直覺手術 (ISRG) 2003 Q2 法說會逐字稿

Good afternoon and thank you for waiting.

Welcome to Intuitive Surgical second quarter earnings release conference call.

All participants will be able to listen only until the question and answer session of the call.

This conference is being recorded.

If you have any objections, please disconnect at this time.

I would like to introduce your speaker for today's call, Mr. Ben Gong, Vice President of Finance, Treasurer and Corporate Controller of Intuitive Surgical, Incorporated.

Mr. Gong, you may begin.

Thank you.

Hello and welcome to Intuitive Surgical's second quarter conference call.

With me today, we have Lonnie Smith, our Chairman and CEO, Susan Barnes, our Chief Financial Officer, and Aleks Cukic, our Vice President of Business Development and Strategic Planning.

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 & 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 archive 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 the second quarter as described in our press release announced earlier today, followed by a question and answer session.

First, Lonnie will present the business highlights of the second quarter.

Susan will follow with a review of our second quarter's financial results.

Aleks will discuss sales, marketing, regulatory affairs, and give an overview of the Computer Motion merger.

Then I will present a financial summary of our merger transaction and provide an outlook for the rest of the year.

Finally, we will host a question and answer session.

With that, I would like to introduce Lonnie Smith, our Chairman and CEO.

Thank you, Ben.

I'd like to thank each of you for taking the time to join us for today's conference call.

Before addressing our results for this quarter, I'd like to provide a little historical context.

In December of last year, I made a presentation to our employees at a company meeting that focused on our past quarterly performance in three areas -- revenue growth, contribution margin, being defined as revenue less variable expenses, and fixed costs, those costs that do not vary with manufacturing, selling, shipping or installing an incremental revenue unit.

While we achieved excellent improvement in our contribution margins and solid revenue growth, fixed costs have grown at nearly the same rate as revenue.

And I challenged ever member of the Intuitive team to focus on controlling our fixed cost spending.

I'm delighted with the progress our team has made in the past six months and the results that they have delivered.

Intuitive Surgical is profitable in the second quarter.

This is a fundamental milestone in the foundation of our company's development.

We continue to make progress in our operating metrics.

We generated a second quarter profit of approximately $900,000, compared to a loss of $3.7 million in the second quarter of last year, and a loss of $2.3 million last quarter.

Total revenue grew to $21.5 million, up 11% from prior year.

Recurring revenue grew to $6.4 million, up 66% from the prior year, comprising 30% of total revenue.

We shipped 14 da Vinci Surgical Systems and nine fourth arms, ending the quarter with 177 systems installed worldwide.

Our gross profit margin improved dramatically to 63.2% from 52.4% in the second quarter of last year, largely reflecting the fruits of our product quality and reliability improvements and lean manufacturing processes.

Lastly, we were cash flow positive from operations in the quarter, generating $2 million in cash.

We completed our merger with Computer Motion at the end of the quarter, and earned the litigation between the companies, consolidating almost all the intellectual property in the field of surgical robotics and ending a very disruptive quarter in the marketplace as the two sales forces fought their final battles.

Our primary postmerger objectives remain.

First, profitability.

Second, superior products and services for our customers and their patients, and third, a results-driven company culture in which we measure ourselves by our accomplishments.

Execution of our integration plan began day 1.

And a little over one month into the process we are on or ahead of schedule in every area.

We do not underestimate the challenge of combining the two companies, but it is our goal to complete most of the heavy lifting during the third quarter and to be substantially complete by the end of the year.

We expect to meet and exceed the $18 million annual operating cost savings we estimated in the S-4.

We have merged the two sales organizations into a single sales force and are in the process of consolidating our administrative, engineering, manufacturing, and marketing organizations.

We now have a sound assessment of the regulatory status of the Zeus product and we have made significant progress that Aleks will explain later.

We have analyzed the customer usage patterns of the Computer Motion products and are in the process of conducting a customer survey and analysis as we develop our product strategy.

Our future product offering will align with our core competencies and our market strategy.

We will manage within realistic financial constraints, focus on the vital few things that will truly make a difference, and future product investment priorities will be driven by clinical need and economic return.

Customer response to the da Vinci fourth arm and the new three channel endoscope have been very encouraging, and our instrument engineering team has made great progress on our new 5 millimeter instrument platform.

We completed the clinical portion of our Totally Endoscopic Coronary Artery Bypass (TECAB) trial for the FDA and Aleks will give you more details later in the conference call.

While our systems unit sales lagged our expectations, this second quarter has been a period of extraordinary confusion in the marketplace, with announcement of the merger, two highly competitive sales forces calling on potential buyers with very different messages on the implications of the pending merger, the uncertainty created in the minds of those potential buyers and our inability to specifically address the issues until after the merger was actually consummated.

We are now working very hard to address the issues and remove uncertainty.

On a separate note, I'm delighted to announce that Eric Miller has agreed to join Intuitive Surgical as our new Senior Vice President of Marketing.

Until the end of last month, Eric served as the President and CEO of Optimize.

He brings extensive experience in surgical instrumentation and a reputation as a highly creative and excellent leader.

I sincerely believe that we have one of the best management teams in the medical device industry, and I look forward to the results that team will deliver in the coming years.

As a side note, Joe DeVivo, former President of Computer Motion, decided not to join Intuitive after the merger closed, and has accepted the position of President and CEO of Rita Medical in Mountain View, California.

We wish him great success in this new position.

Finally, on a very positive note, the July 28th issue of U.S.

News and World Report, contained their annual list of America’s best hospitals.

Every one of the 17 hospitals listed in their honor roll of the very best hospitals has made a serious commitment to surgical robotics, and owns one or more da Vinci or Zeus Surgical Systems.

I believe this represents a strong affirmation of the role that surgical robotics will play in the future of surgery.

With that, I pass the time over to Susan, our Chief Financial Officer, who will discuss our second quarter financial results.

Thank you, Lonnie.

Overall, as Lonnie mentioned earlier, we achieved many financial milestones this second quarter.

Specifically, we recorded our first quarterly profit, with second quarter net income of $900,000, or 5 cents per share.

We realized record quarterly revenue of $21.5 million, up 11% from our second quarter 2002.

We grew recurring revenue to $6.4 million, up 66% over last year, and up $1 million sequentially over first quarter 2003.

We significantly improved gross margin to 63.2%, we continued to reduce our operating expenses with our second quarter operating expenses coming in at 10% below Q2, 2002.

We executed a one-for-two reverse stock split, and we closed our merger transaction with Computer Motion as scheduled on June 30th.

Ben will provide a detailed analysis of the merger later in the call.

Please note, however, that since the merger did not close until the last day of the quarter, Computer Motion's operating results have not been consolidated into Intuitive's second quarter income statement.

We thus will focus our discussion today on our GAAP based financial statements, although I will also provide a few selected highlights from Computer Motion's second quarter.

Pro forma operating results will be published in our 10-Q.

Total second quarter 2003 sales of $21.5 million were up 11% from the $19.4 million reported for the second quarter of 2002, driven primarily by continued recurring revenue growth.

Second quarter 2003 recurring revenue totaled $6.4 million, up $2.6 million over the prior year and up $1 million sequentially from the first quarter 2003.

Excluding the impact of the second quarter 2002 non-routine surgical console shipment included in accessory revenue last year, our Q2 2003 revenue was up 94% over last year.

We were quite pleased with our recurring revenue growth and the fact that our recurring revenue continues to increase as a percentage of our total revenue.

Recurring revenue grew to 30% of total revenues the second quarter, as compared to 20% in the second quarter last year.

Our recurring revenue continues to climb each quarter, as we place more systems and our customers perform more robotic procedures.

We shipped 14 da Vinci Surgical Systems during the quarter, ten in North America, two in Europe and two in the rest of the world.

The 14 total units shipped were down two, compared to 16 units shipped during the second quarter of 2002.

We now have cumulative placements of 177 systems, 123 in North America, 43 in Europe and 11 in the rest of the world.

Second quarter 2003 system revenue was bolstered by our successful launch of the fourth arm upgrade to our da Vinci platform.

We shipped nine units during the quarter at an average selling price of $190,000.

Five fourth arm units were shipped with new systems and four to the installed base.

These units are recorded in system revenue.

Total Q2 2003 revenue by product group was as follows.

Systems, $15.1 million, instruments and accessories, $4.2 million and service, $2.2 million.

Our year-to-date sales totaled $40.7 million, up 20% compared to the $33.8 million last year.

Our gross margin for the second quarter of 2003 increased significantly to 63.2%, compared to 52.4% for the second quarter of 2002.

On a year-to-date basis our gross margin was 59.1% ,compared to 50.5% for the same period last year.

Improved 2003 gross margin was driven by significantly lower warranty costs resulting from system reliability improvements and improved factory productivity.

Our reliability improvements and operating efficiencies were achieved while maintaining system average selling prices.

Total operating expenses for the second quarter 2003 were $13 million, down $1.4 million or 10% compared to the second quarter of 2002.

Operating expenses were also down $600,000 sequentially compared to the first quarter of this year.

Note that the direct costs related to the closing of the merger with Computer Motion of $1.8 million have not been recorded in the operating expenses, but rather under GAAP standards, have been capsulized as part of the purchase price and included in goodwill on the balance sheet.

We ended the quarter with 262 regular Intuitive employees, down 11 from the previous quarter end, as we began to create space in the organization for the anticipated Computer Motion addition.

SG&A expenses for the second quarter were $9.4 million, down 4% from the $9.8 million for Q2 2002.

The year-over-year decrease was primarily due to the elimination of Computer Motion litigation expenses after announcing the planned merger in March 2003, partially offset by higher headcount and travel related cost associated with supporting a larger installed base of the da Vinci Surgical Systems.

Research and development expense was $3.6 million in the second quarter of 2003, down approximately $1 million from the $4.6 million in the second quarter last year.

The decrease versus the prior year resulted primarily from lower project material costs and a decrease in clinical trial expenses as we gained more FDA clearances.

Other income was approximately $300,000 for Q2, 2003, compared to $500,000 the second quarter of 2002.

The decrease was due to lower interest income earned on lower investment balances this year versus last.

Our net income for the second quarter 2003 was $900,000, or 5 cents per diluted share, after giving effect to our recent one-for-two reverse split.

This compares to a net loss of $3.7 million, or 21 cents per share, during the second quarter of last year.

We were able to achieve profitability this quarter due to record revenue, significant margin improvements and cost reduction and containment.

Our net loss for the first half of 2003 was $1.4 million, or 8 cents per share, compared to $9.4 million or 51 cents per share last year.

Basic shares outstanding for EPS calculations were 18.6 million shares for the second quarter of 2003, compared to 18.2 million for the same period last year.

I'm delighted that we had the opportunity to calculate diluted shares outstanding for our profitable second quarter.

Average Q2 diluted shares were 19 million, an increase of 400,000 shares, or 2.6% above basic shares outstanding.

The increase is due to the impact of outstanding in the money options calculated using the treasury method.

Now, regarding the second quarter results of Computer Motion.

First of all, there will be no separate Computer Motion results reported for the second quarter, based on applicable SEC rules and due to the merger.

As I have mentioned, since the merger closed on the last day of the quarter, Computer Motion's offering results have not been included in Intuitive income statements.

We will report pro forma operating results on our 10-Q filing next week.

Today I will provide just a few Computer Motion highlights.

Second quarter net revenue was $4.1 million, comprised by product line of Aesop, $1.7 million on 16 systems, Zeus, $1.6 million on two systems, Hermes, $500,000, Socrates, $100,000, and engineering grant revenue of $200,000.

In the future, Intuitive will book grant money received as an offset to R&D expense, rather than as revenue.

Second quarter Computer Motion net loss was $5.9 million.

Now, in regards to our balance sheet.

Our overall quarter-end consolidated balance sheet reflects the impact of the Computer Motion merger transaction, and includes the combined balances of Intuitive Surgical and Computer Motion.

We ended the quarter with $42.9 million in cash, down $2.1 million from the previous quarter end.

Excluding the impact of $5.3 million loan to Computer Motion during the second quarter, and $1.2 million in cash acquired in the merger, we were $2 million cash positive during the quarter.

Our quarter ending accounts receivable balance of $21.9 million was up $1 million from the previous quarter-end.

The increase was due to $4.5 million in accounts receivable acquired from Computer Motion, offset by a $3.5 million reduction in Intuitive based accounts receivable.

Our Q2 ending average days outstanding was 78 days, down from 98 at the end of Q1.

Ending second quarter net inventory was $13.6 million, up $5.3 million from $8.3 million at the previous quarter end.

The increase was primarily due to the fair value of inventory acquired from Computer Motion of $4.7 million.

Our annual inventory turns declined to 3.6 from 4.2 ending the previous quarter.

Ben will cover more merger highlights and guidance for the rest of the year later in the call.

And with that I'd like to turn it over to Aleks who will provide a summary of our latest sales and marketing highlights.

Thank you, Susan.

As mentioned earlier during the second quarter we shipped 14 da Vinci systems, ten in North America, two to Europe and two to rest of world locations.

Of these 14 placements, several were notable.

Included were the University of Minnesota, University of Virginia, Indiana University, London Health Sciences, which is one of Canada's most established MIS centers, and to the Urology Associates of North Texas.

This sale to the Urology Associates of North Texas represents Intuitive's second sale to a self-standing physicians’ group -- in this case, one of the busiest urology groups in the southwest.

The surgeons within Urology Associates will be focused on establishing DVPs, or da Vinci prostatectomies, as a significant new patient offering to men within the Dallas metropolitan area.

As you can see in the recurring revenue line, we had an excellent quarter with respect to system utilization and procedure growth.

The procedure mix within surgical fields is almost equally divided between cardiac, urology and general surgery procedures.

Our procedure growth rate within the fields of cardiac and urology continues to exceed our objectives.

There are four key procedures which exhibit particularly impressive growth trends.

DVPs, pediatric procedures, mitral valve repairs, and the MVST, or multivessel small thoracotomy procedure.

Last quarter we introduced the MVST procedure as a new company focused procedure.

An MVST procedure provides the patient with a multivessel MIS operation, which we believe represents a natural surgical progression towards a totally endoscopic [inaudible] procedure.

As part of our alliance to Medtronic, we are working together to drive adoption of this important new procedure.

Both Medtronic and Intuitive have revenue opportunities to realize from the growth of this procedure -- Medtronic from its new Starfish NS and Stabilizer products, and Intuitive from its da Vinci instrument sales.

In the third quarter there are several scheduled co-marketing events, which we plan to conduct to further thrive adoption.

On a related topic, Intuitive's totally endoscopic coronary artery bypass, or TECAB trial, we are on track to file our 510K submission with the FDA in the third quarter.

We have completed our clinical procedures and are now in the postoperative, follow up, and data collection phase.

Following our 510K submission this quarter we anticipate a standard FDA review process which would place our anticipated clearance late in Q4 or early in Q1 of '04.

During the second quarter, we ramped up shipments of several new products, most notably the fourth arm.

During the quarter we shipped nine fourth arms.

The mix is represented by five totally new four-arm da Vinci systems along with four fourth arm upgrades to existing da Vinci sites.

The early data on the fourth arm usage is also encouraging, with cardiac, urologic, and general surgeons each participating in product demand and usage.

Also during the quarter we began commercial shipment of the da Vinci three channel vision system which you may recall is a result of our strategic with Olympus Corporation.

Both Olympus and Intuitive are pleased with the initial, favorable customer response to this innovative new product.

During the quarter we launched several of what I would classify as improved ease of use products, products such as the da Vinci integrated audio communication system, twist lock [cannula] mount system and the permanent spatula-tipped cautery instrument.

We expect these products to lead to easier da Vinci use in terms of system setup and instrument changes, which will continue to enhance customer experiences.

We believe that ease of use improvements to da Vinci, which independently may appear benign but collectively are significant, will lead to increased utilization of the system.

Now turning to the integration of CMI's customers products and workforce with those of Intuitive.

The second quarter with respect to planning, and to this point the third quarter, have been quite busy.

First, the cross-training of the sales organizations is largely complete.

We have also rationalized many of the marketing plans and have eliminated duplicate space at future trade shows.

Also, both manufacturing and administrative support organizations are on target to consolidate to Sunnyvale by October 1st of this year.

Likewise, the European operations will consolidate into one facility within this same time frame.

Within Galeta, we have already vacated and subleased 11,000 square feet of space, and we are actively pursuing the subleasing of an additional 21,000 square feet.

With regard to headcount, we have eliminated approximately half of the prior positions held at Computer Motion to date, and an additional 25% are in transition to be eliminated by the end of the year.

Now, moving to regulatory plans.

The regulatory environment, specifically as it pertains to the FDA and the Zeus platform, is becoming clear.

Prior to the merger, CMI had embarked on several FDA sanctioned events.

After careful and thoughtful assessment, we have decided not to pursue any additional Zeus clearances.

A great deal of thought went into this decision, but at the end of the day it boiled down to the following four key points.

One, the FDA has already granted these clearances to Intuitive for the da Vinci platform.

Second, the case volume, training pathways and favorable clinical results are already significant with respect to da Vinci.

The perceived value of a second set of similar clearances was not very meaningful.

Third, there was uncertainty with regard to a successful or meaningful end point under the proposed trial designs.

And finally, the resources required to initiate and complete these trials was cost prohibitive.

The more we reviewed these decisions, the clearer it became.

For both clinical and commercial reasons da Vinci is the platform in which we will continue to invest heavily.

During the month of July, we met with most of the existing Zeus customers to communicate our customers' future direction, and their responses could be generalized in one of two ways.

Some were satisfied with the Zeus and will remain committed to robotic surgery, while others were interested in trading in their Zeus for a da Vinci.

We are actively engaged with several customers in this regard.

We will work closely with all of our customers to help them through this process, and remain committed to help them ensure success within each of their individual robotic initiatives.

As far as the remaining products within the portfolio, we are very encouraged to offer customers a full suite of products, ranging from Hermes to Aesop to da Vinci.

To this point, a large percentage of our customers currently own all three of these technologies.

We have always felt that the synergy between da Vinci, Hermes, and Aesop is strong.

We expect this to continue and strengthen in time.

You may recall that CMI had spent a good deal of effort in the area of telesurgery and robotic networkings, through its Zeus and Socrates platforms.

We remain optimistic that robotic networking will one day represent a good business opportunity, perhaps in training or remote outreach surgery, but as far as today's internal resource commitments, we will study robotic networking on a prudent level while expending very limited internal resources in the near term.

It is our belief that today, Intuitive Surgical is in stronger position than at any time in its history to best certain its surgeon, hospital, and patient customers.

We look forward to operating the post-merger organization while delivering next generation surgical products to our customers.

With that I will now turn the time over to Ben.

Thank you, Aleks.

I will now provide some financial details of our Computer Motion merger transaction, review the changes to our capital structure and provide an outlook for the second half of this year.

As you know, we closed our merger with Computer Motion on June 30th.

The overall valuation for the transaction was approximately $149 million, based primarily on the market price of Intuitive stock issued to former Computer Motion shareholders.

The transaction resulted in the following additions to our quarter-end balance sheet.

Goodwill of $142.7 million, intangible assets of $8.6 million, deferred compensation of $400,000, net tangible assets of $200,000, and a restructuring reserve of $3.4 million.

Our goodwill balance of $142.7 million will not be amortized into future expense, but rather will be tested for impairment on a periodic basis.

If any impairment is identified, it will be expensed in the period identified as a non-cash expense.

Our intangible assets of $8.6 million acquired in the merger consist primarily of developed and core technology and customer relationships.

These intangible assets will be amortized on a straight line basis over a period of approximately seven years.

An additional $100,000 related to end process R&D was already recognized as expensed in our second quarter income statement.

Deferred compensation of $400,000 relates primarily to the intrinsic value of unvested options assumed in the merger.

These options will amortize over a period of three years on an accelerated basis.

Altogether we expect the non-cash amortization of merger related items to be approximately $650,000 per quarter over the next four quarters.

Approximately $500,000 of this will be in cost of sales and the balance in operating expense.

In relation to the restructuring plan that Aleks described earlier, we have established a restructuring reserve in the amount of $3.4 million to cover employee severance pay and costs associated with exiting facilities leases.

Now regarding our capital structure.

Prior to the merger, Intuitive had approximately 37.2 million shares outstanding, and Computer Motion had 31.3 million.

Computer Motion shares were converted into 16.1 million shares of Intuitive stock as a result of the merger, which resulted in 53.3 million shares outstanding.

After the close of the merger, Intuitive immediately executed a one-for-two reverse stock split, which then resulted in approximately 26.6 million shares outstanding on July 1.

For EPS purposes, the issuance of shares to CMI shareholders on the last day of the quarter had only a nominal impact on the shares outstanding for our Q2 EPS calculation.

Therefore as Susan mentioned earlier, average shares outstanding for Q2 was about 19 million shares on a diluted basis.

Going forward, EPS calculations will be based on the 26.6 million shares outstanding to start Q3, plus any dilutive impact of in the money warrants and options.

Regarding future financial reporting, results of operations will be reported on a GAAP basis.

As such, future operations will be reported as a combined entity.

There will be no separate Computer Motion entity going forward.

The 2003 annual results will be comprised of the first two quarters of Intuitive, plus the last two quarters of the combined entity.

The results of Computer Motion's first two quarters will only be reported on a pro forma basis in our SEC filings.

We will report quarter-to-quarter and year-to-year comparisons on a GAAP basis in future calls, as we feel these comparisons are more meaningful than pro forma comparisons.

Now with regard to our outlook for the second half of this year.

We expect revenue to total between $50-60 million for the second half of this year, up from $38 million in the second half of 2002.

Recurring revenue will grow to between $14-15 million, up from $8.6 million reported in the second half of last year.

Therefore, we continue to expect recurring revenue to comprise 25-30% of total revenue for the rest of the year.

We expect gross margins to come down from our Q2 results to between 55-60% for the second half, including the impact of purchase accounting amortization.

The impact of purchase accounting amortization will be to decrease gross margins by about 2% in each of the next two quarters.

Another reason for the expected decrease in gross margin is the impact of our planned Zeus trade-in program and near term manufacturing integration and transition costs.

We see total operating expenses for Q3 and Q4 to be between $16-18 million per quarter.

Amortization of intangibles and deferred compensation related to the merger will be approximately $150,000 per quarter in operating expense.

Previously, we had reported that we expected to achieve $18 million in annual savings after the integration of the two companies.

This is in addition to savings from the elimination of litigation costs between the two companies.

At this point we believe that we will have substantially achieved our $18 million annualized savings goal by the end of the third quarter.

These savings stem from those activities described earlier by Aleks.

With regard to profitability, we are expecting topline growth in each of the next two quarters.

Our increase in operating expenses related to the merger has raised our breakeven point.

We do not expect to report a profit in the third quarter, but we are expecting to return to profitability in the fourth quarter and beyond.

Shares for EPS.

We expect average shares outstanding for EPS purposes to be approximately 27 million shares in Q3 and 28 million shares in Q4.

Finally with respect to cash, we expect to use $10-15 million in cash over the next two quarters to cover merger related expenses, severance costs, reduction of acquired accounts payable and operating costs until becoming cash positive at the end of the fourth quarter.

We expect to end the year with $25-30 million in cash.

With that, I'll turn the time back to Lonnie.

That concludes our formal presentation.

We'll now open the floor to any questions you may have.

Thank you.

At this time, if you would like to ask a question, please depress star 1.

You will be announced prior to asking your question.

To withdraw your question, please depress star 2.

Once again, to ask a question, please depress star 1.

One moment please.

Rick Wise of Bear Stearns, you may ask your question.

Hi guys, and congratulations on your first profitable quarter.

Thank you.

Couple of questions.

First, can you quantify the fourth arm opportunity, I mean, the installed base, you know, is what it is.

Is everybody going to do this, and how quickly, just talk a little bit about that perhaps?

I'll take a shot and then I'll let Aleks.

I don't think everyone will convert to a fourth arm, but we have seen significant interest.

And I think as Aleks mentioned, five of the nine were upgrades.

Four?

Four of the nine were upgrades.

Anyway, it's -- I think there's a lot of interest.

We'll see how that proceeds.

It is clearly enabling, surgically enabling for certain procedures, allowing the surgeon to assist, and to track, and to provide traction, countertraction and to provide exposure.

So we think it's a very significant opportunity, exactly what percentage will -- will choose to upgrade, you know, I think is a question at this point in time.

Rick, this is Aleks.

I'll just weigh in with a couple of other observations so far in the first quarter that we’ve opened this up for sale.

We have seen participation as I mentioned from all of our three primary specialties, which is a good sign.

And so I think we're going to be collecting quite a bit of data over the next quarter and helping to cultivate stories within each of those surgical specialties.

The second observation I'll make is that I think it's a really good testament to the strength of robotics, within existing customers, where people already have a $1 million ante in to robotics and are willing to invest nearly $200,000 to continue down that path to further advancing the cause.

So we're very encouraged by it and we will be trying to model this thing out over the next few quarters.

When I think about your second quarter sales, you know, without a lot of input, you know, the unit sales were a shade lower than we thought, but obviously the arm sale’s off that.

The net combination of the two saw gross margins well above what we looked for.

How do I think about that for the second half, and like why would gross margins go back down so much if you're just starting to sell these clearly nicely margined arms, and you're probably going to be more focused anyway on your markets maybe with a little less distraction from the merger issues.

Is that the right way to think about it?

I'll try and take a shot at that Rick.

The one thing is, going forward at least in the next couple of quarters is going to be a 2% per quarter margin hit from just amortization of merger related expenses.

So that's not something that we actually had in the second quarter.

I see.

The other thing is, you know, we are going to have a Zeus trade-in program.

And that program will impact gross margins at least, we think, in the next couple of quarters.

So we try to build that into our forecast for gross margin going forward.

We still believe we are definitely on an outboard trend on gross margins, but at least in the next couple of quarters it might be muted a bit from Zeus trade-in.

This is Susan.

We’re reporting everything on a GAAP basis so that transition employees that are still on the books through October will be borne into the cost of goods sold in the manufacturing arena.

One last question from [inaudible] just right now, just a general question.

There’s ongoing concerns about the hospital environment and the capital spending budgets.

Are you all seeing anything that makes you anxious at the margin at all about slowdown or stretch-outs, any just sort of touchy feely responses there?

I would say Rick, as a general observation, when the hospital is spending $1 million on a piece of capital equipment, it's usually for one of three reasons.

Either it's operation or maintenance purchase or it's an infrastructure purchase or it's a strategic investment.

And the difference might be an MRI that breaks that needs to be replaced versus a hospital IT system to build a, call it an online campus for credentialing, et cetera, and then da Vinci fitting in a strategic -- what we believe is a strategic acquisition.

When we're talking to hospitals, we're getting the impression that some of the other areas are being impacted, some of the infrastructure plays.

Some of the maintenance plays or purchases might be affected in that they're using equipment longer, but we haven't seen any notable changes in the purchasing environment for the da Vinci over the past few quarters.

Thank you.

Larry Haimovitch of HMTC, you may ask your question.

Good afternoon.

Congratulations on your first profitable quarter.

Some financial questions.

How much did the -- how much did the reduction of warranty costs contribute to the gross margin improvement?

Is that a significant piece of it?

Larry, this is Ben.

We actually have seen a continual trend, I think we mentioned it last quarter and the quarter before, an ongoing reduction in warranty cost.

We expect that to continue, and that has just led to the continual sort of gross margin improvement.

Now, what is the accounting for this?

Is this a little bit like if you have accounts receivable and you're seeing your collections are going very well you can reduce your bad debt reserve?

Is this the same kind of idea, the warranty as a reserve that you use for future upgrades or not upgrades, but for future expenses, or how does that work then?

It's more rather if we're actually sending out less spare parts to -- for purposes of warranty.

You're not expending that amount of money for warranty expenses.

Uh-huh.

So it's based on actual rather than estimated, as if with bad debt reserves you could estimate going forward, this is based on actual expenses of the warranty costs you incur?

Yes, we do.

The reduction of the reserve is based on actual activity.

Okay.

And then in the area of legal costs, I don't know if you quantified that on the call or not, I don't think I heard that.

Can you quantify how much the legal costs went down in Q2, versus Q1, because of the end of the legal battle with you and Computer Motion?

You know, Larry, we've never really broken out our legal costs and we don't ever plan to.

Okay.

Following up on Rick Wise's question, are there any changes in reimbursement at the hospital level, because as you know, CMS is publishing their 2005 numbers.

Is there anything you have seen that would have any particular effect on the business, Susan, or anyone else?

No, nothing that has changed in any direction.

And another question.

Computer Motion sales were lower than I would have anticipated.

Is that reflecting the fact that there was uncertainty amongst the customers and they knew there was a transition to a combined company, perhaps weren't willing to commit to the Zeus and the other product lines?

Think there is a little bit of that on both sides, but I think this is also a period of time of enormous transition, as you can imagine, within Computer Motion, at a very disruptive period of time in the marketplace and certainly internally within Computer Motion.

Uh-huh.

I'm not sure I completely understood the reason for unprofitable operations in Q3 and then back to profitability in Q4.

I wonder if you could expand on that just a little bit.

We just absorbed 200 some employees that we are in the -- transitioning out and you know, there's a lot of transition expense in that process.

So that's the main reason?

Yes.

Yeah, I mean, a fair amount of it's going to be transition.

And again, well Aleks mentioned that, you know, a fair number of the positions have been eliminated, we've also certainly added a fair number of positions, too.

So you know, there's just not enough in Q3, we think, in revenue to offset that.

We'll try to give that you guidance.

And that's why Ben said in the script that we have raised our breakeven with this acquisition.

But obviously you've picked up some revenue as well?

Yes, that's correct.

What is the breakeven point, do you believe?

Well, we're going to let you model that, but we'll try to give you some modeling points with the $50-60 million in revenue for the second half, and we're committing to getting back to profitability in Q4.

Okay.

Thanks very much.

Mark Smillie of Seidler Company.

You may ask your question.

Good afternoon, everybody, congratulations.

Thank you.

Quick question on the number of people you've got in there.

You just said you've got 207 employees that you’ve absorbed.

Ben had mentioned you were kind of going through that and eliminating some of those positions.

What did it look like at the end in terms of Computer Motion?

I think we said earlier in the call, Mark, it's Susan, that we have eliminated 50% of those now.

Okay, and there’s now 25% left over?

And we have 25% to be eliminated by end of year.

That leaves 25% left.

Okay, great.

How many people do you have or will you have on the sales team once this is all done?

In the sales organization?

Yes.

Um -- actually, don't have that number off the top of our heads.

Sorry about that.

We'll have some of that broken out in the Q.

Okay, great.

Thank you.

I'm going to get back in the queue.

Billy [Deerman] of Atlas Capital.

You may ask your question.

Hey guys, thanks for taking my question.

A great quarter.

I had a quick question -- I missed the cash burn, was it -- there was $2 million that you would have been positive if there wasn't the $5 million loan to Computer Motion, is that right?

The loan was $2 million -- I'm sorry, $5.3 million, and then we acquired cash of $1.2 million, and we generated our own cash of $2 million, so in the end we burned $2.1 million.

Okay.

But without that, then it was positive $3 million, without the loan?

Positive 2.

Positive 2.

Positive 2, okay, perfect.

From operations.

Then on the acquisition did I understand you right that you're not going to pursue some of the activities as far as FDA approvals with Zeus and I would understand or infer from that that you don't intend on continuing to sell that product?

We will -- we will provide it if somebody would like it.

But it -- you know, the marginal return for us to pursue those additional clearances for a device we already have cleared is very unattractive.

It's a negative return.

And so you have to ask yourself why we would do that.

Right.

Well, I guess, then, just looking at the remaining parts of their business, kind of where I thought revenues were, is it about $14 million kind of in annual revenue aside from Zeus is that about right?

Looked like they did about $25 million trailing 12 months, is it about $14 million that's remaining?

Historically it was a little bit more than that, historically.

They did approximately, the former CMI did roughly $9 million in Zeus.

Okay. $9 million.

So it's like around $15 million.

So you all paid about ten times revs for them, does that sound right?

As far as the remaining business that will keep going?

I guess that's right.

That is certainly not you know the way that evolved.

Obviously when we did that acquisition, we did the merger it was at a time that both our stock price are considerably lower than they are today.

Where we actually closed it they were much higher, but this was driven -- more a strategic acquisition than it was based on multiple of revenue or multiple -- but obviously --

Strategy from a legal standpoint or I mean I guess I'm a little confused because it seems like you know you talked about absorbing 200 people and, you know, that that's one of the reasons that, you know, you're going to lose the profitability for the third quarter.

There's not that much revenue left, so it's like ten times rev on whatever the final price was.

I guess I'm just a little confused on where the return on capital is there for the investors, unless it is just the legal expense side.

Well not legal expenses, you've got to take legal expenses and the probability of different outcomes.

Okay.

And the advantage of having all the intellectual property in one place, and not confusing the market with a lot of different products that -- and a lot of claims about those products, eliminating enormous redundancy in the organizations, and including clinical trials and the things we've discussed earlier.

Okay.

Well, I just was hoping to get a little bit more clarification there.

Thanks so much.

I appreciate it.

Great quarter and look forward to more quarters of profitability.

Operator, I think we'd like to take one more question.

Our last question comes from Rick Wise of Bear Stearns.

Sir, you may ask your question.

I didn't know we could sneak in again.

I have one and Sheetal has one.

I just wanted to, as long as we've got you in public here, I know it's tough to talk about '04.

But any general thoughts about '04?

Especially in terms of profitability?

You've got your first profitable quarter, you're hoping to have another one in the fourth quarter.

I assume you'll be profitable for the whole '04 year.

Will you be profitable in every quarter of the year as we think about the model?

That's certainly -- that's certainly our intention.

Okay.

And I think Sheetal had a couple of questions.

I'd like to extend my congratulations as well.

Could you just give an update on the Brookhill-Wilk litigation, just so we know where that is, and how we should think about that?

I think that [inaudible] said we had an appeal in the -- that we lost and it got sent back down to the circuit court, and we'll still in the circuit court, and still continuing to litigate that.

We don't feel it's material to our business, on no new events have happened on that.

I think essentially it's no change.

No change.

Okay.

And then lastly could you just address, you guys were fairly stronger than we were looking for outside the United States.

Are you seeing some type of rebound there and you're really starting to make some headway in Asia?

Could you just talk about the international markets briefly?

One of the things that was encouraging is that in the rest of the world sales, both of those sales went into existing markets, markets that we introduced two quarters ago as new markets, primarily India and Saudi Arabia.

So the – you know, the strategy has always been to build markets and to build regions as opposed to finding one-offs and so we're encouraged by that.

Europe as you may recall, we had had a reorganization in Europe.

It is now under the leadership of [Esco Ascari] and we are very encouraged by the early returns of the changes we have made there too.

Great.

Thanks and congrats again.

Thanks very much.

That concludes our presentation and the question and answer period.

I'd like to summarize the highlights of the second quarter.

We achieved our first quarter of profitability as we've mentioned multiple times here, generating profit of approximately $900,000.

We recorded revenue of $21.5 million, up 11% from prior year.

We shipped 14 da Vinci Surgical Systems, ending the quarter with 177 systems installed worldwide.

We grew recurring revenue to $6.4 million, up 94% from prior year on a comparable basis.

We improved our gross margin to 63.2% from 54.5% last year, an increase of nine points or almost nine points.

And 16.6%, we completed the clinical portion of our [inaudible] trial.

We began selling several new products, including the fourth arm, which had a significant impact in the quarter.

We consummated our merger with Computer Motion, and the merger integration process is well under way and ahead of our initial schedule.

That concludes today's call.

We thank you for your participation and look forward to talking to you in three months.