Good afternoon, ladies and gentlemen, and welcome to Masimo's Second Quarter 2011 Earnings Conference Call. The company's press release is available at www.masimo.com. [Operator Instructions] I am pleased to introduce Sheree Aronson, Masimo's Vice President of Investor Relations.

Hello, everyone. Joining me today are Chairman and CEO, Joe Kiani; and Executive Vice President of Finance and CFO, Mark de Raad. This call will contain forward-looking statements which reflect Masimo's best current judgment. However, they are subject to risks and uncertainties that could cause actual results to differ. Risk factors that could cause our actual results to differ materially from our projections and forecast are discussed in detail in our SEC filings. You'll find these in the Investor section of our website. With that, I'll pass the call to Joe Kiani.

Thank you, Sheree. Good afternoon, ladies and gentlemen, and thank you for joining us for an update on our second quarter 2011 financial and operational performance. Our product revenue grew 17%, driven by a 24% increase in our direct business and a 26% increase in our Rainbow revenue. In addition, we shipped 37,300 new drivers, growing our global installed base of drivers by 17% to roughly 922,000. All signaling continued demand for our breakthrough technologies and on a global basis. Despite challenging conditions, including the weak global economy, natural and civil unrest in certain parts of the world and the challenging U.S. regulatory environment, Masimo continued to post double-digit revenue growth, evidence of the strength of our innovations, business model and growth strategy. Our confidence in Masimo's long-term growth prospects and commitment to return value to shareholders was underscored today with our announcement that the board had authorized a stock repurchase program of up to 3 million shares of our common stock over the next 24 months. We are excited to be putting this program in place. I'll provide a strategic summary and market update in a few minutes. But first, I'll pass the call to Mark for an updated detailed review of the results of Q2. Mark?

Thank you, Joe, and good afternoon, everybody. Second quarter 2011 total revenue rose 9% to $109.6 million versus $100.1 million in the year-ago period. Growth was driven by a 17% rise in product revenues to $102.6 million, representing primarily increased consumable sales. Product revenue growth was partially offset by an expected 42% decline in royalty revenue to $7 million, reflecting the impact of the new lower Covidien royalty rate from 13% to 7.75%, effective March 15, 2011. Second quarter SET revenue grew 16% to $93.5 million, reflecting increases in both U.S. and international markets and across both acute and alternate care channels. The total product U.S. growth rate was 13%, while our OUS growth was 25%. Our OUS growth rate was impacted or benefited from stronger direct revenues, while our U.S. growth rate was impacted by lower OEM revenues. Rainbow revenue rose 26% in the second quarter of 2011 to $9.1 million versus $7.2 million 1 year ago. The increase reflects higher sales across all major Rainbow product categories, consumables, licensing, boards and instruments. Total hemoglobin sales were particularly strong, up more than 50% versus the year-ago quarter. Our worldwide end user or direct business, which includes sales through just-in-time distributors, grew 24% in the second quarter to $84.7 million versus $68.1 million 1 year ago. Second quarter 2011 OEM sales were down 10% to $17.9 million from $19.8 million in 2010 due to the reduction of OEM sales of Masimo sensors. However, despite the decline in OEM consumable sales, OEM board sales remained strong, demonstrating the continued demand for our technology among both our OEM partners and their customers. Our direct business represented 83% of product revenues versus 77% in the year-ago quarter, while OEM revenue accounted for 17% of product revenue in the quarter versus 23% in the…

Thank you, Mark. I'll frame my strategic update with the key objectives that provided investors at the start of 2011, beginning with leveraging our global sales force. We've held the size of our sales organization relatively steady over the past few quarters while still delivering 24% growth in direct SET and Rainbow SET sales. And as evidenced by our expanding installed base, we continue the pace of new business wins and renewals. Among the recent additions are Mount Sinai Medical Center in New York, which includes Mount Sinai hospital, one of the nation's largest and most respected hospitals; and South Broward Hospital District, known as Memorial Healthcare. This system includes 6 acute care hospitals serving South Florida. As a strong outside the U.S. revenue performance indicates, we're also experiencing a rise in new international customers, more outside the U.S. healthcare systems are recognizing the benefits of hospital-wide conversion to Masimo. The pace of new multiyear contracts was particularly strong for us in Germany in the second quarter, with recent new Masimo hospital customers in Europe, including DRK Kliniken Berlin, which is a 5-hospital system; and Erasmus Medical Center, a 1,320-bed acute care hospital in Rotterdam, Poland. The key to our progress is our ability to complement our gold standard Signal Extraction Technology pulse oximetry with breakthrough technology such as noninvasive hemoglobin, carbon monoxide and Rainbow acoustic respiration rate monitoring, as well as our Patient SafetyNet system for monitoring patients on the general ward. Another 2011 objective is to increase Rainbow awareness and adoption. In June, despite our ongoing intellectual property litigation, we entered into a long-term Rainbow agreement with Philips. We are now engaged in diligent co-development with Philips, which should allow Rainbow SET platform to be available in Philips products worldwide. Given Philips' significant market share, we believe the…

[Operator Instructions] Your first question comes from the line of Bill Quirk with Piper Jaffray.

First question. In terms of -- thanks, by the way, for the update as it relates to the top line guidance, as well as gross margin. I'm sorry, Joe, did you mention what the -- I guess, what the new expectation is relative to the bottom line at this point?

I did not, but we are not changing our guidance.

Okay, got it. Suffice it to say though, I sense it's looking at the lower end is I think probably the right way to think about it?

Probably.

Okay, got it. And then just thinking about, I guess, the next 6 to 12 months, Joe, if we -- taking your comments about the fact that we haven't really hired many sales reps recently and then just thinking about of the time that it takes generally to train one of these reps. Are you concerned at all about the top line for the business slowing down, I guess, perhaps over and above what you're seeing in the market just because we're going to have a bit of a gap in terms of your new sales assets coming on?

I am not, Bill. And while -- like our technology, we pride ourselves in being adaptive. So we will continue to watch what is going on in the marketplace. And if we need to change what we do with our sales force, whether we should increase it or not or restructure it or whatever may be the case, at this point, just like a year or 2 or 3 years ago, we still believe we built the sales force that is the minimum we need for critical mass in the worldwide markets. So we think with the current sales force we have, we have years of growth ahead of us. And additional salespeople, we will add them slowly, but it won't be the dramatic rise we had in the sales force to get to that critical level that we've done in the last few years.

Understood. And then if I can just sneak in one last one and maybe for Mark. Mark, could you give us a little additional color on the OEM sensors? You mentioned that they were off 10%. Can you give us some additional color here? Or is this any type of restocking effect? Or I guess any additional color would be great.

Sure. In essence, Bill, the primary reason is that some of our OEM customers we believe have opted to essentially no longer purchase our sensors, which in effect, at the end of the day, isn't necessarily a bad thing for us because we believe those sensors ultimately will be procured. They'll just be procured through our direct channel. So ultimately, the devices that are in the field that are being utilized, of course, need those sensors. And if they are not getting them through our OEM partner channel, then they'll pick them up through our direct channel. So it's a bit of a shift, if you will, we believe between those 2 segments of business.

Your next question comes from the line of Joanne Wuensch with BMO Capital Markets.

I have 2 questions. One, we are seeing more and more of a shift outside the United States in terms of revenue growth versus inside United States. Is that a shift in your resources? Or is that sort of a shift in hospital utilization being reflected in those numbers?

We believe it's due to the higher increase in sales force expansion outside the U.S. that we've had in the past few years compared to the U.S. We basically, a few years ago, Joanne, started at almost 0 salespeople outside the U.S. We were mainly relying in our OEM and distributors. In the past few years, we've grown that to about 100 salespeople. In the U.S., we had 30, 40 salespeople that we have now doubled in the past few years in the U.S. So I think the increase is mainly due to the investment we made outside the U.S.

Okay. And then I wanted to ask you this new product that you're talking about launching. What is the name of that? You said E1, but I'm not sure if that's a trade name or an internal name?

That's a trademark, trade name that we call it E1. It's a single-patient-use ear sensor. We think it will have strong application in the trauma, as well as during operation in the OR suite.

And that's being launched now or what is the timeline for that?

Limited market release now, and based on customer feedback, hopefully we'll be launching it in the next few months.

And you have FDA approval for that?

Excuse me?

You have FDA approval for that?

Yes, we do.

Your next question comes from the line of Brian Weinstein with William Blair.

It's actually Pete in for Brian. So about the Rainbow sales, it looks like you're at about $16 million to $17 million for the first half of the year, which analyzes to about the low 30s. Aside from Pronto-7, what factors need to really fall into place in order for you to hit the bottom end of your guidance at $40 million?

Well, I think at the bottom, we're now unfortunately assuming Pronto-7 won't hit in the U.S., although we hope that we still will get Pronto-7 cleared in the U.S. in the next few months. But for now, we're assuming it won't. So I think to hit the lower part of our guidance, there's really no outside factors. It's really just internally delivering on our planned sales throughout our both direct sales force, as well as our OEMs.

And do remember, the Pronto-7 is now shipping internationally. So clearly, we expect some benefit from that in the second half of the year.

Okay. And then, as far as this change that you discussed about to your sensors, is this retroactive to the existing driver units? And can you give us any idea of what the percent cost increase would be per sensor?

Well, it will be retroactive to all of the devices that are prepared to handle this new technology, which will be all of the Rainbow platforms and the new Masimo SET platforms that have been shipping for the last few years. As far as the cost of goods increase, we prefer not to get into that except to let you know that change is initially going to hurt our margins a bit. But we've been working on some very good investments in vertical integration, and we expect to gain that cost back and some in the next, let's say, 6 to 12 months.

Your next question comes from Matt Dolan with Roth Capital Partners.

Just wanted to follow up on that Rainbow question. Going in the back half of the year, clearly, you need to ratchet up the revenue there in the next 2 quarters. Is there any more granularity outside of Pronto-7 you can give on why that increase comes through? I know you had some big orders to compare to last year, so I just want to understand that a little more.

Well the one thing, Matt, I can tell you last year, we kind of did the same thing, although I'm not saying it's going to repeat again, where we lowered our Rainbow estimate for the year and then ended up hitting it anyway because in the first half, we saw kind of numbers that were less than what we projected. But then in the second half, they came back roaring forward. Now this year, it might be a little bit different because due to a lot of the cutbacks on expenditures, we're now less certain about the military order that we received last year that was very helpful. So without that military order happening fully, we still hope to meet the lower end of that range I just spoke about earlier, the $40 million. If we get the military order, then it could be in the middle, but we'll see.

Okay, got it. And then secondly, Joe, we've had a lot of questions in general around the purchasing environment both in Europe and the U.S. Can you give us any feedback in terms of what you're seeing either from your direct group or OEM partners and how that plays into your business here going forward?

Well, yes, sure. I mean, there are certain places like, of course, Japan, that got hit really hard by the earthquake, certain places like around the Middle East, like Egypt, which things have changed so much that orders that were about to come unfortunately were put off indefinitely. So those things have hurt, but the major markets in general to date at least, we have not seen any negative buying indications. As I said earlier, the pace of hospital conversions outside the U.S. is strong and adoption of Rainbow is strong. And I recently traveled around Europe, to several countries. And hopefully, I got the true sampling of our customers. But the customers I went and visited seem to have budget, seem to be motivated to move forward and do positive things for their patients.

Okay, great. And then finally, on the new sensor, are there -- maybe you can walk through some of the competitive implications. Are there any customers that are opting for an alternative sensor for cost reasons and not telling you? And therefore, should we think of any revenue impact relating to this move?

Well, we have been working on this new sensor technology for several years and mainly because we have seen copycat knockoff sensors that are shipped to our customers, and they've performed so poorly that, forget challenging conditions like motion artifact and low perfusion, just normal desaturations of oxygen, they fail to pick up. So we talked to our Scientific Advisory Board, our Customer Advisory Board about this issue several years ago, and they all concluded with us that the best thing to do is to create a technology in the sensors that prevents that to the greatest extent we can. So we hope that our advisors are not just telling us what we want to hear but really are telling us what is exemplary of the customers out there. And if that's the case, no, we should only see a positive impact to what we're doing, except for the initial reduction in margins as we roll this new technology into all of our sensors.

Your next question comes from the line of Lawrence Keusch with Morgan Keegan. Lawrence Keusch - Morgan Keegan & Company, Inc.: I guess either for Joe or for Mark, just philosophically, why return cash to shareholders this time around in a share repurchase versus what you've done in the past with the dividends?

Well, dividends were not something we had ever thought we would do. We may have -- obviously, we reacted foolishly to fears that the capital gains tax were going to go up in 2011. So that's the reason we did the dividends last year. Unfortunately, they did not go up and therefore -- and doesn't look like they're going to go up, especially with the way the economy is going. But -- so we felt this time around, as we think about how to best do what's right for the shareholders, as well as feeling like the stock price is where it's trading recently, seem so out of line with the growth we've experienced since our IPO. In 2007, when we've been public, we've been public at $17 a share. The stock community traded at $21. Since then, we have grown 200%. We've grown a lot, earnings and stability of Rainbow. I mean, there's so much good things. I mean, the new Philips agreement, yet those are not translating to the stock price. So we just felt that maybe the best thing to do right now is to buy some of our shares back. Lawrence Keusch - Morgan Keegan & Company, Inc.: So what you're really saying, it sounds like, just relative to share repurchases, you think now at these levels, this is an opportune time for this company to be buying its stock back in?

That's correct. I mean, we can't predict what's going to happen, but when we look at all of our other options from buying our corporate headquarters to buying companies, we can't see another opportunity that has the same level of return on our investment in the near term. Lawrence Keusch - Morgan Keegan & Company, Inc.: Okay. And then just 2 other ones. Joe, you've commented in past calls that the competitive environment has been one of the factors out there as well. Again, I'm just wondering if you can speak a little bit to what that environment looks like, and I guess if you can parse it into 2 parts. Sort of what are we seeing on contract renewals relative to sensor pricing and then the other part of it, where I think there's some misunderstanding in the marketplace, is just the competition amongst the various competitors out there. Obviously, you and your biggest competitor are probably 80% of the market, and I suspect nobody wants to be too competitive. So if you could just speak to that, that would be helpful.

Sure. I'll be happy to. First of all, we think -- Mark and I believe, along with the board, that our job in these earnings call is to not be cheerleaders for the company, as much as try to express the risks that we see potentially out there. But sometimes we may overemphasize things that are not as bad as they seem. But at the time, we think, "Okay, in hindsight, could we be viewed that we're not sharing as much as we could with our shareholders about the negative?" So last time, we did spend some time talking about the competitive environment. But obviously, that's always there. There's always price pressure there as you compete for market share, which is what we've been in competition for the last several years, close to GPOs opening up to Masimo in the U.S. But I can tell you that things are working fine. We're doing things that are going to reduce our costs, hopefully, more than the competition is going to reduce our ASP. So -- and if I just look at Q2, I can tell you, looking back at Q2, we felt that while prices have adjusted since several years ago when we first got on GPO contracts, it didn't feel like Q2, there was any more downward pressure than we felt any other time. Lawrence Keusch - Morgan Keegan & Company, Inc.: Okay, great. And then lastly, I think you mentioned that hemoglobin sensor sales were up 50% year-over-year. Again, if you could just sort of speak to were they up sequentially, which I assume they were. And kind of, again, what's driving that big year-over-year increase?

Sure. I mentioned hemoglobin in general was up over 50%. The consumables actually did better than that. But, yes, and the growth was not just quarter-to-quarter from a year ago but also sequential.

Your next question comes from the line of Sara Michelmore with Brean Murray. Sara Michelmore - Brean Murray, Carret & Co., LLC: Anyways, just again some granularity on the gross margin outlook here. So it sounds like the 2 items that are kind of flowing through the next 2 quarters, it's the sensor change. And Mark, if you could just talk us through this amortization cost with the instruments because you do have kind of a bolus of that coming through. And just sequentially looking into Q2 and Q4, what should we keep in mind as we do our models, Q2 to Q3 and Q3 into Q4?

Sure. I think what I do first though is just sort of reiterate what Joe had mentioned in some of his prepared remarks and that is that towards the back end of the year, essentially, relative to where we were earlier in the year, we see 2 changes. One is the slight incremental cost that these new sensors are going to contain within them that we've been talking about. And the second is basically the reduction of that Rainbow revenue total, because we had said earlier that one of the ways in which we had hoped to reach the upper end of that gross margin range was on the assumption that we'd be able to do the upper end range of that Rainbow number. So by taking that Rainbow number down, as Joe talked about, that's really the secondary pressure, if you will, on Q3 and Q4 margins. The box placement amortization that you referred to, really, that's something that hasn't changed at all throughout the year. It's something that we did highlight as part of our margin guidance earlier in the year because of the fact that remember, we placed so much capital equipment last year. In fact, the number almost 3x what we've done in prior years. And so that equipment obviously needs to be amortized over the life of that related contract. And because of that, because we placed a lot more equipment in 2010, we're going to see a much higher amortization charge flowing through the cost of sales this year versus what we saw last year. But that was already contemplated in the guidance that we provided earlier in the year. Sara Michelmore - Brean Murray, Carret & Co., LLC: Okay. And then sequentially then, we shouldn't expect any kind of -- I think there is some concern out there that, that number could balloon on you. So it sounds like it's sort of steady-state is what you're saying.

Well, yes. Again, remember, most of that equipment was placed into the market in 2010. Most of that is under 4-, 5-year long-term sensor agreements, and nearly all of that equipment has already been placed. So we start amortizing as soon as that equipment gets placed. And as a result, the current amortization rate that is representative of that large 2010 deployment is essentially already flowing through our numbers. Sara Michelmore - Brean Murray, Carret & Co., LLC: Okay, understood. And then on the SG&A trajectory, the OpEx guidance that you had stated previously sounds like you're not changing anything there. Again, any sort of dynamics Q3 versus Q4 on the OpEx we should keep in mind? And the one I would probably be most interested in was just the legal fees and how you think that's going to translate in the next couple of quarters since that's the big pickup year-on-year.

Sure. Well, the original guidance for the year we provided was $210 million to $215 million in terms of total worldwide operating expenses, and that remains unchanged. Given the operating expenses that we just reported today, $53.1 million, I would -- versus the $51.6 million for the first quarter, I would direct you to sort of look at our quarterly operating expense trends for the past couple of years. And typically, what you see is a slight upward movement in the third quarter and then a more substantial upward movement in the fourth quarter, primarily because that's our big trade show quarter. And so we see a lot of additional expenses there, and typically, it's a stronger revenue quarter. So our sales variable expenses tend to increase in that quarter as well. So I don't see anything to change that trajectory, if you will, of operating expenses for the back end of the year. And as I said before, we still think when you add that all up, it will fall within that $210 million to $215 million range. Legal expenses are always very difficult to forecast because obviously, they're very dependent upon, in our case, when our judge decides to release his next round of instructions. So that -- we have assumed within those operating expense numbers a certain amount of legal expense. But clearly to the extent that we're higher or lower, that could change. But that's something that's very, very difficult to gauge on a quarterly basis. Sara Michelmore - Brean Murray, Carret & Co., LLC: Okay. And finally, just my last question. At this point, do you have any sense in terms of the installed base? What is the portion of the SET gear that's out there of this Rainbow-ready version that you've been shipping for the last several years?

No, I don't think there's any specific detailed information we have. I think, as you know, we typically try to address that more from the perspective of the Rainbow-ready devices that are out there, and as you remember, every bedside device that we shipped since January 2006 is Rainbow-ready. Our best estimate of that, I would say, today, is probably on the order of -- typically, it's been about 10%. So that would get us up today to about 100,000 devices that technically are Rainbow-ready.

Your next question comes from the line of Ben Hanner with Felty & Company. [ph]

Just a couple of big picture items, most of the specific stuff has been asked. On the new E1 sensor, is that a proprietary hardware? Is that a software that you're using to stop the knockoff problem?

Well, first of all, the E1 sensor we believe is protected by patents, some that we acquired from UCSD and some that we developed inside. But then the technology inside of it that allows the accuracy to come out is something we refer to as X-Cal. It's a technology that we put inside our Rainbow systems from the beginning. And all of our reusable products, we're just putting it now into single-patient-use sensors, which will start happening in Q3. And E1, as you know, is a single-patient-use sensor.

Okay. But isn't that something that someone in China could just plug into a logic analyzer and kind of figure out where -- what the signals are doing?

No. Each -- these technologies we're putting in, each of them are proprietary to Masimo that have a specific serial number. There's encryption built into it. So I think they'll find better ways of making a living than messing up with patient care.

Okay. That makes sense. And then after Halo, do you guys have kind of a next math measurement parameter or picked out at least internally? Or is that something that you haven't decided upon yet?

We have. We're working on a couple of hopefully breakthrough products that we hope one of them will prove feasibility soon. And if it does, then we're going to hopefully be announcing it.

[Operator Instructions] You have a follow-up question from the line of Bill Quirk with Piper Jaffray.

Quick, I guess, follow-up question on the new proprietary sensors, Joe. Obviously, I certainly understand the rationale behind wanting to interrupt and arrest any counterfeiting that's going on. But I guess I'm a little confused, from the customer's perspective, do they think that they are currently ordering Masimo sensors and so they are being delivered knockoffs? Or are they deliberately ordering some of these knockoff sensors? I guess I'm just trying to get my arms around just the overall dynamic there.

Bill, both of those things happen. There are some knockoff sensors that we've heard about that -- that have our logo, everything is Masimo. And then there are some that are just knockoff sensors that someone in purchasing decides to buy to save money that the clinicians did not ask for or want. And then they think it's not going to affect anything, yet they put those sensors on, and as you can imagine, it affects, as I mentioned, a lot.

And then -- so from the customer's perspective, I mean, if I want to order knockoff sensors, I guess how is the new sensor going to prevent me from doing that? I mean, I guess I would think that just keeping order records of customers, what their usage patterns have been, if we see a big drop-off but they're on contract, that would clearly be indicative that they're looking at some type of counterfeit product.

Okay, let me explain a little bit more. Right now, we have patents that protect our sensors worldwide. Almost every country, there are some exceptions. And many countries, people do respect the patents, but in some places, they don't. And it's easy for them to violate that patent technologically. With, X-Cal, even if they want to violate the X-Cal patents, the chip that we use in there, they cannot reproduce. And that's why even if they want to create copycat sensors of X-Cal, they should not be able to anymore. I think with that, we're going to end the call. We really appreciate you all joining us and look forward to our next call. Thank you.

This concludes today's Masimo's Second Quarter 2011 Earnings Conference Call. You may now disconnect.