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.

John Hsu - Raymond James & Associates, Inc. William R. Quirk - Piper Jaffray & Co. Brian D. Weinstein - William Blair & Co. LLC.

Good afternoon, ladies and gentlemen, and welcome to Masimo's Second 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 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. You may begin..

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 Investor 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 second quarter 2016 earnings call. We're happy to again report results that surpassed our projections.

As in the first quarter, we continue to see strong worldwide adhesive sensor growth, which we believe was attributable both to increase in hospital census and our growing base of new customers as evidenced by the prior two quarters' growth and another strong quarter of driver shipments as we shipped 45,300 additional SET and rainbow SET oximeters in Q2, excluding our handheld and finger (sic) [fingertip] (01:56) pulse oximeters.

Here are some of other highlights from our second quarter. Our product sales grew by nearly 12%. Our second quarter 2016 GAAP earnings per share was $0.55, including an $0.08 per share gain related to the new accounting rules for gains realized on stock option exercises, and an approximate $0.04 FX benefit.

This is a 58% increase from our GAAP earnings a year ago – 57%, excuse me. Important new clinical studies (02:32) were published during Q2 continuing to validate the growing list of Masimo technologies and products that are reducing costs and improving patient care.

And we received two important FDA clearances, which will expand our domestic product portfolio and on which, I will discuss later in today's call.

We're encouraged that our 10-year plan to achieve strong earnings growth built on a solid foundation of breakthrough products and strong and broad service has continued to become more visible and consistent over the last two years.

Encouragingly, our results for the first half of 2016 have exceeded our original projections; and as a result we are very happy to be able to once again increase our financial guidance for the rest of 2016. Next, Mark will review our second quarter financial results in more detail and also provide you with our new 2016 financial guidance.

I will then discuss some additional second quarter business, product, and clinical highlights.

Mark?.

Thank you, Joe, and good afternoon everybody. Our second quarter 2016 total revenues were $172.6 million, which was up 10.9% from $155.7 million in the prior year period. Total product revenues rose by 11.5% or 11.1% on a constant currency basis versus the second quarter of 2015.

Product revenues for Q2 exceeded our expectations due, as Joe noted, to both continued strength in attracting new customers, notably in some of our key OUS regions, as well as an increase in U.S. hospital census. rainbow product revenues for Q2 totaled $14.9 million, which was up 10.6% from $13.5 million in the prior year period.

This increase is consistent with our projected total annual rainbow growth of approximately 10%. Our Q2 SpHb revenues declined to $3.6 million from $4.4 million in the prior year period.

This decline was due primarily to a difficult comparison involving two large license orders last year, as well as the slight delay in the shipment of an OUS order, which will now be realized in Q3.

Our worldwide end-user or direct business, which includes sales through just-in-time distributors, grew 12.7% in the second 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 by 5.1% versus the prior year period to $23.7 million. By geography, total U.S. product revenue increased by 10.2% to $117 million compared to $106.2 million in the same quarter of 2015.

Our total OUS product revenues of $47.6 million rose by 15% versus $41.4 million in the same prior year period, and were up 13.6% on a constant currency basis. OUS revenues represented approximately 29% of total Q2 product revenues, up from 28% in the prior year quarter.

Our second quarter 2016 GAAP product gross margin was 65.1%, up by 90 basis points from the previous year, 64.2%.

This improvement is attributable to a number of factors including a more favorable product mix, the continuing benefits from our value engineering efforts and other manufacturing cost initiatives, as well as favorable FX movements, including the year-over-year decline in the value of the Mexican peso versus the U.S. dollar.

Reported second quarter 2016 total operating expenses were $78.7 million, an increase of $3.6 million or 4.9% versus $75.1 million in the prior year period. Our SG&A expenses were $63.9 million, an increase of $2.2 million or 3.6%, while our R&D spending was $14.8 million, an increase of 10.6% versus the year ago period.

The increase in R&D expenses related to additional engineering resources to support both ongoing Masimo new product development efforts, as well as additional staffing related to our commitment to reinvest the medical device tax savings. Second quarter 2016 operating income was $36.4 million compared to $27.8 million in the prior year period.

This significant increase in year-over-year operating income is a result of a combination of factors, including strong product revenue growth, improved product gross margins and continued operating expense control.

Encouragingly for the third quarter in a row, our operating income margin has exceeded 21% and in fact was up over 300 basis points above the same prior year quarter. Q2 2016 non-operating income was approximately $500,000 compared to non-operating expense of $1.1 million in the prior year period.

The $500,000 in Q2 non-operating income includes approximately $1 million in net interest expense, related to borrowings under our line of credit, less other interest income.

This interest expense was more than offset by approximately $1.5 million in favorable foreign exchange translation gains, resulting from changes in foreign exchange rates from April 2, 2016 to July 2, 2016, on our OUS local currency denominated balance sheets.

Our second quarter 2016 effective tax rate fell to 18.6%, down from 30% in the same period last year and well below our expected rate of approximately 30%.

This lower than expected Q2 effective tax rate was due to a $4.1 million benefit we recognized related to our adoption of ASU 2016-09, the new accounting rule regarding the reporting of tax benefits resulting from the exercise of stock options.

As you'll recall, the new accounting rules require that the tax benefit related to the exercise of stock options are reported as a discrete benefit to the current quarter effective tax rate as part of the profit and loss statement. In the past, these tax benefits were reported directly to equity.

Without this discrete item, our adjusted Q2 effective tax rate would have been 29.7%, very close to our 30% projection. As a result of this new accounting rule, our Q2 2016 fully diluted EPS was increased by $0.08 per diluted share, following a $0.02 increase in Q1 2016.

Our average shares outstanding for Q2 were 52.7 million, down from 53.7 million in the year ago period, but up from 51.9 million in Q1 2016. During the Q2 quarter, we repurchased an additional 400,000 shares increasing our year-to-date purchases to 1.5 million shares.

The sequential increase in our Q2 weighted share count was primarily due to the impact that a higher stock price has on the dilutive value of stock options outstanding under the treasury stock method.

Second quarter GAAP net income increased by approximately 55% to $30 million or $0.57 per diluted share, including the $0.08 per diluted share benefit related to the discrete Q2 accounting change and the 4% benefit from movements in foreign exchange rates.

As of July 2, 2016, our DSO was 47 days compared to 52 days as of April 2, 2016, and compared to 46 days as of January 2, 2016. Our inventory turns remained at 3.7%, consistent with the April 2, 2016, level and were down from 4.2% as of January 2, 2016.

Total cash and cash equivalents as of July 2, 2016, were $116.1 million compared to $132.3 million as of January 2, 2016. During the first six months of the year, we have generated approximately $56.7 million in cash from operations and $19 million from the exercise of stock options.

These funds were used in part to repurchase 1.5 million shares at a cost of approximately $63.4 million, and to repay approximately $10 million in our line of credit borrowings and to fund our operations.

During the most recent second quarter alone in addition to the repurchase of approximately 400,000 shares at a cost of approximately $20.5 million, we also repaid $50 million on our line of credit, lowering our total borrowings outstanding from $225 million at the end of Q1 to $175 million at the end of Q2.

Now, I'd like to take just a moment to update our fiscal 2016 financial guidance, which is based on the best information we have available to us.

We are now projecting that our total fiscal 2016 GAAP revenues will be approximately $689 million, including $658 million in product revenues, up from our prior estimate of $647 million, which was then up (12:58) from our original fiscal 2016 guidance of $640 million in product revenues.

We now expect our annual GAAP 2016 product gross profit margins to be approximately 65%, up from our prior guidance of 64.7%. We now also expect our fiscal 2016 operating expenses to be approximately $314 million, which is up slightly from our prior guidance of approximately $312 million.

We continue to expect that our tax rate for the remaining six months of fiscal 2016 will be approximately 30%. We are projecting that our average quarterly weighted shares outstanding for the rest of fiscal 2016 to be between $53 million and $54 million.

And as a result of these changes, we are now expecting our 2016 GAAP EPS to be approximately $2.01, up from our prior estimate of $1.83 per diluted share, and our original projection at the start of the year of $1.69 per diluted share. And with that, I'll turn the call back to Joe..

Thank you, Mark. I want to congratulate our team for our performance through the first half of the year. We intend to continue to achieve results that exemplify our greater growth potential stemming from our breakthrough technologies that have had a profound impact on patient care and cost of care.

As Mark just described, we have once again boosted our full year forecast to incorporate a more positive outlook for 2016. We are realizing higher revenues per drivers across our installed base as utilization has risen.

In addition, steady growth for rainbow and recent regulatory clearances where important new products provide us with greater confidence that we'll exceed our prior target set at the beginning of this year. We're consistently winning new hospital conversions for Masimo SET and rainbow SET oximeters.

During Q2 we received two noteworthy product clearances from the FDA. First, we received FDA clearance for our O3 Regional Oximetry monitor, enabling us to participate in an estimated $125 million market that is growing by 10% annually.

Given the accuracy and ease-of-use of O3 compared to competitive monitors in the field, we hope to capture meaningful share in this market in the next few years.

In fact, one of the world's leading centers for cardiovascular medicine and transplantation, DHZB, the German Heart Center in Berlin has adopted our O3 Regional Oximetry and SedLine Brain Function Monitoring technologies to monitor their patients in the operating room and intensive care unit.

DHZB is a specialized hospital dedicated to the diagnosis and treatment of cardiovascular and thoracic diseases, implantation of mechanical circulatory support systems, and heart and lung transplantations, and treats more than 7,200 inpatients and 24,000 outpatients annually.

The second novo (16:28) FDA clearance we received in Q2 was for our wearable, tetherless Radius-7 monitor with rainbow measurement capabilities.

The rainbow version of Radius-7 allows for patient mobility within the hospital, and includes continuous hemoglobin measurement as an option, which may be useful for detecting post-operative internal hemorrhage.

We also recently initiated the launches of next-generation SedLine and next-generation SpHb products in Europe, both of which incorporate substantially improved technology that increases their clinical utility.

On a related note, we are happy to report that the rollout of rainbow parameters within both low-acuity and high-acuity monitors made by Philips have commenced. GE is also now selling rainbow, and its low-acuity monitor line.

Unfortunately, we've recently learned that GE's rollout of rainbow in their high-acuity monitors would likely be delayed by two years to three years. On the clinical front, two papers were recently published that support the clinical utility of Masimo's innovative technologies.

In a study utilized using the first-generation Pronto Pulse CO-Oximeter to non-invasively measure total hemoglobin and 114 patients, SpHb was successfully measured 89% of the time.

With being (18:03) lab-based hemoglobin values of 12.6 plus and minus 1.9 grams per deciliter and mean non-invasive SpHb value of 12.3 plus or minus 1.6 grams per deciliter. The authors Dr.

Ryan and colleagues at the University of Tennessee Health Science Center, at Le Bonheur Children's Hospital found that non-invasive and invasive measurements correlated well and that the rapid availability of results and the lack of requirement of venipuncture, noninvasive hemoglobin monitoring may be a valuable adjunct in the initial evaluation and monitoring of pediatric trauma patients.

They also noted that noninvasive SpHb testing may be most effective in determining when invasive testing of hemoglobin is warranted. A paper just published in Transplantation Proceedings authored by Dr.

Lee and colleagues at Chang Gung Memorial Hospital in Taiwan investigated the utility of PVI and concluded that PVI may serve as a reliable estimate of cardiac preload status in patients undergoing orthotopic liver transplantation as higher PVI values correlated with lower right ventricular end-diastolic volume value (19:31), so that an increase in ventricular preload status could be inferred from a decrease in PVI during OLTs.

They also noted that right ventricular end-diastolic volume was better correlated with PVI than with other static filling pressure such as central venous pressure or pulmonary artery occlusion pressure; therefore, giving a safer, faster and better estimate of fluid responsiveness.

These two papers are just the latest examples of the high clinical value that our technologies provide to clinicians as they strive to improve patient care. In fact, we estimate that the use of SET pulse oximeter, rainbow SpHb and PVI will save an average hospital $1.3 million a year.

In the age (20:27) of both the Affordable Care Act and the expansion of ACOs, technologies that help clinicians get it right the first time are what hospitals want. In closing, our focus on delivering on our 10-year plan is based on our guiding principles of remaining faithful to our promises and responsibilities.

We are encouraged that our first half of 2016 financial performance has exceeded our original 2006 guidance, and in doing so has allowed us to, once again, increase our financial guidance for the year. We are looking forward to what will be a record year in 2016 as we head into the final stretch of our 10-year plan in 2017.

As always, we remain focused on our mission to improve patient outcomes and reduce the cost of care by taking noninvasive monitoring to new sites and applications with our breakthrough noninvasive monitoring technologies. With that, we'll open the call to questions.

Operator?.

Thank you. Our first question comes from the line of Lawrence Keusch from Raymond James. Your line is open..

Hello..

Good afternoon, everyone. Hi, this is – hey, Joe. This is John Shu in for Larry.

How are you?.

Oh, good. Hi, John.

How are you?.

Doing well, thanks. Doing well. Hey. So, obviously, a very nice quarter, obviously, looking at Mark's comments on the strong operating margin expansion, maybe we could start there, three straight quarters at 21%. Obviously, you want to get up closer to 25% over the next year couple of years.

So, again, can you just remind us outside of the gross margin opportunity on the product side with value engineering, kind of what gets us there, and your confidence around the timing for that?.

Certainly. Certainly value engineering work that we've been doing the last few years is resulting in some of those gains. Our value based – our pricing (22:51) with our customers and our discipline with that, along with the expansion of the new products.

Obviously, we've been talking about rainbow for a while, but we're seeing excellent growth with SedLine, excellent growth with capnography, and now O3.

So, adding SET, rainbow and now Root, which have these new modalities together along with the open connectivity and creating the connective hub for the hospitals, we think will help us drive strong revenue gains as we manage our expenses to what we believe are sustainable, given the initial investment we made in the first 60%, 70% period of the 10-year plan..

Okay, great. That's helpful. And then just kind of shifting gears to international. I guess, two quick ones for you.

One, the sizing, if you could provide us with the size of the international order in hemoglobin that shifted (24:04) to the third quarter? And then also any updates regarding the size of – and timing for the Middle East tender? Thank you..

Well, not to get too much into the minutia, all I can say, had we had that order in Q2, our revenues for hemoglobin would have grown 10% instead of being in decline; also given some of the factors of the last (24:33) same quarter a period ago. But what I can tell you on the Middle East, we're working really well with them.

The run rate of sales have been excellent. We did regain the tender that we had won last year. And in fact, the hospitals' run rate for that was probably two times, three times of what we did last year with them.

However, there is pressure from the finance minister for these hospitals to not automatically get what they asked for, so they will be working towards getting what they want, but instead of it being preapproved for the whole year, they'll have to seek it on a regular basis.

So, while all of that will mean not much for this year for us because we've already projected worst case anyway and we are more than happy to meet that with the new projections we gave you, we'll have to track what really happens on the Street in Q3 and Q4 and then hopefully Q1 of next year we can tell you what to expect for the rest of the year based on their historical usage pattern because, unfortunately, we can't rely on the tender request and tender win that we had, given the way the finance minister has, I guess, rammed in (25:58) that freedom from the hospitals, and we'll request additional demands on a regular basis..

Okay, great. That's very helpful. And then just lastly, the royalty revenues have, obviously, actually been doing a little bit better versus the prior year. And you did raise guidance by $1 million for the year.

So, just any update you can provide us on the status of discussions with Medtronic on royalty agreement?.

We haven't reached any new agreement, but we still remain optimistic that the royalties will continue till October 2018. Given that we won the IPR on two of the patents that they went (26:46) to try to eliminate, the one that we won goes till October 2018.

The one that we partially lost expires next month, so that – obviously, the royalties haven't changed. So, we think things will remain till October 2018. And if we can do something more with Medtronic, we'll be announcing it as soon as we have it..

Okay, great. Thank you for taking my questions..

Thank you so much..

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

Great. Hi. Thanks..

Hello, Bill..

Good afternoon, everybody. Hi, Joe..

How are you doing, Mr.

Quirk?.

Doing very well, sir. And it sounds like, based on the quarter, I think you guys are as well. Quick question, I guess, for perhaps Mark.

If I'm doing the math correctly here, Mark, when I net out the change from the accounting treatment, as well as FX and of course, your organic EPS upside in the quarter, it looks like you're assuming – again, outside of accounting and outside of FX – that the incremental upside is going to be driven by the core business.

It looks like it's a couple of pennies over the next two quarters relative to previous guidance.

Am I doing the math right there?.

Yeah. Yeah. Directionally, that's exactly right..

Okay..

The success we had in the second quarter made us confident enough to take up our projected revenue guidance for both Q3 and Q4 in the range of about $2 million.

We also, though, because of the higher amount of weighted shares, ended up essentially you could say effectively losing $0.01, because of the impact of the now projected higher share number for Q3 and Q4.

So, the combination of that, the higher revenue of about $2 million each quarter, offset by slightly higher weighted share numbers resulted in a net increase of about $0.01 for both Q3 and Q4..

Okay. Got it, very clear.

And just to be clear, Mark, that's obviously organic, I mean, it sounds like any of this change related to tax treatment is obviously going to be triggered upon exercise of options, correct, and doesn't sound like you really have anything dialed in in terms of expectations there?.

Correct. Yeah. We actually can't, because of the discrete nature of those. We can't even include those in any kind of forward guidance, number one, because it's very difficult, of course, to project what kind of stock option exercises might occur; and secondly, because it simply isn't allowed as part of your forward effective tax rate guidance..

Understood. Okay, thank you. And then a couple for Joe, if I may. Joe, the comment around the GE high-acuity monitor delay, could you add a little bit of color there? And then separately, just curious, we got the update around Medtronic in the previous question, anything to say on with respect to Philips? Thanks..

Sure, sure. On the GE, given that, of course, we are in possession of confidential information that I cannot disclose, all I can tell you this delay had nothing to with us. It's something that is an internal issue for them, but with their permission, we wanted to share with you where they are. The good news is Philips has fully rolled out.

Dräger has been out there for a while with rainbow technology. Welch Allyn, ZOLL, and many other OEMs. So, we're anxious to get GE out there, but I know they're doing everything they can, but fortunately, things like this sometimes happen in the product development cycle.

As far as our litigation with Philips, as you know, it's been broken up in four phases. We won phase one for $467 million verdict, which was not finalized, which actually may end up being a good thing with the (31:03) Supreme Court recently changed the standard for willful infringement.

We think we have a great willful infringement case against Philips, which will be not only bringing up on the phase 2 coming up in January, but we'll seek to bring back on the phase one victory as well, where they have admitted that they infringed our technology, before even the trial began.

For us the (31:29) Phase 3 that will be the antitrust suit and patents used case (31:34) against us, that would happen in March of next year. And then Phase 4 is some additional patents we have against them along with our antitrust suit against them and that has not been scheduled yet.

So in summary, if I was going to tell you what I think will happen, I think, hopefully, assuming we win the antitrust and patent issues (32:02) in March probably about 18 months after that, I'm sure Philips will appeal it to the Court of Appeals, Federal Circuit Court of Appeals, which we expect we should win.

And so we think sometime in about two years from now, we'll have our first check from Philips. And maybe with the prejudgment interest, post-judgment interest, if there is willfulness found (32:32) made, it could be much bigger than the $467 million that we secured in the Phase 1 trial and post-judgment ruling by Judge Stark..

Very comprehensive. Thanks, Joe..

Thank you. Thank you, Bill. One more question..

We have a question from the line of Brian Weinstein from William & Blair (sic) [William Blair] (32:58). Your line is open..

Hey, guys, how are you?.

Hello, Brian..

Hi. And so....

Good.

How are you?.

Good, thanks.

So, question for you on market share, where do you guys think you are in market share in pulse oximetry? And what percentage of the available market are you taking every year at this point?.

We don't really know what our market share is, those are difficult to assess. We do believe we are growing two times, three times the rate of growth in the pulse oximetry market given that we're now – we've been growing for almost two years at above 10% rate. So unfortunately, that's all I have for you.

I know there is surveys that are done by independent surveying companies. I don't know how much I can trust those, so therefore I don't want to state what they say because I know there are ways of guessing at (33:54) those numbers is not a scientific as how sometimes they're truly done when economists get involved in big case trials and so forth..

Okay. Mark, question for you on operating expenses, and I guess, Joe, for you as well. You answered various questions, just talking about kind of controls there.

But in general, what are you guys doing on the operating expense side to kind of make sure that you're going to continue to get that leverage? And what are the programs that you have in place, and can just give us any more color on how you think about managing OpEx?.

Sure, sure Brian.

I think as we've been articulating for the past couple of years now actually, we changed really our direction towards planning our future level of total investment in operating expenses, and we changed it from a perspective of identifying various targeted opportunities and ways to expand the business and essentially determining whether to fund those kind of expenses to one in which we just simply said there's a fixed amount of operating expense that we're willing to invest each year and then we work very, very diligently internally to prioritize all of the various spending initiatives that we have.

But at the end of the day, we're limiting ourselves to X amount of dollars of spending growth. So because of that approach, obviously there is a tremendous amount of control in terms of our ability to dictate essentially what level of spending we're going to be at. And that's something we started at the end of 2014.

It's continued all the way through 2015, and is obviously continuing through this year. And as we look forward for the next couple of years, there is no intention to change that type of forced prioritization of investments in order to hit a fixed amount of aggregate spending dollars increase..

Okay. Thanks for that answer. And my last question is on pricing. Is there any change here when you're signing new contracts? Joe, you talked about kind of pricing discipline. Are you seeing Medtronic use price or are (36:24) they still being a responsible player? Thank you..

So, I don't think anything has changed on pricing. We see Medtronic doing the same thing that Covidien was doing pricing-wise.

Given that we, from clinical studies, have data that shows, we can say that average hospital of 250 beds about $1.3 million a year, we – not to mention the life-saving impact of our technology, the eye damage reduction in the NICU of our technology, we believe our pricing is just right and that's not too low, but consistent to wanting to help our customers reduce cost of care.

We always calculate that into our pricing strategy. So the good news is customers are willing to give us a small premium for the value that our technology brings to them that both saved them money, big money not small pennies, but also helped them take better care of their patients..

Great. Thanks..

Thank you so much, Brian. And I want to just add one thing, the reason we can grow our expenses the way that Mark mentioned in a very disciplined fashion is because we had grown, as you know, our infrastructure a little bit ahead of plan, normal plans, the way we would do things given the royalties we were gaining from Covidien, Medtronic.

And that has allowed us now – I guess, the last part of our 10-year plan to not have to grow our expenses, yet not be choking the company when it comes to both product that saves lives and helps people, as well as the number of people we need from an infrastructure perspective to treat our customers as they are accustomed to.

So, we're really happy that the 10-year plan is working. We're happy that our investors have stuck by us, and now are seeing the stock working. So we will do our best to continue this commitment to you and look forward to our next quarter results in a few months. Thank you all for joining us..

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