10-Q 1 masi-20180630x10q.htm 10-Q Document

 
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 June 30, 2018
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________ to _________
Commission File Number 001-33642
_________________________________________________
masimologoq12018a01.jpg
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 June 30, 2018
Common stock, $0.001 par value
 
52,170,056
 



MASIMO CORPORATION
FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2018
TABLE OF CONTENTS
 
 
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 6.
 
 


2


PART I. FINANCIAL INFORMATION
Item 1.     Financial Statements
MASIMO CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands, except par values)
 
June 30,
2018
 
December 30,
2017
As Adjusted
ASSETS
 
 
 
Current assets
 
 
 
Cash and cash equivalents
$
429,647

 
$
315,302

Accounts receivable, net of allowance for doubtful accounts of $1,694 and $2,116 at June 30, 2018 and December 30, 2017, respectively.
98,290

 
118,532

Inventories
90,848

 
92,259

Other current assets
35,085

 
33,601

Total current assets
653,870

 
559,694

Deferred costs and other contract assets
116,986

 
109,256

Property and equipment, net
164,027

 
164,096

Intangible assets, net
27,979

 
27,123

Goodwill
19,914

 
20,617

Deferred tax assets
20,259

 
19,981

Other non-current assets
4,281

 
4,668

Total assets
$
1,007,316

 
$
905,435

LIABILITIES AND STOCKHOLDERS EQUITY
 
 
 
Current liabilities
 
 
 
Accounts payable
$
34,892

 
$
33,780

Accrued compensation
36,670

 
39,515

Accrued and other current liabilities
22,832

 
24,254

Deferred revenue and other contract-related liabilities, current
34,990

 
32,105

Total current liabilities
129,384

 
129,654

Other non-current liabilities
52,742

 
51,757

Total liabilities
182,126

 
181,411

Commitments and contingencies

 

Stockholders’ equity
 
 
 
Preferred stock, $0.001 par value; 5,000 shares authorized; 0 shares issued and outstanding at June 30, 2018 and December 30, 2017

 

Common stock, $0.001 par value; 100,000 shares authorized; 52,170 and 51,636 shares issued and outstanding at June 30, 2018 and December 30, 2017, respectively
52

 
52

Treasury stock, 15,255 and 15,059 shares at June 30, 2018 and December 30, 2017, respectively
(489,027
)
 
(472,536
)
Additional paid-in capital
493,149

 
461,494

Accumulated other comprehensive loss
(5,997
)
 
(2,941
)
Retained earnings
827,013

 
737,955

Total stockholders’ equity
825,190

 
724,024

Total liabilities and stockholders’ equity
$
1,007,316

 
$
905,435


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

3


MASIMO CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited, in thousands, except per share amounts)
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
2018
 
July 1,
2017
As Adjusted
 
June 30,
2018
 
July 1,
2017
As Adjusted
Revenue:
 
 
 
 
 
 
 
Product
$
202,004

 
$
179,727

 
$
406,393

 
$
362,193

Royalty and other revenue
9,617

 
12,579

 
18,181

 
26,756

Total revenue
211,621

 
192,306

 
424,574

 
388,949

Cost of goods sold
69,474

 
65,405

 
138,766

 
129,634

Gross profit
142,147

 
126,901

 
285,808

 
259,315

Operating expenses:
 
 
 
 
 
 
 
Selling, general and administrative
71,418

 
66,670

 
142,593

 
132,756

Research and development
19,117

 
16,382

 
37,718

 
30,559

Total operating expenses
90,535

 
83,052

 
180,311

 
163,315

Operating income
51,612

 
43,849

 
105,497

 
96,000

Non-operating income
1,405

 
158

 
3,052

 
1,032

Income before provision (benefit) for income taxes
53,017

 
44,007

 
108,549

 
97,032

Provision (benefit) for income taxes
9,164

 
(1,131
)
 
19,066

 
361

Net income
$
43,853

 
$
45,138

 
$
89,483

 
$
96,671

 
 
 
 
 
 
 
 
Net income per share:
 
 
 
 
 
 
 
Basic
$
0.84

 
$
0.87

 
$
1.72

 
$
1.89

Diluted
$
0.79

 
$
0.80

 
$
1.60

 
$
1.73

 
 
 
 
 
 
 
 
Weighted-average shares used in per share calculations:
 
 
 
 
 
 
 
Basic
51,999

 
51,677

 
52,047

 
51,164

Diluted
55,742

 
56,173

 
55,842

 
55,868

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



4


MASIMO CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(unaudited, in thousands)
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
2018
 
July 1,
2017
As Adjusted
 
June 30,
2018
 
July 1,
2017
As Adjusted
Net income
$
43,853

 
$
45,138

 
$
89,483

 
$
96,671

Other comprehensive income, net of tax:
 
 
 
 
 
 
 
Unrealized gains (losses) from foreign currency translation adjustments
(2,785
)
 
2,300

 
(3,056
)
 
2,866

Comprehensive income
$
41,068

 
$
47,438

 
$
86,427

 
$
99,537

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




5


MASIMO CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)
 
Six Months Ended
 
June 30,
2018
 
July 1,
2017
As Adjusted
Cash flows from operating activities:
 
 
 
Net income
$
89,483

 
$
96,671

Adjustments to reconcile net income to net cash provided by (used in) operating activities:
 
 
 
Depreciation and amortization
10,794

 
9,462

Stock-based compensation
12,049

 
6,142

Loss on disposal of property, equipment and intangibles
632

 
365

Provision for doubtful accounts
(356
)
 
(193
)
Provision for deferred income taxes
(274
)
 

Changes in operating assets and liabilities:
 
 
 
Decrease (increase) in accounts receivable
20,209

 
(2,094
)
Decrease (increase) in inventories
1,075

 
(15,615
)
Increase in other current assets
(1,694
)
 
(14,121
)
Increase in deferred costs and other contract assets
(7,809
)
 
(12,871
)
Decrease in other non-current assets
430

 
871

Increase in accounts payable
1,820

 
3,138

Decrease in accrued compensation
(2,771
)
 
(11,679
)
Increase in accrued liabilities
1,776

 
3,600

Decrease in income tax payable
(895
)
 
(71,496
)
Increase (decrease) in deferred revenue and other contract-related liabilities
3,397

 
(8,424
)
Increase in other non-current liabilities
33

 
985

Net cash provided by (used in) operating activities
127,899

 
(15,259
)
Cash flows from investing activities:
 
 
 
Purchases of property and equipment, net
(9,430
)
 
(8,512
)
Increase in intangible assets
(3,643
)
 
(1,574
)
Net cash used in investing activities
(13,073
)
 
(10,086
)
Cash flows from financing activities:
 
 
 
Repayments of capital lease obligations

 
(70
)
Proceeds from issuance of common stock
19,778

 
48,218

Payroll tax withholdings on behalf of employees for vested equity awards
(168
)
 

Repurchases of common stock
(18,478
)
 

Net cash provided by financing activities
1,132

 
48,148

Effect of foreign currency exchange rates on cash
(1,647
)
 
1,825

Net increase in cash, cash equivalents, and restricted cash
114,311

 
24,628

Cash, cash equivalents and restricted cash at beginning of period
315,483

 
308,198

Cash, cash equivalents and restricted cash at end of period
$
429,794

 
$
332,826

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

6


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 six months ended June 30, 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.


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

7

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 six months ended June 30, 2018. The Company carries cash and cash equivalents at cost, which approximates fair value. As of June 30, 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.

8

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 six months ended June 30, 2018 and July 1, 2017 were $0.2 million and $0.3 million, respectively. As of June 30, 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.

9

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 six months ended June 30, 2018 and July 1, 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.

10

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 June 30, 2018 and July 1, 2017, the Company recognized royalty revenue pursuant to this agreement of approximately $9.1 million and $9.2 million, respectively. For the six months ended June 30, 2018 and July 1, 2017, the Company recognized royalty revenue pursuant to this agreement of approximately $17.2 million and $17.4 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 in accordance with authoritative accounting guidance.
Taxes Collected From Customers and Remitted to Governmental Authorities
Pursuant to authoritative guidance, the Company’s policy is to present revenue net of taxes collected from customers and remitted to governmental authorities.

11

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):
 
Six Months Ended
 
June 30,
2018
 
July 1,
2017
Warranty accrual, beginning of period
$
1,149

 
$
910

Accrual for warranties issued
643

 
606

Changes to pre-existing warranties (including changes in estimates)
551

 
(5
)
Settlements made
(502
)
 
(485
)
Warranty accrual, end of period
$
1,841

 
$
1,026

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.

12

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

Comprehensive Income
Authoritative accounting guidance establishes requirements for reporting and disclosure of comprehensive income and its components. Comprehensive income includes foreign currency translation adjustments and any related tax benefits that have been excluded from net income and reflected in stockholders’ equity.
The change in accumulated other comprehensive loss was as follows (in thousands):
 
Six Months Ended 
 June 30, 2018
Accumulated other comprehensive loss, beginning of period
$
(2,941
)
Unrealized gains from foreign currency translation
(3,056
)
Accumulated other comprehensive loss, end of period
$
(5,997
)
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 six months ended June 30, 2018, weighted options to purchase 1.2 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 each of the three and six months ended July 1, 2017, weighted options to purchase 0.1 million shares of common stock 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 each of the three and six months ended June 30, 2018 and July 1, 2017, certain RSUs were considered contingently issuable shares as their vesting is contingent upon the occurrence of certain future events. Since such events had not occurred and were not considered probable of occurring as of June 30, 2018 and July 1, 2017, 2.7 million weighted average shares related to such RSUs have been excluded from the calculation of potential shares.
A reconciliation of basic and diluted net income per share is as follows (in thousands, except per share amounts):
 
Three Months Ended
 
Six Months Ended
 
June 30,
2018
 
July 1,
2017
As Adjusted
 
June 30,
2018
 
July 1,
2017
As Adjusted
Net income
$
43,853

 
$
45,138

 
$
89,483

 
$
96,671

Basic net income per share:
 
 
 
 
 
 
 
Weighted-average shares outstanding - basic
51,999

 
51,677

 
52,047

 
51,164

Net income per basic share
$
0.84

 
$
0.87

 
$
1.72

 
$
1.89

Diluted net income per share:
 
 
 
 
 
 
 
Weighted-average shares outstanding - basic
51,999

 
51,677

 
52,047

 
51,164

Diluted share equivalent: stock options and RSUs
3,743

 
4,496

 
3,795

 
4,704

Weighted-average shares outstanding - diluted
55,742

 
56,173

 
55,842

 
55,868

Net income per diluted share
$
0.79

 
$
0.80

 
$
1.60

 
$
1.73


13

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

Supplemental Cash Flow Information
Supplemental cash flow information includes the following (in thousands):
 
Six Months Ended
 
June 30,
2018
 
July 1,
2017
Cash paid during the year for:
 
 
 
Interest
$
229

 
$
321

Income taxes
21,771

 
81,662

 
 
 
 
Noncash investing and financing activities:
 
 
 
Unpaid purchases of property, plant and equipment
$
663

 
$
2,113

       Unsettled common stock proceeds from option exercises

 
237

 
 
 
 
Reconciliation of cash, cash equivalents and restricted cash:
 
 
 
Cash and cash equivalents
$
429,647

 
$
331,448

Restricted cash
147

 
1,378

Total cash, cash equivalents and restricted cash shown in the statement of cash flow
$
429,794

 
$
332,826

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 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 SEC 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 with no material impact on its consolidated financial statements.
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.
Effective December 31, 2017, the Company adopted ASU 2014-09, Revenue (Topic 606): Revenue from Contracts with Customers. 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.

14

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

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.
The reconciliations below reflect the adoption of ASC 606, the adoption of ASU 2016-16 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


15

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

Condensed Consolidated Statement of Operations:
Three Months Ended
July 1, 2017
 
As Previously
Reported
 
Adjustments
 
As Adjusted
Product revenue
$
182,802

 
$
(3,075
)
 
$
179,727

Royalty and other revenue
10,131

 
2,448

 
12,579

Cost of goods sold
64,496

 
909

 
65,405

Selling, general and administrative
66,377

 
293

 
66,670

Provision (benefit) for income taxes
346

 
(1,477
)
 
(1,131
)
Net income
46,680

 
(1,542
)
 
45,138

 
 
 
 
 
 
Net income per share:
 
 
 
 
 
     Basic
$
0.90

 
$
(0.03
)
 
$
0.87

     Diluted
$
0.83

 
$
(0.03
)
 
$
0.80

Condensed Consolidated Statement of Operations:
Six Months Ended
July 1, 2017
 
As Previously
Reported
 
Adjustments
 
As Adjusted
Product revenue
$
360,899

 
$
1,294

 
$
362,193

Royalty and other revenue
18,336

 
8,420

 
26,756

Cost of goods sold
126,664

 
2,970

 
129,634

Selling, general and administrative
131,949

 
807

 
132,756

Provision (benefit) for income taxes
(919
)
 
1,280

 
361

Net income
92,014

 
4,657

 
96,671

 
 
 
 
 
 
Net income per share:
 
 
 
 
 
     Basic
$
1.80

 
$
0.09

 
$
1.89

     Diluted
$
1.65

 
$
0.08

 
$
1.73



16

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

Condensed Consolidated Statements of Cash Flows:
Six Months Ended
July 1, 2017
 
As Previously
Reported
 
Adjustments
 
As Adjusted
Cash flows from operating activities:
 
 
 
 
 
Net income
$
92,014

 
$
4,657

 
$
96,671

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
 
     Increase in inventories
(15,554
)
 
(61
)
 
(15,615
)
     Increase in other current assets
(14,694
)
 
573

 
(14,121
)
     Increase in deferred costs and other contract assets
(13,700
)
 
829

 
(12,871
)
     (Increase) decrease in other non-current assets
(1,288
)
 
2,159

 
871

     (Decrease) increase in accrued liabilities
(67,641
)
 
71,241

 
3,600

     Decrease in income taxes payable

 
(71,496
)
 
(71,496
)
     Increase (decrease) in deferred revenue and other contract liabilities
327

 
(8,751
)
 
(8,424
)
     Increase in other non-current liabilities
985

 

 
985

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 six months ended June 30, 2018 and such adoption did not have a material impact on the Company’s consolidated financial statements.
Recently Issued 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 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 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.

17

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

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). The new standard requires lessees to recognize most leases on their balance sheets but continue to recognize lease expenses in their income statement in a manner similar to current practice. The new standard states that a lessee will recognize a lease liability for the obligation to make lease payments and a right-of-use asset for the right to use the underlying asset for the lease term. Expense related to leases determined to be operating leases will be recognized on a straight-line basis, while those determined to be financing leases will be recognized following a front-loaded expense profile in which interest and amortization are presented separately in the income statement. ASU 2016-02 is effective for annual and interim fiscal reporting periods beginning after December 15, 2018, and early application is permitted. The Company is currently evaluating the expected impact of this standard on its consolidated financial statements, but anticipates that, among other things, the required recognition of a lease liability and related right-of-use asset will significantly increase both the assets and liabilities recognized and reported on its balance sheet. In addition, the Company anticipates that the classification of certain leases for which the Company is the lessor may change under the new guidance, resulting in the 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 during the next six to nine 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.
Based on authoritative consolidation guidance, 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 $2.0 million and $1.9 million for the three months ended June 30, 2018 and July 1, 2017, respectively. Aggregate liabilities to Cercacor arising under the Cross-Licensing Agreement were $4.5 million and $3.5 million for the six months ended June 30, 2018 and July 1, 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 six months ended June 30, 2018 and July 1, 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 less than $0.1 million in sublease income for each of the three months ended June 30, 2018 and July 1, 2017. The Company recognized less than $0.2 million in sublease income for each of the six months ended June 30, 2018 and July 1, 2017.

18

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

Net amounts due to Cercacor at each of June 30, 2018 and December 30, 2017 were $0.8 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 six months ended June 30, 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 CEO for lease on a time-sharing basis. The Company charges the CEO for personal use based on agreed upon reimbursement rates. For the three and six months ended June 30, 2018, the Company charged the CEO less than $0.1 million related to such reimbursements.
5. Inventories
Inventories consist of the following (in thousands):
 
June 30,
2018
 
December 30,
2017
As Adjusted
Raw materials
$
35,441

 
$
31,200

Work-in-process
7,937

 
8,619

Finished goods
47,470

 
52,440

     Total inventories
$
90,848

 
$
92,259

6. Other Current Assets
Other current assets consist of the following (in thousands):
 
June 30,
2018
 
December 30,
2017
As Adjusted
Prepaid expenses
$
10,932

 
$
10,517

Royalties receivable
7,500

 
7,400

Local tax receivables
6,969

 
6,556

Prepaid income taxes
4,245

 
3,493

Customer notes receivable
2,565

 
2,777

Employee loans and advances
340

 
364

Restricted cash

 
33

Other current assets
2,534

 
2,461

     Total other current assets
$
35,085

 
$
33,601


19

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):
 
June 30,
2018
 
December 30,
2017
As Adjusted
Deferred cost of goods sold
$
102,565

 
$
93,261

Prepaid contract incentives
5,631

 
6,115

Deferred commissions
5,395

 
5,613

Unbilled contract receivables
3,395

 
4,267

     Deferred costs and other contract assets
$
116,986

 
$
109,256

For the three and six months ended June 30, 2018, $7.2 million and $14.8 million, respectively, of deferred cost of goods sold was amortized to cost of goods sold. For the three and six months ended July 1, 2017, $7.1 million and $13.9 million, respectively, of deferred costs of goods sold was amortized to cost of goods sold.
For the three and six months ended June 30, 2018, $0.4 million and $0.8 million of prepaid contract incentives was amortized as a reduction to revenue and to selling, general and administrative expenses, respectively. For the three and six months ended July 1, 2017, $0.5 million and $0.9 million of prepaid contract incentives was amortized as a reduction to revenue and to selling, general and administrative expenses, respectively.
For the three and six months ended June 30, 2018, $0.5 million and $1.1 million of deferred commissions was amortized as a reduction to revenue and to selling, general and administrative expenses, respectively. For the three and six months ended July 1, 2017, $0.6 million and $1.2 million of deferred commissions was amortized as a reduction to revenue and to selling, general and administrative expenses, respectively.
8. Property and Equipment
Property and equipment, net, consists of the following (in thousands):
 
June 30,
2018
 
December 30,
2017
Building and building improvements
$
88,234

 
$
87,999

Machinery and equipment
51,471

 
47,556

Aircraft and vehicles
25,555

 
25,329

Land
23,762

 
23,762

Computer equipment
16,227

 
15,789

Leasehold improvements
16,141

 
15,326

Tooling
13,976

 
13,754

Furniture and office equipment
10,397

 
9,967

Demonstration units
479

 
486

Construction-in-progress (CIP)
7,771

 
6,365

     Total property and equipment
254,013

 
246,333

Accumulated depreciation and amortization
(89,986
)
 
(82,237
)
     Property and equipment, net
$
164,027

 
$
164,096

For the three months ended June 30, 2018 and July 1, 2017, depreciation expense of property and equipment was $4.1 million and $3.5 million, respectively. For the six months ended June 30, 2018 and July 1, 2017, depreciation expense of property and equipment was $8.1 million and $7.0 million, respectively.
The balances in CIP at June 30, 2018 and December 30, 2017 relate 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.

20

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

9. Intangible Assets
Intangible assets, net, consist of the following (in thousands):
 
June 30,
2018
 
December 30,
2017
Patents
$
19,833

 
$
20,623

Customer relationships
7,669

 
7,669

Licenses-related party
7,500

 
7,500

Acquired technology
5,580

 
5,580

Trademarks
4,168

 
4,036

Capitalized software development costs
2,998

 
2,699

Other
5,466

 
3,691

     Total intangible assets
53,214

 
51,798

Accumulated amortization
(25,235
)
 
(24,675
)
     Intangible assets, net
$
27,979

 
$
27,123

Total amortization expense for the three months ended June 30, 2018 and July 1, 2017 was $1.4 million and $1.0 million, respectively. Total amortization expense for the six months ended June 30, 2018 and July 1, 2017 was $2.5 million and $2.1 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)
$
4,288

2019
3,787

2020
3,630

2021
3,395

2022
1,848

Thereafter
11,031

     Total
$
27,979

10. Other Non-Current Assets
Other assets, long-term consist of the following (in thousands):
 
June 30,
2018
 
December 30,
2017
As Adjusted
Prepaid deposits
$
2,619

 
$
3,286

Long term investments
1,515

 
1,234

Restricted cash(1)
147

 
148

Total other assets, long-term
$
4,281

 
$
4,668

______________
(1) Restricted cash long term is generally related to collateral for certain lease deposits or other bank guarantees.

21

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):
 
June 30,
2018
 
December 30,
2017
As Adjusted
Accrued indirect taxes payable
$
7,738

 
$
6,711

Accrued expenses
3,752

 
2,924

Accrued taxes
3,388

 
5,390

Accrued GPO fees
2,081

 
2,351

Accrued warranty
1,841

 
1,149

Related party payables
1,779

 
1,528

Accrued legal fees
1,158

 
975

Accrued stock repurchases

 
1,988

Accrued donations
294

 
548

Other
801

 
690

     Total accrued and other current liabilities
$
22,832

 
$
24,254

12. Deferred Revenue and Other Contract-Related Liabilities
Deferred revenue and other contract-related liabilities consist of the following (in thousands):
 
June 30,
2018
 
December 30,
2017
As Adjusted
Accrued customer reimbursements
$
18,745

 
$
16,896

Deferred revenue
11,321

 
11,589

Accrued rebates and incentives
5,190

 
3,598

Other contract-related liabilities
481

 
259

     Total deferred revenue and other contract-related liabilities
35,737

 
32,342

Less: Non-current portion of deferred revenue
(747
)
 
(237
)
     Deferred revenue and other contract-related liabilities - current
$
34,990

 
$
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 six months ended June 30, 2018 were as follows:
 
Six Months Ended 
 June 30, 2018
Deferred revenue, beginning of the period
$
11,589

  Revenue deferred during the period
4,853

  Recognition of revenue deferred in prior periods
(5,121
)
     Deferred revenue, end of the period
$
11,321

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 June 30, 2018 and the future periods within which the Company expects to recognize such revenue.

22

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
$
173,804

 
$
238,604

 
$
92,500

 
$
14,591

 
$
519,499

13. Other Non-Current Liabilities
Other non-current liabilities consist of the following (in thousands):
 
June 30,
2018
 
December 30,
2017
Income tax payable, long-term
$
25,734

 
$
25,734

Unrecognized tax benefits
15,179

 
14,348

Deferred tax liabilities
9,654

 
9,880

Deferred rent, long-term
1,251

 
1,266

Deferred revenue, long-term
747

 
237

Other
177

 
292

     Total other non-current liabilities
$
52,742

 
$
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 can purchase up to 5.0 million shares of its common stock over a period of up to three years (2015 Repurchase Program). The total remaining shares authorized for repurchase under the 2015 Repurchase Program approximated 1.9 million shares as of June 30, 2018. The Company expects to fund the 2015 Repurchase Program through its available cash, cash expected to be generated from future operations and other potential sources of capital.
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 will become effective in September 2018 upon the expiration of the 2015 Repurchase Program.
The Company’s stock repurchase programs 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 six months ended June 30, 2018 and July 1, 2017 (in thousands, except per share amounts):
 
 
Three Months Ended
 
Six Months Ended
 
 
June 30,
2018
 
July 1,
2017
 
June 30,
2018
 
July 1,
2017
Shares repurchased
 

 

 
198

 

Average cost per share
 
$

 
$

 
$
84.14

 
$

Value of shares repurchased
 
$

 
$

 
$
16,490

 
$


23

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

15. Stock-Based Compensation
Total stock-based compensation expense for the three months ended June 30, 2018 and July 1, 2017 was $6.7 million and $3.3 million, respectively. Total stock-based compensation expense for the six months ended June 30, 2018 and July 1, 2017 was $12.1 million and $6.1 million, respectively. As of June 30, 2018, an aggregate of 12.8 million shares of common stock were reserved for future issuance under the Company’s equity plans, of which 3.3 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):
 
Six Months Ended 
 June 30, 2018
 
Shares
 
Average
Exercise Price
Options outstanding, beginning of period
6,953

 
$
36.26

Granted
356

 
88.62

Canceled
(132
)
 
49.66

Exercised
(693
)
 
28.54

Options outstanding, end of period
6,484

 
$
39.68

Options exercisable, end of period
3,896

 
$
27.34

Total stock option expense for the three and six months ended June 30, 2018 was $3.4 million and $6.8 million, respectively. Total stock option expense for the three and six months ended July 1, 2017 was $2.5 million and $5.5 million, respectively. As of June 30, 2018, the Company had $41.3 million of unrecognized compensation cost related to non-vested stock options that are expected to vest over a weighted average period of approximately 3.7 years. The weighted-average remaining contractual term of options outstanding with an exercise price less than the closing price of the Company’s common stock as of June 30, 2018 was 5.8 years. The weighted-average remaining contractual term of options exercisable, with an exercise price less than the closing price of the Company’s common stock as of June 30, 2018, was 4.4 years.

24

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):
 
Six Months Ended 
 June 30, 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 the three and six months ended June 30, 2018 was $0.2 million and $0.4 million, respectively. Total RSU expense for the three and six months ended July 1, 2017 was $0.1 million and $0.2 million, respectively. As of June 30, 2018, the Company had $0.6 million of unrecognized compensation cost related to non-vested RSU awards expected to be recognized and vest over a weighted-average period of approximately 0.9 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):
 
Six Months Ended 
 June 30, 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 six months ended June 30, 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 and six months ended June 30, 2018 was $3.2 million and $4.9 million, respectively. Total PSU expense for each of the three and six months ended July 1, 2017 was $0.6 million. As of June 30, 2018, the Company had $29.2 million of unrecognized compensation cost related to non-vested PSU awards expected to be recognized and vest over a weighted-average period of approximately 2.6 years.

25

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
 
Six Months Ended
 
June 30,
2018
 
July 1,
2017
 
June 30,
2018
 
July 1,
2017
Risk-free interest rate
2.6% to 2.9%
 
1.8% to 2.0%
 
2.3% to 2.9%
 
1.8% to 2.2%
Expected term (in years)
5.6
 
5.5
 
5.6
 
5.5
Estimated volatility
27.2% to 29.2%
 
29.8% to 30.3%
 
27.2% to 29.7%
 
29.7% to 30.3%
Expected dividends
0%
 
0%
 
0%
 
0%
Weighted-average fair value of options granted
$30.33
 
$28.58
 
$28.96
 
$27.82
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 June 30, 2018 was $375.9 million. The aggregate intrinsic value of options exercisable with an exercise price less than the closing price of the Company’s common stock as of June 30, 2018 was $273.9 million. The aggregate intrinsic value of options exercised during the six months ended June 30, 2018 was $44.4 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 June 30, 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 June 30, 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)
$
3,826

2019
6,398

2020
3,964

2021
2,375

2022
1,815

Thereafter
5,466

Total
$
23,844


Rental expense related to operating leases was $1.7 million and $3.5 million for the three and six months ended June 30, 2018, respectively, and $1.6 million and $3.2 million for the three and six months ended July 1, 2017, respectively.

26

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

Employee Retirement Savings Plan
The Company sponsors a qualified defined contribution plan or 401(k) plan, the Masimo Retirement Savings Plan (MRSP), covering the Company’s full-time U.S. employees who meet certain eligibility requirements. In general, the Company matches an employee’s contribution up to 3% of the employee’s compensation, subject to a maximum amount. The Company may also contribute to the MRSP on a discretionary basis. The Company contributed $0.6 million and $1.3 million to the MRSP for the three and six months ended June 30, 2018, respectively, and $0.6 million and $1.2 million to the MRSP for the three and six months ended July 1, 2017, respectively.
In addition, the Company also sponsors various defined contribution plans in certain locations outside of the United States (Subsidiary Plans). For the three and six months ended June 30, 2018, the Company contributed $0.1 million and $0.2 million to the Subsidiary Plans, respectively. For the three and six months ended July 1, 2017, the Company contributed $0.1 million and $0.2 million to the Subsidiary Plans, respectively.
Employment and Severance Agreements
In July 2017, the Company entered into the First Amendment 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 June 30, 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 June 30, 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 $75.9 million of purchase commitments as of June 30, 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 June 30, 2018, the Company had approximately $1.4 million in outstanding unsecured bank guarantees.

27

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 June 30, 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 June 30, 2018, the Company had $429.6 million of bank balances, of which $2.9 million was covered by either the U.S. Federal Deposit Insurance Corporation limit or foreign countries’ deposit insurance organizations.
While the Company and its contract manufacturers rely on sole source suppliers for certain components, steps have been taken to minimize the impact of a shortage or stoppage of shipments, such as maintaining a safety stock of inventory and designing products that could be modified to use different components. However, there can be no assurance that a shortage or stoppage of shipments of the materials or components that the Company purchases will not result in a delay in production or adversely affect the Company’s business.
The Company’s ability to sell its products to U.S. hospitals depends in part on its relationships with GPOs. Many existing and potential customers for the Company’s products become members of GPOs. GPOs negotiate pricing arrangements and contracts, sometimes exclusively, with medical supply manufacturers and distributors, and these negotiated prices are made available to a GPO’s affiliated hospitals and other members. During the three and six months ended June 30, 2018, revenue from the sale of the Company’s products to U.S. hospitals that are members of GPOs amounted to $115.9 million and $234.9 million, respectively. During the three and six months ended July 1, 2017, revenue from the sale of the Company’s products to U.S. hospitals that are members of GPOs amounted to $105.5 million and $205.1 million, respectively.
For the three months ended June 30, 2018, the Company had sales through two just-in-time distributors that represented 11.3% and 11.1% of total revenue, respectively. For the three months ended July 1, 2017, the Company had sales through the same two just-in-time distributors that represented 13.3% and 11.3% of total revenue, respectively.
For the six months ended June 30, 2018, the Company had sales to two just-in-time distributors that represented 12.5% and 10.9% of total revenue, respectively. For the six months ended July 1, 2017, the Company had sales to the same two just-in-time distributors that represented 13.7% and 11.7% of total revenue, respectively.
As of June 30, 2018, no single customer represented greater than 5.0% 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 six months ended June 30, 2018 and July 1, 2017, the Company recorded $17.2 million and $17.4 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 will be 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 six months ended June 30, 2018. 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.

28

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. 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, but there is no guarantee that the Company will prevail. The Company has not recorded a charge related to this dispute and is 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 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. The Company is unable to determine whether any loss will ultimately occur or to estimate the range of such loss; therefore, no amount of loss has been accrued by the Company in the accompanying consolidated financial statements.
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. Trial on the ‘764 patent is scheduled to begin on September 24, 2018. The Company believes it has good and substantial defenses to the remaining infringement claim relating to the ‘764 patent, but there is no guarantee that the Company will prevail. The Company’s policy is and has been not to settle patent infringement claims where it does not believe there is infringement of a valid patent, even if the cost of litigation would exceed the cost of settlement. Dominion is seeking approximately $5.7 million in alleged damages relating to the ‘764 patent. The Company is unable to determine whether any loss will ultimately occur; therefore, no amount of loss has been accrued by the Company in the accompanying condensed consolidated financial statements.

29

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

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.
17. Segment Information and Enterprise Reporting
The Company’s chief 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
 
Six Months Ended
 
June 30, 2018
 
July 1, 2017
As Adjusted
 
June 30, 2018
 
July 1, 2017
As Adjusted
Geographic area by destination:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
United States
$
140,134

 
69.4
%
 
$
123,265

 
68.6
%
 
$
281,175

 
69.2
%
 
$
252,054

 
69.6
%
Europe, Middle East and Africa
34,328

 
17.0

 
33,385

 
18.6

 
78,374

 
19.3

 
64,175

 
17.7

Asia and Australia
20,497

 
10.1

 
17,491

 
9.7

 
33,403

 
8.2

 
34,074

 
9.4

North and South America (excluding United States)
7,045

 
3.5

 
5,586

 
3.1

 
13,441

 
3.3

 
11,890

 
3.3

     Total product revenue
$
202,004

 
100.0
%
 
$
179,727

 
100.0
%
 
$
406,393

 
100.0
%
 
$
362,193

 
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):
 
June 30, 2018
 
December 30, 2017
As Adjusted
Long-lived assets by geographic area:
 
 
 
 
 
 
 
United States
$
271,951

 
95.3
%
 
$
265,678

 
95.6
%
International
13,343

 
4.7

 
12,342

 
4.4

     Total
$
285,294

 
100.0
%
 
$
278,020

 
100.0
%


30

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 six months ended June 30, 2018 and July 1, 2017, the Company recorded discrete tax benefits of approximately $7.1 million and $30.2 million, respectively, related to excess tax benefits realized from stock-based compensation.
Deferred tax assets and liabilities are determined based on the future tax consequences associated with temporary differences between income and expenses reported for accounting and tax purposes. A valuation allowance for deferred tax assets is recorded to the extent that the Company cannot determine that the ultimate realization of the net deferred tax assets is more likely than not. Realization of deferred tax assets is principally dependent upon the achievement of future taxable income, the estimation of which requires significant judgment by the Company’s management. The judgment of the Company’s management regarding future profitability may change due to many factors, including future market conditions and the Company’s ability to successfully execute its business plans or tax planning strategies. These changes, if any, may require material adjustments to these deferred tax asset balances.
As of June 30, 2018, the liability for income taxes associated with uncertain tax positions was approximately $16.8 million. If fully recognized, approximately $15.8 million (net of federal benefit on state taxes) would impact the Company’s effective tax rate. The remaining balance relates to timing differences. It is reasonably possible that the amount of unrecognized tax benefits in various jurisdictions may change in the next twelve months due to the expiration of statutes of limitation and audit settlements. However, due to the uncertainty surrounding the timing of these events, an estimate of the change within the next twelve months cannot currently be made.
The Company conducts business in multiple jurisdictions and, as a result, one or more of the Company’s subsidiaries files income tax returns in U.S. federal, various state, local and foreign jurisdictions. The Company has concluded all U.S. federal income tax matters through fiscal year 2013. 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.

31


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 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. Rainbow Lite sensors utilize twice as many wavelengths of light as SET® sensors, allowing rainbow Lite sensors to provide ORi and RPVi along with Masimo SET® Measure-through Motion and Low Perfusion pulse oximetry.

32


We also announced in January 2018 that the Rad-97 Pulse CO-Oximeter® had received FDA 510(k) clearance for home use. The 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. Evecombines 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.
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 September 2015, our board of directors (Board) authorized a stock repurchase program, whereby we may purchase up to 5.0 million shares of our common stock over a period of up to three years (2015 Repurchase Program). As of June 30, 2018, approximately 1.9 million shares remained authorized for repurchase under the 2015 Repurchase Program.
In July 2018, our Board approved a new stock repurchase program authorizing usto purchase up to 5.0 million additional shares of our common stock over a period of up to three years (2018 Repurchase Program). The 2018 Repurchase Program will become effective on September 11, 2018, upon the expiration of the 2015 Repurchase Program.
Our stock repurchase programs 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 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.

33


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
 
Six Months Ended
 
June 30,
2018
 
Percentage
of Revenue
 
July 1,
2017
As Adjusted
 
Percentage
of Revenue
 
June 30,
2018
 
Percentage
of Revenue
 
July 1,
2017
As Adjusted
 
Percentage
of Revenue
Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
202,004

 
95.5
%
 
$
179,727

 
93.5
 %
 
$
406,393

 
95.7
%
 
$
362,193

 
93.1
%
Royalty and other revenue
9,617

 
4.5

 
12,579

 
6.5

 
18,181

 
4.3

 
26,756

 
6.9

Total revenue
211,621

 
100.0

 
192,306

 
100.0

 
424,574

 
100.0

 
388,949

 
100.0

Cost of goods sold
69,474

 
32.8

 
65,405

 
34.0

 
138,766

 
32.7

 
129,634

 
33.3

Gross profit
142,147

 
67.2

 
126,901

 
66.0

 
285,808

 
67.3

 
259,315

 
66.7

Operating expenses:
 
 
 
 
 
 
 
 
 
 

 
 
 
 
Selling, general and administrative
71,418

 
33.7

 
66,670

 
34.7

 
142,593

 
33.6

 
132,756

 
34.1

Research and development
19,117

 
9.0

 
16,382

 
8.5

 
37,718

 
8.9

 
30,559

 
7.9

Total operating expenses
90,535

 
42.8

 
83,052

 
43.2

 
180,311

 
42.5

 
163,315

 
42.0

Operating income
51,612

 
24.4

 
43,849

 
22.8

 
105,497

 
24.8

 
96,000

 
24.7

Non-operating income
1,405

 
0.7

 
158

 
0.1

 
3,052

 
0.7

 
1,032

 
0.3

Income before provision (benefit) for income taxes
53,017

 
25.1

 
44,007

 
22.9

 
108,549

 
25.6

 
97,032

 
24.9

Provision (benefit) for income taxes
9,164

 
4.3

 
(1,131
)
 
(0.6
)
 
19,066

 
4.5

 
361

 
0.1

Net income
$
43,853

 
20.7
%
 
$
45,138

 
23.5
 %
 
$
89,483

 
21.1
%
 
$
96,671

 
24.9
%
Comparison of the Three Months ended June 30, 2018 to the Three Months ended July 1, 2017(1)
Revenue. Total revenue increased $19.3 million, or 10.0%, to $211.6 million for the three months ended June 30, 2018 from $192.3 million for the three months ended July 1, 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 June 30, 2018 and July 1, 2017 (dollars in thousands):
 
Three Months Ended
 
June 30, 2018
 
July 1, 2017
As Adjusted
 
Increase/
(Decrease)
 
Percentage
Change
United States
$
140,134

 
69.4
%
 
$
123,265

 
68.6
%
 
$
16,869

 
13.7
 %
Europe, Middle East and Africa
34,328

 
17.0

 
33,385

 
18.6

 
943

 
2.8

Asia and Australia
20,497

 
10.1

 
17,491

 
9.7

 
3,006

 
17.2

North and South America (excluding United States)
7,045

 
3.5

 
5,586

 
3.1

 
1,459

 
26.1

     Total product revenue
$
202,004

 
100.0
%
 
$
179,727

 
100.0
%
 
$
22,277

 
12.4
 %
Royalty and other revenue
9,617

 
 
 
12,579

 
 
 
(2,962
)
 
(23.5
)
     Total revenue
$
211,621

 
 
 
$
192,306

 
 
 
$
19,315

 
10.0
 %


_______________
(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.


34



Product revenue increased $22.3 million, or 12.4%, to $202.0 million for the three months ended June 30, 2018, compared to $179.7 million for the three months ended July 1, 2017. This increase was primarily due to higher sales of consumables, monitors and parameters, as well as the impact of approximately $2.2 million of favorable foreign exchange rate movements from the prior year period that increased the U.S. Dollar translation of foreign sales that were denominated in various foreign currencies, primarily in Europe. During the second quarter of 2018, we shipped approximately 58,700 SET® and rainbow® noninvasive technology boards and monitors, an increase of 8,700 units, or 17.4%, from 50,000 units shipped during the second quarter of 2017.
Product revenue generated through our direct and distribution sales channels increased $15.2 million, or 9.6%, to $172.5 million for the three months ended June 30, 2018, compared to $157.3 million for the three months ended July 1, 2017. Revenues from our OEM channel increased $7.1 million, or 31.7%, to $29.5 million for the three months ended June 30, 2018 as compared to $22.4 million for the three months ended July 1, 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 June 30, 2018, royalty and other revenue decreased by $3.0 million, which was primarily related to lower NRE service revenue, when compared to the three months ended July 1, 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 will be due.
Gross Profit. Gross profit consists of total revenue less cost of goods sold. Our gross profit for the three months ended June 30, 2018 and July 1, 2017 was as follows (dollars in thousands):
 
Three Months Ended
 
June 30,
2018
 
Gross Profit
Percentage
 
July 1,
2017
As Adjusted
 
Gross Profit
Percentage
 
Increase/
(Decrease)
 
Percentage
Change
Product gross profit
$
132,732

 
65.7
%
 
$
115,114

 
64.0
%
 
$
17,618

 
15.3
 %
Royalty and other revenue gross profit
9,415

 
97.9

 
11,787

 
93.7

 
(2,372
)
 
(20.1
)
     Total gross profit
$
142,147

 
67.2
%
 
$
126,901

 
66.0
%
 
$
15,246

 
12.0
 %
Cost of goods sold includes labor, material, overhead and other similar costs related to the production, supply, distribution and support of our products. Cost of goods sold increased $4.1 million for the three months ended June 30, 2018, compared to the three months ended July 1, 2017, primarily due to increased product revenue. Product gross margins increased to 65.7% for the three months ended June 30, 2018 compared to 64.0% for the three months ended July 1, 2017, primarily due to favorable product mix and improved manufacturing efficiencies. Royalty and other revenue gross profit decreased by $2.4 million for the three months ended June 30, 2018 compared to the three months ended July 1, 2017, primarily due to lower NRE service revenue.
Selling, General and Administrative. Selling, general and administrative expenses consist primarily of salaries and related expenses for sales, marketing and administrative personnel, sales commissions, advertising and promotion costs, professional fees related to legal, accounting and other outside services, public company costs and other corporate expenses. Selling, general and administrative expenses for the three months ended June 30, 2018 and July 1, 2017 were as follows (dollars in thousands):
Selling, General and Administrative
Three Months Ended 
 June 30, 2018
Percentage of
Net Revenues
Three Months Ended 
 July 1, 2017
As Adjusted
Percentage of
Net Revenues
Increase/
(Decrease)
Percentage
Change
$71,418
33.7%
$66,670
34.7%
$4,748
7.1%
Selling, general and administrative expenses increased $4.7 million, or 7.1%, for the three months ended June 30, 2018, compared to the three months ended July 1, 2017. This increase was primarily attributable to higher payroll and employee-related costs of approximately $6.4 million, which were partially offset by lower legal fees of $1.9 million. Approximately $5.3 million and $2.6 million of stock-based compensation expense was included in selling, general and administrative expenses for the three months ended June 30, 2018 and July 1, 2017, respectively.

35


Research and Development. Research and development expenses consist primarily of salaries and related expenses for engineers and other personnel engaged in the design and development of our products. These expenses also include third-party fees paid to consultants, prototype and engineering supply expenses and the costs of clinical trials. Research and development expenses for the three months ended June 30, 2018 and July 1, 2017 were as follows (dollars in thousands):
Research and Development
Three Months Ended 
 June 30, 2018
Percentage of
Net Revenues
Three Months Ended 
 July 1, 2017
As Adjusted
Percentage of
Net Revenues
Increase/
(Decrease)
Percentage
Change
$19,117
9.0%
$16,382
8.5%
$2,735
16.7%
Research and development expenses increased $2.7 million, or 16.7%, for the three months ended June 30, 2018, compared to the three months ended July 1, 2017, primarily due to higher payroll and employee-related costs of approximately $1.5 million, lower allocations to cost of goods sold for NRE service costs of approximately $0.6 million and higher occupancy costs of $0.4 million. Included in research and development expenses was approximately $1.4 million and $0.6 million of stock-based compensation expense for the three months ended June 30, 2018 and July 1, 2017, respectively.
Non-operating Income. Non-operating income consists primarily of interest income, interest expense and foreign exchange gains and losses. Non-operating income for the three months ended June 30, 2018 and July 1, 2017 was as follows (dollars in thousands):
Non-operating Income
Three Months Ended 
 June 30, 2018
Percentage of
Net Revenues
Three Months Ended 
 July 1, 2017
As Adjusted
Percentage of
Net Revenues
Increase/
(Decrease)
Percentage
Change
$1,405
0.7%
$158
0.1%
$1,247
789.2%
Non-operating income increased by $1.2 million for the three months ended June 30, 2018, compared to the three months ended July 1, 2017. Non-operating income for the three months ended June 30, 2018 consisted of approximately $1.7 million of net interest income, which was offset by approximately $0.6 million of net realized and unrealized losses on foreign currency denominated transactions. Non-operating income for the three months ended July 1, 2017 consisted of approximately $0.3 million of net realized and unrealized losses on foreign currency denominated transactions and approximately $0.5 million in net interest income.
Provision (Benefit) for Income Taxes. Our provision for income taxes for the three months ended June 30, 2018 and July 1, 2017 was as follows (dollars in thousands):
Provision (Benefit) for Income Taxes
Three Months Ended 
 June 30, 2018
Percentage of
Net Revenues
Three Months Ended 
 July 1, 2017
As Adjusted
Percentage of
Net Revenues
Increase/
(Decrease)
Percentage
Change
$9,164
4.3%
$(1,131)
(0.6)%
$10,295
(910.3)%
For the three months ended June 30, 2018, we recorded a provision for income taxes of approximately $9.2 million, or an effective tax rate of 17.3%, as compared to a benefit for income taxes of approximately $1.1 million, or an effective tax benefit rate of 2.6%, for the three months ended July 1, 2017. The increase in the effective tax rate for the three months ended June 30, 2018, resulted primarily from a decrease in the amount of excess tax benefits realized from stock-based compensation pursuant to ASU No. 2016-09, Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (ASU 2016-09) of approximately $11.2 million compared to the three months ended July 1, 2017. This increase was partially offset by the impact of a net decrease in the overall U.S. federal effective tax rate pursuant to various provisions within the Tax Cuts and Jobs Act of 2017.

36


Comparison of the Six Months ended June 30, 2018 to the Six Months ended July 1, 2017
Revenue. Total revenue increased $35.6 million, or 9.2%, to $424.6 million for the six months ended June 30, 2018 from $388.9 million for the six months ended July 1, 2017. The following table details our total product revenues by the geographic area to which the products were shipped for each of the six months ended June 30, 2018 and July 1, 2017 (dollars in thousands):