Moving on to our last meeting in the morning. It is always a pleasure to welcome the Masimo team, Bilal Muhsin, Chief Operating Officer, and to Bilal's left, Micah Young, Chief Financial Officer. In the audience, the distinguished Eli Kammerman, VP of Business Development and Investor Relations. Great to have all of you here with us today. Thank you so much for joining us. You know, it's a strange place to start. I haven't asked anybody yet today, and somehow I'm inspired to ask you. We just had a major election in the United States, and I thought to ask you just because of your connection to the hospital and your impact in so many ways by the hospital environment, and just any preliminary thoughts or reactions, Bilal or Micah, whoever, just about what any of this means to you, whether it's manufacturing or patient flow or healthcare.
Yeah, I think the biggest focus is tariffs right now based on kind of all the news that's coming out now. We're going to be patient. We know it's a lot of posturing at this moment, but I think China is going to be a big focus for this administration. Thankfully, I think we've prepared well for that from that perspective just because of the years we've had with the China tariffs already. So I think we're set up well there. Now we are going, you know, we are using the exemption for the medical side of things. If that doesn't change, and we hope it doesn't change, then we feel pretty good. In terms of what's going to happen in Mexico, it's a wait and see right now for us.
But we've kind of focused our manufacturing now into Malaysia, which seems to be a good location for us, and it looks like it will pay off even with the tariff situation between China and Mexico moving forward.
Yeah, I'd just add to that. I mean, we faced, all companies faced the tariffs situation several years ago when it was implemented. There was a lot of opportunity, Bilal mentioned the exemptions that, you know, we saw with pulse oximetry was one of those. And just the fact that we had opportunities to navigate it, you know, how we work with vendors and moving manufacturing capabilities or raw materials. And we've put a lot of time and effort into this, you know, even here recently just trying to make sure we get out in front of it. And we're, you know, we've got a lot of flexibility as Bilal mentioned on the Malaysia, moving a lot of our production there. We have very minimal exposure in terms of China.
We don't do, in terms of manufacturing, we only manufacture in China for a small portion that is sold in China. So the majority of our high volume manufacturing has moved to Malaysia from Mexico, and we still have some equipment that we manufacture down in Mexico and some products down there. But the majority of our finished goods in terms of sensors are moved over there. So it gives us a lot of flexibility to navigate it in the future.
Obviously folks are very sensitive to China exposure, but remind us sort of once the consumer separation occurs, today's core healthcare business, China's what percentage perhaps of that?
Well, I mean, where we're exposed, because there's a lot of exemptions, right, in terms of medical goods. Cables is a good example. There's cables, patient cables that we have in terms of raw materials there. Again, it wasn't, it's not something that was really that meaningful in terms of overall impact in the past, and we've been able to navigate it and put plans around it. So that's really what's, you know, what we've been exposed to is more on the cable side.
Next question, you know, given the change, all the changes at Masimo, you brought this up, I think Bilal, you talked about it on the third quarter call that it's wonderful, attrition actually lower after the change rather than it had been before. You know, are all these management corporate governance changes helping, motivating, exciting folks at Masimo? How would you characterize it, Bilal?
Yeah, I think proxy was difficult, right? Two years of proxy battle was difficult, and working on the consumer products within the healthcare team was also difficult for them. So they were stretched very thin. I think we've transitioned now very quickly, I would say, from a timing standpoint, probably ideally. I couldn't see us doing this any faster, but Micah and myself had put a plan together even before this all happened. And what you guys are seeing executed today is the plan we had put together. We got the clearance from the board, or you know, we're aligned with the board both on the vision and the plan, and the team is seeing that, right?
When the team sees that, okay, there is a vision, there is a plan, and they get to go back to what they love doing most, which is serving patients in hospitals and in our telemonitoring space. I think we're able to retain all the talent we needed to retain and lower attrition and have everybody focused now moving forward.
Yeah. Micah, you want to say something? And I don't want to put you on the spot in any way, shape, or form, and I know you're only going to say what you can say, but you know, I'm always fascinated, just personally, I'm just fascinated by change, whether it's in the world or at companies. And I mean, this is a significant change, and I would think for you personally, a significant change. What are you freer now to do or dream or imagine or act on in a way at a high level, Bilal, that you and the team that, you know, again, answer it as you will.
I wouldn't say freer. I would say, look, I think with Joe Kiani at the helm, it was a company that was based on innovation and everybody loved that. But we were doing a lot, and I think at the end we were stretched too thin. And I think today the way I would answer it is a lot more focus is going to bring us a lot more gains.
And I think the biggest change I see is allowing us to focus on what's going to get us the biggest returns and put a process in place now, whether it's on existing programs that we have out there or on the pipeline that we're going to be introducing and putting a process now to really say, these are the projects we should be focused on, these are the projects that are going to give us the biggest returns within a certain period of time that we believe is necessary. And I think that's the biggest change that I feel today, that I feel like, okay, this is now going to, you know, generate, I don't want to call it Masimo 2.0, but the next generation of products and everything we introduce are going to be much more meaningful both to our revenue and to patients and to the company.
We'll drill into that. There's plenty to talk about. I think we'll come back to that. Just to say it and move consumer to the side, it's only been two weeks since you reported. I doubt anything radical has changed or shifted. I'm looking at Micah, assuming you're going to answer this. You know, where are we from last update? It sounds like Masimo is evaluating, of course, all separation pathways, spinoff, pieces, bits and pieces. Anything incremental to add there about the approach, the timing, Micah, anything you want to update us today?
No, I mean, the plan has been to separate our, the consumer business. You know, the board, it's a new board. Again, we've worked very well with them in terms of aligning on the path forward. We have their full support on the plans we've laid out. In terms of the, there's a strategic review though that the board has to go through, and I think that's important that they go through the process as we have a lot of new board members to make sure that they get to the conclusions that we were getting to. You know, they're evaluating whether you sell the audio business, the consumer audio business alone, combine it with consumer health, or look at a spinoff into a separate company. And they've got to pursue all those options and evaluate them. And I think, you know, come to the right conclusion.
If the business continues into next year, and I mentioned this on the earnings call, it is if it continues into 2025 and we have not separated it. Then, you know, at that time that the board decides to only sell a certain part of the business and put the parameters around that, we will move that into discontinued operations as we hold it for sale. You know, right now we've laid out a plan that, you know, getting back to the core, getting back to the focus on the great business model we have. It is a tremendous business model in terms of the opportunities we have with just the core product lines, whether it be SET pulse oximetry, capnography, and gas monitoring, brain monitoring. You know, those are kind of in our more mature markets. The standard of care is in those markets already.
That's a big wave of growth for us because we are growing very well, high single digit, low double digits in those areas. But to really start to, as Bilal mentioned, take a lot of the focus and put back into things like our hemodynamic monitoring platform that we're rolling out, combining that with Rainbow to be able to measure oxygen delivery. That's going to be a big area we can drive in the near term. Another one is the hospital automation and telemonitoring, getting the focuses and more resources back into those areas to launch new product introductions over the next several years. I think we can accelerate some of that because we're able to refocus, and that's going to help us with our top line growth as well.
So, but that recurring revenue stream, we have a razor blade model, and we've come off a couple of years of very strong contracting, so we're positioned very well to really drive earnings next year, regardless of carving out some of the earnings we were getting from the consumer audio business, and that's where I was going with it is, you know, we've laid out a plan for healthcare to be 26% operating margins. You know, top line growth of 7%-10% is what we felt good about, you know, laying out into that long range plan, and we feel good about that going into next year, and if you do the math all the way down through, the earnings power of the business is tremendous, and, you know, even if we strip out the consumer audio business, it's still cash accretive.
So they're still generating profitability and cash flow. So it's not like we're going to lose that in the meantime as we're selling it. And, but the main thing is getting focused back on the core.
Micah, I haven't asked you in a while. Take us through just on the 7%-10% top line. You've, over the years, I've asked you since you've gotten there and you'll talk about market growth, innovation, price, whatever the mix. How are you getting, how do you want us to think about that 7%-10% at a high level?
Yeah, I mean, we, if you look at our kind of four, we've talked about four waves of growth this past year, and the one wave was that the one I mentioned, which was capnography and gas monitoring, SedLine and O3, our brain monitoring products and SET pulse oximetry. If you look at SET pulse oximetry, we are gaining, continuing to gain share at a rapid pace. You've seen it in the strong contracting we've put out there and the True Incremental value of new contracts. And those just waterfall in growth each and every year as we gain share. You know, we expect that to grow 6%-8%. If you look at then capnography and gas, you know, we expect that to grow 10%-20% range, so that's additive to growth.
And then you look at brain monitoring, another area that we expect to grow 10%-20%. Those are sizable markets. Those add up to, you know, you've got $3 billion market, $2-$3 billion for SET pulse oximetry. You've got a $1 billion market for capnography and then about $300 million market for brain. That's the kind of the wave of growth we've been in for a long time. Then you shift to looking at Rainbow and hemodynamic monitoring. You know, that's a, you know, call it a $2 billion plus market opportunity, especially when you're bringing in the hemodynamics platform. And that we expect to grow, you know, 10% plus per year. And we're still early stages in terms of penetrating the opportunity there. The next wave of growth, the third wave is the automation platform.
You know, today, you know, that represents when you look at automation and telehealth, telemonitoring, you know, those are about 4% of our revenue. Still a lot of runway ahead, but we expect that's where we're going to focus a lot of that NPI effort, the R&D, the project effort is around those areas. That's what we expect to grow, and that's going to augment our growth rate even further out in the future.
And why am I not raising my top line growth based on that to 40%? I'm sorry.
No, it's exciting. The underpinnings are strong, obviously. And just briefly, just to touch on it publicly, it seems like I don't, just going through the third quarter, broadly speaking, it seems like hospital census volumes are stable, going well, tracking, I think you're 2.5%-4% kind of so steady as she goes as we're halfway through the quarter kind of thing.
Yeah, we'll start to get the impact of the flu season probably in December and then.
Positively.
Yeah, positively. And then we'll see how that will impact early next year as well.
Gotcha, and nothing new competitively here, as you said, Micah, with SET continuing to gain share.
Yeah, we're seeing very strong contracting. Like I said, I mean, last year was a record year for us in terms of winning new business and contracts. You know, we approached about $400 million of net incremental new contract revenue. And that kind of waterfalls in over a, you know, call it a five-to-seven-year period. So this year we're tracking ahead of that so far. I mean, we're up even versus last year. So everything's, you know, the foundation of this business is very strong going into next year.
One lagging area has been the capital, the OEM side of the business. And since COVID, and I understand all the reasons why and probably everybody here does, any signs of life, you know, what can you do to get that going again? Or you just have to wait around until they start buying again?
No, so I think there's three impacts to our capital business, and I think they should all be favorable now moving or moving in the favorable direction next year. First, it is our OEMs. They did purchase inventory, you know, during COVID, and it didn't impact the sell-through, but the sell-to to them slowed down, right? So the sell-through is still happening into the market, but the sell-to to our OEMs slowed down, and that should now recover in the fourth quarter and start to recover all through next year. In terms of capital at hospitals, they overloaded on monitors during COVID. And then when they got their capital budgets back, they went to things like imaging and so on that they've been waiting to do. But we should start to see that come back into monitoring next year. That's our expectation.
The third one I'll hand to Micah, which is a financial issue with ASC 842.
Yeah, so I don't know if you remember, Rick, but when the rules changed for how to treat, you know, operating versus capital leases, and that was really, you know, we enter into these long-term contracts that are five to seven years, and we really go into them where we'll place equipment in return for the recurring revenue of sensors and service revenue. Those become kind of go into lease accounting rules. Well, those rules changed over the last few years. They've changed them back and forth. And kind of we've been going, you know, it feels like we've been whipsawed a lot here the last few years.
That started moving us away from capital leases where you accelerate the capital revenue on the contract by allocating a portion of that recurring revenue to the capital in the period that you ship it and install it to more operating leases. And that, you know, now we're recognizing that capital revenue over the term of the five to seven years instead. We don't, we no longer accelerate it. That's created a headwind for us the past couple of years, and that's starting to bottom out, and we should start to see that stabilize as we move into 2025 and beyond.
And to talk about with the focus, operational focus and product focus and manufacturing focus, talk about gross margins, especially as it relates to the Malaysia sensor manufacturing transition. Where are we in all that? How much more to go? And what's it all say about gross margins?
I'll kick it off and then Bilal will jump in. So, you know, we laid out a plan back in June to really drive doubling our earnings in the next five years, and we're making very good strides already, as you can see with how we're talking about next year. Part of that was about 70 basis points per year on average of expanding gross margin to try to get that up to 66%, and we want to go above and beyond that, but that's kind of our near, you know, more near-term targets. If you look at that, so 70 basis points of improvement is what we're expecting kind of a cadence into next year. We're hoping to do like we did this year where we're able to exceed those initial expectations, but that's kind of where we're at today.
The Malaysia transition has really helped us advance the ball this year in terms of moving up the gross margins throughout the year. We saw about 62.9% in Q3. That was ahead of our 62.5% guide. We're progressing ahead of that, 63% we're expecting in Q4, and that's setting us up to really start to move that into next year, and we're only getting about half the year benefit from Malaysia this year, so that's going to set us up well and give us a lot of confidence on delivering that gross margin expansion next year of 70 basis points, and we're becoming very efficient there. The operations have been very efficient. We've had lower attrition rates.
You know, it's much more stable than what we've seen down in Mexico where we've seen the government raising, you know, raising wages, about minimum wages by about 25% a year over the last five years. We're now 30%-40% lower labor costs in Malaysia than we are in Mexico. So that push is going to help us to continue to drive margin improvement. And we've got a lot of team of engineers. Bilal has got them back, re-energized and refocused on what we call cost reduction projects within gross margin and trying to reduce our cost of goods sold for products. So a lot of initiatives to really drive that.
That's exactly what I want to tackle. And I apologize, I don't remember whether Micah said it or you said it to me at one point recently, but I was sort of surprised that I always think of Masimo as an amazing manufacturer and very efficient. And I think Bilal runs that, right? Especially because of that. But my sense is that there's actually a fair amount of opportunity to get after COGS in certain areas. Why don't you talk about that?
We approach it a little bit differently than everybody. Instead of just looking at the operational side or any of that, we actually look at the design of the product from the get-go, and we consider high volume manufacturing from the beginning, and every few years technology, you know, advances and we get to re-innovate and we get to look at our product lines and say, you know, how could we redesign this entire product line to reduce its cost and improve its manufacturing and so on, so we take it just like we take any innovation type product project. We take that very seriously at Masimo. We prioritize those what we call co-red projects, but they're cost reduction projects very seriously, and we put our top engineers on it to be able to do that.
It's really a pleasure to be able to see innovation come through with cost reduction to be able to impact patients, improve patient care, and reduce the cost of care at the same time.
So, you know, again, a lot more to go from that perspective. And just last on the cost side maybe, Micah, one of the joys of knowing you over the years is we've had a lot of fun talking about, I always think of you as a sort of an operating kind of a CFO. You got all excited about getting transportation costs down. There've been a lot of projects like that. Are there, you know, are there opportunities like that remaining? Are you now, do you have the bandwidth to get after that?
I think the focus is key. And I think we're excited, Bilal and I, to have, you know, the support that's coming along right now with the, you know, aligning on these initiatives at the board level. And I think, you know, there's a lot of stuff we want to get after. I mean, how are we leveraging our distribution centers? How are we optimizing, you know, our transportation costs? All those things are coming into play. You know, right now we're really attacking the cost structure from a standpoint of how do we, it's not a, this is not trying to target a margin number. This is trying to become the most efficient we can to continue to drive top line growth because we know that we can. And we, you know, maybe there's opportunity too, as we focus to even accelerate it. And we're hopeful of that.
But we're trying to be very thoughtful and focused on how do we drive costs, how the, you know, cost structure improvements that doesn't impact the top line. So there's a lot of things we're looking at now. And I think, you know, we're excited about what we've already done. And we expect at least 26% operating margins next year. And we're going to continue to drive that and see where we can get to. But that's a good starting point within just, you know, call it a few weeks of working with the new board. And we'll see where this goes.
No, it's exciting. And I'm glad you're thinking about at least 26% margin. When I hear a thoughtful financial guy like yourself talk about at least, I say, well, heck, he's being conservative, you know. But seriously, I mean, and I'm trying to think how to ask this without putting you on the spot too much, but I mean, is there a lot more room over years where you can get these efficiencies, increase the volume and drive operating margins meaningfully higher? Or no, you'd want to invest it back in R&D or something else? I don't know.
The great thing about our business model is it's a high leverage model. You know, we expect to continue to expand margins over time, even beyond the efforts we're doing between now and next year. Getting back to that nice cadence of expansion. You know, what's great about it is we, with that recurring revenue model, with driving that through the contracts and how we install, it leverages our sales force. We get, you know, every year we're getting better and better productivity because it's not a high, you know, intensive model in terms of we've got the sales structure in place to really leverage that. You know, we can continue to leverage other areas throughout the P&L and our infrastructure. We feel like we've got the investments where they need to be. Now it's just a matter of refocusing those resources.
I'm going to ask you an odd question. You know, one of the challenges of following Masimo is like what number can we focus on and track? And people, I think, over-focus. I misspoke, it's a bad thing on the driver shipments, you know. And so I'm going to ask you a mundane question first. I mean, you know, it seems like we're stabilizing around 60,000 driver shipments per quarter level. Is that 60 or 60-65 range just the way it's going to be for the future? And sort of go back to the start of my question as you think about answering it. It's like, so in the new Masimo, what do you want us to think, focus on? I mean, that we can track the business. I hope you've got some exciting new ways to think about it so we can stop talking about drivers.
That's a good one for Bilal.
We're working on that. We're working to figure out what is the best metric to track our business, and hopefully we come up with something for you guys that gives you a true indication. Drivers were good when we were looking at just SpO2 and growing that base, right? It was a nice way of saying, are we continuing to penetrate the market? Today we release other numbers out there like our TI, right? Our True incremental business. That's a new contracted, committed business that we're seeing. That's to give you a little bit more insight that even though drivers have slowed down for many different reasons, whether it's capital or so on, it's not impacting the amount of disposable or consumable sensors we're pushing out there based on our contracted commits. Remember, those are always understated by like 20%-30%, right?
They always overachieve on those, right? So we've exposed that. Now we're looking at how we're growing our business in the hospital automation world and in the telemonitor, telehealth or telemonitoring world. And we're trying to figure out how can we come to a number to tell you what is our revenue per bed, right? Is what we're trying to get to. We're seeing if we can get to a number like that, that we can see, okay, are you seeing an increase of revenue per bed eventually? Now we hope we can get there. We're working on it. We hope we can, you know, extract that at a, you know, at a stable rate for you guys in the future.
Yeah. And when you think about new markets, you know, this has been a lot of the home over the years, or what's, is there a focus there that now that you're maybe re-energized and freed from all the change to focus, are you returning to some of these markets like home?
Yeah, I think our two focus areas are going to be our monitoring platform in hospitals that we know we can win and continue to win there, and the telemonitoring space at home. We believe that space is prime for a company like Masimo to own it because we own that patient data, and we own not own the data, but own the accuracy of the data that's delivered for that patient for care in hospital, and it should be the same level at home in order to receive the same type of care and outcomes, so we're primed for that, and we plan to deliver on that promise.
Yeah. And what are the catalysts there, Bilal? I mean, or catalysts or milestones over the next year or two? Where would you hope to be?
Yeah, I think in the next couple of years, what we're going to see is mainly focusing on post-operative patients, right, and there's both the chronic care management and post-operative patients, but the post-operative patients really are a cost factor to hospitals today because they're staying in the hospital for multiple days post-operatively to be monitored. If we can move those patients to be monitored at the same accuracy at home and same outcomes at home, then that would be a massive cost reduction for hospitals and a massive win for patients and clinicians and so on, so I think the biggest thing is we're going to start to see that shift over the next one to two years, and we hope to be leading in that space.
Yeah. I spoke to a hospital a year or so ago. It was two years ago now that had a pilot program. And every patient that left, they were discharged with the Masimo system. Are programs like that happening under the surface? And is that the kind of thing we might dream about?
Yeah, we've been. I don't want to call it limited market, but we've been kind of working with a few hospital systems. One of them is UCHealth out of Colorado, kind of refining that program, right, to a point where we can launch it broadly with the latest 510(k) clearance we got for the W1, allowing it to now provide notifications on our cloud solution. Now we're planning to now focus on that next year and deploy it more broadly across hospital systems in the US.
When I think about, I mean, there's a ton, we could have another hour going through each product, each topic here, but you know, in the early days, actually, when you just joined, I really believed in the Masimo story, and I kept saying, this is a sleep at night stock, you know, and I mean, with 85% of revenues recurring, amazing stability, steady margin improvement, I really believed in Micah's pitch about operating efficiency. Are we almost back to those days of telling that kind of a story?
I think we definitely feel like we're back, and we definitely feel like you're going to recognize Masimo as a stable growing company, and hopefully you start to see more innovative products come out, not at the same rate, maybe at a slower rate, but hopefully more impactful into the market in the future.
More profitable growth.
Yes.
That's more profitable, more predictable, more information for aging analysts, you know, like me. But no, it sounds like a great thing. Thank you so much for being here today. We really appreciate all the insights.
Thank you for having us.
I appreciate it.
Yeah. Thank you.