Okay. Some of our friends are coming in the room still. We'll welcome Masimo, Micah Young, Chief Financial Officer. I have to say, Todd, we have met, and your title is?
Senior Vice President of Finance and lead our Financial Planning and Analysis.
Aha. So you're the person, actually, for driving the margin for us.
I wish I could take credit.
Eli Kammerman of Investor Relations and Business Development and many other titles. Excellent titles. Thank you all for being here. Just as we get going, Micah, I think you're now at Masimo roughly a year or so. It's been an exciting year. When I just reflect on things, I mean, I feel like there were a couple of messages. Early on, I was fortunate enough to spend some time talking to you. I feel like certainly confidence in the growth outlook was one. We'll talk about that. Certainly, especially with Todd here, another reminder about your intense focus on FP&A and cost management and margins and execution. Just at a high level, just to get us going, how would you reflect on the last year relative to your expectations stepping into the role?
Where are you doubling down now as you contemplate, again, at a high level before we get into the details the next few years?
Yeah, so as I think about the last year, and right now, I mean, we have such strong momentum in the business. As you've seen this last couple of quarters, where we started out this year, actually, it even started back into Q3 last year, but our driver numbers that we've been shipping out, we've seen an uptick in drivers in terms of technology boards and monitors that are going out into the market, into our installed base, so we've seen that uptick start around Q3 of last year. We saw that driven by the new partnership we have with Philips, but also, we're continuing to see more and more adoption of our Rainbow technologies as well as our newer product lines, those three newer products: NomoLine Capnography, SedLine Brain Function Monitoring, and O3 organ oximetry.
We've seen contracts like the Department of Defense contract that really helped us step up those driver shipments. We're continuing to expand on contracts, especially some large customers in the Middle East, where we've renewed at a higher level of volume, but also over a longer period of time. There's a lot of strong momentum. We're seeing that through the growth in our drivers. If you look this year, and even the last couple of quarters, we've had about 59,000 drivers, a level of about 59,000 drivers shipped in the quarters. That number used to be in the low 40s. It's gradually improved over time. We're seeing good growth. Our driver shipments are around 15% or better this year. That's a good indicator of what's to come in terms of sensor contracts.
And then if you look at our revenue growth, our revenue growth has continued to sequentially step up this year. We went from 10% growth in constant currency in Q1, 11% in Q2, and then a 13%, roughly 12.8% in Q3. So year to date, we're growing about 11%. And that's been a step up from our long-term growth rate that we've committed to, which is 8%-10%. So we've seen very strong performance this year in Rainbow. We've also seen it in SET, as well as our newer products. And we're seeing a very good, broad adoption across the entire portfolio. And there's a lot of exciting things. Where I see the biggest potential for us is in the area of hospital automation in the future.
We think that the Philips partnership is going to really give us some opportunities next year in terms of sensor contracts and taking what's out there in the installed base and then converting that into contract commitments. But yeah, overall, just great momentum in the business. And we're excited about what 2019 is going to bring.
Thanks for that, and I certainly agree, and you sort of stole my thunder from my big question number two in a wonderful way and steal it every time because I was going to say, I mean, you had a great nearly 13% third-quarter product revenue growth. You're talking still about 12% 2018 growth. I mean, really terrific year. You haven't said feel free to give us 2019 guidance now. Eli told me you were going to do that, but I like to tease Eli, but I mean, gosh, I mean, the first thing out of your mouth is how good you're feeling about the momentum, and we all know there are a lot of positives here. How do we frame these recent strong results, the positive momentum that you're talking about, in the context of your 8%-10% LRP? I mean, gosh, that seems conservative.
What do you feel like you need to have in hand as a financial guy, reality-based guy, before you'd say, "Yeah, no, I think I'd frame it whatever, nine to 11 or 10 to 12? What's necessary?
I mean, if we keep in mind that the long-range plan is over seven years. It's over a long time horizon. So 8%-10% is a very strong growth rate, especially as you start to build off of a larger and larger base. So your growth rate is going to naturally be under pressure over time. That being said, the confidence in our business has definitely increased over the year. We're getting more confidence with the broader adoption. We're seeing strength in Rainbow. We're seeing we've got some great opportunities with our newer products where we're coming out with some line extensions that's going to give us some opportunities, especially in the area of NomoLine Capnography. And that's a big market, growing 15%-20%. And it's about a $500 million-$600 million market opportunity. And we have very low share today, call it in the 5% range.
So we've got a lot of great momentum. We've got things that are going to be good growth drivers for us in the future. But again, as we think of it, I always want to be very prudent and thoughtful about how we provide guidance. We want to provide guidance that we believe that not only can we meet, but we can exceed. And we feel very good about as we head into 2019.
You talked about it on the third-quarter call. I've heard you talk about it in the past. You're emphasizing again this notion of advancing hospital automation solutions. Help us, people who aren't as smart as all the brilliant people at Masimo, understand what that means. I mean, I know you got the products. I know you got the sensors. But what's this vision mean? And is this a new market or thinking about everything you have in the portfolio in a different way? Help us, small people, understand the large vision.
Yeah. And you've heard me talk a lot on the road this year. We've been out with you as well. And we've talked about how we're moving from a product-based company to more of a systems and solutions company. And what I mean by that is we have the ability, with what we've done over the last several years of assembling technologies, and we'll get into those, but to really automate patient management. And that's automating it across a continuum of healthcare. So as we think about that, just to give you an example, and we're hoping to have an analyst day next year that will be able to demonstrate what we mean by hospital automation, how we are automating care, and do that through live demonstration. But I think the thing is understanding how the assembly of all these different technologies we've built over the last several years, like Root.
Root is a connectivity hub that basically brings together all these independent third-party devices, such as multi-parameter monitors, infusion pumps, ventilators, anesthesia machines, all these devices that sit in a hospital room, but they don't communicate well with the EMR, electronic medical record, so if you think about what Root does, it brings these devices together. We can connect those devices, and then we can, through our Patient SafetyNet and Iris Gateway, we translate that data into HL7, which is the language that gets it into the electronic me dical record, and then if you think about Patient SafetyNet, the capabilities of that and why it's important is you can remotely monitor up to 200 patients at a central station of a hospital, so you can pretty much connect all these patients, connect the patient records into electronic medical records, and be able to remotely monitor.
We've also brought out new technology like Replica, which is an application for a smartphone or smart tablet where clinicians can collaborate. It's the only intelligent two-way communication application that I know of that's out there in the marketplace to where it can escalate alarms, collaborate with physicians who are on and off duty, and be able to provide better care for the patient. So when you start to think about that, and then you also think about UniView, which is another technology and software that we've assembled that can take all the information from all these different independent devices in, let's say, an operating room, and it brings it together on a dashboard or a central display monitor. And it creates a cockpit for surgeons or the clinicians that are in the room to where they can collaborate, see the information displayed, and provide the best care.
It reduces the cognitive overload of the clinicians in the room. There's all these things that we're assembling that create this ecosystem that's going to help us to automate patient management. One example is it reduces transcription errors. When you can scan a bed or a badge at the bedside of a patient, you can connect all their data, all their vital signs into that electronic medical record. Those are the things we're doing that's really going to help drive the automation of care across the hospital systems.
Sounds more software-driven.
Very software-driven.
Again, to somebody who knows nothing about software like myself, that sounds like high margins. How big a factor is that as we contemplate positively evolving margins? I mean, this kind of maybe potential product mix evolution.
Yeah. I think you'll see an evolution of what used to be a price per transaction with a sensor that we're evolving as a company where now we're selling capital. We're selling Root. We're selling the sensors, of course, all the other technologies that attach, but also software as a service. I mean, there's an opportunity to monetize the value of being able to maintain a patient safety net system and the hospital automation across that large hospital institution. So there's going to be a lot of different ways that we can monetize and drive revenue. But we think there's a lot of value that hospitals are going to see, and they're going to want to pay for that value.
All right. I want to try to bring out a couple of these big-picture drivers. I mean, one of the things that I'm obsessed with slightly is the internal pipeline. The analyst meeting a couple of years ago, you talked about $3 billion of incremental new opportunity. Where are we in gaining more visibility on that part of the story? Is that something that's going to be more in evidence in 2019 and 2020, or?
Yeah. Aside from ORi, which was not really part of that undisclosed group of products, we'll talk about, I'm sure we'll talk about some of the ORi benefits. But there will be some things that we'll talk more about in the next year, especially as we move into 2019. A lot of things are just always dependent on regulatory approval and the hurdles there. But yeah, there's going to be some things that we'll talk about next year. We're hoping that maybe it's something we talk about even at our analyst day, which we're hoping to be next May or June. So we're trying to set that date right now.
Gotcha. Going back to Philips, you started to see some initial Philips-related board placements last year. We've seen a noticeable uptick in quarterly driver shipments, as you've highlighted. Joe mentioned on the third-quarter call that commercially, you believe the expectations have been exceeded there. That's encouraging. But help us understand when have we seen, and I don't think we have, peak Philips contribution here, or how do we think about the slope or the curve of the Philips impact as, again, not just the next quarter, but over the next couple of years?
Yeah. No, I think we saw, when we saw drivers grow last year, I think in Q3 and Q4 of 2017, I think we saw 12% growth in driver shipments. And that's when we first started to see the inflection in shipments. A lot of that's from where we completed the integration of the Rainbow platform and technologies into their multi-parameter monitors. That's really been a steady amount of shipments each quarter. We don't think that's a peak, I mean, necessarily, because we should see also another inflection where as we integrate the newer product lines, like the NomoLine Capnography, SedLine Brain Function Monitoring, and O3 organ oximetry or cerebral oximetry. Those are three product lines we're working on today. We did a very good job of accelerating the timelines on Rainbow and doing that integration. The other three products have been a little bit longer pathway for us.
And I think that's where Joe mentioned that, "Hey, we've done a nice job of getting Rainbow out there. We still have some work to do on some of the other product lines." But that should be another potential for us to get more and more drivers out. And then we're expecting the sensor revenue to start to come on Rainbow next year and then ultimately on those newer product lines as well.
Hitting on that sensor revenue side of things, obviously, the relationship with Philips, if I can say it succinctly, began with the driver shipments and adoption and sales. You all have been very clear about saying, "Then you all as a corporation have to go out and get the sensor revenue contracts." Where are you in that kind of process? I mean, is it parallel? I mean, I would think it would lag the Philips efforts. Do sensor volumes from Philips-related earlier driver sales and placements, does that accelerate in 2019 and 2020? Again, how do we think about that?
Yeah. I think the drivers are going to be pretty steady. But I think the sensor contracts, that's where we should see the step-up in growth. Because if you keep in mind, the drivers are very low revenue per board that we ship. So it hasn't been a big contributor of our growth this year in terms of revenue. But we expect that to start to see an uptick in driving the adoption with the customers of Philips and being able to bring on those sensor contracts. Because end of the day, Philips sells the monitors to their customers, and we ultimately contract on the sensors for those long-term commitments. So I think it's going to be twofold.
One, we'll be able to, as they put more and more of the installed base, new installed base out, and they start contracting, we'll come alongside them or right behind them for those contracts. I think the other thing is we have opportunities to go out to the Philips customers today who have their monitors and provide board upgrades or software upgrades. And I think that's something that we're starting to see traction on. And I think that that's going to be a great opportunity as well.
Talk about the co-marketing a little bit and give us a little more color if you could. I think you've had some 500 direct reps, clinical specialists, but as the Philips partnership evolves, have you seen an increase in that headcount? Should we expect it? I'm sort of thinking about it from a twofold angle. One, is there a lot more investment required to address that and where are we, if so?
Yeah. I don't expect to see a surge in investments around the partnership. I think we've done a good job of putting the structure in place within our sales force. And we're continuing to balance what's the right level of sales force investment as we continue on. That's going to support our long-term growth plans. But at the same time, we're also trying to drive improvements in productivity in terms of revenue per rep and those types of things that we're starting to get deeper into. That's part of the reason why we're bringing on the team under Todd with the FP&A team and trying to strengthen that team to get into sales rep productivity and some other things that we can talk about. But there's not going to be a big surge just related to the contract.
Okay. Just since you just threw Todd to the wolves, I didn't want to beat up on him right away, but maybe we'll take a side path just for a second. So Todd, what the heck are you doing in leading the FP&A charge? Micah keeps talking about it. What's he really mean? And where are you looking to get sort of venture or efficiencies, cost savings? And where are we in that process?
Yeah. So I joined in April. And pretty quickly, we kind of got into understanding the business where we were in the FP&A cycle, understanding the royalty was going to come off year 2019. And so we pretty quickly got our sleeves rolled up and dug into the plan and really started our planning process to give us some confidence as we exit this year and get into next year that we have confidence on where we can land and really drive the operating margin improvement that we need and expected. So we've looked at a couple of different ways. Certainly, on our gross margins, we kind of think of three levers. One is just we're going to get some increased leverage out of the higher volume as we grow the business.
Two, we'll get better margins as a function of just investing in our engineering efforts, investing in improvements that you have to do the work and upfront in to yield that out over time. And my team helps identify that, works with our engineers and our operations team to get that on a path to execution. And then three, it's really our shift to R&D and getting into the higher margin product as we shift to R&D. And that's a five to six-year process, and we're in the early stages of that. And then on the operating expense front, it's really just getting after some of those. Some of it's just kind of traditional cost reduction, where's your big spend, getting after vendors, trying to get some cost reductions on price concessions, standard blocking and tackling, nothing too.
Talk about regional.
Oh, yeah. So.
So nothing too fancy on the cost reduction front. I just think it's just the good work. It's the efforts that you have to do to get it done. And then I think the company over the course of its history has made investments in the U.S. and outside the U.S. And we're really trying to bring the right analytics to help us understand what of those investments are really yielding the kind of returns that we need and what regions are operating at the right operating margin percentages and where are we and how to maybe pull back some investment and shift to those places where we've got profitable sales growth. I think certainly my experience and Micah's experience has been really taking the company through a process that helps us focus on profitable sales growth.
It's not just cost reductions, but it's driving your top line and your bottom line at the same time. That requires, I think, understanding what the subset of investments you've made are actually yielding, which ones aren't, and then being able to shift and prioritize accordingly.
Can I just add real quick?
Please.
Todd's being bashful, but they've accelerated our planning process by about four months. I just want to brag on the team a little bit. What we would have started last year in October is now we started that in July, August. We've also developed and started building out more three-dimensional seven-year planning capabilities that we're still trying to evolve. They're doing a very nice job. We've never had profitability by country, territory, region. Those are the things that are getting built out now. I think it's just increasing our capability to help us better allocate resources to drive the biggest and best return on invested capital. Those are the things that are really the fruits of their labor, and the team's done a tremendous job.
That's exciting. You talked about, Todd mentioned, but Micah, the number one question I always get asked is about the Medtronic royalty. And where's, you're from California. Where's your head at now on growing through it? And help us think through what's the messaging now just at a high level in 2019 and your ability to sort of grow past or through the Medtronic royalty headwind?
Yeah. I mean, we're becoming increasingly confident we can grow our EPS in 2019. It is a challenge. I mean, we're guiding to $2.92 this year, $0.35 of which is tied to the royalty and the NRE. So that's a big chunk of earnings per share that we've got to overcome. But we are getting more and more confident that we can grow through it. It means that we will have to pull some levers that'll grow us faster in terms of operating margin expansion. What used to be a 100 basis points commitment every year, it's still going to be 100 basis points. But in 2019, we're going to have to pull some additional levers that are going to have to get us growing faster, probably beyond 200 basis points.
And we've identified a lot of those things that we can do, and we're very committed to doing that. We're not going to come out with guidance today, but you'll hear more about it. But there's things like we have a lot of levers in gross margin. I think we've hit on a lot of those. We'll continue to drive sales force productivity, leverage our infrastructure. We've done a lot with contracts this year where we've done requests for price bids and got multiple quotes and tried to improve pricing with our vendor contracts as well. So those are going to be things that will yield benefits next year. But overall, we've got a lot of things that we can pull on in terms of levers.
And then interest income will be an opportunity for us too to grow EPS next year as we're getting better yields on our cash and trying to maintain balance sheet flexibility as well.
Yeah. Several companies have highlighted, actually, to me recently that they're sort of excited about the better returns on cash. And given your excellent balance sheet and growing cash position, is that something that actually might be a little better benefit next year, or?
Yeah. I mean, we've seen an improvement. Of course, the Fed continues to raise rates. We expect there could be another one in December and maybe possibly two or three next year. So right now, even over the past six months, it's been a big step up in terms of the yields on our investments. And we're also looking at going into longer-term maturities with some of our investments that can yield more aggressive yields as well while still balancing the risk and everything as well. So there's some low-risk investments that we're looking to get into that will help accelerate some of our interest yield and definitely take advantage of. But our share price has progressed this year so much that it's converged with the yields we're getting on our cash to where the EPS benefit is not quite as much as it was three to six months ago.
Exactly. So maybe less imperative to go out and buy stock. You're not going to put in—you're not going to become a dividend company. So guess what? That leaves M&A. And I think this—I mean, it seems clear to me, but I think there's some confusion about M&A discussion. It sounds like you have an active pipeline. You talked about a dozen, I think, on the third-quarter call. How are you thinking about it? I mean, people are alternating between thinking you're going to do something tomorrow that could be—excuse me—problematic for dilution or that you're not going to do anything. And if you're investing in longer-term interest-bearing instrument, that doesn't sound like you're rushing out to do anything. Where are we in that?
Number one, we're more and more confident in our core business. We're continuing to grow at an even accelerated rate than we expected, so with that confidence, we don't feel a sense of urgency to do anything right away. I mean, we're continuing to evaluate opportunities. We've had a lot of opportunities that we've turned away the past year, but I think the key thing is that we're looking for opportunities, and most of the ones that really come to the surface are more smaller, digestible type acquisitions, tuck-ins that are just technology additions, but end of the day, we're trying to look at it from two perspectives. One is strategic. We're trying to look at opportunities where we can leverage our clinical expertise. We have a lot of sales and reps in the field. We have a lot of clinical expertise in the field.
So we're interested in any type of acquisition where we can leverage our sales force, leverage our clinical expertise. Number two, we're looking at opportunities where we can leverage our expertise in algorithm processing. We may, as Joe talked about, it may be further in non-invasive monitoring, but we may go a little outside of non-invasive monitoring, which could be minimally invasive type technologies or different things within that we can still leverage our clinical expertise. And then the third is leveraging our manufacturing capability. I mean, we've got a very strong manufacturing capability. So that's one of the three things that we look at from a strategic standpoint. And then from a financial standpoint, we take it through criteria such as making sure that it's supportive of our long-term plans, meaning that the revenue growth is going to help support 8%-10% growth long term.
And then it's supportive of our 30% operating margins long term. And then the third is that it's ROIC accretive within three-five years.
And it sounds like you have an incredibly rich pipeline. I mean, are the odds high? Are they, again, not a fair question, but what the heck? Are the odds high? Are they low that we see something come out of that rich pipeline in the next 12 months? Or it's just, I mean, given the growing competency of the business, which you continue to emphasize, it's more on the lower side of things.
As far as pipeline?
I'm sorry, M&A.
M&A.
Yeah.
I mean, I can't really speak to it. We're just continuing to evaluate. We've turned down a lot more opportunities than we've made. You've seen that, so over the past year, we've had a small tuck-in here recently, but that's really been it and you've seen that, so I think we're just going to continue to evaluate the pipeline. We're going to stay true to our criteria as we evaluate things strategically, things financially. And I think the cash on our balance sheet is going to be sufficient to do what we need to do.
Yeah. Turning to free cash flow, another aspect of this whole discussion, I think you've generated $164 million free cash year-to-date impressively higher than 2017 and 26% cash conversion, if I remember correctly. How sustainable is that rate? How much more can you squeeze out of working capital? Or what's changed in 2018? And how does that set you up for years ahead?
Yeah. So I think one challenge is going to be the royalties. I mean, there's a very strong yield because that's a 100% margin on those royalties. I mean, it's dollar for dollar. The other thing is we've made a lot of work in capital improvements this year. We've taken our daily sales outstanding down from 55 days down to 45 days. And that's a big one-year improvement or nine-month improvement. So those are some things where we're just improving collections. There's going to be more one-time as far as you start to bring your collection periods down, but then you stabilize. So you kind of get that benefit in year one. But as you think about, as I think about sustainability, I think we still should be in that 20% range or low 20s range in terms of yield, is kind of where I expect over the next several years.
But with the royalty falling off, that's going to impact us. And then also just the working capital improvements, some of those being more one-time, one-year in nature. But I still have very strong cash yields. There's not very many companies that are generating 19%-20% yield on their cash.
No, for sure. We don't get to talk much about international just sort of holistically. It's about 30% of sales, I think, if I'm remembering correctly. And that exposure has held pretty consistent. Any OUS opportunities or initiatives you want to highlight that you'd have us focus on for the penetrating OUS markets? Obviously, Philips is part of that. You highlighted the Middle East contracts. Anything else going on that we should be aware of?
No. I mean, we're still. There's a lot of opportunity to continue to go deeper, to drive deeper penetration in some of our larger, more direct countries. And we continue to evaluate opportunities where we can go direct in areas where we have distributors. But I think that's the main thing is really just going deeper. We've talked a lot about Middle East, Saudi opportunities. But we still have low market share in some of these large markets that are more developed markets. And it's just a matter of penetrating deeper in that market and expanding our presence.
One of the questions I have is that Rainbow penetration, if you go back five, six, seven years, whatever it is, obviously was not where Joe and the team dreamt before you arrived. But I think Philips changes this whole debate because they are so focused on Rainbow. I'm just curious now, with the vendors that maybe were less intrigued or felt less compelled or driven to adopt Rainbow, is the Philips interest and changing the views of other customers?
Yeah. I mean, we do believe that with Philips and our partnership, we believe that Rainbow will become the standard of care ultimately. And we're really trying to co-market and push that. I think that's going to put pressure on other OEM partners who can offer that Rainbow technology as well. And so I think there's going to be opportunities there. And I think we're starting to see more broad adoption. We're seeing more and more drivers go out with our OEMs that are Rainbow capable. Almost all of our drivers today that go out that we ship are capable with Rainbow. So it's just more of an opportunity to turn on those parameters in the future.
I mean, you're such a positive individual, I think, with good reason. But when you reflect on some of the challenges, I mean, I feel like Masimo is somewhat insulated from some of the day-to-day things we worry about. But is there anything in terms of tariffs or raw materials prices or trade or currency, anything that's sort of a little higher on your anxiety list as you look ahead to the next year that you'd have us be sensitive to?
Yeah. I mean, we're exposed to currency. That's definitely been a headwind for us, especially in the back part of this year. I think our guidance implies about a 50 basis point year-over-year headwind in currency in the fourth quarter. And we've seen the dollar strengthen against most of our major currencies. So that's continued to be a little bit of a concern for us. We don't hedge cash flows yet. That's something we'll look at as we get larger. And we got to evaluate how much are we hedged through the P&L and work through some of those things. So there is a little bit of risk there to the top line in terms of currency headwinds. But for the most part, we believe those are things that we can overcome in terms of pulling on levers to offset that through EPS.
Other headwinds would be, of course, we've got the year-over-year comp with the flu season. We had a very strong flu season in the first quarter of 2018. That will be a tough comp as we anniversary over that in the first quarter of 2019, but overall, we still feel very good as we're heading into next year. Of course, we're going to be very thoughtful about how we guide to 2019, and you'll probably see similar guidance that we've done in the past. Maybe having to pull a little bit more levers on, of course, operating margin, but we feel very good about heading into 2019, and it's going to be another successful year.
Okay. Maybe we'll stop there and leave it on that note. And thank you so much. Really appreciate you both. Thanks, Todd, for your thoughtful answers as well. We won't pick on you yet. And please don't touch the IR budget. Is that how it's supposed to be?
All right. Thank you.
Thanks.