Masimo Corp (MASI) 2011 Q3 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to Masimo's Third Quarter 2011 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. (Operator Instructions) I am pleased to introduce Sheree Aronson, Masimo's Vice President of Investor Relations.

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 best current judgment. However, they are subject to risks and uncertainties that could cause actual results to differ. Risk factors that could cause our actual results to differ materially from our projections and forecast are discussed in detail in our SEC filings. You will find these in the Investor section of our website. With that, I'll pass the call to Joe Kiani.

Thank you, Sheree. Good afternoon and thank you for joining us for a review of our third quarter 2011 performance. Masimo product revenue grew 10% in the period, as strong SET performance was partially offset by declines in rainbow and OEM revenue.

Here are the highlights -- SET revenue rose 17% demonstrating once again that we are still in the steep part of the S-curve technology adoption for SET, which represents over 90% of our total product revenue. Our worldwide end-user business grew 18%, which sales in our US acute care channel growing above that high team's level. Considering that recent third party hospital surveys indicate flat to declining year-over-year US inpatient surgery volumes in the third quarter, we were happy with this growth. International sales growth was also solid across both the acute and alternate care channels.

Without a repeat military order like the one we had in the third quarter last year, our rainbow business was substantially lower. But even without the military order, rainbow revenue was unimpressive. It was flat versus the year-ago quarter. Still there were some bright spots. For example, excluding the year-ago military order, our SpHb sensory unit volumes and revenue more than doubled.

So while we are disappointed by overall rainbow performance, we are confident rainbow will ultimately be a catalyst for our growth. We also know that, as with any truly breakthrough technology, rainbow performance will be choppy until we start rising on the steep part of the S-curve of technology adoption.

OEM sales were lower in the quarter due, in part, to lower board shipments and consumable revenues. Even so, we added 33,400 new Masimo drivers to the market in the quarter and brought our installed base to approximately 950,000, a 16% increase over the year-ago quarter.

In fact, during the quarter, we shipped our 1 millionth oximeter marking a key milestone for Masimo and underscoring our continued market penetration.

Given our third quarter financial results and current market assessment, we are reducing our annual 2011 product revenue and EPS guidance by approximately 3% and 10%, respectively, as detailed in the press release we issued this afternoon. Part of this annual guidance reduction is related to a $1.5 million Q3 inventory charge-off that Mark will discuss in some more detail.

While we are disappointed in having to reduce our short-term financial expectations, I am confident in our long-term outlook and will speak more about our outlook and strategies in a few minutes.

I will now pass the call to Mark for a detailed review of our Q3 results and revised 2011 guidance. Mark?

Thank you, Joe, and good afternoon, everybody. Masimo's third quarter 2011 total revenue rose 3% to $104 million versus $101 million in the year-ago period. Contributing to this was a 47% decline in royalty revenue from $12.2 million to $6.4 million reflecting the change in the Covidien royalty rate from 13% to 7.75% effective March 15, 2011, and, in addition, lower-than-expected Covidien US pulse oximetry royalty payments, which we received in Q3 compared to what we had accrued in Q2.

Third quarter product revenue rose 10% to $97.6 million representing primarily growth in our acute care channel as recent expansion of our installed base translated into increased year-over-year sensor sales to hospital customers. This is also reflected in SET revenue growth of 17% to $89.8 million.

A couple of developments dampened SET growth in the quarter. First, we believe various macroeconomic factors weighed on the market in the quarter and had an adverse impact on hospital procedure volumes, which, in turn, impacted our SET adhesive volume and revenues as well as capital equipment sales.

Also, we experienced a rise in the number of customers choosing to reprocess single-use, SpO2 sensors through Masimo, which negatively impacted SET sensor ASP sales as our reprocess sensors are sold at a lower price.

In addition, we were expecting to resolve the payment of an additional $3 million for products we provided to a major US hospital system as part of their installation earlier this year. However, the health care system is still working to evaluate and reconcile their records with ours and, as a result, no resolution has occurred, and therefore we were unable to recognize any additional revenue beyond the $760,000 that we previously recognized in Q2 2011. We are obviously working with this customer and hope to have a resolution before the end of the year.

Rainbow revenue was down 35% to $7.8 million versus $11.9 million in the year-ago period when we received a $4 million US Marine Corps order. Unfortunately, the government order we had expected in the third quarter this year did not materialize due, we believe, to the defense cuts following passage of the Budget Control Act. In addition, while we saw increase in volume for SpCO and SpMet through our OEMs, our direct SpCO sales were down, dragging down our total rainbow revenue growth.

In addition, as Joe mentioned, a positive sign for rainbow continues to be a dramatic increase in overall SpHb consumables from the year-ago period.

Our worldwide end-user or direct business, which includes sales through just-in-time distributors, grew 18% in the third quarter to $82.6 million versus $70.1 million one year ago. Third quarter 2011 OEM sales were down 20% to $15 million from $18.7 million in the same period last year due to lower board sales and sensor revenues. In total, our direct business represented 85% of product revenue versus 79% in the year-ago quarter.

By geography, total US product revenue rose 6% to $70.3 million compared to $66.2 million in the 2010 third quarter as solid double-digit growth in the US acute care channel was partially offset by the lower OEM and alternate care channel sales, as we noted earlier.

To illustrate this, our US direct business, which excludes OEM revenue, rose 12%. Product revenue outside the US totaled $27.3 million, up 21% compared to $22.6 million in the third quarter last year, with every major direct sales region contributing to growth and despite a decline in international OEM sales.

Our OUS direct business, excluding OEM revenue, rose 37%, 28% excluding foreign exchange. Total third quarter international product revenue represented approximately 28% of our total product revenue versus 25% in the year-ago period. Favorable year-over-year currency exchange rates added approximately $1.5 million to third quarter international revenue totals.

Note that this foreign exchange benefit was largely offset by approximately $1 million in higher foreign currency denominated operating expenses and approximately $250,000 in higher foreign currency cost of sales.

Our gross profit margin was 63.5% in the third quarter compared to 66.9% one year ago. Our Q3 gross profit margins were negatively impacted by 150 basis points related to our decision to write down inventory associated with product design changes including an earlier version of the 2011 Radical 7 as well as the transition to new products. Without these charges, gross profit margins would have been 65%, which is still slightly below the low end of our updated August fiscal 2011 gross profit margin guidance of 65.5%.

This additional 50 basis-point decline was due primarily to lower rainbow revenue and the increased level of Masimo sensor reprocessing that we are now providing to our customers.

Total gross profit margin, including royalties, was 65.8% in the third quarter versus 70.9% in the same period last year. In addition to the items I just mentioned, the decline in total gross profit was due primarily to the significant decline in Covidien royalty payments.

Operating expenses were $49.5 million versus third quarter 2010 operating expenses of $48.8 million, which included approximately $700,000 in one-time marketing expenses. Excluding these year-ago one-time items, our third quarter 2011 operating expenses rose just 3%. This is the third consecutive quarter of significant declines in the rate of year-over-year operating expense growth demonstrating our ability to control our expenses as we had indicated for the past couple of years.

On a year-to-date basis, our 2011 total operating expense growth adjusted for one-time marketing expenses in 2010 was approximately 7% compared to 19% in 2010. The actual year-over-year increase in third quarter 2011 operating expense was due primarily to slightly increased staffing levels and commission expenses partially offset by declines in legal expenses.

Third quarter 2011 operating expenses also included $9.4 million in R&D spending, which was up 2% from $9.2 million in the year-ago quarter. As I mentioned earlier, foreign exchange rates increased total third quarter 2011 operating expenses by approximately $1 million compared to the same period last year.

Third quarter 2011 operating income was $18.9 million compared to adjusted operating income in 2010's third quarter of $23.5 million, which excludes the year-ago one-time item I mentioned earlier.

Our third quarter 2011 effective tax rate was 20.7%, down dramatically from 30.6% in the year-ago period. The improvement was due primarily to the inclusion of the 2011 tax rate and extension of the federal R&D tax credit, the impact of the change in California's effective tax rate, and the mix of income in jurisdictions where Masimo does business. This rate is substantially lower than the 20% (ph) to 28% range that we had previously forecasted and is due primarily to the larger-than-expected shift in the mix of income in jurisdictions where Masimo does business.

We now expect our 2011 effective tax rate to be between 25% to 26%.

Third quarter net income was $14.8 million, or $0.24 per diluted share compared to GAAP EPS of $0.27 in the year-ago period. Excluding approximately $0.01 in the one-time expenses in the year-ago quarter, our earnings declined approximately $0.04 per share, or 14%. Recall that Q3 2010 included approximately $5.8 million, or almost $0.06 per share in higher royalty revenues.

As of October 1, 2011, total cash and cash investments were $143.2 million compared to $88.3 million at fiscal year-end 2010. This $54.9 million increase was due primarily to cash generated from operations. As of October 1, 2011, our day sales outstanding was 50, up from 48, on January 1, 2011. Over the same period, our inventory turns rose to 3.1 from 2.8.

In August we announced that the board had authorized a stock repurchase program of up to 3 million shares of our common stock over the next 24 months. As of October 1, 2011, we had not repurchased any shares under this plan.

Now I'd like to turn just a moment to our updated 2011 guidance. We now expect that our total revenues will be in the range of $436 million to $439 million, compared to our February 2011 prior guidance of $446 million to $463 million. This revised guidance assumes total product revenue in the range of $404 million to $407 million, and royalty revenues of $31.5 million to $32.5 million. Included in the total product revenue range, we now expect total 2011 rainbow revenues to be in the range of $33 million to $35 million, down from our August guidance at the low end of the original $40 million to $50 million range due to the lack of the FDA approval for the Pronto 7.

In addition, we now expect our total fiscal 2011 product gross margins to be in the $64.5 million range including the impact of the $1.5 million in Q3 writedowns I previously mentioned.

As we mentioned in our Q2 earnings call, the introduction of our new sensor technology will result in higher product costs in the short run, although this is a long-term investment that will improve our business since it ensures that our hospitals, clinicians and, ultimately, their patients, are receiving the benefit of the full performance of Masimo technology.

Our new annual gross profit range projection is 64.5% and assumes a Q4 2011 projection of approximately 64% gross profit margins.

We now expect 2011 operating expenses to be approximately $207 million to $209 million below our original guidance of $210 million to $215 million.

Finally, we believe that our full-year effective tax rate will now be between 25% and 26% compared to our previous guidance of 27%.

Based on this updated financial guidance, we now expect our full-year 2011 earnings per share to be in the range of $1.04 to $1.06 per share, which includes the $0.02 related to the Q3 E&O chargeoff that is down from the original guidance range that we provided of $1.17 to $1.25, although we did indicate in August that we expected to be in the low end of this range.

With that, I'll turn the call back to Joe.

Thank you, Mark. As Mark just noted, our revenue on EPS stars did not align for us in Q3. Our plans for the hard-to-predict rainbow revenue did not materialize. Not only did we have to begin the quarter without Pronto 7 because of the FDA clearance delays, but the military order that we were expecting did not materialize.

As Mark explained, we were also unable to recognize a significant piece of capital revenue for one of our major customers, and based on our sensor volumes, we appeared to have had a slightly greater census (ph) drop in September in the US, which is the largest market for our added (inaudible) sensors.

Although we traditionally see a strong sequential US revenue increase as we move from the lower Q3 utilization period into Q4, we are concerned about some of the early trends we were seeing in early Q4 that began in second half of September.

Typically, we see a very strong OUS fourth quarter, but given the economic uncertainty throughout Europe, we are a bit more cautious on our OUS, outside US, Q4 revenues as well.

While our SET business is growing in line with our installed base expansion at around 16%, we believe our rainbow business, when it kicks in, will help deliver growth well beyond 16%. And while the adoption of our rainbow technology has been slower than we'd like, important developments such as a high rate of adoption by key OEMs, new versions of rainbow, including in vivo adjustment and healthy growth in SpHb and Rad sensor volume, are making us feel positive about the path that we are on.

One of our key objectives for 2011 is to increase rainbow awareness and adoption. We made good progress at the recent American Society of Anesthesiology Conference last week in Chicago, where clinicians responded enthusiastically to the launch of our 2011 Radical 7 bedside monitor, Masimo's flagship device.

This new instrument features various enhancements to improve patient safety as well as the in vivo adjustment that allows clinicians to adjust SpO2, SpHb, SpCO and SpMet values displayed on the monitor based on laboratory reference values.

When reviewing the SpHb data we have collected, once in vivo adjustment is performed, SpHb accuracy measurements improve by about 0.5 gram per deciliter in places that there were high values between SpHb and laboratory hemoglobin and yet not reducing our accuracy in places where SpHb was performing as expected.

Pending FDA clearance in the US, the in vivo adjustment addresses the inability of one calibration curve to fit all patients' needs and variances with laboratory instruments further setting Masimo rainbow SET technology apart from the competition and delivering on our objective to continue our track record of innovation that solved important clinical problems.

Consistent with another 2011 objective to expand our presence to the general ward, the new 2011 Radical 7 also includes rainbow acoustic monitoring, RAM, and provides clinicians the option to display the acoustic weight forum with Plethysmographic weight forum overlaid.

This new display capability may allow clinicians to see important patterns and more readily detect respiratory pause events.

In addition, the ramp (inaudible) was improved to better perform under high ambient noise, improper sensor placement, or other situations that could degrade the acoustic respiration signal.

RAM is Masimo's breakthrough solution for measuring respiration rate in real time and in an unobtrusive way and an important component in our general ward monitoring solution especially for helping clinicians effectively manage post-operative patients on patient-controlled analgesia.

A few weeks ago, RAM received regulatory clearance from the Japanese Ministry of Health, Labor, and Welfare. The Japanese MHLW also recently granted clearance to Pronto 7. We are currently in the midst of launching both RAM and Pronto 7 in Japan.

As you all know, Pronto 7 is currently pending FDA clearance and therefore not yet available to US clinicians and patients. This delay is the biggest reason rainbow revenues for 2011 will be below our original expectations.

In the meantime, the performance of Pronto has nearly caught up with Pronto 7, and we are getting close to a full market release of Pronto in the physician office channel. To see SpHb meet its promise, we continue to help grow the body of clinical evidence, expand the number of OEMs who offer rainbow SET, and increase the number of hospital customers adopting SpHb.

We continue to make important strides on each of these fronts. For example, today there are over 60 research studies on SpHb. Many of these studies are showing SpHb's ability to help clinicians assess hemoglobin status and determine treatment and additional test options in surgery, critical care, outpatient care areas, and emergency departments. These studies are essential to getting anesthesiologists and surgeons actively engaged in a dialog about SpHb's clinical utility.

For example, a recent study published in the Journal of Critical Care Medicine showed that in the ICU SpHb as absolute and trending accuracy similar to widely used invasive methods of hemoglobin measurements at bedside and has the additional advantage of providing continuous measurements non-invasively, which may facilitate earlier detection of occult bleeding in the ICU.

And at the ASA last week, approximately 16 clinical SpHb studies were presented including one by researchers at Johns Hopkins Hospital who found that the combination of continuous SpHb and PVI monitoring may improve the efficacy and safety of the intraoperative otologists normal bulimic hemodilution blood conservation technique that helps avoid allogeneic blood transfusions.

We now have research from two of the US's, perhaps even the world's, highest-rated hospitals -- Hopkins and Mass General Hospital showing the clinical value of SpHb. Recall that last year at ASA researchers from Mass General showed SpHb could dramatically reduce unnecessary blood transfusion.

We also continue to expand the number of OEM partners who are incorporating rainbow SET technology into their multiparameter monitoring devices. As of the end of the third quarter, we achieved our 2011 target to have 30 OEM rainbow licensing applied development agreements in place, and we expect that number to grow by year-end.

Medtronic Physio Control, Zoll and Welch Allyn, are among the first to provide rainbow to our mutual customers. Draeger is expected to begin their launch internationally next month at Medica. And Phillips, the world's largest patient monitoring company, recently announced that they had interned into a long-term rainbow SET agreement with us.

Setting up and expanding the OEM channel is essential to extending rainbow's availability to health care professionals around the world, and we continue to be very encouraged at the rate at which OEMs are signing up to provide rainbow to our mutual customers.

In the third quarter, we announced that Shriner's Hospital for children in Honolulu, which performed hundreds of orthopedic surgeries on children each year, are adopting rainbow for monitoring patients in the OR and ICU. After initiating use of continuous SpHb monitoring during surgeries, Shriner clinicians saw immediate benefits. They tell us that they are doing far fewer blood transfusions and having to put fewer units of blood on standby in advance of surgery where high blood loss is at risk.

What's more, they say that the real-time trending of hemoglobin levels is particularly useful versus having to wait for lab results from invasive blood draws and having to use needles on their younger patients.

Another key objective for 2011 is leveraging our global salesforce; to make sure that we are getting maximum output for both our rainbow and SET businesses, we continue to experiment with modifications to the salesforce structure and considering other innovative single strategies.

We also continue to watch carefully to see which of the markets grow fastest for SpHb -- the intensive care unit, the operating room, recovery, emergency department, or labor and delivery so that we can reinforce the speed of adoption.

Rainbow and the superior performance and reliability of Masimo technology is the primary reasons customers choose us over a competing system. That performance was underscored recently with studies published with Lancet, the British Medical Journal, and the Journal of Pediatrics, showing Masimo SET to be effective in screening newborns for congenital heart defect.

And a few weeks ago, the US Department of Health and Human Services recommended critical congenital heart defect screening using motion-tolerant pulse oximetry, which we invented, and nationwide newborn screening standard. Among the approximately 4 billion babies born in the US each year, congenital heart disease is the most prevalent form of birth defect and is the number-one cause of infant death.

We expect screening with Masimo SET pulse oximetry to play an important role in saving newborn lives as congenital heart disease screening protocols are put in place nationwide.

In the last six months, we have converted over 45 hospitals worldwide including Memorial Health Care Systems in Florida, Mount Sinai in New York City, and the University Medical Center in Las Vegas. We are gaining the oximetry business of these customers mainly due to our technology's superiority and innovation track record.

To close, I'll reiterate that we are managing Masimo with a long-term view. Our strong and growing proposition in the global pulse oximetry market has allowed us to consistently achieve revenue growth rates well above industry levels, even in the midst of a broad economic downturn. Moreover, our expanding installed base is a leading indicator of our ability to continue to advance. Rainbow represents the next way of growth, and we fully expect it to take off on the steep edge of the S-curve before pulse oximetry's trajectory begins to shallow out for us.

I can't say exactly when rainbow revenues will catch up with our excitement over its potential to revolutionize medicine, but I am confident that it ultimately will. The ride may be bumpy, but we fully intend to get there.

So, with that, we'll be happy to take your questions. Operator?

(Operator Instructions)

While we wait, I'd like to congratulate Mark for becoming a grandpa.

Well, thank you, Joe.

Bill Quirk, Piper Jaffray.

Thanks, good afternoon, and I guess congratulations to Mark.

Thanks, Bill.

First question, guys, on drivers -- we had a very torrid pace in 2010, and even the first quarter in 2011. But it slowed down for a couple of quarters now, and I'm just curious, guys, is this all macro? Any signs at all of the drivers picking up? Any competitive dynamics at work here? Thanks.

Well, first of all, we don't believe this competitive dynamic, because we are still gaining market share, as I mentioned earlier. However, we are seeing some of our OEMs having to slow down compared to what they were forecasting.

However, at this point, we believe Q4 we're going to have a stronger driver number than we've had even in the past couple of quarters.

And that's based on -- what -- bookings to date, I take it, Joe?

Correct.

Okay, got it. And then, secondly, if we think about the number of -- or I should say the pickup in the sense that are being reprocessed by Masimo, where are we there, guys, in terms of mix? Kind of where can this go based on the feedback that you're getting from your accounts? Thank you.

That's a good question. The conventional way of trying to be green and save money is to recycle centers. But it is not really green. We've done some studies, and we need to wrap those up and publish them, but early results show that the carbon footprint of recycling sensors is actually greater than new sensors. So ultimately what we expect is for consumers that want to be green and save money, ReSposable Sensors are the way to go.

If you recall, we launched ReSposable Sensors about a year ago, but we've not fully finished the product line. We hope that by beginning of next year, the full product line from neonates to adults for ReSposables will be complete not only for rainbow but for SET.

So we hope, long term, and we expect, long term, based on discussions with key customers that ReSposables should be the way to go. In the meantime, I think you're going to see until that concept holds grip, you are going to see more and more recycling business coming our way.

Understood. And then the last one for me, Joe, and I'll jump back in the queue. It's actually a question for Mark. In terms of the new sensor launch, Mark, thanks for the clarity on what the impact was and what that may be in the fourth quarter. Are we still thinking that this is going to be breakeven to the P&L in the first half of 2012?

There's always the X-Cal sensors.

Yes, that's right.

Yes, we are going to incur that incremental expense that we alluded to in our last call that I mentioned again today. The most significant impact will probably be in the fourth quarter that we're in right now. There are a number of cost reduction initiatives in place that we think will take hold beginning towards the end of the first quarter, beginning of the second quarter of 2011 --

2012.

2012, excuse me -- so that by the time we get to about the middle part of the year, we hope to have essentially removed that short-term incremental cost from the sensors. And then in addition to that, as we've said in the past, there are a number of other initiatives that we're currently working that we think will have a beneficial overall gross margin impacts in the second half of next year.

Matthew Dodds, Citi.

Hi, gentlemen, it's actually Greg Hertz calling in for Matt. And congratulations from me, as well, Mark.

Thank you, Greg.

I just wanted to dive in a little bit more on the commentary on the two hemoglobin centers. You know, you're characterizing the growth in terms of volumes, but certainly I think we're going to be hearing a lot more questions from investors on the dollar growth there. And, you know, I certainly appreciate that you guys haven't really broken out a lot of the detail within the rainbow SET revenue segment as we have. But, you know, I think one could interpret, with the flat sales and the doubling of volumes, that certainly there's been some dramatic pricing erosion on the sensors or the drivers or other components of the SET suite -- you know, the software (inaudible), et cetera.

So could you at least give us a little bit of flavor for what's going on there in the pricing? Because I think the takeaway for some people, or the interpretation is that, you know, with less pricing and going down, there's going to be perceived less value associated with it.

Do you want to take that one?

Sure, sure. I'd start, Greg, by calling out the fact that the reason for us highlighting the strong growth that we're seeing in some of the key areas of rainbow is to ensure that that continued utilization of these products that we're putting into the field is occurring. And, as Joe said earlier, based upon the unit volume increases that we're seeing, admittedly, off of lower levels a year ago, that's still very, very reassuring.

One of the issues in, as you said, the flat year-over-year rainbow revenues, if you exclude the Marine Corps order for last year, is that we've had other reductions in -- we'll call it the more traditional areas of rainbow revenues. For example, CO and Met. There have been areas of that business, for example, our Rad 57 sales that we've actually seen declines in.

So that is going on, if you will, underneath the total rainbow revenue numbers, and that's why we continue to feel very positive about what's happening in the area of SpHb and the area of RAM. Unfortunately, their numbers are not significant enough yet so that some of these movements of other rainbow measurements end up with a net flat number, if you will, year-over-year.

I just want to clarify one thing -- that while the unit volumes we mentioned were up on the hemoglobin sensors, over the revenue at the same rate. And another thing I want to clarify -- while the Rad 57 end-user product we have, the SpCO is down, the rate of CO and Met adoption inside our OEMs products like from Physio Control and Zoll will make the defibrillator that incorporates the rainbow technologies up dramatically.

However, those -- we get about a third of the revenue from those sales compared to when we sell the handheld CO Met product, and that's why they're not making up enough for the decline in the handheld direct sales.

Okay. I appreciate that. And just two quick ones -- one, could you just address the -- you mentioned on the call, in the prepared remarks, that you hadn't utilized any of the share repurchase authorization. Just any view on that in the near term? And then, secondly, another question on the OEMs and the weakness there -- was that more widespread or is that associated with a smaller handful of your OEM partners? That's it for me, thank you.

What was the second half of your question?

Oh, I'm sorry, just as it relates to the OEMs and the weakness in the OEM channel -- just wondering if that was associated with a handful of the OEM partners or if that was more widespread across all of the OEMs?

Okay. Well, let me respond to the second half, and so that really would just -- a couple of OEMs out of maybe close to 70, 80. It was a minority from what I understand.

And, I guess, on the first part of your question, Mark, do you want to answer that?

Sure. On the share repurchase plan, Greg, the board has established certain criteria that we've put in place for certain levels at which we will be repurchasing stock. And so, as I said before, at least through the first -- the end of the third quarter, those triggers were not yet met.

But there is a plan in place, and depending upon the movement in the equity, we plan to be utilizing that plan, when appropriate.

Joanne Wuensch, BMO Capital Mortgage.

Thank you. Joanne Wuensch from BMO Capital Markets. Did you find anything in those quarter relating to city budgets? Is that a piece of the rainbow story?

Yes. Yes, Joanne.

Any way to quantify that impact?

Well, it's a good question. You know, one of the things that we scratch our heads about is while we believe our salesforce when they tell us that the budget for the cities and municipalities has affected the fire departments and, therefore, they don't buy as many handhelds as they did before, our OEMs are doing a much better job of selling their defibrillators with our parameters.

So it's maybe to put aside budgets for defibrillators and including those measurements, it's easier, I don't know. But what I can tell you, that we've been suffering the lack of local budgets ever since the financial collapse of 2008.

Okay. If I heard you correctly, you're optimistic about Pronto 7 by the end of the year. Can you confirm that or comment on that? And then at some stage, my understanding is you're going to have to sign a distributor or some type of agreement to get into the physician's office. Is there any update on that?

Yes. First of all, we can't tell when FDA is going to clear something. All we did at the beginning of this last quarter, we told our investors that, for now, (inaudible) profits have one good clearance (ph) for the year.

They're really -- in our opinion, there's no reason it shouldn't be cleared. We've had a significant amount of data proving its accuracy, proving its value, and compared to other invasive measurement it at good if not better it's available to these physicians based on what we've seen.

But now the good news is, Joanne, that Pronto, as I mentioned in my statement, is getting much closer to the performance characteristics that people like about Pronto 7. So, therefore, we are close to initiating a full market release with Pronto, and we are in the midst of signing up our distribution for the US to get that accomplished.

So, hopefully, with or without Pronto 7, in the new year we should be fully up and running with the physician's office with Pronto. And, of course, and the rest of the world, excluding, I guess, China, Pronto 7 and Pronto both are available, and based on clinician's preference, they can buy either.

Brian Weinstein, William Blair.

Going back to this OEM situation -- in Q2 it was down 10%, and you guys said that you expected that it was just a transition from sensors being purchased by the OEMs that -- where it's going to come back to you guys, and that they would eventually be procured.

It sounds like that hasn't happened, and that there's a little bit extra going on there. Can you just talk about that first part and whether or not you're still confident that that's what, at least, is making up part of this?

Well, I should have read my script from last quarter. (inaudible) last quarter, Brian?

I'm sorry?

What did we say last quarter?

You said last quarter that it was down 10% and that you expected that it was a little bit of a shift in sensor sales going from the OEM channel into the direct channel, and that you expected and that you were confident that those sensors were eventually going to be ordered through Masimo's direct channel. It sounds like there's something a little bit different going on based off of the commentary today, and I'm just trying to reconcile what you said last quarter and what's going on now?

Well, I see your question, and it's a very good question, and you've picked up the subtle difference of what we said and what we're saying today. The reason for that is really a few -- something I'd like to share with you.

One is that we aren't certain anymore that whether the sensor revenues that we used to get from the OEMs is, in fact, going through our direct distribution channel. We think there might be, in some cases, those sensors being lost to copycat sensors which, hopefully, X-Cal will take of. And another instant, although I don't have all the data yet, maybe one of our OEMs is playing a little bit of a fast and loose game with us.

So we're trying to analyze that and figure it out. But one thing we can tell you for sure is that, number one, our OEM revenues are down because of less driver revenues and also less sensor revenues. Now, long term, I would not be disappointed if our OEM business becomes 10% of our business as long as the driver volume is in good shape. And with everything that's going on with this increase of our OEM agreements for rainbow, as well as our improvement and our relationships with just about every one of our relationships, maybe with an exception of one, we are feeling pretty good about that.

Okay, all right. And then on uptake with SpHb -- I mean, we were at ASA all weekend as well, and, you know, we heard it loud and clear that there is perceived value to non-invasive continuous hemoglobin, but the price is the major issue along with hospital bureaucracy and some other stuff. But it's primarily price. So maybe you could be a little bit more specific and how you guys are going to combat this with sales and marketing? And why not just consider a larger price cut at this point in order to gain better traction?

Sure. First of all, I want to thank you, Brian, for taking the time and coming to ASA and doing the work you did. In fact, I'm very much interested to see the survey results.

But what I can tell you, we don't yet believe price is the impediment for the continuous hemoglobin market in the US or even the rest of the world. However, what we're prepared to do is to do some innovative things such as, in certain cases, not every case, to try a risk-sharing program where, you know, we were very confident the value that our parameter brings. And we say to our customers, you know, here is the price of rainbow, let's say, ReSposable Sensors, and let's say $50. And maybe there's a price that they can all agree to, whether it's -- whatever -- let's say $20 -- that is something they would feel happy about with converting their entire hospital to. And we can say, look, there's a delta of $30, and if we track all your expenses before and then after that relates to the installation of continuous hemoglobin, and you don't see the value between that $20 to $50, then perhaps we're willing to go all the way down and return back to that money for even that $30 delta.

So I don't know if that was clear, but what I'm going try, I guess, say is I believe the value and the price of $50 is more than appropriate to not only help improve care but reduce cost of care, and we believe so strongly about that we're willing to back it up. And we're not going to do it at every place, but we're going to select some key customers and offer that program to them.

So you're suggesting a $50 price on SpHb is where you feel comfortable?

Yes, yes. As you know, our disposable is $100, but our ReSposable comes out to about $50. And I think that price, based on all the surveys we did a while ago, is the price where most customers say that's the right price.

Okay, thank you.

But last part, Brian, if we think it's $20, trust me, we'll go to $20. We still will make good business even at $20. But I don't believe we'll be doing our shareholders a service by going to that right away because I'm not sure that's the issue.

Larry Keusch, Morgan Keegan.

Hey, Mark, I'm wondering if you can -- there are, obviously, a bunch of moving parts through the product gross margin line here, and I'm wondering if you can help us, just, think about sort of the puts and takes as we look forward here over the next couple of quarters? What should improve? What seems to be a drag that may be there for a while? Just so we can -- help us think a little bit about, directionally, where this is going?

Sure. Well, let me start with, maybe, reiterating a little bit of what I said in the prepared remarks about the current quarter margins. And what I indicated there was that we'd be at about 65% had it not been for the writedown of the inventory that we spoke about a little while ago.

And so if you use that, essentially, as your starting point, we continue to believe that we are going to drive various costs out of the manufacturing model. These are not necessarily standard costs but other costs within the overall gross margin structure. And that should begin to happen and take effect in the next quarter -- be more significant, as I said, starting next year. So that would be a reason to indicate that -- why we believe margins, over time, are going to head back north again.

In the short term, of course, we've got the impact of the X-Cal, or the component that I spoke about before, that will be entering our new sensor technology in earnest (ph) this quarter. And that's really the reason why, if on an adjusted basis, we're at 65% gross margin for this quarter. That's why I indicated earlier our best forecast right now suggests about 64% margins for Q4 -- because of that impact.

Moving forward into 2012, obviously, we're not providing any specific guidance, but I would like to, at least, relay that the kind of cost improvement initiatives that we've been mentioning for the last couple of quarters are moving very well down the path. And that's why I said before, once some of these short term issues related to this new technology, run through our model in the first couple of quarters of next year. We think, by the middle part of next year, that we should see gross margins beginning to move back up again.

Okay. And, Mark, help us understand what -- sort of -- as you've renewed these sensor contracts, how much impact, for example, in the third quarter do you think that had on your gross margin?

Probably not much at all. Because, remember, contracts that we renew or new contracts that we sign in a contract or in a particular quarter takes some time to actually get implemented because even a renewal contract is usually -- will usually include additional product.

As you know, I mean, the beauty of the razor -- razor blade model from Masimo is that most of these contracts are five-year long-term agreements. So even though we might be feeling some short-term pricing pressure, the impact of that, in any particular quarter, is usually pretty muted. Clearly, if that pricing pressure were to continue year after year, you would begin to see that in the overall revenues that we're generating from those drivers.

But right now, I think, in general, we -- you know, the kind of pricing pressure that we have spoken to earlier in the year has really not changed. It still is a relatively aggressive pricing environment, in some cases, and we continue to do what we need to do to secure those customers.

Okay. And just one other one on margin, and then I have one other question -- as you speak to Pronto 7 and Pronto, again, how should we think about the margin profile between those two products? Are you agnostic as to which one gets going here? Or is there a difference?

Well, we don't necessarily get into specific cost structures of our products, but what I will say is that both of these products are, obviously, fairly young in their lifecycle. Our hope is that when we begin to move, for example, the Pronto 7, that that device, along with a (inaudible) amount of sensor-committed revenue will put us in a position to yield margins that are fairly consistent with the kind of margins that we're enjoying today.

It won't be until those revenues are a very, very large percentage of our total revenues when we think we'll be in a position to start seeing very significant improvements to our overall blended margin because of the impact that, for example, the Pronto 7 would have.

Okay, great. And then the last one for you guys is -- I'm just trying to think about this increase in reprocessing that is being done through you guys and the launch of the new sensor technology. And if I understand that new sensor technology, you really won't be able to reprocess that because of the technology embedded in that sensor.

So how do we think about how you -- the juxtaposition between getting that new sensor out and, again, the pressures for you guys to do more reprocessing?

Well, first of all, the new technology we're implemented, X-Cal will still allow us to reprocess our sensors. We (inaudible) company when we reprocess we actually do change the optical assembly, which is what can go bad during reprocessing. So that won't affect that.

However, what I was referring to, we have a new technology called the ReSposable Sensors, and we call it ReSposable because it has a reusable optical sensor portion and a disposable optical sensor portion. And the disposable portion of that is such that it really is what you effectively would throw away if you were reprocessing.

So -- it allows you to have 100% reprocessing, if you will, at the point of care instead of, maybe, 20% to 30% at most, and best that hospitals can get in reprocessing that you have to ship back and reprocess at factories and then get it shipped back again to them. So I hope that clarifies that.

Yes. And then, lastly, Mark, just on the share repurchase. I know you said there are specific triggers that weren't met, and I know you're not going to give us exactly what those are but is stock price one of them? Any color around some of that would be helpful, if you can.

Yes, no, all we can really say, essentially, is that, as you know, that the board did authorize a total of 3 million shares to be repurchased over the next 24 months. And, as I alluded to before, there's certain criteria that are in place, and obviously we can't control whether or not that criteria is hit or not. But as I said before, we fully intend to deploy the plan in the event that those triggers are hit.

John Putnam, Capstone Investment.

Joe, you just signed another OEM agreement in China. You've gotten a number of product approvals or clearances in Japan. Can you give us a little color and a little thought on how quickly you can bring some of your Asian business up here, both China and Japan?

Well, in Japan we have a great infrastructure led by a very capable and proven country president. So I believe we're going to be able to capitalize on these approvals for Pronto 7 and the rainbow acoustic monitoring very well in Q4.

In China, we're just getting up and running. We don't have the same type of infrastructure and number of direct people nor the history that we have with our Japanese business. So that will be a little bit less predictable.

But as far as percentage growth, Japan, in terms of revenue and growth, happens to probably be only second to the US for us. It's a very important market, and we expect a lot of good things to come from that. And this is the first time ever we've gotten approval for a product in Japan before we have it in the US.

Great. And how many OEMs do you have now in China? Are there three or four?

Good question. I think it's three or four, I don't know. But we have several, but I think for rainbow we may have three now.

Okay. And are they the largest? Or are there still some out there that are larger than the ones that you've captured here?

No, the largest OEM in China is Mindray, and we've not announced anything with Mindray yet regarding rainbow. We obviously have announced our relationship with them regarding SET but not with rainbow.

Sara Michelmore, Brean Murray.

Just a question on the operating expenses. Mark, you did lower the guidance for the full year, and I'm just wondering if you can walk through the delta there. As we start to think about our models for 2012, assuming that the revenue growth trajectory or overall revenue dollars are a little bit below maybe what you guys would have thought earlier in the year -- what kind of ability do you have to better leverage the operating expenses, assuming that you've got a lower revenue forecast to deal with? Thanks.

Sure. So the first part of your question had to do with the specific operating expense guidance that we provided today, which, as you alluded to, was a little bit lower. The majority of that came in areas such as legal expenses. Also it came in areas such as expected hiring for the rest of the year. Obviously, we made certain assumptions earlier in the year, and we've now revised those assumptions given that we have but a quarter left in the year.

That's probably the primary -- or the other area I'd note, on a real positive note, is we have managed to make some significant changes within our deployment of installations all over the country. And, in fact, they're doing that in a much more efficient and effective way. So we've actually seen a very noticeable decline in the cost of installation for us relative to these new customers that we bring on board. So those are the primary drivers of the lowering of the four-year operating expense guidance.

And then on the overall -- I think the bigger-picture question in terms of the overall model, you know, Joe alluded earlier to the fact that there were a number of things that are being considered relative to the overall best way to leverage the sales organization throughout the whole world. We'll be working on various items like that over the next couple of months as part of our planning process. And I think earlier next year, in February, when we are in a position to provide guidance for the whole year, that's probably a better time to talk about what other leverageable opportunities there might be within the model.

Okay, that's helpful. And then just a quick one for Joe. You know, in the context of this rainbow, you talked through price not being an issue or not being the main issue in your mind. The way that you guys look at this thing, what would you say are the key pushbacks or hurdles for the adoption for rainbow at this point? Thanks.

Sara, that's a good question. I really think the hurdle is to get more evidence of the benefit of non-invasive hemoglobin. You know, it might be due to the glucose study that came out several years ago where they said cost titration of glucose could dramatically help improve outcome, and so forth. Unfortunately, that did not play out in future studies.

So that might be a reason why clinicians want to see more studies concerning, for example, what the Mass General study showed a year ago. So I think clinical studies is probably the most important.

Number two, our friends in anesthesiology, which is really the main group we have dealt with for the last 20 years, have even said to us, let's see if we can't go get the help of some of the surgeons who have more pull in the hospital to help them get hemoglobin in their hospital. I don't like making excuses, however, since the financial meltdown of 2008, hospitals are reluctant to try new things. It's harder for anesthesiologists who are not the ones who are bringing the patients to the hospital to go and push for new technologies option, and that's why maybe our idea of doing some kind of a risk-sharing with the hospitals will enable these anesthesiologists to get what they want.

Ben Haynor, Feltl & Company.

Hi, congratulations, Mark. It looks like you had the best quarter in taking share from Covidien since Q2 from last year. Do you think that trend has been accelerated somewhat over the past few months here?

Your question is in terms of total share?

Correct.

Well, I think if you look at the -- I mean, the general answer is we still think -- of course, all we have are our own driver numbers to evaluate, but we strongly would support the latest third party data, which I think still had Masimo shipping approximately 50% of the new drivers into the marketplace. And I think given the $33,000 range that we put in last quarter again, we don't have any reason to believe that's any different.

So we still believe we're outshipping our competitors at a very, very healthy rate. And, of course, ultimately, we should see that in our top line sensor revenues.

Sure. Now, what needs to happen to hit the high end of your revenue guidance? Is that $3 million hospital contract discrepancy part of that at all? Or is that completely aside?

No, there's nothing specific that hinges on whether we hit the high or low end of that. As we talked about earlier, there are a lot of moving parts in the business. We just felt that given where we are right now, that was our best estimate of where we thought our Q4 revenues were likely to fall in. But there is no specific individual item that dictates whether we're at the high or low end of that range.

And then any chance you can quantify how much reprocessing increased during the quarter versus last year versus the previous quarters?

The program that we alluded to today has been in place for a little over a year now. I would say this quarter -- and the reason, frankly, we mentioned it in the call today is that this is the first quarter where we'd seen more than sort of an insignificant amount of reprocessing in the quarter.

As we mentioned in our prepared remarks, it impacts us primarily because the pricing of those reprocess sensors are a little bit lower than the pricing of our traditional disposable sensors. But in terms of dollars, I don't want to provide any specific dollar impacts, but I'll leave it -- it was just a higher number this quarter than it's been in the past couple of quarters.

And probably one, frankly, that we think until some of the transitions occur that Joe mentioned earlier to these other products, it's probably a rate that we're now assuming is going to be pretty consistent for at least the foreseeable future.

Tao Levy, Collins Stewart.

So just to be clear, on the gross margin side, 64% range until mid-2012? Is that kind of right, Mark? On the product side, on the product gross margin?

Again, without providing specific guidance to next year, I would say that the 60 -- remember, I said the impact of this reprocessing is probably going to be the most significant for us in this fourth quarter. So -- the translation of that, obviously, is that we would hope that margins will start improving even earlier than the middle part of next year. I just mentioned that until we get -- it may be until the middle part of next year that we get the incremental cost specifically related to the sensor out of our cost portfolio, if you will.

But there are other cost initiatives that we alluded to before that are in place, and we think we have a good chance of some of those yielding improved margin numbers even earlier than the middle part of next year.

Okay. And Pronto -- you mentioned, I think early on, Joe, a full launch next year in the physician's office with or without Pronto 7. Does that have the same sales opportunity as Pronto 7 has? So basically would it make up the delta from this year's miss by not having Pronto 7, around 10-ish million? Is that something that can be achievable?

I believe so. I believe -- you know, it may not be 100%, but I think we might approach 80%, 90% of what we can achieve with Pronto 7.

Okay. And then just the last question on the SET guidance, you know, if I back into what you guys are implying for the fourth quarter. You kind of have to lower that revenues per driver number to a level that we haven't seen this year in terms of a year-over-year decline. Is there anything in particular with this fourth quarter around contract prices? Or is it just lower expectations in terms of volumes and so forth?

Well, Tao, I think, as we discussed earlier, it's some of our macro fears that make us feel like maybe census will be done, therefore, utilization will be done.

Actually, the numbers that the former company announced recently, pretty much closely matched to what we saw happening in September. Besides that, there may be about a 3%, 4% drop in sensor purchases in the US.

So -- assuming that continues and also worrying that maybe Europe will have even more jitteriness in Q4 is why we guided lower. There wasn't any specific contracts or issues that we were aware of.

(Operator Instructions)

Great, great, I think we have time for one more question.

Lennox Ketner, Bank of America Merrill Lynch.

I just wondered if you guys are interested in the X-Cal component of the new sensor -- one, you said earlier that you will still be able to reprocess it. Are you anticipating that third party reprocessors would be able to reprocess it that, too, or would it have to be done through Masimo?

I believe with X-Cal, it's going to have to be done through Masimo.

Okay. And then, Mark, I'm just struggling with why -- I'm obviously just misunderstanding something, but why the negative gross margin impact from X-Cal would only be a short-term impact? Because I guess the way I'm thinking about it is just if you have a more technologically advanced sensor, isn't -- my sense would be that would cost more to produce permanently, but it would prevent you from losing share to some of the counterfeits. I'm just not sure what I'm misunderstanding there. Why it would only be a short-term impact?

Well, in the long run, it's still slightly incremental. But the point that we're trying to make is that this incremental expense that we're incurring now is based upon, if you will, initial smaller volume levels. And once those get to levels earlier next year, we think that we'll be significantly higher. We'll be able, through volume, to pull average cost out of those sensors. Plus, some of the other improvements that I alluded to before -- we think those will also play into the cost structure of those specific sensors in the first half of next year.

Okay, that makes sense. And then, Joe, you were saying earlier that one of the main gating factors to seeing better uptake on the hemoglobin side is more clinical data. And I think Masimo is actually funding a couple of studies on that. Have you guys given any sense as to when we could see some of the data from those trials?

Yes. I think, if all things go according to the plan, we should have a very large-scale multi-center, multi-country study out probably within a year, year and a half. Maybe as an abstract and then we (inaudible) the year after that is a whole publication. We, for the first time, had gone out with antitrust funds that we got last year on -- antitrust settlement we got last year, as you remember, we spent some significant dollars in filing the company's large clinical research study.

So, hopefully, this should bear some good growth.

Okay, great, that's all I have. Thanks so much.

Thanks so much. And thank you all for joining us. We hope to share better news from now on. Thank you. Have a wonderful evening.

This concludes today's Masimo's Third Quarter 2011 Earnings Conference Call. You may now disconnect.