Focus Article: Masimo Corporation (MASI)

Masimo Corporation (MASI) $19.30

The Company:

Started in one of the co-founder’s garage, Masimo Corporation is a medical technology company that was founded in 1989 by current Chairman and CEO Joe Kiani. The company develops, manufactures, and markets noninvasive patient monitoring products worldwide. Besides having a founder at the helm more than two decades after the company was started and a technology moat through nearly 600 patents, the company has a history of solid revenue growth, sports operating margins of 22% and return on equity of 23%. This small cap company with an enterprise value of just under $1 billion and $439 million in annual revenue has 2,500 employees and saw product revenue increase 4-fold in the last five years.

Pulse Oximetry is a way of assessing a person’s breathing by measuring the oxygen saturation of arterial blood. The conventional pulse oximetry method tends to fail because it cannot distinguish between arterial and venous blood during patient motion. The Masimo SET (Signal Extraction Technology), introduced by the company in 1995 after 6 years of R&D,  identifies the venous blood signal, isolates it, and using adaptive filters, cancels the noise and extracts the arterial signal hence reporting true arterial oxygen saturation and pulse rate. The Masimo SET decreased false alarms by 95% and increased true alarm detection by over 97%.

In the year 2005, Masimo Corporation introduced the Masimo Rainbow SET, the first ever noninvasive blood constituent and acoustic monitor. This device prevents painful needle sticks and time-consuming blood draws and reduces the need to wait for lab results. It helps clinicians observe various blood parameters continuously, enabling early detection and treatment of potentially life-threatening conditions. The acoustic monitor displays continuous respiratory rate of patients.

The Masimo Patient SafteyNet System is a remote monitoring and clinician notification system, using wireless technology for connectivity to allow for more efficient sharing of data across IT platforms in hospitals. A 11 month study done at Dartmouth Hitchcock medical center shows that this device has helped in decreasing patient transfers to ICU by 48%, decreased distress codes and rescue activation by 65% and has saved 135 ICU days annually. The latest product introduced by the company is the SEDline Brain Function Monitoring system that helps improve care of patients under anesthesia or sedation.

In Q1 2012, Masimo Corporation shipped 33,300 new Masimo SET and Masimo rainbow SET Pulse Oximeters and Pulse CO-Oximeters. The current estimated worldwide installed base is just over 1 million units, representing 13% year-over-year growth. The company also has OEM agreements with leading patient monitoring manufacturers including Atom, Datascope, GE Medical, Medtronic, Philips, Spacelabs, and Zoll.

Mr. Kiani, who earned a Bachelor’s and Master’s degree in Electric Engineering from San Diego State University a couple of years before founding Masimo, was named Ernst & Young (Orange County) Entrepreneur of the Year last week.

Business Statistics & Financials:

In the first quarter of 2012, Masimo’s total revenue rose 6% to $119 million versus $113 million in the year-ago period. Product revenue for the quarter rose 11% to $112.2 million  due to higher consumable sales to hospitals. OEM sales remained unchanged at $16.2 million. The company derives 72% of its total revenue from the United States.

So why has a company with so much promise lost nearly a third of its value over the last year and is trading close to its 52 week low? The answer lies in the bottom line and margins.

The company reported a drop in operating income to $22.3 million in Q1 2012 compared to $25.4 million in the year-ago period. First quarter 2012 net income was $15.8 million or $0.27 per diluted share compared to first quarter 2011 EPS of $0.30 per share. Gross margins also declined to 66.5% vs. 68% in Q1 2011.

At first blush eroding margins and earnings paint a negative picture until you get into the details. In 2006 Masimo won a $300 million settlement against a division of Tyco Healthcare (now Covidien) for patent infringement. As part of that settlement, Covidien (COV) also started paying royalties to Masimo with an option to stop paying royalties as of March 14, 2011. Covidien decided to extend royalty payments for three more years amounting to 7.75% of sales starting on March 15, 2011.

These high margin royalty payments have been declining since that new 3 year agreement went into effect last year. The decline in Q1 2012 earnings and margins was due entirely to the $4.5 million reduction in royalty payments over the same comparable periods, reflecting the reduction in the Covidien royalty rate from 13% to 7.75%.

As mentioned above, product revenue increased 11% and product gross margins held steady at 64.4%, indicating the company’s core business is alive and kicking. Since the new royalty agreement went into effect late in Q1 2011, year-over-year comparisons are going to get better starting this quarter.

The company has a very strong balance sheet with nearly $129 million in net cash, which exceeds total liabilities of $105.46 million. Masimo also trades at a reasonable valuation of less than 10 times EBITDA and less than 15 times estimated 2013 earnings.

The company repurchased approximately 1.8 million shares in Q4 2011, around 1 million shares in March 2012 and approximately 200,000 shares in early Q2 2012. As a result, their weighted average shares outstanding in Q1 2012 declined to 59.1 million.

Competitors:

Insider Buying:

Two insiders purchased stock on the open market over the last six months as listed below. You can view a list of all insider transactions for Masimo Corporation here.

Risk Factors:

Masimo depends on domestic sales for a majority of its revenue. Given the weak economic environment in Europe and parts of Asia, the company might run into resistance as it attempts to increase the international slice of its total revenue pie.

The company has also introduced consumer facing products that may not enjoy the same margins as the products sold to hospitals and fire departments (such as its carbon monoxide monitoring product).

Changes in heathcare policies by the government could also negatively affect procedures that utilize Masimo’s products.

The company relies heavily on R&D to generate new technology that powers its products. With R&D spending at less than 10% of revenue, the company’s R&D spending is about in line with industry averages.

Conclusion:

There are several reasons Masimo stands out as an interesting investment including a founder CEO at the helm, strong operating metrics, a strong balance sheet and a real moat powered by hundreds of patents. The company also fits our growth at a reasonable price (GARP) criteria with core product revenue still growing double digits and the company trading for just 9.38 times EBITDA. With a full year of lower royalty payments from Covidien behind us, year-over-year comparisons are going to improve as investors once again shift their attention to core product revenue.

With insiders purchasing the stock and the company also buying back its own stock, quite clearly insiders think the stock is undervalued.