Masimo Corporation
Q2 2014 Earnings Call Transcript

Published: 7 Aug 2014

[Operator:]

Good day, ladies and gentlemen, and welcome to the Masimo Second Quarter 2014 Earnings Conference Call. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to introduce your host for today's conference call, Mr. Eli Kammerman. You may begin, sir.

[Eli Kammerman:]

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 reflects Masimo's 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-K and Form 10-Q. You will find these in the Investors section of our website. I'll now pass the call to Joe Kiani.

[Joe E. Kiani:]

Thank you, Eli. Good afternoon, and thank you for joining us for Masimo's Second Quarter Earnings Call. Our total product and rainbow revenue were disappointing due mainly to the very small year-over-year revenue growth seen in the U.S. acute care market despite a 10% year-over-year increase in our gross pulse oximetry monitor shipments and relatively robust unit volume growth. We believe this year-over-year revenue headwind we have experienced in the U.S. acute care market is due to 2 primary factors

[Mark P. de Raad:]

Thank you, Joe, and hello, everybody. Today, we reported that total revenue and product revenue for the second quarter was $140.9 million and $133.5 million, respectively. Product revenue rose by 3% or 2.8% on a constant currency basis versus the second quarter of 2013. Second quarter 2014 total revenue, including royalties, increased by 2.5% versus the second quarter of 2013. rainbow product revenue was flat in the second quarter at $11.6 million, with the weakness related to the delay in certain Q2 orders that we believe will now move into Q3. In the quarter, approximately 45% of total rainbow revenues were consumables, which was consistent with a year ago. And in a few minutes, Joe will provide some additional information on our Q2 2014 SpHb revenues. Our worldwide end user or direct business, which include sales through just-in-time distributors, grew 5% to $112.4 million versus $107 million in the year ago period. Our direct business represented 84% of total product revenue in the quarter, up from 83% in the prior year period. And OEM sales made up the remaining 16%, which was down about 6% over the same prior year period. By geography, total U.S. product revenue rebounded slightly from the decline we saw in Q1 and rose by 2% to $91.6 million compared to $89.8 million in the same quarter of 2013. The improvement compared to Q1 results was partly attributable, we believe, to the small improvement in recently reported Q2 hospital patient census data that Joe mentioned earlier. Our international product revenues were $41.9 million, a 5.3% increase in the second quarter of 2014 or 4.5% on a constant currency basis versus $39.8 million in the same period last year. As Joe noted a few moments ago, this increase was due primarily to growth in both the EMEA and Japan territories. International revenues represented approximately 31% of total product revenue in the second quarter of 2014, level with a year ago. Our second quarter 2014 product gross profit margin was 64.2% compared to 64.4% in the year ago period and up slightly from 64.1% in the prior quarter. The decline in the year-over-year product gross profit margin was due primarily to the pricing impact of the record 2013 contract renewal activity and the delay in various large Q2 OEM orders to Q3. Despite the slightly lower than anticipated Q2 product gross profit margin, we are continuing to make progress with our ongoing product reengineering efforts to reduce our overall product costs. And as a result, we continue to expect to see higher gross profit margins in the second half of 2014. Our second quarter total gross profit margin, including royalties, was 66.1%, down slightly versus the year ago period. Second quarter 2014 operating expenses, excluding the medical device tax were $73.2 million, which was an increase of 10% versus the year ago quarter. This increase included a $2.5 million charitable contribution that the company made to the Masimo Foundation that was announced in May. As we have previously indicated in our annual 2014 operating expense guidance, this contribution was made in connection with our decision to increase our 2014 royalty revenue projections from $8 million to $28 million, which we addressed in our Q1 earnings call. Importantly, without this charitable contribution, total operating expenses, excluding the medical device tax, would have been up 6.3%. And the remaining year-over-year increase in operating expenses, excluding the medical device tax, was due primarily to a $2.3 million increase in legal expenses related primarily to the ongoing DOJ-FDA investigation. In fact, without the charitable contribution and these specific legal expenses, our total Q2 2014 over Q2 2013 operating expenses, excluding the medical device tax, rose by only 2.8%, exhibiting our continued focus and discipline in controlling total operating expenses. SG&A expenses rose by 13.7% versus the year ago period to $59.9 million. But as I just mentioned, excluding the impact of our charitable contribution and higher year-over-year legal expenses, our SG&A expenses rose by only 4.6%. And R&D spending of $13.3 million actually declined slightly by approximately 3.9% compared to the year ago period due to lower year-over-year engineering equipment, supplies and clinical study expenses. Second quarter 2014 operating income was $18.4 million, down 21% compared to $23.2 million in the year ago period. The $4.8 million decrease in operating income was due entirely to the previously noted $2.5 million charitable contribution and the $2.3 million increase in year-over-year legal expenses. Nonoperating income was $322,000 in the second quarter, primarily due to the positive translation impact of movements in foreign exchange rates. This compares with nonoperating expense of $238,000 in the year ago period, which was the result of the negative effects of changes in foreign exchange rates in that period. Our second quarter 2014 effective tax rate was 25.5%, down from 36.2% in the same period last year. As you may recall, the much higher rate in the year ago period was due to the recording of a $2 million provision for the establishment of a valuation allowance against deferred tax assets of Cercacor, a variable interest entity that we were required to consolidate. The 25.5% current quarter effective tax rate was slightly lower than our last projection of 26% to 28%, and this is due to a change in the mix of our projected U.S. versus o U.S. operating income. Second quarter 2014 net income was $13.8 million or $0.24 per diluted share compared to $17 million or $0.30 per diluted share in the same prior year period. This quarter's earnings per share was negatively impacted by $0.03 due to the $2.5 million charitable contribution. Our average shares outstanding for Q2 was 56.8 million, reflecting a partial benefit from the approximate 2 million shares we repurchased during the quarter at an average price of $24.24 and at a total cost of $49.2 million. As of June 28, 2014, our days sales outstanding was 51, which was down slightly from 52 as of the end of December 2013. Over the same periods, inventory turns declined to 3.3 from 3.7, which was consistent with our plan to increase the level of finished goods inventory to allow us to be even more responsive to our customers. Total cash and cash equivalents as of June 28, 2014, were $97.1 million compared to $95.5 million as of the end of December 2013. The slight increase in 6-month cash levels represent the combination of net cash generated from operations and a $75 million drawdown on our line of credit. And those were offset by the approximate $56 million related to the acquisition of our corporate headquarters building and the $49.2 million for the previously noted Q2 stock repurchases. Now I'll take just a moment to discuss our updated 2014 financial guidance, which again is based upon the best information that we have available. Our new guidance is as follows

[Joe E. Kiani:]

Thank you so much, Mark. We appreciate that update. We are very happy to see that our installed base in the second quarter again expanded much faster than the market, a clear sign that Masimo is increasing its presence around the world. During the quarter, we observed a slight easing of the pressures seen on hospital admission rates compared to the prior 9 months. This shift in patient volume has produced a sequential uptick in our unit volume for SET pulse oximetry sensors, which we are hopeful will continue through the remainder of the year. As I alluded to before, an important development in May Q2 was the FDA clearance for the full-featured Root, our new monitor with the unique feature of expandable functions, enabling clinicians to add capnography, brain function monitoring and soon, tissue and cerebral oxygen monitor. Root contains an advanced feature set, which will allow clinicians to access patient data in an intuitive format that provide immediate benefit for fast interpretation and better decision-making. We expect that over time, Root will provide our customers with a truly new and unique monitoring experience and will, through the IRIS interface, allow Root to act as a hub for the legacy products connected to the patient that don't have a way to communicate to the electronic medical record. And lastly, through MOC-9, it will allow many new and innovative technologies from both Masimo and other companies to be available to patients. As a result, we expect Root to provide Masimo with yet another unique and unparalleled advantage in winning new customers and therefore, advancing patient care and reducing costs. We're also very happy to introduce Radius-7 in CE countries. Radius-7 is a lightweight multi-function wearable device that has a wireless link to our Root monitor. Patients wearing the Radius-7 will have the benefit of always-on monitoring so that the health and data integrity are not jeopardized when around within the hospital. Studies have shown that patient mobility is a key factor in more rapid patient recovery. The value of reliable continuous pulse oximetry in this setting made possible by our Measure-through Motion and Low Perfusion pulse oximetry technology includes reduced failure to rescue events and fewer intensive care unit transfers, both of which have high human and financial cost for hospitals. rainbow sales were below our expectations in the second quarter, but should rebound in Q3 as we record several orders, including the launch outside the U.S. hemoglobin order that have slipped into the third quarter. It's clear that rainbow is achieving higher visibility with clinicians, and adoption is rising on an international level. While we are encouraged to see this increasing adoption of rainbow technology, internationally, we continue to expect that growth to also be propelled by what we hope will be the first launches of some of the initial devices of rainbow technology by GE and Philips later this year. As part of our rainbow sales, total hemoglobin revenues in second quarter were $3.2 million, including continuous measurement as well as spot check tests and devices, down slightly versus the prior year period. There, in Q2, the new blood management team for continuous hemoglobin monitoring continued to see an increase in the number of acute care hospitals that have concluded a favorable evaluation of SpHb, our noninvasive hemoglobin monitor. Of course, translating that clinical recommendation into a capital purchase and deployment is still requiring a significant amount of persistence and attention by our blood management team. However, compared to the second quarter in 2013, the blood management team's revenues have doubled, which is encouraging. Because of our continuous long-term confidence in our business during second quarter 2014, we repurchased approximately 2 million shares. Over the last 6 quarters, this represents a total stock repurchase of approximately 3 million shares or 50% of the 6 million share repurchase authorized by the Board of Directors in Q1 2013. While we currently expect the majority of the remaining $50 million from our recently implemented $125 million line of credit will be used to fund the build-out of our new corporate headquarters, we may also use those funds to facilitate additional stock repurchases as the market conditions allow and/or to respond to other business expansion opportunities. With respect to potential business acquisitions, we continue to consider opportunities to adopt of small businesses with innovative technologies that will complement our portfolio. I would now like to take a moment to thank, Ed Cahill, a long-term Director at Masimo, who is leaving our board. Over the past 15 years, Ed has made very significant contributions to Masimo, and I have relied heavily upon Ed's significant investment banking experience and valuable insight into medical technology companies. Ed has resigned to focus more on his portfolio of companies at HLM Venture Partners. First, I'd like to thank Ed for his unwavering and steadfast guidance over the past 15 years. Ed will be greatly missed. At the same time, in regards to the Masimo board, you may recall that we announced the addition of Craig Reynolds to our board in April. In case you missed that announcement, Craig brings exemplary medical and life science industry experience to our board, including his role as the former Chief Operating Officer of Philips Respironics Home Health Solutions and CEO of Healthdyne Technologies. Craig will obviously help to fill the gap created with Ed Cahill's departure. Please join us in wishing Ed the best in his new pursuits. We have positive long-term outlook and confidence in our ability to achieve our financial goal while achieving our mission to improve patient care and reduce cost of care. Our Q2 worldwide monitor placements illustrate the continuing gains in the marketplace we are realizing as our advanced technology demonstrate superior benefit for patients. While we intend to continue to work to increase our product revenue growth rate, we are also equally focused on achieving progress with our ongoing engineering and manufacturing cost reduction efforts and in general, maintaining disciplined control of our nonlegal operating expenses. Clearly, our ability to see some of the earnings per share leverage in 2014 had been and will unfortunately continue to be impacted by the higher-than-usual legal expenses resulting primarily from the DOJ and FDA activities. In fact, of our new projected $289 million of fiscal 2014 GAAP operating expenses, approximately $10 million is related to this topic, which was absent in our expenses last year. We hope that these investment issues will be concluded soon but cannot estimate a completion date at this time. And despite these distractions, we continue to stay focused on developing breakthrough products to help improve patient care. The launch of our breakthrough products to date and what we expect to announce over the next several months make us very optimistic about the long-term outlook for our company, as is evidenced most clearly by our recent 2 million share stock repurchase. With our guiding principles included to always do what is best for patient care, our leadership in advanced monitoring technology allow us to contribute to improving the practice of medicine and will continue to propel the growth of Masimo. With that, we'll open the call to questions. Operator?

[Operator:]

[Operator Instructions] Our first question comes from Bill Quirk with Piper Jaffray.

[William R. Quirk:]

So I guess the first question guys, we've had a couple of quarters now where the top line guidance has come in and, Joe, you cited that obviously some of the reason for that has a lot to do with some of the deals that you signed in 2013 and the associated price concessions. So I guess I'm a little curious, part of this isn't necessarily new, and so why do we continue to see the slippage in the guidance there? And conversely, given that you're forecasting an acceleration in the back half, can you just help us think about how confident you are there.

[Joe E. Kiani:]

Sure, sure. Bill, first of all, we did anticipate the headwinds from the pricing erosion, the ASP erosion that we experienced due to those conversions we talked about. But we had several large rainbow orders that we had anticipated would come in, in the second quarter, that we have not lost but have slipped into Q3, and therefore, we did not meet our total revenue nor earnings expectations. However, as you've noticed from our guidance for the rest of the year, we do believe we will get them and balance for the year will be very close to what we forecasted at the beginning of the year, both in terms of revenue and earnings. The reason I talked more about the sequential slow growth in our acute care business is not because it was a surprise, but it was because of one of the issues that we're seeing out there. I just wanted to inform our investors.

[William R. Quirk:]

Okay, Joe. And then secondly, and I guess this is a bit of a follow-up to questions that Dave asked last quarter. But given that the business has the first half of the year been slower than expected and obviously you've had the commensurate impact in the earnings line, why go ahead and decide to make a charitable contribution? It was obviously a decision that, in light of the earnings shortfall, you could have at least acquired some of that back?

[Joe E. Kiani:]

Well, I think, first of all, the charitable contribution was done based on the fact that we changed our forecast with royalties from Covidien from $8 million to $28 million. And so that was solely based upon that. But secondly, for example, a very large order that has slipped into Q3, we actually had -- we got the purchase order from our distributors, have actually shifted to the government. We're just being conservative in taking that as a revenue until the government agency has signed an agreement with our distributor. So anyway, so long story short, that -- number one, the contribution is not related to our normal business but the additional royalties from Covidien, and really up until just recently, we did not anticipate not having that sizable order in Q2.

[William R. Quirk:]

Okay. Then I guess just last for me. Joe, you guys have referenced this large order a couple of times now. Can you give us a little sense as to how meaningful that would have been? And then obviously they'll have an effect in the third quarter.

[Joe E. Kiani:]

Yes, it's $7 million. And as I've mentioned, we have over $20 million of orders like it that are in the pipeline. So unfortunately, we're going to see some lumpiness in our quarters, while we're doing our best with our dedicated blood management team that calls on hospitals to build the base business, which is the usage of our noninvasive hemoglobin routinely in the OR ICU recovery room area, which as that business builds, the sensor volume of that business becomes just like our current pulse oximetry business, the great majority of our revenue. But until that happens, you're going to see in the foreseeable future lumpy quarters because, like I said, over $20 million of solid good business, where we're making a huge impact around the world on population care to basically come in millions of dollars at a time and then go and then come back maybe 12-month anniversary to it or 9-month anniversary to their first agreement.

[Operator:]

Our next question comes from Matthew Dodds with Citigroup.

[Matthew J. Dodds:]

Joe, just a question on reprocessing. I mean I thought we were -- that was largely behind us. I'm not exactly sure how much it impacted the quarter, what's still left there. Just give a little more color on how that's impacting you.

[Joe E. Kiani:]

We are not 100% sure of how it's impacting us. What we do know is that maybe due to our success in the marketplace, there's been a focus on reprocessing Masimo sensors by these third-party reprocessors. And that's what I was reporting to you today. Like I said, maybe I didn't quite say it strongly, but our growth year-over-year in terms of driver replacement will match pretty closely with our sensor business. So therefore, it's hard for us to calculate how much we're losing due to reprocessors, but we are hearing a lot from our sales force that there's a lot of pressure out there from third-party reprocessors that are now focused on Masimo installed base. And unfortunately, that pressure undoubtedly has caused us business, we don't know how much. This can be -- if I were to guess, it will be less than 10% in the U.S. But also, it has a negative impact in our reputation because many times, we get called in when accounts are not happy. And every time -- it's not 100% of the time, almost every time, it has to do with a reprocessed sensor on the patient, which then of course makes us wonder when doctors and nurses see those situations, how many times, they don't call us to say anything but they walk away thinking unfavorably about Masimo, which had nothing to do with our products. So we have really stepped up our efforts to minimize those issues, both technologically, with things like X-Cal that will have more and more impact in the coming years and some business solutions that we'd come up with that we're -- have offered customers that we know are reprocessing. And we had some success with those and we hope to see more and maybe not so long from now that these reprocessor issues will be a historical issue. The only thing I would -- just maybe I'll add to that -- sorry, Matt, for a long response. The only thing is while third-party reprocessing might go away substantially, we are reprocessing ourselves more and more too, which has an ASP erosion as well since reprocessed sensors sell for less than new sensors. And I don't see that trend changing. I do see us continue with our reprocessing, because our reprocessing does not minimize the sensor performance since we actually eliminate the components that get bad over time when we reprocess.

[Matthew J. Dodds:]

But I just want to -- Joe, to make sure I got this right, though. X-Cal, that eliminates the ability to reprocess. Or is it just that you only rolled out a certain percent of your drivers with X-Cal and that's going to take time?

[Joe E. Kiani:]

Correct. Correct, Matt.

[Matthew J. Dodds:]

And so do you have an estimate of maybe what percent of the installed base now is X-Cal or up to?

[Joe E. Kiani:]

I'd say 10% at best. And I think that number will change significantly over the next 2 or 3 years because of the rollout of our OEM partners with X-Cal technology.

[Operator:]

Our next question comes from Brian Weinstein with William Blair.

[Brian Weinstein:]

Joe, last quarter, you did make the comment about the Affordable Care Act and the impact that it would have on your business longer term. It sounds like -- I wasn't sure if you were backing off of that a little bit given what we saw just in this most recent quarter or if you still expect to have kind of a longer-term impact. And can you explain to us kind of why you expect to see that sort of an impact on your business longer term from that particular legislation?

[Joe E. Kiani:]

Sure. Last quarter, I've seen 3 quarters in a row where sensors kept dropping in hospitals and we felt it with our sensor volume. This quarter, we've seen mixed results in the papers, in the journals. For example, Modern Healthcare stated there's a 7% reduction in sensors -- in patient sensors. But then Wall Street Journal recently reported some of the public hospitals have reported an increase in admissions and census increase. We've seen with our own sensor volume, for it to match our installed base growth. So putting that together, it feels like Q2 got better than certainly Q1. And the reason I rang the bell last quarter is because we've seen, just part of the second part of your question, we have seen when Massachusetts went through this Affordable Care up several years ago, that our sensor volume and revenue had grown at a fraction of -- for the rest of the country, in that region, in Massachusetts. So those are the reasons. And while I'm not ready to say ACA is not going to have an impact going forward, all I'm letting you know is that Q2, we did not feel that sensors drop.

[Brian Weinstein:]

Okay. And then on the $20 million of orders -- of the larger orders that you referenced, is that all embedded into your guidance that you get all $20 million, or is there some conservatism in there that you're going to just get a fraction of that?

[Joe E. Kiani:]

Yes, we are not including the -- as far as the -- it's over $20 million and a fraction of it, less than 50% of it is what's in our guidance.

[Operator:]

Our next question comes from Tao Levy with Wedbush.

[Tao Levy:]

Sorry, I've just have to ask somebody. You might have already answered this. But I'm trying to better understand the correlation between the increase in the number of placements that you have and the growth that you're seeing in your installed base versus what's happening, it seems, in the pulse oximetry business on the sales side. And if -- there's obviously a lot of moving parts, and I get the pricing difference, but it doesn't seem to account for the full downtick, if you will.

[Joe E. Kiani:]

Tao, we appreciate your frustration because we are frustrated by it, too. Q1 made more sense to us because sensors was down and it impacted our sensor volume. We kind of saw that in the U.S. acute care business. Q2, our sensor volumes were fine, matching our expected installed base growth, but our revenue was down. And I think, clearly, part of it is the approximate 5% reduction in ASPs, which I'll emphasize again, for the last 3 quarters, has remained the same. We're not seeing decrease from what we saw in Q4 2013, Q1 2014 and Q2 2014. ASPs have stabilized, but compared to the previous quarters, obviously ASPs are still down 5%. We'll see that change, hopefully, assuming things continue the way they are, in Q4 of 2014 when year-over-year there may not be more ASP pressures, assuming that things stay the same. But -- so we're scratching our head to why the U.S. acute care business growing at 3% when our overall installed base is growing by 10%, and we believe some of that have to do with obviously the ASP pressures, about 5% of it, maybe 4% of it. Some of it has to do with perhaps reprocessors. And we -- our customers don't come and tell us they're reprocessing because they're not supposed to. So it's hard to get that data from them except for us to kind of go audit hospital by hospital, which we're not in the business of doing. We don't want to be that intrusive to them. So what we're letting you know is our best guess of why U.S. acute business didn't grow by 10%, and we think it has to do with those 2 issues. Now to Bill's statement, we expected some of that erosion, obviously, when we gave you a new guidance. We've given you originally a straight $470 million to $500 million guidance for the year, and then we lowered it to a range of $550 million to $570 million after seeing some of that softness, after having to back off $2.6 million for the inventory issue we had last quarter. So we kind of knew about it and as you noticed, this quarter, we're not changing our guidance much. We're bringing the high end down to $565 million we'll be left alone where it is. So it means we kind of knew this is happening, it might be off a couple of percentages, but not more than what we expected. What really made us miss what we had expected this quarter is the shifting of some of the rainbow business from Q2 to Q3, which one of them was a several million dollar order that we'd actually shipped in Q2 and expected to be able to report it today. So I hope that answers your question.

[Tao Levy:]

Yes. No, I appreciate the thorough answer. And then my follow-up question is, is it possible to -- is there a delay in the way that you record revenues or kind of see the ordering patterns from your direct customers or your OEM so that if you're seeing an improvement out there in hospitals, census numbers or, say, the hospitals are seeing that, that it doesn't get reflected in the way hospitals purchase from you guys until the following quarter? In other words, they're not more of a leading indicator than any results are more of a lagging indicator there?

[Joe E. Kiani:]

A bit, Tao, because when Mark joined as the CFO, I'm glad he did this, he adopted a sell-through model and that sell-through model, the best thing of it is that our do-gooders will never get the wrong idea and try to go book business with distributors that don't have customers for us. I don't have to worry about that anymore. The bad news is we get orders like the ones I've just had to not book for this quarter from our distributors that we don't get to take until we know everything is fine between the distributor and even the customer. And that's o U.S. And then the U.S., as you know, the majority of our business goes through these just-in-time distributors, and we don't really know about their inventory until very late in the game. And then based on that, we make adjustments to our revenue for the quarter. So yes. So in essence, we had a delay and those factors -- and the fact that, as you know, majority of our business comes from consumables, is why we still feel good about the year. We're not having to go recreate the entire wheel in the second half of the year, and although the second half has got to be now much bigger than the first half, we understand where that business is coming from so we feel good about that.

[Operator:]

And I'm not showing any further questions at this time. I'd like to turn the conference back over to our host.

[Joe E. Kiani:]

Well, if there are no other questions, I just want to thank you, all for joining us. I'm frustrated to report the less than what we expected for Q2. The good news is we've not lost these businesses, they've gone into Q3. So I look forward to delivering that performance to you at our Q3 earnings call. Thank you, and enjoy the rest of your summer.

[Operator:]

Well, ladies and gentlemen, that concludes today's presentation. You may now disconnect and have a wonderful day.