in US general surgery, thoracic and benign gynecology procedures. Q2 2019 US procedure growth was 16 percent compared to 17 percent last year and last quarter, reflecting anticipated slight moderation in mature urology and gynecology procedures and general surgery growth rates. In US general surgery, second quarter hernia repair and colorectal procedure growth remained solid, although at slightly lower growth rates than last quarter and last year. Other general surgery procedures such as cholecystectomy, bariatric and liver and pancreatic procedures made increasing contributions to growth in Q2 with higher growth rates than last quarter. As anticipated, US procedure growth in mature urology and gynecology procedures moderated in Q2 compared to last year. US gynecology growth and urology growth were in the mid single digits. DVP growth specifically was in the low single digit range in close alignment with the underlying incident rate for prostate cancer. As a mature procedure category, we believe that our US prostatectomy volumes have been tracking to the broader prostate surgery market. In other US procedures, adoption of lobectomies and other thoracic procedures was again solid during the second quarter. Second quarter OUS procedure volume grew approximately 20 percent compared with 22 percent for the second quarter 2018 and 21 percent last quarter. Second quarter 2019 OUS procedure growth was driven by continued growth in DVP procedures and earlier stage growth in kidney cancer procedures, general surgery and gynecology. Q2 OUS procedure growth faced modest working day headwinds due to the timing of the Easter holiday mostly affecting Europe and other national holidays particularly in Japan. Japan procedure growth remained strong but moderated somewhat in Q2 reflecting lower growth rates and mature urology procedures as we reach higher levels of market penetration, the impact of holidays and the anniversary of the new procedure reimbursements. In China, after several quarters of declining procedure growth, procedure growth accelerated slightly in Q2 driven by procedures performed on new systems installed under the latest system quota. In Europe, procedure growth was driven by strong results in Germany and France. Overall, European procedure growth was largely consistent with prior periods with variation by country. Now turning to the clinical side of our business. Each quarter on these calls we highlight certainly recent published studies of note. However, to gain a more complete understanding of the body of evidence, we encourage all stakeholders to thoroughly review the extensive detail of scientific studies that have been published over the years. We are pleased to see the evidence landscape regarding our recently cleared ion and illuminal systems start to grow. A manuscript describing the first term in use experience led by Dr. David Fielding from the Royal Brisbane and Women's Hospital in Brisbane, Australia has recently been accepted for publication in the peer-reviewed medical journal Respiration. Previously presented at the annual CHEST conference in 2017, this study was designed to evaluate the safety and feasibility of the ion and illuminal platform and included 29 consecutive subjects with follow-up data through six months. Although each nodule was located in the peripheral part of the lung and the mean nodule size was approximately 15 millimeters, approximately 97 percent of the nodules were reached with a tissue sample suitable for assessment obtained. Importantly, across the entire study population, no instances of pneumothorax, bleeding, or device-related adverse events were reported, suggesting a good safety profile. We believe that further scientific study and clinical evidence will be essential to build the market for ion. Soon after receiving FDA clearance for ion in the U.S., we initiated a post-market clinical study called PRECISE, intending to enroll 360 subjects across six key centers in the United States. Full details regarding the construct of the PRECISE study are available on the web at clinicaltrials.gov. In May of this year, a large-scale real-world comparative study using the National Cancer Database was published in the journal Colorectal Disease. The analysis, led by Dr. Ravi Kiran from New York Presbyterian Columbia University Medical Center, compared the results of over 41,000 patients from between 2010 and 2015 by surgical approach. The National Cancer Database captures data from over 1,500 cancer-accredited facilities and represents approximately 70 percent of newly diagnosed cancer cases. The population for this study consisted of approximately 15 percent robotic-assisted, 33 percent laparoscopic, and 52 percent open procedures. In propensity score matched analysis, with over 4,000 subjects in each cohort comparing the robotic LAR approach to the laparoscopic approach, the robotic LAR was associated with shorter length of stay, 6.3 days versus 6.8 days, and lower risk of conversion to open, 7.5 percent versus 14.95 percent, with multivariate analysis showing laparoscopic LAR patients being 2.2 times more likely to be converted to open. Compared to open LAR, the robotic-assisted approach had shorter length of stay, 6.3 days versus 7.8 days, a higher rate of negative margins, 97.01 percent versus 95.96 percent, and higher nodal yield, 17 versus 16.4. The authors concluded, and I quote, for patients with rectal cancer, robotic LAR shows recovery benefits over both open and laparoscopic LAR with reduced conversion to open compared with laparoscopic LAR and less prolonged length of stay compared with laparoscopic LAR and open LAR. Robotic LAR is associated with short-term oncological outcomes comparable to open LAR supporting its use in minimally invasive surgery for rectal cancer. I will now turn to our financial outlook for 2019. Starting with procedures. Last quarter, we forecast 2019 procedure growth of 15 to 17 percent. We are now refining our forecast to the upper half of this range and expect full-year 2019 procedure growth of 16 to 17 percent. Turning to gross profit, on our last call, we forecast our 2019 full-year pro forma gross profit margin to be within 70 and 71 percent of net revenue. We now expect to come in at the higher end of that range. Our actual gross profit margin will vary quarter to quarter depending largely on product, regional, and trade in mix and the impact of new product introductions. Turning to operating expenses, we continue to expect to grow pro forma 2019 operating expenses between 24 and 28 percent above 2018 levels. We continue to expect our non-cash stock compensation expense to range between 320 and 340 million in 2019. We expect other income, which is comprised mostly of interest income, to total between 130 and 135 million in 2019, up from 120 to 130 million forecast on our last call. With regard to income tax, we continue to estimate our 2019 pro forma income tax rate to be between 19 and 20 percent of pre-tax income. That concludes our prepared comments. We will now open the call to your questions.

Ladies and gentlemen, if you wish to ask a question, please press star then one on your touchtone phone. You will hear a tone indicating you have been placed in queue. You may remove yourself from queue at any time by pressing the pound key. If you're using a speakerphone, please pick up the handset before pressing the numbers. Once again, if you have a question, you may press star one at this time. Our first question comes from the line of Bob Hopkins with Bank of America. Please go ahead.

Bob Hopkins, Bank of America Q2 Q1 By RMF, the overall Q2 U.S. growth on the procedure side accelerated a little bit when you take into consideration the year of our comp. But you called out some slight moderation in hernia and colorectal. I was wondering if you could just talk about that a little bit. Was the growth you experienced in hernia and colorectal this quarter different than you expected? And how do you manage through this issue of managing access? Thank you.

Yeah, this is Gary. We saw a tad of moderation. I think demand remains strong. What we're really seeing is what we indicated to you. We have two things going on. One is there are a lot of different procedure types. And now in busy centers, competition for system access, we can of course solve that with additional systems placed as well as work with folks on efficiency of use. And we're doing both. And you've heard that from us over the last several quarters. The next one is our commercial teams have been growing in the United States to support the growth of the company. And it takes some time to have teams come up to full productivity. And we're a percentage of new folks in new territories has been ticking up the last couple of quarters. And the new ratio is amongst the highest we've had in the last few. Employee retention has been great. It's really around increased need to get increased case coverage. So there it's supporting our new folks in the field with tools. And some of it is just time on task.

Yeah, Bob, you know from just a pure mathematical standpoint, you know we track adoption curves pretty regularly around here. And it's a mathematical reality that really all points along the curve. The rate of growth actually declines. So our results here in Q2 is aligned with what we would have expected. And clearly there's a substantial remaining opportunity in both hernia and colorectal procedures and our checks with surgeons generally indicate healthy demand.

That's great. Thank you for the color. And then just one on the system side because revenue growth from system sales this quarter was much higher than the first quarter due to mix as you called out. But the placement numbers and the placement growth in both quarters suggest very strong underlying demand for your systems in both quarters. I was just wondering if you could talk a little bit about the differences you saw from Q1 to Q2 in that mix dynamic and what that suggests about the outlook for the rest of the year on the system side. Thank you.

Yeah, we're – this is Marshall. We have seen as you suggested reasonable strength in terms of system placements. I don't think there's anything really different quarter to quarter other than the mix. In other words, the buying behaviors of the customers haven't changed. We're seeing a nice cycle on tradeouts. But we did see again more excise this quarter and there's volatility or variability between quarter to quarter as it relates to particularly our distribution channel. And so we saw fewer distributor sales this quarter and more direct sales. Our direct sales are at a higher price than what we sell to our distributors since they incur the selling costs associated with those systems. So that's really – that's the color that we would provide on systems revenue. Great. Thank you.

Marshall, is it fair to look at it and say if you view the first half as a whole rather than in different quarters you get a better picture?

That's true, Gary. When you look at the ASPs you should think about the combination of the two because 1.31 was a low point and 1.54 is a high point.

Next question comes from the line of Tycho Peterson with JP Morgan. Please go ahead.

Okay, thanks. Maybe I'll just follow up on that last question. Why should ASPs take a little bit of a step back? You skewed more toward fully featured system sales. Obviously your procedure mix is expanding. Why logically should ASPs step down a little bit going forward?

You should expect that the – again, distributor sales tend to be variable quarter to quarter. I think you should blend the first quarter and the second quarter when you're looking at what level of the distributor sales you should expect. I think same thing with the mix of XI and X. Just depending on the geography, X is targeting geographies where reimbursements are pressured. This quarter just based on mix we wound up selling fewer Xs and that should even out as well.

We've had a couple quarters now of operating leases and the low 30s. It was 29% at the end of last year. Is this the new norm in your view or how should we think about operating leases in terms of mix? I

don't think about it as a norm. I think that there's going to be variability quarter to quarter. Yeah, Q2 was slightly lower if not close to being the same as Q1. I think over time we will accommodate customers and we think that on the other hand, leases are positive for the company and that they – as I said in my prepared remarks, it increases the recurring revenue, it eliminates volatility. It also enables a upgrade cycle when and if new systems come out. We think it's a positive and so we'll supply those to customers as they ask for them. I would guess that over time or we're predicting over time that there's the possibility that the percentage actually will increase.

Okay. Then on IRIS, I know it's early days. I didn't really hear you bring it up in the comments but can you just talk a little bit about interest levels for kidney and liver and how we should think about the expanded use of that going forward?

I think the interest from the forward leading surges is very high. I think in general people looking out saying additional access to data. IRIS, just a reminder for everybody, is the integration of preoperative imaging, 3D imaging into a case in real time. We're not in the clinic yet. We do have our 510K clearance. We're working through agreements with first customers. We don't expect revenue this year. I think directionally there's quite a lot of support. I think part of what we want to develop in the market as we go forward are use cases and really getting the value statement for them in terms of what it drives, either accuracy or efficiency or both. Early response is great but these things take a little time to develop and to develop the evidence base that goes behind it.

Thank you. Next question comes from David Lewis with Morgan Stanley. Please go ahead.

Good afternoon. A couple questions here. I'll start with Gary. Gary, last year procedures began to inflect from a mental perspective and they still remain pretty strong. As you think about the next inflection for procedure growth, do you think it's more likely it comes from new systems, obviously SPION, creating this access you've already talked about on this call or accessing new geographies? You had Japan and China. I noticed you already mentioned that comment that just a few systems in Japan, sorry, in China was able to drive some demand. So across those three buckets, Gary, systems, access, geographies, what is the most likely driver of the next wave of procedure inflection?

I think in the near term, access in core markets is going to be important. And you know what's been nice here the last few years is the procedure base has been building so healthy double digit growth rates and procedures and absolute growth numbers are starting to become substantial and making sure that those surgeons who want access to the system have it has been important. It's been one of the drivers for our increased flexibility and agility in capital acquisition models. As you look at SP and ION, both of those are interesting platforms that I think over time will expand the total available market for robotic systems in diagnostics and in single port or single access surgery. They take some time to develop and the speed with which they develop is, as I said in the transcript, paced by additional indications and manufacturing scale. Longer term I think those things are exciting but it will take some time to go through. Geography, we've seen real successes, but they take time. Japan has been a great success. They're doing a really nice job. But it is really heavy lifting to do all the things required to build market access from octarean networks to training centers to the clinical evidence base to support additional adoption. I think those things are important. We have invested in them and will continue to do so. Short answer, maybe not a perfect modeling answer, but I'll leave that to you.

Okay. Then just to follow up for Gary, I'm just trying to get a sense of thinking about the SP rollout and the ION rollout. Your ION commentary was fairly consistent with the first quarter. If I think about the first four quarters of SP, obviously exiting out the manufacturing issues last quarter, do you see ION rolling out from a system placement perspective in a similar fashion to SP? Is there a reason why it would be faster in the first four quarters of commercialization or slower? Thanks so much.

Yeah. I anticipate a measure in this first four quarters of launch as we optimize our systems on our side and also our gathering our data. After that, we'll see. I don't think I predicted one way or another for you. The indications in ION we feel pretty good about to get started. I think the size of that market is real. We'll see a year from now, I think, as to how fast we want to move. On SP, it has, I think, great long-term potential. It requires additional clearances in the US anyway to keep moving. And so we'll do that in sequence.

Next, we'll go to a line of Amit Hassan with Citigroup. Please go ahead.

Thanks. Good afternoon, guys. Let me start with one on the quarter and just follow that to that. On the quarter, the INA versus procedures, INA was up 22 percent, procedures up 17 percent. That's the widest gap. I can recall in a little while. You touched on it a bit, but maybe just a little bit more color. Is that the new and advanced instruments driving something that's sustainable? Or are there one-time things in there that we should consider?

Yeah, I think in general, we have seen increasing revenue, instrument accessory revenue per procedure. Obviously, there's variability by quarter based mostly on the timing of customer orders. But in general, we've been gradually increasing. The biggest aspect of that has been increasing usage of advanced instruments from vessel sealing, the vessel sealer extend we launched recently, now to stapling as well. The 60-millimeter stapler we launched last year and more fully available this year in the US. So I think that's been the biggest factor that's probably been more than offsetting everything else, whether it's more procedures in general surgery, hernia repair and others that may be lower tool usage. So I think that's the biggest factor there.

Just a slightly longer term question on flexible endoscopy with surgical instruments. One of your bigger future robotic competitors has been talking about this publicly now for the first time in just the past month or so. Can you talk to us how much of a priority this is for intuitive, what you can tell us about the opportunity from a robotic perspective?

Sure. In general, as we've described before, we like to think in platforms. And what I mean by that is if we can build some core technologies from advanced imaging to great precision to great software, then we can mix and match those core capabilities to pursue different endpoints clinically. And so you look at SP. SP is an exceptionally powerful system that brings together four instruments through a single access point. You look at ION and ION has exquisite sensing and a flexible endoscopy or a flexible diagnostic platform. Over time, I think those two different sets of ingredients give us a great opportunity. And so I think those things are interesting and they could open for us additional clinical markets over the long term. That said, product design is subtle and architectural choices are really, really important. Doing it right, getting a great clinical outcome comes down to sub-millimeter precision and microsecond findings of these electronics. And as a result, we want to make sure that we really deliver on the things we put in the market from SP to ION. So we're not sprinting to go as broad as possible. We really want to make sure we deliver against the commitments we make and for the customers who purchase our products. There's a fair amount of history out there of companies that have failed to attend to the details and start strong and peter out. So we're careful and thoughtful about it.

Next question comes from a line of Larry Bilgeson with Wells Fargo. Please go ahead.

Thanks guys. Thanks for taking the question. First, could you talk about the strategic and financial implications of the fiber optics acquisition and add one follow-up?

Sure. I'll speak to why we did it. Shelley is a strong team and a supply chain partner that has been important for us over many years. Clearly, great imaging, manufacturing capability, design capability, image processing is a core part of the surgery of the future and interventions of the future. As we've grown, we've wanted to make sure that we can continue to invest in that space both on the design side and on manufacturing and production capability side. It's been a great partnership with that team. We respect them and have been very productive with them. So that gives us additional optionality and agility going forward in a core part of our business. On more of the deal specifics and logistics, I'll turn it over to Marshall.

So we entered into an agreement to acquire certain assets and operations from Shelley for her cash consideration of approximately $100 million. The exact amount of the consideration and timing of the closing is subject to certain closing conditions. That will occur over the next future periods and the employees will transfer after each of the closing events occurs.

Thanks, Marshall. Then on ION, we haven't heard you talk about the opportunity or timing outside the US. What's the status particularly in China and the rest of the world? Thanks for taking the questions, guys.

Yeah, on the specifics on China, we're in discussions with Chinese regulatory agencies about how best to bring it to market and timing there. I don't have a definitive answer for you yet, but it's an active discussion. Clearly, we believe there are end user opportunities and value, healthcare value to bring in China and in Europe and in other markets. We'll take it in sequence. We think this is a powerful set of technologies and a powerful platform. We are still in the early days. Our greatest organizational focus right now is on really understanding the technology and the use of it carefully. The early clinical results are great and they are differentiated relative to other products in the market so far in these early days. That's really important to us. We will focus there and as we build strength and experience and scale, then it gives us a lot of opportunities to engage the rest of the

world. Next, we go to a line of Lawrence Kush with Raymond James. Please go ahead.

Great, thanks. This is John Chuan for Larry. Maybe if we could start without providing guidance for 2020, can you give us some high-level guideposts for how we should generally think about investment spend next year going into 2019? You obviously have a lot of products on your plate this year, but just any high-level color would be greatly appreciated.

We'll give you a better color when it comes to January about what's going to happen next year, but the things that we're investing in are not short-term investments. They occur over a long period and so you should expect that spending will continue to continue on those and on other matters going forward. As we grow the company, of course, there's an increased amount of support that's necessary to grow the company, particularly on the sales side in terms of personnel and commissions. I think spending will increase. I won't give you anything more specific than that until we get later in the year.

Maybe I'll just speak for philosophy a little bit. We think the opportunity for improved performance and therefore opportunities for the business are substantial. What paces us is to how we decide how much we'll invest and when is that which we think we can do with excellence. Generally speaking, we see more opportunity than we think we can pursue. We wind up saying no to some things that are probably good ideas, but we don't know that we can perform them well. That's what balances our investment portfolio. We'll continue to use that philosophy as we plan out 2020 and go forward.

Great. Then just on the balance sheet, you obviously have five billion plus in cash. You bought back some stock in the quarter. You also did a tuck in acquisition for imaging capabilities. Can you just remind us how you think about your capital deployment priorities at this point?

The philosophy and approach to capital deployment hasn't really changed, but to remind you, we think about that cash obviously to operate the company. We're making investments in our future. We want cash. The market is volatile in terms of the environment is volatile in terms of tariffs and other things going on. We want to make sure we've got proper investments to be able to deal with those. Then ultimately, we look for opportunities to buy back stock and return cash to shareholders.

Okay, great. I could see one last one on the tax rate. I think you mentioned the medical device tax coming back in 2020. By my estimate, I think we're coming up with an impact of roughly $30 million. Is that a decent ballpark for how you're thinking about the impact of product gross margin in 2020?

When we're talking about medical device tax, we were recognizing in the past we charged that expense item to cost of sale, so it impacts our gross margin there. We saw an impact around 70 to 100 basis points then, and it's probably a similar kind of impact should that be reenacted.

Okay, great. Thank you.

Next, we go to a line of JP McKim with Piper Jaffray. Please go ahead.

Hi, good afternoon. Thanks for taking my question. I wanted to ask one on just this push to trade ins and upgrading the install base to generation four. I think after last quarter, I think half the install base was still older generations. Can you give us an update on where that is today and then just strategically how important is that to you to get everyone on Gen 4 ahead of competition that in theory should come sometime next year or after that?

I'll give you the numbers and let Gary talk to the strategy. You heard on this call, it was another 38% of our system sales involved trade ins this quarter. It's likely to continue to be a significant part of our capital sales and future periods. At this point in time, it is about 45% of our install base, 50, 270 systems that are Gen 3 and prior, mostly SIs.

Do we think it helps? As to the strategy, we think our customers appreciate it. Many customers now are multi-system owners or across their integrated delivery network. They have systems at different hospitals where surgeons visit. Having consistency helps them. Gen 4 products have greater access to advanced instruments and other technologies and are well appreciated. In that sense, we think we can lean in and help those organizations go do it. There's a different set of regulatory clearances in different countries around the world. There are different trade and economics in each country. As you think about the analysis, you think a little bit about which region and which country can move most quickly and we work through that as well.

If I could ask one on the comments you made on the general surgery dynamics with hernia and some of the others is tempering based on large numbers. The shift to bariatrics and more on COLE, the shift internally on general surgery, what does that do for your instrument ASPs? Are they more advanced instruments as you shift to different procedures in general surgery?

Highly variable. You look at COLEs, those are lower revenue per procedure cases. You look at bariatrics, it's the other side where a lot of staple fires are used. It's a highly variable landscape.

Bariatrics is in early innings and as we start to optimize the instrument kit therein, we're seeing really pull from the market there. We haven't changed our priorities in the US sales force with regard to general surgery. We continue to believe there is opportunity and value in of course hernia and colorectal procedures. The bariatric side are really customers coming to us and starting to move that along. Thank you.

Next we go to line of Richard Nowitter with SVB Lerink. Please go ahead.

Hi, thanks. I have two in housekeeping. With the housekeeping, can you just quantify what the selling day headwind was, what your procedure growth would have been excluding the, not the selling day, but some of the headwinds that you had described related to the holiday timing and whatnot? And then Gary, I was wondering if there, with respect to the capacity issues, just getting robot time, are there certain types of procedure mix cases or certain types of institutions where you can practically get in front of those capacity issues to get there before they occur? And is there any kind of characteristic of the institution's procedure mix that specifically is leading to the capacity constraints?

Yeah, first on the working days, really minor in the quarter, not a big thing. We mentioned in the commentary overall, maybe a 30-ish basis point impact on procedure volume with a much larger portion attributable outside the US due to the timing of Easter.

On the capacity side, as we've said in the past, our customer base doesn't, one size does not fit all. Each institution runs with different operating cadences within their organization. So in some places we see extremely efficient capital utilization, really a focused, accurate approach where they have very high predictability and get a lot of procedures out of the system. We're delighted to support that and we help to benchmark that and teach others as they need it. We see other institutions that, for various reasons, are operating at lower capital capacity for some reasons that are quite good. Some may be teaching institutions, some may be institutions that take on the most complex comorbid patient sets where predictability of procedure duration is difficult. So you can imagine if you're sharing a system between a thoracic surgeon who's performing lung cancer procedures and a general surgeon who's doing hernia repairs, the cadences and rhythms and scheduling are quite different and you're going to get less optimal scheduling. To the extent that we can have those conversations up front and help them optimize, we do. That's something we've been strengthening over time, so I think we can do better than we do today.

Great, thanks. If I could get one more, the China utilization pick up on just eight systems placed under the quota, did that surprise you that it was able to translate into a pick up in volumes so quickly? It was always an impression that you needed, there was going to be a lag time to train institutions, if you could comment there. Thanks.

I don't know if we were surprised, I'd say we were pleased. That tells you the level of commitment and motivation of those customers to make their investment productive. Last questioner, please.

That's the last question comes from a line of Imran Safar with Deutsche Bank. Please go ahead.

Hi, good afternoon. Thanks all for taking my question. First question is on Japan. I believe you noted some moderation and procedure growth there, but at the same time, we're still seeing some very strong capital equipment placement numbers this quarter. Can you just give us some color on what's driving these placements? Is it more sort of green field robotics programs that are looking to get into presumably urology, or is it the established customers wanting to get more into general surgery in light of sort of the less financial incentive that they have? I'm just wondering if the growth should continue to slow going forward in general surgery.

It's a combination of green fields where you have hospitals that are positioning themselves to do the newer procedures that were approved for reimbursement last year. There's still a trade in cycle going on in Japan. Our distributor had sold SIs on leases, and as those leases are coming due, then we see customers wanting to upgrade to the newer technology.

Okay, thank you. Then we've heard some mention from some surgeons on some third parties that hospitals can ship instruments that are approaching the end of their useful life, and that this limited useful life can be extended presumably via some sort of a software intervention or something. Is this something that you're seeing any impact from, or is there any regulatory preclusion that would limit the ability for companies to do this kind of stuff?

On the... How good an idea is it that the people who reprocess like that are bound by the same regulatory framework that we are in terms of assuring the quality of that product and making sure it's not sold as an adulterated product, and they have to take on that burden and it is a sophisticated one? Calvin, I'll let you respond. No, yeah, I think

that's essentially

it. In terms of materiality.

Yeah, and you look at our revenue per procedure. I mean, we've talked about that a little bit, and I don't think we've seen any impact on that.

Great.

Thanks for taking my question. Thank you. That was our last question. In closing, we believe there is a substantial and durable opportunity to fundamentally improve our patient outcomes, better patient outcomes, better patient experience, better patient outcomes, better patient experience, and better patient outcomes. We believe that accomplishing the same takes the integration of three elements. First, a deep understanding of the human interactions across the continuum of care. Second, smart and connected systems, imaging and instruments that augment care teams. And third, the ability to measure impact through analytic insights and translation of these insights into action driving positive change. Thank you for support on this extraordinary journey. We look forward to talking with you again in three months.

Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation and for using AT&T Executive Teleconference Service. You may now disconnect.