Masimo Corp (MASI) 2012 Q2 法說會逐字稿

Good afternoon ladies and gentlemen and welcome to Masimo's second quarter 2012 earnings conference call. This 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 Sheree Aronson, Masimo's Vice-President of 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 best current judgment. 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-Q. You will find these in the investor section of our website. I also want to remind you that we are hosting our first ever Masimo investor day on the morning of September 20 at the Pierre hotel in New York.

We hope you will plan to join us for this event which will provide an in depth review of Masimo's strategy, technologies and growth opportunities and include executive presentations, clinical panel discussions and product demonstrations. To RSVP, please call or e-mail me using the contact information listed on today's release. With that I will pass the call to Joe.

Thank you, Sheree. Good afternoon and thank you for joining us for Masimo's quarterly review and update. We finished the second quarter with 12% year-over-year growth and product revenue driven primarily by strong performance from our direct business in the US and abroad.

We shipped 37,300 new Pulse Oximeters and Pulse CO-Oximeters in the quarter and now estimate our worldwide installed base to be 1,033,000 units. This is up 12% year-over-year and underscores the clinical advantages of our measure to motion and low profusion Pulse Oximeters and Pulse CO-Oximeters. In addition, we achieved solid increases in adoption of total hemoglobin and acoustic respiration rate monitoring which are rainbow's two major long-term growth engines.

In the second quarter SpHb sales grew 48% versus a year ago period and rainbow Acoustic Monitoring grew by 600%. We are happy to announce today the acquisition of PHASEIN, a Swedish developer and manufacturer of ultra-compact mainstream and sidestream capnometers, multi gas analyzers and hand held capnometry solutions. The acquisition of PHASEIN's technologies complements our breakthrough innovations for patient monitoring with their portfolio of products ranging from OEM solutions for external, plug in and measured gas analyzers and integrated modules to hand held devices.

With multiple measurements delivered to either mainstream for intubated patients or side-stream for un-intubated patients, our customers can now benefit from CO2, N2O and O2 and anesthetic patient monitoring in many hospital environments such as operating rooms, procedural sedation and ICUs as well as the EMS environment. This acquisition fits within Masimo's growth strategy which is to build a durable recurring revenue franchise with breakthrough user friendly patent protected technologies that improve the practice of medicine, advance the standard of care and reduce healthcare costs.

In July 2011, American Society of Anesthesiologists revised its standards to say that during moderate or deep sedation the adequacy of ventilation should be evaluated by continual observation of qualitative clinical signs and monitoring for the presence of exhaled carbon dioxide, or CO2. While we are working with ASA to expand the standard to include rainbow Acoustic Monitoring because we know that our existing rainbow Acoustic Monitoring technology still enjoys many advantages to capnography, we believe that it will be good to have both solutions available to our customers.

In a few minutes I will provide additional perspective on our business and comments regarding our overall growth strategy. But first Mark will review the second quarter financial performance. Mark?

Thank you, Joe and good afternoon everybody. As Joe just noted Masimo's second quarter 2012 total revenue rose 12% to $122.8 million versus $109.6 million in the year-ago period. Second quarter product revenue also rose 12% to $115.3 million reflecting primarily higher sensor sales to our hospital customers. This increase occurred despite movements in foreign exchange rates that reduced our year-over-year revenue by approximately $1 million.

In addition Masimo Semiconductor which we acquired late in the first quarter of 2012 added approximately $800,000 to second quarter product revenue. Rainbow product sales grew 7% in the second quarter to $9.7 million as strong growth in SpHb, RAM and other rainbow measurements was partially masked by a drop in Rad-57 SPCO and SP Met sales, which continued to be impacted by a municipal budget cut facts across the country.

In fact, excluding Rad-57 product sales, total rainbow revenues in the second quarter actually grew it 22%. Also encouragingly we saw nearly 50% growth in SpHb sales and more than 600% year-over-year increase in RAM revenue, indicating increasing interest in this novel rainbow technology. Our worldwide end user or direct business which includes sales through just in time distributors grew 16% in the quarter to $98.4 million versus $84.7 million one year ago.

In total, our direct business represented 85% of product revenue versus 83% in the year-ago quarter. OEM sales represented the remaining 15% of second quarter 2012 product revenue. OEM sales declined 5% in the second quarter to $16.9 million compared to $17.9 million in the same period of 2011. Although down modestly from the year-ago period we do expect that our year-over-year OEM revenues will stabilize through the rest of 2012.

By geography, total US product revenue rose 16% to $83.2 million in the second quarter compared to $71.5 million in the second quarter of 2011. Once again, this growth is due primarily to higher consumable sales. Product revenue outside the US totaled $32.1 million, up 3% or 7% on a constant currency basis compared to $31.1 million in the second quarter last year.

Importantly our OUS direct product revenue rose 15% year-over-year on higher sales in Europe, Canada and Asia. This growth was offset by a 31% decline in our OUS OEM business due primarily to lower revenue from one OEM customer. International product revenue represented approximately 28% of total product revenue in the second quarter versus 30% in the year-ago period. The second quarter product gross profit margin was 64.1% compared to 66.5% one year ago.

As was the case in the prior two quarters, the ongoing incremental cost of our new X-Cal technology, which we have incorporated into every Masimo adhesive sensor since Q4 2011, reduced our Q2 2012 product gross margin by over 150 basis points compared to the prior year quarter. This impact has continued to grow in the last three sequential quarters due to both higher sensor volumes as well as other manufacturing X-Cal transition related costs.

Designed to enhance patient safety and improve clinical efficiency the X-Cal technology addresses the use of imitation or copy cat sensors and cables, the use of cables and sensors far beyond their expected life and the use of third-party reprocessed sensors. We view the investment in X-Cal technology as essential to protect our brand technology integrity and ensure customers of the quality and reliability of Masimo products over the long run.

In addition, as we expected and discussed in our previous earnings call, our second quarter product gross profit margin declined 80 basis points due to the full quarter impact of our recently acquired Masimo Semiconductor business from Spire Semiconductor. This compares to a 30 basis point impact to product gross profit margin in the immediately preceding Q1 2012 quarter.

Based on these comparisons, if it were not or our X-Cal technology and Masimo Semiconductor investments, our pro forma Q2 2012 product gross margins would have been approximately 66.5%, consistent with the 66.5% that we reported in Q2 2011. Total gross profit margin including royalties was 66.3% in the second quarter versus 68.7% in the same prior period last year. This decline was due to the same primary factors I just noted.

Operating expenses were $58.8 million, up 11% from $53.1 million in the second quarter of 2011. The rise reflects a 9% increase in SG&A due primarily to increased payroll and related costs associated with higher staffing levels, as well as higher marketing and acquisition related consulting expenses and $400,000 in Masimo semiconductor expenses. The rise in operating expenses also reflects an 18% increase in R&D spending to $11.1 million from $9.4 million, related primarily to increased payroll and related costs associated with higher R&D staffing levels as well as costs associated with new projects and engineering supplies.

Second quarter 2012 operating income was $22.7 million compared to $22.1 million in the year-ago period. Non-operating expense was $462,000 in the second quarter compared to income of $528,000 in the year-ago period and reflects primarily the recognition of the net realized and unrealized losses on foreign currency denominated transactions. Our second quarter 2012 effective tax rate was 20% compared to 25.4% in the second quarter of 2011.

The decline was due primarily to a $2 million income tax benefit resulting for the conclusion of a prior year tax audit which added $0.03 to our earnings per share in the second quarter. Excluding the benefit of this tax audit resolution, our new effective tax rate estimate for fiscal 2012 rose from 27.5% at the end of Q1 to 28.5% in Q2. As a result, our effective Q2 tax rate, excluding the impact of the prior year tax audit resolution, was approximately 29%.

The slight increase in tax rate projection is due to a slight shift in the mix of income in jurisdictions in which we do business. As you will recall, in April 2012 we completed the two year three million share re-purchase progRAM authorized by our board of directors in August 2011. As a result, our weighted average shares outstanding in Q2 2012 declined to 58.1 million versus 61.2 million one year ago.

Second quarter 2012 net income was $17.7 million or $0.30 per diluted share or $0.27 per diluted share excluding the tax benefit I mentioned earlier. This compares to second quarter 2011 EPS of $0.28 per share. As of June 30, 2012 total cash and cash investments were $121.5 million compared to $129.9 million as of December 31, 2011. Reflecting primarily net cash generated from operations offset by $7.2 million in cash used to purchase the assets of semiconductor and $26.3 million in cash used to re-purchase shares of our common stock. As of June 30, 2012, our DSO was 51 versus 50 at year end 2011. Over the same period inventories turns rose slightly to 3.6 from 3.4.

Now let me turn to a quick update of our 2012 financial guidance which we are adjusting to reflect both our initial estimates of the financial impact of the PHASEIN acquisition as well as some additional updates to our financial expectations for the remainder of 2012. Just to remind you, in March 2012 we indicated that we expected total product revenue to be approximately $486 million, including product revenue of $458 million and royalty revenue of $28 million.

At that time, we also estimated that our annual product gross profit margin would be 64.5% including the expectation that our margins would be below that annual rate in the first half of 2012 and higher in the second half of 2012. We also indicated that we expected annual total operating expenses of approximately $234 million, a tax rate of 28%, and as a result of our stock buy-back progRAM, estimated weighted shares outstanding of approximately 59 million.

We concluded that the combination of all these items would result in a new projected 2012 GAAP earnings per share of $1.15. We expect the impact of the PHASEIN acquisition to add approximately $4 million to 2012 product revenue and approximately $4 million to operating expenses. In total, the PHASEIN acquisition will be approximately $0.04 dilutive to EPS for fiscal 2012 with $0.02 of this dilution related to one time integration costs, $0.01 related to the amortization of intangibles and $0.01 related to the projected operating loss for the remainder of fiscal 2012.

The 2012 operating loss projection is the result of product gross margins that are currently in the 35% to 40% range. Although dilutive in fiscal 2012, we are confident that this business, even with some necessary investments, will be EPS neutral in 2013 and accretive by 2014. In addition to the impact of lower margin PHASEIN product revenue, we are also now expecting a slightly more aggressive pricing environment than we had originally assumed as part of our expansion into the new US distribution channel targeted at the physician office marketplace.

As a result of both these factors, we now expect our 2012 full year product gross profit margin to be 64%. Due primarily to volume expectations we expect Q3 product gross profit margins to be below 64% but then expect Q4 profit product gross margins to be above 64%. We are also increasing our annual effective tax expectations, excluding the Q2 tax benefit resulted from the prior year tax audit, to 28.5% from the 27.5% we had estimated at the end of Q1 2012. This increase is due primarily to revised expectations of the jurisdictions in which we generate our revenue and operating profits.

Finally, we are also updating our guidance to reflect the approximate $1 million in foreign exchange transaction losses we have already incurred this year based primarily on the weakness of the Euro. We are assuming a new weighted average share balance of approximately $58.5 million to $59 million for the year. Offsetting the impact of these three changes in our projections is the $0.03 tax benefit we recognized in the second period as a result of the prior year tax audit resolution.

So in summary, based on the PHASEIN acquisition, our Q2 results and other changes to assumptions, we now expect total product revenue to be approximately $494 million including $466 million in product revenue and $28 million in royalty revenue. We now expect product gross profit margin and total gross margin will be 64% and 66% respectively for the full year and that operating expenses will be approximately $238 million.

Our annual effective tax rate, excluding the Q2 prior year tax audit benefit, is expected to be 28.5% or actually on a net basis 26.1% with the benefit of the Q2 prior year tax audit resolution. And our weighted share count is expected to be 58.5 million to 59 million. We expect 2012 EPS to be approximately $1.11. With that I will turn the call back to Joe.

Thank you, Mark. Our second quarter results, including double digit growth in our product revenue and worldwide installed base, demonstrate that Masimo's superior technology and focus on innovation are drawing in new hospital customers on a global basis and are allowing us to deliver growth rates above those of the overall market. In fact, we continue to convert on average over 100 hospitals every year by displacing our competitor and establishing new agreements that give clinicians access to our gold standard SET Pulse Oximetry which have shown to save baby's eye sight and save lives.

The important clinical advantages of our SET technology were validated once again in a study published in the second quarter by the journal of clinical anesthesia that shows Masimo SET, SpO2 sensitivity and specificity to be substantially higher than that of the competitors studied. At the same time the studies showed our SpO2 and pulse rate failure rates to be substantially lower than competitors during patient motion in case of both normal and depleted oxygen levels.

This performance difference is why clinicians and hospitals rely on Masimo's SET technology to provide patients the best possible care across a wide range of critical care scenarios. Moreover, it is the primary reason that we believe Masimo SET will become the pulse oximetry of choice for new born screening for clinical congenital heart disease, or CCHD, which is one of the most common causes of infant death in developed countries worldwide.

The accuracy and reliability and cost-effectiveness of Masimo SET also makes it a preferred choice for continuous monitoring on the general ward. Paired with the Masimo Patient SafetyNet remote monitoring and clinician notification system, it provides an efficient and intuitive solution to help clinicians keep post surgical patients safe.

In the second quarter Patient SafetyNet systems sales were up more than 150% versus the year-ago quarter. Indicating that an increasing number of hospitals are turning to Masimo as they implement continuous patient surveillance. Contributing to this trend is a powerful evidence that continues to build regarding Patient SafetyNet's benefit .

In the second quarter, the anesthesia patient safety foundation published a follow-up analysis of the 2010 landmark Dartmouth-Hitchcock Medical Center study on Patient SafetyNet, which showed that continuous monitoring with Patient SafetyNet reduced rescue events by 65% and transfers to the ICU by 50%. Resulting in approximately $1.5 million in annual opportunity cost savings in the original orthopedic post surgical unit where the study was conducted along with work flow improvements that increased patient throughput and capacity.

Of note is that after the original study Dartmouth-Hitchcock mandated continuous monitoring for 100% of patients in its medical and surgical ward units. Numerous other institutions are following suit and experiencing the benefits of Masimo Patient SafetyNet remote monitoring system. We are also using our engineering prowess to address some of the green and cost challenges hospitals are facing.

With new sensor technologies including our line of ReSposable SpO2 sensors, currently in limited market release, and set for full market release later this year. Our unique ReSposable sensor system offers the performance and comfort of our single patient use disposable sensors with unprecedented reduction in carbon footprint and waste as well as cost. We expect Masimo's core SET business to continue to deliver attractive growth given the difference between the percentage of our new shipment of oximeters and our installed base percentage, our potential for general ward expansion and our new innovations to address important clinical needs.

But our biggest growth opportunity is the revolutionary Rainbow technology we have brought forward in the recent years. Our upgradable rainbow SET platform is the first and only technology to non-invasively and continuously monitor Total Hemoglobin, methemoglobin, carbon monoxide, fluid responsiveness and respiration rate in addition to SpO2, pulse rate and perfusion index. The power of rainbow is evident in migration of OEMs including Philips and GE Healthcare to this platform.

We believe our OEM partners recognize the clinical and cost savings benefits rainbow delivers to hospitals, clinicians and patients and the competitive necessity to make it available to their customers. Providing further evidence that rainbow adoption is on the rise, total rainbow consumables as a percent of total rainbow product sales approached 50% in the second quarter double the level one year ago and hitting a new high. The stand out rainbow performer in the second quarter was SpHb with sales up 41% versus the year-ago quarter.

As you probably heard me say before, I am confident that continuous SpHb monitoring will become the standard of care. Conventional methods of monitoring hemoglobin levels are invasive and results are delayed and intermittent. Only rainbow SpHb provides real time continuous trending of total hemoglobin levels for earlier and better clinical decision making, improved patient safety and reduced cost of care.

SpHb is already making a difference by demonstrating its life saving potential to help clinicians detect occult bleeding in places like the ICU and labor and delivery and by reducing blood transfusions during surgery, as evidenced by the Mass General Hospital randomized control trial, which showed a 90% reduction in blood transfusion with SpHb. I know SpHb will reach the steep incline of the S curve of technology adoption and while we can't predict when that will happen we are doing all that we can to speed up its adoption.

That includes the recently introduced Better Care Guarantee ProgRAM, which stands for blood transfusion related cost reduction guarantee. Under the progRAM, Masimo guarantees that when a hospital replaces its pulse oximetry and adhesive sensors with Pulse CO-Oximetry ReSposable adhesive sensors and begins monitoring non-invasive hemoglobin, it will experience the reduction in blood transfusion costs in excess of the incremental price paid for the rainbow sensors.

If the hospital doesn't experience a reduction we will refund up to their incremental sensor cost. Blood transfusions are the most common procedures performed in US hospitals and blood is one of the hospital's major expenses. Running roughly ten times the amount of pulse oximetry sensor costs. Moreover, there is growing clinical evidence highlighting the need for improved blood management strategy because blood transfusions carry risks of mortality, infection or other complications.

Our willingness to put our money where our mouth is with the Better Care Guarantee may be a bit unconventional but it shows just how confident we are in the clinical and cost benefits of Total Hemoglobin and it is getting customers' attention. During last quarter's call I mentioned that we were in discussion with over 20 hospitals regarding this new progRAM. I'm happy to report that this list is now up to over 40 hospitals, both in the US and outside the US, and we hope to have at least three of these participating in the progRAM by the end of third quarter.

Consistent with our full market release, we are also making major strides to expand the sales reach of Pronto-7 and Pronto. Under new distribution agreements with Henry Schein Medical and PSS World Medical, we estimate that more than 1,000 distributor reps will soon be selling the Pronto and Pronto-7 to office based physicians, community health facilities, medical clinics and ambulatory surgical centers.

You will recall that a transition to one or more major distributors had long been our stated position office sales strategy in order to achieve broad nationwide sales coverage but we were not going to do that until we were in full market release stage. Our existing in house 20 person physician office sales force is now functioning as a sales management resource order distributors and is in the process of training distributor sales teams.

Finally, we also see tremendous opportunity for rainbow Acoustic Monitoring or Rad. It is easy to use, well tolerated by patients and measures respiration rate unobtrusively and in real time facilitating early detection of respiratory compromise and patient distress. This is important because respiratory depression is common during early post-operative periods and when narcotic analgesics are required for pain management.

In May the first published study on RAM appeared in the [Buddhist] Journal of Anesthesia. This study demonstrated that Ram provided high patient tolerance and similar accuracy compared to captography in post surgical patients. The positive trend in RAM use is evident in our second quarter Ram revenues. Where RAM grew 600% and surpassed Ram sales total for all of 2011. We expect the PHASEIN technology to complement RAM by offering customers a full range of choices. Moreover we see multigas measurements as a $500,000.00 global market opportunity.

In our assessment, PHASEIN has the most accurate gas measurements, the widest array of measurements, and a technology most suited for easy and flexible integration into both Masimo and OEM products. PHASEIN's impressive list of OEM customers and innovative technology portfolio for carbon dioxide, nitrous oxide and oxygen, and anesthetic agents, makes it a perfect addition to Masimo's mission to take non-invasive patient monitoring to new sites and applications.

We are proud to welcome the PHASEIN team to Masimo. In closing I will remind everyone that Masimo went public five years ago August 7. Since 2007 we have tripled the size of our sales and clinical support team, we have doubled our global footprint and product revenue and nearly doubled our earnings per share. We have also proven not only feasibility but commercial sales of continuous and spot check hemoglobin as well as acoustic respiration rate monitoring while pioneering new sensor technologies and continuing to build an impressive product pipeline.

Thanks to the strength of Masimo's innovation engine, few companies have a more promising and compelling set of growth opportunities than we do. Unfortunately, these achievements aren't currently reflected in our stock price which is pretty close to the original IPO price. I'm hopeful this will change as the strength of our franchise and the potential for our technology to improve patient safety, save lives and reduce costs, become evident in our percentage growth.

In the meantime, I continue to be a big believer in Masimo and personally have purchased another 50,000 shares in the open market in the second quarter for a total of 150,000 shares in the past eight months. I am very excited about the future and confident that Masimo's best days are ahead of us. Hopefully you will be able to join us in New York on September 20 and we will be able to shed more light on our rich solutions to some of medicine's most perplexing problems and if timing works we will give you a glimpse of the future.

With that we will be happy to take your questions. Thank you. Operator?

Your first question comes from the line of Bill Quirk with Piper Jaffray.

Yes, thanks and good afternoon, everybody.

Hi, Bill.

Joe, first question is on PHASEIN and I guess I'm just trying to understand the company a little bit more. It looks they have been on the market I think in Europe since about 2003 and in the US since 2005. So I guess I am a little curious. The revenue contribution, or the revenue addition rather that you highlighted of $4 million. Help us think about maybe given these guys have been on the market so long how come it is perhaps not a little larger than where we are at this point?

I think this there are several factors. First of all, PHASEIN's strategy had been to be an OEM company and had also not concentrated on the consumables. They were mostly selling OEM modules and that really has impacted their revenue and growth. We intend to change those.

Not only make more direct products and user products but also create a sound consumable model for the business. But secondly, capnography has not grown rapidly up until maybe a year or two ago when some of these standards were being put in place. A lot of it has been due to the fact that it is difficult to, for patients to adhere to capnography and for clinicians to use it when it comes to sidestream capnography.

We believe because of that, that RAM is a better solution in sidestream applications but in mainstream application we believe capnography will continue to play an important role as evidenced by the sedation standards that ASA has put forward. And some of the new things we can potentially do with their anesthetic patient monitoring as well as their capnography. For example, it may turn out to be a good way to assess the titration of anesthetics in the ICU by monitoring the amount of anesthetic agents coming out.

So I hope that addresses why their revenue is not that high. They had been growing, to our understanding, over 20% a year, year-to-year but I think we could really step that up and with complementary products like we have especially with RAM we can now make a better argument about where Ram really is beneficial and where capnography is beneficial. And we believe Ram is most beneficial for any sidestream applications like on the general floor and so forth.

Understood. Thank you. And then a question, actually probably just a couple of quick ones for Mark. A lot of details around guidance. No comments on rainbow. Historically when you guys don't comment on something it means that those numbers have not changed. We do have this $45 million rainbow target out there.

Looks like we would have to probably step it up quite a bit in the back half to hit that, Mark. Should we be thinking that obviously the other side of the business is growing quite well. It looks like you bumped up the guidance and basically it is kind of a swapping pulse oximetry for rainbow for the balance of the year. Is that the right way to think about it?

Yeah, Bill, I think the reality is, given some of the momentum that we see building in the first half of this year we are actually pretty encouraged looking forward to the second half of the year. And then remember the original $45 million guidance for the year was predicated upon us successfully putting in place distribution agreements which are now in place. So obviously we are working through the initiation part of those agreements right now.

We expect that product will begin shipping through those distributors in the latter part of Q3 and much more significantly in Q4. So because of that uncertainty I think as of the current time we are still not yet prepared to move off of that number. But clearly Q3 will be an important quarter as we gain the positioning that we will need for a very strong fourth quarter which was always what we expected we would need in order to achieve that $45 million.

Got it. And then just last one for me and I will jump back in the queue. I seem to recall on the first quarter we had a little bit of revenue slippage. I want to say the number is about $2 million from the first into the second quarter. Is that, indeed, the case. Did we see that in Q2, I'm trying to figure out was there any kind of one-time revenue in the second quarter. Thank you.

No, no. In fact, we were very pleasantly surprised with the second quarter strength and our total sensor volumes. As you recall, historically the first quarter for us has been the peak quarter for revenues and for sensor volumes. We typically see a reduction in the second quarter and then again in the third quarter and we were actually very pleased with the somewhat consistent level really of total sensor volume as we went from Q1 into Q2. Now, going into Q3 we actually do expect the usual seasonality and then we expect, once again much stronger fourth quarter as we finish up the year.

Perfect. Thanks, guys.

Thank you, Bill.

Your next question comes from the line of Joanne Wuensch with BMO Capital Market.

Good afternoon. I just want to confirm of the $8 million in our revenue guidance variance $4 million is coming from PHASEIN and the other $4 million coming from strength in your core business. Is that the right way to think about this?

That is exactly right.

Okay. Also it is my understanding that right now you are taking on the expenses for X-Cal and gross margins but you are3not getting the benefits from turning it on. If that is true when might we start to see those benefits?

Well, we expect to see the benefits starting to hit in 2013.

Okay, so of your 50 basis point decrease in gross margin, is all of that associated with PHASEIN or is some of that associated with either foreign exchange or something else.

No, Joanne, just to make sure you are talking about the 64.5 to the new 64 times.

Yes.

I think as I mentioned before, that is primarily the result of PHASEIN but it is also partly due to the fact that we are now expecting slightly lower overall gross profit margins on the products that will actually be directed into this new US distribution channel. Earlier in the year, obviously, we had to make some assumptions about pricing and cost of product and now that we are closer, now that we have just signed those two agreements we have a much clearer perspective on what that pricing is going to look like and as a result that was the other reason for the slight downward movement in overall gross profit margins.

But having said that, as I indicated earlier in the prepared remarks, we are still planning to hover right around 64% in the back end of the year. A little below that probably in the third quarter and hopefully a little above that in the fourth quarter.

Very helpful. Thank you.

Your next question comes from the line of Matt Dolan with ROTH Capital Partners.

Hi, guys. Good afternoon. Wanted to shift maybe over to the OEM side and maybe you could walk us through the challenges you are seeing there. Is the international customer something that you have now lost or is this something that we should see recover in the near future?

Hi, Matt. No, we have not lost the customer. There was maybe what I would consider a one-time revenue event last year that did not repeat this year with the OEM so in fact everything is very solid with this OEM and as we noted we expect the OEM business to begin stabilizing in the second half and move forward.

And by the way, I want to mention that, as you know, that there are downward pressure the OEM revenues have had doesn't mean that the downward pressure to OEM shipments. As you noted this quarter, we did over 37,000 drivers which is kind of the new low I guess, that is pretty high compared to historical numbers and allow us to meet the 70,000 drivers that we expected for the year and a lot of that looks on the back of our OEMs doing very well.

Okay. Great. And then I just wanted to follow up on the gross margin conversation. You had some initiatives in place to help improve those into the back half of the year. Are those still going have their effect and these other issues are offsetting them or is there maybe a prolonged or a delay in there in the benefit from some of those programs?

No, Matt, actually those are incorporated in the numbers that we are talking about. We are actually very pleased with what has happened so far and we expect some of those improvements to continue as we said earlier in the year, in the second half of this year and probably more significantly moving into 2013. But those initial benefits that we have been talking about for a couple of quarters are already in those numbers. And I think frankly pretty indicative of the pro forma gross margins that I alluded to in the prepared remarks.

I mean the reality is if you exclude the incremental cost of X-Cal and you exclude the incremental costs, at least at a margin level, of the new business, on a pro forma basis our margins actually are very consistent with where they were same time year ago and that is in an environment where, as we have been saying, pricing has been competitive throughout this entire year. So the reality is some of these cost improvements that have been ongoing have really been there to essentially manage some of this ASP pressures which is what we had indicated we thought would happen and clearly over the next couple of years we expect to continue to see those kind of cost reductions put into the model.

Okay. And then last one for Joe maybe you could just give us an update on your philosophy on the acquisition side of things. You have done SET line and now PHASEIN. Are you starting to see, at least with SET line, some cross selling or at least some technology integration opportunities and maybe layer in to that what we should anticipate in terms of acquisitions going forward. Thank you for the time.

Thank you, Matt. SET line has actually been a successful acquisition. Although we didn't talk about its growth. It did grow quite nicely in Q2. Maybe if Mark could find the numbers and I could tell you how much it grew.

We also have been working in the R&D effort with SET line to make it a much more user friendly product and to really help its sales through a much, much broader usage. One of the things that is very comforting for us is that we go after technologies that we believe are the best. And we are confident that the better technology will ultimately win assuming you have access to the market, which fortunately we seem to have it.

And so we think SET line and PHASEIN, these types of acquisitions are going to be not only good for us but good for the marketplace. In terms of more acquisitions, we see other opportunities, one very seriously we are in the due diligence phase and we may have one more to discuss in the near term. As far as going back to the SET line increase, that business increased 123% this quarter compared to year ago.

That is great. Thanks a lot.

Thank you.

Your next question comes from the line of Brian Weinstein with William Blair.

Hi, thanks for taking the question. You obviously talked about a more competitive pricing environment. Can you talk more specifically about what you are seeing there, are we expecting to see kind of low to mid-single digit price erosion there. How worse is it getting and has it abated at all in the last couple of weeks because I know at our conference you talked about it being down a little bit more than that. Thanks.

Sure, Brian. It hasn't gotten worse but I mentioned at the conference our competitor, maybe I can't blame them, they are dealing with our innovation engine and if I were them maybe I would do the same thing, but they have gone to cost the pulse oximetry is not a commodity and it is our job and duty to make sure clinicians and hospitals are aware of the difference the technology makes. Not only in terms of pulse oximetry, which as I mentioned before has been shown to with our technology to save baby's eye sights and lives and very important cost reductions, but the access to PVI which is a way to measure fluid responsiveness that typically costs hospitals a few hundred dollars to do which comes with our sensors.

Or non-invasive hemoglobin that can dramatically reduce blood transfusion. These are the things we have been successfully been able to convey to customers. While sometime we have no choice but to go to that price because of our inability to articulate and get to the right people to know the differences the product makes, mostly we have been able to defend our value proposition and that is why we have not been eroding. That is why we made the point of showing you what our margin would have been without some of these things like X-Cal and Masimo's [sumatra notre] acquisition.

And the one point that I wanted to make just to make sure everyone is clear, when Mark earlier talked about reducing our margin expectation for the year, he did it based on the Pronto and Pronto-7 pricing that we ended up giving to the distributors. Not because of SPO2 pricing. I think it is important to note that.

Okay. And then I think you mentioned that there was some investments in PHASEIN that need to be made. I think I heard you guys make that comment in the prepared remarks. Can you talk specifically about what those investments are going to be. Is it just in product development, is it in sales and marketing? Where do you think you need to invest there? Thanks.

Well, we actually see the technology as really nice, I guess, piece of diamond in the rough and we think there are things we can do with it both from end user [productisation] as well as, I mentioned earlier, in creating better sensor model for that business. And so mainly those are the areas we are going to focus on in the expansion of our expenses there of our investment which is really R&D. Mainly engineering headcount.

But then there is other areas like what if we can use it for titrating better gases in ICU. So those are the areas. It's definitely not going to be in sales force expansion or that because it is a very complementary product line for our current OEM sales force and our direct sales force.

Thank you.

Thank you Brian.

Your next question comes from the line of Lawrence Keusch with Raymond James.

Hi Guys, This is actually Constantine for Larry. Joe, if I could start with you have kind of now been for the last couple of quarters articulating to the street some frustration with where the stock price is. So, I understand you are going use, at least it sounds like you are intending to use some of your cash to make acquisitions. Can you maybe provide some comments in terms of maybe thoughts on incremental share re-purchases or other ways that you think you can create value?

Yes, I would be happy to. First of all, forgive me if I'm sounding like I'm nagging about the stock price. The market obviously does what the market does and it is an intelligent market so maybe it is just right but I don't think so. As far as use of our cash, as you know we bought three million shares. We have some acquisition opportunities. one we have done already, another one we are in the final phases of decision-making on.

Obviously if these acquisition targets weren't there and we didn't think they added more value long-term to shareholders then stock buy-back, we probably would have done more stock buy-back. And in the past we have also done dividends, very hefty dividends if we don't do them regularly. So we are constantly asking ourself what is the best way to do good for long-term shareholder value and at this point we still believe that unless these acquisition opportunities disintegrate we are better off to spend our cash to do those than to do the stock buy-back.

Okay. That is fair. And then I just want to get your updated thoughts in terms of driver placements. I believe you guys kind of guided initially to 150,000 drivers with 80,000 in the second half of the year. And I think part of it was predicated on accelerated adoption of OEM kind of with OEM adoption of your rainbow parameters. Can you provide updated thoughts on that and also put in that context any update on Philips and kind of have they started out, have they started shipping product?

Okay. First of all, on the big picture, yes we still believe the 150,000 is attainable although we think Q3 will dip and we will have a strong Q4 to make up for the full 150,000 that we are expecting. As far as your second question of Philips and GE, they are, to our understanding they are diligently working on the integration of rainbow into those, into their products.

While I can't predict with certainty, as I have said before, I thought it would take a couple of years from the announcement of our agreement with these two companies to get their product or main products out. I still feel good about that. Which should put Philips out sometime towards July of 2013. And GE not far from that.

Okay. And one last one from me. So we talked about the acquisition about kind of the R&D stuff that you are doing with SET line, but can you shed more light on your internal R&D? I mean you are spending quite a bit of money there and I don't know if you can just provide updated thoughts maybe on some of the newer parameters you are working in or new products, any kind of color would be appreciated?

As I said earlier, I'm hoping in September, on September 20 in New York, if we are close enough to launch we might be able to show you some of the stuff we are working on. It is very exciting. The product pipeline has never been stronger and more, I guess maybe to me, more delightful. We have some really great product offerings that I think are going to help to really improve the process of care for hospitals. We are also working on new parameters.

I will caution you that I don't expect them to be as big of a story as hemoglobin and RAM but nonetheless we think they are going to be valuable. So those are coming as well. I don't know if you have seen the new Radical-7 that we just introduced but the customers are enthralled with it. We were at, we had some really amazing reactions. We had one customer that has been a big proponent of our competitor for a long time and they said to us, everything you have done is good but for us to switch we need to be wowed. We brought in the new Radical-7 and they said wow.

So we have for awhile focused on the fundamental technologies inside the products by ushering in new non-invasive measurements. We are now putting back our focus on how do you make them really work for customers and how do you solve some of the problems that seem simple but no one has done them. Things like Halo and things like, what we are doing with patient safety. Anyway, with that I hope on September 20 we will be able to show some of what we are talking about but if not that means it won't be much longer after that.

Terrific. Thank you.

Thank you.

Your next question comes from the line of John Putnam with Capstone Investments.

Thanks very much. Joe, I just want to go back to PHASEIN for a minute or two. Help me understand. Is this technology going to be incorporated in your existing products or is it going to be a separate product line?

The PHASEIN technology will be put into our existing products and we also are going to make it broadly available to all of our OEMs.

Okay. So it will be incorporated then into existing and new products I'm assuming?

Yes, and new products, of course. The pipeline I mentioned. It is planned and we have been working on it for awhile even as an OEM to PHASEIN. So we are going to be, not too long from now we will have those. Plus PHASEIN has some of their own unique products like a little small hand-held capnometer. So we plan to introduce that for emergency EMF type of environments and also spruce it up a bit to make it more user friendly.

And how large is their organization in terms of people?

I think they are about 35 people. It is not that big but a really nice close knit and bright group of people.

Okay. Great. Thanks very much.

Thank you.

Your next question comes from Lennox Ketner Bank of America.

Hi guys. Thanks so much for taking the questions. First one, Joe, you mentioned that the ReSposable launch I think is, I guess is under a limited launch now but that will expand towards the end of the year. And you said that that obviously will reduce the carbon footprint but also the cost to the hospital. I am just wondering if you can talk a little bit about how we should think about the impact of those, a shift to the ReSposable sensors impacting both sensor pricing and gross margins from a longer term perspective?

Sure. Let's say one day everyone goes to ReSposables. We, which we don't think will happen but let's say they do for a moment, and there are reasons even though we think they are great solution and that everyone is going to use it, the ReSposables are going to have the same dollar margin contribution and actually even a higher gross margin profit percentage contribution albeit at a lower ASP. So while it will impact revenues it should not impact our gross margin dollars and actually make the percentages look better.

Okay and why would your expectation be that most people wouldn't switch to that if it is less expense to the hospital?

Because clinicians prefer the sensor with the cable solution. So a lot of them are going to want to use that. I think it is going to be hospitals that are mainly have a vision of a green environment that are going to want to use that as well as hospitals that are adopting rainbow. I think it will be kind of a combination of those two situations. Plus as I mentioned before when we deal with very competitive prices we deal with those with ReSposables and the ReSposables allow us to be as competitive as we need to be and yet that product has a better indication for use as well as a higher performance than the competing products, even the ones that have the cable connected to it by our competitors.

Okay, thanks. And then just second question, on the, sorry, the Nacho trial you talked in your prepared remarks about the Mass General trial but didn't mention the Nacho trial for SpHb that you had mentioned in the last call. Is that still underway and if so when should we expect to see the data from that?

It is. I'm glad you asked because I should have said it proactively. I'm happy to say it has begun. So hopefully within a year are from now we should start seeing some abstracts coming out of that and hopefully in a couple of years the full manuscript. But it has begun.

Thank you.

The next question from Ben C. Haynor - Feltl and Company.

Good afternoon guys. Thanks for taking the questions. On the Better Care program you said you have been talking to about 40 hospitals so far of the 100 qualifying hospitals you project to offer it to. Have you signed up any one for that as of yet?

No, we are in contract negotiations with a handful. Like I said we think we will have three of them completed in Q3. And we are talking to more than 40 but 40 are in serious dialogue about adopting this program.

Okay. Great. And then on SpHb, just running the numbers from your press release last week. I get the potential hospital savings of roughly 20% to almost two thirds of their blood transfusion costs. Does that seem like it is in the ballpark?

Yes. Yes, it is. If pulse Nacho trial will support the mass general study, although we don't expect it to be as big because they are going to look at heavy blood loss cases where the mass general studies looked at all orthopedic patients, but we believe there should be some where between 40% to 90% reduction in blood transfusion when people adopt continuous non-invasive hemoglobin. Given that the cost of blood is typically five to 10X cost of pulse oximetry sensors we believe the net savings of that is between $20.00 to over $100..00.

Why do you think the uptake has been, well, maybe I shouldn't say relatively slow so far, but is it more studies that need to come out? Is it just the contract re-negotiations? What is kind of the hospital's line on the product?

Well, I think, unfortunately, there's a lot of factors and I usually don't like to lead with them because it sounds like excuses. But I think first of all, we mentioned in the worst time in our history that I remember, not only the great recession but the affordable care act that has made everybody totally focused on costs. Unfortunately, the whole thought of improving care and quality of care is not in the lingo of hospitals any more, at least not the majority of them. So cost is a big factor.

In reality, hospital costs of medical devices is about 5% of their costs. If they took out the entire, if they got everything for free they would not impact their total cost. So what you really have to do is help them improve the process of care. Fortunately, hemoglobin gives that opportunity. Like we talked about with blood transfusion. I think that has a big factor to it. The way the mentality of the customer is today. But I think other factors are when people get non-invasive hemoglobin, the first thing they wanted to do is to do accuracy studies. And accuracy studies are comparing us many times to a standard that is not really the gold standard.

The gold standard is either sinemet hemoglobin which most hospitals don't do, or at best is the culture counter, and we kept getting compared to co-oximeters and I-STAT and HemoCue machines. So that has made people wonder and, of course, when they do studies they are doing anecdotal studies, they are not doing a complete study with the full range of hemoglobin and enough patients to get a true picture of the accuracy. The first study that we wish people would do was done by Praxis in, I think in Leon, France, and they compared non-invasive hemoglobin and the co-oximeter and HemoCue to the gold standard culture counter. And in that study they showed the accuracy was the same, actually was better than those other potential standards that people compare us to.

So I think that whole conversation of people getting comfortable that this is a real good product has been an issue and takes, unfortunately, years for people to get comfortable with that. Probably the most important thing that this mass general study that is helping move things forward along with our guarantee because I think of it, what if we didn't say it was hemoglobin but it was a [ZBox]. But the [ZBox] helps you with just blood transfusion by 90%.

What difference does it make when you aren't even compared to, I guess not a real standard but a silver standard product how it compared to in accuracy. I think sorry for the long discussion but I think it is the economy, it is the way people thought about it, and I think also it could be also our way of marketing it, our way of discussing it with customers. We assume that everybody understands the limitations of not having continuous hemoglobin and we are finding that they don't and we have to talk about problems with blood transfusion and problems with intermittent measurements and not having that information in between.

And finally, the 2012 Radical-7 finally shows all of the rainbow parameters in a way you want to see where before they were tiny little numbers as step child to the pulse oximeter value. And last but not least, the OEM. When Phillips and GE launch their versions, because a lot of customers prefer the integrated version, I think hopefully that along with Nacho coming out then it will take a lot of the issues out of the way and may be able to fly a little faster.

That's very helpful. Thanks for the detailed description. That is really all I had.

Thanks. At this point you are probably sorry you asked.

Well, I will have to reread the transcript.

Me, too.

Alright. Thank you.

Thank you.

Your next question comes from the line of Spencer Nam with ThinkEquity.

Hi, this is Mary in for Spencer. Can you hear me?

Yes.

Oh, good. I just had my question is a little bit about the with the strength of the SpHb numbers. Can you just talk a little bit about what specifically accounted for that strength and whether it was in line or better than or worse than your expectations with the study that you were just talking about, do you think it is more hospitals and doctors understanding its benefit more or the hospital spending? The pressure on the hospital spending lightening a little bit or what would you say accounted for that?

Well, one of the good things about any type of monitor is watching the consumable revenues to see if people are using it after they buy it. And the good news is that the consumable volume and revenues were actually much better than the 48% increase we reported.

That was the revenue total which included a softer licensing sales but, by the way, we shipped more licenses for hemoglobin than ever but because a lot of them were down on their sensor contracts which should be hopefully more and more growth in the future. I really think it is people getting comfortable that hemoglobin is here, the studies are coming out that are done better and showing the true picture of the product and, of course, things like blood transfusion study from mass general are not hurting either.

Okay. And in your prepared remarks I think you said that you notice that the EMT and the firehouse budgets are still under pressure. Just general hospital spending trends, what are you observing? Are they concerned? Is that lightening up at all?

Well, the CO carbon monoxide monitoring, the main market for that has been the EMFs, which is the fire departments, paramedics and their IASS, International Association of Firefighters, National Fire Protection Agency, they all recommended the use of non-invasive carbon monoxide monitoring very early in the game and things were going superb. But then we hit the recession in 2008, because we rolled out the product in late 2005, and the tax revenues that these cities were collecting has dried up to the point that they are laying off firefighters which is uncommon. So that is the problem. It is not the hospital, it is the firefighters and paramedics that are unfortunately not, that don't have the money and are not buying a lot of new products, including ours, that is anchoring our rainbow growth.

Okay. Thank you.

Thank you.

Your last question comes from the line of Bill Quirk with Piper Jaffray.

Great. Thanks. Appreciate taking the quick follow-ups here. Just wanted to, Mark or Joe for that matter, just ask you a little bit more I guess on the distributor side take up rainbow product in the third quarter. Obviously seeing more of that in the fourth. What, I guess do we have some firm commitments there guys which kind of gives you incremental confidence as we kind of think about how not only third quarter but fourth quarter should roll out?

Mark, would you like to respond?

Sure, the contracts that we have established, Bill, include various targeted price levels based upon the components of the individual product solutions and there are also some very minimal commitments related to the overall numbers. So there is no, shall we say, large firm commitment. I think our overall confidence in the ability to allow that channel to begin growing is based more upon the feedback that our own sales team has had relative to working with the sales teams of both of those two new organizations.

So pricing is established. That gives us a sense of where we think, obviously at certain volume levels, revenues would ultimately roll up to. But some of it is guesstimates as well. Simply based upon where we think the product is likely to play out both in Q3 and then probably more aggressively in Q4.

Got it, okay. That's very helpful. Thanks, Mark. Lastly for me, Joe did I hear you correctly on the call when you mentiond that hemoglobin is approaching 50% of rainbow?

Yes. Not the rainbow revenue, but what we said is 50% of the rainbow revenue came from consumables which is double of that last year.

Oh, okay. Understood.

And Bill, we plan to disclose the hemoglobin numbers, like we said, in 2013 so we will start reporting the actual breakout of that, so hopefully it won't remain a mystery.

Okay. I think we are are all looking forward to that. Thanks a lot Joe. Thanks Mark.

Thank you you so much. If there are no other questions then we are going to end our meeting. Thank you all for your interest and on this summer afternoon enjoy it. Look forward to seeing you in New York.

Thank you. This concludes today's conference. You may now disconnect.