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Masimo Corporation (NASDAQ:MASI)

Q4 2013 Results Earnings Conference Call

February 13, 2014 04:30 PM ET

Executives

Eli Kammerman- VP of Business Development and IR

Joe Kiani - Chairman and CEO

Mark de Raad - EVP of Finance and CFO

Analysts

Tao Levy - Wedbush

David Clair - Piper Jaffray

Joanne Wuensch - BMO Capital Market

Brian Weinstein - William Blair

Matthew Dodds - Citigroup

Chris Lewis - Roth Capital Partners

Larry Keusch - Raymond James

Ben Haynor - Feltl and Company

Operator

Good afternoon, ladies and gentlemen, and welcome to Masimo's Fourth Quarter 2013 Earnings Conference Call. The company's press release is available at www.masimo.com again that is www.masimo.com. At this time all lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. I'm pleased to introduce Eli Kammerman, Masimo's Vice President of Business Development and Investor Relations. Please go ahead, sir.

Eli Kammerman

Thank you. Hello, everyone. Joining me today 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 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-K and Form 10-Q. You will find these in the Investor section of our website.

I'll now pass the call to Joe Kiani.

Joe Kiani

Thank you, Eli. Good afternoon and thank you for joining us today. We call it 2013 the clear evidence of both underlying business and operational strength in many areas including fourth quarter driver shipments of 42,000 bringing our 2013 driver shipments to a record 168,000 and 200 SET Pulse Oximetrs and rainbow Pulse CO-Oximetrs an annual increase of 15% over a 146,400 in 2012 and ahead of our expectations.

We also had a 34% increase in rainbow revenues. For the full year our rainbow revenues reached nearly $49 million for 2013 up 21% for the full year. Although this was slightly below our $50 million expectation as we have been able to ship the complete SpCO orders as referenced in the Q3 call we would have exceeded the $50 million.

We also had a 9% constant currency increase in fourth quarter worldwide product revenues which contributed to total fiscal year 2013 product revenue of $517.4 million, up 13% on a constant currency basis. We believe that the operational improvements we have been working for the past number of years will become even more apparent in the 2014.

The combination of continued positive results from our ongoing value engineering and manufacturing and a continuation of the moderation in our operating expense growth gives us confidence in our earnings potential as we enter 2014. Fiscal year 2014 will mark our 25th anniversary which we hope to celebrate with a variety of new product introductions. We have already announced the first of several products we plan on introducing in 2014. This first product is called O3 and it allows Masimo to deliver its first tissue and regional oxygen saturation monitor.

This product which I will speak about in more detail later has many clinical advantages to the existing products and what we believe to be $100 million market opportunity.

In a few minutes I will provide some additional perspectives on what we expect in 2014 and highlight some key achievements from both the fourth quarter and 2013. But first Mark will review fourth quarter and full year 2013 financial results as well as share with you our 2014 financial guidance. Mark?

Mark de Raad

Thank you Joe and hello everybody. Fourth quarter 2013 total revenue including royalties was $142.4 million or up 8% or 9% on a constant currency basis versus the fourth quarter of 2012. Product revenue was $137.7 million, up 8%, or again 9% on a constant currency basis versus the fourth quarter of 2012. The impact of unfavorable foreign exchange rates lowered our year-over-year Q4 2013 revenues by a record $2.3 million and $7 million for the entire year. This was due primarily for the weakening of the year-over-year yen versus U.S. dollar.

As I will note later this material foreign exchange change impacted not only our top line but negatively impacts both our product gross profit margins as well as our operating income. Rainbow product revenues were a record $14.8 million, up approximately 34%. We saw continued strength in our consumable sales including very strong Q4 SpCO orders from our international business.

Consumable revenues accounted for nearly 47% of total Rainbow revenues in the quarter up from 37% in the prior year quarter.

Our worldwide end user or direct business which includes sales through our just in time distributors grew 9% for the fourth quarter to $116.3 million versus $106.8 million in the year ago period.

Our direct business represented 86% of total product revenue in the quarter, slightly higher than the 85% one year ago. OEM sales which made up the remaining 14% declined slightly to $18.4 million compared to $18.5 million in the same period of 2012. By geography total U.S. product revenue rose 6% to $89.3 million compared to $84.4 million in the same quarter of 2012.

Growth was primarily driven by increased SET Pulse Oximetry center sales to hospital customers, resulting from the strong shipments of drivers this year. This growth was less than we expected and do we believe to a few specific reasons. While we ended the year with a record number of hospital contracts, which is excellent news for the business long-term when these new contracts are renewed they are done so pricing lower than the prior five year contract pricing. In addition, we believe that overall U.S. shipments were also impacted by lower year-over-year Q4 hospital ignitions, which were down by approximately 4%.

International product revenues rose 11% or 16.5% on a constant currency basis to $45.4 million in the fourth quarter of 2013 versus $40.9 million in the same period last year. This increase was due primarily to growth in EMEA and Latin America. Unfortunately, we were not able to ship the full rainbow SpCO order that we noted in the Q3 call and had two other largest international orders that did not materialize in the quarter as we expected. Despite these specific orders, our international revenue represented approximately 34% of total product revenue for the fourth quarter of 2013, which was up from 33% a year ago and represented the highest OUS percent of revenue in our history.

Our reported fourth quarter gross profit margin was 61.5% compared to 64.1% one year ago. At the end of the fiscal fourth quarter, based on decisions we made to accelerate our transition to more efficient and lower cost boards and LED components made by Masimo semiconductor and to concurrently write-down the value of certain other terminated automation project related expenses, we took an approximate $4.6 million charge.

Importantly, excluding this charge, our Q4 gross profit margin would have been 64.9% marking a continuation of the improvements we’ve seen in our overall product gross margins for over a year now. Our fourth quarter total gross profit margin including royalties was 63.6%, down from 66% in the year ago period. However, excluding the impact of the Q4 charges I just mentioned, our adjusted total gross profit margins would have been up to 66.8%.

Fourth quarter 2013 total operating expenses was $77.9 million, up approximately 20% over the year ago period. Included in this total was an $8 million charge related to the arbitration award and associated legal fees, $5.4 million of which we noted in our 8-K filed on January 22, 2014. The incremental $2.6 million charge was the result of the decision to accrue the potential legal expenses, which had previously been covered by insurance.

Importantly, without the impact of this $8 million charge and the $1.4 million in medical device taxes, our total operating expenses were $68.5 million, which represented only a 6% increase over the prior year period. The overall increased spending was due primarily the cost associated with new blood management sales team, other legal expenses and various marketing trade show-related expenses.

Fourth quarter 2013 operating income was $12.7 million, down by 43% compared to $22.3 million in the year ago period. However, once again, the $9.6 million decline in operating income was attributable entirely to the $12.6 million in charges recorded in the quarter as we previously mentioned. In fact, without these charges, operating income would have risen by 14% to $25.3 million.

Non-operating expenses were $752,000 in the fourth quarter and were due primarily to the impact again of unfavorable foreign exchange rates on the translation of our foreign currency balance sheets. This compares with the non-operating expense of $1.3 million in the year ago period.

Our fourth quarter 2013 effective tax rate was 22.8%, down from 29.3% in the same period last year. This decline was entirely due to the impact of the $8 million arbitration and related legal expense award, which are all U.S. related expenses. In fact, without the $8 million arbitration award and related legal expense charge, our Q4 effective tax rate would have been 28.5%.

Fourth quarter 2013 reported net income was $9.2 million or $0.16 per diluted share compared to $15 million or $0.26 per diluted share in the same prior year period. However, once again, the two special Q4 charges reduced Q4 EPS by $0.09 and $0.06 respectively. Therefore, without the special charges, our Q4 earnings per share would have been approximately $0.31. The impact of the new medical device tax reduced Q4 EPS by an additional $0.02 per share compared to the prior year. As a result, without these impacts, our Q4 EPS would have been $0.33, up from $0.26 in the prior year.

Now I will provide a brief review of our 2013 full year results, but also direct you to today’s press releases and the Form 10-K, which will be filed later today for more detailed information on our full fiscal year results.

For fiscal year 2013, total revenue rose 11% to $547.2 million from $493.2 million including product revenue of $517.4, million which was up 11% from $464.9 million. Importantly and significantly for the entire year, product revenues would have been up 13% on a constant currency basis, a year-to-date difference of $7 million in total product revenues. Total 2013 royalty revenues rose 5% to $29.8 million from $28.3 million in 2012.

Reported 2013 product gross profit margins were 63.6%, down slightly from 64.1% in 2012. However, once again, adjusted for the Q4 2013 inventory and equipment charges, the adjusted 2013 product gross profit margins would have been 64.5%. Total 2013 operating expenses were $279.1 million, which was up 16% from $241 million in the prior year. Excluding the special charge of $8 million in Q4 2013 and the $6.3 million in medical device taxes this year, our adjusted operating expenses would have been $264.8 million, up approximately 10% from 2012. And without the impact of the new worldwide blood sales management team, our 2013 operating expenses would have increased approximately 7%.

The 2013 tax rate was 26.4%, which was slightly above the 26.1% in the prior year. Again, without the Q4 arbitration award and related legal expenses, our adjusted 2013 tax rate would have been 27.5%. Net income for 2013 was $58.4 million or $1.02 per diluted share compared to $62.3 million or $1.07 per diluted share in 2012. As discussed earlier the one-time charges in our Q4 results reduced our full year 2013 EPS by approximately $0.15, while the medical device reduced 2013 EPS by another $0.07.

And although we have discussed the significant impact of the unexpected unfavorable foreign exchange rates this year on our revenues and product gross profit margins, we've not really exempted to also determine the quarterly impact and now full year impact on our earnings per share. However, for the full, the cumulative impact of the unfavorable 2013 FX rates on our revenues, cost of sales and operating expenses was approximately $0.09 per share while the translation impact reflected in our other expense line item on our profit and loss statement choose 2013 earnings per share by another success.

As of December 28, 2013, our day sales outstanding was 52 compared to 49 as of the same prior year period. And over that same period, inventory turns declined slightly to 3.7 from 3.8. Total cash and cash equivalents as of December 28, 2013 were 95.5 million compared to 71.6 million as of December 29, 2012.

The change reflects net cash generated from operations offset by capital expenditures and 19.8 million in share repurchases in the first half of the year. We did not repurchase any additional shares in the fourth quarter, but for the full year, we repurchased a total of 1 million shares.

Now, I’ll discuss our 2014 financial guidance which is based on the best information we have available to us and in general assumes no significant changes either to the worldwide macroeconomic environment or to the environments in which our primary customers our hospitals operate. In addition, as usual, we make various pricing assumptions including the overall rate of ASP reductions, the level of new contract renewals and the impact of third-party reprocessing on our sensor business. Should any of these assumptions prove to be incorrect, our overall revenue guidance could be impacted. Also these projections assume certain foreign exchange rate assumptions at the beginning of the year and to the extent that these assumptions differ significantly from actual exchange rates, our actual results could vary from our guidance.

We’re now projecting the 2014 revenue of $578 million including product revenue of $570 million and royalty revenue of $8 million. Included within the $570 million in product revenue, we are projecting rainbow revenues of $60 million. Currently, we anticipate that we will see slightly lower overall year-over-year first half 2014 growth rates with higher year-over-year growth rates materializing in the second half of 2014, especially as usual with the strong fiscal fourth quarter.

We believe that the second half 2014 strength will be due to the positive impact we expect from the blood management sales team, the installation and use of additional drivers and the impact of new products. We’re also projecting 2014 royalty rate range of between $8 million to $28 million. Because we have not had any dialog with Covidien on this matter, we are going to assume that Covidien will abide by the current royalty agreement which does require Covidien to provide Masimo with at least 60 days notice of its intention to terminate the current agreement.

Of course as you know this agreement provides Covidien with the covenant not to be sued for patent infringement of their Pulse Oximeter in exchange for the 7.75% royalty payment. Because we have not been notified of their intention to terminate the agreement for now we are assuming that Covidien will continue to pay the royalty agreement through at least April 14, 2014.

As a result, the lower end of our royalty rate assumes approximately 8 million in Q1, Q2 royalties. However, beyond April 2014, we are still not certain as to Covidien’s intention and so in order to provide the broadest range possible, we are also suggesting that if Covidien elects to continue to operate within the terms of the current royalty agreement, that the full year royalties could approximate 28 million. As a result of this uncertainty, we are providing a 2014 range of royalty revenues from $8 million to $28 million.

We expect our full year 2014 product gross profit margin to be approximately 66%, reflecting a continuation of our ongoing focus on overall product cost reduction efforts throughout the year. We expect our gross profit margins to be lower than this overall range in the first half of 2014 but higher in the second half of 2014 as the impact of our cost reduction efforts are implemented into production during 2014.

Assuming only $8 million in 2014 Covidien royalties, we expect our total operating expenses to be approximately $287 million including $2 million for incremental IP legal expenses with Covidien. This operating expense projection also includes the additional remaining incremental cost associated with the complete build out of our new SpHb dedicated sales force, and assumes flat year-over-year other legal expenses.

If our assumption on legal expenses related to the timing of various potential trial dates proves incorrect, our total operating expenses could increase. Assuming that the Covidien royalties continue and reach approximately $28 million for the year, we expect our operating expenses to increase to approximately $292 million due primarily to our ability to invest in additional 2014 business, product and marketing initiatives to support our new product rollouts as well as make certain charitable contributions.

In addition to this operating expense guidance, we are also projecting an estimated medical device tax of approximately $7 million which we intend to continue to report in SG&A expense. We expect our 2014 effective tax rate to be approximately 27% to 29%, depending upon the percentage and level of royalties we will receive.

As previously noted, we are not assuming -- we are assuming constant FX rates based upon the beginning of the year FX assumptions. And as a result, we are not projecting or forecasting any foreign exchange gains or losses within our 2014 product revenues, cost of sales, operating expenses as well as within our non-operating expense section of our P&L. As a result of these assumptions including royalties at $8 million and $28 million, we are now projecting 2014 GAAP earnings per share of approximately $1.13 to $1.28 respectively. This is based on a weighted share assumption of $58.5 million for the year. Of course the total amount of shares outstanding will be impacted by normal treasury stock valuation factors, new options brands and any additional stock repurchases.

With that I’ll turn the call back to Joe.

Joe Kiani

Thank you, Mark. As you’ve just heard Masimo has a grown into a company with sales approaching $600 million annually and significant growth prospects. We began 2014 with mix field; on one hand we see positive business trends, such as high driver shipments, strong label growth, significant product introductions and the prospects of GE and Philips entering the market the rainbow products this year. But we also know the weak senses in U.S. hospital, which has resulted in lower than expected revenue growth rates in the first six weeks of this year. Overall though we remain optimistic and believe that any sluggishness in the first half, we more than offset by a strong second half in 2014.

Last year, we achieved appreciable market share gains as seen in our new driver shipments and in our sales growth. The 11% increase in our installed base is directly attributable to our break through Pulse Oximetry, Pulse CO-Oximetry and Patient SafetyNet technologies. These technologies enables to consistently when compared to Pulse Oximetry agreement with new and existing hospital customers.

In fact, in 2013, we had a record year for such new contracts with new hospitals around the world including the Mayo Clinic, St. Joseph’s Hospital Sytem, Children’s Hospital of Atlanta, St. (inaudible) Health Care, Oklahoma University of Medical Center, Resurrection Health Care, University of Colorado Hospital, Kremlin Hospital in Ireland and Papa Giovanni the 23rd hospital in Italy. Further we continue to gain new installations into the general wards of the hospitals as the value of continuous monitoring for all patients become more apparent.

For the past seven years we have focused on building a strong and knowledgeable worldwide sales and marketing organization, capable of expanding both our SET and rainbow businesses. In 2013, we had another incremental investment in our new worldwide business blood management team which will be primarily focused on our SpHb technology and related products. While we continue to make strategic incremental staffing investments throughout our worldwide organization, we believe that we have now reached the level of staffing needed for our sales marketing engineering and other organizations to be capable of supporting higher product revenue growth.

Also as we have noted, our engineering and operations organizations are continuing to focus a large percentage of their efforts under using the cost of our products, both devices and sensors, while improving them for our customers. As an example the investment we’ve made in acquiring Spire Semiconductor, now Masimo Semiconductor, this acquisition has allowed us to make our own high performance low cost (inaudible) dials for our rainbow sensors which will dramatically reduce the cost of goods for sensors while enhancing the performance.

In summary with the good start we had in 2013 in both improving product gross margins and lowering our operating expense levels we are now ready to continue to drive business and financial leverage through the financial model in 2014 and beyond without sacrificing our future growth. Also as I discussed earlier 2014 is a symbolically important year for us, as Masimo becomes 25 years old.

We have planned many important new product rollouts this year as one example of these new products and technologies a few weeks ago we announced receipt of the CE Mark for our new O3 regional tissue oximeter and Pulse Oximeter compatible with our root monitor. This sensor broadens our reached into operating bone enabling the measurement of cerebral oxygen and the synergistic with our SEDLine brain function monitor.

O3 for the first time ever measures simultaneously with the same sensor, the regional and core oxygen saturation with 4% and 2.5% accuracy respectively which will help clinicians, asses their patients’ status better.

We anticipate filing for FDA 510(k) clearance for O3 during Q1 this year. But the duration of the FDA review process is uncertain. Our root monitor continues to gain interest in hospitals due to expanded information display and expand ability potential. We have now launched three maximal [Mach 9] modules for expanding the functionality of ROOT, SEDLine brain function monitoring, phasing capnography and O3 regional tissue Oximetry.

The phasing capnography and O3 regional tissue Oximetry modules are currently available only in CE mark countries. We expect additional marks and capabilities for ROOT to be launched from our internal research upgrades as well as from the efforts of third party developers.

The full featured version of our ROOT monitor which includes IRIS connectivity capabilities is CE marked and is currently pending FDA 510(k) clearance in the U.S. With IRIS gateway ROOT can connect to other devices such as IV pumps, ventilators and other patient monitors and send the information to the electronic medical records.

We ended 2013 with SpHb revenues of $12.8 million which accounted for roughly a quarter of our total rainbow sales. SpHb revenues for Q4 were $3.3 million and continue to reflect the lumpiness associated with smaller scale revenues affected by seasonality which is certainly (inaudible) care market and periodic large orders.

While quarterly growth comparisons are still subject to such distortions, it is important to note that SpHb revenues for the second half of 2013 grows by 31% over the revenues for the first half of 2013. SpHb continues to gain recognition as a valuable tool for blood management and detection of a cold bleeding in the hospitals with documented benefits of improving outcomes in lowering cost for hospitals. SpHb visibility is expected to grow within pending launch of rainbow-enabled products by our largest OEM partners, Philips and GE expected in the second half of 2014.

This year, we anticipate a notable contribution to our product revenues from our new blood management team. In fact, I’m happy to announce that one of our first better care customers Del Sol Hospital, a [health plus] hospital located in El Paso, Texas has successfully completely their better care program.

Despite already having a successful blood management program in place, which had reduced blood transfusions, implementation of the better care program with SpHb further reduced blood transfusions that was sufficient to more than offset the cost to deploy SpHb. And now Del Sol has chosen to deploy SpHb across many more departments.

We are prompt of our efforts to improve patient care around the world last year, which resulted in addition to the other placements, the installation of the largest patient SafetyNet system in Germany at Children’s Hospital St. Elizabeth in Neuburg. We now have over 250 hospitals that are deploying patient SafetyNet and there are many more in our pipeline.

In the fourth quarter, we launched the prescription version of our mobile oximetry, the iSpO2 Rx in CE marked countries and Japan and initiated collaboration with the new born foundation for making blood oximetry routine for new borns, the BORN Program. The BORN Program is an effort to increase early distraction of life threatening congenital heart disease and instance so that corrected measures can be prescribed before severe illness occurs.

Well there are guiding principles including the guiding principle to always do what is best for patient care, our portfolio of breakthrough monitoring technologies positions us as the clear leader for improving patient care and will continue to propel Masimo’s steady and fast growth.

With that we’ll open the call to question. Operator?

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Tao Levy with Wedbush.

Tao Levy - Wedbush

Good afternoon.

Joe Kiani

Hi Tao.

Tao Levy - Wedbush

So, just a couple of quick questions, first Joe you mentioned the hemoglobin number is sequentially a little bit lower, I know things are still lumpy there, but on the flip side, you had brought on -- you did bring in bunch of new sales reps there. How should we think about how that unfolds throughout 2014? And when do you get a better sense of whether that was a good investment in terms of resources, in terms of expanding that group of sales reps?

Joe Kiani

Thanks Tao. Well, we have that sense already that that was a good investment and I’ll tell you why. From the profit history of non-invasive hemoglobin, we have 9 hospitals that implemented across multiple departments non-invasive hemoglobin, 5 of them being the better care accounts. But I can happily tell you that because of this group, we now have 35 new hospitals that have decided to deploy SpHb across multiple departments.

And I think probably 1 out of 7 or 1 out of 10 times they require a better care type of a guarantee and that’s because while a year or two ago they have to have the guarantee to get hospitals interested in the cause was the major factor, I believe through the efforts of the sales force, through the education of clinicians they are beginning to see the value of non-invasive hemoglobin to not just be away to reduce cost through blood transfusion reduction, but to help with patient safety through detection of occult bleeding. So, we’re feeling pretty bullish about non-invasive hemoglobin’s growth and especially because of this new team that’s been deployed mostly in the U.S., but worldwide.

Tao Levy - Wedbush

Great. And you mentioned regarding the Covidien royalty, obviously you can’t really say too much about that, but you mentioned April 2014, what’s important, why the April of next I guess of this year in terms of what you expect to say more about?

Joe Kiani

Well, we are close to get a 60 day notice from the date that Covidien wishes to stop making the payment. So today is February 13th we haven’t got such a letter, but we have 60 days from tomorrow and that gets us to April 14, 2014.

Tao Levy - Wedbush

Okay. And will you guys put like some notice out if you get a check and it has all more and more royalty than you expected, we won’t find until I guess May when you report numbers?

Joe Kiani

Well, that’s a good question, I have to think about that, but I think right now we’ve given you a range. And while I’m being maybe more pessimistic and I should be prudent about that from what we are seeing out there, we’re not expecting it to end in Q2 either whether it goes for the full year who knows? But again, it’s all a guess work for us. We just have to see. I guess one thing for sure, if we do get the lever (inaudible) that we’ll do in 8-K on.

Tao Levy - Wedbush

Okay, great. Thank you.

Joe Kiani

Thank you.

Operator

Your next question comes from Bill Quirk with Piper Jaffray.

David Clair - Piper Jaffray

Hi, good afternoon everybody. It’s Dave Clair in for Bill. So, first question from me, I am just hoping you can give us a little bit more details on what’s included in the Rainbow guidance. What needs to happen for you guys to hit that number?

Joe Kiani

Well I think, A, the blood management team use to deliver and we’ve been very conservative compared to what they have in their pipeline and they have in their quotas. Secondly, we expect a VP of SpCO order that we got last year towards the end of the year that we talk to you about we think that will continue to happen.

So, I think some disaster [recurring] I think the number that we have given you is quite conservative and we should be able to meet it. Some of the positive signs are out there that may makes us feel better for example with SpCO, we see the cities and the states becoming more solvent and have more financial wherewithal which should eventually trickle down to the fire department, which should trickle down to us, and purchase of SpCO. So I think some good things so far that makes us feel that $60 million number we gave you is one that we can achieve.

David Clair - Piper Jaffray

Okay. Thank you. And then in terms of the blood management sales force, are you at that 60 headcount level and then what percent of these reps would you say are kind of fully up to speed and fully ramped at this point?

Joe Kiani

We have about 50 with another 10 to go, we believe by the middle of the year they will all be quota carrying and at full capacity.

David Clair - Piper Jaffray

Okay. Thank you.

Joe Kiani

Thank you.

Operator

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

Joanne Wuensch - BMO Capital Market

Thank you for taking the question. I’m a little bit confused by something. There was a lot of discussion about taking out the royalties for 2014, because it was unknown. And now it’s sounds like you are putting back to royalties in some way for 2014, given your range. And I just want to know if there is something that has shifted in your conversions, your thought process? And then secondary question is how do you budget quarter-by-quarter not knowing when this money is coming in? So would you -- will you let it just flow through to the bottom-line (inaudible).

Joe Kiani

Well Joanne, unfortunately we don’t, we can’t give you anything more than we've already said, but let me repeat what we have. They need to give a [60 million] in orders, we haven’t gotten one yet. From reading from (inaudible) both what they’ve said in their earnings calls and what we’re hearing on the street, we’re not expecting that to change dramatically. And that’s why we’re taking these that might continue. And as we said that’s not Q2 -- not for the whole year at least for Q2. But again, like I said earlier if we do get a order, we’ll make an announcement of that so you will know. But as far as the second part of your question, how we’re managing the business. We are assuming we’re not going to get those royalties beyond what $8 million that Mark mentioned. So therefore, we’re managing our business, so we were not going to get it. And if we do get it, while we’re going to let majority of it fall to the bottom-line and that’s why you see a big earnings difference between with and without, we are going to spend a little bit more than we have planned and things like sales, marketing and maybe some philanthropic measure.

Joanne Wuensch - BMO Capital Market

Okay. And then my second question is, as you’re talking about gross margin outstanding, a fair amount between 2013 and 2014, call it 130 basis points, how do you get there from point A to point B?

Joe Kiani

Well we had decided a little while ago, maybe a couple of years ago that in preparation for the royalties ending to do -- take our very best people, not all of them, a lot of them, and our engineering department and manufacturing group and have them go to a full value engineering from our sensors to our devices. And the team has done amazing job. We are seeing some amazing differences in our cost going forward and as we bring in line the newly value engineered products into our production; we expect to see dramatic drops in our cost of goods. And given that we believe our sensor pricing, Pulse Oximetry pricing stabilize, we expect that improvement in the cost of goods to help bolster our margins.

Joanne Wuensch - BMO Capital Market

Okay, thank you.

Joe Kiani

You’re welcome.

Operator

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

Brian Weinstein - William Blair

Hey guys good afternoon.

Joe E. Kiani

Hey Brian.

Brian Weinstein - William Blair

My question is on operating expenses can you let us know what the incremental cost is of the new reps in the ‘14 number and sort of what the underlying growth rate is excluding those reps it seems as if your operating expense growth is expected to slow down pretty dramatic where things were in prior years if you back that out if my math is correct so can you give us any kind of inside on that? Thanks.

Mark de Raad

Directionally on an incremental basis to complete not only the build out but of course next year we’ll have that new entire sales force on board for the entire year where as they were hired throughout 2013 of course best guess is that will add an incremental 4 million-ish range to our spending in 2014. So that’s part of the additional operation expense that guidance that we’ve provided and frankly you are right if you remove that if you look at the core underlying operating expense growth of without that we’ll be hovering at the lower end of the numbers we talked about a little bit before in about that 7% range which historically obviously for Masimo is very much at the low end of the range but again very consistent with the overall direction that Joe just articulated in terms of the focus of delivering overall leverage in the model.

Brian Weinstein - William Blair

Okay. And then I might have missed it, but when you give the guidance to rainbow for next year, could you please provide what you expect the percent from consumables to be specifically, what their contribution is expected to be from SpHb? Thanks.

Joe Kiani

So, the SpHb portion, we expect our revenue to go to $18 million from the $12.8 million that was in 2013. As far as the contribution of the consumables, I know this year we ended up, we got 47% in the quarter. And I think that run rate is probably right rate, so I’d say about 50% will be consumables.

Brian Weinstein - William Blair

Okay, thanks guys.

Joe Kiani

Thanks Brian.

Operator

Your next question comes from Matthew Dodds with Citigroup.

Matthew Dodds - Citigroup

On the product revenue guidance for 2014, the last couple of years it’s been pretty consistent in the growth between U.S., OUS. I know Joe your comments about kind of the U.S. volume in the fourth quarter. Directionally, is that going to be the same in your estimation for ‘14 or is there more of a spread in the guidance?

Joe Kiani

Mark?

Mark de Raad

Sure, yeah. No, I think in general math, our expectation is that as I alluded to in the fourth quarter, we were happy with the record of 34% oUS mix. Looking forward to next year on a comparable basis to 2013, we do expect on a percentage basis again to have a higher contribution of total revenues from our oUS business, can’t put a specific number on it of course, but directionally we expect that oUS percentage of total revenues to continue climbing.

Matthew Dodds - Citigroup

And just one follow-up for the total number of installed base into the year the 1.205 million, it looks like that equated to that 17,000 retirements in the quarter which is higher than the recent run rate? Is that right and is that a change or is that kind of bluff when we think about 2014?

Mark de Raad

Matt, you’re number is right, it actually was about 16,500 units. Directionally, we don’t think it’s really bluff, we think as we had forward the next couple of years. That based upon our standard 10 year life assumption, if you obviously dial the clock back 10 years, those were years in which there were significant additional drivers been put into the market place by Masimo. And so it stands to reason that number will continue to grow. You are right in the sense of this was a market increase from about like 12 to maybe 14 range that we have seen before, but directionally it’s probably the right range to be thinking about for the next year.

Matthew Dodds - Citigroup

Thanks Mark, thanks Joe.

Joe Kiani

Thank you, Matt.

Operator

Your next question comes from the line of Chris Lewis with Roth Capital Partners.

Joe Kiani

Hello Chris.

Chris Lewis - Roth Capital Partners

First on the general world opportunity Joe, I was just hoping you could talk about the interest levels and overall adoption rate you are seeing from the field there and how that layers into the growth outlook for 2014?

Joe Kiani

Sure. First of all, maybe it’s circling, but in the circle talk, what I’m talking with feels like general ward monitoring, it feels like low from this 5%, 10% penetration to 80% to 100% some whispers even at CMS where they’re going to recommend monitoring the patient for an opioids, let’s say they talk continuous pretty closely continuous basis. So we’re feeling really good about that market becoming real show some solutions to stop using drugs by opioids that affect respiration rate that the (inaudible) ubiquitous there. So, we had a great year in terms of number of hospitals that implemented patient safety and we think we have a good momentum to increase that in this year.

Chris Lewis - Roth Capital Partners

Okay. And then just for your guidance I think last year when you introduced 2013 guidance you kind of talked about taking a more conservative approach. Can you talk about the methodology you use this year and maybe how that’s change or evolve since a year ago?

Joe Kiani

Yes. We have the same approach this year. We really have tortured the numbers. We’ve taken what our heads of sales and their managers have given and have dialed it back to numbers that we believe should be more than achievable, but things kind of got to go right, I mean we have this whole headwind with FX in Japan that hops to $7 million of product revenues in 2013, which we didn’t anticipate when we rolled out the numbers. And in Q4 a few things didn’t go quite our way from multiple orders that didn’t happen to big SpCO order that we couldn’t fulfill fully to the sensors drop. So you can never say for sure, but we believe we have made it conservative and we hope we’ll meet these numbers that we are giving you.

Chris Lewis - Roth Capital Partners

And then on the M&A front can you just provide an update on your appetite there and anything worth talking about?

Joe Kiani

Yes. We are constantly looking -- we had a couple of -- we had three, but I think now maybe two companies on our, not no more big acquisitions these are all tuck-in types of acquisitions like PHASEIN and SedLine and Masimo Semiconductor, so those are different kinds of level of acquisitions.

Chris Lewis - Roth Capital Partners

Okay. Thank you.

Joe Kiani

Thanks Chris.

Operator

Your next comes from Larry Keusch with Raymond James.

Larry Keusch - Raymond James

Hi, good afternoon. Joe, since as you were mentioning earlier, the general floor seems like really substantial opportunity, it feels like it’s starting to gain some traction and certainly you are certainly, it sounds like you are seeing it in the business. But I am curious given that it could be significant opportunity for the company and it’s sort of right in the core of what you guys do. Is this something that you think you could accelerate the uptake of this in the general floor if you threw more money at it?

So I guess where I am going I am thinking about your SpHv guidance for the year going up to about $18 million, up about 40%, which is good, but it seems to me or I guess the question is could that money be spent elsewhere and perhaps growing at a general floor? So, I am just trying to understand the deepen influence of the growth rate on the general floors you could invest more there?

Joe Kiani

Yes, I mean great question I think certainly I think we will get more if we did have a dedicated sales force they did nothing, but call them to general floor section of hospitals. But I don’t believe though we would get a good return on that because one, we have the ideal of technology for the general floor. The non-invasive process that we made due to a reliability, sensitivity and specificity really has no match and is enabling general for monitoring.

So with that and some of the tools -- this volume that we created like patient SafetyNet system, the rule some new products we are going to be introducing, we believe we’ve got the examples, right technology and we have fix sales and clinical specialist sales force in the U.S. they are calling in hospital regularly and the people that are making the decisions to implement module (inaudible) which will remain call point for our regular hospital business.

So I feel that while we can get more if invested more, I think the return will be there. I think what needs to happen now if not it’s (inaudible) effort of saying enough is enough we’re trying to having people get invested because they want to be monitored and they would give an opioids when completing. We need something like maybe out the joint commission or CMS or people like that to say, enough is enough you got do it, we’re going to check in behalf that they have implemented this continuous non-invasive monitoring on the general floor.

So I think if that happens with their collective business we are already in 1000 of hospitals as the health expenditure, all the health expenditure company in those hospitals. And then the other ones that we’re not in, I can tell you we can cost from them, even though there are (inaudible) account that says look, why don’t you jump for mortuary, and even though we have no force for the rest of hospital, would it come to jump for margin we want to talk to you, are you willing to work with us on a general force area. Yes of course, our answer is yes. So I think well spending more to get more, I don’t think it’s a good investment.

Larry Keusch - Raymond James

Okay. That's helpful. And then one other question and just one very quick one, again on the timing of the GE and Philips introductions as they are maybe compatible products, you’re now saying second half of ‘14. Obviously that's sort of been moving around over the course of the last 12 months. And so I guess the obvious question is how much visibility do you truly have into the timing of those launches?

Joe Kiani

We work really closely with them, we have regular meetings but unfortunately as you know with engineering projects, I have never seen a project delivered on time, maybe it happens but unfortunately I have seen many times when project do get push out and that has happened here, Some (inaudible) for example, (inaudible) which is something that every medical company has to comply with is going to be by this June, July, I mean you’re not compatible, you cannot sell your monitors.

So that has distracted some of our OEMs and even us in those efforts. But I feel pretty good about second half of 2014.Aand don’t forget these companies are integrating rainbow and not just one platform, but multiple platforms. So I think you also seen some of the platforms from both GE and Philips come out maybe beginning of the second half but some of the other ones towards the latter part of the second half. So, we’re getting close but we’re not quite there yet. And I am sorry that the date has pushed out a bit, but I think everyone is working in earnest and it’s coming soon.

Larry Keusch - Raymond James

Okay. That’s really helpful. And then Mark, just quickly the $8 million to $28 million on the royalty that you indicated for the year, just so I understand, is that just purely the lower end as if it ends in April and the high end is if it continues through the full year, is that kind of what we’re thinking about here?

Mark de Raad

Exactly.

Larry Keusch - Raymond James

Okay. Thanks very much guys. I appreciate it.

Joe Kiani

Thank you.

Mark de Raad

Thank you.

Operator

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

Ben Haynor - Feltl and Company

Hi gentlemen.

Joe Kiani

Hello.

Ben Haynor - Feltl and Company

Hey, you mentioned that you have the four SpCO orders shipped during the quarter, you would hit the $50 million in guidance for rainbow. Could you perhaps tell us how much would have gone above the $50 million and also how is that shipped so far in 2014?

Mark de Raad

Yes. It would probably hit over $51 million and we do intend to ship the rest of it this quarter. And we actually, we had meeting for this customer and we expect more orders along that same level in 2014.

Ben Haynor - Feltl and Company

Okay. That’s helpful, great. And then this is might be kind of an odd one, but with Apple picking up some guidance from you from C8 Medisensors closing up, Versant up in Canada, some of these (inaudible) place, what do you suppose were up to there and do you have anything that’s in development on the Raman side?

Joe Kiani

Well first of all I don’t think Apple has picked up C8, Raman technology; we had some insight into that and while it’s an interesting technology, we don’t think that’s the optimal way to go. Did I answer your question?

Ben Haynor - Feltl and Company

And do you guys have anything in development on the Raman side?

Joe Kiani

We -- not Masimo but (inaudible) core is developing or trying to develop noninvasive other noninvasive measurements and we do have an agreement with (inaudible) that if they do, we have to exercise those licenses and those measurements. In fact I think you will notice in our 10-K in Q4, we exercised five new measurements, these are brand new noninvasive measurements, unfortunately they do not include glucose but there are important measurements. And when we exercise that we believe that they reach feasibility on those five measurements. So we are hoping sometime in the future, we will be introducing five additional new noninvasive measurements. As far as glucose we are still working on it and we’ll have to see if ever they get to a point where we think what they have done is useful for our marketplace.

Ben Haynor - Feltl and Company

Okay, great. And should we expect any of those measurements to be the ones that our product introductions that might hit in 2014?

Joe Kiani

No, no those will be probably 2015, 2016 time frame. The 2014 ones, these are products that we are near completion with we will work on it on several years and we hope to on May 2nd if not sooner or later, which is the 25th anniversary of our incorporation to introduce them or at least announce them.

Ben Haynor - Feltl and Company

That’s all I have. Thank you very much.

Joe Kiani

Thank you.

Operator

At this time there are no further questions.

Joe Kiani

Well, thank you all for joining us today. We look forward to talking with you our next call. And as we reach you up (inaudible) or when we come out here. Thank you very much. Have a great day.

Operator

Thank you, this concludes today’s conference. You may now disconnect.

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