Edgar Filing: MASIMO CORP

Document

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 September 30, 2017



¨	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, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.



Large accelerated filer	ý	Accelerated filer	¨

Non-accelerated filer	¨ (Do not check if a smaller reporting company)	Smaller reporting company	¨

		Emerging growth company	¨

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) 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 September 30, 2017
Common stock, $0.001 par value		51,671,144

Table of Contents

MASIMO CORPORATION

FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2017

TABLE OF CONTENTS



PART I. Financial Information

Item 1.	Financial Statements (unaudited):

	Condensed Consolidated Balance Sheets as of September 30, 2017 and December 31, 2016	3

	Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2017 and October 1, 2016	4

	Condensed Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2017 and October 1, 2016	5

	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2017 and October 1, 2016	6

	Notes to Condensed Consolidated Financial Statements	7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	28

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	39

Item 4.	Controls and Procedures	40

PART II. Other Information

Item 1.	Legal Proceedings	40

Item 1A.	Risk Factors	41

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	66

Item 6.	Exhibits	67

Signatures		67

Table of Contents

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

MASIMO CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited, in thousands, except par values)



	September 30, 2017			December 31, 2016
ASSETS
Current assets
Cash and cash equivalents	$	289,944		$	305,970
Accounts receivable, net of allowance for doubtful accounts of $1,413 and $1,698 at September 30, 2017 and December 31, 2016, respectively.	110,614			101,667
Inventories	99,078			72,542
Other current assets	46,844			27,048
Total current assets	546,480			507,227
Deferred cost of goods sold	96,464			79,948
Property and equipment, net	164,579			135,996
Intangible assets, net	27,489			29,376
Goodwill	20,676			19,780
Deferred tax assets	39,029			38,975
Other non-current assets	11,354			9,223
Total assets	$	906,071		$	820,525
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable	$	40,251		$	34,334
Accrued compensation	34,660			43,180
Accrued and other current liabilities	40,189			104,654
Deferred revenue	57,369			38,198
Total current liabilities	172,469			220,366
Deferred revenue	261			25,336
Other non-current liabilities	16,059			14,587
Total liabilities	188,789			260,289
Commitments and contingencies
Stockholders’ equity
Preferred stock, $0.001 par value; 5,000 shares authorized; 0 shares issued and outstanding at September 30, 2017 and December 31, 2016	—			—
Common stock, $0.001 par value; 100,000 shares authorized; 51,671 and 50,188 shares issued and outstanding at September 30, 2017 and December 31, 2016, respectively	52			50
Treasury stock, 14,788 and 14,255 shares at September 30, 2017 and December 31, 2016, respectively	(449,537		)	(404,276		)
Additional paid-in capital	449,050			382,263
Accumulated other comprehensive loss	(2,757		)	(7,027		)
Retained earnings	720,474			589,226
Total stockholders’ equity	717,282			560,236
Total liabilities and stockholders’ equity	$	906,071		$	820,525

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

Table of Contents

MASIMO CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited, in thousands, except per share amounts)



	Three Months Ended					Nine Months Ended
	September 30, 2017		October 1, 2016			September 30, 2017		October 1, 2016
Revenue:
Product	$	181,271	$	160,286		$	542,170	$	488,183
Royalty and other revenue	12,421		7,335			30,757		23,241
Total revenue	193,692		167,621			572,927		511,424
Cost of goods sold	65,027		57,499			191,692		171,954
Gross profit	128,665		110,122			381,235		339,470
Operating expenses:
Selling, general and administrative	65,390		57,845			197,339		184,244
Research and development	15,300		15,673			45,859		44,856
Total operating expenses	80,690		73,518			243,198		229,100
Operating income	47,975		36,604			138,037		110,370
Non-operating income (expense)	287		(546		)	1,319		423
Income before provision for income taxes	48,262		36,058			139,356		110,793
Provision for income taxes	9,027		8,285			8,108		25,420
Net income	$	39,235	$	27,773		$	131,248	$	85,373

Net income per share:
Basic	$	0.75	$	0.56		$	2.55	$	1.73
Diluted	$	0.70	$	0.52		$	2.35	$	1.62

Weighted-average shares used in per share calculations:
Basic	52,079		49,477			51,469		49,386
Diluted	56,163		53,565			55,967		52,837

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

Table of Contents

MASIMO CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited, in thousands)



	Three Months Ended					Nine Months Ended
	September 30, 2017		October 1, 2016			September 30, 2017		October 1, 2016
Net income	$	39,235	$	27,773		$	131,248	$	85,373
Other comprehensive income, net of tax:
Unrealized gains (losses) from foreign currency translation adjustments	1,405		(470		)	4,270		(280		)
Comprehensive income	$	40,640	$	27,303		$	135,518	$	85,093

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

Table of Contents

MASIMO CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited, in thousands)



	Nine Months Ended
	September 30, 2017			October 1, 2016
Cash flows from operating activities:
Net income	$	131,248		$	85,373
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	14,384			12,355
Stock-based compensation	11,192			9,693
Loss on disposal of property, equipment and intangibles	420			478
Gain on deconsolidation of variable interest entity	—			(273		)
Provision for deferred income taxes	—			5,002
Changes in operating assets and liabilities:
Increase in accounts receivable	(17,277		)	(13,398		)
Increase in inventories	(25,998		)	(5,092		)
Increase in other current assets	(11,099		)	(12,911		)
Increase in deferred cost of goods sold	(16,166		)	(11,278		)
Increase in other non-current assets	(964		)	(2,117		)
Increase in accounts payable	3,748			9,386
Decrease in accrued compensation	(9,094		)	(810		)
Decrease in accrued liabilities	(66,918		)	(384		)
(Decrease) increase in deferred revenue	(5,905		)	10,934
Increase in other non-current liabilities	1,456			1,072
Net cash provided by operating activities	9,027			88,030
Cash flows from investing activities:
Purchases of property and equipment, net	(37,830		)	(13,697		)
Increase in intangible assets	(2,220		)	(3,969		)
Acquisition of long-term investments	(1,145		)	(200		)
Reduction in cash resulting from deconsolidation of variable interest entity	—			(763		)
Net cash used in investing activities	(41,195		)	(18,629		)
Cash flows from financing activities:
Borrowings under line of credit	—			45,000
Repayments on line of credit	—			(77,500		)
Debt issuance costs	—			(621		)
Repayments of capital lease obligations	(71		)	(72		)
Proceeds from issuance of common stock	55,709			26,063
Repurchases of common stock	(42,608		)	(68,218		)
Net cash provided by (used in) financing activities	13,030			(75,348		)
Effect of foreign currency exchange rates on cash	3,112			(382		)
Net decrease in cash and cash equivalents	(16,026		)	(6,329		)
Cash and cash equivalents at beginning of period	305,970			132,317
Cash and cash equivalents at end of period	$	289,944		$	125,988

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

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. Description of the Company

Masimo Corporation (the Company) is a global medical technology company that develops, manufactures and markets a variety of noninvasive patient monitoring technologies. The Company’s mission is to improve patient outcomes and reduce cost of care by taking noninvasive monitoring to new sites and applications^®. The Company’s patient monitoring solutions generally incorporate a monitor or circuit board, proprietary single-patient use or reusable 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 SafetyNet¹ 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. In addition, these technologies are supported by a substantial intellectual property portfolio that the Company has built through internal development, 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 accompanying 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 accompanying condensed consolidated balance sheet as of December 31, 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 December 31, 2016 (fiscal year 2016), filed with the SEC on February 15, 2017. The results for the nine months ended September 30, 2017 are not necessarily indicative of the results to be expected for the fiscal year ending December 30, 2017 (fiscal year 2017) or for any other interim period or for any future year.

Principles of Consolidation

The accompanying condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. 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 2017 is a 52 week fiscal year. All references to years in these notes to condensed consolidated financial statements are fiscal years unless otherwise noted.

¹ The use of the trademark Patient SafetyNet is under license from the University HealthSystem Consortium.

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

Use of Estimates

The Company prepares its financial statements in conformity with GAAP, which requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Significant estimates include the determination of accounts receivable allowances, inventory reserves, warranty reserves, rebate accruals, valuation of the Company’s stock options, goodwill valuation, deferred taxes and any associated valuation allowances, distributor channel inventory, royalty revenues, deferred revenue, uncertain income tax positions, litigation costs and related accruals. Actual results could differ from such estimates.

Reclassifications

Certain amounts in the accompanying 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 September 30, 2017. The Company carries cash and cash equivalents at cost, which approximates fair value. As of September 30, 2017 and December 31, 2016, the Company did not have any short-term investments or other financial assets that were required to be measured under the fair value hierarchy.

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.

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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
Aircraft and components	10 to 20 years
Buildings	39 years
Building improvements	7 to 15 years
Computer equipment	2 to 6 years
Demonstration units	3 years
Furniture and office equipment	2 to 6 years
Leasehold improvements	Lesser of useful life or term of lease
Machinery and equipment	5 to 7 years
Tooling	3 years
Vehicles	5 years

Land is not depreciated and construction-in-progress is not depreciated until placed in service. Normal repair and maintenance costs are expensed as incurred, whereas significant improvements that materially increase values or extend useful lives are capitalized and depreciated over the remaining estimated useful lives of the related assets. Upon sale or retirement of depreciable assets, the related cost and accumulated depreciation or amortization are removed from the accounts and any gain or loss on the sale or retirement is recognized in income.

Intangible Assets

The Company’s policy is to renew its patents and trademarks. Total renewal costs for patents and trademarks for the nine months ended September 30, 2017 and October 1, 2016 were $0.5 million and $0.4 million, respectively. As of September 30, 2017, 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.

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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 September 30, 2017 and October 1, 2016.

Revenue Recognition and Deferred Revenue

The Company follows the current authoritative guidance for revenue recognition. Based on these requirements, the Company recognizes revenue from the sale of products or services when: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or services have been rendered, (iii) the price is fixed or determinable, and (iv) collectability is reasonably assured. In the case of the license or sale of software that does not function together with hardware components to provide the essential functionality of the hardware, revenue is recognized pursuant to the software revenue recognition guidance.

The Company derives the majority of its revenue from four primary sources: (i) direct sales under long-term sensor purchase agreements with end-user hospitals where the Company provides up-front monitoring equipment at no up-front charge in exchange for a multi-year sensor purchase commitment, (ii) other direct sales of noninvasive monitoring solutions to end-user hospitals, emergency medical response organizations and other direct customers; (iii) sales of noninvasive monitoring solutions to distributors who then typically resell to end-user hospitals, emergency medical response organizations and other direct customers; and (iv) sales of integrated circuit boards to OEM customers who incorporate the Company’s embedded software technology into their multiparameter monitoring devices.

The Company enters into agreements to sell its noninvasive monitoring solutions and services, sometimes as part of multiple deliverable arrangements that include various combinations of products and services. While the majority of the Company’s sales transactions contain standard business terms and conditions, there are some transactions that contain non-standard business terms and conditions. As a result, contract interpretation and analysis is sometimes required to determine the appropriate accounting, including: (i) how the arrangement consideration should be allocated among the deliverables when multiple deliverables exist, (ii) when to recognize revenue on the deliverables, and (iii) whether undelivered elements are essential to the functionality of the delivered elements. Changes in judgments on these assumptions and estimates could materially impact the timing of revenue recognition.

In the case of multiple deliverable arrangements, the authoritative guidance provides a hierarchy to determine the selling price to be used for allocating revenue to deliverables as follows: (i) vendor-specific objective evidence (VSOE) of selling price, (ii) third-party evidence of selling price (TPE), and (iii) best estimate of the selling price (ESP). VSOE of selling price 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.

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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. These contracts generally do not provide for any payments that are not dependent upon the Company’s future delivery of sensors, which are essential to the functionality of the monitoring equipment and, therefore, represent a substantive performance obligation. As a result, the Company generally does not recognize any revenue when the monitoring and 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 and 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. In cases where such contracts do provide for guaranteed payments that are unrelated to the future delivery of sensors, the Company recognizes the net present value of such payments as revenue from the monitoring and related equipment and expenses the cost of such equipment to cost of goods sold, as the equipment is delivered and when installation and training are complete. Some of the Company’s long-term sensor contracts also contain provisions for certain payments to be made directly to the end-user hospital customer at the inception of the arrangement. These payments are generally treated as prepaid discounts which 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 that they then resell to end-user hospitals that are typically fulfilling their purchase obligations to the Company under such end-user hospital’s long-term sensor purchase commitments. Upon shipment to the distributor, revenue is deferred until the distributor ships the product to the Company’s end-user customers based on an estimate of the inventory held by these distributors at the end of the accounting period.

The Company also earns revenue from the sale of integrated circuit boards and other products, as well as from rainbow^® parameter software licenses, to OEMs under various agreements. Revenue from the sale of products to the OEMs is generally recognized at the time of shipment. Revenue related to software licenses to OEMs is generally recognized upon shipment of the OEM’s product to its customers, as represented to the Company by the OEM.

The Company also provides certain customers with the ability to purchase sensors under rebate programs. Under these programs, the customers may earn rebates based on their purchasing activity. The Company estimates and provides allowances for these programs at the time of sale as a reduction to revenue.

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 majority of the Company’s royalty and other revenue arises from an agreement with Medtronic plc (Medtronic, formerly Covidien Ltd.) that provides for quarterly royalty payments to the Company based upon U.S. sales of certain Medtronic 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 Medtronic royalty report, approximately sixty days after the end of the previous quarter. From time-to-time, the Company also recognizes revenue upon the achievement of pre-agreed milestones related to non-recurring engineering (NRE) services provided for certain OEM customers. Costs incurred by the Company related to these NRE services are generally deferred until such time that the milestones are achieved and the associated revenue is recognized.

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 traditional sales activities, including direct and OEM sales, the Company establishes an accrued liability for the estimated warranty costs at the time of revenue recognition, with a corresponding provision to cost of sales. Customers may also purchase extended warranty coverage separately or as part of a long-term sensor purchase agreement. Revenue related to extended warranty coverage is recognized over the extended life of the contract and the related extended warranty costs are expensed as incurred.

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

Changes in the product warranty accrual were as follows (in thousands):



	Nine Months Ended
	September 30, 2017			October 1, 2016
Warranty accrual, beginning of period	$	910		$	1,222
Accrual for warranties issued	712			722
Changes to pre-existing warranties (including changes in estimates)	(116		)	99
Settlements made	(486		)	(751		)
Warranty accrual, end of period	$	1,020		$	1,292

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.

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 and reflected in stockholders’ equity.

The change in accumulated other comprehensive loss was as follows (in thousands):



	Nine Months Ended September 30, 2017
Accumulated other comprehensive loss, beginning of period	$	(7,027	)
Unrealized gains from foreign currency translation	4,270
Accumulated other comprehensive loss, end of period	$	(2,757	)

Net Income Per Share

Basic net income per share is computed by dividing net income by the weighted-average number of shares outstanding during the period. Net income per diluted share is computed by dividing the net income by the weighted-average number of shares and potential shares outstanding during the 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 both restricted share units (RSUs) and performance share units (PSUs). For the three and nine months ended September 30, 2017, weighted options to purchase 0.6 million and 0.2 million shares of common stock, respectively, were outstanding but 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, weighted options to purchase less than 0.1 million and 1.4 million shares of common stock, respectively, were outstanding, but were not included in the computation of diluted net income per share because the effect of including such shares would have been antidilutive in the applicable period. For the three and nine months ended September 30, 2017 and 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 September 30, 2017 and October 1, 2016, 2.7 million weighted average shares related to such RSUs have been excluded from the calculation of potential shares.

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

A reconciliation of basic and diluted net income per share is as follows (in thousands, except per share amounts):



	Three Months Ended				Nine Months Ended
	September 30, 2017		October 1, 2016		September 30, 2017		October 1, 2016
Net income	$	39,235	$	27,773	$	131,248	$	85,373
Basic net income per share:
Weighted-average shares outstanding - basic	52,079		49,477		51,469		49,386
Net income per basic share	$	0.75	$	0.56	$	2.55	$	1.73
Diluted net income per share:
Weighted-average shares outstanding - basic	52,079		49,477		51,469		49,386
Diluted share equivalent: stock options and RSUs	4,084		4,088		4,498		3,451
Weighted-average shares outstanding - diluted	56,163		53,565		55,967		52,837
Net income per diluted share	$	0.70	$	0.52	$	2.35	$	1.62

Supplemental Cash Flow Information

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



	Nine Months Ended
	September 30, 2017		October 1, 2016
Cash paid during the year for:
Interest (net of amounts capitalized)	$	432	$	2,603
Income taxes	86,759		25,753
Noncash investing and financing activities:
Unpaid purchases of property, plant and equipment	$	3,349	$	1,232
Unsettled common stock proceeds from option exercises	113		476
Unsettled stock repurchases	2,653		—

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.

Recently Issued Accounting Pronouncements

In September 2017, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2017-13, Revenue Recognition (Topic 605), Revenue from Contracts with Customers (Topic 606), Leases (Topic 840), and Leases (Topic 842). The new standard, among other things, provides additional implementation guidance with respect to Accounting Standards Codification (ASC) Topic 606 and ASC Topic 842. ASU 2017-13 is effective for annual and interim fiscal reporting periods beginning after December 15, 2017. The Company is currently evaluating the impact of the new standard, but does not expect it to have a material impact on its implementation strategies or its consolidated financial statements upon adoption.

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

In May 2017, the FASB issued ASU No. 2017-09, Compensation – Stock Compensation (Topic718): Scope of Modification Accounting (ASU 2017-09). The new standard is intended to provide clarity and reduce both (1) diversity in practice and (2) cost and complexity when applying the guidance in ASC Topic 718 to a change to the terms or conditions of a share-based payment award. The amendments in this new standard provide guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply “modification accounting” to such changes. ASU 2017-09 will become effective for all entities for annual and interim periods beginning after December 15, 2017, 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 upon adoption.

In January 2017, the FASB issued ASU No. 2017-04, Intangibles – Goodwill and Other (ASU 2017-04). The new standard is intended to eliminate the requirement to calculate the implied fair value of goodwill to measure a goodwill impairment charge. Instead, a goodwill impairment charge will be based on the excess of a reporting unit’s carrying amount over its fair value. ASU 2017-04 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 upon adoption.

In January 2017, the FASB issued ASU No. 2017-01, Business Combinations (ASU 2017-01). The new standard is intended to clarify the definition of a business and requires an entity to evaluate if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets. If so, the set of transferred assets and activities is not considered to be a business under ASU 2017-01. ASU 2017-01 also requires a business to include at least one substantive process and narrows the definition of business outputs. The new standard will be effective on January 1, 2018, and early adoption is permitted with prospective application to any business development transaction. 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 upon adoption.

In November 2016, the FASB issued ASU No. 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash (ASU 2016-18). The new standard is intended to reduce diversity in practice by adding or clarifying guidance on classification and presentation of changes in restricted cash on the statement of cash flows. ASU 2016-18 is effective for annual and interim fiscal reporting periods beginning after December 15, 2017, 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 upon adoption.

In October 2016, the FASB issued ASU No. 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other than Inventory (ASU 2016-16). The new standard eliminates the exception that allowed the income tax consequences of an intra-entity transfer of assets other than inventory to be deferred until the transferred asset was sold to a third party or otherwise recovered through use, and now requires recognition of such income tax consequences at the time the non-inventory asset is transferred. ASU 2016-16 is effective for annual and interim fiscal reporting periods beginning after December 15, 2017, 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 upon adoption.

In August 2016, the FASB issued ASU 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 upon adoption.

In June 2016, the FASB issued ASU 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 upon adoption.

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

In February 2016, the FASB issued ASU 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 addition, the Company anticipates that the classification of certain leases for which the Company is the lessor may change under the new guidance, resulting in the immediate expensing of certain costs that are currently deferred and expensed over the life of the lease. The Company currently expects to complete its assessment of the full financial impact of the new lease accounting guidance during the next fifteen months.

In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, (ASU 2016-01). The new standard requires that (i) all equity investments, other than equity-method investments, in unconsolidated entities generally be measured at fair value in net income and (ii) changes in fair value due to instrument-specific credit risk be recognized separately in other comprehensive income when the fair value option has been elected for financial liabilities. ASU 2016-01 is effective for annual and interim fiscal reporting periods beginning after December 15, 2017. 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 upon adoption.

In May 2014, the FASB issued ASU No. 2014-09, Revenue (Topic 606): Revenue from Contracts with Customers (ASU 2014-09). The new standard provides a single, principles-based five-step model to be applied to all contracts with customers while enhancing disclosures about revenue, providing additional guidance for transactions that were not previously addressed comprehensively and improving guidance for multiple-element arrangements. ASU 2014-09 will replace most existing revenue recognition guidance under GAAP when it becomes effective. The standard permits the use of either the retrospective or cumulative effect transition method upon adoption. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, which amended ASU 2014-09, providing for a one year deferral period for the implementation of ASU 2014-09. ASU 2014-09 will now be effective for annual and interim periods beginning on or after December 15, 2017. In March 2016, the FASB issued ASU No. 2016-08, Revenue from Contracts with Customers: Principal versus Agent Considerations under FASB ASC Topic 606, which provides guidance on principal versus agent considerations. In April 2016, the FASB issued ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606) – Identifying Performance Obligations and Licensing, which amended ASU 2014-09 by providing clarity in identifying performance obligations and licensing implementation guidance. In May 2016, the FASB issued ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606) – Narrow-Scope Improvements and Practical Expedients, which further amended ASU 2014-09 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. In December 2016, the FASB issued ASU No. 2016-20, Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers (ASU 2016-20). ASU 2016-20 affects narrow aspects of ASC Topic 606, including contract modifications, contract costs, and the balance sheet classification of items as contract assets versus receivables. The Company is continuing to evaluate the expected impact of the new revenue guidance contained in ASC Topic 606 on its consolidated financial statements and 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. The Company is also further evaluating the impact of the new revenue guidance on associated processes, systems and internal controls over financial reporting. The Company currently expects to complete its assessment of the impact of the new revenue recognition guidance, including the method of adoption, during the next three months and to adopt the guidance when it becomes effective for the Company on December 31, 2017 (fiscal year 2018).

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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 is an independent entity that was 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. The Company is also a party to various other agreements with Cercacor.

As a result of 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 remained a VIE, the Company was no longer its primary beneficiary as it could no longer be deemed to have the power to direct the activities of Cercacor that most significantly impact Cercacor’s economic performance and had no 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 accompanying 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.

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 $2.1 million and $1.6 million for the three months ended September 30, 2017 and October 1, 2016, respectively. Actual aggregate royalty liabilities to Cercacor under the license were $5.6 million and $4.7 million for the nine months ended September 30, 2017 and October 1, 2016, respectively.

•

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 and $0.1 million for the three and nine months ended September 30, 2017 and October 1, 2016, 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 less than $0.1 million and $0.3 million in sublease income for the three and nine months ended September 30, 2017, respectively. 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 each of September 30, 2017 and December 31, 2016 were $1.0 million and $0.4 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 former Chief Financial Officer (CFO) is also a Director of the Masimo Foundation.

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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 former 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.

In August 2017, the Company entered into an aircraft time share agreement, pursuant to which the Company has agreed from time to time to make its aircraft available to the CEO for lease on a time sharing basis. The Company charges the CEO for personal use based on agreed upon reimbursement rates. For each of the three and nine months ended September 30, 2017, the Company charged the CEO less than $0.1 million related to such reimbursements.

5. Inventories

Inventories consist of the following (in thousands):



	September 30, 2017		December 31, 2016
Raw materials	$	42,023	$	32,647
Work-in-process	8,217		7,701
Finished goods	48,838		32,194
Total inventories	$	99,078	$	72,542

6. Other Current Assets

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



	September 30, 2017		December 31, 2016
Prepaid expenses	$	15,113	$	13,051
Prepaid income taxes	9,622		981
Due from foreign agent	8,571		—
Royalties receivable	7,800		7,500
Employee loans and advances	338		305
Due from related party	23		77
Other current assets	5,377		5,134
Total other current assets	$	46,844	$	27,048

The Company is currently evaluating the collectability of certain amounts that have been paid by a foreign government customer to the Company’s appointed foreign agent in connection with a foreign government tender, but which have not been timely remitted by such agent to the Company in accordance with the agency agreement. The Company is actively working with such agent to arrange for payment, possibly under an extended payment plan, as well as exploring other potential remedies for recovery of this receivable. As of September 30, 2017, the net amount due the Company from such agent was approximately $8.6 million. The Company is currently unable to determine whether any loss will ultimately occur in connection with the resolution of this matter and has not accrued any loss in the accompanying condensed consolidated financial statements based on its current expectations regarding the collectability of the receivable.

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

7. Property and Equipment

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



	September 30, 2017			December 31, 2016
Building and building improvements	$	86,023		$	85,966
Machinery and equipment	45,718			41,683
Aircraft and vehicles	25,329			45
Land	23,762			23,762
Leasehold improvements	15,015			8,289
Computer equipment	14,440			13,549
Tooling	13,667			12,895
Furniture and office equipment	10,821			9,669
Demonstration units	489			448
Construction-in-progress	8,434			7,923
Total property and equipment	243,698			204,229
Accumulated depreciation and amortization	(79,119		)	(68,233		)
Property and equipment, net	$	164,579		$	135,996

In August 2017, the Company completed its purchase of a corporate aircraft for $25.3 million. For the nine months ended September 30, 2017 and October 1, 2016, depreciation expense of property and equipment was $10.8 million and $9.5 million, respectively.

8. Intangible Assets

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



	September 30, 2017			December 31, 2016
Patents	$	20,715		$	19,950
Customer relationships	7,669			7,669
Licenses	7,500			7,500
Acquired technology	5,580			5,580
Trademarks	3,990			3,777
Capitalized software development costs	2,606			2,539
Other	3,681			3,674
Total intangible assets	51,741			50,689
Accumulated amortization	(24,252		)	(21,313		)
Intangible assets, net	$	27,489		$	29,376

Total amortization expense for the nine months ended September 30, 2017 and October 1, 2016 was $3.7 million and $2.8 million, respectively. All of these intangible assets have a 10 year weighted average amortization period.

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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



Fiscal year	Amount
2017 (balance of year)	$	5,343
2018	4,769
2019	3,710
2020	3,362
2021	2,330
Thereafter	7,975
Total	$	27,489

9. Accrued and Other Current Liabilities

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



	September 30, 2017		December 31, 2016
Contract related payables	$	14,365	$	10,673
Income taxes payable	5,179		76,316
Accrued taxes	4,990		5,135
Accrued customer rebates, fees and reimbursements	4,101		3,893
Accrued stock repurchases	2,653		—
Accrued legal fees	1,263		1,362
Accrued warranty	1,220		910
Related party payable	1,028		525
Accrued donations	634		503
Other	4,756		5,337
Total accrued and other current liabilities	$	40,189	$	104,654

10. Restated Credit Facility

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 currently provides for up to $250.0 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 $350.0 million in the future. 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).

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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 September 30, 2017, the Restated Credit Facility had no outstanding draws and outstanding standby letters of credit totaling $0.3 million. The Company incurred interest expense related to the Restated Credit Facility of $0.5 million and $3.0 million for the nine months ended September 30, 2017 and October 1, 2016, respectively. The Company was in compliance with all covenants under the Restated Credit Facility as of September 30, 2017.

11. Other Non-Current Liabilities

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



	September 30, 2017		December 31, 2016
Unrecognized tax benefit	$	14,078	$	13,442
Deferred rent, long-term	1,350		558
Deferred tax liability, long-term	339		340
Other	292		247
Total other non-current liabilities	$	16,059	$	14,587

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. Stock Repurchase Program

In September 2015, the Company’s Board of Directors (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 privately negotiated transactions. The total remaining shares authorized for repurchase under the 2015 Repurchase Program approximated 2.4 million shares as of September 30, 2017. 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 September 30, 2017 and October 1, 2016 (in thousands, except per share amounts):



	Three Months Ended				Nine Months Ended
	September 30, 2017		October 1, 2016		September 30, 2017		October 1, 2016
Shares repurchased	533		—		533		1,496
Average cost per share	$	84.86	$	—	$	84.86	$	42.39
Value of shares repurchased	$	45,261	$	—	$	45,261	$	63,403

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

13. Stock-Based Compensation

The total stock-based compensation expense for the nine months ended September 30, 2017 and October 1, 2016 was $11.2 million and $9.7 million, respectively. As of September 30, 2017, an aggregate of 14.1 million shares of common stock were reserved for future issuance under the Company’s equity plans, of which 4.0 million shares were available for future grant under the Masimo Corporation 2017 Equity Incentive Plan (2017 Equity Plan). Additional information related to the Company’s current equity incentive plans, stock-based award activity and valuation of stock-based awards is included below.

Equity Incentive Plans

2017 Equity Incentive Plan

On June 1, 2017, the Company’s stockholders ratified and approved the 2017 Equity Plan. The 2017 Equity Plan permits the grant of stock options, restricted stock, restricted stock units (RSUs), stock appreciation rights, performance share units (PSUs), performance shares, performance bonus awards and other stock or cash awards to employees, directors and consultants of the Company and employees and consultants of any parent or subsidiary of the Company. The aggregate number of shares that may be awarded under the 2017 Equity Plan is 5.0 million shares.

The 2017 Equity Plan provides that equity awards issued under the 2017 Equity Plan must generally vest over a period of not less than one year following the date of grant. The exercise price per share of each option granted under the 2017 Equity Plan may not be less than the fair market value of a share of the Company’s common stock on the date of grant, which is generally equal to the closing price of the Company’s common stock on the NASDAQ Global Select Market on the grant date.

2007 Stock Incentive Plan

Effective June 1, 2017, upon the approval and ratification of the 2017 Equity Plan, the Company’s 2007 Stock Incentive Plan (2007 Equity Plan) terminated, provided that awards outstanding under the 2007 Equity Plan will continue to be governed by the terms of that plan. In addition, upon the effectiveness of the 2017 Equity Plan, an aggregate of 5.0 million shares of the Company’s common stock registered under prior registration statements for issuance pursuant to the 2007 Equity Plan were deregistered and concurrently registered under the 2017 Equity Plan.

Stock-Based Award Activity

Stock Options

The number and weighted-average exercise price of options issued and outstanding under all of the Company’s equity plans are as follows (in thousands, except for exercise prices):



	Nine Months Ended September 30, 2017
	Shares		Average Exercise Price
Options outstanding, beginning of period	8,521		$	28.56
Granted	847		86.80
Canceled	(220	)	36.49
Exercised	(2,009	)	27.66
Options outstanding, end of period	7,139		$	35.48
Options exercisable, end of period	3,991		$	26.26

Total stock option expense for the three and nine months ended September 30, 2017 was $2.9 million and $8.2 million, respectively. As of September 30, 2017, the Company had $35.7 million of unrecognized compensation cost related to non-vested stock options that are expected to vest over a weighted average period of approximately 3.7 years. The weighted-average remaining contractual term of options outstanding with an exercise price less than the closing price of the Company’s common stock as of September 30, 2017 was 6.0 years. The weighted-average remaining contractual term of options exercisable, with an exercise price less than the closing price of the Company’s common stock as of September 30, 2017 was 4.3 years.

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

RSUs

The number of RSUs issued and outstanding under all of the Company’s equity plans are as follows (in thousands, except for grant date fair value amounts):



	Nine Months Ended September 30, 2017
	Units		Weighted Average Grant Date Fair Value
RSUs outstanding, beginning of period	2,706		$	41.45
Granted	33		86.42
Canceled	(25	)	85.79
Expired	—		—
Vested	(6	)	43.09
RSUs outstanding, end of period	2,708		$	41.59

Total RSU expense for the three and nine months ended September 30, 2017 was $0.2 million and $0.3 million, respectively. As of September 30, 2017, the Company had $0.5 million of unrecognized compensation cost related to non-vested RSU awards expected to be recognized and vest over a weighted-average period of approximately 0.7 years.

In July 2017, in connection with the First Amendment to November 4, 2015 Amended and Restated Employment Agreement (First Amendment), the Company and Mr. Kiani agreed to, among other things modify certain vesting provisions related to the previous award of 2.7 million RSUs to the Company’s Chairman and Chief Executive Officer (see “Employment and Severance Agreements” in Note 14 to these condensed consolidated financial statements for further details).

PSUs

The number of PSUs outstanding under all of the Company’s equity plans are as follows (in thousands, except for grant date fair value amounts):



	Nine Months Ended September 30, 2017
	Units		Weighted Average Grant Date Fair Value
PSUs outstanding, beginning of period	—		$	—
Granted	248		90.71
Canceled	(15	)	90.87
Expired	—		—
Vested	—		—
PSUs outstanding, end of period	233		$	90.70

During the nine months ended September 30, 2017, the Company awarded 233,000 PSUs that will vest in part over time based on the achievement of certain 2017 performance criteria approved by the Board. If earned, 20% of the PSUs granted will vest upon achievement of the performance criteria and the remaining award will vest in equal installments at the beginning of each of the following four years after the year in which the performance achievement level has been determined. The number of shares that may be earned can range from 0% to 100% of the target amount; therefore, the maximum number of shares that can be issued under these awards is 233,000. Total PSU expense for the three and nine months ended September 30, 2017 was $2.0 million and $2.6 million, respectively. As of September 30, 2017, the Company had $11.4 million of unrecognized compensation cost related to non-vested PSU awards expected to be recognized and vest over a weighted-average period of approximately 2.5 years.

Valuation of Stock-Based Award Activity

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:

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)



	Three Months Ended		Nine Months Ended
	September 30, 2017	October 1, 2016	September 30, 2017	October 1, 2016
Risk-free interest rate	1.7% to 2.0%	1.0% to 1.3%	1.7% to 2.2%	1.0% to 1.9%
Expected term (in years)	5.5	5.7	5.5	5.7
Estimated volatility	30.3% to 32.1%	30.3% to 31.9%	29.7% to 32.1%	30.3% to 35.7%
Expected dividends	0%	0%	0%	0%
Weighted-average fair value of options granted	$27.70	$17.99	$27.74	$13.42

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 September 30, 2017 was $365.9 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 September 30, 2017 was $240.7 million. The aggregate intrinsic value of options exercised during the nine months ended September 30, 2017 was $17.4 million.

The fair value of each RSU and PSU award is determined based on the closing price of the Company’s common stock on the grant date, or the modification date, if any.

14. Commitments and Contingencies

Leases

The Company leases certain facilities in North and South America, Europe, the Middle East and Asia-Pacific regions under operating lease agreements expiring at various dates through November 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 September 30, 2017 and December 31, 2016, accrued rent expense in excess of the amount paid aggregated $1.5 million and $0.7 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 November 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.

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 September 30, 2017
	Operating Leases		Capital Leases⁽¹⁾		Total
2017 (balance of year)	$	1,641	$	—	$	1,641
2018	6,347		—		6,347
2019	5,363		—		5,363
2020	3,165		—		3,165
2021	2,615		—		2,615
Thereafter	7,284		—		7,284
Total	$	26,415	$	—	$	26,415

^{______________________}


⁽¹⁾	As of September 30, 2017, the Company had an outstanding capital lease of less than $0.1 million, which is not reflected in the above table due to rounding.

Rental expense related to operating leases was $1.7 million and $5.0 million for the three and nine months ended September 30, 2017, respectively, and $1.6 million and $4.5 million for the three and nine months ended October 1, 2016, respectively. Included in the future capital lease payments as of September 30, 2017 is interest aggregating less than $0.1 million.

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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 $0.6 million and $1.8 million to the MRSP for the three and nine months ended September 30, 2017, respectively, and $0.5 million and $1.6 million to the MRSP for the three and nine months ended October 1, 2016, 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 September 30, 2017, the Company contributed $0.1 million and $0.2 million, respectively. For the three and nine months ended October 1, 2016, the Company contributed $0.1 million and $0.2 million to the Subsidiary Plans, respectively.

Employment and Severance Agreements

In July 2017, the Company entered into the First Amendment with Joe Kiani, the Company’s Chairman and Chief Executive Officer, which amended that certain Amended and Restated Employment Agreement entered into between the Company and Mr. Kiani on November 4, 2015 (together with the First Amendment, the Amended Employment Agreement). The First Amendment, among other things, eliminates Mr. Kiani’s eligibility for an automatic annual bonus equal to 100% of his base salary, imposes an annual cap on any annual bonus awarded by the Compensation Committee at 200% of his base salary, eliminates his guaranteed grant of 300,000 stock options in fiscal year 2017, modifies certain definitions and conditions related to Mr. Kiani’s ability to terminate his employment with the Company for “Good Reason”, and eliminates the annual 10% reduction of both: (1) the 2.7 million shares subject to the RSU award previously granted to Mr. Kiani (Award Shares) that will vest in certain circumstances, and (2) the $35.0 million cash payment (Cash Payment) that Mr. Kiani will be entitled to receive in certain circumstances.

Pursuant to the terms of the Amended Employment Agreement, upon a “Qualifying Termination” (as defined in the Amended Employment Agreement), 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, the full amount of the Award Shares and the full amount of the Cash Payment. In addition, in the event of a “Change in Control” (as defined in the Amended Employment Agreement) prior to a Qualifying Termination, on each of the one year and two year anniversaries of the Change in Control, 50% of the Cash Payment and 50% of the Award Shares will vest, subject in each case to Mr. Kiani’s continuous employment through each such anniversary date; however, in the event of a Qualifying Termination or a termination of Mr. Kiani’s employment due to death or disability prior to either of such anniversaries, any unvested amount of the Cash Payment and all of the unvested Award Shares shall vest and be paid in full. Additionally, in the event of a Change in Control prior to a Qualifying Termination, Mr. Kiani’s stock options and any other equity awards will vest in accordance with their terms, but in no event later than in two equal installments on each of the one year and two year anniversaries of the Change in Control, subject in each case to Mr. Kiani’s continuous employment through each such anniversary date. As of September 30, 2017, the expense related to the Award Shares that would be recognized in the Company’s consolidated financial statements upon the occurrence of a Qualifying Termination under the Restated Employment Agreement was approximately $233.7 million.

As of September 30, 2017, the Company had severance plan participation agreements with six executive officers. The participation agreements (the Agreements) are governed by the terms and conditions of the Company’s 2007 Severance Protection Plan (the Severance Plan), which became effective on July 19, 2007 and which was amended effective December 31, 2008. Under each of the Agreements, the applicable executive officer may be entitled to receive certain salary, equity, medical and life insurance benefits if he is terminated by the Company without cause or if he terminates his employment for good reason under certain circumstances. The executive officers are also required to give the Company six months advance notice of their resignation under certain circumstances.

Purchase Commitments

Pursuant to contractual obligations with vendors, the Company had $81.6 million of purchase commitments as of September 30, 2017, 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.

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

Other Contractual Commitments

In the normal course of business, the Company may provide bank guarantees to support government hospital tenders in certain foreign jurisdictions. As of September 30, 2017, the Company had approximately $0.3 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 September 30, 2017, 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 in time deposits with major financial institutions. As of September 30, 2017, the Company had $277.6 million of bank balances, of which $3.9 million was covered by either the U.S. Federal Deposit Insurance Corporation limit or foreign countries’ deposit insurance organizations.

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 September 30, 2017, revenue from the sale of the Company’s products to U.S. hospitals that are members of GPOs amounted to $102.7 million and $308.0 million, respectively, and for 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.

For the three months ended September 30, 2017, the Company had sales through two just-in-time distributors that represented 12.3% and 10.9% of total revenue, respectively. For the three months ended October 1, 2016, the Company had sales through the same two just-in-time distributors that represented 14.0% and 13.2% of total revenue, respectively. For the nine months ended September 30, 2017, the Company had sales through two just-in-time distributors that represented 13.2% and 11.4% 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.

As of September 30, 2017, two just-in-time distributors represented 7.3% and 5.1% of the Company’s accounts receivable balance, respectively. As of December 31, 2016, two different just-in-time distributors represented 7.5% and 5.6% of the Company’s accounts receivable balance, respectively.

For the nine months ended September 30, 2017 and October 1, 2016, the Company recorded $25.7 million and $23.2 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 between the companies.

Litigation

On July 26, 2017, a patent infringement complaint was filed against the Company in the U.S. District Court for the District of Delaware by Silkeen, LLC (Silkeen). The complaint alleges that the Company’s pulse oximetry products infringe certain claims of U.S. Patent No. 7,944,469 titled “System and Method for Using Self-Learning Rules to Enable Adaptive Security Monitoring.” The Company’s policy is and has been not to settle patent infringement claims where it does not believe there is infringement of a valid patent, even if the cost of litigation would exceed the cost of settlement. On October 18, 2017, Silkeen dismissed the case against the Company with prejudice.

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

On January 2, 2014, a putative class action complaint was filed against the Company in the U.S. District Court for the Central District of California by Physicians Healthsource, Inc. (PHI). 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. On March 31, 2017, the D.C. Circuit Court of Appeals vacated and remanded the FCC’s decision, holding that the applicable FCC rule was unlawful to the extent it requires opt-out notices on solicited faxes. On April 28, 2017, PHI filed a petition seeking rehearing by the D.C. Circuit Court of Appeals. The D.C. Circuit Court of Appeals denied the requested rehearing on June 6, 2017. The plaintiffs filed a petition for a writ of certiorari with the United States Supreme Court on September 5, 2017 seeking review of the D.C. Circuit Court of Appeals’ opinion. The Supreme Court has not yet ruled on the petition, and the stay of the District Court litigation has not yet been lifted. The Company believes it has good and substantial defenses to the claims in the District Court litigation, 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 in the accompanying condensed consolidated financial statements.

On January 31, 2014, an amended putative class action complaint was filed against the Company in the U.S. District Court for the Northern District of Alabama by and on behalf of two participants in the Surfactant, Positive Pressure, and Oxygenation Randomized Trial at the University of Alabama. On April 21, 2014, a further amended complaint was filed adding a third participant. The complaint alleges product liability and negligence claims in connection with pulse oximeters the Company modified and provided at the request of study investigators for use in the trial. On August 13, 2015, the U.S. District Court for the Northern District of Alabama granted summary judgment in favor of the Company on all claims. The plaintiffs have appealed the U.S. District Court for the Northern District of Alabama’s decision. The appellate hearing before the Eleventh Circuit Court of Appeals was held on December 13, 2016, and the parties are awaiting a decision. On July 7, 2017, the Eleventh Circuit Court of Appeals (Eleventh Circuit) issued a Certification to the Supreme Court of Alabama seeking guidance on a legal question. In that Certification, the Eleventh Circuit stated that the plaintiffs failed to establish that participation in the clinical study caused any injuries, and that the negligence, negligence per se, breach of fiduciary duty and products liability claims, which includes the claims currently alleged against the Company, were properly dismissed. On September 7, 2017, the Supreme Court of Alabama issued an order declining to answer the legal question posted by the Eleventh Court. 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 in the accompanying consolidated financial statements.

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 condensed 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.

Table of Contents

MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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



	Three Months Ended								Nine Months Ended
	September 30, 2017				October 1, 2016				September 30, 2017				October 1, 2016
Geographic area by destination:
United States	$	119,266	65.8	%	$	114,563	71.5	%	$	370,403	68.3	%	$	345,113	70.7	%
Europe, Middle East and Africa	38,127		21.0		23,929		14.9		102,322		18.9		81,887		16.8
Asia and Australia	18,078		10.0		16,630		10.4		51,801		9.6		46,815		9.6
North and South America (excluding United States)	5,800		3.2		5,164		3.2		17,644		3.2		14,368		2.9
Total product revenue	$	181,271	100.0	%	$	160,286	100.0	%	$	542,170	100.0	%	$	488,183	100.0	%

The Company’s consolidated long-lived assets (total non-current assets excluding deferred taxes, goodwill and intangible assets) by geographic area are (in thousands, except percentages):



	September 30, 2017				December 31, 2016
Long-lived assets by geographic area:
United States	$	262,249	96.3	%	$	216,784	96.3	%
International	10,148		3.7		8,383		3.7
Total	$	272,397	100.0	%	$	225,167	100.0	%

16. Income Taxes

The Company has provided for income taxes in fiscal 2017 interim periods based on the estimated effective income tax rate for the complete fiscal year and adjusted for discrete tax events, including excess tax benefits or deficiencies related to stock-based compensation, in the period such events occur. 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. For the nine months ended September 30, 2017 and October 1, 2016, the Company recorded discrete tax benefits of approximately $35.1 million and $7.7 million, respectively, related to excess tax benefits realized from stock-based compensation.

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 September 30, 2017, the liability for income taxes associated with uncertain tax positions was approximately $15.2 million. If fully recognized, approximately $13.5 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 2012. All material state, local and foreign income tax matters have been concluded through fiscal year 2009. The Company does not believe that the results of any tax authority examination would have a significant impact on its consolidated financial statements.

Table of Contents

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 December 31, 2016, which we filed with the SEC on February 15, 2017. Furthermore, such forward-looking statements speak only as of the date of this report. We undertake no obligation to update any forward-looking statements to reflect events or circumstances occurring after the date of such statements.

Executive Overview

We are a global medical technology company that develops, manufactures and markets a variety of noninvasive monitoring technologies. We provide our products directly and through distributors and original equipment 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. 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 patient monitors. We have also developed a remote patient surveillance monitoring system, Patient SafetyNet, which currently allows up to 200 patients per server 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), manage fluid therapy, reduce length of stay and complications, and save lives and costs while reducing rapid response activations and ICU transfers within medical-surgical units.

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

Table of Contents

(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^®), Oxygen Reserve Index^™ (ORi^™) and Rainbow Pleth Variability Index (RPVi^™). Although SpfO₂^™, RRp^®, RPVi^™ and ORi^™ have received the CE Mark, they are not currently available for sale in the U.S.

In March 2017, we announced the CE Mark of our noninvasive blood pressure (NIBP) measurements for the Rad-97^™ Pulse Co-Oximeter^® and connectivity hub. In September 2017, we announced FDA 510(k) clearance and full market release of the Rad-97^™ Pulse CO-Oximeter^®, including configurations with integrated NomoLine^™ capnography and NIBP measurement from SunTech Medical. Rad-97^™ with NIBP enables clinicians to measure arterial blood pressure for adult, pediatric and neonatal patients, with three measurement modes: spot-check, automatic interval (which measures blood pressure routinely, at a desired interval) and stat interval (which continually measures blood pressure for a desired duration). An integrated port allows clinicians to connect a blood pressure cuff inflation hose directly to Rad-97^™, and is compatible with both disposable and reusable cuffs, for a variety of patient types, designed for reliability and patient comfort. In May 2017, we announced the introduction of Rad-G^™, a combined pulse oximeter designed primarily for use in pneumonia screening and spot-checking of oxygen saturation (SpO₂) in low-resource settings. The Rad-G^™ is a low-cost, rugged, handheld pulse oximetry device with a rechargeable battery and LCD display. It uses Measure-through Motion and Low Perfusion^™ SET^®pulse oximetry technology to measure SpO₂, RRp^®, PR and Pi. The Rad-G^™ is not currently available for sale in the U.S.

In June 2017, we announced the limited market release of the Spot-Check Rad-67^™ Handheld Pulse CO-Oximeter^®. Rad-67^™ offers Measure-through Motion and Low Perfusion^™ SET^® pulse oximetry and upgradeable rainbow^® noninvasive monitoring technology in a compact, portable spot-check device. With the universal reusable rainbow^® DCI^®-mini sensor, Rad-67^™ features Next Generation SpHb^® technology. The Rad-67^™ has received the CE Mark, but is not currently available for sale in the U.S.

Following the introduction of our rainbow SET^™ platform, we have continued to expand our technology offerings by introducing additional noninvasive measurements and technologies to create new market opportunities in both the hospital and non-hospital care settings. These offerings include:

•

SedLine^® - Brain function monitoring is most commonly used during surgery to help clinicians monitor sedation under anesthesia. SedLine^® brain function monitoring technology measures the brain’s electrical activity by detecting electroencephalogram (EEG) signals. In contrast to whole-scalp EEG monitoring, which is used for diagnostic purposes, this form of EEG monitoring is often referred to as processed EEG monitoring or brain function monitoring. Brain function monitors display the patient’s EEG waveforms, but these are difficult for clinicians to interpret, so the EEG signals are processed and displayed as a single number called Patient State Index (PSi), which is related to the effects of anesthetic agents. Our SedLine^® brain function monitoring technology can now be delivered through the Masimo Open Connect^® (MOC^®) connectivity port, MOC-9^®, 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 and agent-specific effects on the EEG signal. In 2016, we introduced Next Generation SedLine^®, which improved PSi in the presence of EMG (electrical activity due to muscle movement) artifact and in patients with low power EEG signals (such as geriatric patients). Next Generation SedLine^® has received CE Mark but is not currently available for sale in the U.S.

•

NomoLine^™ Capnography and Gas Monitoring - We offer a portfolio of sidestream and mainstream capnography products, as well as gas monitoring products, which include external “plug-in-and-measure” capnography and gas analyzers, integrated modules and handheld capnograph and capnometer devices. The gas monitoring 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^® - Organ oximetry, also known as regional oximetry, tissue oximetry and cerebral oximetry monitoring, uses near-infrared spectroscopy (NIRS) to provide continuous measurement of tissue oxygen saturation (rSO₂) to help detect regional hypoxemia that pulse oximetry alone can miss under certain conditions. In addition, our Root^® monitor and O³^®sensors can automate the differential analysis of regional to central oxygen saturation derived from our SET^®pulse oximeters. 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).

Table of Contents

In 2016, O3^® regional oximetry with the O3^® pediatric sensor received the CE Mark for use in pediatric patients weighing less than 40kg (approximately 88lbs). In May 2017, O3^® regional oximetry with the O3^® pediatric sensor received FDA 510(k) clearance for use in pediatric patients weighing less than 40kg (approximately 88lbs).

•

rainbow Acoustic Monitoring^® (RAM^™) - Our acoustic-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. Yet, due to its ease of use and wear, RAM^™ is better tolerated by patients than capnography. When used with other clinical variables, RRa^® may help clinicians assess respiratory depression and respiratory distress earlier and more often to help determine treatment options and potentially enable earlier interventions.

•

Root^® - Our Root^® 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, NomoLine^™ capnography and gas monitoring, and O₃^® organ oximetry. In June 2017, we announced our first MOC^® partnership, which enables third parties to utilize Root’s^® open architecture and built-in connectivity to independently develop, obtain regulatory approvals, and commercialize their own external MOC-9^® module or our Open Connect Control (MOC-C^™) App for Root^® using our MOC^® software development kit (SDK). While we support the development efforts of our MOC^® partners as needed, and help increase awareness of the availability of MOC-9^® modules and MOC-C^™ Apps, our MOC^® partners use their existing distribution channels to sell their MOC-9^® module or MOC-C^™ App to customers.

In February 2017, we introduced a limited market release of the Early Warning Score (EWS) for Root^®. EWS aggregates information from multiple vital signs and clinical observations to generate a score that represents the potential degree of patient deterioration. There are several EWS protocols, such as Pediatric Early Warning Score (PEWS), Modified Early Warning Score (MEWS) and National Early Warning Score (NEWS). These various scores require vital signs contributors such as oxygen saturation, pulse rate, respiration rate, body temperature and systolic blood pressure along with contributors input by clinicians, such as level of consciousness, use of supplemental oxygen and urine output. The weighting and number of contributors differ depending upon which EWS protocol is used. Root^® can be customized for various predefined EWS protocols, or hospitals can configure their own set of required contributors, and their relative weights, to create an EWS unique to their care environment.

•

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 from a single server. 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^™(ACE), which enables two-way, Health Level 7 (HL7) based connectivity to clinical/hospital information systems. The ACE 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, Kite^® 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 intake 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 electronic medical record (EMR). The patient-centric user interface of the Patient SafetyNet Series 5000 displays near real-time data from all devices with Kite^®, providing a single unified dashboard of patient information.

•

MyView^™ - MyView^™ is a 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.

Table of Contents

•

Patient SafetyNet Surveillance - Patient SafetyNet Surveillanceis a software option for our Patient SafetyNet solution that provides real-time video images of a patient’s room, including the patient with connected monitoring devices, adding existing communication technology to central monitoring. Two-way audio is available to allow the caregiver to listen to and communicate with the patient. The system utilizes the existing hospital information technology network and can provide viewing of images in the same care area.

•

MightySat^™ and MightySat Rx^™ - Our fingertip pulse oximeters leverage Masimo SET^® and are designed for those who want accurate measurements, even under challenging conditions such as movement and low perfusion. MightySat^™ is intended for personal use and provides SpO₂, PR, RRp^®, PVi^® and Pi measurements in a compact, battery-powered design with an organic light-emitting diode 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 available through online retailers such as Amazon.com and in select 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^® is intended for professional use. MightySat Rx^™ received 510(k) clearance in late 2015. In February 2017, MightySat^™ Rx with the RRp^® measurement received CE Mark, but is not currently available for sale in the U.S.

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 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. See Notes 3 and 4 to the condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information related to Cercacor.

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 September 30, 2017, approximately 2.4 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.

Table of Contents

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
	September 30, 2017		Percentage of Revenue		October 1, 2016			Percentage of Revenue		September 30, 2017		Percentage of Revenue		October 1, 2016		Percentage of Revenue
Revenue:
Product	$	181,271	93.6	%	$	160,286		95.6	%	$	542,170	94.6	%	$	488,183	95.5	%
Royalty and other revenue	12,421		6.4		7,335			4.4		30,757		5.4		23,241		4.5
Total revenue	193,692		100.0		167,621			100.0		572,927		100.0		511,424		100.0
Cost of goods sold	65,027		33.6		57,499			34.3		191,692		33.5		171,954		33.6
Gross profit	128,665		66.4		110,122			65.7		381,235		66.5		339,470		66.4
Operating expenses:
Selling, general and administrative	65,390		33.8		57,845			34.5		197,339		34.4		184,244		36.0
Research and development	15,300		7.9		15,673			9.4		45,859		8.0		44,856		8.8
Total operating expenses	80,690		41.7		73,518			43.9		243,198		42.4		229,100		44.8
Operating income	47,975		24.8		36,604			21.8		138,037		24.1		110,370		21.6
Non-operating income (expense)	287		0.1		(546		)	(0.3	)	1,319		0.2		423		0.1
Income before provision for income taxes	48,262		24.9		36,058			21.5		139,356		24.3		110,793		21.7
Provision for income taxes	9,027		4.7		8,285			4.9		8,108		1.4		25,420		5.0
Net income	$	39,235	20.3	%	$	27,773		16.6	%	$	131,248	22.9	%	$	85,373	16.7	%

Comparison of the Three Months ended September 30, 2017 to the Three Months ended October 1, 2016

Revenue. Total revenue increased $26.1 million, or 15.6%, to $193.7 million for the three months ended September 30, 2017 from $167.6 million for the three months ended October 1, 2016. The following table details our total product revenues by the geographic area to which the products were shipped for each of the three months ended September 30, 2017 and October 1, 2016 (dollars in thousands):



	Three Months Ended
	September 30, 2017				October 1, 2016				Increase/ (Decrease)		Percentage Change
United States	$	119,266	65.8	%	$	114,563	71.5	%	$	4,703	4.1	%
Europe, Middle East and Africa	38,127		21.0		23,929		14.9		14,198		59.3
Asia and Australia	18,078		10.0		16,630		10.4		1,448		8.7
North and South America (excluding United States)	5,800		3.2		5,164		3.2		636		12.3
Total product revenue	$	181,271	100.0	%	$	160,286	100.0	%	$	20,985	13.1	%
Royalty and other revenue	12,421				7,335				5,086		69.3
Total revenue	$	193,692			$	167,621			$	26,071	15.6	%

Product revenue increased $21.0 million, or 13.1%, to $181.3 million for the three months ended September 30, 2017 from $160.3 million for the three months ended October 1, 2016. This increase was primarily due to higher sales of consumables. We estimate that our installed base of circuit boards and pulse oximeters increased to approximately 1,566,000 units at September 30, 2017 as compared to 1,482,000 units at October 1, 2016.

Table of Contents

Product revenue generated through our direct and distribution sales channels increased $21.7 million, or 15.8%, to $159.1 million for the three months ended September 30, 2017, compared to $137.4 million for the three months ended October 1, 2016. Revenues from our OEM channel decreased $0.7 million, or 3.0%, to $22.2 million for the three months ended September 30, 2017 as compared to $22.9 million for the three months ended October 1, 2016. Total rainbow^® product revenue increased by $3.6 million, or 19.9%, to $21.5 million for the three months ended September 30, 2017, compared to $18.0 million for the three months ended October 1, 2016, primarily due to an increase in rainbow^® orders from a large international customer.

Royalty and other revenue consists primarily of royalties received from Medtronic plc (Medtronic, formerly Covidien Ltd.) related to its U.S. sales pursuant to the terms of our settlement agreement, and revenue from non-recurring engineering (NRE) services for certain OEM customers. The $5.1 million increase in royalty and other revenue for the three months ended September 30, 2017 compared to the three months ended October 1, 2016 primarily related to revenue from NRE services.

Gross Profit. Gross profit consists of total revenue less cost of goods sold. Our gross profit for the three months ended September 30, 2017 and October 1, 2016 was as follows (dollars in thousands):



	Three Months Ended
	September 30, 2017		Gross Profit Percentage		October 1, 2016		Gross Profit Percentage		Increase/ (Decrease)		Percentage Change
Product gross profit	$	116,890	64.5	%	$	102,787	64.1	%	$	14,103	13.7	%
Royalty and other revenue gross profit	11,775		94.8		7,335		100.0		4,440		60.5
Total gross profit	$	128,665	66.4	%	$	110,122	65.7	%	$	18,543	16.8	%

Cost of goods sold includes labor, material, overhead and other similar costs related to the production, supply, distribution and support of our products. Cost of goods sold increased $7.5 million for the three months ended September 30, 2017 compared to the three months ended October 1, 2016, primarily due to increased product revenue and higher production costs associated with the expansion of our manufacturing capacity. Product gross margins increased slightly to 64.5% for the three months ended September 30, 2017 compared to 64.1% for the three months ended October 1, 2016, primarily due to favorable product mix. Royalty and other revenue gross profit increased by $4.4 million for the three months ended September 30, 2017 compared to the three months ended October 1, 2016, primarily due to NRE services.

Selling, General and Administrative. Selling, general and administrative expenses consist primarily of salaries and related expenses for sales, marketing and administrative personnel, sales commissions, advertising and promotion costs, professional fees related to legal, accounting and other outside services, public company costs and other corporate expenses. Selling, general and administrative expenses for the three months ended September 30, 2017 and October 1, 2016 were as follows (dollars in thousands):



Selling, General and Administrative
Three Months Ended September 30, 2017	Percentage of Net Revenues	Three Months Ended October 1, 2016	Percentage of Net Revenues	Increase/ (Decrease)	Percentage Change
$65,390	33.8%	$57,845	34.5%	$7,545	13.0%

Selling, general and administrative expenses increased $7.5 million, or 13.0%, for the three months ended September 30, 2017 compared to the three months ended October 1, 2016. This increase was primarily attributable to higher payroll and employee-related expenses of approximately $4.7 million, higher selling and marketing related costs of approximately $1.9 million and higher occupancy costs of approximately $1.0 million Stock-based compensation expense of approximately $4.0 million and $2.5 million was included in selling, general and administrative expenses for the three months ended September 30, 2017 and October 1, 2016, respectively.

Research and Development. Research and development expenses consist primarily of salaries and related expenses for engineers and other personnel engaged in the design and development of our products. These expenses also include third-party fees paid to consultants, prototype and engineering supply expenses and the costs of clinical trials. Research and development expenses for the three months ended September 30, 2017 and October 1, 2016 were as follows (dollars in thousands):

Table of Contents



Research and Development
Three Months Ended September 30, 2017	Percentage of Net Revenues	Three Months Ended October 1, 2016	Percentage of Net Revenues	Increase/ (Decrease)	Percentage Change
$15,300	7.9%	$15,673	9.4%	$(373)	(2.4)%

Research and development expenses decreased $0.4 million, or 2.4%, for the three months ended September 30, 2017 compared to the three months ended October 1, 2016, primarily due to capitalized costs related to customer NRE services of approximately $1.0 million and lower project expenses of approximately $0.3 million, which were offset by higher payroll expenses of approximately $1.0 million. Included in research and development expenses was approximately $0.9 million and $0.8 million of stock-based compensation expense for the three months ended September 30, 2017 and October 1, 2016, respectively.

Non-operating Income (Expense). Non-operating income consists primarily of interest income, interest expense and foreign exchange losses. Non-operating income for the three months ended September 30, 2017 and October 1, 2016 was as follows (dollars in thousands):



Non-operating Income (Expense)
Three Months Ended September 30, 2017	Percentage of Net Revenues	Three Months Ended October 1, 2016	Percentage of Net Revenues	Increase/ (Decrease)	Percentage Change
$287	0.1%	$(546)	(0.3)%	$833	(152.6)%

Non-operating income increased by $0.8 million for the three months ended September 30, 2017 compared to the three months ended October 1, 2016. Non-operating income for the three months ended September 30, 2017 consisted of approximately $0.7 million in net interest income, which was offset by approximately $0.4 million of net realized and unrealized losses on foreign currency denominated transactions. Non-operating income (expense) for the three months ended October 1, 2016 consisted of approximately $0.9 million of interest expense, which was offset by approximately $0.3 million of net realized and unrealized gains on foreign currency denominated transactions.

Provision for Income Taxes. Our provision for income taxes for the three months ended September 30, 2017 and October 1, 2016 was as follows (dollars in thousands)



Provision for Income Taxes
Three Months Ended September 30, 2017	Percentage of Net Revenues	Three Months Ended October 1, 2016	Percentage of Net Revenues	Increase/ (Decrease)	Percentage Change
$9,027	4.7%	$8,285	4.9%	$742	9.0%

For the three months ended September 30, 2017, we recorded a provision for income taxes of approximately $9.0 million, or an effective tax rate of 18.7%, as compared to a provision for income taxes of approximately $8.3 million, or an effective tax rate of 23.0%, for the three months ended October 1, 2016. The decrease in the effective tax rate for the three months ended September 30, 2017 resulted primarily from a discrete tax benefit of approximately $4.9 million related to excess tax benefits realized from stock-based compensation pursuant to Accounting Standards Update No. 2016-09, Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (ASU 2016-09), which substantially exceeded the discrete tax benefit of approximately$2.6 million recorded for such excess tax benefits during the three months ended October 1, 2016.

Comparison of the Nine Months ended September 30, 2017 to the Nine Months ended October 1, 2016

Revenue. Total revenue increased $61.5 million, or 12.0%, to $572.9 million for the nine months ended September 30, 2017 from $511.4 million for the nine months ended October 1, 2016. The following table details our total product revenues by the geographic area to which the products were shipped for each of the nine months ended September 30, 2017 and October 1, 2016 (dollars in thousands):

Table of Contents



	Nine Months Ended
	September 30, 2017				October 1, 2016				Increase/ (Decrease)		Percentage Change
United States	$	370,403	68.3	%	$	345,113	70.7	%	$	25,290	7.3	%
Europe, Middle East and Africa	102,322		18.9		81,887		16.8		20,435		25.0
Asia and Australia	51,801		9.6		46,815		9.6		4,986		10.7
North and South America (excluding United States)	17,644		3.2		14,368		2.9		3,276		22.8
Total product revenue	$	542,170	100.0	%	$	488,183	100.0	%	$	53,987	11.1	%
Royalty and other revenue	30,757				23,241				7,516		69.3
Total revenue	$	572,927			$	511,424			$	61,503	12.0	%

Product revenue increased $54.0 million or 11.1%, to $542.2 million for the nine months ended September 30, 2017 from $488.2 million for the nine months ended October 1, 2016. This increase was primarily due to higher sales of consumables, monitors and semiconductors, which was partially offset by the impact of approximately $1.7 million in unfavorable foreign exchange rate movements from the prior year period that reduced the U.S. Dollar translation of foreign sales that were denominated in various foreign currencies, primarily the British Pound and Japanese Yen. We estimate that our installed base of circuit boards and pulse oximeters increased to approximately 1,566,000 units at September 30, 2017 as compared to 1,482,000 units at October 1, 2016.

Product revenue generated through our direct and distribution sales channels increased $55.1 million, or 13.1%, to $474.4 million for the nine months ended September 30, 2017, compared to $419.3 million for the nine months ended October 1, 2016. Revenues from our OEM channel decreased $1.1 million, or 1.7%, to $67.8 million for the nine months ended September 30, 2017 as compared to $68.9 million for the nine months ended October 1, 2016. Total rainbow^® product revenue increased by $2.8 million, or 5.5%, to $52.6 million for the nine months ended September 30, 2017, compared to $49.8 million for the nine months ended October 1, 2016.

Royalty and other revenue increased by $7.5 million for the nine months ended September 30, 2017 compared to the nine months ended October 1, 2016, primarily due to higher revenue from NRE services.

Gross Profit. Gross profit consists of total revenue less cost of goods sold. Our gross profit for the nine months ended September 30, 2017 and October 1, 2016 was as follows (dollars in thousands):



	Nine Months Ended
	September 30, 2017		Gross Profit Percentage		October 1, 2016		Gross Profit Percentage		Increase/ (Decrease)		Percentage Change
Product gross profit	$	351,190	64.8	%	$	316,229	64.8	%	$	34,961	11.1	%
Royalty and other revenue gross profit	30,045		97.7		23,241		100.0		6,804		29.3
Total gross profit	$	381,235	66.5	%	$	339,470	66.4	%	$	41,765	12.3	%

Cost of goods sold increased $19.7 million for the nine months ended September 30, 2017 compared to the nine months ended October 1, 2016, primarily due to higher product revenue and higher production costs associated with the expansion of our manufacturing capacity. Product gross margins remained unchanged at 64.8% for the nine months ended September 30, 2017 and October 1, 2016. Royalty and other revenue gross profit increased by $6.8 million for the nine months ended September 30, 2017 compared to the nine months ended October 1, 2016, primarily due to NRE services.

Selling, General and Administrative. Selling, general and administrative expenses for the nine months ended September 30, 2017 and October 1, 2016 were as follows (dollars in thousands):



Selling, General and Administrative
Nine Months Ended September 30, 2017	Percentage of Net Revenues	Nine Months Ended October 1, 2016	Percentage of Net Revenues	Increase/ (Decrease)	Percentage Change
$197,339	34.4%	$184,244	36.0%	$13,095	7.1%

Selling, general and administrative expenses increased $13.1 million, or 7.1%, for the nine months ended September 30, 2017 compared to the nine months ended October 1, 2016. This increase was primarily attributable to higher payroll and employee-related expenses of approximately $10.3 million, higher marketing-related costs of approximately $4.6 million and higher

Table of Contents

occupancy costs of approximately $2.4 million, which were partially offset by approximately $4.0 million of lower legal fees. Stock-based compensation expense of approximately $8.7 million and $7.3 million was included in selling, general and administrative expenses for the nine months ended September 30, 2017 and October 1, 2016, respectively.

Research and Development. Research and development expenses for the nine months ended September 30, 2017 and October 1, 2016 were as follows (dollars in thousands):



Research and Development
Nine Months Ended September 30, 2017	Percentage of Net Revenues	Nine Months Ended October 1, 2016	Percentage of Net Revenues	Increase/ (Decrease)	Percentage Change
$45,859	8.0%	$44,856	8.8%	$1,003	2.2%

Research and development expenses increased $1.0 million, or 2.2%, for the nine months ended September 30, 2017 compared to the nine months ended October 1, 2016, primarily due to higher payroll-related costs of approximately $3.0 million, higher project related costs of $0.3 million, higher outside services costs of approximately $0.2 million and higher occupancy costs of $0.2 million, which were partially offset by capitalized costs related to customer NRE services of approximately $2.9 million. Included in research and development expenses was approximately $2.3 million and $2.1 million of stock-based compensation expense for the nine months ended September 30, 2017 and October 1, 2016, respectively.

Non-operating Income. Non-operating income consists primarily of interest income, interest expense and foreign exchange losses. Non-operating income for the nine months ended September 30, 2017 and October 1, 2016 was as follows (dollars in thousands):



Non-operating Income
Nine Months Ended September 30, 2017	Percentage of Net Revenues	Nine Months Ended October 1, 2016	Percentage of Net Revenues	Increase/ (Decrease)	Percentage Change
$1,319	0.2%	$423	0.1%	$896	211.8%

Non-operating income increased by $0.9 million for the nine months ended September 30, 2017 compared to the nine months ended October 1, 2016. Non-operating income for the nine months ended September 30, 2017 consisted of approximately $1.6 million in net interest income, which was partially offset by approximately $0.2 million of net realized and unrealized gains on foreign currency denominated transactions. Non-operating income for the nine months ended October 1, 2016 consisted of approximately $2.6 million of net realized and unrealized gains on foreign currency denominated transactions and an approximate $0.3 million gain resulting from our deconsolidation of Cercacor, which was partially offset by $2.7 million of interest expense.

Provision for Income Taxes. Our provision for income taxes for the nine months ended September 30, 2017 and October 1, 2016 was as follows (dollars in thousands):



Provision for Income Taxes
Nine Months Ended September 30, 2017	Percentage of Net Revenues	Nine Months Ended October 1, 2016	Percentage of Net Revenues	Increase/ (Decrease)	Percentage Change
$8,108	1.4%	$25,420	5.0%	$(17,312)	(68.1)%

For the nine months ended September 30, 2017, we recorded a provision for income taxes of approximately $8.1 million, or an effective tax benefit rate of 5.8%, as compared to a provision for income taxes of approximately $25.4 million, or an effective tax rate of 22.9%, for the nine months ended October 1, 2016. The decrease in the tax rate for the nine months ended September 30, 2017 resulted primarily from a discrete tax benefit of approximately $35.1 million related to excess tax benefits realized from stock-based compensation pursuant to ASU 2016-09, which substantially exceeded the discrete tax provision of approximately $7.7 million recorded for such excess tax benefits during the nine months ended October 1, 2016. Partially offsetting this discrete tax benefit was an increase in our effective tax rate resulting from differences in our expected fiscal 2017 geographic composition of our pre-tax income compared to our expected fiscal 2016 geographic composition as of October 1, 2016.

Table of Contents

Liquidity and Capital Resources

Our principal sources of liquidity consist of our existing cash and cash equivalent balances, funds expected to be generated from operations and funds available under our revolving credit agreement. At September 30, 2017, we had approximately $374.0 million in working capital and approximately $289.9 million in cash and cash equivalents as compared to approximately $286.9 million in working capital and approximately $306.0 million in cash and cash equivalents at December 31, 2016. We carry cash equivalents at cost that approximates fair value. We currently do not maintain an investment portfolio but have the ability to invest in various security holdings, types and maturities that meet credit quality standards in accordance with our investment guidelines.

As of September 30, 2017, we had cash totaling $170.8 million held outside of the U.S., of which approximately $18.3 million was accessible without additional tax cost and approximately $152.5 million was accessible at an incremental estimated tax cost of approximately $47.4 million. In managing our day-to-day liquidity and capital structure, we do not rely on foreign earnings as a source of funds. We currently have sufficient funds on-hand and available under our line of credit to fund our domestic operations and do not anticipate the need to repatriate funds associated with our permanently reinvested foreign earnings. In the event funds that are treated as permanently reinvested are repatriated, we may be required to accrue and pay additional U.S. taxes with respect to any such repatriation.

We are currently evaluating the collectability of certain amounts that have been paid to our appointed foreign agent in connection with a foreign government tender that have not been timely remitted by such agent to us. As of September 30, 2017, the net amount due to us from such agent was approximately $8.6 million. See Note 6 to the condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information.

Our 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) provides for up to $250.0 million in borrowings in multiple currencies, with an option, subject to certain conditions, for us to increase the aggregate borrowing capacity to up to $550.0 million in the future. The Restated Credit Facility also provides for a sublimit of up to $50.0 million for the issuance of letters of credit and a sublimit of $125.0 million in specified foreign currencies. All unpaid principal under the Restated Credit Facility will become due and payable on January 8, 2021. See Note 10 to the condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information.

Cash Flows

The following table summarizes our cash flows (in thousands):