Eli Kammerman - Joe E. Kiani - Founder, Chairman and Chief Executive Officer Mark P. de Raad - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Corporate Secretary.

William R. Quirk - Piper Jaffray Companies, Research Division Matthew J. Dodds - Citigroup Inc, Research Division Brian Weinstein - William Blair & Company L.L.C., Research Division Tao Levy - Wedbush Securities Inc., Research Division.

Good day, ladies and gentlemen, and welcome to the Masimo Second Quarter 2014 Earnings Conference Call. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to introduce your host for today's conference call, Mr. Eli Kammerman. You may begin, sir..

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 reflects Masimo's current judgment. 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 SEC filings, including our most recent Form 10-K and Form 10-Q. You will find these in the Investors section of our website. I'll now pass the call to Joe Kiani..

lower ASPs created by the significant number of hospital-wide conversions and renewal agreement completed in 2013, but with many of these agreements with ASPs that have lowered our U.S.

acute ASPs by approximately 4% to 5%; and a reduction in the typical sensor volume growth expected as a result of the 10% decrease in driver shipments caused by increased focus on Masimo accounts by third-party reprocessors. The good news is that in the past 3 quarters, we have been able to keep U.S. acute sensor ASPs stable.

And equally important, we have continued various business and technology strategy to enhance our ability to recapture sensor volume that otherwise might be lost through third-party reprocessors.

In addition to the volume implications, the biggest problem with the third-party reprocessors is the harm that inferior product performance can have on patients and our reputation.

Our rainbow revenue also came in less than we expected in the second quarter due to many of our bookings getting delayed by 1 quarter, including a large international rainbow order. Based on this shift, as Mark will explain in more detail, we believe our revenue and earnings projections for the full year will substantially be the same.

Some specific highlights from the quarter include shipment of 43,400 drivers, which represent the fifth quarter in a row of unit shipments in excess of 40,000 units. In turn, our global installed base rose to an estimated 1,260,000 and up 10% year-over-year and well above the market growth rate for pulse oximetry.

Number two, strong overall growth in our capnography business, which grew nearly 27% over the year-ago quarter as demand for capnography is rising. This growth is despite the fact that we could not sell our bedside capnography monitor in the U.S. until July 1, 2014, due to lack of FDA clearance.

Now that Root has been cleared with capnography, we expect to be able to compete successfully in the U.S. bedside capnography market. Number three, our direct and distribution business outside the U.S. rose 10% led by growth in both the Japan and Europe, Middle East and Africa regions.

And finally, as I've just mentioned, our rainbow revenues fell below our expectations due to a 1 quarter delay in several orders, including a large outside the U.S. order for noninvasive hemoglobin devices.

I would like to reiterate that until our base business for rainbow gets much larger, we do expect to continue to see lumpy quarters due to the fact that our $60 million rainbow forecast for the year includes a pipeline of over $20 million, including various multi-million dollar opportunities, just like we realized in Q4 2013 and Q1 2014.

In turn [ph], the overall market environment, we saw a slight sequential improvement in U.S.

hospital business, which is consistent with recent third-party in-patient volume reports and a bit of a relief given the potential concern we noted last quarter that the previous 3 quarter trends of negative 4% to 5% growth might remain the same for many years due to the Affordable Care Act.

As I alluded to earlier, I'm also happy to report that in late June, Masimo received FDA clearance for the full-featured Root patient monitor, which includes IRIS connectivity hub and MOC-9 for additional measurements and our normal line capnography and anesthetic agent sidestream monitor, again demonstrating our ability to innovate new technologies that can help advance patient care.

Encouragingly, just last week, we announced the CE marking and limited market release of our newest device, the Radius-7 wearable untethered monitor. The Radius-7 will ensure an unbroken stream of monitor data for patients who leave their bed. And finally, I'm happy to report that we repurchased over 2 million shares of stock in the second quarter.

This repurchase is reflective of the confidence that the board and management share in Masimo's long-term outlook. I'll provide additional comments about our business in a few minutes, but first, Mark will review our second quarter financial results in some more detail and at the same time, provide you with an update to our 2014 financial guidance.

Mark?.

We are narrowing the range of our projected 2014 product revenues from $560 million to $570 million to a new range of $560 million to $565 million. Given the improved gross profit margin expectations for the second half of 2014, we are maintaining our annual gross profit margin guidance at approximately 65%.

We are increasing our operating expense guidance, excluding the medical device tax, from $284 million to $289 million. As we suggested earlier in the year, our operating expense guidance, which excluded the medical device tax, was done with the best information we had at that time, especially as it related to our projected 2014 legal expenses.

Legal expenses associated with responding to the DOJ-FDA investigation in particular have been difficult to predict. And as a result, we are now anticipating that we will need to incur an additional $5 million in legal expenses related to this matter throughout the rest of 2014.

We are reducing our effective tax rate guidance from 26% to 28% to between 25% and 26% as a result of the shift in our projected 2014 o U.S. versus U.S. profitability. And as a result of our Q2 stock repurchases, we are also lowering our estimated weighted shares outstanding to 56 million in Q3 2014 and 56.5 million in Q4 2014.

As a result of all these revisions, we are now adjusting our projected 2014 GAAP earnings per share to $1.24 to $1.30 from our prior range of $1.24 to $1.33. And with that, I'll turn the call back to Joe..

Thank you so much, Mark. We appreciate that update. We are very happy to see that our installed base in the second quarter again expanded much faster than the market, a clear sign that Masimo is increasing its presence around the world.

During the quarter, we observed a slight easing of the pressures seen on hospital admission rates compared to the prior 9 months. This shift in patient volume has produced a sequential uptick in our unit volume for SET pulse oximetry sensors, which we are hopeful will continue through the remainder of the year.

As I alluded to before, an important development in May Q2 was the FDA clearance for the full-featured Root, our new monitor with the unique feature of expandable functions, enabling clinicians to add capnography, brain function monitoring and soon, tissue and cerebral oxygen monitor.

Root contains an advanced feature set, which will allow clinicians to access patient data in an intuitive format that provide immediate benefit for fast interpretation and better decision-making.

We expect that over time, Root will provide our customers with a truly new and unique monitoring experience and will, through the IRIS interface, allow Root to act as a hub for the legacy products connected to the patient that don't have a way to communicate to the electronic medical record.

And lastly, through MOC-9, it will allow many new and innovative technologies from both Masimo and other companies to be available to patients. As a result, we expect Root to provide Masimo with yet another unique and unparalleled advantage in winning new customers and therefore, advancing patient care and reducing costs.

We're also very happy to introduce Radius-7 in CE countries. Radius-7 is a lightweight multi-function wearable device that has a wireless link to our Root monitor. Patients wearing the Radius-7 will have the benefit of always-on monitoring so that the health and data integrity are not jeopardized when around within the hospital.

Studies have shown that patient mobility is a key factor in more rapid patient recovery.

The value of reliable continuous pulse oximetry in this setting made possible by our Measure-through Motion and Low Perfusion pulse oximetry technology includes reduced failure to rescue events and fewer intensive care unit transfers, both of which have high human and financial cost for hospitals.

rainbow sales were below our expectations in the second quarter, but should rebound in Q3 as we record several orders, including the launch outside the U.S. hemoglobin order that have slipped into the third quarter. It's clear that rainbow is achieving higher visibility with clinicians, and adoption is rising on an international level.

While we are encouraged to see this increasing adoption of rainbow technology, internationally, we continue to expect that growth to also be propelled by what we hope will be the first launches of some of the initial devices of rainbow technology by GE and Philips later this year.

As part of our rainbow sales, total hemoglobin revenues in second quarter were $3.2 million, including continuous measurement as well as spot check tests and devices, down slightly versus the prior year period.

There, in Q2, the new blood management team for continuous hemoglobin monitoring continued to see an increase in the number of acute care hospitals that have concluded a favorable evaluation of SpHb, our noninvasive hemoglobin monitor.

Of course, translating that clinical recommendation into a capital purchase and deployment is still requiring a significant amount of persistence and attention by our blood management team. However, compared to the second quarter in 2013, the blood management team's revenues have doubled, which is encouraging.

Because of our continuous long-term confidence in our business during second quarter 2014, we repurchased approximately 2 million shares. Over the last 6 quarters, this represents a total stock repurchase of approximately 3 million shares or 50% of the 6 million share repurchase authorized by the Board of Directors in Q1 2013.

While we currently expect the majority of the remaining $50 million from our recently implemented $125 million line of credit will be used to fund the build-out of our new corporate headquarters, we may also use those funds to facilitate additional stock repurchases as the market conditions allow and/or to respond to other business expansion opportunities.

With respect to potential business acquisitions, we continue to consider opportunities to adopt of small businesses with innovative technologies that will complement our portfolio. I would now like to take a moment to thank, Ed Cahill, a long-term Director at Masimo, who is leaving our board.

Over the past 15 years, Ed has made very significant contributions to Masimo, and I have relied heavily upon Ed's significant investment banking experience and valuable insight into medical technology companies. Ed has resigned to focus more on his portfolio of companies at HLM Venture Partners.

First, I'd like to thank Ed for his unwavering and steadfast guidance over the past 15 years. Ed will be greatly missed. At the same time, in regards to the Masimo board, you may recall that we announced the addition of Craig Reynolds to our board in April.

In case you missed that announcement, Craig brings exemplary medical and life science industry experience to our board, including his role as the former Chief Operating Officer of Philips Respironics Home Health Solutions and CEO of Healthdyne Technologies. Craig will obviously help to fill the gap created with Ed Cahill's departure.

Please join us in wishing Ed the best in his new pursuits. We have positive long-term outlook and confidence in our ability to achieve our financial goal while achieving our mission to improve patient care and reduce cost of care.

Our Q2 worldwide monitor placements illustrate the continuing gains in the marketplace we are realizing as our advanced technology demonstrate superior benefit for patients.

While we intend to continue to work to increase our product revenue growth rate, we are also equally focused on achieving progress with our ongoing engineering and manufacturing cost reduction efforts and in general, maintaining disciplined control of our nonlegal operating expenses.

Clearly, our ability to see some of the earnings per share leverage in 2014 had been and will unfortunately continue to be impacted by the higher-than-usual legal expenses resulting primarily from the DOJ and FDA activities.

In fact, of our new projected $289 million of fiscal 2014 GAAP operating expenses, approximately $10 million is related to this topic, which was absent in our expenses last year. We hope that these investment issues will be concluded soon but cannot estimate a completion date at this time.

And despite these distractions, we continue to stay focused on developing breakthrough products to help improve patient care.

The launch of our breakthrough products to date and what we expect to announce over the next several months make us very optimistic about the long-term outlook for our company, as is evidenced most clearly by our recent 2 million share stock repurchase.

With our guiding principles included to always do what is best for patient care, our leadership in advanced monitoring technology allow us to contribute to improving the practice of medicine and will continue to propel the growth of Masimo. With that, we'll open the call to questions.

Operator?.

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

So I guess the first question guys, we've had a couple of quarters now where the top line guidance has come in and, Joe, you cited that obviously some of the reason for that has a lot to do with some of the deals that you signed in 2013 and the associated price concessions.

So I guess I'm a little curious, part of this isn't necessarily new, and so why do we continue to see the slippage in the guidance there? And conversely, given that you're forecasting an acceleration in the back half, can you just help us think about how confident you are there..

Sure, sure. Bill, first of all, we did anticipate the headwinds from the pricing erosion, the ASP erosion that we experienced due to those conversions we talked about.

But we had several large rainbow orders that we had anticipated would come in, in the second quarter, that we have not lost but have slipped into Q3, and therefore, we did not meet our total revenue nor earnings expectations.

However, as you've noticed from our guidance for the rest of the year, we do believe we will get them and balance for the year will be very close to what we forecasted at the beginning of the year, both in terms of revenue and earnings.

The reason I talked more about the sequential slow growth in our acute care business is not because it was a surprise, but it was because of one of the issues that we're seeing out there. I just wanted to inform our investors..

Okay, Joe. And then secondly, and I guess this is a bit of a follow-up to questions that Dave asked last quarter.

But given that the business has the first half of the year been slower than expected and obviously you've had the commensurate impact in the earnings line, why go ahead and decide to make a charitable contribution? It was obviously a decision that, in light of the earnings shortfall, you could have at least acquired some of that back?.

Well, I think, first of all, the charitable contribution was done based on the fact that we changed our forecast with royalties from Covidien from $8 million to $28 million. And so that was solely based upon that.

But secondly, for example, a very large order that has slipped into Q3, we actually had -- we got the purchase order from our distributors, have actually shifted to the government. We're just being conservative in taking that as a revenue until the government agency has signed an agreement with our distributor.

So anyway, so long story short, that -- number one, the contribution is not related to our normal business but the additional royalties from Covidien, and really up until just recently, we did not anticipate not having that sizable order in Q2..

Okay. Then I guess just last for me. Joe, you guys have referenced this large order a couple of times now. Can you give us a little sense as to how meaningful that would have been? And then obviously they'll have an effect in the third quarter..

Yes, it's $7 million. And as I've mentioned, we have over $20 million of orders like it that are in the pipeline.

So unfortunately, we're going to see some lumpiness in our quarters, while we're doing our best with our dedicated blood management team that calls on hospitals to build the base business, which is the usage of our noninvasive hemoglobin routinely in the OR ICU recovery room area, which as that business builds, the sensor volume of that business becomes just like our current pulse oximetry business, the great majority of our revenue.

But until that happens, you're going to see in the foreseeable future lumpy quarters because, like I said, over $20 million of solid good business, where we're making a huge impact around the world on population care to basically come in millions of dollars at a time and then go and then come back maybe 12-month anniversary to it or 9-month anniversary to their first agreement..

Our next question comes from Matthew Dodds with Citigroup..

Joe, just a question on reprocessing. I mean I thought we were -- that was largely behind us. I'm not exactly sure how much it impacted the quarter, what's still left there. Just give a little more color on how that's impacting you..

We are not 100% sure of how it's impacting us. What we do know is that maybe due to our success in the marketplace, there's been a focus on reprocessing Masimo sensors by these third-party reprocessors. And that's what I was reporting to you today.

Like I said, maybe I didn't quite say it strongly, but our growth year-over-year in terms of driver replacement will match pretty closely with our sensor business.

So therefore, it's hard for us to calculate how much we're losing due to reprocessors, but we are hearing a lot from our sales force that there's a lot of pressure out there from third-party reprocessors that are now focused on Masimo installed base. And unfortunately, that pressure undoubtedly has caused us business, we don't know how much.

This can be -- if I were to guess, it will be less than 10% in the U.S. But also, it has a negative impact in our reputation because many times, we get called in when accounts are not happy.

And every time -- it's not 100% of the time, almost every time, it has to do with a reprocessed sensor on the patient, which then of course makes us wonder when doctors and nurses see those situations, how many times, they don't call us to say anything but they walk away thinking unfavorably about Masimo, which had nothing to do with our products.

So we have really stepped up our efforts to minimize those issues, both technologically, with things like X-Cal that will have more and more impact in the coming years and some business solutions that we'd come up with that we're -- have offered customers that we know are reprocessing.

And we had some success with those and we hope to see more and maybe not so long from now that these reprocessor issues will be a historical issue. The only thing I would -- just maybe I'll add to that -- sorry, Matt, for a long response.

The only thing is while third-party reprocessing might go away substantially, we are reprocessing ourselves more and more too, which has an ASP erosion as well since reprocessed sensors sell for less than new sensors. And I don't see that trend changing.

I do see us continue with our reprocessing, because our reprocessing does not minimize the sensor performance since we actually eliminate the components that get bad over time when we reprocess..

But I just want to -- Joe, to make sure I got this right, though. X-Cal, that eliminates the ability to reprocess.

Or is it just that you only rolled out a certain percent of your drivers with X-Cal and that's going to take time?.

Correct. Correct, Matt..

And so do you have an estimate of maybe what percent of the installed base now is X-Cal or up to?.

I'd say 10% at best. And I think that number will change significantly over the next 2 or 3 years because of the rollout of our OEM partners with X-Cal technology..

Our next question comes from Brian Weinstein with William Blair..

Joe, last quarter, you did make the comment about the Affordable Care Act and the impact that it would have on your business longer term. It sounds like -- I wasn't sure if you were backing off of that a little bit given what we saw just in this most recent quarter or if you still expect to have kind of a longer-term impact.

And can you explain to us kind of why you expect to see that sort of an impact on your business longer term from that particular legislation?.

Sure. Last quarter, I've seen 3 quarters in a row where sensors kept dropping in hospitals and we felt it with our sensor volume. This quarter, we've seen mixed results in the papers, in the journals. For example, Modern Healthcare stated there's a 7% reduction in sensors -- in patient sensors.

But then Wall Street Journal recently reported some of the public hospitals have reported an increase in admissions and census increase. We've seen with our own sensor volume, for it to match our installed base growth. So putting that together, it feels like Q2 got better than certainly Q1.

And the reason I rang the bell last quarter is because we've seen, just part of the second part of your question, we have seen when Massachusetts went through this Affordable Care up several years ago, that our sensor volume and revenue had grown at a fraction of -- for the rest of the country, in that region, in Massachusetts.

So those are the reasons. And while I'm not ready to say ACA is not going to have an impact going forward, all I'm letting you know is that Q2, we did not feel that sensors drop..

Okay.

And then on the $20 million of orders -- of the larger orders that you referenced, is that all embedded into your guidance that you get all $20 million, or is there some conservatism in there that you're going to just get a fraction of that?.

Yes, we are not including the -- as far as the -- it's over $20 million and a fraction of it, less than 50% of it is what's in our guidance..

Our next question comes from Tao Levy with Wedbush..

Sorry, I've just have to ask somebody. You might have already answered this. But I'm trying to better understand the correlation between the increase in the number of placements that you have and the growth that you're seeing in your installed base versus what's happening, it seems, in the pulse oximetry business on the sales side.

And if -- there's obviously a lot of moving parts, and I get the pricing difference, but it doesn't seem to account for the full downtick, if you will..

Tao, we appreciate your frustration because we are frustrated by it, too. Q1 made more sense to us because sensors was down and it impacted our sensor volume. We kind of saw that in the U.S. acute care business. Q2, our sensor volumes were fine, matching our expected installed base growth, but our revenue was down.

And I think, clearly, part of it is the approximate 5% reduction in ASPs, which I'll emphasize again, for the last 3 quarters, has remained the same. We're not seeing decrease from what we saw in Q4 2013, Q1 2014 and Q2 2014. ASPs have stabilized, but compared to the previous quarters, obviously ASPs are still down 5%.

We'll see that change, hopefully, assuming things continue the way they are, in Q4 of 2014 when year-over-year there may not be more ASP pressures, assuming that things stay the same. But -- so we're scratching our head to why the U.S.

acute care business growing at 3% when our overall installed base is growing by 10%, and we believe some of that have to do with obviously the ASP pressures, about 5% of it, maybe 4% of it. Some of it has to do with perhaps reprocessors. And we -- our customers don't come and tell us they're reprocessing because they're not supposed to.

So it's hard to get that data from them except for us to kind of go audit hospital by hospital, which we're not in the business of doing. We don't want to be that intrusive to them. So what we're letting you know is our best guess of why U.S. acute business didn't grow by 10%, and we think it has to do with those 2 issues.

Now to Bill's statement, we expected some of that erosion, obviously, when we gave you a new guidance.

We've given you originally a straight $470 million to $500 million guidance for the year, and then we lowered it to a range of $550 million to $570 million after seeing some of that softness, after having to back off $2.6 million for the inventory issue we had last quarter.

So we kind of knew about it and as you noticed, this quarter, we're not changing our guidance much. We're bringing the high end down to $565 million we'll be left alone where it is. So it means we kind of knew this is happening, it might be off a couple of percentages, but not more than what we expected.

What really made us miss what we had expected this quarter is the shifting of some of the rainbow business from Q2 to Q3, which one of them was a several million dollar order that we'd actually shipped in Q2 and expected to be able to report it today. So I hope that answers your question..

Yes. No, I appreciate the thorough answer.

And then my follow-up question is, is it possible to -- is there a delay in the way that you record revenues or kind of see the ordering patterns from your direct customers or your OEM so that if you're seeing an improvement out there in hospitals, census numbers or, say, the hospitals are seeing that, that it doesn't get reflected in the way hospitals purchase from you guys until the following quarter? In other words, they're not more of a leading indicator than any results are more of a lagging indicator there?.

A bit, Tao, because when Mark joined as the CFO, I'm glad he did this, he adopted a sell-through model and that sell-through model, the best thing of it is that our do-gooders will never get the wrong idea and try to go book business with distributors that don't have customers for us. I don't have to worry about that anymore.

The bad news is we get orders like the ones I've just had to not book for this quarter from our distributors that we don't get to take until we know everything is fine between the distributor and even the customer. And that's o U.S.

And then the U.S., as you know, the majority of our business goes through these just-in-time distributors, and we don't really know about their inventory until very late in the game. And then based on that, we make adjustments to our revenue for the quarter. So yes.

So in essence, we had a delay and those factors -- and the fact that, as you know, majority of our business comes from consumables, is why we still feel good about the year.

We're not having to go recreate the entire wheel in the second half of the year, and although the second half has got to be now much bigger than the first half, we understand where that business is coming from so we feel good about that..

And I'm not showing any further questions at this time. I'd like to turn the conference back over to our host..

Well, if there are no other questions, I just want to thank you, all for joining us. I'm frustrated to report the less than what we expected for Q2. The good news is we've not lost these businesses, they've gone into Q3. So I look forward to delivering that performance to you at our Q3 earnings call. Thank you, and enjoy the rest of your summer..

Well, ladies and gentlemen, that concludes today's presentation. You may now disconnect and have a wonderful day..