Intuitive Surgical Inc (ISRG) — Q2 2021 Earnings Call Transcript

Good afternoon and good morning to folks on the West Coast. I'm Larry Biegelsen, the medical device analyst at Wells Fargo, and it's my pleasure to host this session with the management team from Intuitive Surgical. With us, we have Marshall Mohr, Executive Vice President and CFO; and Philip Kim, Head of Investor Relations. In terms of format, it's going to be a fireside chat. If anyone has a question they want me to ask on their behalf, please email it to me. I think we're going to try to get in one or two polling questions. And I think before we jump in, Phil, you wanted to make some opening remarks.

Sure. Before we get started, I'd like to mention that comments made this morning 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.

All right. So, gentlemen, thanks so much for being here. Really appreciate you guys participating in our conference again this year.

Thanks for having us, Larry. We're happy to be here.

Marshall, I hope next year, we don't have to ask you about COVID. But we feel like we're starting almost all of these conversations with just kind of, any qualitative color you can provide on the Delta variant and what was embedded in your guidance? I went back and looked at kind of your transcript, the low end assumes some impact of resurgence in the U.S. but I'm just curious if you can qualitatively talk about any trends you're seeing.

Yes. Thanks, Larry. Let me say good afternoon to everybody, and thanks for having us at the conference. Yes, we saw in Q2, it was actually a rebound that was quicker than we had expected. And if you look at the compound annual growth rate relative to 2019, so pre-COVID, it was 16.5%. Growth rates back in 2018 and 2019 were in the 18% to 19% range. And so, a little lower then. But if you were to have drawn a line looking at adoption curves and so forth, 16.5% was nearly a recovery. So it was quite nice. Having said that, going into this quarter, obviously we've seen a resurgence of the Delta variant that has had a significant impact on household resources over the past month or so, regionally. You see most severe in places like Texas and Florida and some of the South where vaccination rates are lower. And in those areas, you're actually seeing some level that hospital resources are strained and you're seeing some level of deferral of procedures again. And there is a direct correlation between hospital resource availability and how strained it is and deferrable procedures and da Vinci procedures for that matter, and there are a number of da Vinci procedures that are deferrable in the short-term. Now they’re chronic conditions, so, eventually the patients have to be treated, but they can be things like hernias and cholecystectomies and bariatric procedures can be deferred in the short-term. So, given the resurgence, you should expect that it is having some impact on our procedures. How deep, how much of an impact is really difficult to predict. You have access to the various models out there that the various professionals put out there about what will happen with resurgence. So, you have access to that data, and we're not going to try to predict what the extent or the length of this is going to be. But – and I would also comment that it varies by region within the U.S. You see more severe conditions in the South, and in geographies I mentioned, and much less severe in some of the other geographies like the Northeast and then it varies around the world as well. You see less of an impact in China right now. A little bit of impact in Japan, although the hospitals seem to be getting through things pretty well. You see some impacts in places like the UK and India. So anyway, I don't have something specific to give you. But I can just tell you, just in general what we're saying.

And just a couple follow-ups. One is, maybe, if you can't disclose this, I understand. But is it worse than you kind of expected when you gave your guidance? I mean, it seems like most people didn't expect it to be this bad. Is that a fair conclusion?

Yes, it is. Yes. Going back to our guidance, you said it, so I didn't repeat it, but I'll repeat it now. And that is, our guidance didn't assume any significant disruption or additional costs associated with supply constraints, which, frankly, supply constraints has dealt with potential problems. And then the second one is, I didn't assume any significant or widespread impact of COVID in the United States. And I think we are indeed seeing that.

And it's interesting, because you talked about the 16.5% CAGR in the first half, to your CAGR I think. So big picture, we know whole COVID’s transient, you see these procedures whenever COVID does wane, these procedures coming back? And you can get back to kind of the underlying trajectory, Marshall, just to kind of bring home the point that this is transient, and the underlying trends for your business are still strong.

I think that's right. I think we still believe that the opportunity for computer-aided interventions is significant that robotics that you'll see - long-term, we've talked about a line of sight market of 6 million procedures. There's many more procedures than that that could be done robotically. And we believe that opportunity has not changed. All COVID has done is disrupt sort of the pace at which you get there.

You mentioned earlier in the call about inflation and potential supply constraints, which you've identified as a risk before. However, I believe that up until the second quarter call, it was seen more as a risk rather than something that was actually happening. Could you share what you're observing regarding inflation and supply constraints and how they might be affecting your business?

Yes. Frankly, it's hand-to-hand combat when it comes to supply and I don't think we're unusual. I think you’re reading it in the papers, the car industry, the computer industry, and if any of you are trying to order products that contain semiconductors, you see that the lead times have been extended significantly for all products. So when I say hand-to-hand combat, our teams are working hard with our suppliers to make sure that we have the supplies necessary to be able to supply our customers' needs. And so far they were successful, certainly through Q2, and if I had something significant to say today, I would. But having said that, the risk is still there and the risk is so significant that at some point in time there is the potential that a supplier is unable to supply what we need. We also through Q2 had not seen, you call out, inflation. Either inflation caused by demand supply, normal pressures, or inflation in terms of suppliers just trying to charge us more because the opportunity is there. So, it hasn't had much of an impact at all. I would say that, as we go forward, though, one area that will likely see increased costs is freight. And the reason is that you're having to expedite parts either into the factory or from the factory out to customer. And so we'll see some of that, price is not a huge part of our costs but nonetheless we'll see increased freight.

When we think about kind of next year Marshall, what are some of the puts and takes to think about on the top line and bottom line?

Yes, at a high level, it's currently challenging to forecast the impact of COVID on procedures. We will share our insights on procedures by the end of January 2022. Regarding system placements, we experienced a surprising increase in systems through Q2, as we initially anticipated that hospital finances and resources would be limited. However, hospitals emerged from COVID in a better position than expected at least up to that point. Looking ahead, COVID could still affect us. The dynamics on our top line will also be influenced by the replacement cycle. We have seen positive traction in system replacements, particularly with the transition from third-generation to fourth-generation products. However, over time, the installed base of third-generation systems will decrease, resulting in fewer trade-ins. Additionally, leasing will impact the top line in the short term but is beneficial in the long run. We expect leasing to vary from quarter to quarter but to gradually increase as a fraction of total sales over time, which may have a negative short-term impact. On the bottom line, we believe the opportunities ahead remain consistent, and we will persist in investing in innovation, digital advancements, and enhanced instrumentation and accessory offerings. Consequently, we will continue to invest in Ion and SP. From a cost perspective, spending will remain robust. Therefore, if you're expecting the profitability observed last quarter to remain stable or grow, you may want to reconsider. The profitability witnessed last quarter resulted from revenue recovery outpacing cost recovery. Specifically, costs that had been cut or reduced due to COVID, such as travel and marketing expenses, were still constrained in Q2, while we observed an overall business rebound. Thus, the profitability in Q2 may have been somewhat of an outlier, and we will continue to invest in this environment.

Marshall, a lot to unpack there.

Yes. Sorry. Didn't mean to go on…

So, regarding the procedures we discussed earlier, I believe we've covered that quite thoroughly. As for placements and COVID, many companies have mentioned that the capital environment is still healthy, even recently. I've heard discussions about a favorable capital environment. Can you provide any insights on whether you've noticed any changes in the capital environment?

Yes. We won't discuss the inter-quarter dynamics here. At the end of Q2, things were better than we expected. A significant factor in Q2 was the expansion of existing programs at large integrated delivery networks, which reflects the benefits of robotics in patient treatment and reducing overall care costs. Everyone thought we were emerging from COVID at that point, and there was a preparation for a post-COVID situation. Capital decisions are influenced by various factors, so I won't comment on expectations, as we do not provide guidance due to potential short-term fluctuations. However, procedures drive capital in mature markets, and we monitor utilization statistics as an indication of the balance between capital and procedures. In Q2, they were well aligned. If procedures are significantly reduced due to COVID, it could affect capital. I mentioned that the trade-in cycle will decrease as the third-generation product population in the field diminishes. Leasing is another aspect to consider, and we are unsure how COVID will affect hospital financing moving forward. Additionally, as competition increases, we anticipate longer sales cycles and possible price erosion.

Marshall, when does the trade-in become a challenge for you? Can you provide more details? How many units are still in operation, and when does it transition from a benefit to a challenge?

I'll let Philip provide you the statistics.

Yes, Larry, over time, you should expect the percentage of trade-ins to come down as the installed base of Gen 3 declines and upgrades. Roughly 20% of the worldwide installed base is Gen 3 or older. And so has a lot of large numbers. As we work through that, that should be less of a tailwind. More broadly, with leasing, we've always said in the past that we expect that to continue to be a larger percentage of our placements as time increases and we're just trying to provide our customers with as much flexibility as possible.

And there's about 600 systems in the U.S. that are third generation or older, unlike a number outside the U.S. Outside the U.S., there are places like China where those systems haven't been installed for very long. Xi was not approved regulatory until about 1.5 years, 2 years ago in China. So we expect that element, that set of systems to return more slowly over a longer period of time. In the U.S., what we saw last quarter was that, that decreased the trade-in cycle. It was roughly 20% of the systems outstanding have been traded-in in that quarter. So if that pace were to continue, then you'll see a substantial decline certainly through the end of next year.

Got it. Marshall, you talked about leverage in the P&L a minute ago. Historically, you guys have delivered 1x to 1.5x leverage. Is that ratio come to the lower end next year, should we be thinking based on your commentary? Or I don't know if you can comment on that at all. But the Street right now is kind of has kind of the low end of that for 2022.

Yes. We'll provide specific guidance for 2022 at the end of January. What we are indicating is that this is a period of investment for us. We believe we still need to invest in both Ion and SP, which are still in their early stages. For Ion, we have regulatory approvals and are looking into opportunities outside the United States, as well as exploring other potential applications. For SP, we will be heavily investing in clinical trials to secure additional indications and achieve clearances in other markets outside of the U.S. These are two significant areas of investment. Furthermore, data is likely the largest area of increased investment and will remain so. You can also expect a return to certain expenses, as COVID restrictions ease, leading to increased travel, marketing events, and other activities that were previously limited due to the pandemic. Regarding leverage, as mentioned earlier, you should not anticipate profitability levels similar to what was seen in the second quarter moving forward. The second quarter was an anomaly, and we will continue to invest.

Got it. You mentioned competition a couple of times, particularly with Medtronic potentially entering the European market in the second half of this calendar year. If the selling cycle is prolonged, when would you anticipate that occurring, if at all?

It's happened to some extent. With the smaller competitors out there, hospitals and some government systems like the NHS in the UK or public hospitals in France and Germany are going through tender activities. Previously, they could issue a tender more quickly, but now they must adhere to the full timeline if competitors enter the scene. We expect that more tenders will involve multiple competitors, including companies like Medtronic. As this occurs, timelines will extend. For instance, expect around six-month timeframes outside the U.S. compared to three-month ones. In the U.S., there may also be some consideration regarding competitive products versus ours, which could lead to elongated cycles even without formal tender processes.

Do you think this will begin once they receive the CE Mark, or will people possibly start hesitating or waiting until it is completed?

That's a great question. I think you're already seeing competition trying to get customers to slow down their purchases or wait until their product is ready. That's happened for the last 4 years, frankly, when companies thought they might be coming to market more quickly than they actually have been able to. So I don't know. My expectation is they'll continue to try to get customers to slow down and install, but it hasn't had a significant impact to date.

That's helpful. Can you elaborate on your perception of the ecosystem you've built in comparison to the competition?

Sure. I'll let Philip take the first step at it, and then I'll jump in.

Sure, Larry. You've heard us discuss the ecosystem before as crucial for achieving outcomes, particularly clinical ones. First, we make it a priority to understand our customer base thoroughly. We ensure we have the right technologies, instruments, accessories, systems, and imaging tools to support them. We also focus on optimizing our operational processes, which include training, service and support, as well as marketing and sales coordination. These investments take time to yield results. As you've seen in our presentations at various conferences, building this ecosystem is a lengthy process. It's not just about having a robot or systems and instruments; it also involves engaging with regulatory agencies for clearances, making decisions based on specific indications, and obtaining necessary sanctions. Additionally, we need to develop training pathways and gather clinical evidence. This work involves going country by country, building relationships with surgical societies, and achieving economic validation. It's a challenging task, as you know, requiring effort on a country-by-country and procedure-by-procedure basis. We are committed to investing in this ecosystem as a mission-driven company focused on improving patient outcomes, enhancing the surgeon and treatment experience, and reducing costs. Ultimately, we aim to add value to the ecosystem.

All right. That's helpful. Let's try 1 polling question, but go to the second one, if you can. And if you can't, just we'll move on. The second one. Okay. Good. All right. So the second question is basically, Medtronic plans to launch its Hugo surgical robot in Europe in the second half of calendar 2021. What impact do you expect you guys to have on Intuitive Surgical? A, expect Hugo to reduce Intuitive placements at least in the near term? B, I expect Hugo to be a catalyst for robotic surgery and ISRG, a so-called rising tide? And C, not sure? There's a bit of a lag. It takes time for them to fill it out. So Marshall, I might ask you another question before we get those results. And I wanted to shift the conversation more to kind of the opportunities you guys have, new procedures, new platforms. And maybe just starting with procedures, Marshall. So when we look at the next years, which procedures do you expect to drive the most growth for Intuitive?

Yes. I believe there are procedures already underway, and the growth over the next few years will primarily come from general surgery in the U.S. Within that area, the key focus will be on the continued adoption of bariatrics, cholecystectomy, and hernia, which are the three main categories. However, there are additional segments of general surgeries that are also adopting these procedures, although they are smaller in scale. Outside the United States, we are seeing significant advancements in urology across several countries, especially in Europe. The future growth drivers will include thoracic procedures, which are doing quite well in places like China, along with general surgery procedures. Initially, this growth will be led by cancer-related procedures, eventually expanding to benign ones. However, reimbursement rates for benign procedures outside the U.S. are low, which is why we anticipate cancer procedures will be adopted first.

Are there new procedures that we should be following?

I believe we currently have three platforms. When it comes to multiport procedures, I see a lot of potential in what we have. I wouldn't add anything outside of thoracic procedures without confirmation from Philip. Regarding the other two platforms, specifically Ion, we do anticipate significant growth in lung biopsy interventions, and we are already witnessing positive trends there. For SP, obtaining clinical data is essential to secure clearances both in the United States and internationally, which will take time. Our focus is on procedures where we can provide the most value, especially those that utilize multiport systems. In the long run, we've mentioned the possibility of exploring breast procedures and others, but for now, our priority is obtaining a colorectal indication and expanding our efforts in urology and thoracic fields.

That's helpful. Did you want to add something, Phil? Or do you want to go to the poll results?

Let's go to the poll results. I think Marshall covered it perfectly.

Okay. What do we have? Marshall, catalysts for robotics surgery are experiencing a 42% and 33% near-term headwind. And not sure, sorry, 25%. Any reaction, Marshall?

I think the first two points are valid. I believe that as more competitors enter the market and discuss the advantages of robotics, it actually broadens the market or at least makes certain segments more accessible. This creates a rising tide effect with everyone participating. We've seen evidence of this since around 2018 or 2019 when companies started advocating for the use of robotics in surgeries, which changed perceptions. Regarding Hugo's impact on ISRG placements, it's clear that some surgeons and institutions will want to experiment with Hugo. We will see how that trial process unfolds. However, this may lead to a delay in placing ISRG units. In the long run, we will determine their choices. I find it hard to believe that hospitals with both products would see surgeons frequently switching from one to the other, so it's likely to be one or the other, though we can't be sure at this point. We need to observe what they deliver and how comprehensively they address the necessary components for success.

Okay. Marshall, a couple of minutes left here, but those are very helpful comments. I wanted to sneak a few more in. So Ion, you touched upon it. You're having a lot of success from the placements we've seen early on. How should we think about the pace of adoption of Ion?

Yes, we will continue with a measured rollout for now. The clinical data from the PRECISE trial will be available at the end of next year. This will likely create opportunities for further adoption. Currently, early adopters are moving forward, and once we have the data—and if it turns out as positive as we anticipate—we may see wider acceptance and a faster rate of adoption. For the time being, we expect a gradual increase. We are pleased with last quarter's results, with nearly 1,500 procedures and 20 systems, which we consider a strong performance. We will also begin exploring how to secure clearances outside the U.S. and will keep you informed about our filings and growth expectations as we progress.

In China, it probably is a big opportunity for Ion.

It is. Philip?

Yes. So with respect to China, we have that partnership with Fosun. But right now, the pathway for China is quite long and complex. And so we'll end up sharing timelines, when we have something that's worth sharing.

Okay. Marshall, when do you think we'll know the impact of the Extended Use Instrument Program? It’s likely a bit challenging due to COVID, but when will you be able to provide an update on that impact?

Yes. Thank you. You're right. It is complicated by COVID, and the ability to measure what is COVID versus what is extended use instruments and so forth is really difficult to parse apart right now. What we're hearing from our customers, though, is really positive feedback on the fact that they can do some of these procedures at a lower cost and competitively with other minimally invasive approaches. So we do believe that there will be some elasticity. It's hard for me to answer your question because I really don't know how long COVID is going to have an impact on us. But I think it's probably not for another year that we aren't able to measure it.

Okay. We're out of time. Marshall, I'll give you the last word. We covered a lot of ground, but we have a minute or so if you have any closing remarks or anything you wanted to address that we didn't get to.

No. I think we discussed the key points that are essential for investors to grasp. The opportunity remains unchanged. COVID affects the speed at which we progress, but the opportunity itself has not altered. Therefore, we will keep investing in our infrastructure and innovation to seize as much of that opportunity as we can. In the meantime, we'll observe what happens at the revenue level.

Okay. Perfect. Really appreciate you guys being here. I hope the rest of the day goes well for you, and we'll be in touch. Thanks, again.

Thank you, Larry.

Thanks, Larry.

Bye, everybody.