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Masimo (NASDAQ:MASI)

Q4 2010 Earnings Call

February 15, 2011 4:30 pm ET

Executives

Sheree Aronson - Corporate Vice President, Corporate Communications and Investor Relations

Mark de Raad - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Corporate Secretary

Joe Kiani - Founder, Chairman, Chief Executive Officer and Acting Chief Technology Officer

Analysts

John Putnam - Dawson James Securities

Lawrence Keusch - Morgan Keegan & Company, Inc.

Gregory Hertz - Citi

Pete Vitale

Joanne Wuensch - BMO Capital Markets U.S.

David C. Clair

Operator

Good afternoon, ladies and gentlemen, and welcome to Masimo's Fourth Quarter and Full Year 2010 Earnings Conference Call. The company's press release is available at www.masimo.com. [Operator Instructions] I am pleased to introduce Sheree Aronson, Masimo Vice President of Investor Relations.

Sheree Aronson

Hello, everyone. Joining me today are Chairman and CEO, Joe Kiani; and Executive Vice President of Finance and CFO, Mark de Raad.

This call will contain forward-looking statements, which reflect Masimo's 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 projections and forecast are discussed in detail in our SEC filings. You'll find these in the Investor section of our website.

With that I'll pass the call to Joe Kiani.

Joe Kiani

Thank you, Sheree. Good afternoon, ladies and gentlemen. Thank you for joining us. I am happy to report that Masimo closed out 2010 with another solid quarter driven by strong and increasing demand for our breakthrough Masimo SET and Masimo Rainbow SET technologies. Here are just a few highlights of our fourth quarter.

First, we achieved 14% growth in our core SET business and a 44% increase in Rainbow business. Growth was broad-based, with every major geographic region posting double-digit increases. In all, this performance lifted our total product revenue by 17%. And as Mark will explain later, the true growth was even stronger given that deferred revenues that we had in 2009 that we didn't have in 2010.

Second, we placed a record number of drivers again this quarter with a shipment of 41,800 units, excluding handheld devices. This trend is particularly important as an indicator of future recurring sensor sales in 2011 and beyond. Moreover, within an installed base that now totals 855,000 drivers, we have increased our global footprint by 18% since year end 2009 further strengthening our reach and competitive position. We believe that these results continue to demonstrate our ability to expand relationships with existing customers while attracting new customers through our breakthrough technologies that improve patient care and lower costs across a range of clinical settings.

And speaking of breakthrough technologies, in Q4, we continue to innovate, debuting Halo Index, a dynamic new wellness indicator. Once cleared by the FDA and proven through independent clinical studies, we expect Halo Index it to be an important new tool to inform clinicians of the current patient status and the status of the patient in the future. Halo Index is another example of our commitment to help automate and improve patient care.

And finally, given our strong financial performance, we rewarded stockholders with a special $0.75 dividend, the second in 2010 following a special $2 dividend paid in the first quarter. In total, the $2.75 in 2010 dividends reflect not only our dedication to enhancing stockholder value but also our healthy balance sheet and confidence in our long-term outlook.

In addition, we amended our settlement agreement with Covidien in the beginning of 2011. Under the new agreement, we extended our covenant to not sue them for their N600 Pulse Oximeter in exchange for a 7.75% royalty on their total U.S. pulse oximetry and associated product revenues for at least the next three years, effective March 15, 2011. The amendment allows Covidien to add certain new measurements. If they do, the revenue from such new measurements would also be subject to the 7.75% royalty rate. And should Covidien introduce noninvasive hemoglobin measurement, the royalty rate would increase to 11.75% from 7.75%. We also received a covenant from Covidien for all of our existing products released as of March 14, 2011, and some future products.

As you probably remember, since August 2009, we have indicated that investors and analysts should assume that the Nellcor royalties would end in March 2011, and that at the time, we would likely to incur additional legal expenses from the then expected IP suit against Covidien. Fortunately for all involved -- well, maybe except for some of the lawyers, this assumption did not materialize. We have also suggested for some time now that investors and analysts should expect a significant decline in the growth rate of our operating expenses, which was intended to mitigate some of the risk in the event the royalty payments ended .

Although we now expect a continuation of the royalty payments, we continue to believe it is time for Masimo to be much more prudent in how it invests in its growth. Therefore, most of the incremental royalty revenue will be reflected in our operating income. However, as indicated in our press release on January 31, we will also be retaining a portion of these new royalty revenues to reinvest in the business primarily to fund hemoglobin, SpHb, noninvasive hemoglobin and other key clinical studies and other selected activities all designed to enhance our future standing.

I'll talk more about our 2011 objectives and growth strategies later, but first, Mark will review our fourth quarter and full year 2010 results and discuss our 2011 financial guidance. Mark?

Mark de Raad

Thank you, Joe, and good afternoon, everybody. For the fourth quarter, total product revenue rose 14% to $105.6 million versus $92.6 million in the year ago period. Growth was driven by a 17% rise in product revenue to $93.8 million, partially offset by a 3% decline in royalty revenue to $11.8 million.

As Joe indicated, our fourth quarter SET revenue grew 14% to $85.4 million. Note that in the year ago quarter, we included almost $4.3 million in previously deferred SET revenue. So excluding this deferred revenue from the year ago quarter, our fourth quarter 2010 SET revenue actually rose more than 21%. This performance was achieved despite the well documented declines in hospital procedure volumes, the continued existence of third-party reprocessing activity and a still aggressive pricing environment, including the pricing impact of some new large contracts that we closed and installed in the second half of 2010. Nevertheless, sequential and year-over-year trends for our core business are positive and signal continued share gains.

Rainbow revenue also showed solid advances in the quarter, up 44% to $8.4 million versus the prior year ago quarter. Importantly, we saw growth in both our Rainbow measurement, software and sensor revenues. Continued increases in our quarterly sensor revenues are indicative, we believe, of the continued expanded use of our various Rainbow measurements, including total hemoglobin. This growth occurred despite our decision in December to voluntary recall the Pronto-7 Rainbow 4D Sensors, which precluded any additional Pronto-7 device or sensor sales starting in mid-December.

Encouragingly, since our 8K announcement in which we estimated that we might incur between $500,000 to $700,000 in cost associated with this recall, most of our limited market release customers have indicated a strong preference for retaining their devices while they wait for a replacement sensor. As a result, we recorded only $115,000 in cost related to the recall, of which approximately $100,000 was recorded as a reduction to Q4 Rainbow revenues. While our year-over-year increase was strong, our sequential revenues declined, as we expected, due to the large Rad-57 Rainbow SET shipment we made to the U.S. Marine Corps in Q3.

Our end user or direct business, which includes sales through just-in-time distributors, grew nearly 20% in the fourth quarter to $77.4 million versus $64.6 million one year ago. This direct business represented 83% of product revenue versus 80% in the year ago quarter, and therefore, conversely, OEM revenues represented 17% compared to 20% in the same year ago quarter. While our OEM board shipments have continued to account for much of the strong Q4 and full year 2010 driver growth, more of the sensor-related revenues are moving through our direct business. And this, along with the usual seasonal strength in our direct business, contributed to the year-over-year increase in direct revenues as a percent of total product revenues.

Looking at sales by geography, U.S. product revenue rose 17% to $66.8 million compared to the same period last year with both acute and alternate care channels contributing significant growth. Once again, if you remove the $4.3 million in deferred revenues from the prior period, our year-over-year U.S. product revenue growth was actually up 27% and reflected a very nice sequential rebound from Q3 2010. Product revenue outside the U.S. totaled $27 million, up 15% in both actual and constant currency basis dollars. Japan and the Europe, Middle East, Africa regions were particularly strong contributors. International product revenue was approximately 29% of total product revenue in the fourth quarter, which was unchanged from the prior year quarter.

Our gross profit margin was 66.5% in the fourth quarter, down slightly from 66.7% in the same period last year due primarily to a higher mix of OEM board revenue and lower margins associated with the MX Rainbow SET boards and some impact related to a number of hospital contract renewals, which are priced at 2010 sensor prices. While the overall pricing environment in 2010 has remained relatively consistent, contract renewals often result in slightly lower sensor pricing than in the prior contract period.

The total gross profit margin including royalties was 70.2% in the fourth quarter of 2010 versus 71.1% in the 2009 fourth quarter. The decline is a result of the same items that I just noted as well as the slightly lower royalty revenue versus Q4 of 2009. On a GAAP basis, fourth quarter 2010 operating expenses were $52.5 million, including approximately $1.8 million in onetime marketing related spending. Recall that we received $30.8 million in the first half of 2010 following our settlement award in our antitrust lawsuit win against Nellcor, a division of Covidien.

In February 2010, we indicated that we plan to reinvest approximately $15 million of this award during 2010 to fund special marketing and clinical research programs and to establish the Masimo non-profit foundation, which we did in the first quarter. Including the $1.8 million in the fourth quarter, total 2010 onetime marketing and other related spending amounted to $14.7 million, of which $10.3 million was used to establish the new Masimo Foundation.

Excluding the onetime items, fourth quarter 2010 total operating expenses were $50.7 million, up 14% from $44.5 million in 2009's fourth quarter, due primarily to increased payroll and related expenses associated with the planned rise in selling, general and administrative staffing levels, higher travel expenses related to additional sales reps and their increased travel activities and increased legal expenses related to ongoing litigation activity. Also included was $8.3 million in R&D expenses, which was down from the $8.9 million in the year ago quarter due primarily to lower project-related costs and the impact of a $489,000 onetime grant received in Q4 pursuant to a new federal government grant program.

Foreign currency exchange rates reduced fourth quarter 2010 operating expenses by approximately $200,000 compared to 2009's fourth quarter. GAAP operating income for 2010's fourth quarter was $21.6 million. Excluding the onetime marketing and other related expenses, adjusted operating income was $23.4 million, up 9% from $21.4 million in the year ago period.

Fourth quarter net income benefited from a drop in our effective tax rate to 23.5% compared to 32.2% in the year ago quarter. A combination of factors contributed to the decline in our fourth quarter tax rate, including the December 2010 enactment of the R&D tax credit, which allowed us to take the full year's benefit in the fourth quarter. Increased OUS revenue and resulting profitability as well as the release of previous tax provisions, following the expiration of statutes of limitations on various prior potential tax liabilities.

We finished the fourth quarter of 2010 with GAAP EPS up $0.26, including approximately $0.02 in onetime marketing spending. Due to rounding issues this quarter, as evidenced by our $0.2649 GAAP number, our adjusted EPS, which excludes the onetime marketing expenses, rose $0.03 to $0.29, representing a 26% increase from the $0.23 in the fourth quarter of 2009. In addition, I'd also like to remind you that the additional SEDLine operating expenses, which were not included in our 2010 financial guidance, reduced our adjusted fourth quarter 2010 GAAP and adjusted EPS by nearly $0.01.

In the interest of time, I won't go through the 2010 results in detail but rather, note the highlights and point you to today's press release and the soon to be filed Form 10-K for more complete information. Total 2010 revenue grew 16% to $405.4 million, including a 19% rise in product revenue to $356.4 million. Our SET business grew 15% to $323.5 million in 2010, while Rainbow grew 69% to $32.9 million. Revenue from our direct and distribution channel rose 17% to $283.2 million, while OEM revenue grew 25% to $72.8 million.

The 2010 product gross profit margin of 66.4% was slightly below our 66.6% product gross margin in 2009 as the benefit of higher margin Rainbow revenue was offset primarily by a higher mix of OEM board sales and MX board sales and the 2010 manufacturing transition costs we incurred in the first half of 2010 that we noted in some of our prior quarterly earnings calls. We finished 2010 with adjusted operating expenses of $195.5 million, excluding the Covidien antitrust award and related onetime marketing and other related spending. This was up 17% from $166.6 million in 2009 and was due primarily to increased payroll and related expenses due to higher selling, general and administrative staffing levels, as well as increased sales, related travel expenses and increased legal expenses related to ongoing litigation activity.

Fiscal 2010 GAAP operating income rose 29% to $106.2 million. Excluding the Covidien antitrust proceeds and onetime marketing and other related spending, 2010 adjusted operating income rose 10% to $90.1 million compared to $82.2 million in fiscal 2009. Our full year 2010 effective tax rate was 31.8% versus 34.3% in 2009, reflecting the positive impact of a higher mix of profits from our international operations, a higher favorable impact of the 2010 R&D tax credit and the release of previous tax provisions following the expiration of statutes of limitations on various prior potential tax liabilities. That brought fiscal 2010 GAAP EPS to $1.21 and adjusted EPS, excluding the impact of the $30.8 million Covidien antitrust settlement less the $14.7 million in onetime marketing related expenses, to $1.03, which was up 17% versus 2009.

Moving now quickly to the balance sheet. As of January 1, 2011, total cash, cash equivalents and short-term investments were $88.3 million compared to $189 million at year end 2009. This decline is the result of $162 million in dividends that were paid during the year, offset by a net $16.1 million and net cash received from the antitrust award, less the onetime marketing expenses and cash generated from our operations. At January 1, 2011, our DSO was 48 compared to 44 in January 2, 2010. December 2010 inventory turns declined to 2.8% from 3.4% at year end 2009 due primarily to our decision to carry additional inventory for some large recent customer implementations.

Now I'd like to take just a moment to discuss the 2011 guidance we provided in today's press release. Overall, we believe our 2010 performance underscores the fundamental strength of our business model as we manage through what is still a challenging macro environment for our hospital customers. However, our 2011 guidance assumes stable industry conditions as the year progresses as well as stable foreign exchange rates and tax laws.

With that having been said, we expect 2011 product revenues to be between $415 million and $430 million, including Rainbow revenues of approximately $40 million to $50 million. These projected 2011 Rainbow revenues include the assumption that the Pronto-7 sensors will not be available until the end of Q2 2011, which Joe will discuss in a moment. As we have indicated previously, we do not plan to break out individual Rainbow revenue numbers by parameters until one parameter equals at least 10% of total product sales.

Moving on, as a result of the recently amended agreement with Covidien, we now expect our 2011 royalty revenues to range between $31 million to $33 million, bringing total revenue guidance to a range of $446 million to $463 million. We expect 2011 product gross margins to be in the range of 65.5% to 67.5%. Due to some short-term absorption issues in Q1, we may see a slightly lower margin in Q1, although we then expect slightly higher margins throughout the rest of the year. In addition, there are investments we intend to make in our worldwide manufacturing operations this year, which may have some limited downside impact on overall 2011 gross margins. However, we believe these investments, which will be made in 2011 and into 2012, will provide us with the ability to continue to lower the total cost of manufacturing in the future.

Our guidance assumes 2011 operating expenses in the range of $210 million to $215 million, up at the midpoint about 8.5% over our adjusted 2010 operating expenses of $195.5 million. As Joe alluded to earlier, this projected operating expense range includes costs associated with our previously stated goal of reinvesting a portion of the recently renegotiated Covidien royalties. In comparison, we grew total operating expenses by 17% in 2010. We believe the significant decline in the growth rate of operating expenses is consistent with our previously stated goal of lowering the overall growth rate in our 2011 operating expenses.

Importantly, we now expect our 2011 effective tax rate to be between 28% to 30%. This is a lower rate than our historical rate and is primarily related to the success of our international realignment structure, which as you may recall, we established in Q4 2008. This structure and the concurrent growth in our OUS business will drive a significant reduction in our overall 2011 effective tax rate. In addition, in 2011, we will be benefiting from the new tax law changes and other U.S. and OUS revenue mix shifts that will also contribute to our lower projected 2011 effective tax rate. Please note that this tax rate forecast is based on various assumptions, including stable foreign exchange rates, no changes in tax laws and does not include the impact of any possible onetime items.

In summary, based upon these product and royalty revenues, gross margin, gross profit margin and operating expense and tax rate forecasts, we now expect 2011 earnings per share to be in the range of $1.17 to $1.25, assuming weighted outstanding shares of approximately $61.3 million.

With that, I'll turn the call back to Joe.

Joe Kiani

Thank you, Mark. We entered 2011 with a clear plan for delivering on our financial goals while also advancing our mission to improve patient outcomes and reduce the cost of care by taking noninvasive monitoring to new sites and applications. Although market conditions across healthcare remain challenging, we believe our business model, breakthrough technologies and track record of innovation puts us in an excellent competitive position now and over the long term.

For 2011, we are focused on the following key growth objectives: one, leverage our more experienced worldwide global sales force, which now totals more than 200 sales professionals in order to maximize the investment we have made in the last couple of years; two, expand our presence in the growing general ward opportunity by combining our already existing products, including Patient SafetyNet, with Masimo SET pulse oximetry with the newly full-market released Rainbow Acoustic Monitoring; three, increase Rainbow awareness and adoption by planning more outcome studies on noninvasive hemoglobin, pursuing the regulatory clearance necessary to take Pronto and Pronto-7 to the blood donation market and moving Pronto and Pronto-7 to full-market release after we successfully reintroduce the Pronto-7 Rainbow 4D sensor, which we now hope to do by the end of the second quarter this year; fourth, as a follow-up to our October 2010 introduction of Halo Index, continue our track record of introducing a new measurement every 12 to 18 months; and five, explore opportunities for strategic acquisitions that complement our technology platform.

All of these areas of focus are closely in line with our growth strategy, beginning with leveraging the sales force. Several years ago, we began a multi-year initiative to aggressively expand the size and reach of our global sales organization. This investment is already bearing fruit as evidenced by Masimo revenue growth that is well above industry growth rates, our rising mix of international revenue and continual increase in our share of the global pulse oximetry market. For example, our new driver shipments totaled 153,500 units in 2010, representing a 37.5% increase over 2009 and setting a new Masimo record.

Our expanded global sales force is fueling the strength by increasing the pace of new business wins. Some recent conversion include Prime Healthcare, a 13-hospital system in California; Advantis Healthcare, a mid-Atlantic hospital network; and a number of large wins outside the U.S., including a Mafraq Hospital in Abu Dhabi and University Hospital Coventry in the U.K. to name a few. We are also well underway with the full conversion of Kaiser Permanente, which operates 35 hospitals and numerous medical offices in nine states and serves 8.5 million members.

An expanded and more experienced sales organization will help us take maximum advantage of the tremendous growth opportunity that we believe is beginning to be realized with continuous monitoring on the general floor. Today, numerous professional organizations, payers, government entities and key thought leaders across multiple clinical disciplines are coming together to find ways to improve patient safety not only to reduce avoidable, adverse events with better systems and protocols but also to reduce healthcare costs.

In addition, rating organizations, such as HealthGrades, regularly analyze and publicize individual hospital patient safety performance. And increasingly, hospitals are establishing a chief patient safety officer position to check in the issue throughout their institutions. Patient safety is a rising theme across healthcare, and Masimo is on the leading edge of this movement. Our Signal Extraction Technology and Patient SafetyNet system form a powerful combination that allows accurate, actionable patient alarms to be delivered directly to qualified caregivers, facilitating rapid intervention and keeping patients safe on the general care floors.

With the Dartmouth-Hitchcock study, we have compelling clinical evidence that our system helps clinicians reduce rescue events, ICU transfers and intensive care unit days, dramatically enhancing patient safety and lowering costs. Moreover, we know from the growing number of hospitals using Patient SafetyNet system that it is helping clinicians save lives every day.

In addition, we recently debuted Halo Index, which has received CE marking in Europe and is subject to FDA clearance here in the United States. Halo Index is a dynamic new indicator that facilitates continuous global trending and assessment of multiple physiological measurements to quantify changes in patient status. Currently, clinicians monitor multiple clinical measurements on each patient and respond independently to each of the measurements. Halo Index is designed to provide a single displayed value, which facilitates a simple and comprehensive assessment within a single index. We plan to dedicate resources in 2011 and beyond to collect clinical evidence on Halo Index so that its clinical utility in a variety of care areas and patient types will become more specific.

Our focus on new innovations like Halo Index is the key reason customers choose Masimo. For example, ours is the only upgradable oximetry technology platform that allows hospitals to add breakthrough noninvasive measurements that previously required invasive procedures. Only Masimo Rainbow SET can noninvasively and continuously measure total hemoglobin, oxygen content, carboxyhemoglobin, methemoglobin, PVI and acoustic respiration rate. Real-time results for critical blood constituents and physiological parameters can be important in facilitating earlier detection and treatment of life-threatening conditions.

Several recent clinical studies have demonstrated the accuracy and value of various Masimo Rainbow measurements. A study published in Critical Care Medicine demonstrated that PVI predicts fluid responsiveness with 95% sensitivity and 91% specificity in mechanically ventilated intensive care unit patients. Hemodynamic instability is a common problem for critically ill patients, and the decision to administer fluid in an attempt to improve cardiac output is challenging. When necessary, fluid administration is critical to optimizing patient status and enabling end organ preservation, but unnecessary fluid administration is associated with increased morbidity and mortality. PVI helps clinicians assess whether patients will benefit from fluid administration, enabling personalized, goal-directed fluid therapy.

At the annual Critical Care Congress last month in San Diego, researchers presented a study comparing SpHb monitoring with simultaneous invasive blood samples drawn from ICU patients with clinically low hemoglobin levels. Results showed a mean bias and precision of 0.7 grams per deciliter and 1.05 grams per deciliter for SpHb, respectively, when compared with reference lab hemoglobin values, demonstrating clinically acceptable agreement. The researchers concluded that the ability to measure hemoglobin noninvasively and continuously has the potential to facilitate timely detection of changes in hemoglobin and thus, improve blood management decisions in patients with critically low hemoglobin.

Similarly, at the Society for Technology in Anesthesia Annual Meeting, a study presented by the Johns Hopkins School of Medicine evaluated the accuracy of SpHb in patients undergoing complex spine surgeries. Results showed clinically acceptable accuracy compared to invasive blood samples, and researchers concluded that SpHb monitoring may lead to earlier intervention and improved patient safety and care in the operating room setting.

Also, in October, Massachusetts General Hospital's study was the first to show the ability of SpHb to reduce unnecessary blood transfusions. The study evaluated the impact of SpHb monitoring in a randomized controlled trial in orthopedic surgery patients. Patients in the standard care group had a 4.5% transfusion rate, while patients in the SpHb monitoring group had a 0.6% transfusion rate, representing an 87% reduction in transfusion frequency and a 90% reduction in average blood transfusion with SpHb.

In 2011, we hope to pursue multiple additional studies with the goal of showing similar clinical benefits in different patient populations. As Rainbow clinical evidence grows so does customer awareness and adoption. This is apparent in Rainbow licensing and sensor sales total, which both more than doubled in 2010 versus 2009. An increasing number of OEMs are also migrating to Rainbow. We finished 2010 with more than 20 Rainbow agreements in place compared to about 12 when the year began. We expect this count to grow to more than 30 by the end of 2011, illustrating the clinical demand for Rainbow measurements and our OEM partners recognizing the competitive benefits of offering Rainbow measurements in multi-parameter devices destined for hospitals, the EMS market and alternate care settings.

We are also continuing to expand into new point-of-care settings, such as physician offices, clinics and blood donation centers. Our limited market release of Pronto-7, which provide quick and easy noninvasive hemoglobin, SpO2 and pulse rate spot-check testing, began last summer. The reception for this product was great. However, in December, we initiated a voluntary recall of the Pronto-7 sensor after discovering that in some colder climates, the Pronto-7 may incorrectly measure a patient's actual finger temperature when performing an SpHb measurement. While we initially expected to resume our limited market release with a modified Pronto-7 sensor in the first quarter, we have decided to instead accelerate the release of a previously planned family of sensors, which should not only address the temperature issue but offer additional advantages to our customers. Note also that the impact of this temporary delay in Pronto-7 sales projection is already reflected in the 2011 guidance Mark reviewed earlier.

In the interim, we continue to offer our Pronto device, which like Pronto-7, provides spot check, SpHb measurements, as well as SpO2 and pulse rate. Our objective is to move to full-market release of Pronto and Pronto-7 sometime in the second half of 2011 by the help of a major distributor focused on the physician practice market. We are also taking the necessary steps to make our Pronto and Pronto-7 available to the U.S. blood donation market. This includes pursuing specific regulatory clearance from the FDA Center for Biologics Evaluation and Research, which regulates, among other things, collection of blood components used for transfusion.

While we are happy with the increased visibility our SpHb technology has received, especially as evidenced by the 10 studies introduced at the October ASA Conference in San Diego, we believe that more clinical studies validating both the clinical and economic benefits of continuous and spot-check hemoglobin are necessary to achieve continued awareness and eventually, wide market adoption. To this end, as we have previously noted, we have identified some incremental investment opportunities to help drive toward even more clear and definitive outcome studies both in the U.S. and internationally. Finally, we are working on a host of exciting new technologies and in 2011, expect to remain true to our commitment to introduce a new measurement every 12 to 18 months. We also continue to explore strategic acquisitions that would allow us to add complementary technology to our existing platform and pipeline.

To further enhance our ability to accelerate our growth, we have made some changes to Masimo's management reporting structure. I'm happy to announce that Jon Coleman, previously President of our International Operations, has assumed a new senior management position at Masimo as President of Worldwide Sales, Marketing and Clinical Research. Jon's experience and leadership skills have been instrumental in the successful expansion of Masimo's international business. I'm confident that under his stewardship, this new structure will create greater alignment and efficiency across the organization while allowing me to focus more time on broader strategic priorities for Masimo.

In summary, we are well positioned to execute our 2011 financial and operational goals and expect to make excellent progress against our growth strategy to penetrate the global pulse oximetry market, expand into the general ward and grow adoption of our Rainbow platform for the betterment of patient care and clinicians.

With that, we'll be happy to take your questions. Thank you very much.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Bill Quirk of Piper Jaffray.

David C. Clair

It's actually Dave Clair here for Bill. I guess the first question on this end is on guidance. Just would like a little bit of color on the wide range for Rainbow and what your expectations are at, to guess [ph] (0:47:30), either at the high or low end of that range.

Joe Kiani

Mark, would you like to take that?

Mark de Raad

Sure. The range, essentially, I think is primarily created because of the expectation, as we just alluded to in the prepared remarks, about the introduction of the Pronto-7. So that device obviously has some pretty significant implications relative to its uptake in the second half of the year that would dictate either the lower end or the higher end range of those two numbers.

David C. Clair

And then in the prepared remarks, you discussed an 11.75% royalty if Covidien introduces total hemoglobin. Is that just on total hemoglobin or would that be on the total Covidien business? And then have we heard something that this is something that they're working on?

Joe Kiani

Well, let me address that. It would be on the total Covidien pulse oximetry U.S. business, not just the total hemoglobin but all of it, including total hemoglobin. We are not aware of where they are with that development. This was simply an asset that they had that we addressed during our negotiation.

David C. Clair

And then any kind of color you can give us on just overall market commentary? I mean, how do the hospital capital equipment budgets appear to be shaking out? And any comments there would be great.

Joe Kiani

Well, we read, obviously, the same things you read, so I'm not going to repeat those. But in general, we don't expect more headwinds, but at the same time, we also aren't expecting much of a tailwind. I think we expect the business to be pretty normal, maybe similar to 2010, the new normal. And I think, maybe the only other thing that would be good to note at this point is we had an incredible year for new placement of Masimo SET and Masimo Rainbow SET monitors. I think the number was 153,000. We expect 2011 to be similar. So we're not expecting it to slow down, which as you know, the 153,000 was a big increase to what our normal had been the last two, three years.

Operator

Our next question comes from Joanne Wuensch of BMO Capital Markets.

Joanne Wuensch - BMO Capital Markets U.S.

The effective tax rate that you're lowering next year, is that sustainable through 2012 and beyond?

Mark de Raad

We believe so.

Joanne Wuensch - BMO Capital Markets U.S.

Are there any military orders in your financial guidance?

Joe Kiani

I think the answer is yes to that. While we know the military orders are not something that happens quarterly, we do expect in the same order of revenues if not higher in 2011.

Joanne Wuensch - BMO Capital Markets U.S.

The growth margin guidance, your range was a little bit wider than my memory is of what you've done in the past. I know that you've got a couple of different moving parts, but can you walk us through a little bit more detail what might make it on the bottom versus the top end of that range as we exit the year?

Mark de Raad

Sure, Joanne. Directionally, I think the lower end of the range that we provided today would contemplate sort of a continued reasonably aggressive pricing environment, but most importantly, factor in some of the elements that I alluded to in our prepared remarks. That is a couple of initiatives that we're commencing this year that may require a little bit of incremental cost this year but are being done so to put us in a position to dramatically improve our margins as we look out between 2012 and 2013 and beyond. So there's a little bit of that additional expense that would trigger the lower end of those margin ranges. On the higher end, of course, given our range of Rainbow revenues, clearly, if we were successful in achieving the upper end of that $40 million to $50 million range, that would be a scenario in which we would expect to see margins climbing to the higher end of the range we provided earlier.

Joanne Wuensch - BMO Capital Markets U.S.

Just to push a little bit, are we talking manufacturing facilities outside the United States? What are we talking about to "dramatically" improve gross margins?

Joe Kiani

For some good reasons, Joanne, I think it's better we don't get into details of that.

Joanne Wuensch - BMO Capital Markets U.S.

You mentioned that you are looking at a major distributor for Pronto-7. Is that somebody you've already named?

Joe Kiani

We have had strong interest from the major distributors in the physicians’ office markets. And we've been kind of keeping them interested, because we're very happy to see their interest but at bay until we're ready to go full-market release. So yes, it's been an ongoing dialogue for quite a while, and as soon as the product is ready, we believe that one of those relationships will be also firmed up.

Operator

Our next question comes from Pete Vitale of William Blair & Company.

Pete Vitale

It's Pete in for Brian. I was wondering if you could give us or if you are able to split out or give us an estimate or an idea what the split-out would look like between R&D and SG&A of that incremental Covidien royalty income?

Mark de Raad

Pete, could you say it again?

Pete Vitale

Sure. When you were discussing -- explaining about 50% of the incremental Covidien royalty income from the extension, I was wondering if you can give a split-out between what would be R&D and what would be SG&A.

Mark de Raad

Actually, we can't just because the numbers are fairly dependent upon certain specific projects. And by answering that question, I think we'd be sharing a little bit more publicly than we want to for competitive reasons.

Joe Kiani

But I think -- one thing I'd just like to add is that we ended Q4 with about a $200 million expense run rate. And I think the current projections are contemplating maybe about a $210 million expense line. So you can imagine just between raises and some of the ordinary things that go up year-to-year, the numbers we're investing in those things, both for R&D, sales and even manufacturing, are not that great. Just so we really have tried to keep the investments low and kind of go back to the way we used to invest in the future, earn it and then invest it.

Pete Vitale

But as far as kind of further investments in the sales force, be more on the marketing side than additional heads? Does that sound right?

Joe Kiani

Yes. We're not expecting a big increase in headcount. We feel that we have a critical mass now. Of course, there'll be replacements. There'll be small additions, but no, there won't be major headcount increases.

Pete Vitale

And then I was just wondering if you could give us a little bit of an update on how that rollout to some of those major health system wins is going and whether that's actually showing up in revenue yet.

Joe Kiani

Yes. I think it's going to show up, obviously, in Q1. A little bit of it showed up in Q4. But the rollout is going very well, not just from our perspective but from the feedback we've received from our customers.

Operator

Our next question comes from Larry Keusch of Morgan Keegan.

Lawrence Keusch - Morgan Keegan & Company, Inc.

Joe or Mark, just philosophically, as we think about this three-year tail that you have on this revenue from the royalty income, how should we think about the investments that you guys want to make in the business as we look at 2012, 2013? Should we sort of thinking that you guys will continue to invest some and let a remainder flow?

Joe Kiani

That's a good question. I think you should assume that unless there's some specific small thing that we want to do here and there that we weren't projecting before, but now that we have the royalties, we might do it -- except for those very small things, I think we're going to be investing in our growth based on our own plan. We believe this is a business model that should be leveraged for the benefit of the shareholders and the ability to even do more great things. And we really think 2011, '12, '13, these are the years that we're going to be doing that leveraging, and we're going to be putting more money into the bank and into the bottom line.

Lawrence Keusch - Morgan Keegan & Company, Inc.

Again, in the prepared comments, you guys mentioned the topic of reprocessing. And I know this isn't new, but I just wanted to take your temperature on sort of how you think that's progressing out there. Is it getting -- is it becoming more of a focus for hospitals, for the same? Any commentary would be helpful.

Joe Kiani

I think it's become the new thing, but I think customers who have been doing this for a while are recognizing that reprocessing adhesive SpO2 sensors is not really green. It's not really helping reduce the carbon footprint, because there's so much energy that you have to expend in collecting those sensors and cleaning them and reprocessing them and re-sterilizing them and all that stuff that at the end of the day, I'm beginning to see that some of the major forward-thinking customers of ours are seeing that that is not optimal. And perhaps, being green is more about doing smarter designs, the green designs and ideas. For example, the ReSposable Sensor line that we've been working on, that is green at the point of care, it’s reprocessing at the point of care, and it doesn't require collection. It's 100% reprocessing, if you will, and it really does, I think, what people are after. So we're trying our best to expedite the release of those products into full-market release and filling out that product line so that customers can really achieve this green good idea that they're on.

Lawrence Keusch - Morgan Keegan & Company, Inc.

The new Pronto-7 sensor that you talked about, presumably that does need to go through a 510 clearance. And also Mark, if you can just give us a sense of in the tax -- or said another way, how much of EPS was driven by the R&D tax credit?

Joe Kiani

Well, maybe first, I'll take on kind of the Pronto-7 recall issue but then let Mark answer the tax-related and earnings-related issues. As you know, when we did the recall, it was because the product wasn't working as we had intended it to, but not because we weren't sure whether the accuracy was affected or not. And we recalled it, and we suffer for even some of the complaints we've previously done on these products. And one of the good news I'd like to share with you is that the FDA came to Masimo for over a week, the first week of February, and they left. And basically, they told us before they left that the inspection pertaining to our Pronto and Pronto-7 devices and the investigators left our company on February 11 and without any inspectional observations. So we're pretty happy about that, and we're now -- as we've said earlier, while we could have released, potentially, the product, the sensor for Pronto-7 sooner, we thought if we just put our energy into what's coming out just a little bit later, it might be better for our customers and long term. So with that said, maybe Mark, you can address the second part of the question.

Mark de Raad

Sure. So your question on the R&D tax credit, I presume you're talking primarily about the fourth quarter, where I mentioned earlier the low 23.5% rate that we have. As I alluded to in the comments, there are a number of different items that flowed through this quarter. But clearly, the R&D tax credit and the fact that we are able to recognize that entirely within the fourth quarter was the primary driver behind that. And of that decline, approximately about six percentage points of that decline in the quarter actually resulted from the R&D tax credit.

Lawrence Keusch - Morgan Keegan & Company, Inc.

And Joe, just so I can clarify, do you need an FDA clearance for this end of Q2 launch of this new sensor?

Joe Kiani

Yes, we do, because it's just not just the fix of the old. It's going to be a family of sensors, kind of small to large, and there's some nice unique features of it that we think is going to require 510(k) clearance now. We're still assessing that, but I would assume, for your sake, to please assume that.

Operator

[Operator Instructions] Our next question comes from John Putnam of Capstone Investments.

John Putnam - Dawson James Securities

My question was really about the Pronto-7 sensor. Joe, what I hear you saying is it's just not a replacement. It's going to be an improvement of some sort.

Joe Kiani

Yes. We've been working on an improvement to that sensor pretty much from the day we launched the first version. And when we realized the improvement is only one quarter away from, I guess, the new version, I guess I should say -- just one quarter away from improving the thermistor issue with our current sensor, we decided to hold off on it.

John Putnam - Dawson James Securities

So will it be more sensitive or faster? Or what kind of improvement are you really trying to work on?

Joe Kiani

Well, first half all, right now, we have one sensor that fits all. And we know some of the problems we have that if the sensor isn't positioned properly, it can give erroneous readings. So by having different sizes of sensors, it's going to help get the right sensor for the right size of the finger to minimize that. Secondly, we're putting an additional LED into the product to enhance, hopefully, the hemoglobin and the SpO2 measurement of the product and just some new enhanced algorithms that will be embedded into the sensor that will be delivered to the product. So yes, while I don't have the clinical study results to give you a specific number, we're hoping for better distribution of the accuracy around kind of a zero number. Did I answer your question?

John Putnam - Dawson James Securities

Yes, very well.

Operator

Our next question comes from Gregory Hertz of Citi.

Gregory Hertz - Citi

I'm just calling in for Matt, who is unavailable to be on the call. He's out of the country. Just a quick question, one on revenues and the other on margins. Obviously, it was a strong driver shipment quarter in Q4. I'm just wondering the pace -- you talked about 2011 being able to kind of match the full year. I'm just wondering, should we expect that to be more front-end loaded as a result of the recently launched large contracts?

Joe Kiani

No, I don't think it's going to be front loaded. I think it's going to be even.

Gregory Hertz - Citi

And just also, can we just touch upon the outlook on the annualized revenue per driver and kind of how that ends your views on the revenue outlook? I mean, obviously, the SET revenue per driver is flat to slightly down, at least as we calculated it and flat overall with the benefit of Rainbow. Can you talk about what your outlook is? Is it included in a kind of a flattish -- or is it somewhere thereabouts?

Mark de Raad

In general, Matt, I'd say the answer is yes. We don't necessarily build our revenue model based upon, as you know, the dollar-per-driver calculation, which has a lot of anomalies built within it. But the ultimate outcome, as you point to, alludes to a relatively flat number year-over-year. Now clearly, as I've mentioned before, I mean if we're successful in getting towards the higher end of some of the ranges that we provided today then I think the computation there would suggest a increased dollar per driver, at least over what we saw in 2010. So a lot of it depends upon where we fall out within the range of the revenue guidance that we provided. But in general, I think the conclusion that we're expecting to be fairly consistent within the dollar-per-driver calculation is fair.

Gregory Hertz - Citi

And then just a couple of other questions on the gross margin side. Could you mention again -- maybe I tuned out for a second. But the gross margin range, can you repeat that?

Mark de Raad

Yes. We said it was 65.5% to 67.5%.

Gregory Hertz - Citi

And being on the low end of the range, you said in particular, maybe from a seasonal standpoint, 1Q might be in the lower end. Does that have to do with anything with the deferred COGS as you kind of run that through as it relates to some of the large hospital contracts? If you could just kind of help point out what might be weighing on that seasonally.

Mark de Raad

No. The reason for the potentially slightly lower Q1 margins relate primarily to some manufacturing absorption issues that we had towards the end of last quarter that essentially built into our overall cost of inventory at the end of the year. So those will be rolling out in the first quarter, and that's why we chose to mention that. Directionally, as I said, throughout the rest of the year, we actually expect to see some nice sequential increases in the overall margin. Next year, there is no doubt though that the point you bring up is the impact of box, what we referred to as the amortization cost of that deferred cost, they're going to be higher in 2011 than they were obviously in 2010, because we placed such a tremendous amount of product into the field, again, consistent with the 153,000 drivers that Joe alluded to. So year-over-year, there will certainly be a much higher impact on our cost to sales related to the amortization cost of those deferred cost to sales numbers, but those have been included in the range of margin guidance that we provided today.

Gregory Hertz - Citi

And would you happen to have the deferred COGS balance for the end of the year off hand?

Mark de Raad

Let me see if it's -- we are looking at, on a net basis, $47 million.

Gregory Hertz - Citi

So up sequentially from $35 million.

Mark de Raad

Yes, really strong fourth quarter.

Joe Kiani

I'd like to, at this point, just thank you all for joining us. I know we've gone over an hour, and I feel bad, because Mark and I kind of got long winded today. There was a lot to say, I think. So we hope to see you all and look forward to our next call. Thank you so much for joining us.

Operator

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

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