Let's go ahead and get started here as we progress through the afternoon. My name is David Lewis, Medical Device Analyst at Morgan Stanley. It's my pleasure to have with us here this afternoon Masimo and two members of management, Micah Young, CFO, and Eli Kammerman, VP of IR and Business Development. We're going to jump right into Q&A, as I've said all week so far. Make sure you go to the Morgan Stanley Research Disclosure website and check out my research disclosures for fun facts on me. Mike, I want to start where we left off just a few weeks ago, frankly, with the analyst day and the LRP. There's two things I want to spend the vast majority of our time on today talking about. It's one, sort of the core business. That was the focus of the analyst day.
The analysts day was really about not the core business, everything in the future. We're going to talk about those two theses, so to speak. One is just the LRP outlook, 8%-10%. I can't say that we were expecting dramatically more than that, but I think to a lot of people, maybe it looks somewhat conservative. Let's just talk about how you kind of get there. Our way of thinking about it is it's kind of 68% in the core SET business. You probably get one point from NomoLine, SedLine, and maybe sort of another point from Rainbow. That's kind of a decent way of thinking about it.
That's a way to think about it. So yeah, so just to give you some background, our long-range plan is about a seven-year plan. So my view has been on guidances to provide guidance that we feel very confident not only achieving but exceeding. So as we think about going into a year, we may take the approach of being at the higher end of that growth range. But over the long-term plan, we give that broader range of 8%-10%. With how we're seeing the business right now, you mentioned 85% of our revenue is SET, which is that the pulse oximetry market's about $1.7 billion. And it's growing about 3%-4%. And we're seeing in our long-range plan, we have 6%-8%, but we've been outperforming that. We've also been outperforming the revenue growth for Rainbow.
And with Rainbow, in addition to the five set parameters, we also offer a total of 12 parameters with one fingertip sensor. So we can do a lot of different parameters like total hemoglobin and all those measurements. And we're really the only player in terms of measuring non-invasive continuous monitoring of total hemoglobin, methemoglobin, carboxy, oxygen reserve index, all those different parameters. That's about 10% of our revenues, and that's growing. In our long-term plan, we have it at 10%, and that's been growing at a multiple to that growth rate this year. And then you mentioned the advanced parameters, which make up 5% of our revenue. And that market opportunity for those advanced parameters, which is capnography, SedLine, and O3, it's about an $850 million market opportunity. They're growing double-digit growth.
We put in our long-range plan, 5% of our revenues being those advanced parameters growing 20%. We've seen that growing at least in-line with that. We're seeing outperformance on our core SET business, outperformance on Rainbow, and in-line performance on those advanced parameters. The exciting thing about it is that those advanced parameters is we have not launched or we're just now launching the cannula and disposable line for NomoLine. We've only been able to address half of that market today, the equipment side of the market. Now we're launching the recurring revenue stream with the disposables and the sensors or the disposable cannulas. That's going to give us an opportunity to accelerate that growth rate and hopefully outperform in that area as well. Yeah, 8%-10% is a long-range plan. We've been growing about 12%.
We came into the year guiding to 10%, but as we've gained more confidence, we've set that growth rate at 12% for this year.
Yeah, so you're outperforming that plan. Let's kind of take the core components and break this down a little bit. So one is I've kind of been following pulse ox for longer than I care to admit, but at least 15, 20 years. What's amazing is we are almost 15, 20 years into the DSP cycle, the core technology, the business, but you're still outperforming the market 2x. Let's just break down that 68%, 2x the market, why? And let's also walk through kind of recently first half of the year, some of these recent contracts. It's sort of shocking that there's still untapped market for you to go after this long into the cycle.
That's right. So I think we've obviously had very strong technology. We're clinically superior in terms of true alarm detection, reducing false alarms, especially when you have patients that experience a lot of motion in terms of the NICU and ICU. If you look at that, so when you combine the clinical superiority of Masimo's SET and the accuracy with motion, you combine that with also we're continuing to innovate. And we're seeing, in addition, with the Philips agreement, we entered into the Philips agreement a couple of years ago, and we raised our long-term growth rate at that point. And we've been seeing good success with Philips. It's not only, it's of course centered around Rainbow and driving that as an opportunity to partner together, but it's also pulling through our SET technologies.
So our core five SET parameters, whenever we come up with an opportunity to gain a new contract that a competitor has, they can either pull through SET or they can go with Rainbow. So I think that our core SET technology is also benefiting from that partnership. So that's kind of where we see it. It's a combination of superior technology. The Philips partnership's really taking hold. And then also companies are wanting to be with us as an innovation partner in the future.
Okay. Do you think about that Philips agreement? Where is penetration today? Where can penetration be in two years? And what did you assume embedded in that five-to-seven-year LRP and the core SET business for Philips penetration?
Yeah. So when we originally raised our long-term growth rates, we raised it about a point when we went up to 8%-10%. And we're seeing, like I said, very strong performance so far. We're still kind of in that sell cycle where we launched, we fully integrated Rainbow in late 2017, and through that sell cycle, we're now starting to see that benefit play through. Whenever you look at Philips, they're a large leader in the multi-parameter monitoring market. We have had very little penetration of our sensor business into their accounts. So we have a long runway in terms of tailwind for the business to really drive that penetration up that's closer to what we have with our other OEM partners.
We see an opportunity where this could take us from today, 85% of our revenues are SET, so it implies about low 40% market share in that market. We think that that could go up into the close to around the 60% range in terms of market share penetration.
Is that a combination of just the Philips penetration and share capture from Medtronic or just Philips?
It'll be primarily, I mean, it's going to be a lot of it penetration or share gains from Medtronic, and Philips has their own Philips FAST sensors that they offer as well, but that's where the majority of their share penetration is today.
Okay. So, as to Rainbow, I mean, we obviously don't cover the stock, but years ago we were talking about Rainbow. So where are we sort of in the Rainbow development cycle from innovation pipeline? And where are we sort of at? Has Rainbow sort of hit its inflection point in your mind? It's 10% of the business growing, 10%, one point of growth. But are we sort of at an inflection for incremental Rainbow penetration?
I think so because we're seeing it grow multiples of that growth rate right now. And I think what's really changed over time is we've gotten more accuracy out of how we measure hemoglobin and those other parameters. But also we have the Philips partnership that's helping drive that as well. But we're also gaining more and more clinical data around what total hemoglobin can do in terms of blood loss. There's been studies like the Limoges study over in France that basically looked at the combination of total hemoglobin and PVI, which is really measuring fluid responsiveness. And when you combine those together, what they saw when they did a study on about 18,000 patients in a cohort of about 3,000, they saw that at 30 days post-op, there was a reduction of about 30% in mortality rates.
So there's a lot of good clinical data coming out now, and that's starting to build for us. We need to continue to see more multi-center studies, and I think that's going to be where it drives the next inflection point.
Okay. Emerging markets is a component of the analysis, David. It wasn't necessarily a major component. So what's the opportunity for in the core pulse ox Rainbow business, the opportunity for EM? What's the EM percentage today and sort of where can it go across the LRP?
We're still under-penetrated in terms of if you look at the revenue from our OUS business today, it's about 30% of our total revenue. We believe that over time that could become closer to 40%-50% of our total revenues. So there's a lot of opportunity. There's hospital infrastructures that are building. We're seeing a lot of benefit come out of that because a lot of these infrastructures that are building up are looking for those more advanced type parameters and technologies. So we've seen some success there already, especially with Rainbow.
Okay. You talked about 18 being the second largest contracting year for the business. What's driving that relative rate of inflection? Same kind of question before. This technology has been around a long time. You're second largest contracting year. Is that the Philips agreement? Is that Rainbow? Or is it, frankly, all the other dynamics you're talking about in the business? Starting to talk about the Root pipeline and where large integrated delivery networks can go. And what's driving that contracting momentum?
I think there's several things. I mean, when we look at it, we're seeing a broader adoption across more hospital systems, especially, and we saw some large IDN-related contracts as well. But we're seeing more broad-based contracting. We're also, in terms of the technologies, we're getting more pull-through within our other advanced parameters. When you think of NomoLine, capnography, SedLine, brain function monitoring, and O3 regional oximetry, those are definitely helping drive more and more contracting there. And then, of course, the Philips agreement as well is playing into that. But it's really a lot more broad. I think it's because we have a much broader portfolio today than we did several years ago, and we're seeing that contracting momentum right now.
Okay. That final component of the business, you have 5% of the business, which is capnography, SedLine. You are growing that 20% over the LRP, obviously faster now. Of those different components, what is likely to be the single biggest driver of those three?
We think, I mean, today, what's performing very well is O3 and SedLine. Now that we have the disposable cannulas for capnography, that's going to be a big opportunity. If you were to take that $850 million market opportunity for those three combined, the biggest area is capnography. And that's about $550 million of market share opportunity for us. That's growing anywhere from 10%-15%. We think that now that we've got the full offering with the cannulas as well as the equipment, that's going to give us a big opportunity to drive growth into the future and really penetrate that market.
One of the things that's made you successful is the constant rate of innovation, but it's sort of shocking that there just hasn't been the focus on some of these markets. Typically, med tech markets, we're seeing three or four players aggressively pursuing some of these niche markets. We know your competitor necessarily wasn't pulse ox, and they really haven't invested. But capnography was another area where same competitor had competitive technology. So what is competition most notably sort of Medtronic and Philips in doing, A, on pulse ox, capnography, or any of these markets from an innovation perspective?
I mean, right now, we're not seeing a lot of innovation there. I mean, I think they're looking at other areas of the business and making investments there, but we're not seeing it directly in advancing pulse oximetry. And as we think about what we're doing, we're continuing to innovate. We just took and improved our pulse oximetry even more this past year. We went from an accuracy specification of 3% to 1.5%. So we're continuing to innovate. And I think with all the advanced parameters and all the Rainbow parameters that we can offer, we're starting to bring a lot larger value proposition that's continuing to differentiate us from the competition.
Okay. All right, so that's a lot on just the core business and what's driving what is now 12% growth. You're seeing 8%-10% of a long-range plan. But the visibility on that core getting you double digits here over the near term seems highly visible.
Yeah. We feel very good about the core business right now. There's a lot of momentum. I feel we're hitting our stride. We got the Philips agreement, like we said, playing in our favor now. We came into the year guiding 10%, and as we think about it, we think this is a double-digit growth business just with the core business right now.
Okay. But that wasn't the part of the analysis. The analysis that you held direction was to focus on some things that are non-core.
That's right.
I'm just going to talk through some of those. When we spent the dramatic amount of time in the analysis study, obviously, when I was there was the automation initiatives, so let's just talk broadly about what you're trying to achieve in automation.
Yeah, so as we think about hospital automation, we look at that as how hospitals should run in the future. We've been working on a project for 15 years and taking feedback from clinicians and hospitals, and what the feedback has been is, can you create something for us that will continue to improve our workflows in the hospital, help us to make data more accessible? There's low nurse-to-patient ratios, so they want the data right in front of them when they need it, and there's also cognitive overload, especially when you look in the OR. There's a lot of equipment. There's multiple screens that they have to touch. It's hard to get visibility into all the parameters on those different screens. So they wanted to be able to integrate all that data and be able to display that in a way that they can collaborate as teams.
So what we've done is we came out with Root several years ago, which is an open architecture, high connectivity platform that can take literally all the devices in the room, whether it's an anesthesia machine, an infusion pump, a ventilator, a multi-parameter monitor. It can take the data from all those independent sources that do not connect well today. And it'll bring it together as a central data hub, aggregate the data, and then shuttle it through what we call our Iris Gateway. And the Iris Gateway then translates it into HL7 and gets it into electronic medical records. But the flow of the data is not limited. So we can distribute that data to any endpoint.
For example, if we want to have a central monitoring station where you can monitor up to 200 patients on the general floor, we can take the data and feed that back to where they can manage alarms within a central station for those patients and be able to stay on top of the patient care for all those on the general floor. We can also take the data and shuttle it to what we call UniView, which we can put it on a central display within the OR. It's a large screen where we can take all the different monitoring data that's in the room and display it on the screen, and the clinicians can customize those views so they can better collaborate during surgery. And we can also take it and do data analytics. We can use what we call Halo ION.
So we grab all the parameters from these data sources, and you can have as many parameters in there. And we look at the trends in the data, and that can help us with providing decision support or understanding where the status of the patient is. And then the other thing is Replica. We can take what's showing on a monitor and put it on a smartphone or smart tablet. We have two-way intelligent communication where care teams can collaborate, and it will escalate alarms and alerts to those who are on call and escalate those. So we can create this ecosystem of automating workflow and really just becoming that data provider.
Okay. So I had two takeaways from the analysis study, and this is kind of resonating with some investors as well. Everyone came away for this next-generation basket of portfolio products saying, "God, there's a lot going on here." Clearly, it's going to be added into the 10%-12% or the 8%-10% LRP and maybe 10%-12% near term. I think everyone is struggling with how to financially model it, right?
Yes.
Taking this from its interesting TAMs and getting into the P&L and start with the automation business. Number one, business model. You've always had the business of selling sets. People want you to be a recurring revenue business. This doesn't have a. This is an intangible, right?
Yeah.
So my sense is you try to move to some type of per-bed, per-month model.
That's right.
But that's a bit of a complicated topic for a lot of hospital procurement offers and CFOs. So help us understand those early conversations you're having with large IDNs. Are they receptive to a SaaS-esque per-bed pricing model?
Absolutely. We've already seen we mentioned on the earnings call that there's been one large network that we've been working with in California. We just contracted with them to bring our automation suite into that hospital system. I think they're very interested because if you look at today on how all that information is automated through the hospitals, it requires a different server, a different box that continues to be added. So to offer all the things that we can with that Root and Iris, it would take a handful of servers from a handful of different vendors to provide, and they're all charging a capital fee for each one of those servers or pieces of equipment.
What we can do is create an enterprise-wide solution that you mentioned under a SaaS model and charge what we charge a range of, let's call it $1,000-$5,000 per bed per year. That gives us the opportunity to really bring it all together. We're not subject to just capital sales cycles, which can be volatile. It's something where customers like to understand what's our cost per year. They can quantify how this is going to save them when they look broadly across the system. It's moving away from that capital sell and really providing that annual subscription revenue that we can do over five to seven years of contracts.
Okay. So it's a $1.5 billion TAM. It's basically the same exact TAM as your core sets business. How did you go about defining that TAM?
So we looked at it and we broke it down. If you look at it, about half, a little more than half is the U.S. business and half is OUS. When we looked at the U.S., there's about 125,000 critical care beds in the U.S., and there's about 450,000 general floor beds. And we looked and said, "Okay, even if we could penetrate up to half of the general floor beds, that's 225,000 beds." So now you're looking at a total of 350,000 beds in the U.S. And then add an ASP ranging from $1,000-$5,000. And you think about it, the general floor beds would be more towards the lower end of the range because there's going to be less automation required there. It's going to be more central station monitoring, continuous monitoring on the general floor.
ORs, NICUs, ICUs, that's going to be more on the higher end of the range because you're going to need more of the UniView and all those things that need to be in the room and connecting with Root. So that's kind of how we quantified it. And that.
$2,500 per bed per year.
If you do that math, it's about $25,000-$3,000 bucks per bed per year on average. Yeah.
All right. So what is, obviously, the LRP didn't have any of this sort of in that core number. So what is the right way to think about the adoption model here when you've got?
Yes. Yeah. So we think of it as more of a. It's not going to be a straightforward sales-type model when you look at our SET technology. When we go in and contract sensors at six to 12 months, when we look at this, we're selling more to the IT, biomed teams, the C-suite of a hospital system. And that's about. We look at it as an 18- to 24-month cycle. So that's how we think about.
16-to-18-month software sales cycle.
Yeah. That's right.
Okay. We understand that. So the question is, is this a material driver to the business in 2020? I mean, can this be $10 million-$20 million next year?
We think that this will definitely contribute to revenue. We don't want to commit right now.
It's $1 million in revenue, but.
We think it can be a sizable contribution, especially when you start to model that in based on.
When you talk to the sales force, the commercial team that's working on this, it's going to take several contract wins to really get momentum and start to predicting this business. But is it safe to assume this is more of a 2021 driver than a 2020 driver? I mean, when does this business get momentum?
I think the momentum really builds in 2021. We will see hopefully some good contracts building up in 2020, but I think that's when we really start to see the strong momentum moving to 2020.
I don't want to get out over my skis here. When we talk about a model like this with Root and you've got multiple parameters that can plug in, as the value of the Root system and the feed to Iris and UniView builds, more people plugging into that network or that SaaS model, sort of the sales force AppExchange, right? I mean, so have you thought about the revenue model associated with that platform?
With how they plug in?
Yeah, the revenue. Once you build it out, you've got 1,000 IDNs or 100 IDNs.
That's right.
Other people are going to want to be compliant with that system, and they're going to pay to get access.
Yeah, and we have what we call today, there's Iris ports that you can plug and play the traditional, all the different devices in the room. We have what we call Masimo Open Connect, which is the ports on the side where we allow for new technologies, new innovations to come and plug and play. And then we charge typically a royalty for that access, so.
Okay. Two other things in the same question. I think opioid safety was topical, but once again, I think it's hard for them to get visibility on the model. So what are you trying to achieve in opioid safety?
Opioid safety is one where it's a lot different than hospital automation. We can fill hospital automation right now. Opioid safety, we're still trying to work with the FDA. We think it's going to be one of those things that's binary. It's one of those where we'd like to see things line up in terms of reimbursement, so what we're trying to understand is we're hoping that CMS will collaborate with the FDA. We were chosen as one of eight companies out of 250 applicants to address the opioid crisis challenge that the FDA came out with, and we think because the FDA is pushing it, that there will be some type of reimbursement strategy around that, and hopefully CMS will work with them, and that private payers will then follow, so we're trying to understand reimbursement over this next 90 days.
We're also trying to understand what the FDA labeling status will be. Will it be prescription, or will it be over-the-counter, so those are some of the things that are very important for us to understand, and then commercialization, I mean, as we think about how we commercialize, it's going to be dependent on those two key things: reimbursement, labeling status, but we're really trying to focus right now on one-third of what we think is the opioid prescription population is it's long-term chronic pain patients as well as post-surgical patients, so we think that that initial focus needs to be around how do we promote to surgeons who are going to prescribe opioids post-surgery, and how do we promote to pain specialists who are going to either prescribe or recommend to their patients as well.
So that's where we're going to focus, and that's where some of our Salesforce investment will be at. But we need to really understand what the reimbursement and the labeling status will be.
Yeah. So it's reimbursement and regulatory. The core product set from a development perspective, you're there. Is this another driver? How would you the impact of this driver relative to automation? Is it more 2021? Is it beyond 2021?
This is one where it could really take off and be transformative, or it takes a while because maybe it's more of a self-pay route depending on reimbursement. So we could see it be a much faster contributor, but we need to understand a lot more in the next 90 days. And I think we'll have a lot more updates that'll be coming over that time.
Simply put, if it's mandated.
It's a big market opportunity.
It's going to get big fast. If it's not, it's going to be a little slog.
That's right. And we think it's about a $4 billion market opportunity for us to address.
The last bucket was sort of there's like an innovation bucket here at the end. You had multiple things: continuous pulse ox, you had malaria, a bunch of different things. Of all those additive things, what's the one that stands out as the most near-term revenue driver for the business?
In terms of the new ones in the pipeline?
That's right.
We're very excited about continuous non-invasive PaO2 measurement, partial pressure oxygen. We think that that's going to be something that's going to be a big opportunity for us. We're right now at technological feasibility. That's why we announced both PaO2 as well as malaria. But we're still probably about two years out from commercializing those products.
Okay. Margin outlook, you call for across the LRP 600 basis points of expansion, roughly evenly split from a gross margin and OpEx perspective. I guess I thought about that post the meeting. Does that make sense to me? I think on gross margin, I guess it does. Most of these products are going to be set-driven businesses. I think about the automation business and why it's going to be pretty high margins. Your sets have pretty damn high margins.
It is.
So they're pretty similar to software. So for you, where do you feel better about that? Mix-driven or so it's not going to be a lot of mix-driven expansion over the next five to seven years. It's going to be a lot of just good old-fashioned manufacturing absorption and leverage, I'm assuming.
I think it's going to be a combination, but we think about gross margin going from 60%, call it 67% close to this year, taking that 300 basis points to 70%. We look at that, and it's going to be a few things. Converting to our RD Sensors line, which is a lower-cost, higher-quality sensor. And that's going to help drive some of that 50 basis points of improvement per year. And then we do a lot of design for manufacturing initiatives where we look at products and look at what the cost should be, and then we execute very quickly towards those. It's not an iterative take 4% or 5% out per year. We try to look at it and get there as quickly as possible. And we've got a lot of good projects going there that gives us confidence in getting there.
Then, leveraging our install base as we pull more and more revenue through advanced parameters, Rainbow, we're leveraging with more revenue per driver over time. The cost of the equipment we put out there, we're able to leverage that with more revenue per unit.
I looked at your OM expansion targets, and they looked conservative, if not frankly, not really believable, right? So it basically implies on the OpEx side, you're going to get 100 points of leverage over the next every year through 2024, but you're going to get 150 or 200 basis points. This year you got 350 in 2017. So why is it that the operating margin expansion of the business would be so arrested here over the next four years?
Yeah. I mean, one thing, if we go back when we delivered, we've delivered 540 basis points over the last two years, and you mentioned roughly 350 basis points a couple of years ago. Now, we had some one-time items that if you normalize, it's about 200 basis points we've done two years in a row. And your point is we've committed to 100 basis points per year. The reason we've done that is we accelerated because we knew that we had the royalty revenue coming off and expiring last year. So we accelerated a lot of those initiatives. There's still a lot of opportunity left, of course, but we also want to counterbalance investment in R&D. We want to continue to invest at a high rate, which today we're investing anywhere from 9%-10% of our revenues. We want to maintain that level of investment.
Also, we want to make sure that we're investing in these new initiatives for hospital automation and opioid safety because we think that these could be accelerators to our growth rate in the future. It's more of a balancing now and making sure that we're investing in those new initiatives, which we didn't have those the past few years. Yeah, I mean, I think that's how we're approaching it right now. But we will drop through more as we're able to. If we don't see the need to invest in a couple of those areas as heavy, we'll let that drop through as we go.
What are the terminal margins for this business?
70/30. I think right now we're laser-focused on getting to 30%. We will reevaluate as we get there, and we'll be setting some new goals, but we think there's opportunities beyond 30%.
Okay. Because you're still an inefficient business at 30%.
Yes.
Frankly, you're an average med tech company at 30%. Companies that have sort of your GM profile with your kind of business model are sort of more like, frankly, 32%, 34%, 35%.
Absolutely. Yeah. We see that we can get there long-term.
Okay. We're running out of time here, but do you need capital? This has been the bad thing. This has been kind of a not invented here company with Joe. He's found a lot of innovations sort of internally. Do you need M&A to accelerate this platform? It sounds like this is a double-digit grow without M&A, but given your infrastructure, right, additive M&A could be pretty powerful. Your balance sheet's pretty flexible.
Yeah. We're very excited about the core business. We're excited about the opportunities in front of us. And M&A will be something where we're looking more at smaller tuck-in acquisitions at the moment. And as we see technologies that can come and augment hospital automation or some of the areas of the business we have today, or being close adjacent markets where we can leverage our global footprint, I think those would be some things we'll be interested in. But we're confident in our core business today. We don't need M&A to get to the long-term goals that we have.
Okay. We're out of time, Micah. Eli, thanks so much. Thank you all for listening.
All right. Thank you.
All right.