Earnings Call: Q2 2016

Aug 3, 2016

Afternoon, ladies and gentlemen, and welcome to Massimo's Second Quarter 2016 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'm pleased to introduce Eli Cameron, Masimo's Vice President of Business Development and Investor Relations. You may begin. Hello, everyone. Joining me today are Chairman and CEO, Joe Kiani and Executive Vice President of Finance and CFO, Mark Dorad. This call will contain forward looking statements, which reflect Masimo's current judgment, including certain of our expectations regarding fiscal 2016 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 ks and Form 10 Q. You will find these in the Investors 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's Q2 2016 earnings call. We are happy to again report results that surpassed our projections. As in the Q1, we continue to see strong worldwide adhesive sensor growth, which we believe was attributable both to increase in hospital census and our growing base of new customers as evidenced by the prior 2 quarters growth and another strong quarter of driver shipments as we shipped 45,300 additional SET and rainbow set oximeters in Q2, excluding our handheld and finger pulse oximeters. Here are some other highlights from our Q2. Our product sales grew by nearly 12%. Our Q2 2016 GAAP earnings per share was $0.55 including an $0.08 per share gain related to the new accounting rules for gains realized on stock option exercises and an approximate $0.04 FX benefit. This is a 58% increase from our GAAP earnings a year ago 57, excuse me. Important, new clinical studies were published during Q2 continuing to validate the growing list of Masimo technologies and products that are reducing costs and improving patient care. And we received 2 important FDA clearances, which will expand our domestic product portfolio and on which I will discuss later in today's call. We're encouraged that our 10 year plan to achieve strong earnings growth built on a solid foundation of breakthrough products and strong and broad service has continued to become more visible and consistent over the last 2 years. Encouragingly, our results for the first half of twenty sixteen have exceeded our original projections, and as a result, we are very happy to be able to once again increase our financial guidance for the rest of 2016. Next, Mark will review our Q2 financial results in more detail and also provide you with our new 2016 financial guidance. I will then discuss some additional 2nd quarter business, product and clinical highlights. Mark? Thank you, Joe, and good afternoon, everybody. Our Q2 2016 total revenues were $172,600,000 which was up 10.9% from $155,700,000 in the prior year period. Total product revenues rose by 11.5% or 11.1% on a constant currency basis versus the Q2 of 2015. Product revenues for Q2 exceeded our expectations due, as Joe noted, to both continued strength customers, notably in some of our key OUS regions as well as an increase in U. S. Hospital census. Rainbow product revenues for Q2 totaled $14,900,000 which was up 10.6% from $13,500,000 in the prior year period. This increase is consistent with our projected total annual rainbow growth of approximately 10%. Our Q2 SBHB revenues declined to $3,600,000 from $4,400,000 in the prior year period. This decline was due primarily to a difficult comparison involving 2 large license orders last year as well as a slight delay in the shipment of an OUS order, which will now be realized in Q3. Our worldwide end user or direct business, which includes sales through just in time distributors, grew 12.7% in the 2nd quarter to $140,900,000 versus $125,100,000 in the year ago period. Our direct business represented approximately 86% of total product revenue in the quarter versus 85% in the prior year period. OEM sales comprised the remaining 14% and rose by 5.1% versus the prior year period to $23,700,000 By geography, total U. S. Product revenue increased by 10.2 percent to 100 and $17,000,000 compared to $106,200,000 in the same quarter of 2015. Our total OUS product revenues of $47,600,000 rose by 15% versus $41,400,000 in the same prior year period and were up 13.6% on a constant currency basis. OUS revenues represented approximately 29% of total Q2 product revenues, up from 28% in the prior year quarter. Our 2nd quarter 2016 GAAP product gross margin was 65.1%, up by 90 basis points from the previous year's 64.2%. This improvement is attributable to a number of factors, including a more favorable product mix, the continuing benefits from our value engineering efforts and other manufacturing cost initiatives, as well as favorable FX movements, including the year over year decline in the value the Mexican peso versus the U. S. Dollar. Reported Q2 2016 total operating expenses were 78 $700,000 an increase of $3,600,000 or 4.9 percent versus $75,100,000 in the prior year period. Our SG and A expenses were $63,900,000 an increase of $2,200,000 or 3.6 percent, while our R and D spending was $14,800,000 an increase of 10.6% versus the year ago period. The increase in R and D expenses related to additional engineering resources to support both ongoing Masimo new product development efforts as well as additional staffing related to our commitment to reinvest the medical device tax savings. 2nd quarter 2016 operating income was $36,400,000 compared to $27,800,000 in the prior year period. This significant increase in year over year operating income is a result of a combination of factors, including strong product revenue growth, improved product gross margins and continued operating expense control. Encouragingly, for the Q3 q2222016 non operating income was approximately $500,000 compared to non operating expense of $1,100,000 in the prior year period. The $500,000 in Q2 non operating income includes approximately $1,000,000 in net interest expense related to borrowings under our line of credit less other interest income. This interest expense was more than offset from April 2, 2016 to July 2, 2016 on our OUS local currency denominated balance sheets. Our Q2 2016 effective tax rate fell to 18.6%, down from 30% in the same period last year and well below our expected rate of approximately 30%. This lower than expected Q2 effective tax rate was due to a $4,100,000 benefit we recognized related to our adoption of ASU 20 sixteen-nine, the new accounting rule regarding the reporting of tax benefits resulting from the exercise of stock options. As you'll recall, the new accounting rules require that the tax benefit related to the exercise of stock options are reported as a discrete benefit to the current quarter effective tax rate as part of the profit and loss statements. In the past, these tax benefits were recorded directly to equity. Without this discrete item, our adjusted Q2 effective tax rate would have been 29.7%, very close to our 30% projection. As a result of this new accounting rule, our Q2 2016 fully diluted EPS was increased by $0.08 per diluted share following a $0.02 increase in Q1 2016. Our average shares outstanding for Q2 were 52,700,000, down from 53,700,000 in the year ago period, but up from 51,900,000 in Q1 2016. During the Q2 quarter, we repurchased an additional 400,000 shares, increasing our year to date purchases to 1,500,000 shares. The sequential increase in our Q2 weighted share count was primarily due to the impact that a higher stock price has on the dilutive value of stock options outstanding under the treasury stock method. 2nd quarter GAAP net income increased by approximately 55 percent to $30,000,000 or $0.57 per diluted share, including the $0.08 per diluted share benefit related to the discrete Q2 accounting change and the 4% benefit from movements in foreign exchange rates. As of July 2, 2016, our DSO was 47 compared to 52 as of April 2, 2016 and compared to 46 as of January 2, 2016. Our inventory turns remained at 3.7 consistent with the April 2, 2016 level and were down from 4.2 as of January 2, 2016. Total cash and cash equivalents as of July 2, 2016 were $116,100,000 compared to $132,300,000 as of January 2, 2016. During the 1st 6 months of the year, we have generated approximately 56 $700,000 in cash from operations and $19,000,000 from the exercise of stock options. These funds were used in part to repurchase 1,500,000 shares at a cost of approximately $63,400,000 and to repay approximately $10,000,000 in our line of credit borrowings and to fund our operations. During the most recent second quarter alone, in addition to the repurchase approximately 400,000 shares at a cost of approximately $20,500,000 we also repaid $50,000,000 on our line of credit, lowering our total borrowings outstanding from $225,000,000 at the end of Q1 to $175,000,000 at the end of Q2. Now I'd like to take just a moment to update our fiscal 2016 financial guidance, which is based on the best information we have available to us. We are now projecting that our total fiscal 2016 GAAP revenues will be approximately 689,000,000 dollars including $658,000,000 in product revenues, up from our prior estimate of $647,000,000 which was then up from our original fiscal 2016 guidance of $640,000,000 in product revenues. We now expect our annual GAAP 2016 product gross profit margins to be approximately 65%, up from our prior guidance of 64.7%. We now also expect our fiscal 2016 operating expenses to be approximately $314,000,000 which is up slightly from our prior guidance of approximately 312,000,000 dollars We continue to expect that our tax rate for the remaining 6 months of fiscal 2016 will be approximately 30%. We are projecting that our average quarterly weighted shares outstanding for the rest of fiscal 2016 to be between 53,000,000 54,000,000. And as a result of these changes, we are now expecting our 2016 GAAP EPS to be approximately $2.01 up from our prior estimate of $1.83 per diluted share and our original projection at the start of the year of $1.69 per diluted share. And with that, I'll turn the call back to Joe. Thank you, Mark. I want to congratulate our team for our performance through the first half of the year. We intend to continue to achieve results that exemplify our greater growth potential stemming from our breakthrough technologies that have had a profound impact on patient care and cost of care. As Mark just described, we have once again boosted our full year forecast to incorporate a more positive outlook for 2016. We are realizing higher revenues per drivers across our installed base as utilization has risen. In addition, steady growth for Rainbow and recent regulatory clearances for important new products provide us with greater confidence that will exceed our prior target set at the beginning of this year. We are consistently winning new hospital conversions for Masimo SET and Rainbow SET oximeters. During Q2, we received 2 noteworthy product clearances from the FDA. First, we received FDA clearance for our 03 Regional Oximetry Monitor, enabling us to participate in an estimated 100 and $25,000,000 market that is growing by 10% annually. Given the accuracy and ease of use of 3 compared to competitive monitors in the field, we hope to capture meaningful share in this market in the next few years. In fact, one of the world's leading centers for cardiovascular medicine and transplantation, DHZB, the German Heart Center in Berlin, has adopted R03 regional oximetry and SedLine brain function monitoring technologies to monitor their patients in the operating room and intensive care unit. DHVB is a specialized hospital dedicated to the diagnosis and treatment of cardiovascular and thoracic diseases, implantation of mechanical circulatory support systems and heart and lung transplantations and treats more than 7,200 inpatients and 24,000 outpatients annually. The second normal FDA clearance we received in Q2 was for our wearable TETEROLESS Radius 7 monitor with rainbow measurement capabilities. The rainbow version of Radius 7 allows for patient mobility within the hospital and includes continuous hemoglobin measurement as an option, which may be useful for detecting postoperative internal hemorrhage. We also recently initiated the launches of next generation SedLine and next generation spHb products in Europe, both of which incorporate substantially improved technology that increases their clinical utility. On a related note, we are happy to report that the rollout of rainbow parameters within both low acuity and high acuity monitors made by Philips has commenced. GE is also now selling Rainbow in its low acuity monitor line. Unfortunately, we have recently learned that GE's rollout of Rainbow in their high acuity monitors will likely be delayed by 2 to 3 years. On the clinical front, 2 papers were recently published that support the clinical utility of Masimo's innovative technologies. In a study utilized using the 1st generation PRONTO PULSE co oximeter to non invasively measure total hemoglobin in 114 patients, SPHB was successfully measured 89% of the time. With mean lab based hemoglobin values of 12.6 plus and minus 1.9 grams per deciliter and mean non invasive FTHB values of 12.3 plus or minus 1.6 grams per deciliter. The authors, Doctor. Ryan and colleagues at the University of Tennessee Health Science Center of Le Bonheur Children's Hospital found that non invasive and invasive measurement correlated well and that the rapid availability of results and the lack of requirement of venipuncture non invasive hemoglobin monitoring may be a valuable adjunct in the initial evaluation and monitoring of pediatric trauma patients. They also noted that non invasive SPHB testing may be most effective in determining when invasive testing of hemoglobin is warranted. A paper just published in transplantation proceeding authored by Doctor. Lee and colleagues at Chang'eun Memorial Hospital in Taiwan investigated the utility of PVI and concluded that PVI may serve as a reliable estimate of cardiac preload status in patients undergoing orthoptic liver transplantation as higher PVI values correlated with lower right ventricular end diastolic volume values, so that an increase in ventricular preload status could be inferred from a decrease in PVI during OLT. They also noted that right ventricular end diastolic volume was better correlated with PVI than with other static filling pressures such as central venous pressure or pulmonary artery occlusion pressure. Therefore, giving a safer, faster and better estimate of fluid responsiveness. These two papers are just the latest examples of the high clinical value that our technologies provide to clinicians as they strive to improve patient care. In fact, we estimate that the use of set pulse oximeter, rainbow SPHB and PVI will save an average hospital $1,300,000 a year. In the age of both the Affordable Care Act and the expansion of ACOs, technologies that help clinicians get it right the first time are what hospitals want. In closing, our focus on delivering on our 10 year plan is based on our guiding principles of remaining faithful to our promises and responsibilities. We are encouraged that our first half of twenty sixteen financial performance has exceeded our original 2,006 guidance and in doing so has allowed us to once again increase our financial guidance for the year. We are looking forward to what will be a record year in 2016 as we head into the final stretch of our 10 year plan in 2017. As always, we remain focused on our mission to improve patient outcomes and reduce the cost of care by taking non invasive monitoring to new sites and applications with our breakthrough non invasive monitoring technologies. With that, we'll open the call to questions. Operator? Our first question comes from the line of Lawrence Keuschier from Raymond James. Your line is open. Hi, Larry. Good afternoon, everyone. Hi, this is Joe. This is John Hsu in for Larry. How are you? Good. Hi, John. How are you? Doing well. Thanks. Doing well. Hey, so obviously a very nice quarter. Obviously, looking at Mark's comments on the strong operating margin expansion, maybe we could start there, 3 straight quarters at 21%. Obviously, you want to get up closer to 25% over the next couple of years. So again, can you just remind us outside of the gross margin opportunity on the product side with value engineering, kind of what gets us there and your confidence around the timing for that? Certainly. Certainly, value engineering work that we've been doing the last few years is resulting in some of those gains. Our value based pricing with our customers and our discipline with that along with the expansion of the new products. Obviously, we've been talking about rainbow for a while, but we're seeing excellent growth with SedLine, excellent growth with capnography and now 3. So adding SET, Rainbow and now Root, which has these new modalities together along with the open connectivity and creating the connective hub for the hospitals, we think will help us drive strong revenue gains as we manage our expenses to what we believe are sustainable given the initial investment we made in the first 60%, 70% period of this 10 year plan. Okay, great. That's helpful. And then just kind of shifting gears to international. I guess 2 quick ones for you. 1, the sizing, if you could provide us with the size of the international order that in hemoglobin that chipped into the 3rd quarter? And then also, any updates regarding the size of and timing for the Middle East tender? Thank you. Well, not to get too much into the minutiae. All I can say had we had that order in Q2, our revenues for hemoglobin would have grown 10% instead of being in decline. Also given some of the factors of the last same quarter a period ago. But what I can tell you on the Middle East, we're working really well with them. The run rate of sales have been excellent. We did regain the tender that we had won last year. And in fact, the hospital's run rate for that was probably 2, 3 times of what we did last year with them. However, there is pressure from the Finance Minister for these hospitals to not automatically get what they asked for. So they will be working towards getting what they want, but instead of it being preapproved for the whole year, they'll have to seek it on a regular basis. So while all of that will mean not much for this year for us because we've already projected worst case anyway and we're more than happy to meet that with the new projections we gave you. We'll have to track what really happens in on The Street in Q3 and Q4. And then hopefully Q1 of next year, we can tell you what to expect for the rest of the year based on their historical usage pattern because unfortunately we can't rely on the tender request and tender win that we had given the way the Finance Minister has, I guess, reined in that freedom from the hospitals and will request additional demands on a regular basis. Okay, great. That's very helpful. And then just lastly, the royalty revenues have obviously actually been doing a little bit better versus the prior year. And you did raise guidance by $1,000,000 for the year. So just any update you can provide us on the status of discussions with Medtronic on a royalty agreement? We haven't reached any new agreement, but we still remain optimistic that royalties will continue until October 2018, given that we won the IPR on 2 of the patents that they went to try to eliminate, the one that we won goes till October 2018. The one that we partially lost expires next month. So that obviously the royalties haven't changed. So we think things will remain till October 2018. And if we can do something more with Medtronic, we'll be announcing it as soon as we have it. Okay, great. Thank you for taking my questions. Thank you so much. Thank you. And our next question comes from the line of Bill Keurig from Piper Jaffray. Your line is open. Great. Hi. Thanks. Hello, Bill. Good afternoon, everybody. Hi, Joe. How are you doing, Mr. Quirk? Doing very well, sir. And it sounds like based on the quarter, I think you guys are as well. Quick question, I guess, for perhaps Mark. If I'm doing the math correctly here, Mark, when I net out the change from the accounting treatment, as well as FX and of course your organic EPS upside in the quarter, it looks like you're assuming, again, outside of accounting and outside of FX, that the incremental upside is going to be driven by the core business. Like it's a couple of pennies over the next two quarters relative to previous guidance. Am I doing the math right there? Yes, yes, directionally, that's exactly right. The success we had in the second quarter made us confident enough to take up our projected revenue guidance for both Q3 and Q4 in the range of about $2,000,000 dollars We also though, because of the higher amount of weighted shares ended up essentially, you could say effectively losing a penny because of the impact of the now projected higher share number for Q3 and Q4. So the combination of that, the higher revenue of about $2,000,000 each quarter offset by slightly higher weighted share numbers resulted in a net increase of about a $0.01 for both Q3 and Q4. Okay, got it. Very clear. And just to be clear, Mark, that's obviously organic. I mean, it sounds like any of this change related to tax treatment is obviously going to be triggered upon exercise of options, correct? And it doesn't sound like you really have anything dialed in terms of expectations there? Correct. Yes, we actually can't because of the discrete nature of those. We can't even include those in any kind of forward guidance. Number 1, because it's very difficult, of course, to project, what kind of stock option exercises might occur. And secondly, because it simply isn't allowed as part of your forward effective tax rate guidance. Understood. Okay. Thank you. And then a couple for Joe, if I may. Joe, the comment around the GE high acuity monitor delay, could you add a little bit of color there? And then separately, just curious, we got the update around Medtronic in the previous question. Anything to say on with respect to Phillips? Thanks. Sure. Sure. On the GE, given that of course we are in possession of confidential information that I cannot disclose, all I can tell you is this delay had nothing to do with us. It's something that is an internal issue for them. But with their permission, we wanted to share with you where they are. The good news is Philips has fully rolled out. Draeger has been out there for a while with Rainbow Technology, Welch, Allen, ZOLL and many other OEMs. So we're anxious to get GE out there, but I know they're doing everything they can, but unfortunately things like this sometimes happen in the product development cycle. As far as our litigation with Philips, as you know, it's been broken up in 4 phases. We won Phase 1 for $467,000,000 verdict, which was not finalized, which actually may end up being a good thing because the Supreme Court recently changed the standard for willful infringement. We think we have a great willful infringement case against Phillips, which we'll be not only bringing up on the Phase 2 coming up in January, but we'll seek to bring back on the Phase 1 victory as well where they have admitted that they infringed our technology before even the trial begun. As far as the Phase 3, that will be the antitrust suit and patents use case against us that will happen in March of next year. And then Phase 4 is some additional patents we have against STEM along with our antitrust suit against them and that has not been scheduled yet. So in summary, if I was going to tell you what I think will happen, I think hopefully assuming we win the antitrust and patent misuse in March probably about 18 months after that. I'm sure Phillips will appeal to the Court of Appeals, Federal Circuit Court of Appeals, which we expect we should win. And so we think sometime in about 2 years from now, we'll have our first check from Philips. And maybe with the pre judgment interest, post judgment interest, If there is willfulness bound, if it's just traveling made, it could be much bigger than the $467,000,000 that we secured in the Phase I trial and post judgment ruling by Judge Stark. Very comprehensive. Thanks, Joe. Thank you. Thank you, Bill. Thank you. We have a question from the line of Brian Weinstein from William Blair. Your line is open. Hey, guys. How are you? Good. Thanks. So question for you on market share. Where do you guys think you are in market share in pulse oximetry and what percentage of the available market are you taking every year at this point? We don't really know what our market share is. Those are difficult to assess. We do believe we are growing 2 to 3 times the rate of growth in the pulse oximetry market, given that we're now we've been growing for almost 2 years at above 10% rate. So unfortunately, that's all I have for you. I know there's surveys that are done by independent surveying companies. I don't know how much I can trust those. So therefore, I don't want to state what they say because I know their ways of guessing at those numbers is not as scientific as how sometimes they're truly done when economists get involved in big case trials and so forth. Okay. Mark, question for you on operating expenses and I guess Joe for you as well. You answered Larry's question by talking about kind of controls there. But in general, what are you guys doing on the operating expense side to kind of make sure that you're going to continue to get that leverage? I mean, what are the programs that you have in place? And can you just give us any more color on how you think about managing OpEx? Sure. Sure, Brian. I think as we've been articulating for the past couple of years now actually, we changed really our direction towards planning our future level of total investment in operating expenses. And we changed it from a perspective of identifying various targeted opportunities and ways to expand the business and essentially determining whether to fund those kind of expenses to one in which we just simply said there is a fixed amount of operating expense that we're willing to invest each year. And then we work very, very diligently internally to prioritize all of the various spending initiatives that we have. But at the end of the day, we're limiting ourselves to x amount of dollars of spending growth. So because of that approach, obviously, there is a tremendous amount of control in terms of our ability to dictate essentially what level of spending we're going to be at. And that's something we started at the end of 2014. It's continued all the way through 2015 and is obviously continuing through this year. And as we look forward for the next couple of years, there is no intention to change that type of forced prioritization of investments in order to hit a fixed amount of aggregate spending dollars increase. Okay. Thanks for that answer. And my last question is on pricing. Is there any change here when you're signing new contracts? Joe, you talked about kind of pricing discipline. Are you seeing Medtronic use price? Or are they still being a responsible player? Thank you. Well, I don't think anything has changed on pricing. We see Medtronic do the same thing that Covidien was doing pricing wise. Given that we from clinical studies have data that shows, which is say the average hospital of 2 50 beds about $1,300,000 a year, We not to mention the life saving impact of our technology, The eye damage reduction in the NICU of our technology, we believe our pricing is just right and if not too low, but consistent to wanting to help our customers reduce cost of care, We always calculate that into our pricing strategy. So the good news is customers are willing to give us a small premium for the value that our technology brings to them that both save them money, big money, not small pennies, but also help them take better care of their patients. Great. Thanks. Thank you so much, Brian. And I want to just add one thing. The reason we can grow our expenses the way that Mark mentioned in a very disciplined fashion is because we have grown, as you know, our infrastructure a little bit ahead of plan, normal plan, the way we would do things, given the royalties we were gaining from Covidien, Medtronic. And that has allowed us now at the end, I guess, the last part of our 10 year plan to not have to grow our expenses, yet not be choking the company when it comes to both product that saves lives and helps people as well as the number of people we need from an infrastructure perspective to treat our customers as they are accustomed to. So we're really happy that the 10 year plan is working. We're happy that our investors have stuck by us and now are seeing the stock working. So we will do our best to continue this commitment to you and look forward to our next quarter results in a few months. Thank you all for joining us. Ladies and gentlemen, thank you for