See Note 6 for a detailed discussion of SFAS 123(R).

Basic net income per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of common shares and dilutive potential common shares outstanding during the period. Dilutive potential common shares primarily consist of employee stock options.

Statement of Financial Accounting Standards No. 128, "Earnings per Share", requires that employee equity share options, non-vested shares and similar equity instruments granted by the Company be treated as potential common shares outstanding in computing diluted earnings per share. Diluted shares outstanding include the dilutive effect of in-the-money options which is calculated based on the average share price for each fiscal period using the treasury stock method. Under the treasury stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that the Company has not yet recognized upon the adoption of SFAS 123(R), and the amount of tax benefits that would be recorded in additional paid-in capital when the award becomes deductible are assumed to be used to repurchase shares.

The following table presents the computation of basic and diluted net income per share (in thousands, except per share data).

Employee stock options to purchase approximately 170,720 shares for the three months ended March 31, 2006 and approximately 439,000 shares for the three months ended March 31, 2005, respectively, were outstanding, but were not included in the computation of diluted earnings per share because the effect would have been antidilutive.

The following table summarizes the Company's investments which are all classified as available-for-sale (in thousands):

The following is a summary of the amortized cost and estimated fair value of investments at March 31, 2006, by maturity date (in thousands):

For the three months ended March 31, 2006 and 2005, no realized gains or losses were recognized on the sale of investments. As of March 31, 2006 and December 31, 2005, net unrealized losses of $1.6 million were included in accumulated other comprehensive income in the accompanying Condensed Consolidated Balance Sheets.

The following table provides details of selected balance sheet items (in thousands):

The components of comprehensive income are as follows (in thousands):

The components of accumulated other comprehensive loss are as follows (in thousands):

Effective January 1, 2006, the Company adopted SFAS 123(R) using the modified prospective transition method, which requires the measurement and recognition of compensation expense for all stock-based payment awards made to the Company's employees and directors including stock options and employee stock purchases.  The Company's financial statements as of and for the three months ended March 31, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, the Company's financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Stock-based compensation expense recognized is based on the value of the portion of stock-based payment awards that is ultimately expected to vest. Stock-based compensation expense recognized in the Company's Condensed Consolidated Statement of Operations during the three months ended March 31, 2006 included compensation expense for stock-based payment awards granted prior to, but not yet vested as of December 31, 2005, based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123, and compensation expense for the stock-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). In conjunction with the adoption of SFAS 123(R), the Company elected to attribute the value of stock-based compensation to expense using the straight-line method, which was previously used for its pro forma information required under SFAS 123. Stock-based compensation expense related to stock options and employee stock purchases was $5.1 million for the three months ended March 31, 2006. No stock-based compensation expense was recognized on stock options or employee stock purchases during the three months ended March 31, 2005.

The Company has several stock-based compensation plans (the "Plans") that are described in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2005. The Company, under the various equity plans, grants stock options for shares of common stock to employees and directors. In accordance with the Plans, the stated exercise price for non-qualified stock options shall not be less than 85 percent of the estimated fair market value of common stock on the date of grant. Incentive stock options may not be granted at less than 100 percent of the estimated fair market value of the common stock. The Plans provide that the options shall be exercisable over a period not to exceed ten years. The majority of options granted under the Plans vest over a period of four years. Certain options granted under the Plans vest over shorter periods. A total of 4.2 million shares of common stock were available for grant under the Plans as of March 31, 2006.

When the measurement date is certain, the fair value of each option grant is estimated on the date of grant using the Black-Scholes valuation model and the assumptions noted in the following table. The fair value of options granted were estimated at the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions, assuming no expected dividends:

Expected Term: The Company's expected term represents the weighted-average period that the Company's stock options are expected to be outstanding. The expected term is based on the observed and expected time to post-vesting exercise of options by employees. Beginning the third quarter of 2005, the Company began to use historical exercise patterns of previously granted options in relation to stock price movements to derive an employee behavioral pattern used to forecast expected exercise patterns.

Expected Volatility: Beginning the third quarter of 2005, the Company began to use a blend of historical volatility and market-based implied volatility. Market-based implied volatility is derived based on one-year traded options on the Company's common stock. The selection of the proportion of market-based volatility depends, among other things, on the availability of traded options on the Company's stock and term of such options. Due to sufficient volume of the traded options, during the three months ended March 31, 2006, the Company used, in accordance with SAB 107, 100% market-based implied volatility. During the three months ended March 31, 2005, the Company used 100% historical volatility.

Risk-Free Interest Rate: The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for the expected term of the option.

As stock-based compensation expense recognized in the Condensed Consolidated Statement of Operations for the three months ended March 31, 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based on historical experience. In the Company's pro forma information required under SFAS 123 for the periods prior to January 1, 2006, the Company accounted for forfeitures as they occurred.

The Company recorded $4.6 million of compensation expense relative to stock options for the quarter ended March 31, 2006 in accordance with SFAS 123(R).

A summary of stock option activity under the plans for the three months ended March 31, 2006 is presented as follows:

(1) The aggregate intrinsic value represents the total pre-tax intrinsic value, based on the Company's closing stock price of $118 as of March 31, 2006, which would have been received by the option holders had all option holders exercised their options as of that date.

During the three months ended March 31, 2006 and 2005, the aggregate intrinsic value of options exercised under our stock option plans was $12.6 million and $8.7 million, respectively, determined as of the date of option exercise.

As of March 31, 2006, there was $72.3 million of total unrecognized compensation expense related to non-vested stock options. This unrecognized compensation expense is expected to be recognized over a weighted average period of 3.4 years.

Under the Employee Stock Purchase Plan, eligible employees may select a rate of payroll deduction up to 15% of their eligible compensation subject to certain maximum purchase limitations. The duration for each offering period is twenty-four months long and is divided into four shorter purchase periods approximately six months in length. Offerings are concurrent. The purchase price of the shares under the offering is the lessor of 85% of the fair market value of the shares on the offering date or 85% of the fair market value of the shares on the purchase date. As of March 31, 2006, 392,367 shares were available for grant.

The Company accounts for the Employee Stock Purchase Plan as a compensatory plan and recorded compensation expense of $0.5 million for the quarter ended March 31, 2006 in accordance with SFAS 123(R).

The fair value of the option component of the Employee Stock Purchase Plan shares were estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:

As of March 31, 2006, there was $2.6 million of total unrecognized compensation costs related to employee stock purchases. This unrecognized compensation expense is expected to be recognized over a weighted average period of 1.27 years.

The effect of recording stock-based compensation expense for the three months ended March 31, 2006 is as follows:

Cash received from option exercises and employee stock purchase plans for the three-month periods ended March 31, 2006 and 2005, was $5.2 million and $5.4 million, respectively.

Prior to the adoption of SFAS 123(R), benefits of tax deductions in excess of recognized compensation expenses were reported as operating cash flows. SFAS 123(R) requires that they be recorded as a financing cash inflow rather than a reduction of taxes paid. For the three months ended March 31, 2006, there was no realized excess tax benefit generated from option exercises.

The following table illustrates the effect on reported net income and net income per share for the three months ended March 31, 2005 as if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based compensation (in thousands, except per share data):

As part of the process of preparing the Condensed Consolidated Financial Statements, the Company is required to estimate its income taxes in each of the jurisdictions in which it operates. This process involves estimating the current tax liability under the most recent tax laws and assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in the Condensed Consolidated Balance Sheets.

Income tax expense for the quarter ended March 31, 2006 was $9.5 million, or 39.6% of pre-tax income, compared to $0.5 million, or 5.5% of pre-tax income for the three months ended March 31, 2005. The effective tax rate for the first quarter of 2006 differs from the federal statutory rate primarily due to state income taxes. The effective tax rate for the first quarter of 2005 differs from the federal statutory rate primarily due to the utilization of net operating loss carryforwards for which there was full valuation allowance. In the fourth quarter of 2005, management concluded, based upon recent operating results, expectations of future taxable income, available carryforward periods, and other factors, that it is more likely than not that the Company will realize sufficient earnings to utilize deferred tax assets. Accordingly, the Company reversed the valuation allowance on the net deferred tax assets in the fourth quarter of 2005.

In this report, "Intuitive Surgical," "Intuitive," the "Company, " "we," "us," and "our" refer to Intuitive Surgical, Inc.

This management's discussion and analysis of financial condition as of March 31, 2006 and results of operations for the three months ended March 31, 2006 and March 31, 2005 should be read in conjunction with management's discussion and analysis of financial condition and results of operations included in our Annual Report on Form 10-K for the year ended December 31, 2005.

This report contains "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements relate to expectations concerning matters that are not historical facts. Words such as "projects," "believes," "anticipates," "plans," "expects," "intends" and similar words and expressions are intended to identify forward-looking statements. These forward-looking statements include, but are not limited to, statements related to our expected business, new product introductions, results of operations, future financial position, our ability to increase our revenues, the mix of our revenues between product and service revenues, our financing plans and capital requirements, our costs of revenue, our expenses, our potential tax assets or liabilities, the effect of recent accounting pronouncements, our investments, cash flows and our ability to finance operations from cash flows and similar matters and include statements based on current expectations, estimates, forecasts and projections about the economies and markets in which we operate and our beliefs and assumptions regarding these economies and markets.

These forward-looking statements are based on current expectations and involve known and unknown risks and uncertainties that may cause our actual results, operating performance or achievements to be materially different from those expressed or implied by the forward-looking statements. We believe that the expectations reflected in the forward-looking statements are reasonable but we cannot assure you that those expectations will prove to be correct. Factors that could cause or contribute to such differences include but are not limited to timing and success of product development and market acceptance of developed products, regulatory approvals, clearances and restrictions, guidelines and recommendations in the healthcare and patient communities, intellectual property positions and litigation, competition in the medical device industry and in the specific markets of surgery in which Intuitive Surgical operates, unanticipated manufacturing disruptions, delays in regulatory approvals of new manufacturing facilities or the inability to meet demand for products, charges for option expenses and other costs and other risk factors detailed in the Annual Report on Form 10-K for the fiscal year ended December 31, 2005 and other periodic filings with the Securities and Exchange Commission. All forward-looking statements are expressly qualified in their entirety by these factors and all related cautionary statements. We do not undertake any obligation to update any forward-looking statements.

Intuitive^®, da Vinci^®, da Vinci_®S^™, TilePro™, Solo Surgery™, EndoWrist^®, InSite^®, AESOP^®, HERMES^®, ZEUS^®, SOCRATES^™ and Navigator^™ are trademarks of Intuitive Surgical, Inc.

Products. We design, manufacture and market the da Vinci Surgical System, an advanced surgical system that we believe represents a new generation of surgery-the third generation. The da Vinci Surgical System consists of a surgeon's console, a patient-side cart, and a high performance vision system. The product line also includes proprietary "wristed" instruments and surgical accessories. The da Vinci Surgical System seamlessly translates the surgeon's natural hand movements on instrument controls at a console into corresponding micro-movements of instruments positioned inside the patient through small puncture incisions, or ports. We believe that the da Vinci Surgical System is the only commercially available technology that can provide the surgeon with the intuitive control, range of motion, fine tissue manipulation capability and 3-D visualization characteristic of open surgery, while simultaneously allowing the surgeons to work through the small ports of minimally invasive surgery, or MIS. By placing computer-enhanced technology between the surgeon and the patient, we believe that the da Vinci Surgical System enables surgeons to improve clinical outcomes while reducing the invasiveness of complex surgical procedures. The da Vinci Surgical System is sold into multiple surgical specialties, principally urology, cardiothoracic, general surgery, and gynecology.

Business Model. In our business model, we derive revenue from both the initial capital sales of da Vinci Surgical Systems as well as ongoing recurring revenue, comprised of instrument, accessory, service, and training revenue. We presently realize average revenue of between $1.1 million to $1.2 million per da Vinci Surgical System sold. We then generate recurring revenue as our customers purchase our EndoWrist instruments and accessory products for use in performing procedures with the da Vinci Surgical Sytstem. We generate additional recurring revenue from ongoing system service and customer training. We typically enter into service contracts, at an annual rate averaging between $100,000 to $140,000 per year, depending upon the configuration of the underlying system.

Since the introduction of the da Vinci Surgical System in 1999, our established base of da Vinci Surgical Systems has grown and robotic surgery volume has increased. Recurring revenue has grown at a faster rate than capital revenue. As our business matures, recurring revenue has comprised an increasing percentage of our overall revenue. Over the past four years, revenue generated from the sale of instruments, accessories, service and training increased from 22% of revenue in 2002 to 45% of revenue in 2005. Recurring revenue for the three months ended March 31, 2006 was $34.9 million, or 45% of total revenue. We expect recurring revenues to continue to increase as a percentage of total revenue.

Introduction. Intuitive Surgical experienced rapid growth during 2005 and through the first quarter of 2006. Our growth was driven by the continued adoption of the da Vinci Surgical System for use in urologic, cardiothoracic, gynecologic, and general surgeries. During the first quarter of 2006, we experienced sequential surgical procedure growth in all of our target surgical specialties compared to the fourth quarter of 2005, with the largest procedure growth coming in the urology and gynecology markets. The following events highlighted our first quarter of 2006.

Financial Highlights.

• Revenue grew 86% to $77.3 million from $41.6 million during the first quarter of 2005.
• Recurring instrument, accessory, service, and training revenue grew 72% to $34.9 million from $20.3 million during the first quarter of 2005.
• We sold 35 da Vinci Surgical Systems, an increase of 84% compared to 19 in the first quarter of 2005.
• We ended the quarter with an installed base of 428 da Vinci Surgical Systems, distributed as follows: 323 in North America, 77 in Europe, and 28 in the rest of the world.
• Gross profit margin improved to 66.9% from 65.6% during the first quarter of 2005.
• Operating income grew 144% to $21.7 million, or 28.2% of revenue from $8.9 million, or 21.5% of revenue during the first quarter of 2005.
• Cash, cash equivalents, and investments grew by $18.8 million from the fourth quarter 2005, as we ended the first quarter of 2006 with $221.5 million in cash, cash equivalents, and investments.

Stock Option Compensation. During the first quarter of 2006, in accordance with SFAS 123(R), we began to record stock compensation expense to reflect the estimated value of stock options and stock purchase plan shares issued to our employees. The total first quarter of 2006 stock compensation expense was $5.1 million, of which $0.8 million was charged to cost of revenue, $3.2 million to SG&A expense, and $1.1 million to R&D. We also ended the quarter with $0.2 million of stock compensation cost capitalized in inventory and fixed assets. Stock option expenses are entirely non-cash in nature.

Income Tax Expense. As anticipated, during the first quarter of 2006, we moved to reporting income on a fully-taxed basis. We recorded income tax at an effective rate of 39.6% for the quarter, compared to a nominal effective rate of 5.5% for the first quarter of 2005. Although the company has moved to fully taxed reporting, we anticipate that only a small portion of our 2006 reported tax expense will result in cash outlay, due to our anticipated utilization of net operating loss carry forwards and deductions for stock option exercises.

Regulatory Clearances. We have obtained all of the clearances required to market our products to all of our currently targeted specialties within the United States. The following table lists chronologically our FDA clearances to date:

• July 2000 - General laparoscopic procedures
• March 2001 - Non-cardiac thoracoscopic procedures
• May 2001 - Prostatectomy procedures
• November 2002 - Cardiotomy procedures
• July 2004 - Cardiac revascularization procedures
• March 2005 - Urologic surgical procedures
• April 2005 - Gynecologic surgical procedures
• June 2005 - Pediatric surgical procedures

The following table sets forth, for the periods indicated, certain Condensed Consolidated Statement of Operations information (in thousands):