Intuitive Surgical, Inc. (ISRG) Earnings Call Transcript & Summary

Well, good morning, good afternoon, everyone, depending on your location of Zooming this morning. Welcome to the Morgan Study Healthcare Conference 2020 as we progress through day 2 of a series of exciting meetings. It's my pleasure to have with us here, as we progress through day 2, Intuitive Surgical, both their CFO, Marshall Mohr; and Philip Kim, their VP of IR. Philip is going to give us a brief disclosure. Before I let him do that, just remember my research disclosures are at the morganstanley.com website/researchdisclosures, to see fun facts about me. And Philip, you're going to give us some brief forward-looking statements, and then we'll jump straight into Q&A.

Before we get started, I'd like to inform you that comments mentioned this afternoon 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, which are described in detail in our SEC filings. Investors are cautioned not to place undue reliance on such forward-looking statements.

Thanks, Phil. That was short and sweet. I appreciate it. So Marshall, let's start with you, where we started with a lot of companies here during the last couple of days. Just talking about recovery. You gave us an update on sort of procedures. We're close to 90% of normal at the end of second quarter. How have you seen sort of procedural recovery in sort of that July, August, September time frame? Have things continued to recover? I think you were asked about July, and you said the trend lines were a little murky in July. I imagine they have cleaned up a little bit here in the last 2 months or so. So how has recovery progressed here over the last several months?

Just to rewind the clock, we saw a recovery in Q2. And as you said, David, things had recovered nicely through about the middle of June. And we started to see a little bit of a drop-off. And I think that drop-off was reflective of the expansion of COVID virus spread in the United States, particularly in states like Arizona, Texas and Florida. And in fact, I think it was early July, Texas had basically said that deferrable procedure should be deferred, and that they would dedicate their resources to COVID. So we said in our call that we had anticipated that, that would cause a slower recovery or even a resurgence in terms of lower procedures. We're not going to comment on the intercompany or inter-quarter procedures. I'll just tell you that you should follow all of which you're hearing in the press and that then translates into how procedures are recovering overall. One other factor, I think, that you should take into consideration is it's both the COVID virus and the resources that the hospital has dedicated to the virus that sort of caused lower numbers of elective procedures or deferrable procedures to be done. The other element here is patients. Patients are reluctant to be diagnosed and also to be treated. And so we think that as we talk to our hospital customers and our surgeons, we're hearing that, that patients are reluctant to come back to the hospital. The things that we treat, though, are we're treating very sick patients. And so it's -- eventually, they need to be treated. We don't think there's some exodus to some other type of treatment. We think that, ultimately, they'll be treated with da Vinci. But the combination of COVID virus patient views really can sort of make it very unpredictable as to when those patients return.

Okay. Understood. So here's -- I'm going to parse out some of your comments there because they may be confusing for some investors. General surgery probably recovered faster than most investors would have thought at the time, just based on procedural acuity and you've kind of commented where you were at the end of June. A lot of companies have commented on resurgence dynamics in July. You're bringing up some resource allocation issues what some others have brought up as well. But what I think I'm hearing is, there's no reason to believe you recovered x percent through June, there's no reason to believe your recovery deviated materially from what other medical device companies are sort of seeing, which has been, and generally, a consistent trend in recovery. You're bringing in some different things, but I just -- you've recovered right in line with peers, if not faster. I've tried to figure out if there's a reason why that would have broken trends here in third quarter. It doesn't sound like there is.

Yes. I don't think there's anything unique about da Vinci surgery, other than my comment that we're treating very sick patients. And so it's different than, let's say, orthopedics or something where it's even more deferrable. But as far as just type of surgeries we do, there's no difference between us and them, I would say.

Okay. And then you and I talked to the quarter about this whole dynamic of rescheduled patients versus new patients, and you're pretty unique company, right, because you've got pretty decent tracking information, a good sense of maybe de novo patients versus rescheduled patients. Any concern you have about sort of backlog? You talked about sort of new patient willingness. But I think you sort of felt, at the time of the second quarter, that you weren't -- I think you said you think you had to sort of work down most of that backlog, you don't think there was a significant sort of backlog "effect." How are you feeling about new patients without rescheduling patient dynamic here into the third quarter?

Yes. I -- and actually what happened in Q2, actually, we saw less of a backlog being picked up than we had -- would have expected. In fact, you're right. We have pretty good information, and we validated with surgeons and hospitals, and we think that there was a substantial backlog at the end of Q2. And during the period in which there was this recovery, we were trying to parse out how much of that was the backlog versus how much of that was just certain new patients. I think less of it was the backlog than we would have anticipated. And again, I think that reflects on patients' willingness to come to the hospital to be treated. And so I think, when that backlog actually gets done is questionable.

Okay. Understood. The other dynamic, Marshall, is the other side of your business, which is systems. I would say, in general, the systems business actually fared better than I would have expected in the second quarter, better than I think everyone expected. And we've heard different things. We've heard the CARES Act. We've heard hospital endowments, frankly, are in a better position than they were back in other prior crises. How are you feeling about sort of the capital environment and the state of your capital business? Is it faring a lot better than you would have expected based on some of these information factors? We also didn't see, Marshall, increase in your lease rate in the second quarter, where a lot of other robotic companies saw substantial increases in lease rate. You actually sold these systems, and you sold a lot of them. How are you feeling about the capital environment?

Yes. What we said in the Q2 release was capital did exceed our expectations. But in part, it was the reflection of, in the U.S., we had a few IDNs that purchased -- made large purchases for whatever reason they purchased the product instead of leased it. And those were deals that had been in discussion or negotiation for, frankly, well over 6 months. And so it was the culmination of the negotiation over time. What we did see, as we approached the end of the quarter, though, was hospitals sort of deferring purchases as they go off and they try to figure out where they are from a budgetary and finance perspective. COVID, clearly, has a severe impact on their finances and their P&L. And so I think that a number of them went off to try to figure that out. I would expect it to be a very stressed capital environment going forward for a few reasons. One was we saw a 27% drop in the utilization system. Hospitals will want to fill that capacity before they buy new capital. Second is, I think, that it will take time for hospitals to recover from the financial impacts of COVID. And how they recover and when they start to go back to purchasing capital, we'll see. So we would expect that they continue to utilize the capital that they have more rather than buying new capital. The other impact in Q2, that outside of the U.S., which we did 21 systems in China. That was a pleasant upside, and in China, leasing is not possible either. So those systems, the proportion of China systems relative to the total, was higher and so you get sort of downward pressure on a number of leases. If I take China out, you actually get closer to what was the average run rate for leasing for the company. And if I take out those couple of IDNs, then we were actually higher. So we would anticipate that leasing would increase over time over the next -- over the long term. But clearly, in this environment of COVID, we would expect it to increase even more as hospitals struggle to figure out how to purchase things upfront.

Okay. So you see -- speaking Texas numbers, Marshall, for third quarter, actually have systems revenue down a little bit. And I guess that sort of -- that seems surprising to me. You're saying the environment is still somewhat challenging, but does that make sense to you? Because my view would be the second quarter really should have been the trough quarter. That was sort of the freeze quarter. If hospitals have been opened here in the third quarter, reps have been able to get access to the hospital. Delivery of shipments is easier in the third quarter. So I would just sort of assume that capital revenue could be up sequentially versus what the Street has, which is down slightly.

Yes. I'm not on that boat. I think we'll see. By the way, quarters are always back-ended with capital. So I couldn't even tell you today what I think the ultimate result will be for this quarter. But I think the pressure of the 27% utilization decline and hospitals wanting to fill that first, it's going to be really pressured. Those are big headwinds. So I'm not confident that we'll do better than last quarter or the same as last quarter, which is why we didn't give guidance. We really don't know where it's going to come out, given that there is pressure.

Okay. I think, Marshall, when I think about 2021, I know it's early to sort of think about that guidance. But other -- some companies are willing to share how they think about '21 relative to 2019. And I wonder if anything that you could offer in terms of what your underlying growth rate was and how '21 could look relative to 2019, either on the top line qualitatively or just from a margin structure perspective. Should we assume that 2021 can get back or higher than 2019 margins?

Yes. Margin isn't our first objective. Our first objective really is to increase revenue and increase the market opportunity and accelerate the market opportunity. And so we've always said, "Hey, if we had the opportunity to expand our market, but it might be at the expense of partial point of gross margin or a point of gross margin, we would do that." So I wouldn't want anybody to anchor on that. As far as building leverage back in, this is a big opportunity. We are sitting at a point where competition isn't yet here. The time lines for them to get here are a little longer. We have the opportunity to expand then without that competition. We also think that the total opportunity for robotic surgery is huge. So this is the time to really continue to drive investment. You've seen us do a few things in terms of trying to create customer loyalty through the customer relief program we've previously announced. We're rolling out the extended use instruments that will reduce the cost of -- total cost of surgery. All of those things are really trying to get to where we increase our penetration into the market. So I think that as I think about 2021, we'll give you whatever we can when we get to January, and I don't know how much that will be. Because if the virus is still having large impacts or there are large swings in terms of resurgence, and so they'll make it very difficult for us to [ fix ] anything, but I wouldn't bet on increased margins. And as far as I sit here today, I don't know how long this virus is going to have an impact on us. And then there's the aftereffect of the virus, which is, like I said, hospital finances have declined as a result of the costs of the virus, and we don't know what that will do, what the economic downturn will do overall to it.

Okay. So you announced in the second quarter that was interesting was this dynamic of the longer use instrumentation. You also helped us quantify what that could be. And that erupted than a little bit. The first thing this, Marshall, why now? You've been working on manufacturing improvement operations for years. Gary has talked about it quite a bit. Why is second quarter, in the midst of COVID, do you choose to roll out this new program that begins in early next year, basically in a month?

Yes. It's -- in terms of timing with COVID, it's totally coincidental. You're right. We've been working on things on durability and quality of instruments. From the day you reintroduce a product, you're constantly working on reducing the cost, improving the supply chain and improving the manufacturability of those products. And there's a lot of little incremental things you do over time that, at the end of the day, we got to a year ago, and we look at it, we go -- we really -- we're seeing far fewer that the return rates, the ability to use the instrument, the return rates have declined. The usability of the instruments had increased. We say, could we use them for more? And so we actually go through a validation/verification. It really took all those little incremental steps of changing the type of material, changing -- putting in place automation in the factory that improves quality. It really took all those little things to get to that point where you went to put back and revalidate them. So to be clear for everybody that's listening, our instruments generally timed out after 10 uses. There's a set of instruments, not all of them, but a set of instruments that now will be usable for 12 lives to 18 lives, depending on the instrument. And we've announced that, and we think that, that will be beneficial to our customers, obviously, because their cost per use has declined. Simultaneous with that, we're also modifying the price of a few instruments that are used highly in lower acuity surgeries, where reimbursements are lower. And specifically, cholecystectomy, inguinal hernia, benign hysterectomies. And by doing so then the total cost of those procedures, the combined impact of the extended use as well as the reduction in price for those instruments, then the cost per instrumentation is comparable to other MIS approaches. So we think that it was important to announce it as soon as we got it validated. As soon as we knew we could give it to a customer, we're going to do that. I would hate to sit in front of a customer later and have to look at him in the eye and say, "Oh, yes, I know it could be used more. I just didn't give it to you." So we want to work with our customers. We want to help part of the -- our group of [indiscernible] includes cost of the surgery itself and lower cost of surgery, and so this is all geared towards that.

Are you trying to just -- are you trying to grow your business faster? Or is this a defensive move given competition is coming?

Well, the first one is grow our business faster. Our first reaction to things is not to look on the rearview mirror, where competition is coming and try to fend that off. It's really how can we penetrate markets as fast as we can. So we believe that there is some level of elasticity in the market. And so by introducing these instruments, we think that we've increased the market. And people have asked the question, "Well, how much did you increase it?" We haven't even put the instruments out of the market yet. But what we heard, not uncommonly, was that a resistance to using da Vinci for, let's say, a cholecystectomy because of its cost. And in fact, we know that there were hospital administrators that basically told their surgeons, "You will not do a da Vinci surgery for a cholecystectomy. Period." It was just an edict that came down. We're thinking that this will eliminate that edict, then it will be up to the surgeons to decide whether or not to use it. And so we think that it will increase the market share. As soon as we figure out what we think that increase is, we'll let you know.

Okay. You said a 7% hit to revenue based on these pricing adjustments heading into -- well, you said it for 2019. We just sort of use that number loosely for '21. We assumed that we're not going to see the full 7% hit because there has to be some uplift on procedures, either in new system sales or specifically, in procedures. Is it crazy to assume you get back all of that 7% heading into '21, where it's -- the volume totally offsets the pricing cut?

Yes. I mean the timing of that elasticity of when you start to see that increase in procedures is questionable. That's the part that's hard to predict, both because of COVID, but just in general, adoption is not an easy thing to predict. So I think it would be aggressive to think that we'll recover all of the lost revenue in one period. But I think that over time, you should expect that.

Okay. Is this the last initiative that we're going to see? I mean is this one pricing cut? Or is this a series of pricing cuts targeting different procedures, different regions? Help us put that in context.

Yes. So what we've been describing is the U.S. rollout. OUS, we're looking at similarly, what are the procedures that are lower reimbursed than are stressed. And so the pricing isn't universal. It's not -- this is what we did in the United States. That's what everybody else gets. Period. We're actually looking at country by country, what are the procedures where the reimbursements are stressed that we think we add value. But for the cost of the instrumentation, it's not adopting at the pace that we think it should. And so we're modifying the pricing of instruments differently in different geographies. The rollouts to those geographies will be Europe later in Q4. And in the rest of the world, comes at even later than that, mostly because of regulatory requirements around the world, particularly in China, as an example, where the process to reregister instruments is well over a year or so. The Chinese customers [indiscernible] extended used instruments for until 2022. And so yes, we're trying to take the opportunity. As far as are we working on other initiatives? We're always working on trying to improve quality and durability of instrumentation and systems. And so at any point in time that we reached sort of this point where we think that it can extend the use of the instruments, and we'll make that stop. But well -- again, it doesn't happen with one program, all of a sudden, you're there, it happens with lots of incremental changes over time.

Yes, David. So to quote Gary and Marshall, it's the virtuous cycle. We gain scale, become more efficient, pass along those savings to our customers and then increase penetration in the market. So in the longer term, our investors should think about the virtuous cycle for us.

Okay. So the -- but Marshall, when I think about this dynamic, you were approaching upper teens, if not 20% type procedure growth in times pre-COVID. By some sense, you would not have done this if you don't think you could expand your market and help you grow faster. So despite Phil's comments about the virtuous cycle, you're going to see some price cuts and some volume adjustments. Is there no reason to believe that the kind of growth that you were seeing, sort of pre-COVID, that you can get back to that kind of growth when you think about the existing pipeline and some of these initiatives to expand your TAM?

Yes. I think the opportunity for a computer-aided type of surgery is large. I don't think it changed as a result of COVID. Certainly, the time line, which it adopts, has changed because of COVID. So to your question, do we think we can get back to the same level of growth? It's a good question. I don't have a specific answer for you other than to say it's -- we believe the market size is the same now. It's even larger with, we think, with the extended use instruments. And the big question is timing. When do you get there? Is it possible you get back to the same rates of increase? Of course, you have a lot of large numbers and adoption curves that stand in the way of that, but it's not impossible to get back to those numbers.

Sure. The thing that I've been somewhat surprised on, about 1.5 years ago, maybe longer, when Gary came out at a conference and really started talking about intelligent surgery. What intelligent surgery means to Intuitive, and began to devise some of the parameters of that platform. It's been -- with the exception of IRIS, it's been a little quiet, this last 1.5 years on sort of the formulation of intelligent surgery. With that being said, he came out to speak about it for a reason. The company changed from Intuitive Surgical to Intuitive, right around the same time. We've -- I know you're spending a substantial portion of R&D resources on software and development solutions. So where is intelligent surgery? When are investors going to see the commercial fruits of this, what's been an 18-month communication, a multiyear investment in intelligent surgery?

Yes. So there's a few things. One is the reason for the change from Intuitive Surgical to Intuitive really had more to do with Ion than it did that we were going to get -- come out with a whole different business model. Ion is a diagnosis -- being used for diagnosis right now versus surgery. So you drop the surgical. Second thing is it's not just an IRIS. I mean you look at the stapling instruments and the intelligence, which we've put into the stapling instruments. You look at some of the other technologies that we've rolled out that really, really -- we've tried to incorporate wherever we can. Ion also, by the way, has substantial amounts of intelligence in it. Just as an example, where you're similarly taking a preoperative CT scan and you're designing a Google road map to go get to the suspicious nodule in the lung for biopsy. So it's -- I think we're incorporating those things. But your point is, "Hey, look, we talked about something, and that's because we think that there's way more we could do in terms of intelligent surgery." And so we're making those investments. You said it's quiet. We did this acquisition of some things in Israel called Orpheus, I think you've heard us announce. We're making other smaller investments in external technologies, but we're also growing the group inside the company. So you're right, it's one of the bigger areas of investment for us. But I think that all I would say is there are future versions of IRIS that will come out. There are things that we'll do in conjunction with the system itself that will come out. And then there will constantly be intelligence embedded in some of our other instrumentation and so forth. So I'd just tell you, stay tuned. You'll see these things come out over time. But it is a big area for us and for others. You've heard them talk about it, too.

A few minutes left. Two topics I want to discuss. And one is the biggest "overhang." and I think during COVID, we've seen this overhang lift a bit as the trial system is delayed a little bit, and J&J system delayed more materially. But the products at out there, CMR Surgical has a system as well. How are you feeling about the competitive moat now versus a year ago, as you've learned more about these systems and your business model has evolved? And I'm specifically wondering this fear that investors have about acute disruption to your business as these competitive systems come to market in the next year to 2 years, in some cases.

Yes. I think we feel good about the competitive moat in terms of it's increasing as we go through time. We're introducing more and more technologies, I think, that increase that moat. We're expanding as fast as we can into the market. And I think the more installations, the more training, the more surgeons you have adopted, that just increases the moat. I think that the extension of time lines for Johnson & Johnson and for Medtronic, they also display sort of some changes you see going on with the FDA. And I don't think that really necessarily changes the moat, maybe it changes the time lines because it should be applied equally across all and puts us kind of more a level of playing field with it. But certainly, it put them back in their initial introduction of a product a little bit more than they had anticipated. I think we'll continue to, just like I said, drive technologies and drive expansion into the market.

As you wrap up, Marshall, there's a couple of procedure categories. Obviously, general surgery was driving a substantial amount of growth in hernia. Can you just give us a sense of where you think you are right now in terms of that total hernia market opportunity, which could be close to 1 million procedures? Where do you think you are on penetration? And then you talked about cholecystectomy, which I never thought would be a massive opportunity. But the reality is you were seeing chole traction prior to COVID and you've announced some of these extended life initiatives specifically targeted on getting people more up on that training procedure to drive greater adoption. So what are you seeing on sort of chole adoption? And sort of where are we on the hernia adoption curve?

I'll let Philip start, and then I'll touch on it after. Go ahead, Philip.

Yes. So within hernia, as you said, it's 1 million procedure category. We're in the early part of that mid-innings with respect to hernia. And then chole, that's obviously north of 1 million procedure category as well, and that's a single-digit penetration type of opportunity. And so those are 2 areas that clearly could benefit from extended use. And so there's clear opportunity there.

Yes. In both of those categories, when we talk about middle innings, we're talking about middle innings of what we thought was the addressable market. And the addressable market at each is, like in hernia, has to do with the surgeon approach, the obesity of the patient and the complexity of the surgery. Now with an extended use instrumentation set as well as a reduction in cost, we're hoping that, that expands it even beyond what was previously our opportunity. So we were in the middle innings of a subset of the total of each of those markets. And hope to have expanded it, and hope to see continued growth. In the case of cholecystectomy, I'm with you. We were there once with a single site. This is different. You called it a training procedure. We're finding it less to be a training procedure and more to be one that is where the surgeons that do multiple different types of procedures are just adopting da Vinci for all. And so where the stick rates, we watch how many times surgeons do the surgery and whether they increase or decrease, and we're seeing that stick rates are very good.

And could chole be bigger than hernia has been for the company?

It could. I wouldn't -- I think that there's a better case for parts of hernia from the -- meaning, so far, the clinical evidence is better for hernia than for cholecystectomy versus other approaches. But long term, we'll see because I think that there are some things about cholecystectomy that also we are [indiscernible].

Yes. So in chole, we see firefly utilization, high utilization as well. So surgeons can see the procedure in a way they can't with the naked eye. So that's some positive feedback we get.

Okay. And just lastly, Marshall, when we talk about capital, and quickly as you wrap up here, what has happened in the broad capital environments? Does that also applies for the SP and Ion? I just sort of wonder how SP and Ion traction has fared here as we sort of bounce off the bottom of COVID and think about the back half of the year?

Yes. I mean we're excited about both those platforms, and that's how we think about it is they could be used for multiple different things, right? In the case of Ion, I think the experiences to date are really positive. I think that it's achieving the benefits that we had hope that it would achieve. And what we are working on also was the study, the PRECISE study. And I think there is a little bit of an interruption in terms of the pace at which cases were done under that study, but we're starting to see some of that pick back up. And so we're pretty positive about Ion and getting to where it will -- the ability to market it more broadly will occur. And then there's Ion in the future, and we haven't really pinned our hat on any one particular procedure, but I think it could be in any tubular structure and in a number of different ways. In the case of SP, SP, we're thrilled with what's going on in Korea. In Korea, they have approval and they can use it broadly. They're not limited in terms of what types of procedures. And we're seeing broad adoption in multiple different procedures. Those systems are being utilized more extensively than the Xis that are installed in Korea, which were already higher than the global average. And so we're watching very carefully to see how it's being used. In the United States, we're getting good feedback on transoral procedures and urologic procedures as well. And so I think, longer term, we got a little bit of an interruption again from COVID on trying to push forward with the clinical study for colorectal procedures. Hopefully, we can get back on track and push that forward. And I think -- so we haven't predicted when we'll get any kind of an approval for that, obviously. But SP also can be used more broadly than just those 3 procedures.

Okay. And just lastly, I'll wrap it up here, Marshall, is just trying to quote the remaining 60 systems that were outstanding. Do they still kind of progress over the same time line you expected, which is sort of through '21? Are they accelerating at all? Any delay? Or do you still think that time line makes sense?

Yes. I think the time line still makes sense. I think that you're talking about some will get done yet this year, and then more of them will get done next year. And as long as they've been allocated, which they have, then they get 2 years to complete the acquisition. And so a lot of it will happen next year.

Okay. With that, we're out of time. Marshall, Philip, thanks so much for being here this morning. Enjoy your meetings, and we'll talk soon.

All right. Thanks, David.

Thanks.

Thank you.

All right.