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Masimo (NASDAQ:MASI)

Q3 2011 Earnings Call

October 25, 2011 4:30 pm ET

Executives

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

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

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

Analysts

Lennox Ketner - BofA Merrill Lynch, Research Division

Gregory Hertz - Citigroup Inc, Research Division

John M. Putnam - Capstone Investments, Research Division

Tao Levy - Collins Stewart LLC, Research Division

Ben C. Haynor - Feltl and Company, Inc., Research Division

Joanne K. Wuensch - BMO Capital Markets U.S.

Brian Weinstein - William Blair & Company L.L.C., Research Division

Sara Michelmore - Brean Murray, Carret & Co., LLC, Research Division

Lawrence S. Keusch - Morgan Keegan & Company, Inc., Research Division

William R. Quirk - Piper Jaffray Companies, Research Division

Operator

Good afternoon, ladies and gentlemen, and welcome to Masimo's Third Quarter 2011 Earnings Conference Call. The company's press release is available at www.masimo.com [Operator Instructions] I am pleased to introduce Sheree Aronson, Masimo's 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 risks and uncertainties that could cause actual results to differ. Risk factors that could cause our actual results to differ materially from our projections and forecasts 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 E. Kiani

Thank you, Sheree. Good afternoon and thank you for joining us for a review of our third quarter 2011 performance. Masimo product revenue grew 10% in the period, a strong SET performance was partially offset by declines in Rainbow and OEM revenue. Here are the highlights: SET revenue rose 70% demonstrating once again that we are still in the steep part of the S-curve technology adoption for SET, which represents over 90% of our total product revenue.

Our worldwide end-user business grew 18%, with sales in our U.S. acute care channel growing above that high-teens level. Considering that a recent third-party hospital survey indicates flat to declining year-over-year U.S. inpatient surgery volumes in the third quarter, we were happy with this growth. International sales growth was also solid across both the acute and alternate care channels.

Without a repeat military order like the one we had in the third quarter last year, our Rainbow business was substantially lower. But even without the military order, Rainbow revenue was unimpressive, it was flat versus the year-ago quarter. Still, there were some bright spots. For example, excluding the year ago military order, our SpHb sensory unit volumes and revenue more than doubled. So while we are disappointed by overall Rainbow performance, we are confident Rainbow will ultimately be a catalyst for our growth.

We also know that, as with any truly breakthrough technology, Rainbow performance will be choppy until we start rising on the steep part of the S-curve of technology adoption.

OEM sales were lower in the quarter, due in part to lower board shipments and consumable revenues. Even so, we added 33,400 new Masimo drivers to the market in the quarter and brought our installed base to approximately 950,000, a 16% increase over the year-ago quarter. In fact, during the quarter, we shipped our $1 millionth oximeter, marking a key milestone for Masimo and underscoring our continued market penetration.

Given our third quarter financial results and current market assessment, we are reducing our annual 2011 product revenue and EPS guidance by approximately 3% and 10%, respectively, as detailed in the press release we issued this afternoon. Part of this annual guidance reduction is related to a $1.5 million Q3 inventory charge-off that Mark will discuss in some more detail.

While we are disappointed in having to reduce our short-term financial expectation, I am confident in our long-term outlook, and will speak more about our outlook and strategies in a few minutes.

I will now pass the call to Mark for a detailed review of our Q3 results and revised 2011 guidance. Mark?

Mark P. de Raad

Thank you, Joe, and good afternoon, everybody. Masimo's third quarter 2011 total revenue rose 3% to $104 million versus $101 million in the year-ago period. Contributing to this was a 47% decline in royalty revenue, from $12.2 million to $6.4 million, reflecting the change in the Covidien royalty rate from 13% to 7.75%, effective March 15, 2011, and in addition, lower than expected Covidien U.S. pulse oximetry royalty payments which we received in Q3, compared to what we had accrued in Q2.

Third quarter product revenue rose 10% to $97.6 million, representing primarily growth in our acute care channel, as recent expansion of our installed base translated into increased year-over-year sensor sales to hospital customers. This is also reflected in SET revenue growth of 17% to $89.8 million. A couple of developments dampen SET growth in the quarter. First, we believe various macroeconomic factors weighed on the market in the quarter and had an adverse impact on hospital procedure volumes, which in turn, impacted our SET adhesive volume and revenues, as well as capital equipment sales. Also, we experienced a rise in the number of customers choosing to reprocess single-use SpO2 sensors through Masimo, which negatively impacted SET sensor ASP sales as our reprocessed sensors are sold at a lower price.

In addition, we were expecting to resolve the payment of an additional $3 million for products we provided to a major U.S. hospital system, as part of their installation earlier this year. However, the healthcare system is still working to evaluate and reconcile their records with ours, and as a result, no resolution has occurred, and therefore, we were unable to recognize any additional revenue beyond the $760,000 that we previously recognized in Q2 2011. We are obviously working with this customer and hope to have a resolution before the end of the year.

Rainbow revenue was down 35% to $7.8 million versus $11.9 million in the year-ago period when we received a $4 million U.S. Marine Corps order. Unfortunately, the government order we had expected in the third quarter this year did not materialize, due, we believe, to the defense cuts following passage of the Budget Control Act. In addition, while we saw increase in volume for SpCO and SpMet through our OEMs, our direct SpCO sales were down, dragging down our total Rainbow revenue growth. In addition, as Joe mentioned, a positive sign for Rainbow continues to be a dramatic increase in the overall SpHb consumables from year-ago period.

Our worldwide end-user, or direct business, which include sales to just-in-time distributors grew 18% in the third quarter to $82.6 million versus $70.1 million one year ago. Third quarter 2011 OEM sales were down 20% to $15 million from $18.7 million in the same period last year, due to lower board sales and sensor revenues.

In total, our direct business represented 85% of product revenue versus 79% in the year-ago quarter. By geography, total U.S. product revenue rose 6% to $70.3 million, compared to $66.2 million in the 2010 third quarter as solid double-digit growth in the U.S. acute care channel was partially offset by the lower OEM and alternate care channel sales, as we noted earlier.

To illustrate this, our U.S. direct business, which excludes OEM revenue, rose 12%. Product revenue outside the U.S. totaled $27.3 million, up 21%, compared to $22.6 million in the third quarter last year, with every major direct sales region contributing to growth and despite the decline in international OEM sales.

Our OUS direct business, excluding OEM revenue, rose 37%; 28% excluding foreign exchange. Total third quarter international product revenue represented approximately 28% of our total product revenue versus 25% in the year-ago period. Favorable year-over-year currency exchange rates added approximately $1.5 million to third quarter international revenue totals. Note that this foreign exchange benefit was largely offset by approximately $1 million in higher foreign currency-denominated operating expenses and approximately $250,000 in higher foreign currency cost of sales.

Our gross profit margin was 63.5% in the third quarter, compared to 66.9% one year ago. Our Q3 gross profit margins were negatively impacted by 150 basis points related to our decision to write down inventory associated with product design changes, including an earlier version of the 2011 Radical-7, as well as the transition to new products. Without these charges, gross profit margins would've been 65%, which is still slightly below the low end of our updated August fiscal 2011 gross profit margin guidance of 65.5%. This additional 50 basis point decline was due primarily to lower Rainbow revenue and the increased level of Masimo sensor reprocessing that we are now providing to our customers.

Total gross profit margin, including royalties, was 65.8% in the third quarter versus 70.9% in the same period last year. In addition to the items I just mentioned, the decline in total gross profit was due primarily to the significant decline in Covidien royalty payments.

Operating expenses were $49.5 million versus third quarter 2010 operating expenses of $48.8 million, which included approximately $700,000 in onetime marketing expenses. Excluding these year-ago, onetime items, our third quarter 2011 operating expenses rose just 3%. This is the third consecutive quarter of significant declines in the rate of year-over-year operating expense growth, demonstrating our ability to control our expenses, as we had indicated for the past couple of years.

On a year-to-date basis, our 2011 total operating expense growth, adjusted for onetime marketing expenses in 2010, was approximately 7%, compared to 19% in 2010.

The actual year-over-year increase in third quarter 2011 operating expense was due primarily to slightly increased staffing levels and commission expenses partially offset by declines in legal expenses.

Third quarter 2011 operating expenses also included $9.4 million in R&D spending, which was up 2% from $9.2 million in the year-ago quarter. As I mentioned earlier, foreign exchange rates increased total third quarter 2011 operating expenses by approximately $1 million compared to the same period last year.

Third quarter 2011 operating income was $18.9 million compared to adjusted operating income in 2010's third quarter of $23.5 million, which excludes the year-ago onetime item I mentioned earlier.

Our third quarter 2011 effective tax rate was 20.7%, down dramatically from 30.6% in the year-ago period. The improvement was due primarily to the inclusion of the 2011 tax rate and extension of the federal R&D tax credit, the impact of the change in California's effective tax rate and the mix of income in jurisdictions where Masimo does business.

This rate is substantially lower than the 28% to 28% range that we had previously forecasted and is due primarily to the larger than expected shift in the mix of income in jurisdictions where Masimo does business. We now expect our 2011 effective tax rate to be between 25% to 26%.

Third quarter net income was $14.8 million, or $0.24 per diluted share, compared to GAAP EPS of $0.27 in the year-ago period. Excluding approximately $0.01 in the onetime expenses in the year-ago quarter, our earnings declined approximately $0.04 per share, or 14%. Recall that Q3 2010 included approximately $5.8 million, or almost $0.06 per share, in higher royalty revenues.

As of October 1, 2011, total cash and cash investments were $143.2 million, compared to $88.3 million at fiscal year-end 2010. This $54.9 million increase was due primarily to cash generated from operations. As of October 1, 2011, our day sales outstanding was 50, up from 48 on January 1, 2011. Over the same period, our inventory turns rose to 3.1 from 2.8.

In August, we announced that the board had authorized the stock repurchase program of up to 3 million shares of our common stock over the next 24 months. As of October 1, 2011, we had not repurchased any shares under this plan.

Now, I'd like to turn just a moment to our updated 2011 guidance. We now expect that our total revenues will be in the range of $436 million to $439 million, compared to our February 2011 prior guidance of $446 million to $463 million. This revised guidance assumes total product revenue in the range of $404 million to $407 million and royalty revenues of $31.5 million to $32.5 million. Included in the total product revenue range, we now expect total 2011 Rainbow revenues to be in the range of $33 million to $35 million, down from our August guidance at the low end of the original $40 million to $50 million range due to the lack of the FDA approval for the Pronto-7.

In addition, we now expect our total fiscal 2011 product gross margins to be in the 64.5 range, including the impact of the $1.5 million in Q3 write-downs, I previously mentioned.

As we mentioned in our Q2 earnings call, the introduction of our new sensor technology will result in higher product costs in the short run, although this is a long-term investment that will improve our business, since it ensures that our hospitals, clinicians, and ultimately their patients, are receiving the benefit of the full performance of Masimo technology. Our new annual gross profit range projection is 64.5% and assumes a Q4 2011 projection of approximately 64% gross profit margins.

We now expect 2011 operating expenses to be approximately $207 million to $209 million, below our original guidance of $210 million to $215 million. Finally, we believe that our full-year effective tax rate will now be between 25% and 26% compared to our previous guidance of 27%.

Based on this updated financial guidance, we now expect our full-year 2011 earnings per share to be in the range of $1.04 to $1.06 per share, which includes the $0.02 related to the Q3 eNO charge off, but is down from the original guidance range that we provided of 117 to 125, although we did indicate in August that we expect it to be in the low end of this range.

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

Joe E. Kiani

Thank you, Mark. As Mark just noted, our revenue on EPS stars did not align for us in Q3. Our plans for the hard-to-predict Rainbow revenue did not materialize, not only did we have to begin the quarter without Pronto-7, because of FDA clearance delays, but the military order that we were expecting did not materialize. As Mark explained, we were also unable to recognize a significant piece of capital revenue from one of our major customers, and based on our sensor volume, we appear to have had a slightly greater census drop in September in the U.S., which is the largest market for our adhesive sensors.

Although we traditionally see a strong sequential U.S. revenue increase as we move from the lower Q3 utilization period into Q4, we are concerned about some of the early trends we're seeing in early Q4 that began in second half of September. Typically, we see a very strong OUS fourth quarter, but given the economic uncertainty throughout Europe, we are a bit more cautious on our OUS, outside U.S., Q4 revenues as well.

While our SET business is growing in line with our installed base expansion, at around 16%, we believe our Rainbow business, when it kicks in, will help deliver growth well beyond 16%. And while the adoption of our Rainbow technology has been slower than we'd like, important developments, such as high rate of adoption by key OEMs, new versions of Rainbow, including In Vivo Adjustment and healthy growth in SpHb and RAM sensor volume are making us feel positive about the path that we are on.

One of our key objectives for 2011 is to increase Rainbow awareness and adoption. We made good progress at the recent American Society of Anesthesiology Conference last week, in Chicago, where clinicians responded enthusiastically to the launch of our 2011 Radical-7 Bedside Monitor, Masimo's flagship device. This new instrument features various enhancements to improve patient safety, as well as the In Vivo Adjustment that allows clinicians to adjust SpO2, SpHb, SpCO and SpMet values displayed on the monitor, based on laboratory reference values.

When reviewing the SpHb data we have collected, once In Vivo Adjustment is performed, SpHb accuracy measurements improve by about 0.5 grams per deciliter, in places that there were high values between SpHb and laboratory hemoglobin. And yet, not reducing our accuracy in places where SpHb was performing as expected.

Pending FDA clearance in the U.S., the In Vivo Adjustment addresses the inability of one calibration curve to fit all patient's needs and variances with laboratory instruments, further setting Masimo Rainbow SET technology apart from the competition and delivering on our objective to continue our track record of innovation that solve important clinical problems.

Consistent with another 2011 objective to expand our presence in the general ward, the new 2011 Radical-7 also includes Rainbow Acoustic Monitoring, RAM, and provides clinicians the option to display the acoustic waveform with the plethysmographic waveform overlaid. This new display capability may allow clinicians to see important patterns and more readily detect respiratory pause events. In addition, the RAM [indiscernible] was improved to better perform under high ambient noise, improper sensor placement or other situations that could degrade the acoustic respiration signal.

RAM is Masimo's breakthrough solution for measuring respiration rate in realtime and in an unobtrusive way. And an important component in our general ward monitoring solution, especially for helping clinicians effectively manage postoperative patients on patient-controlled analgesia.

A few weeks ago, RAM received regulatory clearance from the Japanese Ministry of Health, Labor and Welfare. The Japanese MHLW also recently granted clearance to Pronto-7. We are currently in the midst of the launching both RAM and Pronto-7 in Japan. As you all know, Pronto-7 is currently pending FDA clearance and therefore, not yet available to U.S. clinicians and patients. This delay is the biggest reason Rainbow revenues for 2011 will be below our original expectations.

In the meantime, the performance of Pronto has nearly caught up with Pronto-7, we are getting close to a market release of Pronto in the physician office channel. To see SpHb meet its promise, we continue help grow the volume of clinical evidence, expand the number of OEMs who offer Rainbow SET, and increase the number of hospital customers adopting SpHb. We continue to make important strides in each of these fronts. For example, to date, there are over 60 research studies on SpHb. Many of these studies are showing SpHb's ability to help clinicians assess hemoglobin status and determine treatment and additional test options in surgery, critical care, outpatient care areas and emergency department.

These studies are essential to getting anesthesiologists and surgeons actively engaged in the dialogue which -- about SpHb's clinical utility. For example, a recent study published in the Journal of Critical Care Medicine showed that in the ICU, SpHb has absolute and trending accuracy similar to widely-used invasive methods of hemoglobin measurement at bedside and has the additional advantage of providing continuous measurements noninvasively, which may facilitate earlier detection of occult bleeding in the ICU. And at the ASA, last week, approximately 16 clinical SpHb studies were presented, including one by researchers at Johns Hopkins Hospital who found that the combination of continuous SpHb and PVI monitoring may improve the efficacy and safety of the intraoperative autologous normal bulimic hemodilution blood conservation technique that helps avoid allogeneic blood transfusions. We now have research from 2 of the U.S.', perhaps even the world's highest rated hospitals, Hopkins and Mass General Hospital, showing the clinical value of SpHb. Recall that last year at ASA, researchers from Mass General showed that SpHb could dramatically reduce unnecessary blood transfusion.

We also continue to expand the number of OEM partners who are incorporating Rainbow SET technology into their multiparameter monitoring devices. As of the end of the third quarter, we achieved our 2011 target to have 30 OEM Rainbow licensing and product development agreements in place, and we expect that number to grow by year end.

Medtronic Physio-Control, Zoll and Welch Allyn are among the first to provide Rainbow to our mutual customers. Drager is expected to begin their launch internationally next month at MEDICA. And Philips, the world's largest patient monitoring company, recently announced that they had entered to a long-term Rainbow SET agreement with us. Setting up and expanding the OEM channel is essential to extending Rainbow's availability to healthcare professionals around the world and we continue to be very encouraged at the rate at which OEMs are signing up to provide Rainbow to our mutual customers.

In the third quarter, we announced that Shriners Hospital for Children in Honolulu, which performs hundreds of orthopedic surgeries on children each year, are adopting Rainbow for monitoring patients in the OR and ICU. After initiating use of continuous SpHb monitoring during surgeries, Shriners clinicians' saw immediate benefit. They tell us that they are doing far fewer blood transfusion and having to put fewer units of blood on standby, in advance of surgery, where high blood loss is at risk. What's more, they say that the realtime trending of hemoglobin levels is particularly useful versus having to wait for lab results from invasive blood draws and having to use needles on their younger patients.

Another key objective for 2011 is leveraging our global sales force. To make sure that we are getting maximum output for both our Rainbow and SET businesses, we continue to experiment with modifications to the sales force structure and considering other innovative sales strategies. We also continue to watch carefully to see which of the markets grows fastest for SpHb, the intensive care unit, the operating room, recovery, emergency department, or labor and delivery, so that we can reinforce the speed of adoption. Rainbow and a superior performance and reliability of Masimo technology is the primary reason customers choose us over competing system. That performance was underscored recently with studies published with Lancet, the British Medical Journal and the Journal of Pediatrics, showing Masimo SET to be effective in screening newborns for congenital heart defect. And a few weeks ago, the U.S. Department of Health and Human Services recommended critical congenital heart defect screening using motion-tolerant pulse oximetry, which we invented, a nationwide newborn screening standard. Among the approximately 4 million babies born in the U.S. each year, congenital heart disease is the most prevalent form of birth defect and is the #1 cause of infant death. We expect screening with Masimo SET Pulse Oximetry to play an important role in saving newborn lives as congenital heart disease screening protocols are put in place nationwide.

In the last 6 months, we have converted over 45 hospitals worldwide, including Memorial Healthcare Systems in Florida, Mount Sinai in New York City, and University Medical Center in Las Vegas. We are gaining the oximetry business of these customers mainly due to our technology's superiority and innovation track record.

To close, I'll reiterate that we are managing Masimo with a long-term view. Our strong and growing proposition in the global pulse oximetry market has allowed us to consistently achieve revenue growth rates well-above industry levels, even in the midst of a broad economic downturn. Moreover, our expanding installed base is the leading indicator of our ability to continue to advance. Rainbow represents the next wave of growth and we fully expect it to take off on the steep edge of the S-curve before pulse oximetry's trajectory begins to shallow out for us.

I can't say exactly when Rainbow revenues will catch up with our excitement over its potential to revolutionize medicine. But I'm confident that it ultimately will. The ride may be bumpy, but we fully intend to get there. So with that, we'll be happy to take your questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Bill Quirk with Piper Jaffray.

William R. Quirk - Piper Jaffray Companies, Research Division

First question, guys, on drivers, we have a very forward pace in 2010 and even the first quarter in this 2011, but it slowed down for a couple of quarters now. I'm just curious, is this all macro? Any signs at all of the drivers picking up, any competitive dynamics at work here?

Joe E. Kiani

Well, first of all, we don't believe this competitive dynamic because we're still gaining market share, as I mentioned earlier. However, we are seeing some of our OEMs having to slow down compared to what they were forecasting. However, at this point, we believe Q4, we're going to have a stronger driver number that we've had even in the past couple of quarters.

William R. Quirk - Piper Jaffray Companies, Research Division

And that's based on what, bookings to date, I take it, Joe?

Joe E. Kiani

Right.

William R. Quirk - Piper Jaffray Companies, Research Division

And then secondly, if we think about the number of, or I should say, the pick up in sensors that are being reprocessed by Masimo, where are we there, guys, in terms of mix, where can this go based on the feedback that you're getting from your accounts?

Joe E. Kiani

That's a good question. The conventional way of trying to be green and save money is to recycle sensors. But it is not really green. We've done some studies and we need to wrap those up and publish them, but earlier results show that the carbon footprint of recycling sensors is actually greater than new sensors. So ultimately, what we expect is for consumers that want to be green, and save money, the ReSposable Sensors are the way to go. And if you recall, we launched ReSposable Sensors about a year ago, but we've not fully finished the product line. We hope that by beginning of next year, the full product line from new [indiscernible] to adult for ReSposables will be complete, not only for Rainbow, but for SET. So we hope long-term, and we expect long-term, based on discussions with key customers that ReSposables should be the way to go. In the meantime, I think you're going to see, until that concept holds grip, you're going to see more and more recycling business coming our way.

William R. Quirk - Piper Jaffray Companies, Research Division

Understood, and then last one for me then I'll jump in the queue, it's actually a question for Mark. In terms of the new sensor launch, Mark, thanks for the clarity on what the impact was and what that may be in the fourth quarter, are we still thinking that this is going to be break even to the P&L in the first half of 2012?

Joe E. Kiani

It's all but the X-Cal sensors. Yes. We're going to incur that incremental expense that we alluded to in our last call that I mentioned again today. The most significant hint pack will probably in the fourth quarter that we're in right now. There are a number of cost reduction initiatives in place that we think will take hold beginning -- towards the end of the first quarter, beginning of second quarter of 2011, 2012, excuse me. So that by the time to get to the middle part of the year, we hope to have essentially removed that short-term incremental cost from the sensors. And then, in addition to that, as we've said in the past, there are a number of other initiatives that we're currently working, that we think we'll have beneficial overall gross margin impacts in the second half of next year.

Operator

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

Gregory Hertz - Citigroup Inc, Research Division

It's actually Greg Hertz calling in for Matt. I just want to dive in a little bit more in the commentary on the total hemoglobin sensors, you're characterizing the growth in terms of volumes, but certainly, I think we're going to be hearing a lot more questions from investors on the dollar growth there, and I certainly appreciate that you guys haven't really broken out a lot of detail within the Rainbow SET and revenue segment as we have, but I think one could interpret with the flat sales and the doubling of volumes that certainly there has been some dramatic pricing erosion on the sensors or the drivers or other components of the SET suite, the software upgrade, et cetera. So could you at least give us a little bit of flavor for what's going on there in the pricing? Because I think the take away for some people or the interpretation is that with less pricing going down, there's going to be perceived less value associated with it.

Joe E. Kiani

I'd start, Greg, by calling out the fact that the reason for us highlighting the strong growth that we're seeing in some of the key areas of Rainbow is to ensure that, that continued utilization of these products that we're putting into the field is occurring and, as Joe said earlier, based upon the unit volume increases that we're seeing, admittedly off of lower levels a year ago, that's still very, very reassuring. One of the issues in, as you said, the flat year-over-year Rainbow revenues, if you exclude the Marine Corps order from last year, is that we had other reductions in, we call it the more traditional areas of Rainbow revenues, for example CO and met. There have been areas of that business, for example, our Rad-57 sales that we've actually seen declines in. So that is going on, if you will, underneath the total Rainbow revenue numbers. And that's why we continue to feel very positive about what's happening in the area of SpHb and the area of RAM. Unfortunately, their numbers are not significant enough yet so that some these movements of other Rainbow measurements end up with a net flat number, if you will, year-over-year.

Mark P. de Raad

I just want to clarify one thing, while the unit volumes we mentioned were up on hemoglobin sensors, what were their revenue at the same rate. And that the other thing I want to clarify, while the Rad 57 end-user product we have at SpCO is down, the rate of CO and met adoption inside our OEMs products like from Physio-Control and Zoll who make the defibrillators that incorporate the Rainbow technologies up dramatically. However, those -- we get about 1/3 of the revenue from those sales compared to when we sell the handheld CO met product, and that's why they're not making up enough for the decline in the handheld direct sales.

Gregory Hertz - Citigroup Inc, Research Division

And just 2 quick ones. One, can you just address -- you mentioned on the call, the prepared remarks, that you had not utilized any of the share repurchase authorization, just any view on that in the near-term. And then secondly, another question on the OEMs, the weakness there. Was that more widespread or was that associated with a smaller handful of your OEM partners? That's it for me.

Joe E. Kiani

Greg, quick question, what was the second half of your question?

Gregory Hertz - Citigroup Inc, Research Division

The OEMs and the weakness in the OEM channel. Just wondering if that was associated with a handful of the OEM partners or was that more widespread across all the OEMs?

Joe E. Kiani

Well, let me respond to the second half, and that would really just a couple of OEMs, maybe close to 70, 80. It was a minority, from what I understand. And based on the first part of your question, Mark, you want to answer that?

Mark P. de Raad

Sure. On the share repurchase plan, Greg, the board has established certain criteria that we put in place for certain levels at which we will be repurchasing stock. And so as I said before, at least through the first -- the end of the third quarter, those triggers were not yet met. But there is a plan in place and depending upon the movement in the equity, we plan to be utilizing that plan when appropriate.

Operator

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

Joanne K. Wuensch - BMO Capital Markets U.S.

Did you find anything in the quarter relating to city budget? Was that a piece of the Rainbow story?

Joe E. Kiani

Yes, yes, Joanne.

Joanne K. Wuensch - BMO Capital Markets U.S.

Any way to quantify that impact?

Joe E. Kiani

Well, it's a good question. One of the things that we scratch our heads about is, while we believe our sales force when they tell us that the budgets for the cities and municipalities has affected the fire departments, and therefore, they don't buy as many handhelds as they did before, our OEMs are doing a much better job of selling their defibrillators with our parameters. So it's -- maybe they've put aside budgets for defibrillators, and including those measurements, it's easier, I don't know. But what I can tell you that we've been suffering the lack of local budgets ever since the financial collapse of 2008.

Joanne K. Wuensch - BMO Capital Markets U.S.

If I heard you correctly, you're optimistic about Pronto-7 by the end of the year? Can you confirm that or comment on that, and then at some stage, my understanding is that you're going to have sign a distributor or some type of agreement to get into the physician's office, is there any update on that?

Joe E. Kiani

Yes. First of all, we can't tell when FDA's is going to clear something. All we did is that the beginning of this last quarter, we told our investors that for now assume processing on one good clearance for the year. There really, in our opinion, there's no reason it shouldn't be cleared. We've had significant amount of data proving its accuracy, proving its value, and compared to other invasive measurement, it's as good, if not better. It's available to use physicians based on what we've seen. But now the good news is, Joanne, that Pronto, as I mentioned in my statement, is getting much closer to the performance characteristics that people like about Pronto-7. So therefore, we are close to initiating a full-market release with Pronto and we are in the midst of signing up our distribution for U.S. to get that accomplished. So hopefully, with or without Pronto-7, in the new year, we should be fully up and running with the physician's office with Pronto. And of course -- and the rest of the world, excluding, I guess, China, Pronto-7 and Pronto both are available and based on clinician's preference they can buy either.

Operator

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

Brian Weinstein - William Blair & Company L.L.C., Research Division

Going back to this OEM situation. In Q2, it was down 10% and you guys said that you expected that it was just a transition from sensors being purchased by the OEMs that was going to come back to you guys and that they would eventually be procured. It sounds like that hasn't happened and that there's a little bit extra going on there. Can you just talk about that first part and whether or not you're still confident that, that's what -- is making a part of this?

Joe E. Kiani

Well, I should have read my script from last quarter. Now what did we say that last quarter, Brian?

Brian Weinstein - William Blair & Company L.L.C., Research Division

You said last quarter, it was down 10%, you expected that it was a little bit of a shift in sensor sales going from the OEM channel into the Direct channel, and that you expected, and that you were confident that those sensors were eventually going to be ordered through Masimo's Direct channel. It sounds like there's something little bit different going on based off on the commentary today, and I'm just trying to reconcile what you said last quarter and what's going on now.

Joe E. Kiani

You picked up the subtle difference of what we said and what we're saying today. And the reason for that is really a few, which is something I would like to share with you, one is that we aren't certain anymore that whether the sensor revenues that we used to get from the OEMs is in fact, going through our direct distribution channel. We think there might be, in some cases, those sensors being lost to copycat sensors, which hopefully X-Cal will take care of. And another instance, although I don't have all the data yet, maybe one of our OEMs is playing a little bit of a fast and loose game with us. So we're trying to analyze them and figure out. But one thing we can tell you for sure is that number one, our OEM revenues are down because of less driver revenues and also less sensor revenue. Now long-term, I would not be disappointed if our OEM business becomes 10% of our business. As long as the driver volume is in good shape, and with everything that's going on with the increase of our OEM agreements for Rainbow, as well as our improvement in our relationships with just about every one of our -- relationships maybe with the exception of one, we're feeling pretty good about that.

Brian Weinstein - William Blair & Company L.L.C., Research Division

And then uptake with SpHb, I mean we were at ASA weekend as well, and we heard it loud and clear that there is perceived value to noninvasive continuous hemoglobin, but the price is the major issue along with hospital bureaucracy and some other stuff, but it's primarily price, so maybe you could be a little bit more specific in how you guys are going to combat this with sales and marketing, and why not just consider a larger price cut, at this point, in order to gain better traction?

Joe E. Kiani

Sure. First of all, I want to thank you, Brian, for taking the time and coming to ASA and doing the work you did, in fact, I'm very much interested to see the survey results. But what I can tell you, we don't yet believe price is the impediment for the continuous hemoglobin market in the U.S. or even the rest of the world. However, what we're prepared to do is to do some innovative things such as, in certain cases, not every case, to try a risk-sharing program where we were very confident the value that our parameter brings, and we say to our customers, here is the price of Rainbow, let's say, ReSposable Sensors, and that's at $50, and maybe there's a price that they can all agree to, whether it's -- whatever, let's say $20, that is something they would feel happy about with converting their entire hospital to, and we can say, "look, there's a delta 30 and if we track all of your expenses before and then after, that relates to the installation of continuous hemoglobin, and you don't see the value between that 20 to 50, and perhaps, we're willing to go all the way down and return back to them money for even that 30-dollar delta. So I don't know if that was clear, but what I'm trying to say is I believe the value at the price of $50 is more than appropriate to not only help improve care, but reduce cost of care, and we believe so strongly about that, we're willing to back it up. And we're not going to do it at every place, but we're going to select some key customers and offer that program to them.

Brian Weinstein - William Blair & Company L.L.C., Research Division

So you're suggesting a $50 price on SpHb is where you feel comfortable?

Joe E. Kiani

Yes, but you know our disposable is $100, but our ReSposable comes out to about $50, and I think that price, based on all the surveys we did a while ago, is the price where most customers say, that's the right price. But last part, Brian, if we think it's $20, trust me, we'll go to $20. We still will make a good business even at $20. But I don't believe we'll be doing our shareholders a service by going to that, by the way, because I'm not sure that's the issue.

Operator

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

Lawrence S. Keusch - Morgan Keegan & Company, Inc., Research Division

Mark, I'm wondering if you can -- there are obviously a bunch of moving parts thru the product gross margin line here. And I'm wondering if you can help us just think about sort of the puts and takes as we look forward here over the next couple of quarters. What should improve? What seems to be a drag that may be there for a while, just so we can help us think a little bit about, directionally, where this is going?

Mark P. de Raad

Sure. Let me start with maybe reiterating a little bit of what I said in the prepared remarks about the current quarter margins and what I indicated there was that we'd be at about 65% had it not been for the write-down of the inventory that we spoke about a little while ago. And so if you use that essentially as your starting point, we continue to believe that we are going to drive various costs out of the manufacturing model. These are not necessarily standard costs but other costs within the overall gross margin structure, and that should begin to happen and take effect in the next quarter, be more significant, as I said, starting next year. So that would be a reason to indicate that -- why we believe margins over time are going to head back north again. In the short-term, of course, we've got the impact of the X-Cal, or the component that I spoke about before, that will be entering our new sensor technology in earnest this quarter. And that's really the reason why, if on an adjusted basis, we're at 65% gross margins this quarter, that's why I indicated earlier, our best forecast right now suggests about 64% margins for Q4 because of that impact. Moving forward into 2012, obviously we're not providing any specific guidance, but I would like to at least relay that the kind of cost improvement initiatives that we've been mentioning for the last couple of quarters are moving very well down the path. And that's why I said before, when some of these short-term issues related to this new technology run through our model in the first couple quarters of next year, we think by the middle part of next year that we should see gross margins beginning to move back up again.

Lawrence S. Keusch - Morgan Keegan & Company, Inc., Research Division

And Mark, help us understand what sort of the -- as you renewed these sensor contracts, how much impact, for example, in the third quarter, do you think that had on your gross margin?

Mark P. de Raad

Probably not much at all, because remember, contracts that we renew, or new contracts that we signed in a contract, when the particular quarter takes some time to actually get implemented because even a renewal contract is usually -- will usually include additional product. As you know, the beauty of the razor, razor blade model for Masimo is that most of these contracts are five-year, long-term agreements. So even though we might be feeling some short-term pricing pressure, the impact of that, in any particular quarter, is usually pretty muted. Clearly, if that pricing pressure were to continue year after year, you would begin to see that in the overall revenues that we're generating from those drivers. Right now, I think, in general, the kind of pricing pressure that we've spoken to earlier in the year is really not changed. It's still is a relatively aggressive pricing environment, in some cases, and we continue to do what we need to do to secure those customers.

Lawrence S. Keusch - Morgan Keegan & Company, Inc., Research Division

Okay. And just one other one on margin, and then I have one other question. As you speak to Pronto-7 and Pronto, again, how should we think about the margin profile between those 2 products, are you agnostic as to which one gets going here or is there a difference?

Mark P. de Raad

Well we don't necessarily get into specific cost structures of our products, but what I will say is that both of these products are obviously, fairly young in their life cycle. Our hope is that when we begin to move, for example, the Pronto-7 that, that device, along with an appropriate amount of sensor-committed revenue, will put us in a position to yield margins that are fairly consistent with the kinds of margin that we're enjoying today. It won't be until those revenues are very, very large percentage of our total revenues, when we think we will be in a position to start seeing very significant improvements to our overall blended margin because of the impact that, for example, the Pronto-7 would have.

Lawrence S. Keusch - Morgan Keegan & Company, Inc., Research Division

And then the last one for you guys is, I'm just trying to think about this increase in reprocessing that is being done for you guys, and the launch of the new sensor technology, and if I understand that new sensor technology, you really won't be able to reprocess that because of the technology embedded in that sensor. So how do we think about the juxtaposition between getting that new sensor out and getting the pressures for you guys to do more reprocessing?

Joe E. Kiani

Well, first of all, the new technology we're implementing, X-Cal will still allow us to reprocess our sensors. We're, to my knowledge, the only company, when we reprocess, we actually do change the optical assembly, which is what can go bad during reprocessing. So that won't affect that. However, what we're -- what I was referring to, we have a new technology called a ReSposable Sensors, and we call it ReSposable because it is has a reusable optical sensor portion and a disposable optical sensor portion. And the disposable portion of that is such that it really is what you expectably would throw away if you were reprocessing. So it allows you to have 100% reprocessing, if you will, at the point of care, instead of maybe 20%, 30% at best that hospitals can get in reprocessing that they have to shift back and reprocess at factories and then get shipped back again to them. So I hope that clarifies that.

Lawrence S. Keusch - Morgan Keegan & Company, Inc., Research Division

And then lastly, Mark, just on the share repurchase, I know you said there are specific triggers that weren't met and I know you're not going to give us exactly what those are, but is stock price one of them? Any color around some of that would be helpful, if you can.

Mark P. de Raad

Yes, all we can really say essentially is that, as you know, the board did authorize a total of 3 million shares to be repurchased over the next 24 months and, as I alluded to before, there are certain criteria that are in place. And obviously we can't control whether or not that criteria is hit or not. But as I said before, we fully intend to deploy the plan in the event that those triggers are hit.

Operator

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

John M. Putnam - Capstone Investments, Research Division

Joe, you just signed another OEM agreement in China. You've gotten a number of product approvals or clearances in Japan. Can you give us a little color, and a little, I guess, thought on how quickly you can bring some of your Asian business up here, both China and Japan?

Joe E. Kiani

Well, in Japan, we have a great infrastructure led by very capable and proven country president. So I believe we're going to be able to capitalize on these approvals for Pronto-7 and the Rainbow Acoustic Monitoring very well in Q4. In China, we're just getting up and running. We don't have the same type of infrastructure and the number of direct people nor the history that we have with our Japanese business. So that will be a little bit less predictable. But as far as percentage, growth, Japan, in terms of revenue and growth, happens to be only second to the U.S. for us. It's a very important market and we expect a lot of good things to come from that. Then, this is the first time ever we've got an approval for product in Japan before we had it in the U.S.

John M. Putnam - Capstone Investments, Research Division

And how many OEMs do you have now in China, 3 or 4?

Joe E. Kiani

I think it's 3 or 4. I don't know, but yes, we have several, but I think for Rainbow, we may have 3 now.

John M. Putnam - Capstone Investments, Research Division

And are they the largest or are there still some out there that are larger than the ones that you've captured here?

Joe E. Kiani

No, the largest OEM in China as Mindray, and we have not announced anything with Mindray yet regarding Rainbow. We obviously have announced our relationship with them regarding SET, but not with Rainbow.

Operator

Your next question comes from the line of Sara Michelmore with Brean Murray.

Sara Michelmore - Brean Murray, Carret & Co., LLC, Research Division

Just a question on the operating expenses. Mark, you did lower the guidance for the full year, and I'm just wondering if you can kind of walk us through the delta there. And as we start to think about our models for 2012, assuming that the revenue growth trajectory or overall revenue dollars are a little bit below maybe what you guys would have thought earlier in the year. How -- what kind of ability do you have to better leverage the operating expenses, assuming that you've got a lower revenue forecast to deal with?

Mark P. de Raad

Sure, so the first part of your question had to do with the specific operating expense guidance that we provided today, which, as you alluded to, was a little bit lower. The majority of that came in areas such as legal expenses, also came in areas such as, expected hiring for the rest of the year. Obviously, we've made certain assumptions earlier in the year, and we've now revived those assumptions, given that we have but a quarter left in the year. That's probably the primary area. The other area I'd note, on a real positive note, is we have managed to make some significant changes within our deployment of installations all over the country, and in fact, they're doing that in a much more efficient and effective way. So we've actually seen a very noticeable decline in the cost of installation for us relative to these new customers that we bring on board. So those are the primary drivers of the lowering of the full-year operating expense guidance. And then on the overall -- I think the bigger picture question, in terms of the overall model, Joe alluded earlier to the fact, there are a number of things that are being considered relative to the overall, best way to leverage the sales organization throughout the whole world. We'll be working on various items like that over the next couple of months, as part of our planning process, and I think earlier next year, in February, when we are in the position to provide guidance for the whole year, that's probably a better time to talk about what other leverageable opportunities there might be within the model.

Sara Michelmore - Brean Murray, Carret & Co., LLC, Research Division

And then just a quick one for Joe. In the context of this Rainbow, you talked through price not being an issue or not being the main issue, in your mind. I mean, in the way that you guys look at this thing, what would you say are the key pushbacks or hurdles for the adoption for Rainbow at this point?

Joe E. Kiani

I really think the hurdle is to get more evidence of the benefit of noninvasive hemoglobin. It might be due to the glucose study that came out several years ago where they said close titration of glucose could dramatically help improve outcome and so forth and unfortunately, that did not play out in the future study, so that might be a reason why clinicians want to see more studies confirming, for example, what the Mass General study showed a year ago. So I think clinical study is probably the most important. Number 2, our friends in anesthesiology, which is really the main group we have dealt with for the last 20 years have said to us, let's see if we can go get the help of some of the surgeons, who have more pull in the hospital to help them get hemoglobin in their hospitals. I don't like making excuses, however, since the financial meltdown of 2008, hospitals are reluctant to try new things. It's harder for anesthesiologists who are not the ones who are bringing in the patients to the hospital to go and push for new technology adoption, and that's why maybe our idea of doing some kind of risk-sharing with the hospitals will enable these anesthesiologists to get what they want.

Operator

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

Ben C. Haynor - Feltl and Company, Inc., Research Division

It looks like you have the best quarter in taking share from Covidien since Q2 from last year. Do you think that trend has been accelerating somewhat over the past few months here?

Joe E. Kiani

Your question is in terms of total share?

Ben C. Haynor - Feltl and Company, Inc., Research Division

Correct.

Joe E. Kiani

Well, I think if you look at the -- the general answer is, we still think, of course, all we have are our own driver numbers to evaluate. But we strongly would support the latest third-party data, which I think still has Masimo shipping approximately 50% of the new drivers into the marketplace. And I think given the 33,000 range that we put in last quarter again, we don't have any reason to believe that's any different. So we still believe we're out-shipping our competitors at a very, very healthy rate, but of course, ultimately, we should see that in our top line sensor revenues.

Ben C. Haynor - Feltl and Company, Inc., Research Division

Now, what needs to happen to kind of hit the high end of your revenue guidance, is that $3 million hospital contract discrepancy part of that at all or is that completely aside?

Joe E. Kiani

No, there's nothing specific that hinges on whether we hit the high or low end of that. As we talked about earlier, there are a lot of moving parts in the business, we just felt that given where we are right now, that was our best estimate of where we thought our Q4 revenues were likely to fall in, but there is no specific individual item that dictates whether we're at the high or low end of that range.

Ben C. Haynor - Feltl and Company, Inc., Research Division

And then, any chance you can quantify how much reprocessing increased during the quarter versus last year versus the previous quarters?

Joe E. Kiani

We -- the program that we alluded to today has been in place for a little over a year now. I would say this quarter, and the reason frankly we've mentioned it in the call today is that this is the first quarter where we've seen more than sort of an insignificant amount of reprocessing in the quarter. As we mentioned in our prepared remarks, it impacts us primarily because the pricing of those reprocessed sensors are a little bit lower than the pricing of our traditional disposable sensors. But in terms of dollars, I don't want to provide any specific dollar impact, but I'll leave it -- it was just a higher number this quarter than it's been in the past couple of quarters. And probably, one, frankly, that we think, until some of the transitions occur, that Joe mentioned earlier, to these other products, it's probably a rate that we're now assuming is going to be pretty consistent for at least the foreseeable future.

Operator

Your next question comes from the line of Tao Levy with Collins Stewart.

Tao Levy - Collins Stewart LLC, Research Division

Just to be clear, on the gross margin side, 64% range until mid-2012? Is that kind of right, Mark? On the product side, on the product gross margin.

Mark P. de Raad

Again, without providing any specific guidance to next year, I would say that, the 60 -- remember I said -- as the impact of this reprocessing is probably going to be the most significant for us in this fourth quarter, so the translation of that obviously is that we would hope that margins will start improving even earlier than the middle part of next year. I just mentioned that until we get -- it may be until the middle part of next year that we get the incremental cost specifically related to this sensor out of our cost portfolio, if you will. But there are other cost initiatives that we alluded to before that are in place, and we think we have a good chance of some of those yielding improved margin numbers even earlier than the middle part of next year.

Tao Levy - Collins Stewart LLC, Research Division

And Pronto, you mentioned, I think earlier on, Joe, your full launch next year in the physician's office with or without Pronto-7. Does that have the same sort of sales opportunity as Pronto-7 has? So basically, would it make up the delta from this year's miss by not having Pronto-7, around 10-ish million, is that something that can be achievable?

Joe E. Kiani

I believe so. I believe -- it may not be 100%, but I think we might approach 80%, 90% of what we can achieve with Pronto-7.

Tao Levy - Collins Stewart LLC, Research Division

And then, just a last question on the SET guidance, if I back into what you guys have been implying for the fourth quarter, you kind of have to lower that revenues per driver number to a level that we haven't seen this year, in terms of the year-over-year decline. Is there anything in particular with this fourth quarter around contract prices or is it just lower expectations in terms of volumes and so forth?

Joe E. Kiani

Well Tao, as we discussed earlier, some of our macro theorists said they could feel like maybe sensors will be down, definitely utilization will be down. You know we -- actually the numbers that your former company announced recently, pretty much closely matched to what we saw happening in September. We thought there may be about 3%, 4% drop in sensor purchases in the U.S. So assuming that continues, and also worrying that maybe Europe will have even more jitteriness in Q4, that's why we guided lower. There wasn't any specific contracts or issues that we were aware of.

Operator

[Operator Instructions] Your last question comes from Lennox Ketner with Bank of America Merrill Lynch.

Lennox Ketner - BofA Merrill Lynch, Research Division

A few questions on the X-Cal component of the new sensor. One, you said earlier that you'll still be able to reprocess it. Are you anticipating that third-party reprocessors will be able to reprocess that too or will it have to be done through Masimo?

Joe E. Kiani

I believe with X-Cal it going to have to be done through Masimo.

Lennox Ketner - BofA Merrill Lynch, Research Division

And then, Mark, I'm just struggling with why -- obviously there's a misunderstanding, something but why the negative gross margin impact from X-Cal would only be a short-term impact. I guess the way I'm thinking about it is just that if you have a more technologically advanced sensor, isn't -- my sense would be that would cost more to produce kind of permanently, but it would prevent you from losing share to some of the counterfeits. I'm just not sure why in I misunderstanding there, why it would only a short-term impact?

Mark P. de Raad

Well in the long run, it's still slightly incremental, but the point that we're trying to make is that this incremental expense that we're incurring now is based upon, if you will, initial, smaller volume levels. And once those get to levels, earlier next year, we think that will be significantly higher, we'll be able, through volume, to pull average cost out of those sensors, plus some of the other improvements that I alluded before, we think those will also play into the cost structure of those specific sensors in the first half of next year.

Lennox Ketner - BofA Merrill Lynch, Research Division

And then, Joe, you were saying earlier that one of the main kind of gating factors, to seeing better uptake on the hemoglobin side is just more clinical data. And I think Masimo is actually funding a couple of studies on that. Have you guys given any sense as to when we could see some of the data from those trials?

Joe E. Kiani

Yes. I think if the return goes according to a plan, we should have a very large scale multi-center, multi-country study out probably within a year, a year and a half. Maybe an abstract and then maybe 6-months to a year after that is a whole publication. We for the first time have gone out with any trust funds that we got last year, any trusts seldom got last year, as you remember, we spent some significant dollars in funding some of these large clinical research studies. So hopefully, they should bear some good fruit.

Mark P. de Raad

Thank you so much. And thank you all for joining us. We hope to share better news from now on. Thank you. Have a wonderful evening.

Operator

This concludes today's Masimo's Third Quarter 2011 Earnings Conference Call. You may now disconnect.

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