Masimo Corporation (MASI) Earnings Call Transcript & Summary

All right. Good morning, everyone. Why don't we get started here? Sorry for running a minute late here. I'm Jason Bednar, I cover medtech here at Piper. Next fireside chat is with Masimo. Very happy to have with us today Masimo's CFO, Micah Young, and VP of Investor Relations, Eli Kammerman. So thanks a lot for being here, both of you. We appreciate making the trip across the country.

So why don't we get right into Q&A. Micah, a lot to discuss. I asked for actually 2 sessions for your fireside chat. They didn't give it to me. But we're going to talk twice as fast.

All right. We will do that.

So why don't we start with the macro patient census in the hospital, visibility you have on the healthcare side of the business? I think you've counseled us in the past really to focus on hospital census and patient volumes. It's really an indicator of the direction of demand and sensor use. Is that still the best indicator long-term?

Yes, absolutely. So if you look at our sensors over the long term, they track within patient admissions, in-patient surgical volumes, especially if you think about surgical volumes, the throughput that we get from the consumption of sensors that go through on those surgeries. That's really how we track is really around the inpatient. The -- we also get in addition inpatient volumes. If you think about our long-range plan, we've always kind of guiding the high single-digit range. And 1% to 3% usually comes from kind of the normal market growth, the inpatient growth. And then, of course, we get share gains that comes through our strong contracting that we've seen. So -- and that gets us to where we've kind of guided set to that 6% to 8% range. We've guided our overall healthcare revenues to 8% to 10%. But that's kind of the breakdown of it. The inpatient volume gives us that nice tailwind to growth.

Okay. Are there other underlying variables we should have in mind when we consider a sensor utilization?

Yes. I think, one of the things we -- in addition to inpatient volumes, of course, we've been tracking ordering patterns with customers very closely. So in addition to just normal kind of the inpatient flow, the census flow, going through the hospitals, that contracting revenue is what really adds on to give us that growth each and every year and that's what gets us up into that 6% to 8% zone.

Okay. I want to come back a little bit to sensor inventories being pretty topical for you the last couple of quarters. It seems like we've had maybe some encouraging developments, just based on the comments from the last quarter call, at least with respect to the direction of order -- sensor orders. So maybe can you expand on what exactly this means? Are you actually seeing order volumes growing month-over-month, so like July better than June, August better than July, and so on?

Yes. So we're seeing good in terms of the last 4 months, especially as we were moving into providing guidance for this quarter, we've seen steadily improvement in terms of sensor utilization. We think that, that's stabilized. We think the majority of the inventory challenges that we've seen as we kind of transitioned away from those larger ordering patterns that we've experienced over the last few years during COVID. Inventory, we believe, the majority of that is behind us. There will still be some pockets here and there, but the majority of that issue is behind us. Now we've got a much better feel for kind of where things are landing on utilization. We've monitored -- I mean I'm monitoring them daily kind of what we're seeing in terms of ordering patterns from our customers. And we feel like things are back. If you look at another important metric for us is, as we think about consumable revenue per driver, that's -- that we're seeing that very close to what we saw back in 2019. And we had a much smaller installed base back then. It's about 1.8 million drivers. Today, we're sitting around 2.5 million. And if you recall, back during 2020, we shipped probably about 240,000. We shipped double the amount of drivers that we typically ship. We were running about 60,000 a quarter back then, about 240,000 a year, we shipped 480,000. So call it 240,000 of that 2.5 million installed base, call it, 10% of that is probably lower utilization because it's -- they put it beside the beds. They added more beds to hospitals, created more ICU capacity. We had a high-acuity COVID patients going through those hospital systems. And we believe they are moving that and shifting it more to other lower-acuity carriers, but it's going to be -- it's lower utilization. But if you look at the overall revenue per driver of our consumables, even with that 2.5 million drivers today that includes those lower utilization monitors, we're still seeing things kind of get back to that revenue per driver that we saw back in 2019. And we expect that to improve as we move forward.

Okay. I do want to come back to that point. But first -- maybe first on drivers, we mentioned we had a big bolus of demand during the pandemic. I mean you had ventilators and all -- a lot of different connected care respiratory equipment. The hospitals were investing, and your drivers just exploded in second half of '20 through most of '21, never really reset lower. But now, it seems like it's -- that maybe is starting to happen, some of that retrenchment is happening. You're seeing across hospital equipment, but it seems like you're -- nobody is immune, you're not immune, but are we at a defensible level with drivers? Or I mean, what kind of visibility you have as you look forward that you can do, whether it's 65,000 or 70,000 or 75,000 drivers in a given quarter?

Yes. So right now, with hospitals, constrained budgets, cash flow challenges, we have seen pullbacks in the amount of orders, and we've seen that in the last 2 Quarters. I mean, we were up in the 70s, shipping 70,000-plus drivers a quarter. And that's settled down around 64,000, I believe, in Q2, 63,000 in Q4 -- or Q3. And that's come down. I mean the OEMs, our OEM partners have reduced. They've seen their order books reduced as well. What I believe is happening and based on conversations with sales force and their conversations with hospitals is hospitals are extending the life of that installed base. And I think replacement monitors has been something where those capital budgets are constrained. So they're extending the life of how long they're keeping those. When I look at though the health of our business, we've seen strong contract, and we've seen that. We've seen it in our unrecognized contract revenue, which I'm sure we'll talk about. And -- but what I believe is happening is we go into contracts. We entered into contracts with hospitals, 5- to 7-year contracts. There's typically a minimum volume threshold that's put into those contracts for the amount of sensors that we expect, but we place a lot of that equipment free of charge, for example, and return for the commitment on the sensor revenue. So that gives us our recurring revenue. It's a razor-razorblade model. The way I look at it, though, is the better leading indicator of the strength of our business is how well we're contracting because we are -- since we're providing those -- that equipment and we're often funding that equipment, that's not a concern because we're getting those installed, they're not having to come up with the capital for those. And that's allowing us to continue to place and win new customers, convert new customers at a pretty rapid pace. So although -- albeit we're still behind on the pacing that we're winning new customer business in terms of getting that installed, but we're still seeing strong installations. Even if customers are extending the life of the installed base, we still see strength and growth in our business.

Okay. Your Masimo-branded equipment is bigger today than it was 5 years ago, which probably helps buffer a little bit against some of those OEM challenges. Can you give us a sense what's the mix of the drivers that are Masimo-branded drivers versus those that are going into OEMs? What is that today versus maybe what it was pre-pandemic?

Yes, I'd say we're hovering anywhere between 20% to 25%. I think pre-COVID, we were around 20%. So we're getting up closer to 25% of those drivers that are being shipped out are Masimo-branded.

Okay. All right. That's helpful. So then let's go back to, I think, the sensor question. And I guess one of the things I wanted to probe on, you brought it up and you have a much larger installed base today as a result of pulse ox basically being the de facto diagnostic tool during the pandemic to determine if a patient was deteriorating and needed to be admitted to an ICU. So that's all good. But a lot of those new drivers did go to like the general, what are called, lower utilization setting. So why is 2019 -- this is the question I've been wrestling with a lot -- internally and also like -- discussed with a lot of investors, why is 2019 the right level for sensor utilization when a lot of those new drivers that have come out over the last, call it, 4 years have been probably a greater mix towards general ward or maybe aren't even being used because they're on ventilators that are sitting in the closet?

Yes. Well, I mean, what's encouraging to me is we have that 10% extra that was acquired by hospitals during 2020. And we're still seeing revenue per driver now settling in. Currently, we're seeing it settling in utilization at 2019 rate. So if you strip that out, we would see revenue per driver above 2019. So the reason I look at 2019 is, I mean, we typically see a stepped improvement in revenue per driver every year as we're driving -- leveraging the installed base, especially the equipment we're installing. We're continuously driving more revenue per driver. We're also getting premium for certain sensors as well, upcharge for some of those higher premium sensors. So that -- I look at 2019 as kind of -- feel very good about where we're sitting today, the fact that we're sitting right on that number on our consumable revenue per driver and that includes the extra -- the infusion of that extra 10% of those drivers. And we expect utilization per driver is going to go up as we go forward.

Okay. Come back to the unrecognized contract revenue. And I know you and Joe have been talking about this quite a bit, and it is really impressive. I mean the growth of that unrecognized revenue is real. What's it going to take to start realizing some of that business? I mean how much control do you have versus how much is it just dependent on hospitals saying, "Yes, we're ready for your drivers. We're ready for the equipment, and we're going to start buying the sensors that we committed to?"

Yes. I mean the last few months, I've spent a lot of time looking at having the team look at diving into are we seeing the translation from customer contract because we've seen our new customer wins, some of that up 3 -- 2 to 3x what we saw even pre-COVID levels in terms of winning new business. And we have to, to continue to grow at this pace and outpace the market. But we've seen good translation of revenue into -- from those contracts, and that was a concern, are we not seeing it? But it's helping offset some of the lower utilization we've seen. But what we've got to do is there's still challenges. There's really -- right now, there's 2 things that are challenging for us. One is we have seen longer OEM lead times with our partners to be able to get the equipment for install. We've also seen the challenges with scheduling at hospitals that has slowed us down, especially with staffing. It seems like staffing is getting better. So that's going in the right direction now. But some of the things we're doing is -- we've got the resources internally. We've redirected on the team to really focus on the installs to make sure that when things become available, we're ready to go. That's been in our control. The other thing we've done is we've looked at trying to secure some equipment that can help us go in, convert until we have the equipment from the OEMs. So some of those things are helping. But again, the installations that we're seeing, the level of installations is very strong. It's just as strong as it was even back in 2019. But we're not keeping pace with the new customer wins on contract, and that's where we're seeing backlog. Our unrecognized contract revenue increased about 4% sequentially from Q2 to Q3, and we're up about 16% year-over-year. So it's encouraging. That's going to be a nice tailwind for us. We just got to continue to focus on installs.

Okay. I'll ask you the same question I probably asked you probably a half dozen times on this unrecognized contract revenue. I'm going to compare against my notes to see if the answer has changed. What are the -- what's driving -- is there another factor driving it? Is there -- are you talking about now longer contracts that are helping drive some -- like some of that increase in, call it, the backlog? Are the terms just more favorable, more like higher guarantees? Or is this purely all new customers that are coming in or like growth of the customer base?

Yes. I mean it's a combination. So our contract ranges usually are about 5 to 7 years. I would say they were probably more of the 5% to 6% range. We're seeing it probably 6-plus on average, so -- and the reason for that is we're getting much larger customers. And a lot of them will sign up for larger commitments in longer term. So that is a combination, but we're seeing the strength -- really the bulk of that strength coming through just gaining new business.

Okay. I may come back to margins. This is why I needed a full 50 minutes or a full hour to talk to you guys. There's so much to talk about. But let's talk about 2024 for a little bit. I think investors are having really a hard time trying to peg the right growth level for each of your businesses, the healthcare business, the non-healthcare business as well as what margins and earnings are going to look like. I mean, you look at street estimates right now, you could drive a truck through where the street is currently sitting. It's a little atypical for your business. You used to be really predictable, and it was a pretty narrow range out there. So the street is at, I think, modeling 3% revenue growth, 6% EPS growth. I'll just take your temperature on how you feel on each of those right now.

I mean, right now, I feel pretty good. We're still working through the budgets. I mean, in the next 3 weeks, I'm reviewing budgets with our -- with each of our team members, and we'll be able to size all that up. But we feel good about heading into next year. The healthcare business, I mean, it's strong. We just got to work through understanding those comps. I mean we've got tough comps in Q1, easier -- very easy comps in Q2. And I just need to understand kind of the trajectory going into next year. But we believe the underlying health of that business is going to get back to growth. And it's just a matter of what does that look like? Is it mid-single digits? Is it high-single digits? That's what we're working through. On the consumer side, it's more -- I got to work through with the teams to understand -- we've got some tough comps in Q1. That was a very strong quarter for that business, so -- but the hearables products are doing very well. They doubled in revenue year-over-year. They're also now at -- they were, call it, 4% or 5% of revenues a year ago, maybe 3% or 4% of revenues. Now they're up close to 10%. So that could help stabilize where you've got a tough macro environment where the core audio is being challenged right now. But the growth in hearables could help us to offset some of that softness. So still a lot to work through. But based on what the numbers you just mentioned, I'm feeling pretty good.

Okay. All right. Great. Within the outlook and, again, we -- you don't have to get too specific here. But just as we talk -- maybe talk -- think high level and talk about gross margins, they've been under considerable pressure. I know this has been probably a frustration of yours. We've talked a lot about it over the last few quarters. And some of it has been outside your control, especially the situation in Mexico. You're exposed to moving the peso, you're exposed to labor wage inflation in Mexico. But you're shifting a lot of that production over to Malaysia. So maybe give us a sense, does Malaysia enable -- move -- that shift to Malaysia, can you realize benefits in '24 from that shift? That's question one. And then question two would be how much of what you've lost can you get back?

Yes. Before I jump into Malaysia, real quick, I want to step back. The gross margins that we saw when they were kind of around their peak was around -- we were getting around 66%, maybe even a little bit better than that. This year, we're sitting around 61%. So we've had about 500 basis points of headwinds, challenges over the years. And if you look at it, the pace that we're heavy down in Mexico, as you mentioned. The peso has strengthened against the dollar, and that's probably created at least 200 basis points of headwinds for us. We've had supply chain challenges come and go, like it's very heavy in the past couple of years, especially when there's chip shortages, we had to navigate that. We had high freight costs. We've experienced labor inflation, but a lot of that is starting to subside. So that's, underlying, starting to improve, but then we've had those other headwinds with Mexico. So it's not only the peso, but it's also labor inflation. So minimum wages in Mexico have increased over the last 3 years, about 20% to 25% a year. We've been really watching closely because Malaysia now is about 30% cheaper on -- or lower cost on the labor rate. So this last year of increase had -- has put Mexico labor well ahead of -- or higher than what we see in Malaysia, so we're trying to transition there. We want to get up to about 80%, 85% of our high-volume sensors manufactured in Malaysia. And we believe we'll be about halfway there second half of next year. We believe we'll be all the way transitioned by the second half of 2025. So we've already had a lot of transition going on. So a lot of those headwinds are already in our run rate. What we're trying to do is neutralize as we start to move equipment around and shift that over into production over in Malaysia, trying to neutralize the impact of that and hopefully, create a tailwind for us moving forward over the next -- even into 2024. So if we look at it, I think Malaysia could give us 100 -- 200 basis points of margin opportunity over the next couple of years. So -- and we'll be fully ramped up second half of '25.

Okay. As you bring that online in the second half '24, do we see the margin benefits immediately? Or does it take a bit of time to get those?

I think we'll start to see it in the second half of next year.

Okay. Yes. Where are you at in terms of like facility and like the build-out of that facility? Is this a Masimo-owned facility? Are you working with like a contract manufacturing?

No, we're leasing the facility. So that's minimizing some of those headwinds as well.

Okay. All right. Great. Maybe go back to the Investor Day. I know we've got just a few minutes left here. But you laid out some growth rates out to 2028 based off of 2023 numbers, which are different today than they were then. But at least thinking about the growth rates, I want to hold you to like what that implies for '28. I know that's still several years away. But I think you've laid out 7% to 9% revenue CAGR, 10% to 12% EBITDA CAGR. Do you still feel comfortable -- if we were to like have that Investor Day again today, do you feel comfortable with those long-term growth rates that you have out there for revenue and EBITDA?

Yes. We still got to work through '24. But I think over the long term, I think -- that's -- the goal is to be on that track for EBITDA growth. Plus, I think we've seen the worst of the headwinds on gross margins, and I think we've got a great opportunity to continue to lever our operating expenses. So that would be our -- definitely our target for the long term.

Okay. All right. Trying to even figure out how to even manage these last 2 minutes we've got. As an activist investor, you have Apple, you have some corporate governance and Board updates here recently. I really could go on either of these for probably 10, but maybe on Apple. So we're waiting on Biden for -- to basically make a decision on this recent USITC decision. Apple has already said they're going to appeal the Federal Court case -- to the Federal Court. But I guess, do you have a sense on whether or not they're going to get their stay that they're going to try and get , so they can still sell the Apple Watch even while that appeals process is going on?

Still a lot of back and forth with the attorneys. A lot of things I'm not even privy to. So there's 60 days under presidential review, that will take us, I think, to December 26, and we'll know a lot more then. What we're trying to understand is what has Apple done to work around removing the infringing technology. We don't know that -- I don't know that. And -- but then you move forward to December 26, and as long as there's no veto by the President, and either the President supports the decision by the Commission or does nothing, then that ban would go into effect unless they have some stay that comes in place. But still a lot to -- it's hard to speculate on that right now.

Are you anticipating Apple to have some kind of workaround? I mean that's...

I don't know. I can't answer that question, but that's what we're trying to understand.

Okay. All right. I guess last 10 seconds. We can go over maybe 30 seconds, I know, because we're running a little bit late. I know you're working through 2024 budgets. But if we're sitting here, again, a year from now at this conference next year, I guess, how would you expect the business to be different and -- sorry, the same? What's different? What's gotten better? Yes, just maybe a forward-looking view.

Yes. I mean I think the underlying growth of this -- of our healthcare business is going to come back and be fully visible next year. I think we'll see the strength of that coming back. And I think we'll start to see the right progression on gross margins. There's been a lot of focus on that as well as cash flow and inventory and things that have been challenging over the past few years. But I think gross margin improvement, expansion, and hopefully, we'll start to see some very good traction on some of those consumer health products that we are launching.

Okay. Great. Well, thanks so much for being here. I know we're out of time. Micah and Eli, thank you so much for making the trip. Everyone in the room, thanks for your attention, and join me in thanking Micah and Eli.

All right. Thank you.