Eli Kammerman - Head-Investor Relations Joe E. Kiani - Chairman & Chief Executive Officer Mark P. de Raad - Chief Financial Officer & Executive Vice President.

William R. Quirk - Piper Jaffray & Co (Broker) Larry S. Keusch - Raymond James & Associates, Inc. Joseph R. Klein - Gauss Capital Advisors LLC.

Good day, ladies and gentlemen, and thank you for standing by. Welcome to Masimo Corporation Third Quarter 2015 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's presentation, Mr. Eli Kammerman, Vice President of Business Development and Investor Relations at Masimo Corporation. Sir, please begin..

Thank you and hello, everyone. Joining me today are Chairman and CEO Joe Kiani, and Executive Vice President of Finance and CFO Mark de Raad. This call will contain forward-looking statements which reflect Masimo's current judgment, including certain of our expectations regarding fiscal 2015 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 SEC filings, including our most recent Form 10-K and Form 10-Q.

You will find these in the Investors section of our website. We will also discuss certain non-GAAP financial measures. A description of each non-GAAP financial measure and a reconciliation of each non-GAAP financial measure to the most comparable GAAP financial measure can be found in our earnings press release. I'll now pass the call to Joe Kiani..

Thank you, Eli. Good afternoon and thank you for joining us for Masimo's third quarter 2015 earnings call. We are happy with our results for the quarter, as we again surpassed our targets for product revenues, rainbow revenues and shipments of our SET and rainbow SET oximeters.

Despite negative currency effects, our product revenues rose by more than 5% and increased by nearly 9% on a constant currency basis. We realized solid gains across all of our product lines, led by a 30% increase in rainbow revenues. Our market share continues to rise as evidenced by record oximeter shipments.

Our third quarter GAAP EPS of $0.36 per diluted share, up by 33% versus a year ago, is clear proof of the value of our 10-year plan that we initiated in 2007 when we went public.

Our outlook for the final quarter of 2015 is positive, and as Mark will share with you shortly, we are once again happy to be boosting our financial expectations for the year. Next, Mark will review our third quarter financial results in more detail and then provide you with our updated guidance for the year.

Mark?.

Thank you, Joe. Hello, everybody. Reported total revenue and product revenue for the third quarter was $152.6 million and $144.6 million respectively. Product revenue rose by 5.4%, or 8.9% on a constant currency basis, versus the third quarter of 2014.

And as Joe mentioned, due to the adverse foreign exchange rate movements, our Q3 revenues were reduced by $4.8 million.

As has been reported throughout the healthcare industry recently, year-over-year quarterly growth moderated somewhat from the stronger rates we saw in the first half of the year with once-vigorous hospital census increases in the U.S.

Despite this backdrop, though, our Q3 product revenues were stronger than we had expected due largely to growth in our rainbow revenues, including increased demand in both our direct and OEM channels. Q3 2015 rainbow product revenue totaled $17.1 million, up by 29.7% or 32.1% FX-adjusted from $13.2 million in the prior-year period.

This strength was due to a combination of factors, including robust OEM rainbow growth at approximately $1.6 million and additional rainbow revenues related to a large new customer in the Middle East. Our Q3 SpHb revenues increased by 9% to $4.7 million versus $4.3 million last year.

And encouragingly, we have continued to maintain a full sales pipeline for SpHb after realizing over 100 positive hospital evaluations for the technology this year.

Our worldwide end-user, or direct business, which includes sales through just-in-time distributors, grew 3.5% in the third quarter to $120.2 million versus $116.1 million in the year-ago period. And on an FX-adjusted basis, our worldwide end-user direct revenues grew by 7.2%.

Our direct business represented approximately 83% of total product revenue in the quarter, level with the prior-year period. OEM sales comprised the remaining 17% and rose by 16% versus the prior-year period. The strong year-over-year Q3 OEM revenues were primarily attributable to rainbow consumable and licensing shipments. By geography, total U.S.

product revenue increased by 6.5% to $101.5 million compared to $95.3 million in the same quarter of 2014. Our Q3 OUS product revenues of $43.1 million rose by 3.1% versus $41.9 million in the same prior-year period, but were up 14.4% on a constant currency basis.

Excluding the impact of FX rates, OUS year-over-year revenue growth rates were highest in our EMEA and Asia-Japan regions compared to the prior-year period. International revenues represented approximately 30% of total Q3 product revenues, down from 31% in the prior-year quarter.

However, when adjusted for the negative impact of FX rate changes, our Q3 OUS revenues would have been up 32% of total Q3 product revenues.

Our third quarter 2015 GAAP product gross profit margin was 65.2%, up slightly from 65.1% in the prior year as our ongoing value engineering efforts continue to deliver larger product cost reductions than expected.

In fact, if we exclude the impact of year-over-year foreign exchange rates, our comparable product gross profit margins would have been 65.4%. Our third quarter total gross profit, including royalties, was 67%, a modest improvement versus the year-ago period.

Reported third quarter 2015 total operating expenses were $74.1 million, nearly flat with the year-ago quarter. Adjusting for the impact of foreign exchange rates again, our year-over-year operating expenses would have been up approximately 2.5%, consistent with our continued focus on operating expense management.

Selling, general and administrative expenses were $59.6 million, which were also level with the prior-year period. Adjusted for the impact of foreign exchange rates, our year-over-year selling, general and administrative expenses would have been up 2.4%, with R&D spending of $14.5 million being up about 2% versus the prior-year period.

Third quarter 2015 operating income was $28.1 million compared to $22.3 million in the prior period, up 26.4%. This year-over-year increase in Q3 operating income is attributable to the combined benefits of higher product revenues and product gross profit margins along with disciplined control of operating expenses.

Q3 2015 non-operating expense was approximately $1 million compared to an expense of $565,000 in the prior-year period. The Q3 2015 expense is primarily related to $584,000 in net interest expense and $465,000 due to the translation impact of movements in foreign exchange rates on our overseas net asset positions.

Our third quarter 2015 effective tax rate rose to 33.8%, up from 25.7% in the same period last year and was above our most recent projections of approximately 30%. The higher tax rate than originally planned is due to our updated projections of our 2015 U.S.

versus OUS revenue mix and the cumulative impact of the related year-to-date catch-up adjustment required due to this new annual projection. As compared to the prior year, the tax rate was also impacted by the large year-over-year changes in foreign exchange rates and the result that that has had on our 2015 OUS operating income as compared to 2014.

Our average shares outstanding for Q3 was 53.7 million, down from 54.6 million in Q3 2014.

This decline was primarily due to the impact of the approximate 3.5 million shares we have repurchased in 2015, partially offset by the impact of increased stock option exercises and the higher dilutive impact of our existing stock options outstanding due to our higher year-over-year stock price.

Third quarter GAAP 2015 net income was $19.3 million, or $0.36 per diluted share, compared to $14.9 million, or $0.27 per diluted share in the same prior-year period.

It's also noteworthy that the net Q3 2015 impact of foreign currency transactional and translation adjustments, as highlighted in our new GAAP to non-GAAP reporting, reduced our reported earnings per diluted share for Q3 2015 by approximately $0.03 per share.

As with prior quarters, we have provided supplemental non-GAAP schedules which illustrate our non-GAAP gross profit margins, operating expenses, operating income and earnings per share.

We provide these schedules primarily in order to show the impact that year-over-year movements in foreign exchange rates are having on our fiscal 2015 GAAP operating results, as we do not engage in hedging activities unlike many other sizable medical device companies with worldwide exposure.

As of October 3, 2015, our days sales outstanding was 47 compared to 49 as of September 27, 2014, and over the same period our inventory turns declined slightly to 2.8. Total cash and cash equivalents as of October 3, 2015 were $103.6 million compared to $134.5 as of January 3, 2015.

During the nine-month period ended October 3, 2015, we generated approximately $53.5 million in cash from operations, $24.9 million from the impact of stock option exercises and borrowed an additional net $65 million on our credit line.

These funds have been used to repurchase approximately $130.2 million in stock, acquire a building in New Hampshire and complete the build-out and renovations of our new corporate headquarters facility in Irvine, California. Now I'd like to turn to our updated fiscal 2015 financial guidance.

As a result of our Q3 results and our continued optimistic outlook for the rest of 2015, we are updating our 2015 financial guidance.

We are increasing our total revenue guidance from $621 million to $627 million, including an increase in our product revenues from $592 million to $597 million and an increase in our royalty revenue guidance from $29 million to $30 million.

As we stated earlier in the year, we continue to expect our Q4 gross profit margins to rise and are therefore reiterating our full fiscal year 2015 gross profit margin guidance at approximately 65%.

We are also maintaining our fiscal 2015 operating expense guidance at approximately $306 million, including the medical device tax of approximately $7 million. For the reasons I noted earlier, we now expect our Q4 and full-year 2015 effective tax rate to be in the range of 30% to 31%.

And finally, due to the combined impact of our Q3 2015 stock repurchase activity partially offset by assumed stock option exercises, we are now projecting our Q4 weighted shares outstanding to be approximately 53.5 million.

Based on our Q3 results and these updates to our annual guidance, we are increasing our full-year 2015 GAAP earnings per diluted share guidance from $1.43 to $1.49 per diluted share. And consistent with our new non-GAAP reporting, we are also now updating our projected 2015 non-GAAP earnings per share guidance from $1.61 to $1.67 per diluted share.

A reconciliation of our updated GAAP earnings per share to our non-GAAP earnings per share has also been provided in today's press release. And with that, I'll turn the call back to Joe..

Thank you, Mark. Our financial performance in Q3 exceeded our targets for the top and bottom lines as we realized strong rainbow sales and steady growth for our SET pulse oximetry products.

Our earnings growth continues to exceed our product revenue growth because of our disciplined control of operating expenses and our expanding gross margin despite lower ASPs due to the value engineering work we began three years ago.

During Q3 we began shipments on a large multi-year order which we believe could over 2015 and 2016 eventually top approximately $17 million for a key new customer in the Middle East. In Q3 we were able to recognize over $2 million in revenue against this contract, including, as Mark mentioned, approximately $1.6 million in rainbow revenues.

And we expect at least a similar amount in Q4. In total, we estimate that approximately two-thirds of this multi-year order will include rainbow-related technology.

Importantly, this large-scale Middle East order has the opportunity to not just continue but increase with a successful deployment potentially leading to recurring revenue opportunities in 2016 and beyond.

While we are happy with this new opportunity, it is still too early to access overall census levels for 2016, and therefore we would caution against making any major adjustments to your 2016 product revenue projections. We continue to be optimistic about winning similar large orders from other countries throughout the world.

As an example, we recently won an important new customer for rainbow in Q3, Cambridge University Hospital of the United Kingdom, which is adopting SpHb and PVI. As Mark noted, while we believe that the growth in U.S.

hospital admissions in Q3 moderated somewhat compared to the first half of 2015, our core SET pulse oximetry business maintained above-market growth as we shipped 45,800 oximeters, which is a new record. With this record quarterly oximetry shipment, our new installed base has increased to nearly 1.4 million oximeters, excluding handheld oximeters.

It's clear that our SET pulse oximetry products are continuing to gain market share as a result of our technological superiority and proven clinical benefits for improving the quality of care and reducing the cost of care.

As evidence of these share gains, we note that we won a large new contract in Q3 at a prestigious hospital in Jacksonville that will include our SET and patient safety net products.

Our Q3 capnography revenues were also strong, with revenue up over 20% in constant currency as clinical adoption of our ISA sidestream capnograph and EMMA portable capnograph products is accelerating. The availability of our capnography devices for Root is also helping to boost our capnography sales.

As we noted earlier, growth for our rainbow Pulse CO-Oximetry products accelerated in Q3 as the result of strong customer demand.

We are optimistic that the demand for rainbow could continue to increase not only because of the large OUS opportunities now beginning to materialize but also due to the imminent launch of high-acuity monitors from Philips that will allow hospitals to employ a rainbow parameter measurement in the OR and at critical care environments in the integrated patient monitors used in most hospitals around the world.

In fact, at the annual meeting of the American Society of Anesthesiologists two weeks ago we were happy to see the display of rainbow-containing high-acuity patient monitors in the Philips exhibit booth and expect the commercial sale of these products by year-end.

Switching to Root, our patient monitor and connectivity hub, we were glad to see that Root had an excellent reception at the ASA meeting with hundreds of anesthesiologists from all over the world showing interest in this innovative open-architecture monitor and connectivity hub.

The connectivity feature of Root will enable the patient data from all connected sensors to be automatically directed into the electronic medical records for each patient or viewed in a cockpit fashion in the room, vastly increasing the value of Root as an information tool.

Lastly, we note that the growth for Root is still far above that for any product we have launched, with year-to-date unit growth increases now in the triple digits, albeit from a small base. We're encouraged by the reception this new device has received, and we continue to believe it will become a significant revenue contributor in the coming years.

As evidence of the continued confidence that we have in our long-term growth and financial leverage opportunities, we are announcing today a new share repurchase authorization. Our board has approved a new repurchase plan for 5 million shares.

We repurchased approximately 1.2 million additional shares during Q3 at an average price of about $41.44, completing the 9 million share buyback we put in place in 2013. In closing, we are happy to report to you our performance to-date and are looking forward to a great finish for 2015.

We're optimistic about the prospects of completing our 10-year plan during the next two years as we strive to improve patient care and help our customers reduce their costs. Our goals are clearly in line with our customers' and shareholders' interests and we are committed to delivering the results we have targeted.

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

Operator?.

Our first question or comment comes from the line of Bill Quirk from Piper Jaffray. Your line is open..

Great, thanks, and good afternoon, everybody. First question, Joe, if we back out the initial impact from the Middle East deal, it looks like you had a really solid quarter in rainbow despite that. So can you maybe speak to some of the other components there that helped drive the performance of that business? Thank you..

Sure. Yes, we saw an 18% increase in rainbow revenues without this Middle East large order and that strength came from both hemoglobin sales around the world as well as carbon monoxide and methemoglobin sales through two of our OEMs both in the U.S. and Europe..

And Joe, just help us a little bit about rainbow in terms of I guess the recurring side of the business versus some of the I guess the more one-time nature of that, kind of where are we in that split right now? Thanks..

Well, the recurring revenue side is there, and where also – for the increase that you see is from both recurring revenues, from customers we had before, as well as new customers that are coming online..

Okay, got it. Thanks, guys. Nice quarter..

Thank you, Bill..

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

Thank you. Good afternoon, guys. Joe, I just wanted to touch on one comment that you made as it relates to rainbow, and I guess what I am curious about is how would you think about the sort of opportunity/traction of hemoglobin and reception to the technology in the U.S.

versus the OUS? Because it sort of sounds like you are starting to feel like there could be a very good opportunity overseas for this technology..

Yes, Larry. First of all, I think U.S. and Europe probably are most close together in terms of cost-containment measures and cost worries.

So for these two regions, despite very successful hemoglobin evaluations clinically, where the clinicians saw great differences in their ability to do the care that they give, they've been having difficult time getting administrations buy-in to do large-scale implementations.

You have certain regions of the world like the Middle East where the cost-containment pressures are not there.

So what we are seeing in certain parts of the world where you don't have the same cost pressures, the technology seems to be going from clinical evaluation wins to purchase, as you would expect, and sort of the constant delays we have been getting in both U.S. and Europe..

Okay. That's definitely helpful.

And then, not sure what you can say here but just sort of curious in sort of the next steps, any thoughts you can provide for us on the inter partes review that was filed by Medtronic/Covidien?.

Well, I can't obviously get too deep into the legal stuff because now we are in the middle of one. But what I can say to you, I have good reasons to believe that nothing is going to change immediately. By the February earnings call that we have, we should be prepared to give you better color on the future.

We do believe that the filings are not well-thought through, given that once the patents in the case that they have filed inter partes re-exam have – were in front of the Patent Office and Patent Board twice and in front of an appellate court twice.

This is a patent that we had filed interference on against Medtronic, who used to be Covidien/Nellcor, and Medtronic had fought hard to win this patent. So now for them to come out and say that the patent's no good, they should be stopped from doing that.

And I think also there is a little bit of a wishful thinking on the part of new people in this giant Goliath that has not met David yet not thinking through what our actions might be. So stay tuned; in February we will give you more color..

Okay, terrific. Thanks, guys..

Thank you..

Thank you. Our next question or comment comes from the line of Tao Levy from Wedbush. Your line is open..

Hi, guys, this is actually Matt (27:23) filling in for Tao. Congrats on another strong quarter..

Thank you..

Thanks, Matt (27:28)..

No problem.

So I was just wondering with regards to the record quarter for driver shipments, I was wondering when do you expect those pulse ox units to start really driving sensor revenue?.

Well, typically when we get the order it takes about three months for the deployment into the field and consumption of sensors, and then the rate of sensor consumption has a lot to do with census.

So if there is an increase in census, whether it's due to the flu season or people taking advantage of their deductibles and co-pays and so forth before the year-end, we might see a bigger boost. And if there isn't, then we might not see as big of a boost.

So I think within Q4 we should start seeing the impact of what happened for us as far as driver shipments in Q3. But just to remind you, I think this is now the ninth quarter that we have shipped over 40,000 oximeters, excluding the handheld devices. And we see that trend continuing..

Okay. Thank you. That was helpful.

And just going back to rainbow again, you know, how do you think we should think about this going forward? You know, with rainbow sales being higher this quarter due to the Middle East, but are you still expecting to be a little bit lumpy?.

Yeah. I think rainbow, because of just the size of where we are revenue-wise and installed base-wise, will remain lumpy. I think that hopefully will get less and less as they move forward. The good news is with this large Middle East order, it's not supposed to be a one-time order.

So we do expect it to continue hopefully for years, and it might end up being just half of what ultimately it will be. And this is just one of several large businesses we're after with our technologies, including rainbow..

Got it. And just my last question, just a quick clarification. What did you say we should be expecting for rainbow sales next quarter? Thank you..

Sure, Matt. (29:58) In general when we started this year we had provided GAAP revenue rainbow guidance about $57 million or so. I think based upon the strength that we saw in the third quarter, right now we're predicting that number to be in about the $60 million range for the full year.

So we'll see about $3 million higher partly due to the Middle East order that Joe was just alluding to. So about $60 million is the range of where we expect our full-year rainbow revenues to come in at..

Okay. Great. Thank you, guys..

Thank you. I think we have one more question....

I think they just added one other..

Okay. All right. Next question, please..

Our next question is from the line of Skip Klein from Gauss Capital. Your line is open..

Great execution. I just was eager to get an update on where things stand with the Philips patent litigation, update on timelines or court dates..

Sure, Skip. We expect that the next phase of trial, which will be additional patent litigation as well as anti-trust and patent misuse litigation, to happen in Q1 2017. We recently had a hearing that we felt that went well. We should get a ruling from that soon.

And based on some of the things that are going on at both the Supreme Court and other items that we may have to go the long course or we may not. But next thing is Q1 2017..

But we need to go through the next phase before we get any settlement on the first phase. I guess settlement can occur at any point in time, I guess is the way to think about it, but....

Yes, unless there is some settlement between now and then, yes, because until we go through the next phase, both the jury verdict and the judge's ruling is not considered final, so we can't go to the Court of Appeals nor can they I guess; we would not have much to appeal.

But they would not go to Court of Appeals until the final ruling, which is expected to happen after the Q1 2017 trial..

Great. Thanks a lot..

Thank you, Skip..

I think we are done. So I want to thank you all for joining us for this call. And we hope you enjoy the rest of your year and look forward to our call in February. Thank you, bye-bye..

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may now disconnect. Everyone, have a wonderful day..