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Masimo Corporation (NASDAQ:MASI)

Q4 2009 Earnings Call Transcript

February 16, 2010 4:30 pm ET

Executives

Sheree Aronson – VP, IR

Joe Kiani – Chairman & CEO

Mark de Raad – EVP of Finance & CFO

Analysts

Bill Quirk – Piper Jaffray

Tao Levy – Deutsche Bank

Sara Michelmore – Cowen

Peter Lawson – Thomas Weisel

Joanne Wuensch – BMO Capital Markets

Matthew Dodds – Citi

Brian Weinstein – William Blair

Spencer Nam – Summer Street Research

Matt Dolan – Roth Capital

John Putnam – Capstone Investments

Constantine [ph] – Treasure PotsNet [ph]

Operator

Good afternoon, ladies and gentlemen, and welcome to the Masimo Corporation fourth quarter and full-year 2009 earnings conference call. The Company’s press release is available at www.masimo.com. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator instructions)

I am now pleased to introduce Sheree Aronson, Masimo Vice President of Investor Relations.

Sheree Aronson

Good afternoon. Joining me are Chairman and CEO Joe Kiani and Executive Vice President and CFO Mark de Raad who will each make prepared remarks and then take as many of your questions as time permits.

Please not this call contains forward-looking statements. While these forward-looking statements reflect Masimo’s best current judgment, they are subject to risks and uncertainties that could cause our actual results to vary. Risk factors that could cause Masimo’s actual results to materially differ from our forecast are discussed in detail in our filings with the SEC. You’ll find these in the Investor Relations section of our website.

With that, I will pass the call to Joe Kiani.

Joe Kiani

Thank you, Sheree and thank you, ladies and gentlemen, for joining us today. I am happy to report a strong finish for 2009. Our core SET business is delivering sustainable growth, the pulse oximetry business is a solid performer, generating double-digit revenue growth and market share gains that demonstrate continued strong demand for our proprietary technology, including expanding interest in our Patient SafetyNet General Floor monitory systems.

Rainbow’s potential is beginning to take shape. Driving sales increases in a numbers of hospitals adopting the technology and new attractive reimbursement guidelines underscore the clinical and economic benefits of our Rainbow platform, which will be further enhanced in 2010 with introduction of new products.

Our business model is resilient. Year-over-year improvements across a range of sales and operational metrics in 2009 show the fundamental strength of our business model even in tough economic times. For example, in 2009, our total product revenues grew 16% and our end-user direct business grew 20%.

We are investing in our future. At approximately 11% of product sales, our R&D spend reflects our commitment to pursue new breakthroughs with the potential to improve patient care and transform the marketplace. Our multi-year initiative to expand our global sales organization and structure in on track and designed to create future operational leverage.

Our balance sheet is clean and we are generating cash. We finished 2009 with essentially no debt and $189 million in cash and short term investments, representing a 20% rise over year-end 2008 and demonstrating favorable cash flow trends.

While the economy is still bad and healthcare spending remains below historical levels, we are seeing hospitals move forward in converting to Masimo with licensing and sensor agreements that were previously on hold. Activity also appears to be picking up slightly in the OEM channel. Although well documented uncertainties remain regarding the pace of economic recovery, the future of healthcare reform and other factors influencing our market over the near term, all in all we are encouraged by the continuing sign we are seeing in the marketplace.

While it is tougher for all companies to operate in difficult times, opportunities always exist for those with the best solutions for customers. Masimo is clearly one of those unique companies. In a few minutes I will review our strategy and progress in more detail, but first Mark will walk through our financial performance and 2010 guidance. Mark?

Mark de Raad

Thank you, Joe, and good afternoon everybody. For the fourth quarter of 2009 Masimo reported total revenues of $92.6 million, including product revenues of $80.5 million and royalty revenues of approximately $12.1 million. This represented 11% growth in total revenues and 12% growth in product revenues compared to the same prior last year. Favorable year-over-year foreign currency exchange rates added approximately $1.2 million to fourth quarter 2009 revenues compared to the last year.

As Joe mentioned, our growth in product revenues was driven primarily by Masimo SET revenues, which rose 12% to $74.7 million in the fourth quarter as we continued to extend our reach into more hospitals worldwide.

Fourth quarter 2009 SET product revenues also included approximately $4.3 million in previously deferred revenues, which were recognized due the delivery of equipment. This compares to approximately $1.6 million in deferred revenues we recognized in the fourth quarter of last year, which related to the establishment of vendor-specific objective evidence of a product tied a long-term sensor agreement.

Fourth quarter 2009 revenues generated from our end user or direct business, which includes sales through our just-in-time distributors, were up 15% to $64.7 million, and represented 80% of total product revenues. OEM revenues made up the remaining 20% at $15.8 million. This reflects a slight mix shift from the prior year period when direct revenues were 78% and OEM revenues were 22%. Moreover, it illustrates our view that OEMs continue to feel the effects of lower hospital CapEx spending in the fourth quarter, although, as Joe noted, we believe the situation to continuing to improve.

Fourth quarter Rainbow revenues totaled $5.8 million, up 23% compared to the same prior last year reflecting significantly increased year-over-year demand for our Rainbow licensed parameters and sensors offset slightly by continued pressure on Rad-57 sales due to OEM SpCO and SpMet licensed parameter sales and continued constraints on state and municipal EMS spending. Also, recall that in the year-ago Q4 2008 period, we benefited from a large initial order of Rainbow MX boards.

Looking at fourth quarter product revenues by geography, U.S. revenues totaled $56.9 million, up 5% compared to $54 million in the same prior-year period. Product revenues outside the U.S. rose 34% or 27% on a constant-currency basis to $23.5 million. Encouragingly, our fourth quarter OUS revenue rose to 29% of total product sales compared to 24% in the same prior-year period. This relatively strong fourth quarter OUS revenue performance was due primarily to strength in our EMEA, Canadian, and rest of Asia regions.

Turnings to our installed base, excluding handheld devices, we shipped 30,400 new pulse oximeters and Pulse Co-Oximet monitors in the fourth quarter, which was down from 31,700 in the fourth quarter of 2008, but up nicely from the 26,400 that we shipped in the immediately preceding third quarter.

In our third quarter 2009 conference call, we explained that we had conducted an internal review of the useful field life of our products. To recap, after surveying both OEM and direct customers, we determined that the appropriate range for the true useful field life of our monitors is seven to 15 years with the median at 11 years. Based on this, we decided a more realistic, and therefore appropriate useful field life assumption would be 10 years. So, we have recomputed our historical field driver assumption as if we had originally used 10 years.

As we noted in our last call, this data is used mostly by some of our analysts in their modeling and the change only impacts those models by increasing the number of drivers in the field and at the same time decreasing the average revenue dollar per driver. However, I want to be clear that this change in useful life assumption has no impact on our financial statements where we continue to depreciate the cost of these units in the field based on the life of the long term sensor agreement to which the drivers are related, which is typically about four to five years.

Under our new 10-year useful field life assumption, we now estimate our total worldwide installed base at year-end 2009 net of estimated retirements at about 724,000 drivers. That’s up 16% from a revised 625,000 at the end of 2008. Using our old seven-year useful field life assumption, our installed base estimate at year-end 2009 would have been approximately $640,000 drivers compared to $567,000 at the year-end 2008 period.

For those who use our driver information in your models, we have posted a chart on the Investor Information section of our website that provides historical information using both the seven- and 10-year methodology. You will find these under the News and Events tab as a supporting document to today’s call and audio webcast.

Turning back to the income statement, our fourth quarter product gross profit margins rose to 66.7% from 65.7% in the same prior year period due primarily to higher sensor and Rainbow revenues. Adjusted for the impact of foreign exchange rates fourth quarter product gross margins would have been 66.2%. Total fourth quarter gross profit margin including royalties rose to 71.7% from 70.5% in the same prior year period due primarily to a higher mix of Rainbow revenues and the favorable impact of year-over-year foreign exchange rates.

Fourth quarter 2009 engineering expenses were $8.9 million, up 24% compared to $7.2 million in the same prior year period. The rise was due primarily to higher payroll and payroll-related cost associated with planned expansion of our R&D teams and corresponding increases in engineering supplies expense.

SG&A expenses were $35.5 million in the fourth quarter, up approximately 15% compared to $31 million in the prior year period, reflecting increases in payroll, payroll-related and stock-based compensation costs associated primarily with our continuing worldwide sales force expansion.

Fourth quarter operating income was $21.4 million or 23.1% of revenues compared to $20.1 million or 24.2% of revenues in the prior-year period. The slight year-over-year decline in operating margins is due to higher product revenues and related gross profit margin dollars, slightly increased royalties, offset by increased operating expense, as I previously noted.

Our fourth quarter effective tax rate was 32.2%, down from approximately 34.9% through the immediately preceding 2009 third quarter. This improvement in the fourth quarter rate was due to higher-than-anticipated R&D tax credits as well as a higher mix of OUS revenues and profitability.

So, to summarize the 2009 fourth quarter over the prior year quarter, we had a 12% rise in product revenues, a 4% rise in royalty revenues, and 100 basis point rise in product gross margins. These items, combined with higher operating expenses and a lower tax rate resulted in net income of $14.1 million or $0.23 per diluted share. This compares to a net loss of $0.01 in the year-ago quarter, which included a $0.25 tax charge.

Weighted average shares outstanding for the fourth quarter 2009 were 60,289,468 compared to 60,203,595 for the same prior year period.

Highlighting briefly fiscal year 2009 results, total revenues rose 14% to $349.1 million from $307.1 million in 2008. Total product revenues rose 16% to $300.1 million from $259.6 million, including a 46% rise in Rainbow revenues to $19.5 million. Importantly, our total 2009 direct and distribution revenues were $241.7 million, up 20% from $201.1 million in 2008 while OEM revenues were relatively flat at approximately $58.5 million.

Despite a generally difficult 2009 economic environment, we believe these growth rates reflect the inherent demand for our products and strength of our business model and provide clear evidence that our focus on building out a strong worldwide sales organization is being rewarded.

The flat year-over-year OEM revenues are, we believe, due to the more significant impact that the overall economic downturn had on our OEM partners, who rely heavily on large capital equipment sales.

2009 product gross margins were 66.7%, up from 65.5% due primarily to revenue mix-shifts and manufacturing efficiencies derived from higher production levels. Operating expenses rose approximately 14%, reflecting primarily higher payroll and payroll-related costs associated with our expanding staffing increases and R&D and worldwide sales.

Fiscal 2009 operating income rose 15% to $82.2 million. Our full year 2009 effective tax rate was 34.3% versus 55.9% one year ago when we recorded the large one-time tax charge in the fourth quarter of 2008. That brought 2009 earnings per diluted share to $0.88 compared to $0.53 in 2008 or when adjusted for the 2008 fourth quarter tax charge, $0.78.

Weighted shares outstanding for fiscal 2009 were 60,170,484 compared to 60,190,335 for 2008.

Now just a couple of items on the balance sheet. As Joe mentioned earlier, at January 2nd, 2010, total cash, cash equivalents, and short term investments were $189 million, which was up from $146.9 million at the end of the prior year period. This increase was the result of generating $47.1 million in cash from operations despite making a special $11 million tax payment in the first quarter of 2009 related to our international reorganization. In 2009, we also incurred $10.7 million in stock-based compensation, up from $7.7 million in 2008.

At January 2nd, 2010, our days sales outstanding declined to 44 from 47 in the third quarter, but were up slightly from 40 at the end of the fiscal 2008 period. Our inventory turns remain relatively flat at 3.4 as of January 2nd, 2010, compared to 3.6 as of January 3rd, 2009 and 3.2 in the immediately preceding quarter.

And now I would like to share just a few comments regarding our 2010 financial guidance. Let me begin by reiterating the obvious that providing financial guidance in today’s economic and political environment is difficult. However, given our slightly more confident market outlook and Masimo’s unique razor-razor blade model that now includes an estimated 724,000 drivers, and a growing base of long term sensor agreements, we are in position today to provide the following financial guidance for 2010.

We expect 2010 total product revenues to be between $345 million to $360 million. This includes our expectation for total Rainbow revenues of between $30 million and $35 million or approximately 8% to 9% of total projected 2010 product revenues. This compares to 6.5% in 2009, 5.2% in 2008, and 3.7% in 2007, and reflects the continued growth and impact that Rainbow revenues are having on the business model.

We also expect 2010 royalty revenues of between $44 million and $46 million, which brings our total 2010 revenue guidance to a range of $390 million to $405 million. For 2010, we believe our annual consolidated gross margins will be approximately 67% to 67.5% compared to 66.6% in 2009. We expect this improvement due to higher sensor sales, increased Rainbow revenues, and continuing benefits from having shifted during 2009 the majority of our manufacturing activity from Irvine, California, to Mexicali, Mexico.

We expect total operating 2010 expenses to be in the $190 million to $195 million range compared to $166.6 million in 2009. At the midpoint of this range, this 15% year-over-year projected growth is consistent with our expectation that 2010 is likely to be the final year of our major incremental infrastructure investment. Note that in our guidance also includes $14.7 million in stock-based compensation, up from $10.7 million in 2009 and significantly increased legal fees resulting from our expanding litigation activity.

I would also like to remind you that our 2010 revenue, gross margin, and operating expense guidance is based upon our budgeted foreign exchange rates to the extent that these foreign exchange rates move dramatically from these budgeted rates our financial results could differ.

We expect our 2010 effective tax rate to be approximately 34% to 35% although, as we saw in 2009, the actual tax rate will depend upon on variety of factors, including our pretax profits or losses, changes to tax law and geographic composition of future pretax income.

We are projecting weighted outstanding shares of approximately $61 million for the full year.

I would also like to now briefly address the recent $30 million antitrust payment that we received from Covidien. While we are still finalizing plans, Masimo intends to use approximately $15 million to fund various one-time marketing initiatives designed to extend the reach of our products, including accelerated clinical research activities and awareness campaigns, all with a focus on accelerating the adoption of our latest Rainbow measurements, including total hemoglobin and Rainbow acoustic monitoring.

While we expect to incur the majority of the expenses in the first quarter of 2009, the same quarter in which we will be the recording the benefit of the $30 million received, it is possible that some of these expenses may not be incurred until later this year. Therefore, in future quarters, we will report the amount of one-time expenses related to these initiatives that we incur in each quarter. Because we will be utilizing approximately $15 million of this $30 million one-time initiative, we expect the remaining benefit to be approximately $15 million or approximately $0.15 per share.

Including both Masimo’s operating guidance and the impact of the $0.15 one-time benefit from the antitrust payment, Masimo expect 2010 earnings per share to be in the range of $1.12 to $1.18. Again, while we believe this guidance to be appropriate as of today, these are projections and our actual performance could be different.

Before I hand it back to Joe, I’d also like to discuss directionally our expectations as we move through 2010 and into fiscal 2011. As we have said previously, since it is possible to determine whether the current Covidien royalty agreement will continue beyond March of 2011, Masimo is assuming the royalties will not continue and we have recommended that all those modeling our business do the same. Over the past couple of quarters, all of our analysts have, to a large extent, incorporated this assumption into their 2011 financial models.

A change of this magnitude obviously presents a significant challenge for Masimo, but it is a challenge we are well prepared to address. In general, we believe that our ability to continue to see year-over-year EPS growth adjusted to exclude the one-time $0.15 benefit in 2010, despite the potential loss of royalty payments, will require that we deliver on three key concurrent initiatives.

First, total product revenues must return to the 20% growth level that until this past difficult economic year Masimo has enjoyed. Given that our core direct business has continued to grow at this level even in the very difficult 2009 period, we believe we can and will see stronger growth rates in this part of our business as we move through 2010 and into 2011.

We also expect our OEM customers who for the past two years have not seen any growth to begin to experience an upturn in demand based upon both an improving economic backdrop and the replacement cycle that we believe although delayed has not been repealed.

And maybe most importantly, and a key drive to both our own direct and OEM partner product demand will be the expansion of continuous noninvasive monitoring into the general floor. Masimo has long believe that it is only a matter of time until monitoring migrated from critical care into the general floor due to the reliability of the Masimo SET pulse oximeters and the growing awareness that patients die in bed unnecessarily.

Given the success at hospitals like Dartmouth-Hitchcock, we believe continuous monitoring of patients in the general ward is gaining momentum. By 2011, we expect many leading hospitals will have begun initiatives to add continuous monitoring to a portion of their general floor beds, and in some cases 100% of their beds.

In addition to these macro trends, by 2011, our continuous total hemoglobin measurement will have been in the market for over two years and we expect our Pronto 7 unit will be in its first full year of commercial release. We also expect our fully developed and trained worldwide sales force to be in an excellent position to leverage their knowledge and experience to deliver significant sales growth.

For all these reasons, we are confident in Masimo’s ability to see total product revenue growth rates once again the 20% range.

The second key element impacting our ability to achieve targeted operating income levels in 2011 will be the continued expansion in our overall product margins. We expect a higher mix of Rainbow revenues together with a continued focus on reducing overall production costs to allow us to see a continued improvement in gross margins as we move from 2010 to 2011.

And finally, as we have discussed, Masimo has been building its infrastructure ahead of revenues since 2006. As I noted earlier, we believe that we will be able to complete the majority of this infrastructure build by the end of 2010, which will result in a much lower level of 2011 operating expense growth.

Clearly, replacing this royalty stream with improved operating income performance will not be easy. However, we are confident that our focus on these three key areas will allow us to deliver on the goal of achieving higher earnings per share levels in 2011 as compared to 2010.

Thank you for your time, and I will now turn the call back to Joe.

Joe Kiani

Thank you, Mark. Since 1997 Masimo has delivered double digit product revenue growth sequentially year after year. Our progress in 2009 across a range of R&D, sales, and operational metrics as well as our 2010 outlook show the fundamental strength of our technology and business model.

We have set a clear course for our team to improve patient outcomes, and reduce the cost of care by taking noninvasive monitoring to new sites and new application. We are accomplishing this by growing our worldwide share in pulse oximetry, including reaching into the general ward, expanding the use of our Rainbow Pulse CO-Oximeter technologies in the hospitals, EMS market and other settings, and continuing to maintain our technology leadership by inventing new measurements.

We continue to estimate that the total potential worldwide market opportunity for our current SET and Rainbow technologies is in the $3 million to $4 million, which is roughly three to four times the size of the pulse oximetry market and over ten times our current product revenue. Clearly, we are still in the early stages of executing our long term growth strategy.

The foundation of this strategy is our core pulse oximetry franchise, which has consistently delivered double digit year-over-year revenue growth, including a 14% increase in 2009. This performance was achieved despite 2009 challenging economic environment, and against the backdrop of any competitive behavior by some of competitors.

In the U.S. where we still generate the majority of our revenues, our performance is driven by the recurring revenue model that comes from placing monitors and then selling sensors, cables, and others accessories through volume agreements with hospitals. However, the key to our success is our technology whose superiority has been validated over 100 independent studies and is preferred by clinicians for its accuracy, low pulse along [ph] rate and contribution to improved patient outcomes.

As I said earlier, we believe we grew our share of the market this year. Of note, despite a sluggish first half of 2009 in new U.S. contract bookings our fourth quarter sensor contract volume was quite strong. In fact it was a new quarterly high for Masimo and it featured a broad cross-section of healthcare providers. The favorable trend in contract bookings bodes well for our future revenue stream and it is a positive indicator that hospitals are becoming more willing to reengage as we move into 2010.

We are also happy with new monitor placements in the fourth quarter and closed out 2009 with an installed base that was 16% larger than the end of 2008. As you know, new monitor placements are a forerunner to future recurring revenue.

Helping to fuel our growth is our Patient SafetyNet system, which efficiently connects caregivers with patient on the general floor. Today, our system supports up to 80 bedside monitors and immediately notifies clinicians via wireless pagers and touch screen monitors at nurses’ stations when a patient’s oxygenation, restoration rate, pulse rate, or blood level with SpHb moved outside appropriate ranges.

Hospitals are turning increasingly to Patient SafetyNet in order to cost-effectively enhance their response time to patients in distress, and ultimately reduce sentinel event. In fact, this month’s issue of Anesthesiology features the landmark Dartmouth-Hitchcock Medical Center study, which used Masimo SET technology and Patient SafetyNet system to demonstrate their continuous Measure-Through Motion and Low-Perfusion pulse oximetry monitoring and clinician notification system in post-surgical patients on the general floor leads to a significant drop in key clinical outcomes, including a 65% decrease in distress codes and rescue activation, a 48% decrease in patient transfers to the ICU, and 135 ICU days saved annually.

The researcher, Dr. Andreas Taenzer called Masimo’s Patient SafetyNet a new approach to detect unrecognized “operative deterioration,” which is a significant precursor in morbidity and mortality for in-hospital patients. In light of the (inaudible) dramatic results, the publication carried a companion editorial authored by Dr. John Abenstein and Bradley Knorr [ph] from the Mayo Clinic and entitled, “An Ounce of Prevention May Equate to a Pound of Cure.” The editorial states that implications of the study abroad and results could have important implications for hospital wards throughout the country. It also concludes that the study’s researchers have shown us a glimpse of the future. Not only will such a system allow us to improve the quality of care of a patient but will also be a key to lowering cost.

Early demand for our Patient SafetyNet systems appears to illustrate this point with fourth quarter Patient SafetyNet system contract bookings running particularly strong. The positive trend is an encouraging that we are on the right track with our strategy to extend pulse oximetry to the general floor with Masimo SET and Patient SafetyNet.

We also see the general floor as the primary delivery point for our newest Rainbow measurement, Rainbow Acoustic Monitoring, or RAM. RAM, noninvasively and continuously measures respiration rate via an acoustic sensor and integrated acoustic transducer that is applied to a patient’s neck and connected to a Rainbow bedside monitor with a special cable.

When used with other clinical variables, respiration rate monitoring may help clinicians access respiratory status and help determine treatment options. This is especially important for post-surgical patients receiving pain medication as these can induce respiratory depression and place patients at considerable risk of serious injury or death.

RAM is a compelling product that we believe has the potential to become the standards of care. We unveiled it in December at the American Association of Respiratory Care meeting and are now in the midst of a limited market release. Early feedback from clinicians is positive and we currently plan a commercial launch in the second half of 2010.

RAMs further broadens our unique Rainbow platform, which we introduced in 2005 and have expanded every year since with new measurements. In 2009, the biggest Rainbow development was commercial launch of SpHb, which we believe has the potential to revolutionize how hemoglobin is tested. A low or falling hemoglobin measurement provides a primary indication for whether a patient receives a blood transfusion and also helps to identify internal bleeding in places like the ICU.

SpHb is the first and only technology to enable noninvasive continuous and real-time hemoglobin monitoring. When used with other clinical variables, SpHb may help clinicians assess anemic status to help determine treatment and additional test options. It also provides clinical utility in surgery, the ICU, and other critical care areas of the hospital. Although we are no longer providing details regarding the number of quotes request we have received with SpHb, I will say that activity remains brisk.

In another positive development, the AMA granted a CPT code for SpHb, which Medicare has priced at $7.19 for 2010. This allows healthcare professionals in non-hospital environments to bill and receive payment when testing eligible patients. While SpHb measurements on patients in the hospital are reimbursed through DRG payment, the CPT designation is significant to spot SpHb measurement on patients being treated in the emergency department or outpatient clinic or in physician’s offices.

We expect to begin full commercial release of our Pronto device for the physician office in the second half of the year. We’ve assembled an approximate 20% sales force to call on physicians’ offices and expect to grow to about 40 over the next 12 to 18 months.

New and potentially transformative technologies like SpHb are the result of our continued investment in our future. This commitment is evident in our R&D spend, which was 11% of total product sales in 2009, at the high end of industry averages. Our focus is on funding and finding noninvasive monitoring solutions that improve patient care and ultimately save lives.

Several recently published independent clinical studies validate the efficacy and varied applications of our product, including a study in December issue of Inhalation Toxicology, which shows that Masimo Rainbow SET Pulse CO-Oximetry, SPCO, provides a reliable measurement of carbon monoxide in the blood, facilitating fast, accurate diagnosis of CO poisoning in pre-hospital, emergency, and rescue environments.

And a study in the January 27th issue of the European Journal of Anesthesiology, which found that Masimo’s TBI [ph] predicts fluid responsiveness as accurately as invasive stroke volume variation or SVV, and more accurately than invasive central venous pressure, or CVP, in mechanically ventilated patients undergoing surgery.

Our investment in the future extends beyond R&D to building a global sales organization and structure that can support our growing business and meet the needs of customers around the world. Our emphasis has been on increasing our sales and service presence in all of the major markets. As Mark mentioned earlier, we are spending ahead of our growth today and expect to create future operating leverage.

We also continue to explore business development opportunities. In early 2010 we made an investment in SEDLine, a neuromonitoring company that recently acquired the brain function monitoring business of Hospira. SEDLine’s technology offers a preferred alternative to other conscious sedation monitors and their research and development activities are focused on next-generation technologies to further improve the car of patients under anesthesia or sedation.

Finally, we’ve retained approximately $30 million of a payment from Covidien in January. This stems from the Ninth Circuit Court of Appeals affirmance of a Federal District Court’s decision that Tyco Healthcare, now Covidien, violated antitrust laws through anticompetitive business practices. We hope this hard fought victory will open competition giving more care givers and patients access to cost-effective, innovative products.

To that end, we are deploying a portion of these funds to establish a new Masimo Foundation for Ethics, Innovation, and Competition in Healthcare. We are also going to put the rest of this money to good use as Mark mentioned earlier.

To sum up, our results show the resiliency of our business model even in a recession. They also underscore our commitment to improving patient outcomes and reducing the cost of care. Our Masimo SET pulse oximetry has become the gold standard for its proven accuracy and reliability that contributes to better clinical decisions, fewer medical errors and better patient care. And our unique Rainbow platform is enabling breakthrough noninvasive measurements that previously required invasive, time-consuming testing, progress that we believe can lead to earlier and better clinical decisions.

As we move into 2010, we are encouraged yet cautious regarding signs of improving market condition, and we are energized and focused on extending the reach of our gold standard pulse oximetry, advancing awareness and usage of the Rainbow platform, and invest in talent and resources to discover new innovations that solve clinicians’ most pressing problems.

With that, Mark and I will take your questions. Thank you.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Bill Quirk with Piper Jaffray.

Bill Quirk – Piper Jaffray

Thanks, good afternoon guys.

Joe Kiani

Hi Bill.

Bill Quirk – Piper Jaffray

Say, first question, Rainbow has been pretty up and down in recent quarters and I suspect this is because of the license fee component to that, but can you give us a little color in terms of the underlying sensors as to you guys? I assume this trend has been fairly strong and up unto the right [ph] and such?

Joe Kiani

Bill, first of all, you are right that the revenue for Rainbow this quarter was slightly below last quarter, but obviously was higher than even the same quarter previous year. But in there is some information that is I guess hard to understand and one of those is that the reason for the lower year-to-year growth is that we had a huge board order at the end of 2008 last year that didn’t happen end of 2009. But separating that, so the Rainbow license sales has more than doubled and the Rainbow sensor sales have quadrupled. So, it’s – we are feeling very good and we feel that Rainbow and particularly hemoglobin is on track with what we had hoped for and expected.

Bill Quirk – Piper Jaffray

Okay, very good. And the Mark, just thinking about the overall guidance, it looks like just kind of parsing the numbers back in terms of the $30 million and the idea that to spend about half of that, it looks like overall you are guiding to about the same type of bottom line growth that you are at the top line and just to be clear here this – essentially the reason why we shouldn’t expect much leverage here is because the ongoing infrastructure build, doc [ph] based compensation, and then incremental legal expenses, and then the thought process being that in 2011 we should start to see the underlying business, which is to say that the business ex-royalty, we should start to see the leverage there, is that right?

Mark de Raad

That’s exactly right, Bill, yes.

Bill Quirk – Piper Jaffray

Okay, great. And then just last question from me, I will jump back in the queue, any update on the Philips lawsuit? Thank you.

Joe Kiani

Yes. I think well the Philips lawsuit is I guess intensifying although we haven’t had the court date, we had some changes recently also with announcement of our judge changing. But based on Philips’ action, which appears to us to include aggressively escalating sales of what we believe infringes our IP in the marketplace, actions that we are witnessing every day, we now seek to not only defend our intellectual property, but recover the damages we have suffered. It does appear that Philips is intent on continuing to violate our patent, and as a result, we believe we have no choice but to defend it vigorously, which we have every intention of doing.

Operator

Your next question comes from the line of Tao Levy with Deutsche Bank.

Tao Levy – Deutsche Bank

Hey, good afternoon.

Joe Kiani

Good morning, Tao.

Tao Levy – Deutsche Bank

Quick question on the Rainbow part of the business, I know you’d during your comments said about strengths year-over-year, but sequentially it looks like it is a little bit softer than what we saw in the third quarter, anything there that you can explain?

Joe Kiani

Well I say sequentially, one of our key OEM partners had a much stronger shipment of CO and med [ph] hemoglobin parameters in Q3 compared to Q4. So that really is the difference you are seeing sequentially.

Tao Levy – Deutsche Bank

But in terms of sort of like the same question they all kind of asked, the hemoglobin business, the sensors, the recurring part, sequentially, was that better than flat?

Joe Kiani

Yes, absolutely.

Tao Levy – Deutsche Bank

Great. And on the Pronto side of the things, what’s the accuracy that you have in mind put it on the hemoglobin front and are you there yet?

Joe Kiani

The answer is the accuracy that we have in mind is better than one gram per deciliter at one standard deviation, and yes, we believe we are there are already, even with Pronto. As you know we have another device called the Pronto 7 that we have been working on with the help of Masimo Labs, and that device should even have a better accuracy, but from an FDA perspective we are only seeking the same accuracy, one gram per deciliter, although we expect customer will have a better experience than with Pronto.

Tao Levy – Deutsche Bank

Great. And can I ask one last one?

Joe Kiani

Yes.

Tao Levy – Deutsche Bank

You know, generally you’ve had a little bit of visibility into your pipeline like we knew RAM was coming out couple of years ago, we knew hemoglobin about a year and a half before that, but that’s it. Our visibility is kind of ends there. What should we be thinking about a year and a half out of the pipeline?

Joe Kiani

Well, we expect to roll out other important measurements. We have not disclosed what they are yet due to competitive reasons.

Tao Levy – Deutsche Bank

Okay, thanks.

Joe Kiani

Thank you.

Operator

Your next question comes from the line of Sara Michelmore with Cowen.

Sara Michelmore – Cowen

Thanks. So you just clarify on the operating expenses for this year (inaudible) growth of the Street that seems to be where you are running the expenses a little bit higher. So you are accelerating the spending now. It sound like the physician sales force is an element of that and I am just wondering specifically what’s the other piece of that is. Is it R&D or there is specific sales and marketing projects that come separately from the $15 million that you plan to spend out of the Covidien settlement. If you can just give us a little bit more color where – what the drivers of that accelerated spending is.

Mark de Raad

Sara, this is Mark. You are correct in the Q4 period, our spending did accelerate, but if you remember the prior year fourth quarter periods, that’s very normal for us. We typically see our highest level of spending in the fourth quarter, related primarily to that being our large tradeshow quarter. We also, as Joe alluded to, had a really strong finish to the end of the year, so things, variable expenses such as commissions and things of that nature were also up in the fourth quarter. Headed towards 2010, as I suggested in the earlier comments, we are looking for a continued acceleration if you will and that kind of level of spending and just to reiterate what Bill had noted before, those primary areas are headcount related where we continue to focus on building out the rest of the Masimo worldwide sales team. We also, as I alluded to, expect increased stock-based compensation expenses simply resulting from additional stock grants during the year. And then also the legal expense area is one that is accelerating for us in light of some of the activities that Joe alluded to. So, those are really the primary drivers behind the expense rates moving up.

Sara Michelmore – Cowen

Okay. And then on the money from the $30 million that you intend to reinvest, you talked a little bit about using it for onetime marketing in support of hemoglobin and – what types of projects are you referencing specifically?

Joe Kiani

Well, we would like to accelerate clinical research on both measurements. We also feel like there is a lot of direct marketing and advertisement that we’d like to do that normally we don’t do. So, we are going to invest in some of those things, and expect there will be payback in the – in late 2010 if not fully 2011.

Sara Michelmore – Cowen

Okay. And then when you talked about the international growth this quarter, one of the geographies you didn’t discuss was Japan, and I am just trying if we can get an update on that geography and what the growth trend has been. Thanks.

Joe Kiani

Well, our Japan business is growing very nicely in fact higher than our overall growth rate and we are getting three hospitals in Japan converting to Masimo. The excitement about hemoglobin is very high there. We are awaiting the Japanese regulatory clearance. We filed it about 18 months ago and are on track to hopefully getting that in the second half of the year, which is line to what it took for us to get our clearance for Carbon Monoxide in Japan.

Sara Michelmore – Cowen

Alright, great, thank you.

Joe Kiani

Okay.

Mark de Raad

Thank you.

Operator

Your next question comes from the line of Peter Lawson with Thomas Weisel.

Peter Lawson – Thomas Weisel

I just wondered if you could give us initial color on the ARM [ph] after approval in December.

Joe Kiani

Well, sure. The product noted as ARM is that called RAM, but yes we – Rainbow SET Acoustic Monitoring, we began limited market release where the first hospital we’ve put it into the clinicians found it very useful and in fact have expanded into other areas in the hospital. We have expanded RAM LMRs [ph] to some other parts of the country to try to get different location around the country at prestigious hospitals. And it’s all looking very good. I right now – our plan was to launch it commercially in the second half. We should be able to do that if not sooner.

Peter Lawson – Thomas Weisel

Thank you. And then just how should we think about normalized operating expenses first like 2011-2012 timeframe? What’s the eventual goal?

Mark de Raad

Peter, directionally what we’ve said for a long time now is that we believe that as you look out in that latter period of time that you mentioned, eventually we are looking for total operating expenses to fall to the 45% of total product revenues, and eventually down to the 40% level. So, 40% to 45% is where we expect to be and of course that would include our R&D spending, so that would be total operating expenses.

Peter Lawson – Thomas Weisel

Okay, thank you so much.

Mark de Raad

Thank you.

Operator

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

Joanne Wuensch – BMO Capital Markets

Thank you for taking the question. The extra $0.15 that you will be spending on accelerated R&D and direct marketing and advertising that you are thinking of as onetime, will you be calling those out in the coming quarters?

Joe Kiani

Yes.

Joanne Wuensch – BMO Capital Markets

Okay. And you talked about doing a push on the general floor with RAM previously known as ARM, and is that something that – in the competitive landscape any of your competitors are doing?

Joe Kiani

We are not aware any other competitors with such a technology.

Joanne Wuensch – BMO Capital Markets

And final question, when I look at 2011 estimates, obviously you’ve got a fair amount of revenue or royalty coming out because of the – because of the Covidien event. But should we think of it as a sequential up to EPS here?

Mark de Raad

Well, as I included in my prepared comments, obviously we are not providing any specific guidance on numbers, but what we were alluding to was our intention to drive the three different categories that I referenced all in an effort to be in a position to show 2001 EPS numbers that would be above 2010 EPS numbers.

Joanne Wuensch – BMO Capital Markets

Okay. Because one thing I am trying to get out of here is you have extra money coming in and you’ve got a lot big year if you will push with the Covidien royalty and then we get to some sort of a normalized expense ratio and it’s hard to start to think about those pieces without asking you for 2011 guidance.

Joe Kiani

We tried to give you that in a way by explaining what our plans are for 2011. As we have mentioned before, we had been spending way ahead of our norm since 2006 when we began getting these royalties. So, when the royalty stop, we were always ready to stop that growth. So as you’ve noticed in the past few years, we’ve been growing our expenses by over $30 million a year. So in 2011, we will probably not do that, and at the same time we expect a lot of the things we’ve been working on from R&D perspective to the global sales growth, sales force growth, should really begin to hit us right [ph]. So, if everything goes well and we are working hard so that it does, we should have a higher earnings per share in 2011 than 2010 if you take away this onetime antitrust monies that we just got.

Mark de Raad

And Joanne, that’s exactly why I alluded to you before that our intention is to call those expenses out so that you can in fact recognize what the true underlying operating expense run rate is.

Joanne Wuensch – BMO Capital Markets

Very good. Thank you very much.

Mark de Raad

Okay.

Operator

Your next question comes from the line of Matthew Dodds, Citi.

Matthew Dodds – Citi

Hello, a couple of questions. First, Mark, the U.S. sales up 5% year-over-year, I thought with the strong flu season that you do a little better than that, so I am wondering revenue recognition wise, is it not correct to think sort of that it would be instantly recognizable if there was a trend like that.

And then also in the same area, the deferred revenues is that – that $4.3 million, is that U.S., OUS, or a split?

Mark de Raad

Matt, the $4.3 million that I mentioned in the prepared remarks is strictly in the U.S. in terms of the deferred revenue. The first part of your question, I am not quite sure on the question, so let me maybe ask you to restate it–

Matthew Dodds – Citi

Sure. If some other companies that have a disposable stream into the hospital generally had a pretty good fourth quarter in the U.S. on what they categorized as a strong flu season, yet your U.S. revenue was, and the growth rate was a little bit less than we were expecting. So, I am just wondering how we rectify that. Maybe there is a lag on the actual use of the product versus the revenue recognition.

Mark de Raad

Well, I mean, as we said earlier in general we felt really positive about the fourth quarter performance. I don’t think that the overall percentage numbers were necessarily impacted by the inclusion of the deferred revenue item that we were talking about before. We did have, as we noted earlier, a very strong year-over-year OUS performance, but there wasn’t anything overly unique that we saw here in the U.S. relative to the overall flu season. We saw some pretty steady increases in total. Sensor shipments, not only from year-over-year but sequentially up from the third quarter as well.

Joe Kiani

Matt, I have a question for you. Those other companies that you mentioned that grew because of the flu season, what percentage growth did they show?

Matthew Dodds – Citi

Well, I don’t know about this business in particular, but most of them showed a slightly higher year-over-year growth rate in the fourth quarter.

Joe Kiani

How – and how high they were showing, like 20%, 25%, 30%?

Matthew Dodds – Citi

No, I would say probably a third to a half higher than normal just in the fourth quarter in the U.S.

Joe Kiani

Well, our direct sensors grew by over 20% when our OEM business was flat. And I think the sensor volume increase, unfortunately doesn’t help us with our OEM business. That could be also why maybe it wasn’t as high – may be you will like to seeing, but the Company’s we watch ahead [ph] consumables I think have grown faster than the other ones.

Matthew Dodds – Citi

And I was just wondering if you, in a broad base, if you saw much within the flu season, but it sounds like from Mark’s comments not really that much.

Joe Kiani

No we did, we did, but unfortunately the OEM revenues were flat year-over-year, and that’s about $60 million of revenue that just remained flat.

Matthew Dodds – Citi

Okay. That’s actually the – that makes sense, perfect. Thanks, Joe, thanks, Mark.

Joe Kiani

Thank you, Matt.

Operator

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

Brian Weinstein – William Blair

Alright, good afternoon. Talking again about the spot market, are you guys willing to break it down anymore in terms of the submarkets that you are going to target initially? There is a lot of potential applications there between OB/GYN, GPs, oncology, blood donations, et cetera. Can you maybe talk about where you are going to go first there and if there is any of those that you are not planning on targeting initially?

Joe Kiani

We are very excited about those alternate care market the physicians’ offices that you mentioned for the spot check device and in the hospital even the OB/GYNs not just in the physicians’ offices, we are going after primary care OB/GYN, oncology, nephrology, and pediatric clinicians or physicians’ offices. And with the (inaudible) reimbursements for Medicare, we are feeling very bullish about the future of our business in that environment, but we are not breaking it down yet. We had mentioned before that perhaps once the business gets to become – the Rainbow business gets to become about 10% of our total business, assuming we don’t see any competitive issues, then we’ll start breaking down where the different pieces are going.

Brian Weinstein – William Blair

Okay. And then you guys have about $190 million in cash, and as you said, no debt, so a very strong balance sheet. Can you give us an update on kind of planned uses of cash at this point, or maybe just a business development update and how you're thinking about potential acquisitions or anything else you guys are thinking about as far as using that $190 million? Thanks.

Joe Kiani

We as the management team and along with the Board have been discussing ways to use our cash to the benefit of the shareholders. We feel that there is always good opportunities out there, so we are looking, as evidenced by our investment in SEDLine. But we also feel that given the products that we have already introduced or are ready to introduce like with RAM, we have a $3 billion to $4 billion market opportunity, and with a tenth of that in revenue. So we feel that the most important thing we can do is to execute on our business plan, and we look very hard at any acquisition to make sure it doesn't divert us, and if we are going to do it, it better be interesting enough that it will be worth the diversion. So we are continuing to have those dialogs with the Board of how to best use the cash; stay tuned.

Brian Weinstein – William Blair

Okay, great. Thanks guys.

Joe Kiani

Thank you.

Operator

Your next question comes from the line of Spencer Nam with Summer Street.

Spencer Nam – Summer Street Research

Thanks for taking my question. Just a couple of questions here. First question is, on the hemoglobin test, could you guys maybe give us some qualitative description on how the adoption is going right now at different centers?

Joe Kiani

It’s going really well. We were very happy with the rate of growth in terms of both number of hospitals as well as our revenue ramp in 2009, and we're getting very good feedback from customers, and we expect a lot of research on this product is beginning. And we expect that, I guess, as soon as this March, the International Anesthesia Research Society to this fall a lot of those studies will come out and will help continue to fuel the demand for noninvasive hemoglobin measurement.

Spencer Nam – Summer Street Research

And what about the penetration of new accounts, do you guys expect to see some greater activity – level of activities in 2010 versus 2009. How should we think about that even qualitatively?

Joe Kiani

We are having a lot of success in new accounts with hemoglobin. In fact, I guess, if I could say it this way that I think with hemoglobin now, many hospitals are asking themselves, why not switch to Masimo now that we have the best documented technology for pulse oximetry, but it allows for hemoglobin. So we're having a lot of success as I mentioned earlier. In Q4, we had – which is something we don't share usually, but I just wanted to share it with you given some of the potential worries some people have had about our core technology, pulse oximetry growth. We had a tremendous Q4 booking with a lot of amazing new hospitals upgrading their technology to Masimo and as well as some of our existing customers not only doing the upgrade so that they can take advantage of hemoglobin, but also driving our product into the general floor.

Spencer Nam – Summer Street Research

Great. And so final question kind of dovetailing that comment is, we had heard from some of the OEM – the pulse-ox OEMs that – or the patient monitoring OEMs that there is actually a somewhat of a pent-up demand building up due to replacement cycle being extended somewhat over the last 12 to 18 months. Are you seeing your OEM partners, which gave that – in some trouble middle of last year coming back to you with a little more demand here, how do you see the OEM side of your business unfolding at this first half of this year?

Joe Kiani

Yes, the answer is yes. We are seeing more demand and whether that demand will continue into the second half of the year we're not certain, but certainly the first half of the year it looks like all that pent-up demand and products becoming really old and needing replacement is having a nice effect on our OEM business so far this quarter.

Spencer Nam – Summer Street Research

Thank you.

Joe Kiani

Thank you.

Operator

Your next question comes from the line of Matt Dolan with Roth Capital.

Matt Dolan – Roth Capital

Hi, guys. Good afternoon. Just a couple of real quick follow-ups here. On the guidance, can you talk maybe about some of your newer opportunities in 2010? It sounds like you're pretty content the hospital environment is freeing up nicely. First, on the push into the general floor, how much of that are you assuming into your outlook here, which looks like the base business grows kind of in the mid-teens.

And second question, on Pronto, given a reimbursement right now established, how does that change your commercial strategy and bake into these guidance numbers?

Joe Kiani

Well, obviously it is all baked in to the numbers I've given you. And it has helped us feel good about potentially this being the year that we're going to start growing back at 20% again. Thus far in the high side, we have guided up to, for product revenue growth 360, which is a 20% growth from 2009. Yes, we are feeling really good about all of it. I mean general floor monitoring looks like it’s happening. At a broad level I think the convergence of people recognizing that unnecessarily patients are being harmed in the general floor due to heavy dosages of opioids, this new Dartmouth study, Masimo technology and all is looking very good.

And with the $7.19 reimbursement, which is more than double of what reimbursement is given for invasive hemoglobin, but less than what is done by ordering CBC, which is one thing that I think Medicare is calculating by giving us that reimbursement, because it can help save money. Because a lot of times people order CBC, but all they really want is hemoglobin, should help deliver a strong 2010, and more importantly really start hitting our stride in 2011.

Matt Dolan – Roth Capital

Okay. And then for Mark, on the expense side of things, not to beat this one into the ground, but in 2011, should we essentially strip out the $15 million of onetime spend entering that year, or could that trickle into next year as well?

Mark de Raad

No, from a modeling standpoint as we said the 15 million should be assumed as essentially a onetime additional expense in 2010. So as I alluded earlier to as we head towards those targeted ranges of 45% total operating expenses, and then even lower that will have to be done even without that kind of $15 million continuing.

Matt Dolan – Roth Capital

Sure. Okay. And then finally, do you have any new expectations for when your discussions around the Covidien royalty could ensue?

Joe Kiani

We don't.

Matt Dolan – Roth Capital

Okay. Thanks guys.

Joe Kiani

Thanks.

Mark de Raad

Thank you very much.

Operator

Your next question comes from the line of John Putnam with CapStone Investments.

John Putnam – CapStone Investments

Thanks very much. Mark, I was wondering if you could give us a little more color on the gross margin improvement. Will it be sequential, or will it be weighted to one part of the year or another?

Mark De Raad

You are talking about ’10 versus ’09?

John Putnam – CapStone Investments

Correct, yes.

Mark de Raad

I think the assumption should probably be that it will be moving upwards steadily throughout the year. I don't – the numbers we gave were our best judgment for the entire year. Typically what we see as we go through a year, especially based upon some of the continuing cost improvements we are able to make that we see that margin benefiting us a little bit more towards the end of the year. Also, as you can imagine, we are assuming on a relative basis higher Rainbow revenues towards the second half of the year, and those also from a mix standpoint help contribute to improving margins. So the numbers I quoted earlier were really the blend for the entire year. If you are modeling, I suggest may be a little bit lower margins in the first half of the year, a little bit higher in the second half of the year that gets you to those numbers for the full year.

John Putnam – CapStone Investments

Great. Thanks very much.

Joe Kiani

Just as a time check, we probably have time for one more question.

Operator

Thank you. And that would be from the line of Constantine [ph], Treasure PotsNet [ph].

Constantine –Treasure PotsNet

Hi, guys. Thank you so much for taking the question. I just wanted to get more color on your manufacturing footprint, and if you can comment on how you're taking costs out of manufacturing.

Joe Kiani

Sure. First of all, we’ve made a big investment in a facility in Mexicali, where we have over 1,200 people doing the manufacturing, bulk of the manufacturing work for us. We have invested heavily in mechanization. We are doing a lot of vertically integrated value-add work. For example, there are products that can be built by dozens of companies. For those we don't want to vertically integrate, but the parts that one or two vendors can do only around the world, we're bringing it inside to not only improve our quality, but to lower our cost.

Historically, we have been getting about an 8% to 10% reduction in COGS year-over-year. So we don't expect to see that stop in the near term. And we just hired a new head of operations who came from the hard disk drive industry who – they were building 50 million hard disk drives a quarter, and vertically integrated for both the benefit of quality and COGS. So we're hoping with Brian’s [ph] experience, we will be able to take the leaps ahead in both quality and cost of goods.

Constantine – Treasure PotsNet

Thank you.

Joe Kiani

Thank you all. I want to thank you all for taking the time to join us today. We appreciate your continuous interest in Masimo, and we look forward to speaking with you again soon. Thank you.

Operator

Thank you for participating in today's conference. You may now disconnect.

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Source: Masimo Corporation Q4 2009 Earnings Call Transcript
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