Good afternoon, ladies and gentlemen, and welcome to Masimo's second quarter 2017 earnings conference call. The company's press release is available at www.masimo.com. At this time, all lines have been placed on mute to prevent any background noise. After the speakers remark, there will be question and answer session. I'm pleased to introduce Eli Kammerman, Masimo's Vice President of Business Development and Investor Relations. Sir, you may begin.
Hello, everyone. Joining me today are Chairman and CEO, Joe Kiani, and Executive Vice President of Finance and CFO, Mark de Raad. This call will contain forward-looking statements which reflect Masimo's current judgment, including certain of our expectations regarding fiscal 2017 financial performance. However, they are subject to risks and uncertainties that could cause actual results to differ materially. Risk factors that could cause our actual results to differ materially from our projections and forecasts, are discussed in detail in our SEC filings, including our most recent Form 10-K and Form 10-Q. You will find these in the investor section of our website. I'll now pass the call to Joe Kiani.
Thank you, Eli. Good afternoon, and thank you for joining us for Masimo 2017 second quarter earnings call. We are happy to report product revenues and earnings per share that once again exceeded our expectations. We were able to achieve double-digit product revenue growth, which provides solid evidence that our technologies and systems continue to be adopted by more hospitals focused on improving patient care and reducing costs. Encouragingly, we are steadily gaining new customers for our core technology platforms, and also beginning to see higher revenues from our newer products including Root, NomoLine capnography, O3 cerebral oximetry, and SedLine brain function monitoring. Our Q2 product revenues grew to nearly $183 million, an 11% increase. We are very proud to have achieved a new milestone for oximeter shipments, which reached a record 50,000 units, producing a new estimated installed base of 1,545,000 oximeters, excluding our handheld and finger oximeters.
Our Q2 2017 GAAP earnings per diluted share were $0.83, up from $0.57 in the same prior year period. In a moment, I will review some important business updates, but for now, I'll ask Mark to review our Q2 results in more detail and provide you with an update on our 2017 financial guidance. Mark?
Thank you, Joe, and good afternoon, everybody. Our Q2 product revenues rose to $182.8 million, which was up 11.1% or nearly 11.8%, a difference of approximately $1.3 million on a constant currency basis, versus the $164.6 million posted for the second quarter of 2016. The strong growth was attributable to demand for our core technologies in OUS markets, as well as increased contributions from some of our new products, as Joe just alluded to, including Root. Our Q2 OUS revenues benefited from higher than expected follow-on orders from our prior Saudi tender award, as their demand has continued to increase. Encouragingly, we just received word this week that we have been successful in securing a new tender, which will cover the July 2017 through June 2018 period.
In addition to the strong OUS growth, we realized 30% growth in our NomoLine capnography business, as well as more than a 200% increase in revenues for Root and its associated measurements, such as O3 cerebral oximetry and SedLine brain function monitoring. Q2 total revenues, which include royalty revenues, were $192.9 million, which was up 11.8% from $172.6 million in the prior year period. In the second quarter, we were able to recognize approximately $1 million in our Philips NRE revenues related to the completion of work, again related to one product. Due to some new technological testing requirements, we now expect to recognize the remaining $3.4 million in Q3 that we had originally expected to be able to recognize in the second quarter. Rainbow product revenues for Q2 totaled $17.1 million, an increase of 14.6% compared to $14.9 million realized in the prior year period.
The year-over-year growth was due primarily to the strong Saudi order volume, which I just noted, and which we now expect to recur over the next 12 months. Our Q2 SpHb revenues were $5.8 million, up by 62% from $3.6 million in the prior year period. Our worldwide end user or direct business, which includes sales through just-in-time distributors, grew 13.8% in the second quarter to $160.4 million versus $140.9 million in the year ago period. Our direct business represented approximately 88% of total product revenue in the quarter versus 86% in the prior year period. OEM sales totaled approximately $22.4 million, representing 12% of product revenue as compared to $23.7 million in the year ago period, a decline of approximately 5%. By geography, total U.S. product revenue increased by 8% to $126.5 million, compared to $117 million in the same quarter of 2016.
Our Q2 OUS product revenues of $56.3 million rose by 18.5% versus $47.6 million in the same prior year period, and we're up 21.1% on a constant currency basis. Q2 OUS revenues represented approximately 31% of total Q2 product revenues. Our second quarter 2017 GAAP product gross profit margin was 64.8% versus 65.1% in the prior year period. Our Q2 product gross margins were in line with our expectations based upon our ramp-up of our new manufacturing facility. Ironically, we achieved our expected Q2 product gross profit margins despite incurring, for the first time in many years, an approximate 10 BP negative FX impact due to the recent strength of the peso versus the U.S. dollar. Reported second quarter 2017 total operating expenses were $81.6 million, an increase of 3.6%, due primarily to higher staffing levels.
Partially offsetting this increase was the capitalization of selected R&D expenses related to the Philips NRE efforts and some marketing expenses that have now been deferred into the second half of 2017. SG&A expenses were $66.4 million, up by 3.9% versus $63.9 million for the same prior year period, while R&D expenses totaled $15.2 million, up approximately 2.5% from $14.8 million in the prior period. We're pleased that the robust revenue growth, coupled with moderate growth in operating expenses, result in a Q2 operating margin of 24.3%, an improvement of 320 basis points versus the 21.1% in the same prior year period. Non-operating income in Q2 2017 was approximately $200,000 compared to non-operating income of approximately $500,000 in the same prior year period. During the second quarter, we reported net interest income of approximately $700,000 and a $400,000 FX remeasurement loss.
This compares to prior year interest expense of $1.1 million, offset by a $1.5 million remeasurement gain. Our second quarter 2017 effective tax rate was 0.7%. This number is a combination of a Q2 tax provision of approximately $15.4 million or approximately 32.8% on our pre-tax income of approximately $47 million. This was offset by an approximate $15.1 million tax benefit associated with the new accounting rule regarding the reporting of gains from stock option exercises. By comparison, in the same prior year period, we reported a realized tax rate of 18.6%, which was the net result of a 29.7% effective tax rate, reduced by a $4.1 million tax benefit associated with the same new stock option accounting rule. Our average shares outstanding for Q2 rose to 56.2 million, up from 52.7 million in the year ago period and up from 55.5 million in the first quarter of this year.
The 6% year-over-year increase in our weighted share count is due both to the impact of stock option exercises and the dilutive impact that a higher stock price has under the treasury stock method. Second quarter GAAP net income was $46.7 million, or $0.83 per diluted share, compared to $0.57 in the prior period. The $0.83 per diluted share includes a net $0.24 benefit related to the high level of Q2 2017 stock option exercises, so that without the benefit, the Q2 earnings were $0.59. Similarly, this compares to a prior year $0.08 benefit, such that without that benefit, prior year Q2 earnings per diluted share were $0.49.
In the current quarter, the net $0.24 benefit was due to a combination of a final $0.27 per diluted share tax benefit, partially offset by a $0.02 negative impact of higher payroll taxes and a $0.01 impact due to the higher shares outstanding, again, related to the higher stock option exercise activity. To be clear, this net $0.24 per share benefit compared to an estimated Q2 net benefit of $0.16 per fully diluted share, which was included in our Q2 financial guidance. That $0.16 net estimate was the combination of a previous assumption that we would see a benefit of $10.1 million or $0.18 per diluted share tax benefit that would be partially offset by an expected $0.01 reduction for higher payroll taxes and a $0.01 reduction due to the higher weighted shares outstanding.
Please recall that in our updated annual guidance at the end of Q1, we did, as I previously noted, already assume a net benefit of $0.16 in the Q2 period related to the net impact of the new stock option accounting gain as compared to the final $0.24 net benefit that we realized during the quarter. Approximately $0.08 of our higher than expected Q2 earnings per share was related to the higher than projected net benefits from the new stock option accounting rule, and approximately $0.04 was related primarily to our stronger than anticipated Q2 product revenues. As of July 1st, 2017, our day sales outstanding was 52, down from 53 as of April 1st, 2017, while our inventory turns were 2.9 compared to 3.3 for the period ended December 31, 2016.
Total cash and cash equivalents as of July 1st, 2017, were $331 million compared to $306 million as of December 31, 2016. During the second quarter, we expended approximately $13.5 million in cash from operations, actually it's rounded closer to $14, including a $71.4 million tax payment related to the $270 million gain from the Philips settlement that we had recognized in our Q4 2016 financial results. I'd like to discuss our update for fiscal year 2017 financial guidance, which is based on the best information we have available to us. Note that we are providing this updated financial guidance in an environment that continues to be characterized by significant uncertainties related to the overall general business and economic conditions, including the future of the Affordable Care Act, as well as potential changes in U.S. corporate tax policies under consideration in Congress.
With that said, here is our updated 2017 financial guidance. We are now projecting total 2017 revenues of $769 million compared to $759 million, including $736 million in product and other revenues compared to $727 million. We are now also projecting total royalties to be approximately $33 million as compared to $32 million in our prior guidance. We now expect our full year product gross margins to be approximately 65.2%, down slightly from the prior guidance of 65.4%, due primarily to the new unfavorable peso/U.S. dollar FX rate issue and higher amortization cost associated with the record amount of equipment that we were able to place in the field during the first half of 2017. We continue to expect our total annual operating expenses to be approximately $329 million.
We are increasing our estimate for our effective tax rate slightly from 31.5% to 32% for the year due to a slight shift in our overall level of U.S. profitability. Based on all these revised estimates, we are now projecting our full year GAAP EPS to be $2.80, up from our prior guidance of $2.65. With that, I'll turn the call back to Joe.
Thank you, Mark. As you just heard, our strong second quarter results have given us the confidence to once again boost our full year guidance. As we achieved double-digit growth for product sales once again, we were able to post growth for adjusted earnings per share, which was more than one and a half times our sales growth at 20% growth year-over-year. Our other accomplishments during Q2 included a number of clinical and commercial successes that I'll now describe in more detail. One important milestone is the announcement of our first Masimo Open Connect partnership for the Root patient monitoring and connectivity hub. The MOC-9 and MOC program represents a great value opportunity for our customers who can get access to innovative technologies developed by third parties for our Root patient monitoring and connectivity hub.
The MOC-9 announcement with Medable is only the first of many formal MOC-9 and MOC collaborations for Root, which are now underway. Watch for more announcements in the future about these MOC-9 and MOC offerings. By partnering with Masimo, these emerging innovators gain quicker access to the hospital market, while our customers benefit from an ever-expanding measurements and applications for Root that increases Root's clinical value to clinicians and hospitals. Masimo has now executed formal agreements for seven partnerships with our MOC-9 or MOC technologies, and we are in later stage discussions with an additional 20 companies for such agreements. As I stated at the beginning of the call today, we are encouraged that Root and two Masimo parameters that are used with Root, O3 and SedLine, have had aggregate sales in the quarter, which were more than three times the year ago level.
We anticipate continued rapid growth for our Root monitoring and connectivity portfolio as additional parameters and features from Masimo and our MOC-9 and MOC partners are introduced. In the clinical arena, we are happy to report that multiple studies were published during the quarter that support the value of various Masimo measurements, such as ORi, PVi, and SpHb. For example, a study investigating the clinical utility of ORi, led by Dr. Leonard Lee at UC Davis, demonstrated the potential utility of ORi as an advanced warning of arterial oxygen saturation and as an adjunct to SpO2. The study involved 40 adult critically ill patients who were scheduled for elective surgical procedures and found that the average time from the start of ORi alarming to 94% oxygen saturation was 80 ± 38 seconds, providing an average increase in warning time with ORi of 34 ± 23 seconds.
This additional warning time can translate to improved patient safety by allowing earlier calls for help, assistance from a more experienced person, or modification of airway management. ORi hasn't yet been approved for sale in the U.S., and we are hopeful about its potential based upon the accumulating positive data that supports its utility. Our optimism is based upon our success to date with ORi in Japan, where we have already seen ORi being used by four hospitals, and there are an additional 50 hospitals actively planning to implement ORi in the near future. In a recent multi-parameter Multi-center.
In a recent multi-center study of our SpHb parameter led by Doctors Richard Applegate and Patricia Applegate of UC Davis, and Dr. Klaus Torp of the Mayo Clinic in Jacksonville, Florida, showed that SpHb appear to provide similar intraoperative guidance as arterial blood gas measure of hemoglobin and point-of-care hemoglobin measurement regarding HB increase or decrease. More and more hospitals are seeing SpHb as a useful tool added to their other information and tools available to them in making decisions during surgery, as evidenced by 75% increase in sensor volume in the U.S. and multi-million dollar increase in sales of disposable SpHb sensors worldwide. Updates from other clinical studies related to SpHb, the Big Five study has confirmed participation from six centers, and they are in the process of securing the IRB approval to start this multi-center study.
Regarding the NACHO trial, study sponsor, [Sabatolimab], reported that the study needs about 50 more subjects to complete their recruitment based upon their recent review of the recruitment goals. They now expect to complete recruitment and start data analysis in Q4 2017. Also of significance was the Anesthesiology News publication of the favorable results from the Limoges study of PVi and SpHb showing a 30% reduction in mortality, as was presented in abstract form at ASA in October 2016. We expect the full manuscript of this 18,000 plus patient study to be submitted soon for publication by Professor Nathan and colleagues at the Centre Hospitalier Universitaire de Limoges. These positive studies on Rainbow, along with next generation SpHb introduction and Philips partnership, makes us feel optimistic about the adoption of Rainbow, in particular, SpHb and PVi.
Regarding our expanded partnership with Philips, we remain confident about the short-term and long-term potential for our partnership to propel not only sales of Rainbow technology, but other Masimo technologies such as SedLine, O3 and NomoLine. We described at our investor day in early May, our views on the magnitude of the opportunity to increase our market presence in 2018 and beyond with Philips increased contribution is resolutely positive. A recent positive study conducted by researchers at University Medical Center Groningen, Netherlands, compared the performance of our next generation SedLine Patient Safety Index, PSI II, to the original PSI during anesthesia. Our next generation SedLine enhances PSI to make it less susceptible to electromyographic interference and to improve its performance in low-powered EEG cases, as seen on geriatric patients. The investigators concluded that, "PSI II has enhanced signal stability and a better description of the dose-response relationship.
The next generation PSI showed reduced population variability and improved baseline stability as well as lower inter-individual variability. It therefore has improved capacity as a pharmacodynamic monitor of anesthesia compared to PSI one. During the second quarter, we announced the market release of some important new products. June, we announced availability of the Rad-67 Rainbow Pulse CO-Oximeter with next generation SpHb measurement. The Rad-67 offers patient motion tolerance and sensor-to-finger stability, considerably improving accuracy in the clinical setting and providing faster time to display SpHb results. Field performance has been enhanced in lower hemoglobin ranges with next-generation SpHb technology. Late May, we announced FDA clearance of our O3 cerebral oximetry device for pediatric patients, expanding the addressable market for this important new technology for Masimo.
O3 adoption is rising rapidly as clinicians appreciate the superior performance of the technology against competitors, as well as its utility as part of the Root connectivity system. The availability of O3 for patients as young as three months old will serve to broaden O3's potential to help clinicians better care for their patients, especially for infants at risk. Two other significant new products that we announced in second quarter are the Rad-G pulse oximeter and the Kite supplemental display system for Root. The Rad-G is a pulse oximeter designed primarily for use in pneumonia screening as well as spot-checking of oxygen saturation in low-resource settings. Its development has been supported in part by a grant from the Bill & Melinda Gates Foundation.
We are hopeful that enhanced screening for pneumonia with the Rad-G can empower millions of healthcare providers in developing countries by supporting informed decisions related to diagnosis and treatment, with potential improvements in the appropriate administration of antibiotics and oxygen therapy when needed. Separately, the new Kite system for Root expands use and visibility of patient data for clinicians by allowing data from Root to be wirelessly displayed on large-view screens in customized configurations in operating rooms, intensive care units, cardiac theaters, emergency departments, and other venues. The Kite display system can be customized to enable clinicians to view the monitoring parameters, waveforms, and other data they require and in a configuration that they prefer. The increased user-friendliness of data displayed with Kite should enhance clinical decision-making in multiple hospital settings.
In closing, our quarterly performance again exceeded our expectations, increasing our optimism about the potential results we can achieve for 2017. We remain committed to our mission to improve patient outcomes and reduce the cost of care. With that, we'll open the call to questions. Operator?
Thank you. Ladies and gentlemen, if you have any questions or comments at this time, please press the star and then the one key on your touch-tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Once again, if you have any questions or comments, please press star then one. One moment for questions. Our first question comes from Tao Levy with Wedbush. You may proceed.
Yeah. Hi, good afternoon.
Hi, Tao.
Hi. Congratulations on a great quarter. I just have a few questions on my end. Any sense to tease out or distill the Philips contribution to the number of higher socket placements that you had in the quarter, or is there no real contribution yet?
Great question. Yes, Philips definitively helped us achieve this record number. The Philips year-over-year quarter volume increase in sockets were over 50%. I can tell you from a historical volume perspective, we're on a run rate to do twice as much as we've done historically with them. Already we're seeing incredible cooperation, incredible results from our new Philips agreement.
Okay, great. I don't know if you talked about this before, but in terms of the Rainbow revenues and the guidance, I don't think you've provided guidance on or you didn't update the Rainbow guidance. Given that you now have more confidence around the Saudi Arabia customer payments, how should we think about the movement in Rainbow sales throughout the year?
Well, I think given that Rainbow is still relatively a small portion of our business, it's a lumpy business from quarter to quarter. While we're very happy with Saudi Arabia's second quarter orders and what we expect for the next 12 months, given the ebbs and flows that comes with a small tide here, we feel good about the year's guidance but don't feel good about increasing it at this point.
Got you. Okay. Just lastly, when I look at my model and I analyze the sort of product revenue per install, that continues to trend higher. Should our expectations be that trend continues as long as you introduce new products and adoption continues to move favorably?
Yes. We have had a wonderful run with increase in socket shipments, increase in sensor volume shipments. On top of that, with the new products, and I think they're kind of feeding into each other. If you know the last few years, beginning with our 25th anniversary, we've been introducing about a dozen new products per year, and three to four of them each year, brand new market products, where we're opening ourselves to new opportunities. As we said in the Analyst Day, we're very bullish about the future. In fact, increased our projections of our revenue growth to between 8% to 10% per year because of one, Philips, and two, these new products.
Perfect. Thanks a lot.
Thank you, Tao.
Our next question comes from Rick Wise with Stifel. You may proceed, sir.
Hi, good afternoon, everybody. Hi, Joe.
Hi, good afternoon. Welcome to our call.
Thank you very much. I apologize in advance for my occasionally naive questions here as I learn more about Masimo. I'd like to come back to Philips if I could. Obviously you're making progress. You gave us some good comments there and good data. When I go back and look at some of the comments from the Analyst Day, can you talk to us in a little more detail and sort of lay out a roadmap of the agreement and the joint initiatives? What should we expect in terms of joint selling, joint marketing, market development pipeline? How do we think about what's coming next over the next six, 12, 24 months?
Well, I have to be careful here because I don't want to disclose anything that's confidential. I know our partner's sensitivity to that. There was a lot of red lining, I think, to the contract because of that. What I can say to you is, one, we've seen this increased volume with Philips without even the rollout of the marketing programs. We expect the marketing programs to roll out in Q4. We've seen this improved volume, dramatic volume increase, without even some of the new products that are supposed to come out. For example, products with SedLine, NomoLine and O3. We remain really optimistic. It's been a fantastic role. We have an incredible relationship from the CEO of the company, CEO and Chairman of the company, to the key stakeholders in the business.
It's really wonderful to see how our relationship has turned around and blossomed into a good friendship, partnership agreement with them. Forgive me for not disclosing more. I'm just hesitant because I was not involved in the red lining, so I don't know what's in there, what's not. Maybe since Eli and Mark are more familiar with that, if you guys want to add anything more to what I just said, please feel free to do so.
Well, Rick, I would just add that in general, the co-marketing agreements plan for both companies to make rather notable financial commitments to those programs. As Joe said, that's been in development now for the last couple of quarters, and hopefully we'll begin to see some of those efforts roll out towards the end of this year, ideally having an impact, as we've been saying, mostly 2018 and then 2019. There is real hard dollar commitments that have been made by both companies to support the kind of partnership that Joe was just alluding to.
That's great. Turning to Root, just curious, at Root accounts how quickly you're seeing pull-through for other parameters and just where are you having, beyond the Saudi tender, where do you feel like you're seeing the most success with Root placements? Current Masimo users? You're opening up new accounts? Again, any more color would be really welcome.
Certainly. Truly it is all around. We're seeing demand for it in U.S., Europe, Asia, Middle East. The usage is really, right now, focused in two areas, the operating room and the general floor. Operating room because they like features such as Kite, they like the connectivity hub it provides, and they like some of the parameters like SedLine, O3, and NomoLine. In the general ward, but for surgical ward mainly, they like the fact that it has the vital signs capability for spot checking, like blood pressure and temperature. They also like the new early warning system scoring that we introduced for it. That is really is ideal for the general floor because one, it helps connect everything in the room back to the EMR.
Two, it gives them the ability to either have tethered or untethered monitoring Because of the Radius-7 that can be used with it instead of Radical-7. We're seeing really a nice across-the-board pattern of interest and sales. Also, I'm being told by my sales team, sales leadership, that actually Root is so exciting to customers, it's pulling in Masimo Housewide conversions. It really, just like Rainbow, it's just not doing good for itself, it's doing good for our core business.
Yeah. Just last for me, if I could, any updates in your thinking, Joe? I thought you made some really compelling and provocative comments at the Analyst Day about your cash usage, potentially for M&A. Any updated thinking on your part and how we should be thinking about the potential there? Thank you so much, and congrats on the good quarter.
Thank you. Thank you so much. First of all, again, welcome. We love having you covering us, and we appreciate you being on this call. As far as M&A is concerned, I think I said at the call, at the meeting, excuse me, that we're not looking at M&A because we can't grow organically. In fact, we have an 8%-10% growth pattern trajectory for the company, all based on organic growth, all without even the five new products that have reached feasibility that we haven't announced yet. And we're seeing double-digit earnings growth on top of that, great operating margins growth, 30%. Why the M&A? The M&A, one, is because we think we can handle it. Two, because we want to create diversification for Masimo.
I've jokingly said, I don't want the Kodak moment, where somehow, which we're not anticipating, but somehow your core business gets obsolete because of changes, disruptions, and new things coming out, and you're left with nothing. We think it's prudent upon us to look at M&A opportunities, not adjacent to our business, but totally separate from our business. Of course, we'll always do tuck-ins like we have the last few years, things that are adjacent. We're looking for opportunities in big markets, where more than three, four billion dollar size, growing either a double-digit or near double-digit growth.
With strong customer preference, where the customers get to be closer to the choice of what they're going to use, because we're confident whatever we're going to do, we're going to be the best at it, and therefore, we want people to choose us faster than kind of the timelines that we have with our current model. Because we feel so good about our organic growth, we're not interested in buying things that are going to dilute Masimo. We're not looking for this billion-dollar or two billion dollar type of acquisition. We're looking for what I call fixer-uppers in great neighborhoods, which should mean by definition, two things. One, it won't cost us very much. We can pay for it with our own cash. Two, it means they're going to need fixing and upping.
Therefore, it might, for a while, be a little of a downer on our earnings, but we'd only do it if we're totally confident that it's going to pay dividends as we optimize the value of Masimo in a new five to seven-year plan. Long story short, yes, there are some companies we're talking with actively, but I can't say there's anything imminent, given where we are with our due diligence phase.
Very helpful. Thank you so much.
Thank you so much. Thank you.
Our next question comes from Brian Weinstein with William Blair. You may proceed, sir.
Hey, guys. This is Andrew in for Brian today. The real question I had was on utilization per driver. Sorry if you already talked about this, but just quickly, doing the math, it looks like utilization is again growing faster than kind of the overall installed base. Do you guys still see this kind of being equated mostly to reprocessing, or is there something else out there that we should be thinking about? Thanks.
Brian, first of all, thank you for the question. I'll first start off by saying we're not sure exactly, but I can tell you the reasons we think the business is doing better than the drivers would point to. We think number one is probably increase in outpatient census. Some days I wish we could report our sensor volume on a daily basis to you because I think it's probably the best indicator of census because, as you know, we're mostly a single-patient use product in hospitals in the U.S. I think that's number one. I think reprocessing, mostly it's failing on its own, because of customers realizing while they might be paying a lower price, they're getting higher volume purchase. They have to buy more because it doesn't work well. They're recognizing the reprocessors are adulterating the product.
They're not making the motion claims that we make. They're not making neonatal claims and the neonatal sensors used on neonatal patients. Yeah, reprocessing might be slowing down, but we're not 100% on that. The best thing we can look to is really Of the outpatient census increase.
Great. Thanks, guys.
Thank you. I think we have time for one more question.
Our next question comes from Lawrence Keusch with Raymond James. You may proceed.
Good afternoon, everyone. Yep, sorry about that, had the mute button on. Just a couple of questions. Joe or Mark, maybe just starting off, I'm actually thinking ahead and just thinking about 2019, could you talk again sort of philosophically how you're thinking about filling in the royalty gap that occurs when the royalty expires? Are you still sort of planning to grow through that?
Great questions, Larry. We, of course, are doing everything we can so that no one feels a dip. As you know, that royalty of most people have looked at it as a discount valuable value to it. It's not really been part of our multiple in our earnings. Therefore, even if earnings from the royalties drop from 2018 to 2019, we're not, A, expecting that to change our valuation or maybe even more importantly, given compared to 2006 when the royalty started and they were more than 50% of our income, by 2019, they're going to be, I don't know, maybe 10, 15% of our income. I think they become a far less important component.
In the meantime, as you know, because of our 10-year plan and the painful investment we went through with the use of those royalties, in the days we could've just let it drop to earnings and feel good, we now are a much more formidable competitor with much broader product portfolio and feel like it won't really matter much. Larry, we are going to do our best to bridge it, but even if we don't, I guess my response is, so what?
Okay. That's really helpful. Then, just two other ones. On the Saudi tender, which sounds great that they've come back and they're now purchasing again. As you look at the remainder of this year, or in the guidance, is there additional Saudi revenues in there, or are you treating it as upside if it comes in?
Well, our business has a lot of optionality and ups and downs. With the guidance we've given you could say they're in there. Obviously, if other things come in, the numbers could be better. If other things don't come in, we'll meet those numbers. As we look towards the second half of the year, we see more optionality in Q4 than in Q3, given the summer season. All in all, our instinct about the business, and how it's going, is the same. It feels good, but we don't want to get ahead of ourselves, and as you know, we've been raising our guidance every quarter for almost three years, and while we hope we can keep doing that, we don't go into the quarter expecting that. We're not padding.
We're doing our best to give you the best picture we have, so I hope that answers your question, sir.
Lastly, last quarter, you guys gave some indication of what you anticipated the stock option benefit would be to EPS. I'm wondering if you could help us think about that in the third quarter. On the R&D side, it sounded like there was some capitalization. Just wondering how we should be thinking about R&D spend for the year.
Great. I'll let Mark answer these questions. Mark?
Sure. Larry, on the stock option, your first question, as you know, the first couple of quarters, since it was relatively a new phenomenon and because we had insight into some pretty large activity, we provided some initial guidance in each of the quarters. As it turned out, I think that ended up to be a little bit more problematic at the end of the day because there was always a portion of our guidance that included some of those numbers. To eliminate that, and to be honest, partly because the activity this quarter has been a lot lower than it was in the prior two quarters, we've decided just not to attempt to guesstimate that number for Q3 and Q4. We'll just lay that number into the final quarter results when we get to the end of the quarter.
I think it'll be a lot simpler and easier to understand for everybody. In terms of R&D spending, I think directionally, as you know, R&D is the lifeblood of Masimo. As a result, we've always spent, on a relative basis, a higher level than most of our competitors. There's no reason to assume that's going to change. The numbers, as I said, this quarter are a little bit lower because of some of those reclassifications that we took where we had to reclass some of our R&D expenses related to the Philips NRE revenue numbers. Over the next couple of years, we fully expect to continue to see the kind of investments in R&D that we've historically had. In general, that puts us in the range of about eight, nine, sometimes even 10% of our total operating expenses in R&D.
Okay. Very good. Thanks for all the clarifications.
Thank you. Thank you all for joining us today. We really appreciate everyone's interest and support, and we wish you the rest of your summer to be happy and safe. Thank you so much.
Ladies and gentlemen, this does conclude today's conference, and you may all disconnect. Everyone, have a great day.