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Adam Sues adam_sues@unc.edu www.valueuncovered.

Masimo simply takes the guess work out of pulse oximetry, so clinicians never have to guess what brand is the most reliable Antonio Garcia of Frost & Sullivan

BUY: Masimo Corporation (MASI)

Price Target: $25.72

Masimo Corp. (MASI)

Price Market Cap Enterprise Value P/E P/TangBV EV/EBIT
Source: CapitalIQ, Jan 8, 2012

$ $ $

18.47 1,108.26 967.66 17.10x 3.90x 10.78x

Beta Price Change (3mth) Volume Gross Margin EBIT Margin Net Margin

0.74 -17.36% 601,886 68.20% 20.80% 15.30%

ROA ROE ROIC Debt/Equity Dividend Yield Payout Ratio

16.00% 24.40% 39.60% 0.05% N/A N/A

Founded in 1989 and made available to the hospital market in 1998, MASI s SET (signal extraction) technology allows the non-invasive measurement of blood oxygen saturation, a key vital sign for hospital patients. Unlike the competition, MASI s technology works even with low perfusion (blood flow) or when the patient is moving (like a crying newborn). Frost & Sullivan estimates that pulse oximetry is a $1b market that is growing at 6-8% annually (with even faster growth overseas). It is an effective duopoly, with two companies, Masimo and Covidien, controlling over 80% of the market. While the majority of sales still come from its SET technology, MASI introduced its advanced Rainbow SET technology in 2005, expanding the scope of the original product line to include other blood parameters such as Hemoglobin (SpHB), Oxygen Content (SpOC), and Carboxyhemoglobin (SpCO), among others. While the Rainbow technology only contributes $35-40m in annual sales, the additional market for these new markers is estimated at $1-1.5B.

Superior technology provides competitive moat The company pioneered low perfusion pulse oximetry in 1996, and has rattled off industry firsts throughout the last decade with a focus on solving problems that others think are unsolvable. Masimo monitors are generally viewed as the gold standard of care for hospitals, an important label considering their use (often infants and critical care patients) and the current litigious tendency when it comes to medical care.

Adam Sues adam_sues@unc.edu www.valueuncovered.com

With over 600 current and pending patents, MASI has been the clear pioneer in the field of non-invasive measurement. The benefits of MASI s technology have been demonstrated by over 100 independent whitepapers and independent medical studies, with more clinical proof coming out every month. The studies show that Masimo s SET technology significantly reduces the number of false alarms (which can cause a dangerous crying wolf effect) and missed true events an improvement in the standard of patient care while also saving hospitals money:

For example, according to company estimates, a hospital with 250 beds using MASI technology will save roughly $350k per year on fewer false alarms, reduction in average length of stay, and elimination of unneeded tests. This dynamic continues to drive market share growth, as MASI s share of the pulse oximetry market has grown from 15-17% in 2007 to 30-32% in 2011 (the company continues to capture 50%+ of new orders). An example of the power of the technology: According to a study by Cedars-Sinai Medical Center in Los Angeles, MASI s technology reduced the rate of retinopathy of prematurity (ROP) in newborns (a complication from too much oxygen which can cause blindness in infants) from 12.5% to 2.5%. As a small budget item that provides such a critical function, hospitals would be taking a huge legal risk by not using the technology. Attractive razor-and-razorblades business model MASI provides hospitals with the SET monitor (a.k.a the driver ) for free, with the promise of a long-term exclusive contract (typically 5 years), and then charges for the disposable sensors that must continually be replaced a high margin repeat sale that leads to predictable business and attractive returns.

Adam Sues adam_sues@unc.edu www.valueuncovered.com

Consider the growth of the installed base:

Installed Base & Product Revenues

1,000,000 900,000 800,000 700,000 600,000 500,000 400,000 300,000 200,000 100,000 Q3 2011 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 214,000 950,000 450 400 350 300 250 200 150 100 50 0


Revenues ($ mil)

The more drivers in use, the more sensors are sold. The disposable sensors sell for roughly $9-10, and although costs have come down (from $10-12) due to price competition with Covidien, management has indicated that this pressure has abated for now. Continual redesign and improvement in sensors (new Rainbow sensors are in the $40 price range), and the dynamics of the market (as an effective duopoly) should help keep gross margins between 68-70%. Much of this profit falls to the bottom-line, with net income margins north of 15%. In aggregate, the business model is powerful, with a ROIC of 40% for the most recent fiscal year (and a 5-yr average ROIC of 48%). Encouragingly, management has not wasted the cash on acquisitions, but has re-invested it into new product lines (i.e. the Rainbow technology platform), technology improvements, and R&D. Even after receiving legal settlements of almost $400m, the company paid out over half to shareholders in the form of special dividends MASI s balance sheet remains clean with no debt and intangibles at only 4% of equity. CEO deeply committed into the business Masimo is run by the original founder, Joseph Kiani, who holds more than 9% of outstanding shares and was a major inventor of the SET technology. A true success story with a commitment to saving lives, Kiani seems deeply tied to the growth of his company. Kiani is a brilliant engineer, arriving from Iran in the 1970s and graduating with a bachelor s and master s degree from San Diego State by the time he was 22. He started Masimo out of his garage with a $40,000

Adam Sues adam_sues@unc.edu www.valueuncovered.com

second loan on his California home (how are new entrepreneurs going to do it these days!?), and now has been CEO for 23 years. He remains a huge part of the business, and has vigorously defended the company and its technology: (1) Taking on the medical Group Purchasing Organizations (GPOs) for giving out sole source contracts and suppressing technology that saved lives. The story was picked up by Pullitzer prize winning journalist and NYT editor Walt Bogdanich, who exposed GPOs shady business practices and catalyzed a series of Congressional hearings with Masimo as the lead protagonist. (2) Successfully suing Nellcor (now Covidien) for infringing on MASI s patients, leading to a $330m judgment and future royalty payments. (3) Winning a separate lawsuit against Tyco Healthcare on anti-trust practices for $30m. Most importantly, Kiani still owns 9% of the company, aligning his interests with shareholders. With the recent swoon in the stock price, he has also been a big buyer, purchasing $2m worth of shares in November, a big commitment after the company s poor stock performance in 2010.


The stock was down 36% in 2010, as the company missed analysts estimates on revenues (by $6m) and EPS by ($0.03) for the third quarter. In addition, management lowered guidance for the full year from $446-$463m to $436-$439m, with EPS down from $1.17-$1.25 to $1.04-$1.06. While the lower guidance is disappointing, Q3 was impacted by a number of unusual items, many of which do not affect the long-term story: (1) $1.5m charge for write-down on a monitor redesign, impacting gross margins (2) a delay in recognizing a $3m order from earlier in 2011 (3) $5-7m nonrenewal of a military Rainbow order (4) greater percentage of reprocessed sensors, which sell for a $1.50-$2 lower price point (5) a 20% reduction in OEM sales (which make up roughly 20-25% of overall revenues). Together these items created a messy quarter and, along with the recent FDA delay of the Pronto-7 handheld device (a small unit designed to penetrate the physician s office market), caused the share price to slide. The market seems worried about the slow adoption of the Rainbow technology, but is overlooking the continued growth in the core business the install base increased by 33,400 units in Q3 to a total of 950,000, and product revenue was up 10%. There remain significant growth opportunities in the SET technology (via international expansion, overall market share gains, and increased presence in non-critical hospital beds). In light of the long-term story, the recent price action provides an attractive entry point to pick up a great business with revolutionary technology (with tons of potential upside) for a decent price.

Adam Sues adam_sues@unc.edu www.valueuncovered.com VALUATION

At current prices, the stock is near its IPO price of $17 in 2007, and is trading at its lowest valuation on both a P/E and EV/EBIT basis in its history. Looking at MASI compared to the competition (medical tech companies with annual revenue growth of 10-20%):

MASI has a similar margin profile and historical growth rate as the competition, yet trades at a discount of 43% and 50% on an EV/EBIT and P/E basis. So what s holding the multiple down? Compared to the competition, analysts are expecting a slower earnings growth rate across the next two years. However, with the market dynamics and additional catalysts described below, these estimates appear to be very conservative. Assigning a 15x EV/EBIT multiple would yield a per share value of $24.48, while a P/E multiple of 22x would yield a per share value of $23.44 (both are significantly below the competition to account for the struggles in 2011, as well as below MASI s long-term averages of 16.76x and 31.06x respectively). DCF Valuation

DCF - Sensitivity Analysis

Discount Rates
$ Terminal 30.25 13.00x $ 14.00x $ 15.00x $ 16.00x $ 17.00x $ 7.9% 27.74 $ 29.30 $ 30.85 32.41 33.97 $ $ 8.4% 27.20 $ 28.73 $ $ $ $ 31.77 33.29 8.9% 26.68 28.17 29.66 31.15 32.63


$ 30.25

DCF assumes a sales increase of 12% in 2012 (with a step down of 2-3% per year thereafter), and margin improvement from 2011 s historical low of 20.5% back to 23% (primarily from additional economies of scale, increased Rainbow sales and reduced impact of sensor reprocessing).

Adam Sues adam_sues@unc.edu www.valueuncovered.com

Overall Valuation

MASI Valuation
$36.00 $32.00 $30.25 $28.00 $24.00 $20.00 $16.00 EV/EBIT (13-17x) P/E (20-24x) DCF $24.48


The midpoint of each valuation method yields a price target between $23.44 and $30.25, for potential upside of 27%-63% (based on the Jan 6 closing price of $18.47). The mean price target is $25.72.

Market expansion into non-critical applications There are approx. 850k hospital beds, with 730k designated as non-critical. The current U.S. market size for pulse oximetry of $750m is based only on critical beds, but numerous studies have shown that MASI s technology is applicable to non-critical situations. Even a 25% penetration rate would yield a $1b increase in the market for the core SET technology. Conclusion: MASI s U.S. growth potential remains significant. Adoption of additional Rainbow parameters The majority of Rainbow sales still derive from the carbon monoxide parameter, which is marketed to EMS units and local governments (since municipalities are cutting back on budget items, sales will remain slow/lumpy from this segment). Adoption will take time, but there remains significant potential in the other Rainbow parameters. Example: Hemoglobin 400m blood tests per year with current method (painful needle prick and invasive blood draw, followed by waiting for lab results vs. instant, pain-free measurement with Rainbow technology). Analysts are estimating another $500m potential market for MASI. Share repurchase program The board authorized a 3m share repurchase program in 2011 but didn t purchase shares through Q3. At current levels, a price supported by company buybacks is likely. FDA approval of Pronto-7 handheld device Delayed for minor fixes, the device is already approved in Europe. Approval could contribute $5m+ in incremental revenue in 2012. (Edit: Approved on 1/9/12)

Adam Sues adam_sues@unc.edu www.valueuncovered.com DOWNSIDE Risks / Negatives

Cross-Licensing Agreement with Cercacor Spinoff from parent company before IPO (Kiani is CEO of both companies). Cercacor receives minimum royalty payments for Rainbow technology (triples to $15m per year on change in control). Royalty Payments from Covidien Approx. $4050m per year, much of which falls to bottom line, for sales of Covidien products using Masimo s patents. Up for renewal in 2014.

Agreement makes an outright acquisition of MASI more expensive, as acquirer would likely need to purchase both companies. Risk seems mitigated as long as Kiani is in control. If model holds, would represent approx. 7% of revenue in 2014. A risk, but likely to be extended through at least 2017 (when MASI s key patents expire), although at a reduced royalty rate. Executives should be paid for good performance, and the business has performed well. However, the stock price is a different story need to demonstrate results in 2012 to justify higher pay.

Executive Compensation Top executives pull down $10m per year (~2.5% of revenue). Stockbased compensation is high.

FDA Approval Delays in product launch (i.e. Pronto-7). Medical technology is heavily scrutinized.

Company/management has been working with FDA over past 20 years. Numerous parameters have been approved good track record.