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Masimo Corporation (NASDAQ:MASI)

Q2 2010 Earnings Call Transcript

August 3, 2010 4:30 pm ET

Executives

Sheree Aronson – VP, IR

Joe Kiani – CEO & Chairman

Mark de Raad – EVP & CFO

Analysts

Bill Quirk – Piper Jaffray

Joanne Wuensch – BMO Capital Markets

Mayank Gandhi – Cowen

Gregory Hertz – Citi

Brian Weinstein – William Blair

Matt Dolan – Roth Capital Partners

Operator

Good afternoon, ladies and gentlemen, and welcome to the Masimo Corporation’s second 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 speakers’ remarks, there will be a question-and-answer session. (Operator instructions)

I am 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 of Finance and CFO Mark de Raad who will each make remarks and then take questions.

This call contains forward-looking statements, which reflects Masimo’s best current judgment. However, they are subject to risks and uncertainties that could cause actual results to vary. Risk factors that could cause our actual results to differ materially from our forecast are discussed in detail in our SEC filings. You’ll find these in the Investor Relations section of our website.

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

Joe Kiani

Can we just check to make sure everyone can hear us? (inaudible) someone can't. Excuse me one moment; we are just going to make sure people can hear us. Is our moderator on the phone?

Operator

Yes, sir, I am here.

Joe Kiani

There is a delay. Okay, we are fine. Okay. Thank you. Thank you very much. Well, good afternoon. Thank you, Sheree, and thank you, ladies and gentlemen, for joining us today. Masimo achieved solid results with total revenue up 20% making this Masimo’s first ever $100 million revenue quarter.

Performance was driven by a 26% rise in product revenue including a 60% increase in Rainbow revenue. This performance comes despite a still challenging economic climate and reflects double digit sales growth both in the U.S. and internationally. What’s more, shipments of Masimo SET and Masimo Rainbow SET units were up 35% to 36,700 units, excluding handheld devices. Overall, these results reveal momentum across key fronts.

First, our course SET is exhibiting strong growth in share gain. The accuracy and reliability of or pulse oximetry technology along with our efficient Patient SafetyNet solution (inaudible) award are helping us to expand hospital customer relationships and win new business. As a result, Masimo’s second quarter Masimo SET pulse oximetry revenue rose 23%, which is well above industry and competitor growth rates, demonstrating strong demand for our gold standard pulse oximetry technology in both our direct and OEM channels.

Second, our Rainbow platform is gaining traction as more clinicians and patients experience the benefit of our breakthrough noninvasive measurements. At $7.2 million, our Rainbow revenue hit a new quarterly high with growth coming primarily from Rainbow parameter sales, Pronto, sensor, and OEM board sales. We believe the Rainbow platform holds great promise as a long term growth engine for Masimo providing the opportunity to build new markets and further strengthen our competitive position and physician relationships. These latest quarterly figures signal that we are on the right track.

Third, our powerful technology offering and expanded sales organization are delivering sizable increases in our installed base. Remember that our drivers entered the market either through the sale or placement of our bed-side monitors or through our OEM partners, who incorporate them into their multi-parameter devices. As of the second quarter, we estimate our global installed base at 789,000 units, up 17% from the year ago quarter.

Rising driver placements indicate that more hospitals are continuing to chose our technology and pave their way for higher recurring sensor revenue in the future.

Fourth, we are delivering on our innovation promise. The second quarter marked an important step forward with the global launch of Rainbow Acoustic Respiration Rate Monitoring or RAM, and the global limited market release of Pronto-7. Our new hemoglobin spot check device is now available in most countries on a limited market release.

Customer reaction and feedback to both products have been very favorable. To ensure that we continue our track record of introducing breakthrough noninvasive monitoring technologies, we deployed more than 10% of our product revenue to R&D again this quarter.

In addition, a few weeks ago we announced our entry into the brain function monitoring market with the acquisition of SEDLine, which we are now in the process of integrating. I will talk more about the quarter in a few minutes, but first Mark will provide a more detailed overview of our financial results. Mark?

Mark de Raad

Thank you, Joe, and good afternoon, everyone. As Joe indicated, top line product revenue performance was strong in the quarter with favorable growth rates on both a year-over-year and sequential basis. Our total revenue was up 20% to $100.1 million versus $83.6 million in the year-ago period. This was driven by a 26% year-over-year rise in product revenue to $88 million, more than offsetting a 10% year-over-year drop in royalty revenue to $12.1 million.

Favorable foreign currency exchange rates added approximately $300,000 to second quarter 2010 international revenues compared to the same prior period last year. However, this revenue benefit was partially offset by $100,000 increase to operating expenses also related to the same foreign currency exchange rate movement. Given the recent concerns on foreign exchange movements, let me reiterate that our mix of foreign currency denominated revenue versus our local currency operating expense provides Masimo a partial natural net operating income hedge. However, to be clear, we have not employed any formal hedging strategies and to that extent we could still be impacted to translation or re-measurement gains and losses as we translate our local currency balance sheets into U.S. dollars at the end of each period. These gains or losses are reported in other income and/or expense on our profit and loss statement.

Product revenue growth was fueled by the 23% year-over-year rise in Masimo’s SET revenue during the quarter to $80.5 million. Second quarter 2010 revenue generated from our end user or direct business, which includes sales through our just-in-time distributors, rose 18% versus the same quarter last year to $68.1 million and represented 77% of total product revenue.

OEM revenue made up the remaining 23% at $19.9 million and represented a strong 58% year-over-year increase. Recall also that the pull back in hospital capital spending may have been the most severe in the year-ago second fiscal quarter period, which significantly impacted OEM sales levels during that time. Our results in the second quarter of 2010 show that Masimo continues to secure a high percentage of our OEM partners pulse oximetry sales.

Second quarter Rainbow revenue was also strong at $7.2 million, up 60% compared to the prior period last year, reflecting higher year-over-year sales of licensed parameters, sensors, and boards and even some initial sales of Pronto-7.

There was also positive news in our revenue by geography. Our U.S. product revenue rose a healthy 23% on a year-over-year basis to $63 million compared to the same prior period last year with solid performance coming from both our direct and OEM channels. Despite seasonality factors, our second quarter 2010 U.S. product revenues also rose sequentially, up 3% versus the first quarter of 2010.

Product revenue outside the U.S. totaled $24.9 million, up 32% or 31% on a constant currency basis. The regions of Europe, Middle East, Africa, Japan, and the rest of Asia were the most significant contributors to our year-over-year international growth.

International product revenue was 28% of total product revenue in the quarter, marking the third consecutive quarter our OUS mix has been in the 28% to 29% range. This positive and sustained mix shift underscores the fact that our multi-year investment to build an international sales organization and infrastructure continues to gain strength.

As previously noted, we achieved strong growth in our worldwide installed driver base in the quarter. Excluding handheld devices we shipped 36,700 new pulse oximeters and Pulse CO-Oximeter monitors, up 35% compared to 27,100 in the same period last year. We estimate our total worldwide installed base at the end of the quarter net of estimated retirements at 789,000 drivers compared to 675,000 just one year ago. As Joe mentioned, these unit shipment trends are a precursor to future reoccurring sensor sales and we expect additional Rainbow SET license and sensor sales.

Our product gross profit margin was 66.1% in the second quarter compared to 66.3% in the same prior period last year. The slight year-over-year decline is due primarily to the increased mix of OEM board revenue, which generally carries lower overall margins. In addition, as we noted last quarter, we did continue to experience some incremental manufacturing expenses as we completed most of our manufacturing transition from Irvine to Mexicali.

Second quarter gross profit margin, including royalties stood at 70.2% compared to 71.8% in the same period last year due primarily to lower year-over-year royalty expenses and the impact of the OEM mix and manufacturing transition factors I just noted.

On a GAAP basis, our second quarter 2010 operating expenses were $49.3 million, including approximately $1.4 million in one-time marketing related spending. Recall that we received a $30.1 million payment from Covidien in the first quarter of 2010 following our award in an antitrust lawsuit. We indicted at that time that we plan to spend approximately $15 million of this award on special one-time marketing and clinical research programs and to establish a non-profit foundation, which we did in the first quarter.

Adding the $10.9 million we recorded in the first quarter to the $1.4 million in the second quarter brings our total year-to-date one-time marketing expenses to $12.3 million. We expect the remaining $2.7 million or approximately $0.03 per share to be spread over the second half of this year. Our best estimate is that approximately $0.02 will be incurred in Q3 and $0.01 in Q4.

Excluding the one-time gains, our second quarter total operating expenses were $47.9 million, up 20% from $40 million in the same prior period last year. The increase was consistent with our internal targets and are the result of approximately $5.2 million in higher payroll and payroll-related expenses associated primarily with our continuing worldwide sales force expansion; approximately $800,000 in incremental customer installation per diem activities and related costs that are consistent with our record high first half 2010 driver shipment; and approximately $634,000 in SEDLine operating expenses.

Partially offsetting these increases in operating expenses was a $760,000 benefit associated with the receipt of Covidien antitrust appeal legal fees, which we received as a result of winning the appeal.

Last month, we announced the acquisition of SEDLine, a privately-held brain function monitoring company. Remember that in late 2009, we made a $3 million investment in the company. Through July 2nd, 2010, accounting rules required that we consolidate SEDLine’s net operating loss into our consolidated operating results, although as a non-controlling interest we were not required to include their net loss in our earnings per share calculation. As a result of this acquisition, effective Q3 2010, SEDLine’s operating results will be included in our EPS calculation and we expect this to reduce our third and fourth quarter earnings per share by approximately $0.01 in each period.

Included within our total operating expenses noted above, our R&D expense for the second quarter was $9.1 million compared to $7.3 million in the same quarter one year ago. This 25% rise was due primarily to additional engineers, engineering supplies expense and new project costs related to new product development.

Our second quarter 2010 operating income excluding the one-time spending was $22.4 million compared to $19.9 million in the year ago quarter, representing a 13% increase.

Our effective tax rate declined to 34.7% in the second quarter from 35.3% in the prior quarter due to the inclusion of SEDLine as well as an improved OUS profitability expectation based upon our most recent annual forecasts. For the first six months of 2010, our year-to-date tax rate was 35.1% compared to 33.9% for the same period last year.

Our second quarter GAAP net income was $14.3 million or $0.24 per diluted share. Excluding the one-time marketing spending, our adjusted EPS was $0.25 per diluted share, which is up 14% from the $0.22 in the second quarter last year.

Now, turning to the balance sheet, as of July 3rd, 2010, total cash, cash equivalents, and short term investments were $111 million compared to $189 million at year-end 2009. The change over the past six months was due primarily to the $117.5 million dividend payment made in the first quarter, partially offset by net cash received from the antitrust award and cash generated from operations.

At July 3rd, 2010, our DSO’s rose to 51 compared to 44 at year-end 2009 due primarily to a $3 million receivable, which was recorded in January and which was paid in July. Without this receivable, July 3rd, 2010 DSO would have been 48, up four days from the 44 at the beginning of the period. This slight increase in DSO is due largely to the impact of the European financial issues that have resulted in a modest slowing of our OUS payments.

Inventory turns remained fairly constant at 3.2 at July 3rd, 2010 versus 3.4 at year-end 2009. Let me close with just a quick word about our outlook. As you all know, we provided 2010 revenue and GAAP EPS guidance in February when we released our year-end 2009 results. It is our policy not to update annual guidance unless there are material developments, which cause us to believe that our revenue or earnings per share will be significantly outside the range we previously provided. Based on currently available information, we are not providing any update to our annual guidance issued in February.

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

Joe Kiani

Thank you, Mark. As you all know, Masimo’s mission is to improve patient outcomes and reduce the cost of care by taking noninvasive monitoring to new sites and applications. I have never been more enthusiastic about our ability to drive this mission forward than I am today. We are now in the final stages of a multi-year initiative to expand our global sales and marketing organization, an effort that has allowed us to roughly double the size of our sales force in the last two years and strengthen the goal – infrastructure that supports it.

That sales force is now offering a host of new breakthrough technologies that address important clinical needs and have significant market-changing potential. At the same time, our R&D team is pursuing some exciting new ideas to keep Masimo at the forefront of noninvasive monitoring. We are very well positioned to take advantage of multiple growth opportunities today and over the long run.

For example, while pulse oximetry has been the standard of care in critical care areas of the hospital for years, Masimo is now enabling accurate and reliable monitoring not only in the critical care areas, but into areas such as the general ward. The combination of patient controlled analgesia and lower staff-to patient ratios in the general care floors makes is less likely that a clinician will be there to observe an avoidable adverse event. Consequently, continuous monitoring of patients in general care areas of the hospital is growing unmet medical need.

Masimo SET is particularly well suited for this continuous monitoring because it delivers a 95% reduction in false alarms while improving the detection of true alarms to 97% even under the most difficult clinical conditions of motion and low perfusion when other pulse oximeters fall short.

This fact was made clear recently in the ground-breaking general ward study published in the Journal of Anesthesiology. I know many of you are already familiar with this study, but its results are so compelling that they bear repeating.

After deploying Masimo SET and Patient SafetyNet remote monitoring system, (inaudible) experienced a 65% decrease in distress codes and rescue activations, a 48% drop in patient transport to ICU, 135 fewer annualized ICU days, and no sentinel events.

Hospitals are taking notice of how Masimo can help them improve outcomes and decrease the cost of care. We are seeing a growing number of our long term sensor agreement contracts now incorporating some level of continuous general ward pulse oximetry monitoring along with Patient SafetyNet, which is wired or wireless system that allow clinicians to monitor real-time patients data from up to 80 bedside devices, either from a central monitoring station and/or their pagers when an alarm is set up.

When you consider that the general care areas typically have five to seven times the number of beds as the critical care areas of a hospital, it is easy to appreciate the long term potential of pulse oximetry in the general ward. We estimate conservatively that it could double the current million dollar global pulse oximetry market.

To further our opportunity in our general ward, in June we launched Rainbow Acoustic Monitoring, or RAM. RAM uses an innovative acoustic adhesive sensor that is easily and comfortably applied to the patient’s neck. Using advanced signal processing that Masimo is known for and that leverages Masimo SET, the respiratory signal is separated and processed to display a continuous wave form that allows clinicians to view the respiration rate and signal quality.

Clinical studies have shown this measurement to be equivalent to the respiration rate derived from capnography, although better tolerated by patients. Respiration rate is an important vital sign that is often neglected due to prior limitation.

It is especially important for post surgical patients receiving patient controlled pain medications as sedation can induce respiration depression and put these patients at great risk.

We expect RAM to have a significant positive impact on the quality of patient care on the general ward by facilitating early detection of respiratory compromise and patient deterioration. To cite an example, one of our first RAM customers initially began using it in their short stay surgical unit with a cared for post-op patient who had been moved from the recovery room. A strong patient safety advocated; this major multi-facility medical center was already familiar with our continuous pulse oximetry monitoring with Patient SafetyNet. After adding RAM, they reported that clinicians were able to identify patients in distress earlier and then make the necessary clinical interventions.

In a manner of months, the customer decided to expand use of RAM to at-risk, post-op patients across their systems and is currently deploying it in three of their four hospitals. RAM is of course part of our Masimo Rainbow SET platform, the first and only technology to noninvasively and continuously monitory hemoglobin, carbon monoxide, methemoglobin, and fluid responsiveness PVI, measurement that previously required invasive procedures.

The most notable among the Rainbow parameters is SpHb, noninvasive continuous hemoglobin, which we provided – excuse me, which we provide as either a continuous or a spot check measurement. Continuous SpHb measurement are trended over time and play an important role in helping clinicians identify stable and safe hemoglobin levels in order to prevent unnecessary blood transfusions, especially during surgery.

A recent independent study presented at the European Society of Anaesthesiology Annual Congress validated the real world clinical accuracy and utility of SpHb. In the study conducted at Necker University Hospital in Paris, clinicians simultaneously recorded SpHb and invasive hemoglobin measurement on patients undergoing high blood loss surgery. Measurements were taken at the beginning and end of any clinical intervention and before and after blood transfusion. Results showed a strong agreement between the noninvasive Masimo SpHb and invasive blood tests with a bias of 0.26 gram per deciliter and standard deviation of 1.1 gram per deciliter.

Beyond the operating room, we are also seeing increased interest in deployment of SpHb in labor and delivery, where postpartum hemorrhage is one of today’s most common complications for delivering mothers. A study published in the May issue of Anesthesia & Analgesia found that between 1995 and 2004 postpartum hemorrhage increased 28% in prevalence. According to the study, postpartum hemorrhage markedly increased the odds of in-hospital mortality and causes 19% of in-hospital maternal death.

Maternal bleeding is typically discovered after a significant change in vital signs and/or symptoms and then confirmed with an invasive laboratory hemoglobin test. This approach can result in late detection of bleeding that can affect patient outcome whereas continuous SpHb can help clinicians quickly identify and react to significant changes in hemoglobin levels.

Perhaps the most exciting SpHb news during the quarter was the FDA clearance and limited market release of Pronto-7 in late June. Pronto-7 is our new handheld device designed for quick and easy noninvasive hemoglobin spot check testing along with SpO2, pulse rate and perfusion index in virtually any environment. It sells with a special reusable finger clip sensor designed specifically for spot check hemoglobin accuracy, speed, and performance in lower perfusion index condition.

Since hemoglobin is critical to assessing anemia and blood less, it is one of the most commonly ordered tests, both in the hospital and in non-hospital settings. However, current testing requires a painful needle stick for the patient, time consuming blood transfer to clinician and typical provides delayed results. Conversely, the palm sized Pronto-7 provides a needle-less pain-free measurement in less than a minute making it ideal for the needs of point-of-care environments. Patients benefit from immediate face to face counseling with their physicians about the results while physicians benefit from increased efficiency and patient throughput.

In the U.S. Masimo SpHb has received a CPT code for noninvasive hemoglobin measurement and Medicare has set a 2010 reimbursement rate of $7.19 for eligible tests. In addition to the clinical and practice management benefits, we expect this reimbursement to help provide the financial rationale for adoption SpHb testing in physicians’ practices and hospital environments.

Early reviews of the Pronto-7 by customers have been extremely positive and we plan to move to full market release soon, targeting physicians’ office, emergency medical services, emergency departments, blood donation centers, long term care acute care centers, clinics and hospitals. The product is available through all Masimo hospital sales reps and international distributors. In addition, we a physician office sales force in the U.S., which is currently comprised of approximately 20 reps. We are continuing to increase the size of the sales force while we build awareness of the product and perfect a formula for selling. Once it is done, we will likely transition to a major distributor focused on physician practices and point-of-care facilities.

Over the long term, we see enormous potential for our Rainbow platform and SpHb specifically. We are obviously still in the very early adoption phase of what could in our view ultimately be at least a billion dollar market.

Looking to other long term growth opportunities, we announced a few weeks ago the acquisition of SEDLine, the inventor of electorcautery resistant four channel brain function monitoring. Brain function monitoring has become a widely utilized modality for assessing depth of anesthesia and sedation.

Based primarily on analysis of EEG, SEDLine brain function monitors continuously measure the electrical activity of the brain and translate those changes to the level of consciousness. Brain function monitoring has been deployed in a variety of clinical environments including the OR, ICU, and ambulatory surgical centers.

SEDLine currently holds the smallest share of the estimated $125 million global brain function monitoring market. However, we see substantial growth potential for the market with the transition of anesthetic gases to IV based sedation and development of new technologies that provide greater sensitivity, specificity, and reliability.

Following our investment in SEDLine in late 2009, we were able to spend the last six months becoming much better acquainted with their technology and market opportunity and decided to move forward with the acquisition. It is also worth noting that SEDLine customer base is similar to our own and as a result we expect the Masimo sales force to immediately add the SEDLine offering into their product line-up. In addition, SEDLine products are deployed via a razor-razor blade business model, something that we are very familiar with.

We are currently working on CE marketing and getting regulatory clearances in other parts of the world. I also want to remind our shareholders that we plan to not grow our expenses in 2011 anywhere near the level we have for the last four years. We believe we are critical mass for a number of team members, including engineering and sales professionals for the time being. Let me close by saying that we believe our second quarter results within the context of a still challenging economic environment speak to the underlying strength of our business model and value of our technology.

Customer enthusiasm for our newest innovations like continuous SpHb, RAM, Patient SafetyNet and Pronto-7 continues to build. We remain fully focused on the opportunities ahead of us and believe we are in the enviable serial innovation position resulting in a solid business that is growing in double digits and in early stages of an even bigger exciting growth story.

With that, Mark and I will be happy to take your questions. Thank you very much.

Question-and-Answer Session

Operator

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

Bill Quirk – Piper Jaffray

Thanks. Good afternoon, nice results, guys.

Joe Kiani

Thank you, Bill.

Bill Quirk – Piper Jaffray

A couple of questions. First off, with a couple of very strong driver quarters through the first half of the year, can you talk a little bit about whether or not this is the new normal in terms of placements or are we perhaps seeing a bit of an inflated impact just from some pent up customer demand?

Joe Kiani

Well, we actually believe this should continue. Obviously there was pent up demand, Bill, from the last I guess and may be even the quarter before that year as the financial markets became so bad that everybody put a hold on everything (inaudible). So, that pent up demand did create a good first half but from what we see today, we don’t think the drivers will change much in the next couple of quarters.

Bill Quirk – Piper Jaffray

Understood. Thank you. And then as a followup can you guys talk a little or give a little more color into Rainbow in terms of just from a product standpoint, what’s driving that? I assume hemoglobin is doing quite well, but if you wouldn’t mind throwing in a comment about some of the parameters like carbon monoxide and methemoglobin. Thanks.

Joe Kiani

Well, I think you kind of said it. They are all growing really nicely. We are seeing some really nice growth percentage wise. Obviously the numbers are still small and that’s why we are not breaking it down, because when they are that small they can be erratic, but I can tell you it has been growing very nicely and as we talk about it, Bill, we think when one of these parameters start becoming significant like may be 10% of our revenues, that’s the time to start breaking down that parameter out of the group and start talking a little bit more about on it on these types of calls.

Bill Quirk – Piper Jaffray

Very good. Thank you.

Joe Kiani

Thank you.

Operator

Our next question is from the line of Joanne Wuensch from BMO Capital Markets,

Joanne Wuensch – BMO Capital Markets

Thanks for taking the question. Stock-based compensation in the quarter, you used to include a chart in the press release. What does that look like?

Mark de Raad

Joanne, I think the number if I recall is about $2.4 million or so, but I will followup on that and get back to you.

Joanne Wuensch – BMO Capital Markets

Thank you. How much did the SEDLine acquisition add to revenue in the quarter?

Mark de Raad

We are not actually breaking out SEDLine specifically under the general guise of what Joe just mentioned. What we can say is that at least currently SEDLine is a very small portion of our total revenues. However, as Joe just mentioned, we expect that to change dramatically over the next couple of years as we are able to invest the necessary resources, both from an engineering and from a sales standpoint.

Joe Kiani

I would like to add, Joanne, that certainly the growth we had did not come from SEDLine acquisition.

Joanne Wuensch – BMO Capital Markets

Thank you.

Joe Kiani

You are welcome.

Joanne Wuensch – BMO Capital Markets

Another question. You did announce the settlement with Hygia --forgive me if I am mispronouncing that -- over the last week or two. What is the significance of that?

Joe Kiani

Well, Hygia is a lot of – I think the two reprocessors out there and while we are not quite certain of the impact they are having, we think it’s de minimus, but the next thing is that Hygia has agreed to discontinue reprocessing, selling, exporting or otherwise transferring any of Masimo’s pulse oximetry devices originally designated by Masimo as for single use only and or any other company compatible sensors for two years. Now, we are pleased with this outcome, which is consistent with our original request in April, 2009 Hygia (inaudible) processing used Masimo sensors.

Joanne Wuensch – BMO Capital Markets

Okay. My final question is OEM revenue as a percentage of revenue increased in the quarter. Is that reflective of increasing demand from some of the Philips and other larger box manufacturers? Thanks.

Joe Kiani

The short answer is yes.

Joanne Wuensch – BMO Capital Markets

Alright, thank you.

Joe Kiani

Thank you.

Operator

The next question is from the line of Mayank Gandhi from Cowen,

Mayank Gandhi – Cowen

Good evening. Thank you for taking my questions. Can you just talk about gross margin, you know, you again came in a little bit softer this quarter and you mentioned two factors, increased OEM revenues and incremental manufacturing expenses. It is – last quarter I think there was some impact from disposable or disposable dynamics. Is that true this quarter as well and how should we think about going forward?

Mark de Raad

Well the two items that I mentioned before, the impact of the higher percentage of OEM revenues as well as the continuing migration from Irvine, California to Mexicali were essentially the two primary reasons for that. There really are no other significant material items that impacted that margin. So, we hope that by the end of the second quarter, that the vast majority of that manufacturing transition has now been completed. So the slight drag that that has had on our margins for the first couple of quarters of this year, we plan to actually no longer see that in the second half of the year.

Mayank Gandhi – Cowen

Okay. And given that you have Pronto-7 now and is – in the past I know you had mentioned about possibly the – of signing a large physician office distributor. Is that something – how are the discussions going on that front? Is that something we could expect in the near term or something that’s more for the down the line?

Joe Kiani

So, I think further down the line, as I mentioned, we want to make sure we are very comfortable with the product and how to best sell the product. We’ve had dialog with these large distributors. They have shown a lot of interest. We probably will end up selecting one of them and it could be before the end of the year, it could be beginning of the new year that will be comfortable in letting a large sales force like that aided by our regional smaller sales force to start selling Pronto-7 in the market.

Mayank Gandhi – Cowen

Okay. And the margin on Pronto-7 is similar to the corporate margin or is it more than what you have right now, gross margin I meant?

Joe Kiani

Well, we think of the business as – and I assumed your question is Pronto-7 along with the consumables.

Mayank Gandhi – Cowen

Yes.

Joe Kiani

And the answer is yes, it should be at least the same if not larger than what kind of margin we normally have with our Masimo SET business.

Mayank Gandhi – Cowen

Okay. Thank you.

Joe Kiani

Thank you.

Operator

Next question is from the line of Gregory Hertz from Citi.

Gregory Hertz – Citi

Hi, gentlemen, thanks for taking my call. I was just hoping may be just take a bit of a deeper dive on some of the growth you have with – in the OEM channel and also just the benefit you had with the Rainbow SET in the quarter. Just wondering did you say whether or not the OEMs and the increasing contribution of revenues in the quarter was due may be some pent up demand among hospitals or may be was that due to the product design cycle and may be having more of the – your OEM partners having the Rainbow SET available or if you can be just describe a little bit more about the (inaudible) Rainbow SET in the quarter? Thanks.

Joe Kiani

Sure, Greg, I think it’s really the demand from the market and then pent up demand also for devices in general. But I believe more customers globally are requesting Masimo technology from the OEMs and that’s what’s helping us become a bigger, now I think bigger drivers will be a bigger percentage of the shipments of our OEMs.

Gregory Hertz – Citi

And what’s your visibility now, I mean I know you do have certain amount of visibility within your ORM partners. Has that improved and so do you see this as being kind of a sustainable level of revenue contribution for OEMs for the remainder of the year?

Joe Kiani

Well, good question, Greg, and I – what I want to say is to hedge what I am going to say, I am going to say that overall between OEMs and our direct business, we think the number of drivers will roughly remain the same. But obviously Q3 is (inaudible) than Q4 but it doesn’t feel like anything should change there.

Gregory Hertz – Citi

Okay. And then one final one. With respect to the pace of the parameter rollouts, you’ve obviously been pretty consistent here in the last couple of year for launching new parameters. But in light of the SEDLine acquisition, what should we expect to hear with respect to kind of home grown parameter solutions? Should we expect to hear anything later this year or is that something that we would hear may be in 2011? Thank you for your time.

Joe Kiani

Sure, Greg. Masimo Corp. has a very broad product line in its R&D and I don’t know if we’ll deliver on this hope, but we hope to continue to deliver important new parameter each year for the foreseeable future. On top of it, Masimo Labs, which we have a relationship with, is working on a pretty big home grown parameter that we have never said we are going to do, or they ever said they are going to do, but obviously if they develop that, that one particular parameter they are working on should be helpful to Masimo’s rollout as well.

Gregory Hertz – Citi

Thanks for your time.

Joe Kiani

Thank you.

Operator

Our next question is from the line of Brian Weinstein from William Blair.

Brian Weinstein – William Blair

Good afternoon. Thanks for taking the question.

Joe Kiani

Hi, Brian.

Brian Weinstein – William Blair

Hey, so when we met, Joe, we even met last September you indicated that you felt that the accuracy of Pronto-7 would have to be a little bit better than Pronto or that you would reconsider launching it. I believe the wafer [ph] was similar for the two in terms of the accuracy. Is that true then – is there data that you have that we just haven’t seen yet or that’s going to be presented somewhere that’s going to show any type of an increase in accuracy on the Pronto-7?

Joe Kiani

Well, you are right that I did say Pronto-7 is going to be more accurate than Pronto. From the FDA we did not seek a more accurate specification. But the product is more accurate than Pronto. Pronto-7 is more accurate than Pronto. As far as what type of data is going to be published, I don’t know if Pronto-7 data is going to be published any time soon. My guess is that it will start coming out in 2011. I do know at this year’s ASA we expect over ten studies on hemoglobin but I don’t think they are Pronto-7 specific.

Brian Weinstein – William Blair

Okay. And then can you comment – in the past you’ve given some qualitative comments on quote activity around Rainbow. Can you qualitatively talk about quote activity there and has there been any change in the average time to close these accounts?

Joe Kiani

Well, we are not providing any more quote activity because I think the product is more mature, and as you can see the revenues are growing actually for Rainbow and I think that speaks volume for Rainbow and its entirety. I have in the past given you some signals about the percentage growth, hemoglobin we are seeing, and while nothing has changed, I don’t want to do that anymore until, like I said, each parameter becomes big enough as a percentage of our revenue where it warrants to break out. But to answer the second part of your question, we believe that quoting activity and the timeframe to closing have not changed that negatively. It may have changed positively slightly and that has to do with the fact that we are now selling products often to physicians’ offices, which take less time to convert from a demo to a hook, to an order.

Brian Weinstein – William Blair

Okay, great, thank you very much.

Joe Kiani

Thank you.

Operator

The next question is from the line of Matt Dolan from Roth Capital Partners.

Matt Dolan – Roth Capital Partners

Good afternoon. Can we maybe shift over to the international business? It looks like it was flat sequentially and I think, Mark, you mentioned some slower collection cycles over there. What’s the outlook for the international piece of the business as there are some concerns in the Eurozone?

Mark de Raad

Well, in general, Matt, we actually were very pleased with the performance in the second quarter. There was ironically one large transaction that occurred in one of our international entities in the first quarter that did not repeat of course and so as result there was from a direct revenue standpoint a slight decline. That was of course offset by an increase on the OEM side. So, in general we are very pleased with the total OUS performance. In fact against their own internal plans they are measuring ahead of plans for the year. And for the rest of the year, of course, we are heading up into the summer quarter, which is always a difficult one to call in the OUS world. But we expect to continue to see the level, the general level of revenues that we’ve seen over the first half of the year, and then ending up with a relatively strong end of the year period.

Matt Dolan – Roth Capital Partners

Okay, great. And then, Joe, on SafetyNet in the general floor, I know you touched on some good data points in the prepared remarks, but may be – I think last call you talked about entering an inflection point for that particular segment of the market. Can you help kind of recalibrate us there? Are you still equally as optimistic more or less now that you’ve got another few months of hindsight?

Joe Kiani

Yes, I am equally as optimistic as I was last quarter and I recently had a chance to travel around some of the other regions of the world and amazingly even in those regions there is a lot of excitement for Patient SafetyNet. I think that study that came out was with the first of its kind, has really fueled customers’ interest in doing this because they’ve always felt that it was the right think to do for patient care, but they were afraid of cost aspect of it, and that study showed that it actually saved money. So, long story short, yes, that we are quite optimistic about the growth of Masimo Patient SafetyNet into the general ward.

Matt Dolan – Roth Capital Partners

Okay. And then finally just on seasonality and modeling the rest of this year. Obviously, last year was a unique macro environment here in the U.S. Any color you could give us on the trajectory of revenues in the final two quarters here? Thanks.

Joe Kiani

Well, seasonality wise, Q3 is usually the slowest quarter because a lot of Europe shuts down for most of the quarter and the flu season is over and people are vacationing. So – but generally we see still strong demand for our technology in Q3 and Q4 and we are feeling optimistic.

Matt Dolan – Roth Capital Partners

Great. Thanks, guys.

Joe Kiani

Thank you. I think we have time for one more question.

Operator

Our last question is from the line of Larry Keusch from Morgan, Keegan.

Joe Kiani

Hi, Larry. Maybe not.

Mark de Raad

Hello.

Joe Kiani

We have time for one more question, if anyone has it.

Operator

Mr. Keusch, your line is open.

Mark de Raad

Guess we lost Larry.

Joe Kiani

Okay, we lost Larry. Well, if there is nobody else, then I want to thank you all for joining us today and I am looking forward to seeing some of you in person, and Mark and I look forward to our earnings call. Thank you.

Operator

That concludes today’s conference call and you may now disconnect.

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Source: Masimo Corporation Q2 2010 Earnings Call Transcript
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