You should read this discussion together with the financial statements, related notes and other financial information included in this Form 10-K. The following discussion may contain predictions, estimates and other forward-looking statements that involve a number of risks and uncertainties, including those discussed under Item 1.A-"Risk Factors" and elsewhere in this Form 10-K. These risks could cause our actual results to differ materially from any future performance suggested below.

Overview

We are a global medical technology company that develops, manufactures and markets noninvasive patient monitoring products that improve patient care. We invented Masimo Signal Extraction Technology, or Masimo SET, which provides the capabilities of measure-through motion and low perfusion pulse oximetry to address the primary limitations of conventional pulse oximetry. Pulse oximetry is the noninvasive measurement of the oxygen saturation level of arterial blood, or the blood that delivers oxygen to the body's tissues, and pulse rate. Conventional pulse oximetry is subject to technological limitations that reduce its effectiveness and the quality of patient care. In particular, when using conventional pulse oximetry, arterial blood signal recognition can be distorted by motion artifact, or patient movement, and low perfusion, or low arterial blood flow. Low perfusion can also cause the failure of the conventional pulse oximeter to obtain an accurate measurement. Conventional pulse oximetry readings can also be impacted by bright light and electrical interference from the presence of electrical surgical equipment. Published independent research shows that over 70% of the alarms were false outside the operating room using conventional pulse oximetry. Our Masimo SET platform has addressed many of the previous technology limitations. The benefits of Masimo SET have been validated in over 100 independent clinical and laboratory studies. During 2008, we generated product revenue of $258.9 million, representing a compound annual growth rate, or CAGR, of 34.0% for the three years ended January 3, 2009.

We develop, manufacture and market a family of noninvasive blood constituent patient monitoring solutions that consists of a monitor or circuit board and our proprietary single-patient use and reusable sensors and cables. In addition, we offer a remote-alarm/monitoring solution, such as the Masimo Patient SafetyNet. Although our Masimo SET platform is only operable with our proprietary sensors, our sensors have the capability to work with certain competitor pulse oximeters through the use of our adapter cables. In 2005, we launched our Masimo Rainbow SET Pulse CO-Oximetry platform utilizing licensed Rainbow technology from Masimo Labs, which enables the noninvasive measurement of not only arterial blood oxygen saturation level and pulse rate, but also carboxyhemoglobin, or carbon monoxide levels in the blood, methemoglobin saturation levels in the blood and total hemoglobin, or

the oxygen-carrying component of red blood cells. Also, in 2007 we launched Plethysmographic Variability Index, or PVI, which is a measurement that quantifies changes in the plethysmographic waveform over the respiration cycle. Along with the release of our Masimo Rainbow SET Pulse CO-Oximetry products, we have developed multi-wavelength sensors that have the ability to monitor multiple parameters with a single sensor.

We have focused on building our U.S. and international sales and marketing infrastructure to market our products to end-users, such as hospitals, and OEM partners for incorporation into their patient-monitoring products. We market our pulse oximetry products to hospitals and the EMS market through our direct sales force, and market our circuit boards to our OEM partners. Today, the primary focus of our hospital sales force is to facilitate the conversion of hospitals to our Masimo SET or Masimo Rainbow SET products. In the United States, we typically enter into long-term sales contracts with hospitals, pursuant to which we ship and install our pulse oximeters at no cost to the hospital in exchange for a commitment to purchase a minimum number of sensors from us over a specified period of time. With the introduction of Masimo Rainbow SET Pulse CO-Oximetry, we have established a small sales force to concentrate on the EMS market. Over the past year, we have expanded our sales and marketing staffing levels to 324 as of January 3, 2009, from 292 as of December 29, 2007. We supplement our direct sales with sales through our distributors. During this period, direct and distributor sales have increased to $201.1 million, or 77.7%, of product revenue for 2008, from $143.7 million, or 71.9%, of product revenue for 2007. We expect the percentage of our revenue from direct sales to continue to increase as we expand our worldwide direct sales force.

The building of our installed base of pulse oximeters and pulse oximeter circuit boards generates recurring sales of our sensors, primarily single-patient use sensors. A user of one of our pulse oximeters or our OEMs' pulse oximeters can obtain the benefit of the Masimo SET or Masimo Rainbow SET only by using our proprietary sensors that are designed for our system. We currently estimate that our worldwide installed base was approximately 567,000 units as of January 3, 2009, up from 470,000 units as of December 29, 2007. We estimate our installed base to be the number of pulse oximeters and pulse oximeter circuit boards that we have shipped in the past seven years. In the event we increase this assessment period beyond seven years in the future, our estimated installed base may increase materially. We expect our worldwide installed base to continue to increase as we expand our market share and expand the pulse oximetry market to other patient care settings.

On August 13, 2007, we completed our initial public offering, or IPO, of common stock in which a total of 13,704,120 shares were sold, comprised of 10,416,626 shares sold by selling stockholders, 1,500,000 shares sold by us at the initial closing and 1,787,494 shares sold by us pursuant to the underwriters' full exercise of their over-allotment option, at an issue price of $17.00 per share. We raised a total of $55.9 million in gross proceeds from the IPO, or approximately $47.8 million in net proceeds after deducting underwriting discounts and commissions of $3.9 million and estimated other offering costs of approximately $4.2 million. Upon the closing of the IPO, all shares of convertible preferred stock outstanding automatically converted into an aggregate of 34,612,503 shares of common stock. The consolidated financial statements as of and for the period ended January 3, 2009, including share and per share amounts, include the effects of the offering since it was completed prior to January 3, 2009.

Masimo Laboratories, Inc.

Masimo Laboratories, Inc., or Masimo Labs, is an independent entity spun off from us to our stockholders in 1998. Joe E. Kiani and Jack Lasersohn, members of our board of directors, are also members of the board of directors of Masimo Labs. Joe E. Kiani, our Chairman and Chief Executive Officer, is also the Chairman and Chief Executive Officer of Masimo Labs. We are a party to a cross-licensing agreement with Masimo Labs, which was amended and restated effective January 1, 2007, or the Cross-Licensing Agreement, that governs each party's rights to certain of the intellectual property held by the two companies.

Under the Cross-Licensing Agreement, we granted Masimo Labs an exclusive, perpetual and worldwide license, with sublicense rights to use all Masimo SET owned by us, including all improvements on this technology, for the measurement of non-vital signs parameters and to develop and sell devices incorporating Masimo SET for monitoring non-vital signs parameters in any product market in which a product is intended to be used by a patient or pharmacist rather than a professional medical caregiver, which we refer to as the Labs Market. We also granted Masimo Labs a non-exclusive, perpetual and worldwide license, with sublicense rights to use all Masimo SET for the measurement of vital signs in the Labs Market.

From May 1998 through December 2008, Masimo Labs contracted the services of our employees for the development of Rainbow technology. We paid Masimo Labs for the option to market and develop products based on Masimo Labs technology in defined markets. Through December 2005, we had paid Masimo Labs $7.5 million in option fees and nearly all these option fees were used by Masimo Labs to repay us for the services that we had provided to Masimo Labs. In addition, through December 2006, we exercised two licenses, for $2.5 million each, for the right to market products based on the new carbon monoxide and methemoglobin parameter technologies developed by Masimo Labs. As of January 3, 2009, the entire $5.0 million in fees had been used by Masimo Labs to repay us for the shared engineering and other services that we provided to Masimo Labs. We also entered into a Services Agreement with Masimo Labs to govern the services we will provide to Masimo Labs going forward, effective as of January 1, 2007. As part of the Cross-Licensing Agreement, we exercised an additional license for total hemoglobin for a fee of $2.5 million, on January 1, 2007.

The Cross-Licensing Agreement requires us to pay certain royalties on products incorporating the licensed Rainbow technology. The royalty is up to 10% of the Rainbow royalty base, which will include handhelds, tabletop and multi-parameter devices. Handheld products incorporating Rainbow technology will carry a 10% royalty rate. For other products, only the proportional amount attributable for that portion of our products used to measure non-vital sign parameters, sensors and accessories, rather than for measuring vital sign parameters, will be included in the 10% Rainbow royalty base. For multi-parameter devices, the Rainbow royalty base will include the percentage of the revenues based on the number of Rainbow-enabled parameters. Beginning in 2009, for hospital contracts where we place equipment and enter into a sensor contract, we will pay a royalty to Masimo Labs on the total sensor contract revenues based on the ratio of Rainbow enabled devices to total devices.

We are also subject to certain specific annual minimum aggregate royalty payments. These minimum aggregate royalty payments were $481,000 for 2006, $3.2 million for 2007, and $3.5 million for 2008. In 2009 and each year thereafter, the minimum aggregate royalty payments are $4.0 million and $5.0 million, respectively. In addition, in connection with a change in control, as defined in the Cross-Licensing Agreement, the minimum aggregate annual royalties for all licensed Rainbow parameters payable to Masimo Labs will increase to $10.0 million and $15.0 million in 2009 and 2010, respectively, and $15.0 million per year thereafter, and up to $2.0 million per year for each additional Rainbow parameter.

Pursuant to FIN 46(R), Masimo Labs is consolidated within our financial statements for all periods presented. Accordingly, all royalties, option and license fees and other charges between us and Masimo Labs have been eliminated in the consolidation. Also in accordance with FIN 46(R), all direct engineering expenses that have been incurred by us and charged to Masimo Labs have not been eliminated and are included as research and development expense in our consolidated statements of operations. For additional discussion of Masimo Labs, see Note 3 to the Consolidated Financial Statements.

Nellcor Patent Litigation Settlement

In October 1999, we filed a patent infringement lawsuit in the United States District Court for the Central District of California against Mallinckrodt, Inc., now part of Covidien (formerly Tyco Healthcare), and one of its subsidiaries, Nellcor Puritan Bennett, Inc., collectively referred to as Nellcor. Nellcor is one of the largest manufacturers and distributors of pulse oximetry products in the world. The lawsuit was filed for infringement of our pulse oximetry signal processing patents. Nellcor denied our claims and made counterclaims alleging infringement of its patents by us. This lawsuit resulted in a jury verdict that Nellcor had infringed several of our patents, including one of our measure-through motion pulse oximeter patents. In September 2005, the U.S. Federal Court of Appeals ruled that Nellcor infringed several Masimo patents and ordered the lower court to enjoin Nellcor's infringing products. Prior to the issuance of a permanent injunction, Nellcor entered into a settlement agreement with us on January 17, 2006, under which we agreed to settle all pending patent litigation with Nellcor. In return, Nellcor agreed to pay us $263.0 million for damages incurred through January 2006. We granted Nellcor a covenant not to sue on certain new products and Nellcor agreed to pay us royalties on its total U.S. pulse oximetry revenue at least through March 14, 2011. In addition, in January 2006, Nellcor made an advance royalty payment to us of $67.5 million for estimated sales of its products in the United States during the remainder of calendar 2006. Throughout 2006, we received a total of $330.5 million in cash from Nellcor pursuant to the settlement agreement.

We recorded the $263.0 million lump sum payment as patent litigation proceeds in January 2006 and we recognized approximately $68.8 million of royalty revenue in 2006 based on Nellcor's total 2006 U.S. pulse oximetry revenue as report to us. We recognize royalty revenue based on the royalty rate per the settlement agreement multiplied by our estimate of Nellcor's sales for each quarter. This estimate is adjusted prospectively when we receive the Nellcor royalty report, approximately 60 days after the end of each quarter. Per our settlement agreement, the 2007 royalty rate declined significantly from the 2006 rates and declined again in 2008. However, the 2008 rates will remain consistent through March 14, 2011, the remainder of the settlement agreement period, unless Nellcor is able to develop new products that avoid some of our current patent coverage as negotiated in the settlement agreement.

Cash Dividends and Special Bonus Payments

In March 2006, we paid a cash dividend of $3.365 per share, in the aggregate amount of approximately $171.8 million, to holders of our common and preferred stock, assuming the conversion of all outstanding shares of preferred stock into an aggregate of 34,612,503 shares of common stock. Of this amount, $21.7 million relates to dividend payments made to stockholders who exercised stock options by delivering us a promissory note. In accordance with Emerging Issues Task Force, or EITF, 95-16, the $21.7 million in cash dividends have been classified as compensation expense in the accompanying consolidated financial statements, under cost of goods sold, research and development and selling, general and administrative expenses. In February 2007, we paid additional cash dividends of $0.468 per share and $0.257 per share, in the aggregate amount of approximately $37.1 million, to holders of our common and preferred stock assuming conversion into common stock. In March 2006 and March 2007, we also made special bonus payments in the aggregate amount of approximately $9.7 million and $2.0 million, respectively, to our employees and directors who held vested stock options as of March 1, 2006. These cash dividends and special bonus payments were made from the after-tax proceeds that we received from our patent infringement lawsuit against Nellcor and interest earned thereon. We do not intend to distribute any future royalties received from Nellcor under the settlement agreement to our stockholders or our option holders.

The following is share-based payment expense associated with the dividend and special bonus payment discussed above, as well as related to implementation of FASB 123(R), and other stock related compensation for the years ended December 31, 2006, December 29, 2007 and January 3, 2009.

                                                                Functional Expense
                                                             Research          Selling,
                                             Cost of            and           General and
                                            Goods Sold      Development     Administrative      Total
                                                                  (in thousands)
Dividends declared on common shares
securing the outstanding non recourse
notes                                      $        308    $       5,101    $        16,264    $ 21,673
Special bonus payments to holders of
vested options to purchase common stock           1,822            3,990              5,900      11,712
Stock option compensation pursuant to
adoption of SFAS 123(R)                             249              287                794       1,330
Other                                                -                -                 355         355

For the year ended December 31, 2006       $      2,379    $       9,378    $        23,313    $ 35,070

Stock option compensation pursuant to
adoption of SFAS 123(R)                    $        264    $         670    $         2,541    $  3,475
Other                                                -                -                 417         417

For the year ended December 29, 2007       $        264    $         670    $         2,958    $  3,892

Stock option compensation pursuant to
adoption of SFAS 123(R), for the year
ended January 3, 2009                      $        257    $       2,236    $         5,223    $  7,716

Results of Operations

The following tables provide a comparison of our earnings per share calculated under Emerging Issues Task Force Issue No. 03-6, "Participating Securities and the Two-Class Method under FASB Statement No. 128", or EITF 03-6, and Financial Accounting Standards Board No. 128 "Earnings per Share", or FASB 128, in accordance with GAAP and the non-GAAP if converted method based upon FASB 128 for the year ended December 29, 2007, as compared to our earnings per share for the year ended January 3, 2009. The non-GAAP if converted method assumes conversion of all shares of our preferred stock into common stock as of December 31, 2006.

Upon the closing of our initial public offering on August 13, 2007, all outstanding shares of our prior Series A through Series G convertible preferred stock were converted into an aggregate of 34,612,503 shares of common stock. Therefore, effective August 13, 2007, we transitioned from computing earnings per share from the two class method in accordance with EITF 03-6 to the if converted method in accordance with FASB 128. Net income for the year ended December 29, 2007 was allocated between the periods during which two classes of equity securities were outstanding and during which a single class of equity securities was outstanding based on the respective number of days. For the year ended December 29, 2007, two classes of equity securities were outstanding for 224 days and a single class of equity securities was outstanding for 139 days, or 61.7% and 38.3% of the total days in the year end reporting period, respectively.

We believe that the following non-GAAP earnings per share information is relevant and useful information that can be used by analysts, investors and other interested parties to assess our performance on a comparable basis to future reported earnings per share. Accordingly, we are disclosing this information to permit additional analysis of our performance (in thousands, except share data):

                                               Year Ended
                                             January 3, 2009         Year Ended December 29, 2007
                                               As Reported           As Reported            Non-GAAP
Net income attributable to common
stockholders:
Net income - two class method (1)                        N/A      $          26,075
Accretion of preferred stock                             N/A                 (4,837 )
Income attributable to preferred
stockholders                                             N/A                (14,339 )

Net income attributable to common
stockholders                                             N/A      $           6,899

Basic net income per common share:
Weighted average common shares
outstanding - two class method                           N/A             16,654,586

Basic earnings per share for period
during which two classes of equity
securities were outstanding                              N/A      $            0.41

Net income for period during which single
class of equity securities was outstanding
(1)                                              $     31,927     $     16,180     $     42,255

Weighted average common shares outstanding -
single class (2)                                   56,320,712       54,660,216       52,611,674

Basic net income per share for period during
which single class of equity securities was
outstanding                                      $       0.57     $       0.30

Basic net income per common share                $       0.57     $       0.71     $       0.80

Diluted net income per common share:
Weighted average common shares outstanding -
two class method                                          N/A       16,654,586
Diluted common share equivalent: stock
options                                                   N/A        4,078,286

                                                          N/A       20,732,872

Diluted earnings per share for period during
which two classes of equity securities were
outstanding                                               N/A     $       0.33

Net income for period during which single
class of equity securities was outstanding
(1)                                              $     31,927     $     16,180     $     42,255

Weighted average common shares outstanding -
single class (2)                                   56,320,712       54,660,216       52,611,674
Diluted common share equivalent: stock
options                                             3,869,623        5,168,982        4,615,833

                                                   60,190,335       59,829,198       57,227,507

Diluted net income per share for period
during which single class of equity
securities was outstanding                       $       0.53     $       0.27

Diluted net income per common share              $       0.53     $       0.60     $       0.74

(1) Net income for the year ended December 29, 2007 was allocated between the periods during which two classes of equity securities were outstanding and during which a single class of equity securities was outstanding based on the respective number of days. The convertible preferred stock was converted into common stock on August 13, 2007, the closing date of our initial public offering. For the year ended December 29, 2007, two classes of equity securities were outstanding for 224 days and a single class of equity securities was outstanding for 139 days, or 61.7% and 38.3% of the total days in the reporting period, respectively.

(2) Weighted average shares outstanding used to compute basic net income per share after conversion of convertible preferred stock; one class of common shares was outstanding for the period from August 13, 2007 to December 29, 2007.

The following table sets forth, for the periods indicated, our results of operations expressed as dollar amounts and as a percentage of revenue. The patent litigation proceeds and the royalty received from Nellcor in 2006 have significantly affected our revenue, results of operations and financial position. Accordingly, our results of operations for the year ended December 31, 2006 are difficult to compare to our results of operations for the years ended January 3, 2009 and December 29, 2007.

                                            Year ended                Year ended                 Year ended
                                          January 3, 2009          December 29, 2007         December 31, 2006
                                                      % of                      % of                       % of
                                        Amount       Revenue      Amount       Revenue       Amount       Revenue
                                                           (in thousands, except percentages)
Revenue:
Product                                $ 258,895        84.3 %   $ 199,684        77.9 %   $  155,131        69.2 %
Royalty and license fee                   48,179        15.7        56,602        22.1         69,207        30.8

Total revenue                            307,074       100.0       256,286       100.0        224,338       100.0
Cost of goods sold                        89,454        29.1        73,606        28.7         61,640        27.5

Gross profit                             217,620        70.9       182,680        71.3        162,698        72.5
Operating expenses:
Research and development                  25,495         8.3        22,960         9.0         24,875        11.1
Selling, general and administrative      120,069        39.1        91,234        35.6         91,384        40.7
Patent litigation proceeds                    -           -             -           -        (262,605 )    (117.1 )
Antitrust litigation                         706         0.2         1,537         0.6            109          -

Total operating expenses                 146,270        47.6       115,731        45.2       (146,237 )     (65.2 )

Operating income                          71,350        23.3        66,949        26.1        308,935       137.7
Non-operating income (expense):
Interest income                            2,305         0.8         2,361         0.9          6,741         3.0
Interest expense                            (753 )      (0.2 )      (2,475 )      (1.0 )       (1,824 )      (0.8 )
Other                                       (511 )      (0.2 )       1,287         0.5            551         0.2

Total non-operating income (expense)       1,041         0.4         1,173         0.4          5,468         2.4

Income before provision for income
taxes                                     72,391        23.6        68,122        26.5        314,403       140.1
Provision for income taxes                40,464        13.2        25,867        10.0        132,577        59.1

Net income                                31,927        10.4        42,255        16.5        181,826        81.0
Preferred stock dividend                      -           -             -           -         (77,785 )     (34.7 )
Accretion of preferred stock                  -           -         (4,837 )      (1.9 )       (7,985 )      (3.6 )
Undistributed income attributable to
preferred stockholders                        -           -        (14,339 )      (5.6 )      (34,275 )     (15.3 )

Net income attributable to common
stockholders                           $  31,927        10.4 %   $  23,079         9.0 %   $   61,781        27.4 %

Comparison of the Year ended January 3, 2009 to the Year ended December 29, 2007

Revenue. Total revenue increased $50.8 million, or 19.8%, to $307.1 million for the year ended January 3, 2009 from $256.3 million for the year ended December 29, 2007.

Product revenue increased $59.2 million, or 29.7%, to $258.9 million in the year ended January 3, 2009, from $199.7 million for the year ended December 29, 2007. . . .