Edgar Filing: MASIMO CORP

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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 October 1, 2016



¨	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.

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 October 1, 2016
Common stock, $0.001 par value		49,677,592

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MASIMO CORPORATION

FORM 10-Q FOR THE QUARTER ENDED OCTOBER 1, 2016

TABLE OF CONTENTS



PART I. Financial Information

Item 1.	Financial Statements (unaudited):

	Condensed Consolidated Balance Sheets as of October 1, 2016 and January 2, 2016	3

	Condensed Consolidated Statements of Operations for the three and nine months ended October 1, 2016 and October 3, 2015	4

	Condensed Consolidated Statements of Comprehensive Income for the three and nine months ended October 1, 2016 and October 3, 2015	5

	Condensed Consolidated Statements of Cash Flows for the nine months ended October 1, 2016 and October 3, 2015	6

	Notes to Condensed Consolidated Financial Statements	7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	31

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	43

Item 4.	Controls and Procedures	44

PART II. Other Information

Item 1.	Legal Proceedings	45

Item 1A.	Risk Factors	45

Item 5.	Other Information	68

Item 6.	Exhibits	68

Signatures		69

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

MASIMO CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited, in thousands, except par values)



	October 1, 2016			January 2, 2016
ASSETS
Current assets
Cash and cash equivalents	$	125,988		$	132,317
Accounts receivable, net of allowance for doubtful accounts of $1,794 and $1,967 at October 1, 2016 and January 2, 2016, respectively.	94,374			80,960
Inventories	67,047			62,038
Other current assets	37,213			23,827
Total current assets	324,622			299,142
Deferred cost of goods sold	83,066			71,718
Property and equipment, net	133,150			132,466
Intangible assets, net	29,816			27,556
Goodwill	20,252			20,394
Deferred tax assets	39,403			44,320
Other non-current assets	9,144			6,139
Total assets	$	639,453		$	601,735
LIABILITIES AND EQUITY
Current liabilities
Accounts payable	$	32,232		$	25,865
Accrued compensation	37,099			38,415
Accrued and other current liabilities	42,867			47,073
Deferred revenue	32,137			21,280
Total current liabilities	144,335			132,633
Long term debt	152,500			185,071
Other non-current liabilities	9,431			8,319
Total liabilities	306,266			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 October 1, 2016 and January 2, 2016	—			—
Common stock, $0.001 par value; 100,000 shares authorized; 49,677 and 49,881 shares issued and outstanding at October 1, 2016 and January 2, 2016, respectively	50			50
Treasury stock, 14,255 and 12,759 shares at October 1, 2016 and January 2, 2016, respectively	(404,276		)	(340,873		)
Additional paid-in capital	368,501			332,417
Accumulated other comprehensive loss	(5,019		)	(4,739		)
Retained earnings	373,931			288,560
Total Masimo Corporation stockholders’ equity	333,187			275,415
Noncontrolling interest	—			297
Total equity	333,187			275,712
Total liabilities and equity	$	639,453		$	601,735

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

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MASIMO CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited, in thousands, except per share amounts)



	Three Months Ended						Nine Months Ended
	October 1, 2016			October 3, 2015			October 1, 2016		October 3, 2015
Revenue:
Product	$	160,286		$	144,603		$	488,183	$	439,572
Royalty	7,335			7,972			23,241		23,266
Total revenue	167,621			152,575			511,424		462,838
Cost of goods sold	57,499			50,343			171,954		154,600
Gross profit	110,122			102,232			339,470		308,238
Operating expenses:
Selling, general and administrative	57,845			59,607			184,244		182,072
Research and development	15,673			14,485			44,856		42,808
Total operating expenses	73,518			74,092			229,100		224,880
Operating income	36,604			28,140			110,370		83,358
Non-operating income (expense)	(546		)	(1,050		)	423		(2,022		)
Income before provision for income taxes	36,058			27,090			110,793		81,336
Provision for income taxes	8,285			9,161			25,420		24,889
Net income including noncontrolling interest	27,773			17,929			85,373		56,447
Net loss attributable to the noncontrolling interest	—			1,396			—		2,752
Net income attributable to Masimo Corporation stockholders	$	27,773		$	19,325		$	85,373	$	59,199

Net income per share attributable to Masimo Corporation stockholders:
Basic	$	0.56		$	0.38		$	1.73	$	1.15
Diluted	$	0.52		$	0.36		$	1.62	$	1.10

Weighted-average shares used in per share calculations:
Basic	49,477			50,974			49,386		51,653
Diluted	53,565			53,686			52,837		53,946

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

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MASIMO CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited, in thousands)



	Three Months Ended					Nine Months Ended
	October 1, 2016			October 3, 2015		October 1, 2016			October 3, 2015
Net income including noncontrolling interest	$	27,773		$	17,929	$	85,373		$	56,447
Other comprehensive (loss) income, net of tax:
Foreign currency translation adjustments	(470		)	112		(280		)	(2,246		)
Total comprehensive income	27,303			18,041		85,093			54,201
Comprehensive loss attributable to noncontrolling interest	—			1,396		—			2,752
Comprehensive income attributable to Masimo Corporation stockholders	$	27,303		$	19,437	$	85,093		$	56,953

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

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MASIMO CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited, in thousands)



	Nine Months Ended
	October 1, 2016			October 3, 2015
Cash flows from operating activities:
Net income including noncontrolling interest	$	85,373		$	56,447
Adjustments to reconcile net income including noncontrolling interest to net cash provided by operating activities:
Depreciation and amortization	12,355			11,603
Stock-based compensation	9,693			8,132
Loss on disposal of property, equipment and intangibles	478			423
Gain on deconsolidation of variable interest entity	(273		)	—
Provision for doubtful accounts	127			506
Provision for deferred income taxes	5,002			—
Changes in operating assets and liabilities:
Increase in accounts receivable	(13,525		)	(5,048		)
Increase in inventories	(5,092		)	(3,755		)
Increase in other current assets	(12,911		)	(5,003		)
Increase in deferred cost of goods sold	(11,278		)	(1,007		)
Increase in other non-current assets	(2,317		)	(3,661		)
Increase (decrease) in accounts payable	9,232			(4,179		)
Decrease in accounts payable to related party	(1,092		)	—
Decrease in accrued compensation	(810		)	(1,436		)
Increase (decrease) in accrued liabilities	862			(482		)
Increase in deferred revenue	10,857			3,465
Increase (decrease) in other non-current liabilities	1,149			(272		)
Net cash provided by operating activities	87,830			55,733
Cash flows from investing activities:
Purchases of property and equipment, net	(13,697		)	(40,520		)
Increase in intangible assets	(3,969		)	(3,486		)
Reduction in cash resulting from deconsolidation of variable interest entity	(763		)	—
Net cash used in investing activities	(18,429		)	(44,006		)
Cash flows from financing activities:
Borrowings under line of credit	45,000			107,500
Repayments on line of credit	(77,500		)	(42,500		)
Debt issuance costs	(621		)	—
Repayments of capital lease obligations	(72		)	(81		)
Proceeds from issuance of common stock	26,063			24,942
Payroll tax withholdings on behalf of employees for stock options	—			(472		)
Repurchases of common stock	(68,218		)	(130,157		)
Issuance of equity by noncontrolling interest, net of equity issued	—			4
Net cash used in financing activities	(75,348		)	(40,764		)
Effect of foreign currency exchange rates on cash	(382		)	(1,835		)
Net decrease in cash and cash equivalents	(6,329		)	(30,872		)
Cash and cash equivalents at beginning of period	132,317			134,453
Cash and cash equivalents at end of period	$	125,988		$	103,581

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

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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 nine months ended October 1, 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, Cercacor 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 week 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.

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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 nine months ended October 1, 2016. The Company carries cash and cash equivalents at cost, which approximates fair value. As of October 1, 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:



October 1, 2016	Adjusted Basis Cost		Gross Unrealized Gains		Gross Unrealized (Losses)		Estimated Fair Value		Cash and Cash Equivalents
Cash	$	62,488	$	—	$	—	$	62,488	$	62,488
Level 1:
Bank Time Deposits	62,500		—		—		62,500		62,500
Money Market Funds	1,000		—		—		1,000		1,000
Subtotal	63,500		—		—		63,500		63,500
Level 2:
None	—		—		—		—		—
Level 3:
None	—		—		—		—		—
Total assets measured at fair value	$	125,988	$	—	$	—	$	125,988	$	125,988

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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 the first in, first out method, 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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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.

Intangible Assets

The Company’s policy is to renew its patents and trademarks. Total renewal costs for patents and trademarks were $0.5 million and $0.4 million for the nine months ended October 1, 2016 and October 3, 2015, respectively. As of October 1, 2016, the weighted-average number of years until the next renewal was one year for patents and six years for trademarks. Costs to renew patents and trademarks are capitalized and amortized over the remaining useful life of the intangible asset. The Company continually evaluates the amortization period and carrying basis of patents and trademarks to determine whether any events or circumstances warrant a revised estimated useful life or reduction in value. Capitalized application costs are charged to operations when it is determined that the patent or trademark will not be obtained or is abandoned.

Impairment of Goodwill, Intangible Assets and Other Long-Lived Assets

Goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the acquired net tangible and intangible assets. Goodwill is not amortized, but instead is tested annually for impairment, or more frequently when events or changes in circumstances indicate that goodwill might be impaired. In assessing goodwill impairment for each of its reporting units, the Company has the option to first assess the qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. The Company’s qualitative assessment of the recoverability of goodwill considers various macroeconomic, industry-specific and Company-specific factors, including: (i) severe adverse industry or economic trends; (ii) significant Company-specific actions; (iii) current, historical or projected deterioration of the Company’s financial performance; or (iv) a sustained decrease in the Company’s market capitalization below its net book value. If, after assessing the totality of events or circumstances, the Company determines it is unlikely that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. However, if the Company concludes otherwise, then the Company is required to perform the first step of the two-step impairment test by comparing the fair value of the reporting unit, determined using future projected discounted operating cash flows, with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill is not considered impaired; otherwise, goodwill is considered impaired and the loss is measured by performing step two. Under step two, the impairment loss is measured by comparing the implied fair value of the reporting unit goodwill with the carrying amount of goodwill. The Company also has the option to bypass the qualitative assessment and proceed directly to performing the first step of the two-step goodwill impairment test. The Company may resume performing the qualitative assessment in any subsequent period. The annual impairment test is performed during the fourth fiscal quarter.

The Company reviews long-lived assets and identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the future undiscounted operating cash flow expected to be generated by the asset. If such asset is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount exceeds the fair value of the asset. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell.

No impairment of goodwill, intangible assets or other long-lived assets was recorded during the three and nine months ended October 1, 2016 and October 3, 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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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 of fair value (VSOE), (ii) third-party evidence of selling price (TPE), and (iii) best estimate of the selling price (ESP). VSOE 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 cash payments to be made directly to the end-user hospital customer at the inception of the arrangement. These cash 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.

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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 Ltd.), 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):



	Nine Months Ended
	October 1, 2016			October 3, 2015
Warranty accrual, beginning of period	$	1,222		$	1,416
Accrual for warranties issued	722			679
Changes to pre-existing warranties (including changes in estimates)	99			(52		)
Settlements made	(751		)	(828		)
Warranty accrual, end of period	$	1,292		$	1,215

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):



	Nine Months Ended October 1, 2016
Accumulated other comprehensive loss, beginning of period	$	(4,739	)
Foreign currency translation adjustments	(280		)
Accumulated other comprehensive loss, end of period	$	(5,019	)

Net Income Per Share

Basic net income per share attributable to Masimo Corporation for the three and nine months ended October 1, 2016 and October 3, 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 and nine months ended October 1, 2016 and October 3, 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 and nine months ended October 1, 2016, 0.1 million and 1.4 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 and nine months ended October 3, 2015, 0.5 million and 0.6 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 and nine months ended October 1, 2016, certain RSUs were considered contingently issuable shares as their vesting is contingent upon the occurrence of certain future events. Since such events had not occurred and were not considered probable of occurring as of October 1, 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 and nine months ended October 3, 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 and nine months ended October 1, 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):

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)



	Three Months Ended				Nine Months Ended
	October 1, 2016		October 3, 2015		October 1, 2016		October 3, 2015
Net income attributable to Masimo Corporation stockholders:
Net income including noncontrolling interest	$	27,773	$	17,929	$	85,373	$	56,447
Net loss attributable to the noncontrolling interest	—		1,396		—		2,752
Net income attributable to Masimo Corporation stockholders	$	27,773	$	19,325	$	85,373	$	59,199
Basic net income per share attributable to Masimo Corporation stockholders:
Net income attributable to Masimo Corporation stockholders	$	27,773	$	19,325	$	85,373	$	59,199
Weighted-average shares outstanding - basic	49,477		50,974		49,386		51,653
Basic net income per share attributable to Masimo Corporation stockholders	$	0.56	$	0.38	$	1.73	$	1.15
Diluted net income per share attributable to Masimo Corporation stockholders:
Weighted-average shares outstanding - basic	49,477		50,974		49,386		51,653
Diluted share equivalent: stock options and RSUs	4,088		2,712		3,451		2,293
Weighted-average shares outstanding - diluted	53,565		53,686		52,837		53,946
Diluted net income per share attributable to Masimo Corporation stockholders	$	0.52	$	0.36	$	1.62	$	1.10

Supplemental Cash Flow Information

Supplemental cash flow information includes the following (in thousands):



	Nine Months Ended
	October 1, 2016		October 3, 2015
Cash paid during the year for:
Interest (net of amounts capitalized)	$	2,603	$	1,548
Income taxes	25,753		29,854
Noncash investing and financing activities:
Unpaid purchases of property, plant and equipment	$	1,232	$	7,093
Unsettled common stock proceeds from option exercises	476		—

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 frequently experienced a sequential decline in product revenues in its second and/or 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.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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 adopted this standard during the first quarter of the fiscal year ending December 31, 2016. The early adoption of this standard resulted in a $7.7 million reduction to the Company’s income tax provision for the nine months ended October 1, 2016.

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 adoption 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.

Recently Issued Accounting Pronouncements

In August 2016, the FASB issued Accounting Standards Update No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (ASU 2016-15). The new standard amended the existing accounting standards for the Statement of Cash Flows and provides guidance on eight specific cash flow issues. ASU 2016-15 is effective for annual and interim fiscal reporting periods beginning after December 15, 2019, and early adoption is permitted. The Company is currently evaluating the expected impact of this standard but does not expect it to have a material impact on its consolidated financial statements.

In June 2016, the FASB issued Accounting Standards Update No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (ASU 2016-13). The new standard requires entities to use a current expected credit loss model, which is a new impairment model based on expected losses rather than incurred losses. Under this model, an entity would recognize an impairment allowance equal to its current estimate of all contractual cash flows that the entity does not expect to collect. The entity’s estimate would consider relevant information about past events, current conditions, and reasonable and supportable forecasts. ASU 2016-13 is effective for annual and interim fiscal reporting periods beginning after December 15, 2019, with early adoption permitted for annual reporting periods beginning after December 15, 2018. The Company is currently evaluating the expected impact of this standard but does not expect it to have a material impact on its consolidated financial statements.

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, among other things, the required recognition of a lease liability and related right-of-use asset will significantly 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.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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 (ASU 2015-14), 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. In March 2016, the FASB issued Accounting Standards Update No. 2016-08, Revenue from Contracts with Customers: Principal versus Agent Considerations under FASB ASC Topic 606 (ASU 2016-08), which provides guidance on principal versus agent considerations. In April 2016, the FASB issued Accounting Standards Update No. 2016-10, Revenue from Contracts with Customers (Topic 606) – Identifying Performance Obligations and Licensing (ASU 2016-10), which amended ASU 2014-09 by providing clarity in identifying performance obligations and licensing implementation guidance.

In May 2016, the FASB issued Accounting Standards Update No. 2016-12, Revenue from Contracts with Customers (Topic 606) – Narrow-Scope Improvements and Practical Expedients (ASU 2016-12), which further amended ASU 2016-09 by providing additional clarity in recognizing revenue from contracts that have been modified prior to the transition period to the new standard, as well as providing additional disclosure requirements for businesses and other organizations that make the transition to the new standard by adjusting amounts from prior reporting periods via retrospective application. 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 capitalization and 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 (CEO), is also the Chairman and CEO 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 first quarter of 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 discontinued consolidating Cercacor within its consolidated financial statements effective as of January 3, 2016. However, Cercacor continues 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 and nine months ended October 3, 2015, which reflect the Company, Cercacor and related eliminations (in thousands), is included below:

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)



	Three Months Ended																Nine Months Ended
	October 3, 2015																October 3, 2015
Consolidating Statement of Operations:	Masimo Corp			Percentage of Revenue		Cercacor			Cercacor Elim			Total			Percentage of Revenue		Masimo Corp			Percentage of Revenue		Cercacor			Cercacor Elim			Total			Percentage of Revenue
Revenue:
Product	$	144,603		94.8	%	$	—		$	—		$	144,603		94.8	%	$	439,572		95.0	%	$	—		$	—		$	439,572		95.0	%
Royalty	7,972			5.2		1,628			(1,628		)	7,972			5.2		23,266			5.0		4,473			(4,473		)	23,266			5.0
Total revenue	152,575			100.0		1,628			(1,628		)	152,575			100.0		462,838			100.0		4,473			(4,473		)	462,838			100.0
Cost of goods sold	52,065			34.1		—			(1,722		)	50,343			33.0		158,917			34.3		—			(4,317		)	154,600			33.4
Gross profit	100,510			65.9		1,628			94			102,232			67.0		303,921			65.7		4,473			(156		)	308,238			66.6
Operating expenses:
Selling, general and administrative	58,911			38.6		602			94			59,607			39.1		180,264			38.9		1,964			(156		)	182,072			39.3
Research and development	12,103			7.9		2,382			—			14,485			9.5		37,587			8.1		5,221			—			42,808			9.2
Total operating expenses	71,014			46.5		2,984			94			74,092			48.6		217,851			47.1		7,185			(156		)	224,880			48.6
Operating income (loss)	29,496			19.3		(1,356		)	—			28,140			18.4		86,070			18.6		(2,712		)	—			83,358			18.0
Non-operating expense	(1,050		)	(0.7	)	574			(574		)	(1,050		)	(0.7	)	(2,022		)	(0.4	)	574			(574		)	(2,022		)	(0.4	)
Income (loss) before provision for income taxes	28,446			18.6		(782		)	(574		)	27,090			17.8		84,048			18.2		(2,138		)	(574		)	81,336			17.6
Provision for income taxes	9,121			5.9		40			—			9,161			6.0		24,849			5.4		40			—			24,889			5.4
Net income (loss) including noncontrolling interest	19,325			12.7		(822		)	(574		)	17,929			11.8		59,199			12.8		(2,178		)	(574		)	56,447			12.2
Net loss attributable to the noncontrolling interest				—		—			1,396			1,396			0.9		—			—		—			2,752			2,752			0.6
Net income (loss) attributable to Masimo Corporation stockholders	$	19,325		12.7	%	$	(822	)	$	822		$	19,325		12.7	%	$	59,199		12.8	%	$	(2,178	)	$	2,178		$	59,199		12.8	%

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

4. Related Party Transactions

The Company’s Chairman and CEO is also the Chairman and CEO of Cercacor. The Company is a party to the following agreements with Cercacor:

•

Cross-Licensing Agreement - The Company and Cercacor are parties to 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 $1.6 million and $4.7 million for the three and nine months ended October 1, 2016, respectively. Actual aggregate royalty liabilities to Cercacor under the license were $1.7 million and $4.3 million for the three and nine months ended October 3, 2015, respectively, which were eliminated in consolidation. The Company had no sales to Cercacor for the three months ended October 1, 2016, and less than $0.1 million for the nine months ended October 1, 2016 under the Cross-Licensing Agreement. There were no similar sales during the three and nine months ended October 3, 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 and nine months ended October 1, 2016 and October 3, 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 and nine months ended October 1, 2016 and approximately $0.1 million and $0.3 million for the three and nine months ended October 3, 2015, respectively.

•

Sublease Agreement - In March 2016, the Company entered into a sublease agreement with Cercacor for approximately 16,830 square feet of excess office and laboratory space located at 40 Parker, Irvine, California (Cercacor Sublease). The Cercacor Sublease began on May 1, 2016 and expires on November 30, 2019. The Company recognized $0.1 million and $0.2 million in sublease income for the three and nine months ended October 1, 2016, respectively.

Net amounts due to Cercacor at October 1, 2016 and January 2, 2016 were less than approximately $0.1 million and $1.1 million, respectively.

The Company’s CEO 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 (CFO) is also a Director of the Masimo Foundation.

The Company’s CEO 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 CFO serves as the Treasurer and Secretary of PSMF, as well as the Secretary of PSMC.

The Company’s CEO also serves on the board of directors of Atheer Labs, which is working with the Company on the development of next generation Root^® applications, and the board 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.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

5. Inventories

Inventories consist of the following (in thousands):



	October 1, 2016		January 2, 2016
Raw materials	$	31,469	$	25,781
Work-in-process	6,174		4,337
Finished goods	29,404		31,920
Total inventories	$	67,047	$	62,038

6. Other Current Assets

Other current assets consist of the following (in thousands):



	October 1, 2016		January 2, 2016
Prepaid expenses	$	13,023	$	9,930
Prepaid income taxes	7,996		2,404
Royalties receivable	7,500		7,200
Employee loans and advances	301		320
Due from related party	29		—
Other current assets	8,364		3,973
Total other current assets	$	37,213	$	23,827

7. Property and Equipment

Property and equipment, net, consists of the following (in thousands):



	October 1, 2016			January 2, 2016
Building and building improvements	$	85,564		$	78,877
Machinery and equipment	43,184			42,460
Land	23,762			23,738
Computer equipment	15,002			15,023
Tooling	13,234			13,079
Furniture and office equipment	9,502			8,885
Leasehold improvements	8,162			7,734
Demonstration units	979			973
Vehicles	45			45
Construction-in-progress	3,938			7,124
Total property and equipment	203,372			197,938
Accumulated depreciation and amortization	(70,222		)	(65,472		)
Property and equipment, net	$	133,150		$	132,466

During the nine months ended October 1, 2016, the Company completed construction on its initial renovations to its new corporate headquarters and research and development facility in Irvine, California, resulting in the reclassification of approximately $3.4 million from construction-in-progress to building and improvements. Approximately $1.2 million of construction costs related to this facility are included in accounts payable as of October 1, 2016.

The gross value of furniture and office equipment under capital lease obligations was $0.4 million as of both October 1, 2016 and January 2, 2016, with accumulated depreciation of $0.3 million as of both October 1, 2016 and January 2, 2016.

For the nine months ended October 1, 2016 and October 3, 2015, depreciation expense of property and equipment was $9.5 million and $8.6 million, respectively.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

8. Intangible Assets

Intangible assets, net, consist of the following (in thousands):



	October 1, 2016			January 2, 2016
Patents	$	19,449		$	21,619
Customer relationships	7,669			7,669
Licenses⁽¹⁾	7,500			—
Acquired technology	5,580			5,580
Trademarks	3,733			3,944
Capitalized software development costs	2,539			2,539
Other	4,444			2,541
Total intangible assets	50,914			43,892
Accumulated amortization	(21,098		)	(16,336		)
Intangible assets, net	$	29,816		$	27,556


⁽¹⁾	As a result of the deconsolidation of the Company’s 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 October 1, 2016.

Total amortization expense for the nine months ended October 1, 2016 and October 3, 2015 was $2.8 million and $3.3 million, respectively. All of these intangible assets have a 10 year weighted average amortization period.

Estimated amortization expense for future fiscal years is as follows (in thousands):



Fiscal year	Amount
2016 (balance of year)	$	4,424
2017	4,096
2018	3,842
2019	3,479
2020	3,123
Thereafter	10,852
Total	$	29,816

9. Accrued and Other Current Liabilities

Accrued and other current liabilities consist of the following (in thousands):



	October 1, 2016		January 2, 2016
Accrued customer rebates, fees and reimbursements	$	25,066	$	11,857
Accrued taxes	4,661		5,263
Accrued legal fees	2,186		5,785
Income taxes payable	1,941		2,777
Accrued warranty	1,292		1,222
Accrued donations	557		5,612
Accrued stock repurchases	—		4,815
Accrued arbitration award	—		5,391
Other	7,164		4,351
Total accrued and other current liabilities	$	42,867	$	47,073

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

10. Long Term Debt

Long term debt consists of the following (in thousands):



	October 1, 2016		January 2, 2016
Revolving line of credit	$	152,500	$	185,000
Long term portion of capital lease obligations acquisition	—		71
Total long term debt	$	152,500	$	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 Company’s prior credit agreement dated April 23, 2014, as amended (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 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.

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 October 1, 2016, the Restated Credit Facility had outstanding Eurodollar Loan draws totaling $152.5 million at an effective interest rate of 1.8125% and outstanding standby letters of credit totaling $0.3 million. The Company was in compliance with all covenants under the Restated Credit Facility as of October 1, 2016.

The Company incurred interest expense related to the Restated Credit Facility of $3.0 million for the nine months ended October 1, 2016. The Company incurred interest expense related to the Amended Credit Agreement of $1.9 million for the nine months ended October 3, 2015.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

11. Other Non-Current Liabilities

Other non-current liabilities consist of the following (in thousands):



	October 1, 2016		January 2, 2016
Unrecognized tax benefit	$	8,374	$	7,747
Deferred revenue, long-term	375		298
Deferred tax liability, long-term	194		194
Other	488		80
Total other non-current liabilities	$	9,431	$	8,319

Unrecognized tax benefit relates to the Company’s long-term portion of tax liability associated with uncertain tax positions. 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 16 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.

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 2.9 million shares as of October 1, 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 and nine months ended October 1, 2016 and October 3, 2015 (in thousands, except per share amounts):



	Three Months Ended				Nine Months Ended
	October 1, 2016		October 3, 2015		October 1, 2016		October 3, 2015
Shares repurchased	—		1,169		1,496		3,545
Average cost per share	$	—	$	41.44	$	42.39	$	36.71
Value of shares repurchased	$	—	$	48,458	$	63,403	$	130,157

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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):



	Nine Months Ended October 1, 2016
	Shares		Average Exercise Price
Options outstanding, beginning of period	9,202		$	25.46
Granted	1,257		39.34
Canceled	(141	)	29.32
Exercised	(1,292	)	20.43
Options outstanding, end of period	9,026		$	28.05
Options exercisable, end of period	5,222		$	26.01

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):



	Nine Months Ended October 1, 2016
	Units	Weighted Average Grant Date Fair Value
RSUs outstanding, beginning of period	2,703	$	41.45
Granted	6	43.09
Canceled	—	—
Expired	—	—
Vested	—	—
RSUs outstanding, end of period	2,709	$	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).

At October 1, 2016, an aggregate of 16.1 million shares of common stock were reserved for future issuance under the Company’s 2007 Stock Incentive Plan (the 2007 Plan) and prior equity incentive plans, of which 4.3 million shares were available for future grant under the 2007 Plan.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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		Nine Months Ended
	October 1, 2016	October 3, 2015	October 1, 2016	October 3, 2015
Risk-free interest rate	1.0% to 1.3%	1.5% to 1.8%	1.0% to 1.9%	1.3% to 1.9%
Expected term (in years)	5.7	5.5	5.7	5.5
Estimated volatility	30.3% to 31.9%	32.3% to 35.6%	30.3% to 35.7%	32.0% to 37.4%
Expected dividends	0%	0%	0%	0%
Weighted-average fair value of options granted	$17.99	$14.09	$13.42	$11.82

The total stock-based compensation expense for the three and nine months ended October 1, 2016 was $3.5 million and $9.7 million, respectively. The total stock-based compensation expense for the three and nine months ended October 3, 2015 was $2.7 million and $8.1 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 October 1, 2016 was $283.8 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 October 1, 2016 was $174.8 million. The aggregate intrinsic value of options exercised during the three and nine months ended October 1, 2016 was $11.8 million and $37.1 million, respectively.

The unrecognized stock-based compensation expense related to unvested options and RSUs granted after January 1, 2006 was $28.9 million and $0.2 million as of October 1, 2016, respectively. The weighted-average remaining contractual term of options and RSUs outstanding with an exercise price less than the closing price of the Company’s common stock as of October 1, 2016 was 3.5 years and less than 1.0 year, respectively. 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 October 1, 2016 was 3.9 years. No RSUs were exercisable as of October 1, 2016.

14. Commitments and Contingencies

Leases

The Company leases certain facilities in North and South America, Europe, the Middle East 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 October 1, 2016 and January 2, 2016, rent expense accrued in excess of the amount paid aggregated $0.6 million and $0.2 million, respectively, which is classified within other current and non-current 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 September 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.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

Future minimum lease payments, including interest, under operating and capital leases for each of the following fiscal years ending on or about December 31 are (in thousands):



	As of October 1, 2016
	Operating Leases		Capital Leases		Total
2016 (balance of year)	$	1,501	$	11	$	1,512
2017	5,819		100		5,919
2018	5,696		14		5,710
2019	4,641		8		4,649
2020	2,607		4		2,611
Thereafter	5,885		—		5,885
Total	$	26,149	$	137	$	26,286

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 a Single-Tenant Lease originally dated June 22, 2012. Pursuant to the terms of the Third Amendment, the Company’s current lease of certain premises was set to terminate 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 extended 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.

In July 2016, the Company entered into a Single-Tenant Lease with The Irvine Company LLC (New Lease), relating to the rental of space in a building located in Irvine, California that was to have been terminated by the Third Amendment. The date of commencement of the New Lease will be December 2016, and the New Lease will continue in effect for a period of ten years, until November 2026.

Rental expense related to operating leases was $1.5 million and $4.5 million for the three and nine months ended October 1, 2016, respectively, and $1.2 million and $4.1 million for the three and nine months ended October 3, 2015, respectively. Included in the future capital lease payments as of October 1, 2016 is interest aggregating less than $0.1 million.

Employee Retirement Savings Plan

The Company sponsors a qualified defined contribution plan or 401(k) plan, the Masimo Retirement Savings Plan (MRSP), 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 MRSP on a discretionary basis. The Company contributed $0.5 million and $1.6 million to the MRSP for the three and nine months ended October 1, 2016, respectively, and $0.4 million and $1.4 million to the MRSP for the three and nine months ended October 3, 2015 respectively.

In addition, the Company also sponsors various defined contribution plans in certain locations outside of the United States (Subsidiary Plans). For the three and nine months ended October 1, 2016, the Company contributed $0.1 million and $0.2 million, respectively, to the Subsidiary Plans. For the three and nine months ended October 3, 2015, the Company contributed $0.1 million and $0.2 million, respectively, to the Subsidiary Plans.

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.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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 (beginning on January 1, 2018) so that after December 31, 2027, no Special Payment will be due to Mr. Kiani upon a Qualifying Termination. As of October 1, 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 was approximately $195.6 million.

As of October 1, 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 $42.8 million of purchase commitments as of October 1, 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 October 1, 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 October 1, 2016, the Company had 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 October 1, 2016, the Company had $125.0 million of bank balances, of which $2.1 million was covered by either the U.S. Federal Deposit Insurance Corporation limit or foreign countries’ deposit insurance organizations. As of October 1, 2016, the Company had $62.5 million of bank time deposits that are not guaranteed by the U.S. Federal government.

While the Company and its contract manufacturers rely on sole source suppliers for certain components, steps have been taken to minimize the impact of a shortage or stoppage of shipments, such as maintaining a safety stock of inventory and designing products that could be modified to use different components. However, there can be no assurance that a shortage or stoppage of shipments of the materials or components that the Company purchases will not result in a delay in production or adversely affect the Company’s business.

The Company’s ability to sell its products to U.S. hospitals depends in part on its relationships with GPOs. Many existing and potential customers for the Company’s products become members of GPOs. GPOs negotiate pricing arrangements and contracts, sometimes exclusively, with medical supply manufacturers and distributors, and these negotiated prices are made available to a GPO’s affiliated hospitals and other members. During the three and nine months ended October 1, 2016, revenue from the sale of the Company’s products to U.S. hospitals that are members of GPOs amounted to $94.5 million and $279.8 million, respectively, and for the three and nine months ended October 3, 2015, revenue from the sale of the Company’s products to U.S. hospitals that are members of GPOs amounted to $81.0 million and $251.9 million, respectively.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

For the three months ended October 1, 2016, the Company had sales through two just-in-time distributors that represented 14.0% and 13.2% of total revenue, respectively. For the three months ended October 3, 2015, the Company had sales through the same two just-in-time distributors that represented 14.5% and 11.6% of total revenue, respectively.

For the nine months ended October 1, 2016, the Company had sales through the same two just-in-time distributors that represented 15.0% and 12.4% of total revenue, respectively. For the nine months ended October 3, 2015, the Company had sales through the same two just-in-time distributors that represented 14.6% and 12.0% of total revenue, respectively.

As of October 1, 2016, one just-in-time distributor represented 11.5% of the Company’s accounts receivable balance. As of January 2, 2016, two just-in-time distributors represented 5.5% and 5.3% of the Company’s accounts receivable balance, respectively.

For the nine months ended October 1, 2016 and October 3, 2015, the Company recorded $23.2 million and $23.3 million, respectively, in royalty revenues from Medtronic. 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 Settlement Agreement (as defined below).

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 the Company’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. On May 31, 2016, Philips filed a motion to dismiss the Company’s antitrust claims, which is pending before the Court. On June 27, 2016, Philips filed a motion for summary judgment, and a motion to exclude certain testimony by the Company’s experts with respect to the Company’s second phase patent infringement claims, both of which are pending before the Court. On September 12, 2016, Philips filed a motion seeking a bench trial on its antitrust counterclaims and patent-misuse defense, which is pending before the Court. On October 19, 2016, the Company filed a motion for summary judgment with respect to Philips’ antitrust counterclaims and patent-misuse defense, which is pending before the Court. On October 19, 2016, Philips filed a motion to exclude certain testimony by the Company’s experts with respect to Philips’ antitrust counterclaims and patent-misuse defense, which is pending before the Court. On October 31, 2016, the Court denied all of Philips’ motions for summary judgment of no literal infringement with respect to the Company’s second phase patent infringement claims, and denied in part and granted in part Philips’ motions asserting noninfringement under the doctrine of equivalents. The Court also denied Philips’ motion for summary judgment of no willful infringement of one of the Company’s second phase patents, and granted one such motion as to another such patent. The Court denied Philips’ motion asserting the Company is not entitled to lost profits and denied Philips’ motion asserting that it had a noninfringing alternative to the Company’s second phase patents.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

The Court also granted the Company’s motion for summary judgment that certain Philips products infringe one of the Company’s second phase patents and held that the Company is entitled to lost profits as to certain second phase patents. The Court also denied various other motions asserting that the Company’s second phase patents are invalid, and granted in part and denied in part various motions regarding the availability of certain lost profits and the admissibility of certain expert testimony. 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 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 May 18, 2016, the Company filed a petition for a writ of certiorari with the United States Supreme Court seeking reversal of the decision of the Ninth Circuit Court of Appeals. On October 3, 2016, the Supreme Court denied such petition.

On July 20, 2016, the Company was notified that its insurance carrier was seeking reimbursement of certain defense costs previously advanced by the carrier in light of the decision by the Ninth Circuit Court of Appeals reinstating the Arbitration Award. The Company believes it has good and substantial grounds to dispute the coverage determination of the insurance carrier, but there is no guarantee that the Company will prevail. The Company has not recorded a charge related to this insurance coverage dispute and is unable to determine whether any loss will ultimately occur. However, the Company estimates that the potential incremental loss related to this insurance coverage dispute would approximate $2.6 million plus potential interest at the rate of 10% per annum from the date such payments were advanced by the insurance carrier.

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 appellate hearing in the D.C. Circuit Court of Appeals is currently scheduled for November 7, 2016. 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.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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. Oral arguments before the Eleventh Circuit Court of Appeals are currently scheduled for December 13, 2016. 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 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. On September 1, 2016, the Company entered into the Third Amendment to the Settlement Agreement and Release of Claims (Settlement Agreement) with Cercacor Laboratories, Inc., Medtronic, Covidien LP, Nellcor Puritan Bennett LLC and Covidien Holding Inc. (collectively, Medtronic Parties), pursuant to which the Company and the Medtronic Parties agreed not to assert, prior to December 31, 2019: (1) that any of the intellectual property rights of another party are invalid, unpatentable or unenforceable, or (2) any claim of patent infringement against another party based on products of such party that were commercially available as of September 1, 2016. The Company and the Medtronic Parties also agreed to jointly request termination of the IPR petition for review of the claims of the ‘393 Patent, and such IPR petition was dismissed by the PTO on September 23, 2016. Furthermore, the Medtronic Parties agreed to continue paying the Company royalties through October 6, 2018, after which no more royalties will be due under the Settlement Agreement.

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.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

The following schedule presents an analysis of the Company’s product revenues based upon the geographic area to which the product was shipped (in thousands, except percentages):



	Three Months Ended								Nine Months Ended
	October 1, 2016				October 3, 2015				October 1, 2016				October 3, 2015
Geographic area by destination:
United States	$	114,563	71.5	%	$	101,471	70.2	%	$	345,113	70.7	%	$	314,983	71.7	%
Europe, Middle East and Africa	23,929		14.9		25,729		17.8		81,887		16.8		74,125		16.9
Asia and Australia	16,630		10.4		13,657		9.4		46,815		9.6		38,226		8.7
North and South America (excluding United States)	5,164		3.2		3,746		2.6		14,368		2.9		12,238		2.7
Total product revenue	$	160,286	100.0	%	$	144,603	100.0	%	$	488,183	100.0	%	$	439,572	100.0	%

The Company’s consolidated long-lived assets and net assets by geographic area are (in thousands, except percentages):



	October 1, 2016				January 2, 2016
Long-lived assets by geographic area:
United States	$	221,676	96.4	%	$	203,553	96.8	%
International	8,189		3.6		6,770		3.2
Total	$	229,865	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 October 1, 2016, the liability for income taxes associated with uncertain tax positions was approximately $9.4 million. If fully recognized, approximately $8.0 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.

A non-GAAP financial measure for “Adjusted Product Gross Profit” is contained herein as a supplement to the corresponding financial measure prepared in accordance with U.S. generally accepted accounting principles (GAAP). Management has provided this information to assist investors in gaining a better understanding of the effects of the deconsolidation of Masimo’s variable interest entity, Cercacor, and the impact on period-to-period operating results. Investors should consider this non-GAAP financial measure in addition to, and not as a substitute for, or as superior to, the measure of financial performance prepared in accordance with GAAP.

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 manufacturer (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 within medical-surgical units.

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Our rainbow SET^™ platform leverages Masimo SET^® technology and incorporates licensed rainbow^® technology to provide additional continuous noninvasive measurements. Our rainbow SET^™ platform includes our rainbow^® 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 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.

In June 2016, we announced the full market release outside of the U.S. of our next generation SpHb^® spot check technology for use with our Pronto^® Pulse CO-Oximeter^®, substantially improving the clinical accuracy of SpHb^®, reducing the time required to display SpHb^® results and making SpHb^® less susceptible to motion artifact, although it is still not measure through motion. Pronto^® features rainbow SET^™ technology for noninvasive spot checking of SpHb^®, SpO₂, PR and PI. In addition, we released the rainbow^® DCI^®-mini reusable sensor to accompany the Pronto^®. The DCI^®-mini is a universal sensor usable on patients who weigh more than 3 kg. Pronto^® with next generation SpHb^® spot-check and the DCI^®-mini reusable sensor are not currently available for sale in the United States.

In June 2016, we also announced FDA 510(k) clearance for Radius-7^®, the only wearable, tetherless, noninvasive rainbow^® monitor. With this clearance, Radius-7^®, which connects to our Root^® patient monitoring and connectivity platform, now enables noninvasive measurement and monitoring of SpHb^®for the first time in a wearable device within 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.

In May 2016, we announced the CE Mark and scheduled full market release of our next generation SedLine^® Brain Function Monitoring technology. Our next generation SedLine^® enhances how the PSI responds in challenging situations, addressing many of the concerns raised with quantitative EEG while bolstering brain function monitoring support of anesthetic management.

•

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 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^™ MOC-9^™ module to any Root^® monitor through one of its three MOC-9^™ ports. O₃^™ regional oximetry has received the CE Mark and FDA 510(k) clearance for use in subjects larger than 40 kg (approximately 88 lbs). In August 2016, O₃^™ regional oximetry with the O₃^™ pediatric sensor received the CE Mark for use in pediatric patients weighing less than 40kg (approximately 88lbs).

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•

rainbow Acoustic Monitoring^® (RAM^™) - Our sound-based monitoring technology enables noninvasive monitoring of respiration rate (RRa^®). Compared to traditional capnography, which monitors exhaled 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.

In August 2016, we announced the CE Mark of RAS-45, a single-use adult and pediatric acoustic respiration sensor for RAM^™ when monitoring RRa^®. RAS-45 was designed to facilitate placement on and improve attachment to the neck, but with a smaller flexible profile and transparent adhesive. RAS-45 maintains the same performance parameters, range, and accuracy specifications as RAS-125c and is used with patients who weigh more than 10 kg.

•

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, capnography and O₃^™ regional oximetry. 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 electronic medical records (EMRs). Iris Gateway^™ can be deployed on a remote server farm or as a server appliance in the hospital. Root^® is also available with noninvasive blood pressure from SunTech Medical^®, which 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.

•

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 Patient 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.

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•

MightySat^™ - Our fingertip pulse oximeterprovides 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 and in over 100 Apple stores. 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.

Since inception, our mission has been to develop noninvasive monitoring solutions that improve patient outcomes and reduce the cost of 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 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.

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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 October 1, 2016, approximately 2.9 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.

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								Nine Months Ended
	October 1, 2016		Percentage of Revenue		October 3, 2015		Percentage of Revenue		October 1, 2016		Percentage of Revenue		October 3, 2015		Percentage of Revenue
Revenue:
Product	$	160,286	95.6	%	$	144,603	94.8	%	$	488,183	95.5	%	$	439,572	95.0	%
Royalty	7,335		4.4		7,972		5.2		23,241		4.5		23,266		5.0
Total revenue	167,621		100.0		152,575		100.0		511,424		100.0		462,838		100.0
Cost of goods sold	57,499		34.3		50,343		33.0