Masimo Corp

NASDAQ:MASI

Earnings Call Transcript 2019-Q2

[Operator]

Good afternoon, ladies and gentlemen, and welcome to Massimo's Second Quarter 2019 Earnings Conference Call.

The company's press release is available at www.masimo.com. At this time, all lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session.

I'm pleased to introduce Eli Kammerman, Massimo's Vice President of Business Development and Investor Relations. Sir, please go ahead.

[Eli Kammerman]

Thank you, and hello, everyone. Joining me today are; Chairman and CEO, Joe Kiani; and Executive Vice President of Finance and Chief Financial Officer, Micah Young.

This call will contain forward-looking statements, which reflect Masimo's current judgment including certain of our expectations regarding fiscal 2019 financial performance. However, they are subject to risks and uncertainties that could cause actual results to differ materially. Risk factors that could cause our actual results to differ materially from our projections and forecasts are discussed in detail in our periodic filings with the SEC. You will find these in the Investor Relations section of our website.

Also, this call will include a discussion of certain financial measures that are not calculated in accordance with Generally Accepted Accounting Principles or GAAP. We generally refer to these as non-GAAP financial measures. In addition to GAAP results, these non-GAAP financial measures are intended to provide additional information to enable investors to assess the company's operating results in the same way management assess such results. Management uses non-GAAP measures to budget, evaluate and measure the company's performance and sees these results as an indicator of the company's ongoing business performance.

The company believes that these non-GAAP financial measures, increased transparency and better reflect the underlying financial performance of the business. Reconciliation of these measures to the most directly comparable GAAP financial measures are included within the earnings release and supplementary financial information on our website. Investors should consider all of our statements today together with our reports filed with the SEC including our most recent Form 10-K and 10-Q in order to make informed investment decisions.

In addition to the earnings release issued today, we have posted a quarterly presentation within the Investor Relations section of our website to supplement the content we will be covering this afternoon.

Now I'll pass the call to Joe Kiani.

[Joe Kiani, Chairman & Chief Executive Officer]

Thank you. Thank you, Eli. Good afternoon and thank you for joining us for Massimo's second quarter 2019 earnings call. Once again, we're happy to report second quarter results that exceeded expectations.

The growth we achieved in the second quarter illustrates the increasing adoption of our breakthrough technologies based upon their value for improving patient care and reducing the cost of care in multiple health care settings.

Our product revenue increased approximately 15% on a constant currency basis to reach $229.5 million. This reflects our ability to attain over 99% of our existing customers, while also gaining a steady stream of new customers by virtue of the clinical benefit that result in using our breakthrough technologies.

Due to the superior growth we saw in the second quarter and our expectation that the momentum of our business will continue, we are once again raising our revenue and earnings guidance for 2019. I'll discuss more developments later in the call today.

Now I'll ask Micah to review our second quarter results in more detail and provide you with an update on our 2019 financial guidance.

[Micah Young]

Thank you, Joe, and good afternoon, everyone. Before we get started let me remind you that the financial measures I will be covering today will be primarily on a non-GAAP basis unless noted otherwise. Please refer to today's earnings release, supplemental financial information and the quarterly investor presentation on www.masimo.com as well as the 8-K we filed with the SEC for further information regarding our non-GAAP financial measures and reconciliations.

As Joe mentioned, we are very happy with the strong momentum that we are seeing in our business. Our results for the second quarter reflect another strong quarter of product revenue growth, operating margin expansion and earnings performance that exceeded expectations.

During the quarter, we shipped 60,400 technology boards and monitors, which reflects growth of approximately 3% over the prior year quarter and a year-to-date growth of approximately 11%. For the second quarter of 2019, our product revenues were $229.5 million reflecting growth of 13.6% or 14.8% growth on a constant currency basis.

Please note that our product revenues for the quarter included approximately $1.9 million of accelerated monitoring equipment revenue recognized under the new accounting standard ASC 842, which contributed roughly 1% to our growth rate this quarter.

Our revenue performance this quarter was driven by strong growth across all of our major product platforms, which are performing better than the growth rates that we originally laid out in our long-term plan. We continue to grow our presence in key global markets and we are seeing particular strong growth within our U.S. business.

Moving on to the rest of the P&L. For the second quarter, our non-GAAP product gross margin increased 140 basis points to 67.2% compared to 65.8% in the prior year period. This improvement was primarily driven by favorable customer and product mix, increased manufacturing efficiencies and the additional cost reduction activities we've implemented to improve our margins.

Non-GAAP selling, general and administrative expenses decreased 120 basis points to 33.6% of product revenue compared to 34.8% in the prior year period. Non-GAAP research and development expenses increased 60 basis points to 10.5% of product revenue compared to 9.9% in the prior year period. The higher R&D spend was primarily due to increased staffing levels and project related costs reflecting our commitment to investing in innovative technologies that improve patient outcomes while reducing the cost of care.

For the second quarter, our non-GAAP operating profit increased 200 basis points to reach 23.1% compared to 21.1% in the prior year period. We are very excited about the operating leverage that we are seeing in the business.

Our global organization is demonstrating the operational discipline required to deliver increased productivity across the company, which enables us to reinvest in further innovation that fuels growth we are seeing -- that fuels the growth that we are seeing in the business.

Moving further down the P&L. Non-operating income on a non-GAAP basis was approximately $3.5 million for the quarter compared to $2 million in the prior year period. The increase was primarily driven by an increase in net interest income due to our stronger cash position and higher interest yields realized on our invested cash and short-term investments.

Turning to taxes. Our non-GAAP tax expense in the second quarter was $13.4 million, resulting in a non-GAAP effective tax rate of 23.8%, compared to a non-GAAP effective tax rate of 24.2% in the prior year period. Our weighted average shares outstanding for the quarter were 57.1 million compared to 55.7 million in the prior year period.

We repurchased 208,000 of the company's common shares during the quarter for approximately $28 million, mostly towards the end of the period so the benefit of the reduction in shares is not entirely visible in our results this quarter. The 2.4% increase in our weighted average share count over the prior year period is primarily due to the dilutive impact that a higher stock price has under the treasury stock method.

For the second quarter, our non-GAAP net income was $43.1 million or $0.76 per diluted share. In comparison, second quarter 2018 non-GAAP net income was $33.8 million or $0.61 per diluted share. This reflects non-GAAP EPS growth of approximately 25% over the prior year quarter.

Turning to our GAAP results. GAAP net income for the second quarter of 2019 was $44.9 million or $0.79 per diluted share in comparison to second quarter 2018 non-GAAP -- or GAAP net income was $43.9 million or $0.79 per diluted share.

In summary, we are extremely happy with our performance for the second quarter as our global organization delivered constant currency product revenue growth of 15%, non-GAAP operating margin expansion of 200 basis points and non-GAAP EPS growth of 25%.

Now I'd like to provide you with an update on our full year 2019 financial guidance. As a result of our strong performance in the second quarter, we are increasing our 2019 product revenue guidance to $925 million, which reflects year-over-year growth of 11.5% on a reported basis or 12.2% on a constant currency basis. This represents an increase of $7 million above our prior guidance of $918 million.

Please note that our product revenue guidance includes approximately $4 million of accelerated monitoring equipment revenue recognized under ASC 842 in the first half of the year.

Our non-GAAP product gross margin guidance remains unchanged at 66.8% and our non-GAAP operating expense guidance remains unchanged at 42.8% of product revenue. Based on these assumptions, we are continuing to project non-GAAP operating profit margins of 24%, which represents 200 basis points of improvement over the prior year

Moving further down the P&L. We expect to generate approximately $13 million in non-GAAP non-operating income in 2019, which is primarily comprised of interest income. Our non-GAAP tax rate remains unchanged at roughly 23%. And we are estimating that our weighted average shares outstanding for the year will be 57.2 million, which reflects no additional share repurchases for the rest of the year.

Based on all these assumptions, we are now increasing our non-GAAP EPS guidance to $3.15, which represents an increase of $0.03 above our prior guidance of $3.12. As a result our non-GAAP EPS is projected to grow approximately 19% in 2019 and from a GAAP perspective we are now projecting a GAAP tax rate of 19.5% and GAAP earnings per share of $30.30 for the full year, which represents an increase of $0.05 from our prior guidance of $3.25.

For additional details on our full year 2019 financial guidance for GAAP and non-GAAP earnings per share, please refer to today's earnings release and supplemental financial information within the Investor Relations section of our website at masimo.com.

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

[Joe Kiani, Chairman & Chief Executive Officer]

Thank you, Micah. We had another productive quarter, gaining key customers and introducing innovative clinically impactful products. We are seeing increased adoption of our breakthrough technologies, because not only do they improve patient outcomes but they reduce the cost of care.

In keeping with our commitment to launch at least one new product per month this year in honor of 2019 being our 30th anniversary of our founding, in April, we announced the launch of Halo ION. Our proprietary Halo ION index produces a single continuous early warning score based upon aggregate trend data from as few as three physiological parameters: oxygen saturation, pulse rate and profusion index or as much data as available including data from electronic medical records.

Each patient's Halo ION score is displayed on a Masimo Patient's SafetyNet supplemental remote monitoring and clinical notification system as a number ranging from 0 to 100, helping to streamline clinicians' workflow for patient assessment. The Halo ION is part of our hospital automation suite, comprised of multiple hardware and software modules, intended to streamline the storage and presentation of clinical information captured from all types of bedside monitors and devices connected to the patient.

We're feeling quite encouraged about the near-term and long-term potential for our hospital automation initiative after securing a sizable multi-million dollar multi-year contract with a large California hospital network, which will cover over three facilities with a total of nearly 800 inpatient and outpatient beds. This new contract will include our Root patient monitoring and communication hub, Patient SafetyNet, Iris and Vital Signs capture software products.

In addition, this customer is planning to deploy hundreds of our Rad-97 monitors across all of its clinics. And what's more, we have a strong pipeline of customers all over the world eager to deploy our hospital automation technology in their hospitals.

In the area of new products was the FDA clearance in May of our new tetherless SET oximetry sensor, the Radius PPG. The Radius PPG is a SET-based pulse oximetry sensor system comprised of a wireless wearable transceiver that can be attached to any SET or rainbow SET sockets to approximately two million Masimo or OEM brand patient monitors.

The Radius PPG sensor is a very lightweight sensor, while still having a four-day battery life. We're seeing strong interest from hospitals in the Radius PPG in numerous settings from the neonatal ICU to the general ward.

Also, important the Radius PPG will serve as the core sensor device for our whole opioid SafetyNet system, which we hope to launch later this year once we get FDA clearance. The FDA is working closely with us on the timely launch of this product after designating it as a breakthrough product and being selected by the FDA as one of eight products out of over 250 products to potentially help deal with our opioid epidemic.

Another important recent FDA clearance occurred in June with the receipt of the neonatal indication for use with our O3 cerebral oximetry monitor. We're now able to provide our superior technology for cerebral oximetry into the neonatal ICU, where the most vulnerable patients can benefit from O3's unprecedented absolute and trend accuracy of the brain oxygen saturation. There are many clinical scenarios where the brain oxygen saturation does not follow core oxygen saturation, that if missed could lead to permanent brain damage.

Turning to customer activity. One notable customer for us in the second quarter was with the New York Fire Department, which had broadly extended its adoption of our Rad-57 SpCO noninvasive carboxyhemoglobin monitor as well as implementing field use of our EMMA capnography end-tidal carbon dioxide monitor for assessment of lung function as part of a multi- million dollar contract.

A new noteworthy customer gained in the quarter was General Leonard Wood Army Community Hospital, which will begin using our rainbow measurements on a broad basis. This hospital is based in Missouri and as an example of our expanding business with the various branches of U.S. military both directly and through our longtime OEM partner ZOLL.

We also realized important contract renewals in the quarter with many luminary hospital including Children's Healthcare of Atlanta, Loma Linda University Medical Center and Yale Health System. In the international arena, we won significant new contracts in the UAE for our rainbow products as well as a full house win with Ljubljana university hospital in Slovenia for a multi-year multi-million dollar contract.

We also won a significant tender from the Astor health care system in Tuscany for a multi-year period. One notable renewal for us in the second quarter was Charité Berlin Hospital. We believe our global potential is quite high and we are being successful in realizing those opportunities for new business each quarter as we continue to expand our global footprint.

As you have hopefully heard, during our mid-May Investor Day conference here in Irvine, we see great potential ahead to continue to expand our product portfolio and to fulfill our mission to improve patient outcomes and reduce the cost of care by solving what some consider unsolvable problems. We have a culture of innovation that has real impact the kind that empowers clinicians around the world to better care for their patients and afford to provide more care due to the large cost reduction our technologies provide.

We estimate that a U.S. hospital with 250 beds can save over $3 million a year by using our technologies. This is why despite challenges we continue to be optimistic about our future and the future of health care around the world.

With that, we'll open the call to questions. Operator?

[Operator]

[Operator Instructions]

[Joe Kiani, Chairman & Chief Executive Officer]

Okay. Should we take our first question please?

[Operator]

Our first question comes from the line of Matt Taylor from UBS. Your line is open.

[Matt Taylor, UBS]

Nice result. I was hoping that you might be able to give us a little bit more color on your outlook for SET and some of the other new products in the updated guidance. Can you talk about how some of those things are doing differentially? It sounds like you have pretty good momentum across the board?

[Joe Kiani, Chairman & Chief Executive Officer]

Matt, I'm sorry I missed the beginning of your question but I think your question is how our new products are fitting in with our guidance. Is that correct?

[Matt Taylor, UBS]

Yeah. Generally, I was just hoping you might be able to talk about SET and then the new product separately and help us understand how some of those rainbow products are being adopted.

[Joe Kiani, Chairman & Chief Executive Officer]

Micah, do you want to take that?

[Micah Young]

Yeah. I'll go ahead and take that. Yeah. So, Matt if you go back to when we met at Investor Day back in May, we showed where our newer – some of the newer products are growing our SET our rainbow and those advanced perimeters. And at that time, we showed that all those were running at a faster growth rate than our original growth rates in our plans. We're seeing that as well even stronger results in Q2, because we haven't had a step-up in our growth rates in the second quarter. So we're seeing very strong growth rates from SET that's outperforming the original playing growth of that 6% to 8% we had in the plans.

Rainbow, we originally contemplated a 10% growth rate there and it's growing at a multiple of that growth rate. And then those advanced parameters, which are NomoLine capnography SedLine and O3. All those when you look at those in aggregate are growing faster than that 20% growth rate that we originally laid out in the plan. We don't want to get into the – all the details of by product line but I want to kind of give you a high view of where we're performing against the plan.

If you look at our guidance, we're still contemplating very strong growth in the back half that's ahead of those growth rates as well. But you will also have to look at the year-over-year comps in our guidance because last year if you recall the first half of the year, we grew 10.5% on a constant currency basis; the back half we grew 13.2% on a constant currency basis. So we've got very tough comps we're coming up against in the back half.

If you normalize for those tough comps our two-year average growth rates in the first half of the year when you exclude ASC 842 is about 12% growth per year on average over the last two years and the back half implies 12% average growth over the last two years as well. So I think what it shows is we have a high degree of confidence in the momentum we're seeing in this business and our guidance reflects that confidence.

[Matt Taylor, UBS]

Okay. Thanks, Micah, that's very helpful. I was wondering, if maybe second question you could comment on how the Philips agreement is going? And if we're starting to see some of those sensors come through? And any color on how much adoption in that new customer base you're seeing of some of the rainbow and advanced parameters?

[Joe Kiani, Chairman & Chief Executive Officer]

Certainly. Philips relationship is going well. We expect in the second half of the year for two of our three advanced parameters to be introduced within Philips monitors. In addition, I think both from the marketing perspective and from sales force understanding the advantages of our technology that comes from our agreement. We expect to see continued momentum, especially as we enter 2020. As far as new products, there was a time, we were growing I think you know around $40 million to $60 million a year from our SET oximetry growth.

That continues to do that. So the fact that you're seeing us grow more than that now growing to about $200 million a year reflects the contribution of the new products that we have brought forward. And with -- hopefully the FDA clearance of Radius PPG now and upcoming clearance of hopefully opioid SafetyNet we expect that to continue the momentum.

As far as Rainbow is concerned, the rainbow is doing very well. Rainbow' SedLine and NomoLine O3 without getting too much into it they all grew more than 25%. And we're seeing great adoption of hemoglobin. The demand is growing. We're hearing from our OEM partners that more and more they're hearing customers wanting them to provide Rainbow and particularly hemoglobin.

So we're one of those, I guess rare moments where we're feeling very good about short-term as well as a midterm and long-term. It doesn't mean, we don't have our challenges, but I believe what we're seeing is the clinical benefit of our technology is trumping many of the challenges that are out there facing us.

[Matt Taylor, UBS]

Thank you. Thanks Joe.

[Joe Kiani, Chairman & Chief Executive Officer]

Thank you.

[Operator]

Our next question is from the line of Rick Wise from Stifel. Your line is open.

[Drew Ranieri, Stifel]

Hi, Joe and Micah. It's Drew Ranieri on for Rick tonight. Thanks for taking the question. Joe, just to start. On the call, you highlighted multiple new product introductions: Radius PPG, Halo ION just to name a few.

How should we think about these new products impacting growth? Are they more growth-sustaining or growth-enhancing? I’d imagine, it will have a clear positive longer-term impact, but should we see maybe more visible lift from these new products in 2019?

[Joe Kiani, Chairman & Chief Executive Officer]

You're asking to the wrong guy. I'm an optimist entrepreneur. So I'm going to say, obviously Rainbow as well as these new products are momentum enhancing. But we are in an industry where things go slower than you hope. So these should at least help us keep up our momentum.

What I can tell you is when we are out showing the new products, we're getting a lot of interest from high-resource countries to mid-resource countries to famous hospitals to community hospitals. So I think we've hit a chord with these new products and that's why we're kind of seeing the kind of growth we're seeing and that we feel good about continuing the growth that we've been talking about to even their higher level.

[Drew Ranieri, Stifel]

Got it. And then just to touch on shipment at 60,000-plus for the quarter. It was just a little softer than we anticipated. I know shipment growth clearly isn't linear, but you've been growing shipments kind of in that double-digit range for the past eight quarters; and now 3% growth.

I mean was there any particular dynamics in the quarter that played out that maybe we didn't fully appreciate? And then just given all the renewals and new customers that you discussed on the call should we expect shipments to kind of march up higher over the remainder of 2019?

[Joe Kiani, Chairman & Chief Executive Officer]

Well first of all, I think on the last call I was happy to let you know that we anticipate doing 60000-plus of shipments quarterly for the next three quarters. So this is coming in line to what we expected which if you think about our prior year's fully invoiced shipment, it's quite additive to our installed base.

As far as could it have been better? Yes. Unfortunately, we did suffer from some of the Trump -- things he's doing out there. One of our OEMs was hit pretty hard by his work.

So -- but overall, we expected that and it was in there. We do anticipate next year to have even better year than -- better quarters than this year because we do expect Philips to do more, we do expect some of the new OEMs that we brought on board will do more and as well as some of the new parameters that are getting out there.

[Drew Ranieri, Stifel]

Got it. And then just one last one maybe for Micah. Just in regards to your sales force structure. Clearly hospital automation is becoming a greater theme at Masimo and it sounds like your business model might need to shift from driver and sensor to offering this broader solution.

So just how does your sales force have to evolve over time to drive the hospital automation opportunity? And with SG&A being a key operating margin expansion lever, how is that factored into your LRP, if there is an evolution that's needed?

[Micah Young]

Yes. Drew thanks for the question. As we think about that we're continuing to see great opportunity through hospital automation to leverage our global commercial footprint. We're in the right settings within hospitals to be able to do that. And it's a very similar -- it's the same type of call point, but you are addressing a little bit more of the back-office sell of the hospital as well.

Now keeping that in mind we -- it's a great opportunity to continue to leverage in it. It fits very nicely into our long-range plans of trying to drive 100 points of improvement each and every year as we drive to 35% operating margins. And that's because not only can we leverage the footprint, but as we bring more and more pull-through of our service revenue and other products, it gives us the ability to go deeper into accounts and leverage the rep in those accounts.

[Drew Ranieri, Stifel]

Thank you for taking the question.

[Joe Kiani, Chairman & Chief Executive Officer]

Thank you.

[Operator]

Our next question comes from the line of Bill Quirk from Piper Jaffray. Your line is open.

[Bill Quirk, Piper Jaffray]

Great. Thanks. Good afternoon everybody.

[Joe Kiani, Chairman & Chief Executive Officer]

Hi Bill.

[Bill Quirk, Piper Jaffray]

Hi Joe. So, I guess first question is I think probably for Micah. Almost $600 million in cash in the balance sheet. No debts. How are you thinking about capital allocation? You obviously bought some stock back here this quarter. But per the guidance obviously not signaling a continuation of that. Just help us think about where your priorities are.

[Micah Young]

Yes. So, Bill, we -- of course, we put in plans in terms of corporate plans to go back into the market and repurchase shares. That's more of a structure that we put in place. So, we continue to have one outstanding. I'm not saying -- I'm not trying to signal anything with our guidance that we're not repurchasing shares. What I'm trying to say is our guidance does not include if we do repurchase any additional shares this year. So, if we do there would be additional upside in that reduced share count if we do that so.

[Bill Quirk, Piper Jaffray]

Okay understood. And then perhaps Joe just thinking about heading into the Opioid SafetyNet approval and launch, any updated thoughts in terms of market opportunity or kind of the initial segments of the market that you're going to chase upon release?

[Joe Kiani, Chairman & Chief Executive Officer]

Well, I think we're probably going to focus on people that are prescribed opioids first although, we may simultaneously make the product available for those uses as well. We obviously believe both parties will benefit but reaching customers for that product might be easier for those who are prescribed opioids.

And I think we shared this data with you guys before. Of the roughly 90,000 people that died about two years ago from opioid overdose, about 20,000 was due to prescription opioids. And when you look at the number of opioids that are prescribed annually, they're in the neighborhood of 90 million opioid prescriptions a year. So, it's a pretty large problem and large opportunity for us to help out.

[Bill Quirk, Piper Jaffray]

Okay, got it. And then just last one for me. Obviously, great to hear that your kind of products across the portfolio continue to exceed the growth rates. Help us think a little bit about maybe the sustainability. And I'm thinking more so specifically around SET, Joe or Micah, just trying to figure out if there's any particular factors that are I don't know one-off or if you think that this kind of outperformance above that 6% to 8% guidance can continue here over the balance of the year and beyond?

[Joe Kiani, Chairman & Chief Executive Officer]

Well, I think it's really driven by a few factors. One is continued adoption of our technology. So, as we're shipping 60,000-plus drivers a quarter that's adding to the installed base, that's growing the installed base.

Secondly, it has to do with census. We believe census has been moderate to high in Q2. And even though as you remember in Q4 and Q1, the flu season wasn't that strong. So, Q2 unrelated to flu I believe there has been a strong census.

But also the number of hospitals we convert around the world continues to keep up with our historical momentum which we're seeing I think in our numbers is a lot of those contracts that we won in the past six months being implemented in hospitals going live with our technology.

And, of course, last but not least, we're doing a very good job despite some of the challenges to retain our existing customers and would probably -- what might be not normal better than 99% renewal rate of our existing customers. And while I credit my team for doing a great job in the field, but a lot of that is due to the technology delivering on its promise of improving patient care and reducing cost of care.

[Bill Quirk, Piper Jaffray]

Okay, got it. Thanks guys. Nice quarter.

[Joe Kiani, Chairman & Chief Executive Officer]

Thank you.

[Micah Young]

Thanks Bill.

[Operator]

Our next question comes from the line of Mike Matson from Needham & Company. Your line is open.

[Mike Matson, Needham & Company]

Hi. Thanks for taking my questions. I guess I just wanted to start with the Radius PPG product. Just curious how that's being received and to what degree that contributed to growth in the second quarter?

[Joe Kiani, Chairman & Chief Executive Officer]

First of all, the reaction to the product has been very positive. As far as its contribution to Q2 it's been zero. We've been ramping up our production. We're planning to do a full market to release in the next couple of weeks. So we expect the Radius PPG to start helping us in this quarter and the future.

[Mike Matson, Needham & Company]

Okay. Thanks. And then on Opioid SafetyNet, I think, you've said at the Analyst Day that you're planning to go kind of out of pocket at least initially. But do you have plans in place to pursue reimbursement for that product? And would you sort of go about that? What do you think the timing would be?

[Joe Kiani, Chairman & Chief Executive Officer]

That's correct. Well both things that you've said are true. And we're working on reimbursement strategies. Some of the new clarifications by CMS that came out a couple of days ago are promising and we're going to comment on them. And if they become final they might help our Opioid SafetyNet strategy reimbursement plans a lot and ahead of I guess our own thought process.

[Mike Matson, Needham & Company]

Okay. And then finally just a question from Micah. So with this so if I heard you correctly this ASC 842 added about one point to your growth this quarter for product growth I guess. So how does -- what happens next year when you start to lap this? Will it still be like a point that's kind of like in the base, or will that go be like a drag next year or?

[Micah Young]

Yes, Mike. So yes year-to-date we're -- it's contributing about one percentage point both in the second quarter and the first quarter. This new standard we're trying to see how this plays out. We've got -- we are estimating that it's going to be relatively neutral -- it'll be neutral to our revenue in the back half of the year. We're basically implying in our guidance its $4 million for the full year.

We're -- that's why we want to give you the numbers each quarter so you have an idea of how it's contributing and be transparent there. So we think that that will -- it's based on the timing of when we do installations so it can -- there can be timing-related issues with ASC 842, but year-over-year we think it will be relatively similar contribution year-over-year. So it's not -- we don't expect any large growth. But think about it right now it's about 0.5 point on our full year guidance so that's how we would think about it next year.

[Mike Matson, Needham & Company]

Okay. Great. That’s all I have. Thank you.

[Micah Young]

Thank you.

[Operator]

Our next question comes from the line of Ravi Misra from Berenberg Capital. Your line is open.

[Ravi Misra, Berenberg Capital]

Hi. Good afternoon, everyone. Thank you for taking the questions. So I have two; one on rainbow and just one on the gross margin reiterated guidance. So on rainbow Micah and Joe, it sounds like it's going a little bit better at least versus your long-term planned thoughts on growth that was laid out. I was hoping you could help us understand is that coming via kind of incremental activations of the existing base or via new customers picking it up or geographic mix, or just help us think about why rainbow performance has been so strong? And then I'll save my follow-up after the response. Thank you.

[Micah Young]

Yes. So we're definitely seeing from both. If you look at it it's -- we're seeing growing needs and especially if you think about outside the U.S. we're growing -- we're seeing growing infrastructures. There's also -- Joe talked about earlier where we're seeing some larger customers coming on board with it. We saw that with the military orders as well. So we're seeing more broad adoption than we've seen in the past and that's really what's helping drive and contribute to that faster growth rate and that 10% we had in our original plan.

[Ravi Misra, Berenberg Capital]

Great. Thanks and one on the – gross margin -- you put up the sales number in the organic growth yet gross margin kind of stays stable at 66.8%. Just help us think about why there wouldn't be more pull-through if you're doing better with rainbow and it sounds like some of this headline in O3 products as well.

[Micah Young]

With pull-through -- yes. So we're definitely seeing improvements. If you look year-over-year -- and keep in mind the seasonality of this business. So the year-over-year improvements we've made is about 140 basis points of margin expansion. So -- and if you look on the full year we believe it's -- that improvement's going to be roughly 80 basis points. We had a little bit of a headwind in Q1 due to ASC 842, and the lower margins there. But we're tracking very nicely in helping -- offset some of the lower margin coming through on that new accounting standard.

So, we're performing ahead of our internal expectation or in line with our internal expectations as well if not ahead and tracking very well to where we want to be on our long-term plan. So, we do think as we -- we want to see it play out a little bit more with the hospital automation and different things before we would ever get ahead of ourselves on raising any expectations there.

[Ravi Misra, Berenberg Capital]

Great. Thanks, guys.

[Joe Kiani, Chairman & Chief Executive Officer]

Thank you. One more question.

[Operator]

Our next question comes from the line of Larry Keusch from Raymond James. Your line is open.

[Larry Keusch, Raymond James]

Thanks. Good afternoon. So Joe, just on the opioid safety product, could you just give us an update on the expectations for the filing of the 510(k). I know that you said that you do expect to have this thing cleared by the end of the year.

And then along those lines, could you again help us think about or how we should be thinking about whether this is -- can be ultimately prescription product or an over-the-counter product. And then I had one more.

[Joe Kiani, Chairman & Chief Executive Officer]

Well, we intend to file the 510(k) or the -- I don't know what it's called exactly -- application in the next couple of months. I think what I can tell you with our discussions with the FDA, which have been very good, very positive. They see benefit to not just prescription users, but a list of users as well. So, we've been working with them on how to make sure the product has the proper user interface and can be used by just about anybody without much instruction.

We've been collecting a lot of data that FDA likes to see on that as well as those who are chronic users and those who are new users of opioids. So, things are progressing really well. And given this collaboration with the FDA, that's unique for us in terms of working closely together on something like this, we expect once we submit it that it'll be really close to what the FDA is looking for. And therefore we should get clearance by the end of the year, and hopefully if we don't start to revenue by the end of the year it will begin by 2020.

[Larry Keusch, Raymond James]

Okay. Very good. And so it sounds like at this point we should be thinking one way or the other whether it's over-the-counter or prescription. And then just the second question is relative to the hospital automation that you talked about in the California hospital with this multi-year multimillion dollar contract. I know that one aspect of that whole platform is to create a subscription-based revenue stream. And just was wondering is this contract starting out that way or is that an evolution?

[Joe Kiani, Chairman & Chief Executive Officer]

It is. It is starting that way. We do see technology-as-a-service model software-as-a-service model as a way to go with and so do the customers. So yes, that does have that in it. And as I said earlier, this is hopefully just the beginning of many. We do have very strong interest for the product. I think we're just trying to scale up, so we can meet the demand without it distracting the entire organization on just one more product.

[Larry Keusch, Raymond James]

Okay. And I'm sorry just the over-the-counter versus prescription. Just should we be thinking one way or the other on that?

[Joe Kiani, Chairman & Chief Executive Officer]

I think both. I think it should be both without us prompting it. I don't want to speak out of scope, but I think even the FDA thinks it should be both. So, assuming the product can pass some of that over-the-counter hurdles in terms of usability and not requiring clinical or clinician instruction and intervention, it should be both. And I think even if it doesn't start from the beginning both, I think it will get there.

[Larry Keusch, Raymond James]

Okay. Very good. Thank you.

[Joe Kiani, Chairman & Chief Executive Officer]

Thank you much.

[Joe Kiani, Chairman & Chief Executive Officer]

Thank you all for joining us for our second quarter earnings call. We look forward to our next earnings call. Enjoy the rest of your summer. Thank you.

[Micah Young]

Thank you.

[Operator]

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.