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

Lawrence S. Keusch - Raymond James & Associates, Inc. Brian D. Weinstein - William Blair & Co. LLC William R. Quirk - Piper Jaffray & Co (Broker).

Good afternoon, ladies and gentlemen, and welcome to the Masimo's First Quarter 2016 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 speaker's remark there will be question-and-answer session.

I'm pleased to introduce Eli Kammerman, Masimo's Vice President of Business Development and Investor Relations..

Thank you. 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 2016 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. I'll now pass the call to Joe Kiani..

Thank you, Eli. Good afternoon, and thank you for joining us for Masimo's first quarter 2016 earnings call. Our first quarter results were above our expectations. Growth for rainbow in Q1 was especially strong rising by 39% to nearly $17 million, a growth rate influenced by the final portion of the initial large Middle East order.

Overall, our total product revenues grew by nearly 11% to $163 million. Here are some highlights from our first quarter. We had continued strong demand for our technology as we shift 46,300 SET and rainbow SET oximeters, excluding our handheld and finger pulse oximeters. Our OUS sales grew by approximately 24% and 28% on a constant currency basis.

We also repurchased approximately 1.1 million of our shares. Our Q1 2006 (sic) [2016] (02:25) GAAP earnings per share were $0.53, up from $0.38 in the prior-year quarter, an increase of approximately 39%.

On the product side, we were happy to have received FDA clearance for the full featured version of Root with non-invasive blood pressure and temperature monitor. Increasingly the utility and appeal of this innovative product is reaching our customers.

Our stronger than expected Q1 results and our continued positive outlook for the rest of 2016 are causing us to be more optimistic about the year and hence we are increasing our 2016 financial guidance for product revenues, gross product margin and earnings per share.

Next, Mark will review our first quarter financial results in more detail and also provide the updates to this new financial guidance for 2016. I will then provide some additional detail on our achievements and expectations.

Mark?.

Thank you, Joe, and hello, everybody. Our first quarter 2016 total revenues were a $171.2 million, which was up 10.8% from a $163.3 million in the prior-year period. Similarly, total product revenue rose by 10.8% or 11.7% on a constant currency basis versus the first quarter of 2015.

Our Q1 2016 product revenues were reduced by $1.4 million due to the effects of foreign exchange rate movements. Product revenues for Q1 exceeded our expectations due to both the impact of the late flu season, and the acceleration of the final portion of a large Middle East order in Q1, an order that we expect to recur in future periods.

Q1 2016 rainbow product revenue totaled $16.9 million up by 39.2% from $12.12 million in the prior year period. The strength in rainbow revenues was largely due to the impact of the Middle East order, which also contributed to our growth in single patient use rainbow sensors.

Our Q1 SpHb revenue surged by 164% to $6.1 million versus $2.3 million last year with a substantial portion of this increase also attributable to the Middle East order.

Our world-wide end-user or direct business, which includes sales through just-in-time distributors grew 12.7% in the first quarter to $140.9 million versus $125.1 million in the year-ago period. Our direct business represented approximately 86% of total product revenue in the quarter versus 85% in the prior-year period.

OEM sales comprised the remaining 14% and rose 5.2% versus the prior-year period. By geography, total U.S. product revenue increased 5.8% to $113.5 million compared to $107.3 million in the same quarter of 2015.

Our Q1 OUS product revenues of $49.8 million rose by 24.2% versus $40.1 million in the same prior year period and up 27.6% on a constant currency basis. In constant currency OUS year-over-year revenue growth rates were the highest in the EMEA and Japan regions.

OUS revenues represented approximately 30% of total Q1 product revenues or 31% on a constant currency basis, which was up from 27% in the prior-year quarter. Our first quarter 2016 GAAP gross profit margin was 65.1%, level with the prior-year quarter.

Our Q1 2016 financial results for the first time ever will no longer include the financial results of our variable interest entity or VIE, Cercacor.

This change, which we have discussed in our prior 10-Qs and 10-Ks and which we will discuss in a little bit more detail later, included the impact of reducing our Q1 GAAP gross profit margins as well as our total GAAP operating expenses. However, as we have noted in the past, this change will have no impact on Masimo's reported earnings per share.

In fact, had we continued to consolidate Cercacor, our Q1 adjusted product gross margins would have been 66%, up nearly 100 basis points over our original expectations for Q1.

This was due primarily to the favorable product mix shift resulting from a higher percentage of our total product revenues coming from adhesive sensors versus capital equipment than we had expected.

Reported first quarter 2016 total operating expenses were $76.9 million, an increase of $1.1 million or 1.5% versus $75.7 million in the prior-year period. As I just noted, our Q1 2016 operating expenses were reduced by approximately $1.8 million due to the deconsolidation of Cercacor.

Adjusting for the impact of this deconsolidation, our adjusted operating expenses would have increased by approximately 4%. In addition, as a reminder, our year-over-year operating expenses were also lower due to the impact of the two-year medical device tax suspension.

While we still intend to reinvest those tax savings over the next two years, the amount of the new incremental investment in Q1 was relatively small.

Regardless of the reduction in operating expenses due to both the deconsolidation of Cercacor and the impact of the medical device tax suspension, the rather modest year-over-year increase in operating expenses continues to demonstrate our commitment to exercising tight control of expense growth.

Specifically, our SG&A expenses were $62.5 million, an increase of $1.7 million or 2.8% while our R&D spending was $14.4 million, a 3.8% decline versus the year-ago period due primarily to a small reduction in clinical trial and engineering project related expenses.

First quarter 2016 operating income was $37.3 million compared to $27.4 million in the prior-year period. This significant increase in year-over-year operating income is the result of all of the factors I previously noted, including strong product revenue growth, higher than expected product gross margins and continued operating expense control.

Q1 2016 non-operating income was $500,000 compared to $200,000 in the prior year period. Importantly, the $500,000 in Q1 income includes approximately $660,000 in net interest expense related to borrowings under our line of credit.

The remaining benefit in other income is due largely to the favorable foreign exchange translation impact of movements in foreign exchange rates from January 2, 2016 to April 2, 2016 on our OUS local currency denominated balance sheets.

Our first quarter 2016 effective tax rate fell to 27.1%, down from 28% in the same period last year and below our expected rate of approximately 30%.

This lower than expected Q1 2016 effective tax rate was due to our decision to early adopt ASU 2016-09, the new accounting guidance regarding the tax reporting of gains resulting from the exercise of stock options.

As you probably know, the new guidance which came out on March 31, 2016, essentially shifts the movement of the tax gains and losses from equity into the P&L through the quarterly effective tax rate.

This is considered a discrete benefit in the quarter, and as a result, we expect our effective tax rate, absent any other discrete items, to continue to be approximately 30% for the remaining nine months of the year.

Our average shares outstanding for Q1 was 51.9 million, down from 54 million shares in the year-ago period and down from 52.9 million shares in Q4 2015. This decline was due mainly to the impact of our Q1 stock repurchases, partially offset by stock option exercises.

Recall that in Q4 2015 we repurchased approximately 600,000 shares, bringing our total six-month repurchases to 1.7 million shares. First quarter GAAP net income was $27.6 million or $0.53 per diluted share, up 39%.

Included within this amount is a $0.02 per diluted share benefit related to the discrete Q1 2016 accounting change related to the stock option exercises. Just one final comment regarding the deconsolidation of Cercacor.

As you'll recall, Cercacor although a completely separate company spun-off from Masimo in 1998 has been consolidated into Masimo's financial statements for over 10 years. This was done to comply with generally accepted accounting principles.

Over the past couple of years, a variety of changes have occurred within the Cercacor business environment including a recent capital infusion. As a result of these changes, the GAAP literature no longer requires that Cercacor be consolidated.

We also though wanted to be clear that while we are reporting our Q1 2016 financial results on a deconsolidated basis, our prior year Q1 2015 financial statements, again required per GAAP, are presented in the same manner in which they were presented in last year.

And so, as a result, when comparing year-over-year quarterly product gross margin or operating expenses, it is an apples and oranges comparison. However, what is consistent is that the consolidation and now the deconsolidation of Cercacor has never had any impact on Masimo's net income and diluted earnings per share.

As of April 2, 2016, our day sales outstanding was 52 days compared to 46 days and January 2, 2015. Over the same period, our inventory turnover declined slightly from 4.2 to 3.7. Total cash and cash equivalents as of April 2, 2016 were $139.9 million compared to $132.3 million as of January 2, 2016.

During the quarter, we generated $18.8 million in cash from operations, $2.6 million from stock option exercises and borrowed an incremental net $40 million on our line of credit. These funds were used in part to repurchase approximately $48 million in stock in the period.

Now, I'd like to update our financial 2016 guidance, which is based on the best information we have available to us. We're now projecting our total fiscal 2016 GAAP revenues to be approximately $677 million, including $647 million in product revenues, up from our prior estimate of $640 million.

We are maintaining our projection for $30 million in royalty revenues. We continue to expect 2016 GAAP revenues for rainbow to be approximately $68 million. We now expect after the deconsolidation of Cercacor for our new annual GAAP 2016 product profit gross margins to be approximately 64.7% down from the prior GAAP guidance of 65.5%.

However, it is important, as I alluded to before to remember that the impact of the Cercacor deconsolidation was to reduce the prior GAAP guidance of 65.5% by a 110 basis points. In other words, our prior gross profit margin guidance would have been 64.4%.

Therefore, in reality, we are actually increasing our full-year gross profit margin guidance from what would have been 64.4% on an adjusted basis to the current 64.7%, primarily due to the stronger than expected Q1 2016 gross profit margins.

We now expect after the deconsolidation of Cercacor for our new fiscal 2016 operating expenses to be approximately $312 million, down from our prior guidance of approximately $317 million.

This $5 million decline is due to the elimination of approximately $7 million in Cercacor operating expenses offset slightly by a higher Q1 2016 operating expenses that we incurred which were consistent with the higher than expected Q1 2016 product revenues.

Despite the 27.1% effective tax rate in Q1 2016, as I noted earlier, we expect our tax rate for the remaining nine months of fiscal 2016 to be approximately 30%. We also continue to expect that our quarterly other expense will be approximately $1 million per quarter due mostly to interest expense tied to borrowings under our line of credit facility.

We are projecting that our average quarterly weighted shares outstanding for the rest of fiscal 2016 to be approximately $52 million to $53 million. As a result of these changes, we're now expecting our 2016 GAAP EPS to be approximately $1.83, up from our prior estimate of $1.69 per share. And with that, I'll turn the call back to Joe..

Thank you, Mark. Thanks very much. We've started 2016 strongly and we're excited about our prospects for the rest of the year. As you just heard from Mark, we have raised our projections in response to the stronger pace of business.

The pace of expansion for our install base remained steady, while the acceleration of growth for rainbow and new product sales gives us confidence that we will be able to grow our top-line at a higher rate than originally projected.

Our continuing ability to win new hospital conversions to Masimo SET Pulse Oximetry further reinforces our belief that we will grow sales faster than the pulse oximetry market. We attribute this strong demand to the proven clinical superiority of our technology for improving the quality of care, while reducing cost of care.

A key factor of our growth is the contribution we are realizing from newer products. Good examples of our success can be seen in the growth for Root with capnography, Root with SEDLine Brain Function Monitoring, as well as our RAM, Respiratory Acoustic Monitor, which had sales growth of greater than 40%, 50% and 100% respectively in Q1.

During Q1, we were delighted to see two new publications that support the use of our latest rainbow parameter, ORI, which is Oxygen Reserve Index. In a prospective study published in Anesthesiology and conducted at Children's Medical Center in Dallas, Dr.

Peter Szmuk and colleagues evaluated whether ORI could provide a clinically important warning of impending desaturation in pediatric patients with induced apnea after pre-oxygenation.

The research has concluded that during prolonged apnea in healthy and exercised children, the ORI detected impending desaturation in median of 31.5 seconds before noticeable changes in SpO2 occurred. Another study published in Anesthesia & Analgesia and conducted at Loma Linda University by Dr.

Richard Applegate in both patients in which arterial catheterization and intraoperative arterial blood gas analysis were planned during surgery and showed similar findings.

The conclusions of the study included a finding that suggests that intraoperative ORI can distinguish PaO2 between 100 millimeter mercury and 150 millimeter mercury when SpO2 is greater than 98%.

In addition, decreases in ORI to near 0.24 may provide advanced indication of falling PaO2 when SpO2 is still greater than 98% and above the PaO2 level at which SaO2, which is arterial oxygen saturation declines rapidly.

Shifting to our financial performance, our plans to achieve earnings growth that is twice the rate of sales growth are solidly on track for 2016.

In fact, our Q1 product revenues rose by approximately 11%, while our diluted earnings per share rose by approximately 39%, including the $0.02 tax benefit from the new accounting rules that were previously noted by Mark.

While we don't anticipate this continued level of earnings per share year-over-year quarterly growth, our new guidance does now suggest top-line product revenue growth approximately 7% and diluted earnings per share growth of 18%, still more than twice the rate of sales.

As we have previously described, the major factors contributing to increased leverage in our P&L include consistent year-over-year sales growth, continued adjusted year-over-year gross profit margin increases resulting from the value engineering investments that began a few years ago and continued controlled growth in operating expenses.

Our outlook for 2016 therefore continues to be very positive as we head for what we expect to be a very strong finish to our 10-year plan in 2017, a plan that is built on our mission to improve patient outcomes and reduce the cost of care by taking non-invasive monitoring to new sites and applications.

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

Operator?.

Thank you. And our first question comes from Larry Keusch from Raymond James. Your line is now open..

Yeah. Good afternoon, everyone..

Hi, Larry..

Could you talk a little bit, Joe, about you alluded to the Middle East orders in the quarter, obviously that was anticipated, but can you give us a sense of size and you also alluded to you expected this to continue.

Could you help us understand that?.

Certainly, certainly. First of all, this Middle East order we discussed that I think last quarter and we said that we expected it to be in the range of $17 million, which about half of it, we got in 2015 and the other half we were expecting between Q1 and Q2 of this year.

However, we ended up due to their demand accelerating both and we shipped it all in Q1 of this year. Now, the good news and the reason we expect this business to reoccur is we've also recently won the tender again for that same business. So, that's the size and that's kind of the timeframe of what we expect going forward..

Okay. Terrific. And then just one other quick one and I'll jump back in queue.

Mark on the DSOs which increased, again, can you walk us through what was behind the changes there?.

Sure, as I said, they went up from 46 days from the prior quarter to 52 days and ironically as we were just talking about all of that attributable to slightly longer-terms that we made available related to this large initial Middle East order.

So, all of that is related to that one contract and we expect that the repayment plans for that will commence some time in Q2 and will continue through the rest of this year..

Okay. Very good. Thank you very much..

Thank you, Larry..

Thank you. Our next question comes from Brian Weinstein from William Blair. Your line is now open..

Hey, guys. Thanks for taking the question..

Hi, Brian..

Hey, Joe. So, in the U.S., you guys I think you were kind of mid single-digits. Is that the growth rate that we should expect kind of for the core at this point.

What do you see the underlying market growing and then I'm curious to follow-on there, what do you see ORI and O3 and Root potentially adding in terms of growth rates to sort of that core?.

Sure. Sure. First of all, we believe our growth rate in the U.S. will be in the upper single-digit, which is we think two times to three times the normal pulse oximetry growth in the U.S. As far as your second question, O3 and ORI, both products have not yet been cleared by the FDA. So they are currently not our projections for U.S. business.

We do hope they will get approved this year and once they do, depending on when it does, we may even adjust our revenue plans for the U.S. because they are both very successful products that we rolled out in Europe and Japan and the customer demand has been very high. So we hope the same thing will happen in the U.S..

Great. And then, follow-up question. On the blood management sales team, can you quantify, kind of what they've been up to? What type of funnel you're looking at there and kind of a success that they are having? Thank you..

Sure. Sure. I think, as we discussed at the beginning of the year, we decided to consolidate the blood management team within this normal sales organization, but what we did, instead of just having them be part of the normal account management, we created the OR ICU sales team which not only had non-invasive hemoglobin and PVI in their bag.

But they also would have SEDLine, capnography, as well as of once the FDA clears it, O3 and ORI. And then, we also created a special sales force to focus on the post surgical ward.

As far as the funnel for that business, it still remains strong and as you noticed, our revenues picked up nicely although some of that was from the Middle East order that we talked about but it's looking very good.

We have some very large customers who are seeing very good results clinically with SpHb and PVI and we expect that will convert to accelerated adoption of the products.

I think also the other thing, Brian, I want to note, as you may have seen the announcement from Philips that they did launch their high-end markers with rainbow and I think that will also be a benefit, because about 60% of ORs and ICUs, it's not on the world, at least in the U.S.

are still monitored and for them to now have integrated rainbow, it should make it easier for customers to do what they want to do instead of having an additional product in the room..

Okay. Great. Thank you..

Thank you..

Thank you. And our next question comes from Bill Quirk from Piper Jaffray. Your line is now open..

Hi. Thanks. Good afternoon and nice quarter, guys..

Thank you, Bill..

First question, I guess, is for Mark.

On capital allocation, do you guys have continued plans to buyback your stocks? I mean, it looks like you have some additional room from a levered standpoint?.

Bill, we're constantly looking at opportunities to repurchase the stock, there are various ways as you know to do that.

We do have various structures in place that will ensure the continued repurchase of stock at certain levels and then we give ourselves the opportunity to also strategically enter the market any time we think the opportunity is appropriate.

So, yes, absolutely the intention of our standard credit facility that we put in place earlier this year is intended to facilitate that kind of activity should the opportunity present itself..

Got it. And then, sorry, a quick housekeeping question and one more for me and that's just the split of the delta in your OpEx between R&D and SG&A. Mark, can you just give us a little color there of the $5 million delta? Thanks..

Sorry, Bill.

The $5 million delta?.

Yeah. The lower operating expenses of $312 million down from $317 million for the year.

Can you just give us a little color, the balance there between R&D versus SG&A?.

Well, yeah, I think that the two biggest areas – in R&D, as I noted in the comments we just made, those are reduced due to some selective spending in areas of clinical activity and other product related expenses. The change, if you will, year-over-year in SG&A, as I alluded to in the prepared comments really are due to couple of things.

Number one, the fact that we're deconsolidating Cercacor. So as I indicated, that had the effect of reducing our Q1 operating expenses by about $1.8 million. We then also, of course, did not begin the accelerated reinvestment of the med device tax costs that were in prior years SG&A numbers..

We tried by the way. We tried, but the recruiting is not something that happens overnight..

Right, right. So those by themselves, I think represent the greatest reason for, as I said on the call, the flatness, if you will, in year-over-year operating expenses..

Okay. I'll try to take that one offline, I guess. Then last for me is, just like a given, Joe, your comment about winning the additional Middle East tender. And then obviously the potential opportunity that you have with the new products, obviously as you noted, depends on FDA timing.

But, I guess, why not take a slightly bigger swing at revenue guidance for the year? Thanks..

Because, while we won the tender for exact same products, we will not learn about the full scope of the business till June. And last year, when we won the tender and it was announced in June, the revenues did not begin until towards the end of Q3.

So it's hard to understand how that will potentially impact us but I think more broadly speaking, Phil, we are trying to be conservative with our guidance so that we don't disappoint. We hope we'll continue meeting and maybe beating.

As you know in the last five quarters, we have beat our revenue guidance and earnings guidance and we've raised it each quarter and we hope to continue to do that. But at least we feel good about the numbers we've given you that we should meet them..

Very good. Thanks, guys. Appreciate it..

Thank you, Bill. Thank you very much. I think it's busy earning season. So I think that maybe your last question. I don't know if Larry, do you have another follow-up question you want to ask, if not, I will adjourn our call..

Well, it looks like there is no other questions. So, we'll go ahead and end this call. Thank you so much for joining us for our Q1 earnings call. We look forward to our next one in a few months. Thank you very much..

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