Masimo CEO Discusses Q3 2010 Results – Earnings Call Transcript

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 |  About: Masimo Corporation (MASI)
by: SA Transcripts

Operator

Good afternoon, ladies and gentlemen and welcome to the Masimo Corporation third 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 Q&A session. (Operator Instructions) At this time, I’m pleased to introduce Sheree Aronson, Masimo Vice President of Investor Relations.

Sheree Aronson

Good afternoon everyone. 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 your questions. This call contains forward-looking statements which reflect Masimo's best current judgment. However, they are subject to risk 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'll pass the call to Joe Kiani.

Joe Kiani

Good afternoon, ladies and gentlemen and thank you for joining us today. We are happy to report another solid quarter to our shareholders. I believe our results as well as other key developments in the quarter reveal the strength of our technology and mission.

Here are some highlights. First, total revenue was up nearly 16% and topped $100 million for the second consecutive quarter. Product revenue growth drove performance with sales up by 18%, reflecting double-digit gains both in the U.S. and internationally and across both our direct and OEM channels.

Our core SET revenue outpaced market growth rates again this quarter as more hospitals and clinicians demanded the Masimo SET performance. What's more, our innovation prowess were key to landing several major long-term contracts with new customers in recent months, including Banner Health and Kaiser Permanente, which should contribute to our future growth in many ways.

Second, our Rainbow platform was a standout performer as revenue approached $12 million, nearly double the year-ago figure. With Rainbow, we are revolutionizing patient care with breakthrough non-invasive measurements including total hemoglobin, carboxyhemoglobin, methemoglobin, PVI and acoustic respiration rate. These latest sales figures signal increasing demand for all of them.

We also continue to build a body of third-party evidence regarding Rainbow's accuracy, clinical utility and cost saving benefits, including numerous studies released at the recent American Society of Anesthesiologists meeting. Post-market clinical research is, of course, a critical element in driving new technology adoption. And we are happy that so much clinical attention is being directed to our new technologies.

Third, we continue to place drivers into the market at a faster rate, with the new unit shipments up 43% to 37,500. A combination of factors are influencing our recent surge in new unit shipments, including continued demand for our technology by clinicians, resulting in an increasing share of OEM partners' total board shipments and new contract bookings. And what we may also think may be a continued pent-up demand following below normal levels of sales for our OEMs in 2009.

And finally, we achieved GAAP EPS of $0.27 a share and adjusted EPS of $0.28, up 23% and 27% respectively over the year ago period. This EPS performance reflects our third quarter top line growth, record-breaking rainbow sales and modest gross margin expansion as well as a non-operating gain related to foreign currency translations and some tax benefits which Mark will discuss in more detail.

I'll talk more about the quarter in a few minutes but first Mark will provide you the detailed financial overview.

Mark de Raad

Thank you, Joe and good afternoon everybody. As Joe indicated, total revenue rose nearly 16% to $101 million versus $87.4 million in the year ago period. This was driven by an 18% year-over-year rise in product revenue to $88.8 million. The impact on Q3 2010 revenues from foreign exchange was relatively insignificant, resulting in only a $50,000 increase over the prior year.

Masimo SET revenue grew by 11% to $76.9 million. It is important to note that in the year ago quarter, we included approximately $3.4 million in previously deferred SET revenue, which we recognize as a result of the elimination of obligations to provide upgrades under two long-term sensor agreements. If you remove the impact of this deferred revenue adjustment from the year ago quarter, our third quarter SET revenue was up more than 16%.

At $11.9 million, our third quarter Rainbow revenue grew 99% year-over-year. A significant contributor was a 4 million Rad-57 shipment to the U.S. Marine Corps. This represents the culmination of over a year's worth of effort by our U.S. sales organization and is indicative of the new market opportunities we see for Rainbow technologies.

While we anticipate more U.S. military orders in the future, they will likely be sporadic and therefore tough to predict. Rainbow licensing and consumable revenues were up nicely in the quarter. Importantly, we saw a significant rise in SpHb ReSposable sensor sales again this quarter, which is another positive indicator of growing SpHb utilization.

Partially offsetting this were some headwinds we continue to experience in the EMS market where cutbacks in municipal budgets across the country have continued to put pressure on equipment purchases by local fire departments. However, we do see some signs that the federal grant program process is beginning to recover.

Our end-user or direct business, which includes sales through just-in-time distributors, rose nearly 17% to $70.1 million in the third quarter of 2010 versus the same quarter last year and represented 79% of total product revenue. OEM revenue made up the remaining 21% at $18.7 million, up a strong 24% versus the third quarter of 2009.

Geographically, our U.S. product revenues rose 15% to $66.2 million compared to the same period last year, with both our OEM and direct channels contributing solid growth. Once again, if you adjust the prior period numbers for the $3.4 million deferred revenue adjustment in the year ago quarter, our adjusted year-over-year U.S. product growth was actually 23%.

Product revenue outside the U.S. totaled $22.6 million, up 27% on both a reported and constant currency basis. Every OUS region grew by double digits, with particular strength coming from the Europe, Middle East Africa region. Overall, our international product revenue was approximately 25% of total product revenue in the quarter, generally in the range of prior periods.

As Joe noted earlier, new driver placements also continued to accelerate in the quarter. Excluding handheld devices, we shipped 37,500 new SET and Rainbow boards and monitors, up 43% compared to 26,200 in the same prior period last year. We estimate our total worldwide installed base at the end of the quarter net of estimated retirements at approximately 821,000 drivers compared to approximately 697 one year ago.

Our gross profit margin grew to 66.9% in the third quarter from 66.5% in the same period last year. The year-over-year expansion was due primarily to the rise in Rainbow revenue, partially offset by a higher mix of OEM board revenues. Total third quarter gross profit margin including royalties stood at 70.9% compared to 71.2% in the same prior period last year. The modest decline was due primarily to lower year-over-year royalty revenues.

On a GAAP basis, our third quarter 2010 operating expenses were $48.8 million, including approximately $700,000 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 indicated at the time that we planned to reinvest approximately $15 million of this payment in 2010 to fund special marketing and clinical research programs and to establish a nonprofit foundation which we did in the first quarter. Through the third quarter of 2010, we’ve spent approximately $13 million. And we expect to incur the remaining $2 million in the fourth quarter.

Excluding the one-time items, our third quarter total operating expenses were $48.1 million, up 16% from $41.4 million in the same prior period last year. This increase reflects $2.5 million in higher payroll and payroll related expenses and $1.5 million in higher travel expenses, all associated with our continuing worldwide sales force expansion.

We also increased our legal expenses by approximately $850,000 and incurred approximately $700,000 or about a penny per share in third quarter operating expenses from SEDLine, the brain function monitoring company, we acquired at the end of the second quarter of 2010. Foreign currency exchange rates added approximately $280,000 to operating expenses in the third quarter of 2010 compared to the same prior year quarter.

Our third quarter operating expenses also included $9.2 million in R&D expense compared to $7.7 million in the same quarter one year ago. The 19% rise is due to increased payroll and payroll related costs associated with increased R&D staffing levels.

Our third quarter 2010 GAAP operating income was $22.8 million. Excluding the one-time marketing expenses, our adjusted operating income was $23.5 million compared to $20.8 million in the year ago period. Non-operating income was $1.2 million in the third quarter compared to $295,000 in the year ago period.

The recent decline in the value of the U.S. dollar, especially versus the euro and Japanese yen, resulted in approximately $1.1 million in FX or remeasurement gains resulting from the translation of our foreign entities' local balance sheets into U.S. dollars. Our effective tax rate to climb significantly to 30.6% in the third quarter and our updated year-to-date effective tax rate declined from 34.7% at the end of our second quarter 2010 compared to 33.8% at the end of our third quarter.

This sequential decline was due primarily to the release of the previous FIN-48 tax provisions following the expiration of statutes of limitations on various prior potential tax liabilities. As a result of these various components, our third quarter GAAP EPS was $0.27 while our adjusted EPS, removing the impact of our one-time marketing expenses was $0.28, up 27% from $0.22 in the prior year quarter.

Our third quarter 2010 GAAP and adjusted EPS results both include an approximate $0.02 benefit resulting from the non-operating FX gain and the impact of our lower third quarter tax rate. Without this $0.02 benefit, our adjusted EPS would have been $0.26, up 18% from $0.22 in the third quarter last year.

Turning now quickly to the balance sheet, as of October 2, 2010 total cash, cash equivalents and short-term investments were $125.4 million compared to $189 million at year end 2009. The change since year end is the result of our March 2010 $117.5 million dividend payment, partially offset by net cash received from the antitrust award and cash generated from operations.

At October 2, 2010, our DSO rose to 51 compared to 44 at year end 2009, due primarily to higher September sales activities versus the last month of the comparable period, along with some slower payments terms in some of our international locations. Our September ending inventory levels rose significantly due to our decision to procure additional inventory in order to be prepared to support the installation of a new large customer. As a result, our September 20,000 inventory turns declined to 2.7 versus 3.4 at year end 2009.

I'll wrap up with just a quick comment regarding our guidance. As you will recall, Masimo provided its 2010 total and product revenue and GAAP EPS guidance in February 2010. As you also know, our policy is not to update annual guidance unless there are material developments that cause us to believe that our annual total or product revenue or GAAP EPS will be significantly outside the range we previously provided.

Based on currently available information, we are not providing any update to our annual guidance range issued in February. Thank you for your time. And now I'll turn the call back to Joe.

Joe Kiani

Thank you, Mark. This was another good quarter for Masimo, demonstrating the strength of our technology and innovation engine, positioning us well for long-term growth. That's not to say that market conditions aren't still challenging. Like other med tech companies, we continue to see softness in health care spending as hospitals and other providers grapple with the realities of the weak economy.

We're also watching closely the trends in hospital procedure volumes as recent reports indicate that high unemployment and under employment rates, patients' lack of healthcare insurance, more conservative consumer spending patterns overall and other factors caused some people to put their medical procedures on hold.

In the midst of these still challenging times, the good news for Masimo customers, shareholders and employees is that we have a focused strategy in place that provides significant clinical advantages and therefore multiple levers for achieving profitable growth. I said last quarter that I had never been more enthusiastic about Masimo's future prospects and that statement remains true today.

We currently operate in the global critical care pulse oximetry market that is estimated to be over $1 billion. Through execution of our strategy, to take noninvasive monitoring to new sites and applications, we not only have become the market leader but with our continuing list of new breakthroughs and products, we see our addressable market approaching $5 billion over the long-term. Few companies have a similar organic growth opportunity.

In our core SET business, market share gains are evident not only in our sales performance but also in our new driver shipments, which reflect rising demand from some 50 OEM partners, who purchase our circuit boards for their devices. We're also seeing positive momentum in the pace and size of contract (inaudible) which are the multi-year sensor purchase agreements we make with hospitals.

While we continue to build a solid track record of renewing contracts with existing customers, we are most encouraged by the rate of new customer acquisitions, especially the trend with large systems. Some notable recent examples include Memorial Hermann, the largest not-for-profit health care system in Texas; Banner Health, a leading hospital system spanning seven Western states and Kaiser Permanente, with facilities in nine states.

The key takeaway is that we are renewing our existing customers and winning over new customers. Because we are the most innovative company in our market and offer a superior technology platform that helps hospitals advance the practice of health care and patient safety while lowering costs. Most of our new contracts now call for some deployment of continuous monitoring beyond critical care areas and on to the general ward.

General ward monitoring is a growing unmet medical need as the combination of patient controlled analgesia and lower staff to patient ratios makes it less likely that a clinician will be there to observe a patient in distress. Our Signal Extraction Technology is particularly well-suited for general ward deployment due to its unprecedented measure through motion and low-perfusion performance, meaning low false alarm rates and superiority at detecting true alarms.

Moreover, our Patient SafetyNet solution allows for efficient monitoring of real-time patient data from up to 80 bedside devices via a central monitoring station or wireless pagers. Masimo SET and Patient SafetyNet is the only general form monitoring system proven to help clinicians reduce rescue activations, ICU transfers and total ICU days.

Of course, Masimo is also the only company to provide acoustic respiration rate monitoring, which clinicians use for early detection of respiratory compromise and distress particularly in sedated, post-op general ward patients. Rainbow acoustic monitoring or RAM was launched in June and has been shown to be equivalent to respiration rate derived from capnography although much better tolerated by patients. We expect RAM to help drive our expansion to the general ward.

In addition at the recent American Society of Anesthesiologists meeting in San Diego, we previewed several new technologies designed to take patient care to a new level, including a new technology called Halo Index. The Halo Index, which is not FDA cleared, is a dynamic new indicator that facilitates continuous global trending and assessment of multiple physiological parameters to quantify changes in patient steps. Besides a very rich trend display, it produces a specific numeric value and is designed to help clinicians better assess overall patient condition and predict deterioration.

The Halo Index illustrates our continued commitment to introducing new breakthrough technology every 12 to 18 months. And we expect it to play an important role in improving patient care in the years ahead.

Following receipt of regulatory clearance, Halo will be part of the expanded functionality of the Masimo platform, along with real-time or playback of bed sounds to assist clinicians in respiratory assessment. Clinician growing interest in the Masimo offering was also apparent that the recent American Society of Anesthesiologists symposium, we hosted for an overflow crowd of approximately 800 anesthesiologists.

They came to hear some of the leaders in anesthesiology discuss the clinical impact of Masimo noninvasive hemoglobin, PVI, Patient SafetyNet and Rainbow Acoustic Monitoring. ASA is our most significant professional conference of the year. And the 2010 meeting was in all respects a big success for us.

During the conference, there were 21 posters presented that highlighted Masimo technologies, primarily continuous SpHb and other Rainbow parameters. Most notable among them was a study funded by the National Institute of Health and presented as part of the late breaking trials section.

In the study, researchers at Mass General Hospital examined the impact of SpHb monitoring upon transfusion in 327 patients undergoing orthopedic surgery during a six-month period. Patients were randomized to either a standard care group, which was comprised of 157 patients, guided by invasive laboratory hemoglobin measurements alone or Masimo SpHb group, which was comprised of 170 patients guided by SpHb monitoring in addition to standard care.

SpHb measurements were obtained using a Masimo Radical-7 pulse CO-Oximeter and Rainbow SpHb adhesive ReSposable sensor. Of the 327 patients, eight received blood transfusions, seven in the standard of care group and only one in the SpHb group. As a result, the frequency of intraoperative transfusion was 86% lower in the SpHb group compared to the standard care group.

In addition, the average number of units of blood transfused was 90% lower in the SpHb group compared to the standard care group. The lack of blood transfusion in the SpHb group did not subject those patients to added risk as there were no differences in the 30-day complication rates between groups.

Researchers concluded that the use of SpHb monitoring resulted in fewer intraoperative blood transfusions. Additionally, researchers presented a retrospective cohort analysis at the ASA, which showed that in a case-by-case matched group of 327 patients, same age, gender and surgical procedure as each patient in the active study.

These patients taken from the six-month period prior to the study, the transfusion rate on them without SpHb monitoring was 4.6%, consistent with the 4.5% transfusion rate of the standard care group in the active control study. Results from the cohort analysis demonstrate that SpHb monitoring made a key difference in reducing the transfusion rate.

It is important to point out that there is growing evidence that blood transfusions expose patients to significantly increased morbidity and mortality risk with evidence that each unit of blood increases the risk of infection, pneumonia, sepsis and mortality after surgery. Furthermore, the research suggests that these risks could be largely avoided through implementation of better blood management techniques and more appropriate indicators for transfusion.

This MGH study was the first to show the ability to reduce blood transfusions with SpHb monitoring. And we expect it to have important clinical implications in reducing patient surgical risk and reducing costs.

Our opportunity to extend the adoption of continuous SpHb took another step forward late in the third quarter when we received regulatory clearance in Japan. Our Japan team has been working closely with various university and other major hospitals in Japan to educate them on SpHb's benefits. In fact, the third quarter results include some early SpHb license sales. And we expect hemoglobin to be an important contributor to our efforts to build in this region.

Touching quickly on other Rainbow developments in the quarter, as Mark said earlier, we were excited to forge a relationship with the U.S. Marine Corps, which purchased a number of our Rad-57 units fully loaded with Rainbow capability. These Rad-57 devices will be part of USMC medical kits used by shock trauma platoons, providing resuscitative surgical support close to the battlefield.

These medical units provide care to both combat and civilian casualties. And we are gratified to see Masimo's technology being deployed to address such a vital need. Masimo's Rad-57 is now included on the inventory list for U.S. Marine Corps forward medical units. So we expect this to continue to contribute to our growth over time.

Also during the quarter, Frankfurt, Germany officials decided to equip every EMS vehicle in the city with Rad-57, making carbon monoxide screening by Pulse CO-Oximetry, a citywide EMS requirement. Similarly, the Odessa Fire Company in the state of Delaware recently distributed Rad-57 to every fire district in the state, making it the first in the country to place this life-saving technology in every fire response district.

Limited market release of Pronto-7, our new handheld device designed for quick and easy noninvasive hemoglobin spot-check testing, is now in full swing. And we expect to move to full market release soon. Since hemoglobin is critical to assessing anemia and blood loss, it is one of the most commonly ordered tests.

The palm-sized Pronto-7 provides a needleless pain-free measurement in less than a minute, making it ideal for the needs of point of care environments. It is clear that across virtually all categories, we're seeing growing adoption for our own breakthrough technologies, such as RAM as well as Rainbow measurements, including carbon monoxide, methehemoglobin and SpHb.

CO, med, SpHb are technologies licensed to Masimo Corporation as part of a cross licensing agreement with Masimo Labs, an independent entity that was spun off in 1998 from Masimo Corporation to its then stockholders. From time to time, investors inquire about our relationship with Masimo Labs, including whether Masimo Corp. would consider pursuing strategic initiatives at Masimo Labs.

As we have previously disclosed, Masimo Corp. is always reviewing and considering strategic opportunities with third parties including acquisitions, collaborations and other partnerships. As part of these reviews, Masimo Corporation's Board has formed a special committee to be responsible for all activities involving Masimo Corp. and Masimo Labs.

The committee was comprised solely of independent directors. Specifically, neither I nor another one of Masimo Corp's Board members who also sits on the board of Masimo Labs serves on the committee or has any involvement in the special committee's evaluation and discussions.

The special committee was given exclusive power and authority by the Masimo Corp.'s Board to consider and evaluate any and all issues, topics, concerns that involve the interrelationship of Masimo Corp. and Masimo Labs. In that capacity, over the last four months, the special committee investigated whether an expansion of the strategic relationship between the two companies was possible or advisable.

After due consideration the special committee recently reported to the Board that following a detailed review and discussions between independent representatives of the two parties, the special committee had determined not to pursue an expanded relationship between the two companies, up to and including the potential acquisition of Masimo Labs.

The special committee for a variety of reasons that are confidential determined that seeking a potential acquisition of Masimo Labs was not in the best interest of Masimo Corp. or its stockholders. Because of this recent action and in order to address the periodic inquiries about our relationship with Masimo Labs, management was instructed to disclose the results of this review to Masimo Corp.'s stockholders.

Because of the confidentiality of the discussion we do not expect to make any further statements or to discuss the subject in more detail, nor do we expect to discuss the status of any other strategic considerations or analysis that Masimo Corp. may undertake in the future.

In closing, we believe our third quarter performance demonstrates the strength of our mission and technology and the potential for our business. We are executing on our promising opportunity and consider Masimo to be in the early stages of the long-term growth trajectory, based on our current view, we see a strong finish to 2010 and intend to enter 2011 with a highly skilled, motivated and appropriately sized team to take Masimo to the next level.

As an organization, we strive constantly to set ourselves apart through innovation that can truly improve patient care. Our goal to solve the unsolvable problems is more than a catchphrase to us rather it is the motivation that propels us forward and leads to monitoring breakthroughs like SpCO, PVI, SpMet, SpHb, RAM and the new Halo Index I described today. We are proud of the track record we've established thus far and excited about what we believe the future holds.

With that, we will be happy to open the call to your questions. Operator?

Question-and-Answer Session:

Operator

(Operator Instructions) Your first question comes from Bill Quirk of Piper Jaffray.

Bill Quirk – Piper Jaffray

Thanks. Good afternoon.

Joe Kiani

Hello, Bill.

Bill Quirk – Piper Jaffray

A couple of questions, guys. First off, in terms of the Kaiser adoption, I guess has that begun and secondly, how should we think about the pacing of the adoption there?

Joe Kiani

The Kaiser adoption has begun. We expect to finish the installation throughout their system probably by end of Q1.

Bill Quirk – Piper Jaffray

Okay. Very good. And then secondly and somewhat separately, Mark, certainly appreciate the refresh in the moving parts from last year's SET business. Having said that, the business was still off about 5% sequentially, so I'm hoping you can give us a little additional color here into any additional, I guess, moving parts we should be aware of from the June to September quarter? Thanks.

Mark de Raad

Sure, Bill. Yeah. I think from a very high level perspective, certainly as Joe alluded to earlier, the overall lower hospital procedure volumes we think resulted in overall lower sensor purchases for us in the third quarter. Having said that though, historically for us we typically do see lower sensor volume in the third quarter versus the second quarter, so in that respect, it wasn't all that surprising.

Another factor that certainly has been discussed over the last year or so is the impact of certain third-party reprocessing organizations even though we can't quantify the amount, we certainly believe based upon anecdotal evidence that they are having a slightly more dramatic impact on what we've seen in the past, having said that, in the aggregate still a very small total impact on our overall revenues.

And then finally, ironically, maybe consistent with some of the points that Joe alluded to about the challenges facing the hospital still today, are that we actually have seen a slight uptick in the use of reusable SpO2 sensors versus disposable sensors. So tough to tell whether or not that's a reflection of hospitals redirecting some of their operating budgets into reusable sensors as opposed to disposable sensors but that certainly could be occurring.

Now having said all that, as Joe alluded to, we are feeling confident about a return to a higher level of sensor activity in the fourth quarter, which is what we usually see as we head into the fourth quarter and on top of that, of course, some of the large new contract that Joe just alluded to will obviously help in additional sensor shipments in the fourth quarter and into the next year.

Bill Quirk – Piper Jaffray

Great. If I could speak one last one in here. Joe, does the committee's decision not to move forward with any type of M&A around Labs, does that reflect at all anything in terms of the development pipeline around glucose? Thanks.

Joe Kiani

Bill, how much I like to answer all your questions, but I have been asked to not expand further.

Bill Quirk – Piper Jaffray

Understood. Thanks guys.

Joe Kiani

Thank you.

Operator

Your next question comes from Sara Michelmore from Cowen.

Sara Michelmore – Cowen

Joe, just, if you talk about some of these new large accounts that you've added, Kaiser and Banner. Could you just talk about the – are these people that would be adopters of Rainbow products and what role did the availability of Rainbow play, if any, when you were negotiating those contracts? Thanks.

Joe Kiani

Sara, we have been told the reason we got, for example, the contract with Kaiser is our innovation engine for lack of a better word. And innovation engine is not only noninvasive hemoglobin, which is of course something they are very excited about, but if even the ReSposable sensors that help for a more green environment. So what we believe is that, yes, Kaiser, like these other systems, are going to be beyond pulse oximetry and using Rainbow parameters. But at this point, we're going to wait until we hopefully have some historical data to point to instead of projecting.

Sara Michelmore – Cowen

Okay. And then just, I know that you don't want to give details on 2011, but you did say that you want to take the company to the next level, I believe was the words that you used. I'm just curious as you think about all these new products you have and some of the expansion that you're doing, what are the kind of key investment price for the company as you look forward?

Joe Kiani

Well, that's a good question, because maybe it gives me an opportunity to remind our stockholders that we plan for 2011 to not grow our expenditures the way we've grown it in the past. In fact and I have likened it to the Orange County takeoff. For those who have taken off from Orange County, we have been taking off over the last four years and increasing our spending by about $30 million a year and we expect in 2011 to basically shutoff the growth for at least a year.

So we believe with the team that we have assembled that we are rounding out before the end of this year, we're pretty much confident that with that team we can achieve the growth and the trajectory that we hope for the next, at least for the short-term if not for the next few years.

Sara Michelmore – Cowen

Okay. Great. I'll let someone else ask a question. Thank you.

Joe Kiani

Thank you.

Mark de Raad

Thank you, Sara.

Operator

Your next question comes from Matthew Dodds from Citigroup.

Matthew Dodds – Citigroup

Thanks. Joe, I think you alluded early on that the OEM part of the growth that you were seeing something you didn't see a year ago, I thought Mark might comment more about it. But is there something specific with the OEM kind of what's changed in the last year, is it Rainbow or is it more on SET that you alluded to?

Joe Kiani

Well, Matt, I believe, probably, it's going to be a little bit of each, but maybe the majority is kind of the ex – increasing demand by clinicians for technology that the OEMs are reacting to. I think number one, as we have been converting these large systems like Kaiser and Banner and Memorial Hermann and I have not listed even all of them, they are obviously asking more from Masimo.

But then internationally, we've expanded our sales force as you number. We've created direct sales channels in many countries in the world and I think that's creating demand on the OEMs. I would probably say that's probably the number one factor, if I had to make an educated guess.

I think the second one is that, we put increased emphasis with our OEM relationships. We had one of our most tenured management team members, Rick Fishel, who has been managing the OEM relationships in the recent year, year and a half and I think that's helping. Plus as you said, it's the Rainbow, I think, the Rainbow measurement, the Rainbow platform, the MX Board we call it for OEMs, is very compelling.

This board not only provides SpO2 – Masimo SET SpO2 pulse rate and perfusion index, but then it's upgradeable. People can add in the field if they want, hemoglobin, RAM and other measurements, which is a great opportunity for our OEM partners to increase their revenues and in the face of what seems to be at best a flat patient monitoring industry. So, sorry for the long answer, but I think it's really a combination of all these things.

And then, I wanted to finish up with the potential pent-up demand. We clearly in the first half of the year thought some of the growth is pent-up demand from '09, which was very anemic for our OEMs. It was a tough year for them because of capital dollars not being available for buying those types of equipment. But at this point, I'm beginning to think maybe it's not all pent-up demand maybe some but not clearly – it can't be continued in third quarter just being pent-up demand.

Matthew Dodds – Citigroup

Got it. And then one more quick question on the gross margin. Mark, can you really say directionally if the Rad-57 order from the Marine Corp., would that – did that impact the gross margin or are they roughly in the same band as the overall product gross margin?

Mark de Raad

Well, they would impact the overall gross margin in the sense that that was obviously a Rainbow product. And in the past and as you know, we've always talked about in general Rainbow products on average generating a higher level of margin for us overall. So in that respect they were an upward – they would provide an upward bias to the overall gross margin. But, again, it was just, that's $4 million out of $100 million, so not dramatic.

Matthew Dodds – Citigroup

I thought maybe you're giving the Marines a deal but I guess not.

Mark de Raad

All right. Because that’s…

Matthew Dodds – Citigroup

That's all I had. Thanks Joe. Thanks Mark.

Mark de Raad

Yeah.

Joe Kiani

Thank you. We'll try to help the economy by not being overtly expensive to the Marines.

Operator

Your next question comes from Joanne Wuensch from BMO Capital Markets.

Jack – BMO Capital Markets

Good afternoon. Thanks for taking my questions. This is Jack [ph] in for Joanne. You hear me okay.

Joe Kiani

What did you do with Joanne?

Jack – BMO Capital Markets

She couldn't be here, she's very sorry of course.

Joe Kiani

Okay.

Jack – BMO Capital Markets

Just kind of housekeeping, if you can give us a little insight into the fourth quarter tax rate and how, if that might be impacted at all by the different pieces that were there this quarter?

Mark de Raad

Sure. The best we can do as of today is to simply indicate that the effective tax rate that I referred to earlier on a year-to-date basis of 33.8% is our best guesstimate right now as we head into the fourth quarter. Having said that, obviously there are obviously some things that are not quite signed and the law, for example the 2010 R&D tax credit. So should that be signed into law in the fourth quarter, we would see the benefit from that land specifically in the fourth quarter. So there is certainly the opportunity for the tax rate to come down in the fourth quarter but unfortunately we can’t predict that until what I just mentioned occurs.

Jack – BMO Capital Markets

Thank you. And then just my final question, just, I know you don't give the hemoglobin growth and you wanted to wait until we are substantial enough. But can you give us any color in terms of, is there surprising level of sales in any one category that you've been very happy with or something of that nature and that's it? Thank you.

Joe Kiani

Well, I think, probably, the thing we are happiest about is the significant growth we had with our consumables associated with hemoglobin. Whenever we introduce a new parameter one of the things you want to – you look for is that is it being used and that indicates to us that people are buying or using it and they find it of clinical use at a macro level.

Jack – BMO Capital Markets

Thank you.

Joe Kiani

Thank you.

Operator

Your next question comes from Brian Weinstein from William Blair.

Brian Weinstein – William Blair

Hi. Good afternoon. Previously you guys have talked about using the pulse ox market as a good proxy for how hemoglobin would ramp-up. And you guys have talked about kind of 2, 12, 40, 80, 96 million over the first five years as being a reasonable proxy. Do you guys still feel good about that, given where hemoglobin might be today?

Joe Kiani

Well, we are in the game. But it's hard to tell if we're going to hit that 12 million for this year but we haven't given up yet.

Brian Weinstein – William Blair

Okay. And then second question. Where does the Philips litigation stand at this point? What are the next dates for us to look for and has it affected the relationship in the field or has it really just been confined to a corporate issue?

Joe Kiani

Well, I don't think it has affected the relationship in the field in terms of us wanting to continue to work together. Has it made Philips behave in a way that – the sales force in a way that we wish they wouldn't, yes? Do we hope that will change overtime, yes.

But as far as where we are with the Philips case, I think maybe you've seen it. But October 4th, the court limited the number of patents to be construed to four for Masimo and three for Philips and then on October 6th the court denied Philips' motion to bifurcate and stated damages in the patent case. So overall we are feeling very good about our case. We hope that claim construction, which is the next step will begin soon and we hope that the original date for the trial, which I think was early 2012 will still be the date for our trial.

Brian Weinstein – William Blair

Okay. Great. Thank you.

Joe Kiani

Thank you, Brian.

Operator

Your next question comes from Matt Dolan from Roth Capital Partners.

Matt Dolan – Roth Capital Partners

Yeah. Good afternoon.

Joe Kiani

Hi, Matt.

Matt Dolan – Roth Capital Partners

A question on the Rainbow number for the quarter. You didn't update your guidance for the year and looking at the Rainbow numbers it would require a sequential step-down even at the high end of your guidance. So, maybe just help us directionally with where you are in Rainbow and how that could pace from here on out.

Joe Kiani

Well, I think, we – as you noticed with the Marine order, it was a bolus order that though we are not sure it's going to happen every quarter to our best estimate those kinds of orders happen towards the end of each fiscal year for the government, which is end of September. So without anticipating another big order like that, if you take that away we do see sequential growth. If you do include the Marine order then you're right. We are not predicting sequential growth. But we do think we're going to be, like you said between the high end to low end of the number we gave early in the year.

Matt Dolan – Roth Capital Partners

Okay. Fair enough. And just to be clear, Joe, on your commentary on the hospital spending environment, relative to the actual number of drivers placed. Can you recalibrate us on the placement rates per quarter, is this still a new normal in your eyes or do you think as we enter next year that the environment could get a little weaker?

Joe Kiani

We are not seeing any slowdown, so this could be the new normal.

Matt Dolan – Roth Capital Partners

Okay. And then on the legal side was the increase year-over-year primarily related to the Philips case or what accounts for that?

Mark de Raad

We don't speak specifically about what the actual legal expenses are incurred for. So we'll just have to leave it at a general increase of, I think, I said, $850,000 year-over-year.

Matt Dolan – Roth Capital Partners

Okay. If I could speak one more in, on Halo, interested to hear always about new parameters. Can you give us any color on the timing of an expected approval or launch or where this parameter might be most impactful in terms of your target markets? Thanks.

Joe Kiani

Thank you. And speaking to our stockholders only, so if there's any customers on this call, close your ears. We think Halo Index is going to be a very useful measurement and hopefully helping clinicians predict problems before they would catch them today. And that really is for a couple of reasons.

One, we think by taking all these measurements we can do noninvasively, some of them are orthogonal to each other, we can predict events before by looking at them all at once, before any clinician could put it all together to predict what's going on, especially less trained clinicians like maybe floor nurses or ICU nurses and so forth.

And then on top of that, we think this is just the beginning for Halo Index. We have a really nice long-term pipeline of things we're going to do with it that we think is going to continue to really make this a real focus parameter for our customers.

So we're pretty excited about it. As far as timing, unfortunately in any environment I can't tell you but especially under the new environment with the FDA, it's really hard to predict when we'll get it approved. But certainly in other markets like Europe, we plan to launch it soon and hopefully, as soon as, we have word from the FDA and we know what to do there, we'll let you know.

Matt Dolan – Roth Capital Partners

Great. Thanks a lot.

Joe Kiani

Thank you, Matt.

Operator

Your next question comes from Larry Keusch from Morgan, Keegan.

Larry Keusch – Morgan, Keegan

Good afternoon. Joe, I'm wondering, I think in the past you've sort of indicated that directionally you saw when you launched the ReSposable hemoglobin sensor, you saw some pickup off of that and perhaps some flattening out of the growth in the disposable sensor. I was wondering if we could get your thoughts on to the where we think you think we are in that mix shift and have we hit a point now where we would see consistent growth off of whatever level we are at?

Joe Kiani

Yes. I actually think we are at a place where we should see consistent revenue growth on our sensors, adhesive sensors with hemoglobin. We probably are still not at a settling place of how consumers will use the product, whether they'll use disposables or ReSposable. I know there are some customers who really prefer the disposables. But today, probably the majority is ReSposables and that's why I can tell you that I think you have seen us settling out at that phenomenon.

Larry Keusch – Morgan, Keegan

Okay. And then just two, I guess, financial questions. Mark, on the inventory turns which you called out, when you exclude the large customer. I'm wondering if you can give us a sense of how those terms looked up for the quarter versus where we were at the end of the year.

Mark de Raad

Larry, I haven't done the specific calculation but I think if we pulled out the inventory related to that specific customer, I think you’d find yourself back in about the 3.2, 3.3 range. So that would be the range that would be more traditional with what – where we’ve traditionally been.

Larry Keusch – Morgan, Keegan

Okay. So you could consider that sort of a one-time event in terms of managing the inventory levels.

Mark de Raad

Yeah. So we expect that turn number to move back up in the future quarters.

Larry Keusch – Morgan, Keegan

Okay. And then lastly, again, I'm just sort of curious about how you deal with these large chunky orders like this one from the military. How much visibility do you get on those orders before they come through and are completed? And do you get an opportunity to sort of have enough visibility that you can sort of spend against these things and make sure that you're offsetting them?

Joe Kiani

Well, I think going forward, we believe – we do – we have expectations now from not just the Marine Corps, but other military services. They are very excited about hemoglobin, carbon monoxide use in the field next to these war zones, especially. So I guess assuming that unfortunately wars continue, we expect to continue to get these orders. Probably our best guess would be they will happen in Q3 of each year.

Larry Keusch – Morgan, Keegan

Okay.

Joe Kiani

So, I guess, we'll be happy if we don't get the orders as much anymore too.

Larry Keusch – Morgan, Keegan

And Joe, I mean, when you get that order, when do you typically get it? If it's going to happen, does it happen in Q3 and you ship it in Q3 or do you get more insight into that?

Joe Kiani

Yeah. Typically since we know they are coming, we think we should be able to get the order in Q3 and ship it in Q3. But, of course, if a surprise, if the order comes much bigger than we anticipated, then some of it may leak into the following quarter.

Larry Keusch – Morgan, Keegan

Okay. Good enough. Thanks very much.

Mark de Raad

Okay.

Joe Kiani

Thank you. I think at this point I'd like to take one more question. One more, I think, who's next?

Operator

Your final question comes from John Putnam of Capstone Investments.

John Putnam – Capstone Investments

Thanks very much. Joe, I was rather impressed by the hemoglobin study out of the ASA. And, I wondered, if you could maybe give us some idea of how large you think this market – this application might be.

Joe Kiani

Thank you. By the way, thanks to you and Matt for your comments. I know that Investor Business Daily article that came out. We were also very happily, I would say, surprised by that study. We knew the study was going on, but of course we had no idea about its results and what it was going to show. We hoped for that result. But it ended up actually being better than we expected with the level of reduction.

Now, this study of course was used on all orthopedic patients, some of that would probably not expect bleeding and some that would expect a lot of bleeding. So we think the result of the study is actually on the conservative side. We believe if you use this product on the heavier bleeders, you may actually even get better results as far as the units of blood that's transfused.

So, overall, we – our understanding is for example the U.S., there is about 10 million inpatient surgeries and with what the study showed conservatively, we should hopefully see about a 10% reduction in blood transfusion for these 10 million cases.

So we think actually the study in some ways is very helpful because it shows even a general big patient population, SpHb could have an impact and I think as people focus on the heavier bleeders that it's even going to show a bigger impact.

So we think this is the beginning of hopefully a few other studies like it that are going to come out that is going to help not only take away the whole – the whole debate on accuracy, how accurate is the product, because it shows no matter how accurate the product is, it's good enough to have a big clinical impact. But also it's going to drive customers to realize that hey, with this I could really not only reduce my cost, but take away one of the significant risks of surgeries, which is blood transfusion. So thank you for asking, but yeah, we are pretty excited about it.

John Putnam – Capstone Investments

Great. Thanks very much.

Joe Kiani

Thank you. Thank you all for joining us today and we look forward to our next call and seeing hopefully some of you face-to-face. Thank you.

Operator

This concludes today's conference call. You may now disconnect.

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