10-Q
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 April 2, 2016
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 April 2, 2016
Common stock, $0.001 par value
 
48,985,489
 

Table of Contents

MASIMO CORPORATION
FORM 10-Q FOR THE QUARTER ENDED APRIL 2, 2016
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)
 
April 2,
2016
 
January 2,
2016
ASSETS
 
 
 
Current assets
 
 
 
Cash and cash equivalents
$
139,901

 
$
132,317

Accounts receivable, net of allowance for doubtful accounts of $2,017 and $1,967 at April 2, 2016 and January 2, 2016, respectively
93,284

 
80,960

Inventories
62,505

 
62,038

Prepaid income taxes
2,006

 
2,404

Other current assets
19,763

 
21,423

Total current assets
317,459

 
299,142

Deferred cost of goods sold
70,014

 
71,718

Property and equipment, net
133,262

 
132,466

Intangible assets, net
28,826

 
27,556

Goodwill
20,694

 
20,394

Deferred tax assets
41,683

 
44,320

Other assets
9,324

 
6,139

Total assets
$
621,262

 
$
601,735

LIABILITIES AND EQUITY
 
 
 
Current liabilities
 
 
 
Accounts payable
$
25,310

 
$
25,865

Accrued compensation
25,284

 
38,415

Accrued liabilities
35,144

 
44,222

Income taxes payable
7,129

 
2,777

Deferred revenue
26,747

 
21,280

Current portion of capital lease obligations
76

 
74

Total current liabilities
119,690

 
132,633

Deferred revenue
258

 
298

Long term debt
225,003

 
185,071

Other liabilities
8,328

 
8,021

Total liabilities
353,279

 
326,023

Commitments and contingencies

 

Equity
 
 
 
Masimo Corporation stockholders’ equity:
 
 
 
Preferred stock, $0.001 par value; 5,000 shares authorized; 0 shares issued and outstanding at April 2, 2016 and January 2, 2016
—

 
—

Common stock, $0.001 par value; 100,000 shares authorized; 48,985 and 49,881 shares issued and outstanding at April 2, 2016 and January 2, 2016, respectively
49

 
50

Treasury stock, 13,855 and 12,759 shares at April 2, 2016 and January 2, 2016, respectively
(383,757
)
 
(340,873
)
Additional paid-in capital
338,893

 
332,417

Accumulated other comprehensive loss
(3,340
)
 
(4,739
)
Retained earnings
316,138

 
288,560

Total Masimo Corporation stockholders’ equity
267,983

 
275,415

Noncontrolling interest
—

 
297

Total equity
267,983

 
275,712

Total liabilities and equity
$
621,262

 
$
601,735


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

3
Table of Contents

MASIMO CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited, in thousands, except per share amounts)
 
 
 
Three Months Ended
 
 
April 2,
2016
 
April 4,
2015
Revenue:
 
 
 
 
Product
 
$
163,290

 
$
147,357

Royalty
 
7,877

 
7,180

Total revenue
 
171,167

 
154,537

Cost of goods sold
 
56,954

 
51,432

Gross profit
 
114,213

 
103,105

Operating expenses:
 
 
 
 
Selling, general and administrative
 
62,511

 
60,799

Research and development
 
14,365

 
14,929

Total operating expenses
 
76,876

 
75,728

Operating income
 
37,337

 
27,377

Non-operating income
 
498

 
153

Income before provision for income taxes
 
37,835

 
27,530

Provision for income taxes
 
10,258

 
7,708

Net income including noncontrolling interest
 
27,577

 
19,822

Net loss attributable to the noncontrolling interest
 
—

 
701

Net income attributable to Masimo Corporation stockholders
 
$
27,577

 
$
20,523

 
 
 
 
 
Net income per share attributable to Masimo Corporation stockholders:
 
 
 
 
Basic
 
$
0.56

 
$
0.39

Diluted
 
$
0.53

 
$
0.38

 
 
 
 
 
Weighted-average shares used in per share calculations:
 
 
 
 
Basic
 
49,424

 
52,687

Diluted
 
51,949

 
53,964

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
 
April 2,
2016
 
April 4,
2015
Net income including noncontrolling interest
$
27,577

 
$
19,822

Other comprehensive (loss) income, net of tax:
 
 
 
Foreign currency translation adjustments
1,399

 
(2,942
)
Total comprehensive income
28,976

 
16,880

Comprehensive loss attributable to noncontrolling interest
—

 
701

Comprehensive income attributable to Masimo Corporation stockholders
$
28,976

 
$
17,581

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




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Table of Contents

MASIMO CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)
 
Three Months Ended
 
April 2,
2016
 
April 4,
2015
Cash flows from operating activities:
 
 
 
Net income including noncontrolling interest
$
27,577

 
$
19,822

Adjustments to reconcile net income including noncontrolling interest to net cash provided by operating activities:
 
 
 
Depreciation and amortization
4,051

 
3,777

Stock-based compensation
3,027

 
2,894

Loss on disposal of property, equipment and intangibles
152

 
58

Gain on deconsolidation of variable interest entity
(273
)
 
—

Provision for doubtful accounts
127

 
51

Provision for deferred income taxes
2,697

 
—

Changes in operating assets and liabilities:
 
 
 
(Increase) decrease in accounts receivable
(12,266
)
 
2,777

Increase in inventories
(326
)
 
(88
)
Decrease in deferred cost of goods sold
1,799

 
208

Decrease (increase) in prepaid income taxes
353

 
(104
)
Increase in other assets
(621
)
 
(6,464
)
Increase (decrease) in accounts payable
198

 
(3,053
)
Decrease in accounts payable to related party
(1,130
)
 
—

Decrease in accrued compensation
(12,634
)
 
(10,817
)
(Decrease) increase in accrued liabilities
(4,220
)
 
7,183

Increase in income tax payable
4,513

 
866

Increase in deferred revenue
5,427

 
1,949

Increase in other liabilities
352

 
67

Net cash provided by operating activities
18,803

 
19,126

Cash flows from investing activities:
 
 
 
Purchases of property and equipment, net
(5,346
)
 
(17,218
)
Increase in intangible assets
(751
)
 
(737
)
Reduction in cash resulting from deconsolidation of variable interest entity
(763
)
 
—

Net cash used in investing activities
(6,860
)
 
(17,955
)
Cash flows from financing activities:
 
 
 
Borrowings under line of credit
45,000

 
(69
)
Repayments on line of credit
(5,000
)
 
—

Repayments of capital lease obligations
(67
)
 
—

Proceeds from issuance of common stock
2,552

 
4,612

Repurchases of common stock
(47,699
)
 
(2,154
)
Issuance of equity by noncontrolling interest, net of equity issued
—

 
3

Net cash (used in) provided by financing activities
(5,214
)
 
2,392

Effect of foreign currency exchange rates on cash
855

 
(2,296
)
Net (decrease) increase in cash and cash equivalents
7,584

 
1,267

Cash and cash equivalents at beginning of period
132,317

 
134,453

Cash and cash equivalents at end of period
$
139,901

 
$
135,720

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 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 2, 2016 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 2, 2016 (fiscal year 2015), filed with the SEC on February 24, 2016. The results for the three months ended April 2, 2016 are not necessarily indicative of the results to be expected for the fiscal year ending December 31, 2016 (fiscal year 2016) 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 through January 2, 2016, Cercaccor Laboratories, Inc. (Cercacor), the variable interest entity (VIE) of which the Company was the primary beneficiary. Effective January 3, 2016, the Company discontinued consolidating Cercacor within its consolidated financial statements based on its determination that the Company was no longer the primary beneficiary of Cercacor. 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 2016 is a 52 week fiscal year. All references to years in these notes to condensed consolidated financial statements are fiscal years unless otherwise noted.

7
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 to apply the fair value option under this guidance to specific assets or liabilities on a contract-by-contract basis. There were no transfers between Level 1, Level 2 and Level 3 inputs during the three months ended April 2, 2016. The Company carries cash and cash equivalents at cost, which approximates fair value. As of April 2, 2016 and January 2, 2016, 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:
April 2, 2016
Adjusted Basis
Cost
 
Gross Unrealized
Gains
 
Gross Unrealized
(Losses)
 
Estimated
Fair Value
 
Cash and Cash
Equivalents
Cash
$
89,700

 
$
—

 
$
—

 
$
89,700

 
$
89,700

Level 1:
 
 
 
 
 
 
 
 
 
          Bank Time Deposits
50,000

 
—

 
—

 
50,000

 
50,000

          Money Market Funds
201

 
—

 
—

 
201

 
201

               Subtotal
50,201

 
—

 
—

 
50,201

 
50,201

Level 2:
 
 
 
 
 
 
 
 
 
          None
—

 
—

 
—

 
—

 
—

Level 3:
 
 
 
 
 
 
 
 
 
          None
—

 
—

 
—

 
—

 
—

Total assets measured at fair value
$
139,901

 
$
—

 
$
—

 
$
139,901

 
$
139,901


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

January 2, 2016
Adjusted Basis
Cost
 
Gross Unrealized
Gains
 
Gross Unrealized
(Losses)
 
Estimated
Fair Value
 
Cash and Cash
Equivalents
Cash
$
57,168

 
$
—

 
$
—

 
$
57,168

 
$
57,168

Level 1:
 
 
 
 
 
 
 
 
 
          Bank Time Deposits
55,000

 
—

 
—

 
55,000

 
55,000

          Money Market Funds
20,149

 
—

 
—

 
20,149

 
20,149

               Subtotal
75,149

 
—

 
—

 
75,149

 
75,149

Level 2:
 
 
 
 
 
 
 
 
 
          None
—

 
—

 
—

 
—

 
—

Level 3:
 
 
 
 
 
 
 
 
 
          None
—

 
—

 
—

 
—

 
—

Total assets measured at fair value
$
132,317

 
$
—

 
$
—

 
$
132,317

 
$
132,317

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.
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 net realizable value. 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 in inventory.
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 improvements
7 to 15 years
Leasehold improvements
Lesser of useful life or term of lease
Machinery and equipment
5 to 7 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

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

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.
For the three months ended April 2, 2016 and April 4, 2015, depreciation and amortization expense of property and equipment was $3.3 million and $2.7 million, respectively.
Intangible Assets
The Company’s policy is to renew its patents and trademarks. Total renewal costs for patents and trademarks were $0.2 million and $0.1 million for the three months ended April 2, 2016 and April 4, 2015, respectively. As of April 2, 2016, 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 months ended April 2, 2016 and April 4, 2015.
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.

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

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 certain monitoring-related equipment, software, installation, training and/or warranty support 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; and (iv) sales of integrated circuit boards to OEM customers who incorporate the Company’s embedded software technology into their multi-parameter monitoring devices.
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 (VSOE) of fair value, (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-related 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 six years. The sensors are essential to the functionality of the monitoring equipment and, therefore, represent a substantive performance obligation. The Company generally does not recognize any revenue when the monitoring-related equipment and software are delivered to the hospitals, but rather recognizes revenue for these delivered elements on a pro-rata basis as the sensors are delivered under the long-term purchase commitment, when installation and training are complete. Accordingly, the cost of the monitoring-related 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. Some of the Company’s long-term sensor contracts also contain provisions for certain payments to be made directly to the end-user hospital customer at the inception of the arrangement. These payments are generally treated as prepaid discounts that are deferred and amortized on a straight-line basis as contra-revenue 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.

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

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.
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 Medtronic plc (Medtronic, formerly Covidien), and is due and payable quarterly based on U.S. sales of Medtronic’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 royalty report from Medtronic, 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 forty-eight 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 six 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):
 
Three Months Ended
 
April 2,
2016
 
April 4,
2015
Warranty accrual, beginning of period
$
1,222

 
$
1,416

Accrual for warranties issued
405

 
339

Changes to pre-existing warranties (including changes in estimates)
(50
)
 
(17
)
Settlements made
(290
)
 
(258
)
Warranty accrual, end of period
$
1,287

 
$
1,480

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: (a) the recovery is probable, and (b) 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.

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

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.
The change in accumulated other comprehensive loss was as follows (in thousands):
 
Three Months Ended 
 April 2, 2016
Accumulated other comprehensive loss, beginning of period
$
(4,739
)
Foreign currency translation adjustments
1,399

Accumulated other comprehensive loss, end of period
$
(3,340
)
Net Income Per Share
Basic net income per share attributable to Masimo Corporation for the three months ended April 2, 2016 and April 4, 2015 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 months ended April 2, 2016 and April 4, 2015 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 and the vesting of restricted share units (RSUs). For the three months ended April 2, 2016 and April 4, 2015, 1.5 million and 3.2 million, respectively, weighted options to purchase shares of common stock 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 months ended April 2, 2016, certain RSUs were considered contingently issuable shares as their vesting is contingent upon the occurrence of certain future events. Since such events have not occurred and are not considered probable of occurring as of April 2, 2016, 2.7 million weighted average shares related to such RSUs have been excluded from the calculation of potential shares. 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 months ended April 4, 2015 to determine its net income attributable to its stockholders. Since the Company discontinued consolidating Cercacor effective January 3, 2016, a similar adjustment was not required for the three months ended April 2, 2016.
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
 
April 2,
2016
 
April 4,
2015
Net income attributable to Masimo Corporation stockholders:
 
 
 
Net income including noncontrolling interest
$
27,577

 
$
19,822

Net loss attributable to the noncontrolling interest
—

 
701

Net income attributable to Masimo Corporation stockholders
$
27,577

 
$
20,523

Basic net income per share attributable to Masimo Corporation stockholders:
 
 
 
Net income attributable to Masimo Corporation stockholders
$
27,577

 
$
20,523

Weighted-average shares outstanding - basic
49,424

 
52,687

Basic net income per share attributable to Masimo Corporation stockholders
$
0.56

 
$
0.39

Diluted net income per share attributable to Masimo Corporation stockholders:
 
 
 
Weighted-average shares outstanding - basic
49,424

 
52,687

Diluted share equivalent: stock options and RSUs
2,525

 
1,277

Weighted-average shares outstanding - diluted
51,949

 
53,964

Diluted net income per share attributable to Masimo Corporation stockholders
$
0.53

 
$
0.38


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

Supplemental Cash Flow Information
Supplemental cash flow information includes the following (in thousands):
 
Three Months Ended
 
April 2,
2016
 
April 4,
2015
Cash paid during the year for:
 
 
 
Interest (net of amounts capitalized)
$
1,335

 
$
413

Income taxes
2,303

 
6,673

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

 
$
36

Unpaid purchases of property, plant and equipment
3,600

 
4,346

       Unsettled common stock proceeds from option exercises
896

 
395

       Unsettled stock repurchases
—

 
6,079

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 the flu season has moderated and 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 Adopted Accounting Pronouncements
In March 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-09, Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (ASU 2016-09). The new standard makes several modifications to Topic 718 related to the accounting for forfeitures, employer tax withholding on stock-based compensation and the financial statement presentation of excess tax benefits or deficiencies. ASU 2016-09 also clarifies the statement of cash flows presentation for certain components of stock-based awards. The standard is effective for interim and annual reporting periods beginning after December 15, 2016, with early adoption permitted. The Company early adopted this standard during the three months ended April 2, 2016 resulting in a $1.0 million reduction to the Company’s income tax provision for such period.
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 adopted this standard during the first quarter of the fiscal year ending December 31, 2016, and its adoption did not have a material impact on the Company’s consolidated financial statements by increasing assets and liabilities.
Recently Issued Accounting Pronouncements
In February 2016, the FASB issued Accounting Standards Update No. 2016-02, Leases (Topic 842): (ASU 2016-02). The new standard requires lessees to recognize most leases on their balance sheets but continue to recognize lease expenses in their income statement in a manner similar to current practice. The new standard states that a lessee will recognize a lease liability for the obligation to make lease payments and a right-of-use asset for the right to use the underlying asset for the lease term. Expense related to leases determined to be operating leases will be recognized on a straight-line basis, while those determined to be financing leases will be recognized following a front-loaded expense profile in which interest and amortization are presented separately in the income statement. ASU 2016-02 is effective for annual and interim fiscal reporting periods beginning after December 15, 2018, and early application is permitted. The Company is currently evaluating the expected impact of this standard on its consolidated financial statements, but anticipates that the required recognition of a lease

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

liability and related right-of-use asset will likely increase both the assets and liabilities recognized and reported on its balance sheet.
In May 2014, the FASB issued Accounting Standards Update No. 2014-09, Revenue (Topic 606): Revenue from Contracts with Customers (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 retrospective or cumulative effect transition method upon adoption. In August 2015, the FASB issued Accounting Standards Update No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, which amended ASU 2014-09, providing for a one year deferral period for the implementation of ASU 2014-09. 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 but anticipates, among other things, that the adoption of such standard will result in the acceleration of certain revenue from product sales to distributors that is currently deferred under the “sell-through” method, as well as the deferral of certain contract-related costs that are currently expensed when incurred.
3. Variable Interest Entity (VIE)
The Company follows authoritative guidance for the consolidation of a 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
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.
As a result of recent changes in the capital structure of Cercacor, as well as certain of its contractual relationships with the Company, the Company completed a re-evaluation of the authoritative consolidation guidance during the three months ended April 2, 2016 and determined that although Cercacor remains a VIE, the Company is no longer its primary beneficiary as it can no longer be deemed to have the power to direct the activities of Cercacor that most significantly impact Cercacor’s economic performance and can no longer be deemed to have an obligation to absorb Cercacor’s losses pursuant to the Company’s on-going contractual relationships with Cercacor. Based on such determination, the Company has discontinued consolidating Cercacor within its consolidated financial statements effective as of January 3, 2016. However, Cercacor will continue to be a related party following its deconsolidation. The Company recognized a gain of $0.3 million upon such deconsolidation, which has been reported within non-operating income in the condensed consolidated statement of operations. See Note 4 to these condensed consolidated financial statements for a description of the Company’s continuing business relationships with Cercacor.
Cercacor continues to be included within the Company’s condensed consolidated financial statements for all periods prior to January 3, 2016. Accordingly, for periods prior to January 3, 2016, 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 consolidation. However, for periods prior to January 3, 2016, all direct operating expenses that were incurred by the Company and charged to Cercacor, or that were incurred by Cercacor and charged to the Company, have not been eliminated and are included within operating expenses in the Company’s condensed consolidated statements of operations. The consolidating statement of operations for the three months ended April 4, 2015, which reflect the Company, Cercacor and related eliminations (in thousands), is included below:



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

 
 
Three Months Ended
 
 
April 4, 2015
Consolidating Statement of Operations:
 
Masimo
Corp
 
Percentage
of Revenue
 
Cercacor
 
Cercacor
Elim
 
Total
 
Percentage
of Revenue
Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
Product
 
$
147,357

 
95.4
%
 
$
—

 
$
—

 
$
147,357

 
95.4
%
Royalty
 
7,180

 
4.6

 
1,375

 
(1,375
)
 
7,180

 
4.6

Total revenue
 
154,537

 
100.0

 
1,375

 
(1,375
)
 
154,537

 
100.0

Cost of goods sold
 
52,682

 
34.1

 
—

 
(1,250
)
 
51,432

 
33.3

Gross profit
 
101,855

 
65.9

 
1,375

 
(125
)
 
103,105

 
66.7

Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
Selling, general and administrative
 
60,276

 
39.0

 
648

 
(125
)
 
60,799

 
39.3

Research and development
 
13,501

 
8.7

 
1,428

 
—

 
14,929

 
9.7

Total operating expenses
 
73,777

 
47.7

 
2,076

 
(125
)
 
75,728

 
49.0

Operating income (loss)
 
28,078

 
18.2

 
(701
)
 
—

 
27,377

 
17.7

Non-operating income
 
153

 
0.1

 
—

 
—

 
153

 
0.1

Income (loss) before provision for income taxes
 
28,231

 
18.3

 
(701
)
 
—

 
27,530

 
17.8

Provision for income taxes
 
7,708

 
5.0

 
—

 
—

 
7,708

 
5.0

Net income (loss) including noncontrolling interest
 
20,523

 
13.3

 
(701
)
 
—

 
19,822

 
12.8

Net loss attributable to the noncontrolling interest
 
—

 
—

 
—

 
701

 
701

 
0.5

Net income (loss) attributable to Masimo Corporation stockholders
 
$
20,523

 
13.3
%
 
$
(701
)
 
$
701

 
$
20,523

 
13.3
%

4. Related Party Transactions
The Company’s Chairman and Chief Executive Officer is also the Chairman and Chief Executive Officer of Cercacor. The Company is a party to the following agreements with Cercacor:
•
Cross-Licensing Agreement - The Company is party to a Cross Licensing Agreement with Cercacor, (the Cross-Licensing Agreement), which governs each party’s rights to certain intellectual property held by the two companies. The Company is subject to certain annual minimum aggregate royalty obligations for use of the rainbow® licensed technology. The current annual minimum royalty obligation is $5.0 million. Actual aggregate royalty liabilities to Cercacor under the license were $1.5 million and $1.3 million for the three months ended April 2, 2016 and April 4, 2015, respectively, the latter of which was eliminated in consolidation. Pursuant to the terms of the Cross Licensing Agreement, the Company also had sales of certain integrated circuit boards to Cercacor of less than $0.1 million for the three months ended April 2, 2016. There were no similar sales during the three months ended April 4, 2015.
•
Administrative Services Agreement - The Company is a party to an administrative services agreement with Cercacor (G&A Services Agreement), which governs certain general and administrative services that the Company provides to Cercacor. Amounts charged by the Company pursuant to the G&A Services Agreement were less than $0.1 million for each of the three months ended April 2, 2016 and April 4, 2015.
•
Consulting Services Agreement - The Company is also a party to a consulting services agreement (Consulting Agreement) with Cercacor that governs certain engineering consulting and clinical studies support services that Cercacor may provide to the Company from time-to-time. Expenses incurred by the Company related to this Consulting Agreement were less than $0.1 million for the three months ended April 2, 2016 and approximately $0.1 million for the three months ended April 4, 2015.
Net amounts due from (due to) Cercacor at April 2, 2016 and January 2, 2016 were approximately $0.1 million and $(1.1) million, respectively.

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

The Company’s Chief Executive Officer is also the Chairman of the Masimo Foundation for Ethics, Innovation and Competition in Healthcare (Masimo Foundation), a non-profit organization that was founded in 2010 to provide a platform for encouraging ethics, innovation and competition in healthcare. The Company’s Chief Financial Officer is also a Director of the Masimo Foundation.
The Company’s Chief Executive Officer is the Chairman of both the Patient Safety Movement Foundation (PSMF), a non-profit organization that was founded in 2013 to work with hospitals, medical technology companies and patient advocates to unite the healthcare ecosystem and eliminate the more than 200,000 U.S. preventable hospital deaths that occur every year by 2020, and the Patient Safety Movement Coalition (PSMC), a not-for-profit social welfare organization that was founded in 2013 to promote patient safety legislation. The Company’s Chief Financial Officer serves as the Treasurer and Secretary of PSMF, as well as the Secretary of PSMC.
The Company’s Chief Executive Officer serves on the board of directors of Atheer Labs, which is working with the Company on the development of next generation Root® applications, as well as on the boards of directors of Children’s Hospital of Orange County and CHOC Children’s at Mission Hospital, two non-profit hospitals devoted exclusively to caring for children, both of which are also customers of the Company.
5. Inventories
Inventories consist of the following (in thousands):
 
April 2,
2016
 
January 2,
2016
Raw materials
$
29,128

 
$
25,781

Work-in-process
4,617

 
4,337

Finished goods
28,760

 
31,920

     Total inventories
$
62,505

 
$
62,038

6. Other Current Assets
Other current assets consist of the following (in thousands):
 
April 2,
2016
 
January 2,
2016
Prepaid expenses
$
8,764

 
$
9,930

Royalties receivable
7,200

 
7,200

Employee loans and advances
330

 
320

Due from related party
47

 
—

Other current assets
3,422

 
3,973

     Total other current assets
$
19,763

 
$
21,423


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

7. Property and Equipment
Property and equipment, net, consists of the following (in thousands):
 
April 2,
2016
 
January 2,
2016
Building and building improvements
$
85,296

 
$
78,877

Machinery and equipment
42,361

 
42,460

Land
23,737

 
23,738

Computer equipment
14,608

 
15,023

Tooling
12,893

 
13,079

Leasehold improvements
7,299

 
7,734

Furniture and office equipment
8,939

 
8,885

Demonstration units
984

 
973

Vehicles
45

 
45

Construction-in-progress
1,903

 
7,124

     Total property and equipment
198,065

 
197,938

Accumulated depreciation and amortization
(64,803
)
 
(65,472
)
     Property and equipment, net
$
133,262

 
$
132,466

During the quarter ended April 2, 2016, the Company completed construction on certain additional renovations to its new corporate headquarters and research and development facility in Irvine, California, resulting in the reclassification of approximately $6.2 million from construction-in-progress to building and improvements. Approximately $0.3 million of the remaining construction-in-progress relates to purchase and renovation costs for the corporate headquarters and research and development facility. Approximately $3.7 million of construction costs related to this facility are included in accounts payable as of April 2, 2016.
The gross value of furniture and office equipment under capital lease obligations was $0.4 million as of both April 2, 2016 and January 2, 2016, with accumulated depreciation of $0.3 million as of both April 2, 2016 and January 2, 2016.
8. Intangible Assets
Intangible assets, net, consist of the following (in thousands):
 
April 2,
2016
 
January 2,
2016
Patents
$
18,633

 
$
21,619

Customer relationships
7,669

 
7,669

Licenses(1)
7,500

 
—

Acquired technology
5,580

 
5,580

Trademarks
3,704

 
3,944

Capitalized software development costs
2,539

 
2,539

Other
2,535

 
2,541

     Total intangible assets
48,160

 
43,892

Accumulated amortization
(19,334
)
 
(16,336
)
     Intangible assets, net
$
28,826

 
$
27,556

(1)
As a result of the deconsolidation of our prior VIE, Cercacor, $7.5 million of licenses that were previously eliminated in consolidation are now included as part of the Company’s intangible assets at April 2, 2016.
Total amortization expense for the three months ended April 2, 2016 and April 4, 2015 was $0.9 million and $1.2 million, respectively. All of these intangible assets have a 10 year weighted average amortization period.


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

Estimated amortization expense for future fiscal years is as follows (in thousands):
Fiscal year
Amount
2016 (balance of year)
$
4,125

2017
3,865

2018
3,656

2019
3,272

2020
3,019

Thereafter
10,889

     Total
$
28,826

9. Accrued Liabilities
Accrued liabilities consist of the following (in thousands):
 
April 2,
2016
 
January 2,
2016
Accrued customer rebates, fees and reimbursements
$
13,424

 
$
11,857

Accrued arbitration award
5,391

 
5,391

Accrued legal fees
4,885

 
5,785

Accrued taxes
3,022

 
5,263

Accrued warranty
1,287

 
1,222

Accrued donations
532

 
5,612

Accrued stock repurchases
—

 
4,815

Accrued other
6,603

 
4,277

     Total accrued liabilities
$
35,144

 
$
44,222

10. Long Term Debt
Long term debt consists of the following (in thousands):
 
April 2,
2016
 
January 2,
2016
Revolving line of credit
$
225,000

 
$
185,000

Long term portion of capital lease obligations acquisition
3

 
71

     Total long term debt
$
225,003

 
$
185,071

In January 2016, the Company entered into an Amended and Restated Credit Agreement (Restated Credit Facility) with JPMorgan Chase Bank, N.A., as Administrative Agent and a Lender, Bank of America, N.A., as Syndication Agent and a Lender, Citibank, N.A., as Documentation Agent and a Lender, and various other Lenders (collectively, the Lenders). The Restated Credit Facility amends and restates the previous credit agreement and provides for up to $450.0 million in borrowings in multiple currencies, with an option, subject to certain conditions, for the Company to increase the aggregate borrowing capacity to up to $550.0 million in the future. The Restated Credit Facility also provides for a sublimit of up to $50.0 million for the issuance of letters of credit and a sublimit of $125.0 million in specified foreign currencies. All unpaid principal under the Restated Credit Facility will become due and payable on January 8, 2021.
Borrowings under the Restated Credit Facility will be deemed, at the Company’s election, either: (i) an Alternate Base Rate (ABR) Loan, which bears interest at the ABR 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 2.0%. 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.

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

The ABR 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 Restated Credit Facility 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 Restated Credit Facility, 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 Restated Credit Facility are secured by substantially all of the Company’s personal property, including certain equity interests in U.S. domestic and first-tier foreign subsidiaries.
As of April 2, 2016, the Restated Credit Facility had outstanding Eurodollar Loan draws totaling $225.0 million at an effective interest rate of 1.7181%, and the Company was in compliance with all covenants under the Restated Credit Facility.
11. Other Liabilities, Long-Term
Other long-term liabilities consist of the following (in thousands):
 
April 2,
2016
 
January 2,
2016
Unrecognized tax benefit
$
7,741

 
$
7,747

Deferred tax liability, long-term
193

 
194

Other
394

 
80

     Total other liabilities, long-term
$
8,328

 
$
8,021

The unrecognized tax benefit relates to the Company’s long-term portion of tax liability. Authoritative guidance prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. See Note 15 to these condensed consolidated financial statements for further details.
12. Equity
Series A Junior Participating Preferred Stock and Stockholder Rights Plan
In November 2007, the Company authorized and declared a dividend of one preferred stock purchase right (Right) for each outstanding share of its common stock to stockholders of record at the close of business on November 26, 2007 (the Record Date) pursuant to a Rights Agreement, dated as of November 9, 2007, with Computershare Trust Company, N.A., as Rights Agent (the Rights Agreement). In addition, one Right was issued with each share of common stock that became outstanding after the Record Date. Each Right entitled the registered holder to purchase from the Company one thousandth of one share of the Company’s Series A junior participating preferred stock, par value $0.001 per share, at a purchase price equal to $136.00 per Right, subject to adjustment.
On February 12, 2016, the Company entered into an amendment to the Rights Agreement (the Rights Amendment). The Rights Amendment accelerated the expiration of the Rights from the close of business on February 8, 2017 to the close of business on February 16, 2016, and had the effect of terminating the Rights Agreement on that date. Upon the termination of the Rights Agreement, all of the Rights distributed to holders of the Company’s common stock pursuant to the Rights Agreement expired.

20
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

Stock Repurchase Programs
In September 2015, the Board authorized a stock repurchase program, whereby the Company may purchase up to 5.0 million shares of its common stock over a period of up to three years (2015 Repurchase Program). The 2015 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. The total remaining shares authorized for repurchase under the 2015 Repurchase Program approximated 3.3 million shares as of April 2, 2016. The Company expects to fund the 2015 Repurchase Program through its available cash, future cash from operations, funds available under the Restated Credit Facility or other potential sources of capital.
The following table provides a summary of the Company’s stock repurchase activities during the three months ended April 2, 2016 and April 4, 2015 (in thousands, except per share amounts):
 
Three Months Ended
 
April 2,
2016
 
April 4,
2015
Shares repurchased
1,096

 
250

Average cost per share
$
39.13

 
$
32.89

Value of shares repurchased
$
42,884

 
$
8,233

13. Stock-Based Compensation
Stock-Based Award Activity
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):
 
Three Months Ended 
 April 2, 2016
 
Shares
 
Average
Exercise Price
Options outstanding, beginning of period
9,202

 
$
25.46

Granted
1,101

 
37.87

Canceled
(32
)
 
24.72

Exercised
(199
)
 
17.29

Options outstanding, end of period
10,072

 
$
26.98

Options exercisable, end of period
5,870

 
$
25.10

The number of RSUs issued and outstanding under all of the Company’s stock option plans are as follows (in thousands, except for grant date fair value amounts):
 
Three Months Ended 
 April 2, 2016
 
Units
 
Weighted Average Grant
 Date Fair Value
RSUs outstanding, beginning of period
2,703

 
$
41.45

Granted
—

 
—

Canceled
—

 
—

Expired
—

 
—

Vested
—

 
—

RSUs outstanding, end of period
2,703

 
$
41.45

Approximately 2.7 million of the total RSUs outstanding were awarded to the Company’s Chairman and Chief Executive Officer in connection with the previous amendment and restatement of his employment agreement (see “Employment and Severance Agreements” in Note 14 to these condensed consolidated financial statements for further details).

21
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

At April 2, 2016, an aggregate of 17.2 million shares of common stock were reserved for future issuance under the 2007 Plan and prior equity incentive plans, of which 4.4 million shares were available for future grant under the 2007 Plan.
Valuation of Stock-Based Award Activity
The fair value of each RSU award is determined based on the closing price of the Company’s common stock on the grant date.
The Black-Scholes option pricing model is used to estimate the fair value of options granted under the Company’s stock-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
 
April 2,
2016
 
April 4,
2015
Risk-free interest rate
1.3% to 1.9%
 
1.3% to 1.8%
Expected term (in years)
5.7
 
5.5
Estimated volatility
34.6% to 35.7%
 
33.5% to 37.4%
Expected dividends
0%
 
0%
Weighted-average fair value of options granted
$13.13
 
$10.35
The total stock-based compensation expense for the three months ended April 2, 2016 and April 4, 2015 was $3.0 million and $2.9 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 April 2, 2016 was $156.1 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 April 2, 2016 was $101.9 million. The aggregate intrinsic value of options exercised during the three months ended April 2, 2016 was $4.4 million.
The unrecognized stock-based compensation expense related to unvested options granted after January 1, 2006 was $32.3 million as of April 2, 2016. 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 April 2, 2016 was 3.5 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 April 2, 2016 was 4.0 years.
14. Commitments and Contingencies
Leases
The Company leases certain facilities in North America, Europe and Asia under operating lease agreements expiring at various dates through May 2026. 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 each of April 2, 2016 and January 2, 2016, rent expense accrued in excess of the amount paid aggregated $0.2 million, which is classified as other liabilities in the accompanying condensed consolidated balance sheets. In addition, the Company leases automobiles in the U.S. and Europe that are classified as operating leases and expire at various dates through March 2020. 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.

22
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

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 April 2, 2016
 
Operating
Leases
 
Capital
Leases
 
Total
2016 (balance of year)
$
3,374

 
$
7

 
$
3,381

2017
4,393

 
75

 
4,468

2018
4,486

 
—

 
4,486

2019
3,726

 
—

 
3,726

2020
2,036

 
—

 
2,036

Thereafter
58,105

 
—

 
58,105

Total
$
76,120

 
$
82

 
$
76,202

In January 2016, the Company entered into the Third Amendment to Lease with The Irvine Company LLC (Third Amendment) relating to the rental of space in a building located in Irvine, California. Pursuant to the terms of the Third Amendment, the Company’s current lease of certain premises will be terminated in exchange for the Company’s leasing of approximately 70,700 square feet of space in another building in Irvine, California, located near the Company’s new corporate headquarters (New Premises). The Third Amendment also extends the term of the original lease to the end of the month in which the ten-year anniversary of the date of commencement (Commencement Date) of the lease for the New Premises occurs. The Commencement Date will occur following the completion of certain improvements to the New Premises, which the Company currently expects to be no later than November 2016.
Rental expense related to operating leases was $1.2 million and $1.5 million for the three months ended April 2, 2016 and April 4, 2015, respectively. Included in the future capital lease payments as of April 2, 2016 is interest aggregating less than $0.1 million.
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. For each of the three month periods ended April 2, 2016 and April 4, 2015, the Company contributed $0.5 million to the Plan.
Employment and Severance Agreements
On November 4, 2015, the Company entered into an Amended and Restated Employment Agreement with Joe Kiani, the Company’s Chairman and Chief Executive Officer (the Restated Employment Agreement). The Restated Employment Agreement, among other things, eliminates the tax gross-up payments, “single trigger” change in control payments and certain survival provisions, as well as phases out the fixed annual stock option grants guaranteed to Mr. Kiani under his previous employment agreement. Pursuant to the terms of the Restated Employment Agreement, upon a “Qualifying Termination” (as defined in the Restated Employment Agreement, including a change in control), Mr. Kiani will be entitled to receive a cash severance benefit equal to two times the sum of his then-current base salary and the average annual bonus paid to Mr. Kiani during the immediately preceding three years. In addition, upon a Qualifying Termination prior to 2018, Mr. Kiani will receive 2.7 million shares of common stock (subject to adjustment for recapitalizations, stock splits, stock dividends and the like) upon the vesting of certain RSUs granted to Mr. Kiani in connection with the Restated Employment Agreement, and an additional cash payment of $35.0 million related to a Non-Competition and Confidentiality Agreement between Mr. Kiani and the Company (collectively, the Special Payment). For any Qualifying Termination occurring on or after January 1, 2018, the number of shares to be issued to Mr. Kiani pursuant to the RSUs and the cash payment will each be reduced by 10% of the original amount each year so that after December 31, 2026, no Special Payment will be due to Mr. Kiani upon a Qualifying Termination. As of April 2, 2016, the expense related to the Special Payment that would be recognized in the Company’s condensed consolidated financial statements upon the occurrence of a Qualifying Termination under the Restated Employment Agreement approximated $149.7 million.

23
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

As of April 2, 2016, the Company had severance plan participation agreements with seven other 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 $54.1 million of purchase commitments as of April 2, 2016, 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.
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 April 2, 2016, the Company had approximately $0.5 million in unsecured bank guarantees.
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 April 2, 2016, 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 time deposits and money market accounts with major financial institutions. As of April 2, 2016, the Company had $89.7 million of bank balances, of which $3.0 million was covered by either the U.S. Federal Deposit Insurance Corporation limit or foreign countries’ deposit insurance organizations. As of April 2, 2016, the Company had $0.2 million in money market funds and $50.0 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 months ended April 2, 2016 and April 4, 2015, revenue from the sale of the Company’s products to U.S. hospitals that are members of GPOs amounted to $91.9 million and $86.3 million, respectively.
For the three months ended April 2, 2016, the Company had sales through two just-in-time distributors, which represented 16.0% and 11.2% of total revenue, respectively. For the three months ended April 4, 2015, the Company had sales through the same two just-in-time distributors, which represented 14.0% and 13.0% of total revenue, respectively. As of April 2, 2016, three just-in-time distributors represented 7.8%, 7.9% and 6.2% of the Company’s accounts receivable balance, respectively. As of January 2, 2016, two of the same just-in-time distributors represented 5.5% and 5.3% of the Company’s accounts receivable balance, respectively.

24
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

For the three months ended April 2, 2016 and April 4, 2015, the Company recorded $7.9 million and $7.2 million, respectively, in royalty revenues from Medtronic pursuant to the original settlement agreement and amendments. In exchange for these royalty payments, the Company has provided Medtronic the ability to ship its patent infringing product with a covenant not to sue Medtronic as long as Medtronic abides by the terms of the agreement. The current royalty rate is 7.75% and the amended agreement can be terminated by Medtronic upon 60 days written notice.
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 and 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. Philips has indicated that it intends to appeal the damages award once a final judgment has been rendered in the case. On September 18, 2015, the Court set a schedule for the trials related to Masimo’s second phase patents against Philips and Philips’ antitrust counterclaims and patent misuse defense, with both trials scheduled to take place in the first quarter of 2017. On November 16, 2015, the Company asserted three antitrust claims against Philips. On December 9, 2015, the Court dismissed with prejudice Philips’ sole remaining patent infringement claim against the Company. On January 4, 2016, the Court granted Philips’ motion to strike the Company’s antitrust counterclaims, ruling that the Company must bring these claims in a separate litigation. On March 4, 2016, the Company filed an additional case against Philips alleging antitrust violations and patent infringement in the District of Delaware. The Company believes that it has good and substantial defenses to the remaining antitrust 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.
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 appealed the District Court’s decision and an argument on the appeal was held in the Ninth Circuit Court of Appeals on February 1, 2016. On February 19, 2016, the Ninth Circuit Court of Appeals affirmed the summary judgment of the District Court.
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 (the Arbitration Award). 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. The former sales representatives appealed the District Court’s decision, and the appeal argument was held in the Ninth Circuit Court of Appeals on February 1, 2016. On February 19, 2016, the Ninth Circuit Court of Appeals reversed the decision of the District Court vacating the award, and remanded the case to the District Court with instructions to confirm the Arbitration Award. On March 23, 2016, the District Court entered final judgment confirming the Arbitration Award, and on April 8, 2016 the Company remitted $6.2 million to the plaintiffs in full payment of the Arbitration Award and related interest. On April 22, 2016, the Company filed a notice of appeal.

25
Table of Contents
MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

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 Company’s 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 ultimately 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. On August 13, 2015, the U.S. District Court for the Northern District of Alabama granted summary judgment in favor of the Company on all claims. The plaintiffs have appealed the U.S. District Court for the Northern District of Alabama’s decision. The Company is unable to determine whether any loss will ultimately 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 October 21, 2015, Medtronic plc (Medtronic) filed three separate inter partes review petitions (IPR Petitions) with the Patent Trial and Appeal Board (PTAB) of the U.S. Patent and Trademark Office (PTO), challenging several of the claims of the Company’s U.S. Patent Nos. 7,496,393 (the ‘393 Patent), titled “Signal processing apparatus”, which expires in September 2016, and 8,560,034 (the ‘034 Patent), also titled “Signal processing apparatus”, which expires in October 2018. On April 27, 2016, the PTAB denied Medtronic’s IPR Petitions with respect to the ‘034 Patent. On April 28, 2016, the PTAB granted Medtronic’s IPR Petition for review of certain claims of the ’393 Patent, and denied Medtronic’s IPR Petition for review of other claims of the ’393 Patent. The Company intends to defend the claims of the ’393 Patent for which review was granted. Although the Company believes it has good and substantial positions for the patentability review and trial of ‘393 Patent, there is no guarantee that the Company will prevail.
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.
15. 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 and long lived assets.

26
Table of Contents
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
 
 
April 2, 2016
 
April 4, 2015
Geographic area by destination
 
 
 
 
 
 
 
 
United States
 
$
113,505

 
69.5
%
 
$
107,276

 
72.8
%
Europe, Middle East and Africa
 
31,970

 
19.6

 
24,061

 
16.3

Asia and Australia
 
13,582

 
8.3

 
11,818

 
8.0

North and South America (excluding the United States)
 
4,233

 
2.6

 
4,202

 
2.9

     Total product revenue
 
$
163,290

 
100.0
%
 
$
147,357

 
100.0
%
The Company’s consolidated long-lived assets and net assets by geographic area are:
 
 
Three Months Ended
 
 
April 2, 2016
 
January 2, 2016
Long-lived assets by geographic area
 
 
 
 
 
 
 
 
United States
 
$
206,385

 
96.6
%
 
$
203,553

 
96.8
%
International
 
7,338

 
3.4

 
6,770

 
3.2

     Total
 
$
213,723

 
100.0
%
 
$
210,323

 
100.0
%
16. Income Taxes
The Company has provided for income taxes in fiscal 2016 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.
As of April 2, 2016, the liability for income taxes associated with uncertain tax positions was approximately $8.7 million. If fully recognized, approximately $7.3 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.
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 2011. The Company’s 2012 income tax return is currently under examination by the U.S. Internal Revenue Service. All material state, local and foreign income tax matters have been concluded through fiscal year 2008. The Company does not believe that the results of any tax authority examination would have a significant impact on its financial statements.

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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 2, 2016, which we filed with the SEC on February 24, 2016. 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 original equipment manufacturers (OEM) partners to hospitals, emergency medical service providers, physician offices, veterinarians, long-term care facilities 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.
Our core business is Measure-through-Motion and Low-Perfusion™ pulse oximetry monitoring, known as Masimo Signal Extraction Technology® (SET®) pulse oximetry. Our product offerings have expanded significantly over the years to also include monitoring blood constituents with an optical signature, optical organ oximetry monitoring, electrical brain function monitoring, acoustic respiration monitoring, exhaled gas monitoring, patient monitoring with connectivity platforms, bedside and portable patient monitors and wearable wireless patent monitors. We have also developed a remote patient surveillance monitoring system, which currently allows up to 200 patients to be monitored simultaneously and remotely through a PC-based viewing station or by care providers through their pagers, voice-over-IP phones or smartphones.
Masimo SET® was designed to overcome the primary limitations of conventional pulse oximetry by maintaining accuracy in the presence of motion artifact, low perfusion and weak signal-to-noise situations. 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 inside and outside 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 to 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.
Our rainbow SET™ platform leverages 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 (RRa™), rainbow SET™ Pulse CO-Oximetry has the ability to provide noninvasive monitoring of total hemoglobin (SpHb®), carboxyhemoglobin (SpCO®) and methemoglobin (SpMet®), as well as the calculation of Oxygen Content (SpOC™). The rainbow SET™ platform also allows for

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monitoring of arterial oxygen saturation, even under the presence of carboxyhemoglobin and methemoglobin, known as fractional arterial oxygen saturation (SpfO2™), Respiration Rate from the Pleth (RRp™) and Oxygen Reserve Index™ (ORI™). Although SpfO2™, RRp™ and ORI™ have received the CE Mark, they are not currently available for sale in the U.S.
Following the introduction of our rainbow SET™ platform, we have continued to expand our technology offerings by introducing additional noninvasive measurements and technologies to create new market opportunities in both the hospital and non-hospital care settings. These offerings include:
•
SedLine® - Brain function monitoring is most commonly used during surgery to help clinicians monitor sedation under anesthesia. SedLine® brain function monitoring technology measures the brain’s electrical activity by detecting electroencephalogram (EEG) signals. 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 number called Patient State Index (PSI), which gives a continuous indication of the patient’s depth of sedation. Our SedLine® brain function monitoring technology can now be delivered through the Masimo Open Connect™ (MOC-9™) connectivity port within our Root® patient monitoring and connectivity platform, which integrates our 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 PSI trend and the Density Spectral Array view to allow clinicians to compare EEG power in both sides of the brain over time to facilitate the detection of asymmetrical activity.
•
Capnography and Gas Monitoring - 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 carbon dioxide (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.
•
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.
•
rainbow Acoustic Monitoring® (RAM™) - Our sound-based monitoring technology 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.
•
Root® - This powerful patient monitoring and connectivity platform 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 (EMR) through our Patient SafetyNet™ solution. In combination with a Radical-7® handheld monitor, Root® will display alarm information, thereby 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. For example, our Root® connectivity and patient monitoring platform 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.

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In March 2016, we announced Iris Gateway™, a server-based software solution for integrating medical device data. The Iris™ ports on our Root® patient monitor allow other medical devices (such as infusion pumps, ventilators, patient monitors and “smart” beds) to connect to Iris Gateway™ via Root®. Iris™ Gateway can provide a timely and cost-effective solution for the integration of medical device data by connecting to existing medical devices and performing the required translations to move the data from the devices into EMRs. Iris Gateway™ can be deployed on a remote server farm or as a server appliance in the hospital.
•
Patient SafetyNet™ - Our patient surveillance, remote monitoring and clinician notification solution 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 phone. 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 demonstrates our commitment to innovation that automates patient care with open, scalable and standards-based connectivity architecture.
The Patient SafetyNet Series 5000™, together with Iris™ Connectivity and MyView™ through the Root® patient monitoring and connectivity platform, offers a new level of interoperability designed to enhance clinician workflows and reduce the cost of care, from operating rooms to medical-surgical units. Patient SafetyNet Series™ 5000™ with Iris™ enables Root®  to accept data from all devices connected to the patient, thereby 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 EMR. The patient-centric user interface of the Patient SafetyNet™ Series 5000™ displays near real-time data from all devices, providing a single unified dashboard of patient information. 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™ 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.
In March 2016, we introduced SafetyNet Surveillance™, a software option for our Patient SafetyNet™ solution that provides real-time video images of a patient’s room, including the patient with connected monitoring devices, adding existing communication technology to central monitoring. Two-way audio is available to allow the caregiver to listen to and communicate with the patient. The system utilizes the existing hospital information technology network and can provide viewing of images in the same care area.
•
MightySat™ - Our fingertip pulse oximeter 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™ provides SpO2, PR, RRp™, PVI® 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. Its 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 perfusion index 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 general health and wellness use and is not intended for medical use. However, MightySat™ Rx, the medical version of the product with optional Bluetooth®, received 510(k) clearance in late 2015. MightySat™ Rx with the RRp™ measurement is not currently available for sale in the U.S.
•
MyView™ - This wireless, presence-detection system 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.

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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;
(5)
expand the use of Root® in hospital settings;
(6)
utilize our customer base and OEM relationships to market our rainbow SET™ products incorporating our licensed rainbow® technology, as well as our other non-invasive specialty products including O3™, SedLine® and capnography monitoring; and
(7)
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. In addition, we have exclusively licensed certain rainbow® technology from Cercacor Laboratories, Inc. (Cercacor) and have the right to incorporate such rainbow® technology into products that are intended for use 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.
As a result of recent changes in the capital structure of Cercacor, as well as certain of its contractual relationships with us, we completed a re-evaluation of the authoritative consolidation guidance during the three months ended April 2, 2016 and determined that although Cercacor remains a VIE, we are no longer its primary beneficiary. Based on such determination, we have discontinued consolidating Cercacor within our consolidated financial statements effective as of January 3, 2016. However, Cercacor continues to be consolidated within our condensed consolidated financial information for all periods prior to January 3, 2016. See Note 3 to the condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information.
Stock Repurchase Program
In September 2015, our board of directors (Board) authorized a stock repurchase program, whereby we may purchase up to 5.0 million shares of our common stock over a period of up to three years. As of April 2, 2016, approximately 3.3 million shares remained authorized for repurchase under this program.
Our 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 current stock repurchase program, see Note 12 to the condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.

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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
 
April 2,
2016
 
Percentage
of Revenue
 
April 4,
2015
 
Percentage
of Revenue
Revenue:
 
 
 
 
 
 
 
Product
$
163,290

 
95.4
%
 
$
147,357

 
95.4
%
Royalty
7,877

 
4.6

 
7,180

 
4.6

Total revenue
171,167

 
100.0

 
154,537

 
100.0

Cost of goods sold
56,954

 
33.3

 
51,432

 
33.3

Gross profit
114,213

 
66.7

 
103,105

 
66.7

Operating expenses:
 
 

 
 
 
 
Selling, general and administrative
62,511

 
36.5

 
60,799

 
39.3

Research and development
14,365

 
8.4

 
14,929

 
9.7

Total operating expenses
76,876

 
44.9

 
75,728

 
49.0

Operating income
37,337

 
21.8

 
27,377

 
17.7

Non-operating income
498

 
0.3

 
153

 
0.1

Income before provision for income taxes
37,835

 
22.1

 
27,530

 
17.8

Provision for income taxes
10,258

 
6.0

 
7,708

 
5.0

Net income including noncontrolling interest
27,577

 
16.1

 
19,822

 
12.8

Net loss attributable to the noncontrolling interest(1)
—

 
—

 
701

 
0.5

Net income attributable to Masimo Corporation stockholders
$
27,577

 
16.1
%
 
$
20,523

 
13.3
%
(1)  
Effective January 3, 2016, we determined that we are no longer the primary beneficiary of Cercacor, and, therefore, we discontinued consolidating Cercacor in our consolidated financial information. Pursuant to authoritative accounting guidance, all periods prior to January 3, 2016 continue to include Cercacor in our consolidated financial information. See Note 3 to the condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information.
Comparison of the Three Months ended April 2, 2016 to the Three Months ended April 4, 2015
Revenue. Total revenue increased $16.6 million, or 10.8%, to $171.2 million for the three months ended April 2, 2016 from $154.5 million for the three months ended April 4, 2015. The following chart details our total product revenues by the geographic area to which the products were shipped for each of the three month periods ended April 2, 2016 and April 4, 2015 (dollars in thousands):
 
Three Months Ended
 
April 2, 2016
 
April 4, 2015
 
Increase/
(Decrease)
 
Percentage
Change
 
 
 
 
 
 
 
 
 
 
 
 
       United States
$
113,505

 
69.5
%
 
$
107,276

 
72.8
%
 
6,229

 
5.8
%
Europe, Middle East and Africa
31,970

 
19.6

 
24,061

 
16.3

 
7,909

 
32.9

Asia and Australia
13,582

 
8.3

 
11,818

 
8.0

 
1,764

 
14.9

North and South America (excluding United States)
4,233

 
2.6

 
4,202

 
2.9

 
31

 
0.7

Total Product Revenue
$
163,290

 
100.0
%
 
$
147,357

 
100.0
%
 
$
15,933

 
10.8
%
Royalty
7,877

 
 
 
7,180

 
 
 
697

 
 
Total Revenue
$
171,167

 
 
 
$
154,537

 
 
 
$
16,630

 
 

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Product revenue increased $15.9 million, or 10.8%, to $163.3 million for the three months ended April 2, 2016 from $147.4 million for the three months ended April 4, 2015. This increase was primarily due to higher sales of consumable products. This increase in product revenue was partially offset by the impact of approximately $1.4 million related to 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. We estimate that our installed base of circuit boards and pulse oximeters increased to 1,438,000 units at April 2, 2016 as compared to 1,340,000 units at April 4, 2015.
Product revenue generated through our direct and distribution sales channels increased $15.9 million, or 12.7%, to $140.9 million for the three months ended April 2, 2016, compared to $125.1 million for the three months ended April 4, 2015. Revenues from our OEM channel were unchanged at $22.3 million for the three months ended April 2, 2016 as compared to the three months ended April 4, 2015. Total rainbow® product revenue increased by $4.8 million, or 39.2%, to $16.9 million for the three months ended April 2, 2016, compared to $12.2 million for the three months ended April 4, 2015.
Royalty revenue consists of amounts received from Medtronic plc (Medtronic, formerly Covidien) related to its U.S. sales pursuant to the terms of our amended settlement agreement. Based on the terms of such agreement, Medtronic has the right to stop paying us royalties, subject to certain notice requirements. In addition, on October 21, 2015, Medtronic filed three separate inter partes review petitions (IPR Petitions) with the Patent Trial and Appeal Board (PTAB) of the U.S. Patent and Trademark Office, challenging several of the claims of two U.S. patents titled “Signal processing apparatus” that are owned by us. On April 27, 2016, the PTAB denied the IPR Petitions with respect to one patent. On April 28, 2016, the PTAB granted the IPR Petition for review of certain claims of the other patent while denying the IPR Petition for review of other claims with respect to such patent. We intend to defend the claims of the patent for which review was granted. See Note 14 to the condensed consolidated financial statements under the caption “Litigation” included in Part I, Item 1 and “Medtronic may seek to avoid paying any royalties to us, which would significantly reduce our royalty revenues and adversely affect our business, financial condition and results of operations” under Part II, Item 1A - Risk Factors, in this Quarterly Report on Form 10-Q for additional information.
Gross Profit. Gross profit consists of total revenue less cost of goods sold. Our gross profit for the three months ended April 2, 2016 and April 4, 2015 was as follows (dollars in thousands):
 
Three Months Ended
 
April 2, 2016
 
Gross Profit Percentage
 
April 4, 2015
 
Gross Profit Percentage
 
Increase/
(Decrease)
 
Percentage
Change
Product Gross Profit
$
106,336

 
65.1
%
 
$
95,925

 
65.1
%
 
$
10,411

 
10.9
%
Royalty Gross Profit
7,877

 
100.0

 
7,180

 
100.0

 
697

 
9.7

Total Gross Profit
$
114,213

 
66.7
%
 
$
103,105

 
66.7
%
 
$
11,108

 
10.8
%
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 $5.5 million for the three months ended April 2, 2016, compared to the three months ended April 4, 2015, primarily due to the increase in our product revenues and the impact of approximately $1.5 million of Cercacor royalty expense that is no longer eliminated in consolidation. Product gross margins were unchanged at 65.1% for the three months ended April 2, 2016 as compared to the three months ended April 4, 2015, primarily due to the impact of the non-elimination of such Cercacor royalty expense for the three months ended April 2, 2016. We incurred $1.3 million in Cercacor royalty expenses for the three months ended April 4, 2015 that was eliminated in our condensed consolidated financial statements for such period. Had such royalty expenses not been eliminated in consolidation, product gross profit margin would have been 64.2% for the three months ended April 4, 2015, compared to our reported product gross profit margin of 65.1% for the three months ended April 2, 2016. This increase in product gross margin resulted primarily from our continued cost reduction efforts, as well as from differences in our product sales mix. See Note 3 to the condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information related to the deconsolidation of Cercacor.
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 April 2, 2016 and April 4, 2015 were as follows (dollars in thousands):

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Selling, General and Administrative
Three Months Ended 
 April 2, 2016
Percentage of
Net Revenues
Three Months Ended 
 April 4, 2015
Percentage of
Net Revenues
Increase/
(Decrease)
Percentage
Change
$62,511
36.5%
$60,799
39.3%
$1,712
2.8%
Selling, general and administrative expenses increased $1.7 million, or 2.8%, for the three months ended April 2, 2016 compared to the three months ended April 4, 2015. This increase was primarily attributable to higher payroll related costs of approximately $3.1 million, higher marketing related fees of approximately $1.5 million and higher travel related costs of approximately $0.7 million, which were partially offset by a decrease of approximately $1.8 million in medical device excise tax as a result of the two year moratorium signed into law on December 18, 2015 under the Consolidated Appropriations Act, and lower legal and professional fees of approximately $1.0 million. Also offsetting these increases was the current period deconsolidation of Cercacor, which resulted in the exclusion of approximately $0.6 million of Cercacor’s selling, general and administration expenses from our consolidated results of operations for the three months ended April 2, 2016, as compared to the inclusion of approximately $0.7 million of Cercacor’s selling, general and administration expenses in our consolidated results of operations for the three months ended April 4, 2015. (See Note 3 to the condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information related to the deconsolidation of Cercacor.) Stock-based compensation expense of approximately $2.2 million and $2.0 million was included in selling, general and administrative expenses for the three months ended April 2, 2016 and April 4, 2015, 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 April 2, 2016 and April 4, 2015 were as follows (dollars in thousands):
Research and Development
Three Months Ended 
 April 2, 2016
Percentage of
Net Revenues
Three Months Ended 
 April 4, 2015
Percentage of
Net Revenues
Increase/
(Decrease)
Percentage
Change
$14,365
8.4%
$14,929
9.7%
$(564)
(3.8)%
Research and development expenses decreased $0.6 million for the three months ended April 2, 2016 compared to the three months ended April 4, 2015, primarily due to the current period deconsolidation of Cercacor, which resulted in the exclusion of approximately $1.3 million of Cercacor’s research and development expenses from our consolidated results of operations for the three months ended April 2, 2016, as compared to the inclusion of approximately $1.4 million of Cercacor’s research and development expenses in our consolidated results of operations for the three months ended April 4, 2015. (See Note 3 to the condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information related to the deconsolidation of Cercacor.) Also contributing to the decrease in research and development expenses were lower project related supply costs of approximately $0.9 million during the three months ended April 2, 2016. Offsetting these decreases during the three months ended April 2, 2016 were higher payroll related costs of $0.9 million and higher occupancy related costs of $0.5 million. Included in research and development expenses was approximately $0.7 million of stock-based compensation expense for each of the three month periods ended April 2, 2016 and April 4, 2015.
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 April 2, 2016 and April 4, 2015 was as follows (dollars in thousands):
Non-operating Income (Expense)
Three Months Ended 
 April 2, 2016
Percentage of
Net Revenues
Three Months Ended 
 April 4, 2015
Percentage of
Net Revenues
Increase/
(Decrease)
Percentage
Change
$498
0.3%
$153
0.1%
$345
225.5%
Non-operating income increased by $0.3 million for the three months ended April 2, 2016 compared to the three months ended April 4, 2015. Non-operating income for the three months ended April 2, 2016 consisted of $0.7 million of interest expense offset by $0.9 million of net realized and unrealized gains on foreign currency denominated transactions resulting primarily from the weakening of the U.S. Dollar against the Japanese Yen, Euro and Canadian Dollar, which were negatively impacted by losses due to the weakening of the U.S. Dollar against the Swedish Krona, and a $0.3 million gain resulting from our deconsolidation of Cercacor. See Note 3 to the condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information on the deconsolidation of Cercacor.

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Non-operating income for the three months ended April 4, 2015 related primarily to $0.5 million of interest expense which was offset by $0.6 million of 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 British Pound. 
Provision for Income Taxes. Our provision for income taxes for the three months ended April 2, 2016 and April 4, 2015 was as follows (dollars in thousands):
Provision for Income Taxes
Three Months Ended 
 April 2, 2016
Percentage of
Net Revenues
Three Months Ended 
 April 4, 2015
Percentage of
Net Revenues
Increase/
(Decrease)
Percentage
Change
$10,258
6.0%
$7,708
5.0%
$2,550
33.1%
Our provision for income taxes was $10.3 million, or an effective tax rate of 27.1%, for the three months ended April 2, 2016, compared to $7.7 million, or an effective tax rate of 28.0%, for the three months ended April 4, 2015. The lower effective tax rate for the three months ended April 2, 2016 is primarily due to a discrete tax benefit of $1.0 million during the three months ended April 2, 2016 related to excess tax benefits realized for stock-based compensation, pursuant to our adoption of Accounting Standards Update No. 2016-09, Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (ASU 2016-09). No similar tax benefit was recognized in our provision for income taxes during the three months ended April 4, 2015. (See Note 2 to the condensed consolidated financial statements under the caption “Recently Adopted Accounting Pronouncements” included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information on our adoption of ASU 2016-09.) Partially offsetting this tax benefit was an increase on our effective tax rate resulting from differences in our expected fiscal 2016 geographic composition of our pre-tax income as compared to our expected fiscal 2015 geographic composition as of April 4, 2015.
Liquidity and Capital Resources
Our principal sources of liquidity consist of our existing cash and cash equivalent balances, funds expected to be generated from operations and funds available under our revolving credit agreement. At April 2, 2016, we had approximately $197.8 million in working capital and approximately $139.9 million in cash and cash equivalents as compared to approximately $166.5 million in working capital and approximately $132.3 million in cash and cash equivalents at January 2, 2016. We carry cash equivalents at cost that approximates fair value. We currently do not maintain an investment portfolio but have the ability to invest in various security holdings, types and maturities that meet credit quality standards in accordance with our investment guidelines.
As of April 2, 2016, we had cash totaling $81.2 million held outside of the U.S., of which approximately $13.6 million was accessible without additional tax cost and approximately $67.5 million was accessible at an incremental estimated tax cost of approximately $20.4 million. In managing our day-to-day liquidity and capital structure, we do not rely on foreign earnings as a source of funds. We currently have sufficient funds on-hand and available under our line of credit to fund our domestic operations and do not anticipate the need to repatriate funds associated with our permanently reinvested foreign earnings. In the event funds that are treated as permanently reinvested are repatriated, we may be required to accrue and pay additional U.S. taxes with respect to any such repatriation.
On January 8, 2016, we entered into an Amended and Restated Credit Agreement (Restated Credit Facility) with JPMorgan Chase Bank, N.A., as Administrative Agent and a Lender, Bank of America, N.A., as Syndication Agent and a Lender, Citibank, N.A., as Documentation Agent and a Lender, and various other Lenders (collectively, the Lenders). The Restated Credit Facility amends and restates the Amended Credit Agreement and provides for up to $450.0 million in borrowings in multiple currencies, with an option, subject to certain conditions, for us to increase the aggregate borrowing capacity to up to $550.0 million in the future. The Restated Credit Facility also provides for a sublimit of up to $50.0 million for the issuance of letters of credit and a sublimit of $125.0 million in specified foreign currencies. All unpaid principal under the Restated Credit Facility will become due and payable on January 8, 2021. See Note 10 to the condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information.
During the three months ended April 2, 2016, we received $7.9 million from Medtronic for royalties related to its U.S. sales pursuant to the terms of our amended settlement agreement. Based on the terms of such agreement, Medtronic has the right to stop paying us royalties, subject to certain notice requirements. In addition, on October 21, 2015, Medtronic filed three separate inter partes review petitions (IPR Petitions) with the Patent Trial and Appeal Board (PTAB) of the U.S. Patent and Trademark Office, challenging several of the claims of two U.S. patents titled “Signal processing apparatus” that are owned by us. On April 27, 2016, the PTAB denied the IPR Petitions with respect to one patent. On April 28, 2016, the PTAB granted the IPR Petition for review of certain claims of the other patent while denying the IPR Petition for review of other claims with

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respect to such patent. We intend to defend the claims of the patent for which review was granted. See Note 14 to the condensed consolidated financial statements under the caption “Litigation” included in Part I, Item 1 and “Medtronic may seek to avoid paying any royalties to us, which would significantly reduce our royalty revenues and adversely affect our business, financial condition and results of operations” under Part II, Item 1A - Risk Factors, in this Quarterly Report on Form 10-Q for additional information.
Cash Flows
The following table summarizes our cash flows (in thousands):
 
 
Three Months Ended
 
 
April 2,
2016
 
April 4,
2015
Net cash provided by (used in):
 
 
 
Operating activities
$
18,803

 
$
19,126

Investing activities
(6,860
)
 
(17,955
)
Financing activities
(5,214
)
 
2,392

Effect of foreign currency exchange rates on cash
855

 
(2,296
)
(Decrease) increase in cash and cash equivalents
$
7,584

 
$
1,267

Operating Activities. Cash provided by operating activities was $18.8 million in the three months ended April 2, 2016, arising primarily from net income of $27.6 million, non-cash activity for depreciation and amortization of $4.1 million, stock-based compensation of $3.0 million and deferred income taxes of $2.7 million. In addition, deferred revenue and income taxes payable increased by $5.4 million and $4.5 million, respectively. These sources of cash were primarily offset by other changes in operating assets and liabilities related to a decrease in accrued compensation of $12.6 million and a decrease in accrued liabilities of $4.2 million, both due to the timing of related payments, and an increase in accounts receivable of $12.3 million due to the timing of collections.
Cash provided by operating activities was $19.1 million for the three months ended April 4, 2015, arising primarily from net income of $19.8 million, non-cash activity for depreciation and amortization of $3.8 million and stock-based compensation of $2.9 million. In addition, deferred revenue and accrued liabilities increased by $1.9 million and $7.2 million, respectively, and accounts receivable decreased by $2.8 million due to the timing of collections. These sources of cash were primarily offset by other changes in operating assets and liabilities related to an increase in other assets of $6.4 million primarily due to an increase in prepaid discounts, a decrease in accounts payable of $3.1 million related to the timing of payments and a decrease in accrued compensation of $10.8 million due to the payment of fiscal year 2014 annual bonuses.
Investing Activities. Cash used in investing activities for the three months ended April 2, 2016 was $6.9 million, consisting primarily of $5.3 million for purchases of property and equipment, $0.8 million of intangible assets related to capitalized patent and trademark costs and $0.8 million related to the deconsolidation of Cercacor. See Note 3 to the condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information related to the deconsolidation of Cercacor.
Cash used in investing activities for the three months ended April 4, 2015 was $18.0 million, consisting of $17.2 million for purchases of property and equipment and $0.7 million for the increase in intangible assets related to capitalized patent and trademark costs.
Financing Activities. Cash used in financing activities for the three months ended April 2, 2016 was $5.2 million, primarily resulting from common stock repurchase transactions during the quarter totaling $47.7 million, offset by net borrowings under our Restated Credit Facility of $40.0 million and proceeds from the issuance of common stock (upon exercise of options) totaling $2.6 million.
Cash provided by financing activities for the three months ended April 4, 2015 was $2.4 million, primarily due to proceeds from the issuance of common stock (upon exercise of options) totaling $4.6 million, offset by common stock repurchase transactions that settled during the quarter totaling $2.2 million.
Capital Resources and Prospective Capital Requirements
As of April 2, 2016, we had $225.0 million in outstanding loan draws under our Restated Credit Facility, leaving available borrowing capacity of $225.0 million. We also had outstanding capital lease obligations of $0.1 million related primarily to office and computer equipment. We had no other debt obligations and are in compliance with all bank covenants.

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In September 2015, the Board authorized a stock repurchase program for the repurchase of up to 5.0 million shares of our common stock over a period of up to three years. 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.  As of April 2, 2016, approximately 3.3 million shares remain authorized for repurchase under this stock repurchase program. For additional information regarding our stock repurchase program, see Note 12 to the condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.
We expect to fund our future operating, investing and financing activities through our available cash, future cash from operations, funds available under our Restated Credit Facility and other potential sources of capital. In addition to funding our normal working capital requirements, we anticipate additional capital purchases related to renovating our new corporate headquarters. We also anticipate that we will continue to repurchase stock under our authorized stock repurchase program subject to the availability of our stock, general market conditions, the trading price of our stock, available capital, alternative uses for capital and our financial performance. Possible additional uses of cash may include the acquisition of technologies or technology companies. The amount and timing of our actual investing activities will vary significantly depending on numerous factors, including the timing and amount of costs related to the renovation of our new corporate headquarters facility and other capital expenditures, costs of product development efforts, stock repurchase activity and costs related to our domestic and international regulatory requirements. Despite these investment requirements, we anticipate that our existing cash and cash equivalents, as well as amounts available under the Restated Credit Facility, will be sufficient to meet our working capital requirements, capital expenditures and other operational funding needs for at least the next 12 months.
Off-Balance Sheet Arrangements
We do not currently have, nor have we ever had, any relationships with unconsolidated entities or financial partnerships, such as entities referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. In addition, we do not engage in trading activities involving non-exchange traded contracts. As a result, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we engaged in these relationships. As of April 2, 2016, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K promulgated by the SEC.
Critical Accounting Policies and Estimates
The discussion and analysis of our financial condition and results of operations is based on our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these condensed consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of net revenues, expenses, assets and liabilities. We regularly evaluate our estimates and assumptions related to our critical accounting policies, including revenue recognition and deferred revenue, inventory and related reserves for excess or obsolete inventory, allowance for doubtful accounts, stock-based compensation, goodwill, deferred taxes and related valuation allowances, uncertain tax positions, tax contingencies, litigation costs and loss contingencies. We base our estimates and assumptions on current facts, historical experience and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the recording of revenue, costs and expenses that are not readily apparent from other sources. Changes in judgments and uncertainties relating to these estimates could potentially result in materially different results under different assumptions and conditions. If these estimates differ significantly from actual results, the impact on our condensed consolidated financial statements and future results of operations may be material. For a description of our critical accounting policies, please refer to “Critical Accounting Estimates” in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the fiscal year ended January 2, 2016, filed with the SEC on February 24, 2016. There have been no material changes to any of our critical accounting policies during the three months ended April 2, 2016.
Recent Accounting Pronouncements
See Note 2 to the condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for a description of recently issued or adopted accounting standards.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market risk represents the risk of changes in the value of market risk sensitive instruments caused by fluctuations in interest rates, foreign exchange rates and commodity prices. We are exposed to various market risks that may arise from adverse changes in market rates and prices, such as interest rates, foreign exchange fluctuations and inflation. We do not enter into derivatives, including forward contracts, or other financial instruments for trading or speculative purposes.

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Interest Rate Risk
Our exposure to market risk for changes in interest rates relates to the increase or decrease in the amount of interest income we can earn on our investment portfolio and on the increase or decrease in the amount of interest expense we must pay with respect to our various outstanding debt instruments. Our risk associated with fluctuations in interest expense is limited to interest associated with our outstanding capital lease arrangements, which have fixed interest rates, and any borrowings under our Restated Credit Facility and any amendments thereto. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. We ensure the safety and preservation of our invested principal funds by limiting default risk, market risk and reinvestment risk. We reduce default risk by investing in investment grade securities. A hypothetical 100 basis point change in interest rates along the entire interest rate yield curve would not significantly affect the fair value of our interest-sensitive financial instruments at April 2, 2016. Declines in interest rates over time will, however, reduce our interest income and expense while increases in interest rates will increase our interest income and expense.
Foreign Currency Exchange Rate Risk
A majority of our assets and liabilities are maintained in the United States in U.S. Dollars and a majority of our sales and expenditures are transacted in U.S. Dollars. However, we also transact with foreign customers in currencies other than the U.S. Dollar. These foreign currency revenues, when converted into U.S. Dollars, can vary depending on average exchange rates during a respective period. In addition, certain of our foreign subsidiaries transact in their respective country’s local currency, which is also their functional currency. As a result, expenses of these foreign subsidiaries, when converted into U.S. Dollars, can vary depending on the average exchange rates during a respective period.
We are exposed to foreign currency gains or losses on outstanding foreign currency denominated receivables and payables, as well as intercompany transactions. Realized and unrealized foreign currency gains or losses on these transactions are included in our statements of comprehensive income as incurred. Furthermore, other transactions between us or our subsidiaries and a third-party, denominated in a currency different from the functional currency, are foreign currency transactions. Realized and unrealized foreign currency gains or losses on these transactions are included in our statements of comprehensive income as incurred, and are converted to U.S. Dollars at the average exchange rates for a respective period.
The balance sheets of each of our foreign subsidiaries whose functional currency is not the U.S. Dollar are translated into U.S. Dollars at the rate of exchange at the balance sheet date and the statements of comprehensive income and cash flows are translated into U.S. Dollars using the average monthly exchange rate during the period. Any foreign exchange gain or loss as a result of translating the balance sheets of our foreign subsidiaries whose functional currency is not the U.S. Dollar is included in equity as a component of accumulated other comprehensive income.
Our primary foreign currency exchange rate exposures are with the Euro, Japanese Yen, Swedish Krona, Canadian Dollar, British Pound, Mexican Peso and Australian Dollar, against the U.S. Dollar. Foreign currency exchange rates have experienced significant movements recently, particularly when compared to the same prior year period, and such volatility may continue in the future. Specifically, during the three months ended April 2, 2016, we estimate that changes in the exchange rates of the U.S. Dollar relative primarily to the Euro, Japanese Yen, Swedish Krona, Canadian Dollar, British Pound and Australian Dollar, negatively impacted our revenues by $1.4 million when compared to foreign exchange rates from the prior year period. We currently do not enter into forward exchange contracts to hedge exposures denominated in foreign currencies and do not use derivative financial instruments for trading or speculative purposes. The effect of a 10% change in foreign currency exchange rates could have a material effect on our future operating results or cash flows, depending on which foreign currency exchange rates change and depending on the directional change (either a strengthening or weakening against the U.S. Dollar). As our foreign operations continue to grow, our exposure to foreign currency exchange rate risk may become more significant.
Inflation Risk
We do not believe that inflation has had a material effect on our business, financial condition or results of operations during the periods presented. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could have a material adverse effect on our business, financial condition and results of operations.
Item 4. Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, as amended (the Exchange Act) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s (SEC) regulations, rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure.

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In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. As required by Rule 13a-15(b) or Rule 15d-15(b) promulgated by the SEC under the Exchange Act, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report on Form 10-Q.
There has been no change in our internal control over financial reporting during the quarter ended April 2, 2016 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
The information set forth in Note 14 to the condensed consolidated financial statements under the caption “Litigation” included in Part I, Item 1 of this Quarterly Report on Form 10-Q is incorporated herein by reference.
Item 1A. Risk Factors
Before you decide to invest or maintain an interest in our common stock, you should consider carefully the risks described below, which have been updated since the filing of our Annual Report on Form 10-K for the fiscal year ended January 2, 2016, filed with the Securities and Exchange Commission (SEC) on February 24, 2016, together with the other information contained in this Quarterly Report on Form 10-Q, and any recent Current Reports on Form 8-K. We believe the risks described below are the risks that are material to us as of the date of this Quarterly Report on Form 10-Q. Other risks and uncertainties, including those not presently known to us or that we do not currently consider material, may also impair our business operations. If any of the following risks comes to fruition, our business, financial condition, results of operations and growth prospects would likely be materially and adversely affected. In these circumstances, the market price of our common stock could decline, and you could lose all or part of your investment or interest.
Risk factors marked with an asterisk (*) below include a substantive change from or an update to the risk factors included in our Annual Report on Form 10-K for the fiscal year ended January 2, 2016, filed with the SEC on February 24, 2016.
Risks Related to Our Revenues
We currently derive substantially all of our revenue from our Masimo SET® platform, Masimo rainbow SET™ platform and related products. If this technology and the related products do not continue to achieve market acceptance, our business, financial condition and results of operations would be adversely affected.
We are dependent upon the success and market acceptance of our proprietary Masimo SET® technology. Currently, our primary product offerings are based on the Masimo SET® platform. Continued market acceptance of products incorporating Masimo SET® will depend upon our ability to continue providing evidence to the medical community that our products are cost-effective and offer significantly improved performance compared to conventional pulse oximeters. Health care providers that currently have significant investments in competitive pulse oximetry products may be reluctant to purchase our products. If hospitals and other health care providers do not believe our Masimo SET® platform is cost-effective, safe or more accurate or reliable than competitive pulse oximetry products, they may not buy our products in sufficient quantities to enable us to generate revenue growth from the sale of these products. In addition, allegations regarding the safety and effectiveness of our products, whether or not substantiated, may impair or impede the acceptance of our products. If we are unable to achieve additional market acceptance of our core technology or products incorporating Masimo SET®, we will not generate significant revenue growth from the sale of our products, which would adversely affect our business, financial condition and results of operations.
Some of our products, including those based on licensed rainbow® technology, are in development or have been recently introduced into the market and may not achieve market acceptance, which could limit our growth and adversely affect our business, financial condition and results of operations.
Products that we have introduced into the market in recent years, including, but not limited to, those based on rainbow® technology, a technology that we license, may not be accepted in the market. If our products do not gain market acceptance or if our customers prefer our competitors’ products, our potential revenue growth would be limited, which would adversely affect our business, financial condition and results of operations.
Given that certain rainbow® technology products are relatively new to the marketplace, we do not know to what degree the market will accept these products, if at all. Even if our customers recognize the benefits of our products, we cannot assure you that our customers will purchase them in quantities sufficient for us to be profitable or successful. We are continuing to invest in significant sales and marketing resources to achieve market acceptance of these products with no assurance of success. The degree of market acceptance of these products will depend on a number of factors, including:
•
perceived clinical benefits from our products;
•
perceived cost effectiveness of our products;
•
perceived safety and effectiveness of our products;

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•
reimbursement available through Centers for Medicare and Medicaid Services (CMS) programs for using some of our products; and
•
introduction and acceptance of competing products or technologies.
In general, our recent noninvasive measurement technologies are considered disruptive. These recent technologies have performance levels that we believe are acceptable for many clinical environments but may be insufficient in others. In addition, these technologies may perform better in some patients and settings than others. Over time, we hope to continue to improve the performance of these technologies and, if we do, we expect them to become more useful in more environments and to become more widely adopted. While this is the adoption pattern experienced historically with other new noninvasive measurements, such as oxygen saturation, we are unable to guarantee that such adoption pattern will apply to our recent and future technologies.
Our ability to commercialize new products, new or improved technologies and additional applications for Masimo SET® and our licensed rainbow® technology is limited to certain markets by our Cross-Licensing Agreement with Cercacor Laboratories, Inc. (Cercacor), which may impair our growth and adversely affect our business, financial condition and results of operations.
In May 1998, we spun off a newly-formed entity, Cercacor, and provided it rights to use Masimo SET® to commercialize non-vital signs monitoring applications, while we retained the rights to Masimo SET® to commercialize vital signs monitoring applications. On May 2, 1998, we entered into a cross-licensing agreement with Cercacor, which has been amended several times, most recently in an Amended and Restated Cross-Licensing Agreement, effective January 1, 2007 (the Cross-Licensing Agreement). 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 parameters and to develop and sell devices incorporating Masimo SET® for monitoring non-vital signs parameters in any product market in which a product is intended to be used by a patient or pharmacist rather than by a professional medical caregiver, which we refer to as the Cercacor Market; and
•
a non-exclusive, perpetual and worldwide license, with sublicense rights, to use all Masimo SET® for measurement of vital signs in the Cercacor Market.
Non-vital signs measurements consist of body fluid constituents other than vital signs measurements, including, but not limited to, carbon monoxide, methemoglobin, blood glucose, hemoglobin and bilirubin. Under th