Chief Financial Officer. Is Micah here? I don't know. Is he hiding, lurking? Eli Kammerman, Vice President of Business Development, Investor Relations, man about town, you know, many other good things. Thank you both for being here. You know, this is a great time to talk to you about, you know, the reaction to the third quarter, sort of fundamentals generally. We're going to talk about the fourth quarter trends, early thoughts about the outlook. Of course, I know you said, Micah, you're going to tell us all the details about the analyst meeting and the bottom line, and so we can all be ready. Seriously, let's start with the reaction to the quarter. I think people were, I don't think it's too much to say, shocked and surprised at the early, some of your early commentary about currency pressures on the 2023 top line, margin performance.
I just assumed, right or wrong, $0.50 of FX impact and $0.15 of interest, extra interest. Do you think, how can I put this? I feel like you've always set up the next year in the five years you've been there, six years, conservatively, carefully, thoughtfully, prudently. Is this Micah being Micah? Did Eli make you do this? I mean, it's like, talk to us about the factors
behind your input and the setup for next year.
Yeah. So, Rick, when we came out of Q2, the second quarter, so we had our second quarter results. I laid out a lot of the margin or the FX headwinds. If you go back and look at our investor presentation coming out of Q2, I laid out the guidance was changing about $44 million of headwinds incrementally from Q2 guidance to Q3. And that was dropping through. We were seeing a drop-through rate of about 57%, so about $25 million on the $44 million. What I was concerned about when I exited Q2 and we started seeing consensus numbers rolling in was, and I started looking out at 2023, and I was concerned that, you know, things weren't being considered as far as FX headwinds as they annualize out next year.
And we saw even, you know, throughout this past year, we've seen the dollar strengthen against our major currencies.
If you get the euro, probably as our top currency, it's strengthened about 10% against the euro over the past year, and the dollar's strengthened about 20% against the yen, which is probably our second major currency. That got even more persistent as far as those headwinds as we got into Q3, throughout Q3. We saw the dollar strengthen more. The one thing I wanted to make sure was, if you look at this year's revenue mix, and we're still working through the plans for next year, but based on this year's revenue, the mix, those headwinds were significant, and I was concerned that those were not being factored into next year. I was very intentional on the earnings call.
I had my prepared remarks that we, based on current FX rates, if they hold where they are today and where revenue mix is today, you know, we see about $70 million of headwinds next year on the top line, and if that drops through at the rate that we saw going from our prior guidance to current guidance, we felt that that was going to see about 57 cents on the dollar, which is a big impact on next year, so I wanted to make sure that those were being thought through because we still see good results on a constant currency, organic growth of the business, but we felt that those headwinds were not being factored in, so that was one thing. Number two, you know, we've had a year of supply chain challenges. I think, you know, we've done a great job of navigating them.
The global team has done a great job of navigating those headwinds in the past through COVID, some of the most challenging years that I've seen, but they navigated through them, but we're now starting to see some of those costs playing into our P&L, and I wanted to make sure that those were being thought through as well. So one thing I signaled was, you know, if you look at our Q4 guidance, which really didn't change a lot from a gross margin standpoint from the prior guidance, but I didn't feel like those were being factored in as well, so those, the gross margins we see in Q4, we think that those are nearing the bottom. If you look at healthcare, it's about 63%. I think overall consolidated gross margin is about 51% for Q4 guidance, and those will continue into the first half of next year.
A lot of this takes time to turn through the inventories, and those roll out over a six-month period. We are hoping we're doing everything we can right now. We've got initiatives internally to try to improve that, but it's going to take time to work through those inventories and start to impact the back half of next year. And hopefully, we'll start to see some of those. We're seeing it stabilize. It's not improving as far as the supply chain challenges that we're seeing and the inefficiencies, but they are. We're seeing them stabilize, and they're not getting better. They're not getting worse. But we need to start seeing those getting better before we start to see that path back to the margins we saw pre-COVID.
I think the confusing part for me, or one aspect of confusion, was you really had a good third quarter. Both aspects of the business, both divisions of the business performed extremely well. Sound United really, the third quarter in a row, significantly beat. It seems like demand is strong. Performance is excellent. And so to what extent, Micah, did you incorporate, again, based on what the current realities are, sort of a worst-case currency scenario, but not really fully reflect the kind of momentum in both parts of the business, irrespective of whatever new products we're going to hear about?
Yeah. Yeah, I think, you know, we feel very good about the business. I mean, Q3, we saw, you know, our healthcare business delivered 10% constant currency growth, you know, above that midpoint of our guidance range. We saw the consumer audio business deliver above the high end of the range. You know, we're, you know, we are being cautious right now just because there are a lot of challenges right now in the macro environment. We're trying to be thoughtful about the. If you look at the consumer audio side, for example, our luxury brands like Bowers & Wilkins, Marantz continue to perform very, very well in a tough environment. Denon performing. It's stable. It's performing well. We have seen some challenges in our Polk brand, which is more priced near the mass consumer pricing. That's been challenged throughout this year, and we've got that contemplated in our guidance.
But we want to kind of continue to see how things are playing out. Do we see any more erosion that works its way up through maybe into some of those other premium brands? We haven't seen it yet, but, you know, we're trying to be conscious of that. So that's more on the consumer audio front. But we've had strong performance. We're guiding to 5%-10% constant currency growth for that business in Q4. And so that's a strong, strong growth outlook for Q4 versus what we're seeing in the market. They're outperforming the rest of the market, so they are taking share in the markets they play in. On the healthcare front, we, you know, we're continuing to take share there in a big way. You know, we're guiding to 7%-11% growth in the fourth quarter, 9% constant currency growth midpoint.
We're being thoughtful about the challenges right now. We have had challenges this year installing under contracts. We've got a contract backlog that's up to about $1.24 billion right now at the end of Q3. It's up 25% year- over- year. We haven't been able to get the installations done as fast as we want. And once we do, we'll start recognizing the sensors on those contracts. But there's also been very choppy census we saw in Q3. And I mentioned that on the earnings call as, you know, we've seen softer census than we expected. You know, we're being thoughtful about the hospital buying patterns because we recognize our revenue on sell to the customer. And we're just being cautious there just because we came out of a soft quarter. We are expecting that to tick up for normal seasonality of the business.
And then there's also a, you know, what we're seeing is a pretty heavy flu season starting. So if what we're seeing on the CDC, for example, if you go to the CDC website, you'll see the flu data, it's ticking up pretty strong right now. The question is, how much of those outpatient volumes that they're seeing there or the diagnosed flu volumes will those translate into inpatient admissions? Because our sensors track to inpatient admissions as far as the volume. So we got a wider range there, but it's contemplating some of that softer census, but also a potentially stronger flu season. Plus, you know, we do believe that there's some, you know, backlog of surgeries that are still out there that could pick up in Q4 as well. So that's kind of how we're thinking about Q4.
And, you know, we still are encouraged by the growth in both businesses right now and as we head into next year. And the healthcare business has some very strong, you know, great opportunities and tailwinds behind it in terms of the contract backlog. And we're seeing a growing install base. It's up 7% year- over- year as well.
I know. I think your wins in the last nine months have been a period of record contract wins. Your major competitors spinning off its business, sort of throwing in the towel, it feels like a little bit, so it does seem like the setup is encouraging. One thing I don't understand. As you were talking about the $1.2 billion contract backlog, help us understand that better. A couple of simple questions. One, how quickly do you expect that to be worked through? What's a normal level? I mean, I would assume that there's always something in that backlog, but what could the implications be for 2023?
It's a good tailwind going into 2023 in our outlook for next year as well as beyond because a lot of our contracts, as you know, those are called four or five-year terms as far as the length of the contract. So the backlog, when we talk about that, and you see it in our quarterly filings, that backlog represents undelivered equipment under contract as well as undelivered sensors. So that will give a nice tailwind over the next five years as we start to install under those contracts and roll out the equipment.
So it's always going to be at sort of these levels, but it's just a steady, consistent pretty tailwind.
Yeah. I think what we're seeing is, you know, I mentioned on the call about the first nine months of the year. We've got record contracting. It's going to be tough to top what we did last year because we had such a strong fourth quarter of contracting. But, you know, we're tracking very well this year, taking share. We're seeing that in our contract, the new contracts, winning new customers to Masimo. We're also seeing strong renewals as well. So all those things are lining up very well for us as we move into next year.
I assume at the analyst day, we're going to hear more about the, on the healthcare side, the new product pipeline, among many other topics. But this does not seem to appear that major core healthcare product launches. Am I wrong? Could that pace pick up as well next year on the internal organic innovation front?
Absolutely. We've got a lot of projects internally focused around our healthcare business and, you know, continue to really focus around. We've got a great hospital automation platform, and we're looking to continue to innovate in that space. We're starting to see things play out in our telemonitoring. We just launched the W1. That's going to be more geared towards telehealth telemonitoring. We're also making it available to consumers, but that's where the focus is because we think we can provide the solution for patients who are, whether it's discharged from surgery and they're going home to be monitored for a few weeks, and maybe that's Radius PPG, which is our wearable wireless sensor, or they can use the W1, which hospital systems can basically monitor patients with long-term chronic conditions like COPD and CHF.
We're going to talk about this more later, but talk about the W1 launch. You know, it's challenging for me to explain it to people in the sense that, I mean, you're being very clear about your idea about the W1, and I know it's a first step into this market. What are your expectations? What do you want us to look for in terms of the W1, and say it as you will in terms of revenues or incremental growth? Are you dialing into your guidance for next year? I mean, help us give us some perspective.
Yeah. As far as how our view on W1, and my personal view is, you know, this is going to be a great product, like I mentioned, for telemonitoring. We do have some pilot programs we're working through in the Middle East and Saudi, the Saudi market. That's going to be something to stay tuned on is how do those turn into, translate into contracts for us. Right now, there are pilots. Joe mentioned on the call that, you know, we're looking at starting out with hundreds of units, and that has the potential to get into 10,000s of units. So, you know, it's going to continue to be an opportunity to expand from there. But we want to see, you know, that turn into contracting, and I think that that's going to be a great opportunity.
It's also going to be a reference point for us as we try to expand on that platform and the capabilities there. The other thing I'd like to see is we're starting to do some early, you know, work with some of the large hospital systems here in the U.S. And we're pending 510(k) approval on the watch. Right now, we submitted, I believe it was in September, we submitted the 510(k) application. So that's pending review with the FDA. And that's going to be kind of, you know, a key milestone for us is getting approval for that because we're basically using this as a, it's a medical grade, you know, technology that can be used for patients with those long-term chronic diseases. So that's what, you know, we'd like to see some of those pilots and those programs play out in the U.S.
and translate into a contract, you know, with a large system. And that'll be a good reference site for us as well.
I just want to make sure. When do you expect FDA clearance in the U.S.? I mean, is it three, six?
I wish I could predict FDA timelines. You know, we've had a lot of challenges there over the years, but, you know, this one should be a faster pathway, but we'll keep our fingers crossed.
So hoping for a 2023 approval. Talk about, if you would, the Sound United side of the business. I mean, I know we're going to hear more at the analyst day, but there's sort of the everyday consumer business. You touched on it. But I'm guessing we're going to hear more about how we should imagine Sound United accelerating your wearables. You know, I like the phrase, this following the consumer wherever they go strategy. Is that the right way? Is that the right expectation?
Yeah. I mean, we look at it as, you know, and we'll talk a little bit more about this in investor days. They've got a strong retail channel, over 23,000 points of retail distribution. But they also are building a good channel for their direct-to-consumer. And that's, you know, you can go out there and look at some of the websites like bowers and wilkins.com, denon.com. They've got the presence. They know how to market to consumers. And that's, you know, they've got a very capable team. So we want to leverage that channel, both the retail as well as their direct-to-consumer channel. And that's going to be a great opportunity for us to take some of these medical-grade technologies into the home and to consumers.
Yeah. The Freedom Watch is, I know it is the next-gen version of W1. Is it still on track for a launch next year? Any additional details you can share, and maybe you should tell us. I see you're wearing a W1. What's the experience like, and do you get a free upgrade to the Freedom?
No, it's a great watch. I mean, the technology we have with the vital signs, with, you know, if you think about it, a lot of our core SET Pulse Oximetry measurements are in here. So you've got blood oxygen saturation, pulse rate, respiration rate, Perfusion Index, and Pleth Variability Index. So you've got a lot of the core measurements. And this is going to be the first continuous medical-grade type technology that's on the market in terms of wearables. And this is going to be a learning experience for us with W1. We're making it available to consumers. We're hoping to learn as much as we can, trying to continuously improve the user interface, the design, software applications in preparation for the launch of Freedom. And that's going to, you know, that feedback loop is happening now, and that's going to work through the course of next year.
We'll probably touch more on timing of the next generation Freedom Watch at Investor Day. But we're excited. You're probably looking within the next 12 months or so.
When I think about the math, whether it's the $500 version or the $1,000 version, I don't know whether it doesn't sound like a lot to me to say, you know, 10, 20, 25,000 units really adds, you know, 25-50 basis points to top-line growth. Is that the right kind of rough math?
We're working on there, yeah.
Yeah, I really am.
Keep in mind, you know, the main milestones here are going to be in the telemonitoring side. So what's going to be the catalyst for revenue growth and contribution is going to be those contracts. So if we start to see that play out in the Middle East and some of those in the U.S., that's what'll move the needle. But in terms of the consumer health side, which, you know, those can have a quicker uptake on revenue, that's going to be more dependent on the timing of our Freedom launch.
Gotcha. Micah, you've done an amazing job since you got there. I've been very conscious of it in terms of driving efficiency, you know, focus on cash generation, all sorts of things. COVID and supply chain have made your life, I mean, I won't say hell, but I hope not, but it's been tough. What are your priorities for next year? Again, beyond integrating Sound United and rolling out the strategy, whatever that we're going to hear about, but from just running the company and doing what you've done outstandingly, getting it back to basics, if you will.
Yeah. Well, I mean, our priorities are revenue growth and earnings growth, and we've got to put together plans right now, and we can't fully overcome currency, right? So currency is going to be a headwind for us, but if you look at the organic growth in the business, we want to drive top-line revenue growth and earnings growth. We also need to be balanced in the investment that's going to be required to successfully launch some of these products, so we are working through that. I mentioned on the earnings call. I think I got a question on all the marketing investment and, you know, how we're thinking about it, and we're trying to be as balanced as possible to deliver the earnings growth. It's important to me. It's important to Joe. It's important to our leadership team, so I think, you know, we're going to be measured.
We got to figure out how to balance that, but make the right investments because it is important to successfully launch these products.
All right. No question about it. It's hard for me to not ask you about your activist investor. I'm guessing it's challenging to comment. I'm sure that there are other people involved in this discussion. But so I'm not asking about specifics, but, you know, what do you want the investors in the room to know? What do you want me to know about some of their ideas and thoughts? What's Masimo's response to this? How are you going to respond?
I mean, right now it's in the hands of our legal teams. I can't talk a lot about it, but what I can say is, you know, the complaint's been filed. You can go read that. We've also had a press release with our response back on that complaint. And I think, you know, the thing for us is, you know, I'm hoping we can get this behind us soon. And probably looking at right now, it's in the Delaware court. And we're hopeful that there will be some resolution by maybe March of next year. So.
Okay. You know, turning to Analyst Day, you know, I'm sure you're going to have some good surprises up your sleeve, I trust, but that you'll only talk about it there. But what are your priorities? This is the first analyst meeting, Eli, in three years, four years?
Three.
Three years. So that's an event in itself. Yeah. What are your key priorities to accomplish at this meeting?
I think from my standpoint, I mean, we want to give an outlook into next year, and in 2023, we want to lay kind of the foundation for how we're looking at our outlook beyond 2023 and over the next five years. We want to hit on a lot of the, you know, some of the things we're working on. There will be some consumer-related products, and we'll also get into more telehealth, telemonitoring, kind of what we're doing in that space. I know Bilal Muhsin, who's our Chief Operating Officer for healthcare, he's going to focus a lot around kind of similar to what we did with hospital automation back in our 2019 investor day, talk a lot more about telehealth, telemonitoring, W1, the capabilities we have there. You know, there's tons of opportunity that we have in that space to be a great solution provider for hospital systems.
And then, you know, we'll hit on some of the consumer health product that are coming out, touch on some of the timelines there. And then, you know, Blair Tripodi, who's our Chief Operating Officer for the Consumer Division, he'll hit on some of their core business, the consumer audio business, as well as some of the go-to-market plans for our consumer health business.
More shipments is a topic we haven't talked about a ton in this year. Other topics have been on the table. But this was the fifth consecutive quarter, the third quarter. It was the fifth quarter in a row where you, yeah, plus minus, you've been delivering 75,000. Last year, it was more like 60,000. Is 75,000 drivers the new norm? And, you know, talk about the drivers of the drivers, if you will.
Yeah, absolutely. So, yeah, new driver levels, what we're forecasting now is at least 75,000 a quarter. Installed base, as I mentioned earlier, is up about 7% year- over- year. I think a lot of concern is coming out of COVID. I mean, we saw almost double the amount of drivers the year of 2020. A lot of concern was, is the installed base going to slow down? And is it going to, or could it even contract? What we're seeing is good stability in the installed base. It's continuing to grow. It's growing at the pace it was even pre-COVID, which is pretty incredible. So up 7%. And as you know, you know, we tend to drive that double-digit growth with pulling through more and more revenue on those drivers over time. So we've got a great foundation for growth as we move into next year.
And, yeah, driver shipments up, you know, 75,000 now. I think pre-COVID was below 60,000. So we're seeing good demand out there.
Yeah. That's great. And good demand from your OEM customers as well. Have they retrenched at all in any way, shape, or form?
No, it's been pretty consistent. We've always had a split of about, call it 75%-80% as OEM drivers that go into our installed base. And 20%-25% is Masimo branded equipment. So those drivers have stayed pretty consistent as far as the demand.
Great. Back to Sound United. I mean, again, it's been. I would not have predicted that they would have outperformed three quarters in each of the three quarters reported this year. That says to me, in a simple-minded way, that things are going well. But talk about the integration. There were some noisy leadership transitions. Is it fully integrated? Are they on track? Where are we now? What's left to do, maybe?
Right now, we're going through collaboration among our R&D and development teams. So those projects are underway. They're working together. A lot of those projects are, you know, two-year-plus type contracts or projects. The back office, we've been integrating more of the back office. That's been driving some efficiencies there for us. We're through the majority of the integration. So we still have some systems integrations that we need to work through, but it's going very well so far.
Pricing and price inflation, cost inflation is a topic I've been bringing up a lot lately. To what extent are you, at this point, able to talk to your customers and raise prices to offset some of your costs? Is that underway? How significantly? Any color there?
Yeah, we're in the process right now of enacting price increases. We've been putting in place the CPIs under contracts. We've been enforcing those. We did take a little bit of time off during COVID just because, you know, customers were challenged. I mean, they were suffering in terms of cash flows. And, you know, I talked to several CFOs during that environment from hospitals. And it was a challenging environment for them. But we did take a pause. But now we're enacting those CPIs in the contracts. We do kind of butt up against some of the GPO pricing and contracts. So a lot of times, whenever we enter into contracts with larger customers, there are some levels of discounts there. And we can raise price over time, but then you're kind of capped out with GPO contracts. So we can't go higher than that.
So that does, you know, limit our ability somewhat to continuously raise prices there. But, you know, outside the U.S., you know, you tend to get more off-contract type business there. So those are the same things where we're trying to raise prices to offset some of the inflation.
During the quarter, we saw that on the Apple litigation front, we saw the ITC administrative judge delayed his preliminary decision, I think twice, if I remember correctly. It's now expected December 19th. I haven't been able to catch up with our litigation expert yet. But what are you thinking and hearing about this case now? Is delay good? Does it mean something? Is it concerning?
I think it's a complex case, and I think that that's what's being delayed right now. If you look at the ITC for us, it was originally supposed to be October. That's now moved to, I think, December 19th or 20th, and that's where the ALJ will make a decision whether or not to ban the watch within the U.S. So, you know, I think it's gotten more complex. I think there's, you've seen that complexity shake out even in the AliveCor case. That's been delayed as well, and that's actually sitting with the International Trade Commission as we speak. So I think there's a lot of complexity. That's been moved back more by the judge just due to the time needed to work through this.
And then, of course, if that moves on, then it goes to the International Trade Commission, which will be a review. Probably that'll be; we'll hear more about probably next March if it keeps moving through. So, and then the final step would be onto the president for signature if it keeps moving all the way through.
Gotcha. On that note, we have to stop. Thank you very, very much, Micah.
All right.
Eli, appreciate you being here.
All right.
Thank you.
Thanks, Rick.