MASI-2015.07.04-10Q
Table of Contents

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
________________________________________________
FORM 10-Q
________________________________________________
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended July 4, 2015
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________ to _________
Commission File Number 001-33642
_________________________________________________
MASIMO CORPORATION
(Exact Name of Registrant as Specified in its Charter)
________________________________________________
Delaware
 
33-0368882
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer
Identification Number)
 
 
52 Discovery
Irvine, California
 
92618
(Address of Principal Executive Offices)
 
(Zip Code)
(949) 297-7000
(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
 
ý
 
Accelerated filer
 
¨
 
 
 
 
Non-accelerated filer
 
¨  (Do not check if a smaller reporting company)
 
Smaller reporting company
 
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:
Class
 
Number of Shares Outstanding as of July 4, 2015
Common stock, $0.001 par value
 
50,990,801
 

Table of Contents

MASIMO CORPORATION
FORM 10-Q FOR THE QUARTER ENDED JULY 4, 2015
TABLE OF CONTENTS
 
 
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 2.
 
 
 
Item 6.
 
 


2
Table of Contents

PART I. FINANCIAL INFORMATION
Item 1.
Financial Statements
MASIMO CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands, except par values)
 
July 4,
2015
 
January 3,
2015
ASSETS
 
 
 
Current assets
 
 
 
Cash and cash equivalents
$
119,397

 
$
134,453

Accounts receivable, net of allowance for doubtful accounts of $1,930 and $1,890 at July 4, 2015 and January 3, 2015, respectively
73,865

 
71,017

Inventories
71,588

 
69,718

Prepaid income taxes
6,266

 
417

Other current assets
20,463

 
21,471

Deferred tax assets
18,060

 
18,065

Total current assets
309,639

 
315,141

Deferred cost of goods sold
66,033

 
67,485

Property and equipment, net
122,723

 
101,952

Intangible assets, net
28,036

 
27,771

Goodwill
20,367

 
20,979

Deferred tax assets
24,150

 
24,193

Other assets
12,668

 
7,485

Total assets
$
583,616

 
$
565,006

LIABILITIES AND EQUITY
 
 
 
Current liabilities
 
 
 
Accounts payable
$
32,467

 
$
38,045

Accrued compensation
28,923

 
33,600

Accrued liabilities
28,180

 
24,541

Income taxes payable
2,668

 
6,562

Deferred revenue
21,979

 
21,067

Current portion of capital lease obligations
80

 
79

Total current liabilities
114,297

 
123,894

Deferred revenue
376

 
453

Long term debt
177,604

 
125,145

Other liabilities
7,273

 
7,773

Total liabilities
299,550

 
257,265

Commitments and contingencies

 

Equity
 
 
 
Masimo Corporation stockholders’ equity:
 
 
 
Preferred stock, $0.001 par value; 5,000 shares authorized; 0 shares issued and outstanding at July 4, 2015 and January 3, 2015
—

 
—

Common stock, $0.001 par value; 100,000 shares authorized; 50,991 and 52,594 shares outstanding at July 4, 2015 and January 3, 2015, respectively
51

 
52

Treasury stock, 10,987 and 8,611 shares at July 4, 2015 and January 3, 2015, respectively
(267,606
)
 
(185,906
)
Additional paid-in capital
310,546

 
288,686

Accumulated other comprehensive loss
(4,451
)
 
(2,093
)
Retained earnings
245,134

 
205,260

Total Masimo Corporation stockholders’ equity
283,674

 
305,999

Noncontrolling interest
392

 
1,742

Total equity
284,066

 
307,741

Total liabilities and equity
$
583,616

 
$
565,006


The accompanying notes are an integral part of these condensed consolidated financial statements.

3
Table of Contents

MASIMO CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(unaudited, in thousands, except per share amounts)
 
 
Three Months Ended
 
Six Months Ended
 
July 4,
2015
 
June 28,
2014
 
July 4,
2015
 
June 28,
2014
Revenue:
 
 
 
 
 
 
 
Product
$
147,612

 
$
133,493

 
$
294,969

 
$
265,725

Royalty
8,114

 
7,430

 
15,294

 
15,012

Total revenue
155,726

 
140,923

 
310,263

 
280,737

Cost of goods sold
52,825

 
47,828

 
104,257

 
95,341

Gross profit
102,901

 
93,095

 
206,006

 
185,396

Operating expenses:
 
 
 
 
 
 
 
Selling, general and administrative
61,666

 
61,347

 
122,465

 
117,469

Research and development
13,394

 
13,343

 
28,323

 
27,339

Litigation award and defense costs
—

 
—

 
—

 
(8,010
)
Total operating expenses
75,060

 
74,690

 
150,788

 
136,798

Operating income
27,841

 
18,405

 
55,218

 
48,598

Non-operating (expense) income
(1,125
)
 
323

 
(972
)
 
523

Income before provision for income taxes
26,716

 
18,728

 
54,246

 
49,121

Provision for income taxes
8,020

 
4,776

 
15,728

 
12,678

Net income including noncontrolling interest
18,696

 
13,952

 
38,518

 
36,443

Net loss (income) attributable to the noncontrolling interest
655

 
(150
)
 
1,356

 
(9
)
Net income attributable to Masimo Corporation stockholders
$
19,351

 
$
13,802

 
$
39,874

 
$
36,434

 
 
 
 
 
 
 
 
Net income per share attributable to Masimo Corporation stockholders:
 
 
 
 
 
 
 
Basic
$
0.38

 
$
0.25

 
$
0.77

 
$
0.65

Diluted
$
0.36

 
$
0.24

 
$
0.74

 
$
0.63

 
 
 
 
 
 
 
 
Weighted-average shares used in per share calculations:
 
 
 
 
 
 
 
Basic
51,300

 
55,876

 
51,993

 
56,290

Diluted
53,675

 
56,818

 
53,908

 
57,403

The accompanying notes are an integral part of these condensed consolidated financial statements.



4
Table of Contents

MASIMO CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(unaudited, in thousands)
 
 
Three Months Ended
 
Six Months Ended
 
July 4,
2015
 
June 28,
2014
 
July 4,
2015
 
June 28,
2014
Net income including noncontrolling interest
$
18,696

 
$
13,952

 
$
38,518

 
$
36,443

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Foreign currency translation adjustments
584

 
(1,729
)
 
(2,358
)
 
(1,710
)
Total comprehensive income
19,280

 
12,223

 
36,160

 
34,733

Comprehensive loss (income) attributable to noncontrolling interest
655

 
(150
)
 
1,356

 
(9
)
Comprehensive income attributable to Masimo Corporation stockholders
$
19,935

 
$
12,073

 
$
37,516

 
$
34,724

The accompanying notes are an integral part of these condensed consolidated financial statements.




5
Table of Contents

MASIMO CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)
 
Six Months Ended
 
July 4,
2015
 
June 28,
2014
Cash flows from operating activities:
 
 
 
Net income including noncontrolling interest
$
38,518

 
$
36,443

Adjustments to reconcile net income including noncontrolling interest to net cash provided by operating activities:
 
 
 
Depreciation and amortization
7,697

 
6,113

Share-based compensation
5,429

 
5,208

Provision for doubtful accounts
162

 
183

Provision for deferred income taxes
—

 
2,926

Income tax benefit from exercise of stock options granted prior to January 1, 2006
1,607

 
44

Excess tax (benefit) deficit from share-based compensation arrangements
(95
)
 
15

Changes in operating assets and liabilities:
 
 
 
(Increase) decrease in accounts receivable
(3,121
)
 
1,233

Increase in inventories
(2,060
)
 
(1,616
)
Decrease (increase) in deferred cost of goods sold
1,347

 
(2,424
)
(Increase) decrease in prepaid income taxes
(5,852
)
 
348

Increase in other assets
(4,252
)
 
(2,142
)
(Decrease) increase in accounts payable
(7,378
)
 
1,210

Decrease in accrued compensation
(4,271
)
 
(5,731
)
Increase (decrease) in accrued liabilities
3,805

 
(4,365
)
Decrease in income taxes payable
(3,754
)
 
(1,605
)
Increase in deferred revenue
836

 
3,339

Decrease in other liabilities
(342
)
 
(354
)
Net cash provided by operating activities
28,276

 
38,825

Cash flows from investing activities:
 
 
 
Purchases of property and equipment, net
(24,665
)
 
(62,093
)
Increase in intangible assets
(2,344
)
 
(1,901
)
Net cash used in investing activities
(27,009
)
 
(63,994
)
Cash flows from financing activities:
 
 
 
Borrowings under line of credit
65,000

 
75,000

Repayments on line of credit
(12,500
)
 
—

Repayments of capital lease obligations
(77
)
 
(95
)
Proceeds from issuance of common stock
15,178

 
2,209

Payroll tax withholdings on behalf of employees for stock options
(472
)
 
—

Excess tax benefit (deficit) from share-based compensation arrangements
95

 
(15
)
Repurchases of common stock
(81,700
)
 
(49,152
)
Issuance (repurchases) of equity by noncontrolling interest, net of equity issued
3

 
(38
)
Net cash (used in) provided by financing activities
(14,473
)
 
27,909

Effect of foreign currency exchange rates on cash
(1,850
)
 
(1,114
)
Net increase in cash and cash equivalents
(15,056
)
 
1,626

Cash and cash equivalents at beginning of period
134,453

 
95,466

Cash and cash equivalents at end of period
$
119,397

 
$
97,092

The accompanying notes are an integral part of these condensed consolidated financial statements.

6
Table of Contents

MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

1. Description of the Company
Masimo Corporation (the Company) is a global medical technology company that develops, manufactures and markets a variety of noninvasive patient monitoring technologies. The Company’s mission is to improve patient outcomes and reduce cost of care by taking noninvasive monitoring to new sites and applications. The Company’s patient monitoring solutions generally incorporate a monitor or circuit board, proprietary single-patient use, reusable or resposable sensors, software and/or cables. The Company primarily sells its products to hospitals, emergency medical service (EMS) providers, home care providers, physician offices, veterinarians, long term care facilities and consumers through its direct sales force, distributors and original equipment manufacturer (OEM) partners.
The Company invented Masimo Signal Extraction Technology® (SET®), which provides the capabilities of Measure-Through-Motion and Low-Perfusion™ pulse oximetry to address the primary limitations of conventional pulse oximetry. Over the years, the Company’s product offerings have expanded significantly to also include noninvasive optical blood constituent monitoring, optical organ oximetry monitoring, electrical brain function monitoring, acoustic respiration monitoring and optical gas monitoring. The Company also developed the Root® patient monitoring and connectivity platform and the Masimo Patient SafetyNet™ remote patient surveillance monitoring system. These solutions and related products are based upon Masimo SET®, rainbow® and other proprietary algorithms. These software-based technologies are incorporated into a variety of product platforms depending on customers’ specifications. This technology is supported by a substantial intellectual property portfolio that the Company has built through internal development and, to a lesser extent, acquisitions and license agreements.
2. Summary of Significant Accounting Policies
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) have been condensed or omitted pursuant to such rules and regulations. The condensed consolidated financial statements have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, including normal recurring accruals, necessary to present fairly the Company’s condensed consolidated financial statements. The condensed consolidated balance sheet as of January 3, 2015 was derived from the Company’s audited consolidated financial statements at that date. The accompanying condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes contained in the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2015 (fiscal year 2014), filed with the SEC on February 17, 2015. The results for the three and six months ended July 4, 2015 are not necessarily indicative of the results to be expected for the fiscal year ending January 2, 2016 (fiscal year 2015) or for any other interim period or for any future year.
Principles of Consolidation
The condensed consolidated financial statements include the accounts of the Company, its wholly-owned subsidiaries and the variable interest entity (VIE) of which the Company is the primary beneficiary. All intercompany balances and transactions have been eliminated in consolidation. In accordance with GAAP, current authoritative guidance is applied when determining whether an entity is subject to consolidation.
Fiscal Periods
The Company follows a conventional 52/53 week fiscal year. Under a conventional 52/53 fiscal year, a 52 week fiscal year includes four quarters of 13 fiscal weeks while a 53 week fiscal year includes three 13 fiscal week quarters and one 14 fiscal week quarter. The Company’s last 53 week fiscal year was fiscal year 2014. Fiscal year 2015 is a 52 week fiscal year. All references to years in these notes to condensed consolidated financial statements are fiscal years unless otherwise noted.

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Table of Contents
MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

Use of Estimates
The Company prepares its financial statements in conformity with GAAP, which requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Significant estimates include the determination of accounts receivable allowances, inventory reserves, warranty reserves, rebate accruals, valuation of the Company’s stock options, goodwill valuation, deferred taxes and any associated valuation allowances, distributor channel inventory, royalty revenues, deferred revenue, uncertain income tax positions, litigation costs and related accruals. Actual results could differ from such estimates.
Reclassifications
Certain amounts in the condensed consolidated financial statements for prior periods have been reclassified to conform to the current period presentation.
Fair Value Measurements
Authoritative guidance describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value:
●
Level 1—Quoted prices in active markets for identical assets or liabilities.
●
Level 2—Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that can be corroborated by observable market data for substantially the full term of the assets or liabilities.
●
Level 3—Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
Pursuant to current authoritative guidance, entities are allowed an irrevocable option to elect the fair value for the initial and subsequent measurement for specified financial assets and liabilities on a contract-by-contract basis. The Company did not elect the fair value option under this guidance as to specific assets or liabilities. There were no transfers between Level 1, Level 2 and Level 3 inputs during the three and six months ended July 4, 2015. The Company carries cash and cash equivalents at cost, which approximates fair value. As of July 4, 2015 and January 3, 2015, the Company did not have any short-term investments.
The following tables represent the Company’s financial assets (in thousands), measured at fair value on a recurring basis:
July 4, 2015
Adjusted Basis
Cost
 
Gross Unrealized
Gains
 
Gross Unrealized
(Losses)
 
Estimated
Fair Value
 
Cash and Cash
Equivalents
Cash
$
80,030

 
$
—

 
$
—

 
$
80,030

 
$
80,030

Level 1:
 
 
 
 
 
 
 
 
 
          Bank Time Deposits
32,500

 
—

 
—

 
32,500

 
32,500

          U.S. Treasuries
—

 
—

 
—

 
—

 
—

          Money Market Funds
6,867

 
—

 
—

 
6,867

 
6,867

               Subtotal
39,367

 
—

 
—

 
39,367

 
39,367

Level 2:
 
 
 
 
 
 
 
 
 
          None
—

 
—

 
—

 
—

 
—

Level 3:
 
 
 
 
 
 
 
 
 
          None
—

 
—

 
—

 
—

 
—

Total assets measured at fair value
$
119,397

 
$
—

 
$
—

 
$
119,397

 
$
119,397


8
Table of Contents
MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

January 3, 2015
Adjusted Basis
Cost
 
Gross Unrealized
Gains
 
Gross Unrealized
(Losses)
 
Estimated
Fair Value
 
Cash and Cash
Equivalents
Cash
$
92,888

 
$
—

 
$
—

 
$
92,888

 
$
92,888

Level 1:
 
 
 
 
 
 
 
 
 
          Bank Time Deposits
40,500

 
—

 
—

 
40,500

 
40,500

          U.S. Treasuries
—

 
—

 
—

 
—

 
—

          Money Market Funds
1,065

 
—

 
—

 
1,065

 
1,065

               Subtotal
41,565

 
—

 
—

 
41,565

 
41,565

Level 2:
 
 
 
 
 
 
 
 
 
          None
—

 
—

 
—

 
—

 
—

Level 3:
 
 
 
 
 
 
 
 
 
          None
—

 
—

 
—

 
—

 
—

Total assets measured at fair value
$
134,453

 
$
—

 
$
—

 
$
134,453

 
$
134,453

Accounts Receivable and Allowance for Doubtful Accounts
Accounts receivable consist of trade receivables recorded upon recognition of revenue for product revenues, reduced by reserves for estimated bad debts and returns. Trade accounts receivable are recorded at the invoiced amount and do not bear interest. Credit is extended based on evaluation of the customer’s financial condition. Collateral is generally not required. The allowance for doubtful accounts is determined based on historical write-off experience, current customer information and other relevant factors, including specific identification of past due accounts, based on the age of the receivable in excess of the contemplated or contractual due date. Accounts are charged off against the allowance when the Company believes they are uncollectible.
Inventories
Inventories are stated at the lower of cost or market. Cost is determined using a standard cost method, which approximates FIFO (first in, first out) and includes material, labor and overhead costs. Inventory reserves are recorded for inventory items that have become excess or obsolete or are no longer used in current production and for inventory items that have a market price less than carrying value.
Property and Equipment
Property and equipment are stated at cost. Depreciation is calculated using the straight-line method over estimated useful lives as follows:
 
Useful Lives
Buildings
39 years
Building and land improvements
7 to 10 years
Leasehold improvements
Lesser of useful life or term of lease
Machinery and equipment
5 years
Vehicles
5 years
Tooling
3 years
Computer equipment
2 to 6 years
Furniture and office equipment
2 to 6 years
Demonstration units
3 years
Land is not depreciated and construction-in-progress is not depreciated until placed in service. Normal repair and maintenance costs are expensed as incurred, whereas significant improvements that materially increase values or extend useful lives are capitalized and depreciated over the remaining estimated useful lives of the related assets. Upon sale or retirement of depreciable assets, the related cost and accumulated depreciation or amortization are removed from the accounts and any gain or loss on the sale or retirement is recognized in income.

9
Table of Contents
MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

For the six months ended July 4, 2015 and June 28, 2014, depreciation and amortization expense of property and equipment was $8.0 million and $6.2 million, respectively.
Intangible Assets
The Company’s policy is to renew its patents and trademarks. Total renewal costs for patents and trademarks were $0.3 million for both the six months ended July 4, 2015 and June 28, 2014. As of July 4, 2015, the weighted-average number of years until the next renewal was one year for patents and five years for trademarks. Costs to renew patents and trademarks are capitalized and amortized over the remaining useful life of the intangible asset. The Company continually evaluates the amortization period and carrying basis of patents and trademarks to determine whether any events or circumstances warrant a revised estimated useful life or reduction in value. Capitalized application costs are charged to operations when it is determined that the patent or trademark will not be obtained or is abandoned.
Impairment of Goodwill, Intangible Assets and Other Long-Lived Assets
Goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the acquired net tangible and intangible assets. Goodwill is not amortized, but instead is tested annually for impairment, or more frequently when events or changes in circumstances indicate that goodwill might be impaired. In assessing goodwill impairment for each of its reporting units, the Company has the option to first assess the qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. The Company’s qualitative assessment of the recoverability of goodwill considers various macroeconomic, industry-specific and Company-specific factors, including: (i) severe adverse industry or economic trends; (ii) significant Company-specific actions; (iii) current, historical or projected deterioration of the Company’s financial performance; or (iv) a sustained decrease in the Company’s market capitalization below its net book value. If, after assessing the totality of events or circumstances, the Company determines it is unlikely that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. However, if the Company concludes otherwise, then the Company is required to perform the first step of the two-step impairment test by comparing the fair value of the reporting unit, determined using future projected discounted operating cash flows, with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill is not considered impaired; otherwise, goodwill is considered impaired and the loss is measured by performing step two. Under step two, the impairment loss is measured by comparing the implied fair value of the reporting unit goodwill with the carrying amount of goodwill. The Company also has the option to bypass the qualitative assessment and proceed directly to performing the first step of the two-step goodwill impairment test. The Company may resume performing the qualitative assessment in any subsequent period. The annual impairment test is performed during the fourth fiscal quarter.
The Company reviews long-lived assets and identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the future undiscounted operating cash flow expected to be generated by the asset. If such asset is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount exceeds the fair value of the asset. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell.
No impairment of goodwill, intangible assets or other long-lived assets was recorded during the three and six months ended July 4, 2015 or June 28, 2014.
Revenue Recognition and Deferred Revenue
The Company follows the current authoritative guidance for revenue recognition. Based on these requirements, the Company recognizes revenue from the sale of products or services when: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or services have been rendered, (iii) the price is fixed or determinable, and (iv) collectability is reasonably assured. In the case of the license or sale of software that does not function together with hardware components to provide the essential functionality of the hardware, revenue is recognized pursuant to the software revenue recognition guidance.
The Company derives the majority of its revenue from four primary sources: (i) direct sales under long-term sensor purchase agreements with end-user hospitals where the Company provides up-front monitoring equipment at no up-front charge in exchange for a multi-year sensor purchase commitment, (ii) other direct sales of noninvasive monitoring solutions to end-user hospitals, emergency medical response organizations and other direct customers; (iii) sales of noninvasive monitoring solutions to distributors who then typically resell to end-user hospitals, emergency medical response organizations and other direct customers, many of which have long-term sensor purchase agreements with the Company; (iv) sales of integrated circuit boards

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Table of Contents
MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

and consumables to original equipment manufacturer (OEM) customers who incorporate the Company’s circuit boards and embedded software technology into their multi-parameter monitoring devices and resell the consumables.
The Company enters into agreements to sell its noninvasive monitoring solutions and services, sometimes as part of multiple deliverable arrangements that include various combinations of products and services. While the majority of the Company’s sales transactions contain standard business terms and conditions, there are some transactions that contain non-standard business terms and conditions. As a result, contract interpretation and analysis is sometimes required to determine the appropriate accounting including: (i) how the arrangement consideration should be allocated among the deliverables when multiple deliverables exist, (ii) when to recognize revenue on the deliverables, and (iii) whether undelivered elements are essential to the functionality of the delivered elements. Changes in judgments on these assumptions and estimates could materially impact the timing of revenue recognition.
In the case of multiple deliverable arrangements, the authoritative guidance provides a hierarchy to determine the selling price to be used for allocating revenue to deliverables as follows: (i) vendor-specific objective evidence of fair value (VSOE), (ii) third-party evidence of selling price (TPE), and (iii) best estimate of the selling price (ESP). VSOE of fair value is defined as the price charged when the same element is sold separately. VSOE generally exists only when the deliverable is sold separately and is the price actually charged for that deliverable. TPE generally does not exist for the majority of the Company’s products. The objective of ESP is to determine the price at which the Company would transact a sale if the product was sold on a stand-alone basis. In the absence of VSOE and TPE, the Company determines ESP for its products by considering multiple factors including, but not limited to, features and functionality of the product, geographies, type of customer, contractual prices pursuant to Group Purchasing Organization (GPO) contracts, the Company’s pricing and discount practices, and market conditions.
A deliverable in an arrangement qualifies as a separate unit of accounting if the delivered item has value to the customer on a stand-alone basis. Most of the Company’s products in a multiple deliverable arrangement qualify as separate units of accounting. In the case of the Company’s monitoring equipment containing embedded Masimo SET® or rainbow® SET software, the Company has determined that the hardware and software components function together to deliver the equipment’s essential functionality and, therefore, represent a single deliverable. However, software deliverables, such as rainbow® parameter software, which do not function together with hardware components to provide the equipment’s essential functionality, are accounted for under software revenue recognition guidance. The revenue for these multiple-element arrangements is allocated to the software deliverables and the non-software deliverables based on the relative selling prices of all of the deliverables in the arrangement using the hierarchy in the revenue recognition accounting guidance for arrangements with multiple deliverables.
Sales under long-term sensor purchase contracts are generally structured such that the Company agrees to provide at no up-front charge certain monitoring equipment, software, installation, training and/or warranty support in exchange for the hospital’s agreement to purchase sensors over the term of the agreement, which generally ranges from three to seven years. The sensors are essential to the functionality of the monitoring equipment and, therefore, represent a substantive performance obligation. The Company does not recognize any revenue when the monitoring and related equipment and software are delivered to the hospitals. The Company recognizes revenue for these delivered elements, on a pro-rata basis when installation and training are complete, as the sensors are delivered under the long-term purchase commitment. The cost of the monitoring equipment initially placed at the hospitals is deferred and amortized to cost of goods sold over the life of the underlying long-term sensor purchase contract.
Many of the Company’s distributors purchase sensor products which they then resell to end-user hospitals that are typically fulfilling their purchase obligations to the Company under such end-user hospital’s long-term sensor purchase commitments. Upon shipment to the distributor, revenue is deferred until the distributor ships the product to the Company’s end-user customers based on an estimate of the inventory held by these distributors at the end of the accounting period.
The Company also earns revenue from the sale of integrated circuit boards and other products, as well as from rainbow® parameter software licenses, to OEMs under various agreements. Revenue from the sale of products to the OEMs is generally recognized at the time of shipment. Revenue related to software licenses to OEMs is generally recognized upon shipment of the OEM’s product to its customers, as represented to the Company by the OEM.
The Company also provides certain customers with the ability to purchase sensors under rebate programs. Under these programs, the customers may earn rebates based on their purchasing activity. The Company estimates and provides allowances for these programs at the time of sale as a reduction to revenue.

11
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

In general, customers do not have a right of return for credit or refund. However, the Company allows returns under certain circumstances. At the end of each period, the Company estimates and accrues for these returns as a reduction to revenue and accounts receivable. The Company estimates returns based on several factors, including contractual limitations and past returns history.
The Company’s royalty revenue arises from one agreement with Covidien, which was recently acquired by Medtronic plc, and is due and payable quarterly based on U.S. sales of Covidien’s infringing products. An estimate of these royalty revenues is recorded quarterly in the period earned based on the prior quarter’s historical results, adjusted for any new information or trends known to management at the time of estimation. This estimated revenue is adjusted prospectively when the Company receives the Covidien royalty report, approximately 60 days after the end of the previous quarter.
Product Warranty
The Company generally provides a warranty against defects in material and workmanship for a period ranging from six to fourteen months, depending on the product type. In the case of long-term sales agreements, the Company typically warrants the products for the term of the agreement, which generally ranges from three to seven years. In traditional sales activities, including direct and OEM sales, the Company establishes an accrual for the estimated costs of warranty at the time of revenue recognition. Estimated warranty expenses are recorded as an accrued liability, with a corresponding provision to cost of sales. In long-term sales agreements, revenue related to extended warranty is recognized over the life of the contract, while the product warranty costs related to the long-term sales agreements are expensed as incurred.
Changes in the product warranty accrual were as follows (in thousands):
 
Six Months Ended
 
July 4,
2015
 
June 28,
2014
Warranty accrual, beginning of period
$
1,416

 
$
1,161

Accrual for warranties issued
585

 
489

Changes to pre-existing warranties (including changes in estimates)
(134
)
 
(91
)
Settlements made
(490
)
 
(446
)
Warranty accrual, end of period
$
1,377

 
$
1,113

Litigation Costs and Contingencies
The Company records a charge equal to at least the minimum estimated liability for a loss contingency or litigation settlement when both of the following conditions are met: (i) information available prior to issuance of the financial statements indicates that it is probable that a liability had been incurred at the date of the financial statements, and (ii) the range of loss can be reasonably estimated. The determination of whether a loss contingency or litigation settlement is probable or reasonably possible involves a significant amount of management judgment, as does the estimation of the range of loss given the nature of contingencies. Liabilities related to litigation settlements with multiple elements are recorded based on the fair value of each element. Legal and other litigation related expenses are recognized as the services are provided. The Company records insurance and other indemnity recoveries for litigation expenses when both of the following conditions are met: (i) the recovery is probable, and (ii) collectability is reasonably assured. Insurance recoveries are only recorded to the extent the litigation costs to which they relate have been incurred and recognized in the financial statements.
Comprehensive Income
Authoritative accounting guidance establishes requirements for reporting and disclosure of comprehensive income and its components. Comprehensive income includes foreign currency translation adjustments and any related tax benefits that have been excluded from net income including noncontrolling interest, and reflected in Masimo Corporation stockholders’ equity.

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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

The change in accumulated other comprehensive loss was as follows (in thousands):
 
Six Months Ended 
 July 4, 2015
Accumulated other comprehensive loss, beginning of period
$
(2,093
)
Foreign currency translation adjustments
(2,358
)
Accumulated other comprehensive loss, end of period
$
(4,451
)
Net Income Per Share
Basic net income per share attributable to Masimo Corporation for the three and six months ended July 4, 2015 and June 28, 2014 is computed by dividing net income attributable to Masimo Corporation stockholders by the weighted-average number of shares outstanding during each period. The diluted net income per share attributable to Masimo Corporation stockholders for the three and six months ended July 4, 2015 and June 28, 2014 is computed by dividing the net income attributable to Masimo Corporation stockholders by the weighted-average number of shares and potential shares outstanding during each period, if the effect of potential shares is dilutive. Potential shares include incremental shares of stock issuable upon the exercise of stock options. For the three and six months ended July 4, 2015, weighted options to purchase 0.6 million and 1.0 million shares of common stock, respectively, were outstanding, but were not included in the computation of diluted net income per share because the effect of including such shares would have been antidilutive in the applicable period. For the three and six months ended June 28, 2014, weighted options to purchase 4.1 million and 3.6 million shares of common stock, respectively, were outstanding, but were not included in the computation of diluted net income per share because the effect of including such shares would have been antidilutive in the applicable period. Based on authoritative accounting guidance, the Company adjusted its net income including noncontrolling interest by the amount of net (income) loss attributable to the noncontrolling interest for the three and six months ended July 4, 2015 and June 28, 2014, to determine its net income attributable to its stockholders. A reconciliation of basic and diluted net income per share attributable to Masimo Corporation stockholders is as follows (in thousands, except per share amounts):
 
Three Months Ended
 
Six Months Ended
 
July 4,
2015
 
June 28,
2014
 
July 4,
2015
 
June 28,
2014
Net income attributable to Masimo Corporation stockholders:
 
 
 
 
 
 
 
Net income including noncontrolling interest
$
18,696

 
$
13,952

 
$
38,518

 
$
36,443

Net loss (income) attributable to the noncontrolling interest
655

 
(150
)
 
1,356

 
(9
)
Net income attributable to Masimo Corporation stockholders
$
19,351

 
$
13,802

 
$
39,874

 
$
36,434

Basic net income per share attributable to Masimo Corporation stockholders:
 
 
 
 
 
 
 
Net income attributable to Masimo Corporation stockholders
$
19,351

 
$
13,802

 
$
39,874

 
$
36,434

Weighted-average shares outstanding - basic
51,300

 
55,876

 
51,993

 
56,290

Basic net income per share attributable to Masimo Corporation stockholders
$
0.38

 
$
0.25

 
$
0.77

 
$
0.65

Diluted net income per share attributable to Masimo Corporation stockholders:
 
 
 
 
 
 
 
Weighted-average shares outstanding - basic
51,300

 
55,876

 
51,993

 
56,290

Diluted share equivalent: stock options
2,375

 
942

 
1,915

 
1,113

Weighted-average shares outstanding - diluted
53,675

 
56,818

 
53,908

 
57,403

Diluted net income per share attributable to Masimo Corporation stockholders
$
0.36

 
$
0.24

 
$
0.74

 
$
0.63


13
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

Supplemental Cash Flow Information
Supplemental cash flow information includes the following (in thousands):
 
Six Months Ended
 
July 4,
2015
 
June 28,
2014
Cash paid during the year for:
 
 
 
Interest (net of amounts capitalized)
$
952

 
$
117

Income taxes
23,523

 
10,298

Noncash investing and financing activities:
 
 
 
Assets acquired under capital leases
$
36

 
$
—

Unpaid purchases of property, plant and equipment
6,251

 
474

       Unsettled common stock proceeds
25

 
—

Seasonality
The healthcare business in the United States and overseas is subject to quarterly fluctuations in hospital and other alternative care admissions. Historically, the Company has typically experienced higher product revenues during the traditional “flu season” that often increases hospital and acute care facility admissions in the Company’s first and fourth fiscal quarters. At the same time, the Company has often experienced a sequential decline in product revenues in its second and third fiscal quarters primarily due to the summer vacation season during which people tend to avoid and/or delay elective procedures. Because the Company’s non-sales variable operating expenses often do not fluctuate in the same manner as its quarterly product sales, its quarterly operating income may fluctuate disproportionately to its quarterly revenue.
Recently Issued Accounting Pronouncements
In April 2015, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2015-05, Intangibles-Goodwill and Other-Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement (ASU 2015-05). The new standard provides guidance about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the software license element of the arrangement should be accounted for as an acquisition of a software license. If a cloud computing arrangement does not include a software license, it should be accounted for as a service contract. ASU 2015-05 is effective for fiscal years beginning after December 15, 2015, and may be applied retrospectively, with early application permitted. The Company is currently evaluating this standard but does not expect that its adoption will have a material impact on its consolidated financial statements.
In April 2015, the FASB issued Accounting Standards Update No. 2015-03, Interest-Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs (ASU 2015-03). The new standard requires that debt issuance costs related to a recognized debt liability be presented on the balance sheet as a direct deduction from the carrying amount of the related debt liability instead of being presented as an asset. ASU 2015-03 requires retrospective application and represents a change in accounting principle. ASU 2015-03 is effective for fiscal years beginning after December 15, 2015. Early adoption is permitted for financial statements that have not been previously issued. The Company is currently evaluating this standard but does not expect that its adoption will have a material impact on its consolidated financial statements.
In February 2015, the FASB issued Accounting Standards Update No. 2015-02, Consolidation (Topic 810): Amendments to the Consolidation Analysis (ASU 2015-02). The amended standard applies to entities in all industries and eliminates the deferral of certain consolidation standards for entities considered to be investment companies as well as modifies the consolidation analysis performed on certain types of legal entities. ASU 2015-02 is effective for annual and interim fiscal reporting periods beginning after December 15, 2015, and may be applied retrospectively, with early application permitted. The Company is continuing to evaluate the expected impact of this standard on its consolidated financial statements.
In May 2014, the FASB issued Accounting Standards Update No. 2014-09, Revenue (Topic 606): Revenue from Contracts with Customer (ASU 2014-09). The new standard provides a single, principles-based five-step model to be applied to all contracts with customers while enhancing disclosures about revenue, providing additional guidance for transactions that were not previously addressed comprehensively and improving guidance for multiple-element arrangements. ASU 2014-09 will replace most existing revenue recognition guidance under GAAP when it becomes effective. The standard permits the use of either the

14
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

retrospective or cumulative effect transition method upon adoption. In July 2015, the FASB approved a one-year deferral of ASU 2014-09, and ASU 2014-09 will now be effective for annual and interim periods beginning on or after December 15, 2017. The Company is continuing to evaluate the expected impact of this standard on its consolidated financial statements.
3. Variable Interest Entity (VIE)
The Company follows authoritative guidance for the consolidation of its VIE, which requires an enterprise to determine whether its variable interest gives it a controlling financial interest in a VIE. Determination about whether an enterprise should consolidate a VIE is required to be evaluated continuously as changes to existing relationships or future transactions may result in consolidating or deconsolidating the VIE.
Cercacor Laboratories, Inc. (Cercacor)
Cercacor is an independent entity spun off from the Company to its stockholders in 1998. Joe Kiani, the Company’s Chairman and Chief Executive Officer, is also the Chairman and Chief Executive Officer of Cercacor. The Company is a party to a Cross-Licensing Agreement with Cercacor, which was most recently amended and restated effective January 1, 2007 (the Cross-Licensing Agreement), that governs each party’s rights to certain intellectual property held by the two companies. In addition, the Company entered into a Services Agreement with Cercacor effective January 1, 2007, which governs the general and administrative services the Company provides to Cercacor.
Under the Cross-Licensing Agreement, the Company granted Cercacor an exclusive, perpetual and worldwide license, with sublicense rights, to use all Masimo SET® owned by the Company, including all improvements on this technology, for the monitoring of non-vital signs measurements and to develop and sell devices incorporating Masimo SET® for monitoring non-vital signs measurements in any product market in which a product is intended to be used by a patient or pharmacist rather than a professional medical caregiver. The Company refers to this market as the Cercacor Market. The Company also granted Cercacor a non-exclusive, perpetual and worldwide license, with sublicense rights, to use all Masimo SET® for the measurement of vital signs in the Cercacor Market.
The Company exclusively licenses from Cercacor the right to make and distribute products in the professional medical caregiver markets, which the Company refers to as the Masimo Market, that utilize rainbow® technology for certain non-invasive measurements, including carbon monoxide, methemoglobin, fractional arterial oxygen saturation and hemoglobin. The Company also has the option to obtain exclusive licenses to make and distribute products that utilize rainbow® technology for the monitoring of other non-vital signs measurements, including blood glucose, in product markets where the product is intended to be used by a professional medical caregiver. To date, the Company has developed and commercially released devices that measure carbon monoxide, methemoglobin and hemoglobin using licensed rainbow® technology. The Company also markets certain other rainbow technologies, such as rainbow Acoustic Monitoring™, the rights to which are owned by the Company and for which no licensing fee is paid to Cercacor.
The Company’s license to rainbow® technology for these parameters in these markets is exclusive on the condition that the Company continues to pay Cercacor royalties on its products incorporating rainbow® technology, subject to certain minimum aggregate royalty thresholds, and that the Company uses commercially reasonable efforts to develop or market products incorporating the licensed rainbow® technology. The royalty rate is up to 10% of the rainbow® royalty base, which includes handhelds, tabletop and multi-parameter devices. Handheld products incorporating rainbow® technology will carry up to a 10% royalty rate. For other products, only the proportional amount attributable to that portion of the Company’s devices used to monitor non-vital signs measurements, rather than to monitor vital signs measurements, and sensors and accessories for measuring only non-vital signs parameters, will be included in the 10% rainbow® royalty base. Effective January 2009, for multi-parameter devices, the rainbow® royalty base includes the percentage of the revenue based on the number of rainbow® enabled measurements. For hospital contracts where the Company places equipment and enters into a sensor contract, the Company pays a royalty to Cercacor on the total sensor contract revenues based on the ratio of rainbow® enabled devices to total devices.
The current annual minimum aggregate royalty obligation under the license is $5.0 million. Actual aggregate royalty liabilities to Cercacor under the license were $1.3 million and $2.6 million for the three and six months ended July 4, 2015, respectively, and $1.7 million and $3.2 million for the three and six months ended June 28, 2014, respectively. In connection with a change in control of the Company, as defined in the Cross-Licensing Agreement, the minimum aggregate annual royalties for licensed rainbow® measurements payable to Cercacor related to carbon monoxide, methemoglobin, fractional arterial oxygen saturation, hemoglobin and blood glucose will increase to $15.0 million, plus up to $2.0 million for other rainbow® measurements.

15
Table of Contents
MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

In February 2009, in order to accelerate the product development of an improved hemoglobin spot-check measurement device, Pronto-7®, the Company’s board of directors agreed to fund additional engineering expenses of Cercacor. Specifically, these expenses included third-party engineering materials and supplies expense as well as 50% of Cercacor’s total engineering and engineering-related payroll expenses. Beginning in 2012, the Company’s board of directors approved an increase in the percentage of Cercacor’s total engineering and engineering-related payroll expenses funded by the Company from 50% to 60%. This arrangement was discontinued by mutual agreement effective as of January 4, 2015. During the three and six months June 28, 2014, the expenses for these additional services, materials and supplies totaled $0.9 million and $1.8 million, respectively.
Pursuant to authoritative accounting guidance, Cercacor is consolidated within the Company’s financial statements for all periods presented. The Company is required to consolidate Cercacor since the Company is currently deemed to be the primary beneficiary of Cercacor’s activities. This determination is based primarily on the facts that the Company is Cercacor’s sole customer and Cercacor is currently financially dependent on the Company for funding. Accordingly, all intercompany royalties, option and license fees and other charges between the Company and Cercacor, as well as all intercompany payables and receivables, have been eliminated in the consolidation. Also, all direct engineering expenses that have been incurred by the Company and charged to Cercacor, or that have been incurred by Cercacor and charged to the Company, have not been eliminated and are included as research and development expense in the Company’s condensed consolidated statements of comprehensive income. Upon consolidation, $6.3 million and $6.5 million of deferred revenue related to technology licensed to the Company as of July 4, 2015 and January 3, 2015, respectively, were eliminated. In addition, net receivables of $1.9 million and $2.0 million due from the Company as of July 4, 2015 and January 3, 2015, respectively, were eliminated.
Assets of Cercacor can only be used to settle obligations of Cercacor and creditors of Cercacor have no recourse to the general credit of the Company. The condensed consolidated balance sheets include a noncontrolling interest in Cercacor of $0.4 million and $1.7 million as of July 4, 2015 and January 3, 2015, respectively, which represents the value of common stock, additional paid-in capital and retained earnings of Cercacor that are not available to the Company. In addition, the condensed consolidated balance sheets include, net of intercompany eliminations, total assets of $6.1 million and $7.2 million as of July 4, 2015 and January 3, 2015, respectively, related to Cercacor. Cercacor’s total assets as of July 4, 2015 included $4.8 million for intangible assets and $0.9 million for property and equipment. Cercacor’s total assets as of January 3, 2015 included $4.7 million for intangible assets and $1.2 million for property and equipment. The Company’s condensed consolidated balance sheets include total liabilities related to Cercacor, net of intercompany eliminations, of $1.6 million as of July 4, 2015 and $1.2 million as of January 3, 2015.
For the foreseeable future, the Company anticipates that it will continue to consolidate Cercacor pursuant to the current authoritative accounting guidance; however, in the event that Cercacor is no longer considered a VIE under such accounting guidance, the Company may discontinue consolidating the entity.
The changes in noncontrolling interest for Cercacor were as follows (in thousands):
 
Six Months Ended 
 July 4, 2015
Noncontrolling interest, beginning of period
$
1,742

Increase in additional paid-in capital of noncontrolling interest
6

Net loss attributable to noncontrolling interest
1,356

     Noncontrolling interest, end of period
$
392

4. Cash and Cash Equivalents
The Company considers all highly liquid investments with an original maturity from date of purchase of three months or less, or highly liquid investments that are readily convertible into known amounts of cash, to be cash equivalents. As of July 4, 2015, the Company’s cash balance was $80.0 million, which was primarily comprised of checking accounts. Additionally, the Company had cash equivalents of $39.4 million, which consisted of $32.5 million of bank time deposits and $6.9 million of money market funds. As of January 3, 2015, the Company’s cash balance was $92.9 million, comprised of primarily checking accounts. Additionally, the Company had cash equivalents of $41.6 million, consisting of $40.5 million of bank time deposits and $1.1 million of money market funds.

16
Table of Contents
MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

5. Inventories
Inventories consist of the following (in thousands):
 
July 4,
2015
 
January 3,
2015
Raw materials
$
34,333

 
$
33,056

Work-in-process
5,260

 
6,020

Finished goods
31,995

 
30,642

     Total inventories
$
71,588

 
$
69,718

6. Other Current Assets
Other current assets consist of the following (in thousands):
 
July 4,
2015
 
January 3,
2015
Royalties receivable
$
7,000

 
$
7,200

Prepaid expenses
7,912

 
9,816

Employee loans and advances
324

 
385

Other current assets
5,227

 
4,070

     Total other current assets
$
20,463

 
$
21,471

7. Property and Equipment
Property and equipment, net, consists of the following (in thousands):
 
July 4,
2015
 
January 3,
2015
Machinery and equipment
$
41,269

 
$
38,588

Building and improvements
44,469

 
30,678

Land
23,549

 
22,894

Computer equipment
14,640

 
13,035

Tooling
12,991

 
12,317

Leasehold improvements
7,212

 
9,912

Furniture and office equipment
7,155

 
4,864

Demonstration units
980

 
972

Vehicles
45

 
45

Construction-in-progress
29,843

 
25,731

     Total cost
182,153

 
159,036

Accumulated depreciation and amortization
(59,430
)
 
(57,084
)
     Property and equipment, net
$
122,723

 
$
101,952

In June 2015, the Company, through a wholly owned subsidiary, completed the purchase of its previously leased 90,000 square foot manufacturing, office and warehouse facility located in New Hampshire (the Property). The total purchase price of the Property, inclusive of closing costs and amounts allocable to certain intangible assets and the termination of the existing lease, was $8.5 million, of which $6.3 million was recorded to land, building and improvements.
Approximately $27.2 million of construction-in-progress is related to the purchase and renovation costs incurred in connection with the Company’s new corporate headquarters and research and development facility in Irvine, California, of which approximately $6.2 million is still recorded in accounts payable.
The gross value of furniture and office equipment under capital lease obligations was $0.6 million as of both July 4, 2015 and January 3, 2015, with accumulated depreciation of $0.5 million and $0.4 million as of July 4, 2015 and January 3, 2015, respectively.

17
Table of Contents
MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

8. Intangible Assets
Intangible assets, net, consist of the following (in thousands):
 
July 4,
2015
 
January 3,
2015
Patents
$
21,081

 
$
20,459

Customer relationships
7,669

 
7,669

Acquired technology
5,580

 
5,580

Trademarks
3,772

 
3,562

Capitalized software development costs
2,332

 
2,066

Other
2,527

 
1,450

     Total cost
42,961

 
40,786

Accumulated amortization
(14,925
)
 
(13,015
)
     Intangible assets, net
$
28,036

 
$
27,771

Total amortization expense for the six months ended July 4, 2015 and June 28, 2014 was $2.4 million and $1.7 million, respectively. All of these intangible assets have a 10 year weighted average amortization period. Estimated amortization expense for future fiscal years is as follows (in thousands):
Fiscal year
Amount
2015 (balance of year)
$
3,486

2016
3,181

2017
3,051

2018
2,558

2019
2,351

Thereafter
13,409

     Total
$
28,036

9. Accrued Liabilities
Accrued liabilities consist of the following (in thousands):
 
July 4,
2015
 
January 3,
2015
Accrued customer rebates, fees and reimbursements
$
17,207

 
$
11,645

Accrued taxes
3,616

 
4,372

Accrued warranty
1,377

 
1,416

Accrued other
5,980

 
7,108

     Total accrued liabilities
$
28,180

 
$
24,541

10. Long Term Debt
Long term debt consists of the following (in thousands):
 
July 4,
2015
 
January 3,
2015
Revolving line of credit
$
177,500

 
$
125,000

Long term portion of capital lease obligations acquisition
104

 
145

     Total long term debt
$
177,604

 
$
125,145

In September 2014, the Company executed Amendment No. 1 to Credit Agreement (Amendment 1) with JPMorgan Chase Bank, N.A., as Administrative Agent and a Lender (JPMorgan), and Bank of America, N.A., as a Lender (BofA). Amendment 1 modified the credit agreement dated April 23, 2014, by and among the Company, the Lenders from time to time party thereto and JPMorgan (the Credit Agreement and collectively with Amendment 1, the Amended Credit Agreement). The Amended

18
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

Credit Agreement increased the Company’s borrowing capacity by $125.0 million, bringing the total available borrowing capacity to $250.0 million with an option, subject to certain conditions, for the Company to increase the aggregate borrowing capacity up to $350.0 million in the future. The Amended Credit Agreement also provides for a sublimit of up to $50.0 million for the issuance of letters of credit and a sublimit of $75.0 million for borrowings in specified foreign currencies. All unpaid principal under the Amended Credit Agreement will become due and payable on September 29, 2019.
Borrowings under the Amended Credit Agreement will be deemed, at the Company’s election, either: (i) an ABR Loan, which bears interest at the Alternate Base Rate (as defined below), plus a spread (ABR Spread) based upon a Company leverage ratio, or (ii) a Eurodollar Loan, which bears interest at the Adjusted LIBO Rate (as defined below), plus a spread (Eurodollar Spread) based upon a Company leverage ratio. The ABR Spread is 0.125% to 1.00% and the Eurodollar Spread is 1.125% to 2.000%. Subject to certain conditions, the Company may also request swingline loans from time to time (Swingline Loans) that bear interest similar to an ABR Loan.
The Alternate Base Rate is determined by taking the greatest of (i) the prime rate, (ii) the federal funds effective rate plus 0.50%, and (iii) the one-month Adjusted LIBO Rate plus 1.0%. The Adjusted LIBO Rate is equal to LIBOR for the applicable interest period multiplied by the statutory reserve rate for such period.
The Company is obligated under the Amended Credit Agreement to pay a fee ranging from 0.175% to 0.300% per annum, based upon a Company leverage ratio, with respect to any unused portion of the line of credit. This fee and interest on any ABR Loan are due and payable quarterly in arrears. Interest on any Eurodollar Loan is due and payable at the end of the applicable interest period (or at each three month interval in the case of loans with interest periods greater than three months). Interest on any Swingline Loan is due and payable on the date that the Swingline Loan is required to be repaid. The Company may prepay the loans and terminate the commitments in whole at any time, without premium or penalty, subject to reimbursement of certain costs in the case of Eurodollar Loans.
Pursuant to the terms of the Amended Credit Agreement, the Company is subject to certain covenants, including financial covenants related to a leverage ratio and an interest charge coverage ratio, and other customary negative covenants. The Company’s obligations under the Amended Credit Agreement are secured by substantially all of the Company’s personal property, including all equity interests in domestic subsidiaries and first-tier foreign subsidiaries.
As of July 4, 2015, the Amended Credit Agreement had outstanding Eurodollar draws totaling $177.5 million at an effective interest rate of 1.4375%, and the Company was in compliance with all of its covenants.
11. Stock Repurchase Program
In February 2013, the Company’s board of directors authorized the repurchase of up to 6.0 million shares of the Company’s common stock under a stock repurchase program. In October 2014, the Company’s board of directors increased the number of shares of the Company’s common stock authorized for repurchase by 3.0 million shares, bringing the total number of shares of the Company’s common stock authorized under such repurchase program from inception to 9.0 million. The stock repurchase program may be carried out at the discretion of a committee comprised of the Company’s Chief Executive Officer and Chief Financial Officer through open market purchases, one or more Rule 10b5-1 trading plans, block trades and in privately negotiated transactions. During the three months ended July 4, 2015, approximately 2.1 million shares were repurchased at an average cost of $34.56 per share for a total repurchase cost of $73.4 million. During the six months ended July 4, 2015, approximately 2.4 million shares were repurchased at an average cost of $34.39 per share for a total repurchase cost of $81.6 million. During the three and six months ended June 28, 2014, approximately 2.0 million shares were repurchased at an average cost of $24.27 per share for a total repurchase cost of $49.2 million. 

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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

12. Share-Based Compensation
The number and weighted-average exercise price of options issued and outstanding under all of the Company’s stock option plans are as follows (in thousands, except for exercise prices):
 
Six Months Ended 
 July 4, 2015
 
Shares
 
Average
Exercise Price
Options outstanding, beginning of period
9,956

 
$
23.59

Granted
726

 
$
34.80

Canceled
(138
)
 
$
24.12

Exercised
(786
)
 
$
19.34

Options outstanding, end of period
9,758

 
$
24.75

Options exercisable, end of period
5,786

 
$
24.39

Options available for grant, end of period
5,185

 
 
The Black-Scholes option pricing model is used to estimate the fair value of options granted under the Company’s share-based compensation plans. The range of assumptions used and the resulting weighted-average fair value of options granted at the date of grant were as follows:
 
Three Months Ended
 
Six Months Ended
 
July 4,
2015
 
June 28,
2014
 
July 4,
2015
 
June 28,
2014
Risk-free interest rate
1.4% to 1.9%
 
1.5% to 1.8%
 
1.3% to 1.9%
 
1.4% to 1.8%
Expected term (in years)
5.5
 
5.1
 
5.5
 
5.1
Estimated volatility
32.0% to 34.0%
 
32.2% to 33.1%
 
32.0% to 37.4%
 
31.8% to 33.1%
Expected dividends
0%
 
0%
 
0%
 
0%
Weighted-average fair value of options granted
$12.45
 
$7.6
 
$11.64
 
$8.65
The total share-based compensation expense for the three and six months ended July 4, 2015 was $2.5 million and $5.4 million, respectively. The total share-based compensation expense for the three and six months ended June 28, 2014 was $2.6 million and $5.2 million, respectively.
The aggregate intrinsic value of options is calculated as the positive difference, if any, between the market value of the Company’s common stock on the date of exercise or the respective period end, as appropriate, and the exercise price of the options. The aggregate intrinsic value of options outstanding, with an exercise price less than the closing price of the Company’s common stock, as of July 4, 2015 was $53.7 million. The aggregate intrinsic value of options exercisable, with an exercise price less than the closing price of the Company’s common stock, as of July 4, 2015 was $23.7 million. The aggregate intrinsic value of options exercised during the three and six months ended July 4, 2015 was $8.3 million and $11.6 million, respectively.
The unrecognized share-based compensation expense related to unvested options granted after January 1, 2006 was $25.4 million as of July 4, 2015. The weighted-average remaining contractual term of options outstanding, with an exercise price less than the closing price of the Company’s common stock, as of July 4, 2015 was 5.8 years. The weighted-average remaining contractual term of options exercisable, with an exercise price less than the closing price of the Company’s common stock, as of July 4, 2015 was 4.2 years.
13. Commitments and Contingencies
Leases
The Company leases certain facilities in North America, Europe and Asia under operating lease agreements expiring at various dates through December 2020. Certain facility leases contain predetermined price escalations and in some cases renewal options. The Company recognizes the lease costs using a straight-line method based on total lease payments. The Company has received leasehold improvement incentives in connection with certain leased facilities in the U.S. These leasehold improvement incentives have been recorded as deferred rent and are being amortized as a reduction to rent expense on a straight-line basis over the life of the lease. As of July 4, 2015 and January 3, 2015, rent expense accrued in excess of the amount paid aggregated

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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

$0.4 million for each period, which is classified as other liabilities in the accompanying condensed consolidated balance sheets. In addition, the Company leases automobiles in Europe that are classified as operating leases and expire at various dates through January 2016. The majority of these leases are non-cancellable. The Company also has outstanding capital leases for office equipment and computer equipment, all of which are non-cancellable. Future minimum lease payments under operating and capital leases for each of the following fiscal years ending on or about December 31 are (in thousands) (including interest):
 
As of July 4, 2015
 
Operating
Leases
 
Capital
Leases
 
Total
2015 (balance of year)
$
1,791

 
$
9

 
$
1,800

2016
2,721

 
88

 
2,809

2017
2,354

 
82

 
2,436

2018
2,084

 
8

 
2,092

2019
1,909

 
8

 
1,917

Thereafter
1,033

 
3

 
1,036

Total
$
11,892

 
$
198

 
$
12,090

Rental expense related to operating leases was $1.4 million and $2.9 million for the three and six months ended July 4, 2015, respectively, and $1.5 million and $3.1 million for the three and six months ended June 28, 2014, respectively. The Company leases office equipment and computer equipment, which have interest rates ranging from 4.3% to 5.2% per year and mature on various dates from February 2017 through June 2020.
Employee Retirement Savings Plan
The Company maintains a 401(k) plan, the Masimo Retirement Savings Plan (the Plan), covering the Company’s full-time U.S. employees who meet certain eligibility requirements. In general, the Company matches an employee’s contribution up to 3% of the employee’s compensation, subject to a maximum amount. The Company may also contribute to the Plan on a discretionary basis. The Company contributed $0.6 million and $1.2 million to the Plan for the three and six months ended July 4, 2015, respectively, and $0.6 million and $1.2 million to the Plan for the three and six months ended June 28, 2014, respectively.
Employment and Severance Agreements
As of July 4, 2015, the Company had an employment agreement with one of its key employees that provides for an aggregate annual base salary with annual increases at the discretion of the Compensation Committee of the Company’s board of directors. The employment agreement provides for an annual bonus based on the Company’s attainment of certain objectives and goals. The agreement has an initial term of three years, with automatic daily renewal, unless either the Company or the executive notifies the other party of non-renewal of the agreement. Also, under this employment agreement, the key employee may be entitled to receive certain salary, equity, tax, medical and life insurance benefits if he is terminated by the Company, if he terminates his employment for good reason under certain circumstances or if there is a change in control of the Company.
As of July 4, 2015, the Company had severance plan participation agreements with seven of its executive officers. The participation agreements (the Agreements) are governed by the terms and conditions of the Company’s 2007 Severance Protection Plan (the Severance Plan), which became effective on July 19, 2007 and which was amended effective December 31, 2008. Under each of the Agreements, the applicable executive officer may be entitled to receive certain salary, equity, medical and life insurance benefits if he is terminated by the Company without cause or if he terminates his employment for good reason under certain circumstances. The executive officers are also required to give the Company six months advance notice of their resignation under certain circumstances.
Purchase Commitments
Pursuant to contractual obligations with vendors, the Company had $81.8 million of purchase commitments as of July 4, 2015, which are expected to be purchased within one year. These purchase commitments have been made for certain inventory items in order to secure sufficient levels of those items and to achieve better pricing.

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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

Other Contractual Commitments
In the normal course of business, the Company may provide bank guarantees to support government hospital tenders in certain foreign jurisdictions. As of July 4, 2015, there were approximately $0.4 million in unsecured bank guarantees and $1.6 million in standby letters of credit outstanding related to such tenders.
In certain circumstances, the Company also provides limited indemnification within its various customer contracts whereby the Company indemnifies the parties to whom it sells its products with respect to potential infringement of intellectual property, and against bodily injury caused by a defective Company product. It is not possible to predict the maximum potential amount of future payments under these or similar agreements, due to the conditional nature of the Company’s obligations and the unique facts and circumstances involved. As of July 4, 2015, the Company has not incurred any significant costs related to contractual indemnification of its customers.
Concentrations of Risk
The Company is exposed to credit loss for the amount of its cash deposits with financial institutions in excess of federally insured limits. The Company invests its excess cash deposits in U.S. Treasury bills and money market accounts with major financial institutions. As of July 4, 2015, the Company had $80.0 million of bank balances, of which $3.3 million was covered by either the U.S. Federal Deposit Insurance Corporation limit or foreign countries’ deposit insurance organizations. As of July 4, 2015, the Company had $6.9 million in money market funds and $32.5 million of bank time deposits that are not guaranteed by the U.S. Federal government.
While the Company and its contract manufacturers rely on sole source suppliers for certain components, steps have been taken to minimize the impact of a shortage or stoppage of shipments, such as maintaining a safety stock of inventory and designing products that could be modified to use different components. However, there can be no assurance that a shortage or stoppage of shipments of the materials or components that the Company purchases will not result in a delay in production or adversely affect the Company’s business.
The Company’s ability to sell its products to U.S. hospitals depends in part on its relationships with GPOs. Many existing and potential customers for the Company’s products become members of GPOs. GPOs negotiate pricing arrangements and contracts, sometimes exclusively, with medical supply manufacturers and distributors, and these negotiated prices are made available to a GPO’s affiliated hospitals and other members. During the three and six months ended July 4, 2015, revenue from the sale of the Company’s products to U.S. hospitals that are members of GPOs amounted to $84.5 million and $170.8 million, respectively. During the three and six months ended June 28, 2014, revenue from the sale of the Company’s products to U.S. hospitals that are members of GPOs amounted to $78.6 million and $153.8 million, respectively.
As of July 4, 2015, two different just-in-time distributors each represented 11% and 10% of the accounts receivable balance, respectively. As of January 3, 2015, three different just-in-time distributors each represented 9%, 6% and 5% of the accounts receivable balance, respectively.
For the three months ended July 4, 2015, the Company had sales through two just-in-time distributors, which each represented 15% and 12% of total revenue, respectively. For the three months ended June 28, 2014, the Company had sales through two just-in-time distributors, which each represented 14% and 12% of total revenue, respectively.
For the six months ended July 4, 2015, the Company had sales through two just-in-time distributors, which each represented 15% and 12% of the total revenue, respectively. For the six months ended June 28, 2014, the Company also had sales through two just-in-time distributors, which each represented 14% and 11% of the total revenue, respectively. For the three and six months ended July 4, 2015 and July 4, 2015, the just-in-time distributors took and fulfilled orders from the Company’s direct customers, many of whom have signed long-term sensor agreements with the Company.
For the three months ended July 4, 2015 and June 28, 2014, the Company recorded $8.1 million and $7.4 million, respectively, in royalty revenues from Covidien pursuant to the original settlement agreement and amendments. For the six months ended July 4, 2015 and June 28, 2014, the Company recorded $15.3 million and $15.0 million, respectively, in royalty revenues from Covidien pursuant to the original settlement agreement and amendments. In exchange for these royalty payments, the Company has provided Covidien the ability to ship its patent infringing product with a covenant not to sue Covidien as long as Covidien abides by the terms of the agreement. The current royalty rate is 7.75% and the amended agreement can be terminated by Covidien upon 60 days written notice.

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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

Litigation
On February 3, 2009, the Company filed a patent infringement suit in the U.S. District Court for the District of Delaware against Philips Electronics North America Corporation and Philips Medizin Systeme Böblingen GmbH (collectively, Philips) related to Philips’ FAST pulse oximetry technology and certain of Philips’ patient monitors. On June 15, 2009, Philips answered the Company’s complaint and Philips Electronics North America Corporation filed antitrust and patent infringement counterclaims against the Company, as well as counterclaims seeking declaratory judgments of invalidity of the patents asserted by the Company against Philips. On July 9, 2009, the Company filed its answer denying Philips’ counterclaims and asserting various defenses. The Company also asserted counterclaims against Philips for fraud, intentional interference with prospective economic advantage and for declaratory judgments of noninfringement and invalidity with respect to the patents asserted by Philips against the Company. Philips later added a claim for infringement of one additional patent. Subsequently, the Court bifurcated Philips’ antitrust claims and its patent misuse defense, as well as stayed the discovery phase on those claims pending trial in the patent case. In addition, the Company asserted additional patents in 2012, and the Court ordered that these patents and some of the originally asserted patents be tried in a second phase. On May 23, 2014, Philips filed a motion for leave to amend its answer and counterclaims to allege inequitable conduct. The Court granted Philips’ motion for leave to amend. A jury trial commenced on September 15, 2014 with respect to two of the Company’s patents and one of Philips’ patents. On October 1, 2014, the jury determined that both of the Company’s patents were valid and that the damages amount for Philips’ infringement was $466.8 million. The jury also determined that the Company did not infringe the Philips patent. The Court held a bench trial on an inequitable conduct defense raised by Philips and heard oral arguments on the post-trial motions. The Court denied Philips’ post-trial motions and found that Philips failed to prove inequitable conduct. The Court also denied a motion brought by the Company seeking judgment on the pleadings of Philips’ patent misuse defense. Philips has indicated that it intends to appeal the jury verdict. Although specific dates have not been set, the Court has indicated that the trials related to the second phase patents and the Philips’ antitrust counterclaims and patent misuse defense will be scheduled for the fourth quarter of 2016. The Company believes that it has good and substantial defenses to the antitrust and patent infringement claims asserted by Philips. The Company is unable to determine whether any loss will occur or to estimate the range of such potential loss; therefore, no amount of loss has been accrued by the Company as of the date of filing of this Quarterly Report on Form 10-Q. Furthermore, there is no guarantee that the Company will prevail in this suit or receive any damages or other relief if it does prevail.
On December 21, 2012, the Company filed suit against Mindray DS USA, Inc. and Shenzhen Mindray Bio-Medical Electronics Co, Ltd. (Shenzhen Mindray) in the U.S. District Court for the Central District of California. The complaint alleges patent infringement, breach of contract and other claims. Mindray DS USA, Inc. was dismissed from the case based on venue. On June 3, 2013, Shenzhen Mindray answered the Company’s complaint and filed antitrust and related counterclaims against the Company, as well as counterclaims seeking declaratory judgments of invalidity and non-infringement of the patents asserted by the Company against Shenzhen Mindray. On June 24, 2013, the Company filed its answer denying Shenzhen Mindray’s counterclaims and asserting various defenses. On July 17, 2013, the Court granted Shenzhen Mindray’s motion to dismiss the patent claims without prejudice to allow the Company to amend the complaint to provide additional detail supporting Shenzhen Mindray’s direct and indirect infringement of the Company’s patents. On the same day, the Court denied Shenzhen Mindray’s motion to dismiss the Company’s non-patent claims. On August 5, 2013, the Company filed a first amended complaint. On August 21, 2013, Shenzhen Mindray answered the Company’s complaint and reasserted the counterclaims it asserted on June 3, 2013, as well as two additional counterclaims alleging patent infringement. On September 16, 2013, the Company filed its answer denying Shenzhen Mindray’s counterclaims and asserting various defenses. On October 31, 2013, the Court issued a scheduling order setting a trial date of November 4, 2014. On December 10, 2013, Shenzhen Mindray filed a second amended answer and counterclaims, including a new counterclaim for tortious interference. On January 2, 2014, the Company filed a motion for judgment on the pleadings as to Shenzhen Mindray’s antitrust counterclaims and inequitable conduct counterclaims and defenses. The Court granted judgment on the pleadings with leave to amend. On March 27, 2014, Shenzhen Mindray filed a third amended answer and counterclaims. On April 10, 2014, Shenzhen Mindray filed a fourth amended answer and counterclaims. On May 5, 2014, Shenzhen Mindray filed a partial motion for summary judgment of no patent infringement, which the Court denied on June 19, 2014. On May 19, 2014, Shenzhen Mindray filed a motion for judgment on the pleadings contending that Masimo International SARL (a subsidiary of the Company), not Masimo Corporation, has standing to assert its claims relating to breach of contract. The Company opposed this motion and filed a motion to add Masimo International SARL as a plaintiff. On June 26, 2014, the Court granted the Company’s motion and denied Shenzhen Mindray’s motion. The Court also vacated the case schedule. On July 7, 2014, the Company filed a second amended complaint adding Masimo International SARL as a plaintiff. On August 18, 2014, the Court adopted the Company’s proposed case schedule, setting a new trial date of December 1, 2015. The Company believes that it has good and substantial defenses to the antitrust, patent infringement and other counterclaims asserted by Shenzhen Mindray. The Company is unable to determine whether any loss will occur or to estimate the range of such potential loss; therefore, no amount of loss has been accrued by the Company as of the date of filing

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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

of this Quarterly Report on Form 10-Q. Furthermore, there is no guarantee that the Company will prevail in this suit or receive any damages or other relief if it does prevail.
On March 6, 2013, Shenzhen Mindray filed a complaint against the Company under the Anti-Unfair Competition Law of the People’s Republic of China (PRC) before the Shenzhen Municipal Intermediate People’s Court, alleging violation of PRC competition laws. On March 10, 2014, the Guangdong Higher People’s Court of PRC held that the Shenzhen Court did not have jurisdiction. On December 23, 2014, the Supreme People’s Court of PRC reversed the Guangdong Court’s ruling. Following the Supreme People’s Court’s ruling, the case was remanded to the Shenzhen Court for a ruling on the merits of Shenzhen Mindray’s claims. Shenzhen Mindray also filed a complaint in Shenzhen Intermediate People’s Court against the Company and Shenzhen Comen Medical Instruments on February 6, 2015, alleging infringement of Chinese Patent No. 00808884.5. Additionally, a separate lawsuit was filed against Masimo Sweden AB on the same day and in the same court alleging infringement of Chinese Patent No. 200710305061.9. The Company believes that it has good and substantial defenses to Shenzhen Mindray’s claims, but there is no guarantee that the Company will prevail in these suits. The Company is unable to determine whether any loss will occur or to estimate the range of such potential loss; therefore, no amount of loss has been accrued by the Company as of the date of filing of this Quarterly Report on Form 10-Q.
On December 10, 2013, the Company filed suit against Mindray DS USA, Inc., (Mindray USA), Shenzhen Mindray and Mindray Medical International Ltd. in the Superior Court of New Jersey. The complaint alleges breach of contract and related claims. In January 2014, Mindray USA removed the case to the U.S. District Court for the District of New Jersey. In February 2014, the Company filed a motion to remand the action to the Superior Court of New Jersey. In May 2014, Mindray USA filed an answer and counterclaims in the U.S. District Court asserting patent infringement and federal antitrust counterclaims. On January 7, 2015, the U.S. District Court remanded the action to the Superior Court of New Jersey. On January 22, 2015, Mindray USA filed an answer and counterclaims in the Superior Court of New Jersey asserting patent infringement and federal antitrust counterclaims, and again removed the case to the U.S. District Court for the District of New Jersey. On January 29, 2015, Mindray USA, Shenzhen Mindray and Mindray Medical International, Ltd. filed separate motions to dismiss the action, each of which is currently pending before the U.S. District Court. On February 23, 2015, the Company filed a motion to remand the case to the Superior Court of New Jersey, which is currently pending before the U.S. District Court. There is no guarantee that the Company will prevail in this suit or receive any damages or other relief if it does prevail.
In September 2012, a shareholder derivative lawsuit was filed in the U.S. District Court for the District of Delaware by Joseph Ausikaitis naming certain of the Company’s directors and certain executive officers as defendants and the Company as the nominal defendant. The lawsuit alleged claims of breach of fiduciary duty and unjust enrichment in connection with the grant or receipt of stock options under the Company’s 2007 Stock Incentive Plan and related policies. The lawsuit sought unspecified monetary damages on the Company’s behalf from the officer and director defendants, various forms of equitable and/or injunctive relief, attorneys’ and other professional fees and costs and various other forms of relief. On May 5, 2015, the plaintiff and the defendants entered into a Stipulation and Agreement of Settlement providing for an agreement to settle the lawsuit, which was approved by the Court on June 17, 2015. Pursuant to the Stipulation and Agreement of Settlement, the Company agreed to implement certain corporate governance measures and changes, and to ensure that such measures and changes remain in effect for at least 5 years. The Company is not required to pay, and will not receive, any monetary damages under the settlement.
In April 2011, the Company was informed by the United States Attorney’s Office for the Central District of California, Civil Division, that a qui tam complaint had been filed against the Company in the U.S. District Court for the Central District of California by three of the Company’s former physician office sales representatives. The qui tam complaint alleged, among other things, that the Company’s noninvasive hemoglobin products failed to meet their accuracy specifications, and that the Company misled the U.S. Food and Drug Administration (FDA) and customers regarding the accuracy of the products. In November 2011, the United States declined to intervene in the case, and in October 2013, the District Court granted summary judgment in favor of the Company. The former sales representatives have appealed the District Court’s decision.
In September 2011, two of the same former sales representatives filed employment-related claims against the Company in arbitration also stemming from their allegations regarding the Company’s noninvasive hemoglobin products. On January 16, 2014, the Company was notified that the arbitrator awarded the plaintiffs approximately $5.4 million in damages, which the Company accrued in fiscal 2013. In addition, the Company’s insurance carrier notified the Company that it believed certain defense costs related to the arbitration may no longer be reimbursable in view of the arbitration decision. As a result, the Company accrued a liability of $2.6 million in fiscal 2013 for the costs estimated to have been paid by the insurance carrier. The Company challenged the arbitration award in the U.S. District Court for the Central District of California, and on April 3, 2014, the District Court vacated the award. Accordingly, the Company reversed the $8.0 million charge in the quarter ended March 29, 2014. The former sales representatives have appealed the District Court’s decision. The Company is unable to

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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

predict the final outcome of the qui tam and employment matters. A reversal of the District Court’s decision in either matter could have a material adverse effect on the Company’s consolidated financial condition, results of operations or cash flows. The Company is unable to determine whether any loss will occur or to estimate the range of such loss; therefore, no amount of loss has been accrued by the Company as of the date of filing of this Quarterly Report on Form 10-Q.
In the third quarter of 2013, the Company was notified that the FDA and the United States Attorney’s Office for the Central District of California, Criminal Division (USAO), were investigating the allegations regarding its noninvasive hemoglobin products. In the second quarter of 2014, the Company received grand jury subpoenas requesting documents pertaining to, among other things, the testing, marketing and sales of its Pronto® and Pronto-7® products. On May 7, 2015, the Company received a letter from the USAO stating that, at this time, the USAO has decided not to initiate any criminal charges against the Company or any of its current or former employees in connection with the investigation. The USAO reserved the right to revisit its decision at any time.
On January 2, 2014, a putative class action complaint was filed against the Company in the U.S. District Court for the Central District of California by Physicians Healthsource, Inc. The complaint alleges that the Company sent unsolicited facsimile advertisements in violation of the Junk Fax Protection Act of 2005 and related regulations. The complaint seeks $500 for each alleged violation, treble damages if the District Court finds the alleged violations to be knowing, plus interest, costs and injunctive relief. On April 14, 2014, the Company filed a motion to stay the case pending a decision on a related petition filed by the Company with the Federal Communications Commission (FCC). On May 22, 2014, the District Court granted the motion and stayed the case pending a ruling by the FCC on the petition. On October 30, 2014, the FCC granted some of the relief and denied some of the relief requested in the petition. Both parties appealed the FCC’s decision on the petition. On November 25, 2014, the District Court granted the parties’ joint request that the stay remain in place pending a decision on the appeal. The Company believes it has good and substantial defenses to the claims, but there is no guarantee that the Company will prevail. The Company is unable to determine whether any loss will occur or to estimate the range of such loss; therefore, no amount of loss has been accrued by the Company as of the date of filing of this Quarterly Report on Form 10-Q.
On January 31, 2014, an amended putative class action complaint was filed against the Company in the U.S. District Court for the Northern District of Alabama by and on behalf of two participants in the Surfactant, Positive Pressure, and Oxygenation Randomized Trial at the University of Alabama. On April 21, 2014, a further amended complaint was filed adding a third participant. The complaint alleges product liability and negligence claims in connection with pulse oximeters the Company modified and provided at the request of study investigators for use in the trial. A previous version of the complaint also alleged a wrongful death claim, which the Court dismissed on January 22, 2014. The amended complaint seeks unspecified damages, costs, interest, attorney fees and injunctive and other relief. On January 30, 2015, the Company filed a motion for summary judgment, which is currently pending before the Court. The Company believes it has good and substantial defenses to the remaining claims, but there is no guarantee that the Company will prevail. The Company is unable to determine whether any loss will occur or to estimate the range of such loss; therefore, no amount of loss has been accrued by the Company as of the date of filing of this Quarterly Report on Form 10-Q.
From time to time, the Company may be involved in other litigation and investigations relating to claims and matters arising out of its operations in the normal course of business. The Company believes that it currently is not a party to any other legal proceedings which, individually or in the aggregate, would have a material adverse effect on its consolidated financial position, results of operations or cash flows.
14. Segment Information and Enterprise Reporting
The Company’s chief decision maker, the Chief Executive Officer, reviews financial information presented on a consolidated basis, accompanied by disaggregated information about revenues by geographic region, for purposes of making operating decisions and assessing financial performance. Accordingly, the Company considers itself to be in a single reporting segment, specifically noninvasive patient monitoring solutions and related products. The Company does not assess the performance of its geographic regions on other measures of income or expense, such as depreciation and amortization, operating income or net income including noncontrolling interest. In addition, the Company’s assets are primarily located in the U.S. The Company does not produce reports for, or measure the performance of, its geographic regions on any asset-based metrics. Therefore, geographic information is presented only for revenues.

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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

The following schedule presents an analysis of the Company’s product revenues based upon the geographic area to which the product was shipped (in thousands, except percentages):
 
Three Months Ended
 
Six Months Ended
 
July 4, 2015
 
June 28, 2014
 
July 4, 2015
 
June 28, 2014
Geographic area by destination
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
North and South America
$
110,526

 
74.9
%
 
$
95,462

 
71.5
%
 
$
222,004

 
75.3
%
 
$
188,115

 
70.8
%
Europe, Middle East and Africa
24,335

 
16.5

 
22,717

 
17.0

 
48,396

 
16.4

 
49,729

 
18.7

Asia and Australia
12,751

 
8.6

 
15,314

 
11.5

 
24,569

 
8.3

 
27,881

 
10.5

     Total product revenue
$
147,612

 
100.0
%
 
$
133,493

 
100.0
%
 
$
294,969

 
100.0
%
 
$
265,725

 
100.0
%
United States
$
106,236

 
 
 
$
91,589

 
 
 
$
213,512

 
 
 
$
179,636

 
 
The Company’s consolidated long-lived assets and net assets by geographic area are:
 
 
July 4, 2015
 
January 3, 2015
Long-lived assets by geographic area
 
 
 
 
 
 
 
 
United States
 
$
205,490

 
94.8
%
 
$
185,461

 
94.0
%
International
 
11,302

 
5.2
%
 
11,748

 
6.0
%
     Total
 
$
216,792

 
100.0
%
 
$
197,209

 
100.0
%
 
 
July 4, 2015
 
January 3, 2015
Net assets by geographic area
 
 
 
 
 
 
 
 
United States
 
$
124,886

 
43.9
%
 
$
144,541

 
47.0
%
International
 
159,564

 
56.1
%
 
163,197

 
53.0
%
     Total
 
$
284,450

 
100.0
%
 
$
307,738

 
100.0
%
15. Income Taxes
The Company has provided for income taxes in fiscal 2015 interim periods based on the estimated effective income tax rate for the complete fiscal year. The income tax provision is computed on the estimated pretax income of the consolidated entities located within each taxing jurisdiction based on legislation enacted as of the balance sheet date. Deferred tax assets and liabilities are determined based on the future tax consequences associated with temporary differences between income and expenses reported for accounting and tax purposes. A valuation allowance for deferred tax assets is recorded to the extent that the Company cannot determine that the ultimate realization of the net deferred tax assets is more likely than not.
Realization of deferred tax assets is principally dependent upon the achievement of future taxable income, the estimation of which requires significant judgment by the Company’s management. The judgment of the Company’s management regarding future profitability may change due to many factors, including future market conditions and the Company’s ability to successfully execute its business plans or tax planning strategies. These changes, if any, may require material adjustments to these deferred tax asset balances. A valuation allowance has been previously recorded against all of the deferred tax assets of Cercacor. On a quarterly basis, Cercacor’s management reassesses the need for these valuation allowances based on operating results and its assessment of the likelihood of future taxable income and developments in the relevant tax jurisdictions. Cercacor continues to maintain a full valuation allowance as of July 4, 2015 against its net deferred tax assets.
As of July 4, 2015, the liability for income taxes associated with uncertain tax positions was approximately $8.6 million. If fully recognized, approximately $7.1 million (net of federal benefit on state taxes) would impact the Company’s effective tax rate. The remaining balance relates to timing differences. It is reasonably possible that the amount of unrecognized tax benefits in various jurisdictions may change in the next twelve months due to the expiration of statutes of limitation and audit settlements. However, due to the uncertainty surrounding the timing of these events, an estimate of the change within the next twelve months cannot currently be made.

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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

The Company conducts business in multiple jurisdictions and, as a result, one or more of the Company’s subsidiaries files income tax returns in U.S. federal, various state, local and foreign jurisdictions. The Company has concluded all U.S. federal income tax matters through fiscal year 2010. All material state, local and foreign income tax matters have been concluded through fiscal year 2007.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Quarterly Report on Form 10-Q contains “forward-looking statements” as defined in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, in connection with the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially and adversely from those expressed or implied by such forward-looking statements. Such forward-looking statements include any expectation of earnings, revenues or other financial items; any statements of the plans, strategies and objectives of management for future operations; factors that may affect our operating results or financial condition; statements concerning new products, technologies or services; statements related to future capital expenditures; statements related to future economic conditions or performance; statements related to our stock repurchase program; statements as to industry trends and other matters that do not relate strictly to historical facts or statements of assumptions underlying any of the foregoing. These statements are often identified by the use of words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may” or “will,” the negative versions of these terms and similar expressions or variations. These statements are based on the beliefs and assumptions of our management based on information currently available to management. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results and the timing of certain events to differ materially and adversely from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Risk Factors” included elsewhere in this Quarterly Report on Form 10-Q and in our other Securities and Exchange Commission (SEC) filings, including our Annual Report on Form 10-K for the fiscal year ended January 3, 2015, which we filed with the SEC on February 17, 2015. Furthermore, such forward-looking statements speak only as of the date of this report. We undertake no obligation to update any forward-looking statements to reflect events or circumstances occurring after the date of such statements.
Executive Overview
We are a global medical technology company that develops, manufactures and markets a variety of noninvasive monitoring technologies. We provide our products directly and through distributors and OEM partners to hospitals, emergency medical service (EMS) providers, home care providers, physician offices, ambulatory surgery centers, long-term care facilities, veterinarians and consumers. Our mission is to improve patient outcomes and reduce the cost of care by taking noninvasive monitoring to new sites and applications. We were incorporated in California in May 1989 and reincorporated in Delaware in May 1996.
We invented Masimo Signal Extraction Technology® (Masimo SET®) Measure-Through-Motion and Low-Perfusion™ pulse oximetry monitoring to address the primary limitations of conventional pulse oximetry. Pulse oximetry is the noninvasive measurement of the oxygen saturation level of arterial blood, which delivers oxygen to the body’s tissues, and pulse rate. Pulse oximetry is one of the most common measurements taken in and out of hospitals around the world. We believe that Masimo SET® is trusted by clinicians to safely monitor approximately 100 million patients each year. Masimo SET® pulse oximetry has been shown by more than 100 independent studies and thousands of clinical evaluations during patient motion and low-perfusion conditions to provide more accurate measurements than other non-Masimo pulse oximeters, as well as significantly reduce false alarms (specificity), and accurately detect true alarms (sensitivity) that can indicate a deteriorating patient condition. The use of Masimo SET® pulse oximetry has also been shown to improve patient outcomes by helping clinicians reduce retinopathy of prematurity in neonates, screen newborns for critical congenital heart disease, reduce ventilator weaning time and arterial blood gas measurements in the intensive care unit (ICU), and save lives and costs while reducing rapid response activations and ICU transfers on the general floor.
Since introducing Masimo SET®, we have continued to innovate by introducing additional breakthrough noninvasive measurements that go beyond arterial blood oxygen saturation and pulse rate, and which create new market opportunities in both the hospital and non-hospital care settings. Our product offerings have expanded significantly over the years to include fluid responsiveness monitoring, noninvasive optical blood constituent monitoring, optical organ oximetry monitoring, electrical brain function monitoring, acoustic respiration monitoring and optical gas monitoring. In addition, we have developed the Root® patient monitoring and connectivity platform and Patient SafetyNet™ remote patient surveillance monitoring system.
Our Masimo rainbow® SET® platform leverages our Masimo SET® technology and incorporates licensed rainbow® technology to enable real-time monitoring of additional noninvasive measurements. Our rainbow® SET® platform includes our rainbow® SET® Pulse CO-Oximetry products, which we believe are the first devices cleared by the U.S. Food and Drug Administration (FDA) to noninvasively and continuously monitor multiple blood-based measurements using multiple wavelengths of light, which previously was only possible through intermittent invasive procedures. In addition to monitoring oxygen saturation (SpO2), pulse rate (PR), perfusion index (PI), Pleth Variability Index (PVI®) and Respiration Rate from Pleth (RRp™), Masimo rainbow® SET® Pulse CO-Oximetry has the unique ability to measure and distinguish oxygenated hemoglobins from certain

28
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dyshemoglobins, hemoglobins that are incapable of transporting oxygen, and allows for the rapid noninvasive monitoring of hemoglobin (SpHb®), carboxyhemoglobin (SpCO®) and methemoglobin (SpMet®). The Masimo rainbow® SET platform also allows for monitoring of arterial oxygen saturation even under the presence of carboxyhemoglobin and methemoglobin, known as fractional arterial oxygen saturation (SpfO2™). Additionally, the rainbow® SET platform also allows for the calculation of Oxygen Content (SpOC®) and Oxygen Reserve Index (ORI™). Although RRp™, SpfO2™ and ORI™ have received CE Mark, they are not currently available for sale in the U.S.
Our O3™ regional oximetry monitoring, also known as tissue oximetry and cerebral oximetry monitoring, uses near-infrared spectroscopy to provide for continuous measurement of tissue oxygen saturation (rSO2) to help detect regional hypoxemia that pulse oximetry alone can miss. In addition, our Root® patient monitor and O3™ sensors can automate the differential analysis of regional to central oxygen saturation. O3™ monitoring involves applying O3™ regional oximetry sensors to the forehead and connecting our O3™ Masimo Open Connect™ (MOC-9™) module to any Root® monitor through one of its three MOC-9™ ports. O3™ regional oximetry is currently intended for use in subjects larger than 40 kg (approximately 88 lbs) and has received the CE Mark, but is not currently available for sale in the U.S.
Brain function monitoring is most commonly used during surgery to help clinicians avoid over-and under-titration of anesthesia and sedation. Our SedLine® brain function monitoring product measures the brain’s electrical activity by detecting electroencephalogram (EEG) signals. In contrast to whole scalp EEG monitoring, which is used for diagnostic purposes, this form of EEG monitoring is often referred to as processed EEG monitoring, or brain function monitoring. Brain function monitors display the patient’s EEG waveforms, but these are difficult for clinicians to interpret, so the EEG signals are processed and displayed as a single index that gives a continuous, quantitative indication of the patient’s depth of anesthesia and sedation. Our SedLine® brain function monitoring technology can now be delivered through the MOC-9™ connectivity port within our Root® patient monitoring and connectivity platform that integrates our breakthrough rainbow® and SET® measurements with multiple additional parameters, such as SedLine®. In addition, our SedLine® brain function monitoring technology also displays raw EEG waveforms, the Patient State Index (PSI) and the Density Spectral Array view.
Our sound-based monitoring technology, rainbow Acoustic Monitoring™ (RAM™), enables noninvasive monitoring of respiration rate (RRa®). Compared to traditional capnography which monitors exhaled carbon dioxide (CO2), most often through a nasal cannula, multiple clinical studies have shown that the noninvasive measurement of RRa® provides as good or better accuracy to monitor respiration rate and detect respiratory pause episodes, defined as a cessation of breathing for 30 seconds or more. When used with other clinical variables, RRa® may help clinicians assess respiratory depression and respiratory distress earlier and more often to help determine treatment options and potentially enable earlier interventions.
Our portfolio of capnography and gas monitoring products include external “plug-in-and-measure” capnography and gas analyzers, integrated modules, and handheld capnograph and capnometer devices. These products have the ability to measure multiple expired gases, such as CO2, nitrous oxide (N2O), oxygen (O2) and other anesthetic agents. In the case of capnography, respiration rate is also calculated from the CO2 waveform. These measurements are possible through either mainstream monitoring, which samples gases from a ventilated patient’s breathing circuit, or sidestream monitoring, which samples gases from a breathing circuit in mechanically ventilated patients or through a cannula or mask in spontaneously breathing patients. In addition, our EMMA™ Capnograph with waveform display offers clinicians greater assessment of end-tidal CO2 and respiration rate, as well as assists in recognition of return to spontaneous circulation, for a variety of clinical settings, including emergency medicine and transport, operating rooms (ORs), ICUs, patient rooms and clinics. EMMA™ fits in the palm of the hand, and we believe it is the smallest and most portable capnograph in the world.
Root® is a powerful patient monitoring and connectivity platform that integrates our breakthrough rainbow® and SET® measurements with multiple additional specialty measurements through its MOC-9™ connectivity ports in an integrated, clinician-centric platform. The first three Masimo MOC-9™ technologies for Root® were SedLine® brain function monitoring, Phasein™ capnography and O3™ regional oximetry. In addition, Iris™ connectivity in Root® enables third party devices such as intravenous pumps and ventilators to connect through Root® and enables display, notification and documentation to the electronic medical record through our Patient SafetyNet™ solution. In combination with a Radical-7® handheld monitor, Root® will display alarm information simplifying patient care workflows and potentially helping caregivers make quicker patient assessments. Root® can also be connected with monitoring devices from other medical device companies that develop their own MOC-9™ compatible modules.
Our patient surveillance, remote monitoring and clinician notification solution, Patient SafetyNet™, allows for monitoring of the oxygen saturation, pulse rate, perfusion index, hemoglobin, methemoglobin, and respiration rate of up to 200 patients simultaneously. Patient SafetyNet™ offers a rich user interface with trending, real-time waveform capability at the central station and remote notification via pager or smart phones. Patient SafetyNet™ also features the Adaptive Connectivity Engine™, which enables two-way Health Level-7 (HL7) based connectivity to clinical/hospital information systems. The Adaptive Connectivity Engine™ significantly reduces the time and complexity to integrate and validate custom HL7 implementations, and

29
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demonstrates our commitment to innovation that automates patient care with open, scalable, and standards-based connectivity architecture. Halo Index™ can be used with our Patient SafetyNet™ to allow continuous global trending and assessment of multiple physiological measurements of a patient with a single number displayed on the Patient SafetyNet™ screen. Halo Index™ is CE marked, but not currently available for sale in the U.S.
In January 2015, we introduced our MightySat™ fingertip pulse oximeter for personal use. MightySat™ provides oxygen saturation and pulse rate measurements and is designed for those who want accurate measurements even under challenging conditions such as movement and low perfusion. MightySat™ is available in three versions, each of which provides SpO2, PR, and PI measurements in a compact, battery-powered design with a large color screen that can be rotated for real-time display of the pleth waveform as well as measurements. Optional Bluetooth wireless functionality enables measurement display via the free, downloadable Masimo Personal Health app on iOS and Android mobile devices, as well as the ability to trend and communicate measurements and interface with the Apple Health app. MightySat™ is also available with optional PVI®, a measure of the dynamic changes in the PI that occur during one or more complete respiratory cycles. MightySat™ is available through online retailers such as Amazon.com. In the U.S., MightySat™ is intended for sports and aviation use only and is not intended for medical use.
In April 2015, we introduced the Patient SafetyNet Series 5000™ along with Iris™ Connectivity and MyView™ through the Root® patient monitoring and connectivity platform. This series of Patient SafetyNet™ offers a new level of interoperability designed to enhance clinician workflows, and reduce the cost of care, from operating rooms to medical-surgical units. The Patient SafetyNet Series 5000™ with Iris™ enables Root® to intake data from all devices connected to the patient, acting as an in-room patient monitor and connectivity hub. Alarms and alerts for all devices are seamlessly forwarded to the patient’s clinician and all device data are effortlessly documented in the patient’s electronic medical record (EMR). The patient-centric user interface of Patient SafetyNet Series 5000™ displays near real-time data from all devices, providing a single unified dashboard of patient information. Having such a holistic view can enable caregivers to more quickly assess patient status, allowing for faster clinical decisions. To simplify documentation of patient data, Root® enables clinicians to easily verify and send patient vitals, as well as all connected medical device information data to the EMR directly from Root®. Data can also be sent to the EMR periodically. An interface between the Patient SafetyNet Series 5000™ Appliance and the hospital admission, discharge and transfer (ADT) system allows clinicians to receive ADT information on Root® for positive patient identification at the bedside. Clinicians can also manually enter additional data on the Root® device, including temperature, blood pressure, level of consciousness, pain score, and urine output.
MyView™ is a wireless, presence-detection system that enables clinicians to automatically display customized clinical profiles on our devices, such as Root®, Radical-7®, and the Patient SafetyNet View Station. When a clinician approaches the device, a clinician-worn MyView™ badge signals the device to display a preselected set of parameters and waveforms tailored to the individual clinician’s preferences. MyView™ gives clinicians the ability to receive and review medical device information in a manner that is most conducive to optimizing their workflow, while the presence mapping data collected by all the Masimo devices can provide information on how clinicians spend time with their patients. This provides nursing leadership and management with the opportunity to examine analytical data on patient and clinician interactions to optimize workflows across the unit, hospital or hospital system.
In June 2015, we announced the CE Mark and pre-market release of noninvasive blood pressure and temperature capabilities for our Root® connectivity and patient monitoring platform. Root® with noninvasive blood pressure from SunTech Medical® enables clinicians to measure arterial blood pressure for adult, pediatric and neonatal patients, with three distinct measurement modes: spot-check, automatic interval and stat interval. The temperature module from Welch Allyn® can measure the temperature of adult, pediatric and neonatal patients.
Also in June 2015, we announced the CE Mark and full market release of MightySat™ Rx fingertip pulse oximeter for clinical use in CE countries, offering the same performance and features as the previously-released MightySat™ for personal use, including Masimo SET® Measure-Through-Motion and Low-Perfusion™ pulse oximetry technology used in the world’s leading hospitals.
Our pulse oximetry technology is generally contained on a circuit board which is placed inside a standalone pulse oximetry monitor, placed inside OEM multi-parameter monitors or included as part of an external “Board-in-Cable” solution which is plugged into a port on an OEM or other device. All of these solutions use our proprietary single-patient use sensors, reusable sensors and/or cables. We sell our products to end-users through our direct sales force and certain distributors, as well as our OEM partners, for incorporation into their products. We also sell certain pulse oximetry products in the consumer market for non-medical use.

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Since inception, our mission has been to develop noninvasive monitoring solutions that improve patient outcomes and reduce the cost of patient care. We intend to continue to grow our business and improve our market position by pursuing the following strategies:
(1)
continue to expand our market share in pulse oximetry;
(2)
expand the pulse oximetry market to other patient care settings;
(3)
expand the use of rainbow® technology in hospital settings;
(4)
expand the use of rainbow® technology in non-hospital settings, including EMS providers and physician offices;
(5)
utilize our customer base and OEM relationships to market our Masimo rainbow® SET® products incorporating licensed rainbow® technology as well as our other noninvasive specialty monitoring products including capnography, gas, brain function and regional oximetry monitoring; and
(6)
continue to innovate and maintain our technology leadership position.
Our solutions and related products are based upon our Masimo SET®, rainbow® and other proprietary algorithms. This software-based technology is incorporated into a variety of product platforms depending on our customers’ specifications. Our technology is supported by a substantial intellectual property portfolio that we have built through internal development and, to a lesser extent, acquisitions and license agreements. We have exclusively licensed from Cercacor Laboratories, Inc. (Cercacor) the right to OEM selected rainbow® technology and to incorporate selected rainbow® technology into our products intended to be used by professional caregivers, including, but not limited to, hospital caregivers and alternate care facility caregivers.
Cercacor Laboratories, Inc.
Cercacor is an independent entity spun off from us to our stockholders in 1998. Joe Kiani, our Chairman and Chief Executive Officer, is also the Chairman and Chief Executive Officer of Cercacor. We are a party to a cross-licensing agreement with Cercacor, which was amended and restated effective January 1, 2007 (the Cross-Licensing Agreement), which governs each party’s rights to certain intellectual property held by the two companies.
Under the Cross-Licensing Agreement, we granted Cercacor an exclusive, perpetual and worldwide license, with sublicense rights, to use all Masimo SET® owned by us, including all improvements on this technology, for the monitoring of non-vital signs measurements and to develop and sell devices incorporating Masimo SET® for monitoring non-vital signs measurements in any product market in which a product is intended to be used by a patient or pharmacist rather than a professional medical caregiver, which we refer to as the Cercacor Market. We also granted Cercacor a non-exclusive, perpetual and worldwide license, with sublicense rights, to use all Masimo SET® for the measurement of vital signs in the Cercacor Market.
We exclusively license from Cercacor the right to make and distribute products in the professional medical caregiver markets, which we refer to as the Masimo Market, that utilize rainbow® technology for certain non-invasive measurements, including carbon monoxide, methemoglobin, fractional arterial oxygen saturation and hemoglobin. The license is currently subject to certain specific annual minimum aggregate royalty payment obligations in the amount of $5.0 million per year. To date, we have developed and commercially released devices that measure carbon monoxide, methemoglobin and hemoglobin using licensed rainbow® technology. We also have the option to obtain exclusive licenses to make and distribute products that utilize rainbow® technology for the monitoring of other measurements, including blood glucose, in product markets where the product is intended to be used by a professional medical caregiver. For additional discussion of Cercacor, see Note 3 to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q and Part I, Item 1. “Business—Cercacor Laboratories, Inc.” in our Annual Report on Form 10-K for the fiscal year ended January 3, 2015, filed with the SEC on February 17, 2015.
Pursuant to authoritative accounting guidance, Cercacor is consolidated within our financial statements for all periods presented. For the foreseeable future, we anticipate that we will continue to consolidate Cercacor pursuant to the current authoritative accounting guidance; however, in the event that Cercacor is no longer considered a variable interest entity (VIE) under such accounting guidance, we may discontinue consolidating the entity.

31
Table of Contents

Stock Repurchase Program
In February 2013, our board of directors authorized us to repurchase up to 6.0 million shares of our common stock under a repurchase program. In October 2014, our board of directors authorized us to repurchase up to an additional 3.0 million shares under this stock repurchase program. The stock repurchase program may be carried out at the discretion of a committee comprised of our Chief Executive Officer and Chief Financial Officer through open market purchases, one or more Rule 10b5-1 trading plans, block trades and in privately negotiated transactions. For additional information regarding our stock repurchase program, see Note 11 to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q and Part I, Item 1.
Results of Operations
The following table sets forth, for the periods indicated, our unaudited results of operations expressed as dollar amounts and as a percentage of total revenues (in thousands, except percentages):
 
Three Months Ended
 
Six Months Ended
 
July 4,
2015
 
% of
Revenue
 
June 28,
2014
 
% of
Revenue
 
July 4,
2015
 
% of
Revenue
 
June 28,
2014
 
% of
Revenue
Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
147,612

 
94.8
 %
 
$
133,493

 
94.7
 %
 
$
294,969

 
95.1
 %
 
$
265,725

 
94.7
 %
Royalty
8,114

 
5.2

 
7,430

 
5.3

 
15,294

 
4.9

 
15,012

 
5.3

Total revenue
155,726

 
100.0

 
140,923

 
100.0

 
310,263

 
100.0

 
280,737

 
100.0

Cost of goods sold
52,825

 
33.9

 
47,828

 
33.9

 
104,257

 
33.6

 
95,341

 
34.0

Gross profit
102,901

 
66.1

 
93,095

 
66.1

 
206,006

 
66.4

 
185,396

 
66.0

Operating expenses:
 
 
 
 
 
 
 
 
 
 

 
 
 
 
Selling, general and administrative
61,666

 
39.6

 
61,347

 
43.5

 
122,465

 
39.5

 
117,469

 
41.8

Research and development
13,394

 
8.6

 
13,343

 
9.5

 
28,323

 
9.1

 
27,339

 
9.7

Litigation award and defense costs
—

 
—

 
—

 
—

 
—

 
—

 
(8,010
)
 
(2.9
)
Total operating expenses
75,060

 
48.2

 
74,690

 
53.0

 
150,788

 
48.6

 
136,798

 
48.7

Operating income
27,841

 
17.9

 
18,405

 
13.1

 
55,218

 
17.8

 
48,598

 
17.3

Non-operating (expense) income
(1,125
)
 
(0.7
)
 
323

 
0.2

 
(972
)
 
(0.3
)
 
523

 
0.2

Income before provision for income taxes
26,716

 
17.2

 
18,728

 
13.3

 
54,246

 
17.5

 
49,121

 
17.5

Provision for income taxes
8,020

 
5.2

 
4,776

 
3.4

 
15,728

 
5.1

 
12,678

 
4.5

Net income including noncontrolling interest
18,696

 
12.0

 
13,952

 
9.9

 
38,518

 
12.4

 
36,443

 
13.0

Net loss (income) attributable to the noncontrolling interest
655

 
0.4

 
(150
)
 
(0.1
)
 
1,356

 
0.4

 
(9
)
 
0.0

Net income attributable to Masimo Corporation stockholders
$
19,351

 
12.4
 %
 
$
13,802

 
9.8
 %
 
$
39,874

 
12.9
 %
 
$
36,434

 
13.0
 %

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Comparison of the Three Months ended July 4, 2015 to the Three Months ended June 28, 2014
Revenue. Total revenue increased $14.8 million, or 10.5%, to $155.7 million for the three months ended July 4, 2015 from $140.9 million for the three months ended June 28, 2014. The following chart details our total product revenues by the geographic area to which the products were shipped for the three months ended July 4, 2015 and June 28, 2014 (dollars in thousands):
 
Three Months Ended
 
July 4, 2015
 
June 28, 2014
 
Increase/
(Decrease)
 
Percentage
Change
North and South America
$
110,526

 
74.9
%
 
$
95,462

 
71.5
%
 
$
15,064

 
15.8
 %
Europe, Middle East and Africa
24,335

 
16.5

 
22,717

 
17.0

 
1,618

 
7.1

Asia and Australia
12,751

 
8.6

 
15,314

 
11.5

 
(2,563
)
 
(16.7
)
Total Product Revenue
$
147,612

 
100.0
%
 
$
133,493

 
100.0
%
 
$
14,119

 
10.6
 %
Royalty
8,114

 
 
 
7,430

 
 
 
684

 
 
Total Revenue
$
155,726

 
 
 
$
140,923

 
 
 
$
14,803

 
 
Product revenue increased $14.1 million, or 10.6%, to $147.6 million for the three months ended July 4, 2015 from $133.5 million for the three months ended June 28, 2014. This increase was primarily due to higher consumable product sales resulting from an increase in our installed base of circuit boards and pulse oximeters which we estimate totaled 1,362,000 units at July 4, 2015, up from 1,260,000 units at June 28, 2014. Offsetting this increase was approximately $5.5 million from the impact of unfavorable movements in foreign exchange rates from the prior year period that reduced the U.S. Dollar translation of foreign sales that were denominated in various foreign currencies, primarily in Europe and Asia.
Product revenue generated through our direct and distribution sales channels increased $11.8 million, or 10.4%, to $125.1 million for the three months ended July 4, 2015, compared to $113.3 million for the three months ended June 28, 2014. During the three months ended July 4, 2015, revenues from our OEM channel rose by $2.3 million, or 11.5%, to $22.5 million from $20.2 million for the three months ended June 28, 2014. Total rainbow® product revenue increased to $13.5 million for the three months ended July 4, 2015, compared to $11.6 million for the three months ended June 28, 2014.
Royalty revenue increased to $8.1 million for the three months ended July 4, 2015 from $7.4 million for the three months ended June 28, 2014.
Gross Profit. Gross profit consists of total revenue less cost of goods sold. Our gross profit for the three months ended July 4, 2015 and June 28, 2014 was as follows (dollars in thousands):
 
Three Months Ended
 
July 4, 2015
 
Percentage
 of Revenue
 
June 28, 2014
 
Percentage
 of Revenue
 
Increase/
(Decrease)
 
Percentage
Change
Product Gross Profit
$
94,787

 
64.2
%
 
$
85,665

 
64.2
%
 
$
9,122

 
10.6
%
Royalty Gross Profit
8,114

 
100.0

 
7,430

 
100.0

 
684

 
9.2

Total Gross Profit
$
102,901

 
66.1
%
 
$
93,095

 
66.1
%
 
$
9,806

 
10.5
%
Cost of goods sold includes labor, material, overhead and other similar costs related to the production, supply, distribution and support of our products. Cost of goods sold increased $5.0 million for the three months ended July 4, 2015 compared to the three months ended June 28, 2014 due primarily to the increase in our product revenues. Our total gross margins approximated 66.1% for each of the three months ended July 4, 2015 and June 28, 2014. Excluding royalties, our product gross margin was also unchanged at 64.2% for each of the three months ended July 4, 2015 and June 28, 2014. During the quarter ended July 4, 2015, the benefits from our continued product cost reduction efforts were entirely offset by the net impact of unfavorable movements in foreign exchange rates from the prior year period. We incurred $1.3 million and $1.7 million in Cercacor royalty expenses for each of the three months ended July 4, 2015 and June 28, 2014 respectively, which have been eliminated in our condensed consolidated financial statements for the periods presented. Had these royalty expenses not been eliminated, our reported product gross profit margin would have been 63.3% for the three months ended July 4, 2015 and 62.9% for the three months ended June 28, 2014.

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Selling, General and Administrative. Selling, general and administrative expenses consist primarily of salaries and related expenses for sales, marketing and administrative personnel, sales commissions, advertising and promotion costs, professional fees related to legal, accounting and other outside services, public company costs, medical device taxes and other corporate expenses. Selling, general and administrative expenses for the three months ended July 4, 2015 and June 28, 2014 were as follows (dollars in thousands):
Selling, General and Administrative
Three Months Ended 
 July 4, 2015
Percentage of
Net Revenues
Three Months Ended 
 June 28, 2014
Percentage of
Net Revenues
Increase/
(Decrease)
Percentage
Change
$61,666
39.6%
$61,347
43.5%
$319
0.5%
Selling, general and administrative expenses decreased $0.3 million, or 0.5%, for the three months ended July 4, 2015 compared to the three months ended June 28, 2014. This decrease was primarily attributable to approximately $2.0 million in lower charitable donations to the Masimo Foundation for Ethics, Innovation and Competition in Healthcare (the Masimo Foundation), which was offset by higher legal and professional fees of approximately $1.8 million, higher headcount related expenses of approximately $0.2 million and increased occupancy costs of $0.4 million in the current year period. Share-based compensation expense of approximately $2.0 million was included in selling, general and administrative expenses for each of the three months ended July 4, 2015 and June 28, 2014. Approximately $1.8 million and $1.6 million of medical device excise tax was included in selling, general and administrative expenses for the three months ended July 4, 2015 and June 28, 2014, respectively. Also included in total selling, general and administrative expenses were $0.7 million and $0.8 million of expenses incurred by Cercacor for the three months ended July 4, 2015 and June 28, 2014, respectively.
Research and Development. Research and development expenses consist primarily of salaries and related expenses for engineers and other personnel engaged in the design and development of our products. These expenses also include third-party fees paid to consultants, prototype and engineering supply expenses and the costs of clinical trials. Research and development expenses for the three months ended July 4, 2015 and June 28, 2014 were as follows (dollars in thousands):
Research and Development
Three Months Ended 
 July 4, 2015
Percentage of
Net Revenues
Three Months Ended 
 June 28, 2014
Percentage of
Net Revenues
Increase/
(Decrease)
Percentage
Change
$13,394
8.6%
$13,343
9.5%
$51
0.4%
Research and development expenses remained substantially unchanged for the three months ended July 4, 2015 compared to the three months ended June 28, 2014. Included in research and development expenses was approximately $0.4 million and $0.5 million of share-based compensation expense for the three months ended July 4, 2015 and June 28, 2014, respectively. Also included in total research and development expenses were $1.4 million and $0.9 million of engineering expenses incurred by Cercacor for the three months ended July 4, 2015 and June 28, 2014, respectively.
Non-operating income. Non-operating income consists primarily of interest income, interest expense and foreign exchange losses. Non-operating income for the three months ended July 4, 2015 and June 28, 2014 was as follows (dollars in thousands):
Non-operating Income (Expense)
Three Months Ended 
 July 4, 2015
Percentage of
Net Revenues
Three Months Ended 
 June 28, 2014
Percentage of
Net Revenues
Increase/
(Decrease)
Percentage
Change
$(1,125)
(0.7)%
$323
0.2%
$(1,448)
(448.3)%
Non-operating income (expense) decreased by $1.4 million for the three months ended July 4, 2015 compared to the three months ended June 28, 2014. Non-operating expense of $1.1 million for the three months ended July 4, 2015 related primarily to $0.6 million of interest expense and $0.5 million of net realized and unrealized losses on foreign currency denominated transactions resulting primarily from the strengthening of the U.S. Dollar against the Japanese Yen and the weakening of the U.S. Dollar against the Swedish Krona, which were partially offset by gains due to the weakening of the U.S. Dollar against the Euro and British Pound. Non-operating income of $0.3 million for the three months ended June 28, 2014 related primarily to net realized and unrealized gains on foreign currency denominated transactions resulting primarily from the strengthening of the U.S. Dollar against the Swedish Krona, which were partially offset by losses due to the strengthening of the U.S. Dollar against the Euro and Japanese Yen.

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Provision for Income Taxes. Our provision for income taxes for the three months ended July 4, 2015 and June 28, 2014 was as follows (dollars in thousands):
Provision for Income Taxes
Three Months Ended 
 July 4, 2015
Percentage of
Net Revenues
Three Months Ended 
 June 28, 2014
Percentage of
Net Revenues
Increase/
(Decrease)
Percentage
Change
$8,020
5.2%
$4,776
3.4%
$3,244
67.9%
Our provision for income taxes was $8.0 million, or an effective tax rate of 30.0%, for the three months ended July 4, 2015, compared to $4.8 million, or an effective tax rate of 25.5%, for the three months ended June 28, 2014. The higher expected tax rate for the three months ended July 4, 2015 is due to a shift in the expected geographic composition of our pre-tax income for fiscal 2015 to higher taxed jurisdictions due primarily to higher U.S. revenue and unfavorable year over year movements in foreign exchange rates that generally reduced international revenues that are denominated in foreign currencies.
Comparison of the Six Months ended July 4, 2015 to the Six Months ended June 28, 2014
Revenue. Total revenue increased $29.5 million, or 10.5%, to $310.3 million for the six months ended July 4, 2015 from $280.7 million for the six months ended June 28, 2014. The following chart details our total product revenues by the geographic area to which the products were shipped for the six months ended July 4, 2015 and June 28, 2014 (dollars in thousands):
 
Six Months Ended
 
July 4, 2015
 
June 28, 2014
 
Increase/
(Decrease)
 
Percentage
Change
North and South America
$
222,004

 
75.3
%
 
$
188,115

 
70.8
%
 
$
33,889

 
18.0
 %
Europe, Middle East and Africa
48,396

 
16.4

 
49,729

 
18.7

 
(1,333
)
 
(2.7
)
Asia and Australia
24,569

 
8.3

 
27,881

 
10.5

 
(3,312