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Masimo Corporation (NASDAQ:MASI)

Q1 2010 Earnings Call

May 4, 2010 4:30 p.m. ET

Executives

Sheree Aronson - Vice President, Investor Relations

Joe Kiani - Executive Vice President,

Mark de Raad - EVP of Finance & CFO

Analysts

Bill Quirk - Piper Jaffray

Imron Zafar - Deutsche Bank

Sara Michelmore - Cowen and Company

Matthew Dodds - Citigroup

Peter Lawson - Thomas Weisel

Joanne Wuensch - BMO Capital Markets

Brian Weinstein - William Blair

Spencer Nam - Summer Street Research

Matt Dolan - Roth Capital

Larry Keusch - Morgan, Keegan

John Putnam - Capstone Investments

Greg Brash - Sidoti & Company

Operator

Welcome to the Masimo Corporation First Quarter 2010 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 speaker’s 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 note 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 our actual results to differ materially 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. Masimo delivered strong first quarter results with total revenues up 15%. Product revenues also rose 15% including a 71% increase in Rainbow revenues.

We also achieved a solid 34% increase in shipments of Masimo SET and Masimo Rainbow SET units. These results prove once again the superiority of our technology and strength of our mission, which is to improve patient outcomes and reduce to cost of care by taking non-evasive monitoring to new sites and applications.

Our first quarter progress can be summed up by four key points. First, our core SET business outpaced both market and competitive growth with a 13% year-over-year rise in revenues. This performance signals additional revenue share gains by Masimo. Coupled with our strong OEM Board and Radical-7 and Rad-87 shipments, it makes clear that hospitals are increasingly turning to Masimo SET Pulse CO-Oximetry not only for deployment in acute care, but also in the general ward where our patients SafetyNet monitoring system connects care givers to patients resulting in improved patient safety and reduced cost.

Second, our Rainbow platform continued to advance with year-over-year sales up 71%. We experienced growth in both licensing and sensor revenues and in general are happy with the progress in all Rainbow categories. The only exception are RAD-57 revenues, which were down slightly due to cannibalization by our OEMs specifically in Medtronic Physio-Control and ZOLL defibrillators with Rainbow and continued EMS market weakness tied to local and municipal budgets.

Importantly, in EMS market, our year-over-year Rainbow SpCO and SpMet unit sales grew by over 75%. Unfortunately because our license fees are significantly lower than our standalone Rad-57 unit ASPs, total revenues were slightly down year-over-year.

During the quarter, we also prepared for the launch of two new Rainbow products. Rainbow Acoustic Monitoring Respiration Rate Monitor and Pronto hemoglobin spot check device. We remain enthusiastic about the long-term prospects of Rainbow and expect sequential and year-over-year growth for the balance of 2010.

Third, we continue to invest in our future. Our first quarter R&D spend equaled 11% of product sales again this quarter as we pushed forward on our new product roadmap. Also we moved closer to completing a multi-year initiative to expand our global sales organization and structure.

We believe that our robust 44% rise in international revenues, 37% in constant currency, in the first quarter is testament to the value of this initiative. Thinking more broadly of ways to benefit patients and care givers and make a positive long-term impact on the strength and vitality of the healthcare market, we also established the Masimo Foundation for Ethics, Innovation and Competition in Healthcare.

Lastly, our strong financial position allowed us to return significant capital to stockholders. On March 31, 2010, we paid out $117,500,000 to stockholders through a special $2 per share dividend, which is our second dividend in the past four years.

This dividend reflects our healthy balance sheet, expectation for continued positive cash flow and confidence in future growth. Despite the dividend payment, we finished the quarter with $112 million in cash and short-term investments and no debt.

Overall, the healthcare market remains challenging, but as our first quarter results illustrate, we are seeing positive signs as more and more hospitals engage in contract discussions and appear more willing to upgrade to Masimo technology. We believe the superior performance of our core SET technology and the broad clinical advantages of our Rainbow platform combined to form a powerful message for hospitals that we can help them deliver better care at lower cost. I’ll provide an update to our strategy and highlight some of the new opportunities we see for Masimo in more detail in a few minutes, but first Mark will review our first quarter financial results. Mark?

Mark de Raad

Thank you, Joe, and good afternoon everyone. First quarter 2010 total revenues rose 15.5%, compared to the same prior year period to $98.8 million. This included 15.3% rise in product revenues to $85.9 million and a 17.3% increase in royalty revenues to $12.9 million.

The increased year-over-year royalty revenues were based on Covidien’s higher than expected Q1, 2009 royalty payments which we received in Q2, 2009 and have factored into our Q1, 2010 estimated royalty revenues. Favorable year-over-year foreign currency exchange rates added approximately $1 million to the first quarter international revenue totals.

Note that this positive foreign exchange benefits revenue was offset to a large extent by approximately $600,000 in increased year-over-year operating expenses. As Joe indicated, product revenue growth was driven primarily by Masimo SET revenues, which rose approximately 13% to $80.5 million in the quarter as we continue to extend our reach into more hospitals worldwide.

First quarter 2010 revenues generated from our end user or direct business, which includes our sales through our just-in-time distributors, were up approximately 14% to $68 million and represented 79% of total product revenues. OEM revenues made up the remaining 21% at $17.8 million and represented a strong year-over-year increase of nearly 19%.

This strong increase is due we believe to some pent-up demand carried over from 2009 and our ability to continue to garner our high percentage of our OEM partners pulse oximetry sales due to hospitals continuing to demand Masimo SET and Rainbow SET technology. First quarter Rainbow revenues were $5.3 million, up approximately 71% compared to the same period last year.

The rise reflects higher year-over-year sales of license parameters and sensors offset as Joe mentioned by a significantly lower Rad-57 sales due to the cannibalization by Physio-Control and ZOLL-related products as well as the continued constraints on state and municipal EMS budgets.

As a side note, lower Rad-57 sales were also the primary factor in the sequential decline in Rainbow revenues versus the fourth quarter of 2009. Looking at the first quarter of product revenues by geography, U.S. revenues totaled $60.9 million, up approximately 6%, compared to $57.2 million in the same period last year.

This increase which is lower than our historical norm is due we believe to a combination of factors including longer installation periods, a higher mix of OUV versus U.S. OEM revenue growth and the impact of some pricing pressure especially related to some unique contracts that we signed in 2009.

Through the first quarter of 2010 however, we see signs of a more stable pricing environment and we are very encouraged by the strong first quarter U.S. driver shipments which should continue to add to additional quarterly increases in year-over-year U.S. revenues.

Product revenues outside the U.S. were $24.9, up approximately 44% or 37% on a constant currency basis. Importantly each of our international regions contributed double digit growth. This was the second consecutive quarter that totaled OUS product revenues reached 29% of product revenues, which we believe is an indication that our past and continuing multi-year investments have build an international sales organization is working.

As we previously noted, we achieved strong growth in our worldwide installed driver base in the quarter excluding hand held devices we ship 37,100 new Pulse Oximeters and Pulse-CO Oximeters, compared to 27,700 in the same period last year, and 30,400 in the immediately preceding fourth quarter of 2009.

We now estimate our total worldwide installed base at the end of the quarter net of estimated retirements at about 757,000 drivers, that’s up 16% from 651,000 drivers one year ago. Continuing with the income statement, our gross profit margin was 66% in the first quarter, compared to 66.8% in the same period last year.

The slight year-over-year decline is due to a combination of higher OEM board sales, which carry lower margins along with unfavorable manufacturing variances due to the transition of production to Mexicali and selected first quarter 2010 inventory reserves we took related to our SpHb improvement and transition.

This additional inventory reserves, we reduced our first quarter gross profit margin by approximately 50 basis points. Total first quarter gross profit margin including royalties stood at 70.7% compared to 71.1% in the same period last year. The decline is due primarily to the same factors that I just noted.

On a GAAP basis, our first quarter 2010 operating expenses were $20.8 million, which included $30.1 million one time gain related to the resolution of an antitrust law suit against Covidien offset by $10.9 million in related one time marketing expenses.

This one time spending is included in our SG&A expenses and reflects approximately $10.3 to fund the new Masimo foundation with the remainder used to fund various educational programs, grants and some clinical research designed to accelerate Rainbow awareness and adoption.

As we discussed in the last quarter’s conference call, we have plan to deploy approximately $15 million of the gain for various marketing initiatives including the possible establishment of a foundation. We continue to evaluate other one time marketing-related expenses and depending on our review we may or may not incur the additional $4 million later this year.

However, should we continue to incur any of these additional one time marketing and clinical research expenses, we will identify them and discuss them separately in future quarterly calls. Excluding the one item items, our first quarter total operating expenses were $47.8 million, up 17% from $40.7 million in the prior year quarter.

This increase was due primarily to $4.1 million in higher payroll and payroll-related expenses associated primarily with our continuing worldwide sales force expansion. Legal expenses also rose by approximately $800,000. As I previously noted, nearly 600,000 of the increase in expenses was due to foreign exchange conversion rates.

Finally, as you will recall in the fourth quarter of 2009, we invested approximately $3 million in SEDLine, a newly formed private Company focused on neuromonitoring technologies. Also pursuant to ASC Topic 810, Masimo is required to consolidate SEDLine and as a result, our first quarter 2010 statement of operations included nearly 787,000 in operating expenses from SEDLine.

It is important to note that although we are required to consolidate SEDLine’s net operating loss in our consolidating income, we are not required to include SEDLine’s net loss in our EPS calculations. As a result, SEDLine’s net loss is removed from our EPS calculation in the line item entitled net income or loss attributable to non-controlling interests.

Our first quarter 210 research and development expenses totaled $9.4 million which was 21% increase from $7.8 million in the first quarter of 2009. The rise is due primarily to increased engineering headcount as well as higher clinical engineering project-related and supplies expenses.

Our first quarter 2010 operating income was $40.8 million including $19.2 million related to the benefit of the $30.1 million in proceeds for Masimo’s antitrust litigation against Covidien offset by $10.9 million in one time marketing expenses. Our first quarter 2010 effective tax rate was 35.3%, compared to 34.3% in fiscal 2009.

The slightly higher tax rate is primarily due to our inability to benefit from R&D tax credits in the first quarter of 2010, and the impact of the net gain from the Covidien litigation which is all U.S. based income.

If and when the U.S. government and actually R&D tax credit legislation in 2010, we expect to be able to benefit from that which will reduce results in the tax rate more commensurate with 2009.

First quarter 2010 net income was $26.7 million, or $0.44 per diluted share. As we discussed this included approximately $0.20 associated with the net $19.2 million one time gain excluding the one time items, our diluted EPS would have been $0.24. This compares to $0.22 in the first quarter last year.

Weighted average shares outstanding for the first quarter were $60.5 million, compared to $60.2 million for the same prior period. Now turning to a few quick balance sheet items.

At April 3rd, 2010 total cash and cash equivalents and short-term investments were $112.1, compared to $189 million at year-end 2009. This $76.9 million decline is in due entirely to the $117.5 million dividend payment we made at the end of March. Excluding the impact of the dividend payment, cash rose by $40.6 million due primarily to the $19.2 million in net cash received from the combination of the $30 million in antitrust litigation receipts less the $10.9 million in associated market expenses.

In addition, we generated $5.4 million in proceeds from the issuance of common stock while the remainder was generated from operations. At April 3, 2010 our day sales outstanding stood at 43, compared to 44 at year-end 2009, and inventory returns were 3.5 versus 3.4 as of January 3rd 2010.

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

Joe Kiani

Thank you, Mark. As you all have heard me say many times before, I believe Masimo is still on to the early stage as of executing and exciting long-term growth strategy.

We were writing three technology adoption curves. First, Masimo SET Pulse Oximetry and the $1 billion critical share market where we are in the steep part of the S-curve. Second, Masimo SET Pulse Oximetry to general floor also estimated to be a $1 billion market, where we are just beginning to enter what we believe will be a fairly aggressive S-curve.

And third Rainbow estimated to be $2 billion market with most measurements just beginning to form the S. this is a tremendous opportunity that we are addressing by continuing to maintain our technology leadership by inventing new measurements and improving our current measurements and establishing a critical math sales force in hospital and alternate care markets worldwide.

What inspires and drive the Masimo team to deliver against this objectives is the chance to make a meaningful and lasting impact on patient’s life by providing caregivers the resources they need to make better and faster decisions. We made some important strides in the first quarter, which I’d like to review briefly before opening the call up to your questions.

Based on our double digit SET revenue growth, and our 34% year-over-year increase in new driver shipments, we are confident that we grew our share of the Pulse Oximetry market during the first quarter both in the U.S. and internationally.

We are seeing better demand not only in acute care, but also in the general floor with the combination of our Masimo SET technology and Patient SafetyNet Monitoring System does capturing the attention of care givers and administrators for its ability to cost effectively enhance response times to patients in distress, and ultimately reduce sentinel events.

In fact, with the Masimo SET and Patient SafetyNet ground breaking general floor study by Dartmouth-Hitchcock, I believe we’ve reached the tipping point in the adoption of Masimo SET Pulse Oximetry on the general floor.

For the first time, hospital see that they can provide better care for patients and reduce cost. We believe that combining the general floor study with what has already been proven today about Masimo SET including reduction of Retinopathy of Prematurity in the Neonatal ICU detection of congenital heart disease, reduction in sensor ways, reduction in ventilation amount and reduction in unnecessary blood gas could yield total annual U.S. healthcare savings of roughly $5 billion if all U.S. hospitals implemented Masimo technology to its maximum potential.

Given the bright spotlight now being focus on healthcare spending, we believe this numbers established it timely in compelling rational for adopting Masimo technology by all hospitals. To further extend our impact in the general floor, we continued in the first quarter to prepare for that full market release of Rainbow Acoustic Monitoring, which we call RAM.

In the second half of this year, we hope to begin the full market release. RAM non-evasively and continuously respiration rate via an adhesive sensor and integrated the acoustic transducer applied to the patient’s neck.

Continuous monitoring of breathing status is especially important for post-surgical patient receiving patient control, pain medication. So much so that the Anesthesia Patient Safety Foundation recommends continuous oxygen emission and ventilation monitoring in all patients of opioid based pain medication.

We expect the introduction of RAM to represent a significant step forward in hospital’s ability to comply with this recommendation given it advantage in terms of ease of use and patient comfort and compliance. Using Masimo Rainbow Pulse Co-Oximetry and RAM, we will allow clinicians to follow not only the patient’s oxygenation, but also circulation through Masimo SET Pulse rate ventilation through RAM, respiration rate monitoring bleeding through SpHb and slowed responsiveness through PVI.

Together these measurements provide immediate and critical information to a decision making and action, which often revolve around when and whether to give fluid over transfused blood. SpHb plays an important role in helping clinicians continuously identify stable and safe hemoglobin levels that prevent unnecessary blood transfusions especially during surgery. This has the potential to reduce patient morbidity and mortality while also lowering cost.

In fact, a static publishing to April issue of transfusion estimated that the actual fully loaded cost for a unit of blood went up to nearly $1200 per unit higher than previous estimates. The study prospectively analyzed more than 20,000 surgical patients mapping all activities involved in the transfusion of blood and real world surgical settings.

The research not only show that total annual blood cost are largely driven by transfusion rate, but also provided a roadmap for institutional administrators to evaluate hospital processes in order to reduce and optimize blood usage.

We believe Masimo SpHb can play an important role in this effort, and other study conducted Cincinnati Children’s Hospital Medical Center showed that SpHb provided total hemoglobin accuracy comparable point-of-care invasive measurements versus standard invasive laboratory test.

This was the first SpHb study presented in pediatric patient and the gynecologist achieved at that Cincinnati Children’s Hospital said the result indicated that SpHB has the potential to replace the need for invasive blood clots in infants and children undergoing surgery.

We expect these and other studies along with customers real world experience using Rainbow to continue to spur new demand and allow us to build on the 71% year-over-year Rainbow sales performance we posted in the first quarter delivering nice growth rate throughout the rest of the year.

In terms of furthering Rainbow adoption, we are also enthusiastic about the prospects of Pronto. The first ever hand held device for non-invasive hemoglobin spot check testing. Hemoglobin is among the most commonly ordered test in both in and outside the hospital and product because it is critical to accessing anemia.

And so Pronto, the only way to access hemoglobin status in the physician offices has been through a needle stick and invasive time consuming blood test conversely Pronto provides the painless hemoglobin reading in a couple of minutes.

We see applications across various healthcare settings and are targeting our sales and marketing efforts towards physicians offices, clinics, blood donation centers and hospital emergency departments. We also have a new product called Pronto 7 that has been designed specifically towards spot check SpHB and is capable of measuring SpHB in 45 seconds.

We expect to begin a limited market release in Europe in the second quarter with full market release in the second half of 2010. We called that in the U.S. our hemoglobin spot check measurement will be reimbursed at $7.19 for test for eligible patients for the 2010 CPT code designations. We expect this to help, provide the financial justification for office physicians to deploy the device and their practices.

Pronto and soon to come out Pronto 7 is emblematic of our constant focus on breakthrough innovation with market changing potential on solving the unsolvable problems.

This focus pours the foundation of our success thus far and it’s key to maintaining our technological leadership moving forward. Equally important to pursuing excellence within Masimo is doing our part outside the Company to promote the healthcare environment that thrive in competition provides path off new ideas and strives to make better care available to more patients at a lower cost.

With this in mind, we have formed the Masimo foundation for Ethics, Innovation and Competition and Healthcare. This non-profit foundation will facilitate Masimo’s philanthropic efforts. As announced last week, we funded to Foundation with $10.3 million from the Covidien antitrust award, which seems to us a worthy and fitting use of these dollars as well as another way for us to demonstrate our commitment to do what is right on behalf of patients.

We hope this gift begins a long and impactful effort by the Masimo Foundation and others to support programs and research that improve patient safety and deliver advanced healthcare to people worldwide to find better and more cost effective healthcare solutions and protocol and create an environment of healthy and ethical competition, which we believe is the ultimate answer to lowering healthcare costs across the U.S. and throughout the world.

With that Mark and I will take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). So, our first question comes from the line of Bill Quirk with Piper Jaffray.

Bill Quirk - Piper Jaffray

Joe, you had a comment I think it was in your first said prepared remarks talking about expectations for sequential in the year-over-year growth for the balance of the year. Were you referring to the overall business or specifically Rainbow? Thanks.

Joe Kiani

Both we believe we should continue to enjoy sequential growth as well as obviously stronger year-to-year growth with both SET and Rainbow. Now while the Rainbow may not be happening at 71%. We expect it to be at healthy levels and makes us feel good about the present and the future.

Bill Quirk - Piper Jaffray

And so just I guess get a better sense Joe, is to the impact of Rad-57 on that metrics during the quarter. Can you help us think in recent rough terms with the overall mix of Rainbow is between sensors and licensees?

Joe Kiani

Yes. Let me try to do that for you. First of all, our unit sales of Rainbow licenses was up over two times, compared to the same quarter last year, but because some of that now is happening by our OEMs like Medtronic Physio Control and ZOLL. The overall revenue from that business, from that license sale has been slightly down. Our total rainbow center sale have seen a very nice increase again unit wise but again because of the mix that is shifting from the disposables to the Resposable is a reason we saw the kind of growth we have had, otherwise the growth unit wise it was very robust much more than the numbers we gave you for the total revenue growth quarter-to-quarter, year-to-year.

Bill Quirk - Piper Jaffray

Okay very good, and then last one from me, you guys didn’t touch on it but in terms of the overall 2010 guidance as if you are comfortable with the numbers you have put out after the fourth quarter call.

Joe Kiani

Okay, let me get to my lawyers (inaudible) to answer your question on that, basically as you know we provided guidance for 2010 in our earnings release issued in February 16, 2010. It is our policy not to update annual guidance on unless they are material developments which cause management to believe there are revenues or earnings per share will be significantly outside the range previously provided.

Based on the current available information we are not providing any update to our annual guidance issued in February.

Bill Quirk - Piper Jaffray

Is there any other if you thought you guys are going to meaningfully exceed or meaningfully miss you would say something. Since you are not saying anything its reasonable to assume that things are generally going to be inline.

Joe Kiani

I think that’s a good conclusion.

Operator

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

Imron Zafar - Deutsche Bank

This is actually Imran Zafar in for Tao Thank you for taking my question. Just a follow-on to Bill’s question and I am sorry I am been a little picky here but in terms of your confidence in the sequential growth and in Rainbow over the balance of the year, does that include contribution from RAM and Pronto on the back half of the year and increase in EMS spend. Just trying to get an apples-to-apples sense of how should we think about growth within in the Rainbow portfolio.

Joe Kiani

It surely does include Pronto and RAM in it, but I would say to you that we will see sequential growth even without those option rates.

Imron Zafar - Deutsche Bank

Okay and then a little more detail not the non-invasive SpHb launch. Can you just talk maybe even qualitative terms Joe about the interest levels from hospitals; I know you have commented on this past, how is that looking from a qualitative perspective.

Joe Kiani

It’s looking very good; we have liked what our customers are seeing with the product both its performance and the clinical utility that it’s providing them. We like the increased word of mouth that going around about successful usage of the product and the overall demand for SpHb.

Imron Zafar - Deutsche Bank

Okay great and then on once you place a the hemoglobin technology in the hospital, those within your current install base, how are the utilization trends tracking in terms of over the last couple of quarters those early adopters, are you seeing an increase in usage within that institution.

Joe Kiani

I don’t have institution by institution number but what I can tell you is we are getting usage based on the macro level of sensor increase that I alluded to earlier and my own personal contact with the number of customers I have been in contact with. No one has put it back on the shop everyone is using it, in fact they are using more, they want to buy more. So, we are feeling very good especially for a new product that hasn’t had routine usage for it to find its way in normal use day to day it’s very reassuring. Now as I have said earlier we are on the S-curve technology adoption, so we are at the beginning of that.

Obviously we are dealing with early adopters, we hope to get to the steep part with the mass market, so I don’t by answering your question I also don’t want you to think that we think everything is perfect, it should be perfect but you can’t tell until you move from earlier adopters to the mass market.

Imron Zafar - Deutsche Bank

Okay and then one last quick question on procedure volume trends in the quarter. We have seen some conflicting commentary from the procedures on to the Medtech companies, can you just give us some observations on what you saw in the quarter on procedure volumes and what impact right flu season had on sensor volumes because you did post a very good sensor not withstanding a right flu season. Thanks.

Joe Kiani

Sure, we obviously Q4, of the year is – Q1 of the year is the flu season. I don’t think we fortunately we did not see epidemic swine flu problem like we had worried about but my belief is we did see some seasonal increase in our sensor volume but given the strong drivers that we shift in Q1, I am not expecting that seasonality too cause an issue for us going forward. I don’t know if I am clear but I think we should be able to maintain the growth because of the strong placement of the 37,000 Masimo Rainbow SET units.

Imron Zafar - Deutsche Bank

Great, thanks so much.

Operator

Our next question comes from the line of Sara Michelmore with Cowen and Company.

Sara Michelmore - Cowen and Company

Joe you mentioned a few times saw it in the press release as well. But just wondering if you can just give us a little more color on what you are seeing in the general word and how that Patient SafetyNet product is driving things. Is it something that you think is going to be a substantial part of the revenue contribution or growth contribution going forward or how should we think about that? Thanks.

Joe Kiani

I will give you my best answer but it may not be the right answer. My best answer is that we feel we have hit the tipping point with general floor monitoring and we are not yet at the revenue level at the steep part of the S-curve but we certainly are at the demand level and interest level at the steep part of the S-curve.

It looks like the combination of the Dartmouth-Hitchcock study showing the value of Patient SafetyNet as well as for Dartmouth and other institutions that have been using it is not only driving I want to say just about every customer that I stay in touch with too long to move into general floor monitoring continuous monitoring which is very exciting but even though once that would have been working with us in past expanding beyond what they thought they were initially going to do for which some of them was okay, we are just going to do post orthopedic surgery or and they are just going, just about every bed in the ward. So, it is a very exciting time.

We are actually working hard to keep up with the demand and we don’t want that to ever be an issue but well hopefully I can -- hopefully I am right and the next several quarters and the years we will be able to look back and see that it was really the tipping point.

Sara Michelmore - Cowen and Company

That’s helpful Joe and then on the OEMs its nice to see you have a good quarter there, seems like it might have been a little bit pent up demand. I mean how sustainable is that trend going forward, you think you kind of, was this a one half quarter or are you back to maybe more normal ordering patterns. Thanks.

Joe Kiani

Again the best information I have, this is not a one time event. It looks like we are heading towards a good year. Now we have heard from some of our very larger OEMs who economists and alike telling us the second half may not be as strong for them as the first half. So, we don’t I can’t really tell you about Q3 and Q4 but I will tell you its been a combination as you said pent up demand as well as an increase in the percentage of demand within those company for Masimo technology versus competitive technology as more hospitals are seeing the benefit of our technology and asking the OEMs to deliver Masimo by name and specifically demanding Masimo.

Sara Michelmore - Cowen and Company

Thanks for the color, Joe.

Operator

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

Matthew Dodds - Citi Group

Mark for the revenue split, this is the second straight quarter the OUS has gone a lot faster than U.S. and I now you have put resources, can you give us any color if any region is outsized growth versus some of the others and I guess this three I would highlight like Western Europe, Japan and then kind of all other just any color you can provide us on one of those regions?

Mark de Raad

Well Matt as I have said in the prepared remarks the good news we had double digit growth in every region throughout the world, your question more specifically on which specific region certainly we saw strength our EMEA region, Japan was very strong for us and the we saw a couple of sub-elements of the rest of the world, we had a very nice quarter in Canada and also some activity that we are seeing in Australia.

Matthew Dodds - Citi Group

And do you think a lot of that relates to the expansion you have made in the sales force versus internationally or do you feel the growth internationally is been stronger in terms of plus Masimo market.

Mark de Raad

While we have -- the investment certainly that we have been making over the last two, three years and continue to expect to make for the rest of the year, this year, we believe is the primary reason we have got today, probably about four times the number of feed on the street that we had in these regions about three years ago.

A lot of that hiring was done the early part of last year, so we believe that as we said in the earlier remarks that the investment that we have made and you know this is a business that unfortunately requires a bit of longer sales cycle than most, so we think the investments over the last couple of years are beginning to pay off in all of these regions around the world.

Matthew Dodds - Citi Group

Thanks Mark.

Operator

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

Peter Lawson - Thomas Weisel

Hi, Mark, I wonder if you could just comment on the negative manufacturing variances and whether this is going to disappearing in 2Q?

Mark de Raad

Sure, well, I think if you go back to the prior maybe three or four calls that we have had, we have occasionally mentioned the fact that some of our positive margin movement quarter-over-quarter has been due to favorable manufacturing variances. This quarter, Mark, what we essentially believe is sort of the final major push of our production activity from Irvine down to Mexicali and so as a result there was a bit of a overlapping hiring process that went on in this quarter where we had to hire people in one location and get them transitioned as quickly as possible obviously before we could make the appropriate adjustments at the other locations.

So, that’s primarily what generated the event in this quarter and we don’t think its something that will continue.

Peter Lawson - Thomas Weisel

Thank you, it’s helpful. And then I wonder if you could elaborate on that pricing pressure you talked about in North America, what was responsible for that?

Mark de Raad

Well, the comment that we made I think was in a reference to 2009, and obviously 2009 the year, we all just came out was an extremely difficult one economically. We had throughout the year the challenge of convincing customers to complete contracts with us in an environment where they were ensure of their financial situation. And so as a result as you can imagine pricing pressure was such that on occasion we entered into certain deals last year at price points that at least historically were lower than what we have seen.

As I alluded to in the comments, the good news is we believe that sort of unique economic environment that was precipitating some of those larger than usual pricing adjustments has ended and that we are looking at a much more stable pricing environment going forward.

Peter Lawson - Thomas Weisel

So, those should roll off this year basically?

Mark de Raad

Well remember most of those contracts could be contracts anywhere from three, four, five years. So, the impact of any one off pricing deals that we would have done in 2009, those will continue with us for a while. My comments are more in relationship to the new contracts that we would be signing and of course those new revenue streams will be laid up on the building revenue streams from the over 700 long-term sensor agreements that we have today.

Peter Lawson - Thomas Weisel

Okay. Thank you so much.

Operator

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

Joanne Wuensch - BMO Capital Markets

A couple of things, you had commented that the litigation expense was about 800,000 higher than you had expected, anything in particular there?

Joe Kiani

No, we didn’t say it was higher than expected, we just said it was the reason for the increase year-over-year. Remember we went into this year and actually we went into the back end of last year highlighting the fact that the litigation that we had ongoing at this stage was something was front and center as we looked at our operating expenses and clearly it was risk to our total operating expenses but I wouldn’t say actually the number that we called out as a reason for the increase wasn’t necessarily a surprise to us.

Joanne Wuensch - BMO Capital Markets

Okay, maybe it was just a surprise to me. My second question has to do with, is it fair to say that the hemoglobin revenue while you won’t break it out is sequentially increasing?

Joe Kiani

I would say in general that our hemoglobin total revenue levels over the last couple of quarters have been in a fairly consistent range. Some quarters up, some quarters a little bit down but very, very consistent.

Joanne Wuensch - BMO Capital Markets

And is it that you are still in the new adopters and haven’t gone broader yet? And if that’s the reason what does it take to go broader?

Joe Kiani

I really believe it’s the transition of customers from disposables which had an ASP over $100 to resposables which have an ASP of about $50, the actual volume is up 400%.

Joanne Wuensch - BMO Capital Markets

That’s very helpful. Thank you very much.

Operator

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

Brian Weinstein - William Blair

Just want to get a little bit of clarification on Pronto, is it fair to say that you will not really launch the product until you get approval of the Pronto 7, in other words that the first generation products will not be what’s really launched here in the U.S?

Joe Kiani

No, that is not correct. We have launched Pronto full market release earlier this quarter in the U.S. We have not launched it internationally because we have a predictable path to launching Pronto 7 internationally since we don’t have to wait for FDA clearance. So, the plan is to launch Pronto 7 in a limited market release in this quarter and then by second half of the year do a Pronto 7 full market release and we don’t know when we are going to get FDA clearance but when and hopefully if and when we do obviously we will launch a full market release in the U.S. at the same time. But Pronto is selling in the U.S. physicians offices and we have gone from limited market release of that to full market release.

Brian Weinstein - William Blair

Can you remind us when you submitted Pronto 7, I think it was in the fall, is that correct?

Joe Kiani

Yes, it seems like a long time ago. I think as you maybe aware everything has taken longer with FDA, we’ve had some dialogue back and forth with them about the application and we have – we’re waiting but we’ve got assurance of when and if we are ever going to get the clearance. So, we have as a result launched with Pronto just to make sure we get started and hopefully when Pronto 7 is released it’s a better product and we are anxious to launch it in the U.S. as well.

Brian Weinstein - William Blair

Great. And my last question is, when you guys are talking about Patient SafetyNet and really getting through the S-curve here pretty quickly and moving along that curve, it seems like it’s quicker than what you originally thought. Was this what you were thinking when you guys provided your guidance back three, four months ago or have things really, it seems like things have really accelerated since then.

Joe Kiani

Yes, things have accelerated further than we have expected. However, I want to caution you that there was a long cycle of installations for Patient SafetyNet. So, while we have a lot of interest and a lot of contracts, a lot of them have not been deployed yet. So the revenues it’s going to take a little time for them to start adding up.

Brian Weinstein - William Blair

Okay, great. Thanks.

Operator

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

Spencer Nam - Summer Street Research

Just have a couple of questions here, so I think it may have been you, Joe, you mentioned that looking at the S-curve adoption of the hemoglobin test that we may be at the steep part of the demand cycle if you will but adoption may be a little bit behind.

What brings the gap closer, what do you think is, why are these physicians who maybe interested in the device are still kind of waiting on the sideline?

Joe Kiani

Well, I believe I mentioned that we are in the steep part of the interest and demand in taking about Patient SafetyNet system of the S curve. With Rainbow and hemoglobin specifically I can call it up I said Rainbow measurement I think we are at the beginning of the S-curve, although we are seeing great interest, great demand but obviously the numbers are not that big yet. But I think still to answer your question, what’s bridging the gap between what we believe ultimately is going to be very successful product to commercially to where it is today. I think it’s a combination of us understanding the first killer market, killer app market for this technology and as well as clinical studies and research coming out and validating what some early studies have shown. Of course, user word of mouth acceptability, I think those are all kind of go together.

Spencer Nam - Summer Street Research

I appreciate that, second question I have is, is there any update on the discussions between -- I don’t know if you guys are even having a discussion with Covidien about the royalty issues beyond first quarter of next year.

Joe Kiani

No. As you can imagine we are not on daily speaking terms. So, there isn’t any and unfortunately I have nothing new to report to you on that.

Spencer Nam - Summer Street Research

Okay, thank you.

Operator

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

Matt Dolan - Roth Capital

Just a couple of quick follow-ups. Mark, first, can you talk about where you are on your infrastructure build this year relative to the pro forma operating spend we saw in Q1, how should we think about continued investment going forward?

Mark de Raad

I think, Matt, from a calendar standpoint obviously we have completed one fourth of that calendar so I think even from an headcount standpoint the assumption should be that you will see additional headcount increases throughout the rest of the year which will at least sequentially cause revenues or expenses to continue to climb as we move out into the next couple of quarters. Having said that, there is always a few expenses in the first quarter that are somewhat unique. So, we expect some of those expenses to decline a little bit as we move forward. So, overall we are still comfortable with the guidance that we provided back in February in terms of our operating expense range and the build out of our infrastructure should fit within that.

Matt Dolan - Roth Capital

Okay great and then looking to the foundation in some of the specialty marketing initiatives the Covidien and I trust money. Where you expecting some, is there any numerical impact that you are anticipating or some type of fundamental particularly from a marketing programs that you are looking forward later this year?

Joe Kiani

All I can tell you that obviously we wouldn’t do it, if we didn’t expect something to come out of it but we are using the money, we are investing in more clinical research activities than before and more maybe some advertising or unique marketing work with the hope that the combination of all these is going to increase the awareness of that benefits of our technology but if you can imagine in marketing you never know what part is going to work.

So, and the timing of it my guess it wont be immediately felt there will be more solely felt.

Matt Dolan - Roth Capital

Okay and then finally on a little bit of a longer term question, you paid out the dividend in March. Can you touch on your any business development plans in the future for the company and also maybe the new measurement pipeline when should we think about the next quarter coming?

Joe Kiani

Business development wise we’re constantly looking at new opportunities and we to-date have not seen anything that we have felt was worth the risk of taken eyes off the current goal that we have in our hands and we think is there a lot of room for growth and one of the exciting things at Masimo is that our revenue run rate is lets say $350 million but our total market potential is somewhere around $4 billion.

So, we feel that we have a lot of headroom for growth. As far as new parameters are concerned, I am not sure we will deliver on this but our hope is to deliver a new parameter or a new measurement every year. So, we are seriously working several exciting fronts and with the hope that they will start coming out and in fact they have been coming out the last few years, year-after-year.

Matt Dolan - Roth Capital

Great, okay. Thanks a lot guys.

Operator

Your next question comes from the line of Larry Keusch of Morgan, Keegan.

Larry Keusch - Morgan, Keegan

Just a couple of questions, Joe just to make sure that I understand this in terms of pushing out pulse oximetry into the general floor areas, its not like you are saying that interest is growing perhaps at a rate better than you guys had been thinking, a lot of that has been driven by the Dartmouth-Hitchcock study and then also sounded like you indicated that there are some contracts been signed, they haven’t necessarily translated to revenues yet. But I just want to make sure that I am getting that, it feels like there is some increasing momentum under this.

Joe Kiani

Yes you are correct. Again I said I am giving you the best answer I can at this point and at this point we feel that that market is happening, right now its alive and we are at the company that people are coming to most but it is happening and we believe it’s a $1 billion market that is barely penetrated and its about to go.

Larry Keusch - Morgan, Keegan

Got you, okay and then you used the word when you were talking about your expectations for the launch of RAM in the second half of 2010. I think you had in your prepared comments that you said that you hope to launch it in the second half of 2010. So, I just wanted to again make sure I am understanding correctly what you are saying, is there something that would cause that not to happen?

Joe Kiani

If we have got any negative reaction to the product things that we felt that we couldn’t complete in time, yes, but I can tell you so forth we have done limited market release and few sides and the reaction has been very positive and in fact I knew at least one of those sides has now come all over their place with RAM. So, I used to work -- because it is a word of the year, I mean that’s paced up but I used the word hope because until it’s up, it is not up.

Larry Keusch - Morgan, Keegan

Got you, I want to make sure I understood that and then lastly just for Mark two questions here. Just got to help us and you have touched on this earlier but again what are the targets for the sales force expansion for this year and then secondly your DSOs were up I am assuming part of that is driven by your OUS sales and also you had about a $2.5 million in your deferred revenues in the quarter and so I will make sure I am clear on what is happening on those metric?

Mark de Raad

Sure, first of all in terms of where are we on the sales force expansion, you are right I alluded to that before but just more specifically today throughout the world we are probably at about 160, 165 direct sales reps, 200 is the number that we have been articulating really for the past two years or so that’s still is the number that we are headed towards.

Larry Keusch - Morgan, Keegan

Okay.

Mark de Raad

On the DSO question, you are absolutely right. The two factors that contributed to that increase number one were the increased level of revenues outside of the U.S. and as you are probably aware in general terms outside of U.S. are bit more lengthy than here in the U.S and we have actually experienced some collection issues in some parts of world as you can imagine that are struggling, Spain being a good example. So, some of our DSO numbers internationally have expanded a bit over the last quarter and then the other portion of that you correctly pointed out was an increase in deferred revenue that we have this quarter as a result of a contract that we closed during the quarter and are going to have to recognize that revenue over a period of time.

So, that accounts receivable goes onto the balance sheet and it becomes an element in the competition.

Larry Keusch - Morgan, Keegan

Thanks very much.

Operator

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

John Putnam - Capstone Investments

Joe I was wondering if you could give us a little color on the foundation in terms of staffing and expenses, ongoing expenses and perhaps the need to contribute to the foundation at some point greater than the initial contribution?

Joe Kiani

We don’t have any staff per say, we really want to keep it at a board level the most of the work. We do have one part time person who is going to take care of the back office for it and I think due to the point of it is we want to make sure the money gets to the right people instead of a staff. But secondly as far as future whether we are going to put more money into it, it’s possible I think there might be other nice events that are outside of our normal business that may come in that will prompt us to want to put more money into it. But we feel very good about the current funding of it and I think it can do some real good for healthcare as it is right now.

John Putnam - Capstone Investments

Thanks very much.

Joe Kiani

If you don’t mind we are doing a time check here, its about 2:30 and maybe we will take one more question.

Operator

Your final question comes from the line of Greg Brash with Sidoti & Company.

Greg Brash - Sidoti & Company

I know you are not changing your guidance here but I mean do you still with some of the trends you are seeing in Rainbow, your Rad-57, you may seem more cannibalization through the year and you may see more conversions to Resposable from disposable centers. Are you still comfortable with the guidance you outlined of $30 million to $35 million in Rainbow for 2010?

Mark de Raad

Greg I think as we said earlier I mean all we can really do today is just reiterate what we said back in February and as Joe alluded too before that’s essentially what we are doing today.

Greg Brash - Sidoti & Company

Okay fair enough, and then the general floor and the demand you are seeing there is that primarily U.S. phenomenon?

Joe Kiani

Yes we are seeing some pockets of interest in other countries but really there is tipping point that I have mentioned is happening here not anywhere else.

Greg Brash - Sidoti & Company

Great, thanks for taking my questions.

Joe Kiani

Thank you all. I want to thank you all for joining us this afternoon and I am happy that unlike last year which this time, we had a wonderful quarter to report but we have to caution you about the future. We don’t have to be there, we hope to speak with you all more along and hopefully together very shortly.

Thank you for your time.

Operator

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

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Source: Masimo Corporation Q1 2010 Earnings Call Transcript
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