Okay. Good afternoon. Thank you all for joining us. My name is Jay Chadha. I work on the medical device team here at Morgan Stanley. Pleased to have Masimo with us here. We have Micah Young and Eli Kammerman. Before we begin, just please take a moment to review all the applicable disclosures available on Morgan Stanley's website. Micah, just to help level set everyone, for those investors that are less familiar with the company, could you just give us a brief overview of Masimo and the industry you operate in?
Yeah. So just a high-level overview. We're a company that's focused on innovating within the non-invasive monitoring technology space. And if you look at where we started, we started really with pulse oximetry, and we were able to solve the unsolvable, which is trying to measure through motion and low perfusion.
And that's why we're the leader today in pulse oximetry. We have roughly 17 of the top 20 hospitals within the U.S. And if you look at our footprint, we're operating in over 140 countries, and we're touching over 100 million patient lives each year with our technologies. If you look at just a high-level glance at our financials, you'll see that we're guiding this year to $822 million in revenue, which is about 11% growth, a little more than 11% growth. Our long-range plans have about 8%-10% growth is how we look at it over a longer multi-year horizon. But we're definitely growing at a faster pace today, which is around 11%. If you look at our non-GAAP EPS, our earnings for the year, we're guiding to $2.90, which is about 26% growth. So that's kind of the financial side.
If you look at how we're transforming and evolving as a company and where we are really today, we've gone from what used to be just a product-based company that was really focused around pulse oximetry. We also brought on a technology called Rainbow that had more parameters. But we're moving from a product-based company that just sells widgets to now what's become more of a portfolio-based company where we've assembled a lot of products over the years. But where we're heading is, and where we're moving today is more into a systems-based company. We're selling systems and really healthcare solutions. And we can get into this. And I think talk a little bit more about hospital automation, but that's kind of where we're moving towards is providing the full solution to automating hospitals and helping them become more efficient as they work patients through the continuum of care.
Yeah. Okay. That's very helpful. Maybe we can just start with a partnership you formed a couple of years ago, the Philips partnership. It's not quite new, but Philips has about half the OEM market. And this deal wasn't very traditional in the sense of buyer-seller relationship. So what about the Philips deal was so unique? And why is it such a key component to your growth?
Yeah. Philips, the reason they had a small share in terms of our share with them with the pulse oximetry market is that relationship. They had their own sensor line, and they were basically competing with us within that space. And in 2016, there was a settlement between the companies. And through that process, we found that there's a two-way relationship here that we can both benefit and win together. So that gave us the opportunity to help really drive our Rainbow technologies as a standard of care. And it also helped them differentiate against other players in the market that they compete in. So that was a great opportunity for us. If you look at kind of how that's evolved is back in Q4 of 2016, we entered the agreement.
We went through about nine to 12 months of integrating that Rainbow or Rainbow technologies into their multi-parameter devices and monitors, and then late last year, we finished that integration, and we started putting our boards into their monitors, so they're starting to build up an installed base, and we're expecting that there's going to be some good sensor revenue that's going to come along and pull through from that installed base in the future.
Okay, so when you look at your penetration rates for Philips relative to other OEMs or your market penetration in pulse oximetry more broadly, it's maybe about a quarter.
Yes.
Can you reach that same level of penetration at the 40%+ level with Philips? And how long will it take you to get there?
Absolutely. I mean, we have a high degree of confidence that this relationship is really going to drive that kind of penetration. If you think about the contracting cycle, it's about five to seven years for sensor contracts with hospitals. So it will take time to move through. They're going through, of course, their capital selling process. We're coming alongside with sensor contracts, but it's about a five to seven-year contracting cycle. So this gives us a great opportunity to continue to augment our growth and potentially accelerate our growth as we move forward with the Philips partnership.
Okay. And then if we look at the drivers of growth here from a business segment perspective, if we really break down your business, it's kind of pulse oximetry, Rainbow, and then you have new products that you're rolling out. So just starting with pulse oximetry, it's the core of your business, and you've outgrown the market for a while now. What are you doing that's outpacing the market growth? And why can that continue?
Yeah. So if you look at our technology, for one, I mean, we do have the most accurate technology that's out there. And it's proven through published data and abstracts and all those things. So that continues to give us the upper hand there in terms of how we continue to penetrate. I mean, we have over a 98% renewal rate on existing business, and then we're taking a significant share of new contracts as they come due. One thing that we look at is in our long-term growth rates, and we think about that 8%-10% long-term growth rate. That assumes that our core SET business is growing about 6%-8%. And that's a multiple to the market that's growing at 3%-4%. And it's about a $1.6 billion market.
So we think that there's still a tremendous amount of opportunity to continue at that pace. That's why we've had the confidence of putting that in those long-range goals. The other thing is the opportunity we have to expand to the general floor. And if you look at our current business today, it's really focused around critical care. And if you look at in the U.S., just for example, there's about 125,000 roughly critical care beds in the U.S. The general floor beds are about 425,000. So there's a good three to four times opportunity there that we can really get into as we start to move to the general floor. And we've just now, over the last couple of years, assembled the right products that are going to be able to help us get there.
What I mean is our Root technology where you can connect all these independent devices, and we'll talk, I'm sure, more about that, but also the ability to take all that data from all those different devices as well as our devices and communicate that all the way through into the electronic medical records of a hospital and then remotely monitor up to 200 patients with Patient SafetyNet. That's the whole ecosystem that helps us to capture that share of the general floor.
Yeah. Now, I do want to get to Root. If you look at pulse oximetry being 6-8, the next kind of lever that gets you to 8-10 is kind of Rainbow, 10% of your business growing, 10% point of growth. The capital cycle here and the Philips partnership are important drivers of that growth. Working at Philips partnership really take the 10% growth profile. I mean, is 15%-20% growth out of hand?
No. I mean, I think when you think about the large market share they have with being the largest player in the OEM market, half the market, and the potential we have to take what's very low share of their business today that we have and bring that to the levels of some of those other OEMs, the over 70 OEMs we work with, and bring it to that level of share, we think that there's no reason we can't accelerate that growth. And we're actually seeing stronger growth than that long-range planned growth of 10%. We're seeing that this year. We've demonstrated it. And the great thing about the potential of Philips is all that we've seen so far is just the sale of our boards that are going into their devices.
So there will be a waterfall effect as there continues to be more and more of those sensor contracts that come along and get pulled through as they push that installed base out into the field. So there's a lot of potential there. It's not inconceivable that we could see those types of growth rates. But again, we're trying to be thoughtful in how we set our guidance and make sure that we can set guidance that we can achieve or exceed.
Okay. And then you have a few newer products, right? There are three, SedLine, Cap. These products are less than 5% of sales today, but they're really seeing robust growth, 20%+. That's another point of growth. What's the market opportunities that you see here for these new products?
Yeah. So if you look at just all those three products combined, it's about a $700 million-$800 million market opportunity, and if you broke that down further, you would see about a $500 million market for capnography, where we play with NomoLine capnography. SedLine, the brain function monitoring, as well as the cerebral oximetry market, we believe that that's about $125 million each. So that kind of gets you in that $700 million-$800 million total market, and it's a fast-growing market, so it's a great opportunity for us to grab one of the coattails of how fast that market's moving.
But it's also a great opportunity as we start to look at not only what we can do ourselves, but even the Philips, the partnership we have with them. We're starting to integrate those newer product lines into their technologies just like we did with Rainbow. And that'll happen over the next 6 to 12 months. And then we're hoping that those will be launched over that time horizon. And that's going to be another opportunity for us as well as continue to integrate with our other OEMs. So those are going to be ways that we can really drive acceleration. And there's no reason we can't see getting to that 40% share of that market over time just like we have with our core business.
That was my next question.
Oh, sorry.
No, that's fine. Single-digit share here, high level of confidence that you can move from the single-digit and the $800 million market to 40%+ where you are today.
Yeah. Yeah. We feel very good about where we're at. It'll take time, though. I mean, it's, again, longer contracting periods, but we see that in the time horizon. Yeah.
So when I just look at putting the pieces together, you have six to eight from pulse oximetry, one from Rainbow, another point from these new products gets you kind of to eight to 10. This is, you've delivered double-digit growth already for maybe three straight quarters. If Rainbow accelerates to 20% growth and these new products grow as a bigger percent of your revenue, I mean, it's inconceivable that 10%-12% growth longer term is kind of maybe a floor.
We believe, I mean, we're setting guidance, and we think about our long-term guidance. We don't want to get ahead of ourselves. We think that we can grow on a multi-year basis of 8%-10%. These absolutely could turn into headwinds or tailwinds for us that could potentially accelerate our growth profile of the business. It's something we want to see play through before we'd ever commit to something at that level. But it's definitely not inconceivable. I think we've got a lot of opportunities as you think about the Philips partnership, where we're positioned with hospital automation, expanding the general floor to the general floor of the hospital, all great opportunities. And also opioid monitoring. We think that that's another opportunity for us in really addressing the opioid crisis in the U.S.
Yeah. Okay. And then you mentioned Root. This may be an underappreciated longer-term driver of the portfolio. It's unique in its hospital automation offering. Just give us a quick overview of the product and what the longer-term opportunity for the market is here.
Yeah. I mentioned a little bit earlier about Root, how it can connect all these third-party devices, devices that don't have that connection all the way through to the Electronic Medical Records of the hospital and the EMR. So what Root does is it's basically a connectivity hub that brings all those different devices, including our devices, together. That information then gets sent through what's called an Iris Gateway. And that translates the data into HL7 that goes directly into the EMR. We also, when you combine Patient SafetyNet with Root, you have the ability to monitor up to 200 patients. And then we've been assembling other technologies, for example, Replica, that can work with Root as well or with Patient SafetyNet and that whole kind of ecosystem to where clinicians can then see the central monitoring in terms of all those 200 patients.
They can bring them up on their smartphone or their tablet, see the patient's status, get alarm notifications and escalations. And it's two-way intelligent notification. So it can help escalate. If a physician's off duty, it can escalate to the next level. So basically, Root becomes this whole connectivity hub that allows us to bring automation to hospitals. And by doing that, you eliminate all the manual transcribing from clinicians where they have to go in, basically do spot checks on site, and then they log all the vital signs and all that information. All that stuff can be done through Root. The other thing that is great about creating that ecosystem is as we start thinking about how do we take all this information and start driving decision support.
So as you think about somebody that you're trying to determine, will they respond to fluids and anesthesia and certain drugs? Those types of things can help by having all that information to help drive decision support through the hospital.
So you've got some new, I guess, third-party apps and such that are coming onto the system. What kind of adoption have you seen historically, and what do you expect this innovation, I guess, can help, or more players can help drive adoption going forward?
Yeah. I mean, with what we call Masimo Open Connect, it's a MOC-9 portal. It's what really connects the devices we've acquired over the years, like SedLine, brain function monitoring, NomoLine, and O3 organ oximetry. Those all can connect through that MOC-9 portal. That's why we've kept that as what we call Masimo Open Connect. All these different companies that are out there have an opportunity to be able to come in, plug and play into our Root devices. What it does is really opens it up. It provides more access to technology. By partnering with those companies, we may find that there's a partnership there for us, or maybe that technology is something that's very interesting to us. There's a lot of great things that we can do with Root, and it expands the opportunities in the hospital.
Okay. The royalty is going to be a headwind for you going into fiscal 2019. That's probably $25 million top line, about $0.35 to earnings. What levers can you pull to really offset the top and bottom line headwinds here?
Yeah. I think it's really about replacing that bottom line EPS because if you think about, there's not a lot of things other than growing that 8%-10% or even accelerating maybe a little faster to offset that big of a royalty falling off. But it's really the EPS and that $0.35. So if you think about some of the levers that we have, of course, our 8%-10% growth in products, growing in that range is going to give us some nice leverage. Our expansion, we're committed to growing and expanding our margins by at least 100 basis points. So those two combined should offset the majority of that royalty.
The other lever to really try to drive growth, which is what we're really committed to figuring out how do we drive growth, is either accelerating the pace of operating margin expansion, which we're evaluating and looking at that right now and seeing what opportunities we have during our planning cycle, but also, we've got $430 million of cash on the balance sheet as of the end of last quarter. And that can be put to use with a larger share repurchase program. And we're continuing to evaluate that, so.
So your level of confidence that earnings can grow in fiscal 2019?
I have a high degree of confidence. I think we can neutralize with just the core growth and what our baseline growth is in the business, and we may be able to accelerate with some other levers and have a good confidence there.
Okay. And as these patents expire, competition is likely to increase. How do you think about the environment changing? And what do you think the impact will be on the growth profile of the business?
I don't see the competitive environment changing all that much. I mean, if you look at our technologies and you compare those to the technologies that are out there, we have such a much higher degree of accuracy than anything out there in the marketplace. The other thing is just because the royalty stream's falling off, it's more of we will no longer be receiving a check. But if you think about the patents, we did not put all of our algorithms and our trade secrets when we filed for those patents. We didn't put those in the submissions. And really, all those are embedded and encrypted in the chips that go into the boards. So it's not like those are out there. They can be copied. It's more in our trade secrets. And we still think that we have a highly competitive advantage in terms of accuracy.
As you think about Rainbow, and hopefully later this year, we'll have FDA approval on ORI, which is Oxygen Reserve Index. We continue to just innovate and differentiate ourselves from the competition. The degree of separation from even back when the royalty started to now is even greater. I don't think it changes that much.
Okay. And you just mentioned margins. You previously talked about 100 basis points of margin growth expansion annually, 50 basis points to the gross margin level, 50 basis points from OpEx. What are the drivers both on gross margin and OpEx that kind of get you to 100 basis points?
Yeah. So let's start with gross margin. So if you look at our gross margins, the biggest lever we have and our commitment to 50 basis points improvement per year is really around the ability to convert customers to our RD sensor line. It's a much lower cost, higher quality, more patient-compliant sensor. So as we gain new business, we're putting all those customers on the RD line. As we renew contracts, we're putting those customers on RD. And we also have an opportunity to convert some customers earlier through maybe mean that we have to make some investment in cables to be able to do that conversion. But that's going to be the big lever. And due to the cost reduction from our old sensors to new, we're still in the early innings. We're in the first inning. It's about 10% converted today.
So that's going to be a great opportunity for us over the next five to seven years to continue to leverage our gross margins. The other opportunity is continuing to take costs out of our boards. We see opportunities there. We also see opportunities with driving costs out of our becoming more efficient in our distribution and logistics and lowering our freight costs. So those are some things that we've really dug into this year. And there's some opportunities there to continue to lever that as well. Do you want me to hit on SG&A?
Absolutely.
Yeah. So the other opportunity is 50 basis points improvement per year on operating expenses. So we want to continue to invest at the levels we are with R&D. That's our goal. So really, where we're going to try to lever and continue to lever is in the SG&A line. And that's through just becoming more efficient, leveraging the investments we've made over the years to go direct into international markets. We've made those investments. Now it's just growing our revenue that's going to help us scale and leverage more of those costs. We've also made investments in our back office functions and other areas of the business that we believe that we can leverage. And we're also trying to dig into a lot of our spending and find opportunities to either renegotiate or improve our contract pricing in certain areas. And those are things we're working on as well.
But there's quite a few things that we have that's going to help us improve and drive that over time.
It feels like the business is starting to show some pretty meaningful leverage. And as you think about this 100 basis points annually and 30% operating margins longer term, it's starting to feel like maybe that can be more of a floor. What are your thoughts there?
Yeah. I mean, we're only committing at this point to 30% over the next seven years. But you're right. I mean, we've been delivering at a faster pace. We saw our margins expand by more than 100 basis points last quarter. I think it was about 160 basis points. So every opportunity we have, we're going to drive and allow that to flow through. But we also want to make sure we're being conscious that we're investing in R&D and investing in innovation. So we're committed to 30%. But you're right. There's some opportunities. There's some levers that we could possibly go a little bit faster. And internally, that's our goal. But we just want to make sure we set up expectations that we think we can exceed.
Okay. And last year on M&A, you were close to closing a deal but seemed to walk away from it. And this year, M&A has been less of a focus for you. How has your approach to M&A changed this year in 2018 and going forward versus what you were looking at last year?
Yeah. I think we've definitely looked at we're going through a lot more financial parameters, the metrics. And we're also trying to make sure it fits both financially, but even more importantly, strategically. So we're looking at all those things. And if you look at what's out there and if you go through our parameters, so some of the key things are finding a target company that's in a high-growth market, has a potential to grow faster than our 8%-10% long-range revenue growth. So it's got to be accretive to our revenue growth profile. It's the operating margins. We want to find a company that can support our operating margin targets of 30% long-term. And then investments that are ROIC accretive within five years, so greater than our 10%-12% weighted average cost of capital.
So there's a lot of things that just don't fall into that in terms of the size of the market we're looking for, the growth rate that we expect. And then, of course, if you're going to find something, the valuation tends to be high. So we're trying to balance all those things and also make sure they fit strategically in terms of leveraging our signal processing capabilities, our manufacturing capability, and our clinical strength of our business.
Okay. Just a couple of minutes left. Let's just round out with the pipeline. You've teased a couple of new products coming on differentiated platforms. Could you give us a little bit more details on what the pipeline looks like going forward?
Yeah. We don't get into a lot of details on the undisclosed product that we talked about at the investor day. But I think what you'll see, and I think we'll have one of those three more to talk about there in the next six to 12 months. Of course, we don't get ahead of ourselves before an approval to get much into those details in terms of FDA approval. But I think you should see something within the next six to 12 months that we start talking about. And these are going to be outside of our core business today. So it's not what you typically see in our platforms today. Now, it's within healthcare. It's not going far outside of healthcare. But it's something where we can leverage some of our infrastructure today.
But it's going to be a little bit different platform than you've seen in the past.
Is it your expectation that if you're talking about a 6-12 months from now, your expectation would be to bring that to market soon after?
Yes.
Okay. And then last question on this is your expectation would be that the new products are currently not contemplated in the long-term guidance of 2018?
No. No. So our 8%-10% growth and our 30% operating margins, they do not include anything from M&A or those large products in the pipeline.
Your expectation would be that they are accretive to the growth profile of the business?
Yes. Absolutely.
Okay. Great. Just stop right there and see if there are any questions from the audience. Okay. If not, Micah, Eli, thanks so much for joining us.
All right. Thank you.
Thanks, Jay.
All right.