Masimo Corp

NASDAQ:MASI

Earnings Call Transcript 2018-Q3

[Operator]

Good afternoon, ladies and gentlemen, and welcome to Masimo's Third Quarter 2018 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, Masimo's Vice President of Business Development and Investor Relations.

[Eli Kammerman, Masimo Corp.]

Thank you. 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 2018 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'll 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 operations in the same way management assesses operations.

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 increase 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 with the earnings release and supplementary financial information on our website. Investors should consider all of our statements today, together with our 10-Q for the third quarter to be filed with the SEC 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 now.

I'll pass the call to Joe Kiani.

[Joseph Kiani, Masimo Corp.]

Thank you, Eli. Good afternoon, and thank you for joining us for Masimo's third quarter 2018 earnings call. We, once again, achieved double-digit growth for product revenues, which reached $210 million, a 12.4% increase compared to the same quarter a year ago. Also for the third quarter, our worldwide shipments of non-invasive technology boards and monitors, excluding handheld and finger oximeters rose to a record 59,100 units, which reflects an increase of approximately 16% over the prior-year quarter. The growth is attributable to strong customer demand in both our direct and our OEM business. I'll discuss more in the call today.

Now, I'll ask Micah to review our Q3 results in more detail and provide you with an update to our 2018 financial guidance. Micah?

[Micah Young, Masimo Corp.]

Thank you, Joe, and good afternoon, everyone. Before we get started, let me remind you that many of the financial measures covered in today's call are on a non-GAAP basis, unless noted otherwise. Please refer to today's earnings release, supplemental financial information, and the quarterly investor presentation on masimo.com for further information regarding our non-GAAP reconciliations.

As Joe mentioned, we saw a meaningful increase in our business this quarter due to the rising adoption of our innovative technologies and systems, which enable our customers to improve patient care and automate patient management across the continuum of care. Our results for the third quarter reflect another quarter of double-digit top line growth, continued operating margin expansion, and 27% growth in our non-GAAP earnings per share. We also shipped a record 59,100 non-invasive technology boards and monitors during the quarter, which reflects growth of approximately 16% over the prior-year quarter, that's exceptional year-over-year growth in the quarter. Our driver growth continues to accelerate and on a year-to-date basis, our growth is a very strong 15%. This growth reflects rising demand for our technologies through both our direct and OEM-based sales efforts.

For the third quarter of 2018, we reported total revenue including royalty and other revenue of $210.6 million, reflecting growth of 8.9% over the prior-year quarter. Our product revenues were $202.1 million for the quarter, which reflects growth of 12.4%, or 12.8% on a constant currency basis. We are continuing to see strong growth from our rainbow platform. Royalty and other revenue was $8.5 million for the quarter, compared to $13.7 million for the third quarter of 2017. The current quarter results included $8.1 million in royalties, compared to $8.4 million in the prior-year quarter. In addition, the current quarter included approximately $400,000 of NRE revenue, compared to $5.3 million in NRE revenues in the prior-year quarter.

The year-over-year reduction in NRE revenue is primarily due to the significant amount of work that we finished last year to integrate our rainbow technology into the Philips monitors. Our partnership activities with Philips include continuing efforts to integrate our newer technologies, including NomoLine Capnography, SedLine Brain Function Monitoring, and O3 Regional Oximetry into the Philips monitoring platform.

Now let's turn to the rest of the P&L. Our third quarter non-GAAP gross margin, including royalty and NRE revenue, was 66.9% versus 64.2% in the prior-year period. Our product gross margin for the third quarter increased 360 basis points to 65.6%. Once again, the improvement was driven by increased manufacturing efficiencies, mix benefits from customers upgrading to our newer sensor line, as well as additional cost reduction activities we've implemented to improve gross margins.

Non-GAAP selling, general, and administrative expenses as a percentage of total revenue rose by 40 basis points to 34.2%, compared to 33.8% in the same quarter last year. The higher SG&A spend was primarily due to an increase in share-based compensation, which was primarily driven by the substantial rise in our share price.

Non-GAAP research and development expenses increased 130 basis points to 9.2% of total revenue, compared to 7.9% in the same quarter last year. The higher R&D spend was primarily due to increased staffing levels and higher project related costs as we continue to invest in delivering innovative technologies to the marketplace.

Our efforts to drive profitability improvements are bearing fruit with non-GAAP operating profit margin increasing 100 basis points to 23.5% in the third quarter, compared to 22.5% in the same quarter last year. The 100 basis point improvement was especially meaningful, considering that we increased our R&D investment by 130 basis points, as we continue to invest in opportunities to drive future growth.

Most importantly, we are making this progress on the profitability front, while at the same time accelerating the growth profile of the overall business.

Moving further down the P&L, non-operating income on a non-GAAP basis was approximately $2.3 million for the quarter, compared to $700,000 in the same period last year. The increase was primarily driven by an increase in net interest income due to having a much stronger cash position and the higher interest yields associated with the invested cash.

Turning to our tax expense. Our non-GAAP tax expense in the third quarter was $11.8 million, resulting in a non-GAAP effective tax rate of 22.7%, compared to a non-GAAP effective tax rate of 28.3% in the year-ago period. The lower tax rate, once again, reflected the recent changes in U.S. tax laws.

Our weighted average shares outstanding for the quarter was approximately 56.2 million, which was level with the prior-year period.

Third quarter 2018 non-GAAP net income was $40.1 million, or $0.71 per diluted share. In comparison, third quarter 2017 non-GAAP net income was $31.7 million, or $0.56 per diluted share.

With a strong revenue and profitability performance this quarter, our non-GAAP earnings per share increased 26.8% over the prior-year period.

Now turning to our GAAP results. GAAP net earnings for the third quarter of 2018 were $57.1 million or $1.02 per diluted share, which included a $0.26 tax benefit related to stock option exercises. In comparison, third quarter 2017 GAAP net earnings were $35.9 million, or $0.64 per diluted share, which included a $0.09 tax benefit related to stock option exercises.

Adjusted EBITDA margin, which excludes the impact of non-cash share-based compensation, was 29.4% for the third quarter of 2018. This represents a 200 basis point improvement compared to 27.4% in the same quarter last year and reflects significant operating leverage in the business.

Our days sales outstanding was 45 days in the third quarter, which was up slightly from 44 days at the end of the second quarter, but down significantly from 45 days at the end of last year. These strong results are primarily due to improved cash collections outside the U.S., where we typically have longer payment terms.

Our inventory days on hand was 120 days in the third quarter, which was up from 118 days at the end of the second quarter but down from 121 days at the end of last year.

As a result of our strong earnings performance and working capital improvements, we've generated approximately $164 million of free cash flow during the first nine months of 2018. That's an incredible result when you consider that we have converted 26% of our revenue into cash this year. Furthermore, our cash and short-term investments increased by $178 million to $493 million at the end of the third quarter, compared to $315 million at the end of last year.

Now I'd like to update you on our full-year 2018 financial guidance. For 2018, we are now projecting total revenue including royalty and other revenue to be approximately $854 million, up from prior guidance of $850 million. We are now increasing our product revenue guidance to $826 million, which reflects year-over-year growth of approximately 11.9% on a reported basis, or 11.3% on a constant currency basis. This represents an increase of $4 million above our prior guidance of $822 million.

Our guidance for royalty and other revenue remains unchanged, as we are still anticipating approximately $28 million for the year. Our expectation for total non-GAAP gross margins including royalty and other revenue remains unchanged at 66.8% for the year. Our non-GAAP product gross margin guidance remains unchanged at 65.8%. And our total non-GAAP operating expense guidance remains unchanged at 42.4% of total revenue.

Based on all these assumptions we are continuing to project total non-GAAP operating profit margins of approximately 24.4% of total revenue.

Moving further down the P&L, we expect to generate approximately $7 million in non-GAAP non-operating income in 2018 and our non-GAAP tax rate remains unchanged at approximately 24%. Also we are still estimating that our weighted average shares outstanding for the year will be approximately 56 million, which does not reflect any additional share repurchases for the remainder of this year.

Based on all of these assumptions, we are now increasing our non-GAAP EPS guidance to $2.92, which reflects year-over-year growth of approximately 27%. This represents an increase of $0.02 above our prior guidance of $2.90. And from a GAAP perspective, we are projecting a GAAP tax rate of approximately 11%, and GAAP earnings per share of $3.37 for the year, up $0.30 from our prior guidance of $3.07. For additional details on our full-year 2018 financial guidance for GAAP and non-GAAP earnings per share, please refer to today's earnings release within the Investor Relations section of our website at masimo.com.

With that, I will turn the call back to Joe.

[Joseph Kiani, Masimo Corp.]

Thank you, Micah. Our third quarter results, once again, showed the value of our innovative technologies and solutions. We're also driving growth from a broader portfolio of products today than at any point in our history. We're realizing steady progress in advancing our hospital automation solutions for our customers who desire to institute systems and processes to minimize cognitive overload for their clinicians and maximize team communication to improve patient safety. In Q3, we introduced a product that enables hospitals to automate data collection, Root with Vital Signs Check. This addition for the Root patient monitoring and connectivity platform consists of an integrated patient data collection and workflow application.

Vital Signs Check is implemented through a software upgrade and augments Root's versatility by helping to automate hospital vital signs testing workflows. During this quarter, our solution set further expanded as we received FDA clearance for the neonatal, an infant version of our RAS-45 acoustic respiration sensor for rainbow acoustic monitoring. With this clearance for use with newborns and neonates, RAS accuracy range has been expanded up to 120 breaths per minute while still providing an accuracy of plus or minus one breath per minute, facilitating accurate measurement of the higher respiratory rate in this population.

The sensor itself is significantly smaller than the adult and pediatric version on the sensor and has a diameter of approximately 2 centimeters, making it only slightly larger than a nickel. Similarly the sensors weighs very little at 13 grams so that its presence should be barely noticeable. The size and weight advantages make it particularly well-suited for the smaller stature and delicate skin of infants and neonates.

Sales growth for our SET pulse oximetry products continues to be above the market growth rate. As the advantages of our Measure-through Motion and Low Perfusion technology are complemented by the highly differentiated technology embedded in our rainbow products such as SpHb, PVi, and ORi. We're hopeful about receiving a timely FDA clearance for ORi, but can't be certain that it will happen imminently, although the product is now being successfully sold overseas.

In fact, two new positive clinical studies of the technology were published in this quarter. In one study, Dr. Koishi and colleagues at Iwate Medical University in Morioka, Japan sought to evaluate whether ORi could serve as an early warning of desaturation in patients undergoing one-lung ventilation as such patients are often prone to hypoxemia. They assessed whether ORi decreased earlier than SpO2 during one-lung ventilation and evaluated how well ORi correlated with an invasive PaO2 measurement. The research has found that from the start of one-lung ventilation, ORi decreased at a mean of 171-second versus a mean of 372-seconds for SpO2. They also found a significant strong correlation between ORi and PaO2.

These researches concluded that ORi decreased significantly earlier than SpO2 during one-lung ventilation suggesting that monitoring ORi might allow earlier detection of the deterioration of blood oxygenation then monitoring SpO2 alone contributing to a reduction in the patients' risk of exposure to complications from one-lung ventilation.

In the other study of ORi, a recent abstract presented at the 2018 Congress of the French Society of Anesthesia and Resuscitation in Paris by researchers at CHU Angers in France investigated the ability of ORi to help clinicians reduce the number of days ICU patients experience hyperoxemia, while on mechanical ventilation. These investigators found that the percentage of days with hyperoxemia was significantly lower in the ORi group with a median of 14% versus 29% in the control group. The research has concluded that the use of ORi may help clinicians reduce the percentage of days with hyperoxemia adding that additional studies may be useful in evaluating the impact of this monitoring on the morbidity and mortality of patients.

Lastly, I'm happy to state that we had another strong quarter in getting new customers and renewing our existing customers. In closing, as we entered the final period of 2018 we continue to be excited about the expanding potential of our innovative solutions to improve care and enable hospital automation. Our outlook for the remainder of the year is positive and we're looking forward to entering 2019 with even greater potential to deliver increasing shareholder value as we help caregivers improve their patient care practices and associated outcomes as well as reducing the cost of care.

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

[Operator]

Thank you. Our first question comes from Rick Wise of Stifel. Your line is now open.

[Rick Wise, Stifel, Nicolaus & Co., Inc.]

Hi. Good afternoon, everybody and truly congrats, yet again, on another excellent quarter. But let me show my ingratitude and instantly ask about guidance and maybe why it couldn't even be a bit better? You beat by $0.02, Micah, and basically fiscal year numbers went up by roughly the beat, given what seems like a great deal of visible year-to-date momentum – great momentum in the third quarter. Why wouldn't we think that the fourth quarter and full-year number could be even more robust?

[Micah Young, Masimo Corp.]

Yes so Rick, if you look at our guidance for the full year, it implies that now Q4 is about a growth rate on constant currency basis of about 11.3% in constant currency, so we are guiding to very strong growth in the fourth quarter for our product revenues.

And if you look at year-to-date our product revenues have grown 11.3% on a constant currency basis. So keep in mind that the first nine months of the year we had a 90 basis points – about a 100 basis points tailwind in currency and in the fourth quarter we're going to have about a 50 basis point headwind in currency. So we're being very thoughtful about the strengthening of U.S. dollar.

But if you look at our results we're forecasting product growth it's in line with that 11.3% that we saw year-to-date. So we're expecting that same growth rate and the goals we even do better than that, but we want to be thoughtful about how we guide for the full-year.

[Rick Wise, Stifel, Nicolaus & Co., Inc.]

No. For sure. And it's early to think about 2019, I appreciate this is not when you guide, but it does seem like you're on a higher growth trajectory than recent trends. Any reason why we would think that this type of growth wouldn't be sustained through next year?

[Joseph Kiani, Masimo Corp.]

Well, Rick, I certainly hope that it will be. I think we're just trying to manage our own excitement maybe a little bit yours, because we know that the historical growth had been lower or most recently has been higher. And we just want to see more of it before...

[Technical Difficulty] (24:17 – 24:45)

[Joseph Kiani, Masimo Corp.]

Did we lose the call? Is there anyone on the call?

[Micah Young, Masimo Corp.]

Hello.

[Rick Wise, Stifel, Nicolaus & Co., Inc.]

Sorry about that. Somehow we cut out for a second, not only whether it's us or something else. So I apologize. I didn't catch your answer on that, Joe.

[Joseph Kiani, Masimo Corp.]

Sure. Well, I will just make a long story short we just try not to get ahead of ourselves. We were seeing obviously recently much stronger growth than we had historically and we're just trying to see more of it before...

[Technical Difficulty] (25:17 – 25:43)

[Rick Wise, Stifel, Nicolaus & Co., Inc.]

I think we better go on. I apologize something's wrong with our line maybe. Thanks, Joe, we'll catch you later.

[Joseph Kiani, Masimo Corp.]

All right, Rick, thank you.

[Micah Young, Masimo Corp.]

Thank you, Rick.

[Technical Difficulty] (25:53 – 28:33)

[Operator]

And we are back in the conference you may resume.

[Joseph Kiani, Masimo Corp.]

Thank you. I hope you can all hear us better now. We're actually calling you from the mobile phone just in case the problem with our landline. But let's continue with the questions. Rick, I just want to make sure if you're still listening, we're just being – we're being cautiously optimistic, we guided 8% to 10% growth if you remember about two years ago, obviously we're seeing better than that.

And we just want to have more time to see if this is going to continue happening. And obviously as we get to bigger numbers it's going to be also harder to grow percentage wise bigger numbers. But trust us, we're certainly working hard to keep it going. And give us a few more quarters. If it keeps happening then we'll know we can project bigger numbers.

So let's go to the next question, please.

[Operator]

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

[Mike Matson, Needham & Co. LLC]

Hi. Thanks for taking my questions. I guess I'm somewhat new to Masimo. And so I apologize if this question has been asked in the past. But just given all the headlines, I was wondering if you could talk about whether or not you have any sort of tariff exposure at all from the tariffs in China?

[Joseph Kiani, Masimo Corp.]

Hi, Mike. Thanks for joining. The good news is it's almost zero and maybe at most $6,000 I think we saw for the whole quarter. So we don't have much exposure. We planned years ago to minimize what we manufactured in China, how we relied on China for other reasons, and looks like that has paid off now.

[Mike Matson, Needham & Co. LLC]

Okay. Thanks. And then I know that there's been various things proposed to kind of offset this royalty cliff next year. And I know you're not going to tell us exactly what you're planning, if anything. But I know one of the things you talked about is M&A.

And so I was just wondering if you could maybe give us an update on kind of your thinking about M&A and criteria for M&A in terms of what you're looking for? What kind of financial thresholds you would need to see to do something?

[Joseph Kiani, Masimo Corp.]

Sure. Well, first I want to congratulate our shareholders and analysts who've suffered through this quarterly issue of royalties after 12.5 years of receiving royalties from Medtronic and before that Covidien. It ended October 6. So we no longer have a royalty discussion. We will have some NRE number, small in the future, but not much.

So as you all know, we've been planning for many years for this day to come. And we do have a lot of different opportunities to try to mitigate that number of loss.

But I just want to remind everyone that as our analyst and ourselves should be – did, we were not given credit on a P/E multiple to the royalties. It was just added as a discounted cash flow that we were getting from the number.

So the good news is we do have a few levers that we had created for many years that we're going to be able to optimize to minimize the hit. Acquisition is one of them. We have now about $500 million in the bank. And we're creating incredible positive cash flow.

So there's about a dozen companies in our radar that we're looking at. And as we do our due diligence, one or few of them may pan out.

We also have the good fortune of interest rising, just as we have more cash in the bank. So we're looking at that, plus maybe stock buyback, and trying to optimize what we do between cash investment yields and stock buyback.

But trust me, we are very aligned with shareholders' interests. And we're going to do whatever is best for our shareholders.

[Mike Matson, Needham & Co. LLC]

Okay. I understand. I guess just more specifically though with regard to acquisitions, can you just talk a little bit about kind of what you would be looking for in a prospective deal? And if you have any kind of financial hurdles or anything like that?

[Joseph Kiani, Masimo Corp.]

Well, yes, of course. I think as we had articulated before, we're looking for two types of potential acquisitions. One type is one that we've always done, which is tuck-in. That helps reinforce our current solution for the markets we're addressing. That's something we're always looking at.

But we're looking also opportunistically at acquisitions that might help diversify Masimo. But given that these will be different from synergistic acquisition, we're looking for opportunities that are – markets that are billion-dollar plus, growing double-digits that we think we have strengths that we could bring forward to the acquired company to make them become a stronger player in the marketplace.

So that's roughly what we're looking at. I know it's not being very helpful to you, but at least you get the process. And maybe the last piece of it, products that are more closer to either the consumer or the person making decisions about what gets purchased in hospitals.

[Mike Matson, Needham & Co. LLC]

Okay. That's actually quite helpful. And then final question just on the gross margin, so we're seeing really good gross margin improvement. And a part of that is product mix, particularly with regard to the RD sensor. So can you talk about how much of the customers have converted over to RD? I don't know if you disclose that. And how much runway do we have there? And...

[Micah Young, Masimo Corp.]

Yeah.

[Mike Matson, Needham & Co. LLC]

...can we continue to see gross margins improving at hundreds of basis points a year?

[Micah Young, Masimo Corp.]

Yeah, Mike. This is Micah. Just want to address that question. So if you look at the conversion of the new customers, we're still – what we've really said out there is that we're in the first inning of nine, so call it low – call it 10% to 15% converted today. So there's a lot of runway yet.

It's a higher quality sensor with much lower cost. So we look at this as something that's going to help benefit our gross margins for the next five years to seven years as we continue to renew – new contracts, we put them on the new sensor line, or we renew contracts and try to convert customers to the sensor line.

So this is something that gives us a tailwind over the next five years to seven years. We've also got some – we're driving better manufacturing efficiencies in our plan as we continue to vertically integrate down in our plant in Mexico. And then also we're driving some new cost reduction activities that should benefit us in the future as well, but the sensors were still in the very early innings.

[Mike Matson, Needham & Co. LLC]

Okay.

[Joseph Kiani, Masimo Corp.]

And Mike, I also want to add. Obviously, you saw the press release we did recently. Because it was in Q4 we didn't talk about it in our statements, but we recently got FDA clearance for an accuracy that was twice better than our previous accuracy. So RD now, has an accuracy specification of oxygen saturation of 1.5% during motion.

[Mike Matson, Needham & Co. LLC]

Okay. Great. Thank you.

[Joseph Kiani, Masimo Corp.]

Thank you.

[Operator]

Thank you.

[Joseph Kiani, Masimo Corp.]

Thank you so much. Next question? Yeah.

[Operator]

Perfect. Your next question comes from Bill Quirk of Piper Jaffray. Your line is now open.

[William R. Quirk, Piper Jaffray & Co.]

Great. Thanks. Good afternoon. And nice quarter, guys.

[Joseph Kiani, Masimo Corp.]

Thank you, Bill.

[Micah Young, Masimo Corp.]

Thank you, Bill.

[William R. Quirk, Piper Jaffray & Co.]

First question, and this came up a fair amount on the 2Q call, but Micah or Joe, just thinking about the sustainability of that driver number. We've had a couple quarters in a row in the high-50s. Now, I know you guys historically tend to be a little cautious before you start endorsing bigger numbers like that. But how are you thinking about that overall driver performance and sustainability there?

[Micah Young, Masimo Corp.]

Yeah, I think Bill, this is Micah. As far as the drivers we want to continue to see a few more quarters. We did mention on the last call we'd like to see, call it, two quarters or three quarters of that stronger number before we start taking the position where we are longer-term. We have said that we expect somewhere in that mid-50s range. We've been running in the high-50s, but that's probably closer to the range we'd see as a normalized range right now, and we'll continue to evaluate.

If you look at the strength it's coming from what we've talked about on the last call was we have a large military contract that's helping improve those driver numbers. And also just we're getting a broader increase in shipments across more of our OEMs and just the ones that we saw late last year, which we saw a big step up whenever we integrated all the rainbow products with Philips. So if you look at it's much broader with our OEMs now. So we're seeing that increase across the board, but we would like to see a couple more quarters of it before we step up that expectation.

[William R. Quirk, Piper Jaffray & Co.]

Understood. And then maybe one quick follow-up there and then a second question. So the duration of that contract, Micah? And then separate from that, Joe, hopefully we're getting close to the ORi approval. How should we – or how long should we think about this before it starts to impact the top line? And maybe you could characterize we've assumed that you see this as part of a broader deployment when you win new accounts as compared to more selective rollout. Is that the right way to think about that product?

[Joseph Kiani, Masimo Corp.]

Yes, I think on the terms of the contract with the Department of Defense. I think it was over several years. So hopefully we'll see more of that at least in the next year or two. Although, I think you know there's been a lot of money coming to the military. So they might be buying ahead of their schedule. But they did have a lot of products in the fleet that they wanted to convert 100% to the ZOLL product with our technology insight.

As for ORi, we're just really desperately awaiting FDA clearance and I think we worked really well with them to give them what they want now it's pending FDA clearance. Up on clearance, we're planning to rollout a new four LED sensor that we think it has a lot of potential benefit, because it can give you ORi, it can give you PVi as well as a new improved version of PVi, we call it RPVi, which is great for doing fluid responsiveness as well as SpO2 pulse rate perfusion and respiration rate.

So it's a dynamite product. The delta between the SET sensors, which is the two LED system versus the four LED is not going to be that high. So, we hope to see a lot of our customers standardize on this new sensor, which we consider the new standard for oximetry for most people whereas some may want hemoglobin and other parameters, which will go to the 8 or 10 LEDs system. But it's – given that you and I were at the beginning trying to predict how hemoglobin will rise, I'm going to get out of the prediction game and hopefully report on what we end up doing with it.

So we're very excited. The clinical community is very excited about it in places like Japan where we're selling it. We're getting a lot of traction. So, we're optimistic about it. I mean I don't know some of you are old enough to been around in the late 1980s, early 1990s. There was a lot of research and development going on to create OPTOS (41:20) or biosensors, these were invasive in-dwelling catheters that were designed to measure partial pressure of oxygen, carbon dioxide, and one other primary, I think pH. And these were $250 sensors that would have to be inserted. And the main information that we were looking for was the PaO2. So ORi, well not exactly PaO2 as you've seen from the studies we've been discussing gets you pretty close to it for a non-invasive product that costs a fraction of that $250 number. So if things go as we expect, it should really make a big impact in, in critical care.

[William R. Quirk, Piper Jaffray & Co.]

Very good. No. Thanks. I appreciate all of the contents and I certainly appreciate your comments regarding trying to stay out of the prediction business, Joe. But I hope certainly – certainly hope that enthusiasm translates into more orders. Thanks guys.

[Joseph Kiani, Masimo Corp.]

Thank you. Thank you. And Happy Halloween.

[Micah Young, Masimo Corp.]

Thank you, Bill.

[Joseph Kiani, Masimo Corp.]

Anyone else?

[Operator]

Yes. We do have...

[Joseph Kiani, Masimo Corp.]

Do we have questions?

[Operator]

Yes. We do have another question. Yes, we do.

[Joseph Kiani, Masimo Corp.]

Okay. Go ahead.

[Operator]

Our next question is from Sean Lavin of BTIG. Your line is now open.

[Marie Thibault, BTIG LLC]

Thank you. It's Marie Thibault on for Sean. How are you?

[Joseph Kiani, Masimo Corp.]

Good. How are you doing?

[Marie Thibault, BTIG LLC]

Good, good. Thanks for taking the questions. I wanted to ask one on the Philips co-marketing agreement. I know you're a little limited in what you can say publicly, but you mentioned you're doing the integration right now of some of the newer technology. I wanted to kind of just get a sense of where you are. I know it's cliché but maybe you could use innings or something like that to kind of give us a sense of how you are doing in terms of selling into hospitals alongside Philips.

[Joseph Kiani, Masimo Corp.]

All right. I'm not as good of a baseball fan as Micah, but I would guess we're in the third inning. And I think – in a nine inning game, right. So I – in some ways, we're ahead of schedule. What I mean by that is when we set out our targets, when we created this new collaboration that there were goals that we had on how we do together commercially that I believe have been exceeded.

They instantly exceeded our expectations. In some ways we're delayed, we're delayed on the integration of some of the new parameters. They should have been done by last quarter. Now we're looking at middle of next year. But then when you think about the overall where we're going with the co-marketing as we mentioned with rainbow, on that front, we're just at the beginning. It's great. We just recently met with their senior leadership. They really get it. They understand the impact this is going to have clinically and what it does for our team both Masimo and Philips are big proponents of data integration and predictive algorithms and decision support.

And when you think about all the new parameters to come up with, the only company that has them is Masimo. And these parameters are orthogonal data to the data that's been there before and can be really helpful in helping these types of predictive algorithms, assist clinicians in knowing how the patient is doing. So they get that. We of course are delighted that they get that and we're working through I think what's going to be a great relationship.

[Marie Thibault, BTIG LLC]

Great. And when it comes to that agreement. I know the initial agreements outlined five different countries that you'd work together in. Is there any possibility that this agreement kind of progresses that there could be changes to the terms of that. For instance, more countries or anything specific like that?

[Joseph Kiani, Masimo Corp.]

Yeah I think, so I think the good news is we have already expanded it to six countries. And I think we're about to go to seven. So I think – and that was just the way to kind of go where we both felt were the strongest markets that we're going to be looking for innovations to help health care get better. But by no means that we think we're going to limited there, in fact the products are available worldwide, so their entire channel and it's just the countries we are focusing our marketing attentions to that or dictated.

But yeah, I don't see it stopping. Our goal is to make Philips even more successful with our relationship than this relationship has helped make Masimo successful. So we're going to work towards that.

And of course we have other OEMs that we've had excellent relationship over the years with that we're continuing. Our relationship with like GE, like ZOLL, like Atom, I mean the list is about 80 companies. But obviously Philips with 50%, 60% of the market is a huge impact to – not just to us but to what we could do together for patient care.

[Marie Thibault, BTIG LLC]

Okay. Great color. One last one if I may, speaking of various countries and opportunities. The last quarter you talked about the newborn screening initiative that was recently announced in China. I just wanted to hear what Masimo's role, if anything, is in that initiative at this stage? Anything else in terms of the progress on that?

[Joseph Kiani, Masimo Corp.]

Well, thank you for asking. I hope this doesn't sound anything but scientific. CCHD screening that can be done for the masses, wouldn't have been possible without Masimo's technology. And still to date, can't be done with any other technology.

What allowed CCHD screening to become universal is the accuracy of our pulse oximeter and its reliability for these newborns that were wiggling around even during their motion. In fact, the original study tried with our technology and another popular pulse oximetry technology more than ours at the time. And they had to abandon the use of that other technology, because either it failed to work entirely or gave too many false readings.

So after three large scale trials in Sweden and the UK and China, CCHD screening has become universal in most countries, latest being China. And we are getting the lion's share of that business.

Unfortunately, some other companies do participate in that. And I only say unfortunately because the customers are not going to get the same results.

But we're continuing to get the message out there. It's definitely working on its own. And we're also creating new products to make it easier for low resource and mid-resource countries to adopt CCHD screenings, like the Rad-G that was partially funded by the Bill & Melinda Gates Foundation. So we're going to stay on the forefront of that until it's everywhere.

[Marie Thibault, BTIG LLC]

Wonderful. Thank you, Joe. Thanks, Micah.

[Micah Young, Masimo Corp.]

Thank you.

[Joseph Kiani, Masimo Corp.]

Thank you. Any other question?

[Operator]

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

[Lawrence Keusch, Raymond James & Associates, Inc.]

Great. Thanks. Good afternoon, guys. So I just – Joe and Micah, I had sort of two high-level questions for you. Joe, you in your prepared comments made a mention of hospital automation. And you start to talk more about that. So I just wanted to take your temperature on kind of what do you think the – or what is the vision there? And sort of what products are going to be central to that? And I guess over what time period do you think that develops?

[Joseph Kiani, Masimo Corp.]

Thank you, Larry. And thanks for joining us. For just as long as I remember, just about every medical conference I went to or every doctor I've sat down with have talked about the clutter in the OR, the clutter in the ICU. And you may have seen some of these pictures, where there is monitors and IV pumps and anaesthesia machines and ventilators all over the patient. And the clinicians are looking at array of displays and hearing array of alarms.

And that has caused a cognitive overload for the clinicians. That has caused a less than ideal diagnosis for the patient and have caused patient harm.

So years ago with clinicians coming to us frustrated by that and asking us to do something about it, we began thinking about what could we do with a blank piece of paper. And we began over 10 years ago. And we came up with elements that we thought were necessary.

The first one was to build a system like Crestron or Savant for – that has been around for home automation and office automation, where everything is connected together with a service organization that can go deploy it to get rid of the clutter and show the data they want to see, the clinicians, give them a central command to control and respond to the things that they are witnessing and help dramatically improve their ability to react to what's happening with the patient. And part of that is predictive algorithms and decision support.

So in came the technology for Root, in came the technology called Patient SafetyNet and Iris and Replica. So a lot of stuff began on our drawing board. And I'm happy to say that the bulk of them are out now. By middle of next year, we'll have pretty much all the key elements available. Of course, we're going to be forever improving and learning and making it better.

But we're ready. We're ready right now to go live. We have several customers in Europe, in the U.S., Middle East that are talked – have done agreements with us to go live.

So we're really excited about this, because the reaction from clinicians, from countries you think they can't afford this to countries that certainly can, has been universally positive. And I don't believe there's another solution like ours out there. If I could maybe use an iPhone analogy, I think our solution is probably the closest thing to the iPhone versus probably closest thing to us might be the BlackBerry.

So we're excited about it and we're hoping that this is something that will help in many ways, both the patients' involvement with their care, the clinicians' ability to be happy with what's happening and not get over – not get burned out and not miss the things that matter.

[Lawrence Keusch, Raymond James & Associates, Inc.]

That's helpful, Joe. And presumably just thinking about the physician interface, it sounds like your system as it's brought together with all the various elements may have some very customizable displays or an interface you know with that physician, depending on what they see is important?

[Joseph Kiani, Masimo Corp.]

Yes. Yes. And it's – so first, like – thanks for bringing that up. Number one everything in the room gets connected to the system and you can have as many different displays as you want including, we're working on heads up displays with Augmented Reality to help even take it right to the clinician wherever they're looking at to remote devices that be in a different city, looking real time at what's happening with the patient remotely with something we call Replica. But all of that data can be customized, in many ways it could be so when a clinician walks into the room with the iPhone or Android phones they're carrying or a device we create called presence detection tag, when they enter the room, it will customize the display for what they want to see. And there's rules on if multiple people are in the room what gets viewed and that could be even established by the hospital who gets to have it or just it becomes superset. So it becomes something that, I think, will be useful from the lowest level of care providers, to the highest level of care providers to see what they need to see to do what's best for the patient.

Now one thing I'm going to – we're going to be inviting you guys out soon to the next Analyst Day at Masimo. I think it'll be around the May period. Micah will get with you. Because I think this is one of those things you got to see it to appreciate it. It's hard to explain it, but you will see it very soon.

[Lawrence Keusch, Raymond James & Associates, Inc.]

Okay. Terrific. And then just one, one last one, and I just wanted to push you a little bit on the M&A comments earlier and I fully understand look you've got a very strong balance sheet. You've historically done M&A. And I totally get sort of the tuck-in nature in that side of it. I guess what I struggle with a little bit is when you sort of go outside of that and I'm not sure if this is your comments were implying that deals may get larger or you certainly use the words diversifying so may that moves around away from the core a little bit. But why go after those when it looks like you've got a really incredible runway here of strong top line growth. You're very much in control what's going on.

My take on integration risk and potential move into an area that's sort of new. I'm just trying to make sure I understand that.

[Joseph Kiani, Masimo Corp.]

Yeah. You're absolutely right. I mean we could make our lives a lot easier just by not doing anything except what we're doing right now with tuck-ins, with what we're developing. The product pipeline is incredibly rich here, not only what's coming out in the next six months, but what's coming out hopefully in the next 10 years. I mean we think that far ahead and we'll invest in R&D that's far ahead and of course some of the stuffs you'll never see because it didn't work and we don't tell you about it. But you'll see the ones that do. And so yes, we are not desperate to diversify, but we have, at this point, the ability to diversify.

And what do I mean at this point, we're not only rich in product pipeline and solution, but we're rich in an incredible team of people, an incredible bench that could be all-star teams by themselves. So while we have that ability if we see something that we think is of interest and helps to diversify, I think we should. I mean the question could have been to Kodak years ago, why diversify. I mean remember every block there was five film shops and fast photo and (57:47) and everybody were printing money for Kodak. So while I think my job is to do what's right this quarter and the next three years and the next five years, I see as part of our job as a management team to think ahead, and if we can to set the company up for anything that may come so that the company can continue to thrive for hopefully decades to come.

[Lawrence Keusch, Raymond James & Associates, Inc.]

Okay. Perfect. Thank you very much for the perspective. I appreciate it.

[Joseph Kiani, Masimo Corp.]

Thank you. But the one thing I want to tell you, and I'll never say never but because of how good we feel about our own business, we're not interested in diluting ourselves. So unless something comes up that's really, really hard to resist, our diversification strategy should be a non-dilutive exercise.

[Operator]

And there are no further questions.

[Joseph Kiani, Masimo Corp.]

Well, thank you all for joining. I know, we made a habit of having these calls on October 31, we might change that next year, just so we don't hold your little monsters from trick or treating, but happy Halloween, be safe. And we look forward to our call in February. Thank you.

[Micah Young, Masimo Corp.]

Thank you.

[Operator]

Ladies and gentlemen, Thank you for participating in today's conference. This does conclude today's program and you may now disconnect. Everyone, have a great day.