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Executives

Sheree Aronson

Joe E. Kiani - Founder, Chairman and Chief Executive Officer

Mark P. de Raad - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Corporate Secretary

Analysts

William R. Quirk - Piper Jaffray Companies, Research Division

Joanne K. Wuensch - BMO Capital Markets U.S.

Brian Weinstein - William Blair & Company L.L.C., Research Division

Matthew Dolan - Roth Capital Partners, LLC, Research Division

Ben C. Haynor - Feltl and Company, Inc., Research Division

Lennox Ketner - BofA Merrill Lynch, Research Division

Masimo (MASI) Q4 2012 Earnings Call February 14, 2013 4:30 PM ET

Operator

Good afternoon, ladies and gentlemen, and welcome to Masimo's Fourth Quarter 2012 Earnings Conference Call. The company's press release is available at www.masimo.com. [Operator Instructions] I'm pleased to introduce Sheree Aronson, Masimo's Vice President and Investor Relations.

Sheree Aronson

Hello, everyone. Joining me are Chairman and CEO, Joe Kiani; and Executive Vice President of Finance and CFO, Mark de Raad. This call will contain forward-looking statements, which reflect Masimo's best current judgment. However, they are subject to risks and uncertainties that could cause actual results to differ materially. Risk factors that could cause our actual results to differ materially from our projections and forecasts are discussed in detail in our SEC filings, including our most recent Form 10-Q and the Form 10-K to be filed later today. You will find these in the Investor section of our website.

I will now pass the call to Joe Kiani.

Joe E. Kiani

Thank you, Sheree. Well, first, let me wish everybody a Happy Valentine's Day. Thank you for joining us and becoming our Valentine. We are very happy with our progress, and while we always wish for more and we hope to deliver more, we're happy to be sharing with you our progress in 2012 and talk about our plans in 2013.

And as they say, love is in the eye of the beholder, so we hope you will enjoy what you're hearing. So good afternoon, and thank you for joining us for a financial and strategic update on Masimo.

We delivered a strong finish to 2012 in many respects, including a 20% rise in the fourth quarter product revenue, a 31% constant currency increase in fourth quarter international revenue, fueled by strengths in nearly every outside U.S. region, especially Europe, Middle East and Africa, Japan and the rest of Asia.

We also experienced a 24% rise in fourth quarter driver shipments, bringing 2012 drivers shipments to 146,000 and expanding our global installed base by a net of 11% to 1.09 million units.

And we saw a 13% rise in year-over-year earnings per share, finishing the fourth quarter at $0.26 a share, compared to $0.23 a share in the prior year period.

During the quarter, foreign currency losses and inability to benefit from a 2012 federal research tax credit as we had planned, will reduce fourth quarter EPS by $0.03.

During 2012, we generated approximately $75 million in operating cash flow, which, along with our strong balance sheet, allowed us to complete 2 strategic acquisitions, repurchase $26 million in Masimo stock and paid a $57 million dividend to stockholders in December 2012.

And today, we announced that the board has authorized the repurchase of up to 6 million shares of our common stock during the next 3 [ph] years, underscoring our confidence and the power of our technology platform, global franchise and business model to take full advantage of our growth potential over the long term.

We've entered 2013 fully focused on advancing our strategy, which is to grow our core set business by increasing our presence in Critical Care and the general ward while leveraging our Rainbow platform to pursue new opportunities in and beyond the hospital and continuing to execute on our long-term plan.

I'll discuss our 2013 plans in a few minutes. But first, Mark will review fourth quarter and full year 2012 financial performance and provide 2013 financial guidance. Mark?

Mark P. de Raad

Thank you, Joe. Hello, everybody. Fourth quarter 2012 product revenue was $125.3 million, up 20% versus the fourth quarter of 2011, due primarily to strong growth in our SET pulse oximetry sales to hospital customers and growth in international markets.

Fourth quarter product revenue included approximately $1 million in revenue from Masimo Semiconductor, which we acquired in March 2012; and $2.8 million of revenue from PHASEIN, which we acquired in July 2012.

Excluding these, total product revenue rose 16% versus the year-ago period. Movements in foreign exchange rates reduced fourth quarter 2012 product revenue as compared to the prior year quarter by approximately $800,000.

Rainbow product revenue grew 13% in the fourth quarter to $11.1 million. The growth reflects primarily increased licensing and consumable sales, primarily related to our SpHb and RAM technology. Total hemoglobin sales rose 8%, and RAM sales rose nearly 300% in the fourth quarter versus the year-ago period. Although we achieved near-record quarterly total rainbow revenues, the quarter was slightly less than we expected due to a large international order, which was delayed into the first half of 2013 and lower-than-expected revenue from our U.S. physician office distribution channel.

Our worldwide end-user or direct business, which includes sales through just-in-time distributors, grew 18% in the fourth quarter to $106.8 million versus $90.2 million in the year-ago period. Our direct business, representing 80 -- represented 85% of total product revenue in the quarter versus 86% 1 year ago.

OEM sales, which made up the remaining 15%, rose 28% to $18.5 million, compared to $14.5 million in the same period of 2011. Excluding the impact of acquisitions in 2012, our direct and OEM businesses grew 17% and 12%, respectively, in the fourth quarter.

By geography, total U.S. product revenue rose 16% to $84.4 million in the fourth quarter, compared to $72.9 million in the same quarter of 2011. Additional hospitals gained during the year and higher consumable sales drove this growth.

Product revenue outside the U.S. totaled $40.9 million, up 29% or as Joe mentioned, 31% on a constant currency basis, compared to $31.8 million in the same period last year. The increase reflects solid double-digit growth across all major international regions, especially, as Joe noted again, in Japan, EMEA and the rest of Asia.

In fact, international product revenue hit a new all-time high in the fourth quarter, representing 33% of total product revenue, compared to 30% in the fourth quarter of 2011.

Our fourth quarter product gross profit margin was 64.1%, compared to 63% 1 year ago. Our 2012 acquisitions combined to reduce fourth quarter 2012 product gross margin by approximately 180 basis points. In addition, the ongoing incremental cost of our X-Cal technology reduced fourth quarter 2012 product gross margins by an additional 130 basis points when compared to the year-ago period.

Therefore, excluding the impact of 2012 acquisitions and X-Cal, our year-over-year fourth quarter product gross margin would have been approximately 310 basis points higher or 67.2%, which, at least on a pro forma basis, would've resulted in the highest quarterly product gross profit margin in our history.

Throughout 2012, we have noted the negative gross profit margin impact of these items so that the offsetting positive results from our product cost reduction efforts could be recognized. These efforts, which we began discussing in late 2012, began to turn into realized benefits and -- excuse me, which we began discussing in 2011 began to turn into realized benefits in 2012, and have included improved manufacturing processes, supply-chain efficiencies and other cost improvement initiatives.

Our fourth quarter total gross profit margin, including royalties, was 66%, compared to 65.5% in the same period last year. Fourth quarter 2012 operating expenses were $64.9 million, up 21% from $53.5 million in the fourth quarter of 2012.

Excluding the impact of 2012 acquisitions, operating expenses rose 17%. SG&A expenses increased $7.6 million or 17% to $51.6 million in the fourth quarter compared to the year-ago period.

Excluding the impact of 2012 acquisitions, SG&A expenses increased 14%, due primarily to higher staffing levels as well as higher year-over-year legal, marketing and trade show expenses.

Total R&D spending rose 39% in the fourth quarter to $13.3 million from $9.6 million in the year-ago period. Again, excluding the impact of 2012 acquisitions, R&D expense rose 32%, due primarily to higher staffing levels and engineering project expenses associated with the large number of new product initiatives, such as ROOT, iSpO2, Universal ReSposable sensors, SpfO2, the SuperSensor, new SpHb sensors and additional products yet to be announced.

In total, our R&D spending was approximately 10% for the fourth quarter 2012 total revenues.

Fourth quarter 2012 operating income was $22.3 million, up 11%, compared to $20.1 million in the year-ago period. Excluding the impact of 2012 acquisitions, operating income was approximately $24.3 million, which would've been up 21%.

Nonoperating expense was $1.3 million in the fourth quarter, compared to $468,000 in the year-ago period. The increase reflects the recognition of realized and unrealized losses on foreign currency-denominated transactions, due almost entirely to the late Q4 2012 strengthening of the U.S. dollar against the Japanese Yen.

Our fourth quarter 2012 effective tax rate was 29.3%, compared to 27.7% in the same period last year. The increase was due primarily to the suspension of the federal research tax credit in 2012. In early January 2013, this tax credit was extended retroactively to 2012 and prospectively through the end of 2013. Because this extension occurred in 2013, we were unable to recognize the benefit in 2012 but will recognize the full year 2012 benefit in the first quarter of 2013.

Had the federal research tax credit been reinstated before our fiscal year end, as we expected, our fourth quarter 2012 effective tax rate would have been 24.6%, reflecting the full 2012 R&D tax benefit in the fourth quarter.

Fourth quarter 2012 net income was $15 million or $0.26 per diluted share, compared to $13.8 million or $0.23 per diluted share in the same period last year. As Joe mentioned at the outset, higher FX-related nonoperating expense and the inability to benefit as we had expected from the 2012 R&D tax credit combined to reduce fourth quarter EPS by $0.03.

In addition, and as expected, our fourth quarter 2012 results included a $0.03 per share loss attributable to the 2012 acquisitions.

In the interest of time, I'll abbreviate my review of 2012 results and direct you to today's press releases and the Form 10-K, which will be filed later today for more information.

In 2012, total revenue rose 12% to $493.2 million, including product revenue of $464.9 million, up 14% versus 2011 or 15% on a constant currency basis. Excluding 2012 acquisitions, product revenue grew 13%. Total 2012 royalty revenues declined from $32.5 million to $28.3 million as a result of a decline in the royalty rates.

Product gross profit margin was 64.1% in 2012, down slightly from 64.4% in 2011, reflecting primarily the negative impact of X-Cal and the lower gross margin models of the businesses we acquired in 2012.

Operating expenses totaled $241 million, up 16% from the $207.6 million in the prior year period due to the impact of the 2012 M&A activity, higher staffing levels and increased marketing and legal expenses.

Excluding M&A activity, total operating expenses increased 14%. The 2012 tax rate was 26.1%, relatively flat with 26% in the prior year period. Net income for 2012 was $62.3 million or $1.07 per diluted share, compared to $63.7 million or $1.05 per diluted share in 2011.

As expected and discussed throughout the year, our 2012 acquisitions reduced full year 2012 EPS by approximately $0.06. In addition, the primarily Q4 2012 FX-related nonoperating expense, and once again, the inability to benefit from the extension of the R&D tax credit in 2012, reduced our total 2012 EPS by another $0.03.

As of December 29, 2012, our DSO was 49 versus 50 in the year-ago period. Over the same period, inventory turns rose slightly from 3.4% to 3.8%, in fact, marking the highest level of inventory turns since early 2007.

Total cash and cash investments as of December 29, 2012 were $71.6 million, compared to $129.9 million as of December 31, 2011. The change reflects, primarily, net cash generated from operations, offset by $7.2 million in cash used to purchase the assets of Spire Semiconductor in Q1 2012, $26.2 million in cash used to repurchase shares of our common stock in the first half of 2012, $30.4 million used to purchase PHASEIN in Q3 2012 and $57.3 million used to pay a $1 per share dividend to stockholders in Q4 2012.

Now I'll turn to our 2013 guidance, which is based on the best information we have available to us and, in general, assumes no significant changes to the worldwide macroeconomic environment or to the environment in which our primary customers, hospitals, operate. Also, these projections assume certain FX rate assumptions at the start of the year and to the extent these differ significantly from the actual exchange rates, our guidance could be impacted.

So with those caveats, we are projecting 2013 total revenue of $548 million, including product revenue of $520 million and royalty revenue of $28 million. Included within this $520 million in product revenue, we are projecting Rainbow revenues of $50 million.

We expect our 2013 product gross profit margin to be approximately 64.5%, reflected -- reflecting a continuation of our gross profit margin expansion efforts, offset by the full year negative product gross profit margin impact of the businesses that we acquired in 2012.

We expect our core operating expenses to be approximately $265 million, also including the full year operating expense impact of our 2012 acquisitions and the incremental costs associated with the buildout of a new SpHb-dedicated sales force, which Joe will discuss in more detail later.

In addition, we're projecting an estimated medical device tax of approximately $6.5 million, which we intend to report in SG&A expense. Therefore, including the medical device tax, our total 2013 operating expenses are expected to be approximately $271.5 million.

We expect our 2013 effective tax rate to be approximately 28%, which includes the benefit of the retroactive 2012 and prospective 2013 benefits of the federal research tax credit, offset by a slightly less favorable U.S. o U.S. operating income mix.

As a side note, as a result of the 2012 R&D tax credit being a discrete Q1 2013 item, we expect our Q1 2013 effective tax rate to be approximately 24% to 25%, while each of the other quarters should be approximately 28% to 29%.

As previously noted, we are assuming constant FX rates during the year and as a result, are not projecting or attempting to forecast any foreign exchange gains or losses within our 2013 nonoperating expenses.

As a result of these assumptions, we are now projecting 2013 GAAP earnings per share of $1.13 based on approximately 59 million weighted shares. Unfortunately, as we've discussed in the past, our $6.5 million in 2013 medical device tax projection will have the effect of reducing our 2013 EPS guidance by approximately $0.08 per share. Of course, the total amount of shares outstanding could be lower based upon the impact of the stock repurchase program that we announced today. With that...

Joe E. Kiani

Thank you. I think, Mark, you said that $1.13 instead of $1.14.

Mark P. de Raad

Excuse me, yes, you're right. $1.14 should be the 2013 GAAP earnings per share. Yes.

Joe E. Kiani

Thank you, Mark. We've laid out our 2013 financial guidance with confidence in the tremendous potential of our technology platform to drive meaningful sales growth and margin expansion over the long term and with the belief that targeted investments are essential now to achieve our goals.

Our 2013 plans will focus on 4 key priorities: Achieve continued above-market growth in the worldwide pulse oximetry and emerging general ward monitoring markets; capitalize on SpHb's potential to dramatically lower hospital's blood management costs and save lives; expand our presence in non-hospital markets; and heighten our R&D focus on existing growth drivers.

As you can see from our fourth quarter and full year performance, demand for the superior clinical performance of Masimo's Measure-Through Motion and low perfusion pulse oximetry technology remains strong. Staying the course for future growth, we also continued to renew our partnerships with existing hospitals while converting new ones to Masimo throughout 2012.

So the notable 2012 additions include Yale New Haven Health System; Cleveland Clinic System; Seattle Children's Hospital; Great Ormond Street Hospital in London; King Fahd Medical Center in Saudi Arabia; and Charité, the largest university hospital in Europe; and Erasmus, the largest medical center in The Netherlands.

Our expanding presence through 2012 was also underscored by the pace of our 2012 new driver shipments, which exceeded 145,000 for the third year in a row. We expect the trend to continue with driver shipments targeted to be above 150,000 for 2013.

Contributing to this growth is the movement of continuous patient monitoring beyond Critical Care and onto the general ward, especially for patients receiving opioids and at increased risk of respiratory depression. Masimo is uniquely positioned to help hospitals reduce avoidable, adverse events through implementation of our breakthrough Masimo SET pulse oximetry and Patient SafetyNet systems that facilitate patients' safety.

We offer the only general ward monitoring solutions shown to help clinicians improve outcomes, let alone also lowering costs, an advantage that helped us grow 2012 sales of our Patient SafetyNet remote monitoring system by 50% compared to 2011.

Moreover, we continue to see an increasing number of our long-term sensor contract bookings, include some component of general ward monitoring with Patient SafetyNet. In conjunction with Patient SafetyNet growth, the adoption of Masimo RAM or respiratory rate from acoustic sensor, RRa, is also on the rise. In 2012, RRa revenues, albeit from humble beginnings, rose more than 300%.

Used to detect respiratory depression by non-invasively and continuously monitoring a patient's respiration rate with a sensor that's been attached on the neck, RRa is easy for clinicians to administer and has been shown in independent studies to be well tolerated by patients and as accurate as capnography.

In 2012, we broadened our ventilation monitoring offering with the PHASEIN acquisition, which complements our RAM technology, RRa, with a full range of, not just ventilation monitoring options with capnography, but gas and anaesthetic patient monitoring for our customers.

Turning now to SpHb. On our plan to capitalize on SpHb's potential to lower blood costs and save lives, SpHb is a revolutionary technology that provides continuous realtime hemoglobin trending and identifies significant changes in hemoglobin levels. It has been shown to help clinicians reduce transfusions, detect occult bleeding and lower hospital blood costs.

Since the debut of SpHb in 2008, we have been working to build the market through our global Acute Care sales organization, which had sales responsibility for all Masimo products used in hospitals. Given the expanding awareness of the risks and the costs associated with unnecessary blood transfusions and occult bleeding, as well as the favorable reaction we're getting from clinicians, we believe the time has come to make a more focused push to establish SpHb as a standard of care measurement by investing in the creation of an SpHb-dedicated sales and clinical specialist team.

Therefore, as we have previously suggested, we have already begun to build out a new SpHb blood management sale and clinical team that will eventually include nearly 60 people throughout the world. The team's singular focus will be to drive awareness of SpHb's compelling value proposition to hospitals and grow adoption among current and prospective hospital customers.

This heightened sales focus complements our continuing efforts to refine the SpHb technology. We won't stop refining it until it is as good as our SET pulse oximetry. And buildout of this new SpHb sales team now also ensures we have it in place by early 2014, when we anticipate a significant increase in the number of Rainbow OEM partners and SpHb products coming available.

Leading the new SpHb sales and support team will be Rick Fishel, a proven sales and business development executive with 10 years of senior level experience at Masimo. As President of Worldwide OEM business and Corporate Development, Rick has played the principal role in establishing rainbow OEM partnerships with leading patient marketing companies.

Under Rick's leadership, we have continued to increase the number of OEMs who are currently selling or are planning to introduce rainbow-enabled multi-parameter monitors to the global market. At year-end 2012, more than 40 OEMs had active rainbow integration efforts in place, including 17 with release products.

Recall that roughly 70% to 80% of our drivers into the market is part of an OEM's multi-parameter device, which makes conversions of the OEM community to rainbow SET technology an essential component of our SpHb growth strategy.

Jon Coleman will be running the rest of the worldwide sales marketing and clinical research team. Rick and Jon will be working closely to maximize Masimo's overall potential.

The use of SpHb monitoring to help clinicians make optimal transfusion decisions was underscored again recently with the new award-winning study, which is the first to report the impact of SpHb in high blood loss surgery. Doctors at Cairo University in Egypt conducted a prospective cohort study in 106 neurosurgery patients and found that SpHb monitoring helped clinicians achieve a 56% reduction in the frequency of multi-unit RBC transfusions and a 47% reduction in average number of RBC, which is red blood cell, units transfused.

Moreover, once clinicians determine transfusion was needed, they were able to initiate transfusion 82% faster using SpHb monitoring. The researchers estimated that SpHb monitoring could save roughly $470,000 to $1 million per 1,000 surgeries performed.

These compelling results complement the previous Mass General Hospital's study of 327 lower blood loss orthopedic surgery patients, which also showed that SpHb monitoring helped clinicians reduce red blood cell transfusion frequency and average red blood cell units per patients by nearly 90%.

To help hospitals reduce the risks and costs associated with validating SpHb's ability to lower their blood costs, we offer the "Better Care" guarantee. For hospitals that replace their pulse oximetry adhesive sensors with Masimo ReSposable Rainbow Pulse CO-Oximetry sensors, we guarantee that their blood transfusion-related savings will exceed the incremental cost of the ReSposable Sensors or we will refund the difference.

Thus far, we have secured accounts related to Better Care Program at hospitals in Japan, Holland and in the U.S., including the fourth quarter addition of UCLA, which is in our own backyard.

Encouragingly, we have continued to increase the number of customers with whom we are discussing either the implementation of a Better Care Program or in some cases, just moving directly into the actual purchase and deployment of SpHb technology with the operating room, recovery room intensive care unit, and other critical care areas of the hospital.

We also made progress in our plans to expand our presence in non-hospital settings with news that Libya will become the first country to begin using the Pronto-7 to screen potential blood donors for low hemoglobin levels in all of its major blood donation centers. We see the blood donation market as a key opportunity for the Pronto-7, which provides quick, noninvasive spot-check hemoglobin, SpO2, pulse rate and perfusion index measurement.

In order to enter the U.S. blood donation market, we are pursuing specific regulatory clearance from the FDA Center for Biologics Evaluation and Research. We also continue to work with major U.S. distributors, PSS World Medical and Henry Schein, to penetrate the physician practice market. We are unhappy with their initial results and, as a result, have reiterated our performance expectations to them. We will be monitoring this carefully over the first half of 2013.

Finally, we were happy with the response in our new iSpO2 that -- at the Consumer Electronics Show in Las Vegas last month. Indeed, for aviation -- intended for aviation and sports use, the iSpO2 is a commercially available consumer pulse oximeter for the iPhone, iPad or iPod Touch. It includes our board-in-cable technology, which is a SET technology and downloadable app, which also lets consumers trend measurement and e-mail trend data.

Innovation is the central Masimo competency. Our track record of introducing first-ever technologies has earned us a reputation as the industry's innovation leader. In 2013, we will continue to invest approximately 10% of our total revenue in research and development.

Later this year, for example, we will introduce ROOT, our new open architecture connectivity-based platform that includes a radical docking station with large touchscreen display, rich connectivity options and additional ports for other sensors.

I'll close by saying that few companies had a base business that is as sticky as ours and still grows by double digits. And probably, even fewer companies have growth potential within their existing product portfolio that could rival Masimo's opportunity.

Today, we have a robust global franchise deploying breakthrough technologies that are helping clinicians improve patient care, save lives and reduce costs. With the proper support in the market, I know our technologies are capable of having an enormous impact over time on patient safety and the practice of medicine.

I am confident that we are making the correct and necessary investments now, including creation of a global SpHb-dedicated sales team, to ensure we realize our potential and also achieve our long-term financial goals.

Beginning in 2014, we expect our SpHb and clinical support team to be largely in place, and accordingly, we expect to begin to deliver higher levels of operating leverage.

We've come a long way since our IPO 5 years ago, and we look towards -- we look forward to reporting our progress as we execute the second half of our long-term plan over the next 5 years. We are optimistic it will be an exciting and rewarding journey.

With that, I'll open the call to questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Bill Quirk with Piper Jaffray.

William R. Quirk - Piper Jaffray Companies, Research Division

So first question is regarding rainbow, I guess, specifically thinking about the rainbow guidance, we're looking at effectively an acceleration in over the fourth quarter's performance. And so help us think a little bit, guys, how -- I guess, what would drive that? And perhaps, folding into this discussion, maybe can you just expand on your comments regarding Pronto and how do you accelerate that?

Joe E. Kiani

Thank you, Bill. I think it's a combination of factors, including a dedicated sales force for hemoglobin, including a customer base that has begun using our technology in a wider way some "Better Care" accounts that we'll start implementing. And some of them will be able to measure the cost savings within the fiscal year so that we can hopefully recognize the additional revenues from rainbow. So I think it's a combination of things, and we're hoping to meet and maybe even beat the number.

William R. Quirk - Piper Jaffray Companies, Research Division

So Joe, should we read that to mean then with the exception of the larger order that we should see in the first quarter, I guess, the move from the fourth to the first, that the business should essentially accelerate over the years? Is that the right way to think about the pacing?

Joe E. Kiani

Yes. And just to correct you, we think the business actually happened in the second quarter that we lost in the fourth quarter. It didn't just slip in one quarter, it slipped into the second quarter. So it should happen the first half, maybe in the first quarter. But right now, we're expecting it actually in April timeframe. So having said that, yes. That's what we're expecting. We think acceleration will happen in the fourth quarter, somewhat in the third. But given that the third quarter is usually, because of the vacation season, kind of takes a dip, I'm not sure how much of it you will witness then. But we really think we a nice fourth quarter ramp.

William R. Quirk - Piper Jaffray Companies, Research Division

Okay, got it. And then perhaps, Joe, you could just talk a little bit about Pronto. And I guess, specifically, I guess, I'm thinking more of your feedback from your partners, what are they telling you in terms of the uptake? And why isn't it going faster then perhaps you initially expected?

Joe E. Kiani

Sure. With Pronto and Pronto-7, one of the things we expected, we expected the sales force of our distribution partners to be proactively selling it, given the discussions and the contracts we have. And what we had witnessed in the first 2 quarters of doing business with them, they really were not doing that. And in some ways, were even impeding our sales process because we're no longer selling direct. So I've had discussions with the senior management people at both of these organizations. And we want to be patient, hoping that it's just the learning curve issue, especially given that PSS went through an acquisition that has some distractions. But our patience is not going to be forever, and if we don't get to the targets that we had all established, then we're going to have to make some changes. Now we don't want to get rid of our distributors, but we may agree to sell in parallel with them. Now that's the change that may come if we don't get to the results that we hope to get to without that effort.

William R. Quirk - Piper Jaffray Companies, Research Division

Understood. And then last one for me and I'll jump back to the queue. Mark, can you talk about the 2013 earnings guidance as it relates to the buyback? What does it assume there about the pacing of that?

Mark P. de Raad

Sure. I think, as I mentioned, that current assumption is a weighted average of about 59 million shares, which, given where we are at the end of the fourth quarter, essentially does not include any specific assumptions of stock repurchase. So given the announcement we made today and, of course, depending upon those purchases, that number could obviously move down throughout the year. But since we've not committed to any specific time frame for those purchases because most stock repurchase programs stipulate, we'll do it when market conditions are appropriate, we didn't feel it was appropriate to include some of those assumptions in that EPS guidance number.

Operator

Your next question comes from the line of Joanne Wuensch with BMO Capital Markets.

Joanne K. Wuensch - BMO Capital Markets U.S.

Let's talk a little bit about X-Cal technology and how that's going to help your gross margins increase next year. Maybe I should reword it differently. What is helping you increase your gross margins next year?

Joe E. Kiani

Well, the X-Cal, you're right, does not increase the gross margin. What it should do is increase the user perception of our products and minimize some of the knock-off business that happens around the globe because of generic sensors being sold to our installed base and so forth. But the cost reductions come from a line of initiative that have begun several years ago, but we expect to see benefits from, continuing throughout this year. In fact, we did see some of it last year, but even throughout 2014 and 2015. We are putting a lot of emphasis in our engineering team working on redesigns of products to redesigns of manufacturing equipment to better manufacture products at a higher efficiency.

Joanne K. Wuensch - BMO Capital Markets U.S.

Okay. And is this more a back-end loaded thing or should we be able to see a slow ramp throughout the year as your engineering pieces of the puzzle go into place?

Joe E. Kiani

Joanne, I think from a projections stand, probably a slow ramp is the right way to think about it, given the 64.1% that we ended the fourth quarter with. So a number probably somewhere in the 64% to 64.5% range for the first half of the year and then 64.5% to 65% would probably the right range for the back end of the year, with the overall blend being at that 64.5%.

Joanne K. Wuensch - BMO Capital Markets U.S.

Okay. And then a lot of people have asked me what might happen to your business with healthcare reform. And do you have a view on that?

Joe E. Kiani

Yes. I think healthcare reform, is going to have some snakes as well some ladders. I think, the ladders, I think as hospitals turn from independent hospitals to more to these accountable care organizations, which eventually will be, in our opinion, maybe hundreds of Kaisers, hundreds of Kaisers instead of 5,000 independent hospitals and several Kaisers, the ownership of the quality and the safety of the patients will mean a lot to these customers. So we believe our technologies and products for long-term view customers is ideal. So we think that will help create more traction for our solutions. On the negative, of course, we don't expect the medical device tax to be negative, which we're trying to suck up as best we can through cost-cutting measures and instead of layoffs and things like that and some of it unfortunately translates to our bottom line as well. So that's a definite negative. And then the other, I think, negative is that we don't anticipate additional procedures and therefore, sensor volume from the hospitals because of the increase in the patient population. So if we're fortunate, the volume will stay steady for our product but potentially slightly going down because of what we experienced in Massachusetts. In Massachusetts, when looked at what happened before and after their Affordable Care Act, our growth rate in Massachusetts was less than the neighboring 5 states. So if that was to be a gauge of what could happen, it could mean lower volume for some of our products, and like the disposable products, that is. And I want to emphasize not lower than where they are today, lower than what they could be without the change. So -- but what Massachusetts didn't have to go through is the accountable care organization. So that's the wildcard which is to see in that mode will the volume actually be less than what we'd like to see over the next 5 years.

Operator

Your next question comes from the line of Brian Weinstein with William Blair.

Brian Weinstein - William Blair & Company L.L.C., Research Division

Question is on the SpHb sales force. Can you maybe talk specifically about what they're going to be doing differently than what your reps were doing today? Is it a different call point, is it a different -- just a different level of focus? What's -- what are the specific changes that you're going to see from that sales force versus what your reps are already doing?

Joe E. Kiani

Well, focus. I think, really, the call points will be mostly the same, although there's a higher [indiscernible] pull for SpHb than there is for SpO2 or pulse oximetry business. So it'll be somewhere at that. But really, it's just a focus, Brian. When you have a sales force that has the responsibility of hospital-wide conversions, of Patient SafetyNet into the hospitals that have it right now, and new hospitals are getting -- and you put on top of that, hemoglobin. I think what will happen, they'll go towards whatever is easier instead of going and doing the pioneering work, the missionary work, which you have to do with a new technology that promises to improve the standard of care.

Brian Weinstein - William Blair & Company L.L.C., Research Division

Okay. And then on the general floor opportunity there, how do you measure progress here? How can we measure the progress there? Do you have any idea in terms of where driver placements are going, so the 150,000 next year, how we should think about what percent might be going into more of a general floor opportunity versus the Critical Care? And what the contribution can be from that?

Joe E. Kiani

Sure. First of all, on the 150,000 drivers, we're assuming a very small, like 2%, 3% of the drivers to be from the general ward market opportunity. And we do track those through installation of Patient SafetyNet and monitors that are connected to it. But that's going off of a growth rate that we've seen in the recent past but doesn't take into account what happens when the wall really falls down. APSF, which is the Anesthesia Patient Safety Foundation, for a few years, has been recommending continuous monitoring of patients on the postsurgical general floor beds. And the traction is happening but still is being resisted by people who are worried about costs and worried about monitoring. But J-Co, this last summer, also issued their recommendation for monitoring of patients postsurgically. So we see a tremendous push to make that a reality. So when that happens -- we don't know exactly when that dam will break, the general ward market is actually bigger than the Critical Care market. We estimate in the U.S., for example, there are about 120,000, 150,000 Critical Care beds, including the OR, recovery room and the ICU. But there's at least 450,000 general floor beds. So even if the 1/3 or half of them began to do continues monitoring, which, frankly, eventually we believe all of them will, you'll see a much, much bigger driver of growth than what we're projecting.

Operator

[Operator Instructions] Our next question comes from the line of Matt Dolan with Roth Capital Partners.

Matthew Dolan - Roth Capital Partners, LLC, Research Division

I wanted to follow up on the rainbow topic and maybe approach it from a different angle. You were able to add more than $10 million to that business last year in 2012. So I'm curious what's embedded into your assumptions for, let's call it, only a $10 million increase in 2013? Joe, I think you mentioned, you hope that maybe you can beat that. So I'm trying to understand with Pronto-7 and this new hemoglobin initiative, what's included in that $50 million target?

Joe E. Kiani

Well, first of all, if my memory serves me right, Mark, please correct me, I think we grew from $34 million to $41 million. So we grew by...

Mark P. de Raad

$40 million.

Joe E. Kiani

$40 million. So we grew by about $6 million and not the $10 million. So we are expecting to grow faster than last year, so we're expecting, now, to grow by $10 million, as you put it. But in addition, I'm pretending I'm the new CEO of Masimo and I get to reset expectations. So I'm trying to set expectations so that we can hopefully not meet but beat. So I might have to eat these words, but that's what this forecast is. It's a conservative forecast and hopes to meet and beat.

Matthew Dolan - Roth Capital Partners, LLC, Research Division

Okay, great. And you also mentioned leverage in your prepared remarks. And if we adjust out some of the issues in 2012, we're not seeing a ton on the earnings side. I know you have the medical device tax in your face, but maybe just walk -- and I know you have the investment of the hemoglobin group. Can you walk through the pacing of those investments and then layer in your thoughts on how leverage expands once this investment year is past?

Joe E. Kiani

Sure, Matt. I think, as you pointed out, a part of what's embedded in our 2013 total operating expense guidance is what I would refer to as sort of the continuing incremental cost of the M&A activity that we kicked off in 2012 because, obviously, those acquisitions were done in different periods throughout the year. So this year, we, of course, have the full year impact of those additional operating expenses. So those are an incremental part of our year-over-year growth in operating expenses. As you pointed out, we also have now the incremental SpHb sales management team cost that we've got layered into that projection. And so in reality, when you back those 2 incremental expenses out, the overall true net operating expense increase for Masimo next year, again, excluding those 2 variables, is actually back in the single digits. So while it's not clearly apparent this year because we do have those 2 other contra expense items, there is some underlying operational benefit that we're beginning to build into the model this year. And as Joe suggested earlier, we think they're setting the stage for even better operating leverage performance in 2014 and beyond.

Matthew Dolan - Roth Capital Partners, LLC, Research Division

And Mark, just to sneak one more, did you give what the core growth rate was, stripping acquisitions out in '12 and can you tell me what the product revenue guidance implies in terms of core growth?

Mark P. de Raad

We didn't, but we can suggest that it is in the range of about 10% or so if you look at the core of Masimo SET product revenue growth, excluding the impact of the acquisitions as the benefits of those acquisitions roll into 2013.

Operator

Your next question comes from line of Ben Haynor with Feltl and Company.

Ben C. Haynor - Feltl and Company, Inc., Research Division

Now how quickly do you think you'll be able to add those 60 people on the SpHb side of things?

Mark P. de Raad

We actually think that's going to be rather quick. As Joe alluded to, we began this process in the fourth quarter. Of the 60 total worldwide positions, directionally, we're looking for about 40 in the U.S., 20 o U.S. And we believe there's a very good chance that we'll have very close to 40 of that team here in the U.S. built by the middle part of the year. The o U.S. portion will probably take a little bit longer, probably extending throughout the rest of the year. But that's why I think we've called out the impact of this SpH buildout into our numbers because we actually think it can occur relatively quickly, certainly, the majority of it in the first half of the year.

Ben C. Haynor - Feltl and Company, Inc., Research Division

Okay, great. That's helpful. And then this might be a little bit further off, but about a year from now, you've got the Covidien royalty agreement due to expire. Have you guys had any discussions with them on possibly extending it yet?

Joe E. Kiani

We have not.

Ben C. Haynor - Feltl and Company, Inc., Research Division

Is there anything on the schedule?

Joe E. Kiani

Just so you know, the way the agreement is written, it doesn't expire on 2014. Covidien can choose to stop paying it in, I think, what, March 2014. And if they do, then we have the choice of potentially bringing legal patent litigation against them. So they can keep paying and nothing happens. So we're in no reason to have discussions with them.

Ben C. Haynor - Feltl and Company, Inc., Research Division

Okay. So we find out in March 2014, I guess?

Joe E. Kiani

You got me.

Operator

[Operator Instructions] Your next question comes from line of Lennox Ketner with Bank of America Merrill Lynch.

Lennox Ketner - BofA Merrill Lynch, Research Division

I just wanted to come back to rainbow for a second. Joe, I'm wondering if you can just give an update on when you expect the Philips and the GE contracts to come online? And also, I just want to clarify because I'm just a little bit confused in this. For customers that do buy products through Philip and GE or through other OEMs like rainbow right now, those customers still have access to rainbow but they would have to buy it -- have to use it through a separate Masimo driver rather than having been combined? Is that correct?

Joe E. Kiani

Let me first answer your first question and maybe you could repeat your second because I got to the back and I didn't hear it. So the first question is while we can't be sure because it's GE and Philips that have to produce the products, we signed the contracts, and we expect to have Philips and GE out, if not by the third quarter this year, certainly by Q1 2014. And that's our best estimate. Again, we don't know for sure and like any engineering project, it can slip. But so far, that's the horizon we have. And your second question?

Lennox Ketner - BofA Merrill Lynch, Research Division

Okay. My second question, I'm just trying to understand for customers that purchase their monitoring systems through Philips and GE. Can they still get rainbow right now except that they would have a separate Masimo driver? Or do those customers really not have access to rainbow right now?

Joe E. Kiani

I see. They don't have access to rainbow right now. They will need a new hardware as well as a new software to allow them to have access to rainbow. Because if you think about it, up until now, there's never been a noninvasive hemoglobin carbon monoxide carboxyhemoglobin [ph] DVI measurements. So the work that GE and Philips have or other OEMs, especially them because of their expensive electronic medical records work is they have to create the field for those measurements and pretty much all of their products. And secondly, you need the special hardware that has the rainbow board in it that can then work with our rainbow sensors to deliver those measurements.

Lennox Ketner - BofA Merrill Lynch, Research Division

Okay. I guess my question was whether they could take it or just have a separate Masimo driver with rainbow, but we can talk about it offline.

Joe E. Kiani

You're asking if today, somehow get rainbow today. They can. But the way they would have to do it is to purchase, for example, a Radical-7. And that unit would bolt on their device or somewhere their device. And then that device will be doing the rainbow measurement and they could get the SpO2 and pulse rate shown on the screen of the Philips or GE monitors. And in some cases, even the rainbow parameters. But to get all that data into electronic medical records, they would have to then connect our device, the Radical-7, to some type of interface that then sends the information directly to the electronic medical records, which we have that capability, but that's how they would do it. It's not [indiscernible]. I mean, the issue -- imagine in your automobile, if you have an embedded navigation system versus if you buy an external navigation system. That's probably the best analogy.

Lennox Ketner - BofA Merrill Lynch, Research Division

Okay, and that's very helpful. And then Joe, on the royalty agreement committee, and I know you said there's been no discussions there. But in my conversations with investors, there seems to be some confusion over whether the royalties that are -- of those -- sorry, the patents that those royalties are based on expire in 2014 or not until 2017 or whether it's -- some expire in 2014 and some in 2017. I'm just wondering if you could maybe clarify that for people?

Joe E. Kiani

We have patents that go to 2017 that covers Measure-Through Motion and low perfusion pulse oximetry. It really depends on what their products do today and what they might do in March 2014. So, so far, their products that they have today we believe would violate our patents until 2017.

Lennox Ketner - BofA Merrill Lynch, Research Division

Okay. And then just last question for me. Just on ReSposable launch, which I think you initiated a few months ago. Could you just maybe just talk about what percentage of your customers are choosing to go with the ReSposable sensors?

Joe E. Kiani

Well, on the rainbow side, it's 50-50. On the pulse oximetry side, it's near 100% standard sensors versus ReSposables. It's something that we're just getting customers launched on. It's been a limited market release phase. So we hope soon to go to a full market release, where that percentage might change. And what -- our whole focus with ReSposables, the reason for introducing it was to give choice to customers who truly want to be green. So I think the customers that appreciate ReSposables the most are customers that are not just trying to get cost savings of being green but really get the true carbon footprint and mass fill reduction green part of it. So we have some customers that are very interested in that, and we're working with them. And we think it'll be a great product for them. So my pleasure. So I think that's our last question. So if there are no other questions, we're going to adjourn this call. I want to thank you, all, for joining us and wish you a happy Valentine's evening. Thank you.

Operator

Thank you. This concludes today's conference. You may now disconnect.

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