Intuitive Surgical Inc.'s Margins Go Under the Knife

The top line of Intuitive Surgical 's third-quarter earnings report looked pretty good. Revenue was up 10% on the back of a 10% increase in the number of procedures performed on its machines. The company placed 111 da Vinci Surgical Systems, compared with 101 in the year-ago quarter, an increase of -- you guessed it -- 10%.

So where did gross profits come in? Not 10%. More like a measly 1% year-over-year increase.

Source: Intuitive Surgical.

Gross margin fell to 65.6% in the third quarter. Gross margins have been slipping steadily for the past few years, from 72.1% in 2012 to 70.4% in 2013, but the third quarter sets a new bottom, 1.6 percentage points lower than the second quarter. On a pro forma basis the drop was even worse, coming in at 2 percentage points.

Management blamed the lower margin on a variety of things, including the launch of the new da Vinci Xi system, recalls of its stapler and scope, and the buyout of its Japanese distributor. Fortunately, three-quarters of the 2-percentage-point pro forma quarter-over-quarter decline was non-recurring issues.

The average selling price for a system in the third quarter was $1.45 million, down from $1.5 million in the second quarter and $1.56 million in the year-ago quarter. To get da Vinci systems placed into hospitals, Intuitive Surgical has had to discount machines, especially in Europe, where hospitals are more cost sensitive. The decline in average selling price also reflects a greater number of trade-ins, which is to be expected with the launch of a new system.

Of the 111 systems sold in the third quarter, 59 of them were of the Xi variety, so there's still more room for adoption of the new product. The arms of the Xi can reach more of the body without repositioning the patient, which should drive new procedures.

As you'd expect from the stagnant gross profit and operating expenses that increased in proportion to revenue, income from operations fell year over year. On a non-GAAP basis, income from operations came in at $197 million, down 14% year over year.

Earnings per share looked even worse, down 21% year over year on a non-GAAP basis, but that's just because the year-ago quarter had a one-time tax benefit. Even with the decline, Intuitive Surgical beat analysts' earnings expectations, mostly because the sales were higher than expected.

All told, while it wasn't the best quarter on a gross-margin basis, Intuitive Surgical's business looks healthy from a revenue standpoint. With the solid increase in procedures, management was able to increase its procedure growth guidance for the year to between 8% and 9% from a previous guidance of 5% to 8%.

Those procedures will drive sales of instruments and eventually drive more system sales as time on a hospital's machines becomes limited.

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Brian Orelli has no position in any stocks mentioned. The Motley Fool recommends Intuitive Surgical. and owns shares of the company. Try any of our Foolish newsletter services free for 30 days . We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .

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