Masimo Earnings 2018-09-29

MASI 10Q Quarterly Report

Balance Sheet	Income Statement	Cash Flow

10-Q 1 masi-20180929x10q.htm 10-Q Document

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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 29, 2018



¨	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 every Interactive Data File required to be submitted 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 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	¨	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 29, 2018
Common stock, $0.001 par value		52,995,786

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MASIMO CORPORATION

FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 29, 2018

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PART I. Financial Information

Item 1.	Financial Statements (unaudited):

	Condensed Consolidated Balance Sheets as of September 29, 2018 and December 31, 2017	3

	Condensed Consolidated Statements of Operations for the three and nine months ended September 29, 2018 and September 30, 2017	4

	Condensed Consolidated Statements of Comprehensive Income for the three and nine months ended September 29, 2018 and September 30, 2017	5

	Condensed Consolidated Statements of Cash Flows for the nine months ended September 29, 2018 and September 30, 2017	6

	Notes to Condensed Consolidated Financial Statements	7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	32

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	42

Item 4.	Controls and Procedures	43

PART II. Other Information

Item 1.	Legal Proceedings	44

Item 1A.	Risk Factors	44

Item 6.	Exhibits	70

Signatures		71

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

MASIMO CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited, in thousands, except par values)



	September 29, 2018			December 30, 2017 As Adjusted
ASSETS
Current assets
Cash and cash equivalents	$	493,488		$	315,302
Accounts receivable, net of allowance for doubtful accounts of $1,681 and $2,116 at September 29, 2018 and December 30, 2017, respectively.	101,024			118,532
Inventories	92,952			92,259
Other current assets	48,283			33,601
Total current assets	735,747			559,694
Deferred costs and other contract assets	119,523			109,256
Property and equipment, net	164,605			164,096
Intangible assets, net	28,462			27,123
Goodwill	23,454			20,617
Deferred tax assets	20,209			19,981
Other non-current assets	3,859			4,668
Total assets	$	1,095,859		$	905,435
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable	$	38,940		$	33,780
Accrued compensation	41,293			39,515
Accrued and other current liabilities	27,802			24,254
Deferred revenue and other contract-related liabilities, current	35,592			32,105
Total current liabilities	143,627			129,654
Other non-current liabilities	39,834			51,757
Total liabilities	183,461			181,411
Commitments and contingencies
Stockholders’ equity
Preferred stock, $0.001 par value; 5,000 shares authorized; 0 shares issued and outstanding at September 29, 2018 and December 30, 2017	—			—
Common stock, $0.001 par value; 100,000 shares authorized; 52,996 and 51,636 shares issued and outstanding at September 29, 2018 and December 30, 2017, respectively	53			52
Treasury stock, 15,255 and 15,059 shares at September 29, 2018 and December 30, 2017, respectively	(489,026		)	(472,536		)
Additional paid-in capital	523,051			461,494
Accumulated other comprehensive loss	(5,818		)	(2,941		)
Retained earnings	884,138			737,955
Total stockholders’ equity	912,398			724,024
Total liabilities and stockholders’ equity	$	1,095,859		$	905,435

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

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MASIMO CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited, in thousands, except per share amounts)



	Three Months Ended					Nine Months Ended
	September 29, 2018			September 30, 2017 As Adjusted		September 29, 2018		September 30, 2017 As Adjusted
Revenue:
Product	$	202,068		$	179,696	$	608,461	$	541,889
Royalty and other revenue	8,515			13,664		26,696		40,420
Total revenue	210,583			193,360		635,157		582,309
Cost of goods sold	69,830			69,295		208,596		198,929
Gross profit	140,753			124,065		426,561		383,380
Operating expenses:
Selling, general and administrative	72,670			65,704		215,263		198,460
Research and development	19,442			15,300		57,160		45,859
Total operating expenses	92,112			81,004		272,423		244,319
Operating income	48,641			43,061		154,138		139,061
Non-operating income	1,028			287		4,080		1,319
Income before provision (benefit) for income taxes	49,669			43,348		158,218		140,380
Provision (benefit) for income taxes	(7,457		)	7,495		11,609		7,856
Net income	$	57,126		$	35,853	$	146,609	$	132,524

Net income per share:
Basic	$	1.09		$	0.69	$	2.78	$	2.57
Diluted	$	1.02		$	0.64	$	2.59	$	2.37

Weighted-average shares used in per share calculations:
Basic	52,432			52,079		52,726		51,469
Diluted	56,237			56,163		56,555		55,967

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

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MASIMO CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited, in thousands)



	Three Months Ended				Nine Months Ended
	September 29, 2018		September 30, 2017 As Adjusted		September 29, 2018			September 30, 2017 As Adjusted
Net income	$	57,126	$	35,853	$	146,609		$	132,524
Other comprehensive income, net of tax:
Unrealized gains (losses) from foreign currency translation adjustments	179		1,404		(2,877		)	4,270
Comprehensive income	$	57,305	$	37,257	$	143,732		$	136,794

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

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MASIMO CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited, in thousands)



	Nine Months Ended
	September 29, 2018			September 30, 2017 As Adjusted
Cash flows from operating activities:
Net income	$	146,609		$	132,524
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	15,959			14,384
Stock-based compensation	19,695			11,192
Loss on disposal of property, equipment and intangibles	641			420
Benefit from doubtful accounts	(401		)	—
Benefit from deferred income taxes	(6,747		)	—
Changes in operating assets and liabilities:
Decrease (increase) in accounts receivable	17,384			(17,277		)
Increase in inventories	(1,069		)	(26,354		)
Increase in other current assets	(15,606		)	(9,095		)
Increase in deferred costs and other contract assets	(10,400		)	(9,175		)
Decrease (increase) in other non-current assets	496			(3,525		)
Increase in accounts payable	4,090			3,748
Increase (decrease) in accrued compensation	1,919			(9,094		)
Increase in accrued liabilities	5,695			393
Increase (decrease) in income tax payable	410			(71,177		)
Increase (decrease) in deferred revenue and other contract-related liabilities	3,981			(11,039		)
(Decrease) increase in other non-current liabilities	(6,351		)	1,456
Net cash provided by operating activities	176,305			7,381
Cash flows from investing activities:
Purchases of property and equipment, net	(12,299		)	(37,830		)
Increase in intangible assets	(4,718		)	(2,220		)
Business combination, net of cash acquired, and acquisitions of equity investments	(4,000		)	(1,145		)
Proceeds from sale of equity investments	453			—
Net cash used in investing activities	(20,564		)	(41,195		)
Cash flows from financing activities:
Repayments of capital lease obligations	—			(71		)
Proceeds from issuance of common stock	42,297			55,709
Payroll tax withholdings on behalf of employees for vested equity awards	(168		)	—
Repurchases of common stock	(18,478		)	(42,608		)
Net cash provided by financing activities	23,651			13,030
Effect of foreign currency exchange rates on cash	(1,230		)	3,112
Net increase in cash, cash equivalents, and restricted cash	178,162			(17,672		)
Cash, cash equivalents and restricted cash at beginning of period	315,483			308,198
Cash, cash equivalents and restricted cash at end of period	$	493,645		$	290,526

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

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. Description of the Company

Masimo Corporation (the Company) is a global medical technology company that develops, manufactures and markets a variety of noninvasive patient monitoring technologies. The Company’s mission is to improve patient outcomes and reduce the cost of care. 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 rainbow^® Pulse CO-Oximetry, with its ability to measure and monitor carboxyhemoglobin (SpCO^®), methemoglobin (SpMet^®), total hemoglobin concentration (SpHb^®), fractional arterial oxygen saturation (SpfO₂^™), Oxygen Content (SpOC^™), Pleth Variability Index (PVi^®), rainbow^® Pleth Variability Index (RPVi^™), respiration rate from the pleth (RRp^®) and Oxygen Reserve Index (ORi^™), as well as acoustic respiration monitoring (RRa^®), electrical brain function monitoring (SedLine^®) and optical gas monitoring. The Company also developed the Root^™ patient monitoring and connectivity platform, the Radical-7^®and Rad-97^™ bedside and portable patient monitors, the Radius-7^® wearable wireless patient monitor 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. This technology is supported by a substantial intellectual property portfolio that the Company has built through internal development and, to a lesser extent, acquisitions and license agreements.

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) have been condensed or omitted pursuant to such rules and regulations. The 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 30, 2017 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 30, 2017 (fiscal year 2017), filed with the SEC on February 28, 2018. The results for the nine months ended September 29, 2018 are not necessarily indicative of the results to be expected for the fiscal year ending December 29, 2018 (fiscal year 2018) or for any other interim period or for any future year.

As further discussed below in this Note 2 to these condensed consolidated financial statements, the Company adopted Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) No. 2014-09, Revenue (Topic 606): Revenue from Contracts with Customers (ASU 2014-09) effective December 31, 2017. All prior period amounts and disclosures set forth in this Quarterly Report on Form 10-Q have been updated to comply with the new standard, as indicated by the “as adjusted” notation.

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.

^{___________________________________________}

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

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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 2018 is a 52 week fiscal year. All references to years in these notes to condensed consolidated financial statements are fiscal years unless otherwise noted.

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, royalty revenues, deferred revenue, deferred costs, 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 29, 2018. The Company carries cash and cash equivalents at cost, which approximates fair value. As of September 29, 2018 and December 30, 2017, the Company had an insignificant amount of other financial assets that were required to be measured under the fair value hierarchy, the measurement of which were based on level 1 and level 2 inputs.

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 an 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.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

Inventories

Inventories are stated at the lower of cost or net realizable value. Cost is determined using a standard cost method, which approximates the first in, first out method, and includes material, labor and overhead costs. Inventory reserves are recorded for inventory items that have become excess or obsolete or are no longer used in current production and for inventory items that have a market price less than carrying value in inventory.

Property and Equipment

Property and equipment are stated at cost. Depreciation is calculated using the straight-line method over estimated useful lives as follows:



	Useful Lives
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 10 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 29, 2018 and September 30, 2017 were $0.3 million and $0.4 million, respectively. As of September 29, 2018, 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.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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 a quantitative analysis is unnecessary. However, if the Company concludes otherwise, or if the Company elects to bypass the qualitative analysis, then the Company must perform a quantitative analysis that compares the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill is not considered impaired; otherwise, a goodwill impairment loss is recognized for the lesser of:

(a) the amount that the carrying amount of a reporting unit exceeds its fair value; or (b) the amount of the goodwill allocated to that reporting unit. The annual impairment test is performed during the fourth fiscal quarter.

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

No impairment of goodwill, intangible assets or other long-lived assets was recorded during each of the three and nine months ended September 29, 2018 and September 30, 2017.

Revenue Recognition and Deferred Revenue

Effective December 31, 2017, the Company adopted ASU 2014-09, Revenue (Topic 606): Revenue from Contracts with Customers. Accounting Standards Codification (ASC) Topic 606 (ASC 606) provides a single, principles-based five-step model to be applied to all contracts with customers. ASC 606 generally provides for the recognition of revenue in an amount that reflects the consideration to which the Company expects to be entitled, net of allowances for estimated returns, discounts or sales incentives, as well as taxes collected from customers that are remitted to government authorities, when control over the promised goods or services are transferred to the customer.

The Company derives the majority of its product revenue from four primary sources: (i) direct sales under long-term sensor contracts (LT Sensor Contracts) 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 customers; and (iv) sales of integrated circuit boards to OEM customers who incorporate the Company’s embedded software technology into their multiparameter monitoring devices. Subject to customer credit considerations, the majority of such sales are made on open account using industry standard payment terms based on the geography within which the specific customer is located.

The Company enters into agreements to sell its monitoring solutions and services, sometimes as a part of arrangements with multiple performance obligations that include various combinations of product sales, equipment leases and services. In the case of contracts with multiple performance obligations, the authoritative guidance provides that the total consideration be allocated to each performance obligation on the basis of relative standalone selling prices. When a standalone selling price is not readily observable, the Company estimates the standalone selling price 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 other market conditions.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

While the majority of the Company’s revenue contracts and transactions contain standard business terms and conditions, there are some transactions that contain non-standard business terms and conditions. As a result, contract interpretation, judgment and analysis is required to determine the appropriate accounting, including: (i) the amount of the total consideration, including variable consideration, (ii) how the arrangement consideration should be allocated to each performance obligation when multiple performance obligations exist, including the determination of standalone selling price, (iii) when to recognize revenue on the performance obligations, and (iv) whether uncompleted performance obligations are essential to the functionality of the completed performance obligations. Changes in judgments on these assumptions and estimates could materially impact the timing of revenue recognition.

Sales under LT Sensor Contracts are generally structured such that the Company agrees to provide at no up-front charge certain monitoring-related equipment, software, installation, training and/or warranty support in exchange for the hospital’s agreement to purchase sensors over the term of the agreement, which generally ranges from three to six years. The Company generally recognizes revenue for performance obligations related to software parameters under LT Sensor Contracts with fixed annual commitments at the time such software is delivered to the customer. Revenue allocable to performance obligations related to sensor sales and monitoring-related equipment leased under LT Sensor Contracts is generally recognized as the sensors are delivered to the customer over the life of the contract.

Revenue from direct sales of products to the Company’s end-user hospitals, emergency medical response organizations and other direct customers, as well as to its distributors, is generally recognized upon shipment or delivery to the customer based on the terms of the contract or underlying purchase order.

The Company also earns revenue from the sale of integrated circuit boards and other products, as well as from software parameter 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 provides certain customers with various sales incentives that may take the form of discounts or rebates. The Company estimates and provides allowances for these programs as a reduction to revenue at the time of sale. 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. The Company estimates the revenue constraints related to these forms of variable consideration based on various factors, including expected purchasing volumes, prior sales and returns history, and specific contractual terms and limitations.

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 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. For the three months ended September 29, 2018 and September 30, 2017, the Company recognized royalty revenue pursuant to this agreement of approximately $8.1 million and $8.4 million, respectively. For the nine months ended September 29, 2018 and September 30, 2017, the Company recognized royalty revenue pursuant to this agreement of approximately $25.3 million and $25.7 million, respectively.

From time-to-time, the Company also recognizes revenue related to non-recurring engineering (NRE) services provided to certain OEM customers. NRE revenue is generally recognized on a proportionate basis as the costs of performing such services are incurred by the Company.

Shipping and Handling Costs and Fees

All shipping and handling costs are expensed as incurred and are recorded as a component of cost of goods sold in the accompanying consolidated statements of operations. Charges for shipping and handling billed to customers are included as a component of product revenue.

Taxes Collected From Customers and Remitted to Governmental Authorities

The Company’s policy is to present revenue net of taxes collected from customers and remitted to governmental authorities.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

Deferred Costs and Other Contract Assets

The costs of monitoring-related equipment leased to hospitals under LT Sensor Contracts are generally deferred and amortized to cost of goods sold over the life of the underlying contracts. Some of the Company’s LT 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 contractual incentive payments are generally deferred and amortized on a straight-line basis as contra-revenue over the life of the underlying LT Sensor Contract.

The Company records an unbilled contract receivable related to software delivered under LT Sensor Contracts with fixed annual commitments until such amounts are billed to the customer, which generally occurs at the time of delivery of the sensors over the term of the LT Sensor Contract.

The incremental costs of obtaining a contract with a customer are capitalized and deferred if the Company expects such costs to be recoverable over the life of the contract and the contract term is greater than one year. Such deferred costs generally relate to certain incentive sales commissions earned by the Company’s internal sales team in connection with the execution of LT Sensor Contracts and are amortized to expense over the expected term of the underlying contract.

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 LT Sensor Contract. Revenue related to extended warranty coverage is recognized over the extended life of the contract, which is reasonably expected to be the period over which such services will be provided. The related extended warranty costs are expensed as incurred.

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



	Nine Months Ended
	September 29, 2018			September 30, 2017
Warranty accrual, beginning of period	$	1,149		$	910
Accrual for warranties issued	943			712
Changes to pre-existing warranties (including changes in estimates)	779			(116		)
Settlements made	(974		)	(486		)
Warranty accrual, end of period	$	1,897		$	1,020

Litigation Costs and Contingencies

The Company records a charge equal to at least the minimum estimated liability for a loss contingency or litigation settlement when both of the following conditions are met: (i) information available prior to issuance of the financial statements indicates that it is probable that a liability had been incurred at the date of the financial statements, and (ii) the range of loss can be reasonably estimated. The determination of whether a loss contingency or litigation settlement is probable or reasonably possible involves a significant amount of management judgment, as does the estimation of the range of loss given the nature of contingencies. Liabilities related to litigation settlements with multiple elements are recorded based on the fair value of each element. Legal and other litigation related expenses are recognized as the services are provided. The Company records insurance and other indemnity recoveries for litigation expenses when both of the following conditions are met: (a) the recovery is probable, and (b) collectability is reasonably assured. Insurance recoveries are only recorded to the extent the litigation costs to which they relate have been incurred and recognized in the financial statements.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

Comprehensive Income

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 29, 2018
Accumulated other comprehensive loss, beginning of period	$	(2,941	)
Unrealized gains from foreign currency translation	(2,877		)
Accumulated other comprehensive loss, end of period	$	(5,818	)

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 29, 2018, weighted options to purchase 0.6 million and 1.1 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 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. Certain RSUs are 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 each of September 29, 2018 and September 30, 2017, 2.7 million weighted average shares related to such RSUs have been excluded from the calculation of potential shares for each of the three and nine months ended September 29, 2018 and September 30, 2017.

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 29, 2018		September 30, 2017 As Adjusted		September 29, 2018		September 30, 2017 As Adjusted
Net income	$	57,126	$	35,853	$	146,609	$	132,524
Basic net income per share:
Weighted-average shares outstanding - basic	52,432		52,079		52,726		51,469
Net income per basic share	$	1.09	$	0.69	$	2.78	$	2.57
Diluted net income per share:
Weighted-average shares outstanding - basic	52,432		52,079		52,726		51,469
Diluted share equivalent: stock options and RSUs	3,805		4,084		3,829		4,498
Weighted-average shares outstanding - diluted	56,237		56,163		56,555		55,967
Net income per diluted share	$	1.02	$	0.64	$	2.59	$	2.37

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

Supplemental Cash Flow Information

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



	Nine Months Ended
	September 29, 2018		September 30, 2017
Cash paid during the year for:
Interest	$	184	$	432
Income taxes	29,003		86,759

Noncash investing and financing activities:
Unpaid purchases of property, plant and equipment	$	2,023	$	3,349
Unsettled common stock proceeds from option exercises	259		113
Unsettled stock repurchases	—		2,653

Reconciliation of cash, cash equivalents and restricted cash:
Cash and cash equivalents	$	493,488	$	289,944
Restricted cash	157		582
Total cash, cash equivalents and restricted cash shown in the statement of cash flow	$	493,645	$	290,526

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 Adopted Accounting Pronouncements

In June 2018, the FASB issued ASU No. 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Nonemployee Shares-Based Payment Accounting (ASU 2018-07). The new standard aligns the measurement and classification guidance for share-based payments to nonemployees with the guidance for share-based payments to employees. Under this guidance, the measurement of the equity-classified nonemployee awards will be fixed at the grant date and the term used for measurement can be the expected term or the contractual term. ASU 2018-07 is effective for annual and interim fiscal reporting periods beginning after December 15, 2018. The Company early adopted this standard during the three months ended September 29, 2018 and such adoption did not have a material impact on its consolidated financial statements.

In March 2018, the FASB issued ASU No. 2018-05, Income Taxes (Topic 740) Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118 (ASU 2018-05). ASU 2018-05 amends certain material in ASC Topic 740 for the income tax accounting implications of the recently issued Tax Cuts and Jobs Act of 2017. The Company early adopted this standard when it was issued.

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. The standard required companies to apply a modified retrospective approach with a cumulative catch-up adjustment to opening retained earnings in the period of adoption. Accordingly, the Company recorded a $0.4 million decrease to retained earnings and a corresponding increase to deferred tax assets of $0.1 million, and a decrease to prepaid taxes of $0.5 million as of December 31, 2017.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

Effective December 31, 2017, the Company adopted ASU 2014-09, Revenue (Topic 606): Revenue from Contracts with Customers (ASU 2014-09). ASC 606 provides a single, principles-based five-step model to be applied to all contracts with customers, and generally provides for the recognition of revenue in an amount that reflects the considerations to which the Company expects to be entitled when control over the promised goods or services are transferred to the customer. ASC 606 also enhances disclosures about revenue, provides additional guidance for transactions that were not previously addressed comprehensively and improves guidance for multiple-element arrangements. In addition, ASC 606 includes Subtopic 340-40, Other Assets and Deferred Costs - Contracts with Customers, which requires the deferral of incremental costs of obtaining a contract with a customer.

The Company adopted ASC 606 utilizing the full retrospective method of transition, which requires the Company to restate certain previously reported results, including the impact on the provision for income taxes. Adoption of the new standard resulted in changes to the Company’s accounting policies for revenue recognition and related cost of goods sold, as well as the capitalization and deferral of certain commission expenses, and a cumulative increase to retained earnings of approximately $23.9 million and $17.1 million as of December 31, 2016 and December 30, 2017, respectively. The areas impacted by ASC 606 include: (i) the acceleration of certain revenue from product sales to distributors that was previously deferred under the “sell-through” method; (ii) the acceleration of revenue related to certain software/parameter sales; (iii) the aggregation of all contract modifications occurring prior to the beginning of the earliest period presented; (iv) the acceleration of costs related to equipment for which control transfers up-front under certain contracts, the future consideration for which will now be treated as an optional purchase; (v) the capitalization and amortization of certain contract-related costs that were previously expensed when incurred; and (vi) the corresponding income tax effects related to these adjustments.

The Company applied the new standard using certain practical expedients, including: (i) excluding disclosures of transaction prices allocated to remaining performance obligations when the Company expects to recognize such revenue for all periods prior to the date of initial application of ASC 606; (ii) not adjusting the promised amount of consideration for the effects of a significant financing component when the Company expects, at contract inception, that the period between the Company’s transfer of a promised product or service to a customer and when the customer pays for that product or service will be one year or less; (iii) expensing costs as incurred for costs to obtain a contract when the amortization period would have been one year or less; (iv) not recasting revenue for contracts that begin and end in the same fiscal year; and (v) not assessing whether promised goods or services are performance obligations if they are immaterial in the context of the contract with the customer.

Pursuant to the full retrospective method of adoption under ASC 606, the Company has adjusted certain amounts previously reported in its unaudited condensed consolidated financial statements.

During the fourth quarter of the fiscal year ended December 30, 2017, the Company early adopted ASU No. 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash (ASU 2016-18). The new standard was 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. The Company has restated interim periods prior to the date of adoption to reflect the adoption of this ASU.

The reconciliations below reflect the adoption of ASC 606, the adoption of ASU 2016-16, the adoption of ASU 2016-18 and certain other immaterial reclassifications (in thousands, except per share amounts):



Condensed Consolidated Balance Sheet:	December 30, 2017
	As Previously Reported		Adjustments			As Adjusted
Accounts receivable	$	121,309	$	(2,777	)	$	118,532
Inventories	95,944		(3,685		)	92,259
Other current assets	31,563		2,038			33,601
Deferred costs and other contract assets	99,600		9,656			109,256
Deferred tax assets	23,898		(3,917		)	19,981
Other non-current assets	10,782		(6,114		)	4,668
Accrued and other liabilities	42,344		(18,090		)	24,254
Deferred revenue and other contract liabilities, current	35,929		(3,824		)	32,105
Retained earnings	720,842		17,113			737,955

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)



Condensed Consolidated Statement of Operations:	Three Months Ended September 30, 2017
	As Previously Reported		Adjustments			As Adjusted
Product revenue	$	181,271	$	(1,575	)	$	179,696
Royalty and other revenue	12,421		1,243			13,664
Cost of goods sold	65,027		4,268			69,295
Selling, general and administrative	65,390		314			65,704
Provision (benefit) for income taxes	9,027		(1,532		)	7,495
Net income	39,235		(3,382		)	35,853

Net income per share:
Basic	$	0.75	$	(0.06	)	$	0.69
Diluted	$	0.70	$	(0.06	)	$	0.64



Condensed Consolidated Statement of Operations:	Nine Months Ended September 30, 2017
	As Previously Reported		Adjustments			As Adjusted
Product revenue	$	542,170	$	(281	)	$	541,889
Royalty and other revenue	30,757		9,663			40,420
Cost of goods sold	191,692		7,237			198,929
Selling, general and administrative	197,339		1,121			198,460
Provision (benefit) for income taxes	8,108		(252		)	7,856
Net income	131,248		1,276			132,524

Net income per share:
Basic	$	2.55	$	0.02		$	2.57
Diluted	$	2.35	$	0.02		$	2.37



Condensed Consolidated Statements of Cash Flows:	Nine Months Ended September 30, 2017
	As Previously Reported			Adjustments			As Adjusted
Cash flows from operating activities:
Net income	$	131,248		$	1,276		$	132,524
Adjustments to reconcile net income to net cash provided by operating activities:
Increase in inventories	(25,998		)	(356		)	(26,354		)
Decrease in other current assets	(11,099		)	2,004			(9,095		)
Decrease in deferred costs and other contract assets	(16,166		)	6,991			(9,175		)
Increase in other non-current assets	(964		)	(2,561		)	(3,525		)
Increase in accrued liabilities	(66,918		)	67,311			393
Decrease in income taxes payable	—			(71,177		)	(71,177		)
Decrease in deferred revenue and other contract liabilities	(5,905		)	(5,134		)	(11,039		)

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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, 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 adopted this standard during the nine months ended September 29, 2018 and such adoption did not have a material impact on the Company’s consolidated financial statements.

Recently Issued Accounting Pronouncements

In July 2018, the FASB issued ASU No. 2018-09, Codification Improvements (ASU 2018-09). This new standard amends, clarifies, corrects errors in and makes minor improvements to the ASC. The transition and effective date guidance is based on the facts and circumstances of each amendment. Some of the amendments of ASU 2018-09 do not require transition guidance and will be effective upon issuance. However, many of the amendments of ASU 2018-09 that contain transition guidance are effective for the Company for annual 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.

In February 2018, the FASB issued ASU No. 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (ASU 2018-02). The new standard allows a reclassification from accumulated other comprehensive income to retained earnings for the tax effects resulting from “An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018” (the Reconciliation Act) that are stranded in accumulated other comprehensive income. The new standard also requires certain disclosures about stranded tax effects. The new standard, however, does not change the underlying guidance that requires that the effect of a change in tax laws or rates be included in income from continuing operations. ASU 2018-02 is effective for annual and interim periods beginning after December 15, 2018, with early adoption permitted. ASU 2018-02 must be applied either in the period of adoption or retrospectively to each period in which the effect of the change in the U.S. federal corporate income tax rate in the Reconciliation Act is recognized. 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.

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (ASU 2016-02). ASU 2016-02 requires lessees to recognize most leases on their balance sheets but continue to recognize lease expenses in their statement of operations in a manner similar to current practice. ASU 2016-02 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 statement of operations. ASU 2016-02 is effective for annual and interim fiscal reporting periods beginning after December 15, 2018, and early application is permitted. In July 2018, the FASB issued ASU No. 2018-10, Codification Improvements to Topic 842, Leases (ASU 2018-10). ASU 2018-10 provides clarification on the rate implicit in the lease, impairment of the net investment in the lease, lessee reassessment of lease classification, lessor reassessment of lease term and purchase options, variable payments that depend on an index or rate and certain transition adjustments. ASU 2018-10 is effective for annual and interim fiscal reporting periods beginning after December 15, 2018. Also in July 2018, the FASB issued ASU No. 2018-11, Leases (Topic 842): Targeted Improvements (ASU 2018-11). ASU 2018-11 provides a transition option and a practical expedient for lessors to aid in cost reductions and complexity of implementing the new standard. Under the transition option, entities can opt to continue to apply the legacy guidance in ASC Topic 840, Leases (ASC 840), including its disclosure requirements. Entities that elect this option will make only annual disclosures for the comparative periods because ASC 840 does not require interim disclosures.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

Entities that elect this transition option still adopt the new leases standard using the modified retrospective transition method required by the standard, but they recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption rather than in the earliest period presented. The optional practical expedient allows lessors to elect, by class of underlying asset, to not separate non-lease components from the associated lease components if the non-lease components otherwise would be accounted for in accordance with ASC 606 and both of the following criteria are met: (1) the lease component and the associated non-lease components have the same timing and pattern of transfer and(2) the lease component, if accounted for separately, would be classified as an operating lease. ASU 2018-11 is effective for annual and interim fiscal reporting periods beginning after December 15, 2018. The Company is currently evaluating the expected impact of these standards on its consolidated financial statements, but anticipates that, among other things, the required recognition by a lessee of a lease liability and related right-of-use asset for operating leases will increase both the assets and liabilities recognized and reported on its balance sheet as of the adoption date. In addition, the Company anticipates that the classification of certain leases for which the Company is the lessor will change under the new guidance for most circumstances, resulting in the acceleration of revenue under certain contracts, as well as 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, as both a lessee and lessor, during the next three to six months.

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 certain other agreements with Cercacor. See Note 4 to these condensed consolidated financial statements for a description of the Company’s various business relationships with Cercacor.

The Company has determined that it is not the primary beneficiary of Cercacor as it does not have the power to direct the activities of Cercacor that most significantly impact Cercacor’s economic performance and has no obligation to absorb Cercacor’s losses.

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. Aggregate liabilities to Cercacor arising under the Cross-Licensing Agreement were $3.0 million and $2.1 million for the three months ended September 29, 2018 and September 30, 2017, respectively. Aggregate liabilities to Cercacor arising under the Cross-Licensing Agreement were $7.5 million and $5.6 million for the nine months ended September 29, 2018 and September 30, 2017, 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 for each of the three and nine months ended September 29, 2018 and September 30, 2017.

•

Sublease Agreement - In March 2016, the Company entered into a sublease agreement with Cercacor for approximately 16,830 square feet of excess office and laboratory space located at 40 Parker, Irvine, California (Cercacor Sublease). The Cercacor Sublease began on May 1, 2016 and expires on November 30, 2019. The Company recognized $0.1 million in sublease income for each of the three months ended September 29, 2018 and September 30, 2017. The Company recognized $0.3 million in sublease income for each of the nine months ended September 29, 2018 and September 30, 2017.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

Net amounts due to Cercacor at each of September 29, 2018 and December 30, 2017 were $2.1 million and $1.5 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. In addition, the Company’s Executive Vice President (EVP) and General Counsel is a Director and also serves as the Secretary of the Masimo Foundation and the Company’s EVP, Chief Financial Officer (CFO) serves as the Treasurer of the Masimo Foundation. During the three and nine months ended September 29, 2018, the Company pledged $1.0 million to the Masimo Foundation.

The Company’s CEO is the Chairman of both the Patient Safety Movement Foundation (PSMF), a non-profit organization that was founded in 2013 to work with hospitals, medical technology companies and patient advocates to unite the healthcare ecosystem and eliminate the more than 200,000 U.S. preventable hospital deaths that occur every year by 2020, and the Patient Safety Movement Coalition (PSMC), a not-for-profit social welfare organization that was founded in 2013 to promote patient safety legislation. The Company’s EVP, CFO serves as the Treasurer of both PSMF and PSMC, and the Company’s EVP and General Counsel serves 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. Further, he serves on the boards of directors of Children’s Hospital of Orange County and CHOC Children’s at Mission Hospital, two non-profit hospitals devoted exclusively to caring for children, both of which are also customers of the Company.

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 Company’s CEO for lease on a time-sharing basis. The Company charges the Company’s CEO for personal use based on agreed upon reimbursement rates. For the three and nine months ended September 29, 2018, the Company charged the Company’s CEO $0.1 million and $0.2 million, respectively, related to such reimbursements.

5. Inventories

Inventories consist of the following (in thousands):



	September 29, 2018		December 30, 2017 As Adjusted
Raw materials	$	34,652	$	31,200
Work-in-process	6,827		8,619
Finished goods	51,473		52,440
Total inventories	$	92,952	$	92,259

6. Other Current Assets

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



	September 29, 2018		December 30, 2017 As Adjusted
Prepaid income taxes	$	15,377	$	3,493
Prepaid expenses	10,859		10,517
Indirect taxes receivable	7,967		6,556
Royalties receivable	7,250		7,400
Customer notes receivable	2,647		2,777
Employee loans and advances	342		364
Other current assets	3,841		2,494
Total other current assets	$	48,283	$	33,601

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

7. Deferred Costs and Other Contract Assets

Deferred costs and other contract assets consist of the following (in thousands):



	September 29, 2018		December 30, 2017 As Adjusted
Deferred cost of goods sold	$	105,664	$	93,261
Prepaid contract incentives	5,485		6,115
Deferred commissions	4,950		5,613
Unbilled contract receivables	3,424		4,267
Deferred costs and other contract assets	$	119,523	$	109,256

For the three months ended September 29, 2018 and September 30, 2017, $7.4 million and $7.6 million, respectively, of deferred cost of goods sold was amortized to cost of goods sold. For the nine months ended September 29, 2018 and September 30, 2017, $22.2 million and $21.5 million, respectively, of deferred costs of goods sold was amortized to cost of goods sold.

For the three months ended September 29, 2018 and September 30, 2017, $0.5 million and $0.6 million, respectively, of prepaid contract incentives was amortized as a reduction to revenue. For the nine months ended September 29, 2018 and September 30, 2017, $1.3 million and $1.5 million, respectively, of prepaid contract incentives was amortized as a reduction to revenue.

For the three months ended September 29, 2018 and September 30, 2017, $0.5 million and $0.6 million, respectively, of deferred commissions was amortized to selling, general and administrative expenses. For the nine months ended September 29, 2018 and September 30, 2017, $1.6 million and $1.9 million, respectively, of deferred commissions was amortized to selling, general and administrative expenses.

8. Property and Equipment

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



	September 29, 2018			December 30, 2017
Building and building improvements	$	88,403		$	87,999
Machinery and equipment	53,160			47,556
Aircraft and vehicles	25,554			25,329
Land	23,762			23,762
Computer equipment	16,426			15,789
Leasehold improvements	16,323			15,326
Tooling	14,124			13,754
Furniture and office equipment	10,371			9,967
Demonstration units	471			486
Construction-in-progress (CIP)	9,698			6,365
Total property and equipment	258,292			246,333
Accumulated depreciation and amortization	(93,687		)	(82,237		)
Property and equipment, net	$	164,605		$	164,096

For the three months ended September 29, 2018 and September 30, 2017, depreciation expense of property and equipment was $4.0 million and $3.8 million, respectively. For the nine months ended September 29, 2018 and September 30, 2017, depreciation expense of property and equipment was $12.1 million and $10.8 million, respectively.

The balances in CIP at September 29, 2018 and December 30, 2017 related primarily to capitalized costs associated with the implementation of a new enterprise resource planning software system and manufacturing equipment, the underlying assets for which have not been completed or placed into service.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

9. Intangible Assets

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



	September 29, 2018			December 30, 2017
Patents	$	20,924		$	20,623
Customer relationships	7,669			7,669
Licenses-related party	7,500			7,500
Acquired technology	5,580			5,580
Trademarks	4,234			4,036
Capitalized software development costs	3,374			2,699
Other	5,466			3,691
Total intangible assets	54,747			51,798
Accumulated amortization	(26,285		)	(24,675		)
Intangible assets, net	$	28,462		$	27,123

Total amortization expense for each of the three months ended September 29, 2018 and September 30, 2017 was $1.1 million. Total amortization expense for the nine months ended September 29, 2018 and September 30, 2017 was $3.5 million and $3.2 million, respectively. All of these intangible assets have a 10 year weighted average amortization period.

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



Fiscal year	Amount
2018 (balance of year)	$	4,411
2019	3,959
2020	3,714
2021	3,333
2022	1,854
Thereafter	11,191
Total	$	28,462

10. Goodwill

Changes in goodwill were as follows (in thousands):



	Nine Months Ended September 29, 2018
Goodwill, beginning of period	$	20,617
Acquisition through business combination	3,490
Foreign currency translation	(653		)
Goodwill, ending of period	$	23,454

On September 21, 2018, the Company acquired all of the outstanding shares of a private patient monitoring software company for approximately $4.0 million. Based on the Company’s preliminary purchase price allocation, approximately $3.5 million of the purchase price has been assigned to goodwill. All of the assets and liabilities of the acquired company as of September 29, 2018, and its operating results from September 21, 2018 to September 29, 2018, are included in these condensed consolidated financial statements.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

11. Accrued and Other Current Liabilities

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



	September 29, 2018		December 30, 2017 As Adjusted
Accrued indirect taxes payable	$	8,137	$	6,711
Accrued expenses	4,727		4,022
Income tax payable	4,686		4,292
Related party payables	3,116		1,528
Accrued legal fees	2,009		975
Accrued warranty	1,897		1,149
Accrued customer rebates, fees and reimbursements	1,888		2,351
Accrued stock repurchases	—		1,988
Other	1,342		1,238
Total accrued and other current liabilities	$	27,802	$	24,254

12. Deferred Revenue and Other Contract-Related Liabilities

Deferred revenue and other contract-related liabilities consist of the following (in thousands):



	September 29, 2018			December 30, 2017 As Adjusted
Accrued customer reimbursements	$	18,969		$	16,896
Deferred revenue	11,612			11,589
Accrued rebates and incentives	5,255			3,598
Other contract-related liabilities	481			259
Total deferred revenue and other contract-related liabilities	36,317			32,342
Less: Non-current portion of deferred revenue	(725		)	(237		)
Deferred revenue and other contract-related liabilities - current	$	35,592		$	32,105

Deferred revenue relates to contracted amounts that have been invoiced to customers for which remaining performance obligations must be completed before the Company can recognize the revenue. These amounts primarily relate to undelivered equipment, sensors and services under LT Sensor Contracts, extended warranty agreements and NRE service agreements.

Changes in deferred revenue for the nine months ended September 29, 2018 were as follows:



	Nine Months Ended September 29, 2018
Deferred revenue, beginning of the period	$	11,589
Revenue deferred during the period	7,802
Recognition of revenue deferred in prior periods	(7,779		)
Deferred revenue, end of the period	$	11,612

Expected revenue from remaining contractual performance obligations (Unrecognized Contract Revenue) includes deferred revenue, as well as other amounts that will be invoiced and recognized as revenue in future periods, when the Company completes its performance obligations. While Unrecognized Contract Revenue is similar in concept to backlog, Unrecognized Contract Revenue excludes revenue allocable to monitoring-related equipment that is effectively leased to hospitals under LT Sensor Contracts and other contractual obligations for which neither party has performed. The following table summarizes the Company’s estimated Unrecognized Contract Revenue as of September 29, 2018 and the future periods within which the Company expects to recognize such revenue.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

The estimated timing of this revenue is based, in part, on management’s estimates and assumptions about when its performance obligations will be completed. As a result, the actual timing of this revenue in future periods may vary, possibly materially, from those reflected in this table.



	Expected Future Revenue By Period (in thousands)
	Less than 1 year		Between 1-3 years		Between 3-5 years		More than 5 years		Total
Unrecognized contract revenue	$	198,090	$	252,211	$	103,468	$	20,625	$	574,394

13. Other Non-Current Liabilities

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



	September 29, 2018		December 30, 2017
Income tax payable, long-term	$	23,446	$	25,734
Unrecognized tax benefits	10,908		14,348
Deferred tax liabilities	3,430		9,880
Deferred rent, long-term	1,238		1,266
Deferred revenue, long-term	725		237
Other	87		292
Total other non-current liabilities	$	39,834	$	51,757

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 18 to these condensed consolidated financial statements for further details.

14. Stock Repurchase Program

In September 2015, the Company’s Board of Directors (Board) authorized a stock repurchase program, whereby the Company could purchase up to 5.0 million shares of its common stock over a period of up to three years (2015 Repurchase Program). A total of 3.1 million shares were purchased by the Company pursuant to the 2015 Repurchase Program prior to its expiration in September 2018.

In July 2018, the Board approved a new stock repurchase program, authorizing the Company to purchase up to 5.0 million additional shares of its common stock over a period of up to three years (2018 Repurchase Program). The 2018 Repurchase Program became effective in September 2018 upon the expiration of the 2015 Repurchase Program. The Company expects to fund the 2018 Repurchase Program through its available cash, cash expected to be generated from future operations and other potential sources of capital. The 2018 Repurchase Program can be carried out at the discretion of a committee comprised of the Company’s CEO and CFO through open market purchases, one or more Rule 10b5-1 trading plans, block trades and privately negotiated transactions.

The following table provides a summary of the Company’s stock repurchase activities during the three and nine months ended September 29, 2018 and September 30, 2017 (in thousands, except per share amounts):



	Three Months Ended				Nine Months Ended
	September 29, 2018		September 30, 2017		September 29, 2018		September 30, 2017
Shares repurchased	—		533		198		533
Average cost per share	$	—	$	84.86	$	84.14	$	84.86
Value of shares repurchased	$	—	$	45,261	$	16,490	$	45,261

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

15. Stock-Based Compensation

Total stock-based compensation expense for the three months ended September 29, 2018 and September 30, 2017 was $7.6 million and $5.1 million, respectively. Total stock-based compensation expense for the nine months ended September 29, 2018 and September 30, 2017 was $19.7 million and $11.2 million, respectively. As of September 29, 2018, an aggregate of 12.0 million shares of common stock were reserved for future issuance under the Company’s equity plans, of which 3.2 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, RSUs, stock appreciation rights, 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 at least 95% of the equity awards issued under the 2017 Equity Plan must 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 29, 2018
	Shares		Average Exercise Price
Options outstanding, beginning of period	6,953		$	36.26
Granted	480		96.13
Canceled	(170	)	52.96
Exercised	(1,518	)	27.68
Options outstanding, end of period	5,745		$	43.04
Options exercisable, end of period	3,323		$	29.22

Total stock option expense for the three months ended September 29, 2018 and September 30, 2017 was $3.5 million and $2.9 million, respectively. Total stock option expense for the nine months ended September 29, 2018 and September 30, 2017 was $10.3 million and $8.2 million, respectively. As of September 29, 2018, the Company had $41.4 million of unrecognized compensation cost related to non-vested stock options that are expected to vest over a weighted average period of approximately 3.6 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 29, 2018 was 6.2 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 29, 2018, was 4.9 years.

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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 weighted average grant date fair value amounts):



	Nine Months Ended September 29, 2018
	Units		Weighted Average Grant Date Fair Value
RSUs outstanding, beginning of period	2,708		$	95.51
Granted	7		99.05
Canceled	—		—
Expired	—		—
Vested	(8	)	88.40
RSUs outstanding, end of period	2,707		$	95.54

Total RSU expense for each of the three months ended September 29, 2018 and September 30, 2017 was $0.2 million. Total RSU expense for the nine months ended September 29, 2018 and September 30, 2017 was $0.5 million and $0.3 million, respectively. As of September 29, 2018, 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.

PSUs

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



	Nine Months Ended September 29, 2018
	Units		Weighted Average Grant Date Fair Value
PSUs outstanding, beginning of period	233		$	90.70
Granted	197		86.95
Canceled	(86	)	90.71
Expired	—		—
Vested	(31	)	90.70
PSUs outstanding, end of period	313		$	88.34

During the nine months ended September 29, 2018, the Company awarded 197,000 PSUs that will vest three years from the award date, based on the achievement of certain 2020 performance criteria approved by the Board. If earned, the PSUs granted will vest upon achievement of the performance criteria 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 200% of the target amount; therefore, the maximum number of shares that can be issued under these awards is twice the original award of 197,000 PSUs or 394,000 shares. Based on management’s estimate of the number of units expected to vest, total PSU expense for the three months ended September 29, 2018 and September 30, 2017 was $4.0 million and $2.0 million, respectively. Total PSU expense for the nine months ended September 29, 2018 and September 30, 2017 was $8.8 million and $2.6 million, respectively. As of September 29, 2018, the Company had $29.5 million of unrecognized compensation cost related to non-vested PSU awards expected to be recognized and vest over a weighted-average period of approximately 2.3 years.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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:



	Three Months Ended		Nine Months Ended
	September 29, 2018	September 30, 2017	September 29, 2018	September 30, 2017
Risk-free interest rate	2.7% to 3.0%	1.7% to 2.0%	2.3% to 3.0%	1.7% to 2.2%
Expected term (in years)	5.6	5.5	5.6	5.5
Estimated volatility	26.8% to 32.0%	30.3% to 32.1%	26.8% to 32.0%	29.7% to 32.1%
Expected dividends	0%	0%	0%	0%
Weighted-average fair value of options granted	$37.62	$27.70	$31.21	$27.74

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 29, 2018 was $468.2 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 29, 2018 was $316.7 million. The aggregate intrinsic value of options exercised during the nine months ended September 29, 2018 was $119.4 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.

16. 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 29, 2018 and December 30, 2017, accrued rent expense in excess of the amount paid aggregated $1.5 million, which is classified within other current and non-current liabilities in the accompanying condensed consolidated balance sheets. In addition, the Company leases automobiles in the U.S. and Europe that are classified as operating leases and expire at various dates through September 2021. 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.

As of September 29, 2018, estimated future minimum lease payments, including interest, for each of the following fiscal years are as follows (in thousands):



	Total Operating Leases
2018 (balance of year)	$	2,040
2019	6,388
2020	3,964
2021	2,126
2022	1,561
Thereafter	5,424
Total	$	21,503

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

Rental expense related to operating leases was $1.7 million for each of the three months ended September 29, 2018 and September 30, 2017, and $5.2 million and $5.0 million for the nine months ended September 29, 2018 and September 30, 2017, respectively.

Employee Retirement Savings Plan

The Company sponsors a qualified defined contribution plan or 401(k) plan, the Masimo Retirement Savings Plan (MRSP), covering the Company’s full-time U.S. employees who meet certain eligibility requirements. In general, the Company matches an employee’s contribution up to 3% of the employee’s compensation, subject to a maximum amount. The Company may also contribute to the MRSP on a discretionary basis. The Company contributed $0.5 million and $0.6 million to the MRSP for the three months ended September 29, 2018 and September 30, 2017, respectively, and $1.8 million to the MRSP for each of the nine months ended September 29, 2018 and September 30, 2017.

In addition, the Company also sponsors various defined contribution plans in certain locations outside of the United States (Subsidiary Plans). For each of the three months ended September 29, 2018 and September 30, 2017, the Company contributed $0.1 million to the Subsidiary Plans. For the nine months ended September 29, 2018 and September 30, 2017, the Company contributed $0.3 million and $0.2 million to the Subsidiary Plans, respectively.

Employment and Severance Agreements

In July 2017, the Company entered into the First Amendment to the certain Amended and Restated Employment Agreement entered into between the Company and Mr. Kiani on November 4, 2015 (as amended, the Amended Employment Agreement). 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 first and second 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 29, 2018, the expense related to the Award Shares and Cash Payment 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 $292.9 million.

As of September 29, 2018, the Company had severance plan participation agreements with eight 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 $80.6 million of purchase commitments as of September 29, 2018, which are expected to be purchased within one year. These purchase commitments have been made for certain inventory items in order to secure sufficient levels of those items and to achieve better pricing.

Other Contractual Commitments

In the normal course of business, the Company may provide bank guarantees to support government hospital tenders in certain foreign jurisdictions. As of September 29, 2018, the Company had approximately $1.1 million in outstanding unsecured bank guarantees.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

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 29, 2018, 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 29, 2018, the Company had $493.5 million of bank balances, of which $3.4 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 29, 2018, revenue from the sale of the Company’s products to U.S. hospitals that are members of GPOs amounted to $115.3 million and $350.2 million, respectively. 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.

For the three months ended September 29, 2018, the Company had sales through two just-in-time distributors that represented 12.3% and 9.4% of total revenue, respectively. For the three months ended September 30, 2017, the Company had sales through the same two just-in-time distributors that represented 12.3% and 10.9% of total revenue, respectively.

For the nine months ended September 29, 2018, the Company had sales to two just-in-time distributors that represented 12.4% and 10.4% of total revenue, respectively. For the nine months ended September 30, 2017, the Company had sales to the same two just-in-time distributors that represented 13.2% and 11.4% of total revenue, respectively.

As of September 29, 2018, one just-in-time distributor represented 5.3% of the Company’s accounts receivable balance. As of December 30, 2017, one just-in-time distributor represented 6.5% of the Company’s accounts receivable balance.

For the nine months ended September 29, 2018 and September 30, 2017, the Company recorded $25.3 million and $25.7 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. Pursuant to the terms of the Third Amendment to Settlement Agreement and Release of Claims effective September 2016, Medtronic agreed to continue paying royalties to the Company through October 6, 2018, after which no more royalties are due.

Litigation

During the third quarter of fiscal year 2017, the Company became aware that certain amounts had been paid by a foreign government customer to the Company’s former appointed foreign agent in connection with a foreign government tender, but had not been remitted by such agent to the Company in accordance with the agency agreement. On December 28, 2017, the Company initiated arbitration proceedings against this foreign agent after unsuccessful attempts to recover such remittances. As a result, the Company recorded a net charge of approximately $10.5 million during the fourth quarter of fiscal year 2017 in connection with this dispute, of which $0.4 million was recovered during the nine months ended September 29, 2018. The arbitration hearing is scheduled to begin on February 11, 2019. Although the Company intends to vigorously pursue full recovery of the amounts owed by the foreign agent through these arbitration proceedings, as well as explore other avenues for recovery, there is no guarantee that the Company will be successful in these efforts.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

On January 24, 2018, the Company was notified that its former insurance carrier was seeking reimbursement of certain defense costs previously advanced by such insurance carrier in connection with an employment-related arbitration. The Company had previously disputed the insurance carrier’s claim for reimbursement in a letter dated December 14, 2016, and had not received any response from the insurance carrier. Although the insurance carrier is seeking approximately $2.6 million plus interest at a rate of 10% per year from January 15, 2014, the Company believes it has good and substantial grounds to dispute the insurance carrier’s reimbursement claim. Therefore, the Company is currently unable to determine whether any loss will ultimately occur.

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 plaintiff 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’ decision. The Company and the FCC filed oppositions to this petition on January 16, 2018. On February 20, 2018, the Supreme Court denied certiorari. The District Court lifted the stay on April 9, 2018 and set a trial date of November 5, 2019. The deadline for PHI to file its motion for class certification is February 4, 2019. 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 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. On March 3, 2018, the Eleventh Circuit Court of Appeals affirmed the decision of the U.S. District Court for the Northern District of Alabama.

On May 30, 2012, a patent infringement complaint was filed against the Company in the U.S. District Court for the Northern District of California by Dominion Assets LLC (Dominion). The complaint alleged infringement of U.S. Patent No. 5,360,004 titled “Non-invasive determination of analyte concentration using non-continuous radiation” (the ‘004 patent), U.S. Patent No. 5,379,764 titled “Non-invasive determination of analyte concentration in body of mammals” (the ‘764 patent) and U.S. Patent No. 5,460,177 titled “Method for non-invasive measurement of concentration of analytes in blood using continuous spectrum radiation” (the ‘177 patent). On June 27, 2014, the Court dismissed the case for lack of standing. Dominion refiled the case on June 30, 2014, alleging infringement of the ‘764 patent and the ‘177 patent. The Company responded to the complaint on July 24, 2014, and requested declaratory judgment that the asserted patents are invalid, unenforceable, and not infringed. On January 20, 2017, the Court granted summary judgment that the ‘177 patent is invalid. On August 13, 2018, the Company and Dominion entered into a settlement agreement that included, among other things, a mutual release of claims and Dominion’s dismissal of the case against the Company without payment by the Company. The case was dismissed with prejudice on August 14, 2018.

From time to time, the Company may be involved in other litigation and investigations relating to claims and matters arising out of its operations in the normal course of business. The Company believes that it currently is not a party to any other legal proceedings which, individually or in the aggregate, would have a material adverse effect on its consolidated financial position, results of operations or cash flows.

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

17. Segment Information and Enterprise Reporting

The Company’s chief operating decision maker, the CEO, 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. 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.

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 29, 2018				September 30, 2017 As Adjusted				September 29, 2018				September 30, 2017 As Adjusted
Geographic area by destination:
United States	$	136,895	67.7	%	$	118,065	65.7	%	$	418,178	68.7	%	$	370,119	68.3	%
Europe, Middle East and Africa	37,257		18.4		38,300		21.3		115,631		19.0		102,476		18.9
Asia and Australia	21,332		10.6		17,676		9.8		54,627		9.0		51,750		9.6
North and South America (excluding United States)	6,584		3.3		5,655		3.2		20,025		3.3		17,544		3.2
Total product revenue	$	202,068	100.0	%	$	179,696	100.0	%	$	608,461	100.0	%	$	541,889	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 29, 2018				December 30, 2017 As Adjusted
Long-lived assets by geographic area:
United States	$	272,998	94.8	%	$	265,678	95.6	%
International	14,989		5.2		12,342		4.4
Total	$	287,987	100.0	%	$	278,020	100.0	%

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MASIMO CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

18. Income Taxes

The Company has provided for income taxes in fiscal year 2018 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 estimated annual effective tax rate is computed based on the expected annual 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 29, 2018 and September 30, 2017, the Company recorded discrete tax benefits of approximately $21.7 million and $35.1 million, respectively, related to excess tax benefits realized from stock-based compensation. In addition, the Company recorded approximately $4.7 million and $0.8 million of discrete tax benefits related to the derecognition of uncertain tax positions due to the expiration of the statutes of limitations for the nine months ended September 29, 2018 and September 30, 2017, respectively.

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 29, 2018, the liability for income taxes associated with uncertain tax positions was approximately $13.5 million. If fully recognized, approximately $12.5 million (net of federal benefit on state taxes) would impact the Company’s effective tax rate. 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 2014. All material state, local and foreign income tax matters have been concluded through fiscal year 2010. The Company does not believe that the results of any tax authority examination would have a significant impact on its consolidated financial statements.

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

This Quarterly Report on Form 10-Q contains “forward-looking statements” as defined in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, in connection with the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially and adversely from those expressed or implied by such forward-looking statements. Such forward-looking statements include any expectation of earnings, revenues or other financial items; any statements of the plans, strategies and objectives of management for future operations; factors that may affect our operating results or financial condition; statements concerning new products, technologies or services; statements related to future capital expenditures; statements related to future economic conditions or performance; statements related to our stock repurchase programs; 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 30, 2017, which we filed with the SEC on February 28, 2018. 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. Our mission is to improve patient outcomes and reduce the cost of care. We provide our products directly and through distributors and original equipment manufacturers (OEM) partners to hospitals, emergency medical service (EMS) providers, home care providers, long-term care facilities, physician offices, veterinarians and consumers. 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, known as Masimo Signal Extraction Technology^® (SET^®) pulse oximetry. Our product offerings have expanded significantly over the years to also include noninvasive monitoring of blood constituents with an optical signature, optical regional oximetry monitoring, electrical brain function monitoring, acoustic respiration monitoring and exhaled gas monitoring. In addition, we have developed the Root^™ patient monitoring and connectivity platform, the Radical-7^® and Rad-97^™ bedside and portable patient monitors and the Radius-7^®wearable wireless patient monitor. We have also developed the Masimo Patient SafetyNet supplemental remote patient surveillance and monitoring system, which currently allows up to 200 patients to be monitored and viewed simultaneously and remotely through a PC-based monitor or by care providers through their pagers, voice-over-IP phones or smartphones. For an overview of our product offerings and technologies, please refer to “Business” in Part I, Item 1 of our Annual Report on Form 10-K for the fiscal year ended December 30, 2017, filed with the SEC on February 28, 2018.

Our solutions and related products are based upon our proprietary Masimo SET^® and rainbow^® algorithms. These technologies are incorporated into a variety of product platforms designed to meet our customers’ needs. In addition, we provide our technologies to OEMs in a form factor that is easy to integrate into their patient monitors, defibrillators, infant incubators and other devices.

Our technology is supported by a substantial intellectual property portfolio that we have built through internal development and, to a lesser extent, acquisitions and license agreements. We have also exclusively licensed from Cercacor Laboratories, Inc. (Cercacor) the right to certain OEM rainbow^® technologies and to incorporate certain rainbow^® technology into our products intended to be used by professional caregivers, including, but not limited to, hospital caregivers and alternate care facility caregivers.

In January 2018, we announced the CE Mark and release of RD rainbow Lite SET^™ sensors, which enable the monitoring of oxygen reserve index (ORi^™) and rainbow^® pleth variability index (RPVi^™), an improved pleth variability index (PVi^®) that allows clinicians to noninvasively and continuously assess fluid responsiveness at a fraction of the cost of invasive methods, and at a fraction of the cost of rainbow^®sensors. RD rainbow Lite^™ sensors utilize twice as many wavelengths of light as SET^® sensors, allowing RD rainbow Lite^™ sensors to provide ORi^™ and RPVi^™ along with Masimo SET^® Measure-through Motion and Low Perfusion^™ pulse oximetry.

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We also announced in January 2018 that the Rad-97^™ Pulse CO-Oximeter^® had received FDA 510(k) clearance for home use. Rad-97^™ offers noninvasive and continuous monitoring through Measure-through Motion and Low Perfusion^™ SET^® pulse oximetry, upgradeable rainbow^® technologies and integrated noninvasive blood pressure in a compact, standalone monitor that combines advanced connectivity and communication capabilities for telehealth, with an interface easily customized for use at home.

Our Next Generation SedLine^® brain function monitoring also received FDA 510(k) clearance in January 2018. SedLine^® helps clinicians monitor the state of the brain under anesthesia with bilateral acquisition and processing of four leads of electroencephalogram (EEG) signals. Next Generation SedLine^® features an enhanced signal processing engine, driving a variety of performance improvements and helping give clinicians a more complete picture of the brain.

In March 2018, we announced the release of Replica^™, an application for smart phones and tablets that works in conjunction with Masimo Patient SafetyNet, a supplemental remote monitoring and clinician notification system. Replica^™ allows clinicians to view continuous monitoring data for multiple patients, as well as view and respond to alarms and alerts, all from their smart phones, regardless of location.

We also announced the CE Mark of Eve^™, a critical congenital heart disease (CCHD) newborn screening application for the Rad-97^™ Pulse CO-Oximeter^® in March 2018. Eve^™combines the power of Masimo SET^®Measure-through Motion and Low Perfusion^™ pulse oximetry with a pre-ductal to post-ductal synchronization algorithm designed to reduce calculation errors.

In April 2018, we announced the release of UniView^™, an integrated display of real-time data and alarms from multiple Masimo and third-party devices, designed to reduce clinician cognitive overload, improve patient safety and promote data sharing and team coordination among clinicians.

We also announced the CE Mark of the Rad-97^™ Pulse CO-Oximeter^® with integrated NomoLine^® capnography in April 2018. With this clearance, Rad-97^™ is now available both within and outside the United States in three configurations: Rad-97^™, Rad-97^™ with integrated noninvasive blood pressure and now Rad-97^™ with NomoLine^® capnography.

In June 2018, we announced the United States release of TIR-1^™, a non-contact Bluetooth^®enabled thermometer designed to integrate with the Root^™ patient monitoring and connectivity platform. TIR-1^™ was developed in conjunction with Thermomedics, a PositiveID Corporation.

In July 2018, we announced the worldwide release of the Vital Signs Check Application, an integrated patient data collection and workflow application for the Masimo Root^™ patient monitoring and connectivity platform. Vital Signs Check, available for new and existing Root^™ customers through a software upgrade, augments Root’s^™ versatility by helping to automate hospital vital signs testing workflows.

In September 2018, we announced FDA 510(k) clearance of RAS-45, an acoustic respiration sensor for rainbow Acoustic Monitoring^® (RAM^®), for infant and neonatal patients. RAM^® could previously be used to monitor adult and pediatric patients greater than 10 kg using RAS-125c and RAS-45 sensors. With 510(k) clearance of the RAS-45 sensor for infant and neonatal patients, acoustic respiration rate measurement is now, for the first time, possible for patients of all sizes, including neonates, in the United States.

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 (CEO), is also the Chairman and CEO 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 July 2018, our Board approved a stock repurchase program authorizing us to purchase up to 5.0 million shares of our common stock over a period of up to three years (2018 Repurchase Program). The 2018 Repurchase Program may be carried out at the discretion of a committee comprised of our CEO and Chief Financial Officer (CFO) 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 and prior stock repurchase programs, see Note 14 to the condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.

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Results of Operations⁽¹⁾

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 29, 2018			Percentage of Revenue		September 30, 2017 As Adjusted		Percentage of Revenue		September 29, 2018		Percentage of Revenue		September 30, 2017 As Adjusted		Percentage of Revenue
Revenue:
Product	$	202,068		96.0	%	$	179,696	92.9	%	$	608,461	95.8	%	$	541,889	93.1	%
Royalty and other revenue	8,515			4.0		13,664		7.1		26,696		4.2		40,420		6.9
Total revenue	210,583			100.0		193,360		100.0		635,157		100.0		582,309		100.0
Cost of goods sold	69,830			33.2		69,295		35.8		208,596		32.8		198,929		34.2
Gross profit	140,753			66.8		124,065		64.2		426,561		67.2		383,380		65.8
Operating expenses:
Selling, general and administrative	72,670			34.5		65,704		34.0		215,263		33.9		198,460		34.1
Research and development	19,442			9.2		15,300		7.9		57,160		9.0		45,859		7.9
Total operating expenses	92,112			43.7		81,004		41.9		272,423		42.9		244,319		42.0
Operating income	48,641			23.1		43,061		22.3		154,138		24.3		139,061		23.9
Non-operating income	1,028			0.5		287		0.1		4,080		0.6		1,319		0.2
Income before provision (benefit) for income taxes	49,669			23.6		43,348		22.4		158,218		24.9		140,380		24.1
Provision (benefit) for income taxes	(7,457		)	(3.5	)	7,495		3.9		11,609		1.8		7,856		1.3
Net income	$	57,126		27.1	%	$	35,853	18.5	%	$	146,609	23.1	%	$	132,524	22.8	%

Comparison of the Three Months ended September 29, 2018 to the Three Months ended September 30, 2017⁽¹⁾

Revenue. Total revenue increased $17.2 million, or 8.9%, to $210.6 million for the three months ended September 29, 2018 from $193.4 million for the three months ended September 30, 2017. 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 29, 2018 and September 30, 2017 (dollars in thousands):



	Three Months Ended
	September 29, 2018				September 30, 2017 As Adjusted				Increase/ (Decrease)			Percentage Change
United States	$	136,895	67.7	%	$	118,065	65.7	%	$	18,830		15.9	%
Europe, Middle East and Africa	37,257		18.4		38,300		21.3		(1,043		)	(2.7	)
Asia and Australia	21,332		10.6		17,676		9.8		3,656			20.7
North and South America (excluding United States)	6,584		3.3		5,655		3.2		929			16.4
Total product revenue	$	202,068	100.0	%	$	179,696	100.0	%	$	22,372		12.4	%
Royalty and other revenue	8,515				13,664				(5,149		)	(37.7	)
Total revenue	$	210,583			$	193,360			$	17,223		8.9	%

_______________

⁽¹⁾

Certain information presented for periods ending prior to December 31, 2017 has been restated to reflect the full retrospective application of the new revenue accounting standard, Accounting Standards Update (ASU) No. 2014-09, Revenue (Topic 606): Revenue from Contracts with Customers (ASU 2014-09). See Note 2 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 our adoption of this new accounting standard.

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Product revenue increased $22.4 million, or 12.4%, to $202.1 million for the three months ended September 29, 2018, compared to $179.7 million for the three months ended September 30, 2017. This increase was primarily due to higher sales of consumables, monitors and parameters, which was partially offset by the impact of approximately $0.7 million of unfavorable foreign exchange rate movements from the prior year period that decreased the U.S. Dollar translation of foreign sales that were denominated in various foreign currencies, primarily in Australia, Europe and Canada. During the third quarter of 2018, we shipped approximately 59,100 noninvasive technology boards and monitors, an increase of 8,000 units, or 15.7%, from 51,100 units shipped during the third quarter of 2017.

Product revenue generated through our direct and distribution sales channels increased $16.3 million, or 10.3%, to $173.8 million for the three months ended September 29, 2018, compared to $157.5 million for the three months ended September 30, 2017. Revenues from our OEM channel increased $6.1 million, or 27.5%, to $28.3 million for the three months ended September 29, 2018 as compared to $22.2 million for the three months ended September 30, 2017.

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. For the three months ended September 29, 2018, royalty and other revenue decreased by $5.1 million, which was primarily related to lower NRE service revenue, when compared to the three months ended September 30, 2017. Pursuant to the terms of the Third Amendment to Settlement Agreement and Release of Claims effective September 2016, Medtronic agreed to continue paying royalties through October 6, 2018, after which no more royalties are due.

Gross Profit. Gross profit consists of total revenue less cost of goods sold. Our gross profit for the three months ended September 29, 2018 and September 30, 2017 was as follows (dollars in thousands):



	Three Months Ended
	September 29, 2018		Gross Profit Percentage		September 30, 2017 As Adjusted		Gross Profit Percentage		Increase/ (Decrease)			Percentage Change
Product gross profit	$	132,389	65.5	%	$	111,375	62.0	%	$	21,014		18.9	%
Royalty and other revenue gross profit	8,364		98.2		12,690		92.9		(4,326		)	(34.1	)
Total gross profit	$	140,753	66.8	%

Closing Price ($)	Shares Out (MM)	Market Cap ($MM)
$124.39	53	$6,590

10-Q	2018-09-29	Quarter: 2018-09-29
10-Q	2018-06-30	Quarter: 2018-06-30
10-Q	2018-03-31	Quarter: 2018-03-31
10-K	2017-12-30	Annual: 2017-12-30
10-Q	2017-09-30	Quarter: 2017-09-30
10-Q	2017-07-01	Quarter: 2017-07-01
10-Q	2017-04-01	Quarter: 2017-04-01
10-K	2016-12-31	Annual: 2016-12-31
10-Q	2016-10-01	Quarter: 2016-10-01
10-Q	2016-07-02	Quarter: 2016-07-02
10-Q	2016-04-02	Quarter: 2016-04-02
10-K	2016-01-02	Annual: 2016-01-02

8-K	2019-01-09	Earnings, Exhibits
8-K	2019-01-02	Officers, Exhibits
8-K	2018-12-21	Enter Agreement, Off-BS Arrangement
8-K	2018-10-31	Earnings, Regulation FD, Exhibits
8-K	2018-09-27	Other Events
8-K	2018-08-01	Earnings, Regulation FD, Exhibits
8-K	2018-07-31	Exhibits
8-K	2018-05-31	Officers, Shareholder Vote
8-K	2018-05-02	Earnings, Regulation FD, Exhibits
8-K	2018-02-27	Earnings, Regulation FD, Exhibits
8-K	2018-02-15	Leave Agreement

VAR	Varian Medical Systems
LIVN	Livanova
ECOR	Electrocore
IRIX	Iridex
EYES	Second Sight Medical Products
ELMD	Electromed
SLNO	Soleno Therapeutics
VIVE	Viveve Medical
ARDM	Aradigm
RSLS	Reshape Lifesciences

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