Earnings Call: Q1 2018

May 2, 2018

Good afternoon, ladies and gentlemen, and welcome to Masimo's First Quarter 2018 Earnings Conference Call. The company's press release is available at www.masimo.com. At this time, all lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. I am pleased to introduce Eli Kamerman, Masimo's Vice President of Business Development and Investor Relations. Thank you. Hello, everyone. Joining me today are Chairman and CEO, Joe Kiani and Executive Vice President of Finance and Chief Financial Officer, Micah Young. This call will contain forward looking statements, which reflect Masimo's current judgment, including certain of our expectations regarding fiscal 2018 financial performance. However, they are subject to risks and uncertainties that could cause actual results to differ materially. Risk factors that could cause our actual results to differ materially from our projections and forecasts are discussed in detail in our periodic filings with the SEC. You will find these in the Investor Relations section of our website. Also, this call will include a discussion of certain financial measures that are not calculated in accordance with generally accepted accounting principles or GAAP. We generally refer to these as non GAAP financial measures. In addition to GAAP results, these non GAAP financial measures are intended to provide additional information to enable investors to assess the company's operations in the same way management assesses operations. Management uses non GAAP measures to budget, evaluate and measure the company's performance and sees these results as an indicator of the company's ongoing business performance. The company believes that these non GAAP financial measures increase transparency and better reflect the underlying financial performance of the business. Reconciliation of these measures to the most directly comparable GAAP financial measures are included within the earnings release and supplementary financial information on our website. Investors should consider all of our statements today together with our 10 Q for the Q1 to be filed with the SEC in order to make informed investment decisions. In addition to the earnings release issued this afternoon, we have posted a quarterly presentation within the Investors section of our website to supplement the content we will be covering this morning this afternoon. I'll now pass the call to Joe Kiani. Thank you, Hilla. Good afternoon and thank you for joining us for Masimo's Q1 2018 review. We achieved record product revenue of $204,000,000 with non GAAP earnings of $41,900,000 and EPS of $0.75 Our results reflect demand for our breakthrough technologies and solutions and the effective execution of our plan to achieve at least 8% to 10% product revenue growth and 150% of that rate in earnings growth, with expanding operating margins over the next 7 years. We saw strong performance in both our U. S. And international business. We're realizing gains across the healthcare spectrum from internationally recognized institutions to community hospitals as the value of our solutions is increasingly recognized by clinicians our worldwide shipments of non invasive technology boards and monitors rose to 53,600 units, which reflects an increase of 12% over the prior year quarter. The growth is attributable to both our direct and OEM business. We received some noteworthy CE and FDA clearances during the quarter, including a clearance for home use of our new RAD97 telehealth monitor with two way audio and video capabilities. I'll discuss these with some additional business updates later in the call today. Now, I'll ask Micah to review our Q1 results in more detail and provide you with an update to our 2018 financial guidance. Micah? Thank you, Joe, and good afternoon, everyone. Before I get started with the financials, I want to take a moment to discuss the new accounting standard ASC 606, which we adopted during the Q1 of 2018 using the full retrospective method. Although these changes had a modest impact on our Q1 2018 results, the adjustments to our historical results were much more significant. At a high level, the most significant impact of the new accounting standard is that ASC 606 changes the accounting for 2 primary types of transactions here at Masimo. Number 1, product revenues related to sales to our just in time distributors will be reported going forward and have been adjusted in prior periods to reflect revenue recognition on a sell to method under ASC 606 as compared to the sell through method that we had previously historically reported under ASC 605. Number 2, non recurring revenues related to our partnership with Philips will be reported going forward and have been adjusted in prior periods to reflect revenue recognition on a percentage of completion method under ASC 606 as compared to the completion of milestone method that we had historically reported under ASC 605. The implementation of the new accounting standard has resulted in adjustments for prior periods that had the effect of increasing our Q1 2017 product revenues by approximately $4,300,000 and our Q1 2017 non recurring engineering revenues by $6,000,000 As a result of our Q1 of 2017, total revenues were increased by $10,300,000 Also our Q1 2017 non GAAP earnings per share were increased by $0.11 These adjustments to our Q1 2017 numbers have reduced our apparent growth rates for Q1 2018 despite delivering very strong results this quarter that significantly exceeded our expectations. For further information regarding the historical adjustments related to the new accounting standard ASC 60 6, please refer to the supplementary financial information in the Investor Relations section on our website. Now moving on to our financial results for the quarter. As another reminder, the financial measures that I will be covering today will be on a non GAAP basis and will also be based on the new accounting standard ASC 606 unless otherwise noted. For the Q1 of 2018, were $204,400,000 for the quarter, which reflects growth of 12% or 9.9% excluding the impact of FX. As I mentioned previously, the prior period adjustment related to the new 606 accounting standard resulted in the addition of approximately 4 point $3,000,000 to our product revenues from what we had previously reported in Q1 2017. Excluding the prior period adjustment in Q1 2017, our Q1 2018 product revenue increased by approximately 14.8% or 12.6% on a constant currency basis. Just to be clear, there is a this is a comparison of product revenue for the Q1 of 2018 under ASC 606 versus what we had previously reported in the Q1 of 2017 under ASC 605. We did not prepare our Q1 2018 results under ASC 605 since we adopted the new standard using the full retrospective method. Royalty and other revenue was $8,600,000 for the quarter compared to $14,200,000 for the Q1 of 2017. The current quarter results included $8,100,000 in royalties compared to $200,000 in the prior year quarter. In addition, the current quarter included approximately $400,000 of NRE revenue related to the integration of various Masimo Technologies into Philips monitors compared to an adjusted $6,000,000 in NRE revenues in the prior year quarter. The prior period adjustment related to the new 606 accounting standard resulted in the addition of $6,000,000 to our NRE revenues from what we had previously reported in Q1 2017. Now let's turn to the rest of the P and L. For the Q1 of 2018, non GAAP gross margin, including royalty and NRE revenue, was 67.5% versus 67.4% in the prior year period. Our product gross margin for the Q1 increased 70 basis points to 66.2%, which was in line with expectations. We remain positive about the potential to realize increasing gross product margins due to manufacturing efficiencies as well as the favorable mix benefits that we will realize from customers upgrading to the newer RD sensor line. Non GAAP selling, general and administrative expenses increased 8% to $70,900,000 in the first quarter, which was well below the rate our product revenue growth illustrating a clear improvement in operating leverage. Non GAAP research and development expenses increased to $18,600,000 or 8.7 percent of our total revenue due to increased staffing levels and higher project related costs as we continue to invest in delivering innovative technologies to the marketplace. Our first quarter non GAAP operating profit margin was 25.5 which reflects the stronger revenue and profitability we typically see in the 1st and 4th quarters of our fiscal year. Moving further down the P and L, non operating income on a non GAAP basis was approximately 500,000 compared to 300,000 in the same period last year. Now turning to tax. Our non GAAP tax expense in the Q1 was $12,900,000 resulting in a non GAAP effective tax rate of 23.6% compared to a non GAAP effective tax rate of 31.6 percent in the year ago period. The lower tax rate reflected the recent changes in U. S. Tax laws. Our weighted average shares outstanding for the quarter was approximately 55,600,000 essentially level with the year ago period. We repurchased 196,000 shares during the quarter for approximately $16,500,000 at an average price of approximately $84 per share. 1st quarter 2018 non GAAP net income was $41,900,000 or $0.75 per diluted share. In comparison, Q1 2017 non GAAP net income was $36,200,000 or $0.65 per diluted share. As I mentioned previously, the prior period adjustment related to the new 606 accounting standard resulted in the addition of approximately $0.11 to our non GAAP earnings per share from what we had previously reported in Q1 2017. Excluding this adjustment, our Q1 2018 non GAAP earnings per share increased by more than 30% in the Q1. Once again, for further information regarding the historical adjustments related to the new accounting standard ASC 606, please refer to the supplementary financial information in the Investor Relations section on our website. Our days sales outstanding improved from 55 days at the end of last year to 45 days in the Q1 of 2018, primarily due to improved cash collections from outside the U. S. Where we generally have longer payment terms. Our inventory turns were at 3.0 for the Q1, which was in line with our performance at the end of last year. As a result of our strong earnings and working capital improvement, our cash and short term investments increased by $54,200,000 during the quarter to reach $369,500,000 Now I'd like to update you on our full year 2018 financial guidance. For 2018, we are now projecting total revenue, including royalty and other revenue to be approximately $846,000,000 which represents an increase of $10,000,000 from our prior guidance. We are now increasing our product revenue guidance from $810,000,000 up to sorry, from $808,000,000 up to $818,000,000 which now reflects 2018 over 2017 growth of approximately 10% on a constant currency basis. Our guidance for royalty and other revenue remains unchanged as we are still anticipating approximately $28,000,000 for the year, which is still comprised of $3,000,000 in NRE revenues and $25,000,000 in royalty revenues. Our expectation for non GAAP gross margins, including royalty and other revenue, remains unchanged at 66.8% for the year. Our non GAAP product gross margin guidance remains unchanged at 65.8 percent. And our total non GAAP operating expenses our operating expense guidance remains unchanged at 42.4% of total revenue. Based on these assumptions, we are continuing to project total non GAAP operating profit margins of approximately 24.4 percent of total revenue. Moving further down the P and L, we still expect to generate $4,000,000 in net interest income in 2018. And based on our expected mix of U. S. And OUS profits, we are now estimating that our non GAAP tax rate will improve to approximately 24%, which is 100 basis points lower than our prior guidance of 25%. Also, we are still estimating that our weighted average shares outstanding for the year will be approximately 56,000,000 which does not reflect any additional share repurchases for the remainder of this year. Based on all of these assumptions, we are now increasing our non GAAP EPS guidance to $2.88 for the year, up from our prior guidance of $2.80 And from a GAAP perspective, we are projecting a GAAP tax rate of 20.2% and GAAP earnings per share of $3.01 for the year, up from our prior guidance of $2.90 Included in this projection are 8,000,000 dollars of excess tax benefits from stock option exercises and approximately $1,000,000 of after tax foreign exchange gains, which were offset by acquisition related depreciation and amortization expense of approximately $1,300,000 net of tax. With that, I will turn the call back to Joe. Thank you, Michael. Our Q1 results clearly illustrate the expanding adoption of our innovative technologies around the world as we realized set pulse oximetry sales growth well above the market growth rate for pulse oximetry products once again. Our newer product lines including rainbow non invasive blood constituent monitoring, normal line capnography, sedline brain function monitoring and 03 regional oximetry delivered another strong quarter of performance and are adding to our growth rate. As Michael just described, we now expect to realize product revenue growth of 10% in 2018 and deliver earnings growth for our core business that is even faster than our product sales growth this year. In the Q1, we were happy to renew some important customers including Rush University Chicago and the Long Beach Memorial Health System with multiple hospitals in Orange County area. In addition, we won a significant multiyear contract with the John Peter Smith Hospital Network in Texas. Overseas, we secured a substantial contract for RAD 67 Spot Check SBHB with the blood donation program of the transfusion center of the region of Valencia in Spain. Through a large Co Oximetry Technology in a big way. Co oximetry technology in a big way. As we move through 2018, we're excited about our recent product launches and new product pipeline. In January, we received CE Mark for our RD Rainbow Light Sensors, which enable the use of our revolutionary oxygen reserve index and improved rainbow based version of PVI, but in a less costly sensor than the rainbow sensors. We expect to see a growing body of clinical data that supports the use of ORI and RPVI for improving patient outcomes. In a recent reported study from the UC Davis School of Medicine, the potential clinical utility of ORI as an early warning of impending arterial hemoglobin desaturation in obese patients was investigated. The researchers concluded that the study demonstrates the ability of ORI to provide advanced warning of arterial desaturation as an adjunct to SpO2 in this high risk patient population. This additional warning time can potentially translate to improve patient safety by allowing earlier calls for help, assistance from a more experienced person or modification of airway management. In another recent study, researchers at Children's Medical Center in Dallas concluded that ORI could provide clinicians with a median of 31 second advanced warning of impending desaturation in pediatric patients with induced apnea after preoxygenation. Masimo's Eve application for helping clinicians screen newborns for critical congenital heart disease or CCHD received a CE mark for inclusion in our new RAD97 pulse co oximeter in February. Eve incorporates a proprietary pre ductile to post ductile comparison algorithm designed to reduce calculation errors in the screening process for this dangerous condition, which affects approximately 8 newborns for 1,000 live births and requires intervention soon after birth to prevent significant morbidity or mortality. Eve also allows clinicians to incorporate perfusion index into screening, which has been shown to increase sensitivity for the detection of CCHD in infants with pathologically low perfusion. In a study of over 122,000 infants, the largest CCHD screening study to date, CCHD screening sensitivity increased from 77% to 93% with the combined use of Masimo SET, pulse oximetry and clinical assessment. Another study evaluating perfusion index as a biomarker indicated that it would be a useful additional tool in CCHD screening and a recent 2017 study concluded that when PI is included, the sensitivity of CCHD screening can be further improved. Masimo's Eve application allows perfusion index to be incorporated into the Eve screening protocol. A notable new product announcement during the Q1 was for Replica, our application for smartphones and tablets that works in conjunction with Masimo Patient Safety Net. Replika is a supplemental remote monitoring and clinical notification system that allows clinicians to view continuous monitoring data for multiple patients as well as view and respond to alarm and alerts all from their smartphones or smart tablets regardless of location. Replika also displays data relayed from connected bedside, Masimo and 3rd party devices such as ventilators and patient monitors, while also enabling the display of the high fidelity data such as waveforms in near real time to the smartphone screen. Perhaps most importantly, Replica features intelligent two way alarm and alert notification advantages over conventional systems, which send notifications without the confirmation of delivery. Clinicians can respond to notifications from the app choosing to accept or forward and see if other clinicians have already responded, thereby improving their alarm response workflow. ORI, RPVI, EVE and Replica are just a few examples of the product innovation at Masimo. We expect to launch a number of other new products during the remainder of 2018, which will further help clinicians improve outcomes while lowering the cost of care. In closing, we're encouraged by the steady gains we're achieving for increased adoption of our differentiated technology. Masimo is dedicated to helping health care professionals improve their patient care practices and associated outcomes, all while reducing cost of care. With that, we'll open the call to questions. Operator? Your first question comes from the line of Rick Wise from Stifel. Your line is open. Good afternoon, Joe. Good afternoon, everybody. It's great to see yet another excellent quarter and I think what is this 15th in the last 18 that you've exceeded. Maybe just for starters, Joe or Micah, can you talk about your progress to date with the Phillips venture and to what extent that was a driver in the quarter. And I know that the last, whatever, 6, 9 months have been a period of training, cross training the sales forces. Where are you now and where are you now in sort of opening up those accounts, particularly for Rainbow? Thank you, Rick. The Philips relationship really at all levels has been excellent, perhaps even better than we had expected after years of being in the courts with each other. I believe while we haven't done all the things we said we're going to do together, the numbers that we're seeing from the volume of technology adoptions through Philips customers have been ahead of both of our anticipations. And I think that's one of the reasons despite trying to give you our best account of what the future holds, we keep exceeding our numbers. So as far as what's next and the programs ahead, we're excited about the new technologies that are going to be introduced by Philips from Masimo and some of the marketing initiatives that we're going to be jointly doing that have begun to some extent in some of the countries, but still remaining to take shape in other countries. So hopefully we'll continue not just doing what we say we're going to do together and expediting some of the plans we have together that may have not exactly gone at the speed we both hoped. But hopefully, we'll despite that, we'll continue seeing results that are better than both sides had anticipated. So fair to say more to come on that front. One big impact that you haven't talked about some or rather opportunity you haven't talked about yet, Joe, is the general ward. Where are you in addressing that opportunity? And are there any milestones ahead that might help us see and believe that the general award opportunity might gain more visibility in 'eighteen sort of as a setup for years to come, helped by products like Root, etcetera? Well, Rick, the general award market really is in a way dumbfounding because it's a no brainer. By monitoring patients on a general floor with Masimo Technologies, hospitals have over and over and over again have shown dramatic reduction in costs and dramatic reduction, if not elimination of preventable deaths due to opioid overdose. So, while we can brag about over 1,000 systems that have been implemented in the last few years in different general floors around the world with Patient Safety Net and the SET technology, it's still a drop in the ocean. So we see the General 4 market as potentially 3 to 4 times the size of the intensive care unit and operating room market. And yet the business coming out of the general floor is a small fraction of the critical care intensive care market. So when will every hospital say enough is enough, this is something we have to do, it saves us lives, it saves us money, I don't know. We saw the Joint Commission recommended, saw Anesthesia Patient Safety Foundation recommended. Even CMS a couple of years ago recommended it. And it may unfortunately eventually come to maybe some laws that get everybody to do it. Okay. And just two last quick ones for Micah. Micah, you talked about manufacturing efficiencies. And I know that FP and A capability is just something you're very focused on. Maybe talk to us a little bit about the progress you're making or some of your plans right now. And maybe just expand on your comments as well about customers upgrading to the RD sensor. And where are we in that process? I know it's a multiyear process, but it sounds like that probably adds to your confidence in the outlook as well. That's one piece of it. Thanks so much. All right. Thank you, Rick. Just to hit on the first point, on the manufacturing efficiencies, where we saw those were over the course of the last year in 2017, we were kicking off a lot of unfavorable manufacturing variances where we were trying to vertically integrate another plant, manufacturing plant. And that basically we knew we felt going into the year that that was going to get behind us. We're starting to see that turn into more favorable variances. So we're starting to get the absorption that we need out of those fixed overhead costs and we're seeing positive variances for the first time in a while. So that's one thing. And of course, we've got strong volumes. Our underlying volumes of our business, our sensor volumes have been very strong and that's helping us to absorb more of those costs. So that's one thing. On the RD sensors, we're still in the early innings of RD conversions. We've mentioned this before is that it's going to take next several years as we work through converting new customers and renewing contracts with that new sensor line. But it's definitely still very early innings and we've got a lot of opportunity there to drive to a much lower cost, but also a much higher quality sensor. Thank you so much. Thanks, Greg. Your next question comes from the line of Larry Keusch from Raymond James. Joe, you've been kind enough to update us on your thoughts around M and A over the past several quarters. So just wondering if you had any sort of new thoughts there or anything to share as you again think about deployment of cash into M and A. Sure. Thank you, Larry. Well, I think last summer, we were looking at acquiring something that kind of fit very tightly to the parameters we had. And while it may have been short term dilutive, we thought it would be long term quite accretive. Some assumption changed on the 11th hour of that acquisition and we ended up not doing it. Since then, we haven't found anything like the parameters I had explained to what we were looking for. So while we are looking at some tuck ins and small M and As, there's really nothing out there that unfortunately fits what we were looking for. So we'll continue looking. But for the foreseeable future, I don't see a significant M and A in our horizon. Okay. Terrific. That's helpful. So with the cash mounting on the balance sheet, it's certainly at notable levels. How do we think about capital allocation priorities now? Well, I like the Apple announcement today. Stock buyback doesn't seem like a bad idea. So we're going to look at that. I think you noticed we did buy some more shares today, but we might get more aggressive with that in the future. Okay, perfect. And then just one last one. So just in terms of the numbers themselves, any way to help us think about the flu benefit in the quarter? And then I noticed you didn't break out rainbow revenues or SPHB. So if you could provide any thoughts around that, that would be great. Yes, of course. We had another really strong quarter with Rainbow and SPHB specifically. I think even though we decided to not break down everything for you, but it grew over 100%. So it was a nice quarter. As far as the flu season, the flu season was probably one of the worst from a health perspective, but probably one of the best from a pulse oximetry sensor revenue perspective. And so some of that certainly helped in our numbers. The good news is, as indicated by our guidance, we not only increased our guidance for the year based on the additional revenues we saw in Q1, but we even raised it slightly above that because we do continue seeing a very solid outlook, positive outlook, short term, mid term and long term. Okay, perfect. But anyway, just quantify the flu revenues for the quarter? No, it's really I mean, I'm sorry, I don't have that number on the tip of my hand, but what I can tell you is that generally strong very strong flu season may add about 1% to our quarterly numbers. I don't think they're that significant, especially because of the growth we continue to have in our total business. I think if our business was more flat and more falling the oximetry business growth, the impact might look larger. Got it. Perfect. Thanks very much for the time. Thank you so much. It looks like you and Rick have not looked outside your window. It looks like the weather is really nice in New York and Boston. So I think you guys are our only 2 questions today. The rest of the analysts are out playing. So thank you all for joining us. We look forward to our next quarter report. Ladies and gentlemen, this concludes today's conference. Thank you for your participation and have a wonderful day. You may all disconnect.