Aug 4, 2008
Executives
Steve Moran – General Counsel Joe Kiani – President & CEO Mark de Raad – Executive VP & CFO
Analysts
Matthew Dodd - Citigroup Bill Quirk - Piper Jaffray Tao Levy - Deutsche Bank Sara Michelmore - Cowen & Company Philip Legendy - Thomas Weisel Partners Joanne Wuensch– BMO Capital Markets Spencer Nam – Summer Street Research
Operator
Good day ladies and gentlemen, and welcome to the second quarter 2008 Masimo Corporation earnings conference call. (Operator Instructions) I would now like to turn the call over to your host for today's call, Mr.
Steve Moran, Executive Vice President, and General Counsel of Masimo; please proceed sir.
Steve Moran
Welcome to Masimo Corporation second fiscal quarter 2008 earnings release conference call. Our press release was distributed about an hour ago.
If you have not seen the release and would like to, a copy is posted on the Investor Relations page of our website at www.masimo.com. On the call today will be Joe Kiani, Masimo’s President and Chief Executive Officer, and Mark de Raad, Executive Vice President and Chief Financial Officer.
In just a few moments Joe and Mark will deliver remarks on our results achieved during the 2008 second quarter and general comments regarding our business including an update of our fiscal 2008 financial guidance. After Joe and Mark offer their comments there will be a question-and-answer session during which they will answer your questions.
Before we begin, let me remind you that this call may contain forward-looking statements. While these forward-looking statements reflect Masimo’s best current judgment they are subject to risks and uncertainties that could cause our actual results to vary.
Risk factors that could cause Masimo’s actual results to materially differ from our forecast are discussed in detail in our filings with the Securities and Exchange Commission. With that I would like to turn the call over to Joe Kiani, President and CEO.
Joe Kiani
Thank you so much Steve and thank you ladies and gentlemen for joining us on our second quarter 2008 business update and earnings call. With me on the call today is Mark de Raad, our Chief Financial Officer.
Earlier today we announced our financial results for our second quarter. We are happy with the continued adoption of our Masimo SET and Masimo Rainbow SET technology as evidenced by the shipment of an additional 29,000 new drivers into the marketplace.
In fact for the first half of 2008 our unit shipments on an annualized basis grew 24% from a net installed base at the end of December, 2007. Given the current challenging economic environment we were happy by the strength in the second quarter product revenues and in general we are happy with our financial results including our reported $0.18 per common share, well above our expectations.
In addition to our strong second quarter financial results which Mark will review with you in more detail the second fiscal quarter also included some important business and operational milestones including the May, 2008 FDA clearance of our noninvasive continuous hemoglobin measurement via Rainbow SET which took away one of the risks with our expected launch date. This FDA clearance came nearly three months earlier then we anticipated.
We expect the major US introduction of our new noninvasive continuous hemoglobin measurement to be at the ASA meeting this October which will be in Orlando, Florida. I would like to note that while we have received clearance for noninvasive continuous hemoglobin and the associated reusable sensor, we are still awaiting FDA clearance for our single patient adhesive Rainbow hemoglobin sensor which we filed after we received FDA clearance for the SpHb or continuous noninvasive hemoglobin technology.
Later in this call I will discuss our current thoughts regarding the SpHb market opportunities and whenever I refer to SpHb, I’m referring to the continuous noninvasive hemoglobin monitor. Number two, the introduction of the Rad-87, a new cost reduced Masimo Rainbow SET monitor specifically designed for the general floor which we believe with its integrated wireless communication capability will allow us to more aggressively pursue opportunities in the general floor, a market which we believe over time could be as large as the current critical care Pulse Oximetry marketplace.
In addition we expect Rad-87 to do well in international and other more cost sensitive markets. Third in May, Dartmouth-Hitchcock Medical Center presented its findings at the International Conference on rapid response systems which demonstrated Masimo patient SafetyNet delivering improvements in clinical outcomes and patient safety on the general floors which achieving very high marks with nurses.
Number four, in June a new clinical study published in the British Journal of Anesthesia concluded that under their study protocol Masimo’s PVI measurement can predict fluid responsiveness in mechanically ventilated patients under general anesthesia. PVI is one of the Rainbow measurements that’s available with our Pulse Oximetry Pulse CO-Oximetry platforms.
And finally number five, some late breaking news, the American Medical Association provided us formal direction to us that the current invasive hemoglobin reimbursement code CPT85018 could be used when billing for SpHb, which is our noninvasive continuous hemoglobin monitor in outpatient settings such as the physician office and emergency department. These important products and clinical studies and updates which build upon already strong foundations will I believe allow us to continue in our mission of helping clinicians provide better care for their patients.
Mark will now go through our Q2 2008 financial highlights and then discuss our updated 2008 guidance. After Mark’s review I would like to spend a few moments updating you on the general business, our products and our organization.
Then we will be happy to then answer your questions. Thank you.
Mark de Raad
Thank you Joe, hello everybody. Please keep in mind that all my comments will relate to financial results on a GAAP basis.
As a reminder in fiscal 2007 prior to our initial public offering, Masimo was required to report GAAP earnings per share under the two class method. For the benefit of our investors we have continued to include in our quarterly earnings releases as we did today, the non-GAAP 2007 financial statements with 2007 earnings per share computations as if the current if converted method had been used in the prior periods.
As Joe noted earlier today we reported record total second quarter revenues of $74.8 million which consisted of record product revenues of $61.9 million and royalty revenues of $12.9 million. This represented an approximate 30% increase in year-over-year product revenue growth.
We shipped 29,000 new Pulse Oximeters and Pulse CO-Oximeter units in the marketplace and based on these shipments we now estimate that our total worldwide installed base net of estimated retirements to be approximately 515,000 units. Importantly this is up 21% from the estimated 424,000 units of net units installed just one year ago.
As you know the shipment of these new units is important because once installed these units generate future sensor sales which continue to represent the most significant component of our total product solution revenues. During the second quarter we generated approximately $2.9 million in Rainbow related product revenues compared to $2.1 million in the prior year quarter.
This represented an approximate 40% increase in year-over-year Rainbow revenue growth. Of the record $2.9 million in Rainbow revenues, Rad-57 revenues accounted for approximately $2.4 million and other Rainbow revenues including sales of carbon-monoxide methemoglobin and PBI totaled approximately 500,000.
Second quarter 2008 product revenues generated from our direct and distribution channel totaled $48.1 million or 78% of total product revenues while our OEM revenues totaled $13.8 million or 22% of total product revenues. This compared to approximately 69% and 31% in the same prior year periods and is the result we believe of the combined impact of the benefits of our multi year investment in expanding our worldwide direct sales force as well as a slight decline in second quarter 2008 OEM revenues as compared to the same prior year quarter.
In addition our complete transition to direct sales initiatives in both Canada and Australia are continuing to contribute to higher direct product revenues as a percent of total product revenues. During the second quarter our US product revenues totaled $45.3 million or 73% of total product revenues compared to $35.6 million or 75% in the prior year period.
The increase from 25% international revenue in the second quarter of 2007 to 27% in the second quarter of 2008 was primarily due to improved shipments in our European region with notable revenue gains in Germany, France, and The United Kingdom. Our second quarter royalty and license fee revenue decreased to $12.9 million from $16.1 million in the prior year period due to the anticipated lower royalty rates associated with our 2006 settlement agreement with Nellcor, now known as Covidien.
As a reminder our settlement agreement with Nellcor included a 15% royalty rate in 2007 and a 13% rate in 2008. In the second quarter of 2008 we also benefited from approximately $.3 million in additional Covidien royalties then we had expected due primarily we believe to a history of stronger US Covidien sales activity in the early part of the fiscal year.
Our total second quarter product gross profit margins rose to 65.4% from 62.4% in the same prior year period. The year-over-year increase was due primarily to the beneficial impact of increased sensor and Rainbow product sales as well as better then expected manufacturing efficiencies resulting from higher production levels.
Total gross profit margins for the second quarter declined slightly to 71.4% from 71.9% in the same prior year period and was due entirely to the impact of $3.2 million in lower year-over-year royalty revenues. Our second quarter engineering expenses were approximately $6 million compared to $5.5 million in the same prior year period.
The year-over-year increase was due primarily to higher stock-based compensation expenses. Our second quarter selling, general and administrative expenses rose to $30.4 million up from $21.6 million in the prior year period.
This year-over-year increase was the combined result of a $4.1 million increase in payroll, payroll related and stock-based compensation costs associated with an increase in SG&A staffing which rose from 328 at June 30, 2007 to 393 at June 28, 2008 representing a 20% year-over-year increase. In addition to the costs associated with increased staffing levels, professional fee expenses increased $1.7 million due to higher patent litigation expenses and increased tax audit and other professional fees associated with the cost of being a public company including our ongoing SOX compliance activities.
Sales related travel expenses consistent with an increase in direct sales people from 104 at the end of June, 2007 to 123 at the end of June, 2008 rose by $1.4 million over the prior period while trade show marketing expenses increased by $540,000 due to an increase in the number of trade shows that we have attended this year compared to the prior year. Second quarter 2008 income before taxes was $17.4 million down slightly from $17.9 million in the prior year quarter.
This decline is entirely the result of the $3.2 million decline in royalty revenues which was nearly offset by the stronger product revenue and gross margins that I previously mentioned. Our 2008 second quarter effective tax rate fell to 39% from 41% in the prior year quarter due to the continuing benefit we have realized from the completion of an R&D tax credit project in the fourth quarter of 2007.
In summary despite the decline of nearly $3.2 million in second quarter 2008 royalty revenues our strong product revenues and higher product gross margins have resulted in second quarter 2008 net income of $10.6 million or $0.18 of GAAP earnings per common share compared to net income of $10.6 million or $0.13 of GAAP per share earnings in the same prior year period. Now I’d like to make just a few comments on our balance sheet.
For the three month period ended June 28, 2008 total cash increased to $102.9 million from $96.7 million at the end of December, 2007. During the first half of 2008 we generated $34 million in cash from operations and approximately $7.1 million in cash from employee stock option exercises.
This was offset by the use of approximately $30.1 million for the previously announced first quarter repayment of long-term debt and $4.6 million in capital equipment purchases. At June, 2008 our trade dates outstanding were about 43 while our inventory turns were 2.9.
These compared to trade date sales outstanding of about 44 and inventory turns of 3.5 at the end of December, 2007. Our inventory levels in the first six months have increased due to selected product technology transitions, as well as preparing for the introduction of our new products.
Despite these increases, our overall inventory levels are still within our agreed upon allowance and ensure that we’re able to meet the needs of our growing worldwide base of customers. I’d now like to make a couple of comments about our forward guidance.
In our earnings call in April, 2008 we indicated that it was our intention to provide annual financial guidance at the beginning of each fiscal year typically in the first call of that year and that if conditions warranted, and we believed appropriate we would update that guidance. Accordingly based on the results of the first half of 2008 and our updated expectations for the remainder of 2008 we are now offering the following updated annual guidance for fiscal year 2008.
Masimo now expects its total fiscal year 2008 product revenues to be approximately $253 million and total revenues including royalties to be approximately $300 million. These figures are up from the previous guidance of $246 million and $292 million respectively.
Masimo also now expects annual 2008 earnings per common share to be approximately $0.64 per share up from the prior guidance of $0.52 per share. As Joe mentioned at the outset, we’ve been very pleased with our product revenue growth through the first half of 2008 and it provides us with greater confidence in the product revenue assumptions we made at the start of the year and as a result we are increasing our product revenue guidance to the previously noted figures.
While we did receive higher then expected royalty payments in the second quarter we are not revising our second half 2008 estimated royalty revenue as history suggests that the revenues related to these royalty payments tend to decline throughout the year. It is also important to note that while we believe that our business model is relatively immune to the current economic climate if overall general economic conditions continue to deteriorate this could have an impact on our customers and in turn this could potentially have a negative impact on our current expectations.
Moving on to product gross profit margins, we now believe that the stronger then expected first half 2008 product gross margins are sustainable and are therefore increasing our own expectations by about a 70 basis point margin improvement over our prior expectations and we now expect second half 2008 gross profit margins to be in the 64.5% range to the 65% range. Our operating expenses despite our higher then projected revenues have remained slightly below our expectations due primarily to lower than anticipated hiring levels, and lower stock-based compensation expenses.
In fact our new estimates for total 2008 stock-based compensation have declined from $11 million to $8.2 million of which approximately $3.7 million was incurred in the first half of 2008 and approximately $4.5 million will be incurred in the second half of 2008. Partially offsetting these stock-based compensation charges are increased expenses in our sales variable expenses consistent with our higher then planned revenues, as well as other professional fees as previously noted associated with both higher patent litigation expenses, and our first year SOX related implementation costs.
We are retaining our initial 2008 effective tax rate guidance of 39% and based upon our updated stock option assumptions we now believe that our weighted average number of shares at the end of September, 2008 and December, 2008 will be approximately 60.6 million and 61 million respectively down slightly from our prior forecast of 61.3 million and 61.8 million respectively. So in summary the combination of our strong first half performance and the impact of the updated second half 2008 assumptions I have just mentioned will result in our new annual guidance per share of moving from $0.52 to $0.64.
Of course as usual these projections and guidance are estimates only and our actual performance could differ. Thank you for your time.
Now I’ll turn the call back to Joe.
Joe Kiani
Thank you Mark, as a reminder I wanted to reiterate a couple of important messages regarding Masimo and our position within the marketplace. In 1995 we revolutionized Pulse Oximetry with our measure Though Motion and Lower Profusion Masimo SET technology Pulse Oximetry.
Today Masimo SET is helping caring clinicians save numerous lives and eyes and Masimo SET is the gold standard for Pulse Oximetry. In 2005 we revolutionized noninvasive monitoring again with the introduction of Rainbow SET.
Masimo Rainbow SET allows clinicians and emergency professionals to measure carbon-monoxide, methemoglobin, PVI, and now hemoglobin and oxygen content continuously and noninvasively for the first time in addition to our revolutionary SpO2 and pulse rate NPI performance. Analysts have projected that or noninvasive continuous hemoglobin will be a billion dollar plus market bringing Masimo’s total potential market opportunity to between $3 billion and $4 billion a year.
Rainbow is exciting beyond what it will do for us in terms of growth. With it we hope to help clinicians to save and improve the lives of even more people.
I’d like to now provide you with some information regarding how we see the SpHb opportunity. We see two primary markets for SpHb; hospitals and doctors’ offices.
We have completed a significant amount of SpHb market research. I’ll provide an overview of the application in each care area as well as some of the market research findings that clinically and financially supported its use.
First let’s talk about the hospitals, the initial response to SpHb has been even higher then we anticipated. Overall our market research indicates that over 70% of the hospital physicians we surveyed believed that their hospital will obtain SpHb measurement capability.
There are three primary markets in the hospital; the operating room, intensive care unit, and the emergency department. The operating room is likely to be the first place where SpHb will be most used.
Continuous nature of our SpHb measurement is expected to help improve blood transfusion management by allowing transfusing earlier in some patients due to unexpected by dropping hemoglobin and avoiding unnecessary transfusion when hemoglobin is not low or dropping. Our market research showed that the majority of anesthesiologists and surgeons believe that SpHb would help them transfuse earlier when appropriate as well as avoiding unnecessary transfusions.
We believe that SpHb could save at least $75 in cost per surgical patient. In ICU, internal bleeding is a significant risk especially for post surgical cardiac and cancer patients.
Continuous SpHb monitoring will allow earlier identification of bleeding by detecting a drop in hemoglobin allowing clinicians to intervene and avoid negative patient outcomes. Transfusions are also common in the intensive care unit.
In fact 44% of all ICU patients get a transfusion, 85% of those who stay over one week and transfusions are often caused by the repeated blood draws required for lab tests. Our market research shows that the majority of intentisevists believe that continuous SpHb monitoring would help them identify bleeding earlier.
We believe that SpHb could save more then $80 per ICU patient monitored. In the emergency department where the spot check devise is probably the most difficult use model the current practice is to check hemoglobin in any patient with potential anemia.
In the US about one-third of the ED visits result in a hemoglobin measurement typically as part of a complete blood count or CBC while some hospitals check all patients. Spot checking with SpHb will allow ED physicians to act immediately in their diagnosis, treatment, and disposition of the patient and improve emergency department efficiencies by reducing the waiting time for labs to make decisions.
Our market research shows that the majority of ED physicians believe that SpHb will allow their ED to see five or more additional patients per day. We believe that SpHb testing in the ED will financially justify itself based on the reimbursement alone on a per test basis which I touched on earlier but could also result in significant increases in revenues due to increased patient through puts as five more patients per day, at $500 in revenue per patient, that would result in $2,500 more in total revenue each day at each emergency department.
So the second market opportunity that we see as kind of the first two large opportunities is the doctors’ office. Most doctors’ offices perform hemoglobin testing either through a lab or in their office.
So most offices are good targets for SpHb. Overall the initial physician office response has been even higher than we anticipated.
Our market research has shown that overall about two-thirds of physicians expect to make SpHb testing available in their office. The type of doctors that are most likely to perform SpHb testing are family practice, internal medicine, cardiology, OBGYN, hematology/oncology and pediatrician offices.
Current methods for hemoglobin testing include sending their patients to a reference lab which is a third of the time roughly, taking the blood samples themselves and sending it to a reference lab, which is another third of the time, performing point of care hemoglobin testing with one of the invasive devices currently available on the market which is 15% of the time, or through an in-office hematology analyzer which is another roughly 20% of the time. The current reimbursement depends on how the testing is performed.
If a physician sends their patients to a lab they get no reimbursement and the lab gets the reimbursement. If they take a blood sample and send the sample to the lab they get $3.00 for the blood draw and the lab typically gets $11.00 for full CBC differential test.
If they do point of care hemoglobin testing they get $3.31 per test for taking the blood through a finger stick and performing the test. If they do full lab testing in their office, they get $3.00 for the blood draw and $11.00 for full CBC differential test.
While reimbursement will be helpful in helping physician offices recover their costs for SpHb testing we believe their primary motivation in considering the test is not related to per test reimbursement. Our market research indicates that the reason office based physicians are most interested in SpHb are number one, the ability to incorporate hemoglobin test results immediately into diagnosis and treatment decisions.
Number two reducing needle sticks to their patients and three reducing staff time related to blood draws. From our data about three-quarters of the physicians believe that SpHb testing would allow them to see one or more additional patients per day due to improved efficiencies.
And over half believe it would allow them to see two our more patients per day. Overall they expect that SpHb could replace between a third to half of their current CBC testing.
As you know in discussions regarding geographic rollouts and commercialization it’s probably best to talk about where we are. We have FDA clearance for the technology and the reusable sensor.
We will have CE markets as soon as we complete full manufacturing process validation which is expected sometime in Q3. Additionally there are a variety of country-specific registrations that we are pursuing and expect in Q4 and throughout 2009.
To date we have completed sales training for our direct US and Europe sales teams and will be conducting training with other areas of the world in coordination with expected regulatory approvals. We expect to ship to a small group of initial US and European customers between 10 to 20 hospitals in Q3/Q4 and then fully commercialize the product in 2009.
As far as worldwide market size estimates analysts have put the market opportunity for SpHb in the $1 billion or more range. We think the market is at least this large and also note that any other new technology market adoption will occur over a long period of time; 10 years or more.
With that said, I want to end my talk with a couple of closing thoughts. Our clinical contribution and business model has allowed us to build a solid business with our breakthrough measure through motion pulse oximetry with room to grow as we bridge the gap between our new Pulse Oximetry and Pulse CO-Oximetry shipments and install bases which drives the sensor sales which is the most of our revenue.
In fact I’ve mentioned this before but with 2007 product revenue of $200 million and a billion dollar plus market growing at 6% to 8%, our 2007 revenues represented 20% of the worldwide Pulse Oximetry markets. Yet according to [inaudible] report in 2006 [inaudible] 38% of new Pulse Oximeters sold in the US hospital.
In 2007 we shipped even more Pulse Oximeters then 2006 in the US and grew at least three times more then the industry growth. If we continue at these rates within five years due to accumulation of the installed base our revenue market share should start matching our annual shipment percentages.
We have a great innovation engine. We have a very bright and talented engineering team as well as the overall team and we are eager to solve more of the remaining problems, clinicians and care providers face.
I would now like to open the call for your questions.
Operator
(Operator Instructions) Your first question comes from the line of Matthew Dodd - Citigroup
Matthew Dodd – Citigroup
From a gross margin standpoint how we should start thinking about how dilutive if at all the initial ramp and manufacturing for total hemoglobin reusable’s and for the disposable sensors might be and if they are at all dilutive how long will it take for them to be accretive to the gross margin going forward?
Joe Kiani
They will not be dilutive.
Matthew Dodd – Citigroup
Would you care to characterize perhaps how accretive they would be to margins?
Joe Kiani
I don’t believe they will be accretive as well. They’re in line with the current margin for now.
As efficiencies grow perhaps the margins will improve but for now they’ll be neither dilutive nor accretive.
Matthew Dodd – Citigroup
If you could go into more detail between the hospital and doctors office opportunity clearly the hospital is where you are at today. The doctors’ office is a new opportunity where you don’t necessary have the touch points, what do you consider to be a realistic timeframe to go after that market opportunity and what would be the best way to pursue that?
Joe Kiani
One of the things that I should probably bring up is that in the first half of the year we have brought together a very great bunch of good new hires with [Paul Janzen] as our EVP of Marketing, Dr. Michael O’Reilly as our EVP of Medical Affairs, Steve Moran who you met on the phone today is our EVP and General Counsel and Secretary, and we are in the process of some other key hires including the VP of Physician Offices as well as our head of international sales and head of business development.
So we think as far as timing is concerned, we hope to have the new VP of Physician Offices onboard with us in the next two months and our plan is to hopefully recruit a handful of sales people across the country to manage important territories and subject to clearance of our spot check device which is pending right now, we have a specific device in build for doctors’ offices for spot check of hemoglobin. We could be rolling into the market Q1 2009 with that device.
Matthew Dodd – Citigroup
You did mention the OEM sales were down year to year, can you discuss what was driving that and is that more of a secular trend or maybe just a little more insight.
Joe Kiani
I will do my best to answer that question, what I may say to you may not be the true answer but it’s the best answer we know. It seems that the OEMs especially the ones selling the more expensive patient monitors have had slowdown in their business due to the tightening of the capital markets that’s affected hospital purchases of their types of instruments.
So what we believe is that that trend might continue. Fortunately because the majority of our business comes from our own direct business which is not a business that requires capital equipment expenditure that’s why we’ve seen a continued rise in our business while unfortunately many of our OEMs have not done so well.
Operator
Your next question comes from the line of Bill Quirk - Piper Jaffray
Bill Quirk - Piper Jaffray
Just to expand on your comments about SpHb in terms of the full launch for both the US and Europe in 2009 should we be thinking about the front part, i.e. the first quarter here?
Joe Kiani
I sure hope so.
Bill Quirk - Piper Jaffray
So that’s what the plans are in other words.
Joe Kiani
Yes, assuming the rollout to select customers is successful without any major changes required, we expect to roll it out fully commercially in Q1, 2009.
Bill Quirk - Piper Jaffray
So we’re not looking for any more particular approvals once we get beyond the single sensor, correct?
Joe Kiani
In the US, no, in Japan we would have to get approval and in China we still would have to have approval for hemoglobin.
Bill Quirk - Piper Jaffray
Can we talk a bit about launch in Asia for hemoglobin?
Joe Kiani
Yes, of course, I just in fact returned from a long trip to Asia. Was happy to see our progress in both Japan and the rest of Asia.
Japan we have a great group of people that are supporting us clinically for the most expeditious regulatory approval as well as reimbursement in Japan. These are the leadership in anesthesiology and emergency in Japan.
So I’m very proud that these groups have assembled and are assisting us. Typically approval in Japan takes about 14 months.
We submitted our application several months so we should get approval in 2009 but I will caution you that Rad-57 which was our first Rainbow technology that we sought approval for in Japan took two years.
Bill Quirk - Piper Jaffray
So we should probably be thinking late 2009?
Joe Kiani
Yes.
Bill Quirk - Piper Jaffray
Just as we think about the overall list pricing it does appear to be coming in better than expected, is $1 million to $2 million still a pretty good number to be thinking about in terms of the contribution for 2008?
Joe Kiani
I think so. I think we obviously have to finish the process validation and roll the product out as we hope in Q3, Q4 but assuming we do there seems to be pretty good demand from the customer then we should be able to meet that.
But the good news is from what I understand out projections do not include today the hemoglobin revenues.
Bill Quirk - Piper Jaffray
So we should be thinking about $1 to $2 million but the guidance that you just gave us does not include that?
Joe Kiani
Correct.
Operator
Your next question comes from the line of Tao Levy - Deutsche Bank
Tao Levy - Deutsche Bank
Did you mention the price of the hemoglobin or what we should be thinking of that?
Joe Kiani
I did not. I think the price, I always fear I’m talking to my competitors, but the price on the hemoglobin is ranging between $2,000 to $8,000 depending on volume.
On the sensors it’s ranging between $90 to $130 depending on volume and that’s once the adhesive sensors get approved. Currently we’re not quoting prices on the adhesive sensors because we don’t have approval in the US although we are doing it in Europe.
And then as far as the reusable sensors, its roughly under $1,000 and it does have some limited life as far as how many hours it can be used. So I think for now that hopefully will cover it.
As far as the spot check device given the reimbursement for hemoglobin is $3.31 we’re looking at a spot check sensor that will cost roughly between $2.00 and $2.50 per test.
Tao Levy - Deutsche Bank
In terms of the hemoglobin launch what the [inaudible] from your partners perspective. Obviously you’ve incorporated SET into your OEMs and GE etc.
how do we get Rainbow to that level and any updates on getting hemoglobin incorporated there?
Joe Kiani
We are making good progress with our OEMs I think it would be a fair statement to say just about every one of our OEMs want hemoglobin, want Rainbow. We’re just looking at what kind of agreements make sense to give our OEMs the Rainbow technology.
So while to date we’ve signed up about over 10 companies, a few of the big ones like [Draeger] that we have announced. We have not announced any other agreements with some of the larger companies.
Tao Levy - Deutsche Bank
Do you have agreements with—or you just haven’t announced them or they’re in the works.
Joe Kiani
Well we do have some agreements with a couple of large companies that we’ve not yet announced but we don’t have any agreements at this point with the two biggest patient monitoring companies.
Tao Levy - Deutsche Bank
The right way to think about it then is its not going to be in the hospital’s hands at least into September, is that the right timeframe or maybe even a little bit thereafter, and then you have a big sort commercial or big launch at ASA in October, but the hospitals really aren’t going to be using it until October, November timeframe?
Joe Kiani
That’s sounds like the probable timeframe, yes.
Operator
Your next question comes from the line of Sara Michelmore - Cowen & Company
Sara Michelmore - Cowen & Company
On the hemoglobin, it sounds like in the course of your market research you did so some cost analysis is there an intention on your part to do some more formal cost benefit analysis or clinical trials that would examine that certain setting?
Joe Kiani
Yes in fact we have commissioned such an independent study; [Cap Gemini] is the group that’s going to do it. We should hopefully be rolling that out with the product in Q3/Q4 timeframe.
Sara Michelmore - Cowen & Company
Do you have the foreign exchange impact in the quarter in terms of the revenue impact there and can you talk us through how that works with the P&L, is that actually a negative gross margin dynamic for you?
Mark de Raad
The range of the numbers for the most recent quarter was we benefited to the extent of about $700,000 or when I mentioned the movement year-over-year from 25% to 27%, ballpark about 1% of that improvement was actually—we received that benefit courtesy of the foreign exchange benefit. We don’t actually have that much or that significant a foreign exchange impact on our revenue line primarily because literally half of our European revenues are actually dollar denominated.
However to the other side of your question our operating expenses are in local currency and so we actually do receive the full brunt, the negative impact of the exchange rate on our operating expenses. The net impact of the two on the bottom line was almost negligible this quarter.
Sara Michelmore - Cowen & Company
In terms of the set units that were shipped out this quarter at 29,000 should we think about that plus or minus being a good run rate for you going forward?
Mark de Raad
Traditionally we’ve talked about a 25,000 to 30,000 unit range as being the range that we’re very pleased with every quarter because remember those are new drivers being loaded on top of the already huge installed base of drivers. We’d like to be towards the high end of that 25,000 to 30,000 but I think 25,000 to 30,000 is the right range to be thinking about.
Operator
Your next question comes from the line of Philip Legendy - Thomas Weisel Partners
Philip Legendy - Thomas Weisel Partners
I wanted to ask if you can give the number of folks that you sampled in some of those marketing studies that you did. How many people were involved in these market research studies?
Joe Kiani
For the information that I gave you on the hospital we surveyed 200 physicians and for the doctors offices we surveyed 600 physicians.
Philip Legendy - Thomas Weisel Partners
How confident are you that you’re going to have adequate manufacturing capacity when you are ready to go into your full push with the hemoglobin parameter?
Joe Kiani
Frankly that’s what we’re working through right now because obviously we know how to make low volume prototypes so we’re not going to roll it out until we are confident that we can make it in the volumes necessary. I don’t expect we’ll be able to meet the entire order if everything came in at once but based on our modeling we believe capacity will not be an issue.
Philip Legendy - Thomas Weisel Partners
On the OEM partners what proportion of drivers today are placed by those OEM partners?
Joe Kiani
Normally I would say its 80% OEMs, 20% Masimo but I think in the past couple of quarters it’s probably been more like 70/30.
Philip Legendy - Thomas Weisel Partners
What proportion of or just the unit number, how many units out there are currently easy to upgrade to Rainbow capabilities?
Joe Kiani
The answer about 30,000 to maybe 50,000 are easy to upgrade. Another 50,000 require a hardware upgrade but its important to note that that is not what we think will be the limitation of our success with hemoglobin.
We’re not seeing a differentiation between hospitals that already have our devices that have a very easy upgrade solution versus hospitals that don’t have our devices at all and would need to purchase a device along with hemoglobin.
Operator
Your next question comes from the line of Joanne Wuensch– BMO Capital Markets
Joanne Wuensch– BMO Capital Markets
On R&D in the quarter R&D dipped a bit as a percentage of sales and that looks like something that may reoccur in the second quarter, could you tell us why that happened and how we might think about R&D as a percentage of sales going forward?
Mark de Raad
In the second quarter we actually had about $300,000 or so of engineering expenses that was capitalized pursuant to FAS 86, the software capitalization requirement. As soon as we received FDA approval our policy is that any future development expenses related to bringing that product to market are actually capitalized under that FAS 86.
So about $300,000 essentially came out of the Q2 engineering expense and went on to our balance sheet to be amortized over the life of the product once it’s actually introduced. So that’s something that we expect to continue through this quarter but then as soon as we actually ship the product that will discontinue.
So we’ll see a little bit of a pickup in that in the fourth quarter. Going forward in terms of percent of revenues we’ve traditionally hovered in the low double-digit range of engineering as a percent of revenues.
If you were to go out two, three, four years we expect that will probably remain right around 10%, 11%. That’s what we’re modeling, that’s where we expect to be.
That’s where we think we need to be frankly to continue to deliver the kind of technology that Masimo is bringing to the marketplace.
Joanne Wuensch– BMO Capital Markets
On cash, as you begin generate and build some more cash here, how do you think about the best uses of cash sort of in the near-term and then the medium to long-term?
Joe Kiani
We of course like to have the cash for a rainy day but also one of the things that we’re going to look at, we’re going to look at bringing in technology into the company and sometimes we think those can be done with cash acquisition because typically those are not very high valuation acquisitions. We’ve done a few of those in the past couple of years and we anticipate doing some more of them.
Operator
Your next question comes from the line of Spencer Nam – Summer Street Research
Spencer Nam – Summer Street Research
You outlined the opportunities in the hospital segment, the three areas that the SpHb could go into, which of those areas would be the largest opportunity or are they pretty similar in terms of the total opportunity?
Joe Kiani
The hospital market is bigger then the physicians’ offices market opportunity.
Spencer Nam – Summer Street Research
What about within the hospital, the surgical versus ICU versus ED?
Joe Kiani
I think long-term ICU will be the biggest but I think initially OR will be a bigger revenue generation for us then the ICU and the ED.
Spencer Nam – Summer Street Research
Just based on the descriptions of the survey, the results of the survey, it looks like there’s a pretty strong demand from the physicians and hospitals on the SpHb, what are you thoughts, and then you kind of mentioned at the end this is going to be a long-term adoption process, maybe even 10 yeas, how do you reconcile those two data points as many as 70% of the hospitals may be interested in bringing SpHb onboard, that sounds like it could be a fairly rapid adoption here.
Joe Kiani
Yes, it does and I’m basing the statement that it could take 10 plus years for market adoption as far as what it takes to get to standard of care, 70% to 80% of ORs, ICUs, EDs having SpHb, what I’ve seen in the past, it took Pulse Oximetry about 15 years to get there. It took defibrillators about 15 yeas to get there.
I’m basing that statement not on the reaction of our customers but historical products that had a lot of benefit and the time it took for them to reach their maximum adoption.
Spencer Nam – Summer Street Research
Based on your new guidance is there a different adoption behavior that’s going on in terms of Pulse Oximetry now versus six months ago when you provided your previous guidance, are you seeing an acceleration in the customers favoring the Masimo versus the competitors or is it just a revision bases on what your seeing as a steady growth that you had expected over the last six months.
Joe Kiani
I think I could give you two or three answers on that one. Number one we have been projecting 20% growth yet we’ve been delivering 30%.
I’m not certain how long we’ll be able to deliver that. Things haven’t changed in a negative so don’t take my statement in a wrong way but we keep getting pleasantly surprised by the excitement and success of our sales force.
The excitement of our customers and the success of our sales force, secondly with Masimo SET our technology was so much better then the competition that we’ve had for years, the guaranteed, that today its 500,000 over guarantee that we are better clinically then any other Pulse Oximeter technology. So certainly that level of confidence has meant that we keep winning every time clinically when there’s a true study done that compares products side by side in a scientific way, in a clinical way.
But of course the add of Rainbow giving CO to customers in the emergency department area, methemoglobin throughout the hospitals and PVI, OR and now hemoglobin certainly has made Masimo a more compelling choice then ever before compared to any other Pulse Oximetry company. So we’re seeing benefits of that and I hope we’ll continue to see the benefits of that.
Operator
Your final question is a follow-up from the line of Matthew Dodd - Citigroup
Matthew Dodd – Citigroup
Your guidance for gross margin is 64.5% to 65% implies a potential for a sequential decline in the margin, just wondering if you could comment on that.
Mark de Raad
Last quarter as I noted in my comments, we benefited from some unexpected favorable manufacturing variances. We believe the underlying gross margin improvement is what results in us being able to take our own internal projections up by those 70 basis points that I referred to.
However taking those up will still bring us slightly below, you’re right, the current quarter and again the current quarter was benefited by some what we expect were probably unique one-time manufacturing variances.
Matthew Dodd – Citigroup
If you give a little more insight as you work through getting some of the last big OEM accounts over, could you characterize maybe the conversations you had with, you’re having now with your OEM partners as far as volume commitments or what are the moving parts now as opposed to what they were the last time when you rolled out the Rainbow parameters?
Joe Kiani
Well all I can tell you is that these are confidential sensitive dialogues that I can’t get into the details of but I can tell you that some days we feel we’re very close to signing up with one or both of them and other days we feel like its never going to work out. These are just negotiations that is going to take place and we’re going to do what we think is in the best interest of Masimo.
The good news is the Rainbow platform which with one sensor, now can measure eight different parameters and many people believe may be even more important then some of the parameters they’re measuring with a patient monitors today. It can stand on its own next to one of those machines.
So unless we get agreements that we think are better then what we could do on our own, we’re not interested in licensing Rainbow to companies.
Matthew Dodd – Citigroup
Would it be fair to say that you feel more comfortable taking a more aggressive stance in negotiations at this point compared to prior?
Joe Kiani
I wouldn’t say aggressive, we’re looking for really two scenarios, either a full partnership or vendor customer scenario where it doesn’t have some of the perks of a full partnership. We’re going to have to decide, some of our OEMs will have to decide what if any of those they choose.
Operator
This now concludes the Masimo second quarter 2008 earnings conference call.