Eli Kammerman - Masimo Corp. Joe E. Kiani - Masimo Corp. Mark P. de Raad - Masimo Corp..

Tao L. Levy - Wedbush Securities, Inc. William R. Quirk - Piper Jaffray & Co. Lawrence Keusch - Raymond James & Associates, Inc..

Good afternoon, ladies and gentlemen, and welcome to Masimo's First Quarter 2017 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 am pleased to introduce Eli Kammerman, Masimo's Vice President of Business Development and Investor Relations. Please go ahead..

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 2017 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 2017 first quarter review. Today, we are reporting product revenue results that illustrate the strength in our solutions that are helping care providers improve their care and reduce their cost. Our Q1 product revenue exceeded our expectations.

As is evident from these results, we continue to successfully win new customers, not only due to our SET pulse oximetry and rainbow Pulse CO-Oximetry technology platforms, but also due to our expanding new products including Root, our new patient monitoring and connectivity hub. Our Q1 product revenues grew to $178.1 million, a 9% increase.

We shipped 47,900 oximeters in Q1, producing a new estimated installed base of 1.525 million oximeters, excluding our SET handheld and finger pulse oximeters. Our Q1 2017 GAAP earnings per diluted share were $0.82, up from $0.53 in the same prior-year period.

The Q1 2017 earnings per diluted share including a net benefit of $0.25 due to stock option exercises versus $0.02 in the prior-year quarter. In just a moment, Mark will provide you with a more detailed description of our quarterly financial results.

I will be brief in my comments today, given that we will be hosting our Investor Day next week on Tuesday May 9, at our California headquarters. The goal of next week's meeting is to provide you with a broad overview on various topics regarding Masimo's outlook and vision for the next chapter after the completion of our 10-year post-IPO plan in 2017.

The day will include demonstrations and discussions about our products, our business as well as some directional insight into our long-term financial goals. I hope you have already registered and if not, please do so at the investor events section of our website.

Now, I will ask Mark to review in more detail our Q1 results and to provide you with a refinement on some of our original 2017 financial guidance.

Mark?.

Thank you, Joe, and good afternoon everybody. Our Q1 product revenues rose to $178.1 million or up 9.1%, or 9.5%, a difference of approximately $700,000 on a constant currency basis, versus the $163.3 million posted for the first quarter of 2016. The strength was attributable to strength in demand for our core technologies in U.S.

and OUS markets as well as contributions from some of our new products including Root. As a remainder, we had expected our first quarter total revenue and rainbow revenue year-over-year comparisons to be more difficult due to the impact of the large $8.1 million total revenue order from a Saudi customer last year.

As expected, due to the continuing financial constraint in Saudi Arabia, in the most recent quarter we generated $2.8 million from the same Saudi customer. Still despite this $5.3 million year-over-year decline, the fact that our product revenues were approximately $6 million higher than we expected and up 9.1% was very encouraging.

We believe that part of this Q1 product revenue strength was due to the relatively severe flu season. Our Q1 total revenues which include royalty revenues were $186.3 million, up 8.8% from $171.2 million in the prior-year period.

It's noteworthy to mention that this increase occurred despite not being able to recognize approximately $4 million in deferred revenue related to our Philips integration activities in Q1.

While we were not able to recognize this additional revenue in Q1, we do expect to be able to do so in our second fiscal quarter and our estimate for this revenue has actually increased slightly to $4.4 million. rainbow product revenues for Q1 totaled $13.9 million, which was down by 17.8% from $16.9 million in the prior-year period.

The decline in rainbow sales was due entirely to a decline of $4.2 million in rainbow revenues from the same large Saudi Arabia customer that I noted previously. In fact, without the impact of this one customer, our year-over-year rainbow revenues would have been up approximately 10%.

Our Q1 SpHb revenues were $2.8 million, down from $6.1 million in the prior period, and again, $3.7 million of this decline was due to the same large Saudi customer. Without the impact of this one customer, our SpHb revenues were up approximately 18%. And encouragingly, sales of our U.S.

single-use rainbow adhesive sensors rose by 30% over the same prior-year quarter. Our worldwide end-user or direct business, which includes sales through just-in-time distributors, grew 9.9% in the first quarter to $154.9 million, versus $140.9 million in the year-ago period.

Our direct business represented approximately 87% of total product revenue in the quarter, versus the same level in the prior-year period. OEM sales totaled $23.2 million, representing 13% of product revenue, as compared to $22.3 million in the year-ago period, which was up approximately 4%. By geography, total U.S.

product revenue increased by 9.8% to $124.7 million, compared to $113.5 million in the same quarter of 2016. Our Q1 OUS product revenues of $53.4 million rose by 7.3% versus $49.8 million in the same prior-year period and were up 8.6% on a constant currency basis.

Excluding our business related to the one large customer in Saudi Arabia, our OUS business in Q1 grew by approximately 21.3% or 22.8% on an FX-adjusted basis compared to the same year-ago period. Q1 OUS revenues represented approximately 30% of total Q1 product revenues. Our first quarter 2017 GAAP product gross margin was 65.1%.

Our Q1 product gross margins were slightly lower than we had expected due to our decision in the middle of Q1 to accelerate the expansion of our worldwide manufacturing capacity.

This expansion will not only double the manpower and enhance the capacity for production of our single-patient adhesive sensors, but will also improve our disaster recovery capability.

Because of the short-term start up costs associated with this ramp up, our Q1 margins were negatively impacted by about 40 bps and we expect this ramp up to continue to impact our Q2 gross profit margins. However, by the second half of 2017, we expect to be able to return to the product margins we expected at the start of the year.

Also during the quarter, we have slightly increased cost associated with our RD sensor conversion program, in which replacement RD cables were provided to certain customers to facilitate those RD conversions.

And encouragingly the RD conversion is moving more quickly than we expected and as a result, while we might incur a slight higher cost related to the RD cables in the short run, the acceleration of the conversion to the RD sensor will benefit our overall margins in the future as well, of course, enhance customer satisfaction.

Reported first quarter 2017 total operating expenses were $80.9 million, an increase of 5.3%, slightly below our expectations, as some of these expenses we anticipated incurring in Q1 are now anticipated to shift out to later in the year. SG&A expenses were $65.6 million, up 4.9% versus $62.5 million in the prior-year period.

While our R&D expenses totaled $15.4 million, up approximately 7% from $14.4 million in the prior period.

We're pleased that the combination of our top line growth coupled with slightly lower operating expenses albeit with a slightly lower gross margin resulted in Q1 operating income margin of 23.2%, an improvement of 140 basis points versus the 21.8% in the same prior-year period.

Non-operating income in Q1 2017 was $900,000 compared to non-operating income of about $500,000 in the prior-year period. During the first quarter, we reported net interest income of approximately $300,000 and a approximate $600,000 foreign exchange re-measurement gain.

This compares to prior-year interest expense of approximately $700,000 offset by a $1.2 million re-measurement gain. Our first quarter 2017 effective tax rate, included a tax benefit of approximately $1.3 million or 2.9%.

This number is the combination of a $13.9 million tax provision on our pre-tax income of approximately $44.1 million or the expected rate of 31.5%. However, this was offset by an approximate $15.1 million tax benefit associated with the new accounting rule regarding the reporting of gains from stock option exercises.

By comparison, in the same prior-year period, our effective tax rate was 27.1%, which was the result of a 29.8% effective rate reduced by a $1 million tax benefit associated with the same accounting rule.

Our average shares outstanding for Q1 rose to 55.5 million, up from 51.9 million in the year-ago period, and up from 54.2 million in the Q4 2016 period.

The increase in our weighted share count over the prior-year period is due to both the impact of stock option exercises and the dilutive impact that a higher price has under the treasury stock method. In fact, in the first quarter, we had the second highest level of stock option exercises in any quarter since we went public.

First quarter GAAP net income was $45.3 million or $0.82 per diluted share, compared to $0.53 in the prior-year period. The $0.82 per diluted share includes a net $0.25 benefit related to the high level of Q1 stock option exercises. This compares to a $0.02 benefit that we incurred in the same prior-year quarter.

In the current quarter, the net $0.25 benefit was due to a combination of $0.27 per diluted share benefit, partially offset by a $0.02 negative impact due to higher payroll taxes resulting from the same higher stock option exercises.

So, excluding the net $0.25 adjustment to the Q1 2017 earnings per share, we would have reported $0.57 as compared to an adjusted $0.51 in the prior-year period. And it's also important to recall that we did include $0.06 in our Q1 and full-year EPS estimates when we provided our original financial guidance in February.

So the net incremental quarterly impact to our original stock option gain guidance was $0.25 less the $0.06 we initially provided or a net increase of $0.19.

As of April 1, 2017, our days sales outstanding was 53, which was unchanged from 53 as of December 31, 2016 while our inventory turns were 3.1, compared to the 3.3 for the period ended December 31, 2016. Total cash and cash investments as of April 1, 2017 were $344 million, compared to $306 million as of December 31, 2016.

During the first quarter, we generated approximately $15.4 million in cash from operations, and received $27.3 million from the exercise of stock options. As a side note, in April 2017, we did remit a $71.4 million tax payment to the U.S. government for the U.S.

taxes associated with the $270 million gained from the Philips settlement recognized in our Q4 2016 financial results. Now, I'd like to discuss our fiscal year 2017 financial guidance, which is based on the best information we have available to us.

Please note that we're providing this updated financial guidance in a period of time in which significant uncertainty exists regarding the overall general business and economic environment, including the future of the Affordable Care Act as well as potential changes in U.S. corporate tax policies being considered.

With that said, here is an update to our 2017 financial guidance.

We are now projecting total 2017 revenues of $759 million, compared to $752 million, including $727 million in product revenues compared to $721 million, of which approximately $4.4 million is attributed to the non-recurring engineering revenues that we expect to recognize in the second quarter.

At the same time, we are also increasing our full-year royalty projections to approximately $32 million from $31 million. Due to the more rapid expansion of our worldwide manufacturing capacity, we now expect our full-year gross profit margins to decline slightly from 65.7% to 65.4%.

We also now project our operating expenses to be approximately $329 million, up from approximately $327 million, due primarily to the higher payroll taxes associated with the increased stock option exercises.

We are not making any changes to our estimated effective tax rate range of 30.5% to 32.5% for the year and so continue to use 31.5% as the midpoint in our projections. Due to the higher stock option exercises, we are also increasing our full-year weighted average shares outstanding assumption from 55.3 million to 56.4 million.

Finally, as we did in February, we are including within our updated annual guidance the benefits from stock option gains that we have already realized in Q2 2017. Accordingly, we are adding an additional $10.1 million tax benefit to our projected Q2 effective tax provision resulting in a net Q2 projected tax rate of approximately 8% to 9%.

Based on these revised estimates, we're now projecting our full-year GAAP EPS to be $2.65, up from $2.30. Included in this $2.65 is a net full-year estimated stock-based compensation gain of $0.38 per share.

The reference to net gain is important because it is meant to reflect the combination of the benefit of the stock option gain offset by the increased payroll taxes that we've attempted to forecast through April, and higher weighted average shares, that of course continue throughout the entire year, all resulting from the higher than expected stock option exercise activity.

However, it's also important to remind everybody that because $0.06 of this gain was already included in our original 2017 EPS guidance of $2.30 per diluted share, the incremental increase is $0.32.

Therefore, of the total $0.35 increase in our updated 2017 EPS guidance, $0.32 relates to increases in our expectations of the net benefit of stock option gains, and $0.03 relates to increased operating guidance. Now with that, I'll turn the call back to Joe..

Thank you, Mark. We have begun 2017 with a better than expected first quarter result.

Given the partnership with Philips, the new studies on SpHb and PVi, the next generation rainbow SpHb performance and some of the new rainbow parameters including ORi, we are more confident about the potential for rainbow, particularly SpHb and PVi to become a standard of care in hospitals and we are diligently working towards educating clinicians about the benefits of using these measurements to achieve improved outcomes and reduced cost of care.

On a related note, a recent study conducted at College at York Teaching Hospital in York, United Kingdom evaluated the performance of Masimo PVi monitoring in guiding fluid management, as compared to that of an established technology, esophageal Doppler.

The researchers measured the absolute volume of fluid given intraoperatively and fluid volume at 24 hours and found no significant difference between PVi and esophageal Doppler groups in mean total fluid administered or mean intraoperative fluid balance.

Therefore, they concluded that PVi offers a non-invasive consumable free alternative for intraoperative fluid optimization in fit patients undergoing major colorectal surgery, where intraoperative goal-directed therapy is deemed a standard of care, but there is no requirement for arterial cannulation.

With that, our call today is somewhat briefer than unusual because we are planning to share much more detail about our business with everyone in six days, next Tuesday, May 9, when we hold our Investor Day in Irvine for the first time.

We will be sharing an overview of our outlook for the next phase of our company including long range technology, product, sales, manufacturing, and financial direction for the next seven-year period. In closing, we once again, exceeded our projections with our Q1 financial results giving us confidence about our performance for the remainder of 2017.

We've remained committed to our mission to improve patient outcomes and reduce the cost of care. We hope to see you next week in Irvine. With that, we'll open the call to questions.

Operator?.

And our first question comes from Tao Levy from Wedbush. Your line is now open..

Great. Thanks. Good afternoon, everyone..

Good afternoon..

Hi, Tao..

Maybe just, if you can talk about the first quarter and the flu season and any guesstimates as to what type of contribution that might have had on the business and now historically, we've always thought of it as impacting just to pull socks, but is there – could have, have a positively impacted other parts of them over the product portfolio?.

Well, the flu season in Q1, Tao, was probably the second highest in the last several years, but that tailwind was offset somewhat by the headwind that we heard off from hospitals seeing a lower senses for elective surgeries. So we think while, certainly, it helped because without it maybe Q1 would have been a strong.

We are not anticipating a big change going forward for the next three quarters..

Got it.

And so as we think about the next few quarters and the way my model is built, I try to back into revenues per install, is there sort of like some sort of discount fact that we should apply to the first quarter because of flu, so that we don't over increase the remaining quarters?.

Well, yes, and no. Broadly speaking, yes, because we believe overall procedures will be less in Q2 and Q3. However, there are international opportunities that sometimes come and go and sometimes balloon like last year did this for us in Q1 and who knows it could balloon for us in Q2 this year.

So I think, normally, I would say, yes, I would say maybe couple percent lower on sensor consumption would be the right thing, but I think it might get offset by other opportunities around the world, in Middle East and Latin America. And also we've been doing really well with our new products like Root, like MightySat, and Radius-7 and so forth.

So we feel that, while maybe there will be obviously less procedures normally in places like the U.S., we think it should be offset by what we end up doing around the world and in some of the new capital areas..

Got you. Very helpful.

And just lastly for Mark, because you didn't collect some of that, the R&D revenues from Philips in Q1, does that also mean there wasn't sort of like an R&D expense and both of those events will now be in the second, take place in the second quarter?.

Tao, yes. Tao, what is occurring is we're incurring these engineering expenses related to these deliverables. And so when we recognize the revenue like we will next quarter, what will happen is we'll take some of those engineering expenses and reclassify them from operating expenses up into the cost of sales section of the P&L..

Okay. Thank you very much..

Right. Thank you..

Thank you, Tao..

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

Great, thanks. Good afternoon, everybody..

Hi, Bill.

How are you doing?.

Hi, Bill..

Very well. So I apologize if you talked about this in your prepared comments. I did unfortunately have to jump on a few minutes late.

But can you just maybe help talk us through some of the partnership with Philips and maybe some examples of how the two companies are working together to try to better integrate Masimo into some of their patient monitoring technologies?.

Sure, sure. First of all the partnership is going very well at all levels of the organization. I've had calls with and meetings with the CEO of Philips a few times since we entered into our agreement.

The teams are working collectively to launch our co-marketing campaigns as well as new products with our technology from rainbow to some of the new measurements like SedLine brain function monitoring, Nomoline capnography and gas monitoring and O3 organ oximetry or regional oximetry technologies.

We are kicking things off officially in the next couple of weeks and we expect to get some benefit showing up in the second half, if not sooner. I think the goodwill that's been generated from this relationship is already translating itself into healthier growth. I think we had projected normally 7% growth annually.

Because of Philips, we increased it to 8%. And I think we reported over 9% in Q1. And certainly, Philips is playing a part in that. So we're pretty excited. I think you're going to start seeing some announcements.

Certainly next week when we meet for the Analyst Day, we'll talk more about it and give you some examples, more specific examples of what's to come..

Very good. Thanks, guys. Nice quarter..

Thank you, Bill..

Thanks, Bill..

And our next question comes from Larry Keusch from Raymond James. Your line is now open..

Great. Good afternoon, everyone..

Hi, Larry..

Hi, Larry..

Hello. So listen, just a couple quick questions for you guys. First off, could you talk a little bit about the cash balance? So if I understood it correctly, Mark, what you essentially said was in April, there was this $70 million-ish payment that would presumably reduce the reported cash balance that you talked about.

Is that correct?.

That's correct..

Okay, perfect.

And then the bigger picture question is now with this cash on the balance sheet, which is still very healthy, what are the thoughts on the uses for that cash is, as you look forward here?.

Well, who knows what future truly holds, but right now we're expecting to use our cash and maybe even some borrowing for acquisitions in the future. We've recently brought on board, Thierry Leclercq, who was for 30 years at GE, most recently running their patient monitoring business to head up business development for us.

For those who are coming in next week, you'll meet him. So we – as we look forward to kind of the next seven years, we not only expect to grow organically in the range that Mark has been forecasting, but hopefully adding on to that growth from new acquisitions..

And what about thoughts around share repurchase? I actually don't think, if my memory is correct, you haven't repurchase any stock since the second quarter of 2016.

But where does that priority fit in, when you compare it to M&A?.

Well, I think it really depends. If we find the right companies with the right future that we think will help us get a much better return on acquiring them versus buying our own shares we'll do that. If we don't, which I hope we will, but if we don't then obviously buying back our own shares is probably the next best thing..

Okay. Terrific.

And then last question, just can you remind us again the expected timing for a readout on the NACHO trial?.

Good question. We're going to give you an update next week, but my understanding is that the enrollment is complete, and they're doing their analysis. So we hope they'll complete that in the next couple of months and they'll submit their manuscript for publication in the next few months..

Okay, terrific. Thanks guys. See you next week..

Thank you..

Thanks, Larry..

Thank you so much. Looks like you guys are as brief as we are today given the anticipated Analyst Day next week. We really appreciate you joining us. This marks our 28th anniversary, May 2 was the 28th anniversary of our incorporation in California. So we're excited and look forward to seeing you all and hopefully the weather will be great.

So thank you so much. Have a wonderful day..

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