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Presentation

Operator: Good afternoon ladies and gentlemen and welcome to Masimo’s First Quarter 2024 Earnings Conference Call. The company’s press release is available at www.masimo.com. At this time, all lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. I’m pleased to introduce Eli Kammerman, Masimo’s Vice President of Business Development and Investor Relations. Please go ahead.

Eli Kammerman: Hello, everyone. Joining me today are Chairman and CEO, Joe Kiani; and Executive Vice President and Chief Financial Officer, Micah Young. This call will contain forward-looking statements which reflect management’s current judgment including certain of our expectations regarding fiscal year 2024 financial performance. However, they are subject to risks and uncertainties that could cause actual results to differ materially. Risk factors that could cause our actual results to differ materially from our projections and forecasts are discussed in detail in our periodic filings with the SEC. You will find these in the Investor Relations section of our website. This call will also include a discussion of the potential separation of our consumer business and a preliminary estimate of the financial impact of a potential separation.

However, the estimate is being provided solely for illustrative and informational purposes. The company is currently evaluating the structure of any potential separation of its consumer business and the method structure, timing and terms of any such potential separation are still under consideration and have not been determined, approved or finalized. Please refer to Slides 2 and 3 of our earnings presentation for additional factors to consider in evaluating and reviewing the information relating to the potential separation of our consumer business. Also, this call will include a discussion of certain financial measures that are not calculated in accordance with generally accepted accounting principles or GAAP. We generally refer to these as non-GAAP financial measures.

In addition to GAAP results, these non-GAAP financial measures are intended to provide additional information to enable investors to assess the company’s operating results in the same way management assesses such results. Management uses non-GAAP measures to budget, evaluate and measure the company’s performance and sees these results as an indicator of the company’s ongoing business performance. The company believes that these non-GAAP financial measures increase transparency and better reflect the underlying financial performance of the business. Therefore, the financial measures we will be covering today will be primarily on a non-GAAP basis unless noted otherwise. Reconciliation of these measures to the most directly comparable GAAP financial measures are included within the earnings release and supplementary financial information on our website.

Investors should consider all of our statements today, together with our reports filed with the SEC, including our most recent Form 10-K and 10-Q in order to make informed investment decisions. In addition to the earnings release issued today, we have posted a quarterly earnings presentation within the Investor Relations section of our website to supplement the content we will be covering this afternoon. I’ll now pass the call to Joe Kiani.

Joe Kiani: Thank you so much, Eli. Good afternoon and thank you for joining us for Masimo’s first quarter 2024 earnings call. For the quarter, we achieved results that show our business is back on track. After a period of robust growth during COVID and the wake of volatility that followed it seems the market has stabilized and we are once again able to forecast more accurately. Our healthcare revenues of $340 million were at the high end of our guidance range driven by strong sensor orders in the U.S. and Europe. We also had record contracting from hospital customers as for the first time ever, we achieved over $100 million in true incremental contract value in the first quarter, demonstrating continued gains in our market share.

Our success in moving the bulk of our manufacturing ahead of schedule to Malaysia from Mexico has yielded improved gross margins. Given that over 2/3 of our sensor production is now in Malaysia as of the end of the first quarter, we see great opportunities ahead for further increases in profitability. We are increasing our guidance today for health care revenues and non-GAAP EPS based on our first quarter results in combination with a more positive outlook for hospital census in 2024. As we announced 1.5 months ago, we are working to separate consumer health care from professional health care on the behest of most of our shareholders. We have made significant progress on the proposed structures for separation and Micah and I will share more details about this later in the call.

With that, I’ll pass it over to Micah to review our first quarter results in more detail and provide an update on our 2024 guidance.

Micah Young: Thank you, Joe and good afternoon, everyone. For the first quarter, our consolidated revenue was $493 million. Health care revenues were $340 million which were at the upper end of our guidance range and represented a 2% decline versus last year. These results were encouraging given the business faced its most difficult year-over-year comparison this quarter. In the second quarter, we expect those comparisons to start to normalize on a year-to-date basis and throughout the rest of this year which is implied in our full year guidance range of 6% to 9% revenue growth. On a constant currency basis, our consumables and service revenues grew 2%, partially offsetting a 21% reduction in capital equipment and other revenues versus the prior year period.

The decline in capital is expected given the extra purchasing many hospitals did during COVID. Within consumables and service revenues, our SET pulse oximetry consumables grew 2% due to a difficult comparison but we expect growth to normalize throughout the remainder of this year. Our capnography disposables grew 27% and now comprise over half of the category. Additionally, brain monitoring sensors grew 17% as our SedLine and O3 products continued to gain market share. Offsetting this growth was an 11% decline in rainbow consumable revenues due to the timing of shipments outside the U.S. Most importantly, you can see evidence of our market share gains and our strong contracting with hospitals. As shown in our slides today, the value of incremental new contracts signed in the quarter has more than doubled over the past 4 years, yielding appreciable market share gains.

This has contributed to 11% growth in our unrecognized contract revenues over the past 12 months. This consistent growth in our contracts demonstrates our decades-long experience and relationships with hospital systems and our success in continuing to win new customers from our competitors. And we expect these contracts to translate into a meaningful source of revenue growth this year and beyond. It is clear to us that over any meaningful period of time, we have gained tremendous market share. Non-health care revenues were $153 million which was at the midpoint of our guidance range and represented a 29% decline on a constant currency basis versus the prior year. Like health care, this business also faced its most difficult year-over-year comparison this quarter.

If you recall, our consumer business had a strong first quarter last year before macroeconomic conditions, including higher interest rates, began weighing heavily on consumer spending for luxury and premium products. While we expect comparisons to ease over the course of the year, market conditions remained challenging as we expected. Now moving down the P&L. For the first quarter of 2024, we reported consolidated non-GAAP gross margin of 52% which included 62% gross margins in health care and 29% in non-health care. Notably, health care gross margins improved by 110 basis points sequentially and were 50 basis points above the high end of our guidance range. The health care margin improvement is attributable to the benefits of moving our sensor manufacturing to Malaysia, combined with increased operational efficiencies and a favorable mix from consumables and service.

For our consolidated business, non-GAAP operating profit was $68 million and non-GAAP earnings per share was $0.77 for the first quarter. Moving to cash flow. We generated operating cash of $46 million in the first quarter which helped to pay down $28 million of debt. Strong cash flow generation continues to be a key area of focus and results have improved significantly. With the first quarter behind us, we have moved past the difficult comparisons for the health care business and our guidance implies 7% to 8% revenue growth for the first half of the year and 6% to 9% growth for the second half. Our continued strong hospital contracting and sizable increases in unrecognized contract revenue give us confidence in our outlook for revenue growth.

Now, I’d like to provide an update on our full year 2024 guidance. We are now projecting a consolidated revenue range of $2.055 billion to $2.165 billion. For our health care segment, we are now projecting revenues of $1.355 billion to $1.385 billion which reflects an increase of $10 million for the low end of the range. Although hospital contracting is the most important leading indicator for market share gains and revenue growth, I’d like to address driver shipments for 2024. As I mentioned on last quarter’s call, we think that the replacement cycles of existing equipment have slowed temporarily after the robust COVID demand and have hit a low point in the first quarter. However, we expect to see shipments increase to 55,000 or more in the second quarter and returned to 60,000 or more in the third and fourth quarters of this year.

For the health — for the non-health care segment, we are maintaining our projection for revenues of $700 million to $780 million. Based on our strong first quarter results and how inventory flows through the P&L, we expect to see gross margin further increase this year. Gross margin expansion is a critical focus area for us as it is one of the most significant factors in generating earnings leverage. We are excited to announce that we have already transitioned a large portion of our sensor manufacturing to Malaysia and expect to realize increased efficiencies and lower production costs moving forward. As a result, we are increasing our health care gross margin guidance by approximately 60 basis points at the midpoint to reflect our progress on this important initiative.

For fiscal 2024, we are projecting consolidated non-GAAP gross margin of 52% which now reflects a 62.4% margin for our health care segment and a 32% to 33% margin for our non-health care segment. Due to our strong performance and improved outlook for the health care revenues and gross margins, we are now projecting consolidated non-GAAP operating profit of $309 million to $324 million. Based on these assumptions, we are projecting — we are now projecting a non-GAAP EPS range of $3.54 to $3.70 which represents an increase of $0.10 from prior guidance at both ends of the range, highlighting our strong commitment to operating leverage and earnings growth. Now, turning to our outlook for the second quarter. We are projecting consolidated revenue of $480 million to $510 million.

Non-GAAP operating profit of $67 million to $72 million and non-GAAP earnings per share of $0.73 to $0.79. Please reference the earnings presentation on our investor website for further details. In summary, the outlook for the health care business has improved and we anticipate accelerating growth and expanding margins throughout the year. We have added many new customers to our large contract backlog which should produce higher sensor volumes this year. Now, I’d like to provide you with an update on the ongoing evaluation of options to separate our consumer business. The Masimo executive team is working diligently to gather information and assess the advantages and disadvantages of potential pathways for a separation. The conclusions will then be presented to the Board for their ultimate decision.

The options being considered, among others, are a spin-off of the consumer business in the form of this new stock issued to existing shareholders as a dividend or the sale of at least a majority stake in the consumer business to a third party. A key objective is that any separation would result in a full deconsolidation of the 2 businesses in our financial statements. Another key objective for the proposed structure is to give both businesses the appropriate capital structures and resources to achieve long-term success and maximize shareholder value. We provided a preliminary estimate of the financial impact of a separation on Slide 7 of our earnings presentation. Notably, assuming a separation is completed as outlined, we estimate that health care non-GAAP operating margins would improve by 220 to 380 basis points to reach 23% to 25%.

This would be a big step towards reaching our long-term goal of 30% operating margins for the health care business. Further, if the separation transaction results in cash proceeds to Masimo, we expect to use those proceeds to pay down debt and reduce interest expense which currently amounts to $47 million in our guidance. The timetables for these 2 types of transactions are quite different. A spin to shareholders is likely to be more time consuming could take 12 months to complete. The sale of at least a majority stake in the consumer business could take 4 to 6 months following board approval depending on receipt of required regulatory clearances. We’re advancing the evaluation quickly but rigorously and expect to make significant progress over the next few months.

We will make — we will provide investors with a more detailed update when the Board makes a final decision. With that, I’ll turn the call back to Joe.

Joe Kiani: Thank you, Micah. As our good results and improved outlook for the year show, Masimo is back on track. But before we take your questions, I want to share a few additional thoughts on the separation of our consumer business. Before we announced our plans to evaluate the separation of the consumer business, we engage with and listen carefully to our shareholders’ perspectives. While we believe the consumer health and professional health care have greater potential together, the Board and management are confident we have come up with a way to enact our shareholders’ wishes without materially sacrificing the vision we have for making lives better and building greater shareholder value. With the proposed separation, the consumer business will consist of consumer health products such as freedom and consumer audio products, including Hearables, powered by Masimo technology on some Masimo team members, the consumer business will be appropriately resourced to continue to innovate and pursue this fast-growing and developing market.

Professional health care will retain everything else, including our telehealth and remote patient monitoring products where we continue to see significant interest from hospitals and health care providers and reducing costs and improving outcomes with our transformative technologies and hospital-at-home models. As Micah shared earlier, we expect the concede separation will have an immediate positive impact on the profitability of our professional health care business. I’m incredibly excited about the future for both Masimo businesses and look toward sharing more details about a separation as we make further progress. With that, we’ll open the call to questions. Operator?

Operator: [Operator Instructions] The first question comes from the line of Rick Wise from Stifel.

Rick Wise: Let me start with drivers, if I could. I’m already getting a bunch of questions there. Micah, I heard your comments and you’ve talked about it before. This issue of the COVID-driven demand and buildup of installed base. But several things. One, I don’t think any of us expected a 50,000-unit number. I’m not looking at the approximate number. In the first quarter, help us understand what happened there? And help us more concretely understand why the step-up in subsequent quarters is — you believe it and we should believe it as well?

Micah Young: Absolutely. Thanks, Rick. Yes. So as you mentioned, we hit a low point 50,000 this quarter. If you recall back on the fourth quarter call, I mentioned that we expected to see a low point in drivers before climbing — before recovering back in the first quarter. Right now, we’re expecting that those will step up to 55,000 or more, as I mentioned in my prepared remarks and then 60,000 or more in the back half of the year. What we believe has happened is that there’s been a slower replacement cycle for existing equipment out there. We saw a slowdown of orders coming from our OEM partners. Last year, we expected that it would be soft as we entered the year but then starting to recover back based on what we’re seeing from our internal forecast from our OEM team as well as our direct team in terms of the Masimo-branded equipment.

The Masimo-branded equipment is — demand has still been very strong. And I think that’s heading the right direction as well but the biggest pullback in drivers is really on the OEM side. And like I said, we’re seeing good forecast internally. That’s why we’re including expectations for the remaining quarters of the year and we think it will start to normalize back to above the 60,000 level which is kind of where we were back pre-COVID. One other thing to add is when I look at consumable revenue, we’re seeing good utilization on our — in terms of revenue per driver. As you know, we shipped about 2x the amount of drivers back in 2020 during COVID. We shipped an extra 240,000. That’s about 10% added to our installed base above normal. And the great thing is that we’re still seeing our consumable revenue per driver today is higher than what it was pre-COVID.

It’s a tick higher which tells us that we’re still seeing very good utilization across the installed base and we expect to see consumable revenue per driver increase as we move forward.

Rick Wise: Yes, that’s a great perspective, Micah. I guess I’ll turn 2 other questions, if I could. One, I’m hoping you’ll talk a little bit about the second quarter guide. Solid but maybe a little softer than I might have expected, especially the business stabilizing. It sounds like you’re optimistic on the driver front, we’re seeing new products launching and inpatient admission growth is at the higher end of the 0% to 1% actually above, it seems the 0% to 1% you’ve guided for the year, why aren’t we seeing a stronger second quarter guide, Micah? And then I have one more, if I might.

Micah Young: Yes. Good question, Rick. We believe both businesses this year are back to kind of where we see them historically in terms of kind of back to 2019 and prior. When I look at the health care business, revenues for health care typically have been about 24.7%, 24.8% of full year. Somewhere in that range. And Q2 has always stepped down about 24.4% historically and in Q3 as well. Right now, the guidance is really aligned with that seasonality for the year. And we feel good about kind of where we’re sitting in terms of the guide for the full year. What gives us much more confidence is what we’ve seen in contracting. We’ve seen, like I mentioned, strong contract in the quarter and increase in the contract backlog but it’s still early in the year.

And we don’t want to get ahead of ourselves. We want to be thoughtful and prudent about our guidance. And that’s why we’re holding still the back 3 quarters. But we’re feeling very good about where we are today in terms of the strength of the business.

Rick Wise: And just again, if I could be self and I could ask one more. On Malaysia, I mean one clear stands at positive, obviously, is the progress you’re making in transferring production to Malaysia, 2/3 [ph], I mean, this is well ahead of what I might have expected. Talk about that volume and as that ramps, the implications for the rest of the year as we start to think about gross margin and beyond. It seems like over the next few years, you really — I mean, I feel like your past comments, Micah, have suggested that this could add literally hundreds of basis points back to the P&L. Where are we? How quickly does that happen? And especially this year?

Micah Young: Yes, absolutely. Thank you, Rick. Well, if you look at our guidance, we’re increasing it by about 60 basis points at our midpoint. And we beat the first quarter. We came in better. We’re seeing that transition to Malaysia, taking hold faster than we expected. I think we’re estimating 50% by — as we pass the midyear point and we’re already at 2/3. So I think we expect that to ramp. It’s implied in our guidance for the year. We expect it to continue to ramp up in Q2 and then especially as we exit into Q4. That’s going to give us that 60 basis point increase in the guidance. It was really driven by the transition with Malaysia faster than we expected. And then if you look further out, I mean, we’ve laid out in our earnings presentation, a slide that shows where we think we can take gross margins.

If you look at it, it’s about 350 basis points of improvement as we drive towards our long-term goal of 30% margins. Today, we’re sitting at 62.5%. So that would imply that we get up to 66% to reach that 30% op margin goal. And we’re not giving up. We’re going to — we’ll still continue to focus on moving it even higher than 66%. But right now, we’re comfortable with putting out there a 66% gross margin and 30% operating margin long-term goal. And I think as we look at the initiatives, the 3 key initiatives are continuing to have our engineering teams work on initiatives to reduce product costs, manufacturing initiatives, becoming more efficient as we transition to Malaysia. Not only are we going to see lower labor costs but we’re also going to see — we expect to see increased efficiency.

And then third is really just leveraging the installed base that we’re putting out there and the equipment.

Joe Kiani: One point I just want to make sure the group gets, I’m sure Rick knows this but majority of our drivers come from OEMs. And during COVID, the OEMs ordered a lot. And post-COVID, it’s kind of come back down. I think they’re suffering mostly from dearth of capital dollars. We’re not tied to that. That’s why you’re seeing our true incremental hit a record $100 million because we are converting more and more hospitals. And a lot of that is driving up the drivers that we’re getting, not what they’re normally doing. So if we weren’t doing TIs [ph], is the way we’ve been doing TIs for a couple of years, you see even less driver because a lot of the OEMs are not doing that well.

Operator: The next question comes from the line of Marie Thibault from BTIG.

Marie Thibault: Congrats on a very nice Q1. Nice to see that guide moving higher for the year. I wanted to ask here about the operating margin that you laid out here in the slides for the remain co healthcare, the 23.2% to 24.8%, that was a bit higher than we expected. We were right there with you from that 600 bps of uplift from the consumer audio separation but I don’t think I was factoring in another 220 to 380 bps for additional separation adjustments. Can you help me understand what some of those adjustments are on sort of a practical level? And help us understand how you’re able to get that leverage despite gross margins not at where they were pre-COVID but even though they are improving, not at where they were pre-COVID. So I would love to understand that additional uplift.

Micah Young: Yes. Thank you, Marie. When you look at our health care business and kind of break that down, you mentioned the consumer audio. I’ll start there with consumer audio. Consumer Audio, we’re basically backing off $740 million [ph] of revenue and $29 million of operating profit in our guidance for the year, about 4% operating profit margin. And then, the 220 to 380 basis points is really the improvement from there, taking our healthcare segment margins, operating margins of 21% and moving those up to 23.2% to 24.8% range. What that is, is, if you recall, when we did the acquisition, we put in about a point of investment from selling and marketing expenses. But this also includes another carve-out of expenses for R&D expenses for the team that’s really focused on the wearable products for consumer health.

So when we look at the range, we’re estimating a range of $28 million to $51 million that would get carved out. Again, we’re going with a broad range because we still have a lot to work through internally before we can present to the Board what that — what the parameters look like. But that’s the range we expect. And that would land us at 23.2%, like I said, 24.8% and set us very well on that path to the 30% margin goal long term.

Marie Thibault: Okay. That’s really helpful to understand. And then I heard the commentary about cash flow from operations, generating some of that cash flow this quarter being able to pay down some debt. Pre-Sound United acquisition, one of the key strengths of Masimo was the free cash flow generation. Any way for us to think about with this preliminary estimate, what we could eventually see some of that free cash flow generation return to? Are there levels that we should think about or ways to back into some of those numbers?

Micah Young: Yes, absolutely. If you look at the carve-out costs and we laid those out in the slide, not only do you have on a non-GAAP basis, $28 million to $51 million. But we’re also assuming for now and we still got to work through a lot of this but we’re assuming 50% of the Apple litigation expenses get split. So that’s another, call it, $19 million for the year or $38 million in total but $19 million that we get carved out under that assumption. So what’s been weighing on cash flow has been the litigation expense and also just some of the expenses during the proxy season. And also, just last year, what’s been weighing on it is just we saw some increases in net working capital and now we’re starting to move that in the right direction with our accounts receivable and inventory management.

So I think we would expect to get our cash flow back on track for that long-term goal. Our long-term goal is to get that back up over time to $300 million plus. And it will take a little time to get back there. But I think long term, that’s where we expect to see that cash flow generation from the core health care business.

Operator: The next question comes from the line of Vik Chopra from Wells Fargo.

Vik Chopra: Two for me. So I’ll start with the first one. Really helpful that you put that slide out about the potential impact from the separation. But I was just wondering, when you expect to present the Board with a list of strategic options? Anything you could share about time lines? And then a follow-up, please.

Micah Young: Vik, it was very hard to understand that. What was that on the time line?

Vik Chopra: I’m sorry. I apologize. I was just wondering if you could share anything on the time line about when you can present the Board with a list of options?

Micah Young: We’ve got — we saw some work to do internally. We’re pacing as far as — right now, we’re working as fast as we can to follow the process. We’ve got some things we’re working through on both — on the various options we’ve laid out in the prepared remarks. And we can’t give a definitive time line at this point but we expect to make a lot of progress over the next 30 to 45 days.

Vik Chopra: Okay. Very helpful. And apologies if you already mentioned this before, I was jumping around on calls. But I think you initially assumed in your guidance, 0% to 1% in patient growth. I’m just wondering if you have an update to that and what impacts the higher rotation volumes or — that you’re seeing in the field out there and what impact that has to your guidance?

Micah Young: Yes. Yes. The strength of our quarter really came from sensor growth — sensor volumes that are both in the U.S. and Europe. That also based on what we’re hearing out there in the market is some have reported out early. Some have shown census as high as 3% right now. And we’re still waiting to see others report out but that’s definitely helping our growth. And if that continues, that could be upside for the year for us.

Operator: The next question comes from the line of Mike Polark from Wolfe Research.

Mike Polark: Question for Micah. Wondering if you can provide this disclosure the installed base or the driver base year-on-year in the first quarter, what was the growth rate?

Micah Young: I don’t have the driver installed base right in front of me, I apologize, Jason. Again, we’re really laser-focused right now on the true incremental and how we’re viewing the contracting and how that’s playing into our forecast.

Mike Polark: Okay. Can I maybe ask then like the 50,000 driver shipments, would you — at a high level, I don’t need the precision number but what is the mix of replacements versus net new in that figure?

Micah Young: On the replacements versus net new? We typically [indiscernible].

Joe Kiani: So I think the best way to think about it, Mike, is that whatever our market share is today, that’s probably replacement and the rest is new. We’re not here to tell you what that market share is but what we can tell you is that we think today, the minority of the drivers are new shipments. And a lot of the shipments that we look towards an increasing our business in the future come from what we do as true incremental when we sign up new hospitals to switch from our competitor to Masimo.

Mike Polark: For my second topic, I want to just ask a follow-up on Malaysia and the gross margin update. I’m curious what — when this is fully transitioned, I heard the comment about the change to ’24 60 bps but it’s obviously phasing in throughout the year and ramping throughout the year and then 350 bps on the longer-term margin bridge from gross margin. I’m just curious, the mechanical shift of Mexico to Malaysia kind of from, say, last year to when you think it’s optimized, how much in total is that impact?

Micah Young: Yes, Mike, if you look at the initial impact and we’re reflecting some of that and as you can see in our guidance as we raised it by 60 basis points. But for this year — or for the early start of the transition, the benefit is going to be more in terms of the direct labor benefit and that should be — we’re estimating that to be about 60 basis points of improvement per year. And from that point, we expect to drive increased efficiencies in our manufacturing there as we have improved rates of attrition, turnover in the workforce. We expect it to be a much more stable workforce for us and more efficient workforce based on what we’re seeing so far. So that can definitely get us well above that 60 basis points that we’re seeing. And we’ll see how that plays out. But I would expect that we’re going to be probably over 100 basis points of improvement just from that once we start to see all the efficiencies.

Joe Kiani: Thank you so much, everyone, for joining us for our Q1 earnings call. We look forward to presenting our Q2 with you very soon. Have a wonderful rest of your spring and summer. Thank you.

Operator: Ladies and gentlemen, this concludes today’s conference call. Thank you for your participation and you may now disconnect.