Intuitive Surgical, Inc.
Q1 2009 Earnings Call Transcript

Published: 18 Apr 2009

[Operator:]

Good afternoon. Welcome to the Intuitive Surgical’s first quarter 2009 conference call. (Operator Instructions). I would now like to turn the call over to Ben Gong, Vice President of Finance.

[Benjamin Gong:]

Good afternoon and welcome to our first quarter conference call. With me today we have Lonnie Smith, our Chairman and CEO; Gary Guthart, our President and Chief Operating Officer; Marshall Mohr, our Chief Financial Officer; and Aleks Cukic, our Vice President of Strategic Planning. Before we begin, many of you are aware that our Form 8-K containing our press release was filed earlier than normal. That was unintentional. Our vendor for filing 8-Ks mistakenly filed it early this morning instead of waiting until after the press release went out. We apologize for any confusion this may have caused. Moving on, 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. Prospective investors are cautioned not to place undue reliance on such forward-looking statements. Please note that this conference call will be available for audio replay on our website at www.intuitivesurgical.com on the Audio Archives section under our Investor Relations page. In addition, today’s press release has been posted to our website. Today’s format will consist of providing you with highlights of our first quarter results as described in our press release announced earlier today followed by a question-and-answer session. First, Lonnie will present the quarter’s business highlights. Gary will follow with operational highlights. Marshall will provide a review of our first quarter financial results. Aleks will discuss marketing and clinical highlights. I will provide an update on our financial forecast for 2009, and finally, we will host a question-and-answer session. With that, I would like to introduce Lonnie Smith, our Chairman and CEO.

[Lonnie M. Smith:]

Thank you for joining us today. Despite the challenging economic environment, I feel that our team’s operational execution was excellent. Revenues were up 11% over the prior year. We saw a one-time $20 million revenue deferral associated with our offer to customers who purchased the da Vinci S this past quarter to upgrade to the new da Vinci Si. Marshall will discuss the details of that accrual later. Procedures grew by 60% and operating costs were effectively controlled. Two factors affected our year-over-prior-year growth as hospitals responded to the current economic environment. We sold 8 fewer systems in the first quarter of 2009 than we did in 2008, and as a part of their effort to improve cash flow, hospitals reduced inventories by slowing the purchase of incoming supplies and that reduced the growth of our instrument and accessory revenue. With that as background, operating highlights for the first quarter excluding the one-time $20 million revenue deferral are as follows

[Dr. Gary S. Guthart:]

Thank you, Lonnie. For the past several quarters we have made significant investments in research, development, and manufacturing. We’re pleased with the progress of our product development teams, our operating teams, and our technology partners, both in the depth of their achievements and in the speed with which they are accomplishing them. We continue to invest in developing novel instruments for our da Vinci platform, in improving and expanding our imaging capabilities, in developing new patient-side mechanisms, and in creating surgical networking and training technologies. On April 2nd we announced the availability of our newest da Vinci model, the da Vinci Si. The Si brings to market three significant innovations. First, it introduces a dual surgeons’ console for use during surgery which will allow new methods of training da Vinci surgeons and enable collaborative da Vinci surgery. With the Si, a surgeon sitting at a second console can view the same surgery as the primary surgeon and can be passed control of some or all of the da Vinci arms during a case. We believe this will both shorten the learning curve for new surgeons and will allow collaborative surgery in complex cases. Secondly, our InSite imaging system has been substantially redesigned for increased visual acuity and improved ease of use. The HD imaging system’s increased performance is analogous to the move from 720P to 10AVI in commercial television. We believe that the increased visual performance will continue to increase surgeon precision and confidence and will contribute to improved patient outcomes and shorter procedure times. The third significant improvement is the Si’s users interface which has been redesigned to allow simplified and integrated control of da Vinci and other operating room devices such as electrosurgical units. The simplified interface and improved ergonomics will allow for easier surgeon training and decreased surgeon workload during surgery. The Si system is FDA approved and CE marked. It is currently available in the United States and most of Europe. SI systems will be available with an option to purchase a second console. Existing S instruments and most S accessories are compatible with the Si systems and upgrade to S systems to the Si system is available for our current customers. In other developments, this quarter we acquired the assets of a Silicon Valley company, NeoGuide Systems that has been developing robotics for medical applications. Included in the purchase of patents and applications with early issue and filing dates covering basic concepts and the design and control of multi-link snake robotic systems for use in medicine. The addition of NeoGuide’s intellectual property to our organically developed technology and in-license technology from groups like Hansen Medical, Luna Innovations, SurgiQuest, and USGI Medical has established a strong IP base for Intuitive in single-incision and potentially NOTES robotics. Overall, we continue to drive our teams and investments into both our da Vinci platform and into new technologies that will advance robotic surgery. With that, I will turn the call over to Marshall for a review of financial highlights and to take you through the financial implications of the Si launch.

[Marshall L. Mohr:]

Thank you, Gary. As Lonnie mentioned, our first quarter 2009 revenue of $188 million was net of $20.1 million of revenue deferred in association with the da Vinci Si upgrade offers. With the launch of the Si we made offers to first quarter da Vinci S customers to upgrade their systems to the new Si model and a discount to the upgrade price. We also extended offers to those customers to exchange da Vinci S camera equipment for Si camera equipment. We made these offers to be fair to the recent purchasers of da Vinci S systems who wanted to own the most capable system available. As a result of this program we deferred $18 million of system revenue and $2.1 million of accessory revenue. The $20.1 million of deferred revenue is anticipated to be realized before the end of this year as the upgrade-completed da Vinci Si camera equipment is shipped where the offers are declined. Net of the deferral are $188 million first quarter revenue was roughly equal to our first quarter of 2008 revenue and $43 million lower than the fourth quarter of 2008. First quarter revenues by product category are as follows

[Aleks Cukic:]

During the first quarter we sold 66 da Vinci systems, 44 in United States, 17 in Europe, and 5 into rest of world markets. A total of 6 system sales were part of trade-up transactions. The net 60 new system installations brings to 1171, the cumulative number of da Vinci systems worldwide; 863 in the US, 211 in Europe, and 97 in rest of world markets; 17 of these 60 net systems installed during the quarter represented repeat system sales to existing customers that included a fifth system which was an Si system to Hartford Hospital in Connecticut and third systems to UCLA Medical Center, Northside Hospital in Atlanta, and the Karolinska Institute in Stockholm, Sweden. This brings to 146 the total number of customers which own two or more da Vinci systems. International sales were particularly strong and included 3 more da Vinci placements into China, Germany, Italy, and Spain. Clinically, we had an excellent quarter with strong double-digit sequential procedure growth, both domestic and internationally. Demand for da Vinci hysterectomy both for benign and malignant conditions, sacral colpopexy, myomectomy, partial nephrectomy, cystectomy, and da Vinci prostatectomy were most notable. We also experienced strong international demand for several general surgery procedures, specifically da Vinci colon and rectal procedures and da Vinci thyroidectomy. In Q1, well over 200 da Vinci related clinical publications and abstracts appeared within various peer reviewed journals, and our participation at the medical conferences was robust. Several case studies and series presentations were provided, but I’ll limit and highlight just a few. Last week, we had the clinical unveiling for the new da Vinci Si system at the World Robotics Symposium in Orlando, Florida. The conference featured 12 live da Vinci procedure broadcast which included DVPs, partial nephrectomy, cystectomy, and radical hysterectomy. The Orlando attendance represented approximately 300 clinicians, but the program was also simulcast to 150 urologists in Milan, Italy and over 100 in Seoul, Korea. The highlight of the program was the unveiling of the da Vinci Si, specifically, the cases performed with a dual console. The first case was a DVP performed by Dr. Vip Patel where Dr. Vip Patel controlled the instruments from one console and Dr. Bob Myers, Chairmen of the Department of Urology at the Mayo Clinic observed and learned from the second console. The second DVP incorporated a second surgeon into the operation, Dr. Jeff Collins, a urologist from Australia, assisted Dr. Patel throughout the operation from the second console. The US, European, and Asian audiences observed with several described as a paradigm shifting approach to robotic training as well as an interesting new multi-surgeon approach in the management of very complex surgical procedures. The commentary from the surgeons also included very positive reviews on Si’s next generation vision system, enhanced motion scaling, and expanded user interfaces. All in all, it was a very positive launch for what we believe to be an exciting new product offering in Intuitive Surgical’s product line. In the January edition, The Journal of Robotic Surgery, a publication from a urology group out of Korea led by Dr. Sung entitled the halo effect in Korea, change in practice patterns since the introduction of robotic assisted radical prostatectomy highlighted an interesting phenomenon taking place in urology centers around the world. We’ve often discussed the expansion of the hospitals’ prostatectomy business following the initiation of the da Vinci program, but I don’t recall it being detailed this clearly with empirical evidence in a peer review publication. This analysis tracked the relationship between three variables; open prostatectomy, da Vinci prostatectomy, and overall prostatectomies performed over a 33-month period beginning in July of 2005. The numbers were as follows

[Benjamin Gong:]

I will be providing an update on our forecast for 2009 based on our results in Q1. First, as outlined by Marshall earlier, we expect that $20 million of revenue we deferred in Q1 to be recognized starting in the second quarter and completely recognized by the end of 2009. As a result, this should have no impact on our revenue for the year. Moving on to procedures, our procedure growth has been stronger than we previously expected. Procedures grew approximately 60% in the first quarter consistent with our procedure for all of 2008. As a result, we expect procedures to grow more than 40% this year compared with our previous forecast of 3% to 40%. Procedure growth will continue to drive significant growth in our total instrument and accessory revenues this year. However, stocking orders which are tied to new system sales are likely to fluctuate in the near term. In addition, as we saw in Q1, our customers ordering patterns could cause some fluctuations in our revenues per procedure. While our revenues per procedure have normalized over time, we could see increases or decreases on a quarterly basis this year. Previously, we forecasted 25% to 30% revenue growth in our instrument and accessory revenues. Although we expect procedures to grow more than we previously forecast, we are less certain that we will achieve this revenue forecast. At this time, we are suspending our previous guidance for instrument and accessory growth. When we gain better visibility, we plan to resume providing you with a revenue forecast for instruments and accessories. We would like to emphasize that in the longer term, instrument and accessory revenue growth should more closely match our growth in procedures. While procedures drive our revenue growth in the short-term, the environment for hospital capital spending remains highly uncertain and difficult to predict. As an example, we sold approximately 10% fewer systems in the first quarter than we previously expected. Last quarter, we forecasted flat system sales for the year. Although demand for systems continues to be strong, we are suspending guidance for systems revenue. Once again, when we gain better visibility, we plan to resume providing you with the revenue forecast for systems. Our service revenue model has been very consistent and we expect it to remain as it has in the past. We are generating an average of about $140 in service revenue per system per year. Since our service revenue was driven largely by the installed base, we continue to expect service revenue to grow approximately 35% this year. With regard to gross margin, it should be noted that we did not defer any cost of sales along with the $20 million revenue deferral in Q1. Therefore, when the deferred revenue is recognized in the ensuring quarters this year, it will result in increased gross margin. For the year, the deferral should have no net impact. We continue to expect our gross margin for the year to come in between 70% and 71%. With regard to operating expense, last quarter we provided a forecast of growing our GAAP operating expense by approximately 20% in 2009. Based on our current plans for the remainder of the year, we expect our GAAP operating expense to grow by approximately 17% from 2008 to 2009. Included in this estimate are some significant increases in non-cash expenses. First, with regard to SFAS 123R, in 2008 we recorded $77 million stock compensation expense. In 2009, we expect stock compensation expense to increase 24% to approximately $95 million. Secondly, with regard to IP amortization charges, we are scheduled to record approximately $16 million in the R&D expense line for 2009, up 60% from the $10 million we recorded in 2008. We will continue to manage our fixed cost closely as we demonstrated in Q4 and Q1, however, we will continue to add resources in the sales and R&D functions as we view these as important investments to continue driving growth in the near term and the long term. With regard to income tax, the tax adjustment related to changes in state tax laws that impacted our Q1 tax rate is not expected to recur in the balance of the year. Going forward in 2009, we expect to report a GAAP tax rate of approximately 40%. For calculating earnings per share, we ended the quarter with 37.9 million shares outstanding after buying back and returning approximately 1.4 million shares through our accelerated buy-back program. We will complete the accelerated buy-back by the middle of June though the number of additional shares we receive under the program will be small compared with the 1.4 million already received. Approximately 500,000 shares were added to the diluted share count for calculating EPS in Q1. Therefore we expect our share count for calculating EPS in Q2 to be approximately 38.4 million shares. Finally, when analyzing and forecasting our cash flows, it is important to note that while we reported net income of approximately $28 million in Q1, we generated approximately $90 million in cash from operations during the first quarter. The $20 million revenue deferral causes significant part of this difference, and the larger contributor to the difference was our recording of approximately $23 million of SFAS 123R stock compensation expense, and we expect to continue to record approximately $24 million per quarter for the rest of the year. As a result, our cash flow should continue to be significantly higher than our reported net income. That concludes our prepared remarks. We will now open the call to your questions.

[Operator:]

(Operator Instructions). The first question is from the line of David Lewis - Morgan Stanley.

[David Lewis:]

I’ll try to limit this to just a few questions; first of all, may be just if you could talk us through thematically the decision to suspend guidance, were these the things you learned incrementally into the first quarter with the difficulty in filling boxes in the first quarter that led you to this or simply the operating environment got less physical materially in the last 6 weeks, so there’s too many factors to control for and so suspension of guidance seems most prudent?

[Marshall L. Mohr:]

I think you’re on to it David. Given the current environment, our visibility in the system sales is not very good, and this was evidenced in the first quarter where we missed our system forecast by about 10%; so rather than give you guidance that has a high degree of uncertainty, we’re just going to suspend guidance at this time, and when visibility improves, we plan to resume giving you guidance.

[David Lewis:]

Would you say this means that your visibility from 3 months ago is better, worse, or the same?

[Marshall L. Mohr:]

It’s probably relatively the same.

[Aleks Cukic:]

I actually think it might be a little bit better. Actually, in terms of just the range of what could have happened, I think that we performed quite well, but if we were to give guidance, it would be such a wide range it might not be very meaningful, so we decided let’s see what happens, and as we get further down this path where we will be more confident in our ability to forecast, we will be willing to do so.

[Benjamin Gong:]

Just to add one point, David, is that, as you know we manage a pipeline and we work on a lot of different deals which become difficult as not knowing what deals you’re working on but trying to predict the demand and reconciling it to when it is going to close, and predicting that within 90-day windows became very hard, but again, working on a lot of systems is something that we continue to do.

[David Lewis:]

Okay, just a couple more questions; just on instruments specifically, would you say that more of the variability is tied to the pricing and mix issues than we talked about last year or is this more not understanding the inventory in that channel with customers today?

[Marshall L. Mohr:]

For changes that happened pretty rapidly like Q4 to Q1, the things I can move the fastest or things like changes in stocking orders which we definitely saw and also changes in, let’s say, customers managing their inventory; the things that we talked about before like efficiencies and procedure mix, those are things that gradually impact the revenue per procedure over longer periods of time.

[David Lewis:]

And then just last question, I want to kind of get back to the deferral of revenue; if Marshall can provide with some detail on how many customers were affected by the deferral in this quarter, so how many specific upgrades, and then how many were actually affected by the specific accessory upgrade?

[Marshall L. Mohr:]

This was a program that we developed in order to make sure we were being fair to customers that were buying da Vinci S in the quarter just before we introduced the new product, and so, when you say how many customers were affected, we effectively offered all customers of the S the opportunity to upgrade. Now the accounting rules are kind of convoluted and they basically require us then to defer the amount of discount that we’re offering them to buy the upgrade at and the discount being that from list price, but we made the offer so that effectively if they bought an S, the amount they’ll have to pay to get to the Si equivalent is equal to what we would have sold an Si for.

[Benjamin Gong:]

There were 44 customers who got an offer for a discounted upgrade, and if I can just give you one example, it helps you understand how this works because it is a little bit complex; let’s assume that you bought a system for $1.6 million this quarter, and the normal price of an upgrade is $600,000, but we offered to that particular customer an upgrade for $150,000 to get them to a list price of $1.75 million for da Vinci Si. So, what we deferred, let’s say for that customer, is $450,000. That’s the difference between the $600,000 list price of the upgrade and the $150,000 that they would pay if they choose to do the upgrade, and then we withheld that $450,000 from the recognition of the $1.6 million sale in Q1. If the customer chooses not to upgrade and we did give them a limited timeframe to make this decision, if they choose not to upgrade, we’re going to recognize the $450,000 when the offer expires. If they choose to upgrade, we’re going to recognize $600,000 at the time that they upgrade. I hope that helps clear it up.

[David Lewis:]

That’s actually very very helpful. Lastly, and I’ll jump back in queue and let someone else take a crack here; in terms of the timing of this system, you’ve launched new systems before at various times during the quarter. I’m just curious as to we have seen a significant deferral program before. So, was the economic sensitivity tied to the specific timing or nature of this program or were they unrelated.

[Benjamin Gong:]

Really again, what we’re trying to do is to be fair to customers who are buying a da Vinci S. So, the timing is unrelated. It had to do with upfront thinking about the rollout program and what made sense.

[Dr. Gary S. Guthart:]

The other thing is the last major larger product launch was standard da Vinci to da Vinci S. Those two were not compatible in terms of an upgrade; that would have been missing. In other words, the S can be upgraded to the Si. The standard could not be upgraded to the S.

[Marshall L. Mohr:]

We also learned from that experience with S that we had a few very unhappy customers and the accounting rules because of the way we treat it did not allow us to talk with them for 6 months to even communicate anything, and that’s just not the way to run a business. Long-term, these are our customers. We would all be happy and want to treat them as we would want to be treated, and so we’ve restructured this and taken the hit in this quarter because we believe long-term we’ll have a better relationship with those customers than if we treated as we did with the S.

[Operator:]

Your next question comes from the line of Tao Levy - Deutsche Bank.

[Tao Levy:]

How long does it take to upgrade an S system? You guys had mentioned anywhere between 2Q and the rest of ’09 you’ll get a decision. Is it relatively quick? Is it mostly software?

[Dr. Gary S. Guthart:]

I’ll first of all make clear that the offer is valid till the end of June. So they have till the end of June to decide whether they want to be upgraded.

[Marshall L. Mohr:]

Gary, glad you answered this. It’s both software and hardware.

[Dr. Gary S. Guthart:]

In terms of physically what it is, it’s a fair amount of hardware as well as the software that goes in it and physically it is half a day, an afternoon.

[Tao Levy:]

Basically all of the S out there could potentially be upgraded; do you have a number roughly of how many of S out there that could be upgraded?

[Marshall L. Mohr:]

Of the 1171 systems that are out there, I think over 700 of them are the S variety.

[Tao Levy:]

Just to be clear; in terms of on a go-forward basis, you don’t target to have anymore of the deferred revenues? So, this offer is only for Q1 customers and not for Q2 or anything like that?

[Marshall L. Mohr:]

Correct.

[Tao Levy:]

Last question, you provided a little bit of insight into your thinking around the single incision. Gary, I was wondering if you could maybe flush that out. Are there are milestones, timing of when something like that could become more visible out of Intuitive?

[Marshall L. Mohr:]

I guess I’d say we’ll share with you as we progress where we are. Right now we’re in the early phases. We’re looking closely at both the technology and the IT required to do it, and that work progresses and there is an appropriate milestone, we’ll let you know.

[Lonnie M. Smith:]

By policy we do not pre-announce products and nor would we start.

[Tao Levy:]

Yes, I was just trying to get a sense of where it was and the progress. Last question this time; I know you’re not providing full year guidance because of the visibility, but Ben, any trends heading into the second quarter that might be helpful for us?

[Benjamin Gong:]

I think the best data point we have is that we just sold 66 systems in Q1 and again that was down by about 10% from Q1 of last year, and I know there is a wide range out there of forecasts and some people were thinking that we do quite a few less than that. Some people thought it would be more. We were hoping for more, but I think that’s probably our best data point at this point.

[Operator:]

Your next question comes from the line of Mimi Pham - JMP Securities.

[Mimi Pham:]

Can you just clarify that in the 66 systems for first quarter none of these are double-counted right? I mean, if there was someone who bought an S in the first quarter and then upgraded to an Si, do they count twice or all of these were…

[Lonnie M. Smith:]

We sold 66 systems in Q1. We announced the Si after Q1 was over. So, there’s no overlap or double counting, and just to reiterate what Marshall said, we did the launch with the plan of going back to those Q1 customers who just purchased to give them an offer to upgrade so that they could feel like they were given the opportunity to buy Si if they could.

[Dr. Gary S. Guthart:]

Mimi, to answer your question, no there was no double counting and nor will it be when we upgrade, we will not count that as an additional system. We’ll count it as an upgrade.

[Mimi Pham:]

Thank you so much for that clarification. I know you’re not giving guidance, but in terms of what we normally see for your guidance for the first quarter, whatever you do in first quarter for system sales, we generally see a better number second and third quarter and then a better number than that in the fourth quarter. Is that what you expect to see or is there a risk just given what we’re seeing in the environment even though second quarters being sequentially lower than first quarters?

[Dr. Gary S. Guthart:]

I think what we can say is you’re right. The seasonality that we’ve seen in the past is that the second quarter is typically up from the first quarter, and by the way for service revenues and instrument accessory revenues, you’re going to expect some sequential growth. With system revenues, there’s less certainty there. All things being equal, you’d expect sequential growth, but we don’t have enough visibility to make that call at this time.

[Lonnie M. Smith:]

It gets right back down to the pipeline. It’s the point that Aleks made earlier and we made it actually on the last call. You get right down to the last signature and somebody decides not to do it because of concern for the current financial situation. On the other hand, the economy if it does get better and people gain some confidence, then perhaps that’ll be a positive. So, it just depends on what happens in the environment.

[Marshall L. Mohr:]

We overlay it all. Demand comes from really three areas. You’ve got procedure demand, you’ve got physician demand to deliver those procedures, and you have hospital demand to build robotic initiatives. The demand is strong in all of those universes. The challenge is converting the last one to an actual sale in a predictable time period, but the sales people are very active, and as you can tell by global procedure expansion during Q1 probably the most important component is well intact and that is the procedure demand.

[Mimi Pham:]

I guess you addressed this a little bit on the last question, but in terms of the international markets, are you seeing less visibility in there in terms of delays hitting their CapEx purchase decisions more than what you’d seen in the fourth quarter?

[Marshall L. Mohr:]

Again, as we sometimes mention on these calls is that it’s really hard to give a single answer for the international market because Europe is made up on 26 markets and Asia is made up of a number and the Americas, etc., but again, when I look across the board, across Europe into Belgium, Denmark, France, and Germany, their procedure numbers were exceptionally strong. If I look at Korea, Canada, and Brazil in our OUS distribution market, very very strong, and even the distribution within Europe, be it Romania, Turkey, and what not. So, in general, each country is a little bit different and each region is different. Q1 we sold 22 systems and our procedure growth was exceptional. I think it was a very good performance.

[Mimi Pham:]

Last question; we’ve heard a feedback that the Si is really a great tool for teaching hospitals. Can you let us know how many of your customers in US are teaching hospitals that might be the best candidates for the Si upgrade?

[Marshall L. Mohr:]

I can’t give you the exact number of customers, but I can tell you that less than 2% of the US hospitals are academic medical centers, which is approximately 150 medical schools across the United States, but when you then add in the caveat of teaching, we have teaching centers that are not university based that are very large community hospitals or large active community hospitals that can be teaching centers for us. So, it isn’t as clean an answer to say or I can’t give you a much cleaner answer. There are a number of center and there are a number of academic hospitals that have residency programs, and I think your reconnaissance is accurate. I think it changes the potential paradigm for how robotic training can go forward.

[Operator:]

Your next question comes from the line of Benjamin Andrew - William Blair & Co.

[Benjamin Andrew:]

Just following up on the time to close question; can you characterize the magnitude of the change. I mean, if you missed by 10%, can we extrapolate that and we’re still getting to closing, but 10% slower, and like you said, the pipeline is still quite full. So, over the course of several quarters you should see those same orders come back through. Is that the way you’re looking at it?

[Lonnie M. Smith:]

In Q1 we got some of the orders that were postponed in Q4 and as you might expect you have people that are taking longer to make some of those decisions and that’s what is causing some of the uncertainty and when these things are closing. I am not sure you can do a straight extrapolation that says 10% down is going to be where it’s going to be for the rest of the year, but that’s what we see so far.

[Marshall L. Mohr:]

I guess it’s a trend that will turn around, when we get these; we only believe we will get them, we just don’t know when. We think longer term as the economy stabilizes a little bit, I don’t think it’ll get it back to where it was, but as it normalizes, then the confidence will build and people will buy those if the capital freezes on at this point in time.

[Benjamin Andrew:]

If we can talk a little bit more about the upgrade; the Si, is there only one variety of upgrade or can somebody take the functional upgrade without the training console?

[Lonnie M. Smith:]

I think I sense a little bit of confusion; this is a new system version that’s called the Si, and you can upgrade from the S to the Si. So we didn’t launch just an upgrade, we launched a new system, and you can actually convert the S to the Si.

[Marshall L. Mohr:]

But the second console is available as an option. So, you convert the base system from S to Si and then you can buy the second console as your additional. The second console is not necessarily part of the upgrade.

[Benjamin Andrew:]

Understand. So, the upgrade costs would be the $600,000 that you mentioned; the list price?

[Marshall L. Mohr:]

Correct.

[Lonnie M. Smith:]

The list price of a new system with a single console is $1.7 million and the list price of a second console is $500,000.

[Benjamin Andrew:]

So, the Si will essentially replace the S as your top of the line product. Will you continue selling the S or does that get discontinued?

[Dr. Gary S. Guthart:]

That’s a good question. We will continue to see both S and Si and we expect to sell the S version for quite some time.

[Benjamin Andrew:]

As you think about the customers that purchased the S before the first quarter there might be some grumpiness there too in terms of the relative near-term nature of the upgrade. Have you thought through offering some of those customers upgrades at some sort of a discount and is there a systematic process to go back to them or are you forbidden under the 6-month rule of doing them?

[Marshall L. Mohr:]

We’ll try not to let the accounting rules dictate everything we do, but we will try to work with each of our customers, the people who bought maybe in Q4 or in 2007 and work with them as best as we can.

[Benjamin Andrew:]

You meant 2008 of course?

[Marshall L. Mohr:]

Yes, and the ones in 2007.

[Lonnie M. Smith:]

We’ll work with all upgrades.

[Benjamin Andrew:]

Last question on the instrument pull-through; there is a question relative to the revenues relative to the procedure volumes and you’ve characterized some of the different dynamics there, some of them move more quickly than others; how much movement has there in been in hospitals relative to that gain of efficiency. So, trying to tease out that effect of somebody using fewer instruments per case if you will or being more efficient with how they use these expensive instruments.

[Dr. Gary S. Guthart:]

I think when you think of efficiencies even, there are some subcomponents of efficiencies. For example, if you look at a hospital’s inventory system, they may have a few instruments in the operating room, they may have central storage, they may have a couple of different places to make sure they do not have to cancel a case because they’re missing one key instrument. That sort of par level setting and managing of inventory is a pretty natural progression through just about any medical device technology I’ve been associated with for a long time, and so I think that’s one component. The other is surgeons becoming more efficacious with the instruments used in the operation. I think that tends to mere procedure efficacy more than it does, “how do I get $200 out of this case?” and so when we talk about stocking orders we are often referring to the initial system purchase and the instruments that come with it. When we talk about efficiencies, it can be in the management of inventory within the hospital and then there are certainly components which we totally expect as we become more readily used in simple procedures and that’s the instrument mix in the actual procedure.

[Benjamin Andrew:]

So that combined with the procedure mix because obviously a prostatectomy might use a different number of instruments or cost of instruments than say a hysterectomy?

[Dr. Gary S. Guthart:]

Yes, and I would point to the area and I think we called this out in one of the previous calls that some of the nine gynecologic procedures can perhaps consume fewer instruments and we’re perfectly happy about that because as we go into these simple cohort of procedures, the volumes are significantly larger and I think moving into that is a very positive thing. We might rather have three instruments or four instruments in a universe of significantly large procedures than we would to have five instrument procedures in relatively smaller universes.

[Operator:]

Your next question comes from the line of Vincent Ricci - Wachovia Capital Markets.

[Vincent Ricci:]

Just a couple of quick question. You guys were really good about explaining this, but I just want to make this abundantly clear; 66 systems were physically placed in the quarter; is that correct, that actually installed?

[Marshall L. Mohr:]

That’s correct.

[Vincent Ricci:]

Okay, and did you recognize the cost of goods sold on this system and that’s why it’s basically $20.1 million in deferred operating income?

[Marshall L. Mohr:]

That’s correct. We did not defer any cost along with the $20 million of revenue.

[Vincent Ricci:]

On your deferred revenue entry on the balance sheet, that’s predominantly your service contracts, but can you just go into it a little bit; do you have orders that someone signed, or the inflation doesn’t slip; how did that work, can you just walk us through that a little bit?

[Marshall L. Mohr:]

What’s in deferred revenue and the balance sheet right now is pretty much the prepaid service contracts and the $18 million of deferred revenue associated with this deferral we just did.

[Vincent Ricci:]

Can you just give us quickly the international and domestic breakup?

[Lonnie M. Smith:]

For the quarter or for the installed base or both?

[Vincent Ricci:]

For the quarter and specifically just overall revenues?

[Marshall L. Mohr:]

The system placements we sold 17 in Europe and 5 in rest of world markets. The revenue I’ll let Ben answer.

[Benjamin Gong:]

It was roughly 75% of our revenues in the US and 25% international.

[Vincent Ricci:]

A quick question on the stuff you guys are working on. I realize you don’t talk about anything in advance, but you have mentioned that you picked up the IP from Power Medical. Can you talk to us a little bit about where you guys are with the surgical stapler?

[Dr. Gary S. Guthart:]

We’re in the process here of development. So far, so good.

[Vincent Ricci:]

Lastly, with the standard system, is that something you’re still selling or is that something you guys are going to phase out over time?

[Dr. Gary S. Guthart:]

We sold standard systems during Q1 and now that it’s maybe a couple of generations older than the latest one, it will probably decrease in terms of the number of these that will sell going forward.

[Lonnie M. Smith:]

But we’re not manufacturing standard systems any longer. We do take them back as trade-ins, we refurbish them and sell them to those people who are looking for a low-price system, who are still willing to use the instruments and they will still do the job, they just don’t do it quite as well as the newer systems.

[Vincent Ricci:]

I realize this is not a large part of your national sales right now, but can you tell us what you’re seeing with the emerging market particularly with the currency movements that have happened?

[Dr. Gary S. Guthart:]

It’s a good question. I don’t know if you call this an emerging market, but in Korea the Korean won has definitely gotten weaker versus the US dollar and in places like that it’s more difficult for those guys to purchase systems and we actually did not sell any in Korea in Q1.

[Vincent Ricci:]

I’ll just make this my last question because I’ve taken up a lot of time. Can you just talk to us a little bit about, you’ve been talking about the de-stocking at hospitals, but can you talk to us a little about any distributors you have, say in Europe and what not. Do you have stocking distributors in Europe and is that an issue potentially?

[Dr. Gary S. Guthart:]

There are normal fluctuations in the buying patterns of our European folks. We did actually do one thing. We took the UK direct; there was distribution up to the end of last year and starting at the beginning of this year, we took it direct. So, there’s a little bit of transition there. It didn’t have a material impact on the quarter’s results.

[Operator:]

Your next question comes from the line of Tycho Peterson - J.P. Morgan.

[Tycho Peterson:]

Just starting, I was wondering on the market opportunity for the Si and I appreciate the color on the mix in some of the discussion on DVP and DVH, but are you anticipating a similar kind of procedure mix, and then can you just talk a little bit about how you’re viewing the Greenfield versus upgrade opportunity and maybe with that in mind talk a little bit about some of these deferred orders too if that mirrors the kind of existing mix; I know it’s a lot of points, but if you could just elaborate, that would be helpful.

[Marshall L. Mohr:]

I’ll take a shot at some of those. Greenfield versus…

[Tycho Peterson:]

If we think about installed base for maybe over the next 12 months for Si; how many of these systems do you anticipate going to new customers versus upgrading your existing installed base?

[Marshall L. Mohr:]

We’ll certainly continue to see to new customer. In Q1, it was a fairly high mix of sales to the existing customers and that can also be a factor of the environment where it’s in a tougher buying environment, the folks would know exactly what they’re getting. Existing customers are more likely to make a decision quicker than some of the ones who don’t, and we may see that continue.

[Aleks Cukic:]

I think that that’s a testament to the value of the system. Actually, those who have it see the value, they see the revenue it brings, and they’re investing heavily in it, and it’s made a priority investment for them, and so they continue to buy because it’s an opportunity for them to take part in care and build revenue.

[Tycho Peterson:]

What you talked about on the deferred revenues; does that mirror the mix you’ve been seeing with the Greenfield versus the upgrades?

[Marshall L. Mohr:]

I believe they’re disconnected in that the deferred has to do with the 44 accounts that purchased in Q1. So when you look at the overall mix of Greenfield versus second systems in Q1 out of the 60 net new systems, 17 were to existing customers. If you look at it including the trade-off transactions, that numbers grows to 23 and most of those were in the United States.

[Tycho Peterson:]

That’s what I was getting at. Have you done a global upgrade; you talked about 44 customer offers for the upgrade which mirrors the US numbers.

[Marshall L. Mohr:]

Of the 44 systems that were impacted, 8 of them were international and the other ones were in the United States. So, we made offers internationally as well.

[Tycho Peterson:]

On service; I guess as it would seem in this environment, it’s going to go up a little bit, both as a function of long utilization and the upgrade path, and you talked about not having a change in your outlook there. Can you just comment as to why that’s not picking up a little bit in this environment or a little bit more beyond what you previously expected?

[Aleks Cukic:]

Remember, service is just the ongoing annual fee that we collect from the installed base. So, there are 1171 systems out there and the reason why the service revenue is not fluctuating too much is that most of the service revenue comes from the installed base and it’ll go up as we install new systems, but in proportion to the installed base, the new systems will be a small percentage, and that’s why you don’t see too much fluctuation of service revenues with fluctuations in new system placements this year.

[Tycho Peterson:]

You’ve talked in the past about leasing picking up a little bit and I think you said last quarter that you weren’t expecting to really expand that program, but any views in light of the current environment as to how you’re looking at that?

[Marshall L. Mohr:]

We’ll answer this one last question Tycho. On leasing, it has been relatively the same; 15% to 20% of our sales in Q1 were leases and they were actually across six different leasing sources, but there continues to be no shortage of leasing available to our customers.

[Benjamin Gong:]

We’ll take one last question.

[Operator:]

Your last question comes from the line of Ed Shenkan - Needham & Co.

[Ed Shenkan:]

Wanted to ask you, on calculating ASPs, maybe you can help me because if I take $1.33 million per system times 60 new systems, I get $79.8 million which is $10 million more than you reported for systems. How do you do the calculation? What am I missing?

[Marshall L. Mohr:]

It’s really straightforward; take the system revenue, add $18 million to it, and then divide that by 66, and you’ll get the ASP of about $1.33 million and it’s about the same or exactly the same as it was in Q4, it’s almost the same as it was in Q1 of last year.

[Ed Shenkan:]

What’s the ASP going forward for the S robots; the Si you said is $1.75 million; and maybe if you could break it out, US and OUS for the S going forward?

[Marshall L. Mohr:]

Average selling prices given the launch of the Si at a higher price and the fact that you can buy it with the feature of a second console could cause our ASPs to go up going forward. As you know, the product mix and the geography mix will have impacts on that on a quarterly basis, but just given the fact that we’ve got a new product out here with a higher price could cause our ASPs to increase.

[Ed Shenkan:]

What would the ASP for the S be going forward? Where it has been if you’re down and where should it be?

[Marshall L. Mohr:]

We’ll see.

[Dr. Gary S. Guthart:]

The list price is staying where it’s at.

[Marshall L. Mohr:]

The list price is staying exactly where it’s at.

[Ed Shenkan:]

Did you have to discount it at all in the first quarter?

[Marshall L. Mohr:]

I think the ASP is indicative of where our pricing has been and continues to be. Pricing was pretty consistent with where it was in Q4 of last year and Q1 of last year.

[Dr. Gary S. Guthart:]

Less the service component.

[Ed Shenkan:]

Last question; is it fair to say then that outside the US per selling system you haven’t seen the weakness even close to what we’ve seen in the US impacting your businesses, is that right?

[Dr. Gary S. Guthart:]

Again, I would hedge back on earlier comments. It varies by country, it really does. Some countries that you have seen systems sold in the past you did not see this quarter and you’ve seen a lot of strength for example out of Korea for some period of time, Germany is picking up strength and the last few quarters has been very strong, Italy has been strong for a long time, but it’s going to vary country by country. At the end of the day, 22 systems from outside the United States were sold in Q1 which was I believe was two more than last year. So, the system placements were actually higher on a year-over-year basis internationally and roughly 10% lower in the United States.

[Lonnie M. Smith:]

As I’ve said previously, while we focus on the financial metrics which is revenues, profits, and cash flow during this conference call, our organizational focus remains on increasing patient value by improving surgical outcomes and reducing surgical trauma. I have been following three patient experiences to give you some sense of what that means in the lives of our patients. The first patient is a 12-year-old girl who was diagnosed with double uterus. When she first began menstruating, she experienced excessive pain, she went to the local hospital at Student Health where excess blood was drained from her non-functioning uterus and the incision closed. She continued to experience extraordinary pain, was seen by a doctor in Miami, Florida. He recognized the anatomical abnormality and the second uterus without the vaginal outlet. He drained 1.5 liters of trapped blood from the redundant isolated right uterus and performed a hysterectomy on that uterus, the right fallopian tube and the right ovary and eventually she left in less than 24 hours after the surgery with minimal pain and resumed to her life as an active 12-year-old. The second patient is the wife of a member of our marketing team who was diagnosed with uterine fibroids. She had a myomectomy performed by a doctor at the University of Maryland. She was treated as an outpatient, returned to the hotel 10 hours after entering the hospital, had dinner with her husband, and went shopping at the mall the next day. The last patient is from Illinois who personally had undergone two da Vinci surgical procedures. On February of 2007, the patient underwent a da Vinci prostatectomy performed by a doctor at the University of Chicago. He was discharged in 24 hours and says he walked out of the medical center, went home, and mowed his lawn the next day. Less than a year later, however, he was diagnosed with a couple blocked arteries and he needed a coronary artery bypass which required a full sternotomy followed by an extended recovery period of 1 month or more. He said that he decided right then and there that he didn’t want anything to do with open chest surgery, he drove home, got on the internet, and learned that he could have a da Vinci surgery for his heart as well. Four days following the double bypass performed by Dr. Srivastava at the University of Chicago, he walked out of the medical center, went home, and played ball with his grandson. Patients like these are strongest advocates for surgery with the da Vinci system and are the very foundation of our operating performance. In closing, I assure you that we remain committed to focusing on the vital few things that truly make a difference as we strive to take surgery beyond the limit of the human hands. This concludes our call today. We thank you for your participation and support on this extraordinary journey. We look forward to talking with you again in 3 months.

[Operator:]

Thank you for participating in today’s conference. You may now disconnect.