INTUITIVE SURGICAL INC quarterly report, Q3 FY2017

Intuitive Surgical, Inc. — Q3 2017 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2017. Intuitive Surgical designs, manufactures, and sells da Vinci surgical systems and related instruments, accessories, and services. Share and per-share figures reflect the three-for-one stock split distributed October 5, 2017.

Financial performance

Metric	Q3 2017	Q3 2016	Nine months 2017	Nine months 2016
Total revenue	$806.1 million	$682.9 million	$2,236.5 million	$1,947.5 million
Gross profit / margin	$566.8 million / 70.3%	$487.0 million / 71.3%	$1,560.8 million / 69.8%	$1,362.9 million / 70.0%
Operating income / margin	$278.6 million / 34.6%	$256.4 million / 37.5%	$727.6 million / 32.5%	$680.8 million / 34.9%
Net income	$297.5 million	$211.0 million	$698.8 million	$531.9 million
Diluted EPS	$2.55	$1.77	$6.03	$4.52

• Q3 revenue rose 18%; product revenue increased 19% and service revenue 13%. Systems revenue rose 26% to $258.1 million, while instrument and accessory revenue grew 15% to $401.2 million.
• Recurring revenue was $548.0 million, up 15%, and represented 68% of Q3 revenue versus 70% a year earlier. Approximately 214,000 procedures were performed, up 15%; 169 systems were shipped versus 134. Installed base reached approximately 4,271 systems, up about 12% year over year.
• Q3 gross margin declined year over year, partly because Q3 2016 included a $7.1 million medical-device excise-tax refund. Service margin also faced higher da Vinci Xi endoscope repair and replacement costs. Operating expenses increased 25% to $288.2 million, including higher R&D, infrastructure, staffing, and litigation costs.
• Q3 net income included an income tax benefit of $8.1 million, compared with $55.8 million of tax expense in Q3 2016. For nine months, the effective tax rate was 7.7% versus 24.5%, primarily reflecting equity-award tax benefits and releases of uncertain tax benefits.

Cash, liquidity, and capital

• At September 30, cash and cash equivalents were $875.0 million; short- and long-term investments totaled $2.927 billion. Combined cash, equivalents, and investments were approximately $3.802 billion, down from $4.838 billion at December 31, 2016.
• Current assets were $2.929 billion and current liabilities $615.7 million. Total liabilities were $684.7 million. The balance sheet reports no borrowings or debt line item.
• Nine-month operating cash flow was $811.9 million, versus $757.3 million in 2016. Investing activities provided $694.5 million, including net investment sales and maturities; capital and intellectual-property purchases were $159.7 million. Financing activities used $1.670 billion, mainly due to a $2.0 billion accelerated share repurchase, partly offset by $381.6 million in employee stock-plan proceeds.
• The company held $3.8 billion in cash, equivalents, and investments at quarter-end and stated that existing resources and expected operating cash flows should meet liquidity needs for the foreseeable future. $1.477 billion was held by foreign subsidiaries; management intends to reinvest undistributed foreign earnings abroad indefinitely.

Changes, outlook, and notable items

• Nine-month revenue increased 15% and net income increased 31% year over year. Procedure growth was about 16% globally: 13% in the U.S. and 24% outside the U.S. Management cited U.S. general surgery and global urology as key growth drivers.
• The da Vinci X launched in the U.S. in May 2017; it offers selected Xi capabilities at a lower price point. Management reported regulatory clearance in Europe, the U.S., and South Korea.
• No specific numerical revenue or earnings guidance is provided in the filing. Management expects substantial and increasing R&D investment, and anticipates the Fosun joint venture will incur losses before commercialization and generate no revenue in 2018.
• China system placements and procedure growth depend in part on future import authorizations or public-hospital quotas and tender processes; timing and magnitude of future authorizations are uncertain. Japan procedure growth may depend on additional reimbursement approvals. Management also cited competition, healthcare spending and reimbursement, regulatory actions, product adoption, and procedure growth as factors that could affect results.
• Q3 revenue included $21.3 million recognized after customer trade-out rights expired unexercised; $2.1 million of related revenue remained deferred at quarter-end. The program was expected to be substantially complete before year-end 2017.
• Q3 included $9.7 million of net pretax litigation charges; nine-month litigation charges were $18.7 million in SG&A, including $15.6 million for product-liability claims and charges for shareholder derivative settlements. Approximately 45 individual product-liability lawsuits were pending, alongside a multi-plaintiff case; the company said excess loss on tolled claims could not be estimated. A separate patent infringement suit concerning EndoWrist Stapler instruments was filed in June 2017, with potential loss not estimable.
• The company recorded $16.7 million in accrued liabilities for a shareholder derivative settlement; court approval followed on October 20, 2017. The securities class action remained active, with the court denying dismissal and class-certification reconsideration motions in September 2017.
• The medical-device excise-tax moratorium was scheduled to end December 31, 2017, with the tax scheduled to resume January 1, 2018. The company also warned that adoption of the new revenue standard in 2018 could accelerate recognition for some system arrangements, though it then expected no material effect on the years presented.

Important facts for investors to verify

• How much reported earnings growth reflects sustainable operations versus lower, potentially variable tax expense and discrete tax-benefit releases.
• Whether procedure growth, system shipments, and recurring revenue continue, especially given lower system ASPs and a changing geographic and product mix.
• Whether endoscope repair and replacement costs, litigation charges, and product-liability exposure increase or materially affect margins and cash flows.
• The status and financial consequences of the patent case, securities class action, derivative settlement, and pending product-liability matters.
• The resumption and impact of the medical-device excise tax, and the realized effects of the 2018 revenue-recognition standard.
• Future cash deployment after the $2.0 billion accelerated repurchase, the remaining $991.6 million repurchase authorization, and any additional funding needs of the Fosun joint venture.