Good afternoon. Thank you all so much for joining us. My name is John Demchuk, and I work on the medical technology team here at Morgan Stanley. I'm pleased to have with us from Masimo Corporation. I have Eli Kammerman, and I have Mark de Raad, the company's CFO. Thank you. For those less familiar with the story, Masimo is a leader in non-invasive patient monitoring, starting in pulse ox, but building well beyond that. Before we get started, I wanted to briefly mention disclosures. You can find those on the Morgan Stanley website. And then, I guess moving on, Mark, Masimo has made a lot of progress over the last few years, last year in particular, and it showed in the stock price performance. I mean, it's up about 40%-50% since, I think, this time last year.
Can you start off by maybe giving us a brief overview of the company and perhaps touching on some of the key accomplishments over the last 12 months?
Sure. Sure. Good afternoon, everybody, and thank you for spending a little time with us. I would say that, essentially, as most of you probably know, Masimo essentially is a core pulse oximetry company. Over the years, we've added, on top of that core technology, today, 11 different Rainbow measurements. The Rainbow business itself is now approximating almost 10% of our total worldwide revenues, and in addition to that, over the last, you were mentioning the last year, year and a half, we've introduced a number of additional exciting products that we think, over the next couple of years, will help to generate consistent, strong revenue growth, including our Root platform, as well as some exciting new technologies in capnography, SedLine, and O3.
So the combination of all of that really, I think, puts us in a position to look very optimistically at the next couple of years of revenue growth.
One thing that's always impressed me about Masimo is its growth potential. And at your analyst day a few months ago, you talked about sustained levels at about 8%-10% growth. And this is above the 7% guidance range that you have been providing. While you outperform that, the big difference, at least as I see it, as I look at the new targets versus that 7% range, is this Philips agreement. So maybe to start off, can you talk about the relationships with Philips, both before and after your recent partnership, and how much of that 1%-3% growth increase is coming from Philips?
Sure. Sure. Just a quick background is that in November of this past year, 2016, Masimo and Philips agreed on a new partnership agreement. And that new partnership agreement will do a couple of very important things for Masimo. Number one, it'll link the future objectives of both companies in terms of establishing certain targets for our rainbow technologies over the agreement period. It'll also, frankly, provide for both companies to provide funding at a fairly substantial level for the additional marketing efforts across the world for rainbow technologies. For many of you who know the Masimo story, while we are fundamentally based on pulse oximetry, the rainbow technologies, the 11 that I mentioned before, are all built upon that platform. What was essential for Masimo in order to see that type of platform begin to continue to expand was a relationship with a partner like Philips.
So that's why the agreement that we struck with Philips back in November of last year was so critical. The great news is that we've been spending most of this year working both marketing and sales teams of them working together, trying to identify the new targeted regions over the world that, towards the end of this year and, more importantly, in 2018 and 2019, a very focused effort will be made on those countries of introducing the concept of rainbow technologies. Because Philips is the world's largest medical device equipment manufacturer, obviously, it was a key relationship for Masimo. And we felt, for a long time, frankly, that the ability for us to take rainbow to the next level, if you will, was dependent upon the kind of relationship that we now have with Philips.
The early indications are very positive, although, frankly, most of the legwork continues to still be built this year. But we indicated in our call last quarter that we've already seen almost a doubling of the number of drivers that we ship with Philips from the same year-ago quarter. Historically, Philips, for us, has been a very under-penetrated OEM partner. And because they're the largest medical device equipment manufacturer in the world, our hope is, over the life of this partnership, that we'll be able to see some very sizable and noticeable increases in overall deployments of our technology as both Masimo and Philips begin to work together to address the huge opportunity that we believe exists.
Mark, you touched on this a little bit, but Philips, I believe, has about half the monitoring share in the country. When you think about your OEM providers, how much share of that do you have with Philips?
We haven't, for obvious reasons. We haven't disclosed the specific numbers. As I alluded to just a moment ago, Philips, in general, was one of the least penetrated OEM partners that we had. We believe if they get to the level that most of our other more fully penetrated partners are at, we have the potential to see almost a fivefold increase in the number of drivers that we would actually, in our vernacular, mean the actual placements of our technology through a board. We have the opportunity to see that number increase by almost five times, we hope, over this contract period.
Okay, so I mean, to sum it up, it sounds like one of the big priorities in with this partnership is to maybe have Philips move more of its share away from the Medtronic and Philips' own in-house brand and more towards Masimo. That's one of the, I guess, key priorities of the partnership.
Well, yeah, I would say the biggest priority is our collective focus on the introduction and the rollout, really, of rainbow technologies. Because, remember, essentially, our incremental rainbow technologies reside on top of Masimo's pulse oximetry technology. So our focus, along with Philips, is to provide the awareness to the world, essentially, of why it makes sense to adopt these various 11 rainbow technologies. When the customers do that, by definition, they will also then have selected, essentially, Masimo's pulse oximetry technology, once again, because the rainbow technologies operate on top of Masimo's pulse oximetry technology. Hopefully, Philips will view this as an opportunity to move into the space along with us as well. We know, collectively, many customers have been clamoring for the rainbow technology. They're very pleased that Philips is now able to integrate our technologies into the Philips multiparameters.
So we hope that that combination puts both companies, really, in a position to take advantage of this market that we hope, at some point, most estimates, frankly, are that the opportunity space we're looking at is in excess of $1 billion of rainbow opportunities. Today, this year, in fact, our goal is to achieve around $73-$74 million in rainbow revenue. So clearly, there's a long way to go between the total market opportunity that exists versus where we are today, and hopefully, this is the first big step towards that.
Taking a step back from Philips and the rainbow technologies for a second, just moving to the pulse oximetry market itself, which is, I think, growing more in the mid-single-digit range. And there's obviously still a lot of opportunity to take share in that market. And there's a lot of opportunity to grow that market, both through additional capabilities, which we've talked about a little bit with rainbow, and also different geographies. I wanted to start with the ability to continually take share in pulse ox. How should we be thinking about Masimo's penetration currently within U.S. hospitals? And then how much room is there to continue to add new customers?
Sure. Well, I would say that, directionally, the Masimo share of the marketplace has grown from essentially about 30%, maybe seven, eight, nine years ago, to today, approximately 50%. And we've done that over the last four or five years by consistently shipping into the marketplace about 50% of the new drivers each year. Because it's a razor-razor blade business model, as these drivers get deployed within the U.S. and, in fact, all over the world, the theory, of course, is that, eventually, the sensor revenue stream follows the deployment of those actual drivers. So to date, it's in that vicinity of approximately 50%. We think the ability to continue growing in our space is very, very real. Every year, we're ticking off the additional very significant, very noteworthy U.S. hospitals.
I think, as of today, we have approximately 17 of the top 20 hospitals in the U.S., as identified by U.S. News & World Report. But even with that coverage, there's still a tremendous amount of additional opportunities that we think are available that will allow us to continue to essentially grow at a rate of at least two times the overall pulse oximetry marketplace, which most people guesstimated at growing at about 3%-5% per year. That's why we've been actually hovering more in the 8%, 9%, 10%, 11% range for the last couple of years.
And what's given you the ability to kind of grow at these almost multiples of the market?
Fundamentally, it boils down to the technology. I don't think there's any dispute that Masimo's pulse oximetry is, in fact, the best pulse oximetry in the world. It has the ability to read through motion, which, of course, distinguishes it from other technologies on the marketplace. I think, over time, as more and more customers begin to realize that, and obviously, when you have 17 out of the top 20, clearly, a lot of hospitals already recognize that. As I said a moment ago, there's still thousands of hospitals that are available for Masimo just here in the U.S., not to mention outside of the U.S. Fundamentally, it's the technology that has really allowed us to grow at that kind of rate.
So you have the technology. There's still, obviously, very large competitors that you're involved competing against. Does price become an issue at some point as competitors continue to fight for share?
I think yes and no. I think price is always an issue. There isn't one deal that we enter that isn't a competitive deal. Having said that, as a company, we made a decision about three years ago that there was a certain value related to the best-in-class Masimo pulse oximetry. And frankly, it was incumbent upon our salesforce to relay that value to our customers and potential new customers. And as a result, we made a decision a couple of years ago that there were certain price points that we would not go below. And that is something that we've held to for the last couple of years. We did it. And obviously, at the time, a little concerned about the risk that that might present.
The good news is, to the best of my knowledge, over the last three years, we've lost a total of two customers related specifically to pricing, and the humorous part of the story is one of those has already returned because, apparently, accuracy is important, so the point of the story really being that there is a value to the kind of lean gold standard, if you will, Masimo pulse oximetry technology, and our customers agree with that, and I would say, in general, our pricing is still relatively competitive, but we won't continue to move down, if you will, a pricing curve simply for the sake of price.
Questions for Mark? Maybe turning back to Rainbow for a second. It's currently a relatively small proportion of your overall business, maybe 10%. But you referenced it a little earlier. There's a lot of potential there. Thinking of Philips as perhaps a key accelerator in adoption, where do you expect Rainbow to go over the next couple of years? 10% of revenues today is where can it be two to three years down the line?
I'll give you our conservative external guidance. I'll give you a hint as to what we hope can happen. For the last couple of years, we've suggested overall Rainbow growth guidance at approximately 10%. This comes after a number of years of providing somewhat higher expectations and having different reasons why we weren't able to achieve those. 10% on the Rainbow end has become, essentially, our targeted growth rate. That, of course, fits within the 8%-10% overall revenue growth rate. To your point about the introduction of our new relationships with Philips and a number of other avenues that we're pursuing related to rolling out Rainbow technologies, I mean, internally, we're looking at growth rates far in excess of 10%.
Our hope would be, I think, if you take a snapshot of the next five years, the hope certainly would be that we would begin to accelerate beyond that 10% year-over-year growth rate, hopefully, in the not-too-distant future, moving towards 15% and then eventually 20% if you're looking at a window over the next five years. Those kind of annual growth rates, we think, are very, very doable, and especially in light of what I mentioned earlier, the new relationship with Philips.
Hemoglobin monitoring is one of the measurements that I would have expected maybe to have a lot stronger adoption than it's had to date, given the broader economic and clinical benefits behind it. Can you talk a bit to these and explain what is really needed to drive further adoption in these areas?
Sure. I mean, that, I think, is total hemoglobin that's been alluded to as one of the 11 Rainbow measurements that we provide on our platform. It's been available now for about six years or so. I think you're correct in the sense that it has not grown at the level that we would have all hoped. I think the list of reasons is, as they say, long and distinguished. But I think, most importantly, it really has been difficult given the very difficult capital environment that we're faced with here, especially in the U.S. More recently, though, the encouraging part is that in the U.S., we've seen some significant acceleration in the adoption of total hemoglobin. We mentioned on our last call, the Middle East is actually an area that's growing very strongly for us.
A huge new partner in the Middle East, literally 50% of all their orders over the last three years have comprised of Rainbow technology. I think the idea of expansion, oh, U.S., is something that's going to continue to support the SpHb growth. There are also a number of clinical studies that continue to appear that support, again, the efficacy of the product and the technology. Hopefully, it'll simply be a continuation of that momentum that will eventually get to the point where SBHB will be used more consistently in hospitals all over the world. It is improving.
Just moving on to Root. Root is another platform that you guys have that could really drive a lot of growth. And I think all the ways that you can, I guess, generate sales off of this platform is pretty interesting. Basically, you can sell the product. You can add additional technologies onto it. Some of the brain and cerebral monitoring functions come to mind. And then you can also even get a royalty payment from third-party providers that are really adding on to the box. So can you talk about the value that Root brings, its recent adoption, and perhaps your expectations into the future there?
Sure.
Well, with Root, that is a communications hub that, at its core, serves to transmit data from the patient hospital room into the electronic medical record, and it functions as a data capture device when different types of monitoring technologies are plugged into it, such as SET, Rainbow, as you mentioned, the O3 brain oximetry, or SedLine brain function monitoring. Root is really the first foray for Masimo into capital sales, but it's a low-priced device. It's only priced at $2,000. But it does need some kind of plug-in to be able to capture physiologic data. Once it's placed into a hospital room, it acts as a wedge to get additional Masimo technologies into that institution, and so it's a great way for us to establish ourselves and generate high-efficiency sales with multiple plug-ins for a single box.
With the third-party technologies coming along, there's going to be a steady stream of new plug-ins for Root, including one that we've announced that monitors pain for people who are either unconscious or in infants, and there are other unannounced deals for both hardware and software plug-ins that will go with Root, which we think create a very exciting new platform.
Questions for the team? Another big topic at the analysts' day was your margin profile, basically expectations that you can move operating margins to about 30%. Can you walk us through how you're planning on getting there?
Sure. There's really two pieces. The first piece of that is our focus on continued cost reduction initiatives relative to our mix of products, some of which we were talking about earlier today. Our longer-term goal is to take our current product margins, which are hovering around 64%-65%, towards 70% over the next five to seven years on the back of the kind of cost reduction efforts that I was just alluding to, and frankly, on a shift in product mix that we expect to see over that period of time. We spoke earlier about the increased expected revenue contribution from Rainbow, obviously a slightly higher margin contribution. So the combination of cost reduction and revenue mix shifts over the next five to seven years, we believe, will give us the opportunity to move towards 70% product margins over that period of time.
At the same time, we're going to continue focusing on what we started focusing on three, four years ago, and that is the idea of driving total operating expenses down as a percentage of revenue. Still means we're obviously making the necessary investments year over year, but ultimately, the goal is to get total operating expenses, including engineering, R&D expense, down to about 40% of total revenues. Sorry about that.
No, that certainly makes a lot of sense. But the one question I guess I'd probably push you on a little bit is that operating expense part, that you plan on reducing it. There's not a lot of companies that are growing as sustainably and fast as you guys are with what seems to be a whole lot of avenues that you can continue to invest in. Why is now the right time to start really seeing some of that operating leverage rather than reinvesting it back into the business?
The way I answer that is that when we went public back in 2006, 2007, actually, the real focus was to take the revenue that we were generating from the company at that time, including the royalty stream that we were receiving, and reinvest it in the company to build the footprint not only in the U.S. but throughout the world to actually be able to support the size business that ultimately we've grown into today. About three years ago, I would argue, we actually made the very clear decision to focus on that leverage. In other words, the investment we had made in the first seven years of the business model. It was time to see the return on that investment.
So we did that by beginning, as I just alluded to, by beginning to actually target certain fixed amounts of operating expense increase year over year, which frankly forced the prioritization of certain spending objectives. We've done that now for three years in a row. That's allowed us to take total operating expenses from about the 50% level to today about the 43, 42, 44% level, depending upon the particular quarter. So a lot of that movement, frankly, we've already achieved. The movement from where we are today to 40% obviously will require a finer pencil because we don't have that much to move yet, frankly. But I think it's certainly doable based upon the kind of track record that we've put in place for the last three years.
Again, the combination of the target toward 70% gross margins, operating expenses at about 40%, that yields the 30% operating target income that we talked about earlier this year.
And I referenced this a little bit. Obviously, it's been a strong year. Performance this year, basically in the last quarter, that you increased guidance by about $10 million for the balance of the year. And guidance, I guess, still calls for, I guess, acceleration into the second half of 2017. Can you walk us through what's driving the acceleration?
Sure. I think, in general, the strength that we enjoyed in the first two quarters resulted in us actually overachieving revenue expectations for those quarters in the range of about $4 million-$5 million per quarter. Heading into the third quarter, third quarter, as for most, it's probably the most difficult quarter to handicap, given the fact that a large part of the world takes vacation in the early part of the quarter. And then usually that comes back in the second half of the quarter. So we very much expect that to repeat again. I think the current consensus, with which we would concur, is to be sequentially down from the second quarter into the third quarter for us, which is normal.
Then in the fourth quarter, if you're comparing first half revenues to second half revenues, traditionally in the fourth quarter, we see a very large acceleration into the fourth quarter. In this case, that increase, that sequential increase for most analysts, I think, is about $12-$14 million sequentially. Remember, a lot of that is simply because of all the drivers that we've placed in the last 12 months and the fact that utilization during the fourth quarter across the world during the proverbial sick season, sick as in SICK, increases. It is very, very consistent. That is really the basis upon which you would expect to see the increase, sequential increase from Q3 to Q4. In the aggregate, that's why the second half of our revenues are expected to increase relative to the first half.
A big focus in the conference today has really been, sadly, these hurricanes that have occurred over the past couple of weeks. You had the one in Houston and obviously recently down in Florida and up the East Coast a little bit. As we think about the potential impact, can you help us maybe quantify the amount of exposure you have in these markets and then also potentially if there is any sort of risk to production in any of these locations?
Sure. Well, as you mentioned, I mean, I guess in a bad news situation, the good news relative to Florida seems to be it wasn't quite as severe as originally feared. To the best of my knowledge, we've got a tremendous amount of hospitals throughout the state of Florida. But to the best of my knowledge, none of them shut down at all. Some of them may have had some lower floor water issues. But I'm not aware of any that shut down. So directionally and relative to Houston, the same thing. We've got obviously a large group of customers in that part of the country as well. But sitting here today, I've not been informed relative to any large hospital shutdowns that might have impact overall demand. So at this point, we don't really expect there to be much of an impact.
Understood. And as we start thinking into 2018, you have a notable headwind with the Medtronic royalty payment stream going away. It should be worth about a point in 2018, a couple points more in 2019. Can you help investors think about the headwind here on the top and bottom lines and also what drivers are at your disposal to kind of mitigate these pressures?
Sure, well, first of all, the fact that the royalties will roll off in October of 2018 is clearly not a surprise, something that we and the world have been aware of for the last five years. So the way in which we expect to be able to bridge that gap, if you will, is first of all through simply the organic growth that we continue to expect to see in the business. There will be a small impact to us in 2018, a larger impact in 2019 when those royalties actually disappear. Having said that, certainly most of our analysts have always viewed that royalty stream from a discounted cash flow standpoint. So the overall valuation, if you will, of that cash relative to the equity price is certainly not directly proportional related to the EPS impact.
So I think that will mitigate a little bit of that as well. We also then have the opportunity through M&A options in front of us to help close a little bit of that gap. And then finally, the balance sheet, which at this point includes no debt, is always available to us should we choose to do that to help, again, alleviate some of that year-over-year EPS change.
Very helpful. And with that, I think we are out of time. Mark, Eli, thank you so much for joining.
Great, Jonathan. Thank you too. Thank you all very much. Appreciate it.