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MASI > SEC Filings for MASI > Form 10-K on 14-Feb-2014All Recent SEC Filings

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Form 10-K for MASIMO CORP


14-Feb-2014

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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 1A-"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.
Executive Overview
We are a global medical technology company that develops, manufactures, and markets noninvasive patient monitoring products. Our mission is to improve patient outcomes and reduce cost of care by taking noninvasive monitoring to new sites and applications. We invented 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. Pulse oximetry is one of the most common measurements made in and out of hospitals around the world. Masimo SET® has been validated in over 100 independent clinical studies and is the only pulse oximetry technology we are aware of that has been proven to help clinicians detect critical congenital heart disease in newborns, reduce retinopathy of prematurity in neonates, and decrease intensive care unit transfers and rapid response activations on the general floor. Our products consist of a monitor or circuit board, and a "Board-in-Cable" solution, for use with our proprietary single-patient use and reusable sensors and cables. We sell our products to end-users through our direct sales force and certain distributors, and also sell some of our products to our OEM partners, for incorporation into their products. As of December 28, 2013, we estimate that the worldwide installed base of our pulse oximeters and OEM monitors that incorporate Masimo SET® and rainbow® SET was more than 1.2 million units. Our installed base is the primary driver for the recurring sales of our sensors, most notably, single-patient adhesive sensors. Based on industry reports, we estimate that the worldwide pulse oximetry market is nearly $1.5 billion in 2014, the largest component of which is the sale of sensors.
After introducing Masimo SET®, we have continued to innovate by introducing breakthrough noninvasive measurements beyond arterial blood oxygen saturation level and pulse rate, which create new market opportunities in both the hospital and non-hospital care settings. We believe our Masimo rainbow® SET platform, that utilizes both Masimo SET® and licensed rainbow® technology, includes the first devices cleared by the FDA to noninvasively and continuously monitor multiple measurements that previously required invasive or complicated procedures. SpCO®, our noninvasive carboxyhemoglobin sensor, allows measurement of carbon monoxide levels in the blood. Carbon monoxide is the most common cause of poisoning in the world. SpMet®, our noninvasive methemoglobin sensor, allows for the measurement of methemoglobin levels in the blood. Methemoglobin in the blood leads to a dangerous condition known as methemoglobinemia, which occurs as a reaction to some common drugs used in hospitals and outpatient procedures. Masimo PVI® monitors fluid administration, which is critical to optimizing fluid status in surgery and critical care where traditional invasive methods to guide fluid administration often fail to predict fluid responsiveness and newer methods are complicated and costly. Our noninvasive hemoglobin sensor, SpHb®, monitors hemoglobin, the oxygen-carrying component of red blood cells. Hemoglobin measurement is one of the most frequent invasive laboratory measurements in the world, often measured as part of a complete blood count. A low hemoglobin status is called anemia, which is generally caused by bleeding or the inability of the body to produce red blood cells. RRa™ allows for the continuous and noninvasive monitoring of respiration rate, via rainbow Acoustic Monitoring™. Respiration rate is the number of breaths per minute. A low respiration rate is indicative of respiratory depression and high respiration rate is indicative of patient distress. Traditional methods used to measure respiration rate are often considered inaccurate or are not tolerated well by patients. Our Halo Index™ sensor allows continuous global trending and assessment of multiple physiological measurements of a patient with a single number displayed on the Patient SafetyNet™ screen. Halo Index™ is CE Marked, but not currently available for sale in the U.S.
In July 2010, we began selling the SedLine® monitor, which measures the brain's electrical activity and provides information about a patient's response to anesthesia. In January 2012, we received FDA clearance for the Pronto-7®, a product designed specifically for spot-checking hemoglobin, along with oxygen saturation and pulse rate. In December 2012, we released iSpO2™, a pulse oximeter cable and sensor with Measure-Through Motion and Low Perfusion Masimo SET® technology for use with an iPhone, iPad or iPod touch. We also offer a remote monitoring and clinician notification solution called Patient SafetyNet™, which includes our Masimo SET® or rainbow® SET monitors at the patient's bedside along with a central assignment station and wired or wireless server. Patient SafetyNet™ wirelessly notifies clinicians who are taking care of multiple patients in different rooms when one of their patients has an alarm, allowing them to intervene sooner and provide potentially life-saving support. We offer Masimo SET® and rainbow® SET through our OEMs and our own end-user products, including the Radical-7®, Rad-87™, Rad-57®, Pronto®, Pronto-7®, Rad-8®, Rad-5®, and Rad-5v™. Our solutions and related products are based upon our proprietary Masimo SET® and rainbow® algorithms. This software-based technology is incorporated into a variety of product platforms depending on our customers' specifications. Our technology is supported by a substantial intellectual property


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portfolio that we have built through internal development and, to a lesser extent, acquisitions and license agreements. As of December 28, 2013, we had 674 issued and pending patents worldwide. We have exclusively licensed from our development partner, Cercacor, the right to OEM rainbow® technology and incorporate rainbow® technology into our products intended to be used by professional caregivers, including, but not limited to, hospital caregivers and alternate care facility caregivers.
Dividend Payments
Our board of directors (Board) continuously evaluates a variety of options to return value to stockholders, including acquisition opportunities, stock buy-back programs and dividends. In 2012 and 2010, after considering all available options at those times, the Board concluded that the best and most direct way to reward stockholders for their continued investment and confidence in Masimo was through the declaration of cash dividends. In February 2010, the Board declared a special dividend of $2.00 per share, or $117.5 million, which was paid in March 2010. In November 2010, the Board declared a second special dividend of $0.75 per share, or $44.5 million, which was paid in December 2010. In October 2012, the Board declared another special dividend of $1.00 per share, or $57.3 million, which was paid out on December 11, 2012 to stockholders of record as of the close of business on November 27, 2012. Both the 2012 and 2010 special dividends represented only a portion of our cash reserves, which the Board believed was sufficient to cover our current operational needs, and to fund continued research and development investments and current strategic initiatives. The Board did not declare any dividends during fiscal year 2013 and there is no assurance with respect to the payment of any dividends in the future.
Stock Repurchase Program
In August 2011, our Board authorized the repurchase of up to 3.0 million shares of common stock under a repurchase program, which terminated pursuant to its terms in April 2012. The stock repurchase program was carried out at the discretion of a committee comprised of our Chief Executive Officer and Chief Financial Officer through open market purchases under a Rule 10b5-1 trading plan. We paid for these repurchases with available cash and cash equivalents. During the year ended December 31, 2011, 1.8 million shares were repurchased, at an average price of $19.61 per share, totaling $36.2 million. During the year ended December 29, 2012, 1.2 million shares were repurchased, at an average price of $22.74 per share, totaling $26.3 million, which completed the stock repurchase program.
In February 2013, our Board authorized the repurchase of up to 6.0 million shares of common stock under a new repurchase program which is expected to continue for a period of up to 36 months from the effective date of the program unless it is terminated earlier by the Board. The stock repurchase program may be carried out at the direction of a committee comprised of our Chief Executive Officer and Chief Financial Officer, through open market purchases, block trades, one or more trading plans adopted in accordance with Rule 10b5-1 of the Securities and Exchange Commission, and in privately negotiated transactions. Any repurchases will be subject to the availability of stock, general market conditions, the trading price of the stock, available capital, alternative uses for capital and our financial performance. We expect to fund the stock repurchase program through our available cash, future cash from operations, or other potential sources of capital. During the year ended December 28, 2013, 1.0 million shares were repurchased, at an average price of $19.79 per share, totaling $19.8 million.
Cercacor
Cercacor is an independent entity spun off from us to our stockholders in 1998. Joe Kiani and Jack Lasersohn, members of our board of directors, are also members of the board of directors of Cercacor. Joe Kiani, our Chairman and Chief Executive Officer, is also the Chairman and Chief Executive Officer of Cercacor. We are a party to a cross-licensing agreement with Cercacor, or the Cross-Licensing Agreement, which was amended and restated effective January 1, 2007, that governs each party's rights to certain intellectual property held by the two companies.
Under the Cross-Licensing Agreement, we granted Cercacor 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 monitoring of non-vital signs measurements and to develop and sell devices incorporating Masimo SET® for monitoring non-vital signs measurements in any product market in which a product is intended to be used by a patient or pharmacist, which we refer to as the Cercacor Market, rather than a professional medical caregiver. We also granted Cercacor a non-exclusive, perpetual and worldwide license, with sublicense rights to use all Masimo SET® for the measurement of vital signs in the Cercacor Market.
We exclusively license from Cercacor the right to make and distribute products in the professional medical caregiver markets, referred to as the Masimo Market, that utilize rainbow® technology for the measurement of carbon monoxide, methemoglobin, fractional arterial oxygen saturation hemoglobin, which includes hematocrit. In December 2013, we exercised our option to license five additional parameters at the pre-established price of $0.5 million per parameter. The license is currently subject to certain specific annual minimum aggregate royalty payment obligations in the amount of $5.0 million per year. To date, we have developed and commercially released devices that measure carbon monoxide, methemoglobin and hemoglobin using licensed rainbow® technology. We also have the option to obtain exclusive licenses to make and distribute products that utilize rainbow® technology for the monitoring of other measurements, including blood glucose, in product markets where the product


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is intended to be used by a professional medical caregiver. In February 2009, in order to accelerate the product development of an improved hemoglobin spot-check measurement device, Pronto-7®, we agreed to fund additional Cercacor's engineering expenses. Specifically, these expenses included third-party engineering materials and supplies expense, as well as 50% of total Cercacor's engineering and engineering related payroll expenses from April 2009 through June 2010, the original anticipated completion date of this product development effort. Since July 2010, Cercacor has continued to assist us with product development efforts and charged us accordingly. Beginning in 2012, due to a revised estimate of the support required by us to complete the various Pronto-7® related projects, our Board of Directors approved an increase in the percentage of Cercacor's total engineering and engineering related payroll expenses funded by us from 50% to 60%. During the year ended December 28, 2013, and until both parties agree to end these services, Cercacor has and will continue to assist us with continuing productization efforts of the new handheld noninvasive multiparameter testing device, that provides spot-check hemoglobin testing. During the year ended December 28, 2013, the total expenses for these additional services, material and supplies totaled $4.1 million.
Pursuant to authoritative accounting guidance, Cercacor is consolidated within our financial statements for all periods presented. This determination is based on our ability to direct the activities that most significantly impact Cercacor's economic performance, and our obligation to absorb Cercacor's expected losses. For the foreseeable future, we anticipate that we will continue to consolidate Cercacor pursuant to the current authoritative accounting guidance; however, in the event that Cercacor is no longer considered a variable interest entity (VIE), or in the event that we are no longer the primary beneficiary of Cercacor, we may discontinue consolidating the entity. For additional discussion of Cercacor, see Note 3 to our accompanying consolidated financial statements.
Business Combinations
On March 9, 2012, we acquired substantially all of the assets of Spire Semiconductor, LLC, a maker of advanced light emitting diode and other advanced component-level technologies. Masimo Semiconductor, Inc. (Masimo Semiconductor), our wholly-owned subsidiary, operates the business. This acquisition provided us an advanced ability to develop custom components, accelerate development cycles, and optimize future product costs. Masimo Semiconductor specializes in wafer epitaxy, foundry services, and device fabrication for biomedical, telecommunications, consumer products and other markets. For additional information, see Note 4 to our accompanying consolidated financial statements. On July 27, 2012, we acquired PHASEIN AB (Phasein), a developer and manufacturer of ultra-compact mainstream and sidestream capnography and gas monitoring technologies. The acquisition of Phasein's technologies complements our breakthrough innovations for patient monitoring with a portfolio of products ranging from OEM solutions for external "plug-in-and-measure" capnography and gas analyzers and integrated modules to handheld capnometer devices. With multiple measurements delivered through either mainstream or sidestream options, our customers can benefit from CO2, N2O, O2, and anesthetic agent monitoring in many hospital environments, such as operating rooms, procedural sedation and intensive care units. For additional information, see Note 4 to our accompanying consolidated financial statements.


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Results of Operations
The following table sets forth, for the periods indicated, our results of operations expressed as Dollar amounts and as a percentage of revenue.

                                       Year ended                Year ended                Year ended
                                      December 28,              December 29,              December 31,
                                          2013                      2012                      2011
                                                 % of                      % of                      % of
                                   Amount       Revenue      Amount       Revenue      Amount       Revenue
                                                     (in thousands, except percentages)
Revenue:
Product                          $ 517,429       94.6  %   $ 464,928       94.3  %   $ 406,487       92.6  %
Royalty                             29,816        5.4         28,305        5.7         32,501        7.4
Total revenue                      547,245      100.0        493,233      100.0        438,988      100.0
Cost of goods sold                 188,418       34.4        166,982       33.9        144,854       33.0
Gross profit                       358,827       65.6        326,251       66.1        294,134       67.0
Operating expenses:
Selling, general and
administrative                     215,469       39.4        193,948       39.3        169,205       38.5
Research and development            55,631       10.2         47,077        9.5         38,412        8.8
Litigation award and defense
costs                                8,010        1.5              -          -              -          -
Total operating expenses           279,110       51.0        241,025       48.9        207,617       47.3
Operating income                    79,717       14.6         85,226       17.3         86,517       19.7
Non-operating income (expense)      (3,991 )     (0.7 )       (1,405 )     (0.3 )           14          -
Income before provision for
income taxes                        75,726       13.8         83,821       17.0         86,531       19.7
Provision for income taxes          20,005        3.7         21,883        4.4         22,478        5.1
Net income including
noncontrolling interests            55,721       10.2         61,938       12.6         64,053       14.6
Net (income) loss attributable
to noncontrolling interests          2,660        0.5            334        0.1           (353 )     (0.1 )
Net income attributable to
Masimo Corporation stockholders  $  58,381       10.7  %   $  62,272       12.6  %   $  63,700       14.5  %

Comparison of the Year ended December 28, 2013 to the Year ended December 29, 2012
Revenue. Total revenue increased $54.0 million, or 11.0% to $547.2 million for the year ended December 28, 2013, from $493.2 million for the year ended December 29, 2012. Product revenues increased $52.5 million, or 11.3%, to $517.4 million in the year ended December 28, 2013 from $464.9 million in the year ended December 29, 2012. This increase was primarily due to higher consumable sales resulting from an increase in our installed base of circuit boards and pulse oximeters which we estimate totaled 1,205,000 units at December 28, 2013, up from 1,088,000 units at December 29, 2012. Contributing to the increase in our product revenue was our rainbow® technology product revenues, which increased $8.5 million, or 21.3%, to $48.8 million in the year ended December 28, 2013 from $40.3 million in the year ended December 29, 2012. Product revenue related to our acquisition of Phasein and Masimo Semiconductor businesses approximated $12.8 million and $3.8 million, respectively for the year ended December 28, 2013, compared to $4.4 million and $3.1 million, respectively, for the year ended December 29, 2012. Revenue generated through our direct and distribution sales channels increased $42.6 million, or 10.8%, to $438.8 million for the year ended December 28, 2013, compared to $396.2 million for the year ended December 29, 2012. During the year ended December 28, 2013, revenues from our OEM channel increased $9.9 million, or 14.4%, to $78.6 million from $68.7 million in the year ended December 29, 2012.
Our royalty revenue increased $1.5 million to $29.8 million in the year ended December 28, 2013, from $28.3 million in the year ended December 29, 2012. This increase in revenue was due to an increase in eligible Covidien U.S. pulse oximetry sales.
Cost of Goods Sold. Cost of goods sold increased $21.4 million to $188.4 million in the year ended December 28, 2013, from $167.0 million in the year ended December 29, 2012. Our total gross margin decreased to 65.6% for the year ended December 28, 2013 from 66.1% for the year ended December 29, 2012. Excluding royalties, product gross margin declined to 63.6% for the year ended December 28, 2013 from 64.1% for the year ended December 29, 2012. This slight decline in product gross margin was primarily due to the negative impact of foreign exchange rates, as well as incremental inventory and asset valuation provisions associated with product and sourcing transitions, which were partially offset by other manufacturing cost reductions. We incurred $5.4 million and $5.0 million in Cercacor royalty expenses for the years ended December 28, 2013 and


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December 29, 2012, respectively, which have been eliminated in our consolidated financial results for the periods presented. Had these royalty expenses not been eliminated, our reported product gross profit margin would have been 62.6% and 63.0% for the year ended December 28, 2013 and December 29, 2012, respectively. Selling, General and Administrative. Selling, general and administrative expenses increased $21.5 million, or 11.1%, to $215.5 million for the year ended December 28, 2013 from $193.9 million for the year ended December 29, 2012. Excluding the new medical device excise tax of $6.3 million, selling, general and administrative expenses increased $15.2 million, or 7.9%, to $209.1 million for the year ended December 28, 2013 from $193.9 million for the year ended December 29, 2012. This increase was primarily due to $8.4 million of additional payroll and related costs associated with higher staffing levels related to the establishment of our new worldwide blood management sales team. Included in total selling, general and administrative expenses are $2.5 million of direct expenses incurred by Cercacor for each of the years ended December 28, 2013 and December 29, 2012.
Research and Development. Research and development expenses increased $8.5 million, or 18.2%, to $55.6 million for the year ended December 28, 2013 from $47.1 million for the year ended December 29, 2012. This increase was primarily due to increased payroll and payroll related costs of $4.1 million associated with increased research and development staffing levels due to investment in research and development efforts. In addition, new project costs and engineering supplies increased $1.2 million related to new product development projects and additional clinical trial costs. Included in total research and development expenses are $3.9 million and $3.7 million of engineering expenses incurred by Cercacor for the year ended December 28, 2013 and December 29, 2012, respectively.
Litigation Award and Defense Costs. For the year ended December 28, 2013, we recorded a charge for $5.4 million in damages awarded by an arbitrator on an employment claim filed by certain former physician office sales representatives. In addition, we recorded a charge for $2.6 million in defense costs related to such employment claim that our insurance carrier believes may not be reimbursable. While we intend to challenge the arbitrator award and the insurance carrier's position, there can be no assurance that we will prevail. We did not record any similar charges in the year ended December 29, 2012. Non-operating income (expense). Non-operating expense was $4.0 million for the year ended December 28, 2013, as compared to non-operating expense of $1.4 million for the year ended December 29, 2012. This net change of $2.6 million was primarily due to the recognition of $4.0 million of net realized and unrealized losses on foreign currency denominated transactions during the year ended December 28, 2013, as compared to $1.6 million during the year ended December 29, 2012. The net realized and unrealized losses recognized during the year ended December 28, 2013 and December 29, 2012 resulted primarily from the strengthening of the U.S. Dollar against the Japanese Yen, partially offset by the weakening of the U.S. Dollar against the Euro.
Provision for Income Taxes. Our provision for income taxes was $20.0 million for the year ended December 28, 2013 compared to $21.9 million for the year ended December 29, 2012. Our effective tax rate increased slightly to 26.4% for the year ended December 28, 2013, compared to 26.1% for the year ended December 29, 2012. This increase in the effective tax rate was due primarily to the establishment of a valuation allowance against the net deferred tax assets of Cercacor, which was partially offset by the retroactive reinstatement of the federal research tax credit pursuant to the American Taxpayer Relief Act of 2012 (Tax Act). The Tax Act extended the research tax credit retroactively to 2012 and prospectively through the end of 2013. The effects of the change in the tax law were recognized in the first quarter of fiscal 2013, which is the quarter when the law was enacted, and resulted in a rate benefit of approximately 1.4% for the year ended December 28, 2013.
Our effective tax rate was lower than the U.S. federal statutory rate primarily due to research and development tax credits and a portion of our earnings being generated from countries other than the U.S., where such earnings are generally subject to lower tax rates than the U.S. We expect this trend to continue in the future. We have made no provision for U.S. income taxes or foreign withholding taxes on the earnings of our foreign subsidiaries as these amounts are intended to be indefinitely reinvested in operations outside the U.S.
Comparison of the Year ended December 29, 2012 to the Year ended December 31, 2011
Revenue. Total revenue increased $54.2 million, or 12.4%, to $493.2 million for the year ended December 29, 2012 from $439.0 million for the year ended December 31, 2011. Product revenues increased $58.4 million, or 14.4%, to $464.9 million in the year ended December 29, 2012 from $406.5 million in the year ended December 31, 2011. This increase was primarily due to higher consumable sales resulting from an increase in our installed base of circuit boards and pulse oximeters which we estimate totaled 1,088,000 units at December 29, 2012, up from 979,000 units at December 31, 2011. Contributing to the increase in our product revenue was our rainbow® technology product revenues, which increased $6.2 million, or 18.2%, to $40.3 million in the year ended December 29, 2012 from $34.1 million in the year ended December 31, 2011. Product revenue of $464.9 million during the year ended December 29, 2012 included $4.4 million and $3.1 million from the recently acquired Phasein and Masimo Semiconductor businesses, respectively. Revenue generated through our direct and distribution sales channels increased $53.3 million, or 15.6%, to $396.2 million for the year ended December 29, 2012, compared to $342.9 million for the year ended December 31, 2011. During the year ended December 29, 2012, revenues from our OEM channel


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increased $5.1 million, or 8.0%, to $68.7 million from $63.6 million in the year ended December 31, 2011. Included in this increase was $3.6 million from the recently acquired Phasein business.
Our royalty revenue decreased $4.2 million to $28.3 million in the year ended December 29, 2012 from $32.5 million in the year ended December 31, 2011. This reduction in revenue was primarily due to a reduction in the royalty rate from . . .

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