10-Q 1 masi-20190330x10q.htm 10-Q
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
________________________________________________
FORM 10-Q
________________________________________________
(Mark One)
ý | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 30, 2019
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
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
Securities Registered pursuant to Section 12(b) of the Act:
Title of each class |  | Trading Symbol(s) |  | Name of each exchange on which registered
Common Stock, $0.001 par value |  | MASI |  | The Nasdaq Stock Market LLC
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 March 30, 2019
Common stock, $0.001 par value |  |  |  | 53,337,183

Table of Contents
MASIMO CORPORATION
FORM 10-Q FOR THE QUARTER ENDED MARCH 30, 2019
TABLE OF CONTENTS

PART I. Financial Information
Item 1. | Financial Statements (unaudited): |
| Condensed Consolidated Balance Sheets as of March 30, 2019 and December 29, 2018 | 3
| Condensed Consolidated Statements of Operations for the three months ended March 30, 2019 and March 31, 2018 | 4
| Condensed Consolidated Statements of Comprehensive Income for the three months ended March 30, 2019 and March 31, 2018 | 5
| Condensed Consolidated Statements of Stockholders’ Equity for the three months ended March 30, 2019 and March 31, 2018 | 6
| Condensed Consolidated Statements of Cash Flows for the three months ended March 30, 2019 and March 31, 2018 | 7
| Notes to Condensed Consolidated Financial Statements | 8
Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 33
Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 41
Item 4. | Controls and Procedures | 42
PART II. Other Information |
Item 1. | Legal Proceedings | 42
Item 1A. | Risk Factors | 42
Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 64
Item 5. | Other Information | 65
Item 6. | Exhibits | 66
Signatures | 67

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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
MASIMO CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands, except par values)

| March 30, 2019 |  | December 29, 2018
ASSETS |  |  |
Current assets |  |  |
Cash and cash equivalents | $ | 412,861 |  |  | $ | 552,490 |
Short-term investments | 180,000 |  |  | — |
Trade accounts receivable, net of allowance for doubtful accounts of $1,738 and $1,535 at March 30, 2019 and December 29, 2018, respectively | 117,822 |  |  | 109,629 |
Inventories | 93,259 |  |  | 94,732 |
Other current assets | 46,355 |  |  | 29,227 |
Total current assets | 850,297 |  |  | 786,078 |
Lease receivable, noncurrent | 41,149 |  |  | — |
Deferred costs and other contract assets | 15,599 |  |  | 126,105 |
Property and equipment, net | 167,288 |  |  | 165,972 |
Intangible assets, net | 27,830 |  |  | 27,924 |
Goodwill | 22,376 |  |  | 23,297 |
Deferred tax assets | 30,464 |  |  | 21,210 |
Other non-current assets | 24,373 |  |  | 4,232 |
Total assets | $ | 1,179,376 |  |  | $ | 1,154,818 |
LIABILITIES AND STOCKHOLDERS’ EQUITY |  |  |
Current liabilities |  |  |
Accounts payable | $ | 32,970 |  |  | $ | 40,388 |
Accrued compensation | 30,040 |  |  | 49,486 |
Deferred revenue and other contract-related liabilities, current | 22,677 |  |  | 33,106 |
Other current liabilities | 35,470 |  |  | 24,627 |
Total current liabilities | 121,157 |  |  | 147,607 |
Other non-current liabilities | 53,143 |  |  | 38,146 |
Total liabilities | 174,300 |  |  | 185,753 |
Commitments and contingencies |  |  |
Stockholders’ equity |  |  |
Preferred stock, $0.001 par value; 5,000 shares authorized; 0 shares issued and outstanding at March 30, 2019 and December 29, 2018 | — |  |  | — |
Common stock, $0.001 par value; 100,000 shares authorized; 53,337 and 53,085 shares issued and outstanding at March 30, 2019 and December 29, 2018, respectively | 53 |  |  | 53 |
Treasury stock, 15,255 shares at March 30, 2019 and December 29, 2018 | (489,026 | ) |  | (489,026 | )
Additional paid-in capital | 547,225 |  |  | 533,164 |
Accumulated other comprehensive loss | (6,776 | ) |  | (6,199 | )
Retained earnings | 953,600 |  |  | 931,073 |
Total stockholders’ equity | 1,005,076 |  |  | 969,065 |
Total liabilities and stockholders’ equity | $ | 1,179,376 |  |  | $ | 1,154,818 |

The accompanying notes are an integral part of these condensed consolidated financial statements.
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MASIMO CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited, in thousands, except per share amounts)

|  | Three Months Ended
|  | March 30, 2019 |  | March 31, 2018
Revenue: |  |  |  |
Product |  | $ | 230,548 |  |  | $ | 204,389 |
Royalty and other revenue |  | 1,116 |  |  | 8,564 |
Total revenue |  | 231,664 |  |  | 212,953 |
Cost of goods sold |  | 80,022 |  |  | 69,292 |
Gross profit |  | 151,642 |  |  | 143,661 |
Operating expenses: |  |  |  |
Selling, general and administrative |  | 74,204 |  |  | 70,217 |
Research and development |  | 21,415 |  |  | 19,559 |
Total operating expenses |  | 95,619 |  |  | 89,776 |
Operating income |  | 56,023 |  |  | 53,885 |
Non-operating income |  | 3,886 |  |  | 1,647 |
Income before provision for income taxes |  | 59,909 |  |  | 55,532 |
Provision for income taxes |  | 10,587 |  |  | 9,902 |
Net income |  | $ | 49,322 |  |  | $ | 45,630 |
Net income per share: |  |  |  |
Basic |  | $ | 0.93 |  |  | $ | 0.88 |
Diluted |  | $ | 0.87 |  |  | $ | 0.82 |
Weighted-average shares used in per share calculations: |  |  |  |
Basic |  | 53,210 |  |  | 51,709 |
Diluted |  | 56,799 |  |  | 55,496 |

The accompanying notes are an integral part of these condensed consolidated financial statements.
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MASIMO CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(unaudited, in thousands)

|  | Three Months Ended
|  | March 30, 2019 |  | March 31, 2018
Net income |  | $ | 49,322 |  |  | $ | 45,630 |
Other comprehensive income, net of tax: |  |  |  |
Unrealized losses from foreign currency translation adjustments |  | (577 | ) |  | (270 | )
Comprehensive income |  | $ | 48,745 |  |  | $ | 45,360 |

The accompanying notes are an integral part of these condensed consolidated financial statements.
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MASIMO CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (in thousands)
| Three Months Ended March 31, 2018
| Common Stock |  | Treasury Stock |  | Additional Paid-In Capital |  | Accumulated Other Comprehensive Loss |  | Retained Earnings |  | Total Stockholders’ Equity
Shares |  | Amount |  | Shares |  | Amount |
Balance at December 30, 2017 | 51,636 |  |  | $ | 52 |  |  | 15,059 |  |  | $ | (472,536 | ) |  | $ | 461,494 |  |  | $ | (2,941 | ) |  | $ | 737,956 |  |  | $ | 724,025 |
Stock options exercised | 314 |  |  | — |  |  | — |  |  | — |  |  | 8,880 |  |  | — |  |  | — |  |  | 8,880 |
Restricted/Performance stock units vested | 31 |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Shares paid for tax withholding | (2 | ) |  | — |  |  | — |  |  | — |  |  | (168 | ) |  | — |  |  | — |  |  | (168 | )
Stock-based compensation | — |  |  | — |  |  | — |  |  | — |  |  | 5,332 |  |  | — |  |  | — |  |  | 5,332 |
Repurchases of common stock | (196 | ) |  | — |  |  | 196 |  |  | (16,490 | ) |  | — |  |  | — |  |  | — |  |  | (16,490 | )
Net income | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | 45,630 |  |  | 45,630 |
Adoption of ASU 2016-16 | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | (426 | ) |  | (426 | )
Foreign currency translation adjustment | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | (270 | ) |  | — |  |  | (270 | )
Balance at March 31, 2018 | 51,783 |  |  | $ | 52 |  |  | 15,255 |  |  | $ | (489,026 | ) |  | $ | 475,538 |  |  | $ | (3,211 | ) |  | $ | 783,160 |  |  | $ | 766,513 |
| Three Months Ended March 30, 2019
| Common Stock |  | Treasury Stock |  | Additional Paid-In Capital |  | Accumulated Other Comprehensive Loss |  | Retained Earnings |  | Total Stockholders’ Equity
Shares |  | Amount |  | Shares |  | Amount |
Balance at December 29, 2018 | 53,085 |  |  | $ | 53 |  |  | 15,255 |  |  | $ | (489,026 | ) |  | $ | 533,164 |  |  | $ | (6,199 | ) |  | $ | 931,073 |  |  | $ | 969,065 |
Stock options exercised | 224 |  |  | — |  |  | — |  |  | — |  |  | 6,867 |  |  | — |  |  | — |  |  | 6,867 |
Restricted/Performance stock units vested | 29 |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Shares paid for tax withholding | (1 | ) |  | — |  |  | — |  |  | — |  |  | (123 | ) |  | — |  |  | — |  |  | (123 | )
Stock-based compensation | — |  |  | — |  |  | — |  |  | — |  |  | 7,317 |  |  | — |  |  | — |  |  | 7,317 |
Cumulative effect of adoption of ASU 2016-02 | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | (26,795 | ) |  | (26,795 | )
Net income | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | 49,322 |  |  | 49,322 |
Foreign currency translation adjustment | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | (577 | ) |  | — |  |  | (577 | )
Balance at March 30, 2019 | 53,337 |  |  | $ | 53 |  |  | 15,255 |  |  | $ | (489,026 | ) |  | $ | 547,225 |  |  | $ | (6,776 | ) |  | $ | 953,600 |  |  | $ | 1,005,076 |

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MASIMO CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)

| Three Months Ended
| March 30, 2019 |  | March 31, 2018
Cash flows from operating activities: |  |  |
Net income | $ | 49,322 |  |  | $ | 45,630 |
Adjustments to reconcile net income to net cash provided by operating activities: |  |  |
Depreciation and amortization | 5,419 |  |  | 5,241 |
Stock-based compensation | 7,317 |  |  | 5,332 |
Loss on disposal of property, equipment and intangibles | 65 |  |  | 429 |
Provision from doubtful accounts | 234 |  |  | (394 | )
Benefit from deferred income taxes | (31 | ) |  | — |
Changes in operating assets and liabilities: |  |  |
(Increase) decrease in accounts receivable | (8,531 | ) |  | 17,776 |
Decrease in inventories | 1,357 |  |  | 1,139 |
Decrease (increase) in other current assets | 3,043 |  |  | (204 | )
Increase in lease receivable, net | (3,104 | ) |  | — |
Decrease (increase) in deferred costs and other contract assets | 7,120 |  |  | (5,706 | )
(Increase) decrease in other non-current assets | (115 | ) |  | 644 |
(Decrease) increase in accounts payable | (6,097 | ) |  | 2,363 |
Decrease in accrued compensation | (19,364 | ) |  | (11,074 | )
(Decrease) increase in accrued liabilities | (2,736 | ) |  | 2,193 |
Increase in income tax payable | 5,566 |  |  | 6,318 |
Increase in deferred revenue and other contract-related liabilities | 2,377 |  |  | 2,381 |
Increase (decrease) in other non-current liabilities | 626 |  |  | (73 | )
Net cash provided by operating activities | 42,468 |  |  | 71,995 |
Cash flows from investing activities: |  |  |
Purchases of short-term investments | (180,000 | ) |  | — |
Purchases of property and equipment, net | (6,963 | ) |  | (3,788 | )
Increase in intangible assets | (1,040 | ) |  | (3,583 | )
Net cash used in investing activities | (188,003 | ) |  | (7,371 | )
Cash flows from financing activities: |  |  |
Proceeds from issuance of common stock | 6,288 |  |  | 8,415 |
Payroll tax withholdings on behalf of employees for vested equity awards | (123 | ) |  | (168 | )
Repurchases of common stock | — |  |  | (18,479 | )
Net cash provided by (used in) financing activities | 6,165 |  |  | (10,232 | )
Effect of foreign currency exchange rates on cash | (261 | ) |  | (225 | )
Net (decrease) increase in cash, cash equivalents, and restricted cash | (139,631 | ) |  | 54,167 |
Cash, cash equivalents and restricted cash at beginning of period | 552,641 |  |  | 315,483 |
Cash, cash equivalents and restricted cash at end of period | $ | 413,010 |  |  | $ | 369,650 |

The accompanying notes are an integral part of these condensed consolidated financial statements.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. Description of the Company
Masimo Corporation (the Company) is a global medical technology company that develops, manufactures and markets a variety of noninvasive patient monitoring technologies and hospital automation solutions. 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 monitor carboxyhemoglobin (SpCO®), methemoglobin (SpMet®), total hemoglobin concentration (SpHb®), fractional arterial oxygen saturation (SpfO 2™), 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®), SedLine® brain function monitoring, NomoLine® capnography and gas monitoring and O3® regional oximetry. These technologies are based upon Masimo SET®, rainbow® and other proprietary algorithms and are incorporated into a variety of product platforms depending on customers' specifications. The Company’s current technology offerings also include remote patient monitoring, connectivity, and hospital automation solutions, including Masimo Patient SafetyNet 1, Masimo Patient SafetyNet Surveillance 1, Replica™, Iris®, MyView®, UniView® and Trace™. The Company's technologies are 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 29, 2018 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 29, 2018 (fiscal year 2018), filed with the SEC on February 26, 2019. The results for the three months ended March 30, 2019 are not necessarily indicative of the results to be expected for the fiscal year ending December 28, 2019 (fiscal year 2019) 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 Accounting Standards Codification (ASC) Topic 842, Leases (ASC 842), effective December 30, 2018. The Company applied the modified retrospective approach using the current-period adjustment method of adoption, whereby all periods beginning on or after December 30, 2018 are presented under ASC 842 with a cumulative effect adjustment to the opening balance sheet as of the first day of fiscal year 2019, and all prior period amounts are not adjusted and continue to be reported in accordance with the legacy accounting requirements under ASC Topic 840, Leases.
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 2019 is a 52 week fiscal year. All references to years in these notes to condensed consolidated financial statements are fiscal years unless otherwise noted.
__________________________________________
1 The use of the trademark Patient SafetyNet is under license from the University HealthSystem Consortium.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
Use of Estimates
The Company prepares its financial statements in conformity with GAAP, which requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Significant estimates include the determination of total contract consideration and how such consideration should be allocated to each performance obligation within a contract, credit loss allowances on accounts and lease receivables, inventory reserves, warranty reserves, rebate accruals, valuation of the Company’s equity awards, goodwill valuation, deferred taxes and any associated valuation allowances, deferred revenue, uncertain income tax positions, and litigation costs and related accruals. Actual results could differ from such estimates.
Reclassifications
Certain amounts in the accompanying condensed consolidated financial statements have been reclassified to conform to the current period presentation, including previously reported selling, general and administrative expenses that have been reclassified as research and development expenses within the condensed consolidated financial statements for the three months ended March 31, 2018.
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 three months ended March 30, 2019. The Company carries cash and cash equivalents at cost, which approximates fair value.
The following tables represent the Company’s financial assets (in thousands), measured at fair value on a recurring basis as of March 30, 2019:

|  |  |  |  |  |  |  |  | Reported as
| Adjusted Basis Cost |  | Gross Unrealized Gains |  | Gross Unrealized (Losses) |  | Estimated Fair Value |  | Cash and Cash Equivalents |  | Short-Term Investments
Cash | $ | 412,861 |  |  | $ | — |  |  | $ | — |  |  | $ | 412,861 |  |  | $ | 412,861 |  |  | $ | — |
Level 1: |  |  |  |  |  |  |  |  |  |  |
Certificates of deposit | 180,000 |  |  | — |  |  | — |  |  | 180,000 |  |  | — |  |  | 180,000 |
Subtotal | 180,000 |  |  | — |  |  | — |  |  | 180,000 |  |  | — |  |  | 180,000 |
Level 2: |  |  |  |  |  |  |  |  |  |  |
None | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Level 3: |  |  |  |  |  |  |  |  |  |  |
None | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Total assets measured at fair value | $ | 592,861 |  |  | $ | — |  |  | $ | — |  |  | $ | 592,861 |  |  | $ | 412,861 |  |  | $ | 180,000 |

As of December 29, 2018, 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 inputs.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
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.
Short-Term Investments
The Company classifies its investments in certificates of deposits maturing in one year or less as short-term investments. The carrying value of such investment approximates fair value and are accessible without any significant restrictions, taxes, or penalties. During the three months ended March 30, 2019, the Company invested $180.0 million in certificates of deposits with maturities ranging from 6 months to one year.
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.
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.
For the three months ended March 30, 2019 and March 31, 2018, depreciation and amortization expense of property and equipment was $5.4 million and $5.2 million, respectively.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
Lessee Right-of-Use (ROU) Assets and Lease Liabilities
As further discussed below in this Note 2 to these condensed consolidated financial statements, the Company adopted ASC 842 effective December 30, 2018. The Company determines if an arrangement contains a lease at inception. ROU assets represent the Company’s right to use an asset underlying an operating lease for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from an operating lease. ROU assets and lease liabilities are recognized at the commencement date based on the present value of lease payments over the lease term. The Company generally estimates the applicable discount rate used to determine the net present value of lease payments based on available information at the lease commencement date. Many of the Company’s lessee agreements include options to extend the lease, which the Company does not include in its lease terms unless they are reasonably certain to be exercised. The Company utilizes a portfolio approach to account for the ROU assets and liabilities associated with certain equipment leases. The Company has also made an accounting policy election not to separate lease and non-lease components for its real estate leases and to exclude short-term leases with a term of twelve months or less from its application of ASC 842. Rental expense for lease payments related to operating leases is recognized on a straight-line basis over the lease term.
Intangible Assets
The Company’s policy is to renew its patents and trademarks. Total renewal costs for patents and trademarks for the three months ended March 30, 2019 and March 31, 2018 were $0.3 million and $0.1 million, respectively. As of March 30, 2019, the weighted-average number of years until the next renewal was less than one year for patents and six years for trademarks. Costs to renew patents and trademarks are capitalized and amortized over the remaining useful life of the intangible asset. The Company continually evaluates the amortization period and carrying basis of patents and trademarks to determine whether any events or circumstances warrant a revised estimated useful life or reduction in value. Capitalized application costs are charged to operations when it is determined that the patent or trademark will not be obtained or is abandoned.
Impairment of Goodwill, Intangible Assets and Other Long-Lived Assets
Goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the acquired net tangible and intangible assets. Goodwill is not amortized, but instead is tested annually for impairment, or more frequently when events or changes in circumstances indicate that goodwill might be impaired. In assessing goodwill impairment, 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 flows 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 months ended March 30, 2019 and March 31, 2018.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
Revenue Recognition, and Deferred Revenue and Other Contract Liabilities
The Company derives the majority of its product revenue from four primary sources: (i) direct sales under deferred equipment agreements with end-user hospitals where the Company provides up-front monitoring equipment at no up-front charge in exchange for a multi-year sensor purchase commitment, (ii) other direct sales of noninvasive monitoring solutions to end-user hospitals, emergency medical response organizations and other direct customers; (iii) sales of noninvasive monitoring solutions to distributors who then typically resell to end-user hospitals, emergency medical response organizations and other 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 generally recognizes revenue following 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 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. Revenue related to equipment supplied under sales-type lease arrangements is recognized once control over the equipment is transferred to the customer, while revenue related to equipment supplied under operating-type lease arrangements is generally recognized on a straight-line basis over the term of the lease.
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) whether the arrangement contains an embedded lease, and if so, whether such embedded lease is a sales-type lease or an operating lease, (iii) how the arrangement consideration should be allocated to each performance obligation when multiple performance obligations exist, including the determination of standalone selling price, (iv) when to recognize revenue on the performance obligations, and (v) 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.
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.
Sales under deferred equipment agreements are generally structured such that the Company agrees to provide certain monitoring-related equipment, software, installation, training and/or warranty support at no up-front charge 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 allocates contract consideration under deferred equipment agreements containing fixed annual sensor purchase commitments to the underlying lease and non-lease components at contract inception. In determining whether any underlying lease components are related to a sales-type lease or an operating lease, the Company evaluates the customer’s rights and ability to control the use of the underlying equipment throughout the contract term, including any equipment substitution rights retained by the Company, as well as the Company’s expectations surrounding potential contract/lease extensions or renewals and the customer’s exercise of any purchase options. Revenue allocable to non-lease performance obligations is generally recognized as such non-lease performance obligations are satisfied. Revenue allocable to lease components under sales-type lease arrangements is generally recognized when the lease commences. Revenue allocable to lease components under operating lease arrangements is generally recognized over the term of the operating lease. The Company generally does not expect to derive any significant value in excess of such asset’s unamortized book value from equipment underlying its operating leases arrangements after the end of the agreement.
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.
Sales of integrated circuit boards and other products to the Company’s OEM customers are generally recognized as revenue at the time of shipment. Revenue related to OEM rainbow® parameter software licenses is generally recognized upon shipment of the OEM’s product to its customers, as reported to the Company by the OEM.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
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 arose from one agreement and was due and payable quarterly in arrears. An estimate of these royalty revenues was 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 was adjusted prospectively when the Company received the underlying royalty report, approximately sixty days after the end of the previous quarter. For the three months ended March 30, 2019 and March 31, 2018, the Company recognized royalty revenue pursuant to this agreement of approximately $0.7 million and $8.1 million, respectively. The Company received its final royalty payment from this agreement during the three months ended March 30, 2019.
The Company also recognizes revenue from time-to-time related to non-recurring engineering (NRE) services. NRE service revenue is generally recognized over time based on actual costs incurred by the Company.
Shipping and Handling Costs and Fees
All shipping and handling costs are expensed as incurred and are recorded as a component of cost of goods sold in the accompanying consolidated statements of operations. Charges for shipping and handling billed to customers are included as a component of product revenue.
Taxes Collected From Customers and Remitted to Governmental Authorities
The Company’s policy is to present revenue net of taxes collected from customers and remitted to governmental authorities.
Deferred Costs and Other Contract Assets
The costs of monitoring-related equipment provided to hospitals under operating lease arrangements within the Company’s deferred equipment agreements are generally deferred and amortized to cost of goods sold over the life of the underlying contracts. Some of the Company’s deferred equipment agreements 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 allocated to the lease and non-lease components and recognized as a reduction to revenue as the underlying performance obligations are satisfied.
The Company generally invoices its customers under deferred equipment agreements as sensors are provided to the customer. However, the Company may recognize revenue for certain non-lease performance obligations under deferred equipment agreements with fixed annual commitments at the time such performance obligations are satisfied and prior to the customer being invoiced. When this occurs, the Company records an unbilled contract receivable related to such revenue until the customer has been invoiced pursuant to the terms of the underlying deferred equipment agreement.
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 deferred equipment agreements 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 deferred equipment agreement. 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.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
Changes in the product warranty accrual were as follows (in thousands):

| Three Months Ended
| March 30, 2019 |  | March 31, 2018
Warranty accrual, beginning of period | $ | 1,910 |  |  | $ | 1,149 |
Accrual for warranties issued | 720 |  |  | 430 |
Changes to pre-existing warranties (including changes in estimates)(1) | 2,447 |  |  | (278 | )
Settlements made | (524 | ) |  | (161 | )
Warranty accrual, end of period | $ | 4,553 |  |  | $ | 1,140 |

______________

(1) | In connection with its adoption of ASC 842 on December 30, 2018, the Company recorded an adjustment to pre-existing warranties of $2.5 million related to equipment previously capitalized under its deferred equipment agreements where the embedded leases were treated as operating leases under prior guidance. See “Recently Adopted Accounting Pronouncements” to these condensed consolidated financial statements for additional information related to the Company’s adoption of ASC 842.

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

| Three Months Ended March 30, 2019
Accumulated other comprehensive loss, beginning of period | $ | (6,199 | )
Unrealized gains from foreign currency translation | (577 | )
Accumulated other comprehensive loss, end of period | $ | (6,776 | )

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 i s 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 months ended March 30, 2019 and March 31, 2018, weighted options to purchase 0.3 million and 0.9 million shares of common stock, respectively, were outstanding but not included in the computation of diluted net income per share because the effect of including such shares would have been antidilutive in the applicable period. Certain RSUs are considered contingently issuable shares as their vesting is contingent upon the occurrence of certain future events. Since such events had not occurred and were not considered probable of occurring as of each of March 30, 2019 and March 31, 2018, 2.7 million weighted average shares related to such RSUs have been excluded from the calculation of potential shares for each of the three month periods then ended.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
A reconciliation of basic and diluted net income per share is as follows (in thousands, except per share amounts):

|  | Three Months Ended
|  | March 30, 2019 |  | March 31, 2018
Net income |  | $ | 49,322 |  |  | $ | 45,630 |
Basic net income per share: |  |  |  |
Weighted-average shares outstanding - basic |  | 53,210 |  |  | 51,709 |
Net income per basic share |  | $ | 0.93 |  |  | $ | 0.88 |
Diluted net income per share: |  |  |  |
Weighted-average shares outstanding - basic |  | 53,210 |  |  | 51,709 |
Diluted share equivalent: stock options, RSUs and PSUs |  | 3,589 |  |  | 3,787 |
Weighted-average shares outstanding - diluted |  | 56,799 |  |  | 55,496 |
Net income per diluted share |  | $ | 0.87 |  |  | $ | 0.82 |

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

| Three Months Ended
| March 30, 2019 |  | March 31, 2018
Cash paid during the year for: |  |  |
Interest | $ | 13 |  |  | $ | 169 |
Income taxes | 2,157 |  |  | 1,023 |
Operating lease payments included in the measurement of lease liabilities | 1,748 |  |  | — |
Non-cash operating activities: |  |  |
ROU assets obtained in exchange for lease liabilities(1) | $ | 22,983 |  |  | $ | — |
Non-cash investing activities: |  |  |
Unpaid purchases of property, plant and equipment | $ | 1,127 |  |  | $ | 1,492 |
Non-cash financing activities: |  |  |
Unsettled common stock proceeds from option exercises | $ | 583 |  |  | $ | 794 |
Reconciliation of cash, cash equivalents and restricted cash: |  |  |
Cash and cash equivalents | $ | 412,861 |  |  | $ | 369,498 |
Restricted cash | 149 |  |  | 152 |
Total cash, cash equivalents and restricted cash shown in the statement of cash flow | $ | 413,010 |  |  | $ | 369,650 |

______________

(1) | In connection with its adoption of ASC 842 on December 30, 2018, the Company recorded a lessee operating lease ROU asset of $22.5 million. See “Recently Adopted Accounting Pronouncements” to these condensed consolidated financial statements for additional information related to the Company’s adoption of ASC 842.

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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
Recently Adopted Accounting Pronouncements
In February 2018, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (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 for certain stranded tax effects from accumulated other comprehensive income to retained earnings, and requires certain disclosures about stranded tax effects. ASU 2018-02 is effective for annual and interim periods beginning after December 15, 2018. The Company adopted this standard during the three months ended March 30, 2019 and such adoption did not have a material impact on its condensed consolidated financial statements.
In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (ASU 2016-02). Subsequent to the issuance of ASU 2016-02, the FASB clarified the guidance through several ASUs. The collective guidance was codified by the FASB in ASC 842, which, among other things (i) requires the Company to recognize an ROU asset and a lease liability for all operating leases for which the Company is the lessee; (ii) changes the classification of certain embedded leases within the Company’s deferred equipment agreements with its customers from operating to sales-type leases, resulting in the acceleration of revenue under certain contracts, as well as the immediate expensing of certain costs that were previously deferred and expensed over the term of the lease; and (iii) requires disclosures by the Company as a lessor and lessee about the amount, timing and uncertainty of cash flows arising from its leases.
On December 30, 2018, the Company adopted ASC 842 using the modified retrospective method for all lease arrangements at the beginning of the period of adoption. Results for reporting periods beginning December 30, 2018 are presented under ASC 842, while prior period amounts were not adjusted and continue to be reported in accordance with the Company’s historic accounting under ASC 840, Leases. Adoption of this new accounting standard had a material impact on the Company’s condensed consolidated balance sheet as of March 30, 2019, but did not have a significant impact on the Company’s consolidated net earnings and cash flows for the three months ended March 30, 2019. For leases that commenced before the effective date of ASC 842, the Company did not elect any of the permitted practical expedients. However, the Company utilized a portfolio approach for purposes of determining the discount rate associated with certain equipment leases and made certain accounting policy elections not to separate lease and non-lease components for its real estate leases and to exclude short-term leases with a term of twelve months or less from its application of ASC 842.
In connection with its adoption of ASC 842, the Company recorded lessee operating lease ROU assets and lessee operating lease liabilities of $22.5 million as of December 30, 2018, primarily related to real estate and equipment leases, based on the present value of the future lease payments on such date. As a lessor, the Company also recorded customer lease receivables of $57.7 million, a reduction to equipment leased to customers (formerly titled deferred cost of goods sold) of $103.5 million, an increase to deferred tax assets of $8.6 million, a decrease to deferred revenue and contract-related liabilities of $13.4 million, an increase in other current liabilities of $3.0 million and a cumulative net decrease to retained earnings of $26.8 million, all related to the reclassification of certain embedded leases in existing deferred equipment agreements from operating to sales-type leases as of December 30, 2018. See Notes 6, 7 and 9 to these condensed consolidated financial statements for additional disclosures required by ASC 842.
Recently Issued Accounting Pronouncements
In August 2018, the FASB issued ASU 2018-15, Intangibles–Goodwill and Other–Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract (ASU 2018-15). The new standard aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). ASU 2018-15 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2019. Early adoption is permitted, including adoption in an interim period. The Company does not expect this standard will have a material impact on its consolidated financial statements upon adoption.
In July 2018, the FASB issued ASU No. 2018-09, Codification Improvements (ASU 2018-09). This new standard amends, clarifies, corrects errors in and makes minor improvements to the ASC. The transition and effective date guidance is based on the facts and circumstances of each amendment. Some of the amendments of ASU 2018-09 do not require transition guidance and are effective upon issuance. The Company does not expect this standard will have a material impact on its consolidated financial statements.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
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). In November 2018, the FASB clarified this guidance with ASU 2018-19, Codification Improvements to Topic 326, Financial Instruments - Credit Losses. The collective new guidance (ASC 326) generally 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. ASC 326 is effective for annual and interim fiscal reporting periods beginning after December 15, 2019, with early adoption permitted for annual reporting periods beginning after December 15, 2018. The Company is continuing to evaluate the expected impact of this ASC 326 but does not expect it to have a material impact on its consolidated financial statements upon adoption.
3. 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 $2.9 million and $2.5 million for the three months ended March 30, 2019 and March 31, 2018, 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 months ended March 30, 2019 and March 31, 2018.

• | 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 March 30, 2019 and March 31, 2018.

Net amounts due to Cercacor at each of March 30, 2019 and December 29, 2018 were $2.4 million and $2.9 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), General Counsel and Corporate Secretary and its EVP, Chief Financial Officer (CFO) are both directors and also serve as Secretary and Treasurer, respectively, of the Masimo Foundation.
The Company’s CEO is also the Chairman of both the Patient Safety Movement Foundation (PSMF), a non-profit organization which 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 also serves as the Treasurer of both PSMF and PSMC, and the Company’s EVP, General Counsel and Corporate Secretary also serves as the Secretary for PSMC.
The Company maintains an aircraft time share agreement, pursuant to which the Company has agreed from time to time to make its aircraft available to the Company’s CEO for lease on a time-sharing basis. The Company charges the Company’s CEO for personal use based on agreed upon reimbursement rates. For each of the three months ended March 30, 2019 and March 31, 2018, the Company charged the Company’s CEO less than $0.1 million related to such reimbursements.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
4. Inventories
Inventories consist of the following (in thousands):

| March 30, 2019 |  | December 29, 2018
Raw materials | $ | 41,520 |  |  | $ | 38,955 |
Work-in-process | 10,677 |  |  | 9,036 |
Finished goods | 41,062 |  |  | 46,741 |
Total inventories | $ | 93,259 |  |  | $ | 94,732 |

5. Other Current Assets
Other current assets consist of the following (in thousands):

| March 30, 2019 |  | December 29, 2018
Lease receivable, current | $ | 19,677 |  |  | $ | — |
Prepaid expenses | 11,957 |  |  | 10,582 |
Indirect taxes receivable | 5,472 |  |  | 6,516 |
Customer notes receivable | 3,402 |  |  | 3,780 |
Prepaid income taxes | 452 |  |  | 3,071 |
Other current assets | 5,395 |  |  | 5,278 |
Total other current assets | $ | 46,355 |  |  | $ | 29,227 |

6. Lease Receivable
The Company adopted ASC 842, the new lease accounting standard, effective as of December 30, 2018. Among other things, the Company’s adoption of ASC 842 resulted in changes to the classification of certain embedded leases within its deferred equipment agreements from operating to sales-type leases. As a result, the Company now recognizes revenue and costs, as well as a lease receivable, at the time the lease commences pursuant to deferred equipment agreements containing embedded sales-type leases. Revenue and costs related to embedded leases within the Company’s deferred equipment agreements are included in product revenue and cost of goods sold, respectively. See “Recently Adopted Accounting Pronouncements” under Note 2 to these condensed consolidated financial statements for additional information related to the Company’s adoption of ASC 842.
Lease receivable consists of the following (in thousands):

| March 30, 2019
Lease receivable | $ | 61,161 |
Allowance for credit loss | (335 | )
Lease receivable, net | 60,826 |
Less: Current portion of lease receivable | (19,677 | )
Lease receivable, noncurrent | $ | 41,149 |

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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
As of March 30, 2019, estimated future maturities of customer sales-type lease receivables for each of the following fiscal years are as follows (in thousands):

Fiscal year | Maturities of Customer Lease Receivables
2019 (balance of year) | $ | 16,617 |
2020 | 15,820 |
2021 | 9,838 |
2022 | 8,124 |
2023 | 5,196 |
Thereafter | 5,231 |
Total | $ | 60,826 |

Estimated future operating lease payments expected to be received from customers under deferred equipment agreements are not material as of March 30, 2019.
7. Deferred Costs and Other Contract Assets
Contract-related assets consist of the following (in thousands):

| March 30, 2019 |  | December 29, 2018
Prepaid contract incentives | $ | 6,487 |  |  | $ | 7,036 |
Deferred commissions | 5,158 |  |  | 5,085 |
Unbilled contract receivables | 3,432 |  |  | 5,567 |
Equipment leased to customers, net(1) | 522 |  |  | 108,417 |
Total contract-related assets | $ | 15,599 |  |  | $ | 126,105 |

______________

(1) | Formerly titled “Deferred cost of goods sold”. In connection with its adoption of ASC 842 on December 30, 2018, the Company recorded a reduction to equipment leased to customers, net, of $103.5 million as a result of the reclassification of certain embedded leases within the Company’s deferred equipment agreements with its customers from operating to sales-type leases. See “Recently Adopted Accounting Pronouncements” to these condensed consolidated financial statements for additional information related to the Company’s adoption of ASC 842.

For the three months ended March 30, 2019 and March 31, 2018, $0.2 million and $7.3 million, respectively, of equipment leased to customers was amortized to cost of goods sold. As of March 30, 2019 and December 29, 2018, accumulated amortization of equipment leased to customers was $0.5 million and $103.1 million, respectively.
For the three months ended March 30, 2019 and March 31, 2018, $0.5 million and $0.4 million, respectively, of prepaid contract incentives was amortized as a reduction to revenue.
For the three months ended March 30, 2019 and March 31, 2018, $0.5 million and $0.6 million, respectively, of deferred commissions was amortized to selling, general and administrative expenses.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
8. Property and Equipment
Property and equipment, net, consists of the following (in thousands):

| March 30, 2019 |  | December 29, 2018
Building and building improvements | $ | 90,974 |  |  | $ | 88,449 |
Machinery and equipment | 57,001 |  |  | 54,525 |
Aircraft and vehicles | 25,555 |  |  | 25,555 |
Land | 23,762 |  |  | 23,762 |
Computer equipment | 18,334 |  |  | 16,582 |
Leasehold improvements | 16,896 |  |  | 16,428 |
Tooling | 14,465 |  |  | 14,212 |
Furniture and office equipment | 10,558 |  |  | 10,459 |
Demonstration units | 465 |  |  | 470 |
Construction-in-progress (CIP) | 11,360 |  |  | 13,320 |
Total property and equipment | 269,370 |  |  | 263,762 |
Accumulated depreciation and amortization | (102,082 | ) |  | (97,790 | )
Property and equipment, net | $ | 167,288 |  |  | $ | 165,972 |

For the three months ended March 30, 2019 and March 31, 2018, depreciation expense of property and equipment was $4.3 million and $4.0 million, respectively.
The balances in CIP at March 30, 2019 and December 29, 2018 related primarily to capitalized costs associated with the implementation of a new enterprise resource planning software system, capital improvements to various facilities and manufacturing equipment, the underlying assets for which have not been completed or placed into service.
9. Lessee ROU Assets and Lease Liabilities
The Company adopted ASC 842, the new lease accounting standard, effective as of December 30, 2018. Among other things, the Company’s adoption of ASC 842 resulted in: (a) the recognition of lessee ROU assets for the right to use assets subject to operating leases; and (b) the recognition of lessee lease liabilities for its obligation to make operating lease payments. See “Recently Adopted Accounting Pronouncements” under Note 2 to these condensed consolidated financial statements for additional information related to the Company’s adoption of ASC 842.
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. In addition, the Company leases equipment in the U.S. and Europe that are classified as operating leases and expire at various dates through September 2023. The majority of these leases are non-cancellable and generally do not contain any material residual value guarantees or material restrictive covenants. The Company recognizes lease costs under these agreements using a straight-line method based on total lease payments. Certain facility leases contain predetermined price escalations and in some cases renewal options, the longest of which is for 5 years.
The Company generally estimates the applicable discount rate used to determine the net present value of lease payments based on available information at the lease commencement date. As of March 30, 2019, the weighted average discount rate used by the Company for all operating leases was approximately 3.8%.
Balance sheet classifications related to the Company’s operating leases for the period ended March 30, 2019 are as follows:

| Balance sheet classification |  | March 30, 2019
Lessee ROU assets | Other non-current assets |  | $ | 20,032 |
Lessee current lease liabilities | Other current liabilities |  | 5,075 |
Lessee non-current lease liabilities | Other non-current liabilities |  | 16,345 |
Total operating lease liabilities |  |  | $ | 21,420 |

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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
The weighted average remaining lease term for the Company’s operating leases was 8.2 years as of March 30, 2019.
As of March 30, 2019, estimated future operating lease payments for each of the following fiscal years were as follows (in thousands):

Fiscal year | Total Operating Leases
2019 (balance of year) | $ | 4,991 |
2020 | 4,130 |
2021 | 2,358 |
2022 | 1,663 |
2023 | 1,487 |
Thereafter(1) | 10,567 |
Total | 25,196 |
Imputed Interest | (3,776 | )
Present Value | $ | 21,420 |

______________
(1) Includes optional renewal period for certain leases.
As of December 29, 2018, the estimated future minimum lease payments, including interest, under operating leases for each of the following fiscal years ending on or about December 31 were as follows (in thousands):

Fiscal year | Total Operating Leases
2019 | $ | 6,926 |
2020 | 4,422 |
2021 | 2,384 |
2022 | 1,701 |
2023 | 1,568 |
Thereafter(1) | 9,921 |
Total | $ | 26,922 |

______________
(1) Includes optional renewal period for certain leases.
Lease costs for the three months ended March 30, 2019 were as follows (in thousands):

| March 30, 2019
Operating lease costs | $ | 1,765 |
Short-term lease costs | 9 |
Sublease income | (52 | )
Total lease cost | $ | 1,722 |

For the three months ended March 31, 2018, rental expense related to operating leases was $1.8 million.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
10. Intangible Assets
Intangible assets, net, consist of the following (in thousands):

| March 30, 2019 |  | December 29, 2018
Patents | $ | 21,889 |  |  | $ | 21,323 |
Customer relationships | 7,669 |  |  | 7,669 |
Licenses-related party | 7,500 |  |  | 7,500 |
Acquired technology | 5,580 |  |  | 5,580 |
Trademarks | 4,273 |  |  | 4,190 |
Capitalized software development costs | 3,436 |  |  | 3,430 |
Other | 5,466 |  |  | 5,466 |
Total intangible assets | 55,813 |  |  | 55,158 |
Accumulated amortization | (27,983 | ) |  | (27,234 | )
Intangible assets, net | $ | 27,830 |  |  | $ | 27,924 |

Total amortization expense for the three months ended March 30, 2019 and March 31, 2018 was $1.1 million and $1.2 million, respectively. All of these intangible assets have a 10 year weighted average amortization period.
Estimated amortization expense for each of the next fiscal years is as follows (in thousands):

Fiscal year | Amount
2019 (balance of year) | $ | 4,283 |
2020 | 3,805 |
2021 | 3,688 |
2022 | 2,636 |
2023 | 1,747 |
Thereafter | 11,671 |
Total | $ | 27,830 |

11. Goodwill
Changes in goodwill during the three months ended March 30, 2019 were as follows (in thousands):

| Three Months Ended March 30, 2019
Goodwill, beginning of period | $ | 23,297 |
Adjustments to goodwill from finalization of purchase price allocation | (651 | )
Foreign currency translation adjustment | (270 | )
Goodwill, end of period | $ | 22,376 |

On September 21, 2018, the Company acquired all of the outstanding shares of a private patient monitoring software company for approximately $4.0 million. Based on the Company’s purchase price allocation, approximately $2.8 million of the purchase price has been assigned to goodwill, $0.7 million of which was recorded as an adjustment to the preliminary purchase price allocation to deferred tax assets based on additional information.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
12. Other Assets, Long-Term
Other assets, long-term consist of the following (in thousands):

| March 30, 2019 |  | December 29, 2018
Lessee ROU assets | $ | 20,032 |  |  | $ | — |
Prepaid deposits | 2,992 |  |  | 2,881 |
Long term investments | 1,200 |  |  | 1,200 |
Restricted cash | 149 |  |  | 151 |
Total other assets, long-term | $ | 24,373 |  |  | $ | 4,232 |

13. Deferred Revenue and Other Contract Liabilities
Deferred revenue and other contract liabilities consist of the following (in thousands):

| March 30, 2019 |  | December 29, 2018
Deferred revenue(1) | $ | 10,960 |  |  | $ | 10,883 |
Accrued rebates and incentives | 6,411 |  |  | 6,282 |
Accrued customer reimbursements(2) | 4,951 |  |  | 16,194 |
Other contract-related liabilities | 490 |  |  | 432 |
Total deferred revenue and other contract-related liabilities | 22,812 |  |  | 33,791 |
Less: Non-current portion of deferred revenue | (135 | ) |  | (685 | )
Deferred revenue and other contract-related liabilities - current | $ | 22,677 |  |  | $ | 33,106 |

______________

(1) | In connection with its adoption of ASC 842 on December 30, 2018, the Company recorded a reduction to deferred revenue of approximately $1.1 million due to the acceleration of revenue as a result of the reclassification of certain embedded leases within the Company’s deferred equipment agreements with its customers from operating to sales-type leases. See “Recently Adopted Accounting Pronouncements” to these condensed consolidated financial statements for additional information related to the Company’s adoption of ASC 842.

(2) | In connection with its adoption of ASC 842 on December 30, 2018, the Company recorded a reduction to accrued customer reimbursements of approximately $12.3 million related to the derecognition of liabilities and leased equipment assets related to certain OEM equipment reimbursements. See “Recently Adopted Accounting Pronouncements” to these condensed consolidated financial statements for additional information related to the Company’s adoption of ASC 842.

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 deferred equipment agreements, extended warranty agreements and NRE service agreements.
Changes in deferred revenue for the three months ended March 30, 2019 were as follows:

| Three Months Ended March 30, 2019
Deferred revenue, beginning of the period | $ | 10,883 |
Revenue deferred during the period | 1,573 |
Recognition of revenue deferred in prior periods | (1,496 | )
Deferred revenue, end of the period | $ | 10,960 |

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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
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 deferred equipment agreements and other contractual obligations for which neither party has performed.
The following table summarizes the Company’s estimated Unrecognized Contract Revenue as of March 30, 2019 and the future periods within which the Company expects to recognize such revenue.

| 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 | $ | 192,795 |  |  | $ | 274,663 |  |  | $ | 120,599 |  |  | $ | 26,109 |  |  | $ | 614,166 |

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.
14. Other Current Liabilities
Other current liabilities consist of the following (in thousands):

| March 30, 2019 |  | December 29, 2018
Income tax payable | $ | 8,629 |  |  | $ | 3,071 |
Lessee lease liabilities, current | 5,075 |  |  | — |
Accrued warranty | 4,553 |  |  | 1,910 |
Accrued indirect taxes payable | 4,234 |  |  | 6,465 |
Accrued expenses | 4,227 |  |  | 2,875 |
Related party payables | 2,436 |  |  | 4,000 |
Accrued customer rebates, fees and reimbursements | 2,205 |  |  | 2,163 |
Accrued legal fees | 1,508 |  |  | 1,481 |
Other | 2,603 |  |  | 2,662 |
Total accrued and other current liabilities | $ | 35,470 |  |  | $ | 24,627 |

15. Credit Facilities
On December 17, 2018, the Company entered into a new Credit Agreement (the 2018 Credit Facility) with JPMorgan Chase Bank, N.A., as Administrative Agent and a Lender, and Bank of the West, a Lender (collectively, the Lenders). The 2018 Credit Facility provides for up to $150.0 million of unsecured borrowings in multiple currencies, with an option, subject to certain conditions, for the Company to increase the aggregate borrowing capacity up to $550.0 million in the future with the initial Lenders and additional Lenders, as required. The 2018 Credit Facility also provides for a sublimit of up to $25.0 million for the issuance of letters of credit and a sublimit of $75.0 million for borrowings in specified foreign currencies. All unpaid principal under the 2018 Credit Facility will become due and payable on December 17, 2023. Proceeds from the 2018 Credit Facility are expected to be used for general corporate, capital investment and working capital needs.
Borrowings under the 2018 Credit Facility will be deemed, at the Company’s election, either: (a) an Alternate Base Rate (ABR) Loan, which bears interest at the ABR, plus a spread of 0.125% to 1.000% based upon a Company leverage ratio, or (b) a Eurocurrency Loan, which bears interest at the Adjusted LIBO Rate (as defined below), plus a spread of 1.125% to 2.000% based upon a Company net leverage ratio. Subject to certain conditions, the Company may also request swingline loans from time to time that bear interest similar to an ABR Loan. Pursuant to the terms of the 2018 Credit Facility, the ABR is equal to the greatest of (i) the prime rate, (ii) the Federal Reserve Bank of New York effective rate plus 0.50%, and (iii) the one-month Adjusted LIBO Rate plus 1.0%. The Adjusted LIBO Rate is equal to the Eurocurrency Rate (as defined within the 2018 Credit Facility) for the applicable interest period multiplied by the statutory reserve rate for such period, rounded upward, if necessary, to the next 1/16 of 1%. The Company is also obligated under the 2018 Credit Facility to pay an unused fee ranging from
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
0.150% to 0.275% per annum, based upon a Company leverage ratio, with respect to any unutilized portion of the 2018 Credit Facility.
Pursuant to the terms of the 2018 Credit Facility, the Company is subject to certain covenants, including financial covenants related to a net leverage ratio and an interest charge coverage ratio, and other customary negative covenants. The 2018 Credit Facility also includes customary events of default which, upon the occurrence of any such event of default, provide the Lenders with the right to take either or both of the following actions: (a) immediately terminate the commitments, and (b) declare the loans then outstanding immediately due and payable in full. As of March 30, 2019, the 2018 Credit Facility had no outstanding draws and $0.1 million of outstanding letters of credit. The Company was in compliance with all covenants under the 2018 Credit Facility as of March 30, 2019.
In January 2016, the Company entered into an Amended and Restated Credit Agreement (Restated Credit Facility) with JPMorgan Chase Bank, N.A., as Administrative Agent and a Lender, Bank of America, as Syndication Agent and a Lender, Citibank, N.A., as Documentation Agent and a Lender, and various other Lenders (collectively, the Lenders). The Company terminated the Restated Credit Facility in February 2018.
For the three months ended March 30, 2019 and March 31, 2018, the Company incurred total interest expense of $0.1 million and $0.6 million, respectively, under the 2018 Credit Facility and Restated Credit Facility.
16. Other Non-Current Liabilities
Other non-current liabilities consist of the following (in thousands):

| March 30, 2019 |  | December 29, 2018
Income tax payable, noncurrent | $ | 21,522 |  |  | $ | 21,522 |
Lessee lease liabilities, noncurrent | 16,345 |  |  | — |
Unrecognized tax benefits | 12,190 |  |  | 11,717 |
Deferred tax liabilities | 2,921 |  |  | 2,956 |
Deferred revenue, noncurrent | 135 |  |  | 685 |
Other | 30 |  |  | 1,266 |
Total other non-current liabilities | $ | 53,143 |  |  | $ | 38,146 |

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 20 to these condensed consolidated financial statements for further details.
17. Stock Repurchase Program
In September 2015, the Company’s Board of Directors (Board) authorized a stock repurchase program, whereby the Company could purchase up to 5.0 million shares of its common stock over a period of up to three years (2015 Repurchase Program). A total of 3.1 million shares were purchased by the Company pursuant to the 2015 Repurchase Program prior to its expiration in September 2018.
In July 2018, the Board approved a new stock repurchase program, authorizing the Company to purchase up to 5.0 million additional shares of its common stock over a period of up to three years (2018 Repurchase Program). The 2018 Repurchase Program became effective in September 2018 upon the expiration of the 2015 Repurchase Program. The Company expects to fund the 2018 Repurchase Program through its available cash, cash expected to be generated from future operations, the 2018 Credit Facility and other potential sources of capital. The 2018 Repurchase Program can be carried out at the discretion of a committee comprised of the Company’s CEO and CFO through open market purchases, one or more Rule 10b5-1 trading plans, block trades and privately negotiated transactions.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
The following table provides a summary of the Company’s stock repurchase activities during the three months ended March 30, 2019 and March 31, 2018 (in thousands, except per share amounts):

|  | Three Months Ended
|  | March 30, 2019 |  | March 31, 2018
Shares repurchased(1) |  | — |  |  | 198 |
Average cost per share |  | $ | — |  |  | $ | 84.14 |
Value of shares repurchased |  | $ | — |  |  | $ | 16,490 |

______________

(1) | Excludes shares withheld from the shares of its common stock actually issued in connection the vesting of PSU awards to satisfy certain U.S. federal and state tax withholding obligations.

18. Stock-Based Compensation
Total stock-based compensation expense for the three months ended March 30, 2019 and March 31, 2018 was $7.3 million and $5.3 million, respectively. As of March 30, 2019, an aggregate of 11.5 million shares of common stock were reserved for future issuance under the Company’s equity plans, of which 2.6 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.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
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):

| Three Months Ended March 30, 2019
| Shares |  | Average Exercise Price
Options outstanding, beginning of period | 5,676 |  |  | $ | 43.61 |
Granted | 227 |  |  | 131.78 |
Canceled | (44 | ) |  | 101.29 |
Exercised | (224 | ) |  | 30.70 |
Options outstanding, end of period | 5,635 |  |  | $ | 47.22 |
Options exercisable, end of period | 3,475 |  |  | $ | 30.97 |

Total stock option expense for the three months ended March 30, 2019 and March 31, 2018 was $3.5 million and $3.4 million, respectively. As of March 30, 2019, the Company had $43.6 million of unrecognized compensation cost related to non-vested stock options that are expected to vest over a weighted average period of approximately 3.6 years. The weighted-average remaining contractual term of options outstanding with an exercise price less than the closing price of the Company’s common stock as of March 30, 2019 was 6.0 years. The weighted-average remaining contractual term of options exercisable, with an exercise price less than the closing price of the Company’s common stock as of March 30, 2019, was 4.7 years.
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):

| Three Months Ended March 30, 2019
| Units |  | Weighted Average Grant Date Fair Value
RSUs outstanding, beginning of period | 2,707 |  |  | $ | 95.54 |
Granted | 88 |  |  | 132.76 |
Canceled | — |  |  | — |
Expired | — |  |  | — |
Vested | — |  |  | — |
RSUs outstanding, end of period | 2,795 |  |  | $ | 96.72 |

Total RSU expense for each of the three months ended March 30, 2019 and March 31, 2018 was $0.2 million. As of March 30, 2019, the Company had $10.7 million of unrecognized compensation cost related to non-vested RSU awards expected to be recognized and vest over a weighted-average period of approximate ly 4.9 y ears.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
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):

| Three Months Ended March 30, 2019
| Units |  | Weighted Average Grant Date Fair Value
PSUs outstanding, beginning of period | 313 |  |  | $ | 88.34 |
Granted | 128 |  |  | 133.50 |
Canceled | — |  |  | — |
Expired | — |  |  | — |
Vested | (29 | ) |  | 90.69 |
PSUs outstanding, end of period | 412 |  |  | $ | 102.22 |

During the three months ended March 30, 2019, the Company awarded 128,000 PSUs that will vest three years from the award date, based on the achievement of certain 2021 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 128,000 PSUs or 256,000 shares. Based on management’s estimate of the number of units expected to vest, total PSU expense for the three months ended March 30, 2019 and March 31, 2018 was $3.6 million and $1.7 million, respectively. As of March 30, 2019, the Company had $55.2 million of unrecognized compensation cost related to non-vested PSU awards expected to be recognized and vest over a weighted-average period of approximately 2.5 years.
Valuation of Stock-Based Award Activity
The Black-Scholes option pricing model is used to estimate the fair value of options granted under the Company’s stock-based compensation plans. The range of assumptions used and the resulting weighted-average fair value of options granted at the date of grant were as follows:

|  | Three Months Ended
|  | March 30, 2019 |  | March 31, 2018
Risk-free interest rate |  | 2.2% to 2.6% |  | 2.3% to 2.7%
Expected term (in years) |  | 5.2 |  | 5.6
Estimated volatility |  | 29.3% to 30.0% |  | 29.3% to 29.7%
Expected dividends |  | 0% |  | 0%
Weighted-average fair value of options granted |  | $41.01 |  | $28.53

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 March 30, 2019 was $513.1 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 March 30, 2019 was $372.9 million. The aggregate intrinsic value of options exercised during the three months ended March 30, 2019 was $21.7 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.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
19. Non-operating income
Non-operating income consists of the following (in thousands):

| March 30, 2019 |  | March 31, 2018
Interest income | $ | 3,433 |  |  | $ | 1,133 |
Realized and unrealized foreign currency gain | 534 |  |  | 1,113 |
Interest expense | (80 | ) |  | (627 | )
Other | (1 | ) |  | 28 |
Total | $ | 3,886 |  |  | $ | 1,647 |

20. Income Taxes
The Company has provided for income taxes in fiscal year 2019 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 three months ended March 30, 2019 and March 31, 2018, the Company recorded discrete tax benefits of approximately $3.4 million and $3.1 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 March 30, 2019, the liability for income taxes associated with uncertain tax positions was approximately $15.8 million. If fully recognized, approximately $14.6 million (net of federal benefit on state taxes) would impact the Company’s effective tax rate. It is reasonably possible that the amount of unrecognized tax benefits in various jurisdictions may change in the next twelve months due to the expiration of statutes of limitation and audit settlements. However, due to the uncertainty surrounding the timing of these events, an estimate of the change within the next twelve months cannot currently be made.
The Company conducts business in multiple jurisdictions and, as a result, one or more of the Company’s subsidiaries files income tax returns in U.S. federal, various state, local and foreign jurisdictions. The Company has concluded all U.S. federal income tax matters through fiscal year 2014. All material state, local and foreign income tax matters have been concluded through fiscal year 2011. The Company does not believe that the results of any tax authority examination would have a significant impact on its consolidated financial statements.
21. Commitments and Contingencies
Employee Retirement Savings Plan
The Company sponsors a qualified defined contribution plan or 401(k) plan, the Masimo Retirement Savings Plan (MRSP), covering the Company’s full-time U.S. employees who meet certain eligibility requirements. In general, the Company matches an employee’s contribution up to 3% of the employee’s compensation, subject to a maximum amount. The Company may also contribute to the MRSP on a discretionary basis. The Company contributed $0.5 million and $0.7 million to the MRSP for the three months ended March 30, 2019 and March 31, 2018, respectively.
In addition, the Company also sponsors various defined contribution plans in certain locations outside of the United States (Subsidiary Plans). For each of the three months ended March 30, 2019 and March 31, 2018, the Company contributed $0.1 million to the Subsidiary Plans.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
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 March 30, 2019, 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 March 30, 2019, 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 $87.3 million of purchase commitments as of March 30, 2019, 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 March 30, 2019, the Company had approximately $1.0 million in outstanding unsecured bank guarantees.
In certain circumstances, the Company also provides limited indemnification within its various customer contracts whereby the Company indemnifies the parties to whom it sells its products with respect to potential infringement of intellectual property, and against bodily injury caused by a defective Company product. It is not possible to predict the maximum potential amount of future payments under these or similar agreements, due to the conditional nature of the Company’s obligations and the unique facts and circumstances involved. As of March 30, 2019, 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 March 30, 2019, the Company had $412.9 million of bank balances, of which $3.5 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.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
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 months ended March 30, 2019 and March 31, 2018, revenue from the sale of the Company’s products to U.S. hospitals that are members of GPOs amounted to $129.7 million and $118.9 million, respectively.
For the three months ended March 30, 2019, the Company had sales through two just-in-time distributors that represented 13.6% and 10.3% of total revenue, respectively. For the three months ended March 31, 2018, the Company had sales through the same two just-in-time distributors that represented 13.6% and 10.7% of total revenue, respectively.
As of March 30, 2019, one j ust-in-time distributor represented 6.5% of the Company’s accounts receivable balance. As of December 29, 2018, one just-in-time distributor represented 6.7% of the Company’s accounts receivable balance.
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 $2.0 million was recovered during the year ended December 29, 2018. An arbitration hearing was held on February 11, 2019. The parties are awaiting the arbitration decision. Although the Company intends to vigorously pursue collection of the remaining amounts owed by the foreign agent, there is no guarantee that the Company will be successful in these efforts.
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 current deadline for PHI to file its motion for class certification is May 20, 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.
From time to time, the Company may be involved in other litigation and investigations relating to claims and matters arising out of its operations in the normal course of business. The Company believes that it currently is not a party to any other legal proceedings which, individually or in the aggregate, would have a material adverse effect on its consolidated financial position, results of operations or cash flows.
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MASIMO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)
22. Segment Information and Enterprise Reporting
The Company’s chief operating decision maker, the CEO, reviews financial information presented on a consolidated basis, accompanied by disaggregated information about revenues by geographic region, for purposes of making operating decisions and assessing financial performance. Accordingly, the Company considers itself to be in a single reporting segment, specifically noninvasive patient monitoring solutions and related products. The Company does not assess the performance of its geographic regions on other measures of income or expense, such as depreciation and amortization, operating income or net income. In addition, the Company’s assets are primarily located in the U.S. The Company does not produce reports for, or measure the performance of, its geographic regions on any asset-based metrics. Therefore, geographic information is presented only for revenues and long-lived assets.
The following schedule presents an analysis of the Company’s product revenues based upon the geographic area to which the product was shipped (in thousands, except percentages):

|  | Three Months Ended
|  | March 30, 2019 |  | March 31, 2018
Geographic area by destination: |  |  |  |  |  |  |  |
United States (U.S.) |  | $ | 156,668 |  |  | 68.0 | % |  | $ | 141,040 |  |  | 69.0 | %
Europe, Middle East and Africa |  | 48,472 |  |  | 21.0 |  |  | 44,037 |  |  | 21.6 |
Asia and Australia |  | 18,118 |  |  | 7.9 |  |  | 12,915 |  |  | 6.3 |
North and South America (excluding the U.S.) |  | 7,290 |  |  | 3.1 |  |  | 6,397 |  |  | 3.1 |
Total product revenue |  | $ | 230,548 |  |  | 100.0 | % |  | $ | 204,389 |  |  | 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):

|  | March 30, 2019 |  | December 29, 2018
Long-lived assets by geographic area: |  |  |  |  |  |  |  |
United States |  | $ | 229,088 |  |  | 92.2 | % |  | $ | 280,215 |  |  | 94.6 | %
International |  | 19,321 |  |  | 7.8 |  |  | 16,094 |  |  | 5.4 |
Total |  | $ | 248,409 |  |  | 100.0 | % |  | $ | 296,309 |  |  | 100.0 | %

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Quarterly Report on Form 10-Q contains “forward-looking statements” as defined in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, in connection with the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially and adversely from those expressed or implied by such forward-looking statements. Such forward-looking statements include any expectation of earnings, revenues or other financial items; any statements of the plans, strategies and objectives of management for future operations; factors that may affect our operating results or financial condition; statements concerning new products, technologies or services; statements related to future capital expenditures; statements related to future economic conditions or performance; statements related to our stock repurchase programs; statements as to industry trends and other matters that do not relate strictly to historical facts or statements of assumptions underlying any of the foregoing. These statements are often identified by the use of words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may” or “will,” the negative versions of these terms and similar expressions or variations. These statements are based on the beliefs and assumptions of our management based on information currently available to management. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results and the timing of certain events to differ materially and adversely from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Risk Factors” included elsewhere in this Quarterly Report on Form 10-Q and in our other Securities and Exchange Commission (SEC) filings, including our Annual Report on Form 10-K for the fiscal year ended December 29, 2018, which we filed with the SEC on February 26, 2019. 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 and hospital automation solutions. Our mission is to improve patient outcomes and reduce the cost of care. We provide our products directly and through distributors and original equipment manufacturers (OEM) partners to hospitals, emergency medical service (EMS) providers, home care providers, long-term care facilities, physician offices, veterinarians and consumers. We were incorporated in California in May 1989 and reincorporated in Delaware in May 1996.
Our core business is Measure-through Motion and Low Perfusion™ pulse oximetry, known as Masimo Signal Extraction Technology® (SET®) pulse oximetry. Our product offerings have expanded significantly over the years to also include noninvasive monitoring of blood constituents with an optical signature, optical regional oximetry monitoring, electrical brain function monitoring, acoustic respiration monitoring and exhaled gas monitoring. In addition, we have developed the Root™ patient monitoring and connectivity platform, the Radical-7® and Rad-97™ bedside and portable patient monitors and the Radius-7® wearable wireless patient monitor. We have also developed the Masimo Patient SafetyNet supplemental remote patient surveillance and monitoring system, which currently allows up to 200 patients to be monitored and viewed simultaneously and remotely through a PC-based monitor or by care providers through their pagers, voice-over-IP phones or smartphones. We have also developed hospital automation and connectivity solutions, such as Iris® and Iris Gateway®, which allow the transfer of data from Masimo and third-party devices to hospital electronic medical records, and UniView™, which provides an integrated display of real-time data from Masimo and third-party devices. 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 29, 2018, filed with the SEC on February 26, 2019.
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 2019, we announced the U.S. launch of Iris® Device Management System (Iris DMS), an automation and connectivity solution designed to streamline management of Masimo devices used throughout a hospital system. Iris DMS is designed to address the challenges of maintaining many patient monitors in a complex hospital environment.
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In January 2019, we announced FDA 510(k) clearance of the measurement of respiration rate from the pleth (RRp®) on the MightySat® Rx spot-check fingertip pulse oximeter, as well as its indication for use in the home environment. MightySat® Rx also measures functional oxygen saturation (SpO 2), pulse rate (PR), perfusion index (Pi), and Pleth Variability index (PVi®).
In March 2019, we announced the CE marking of Next Generation SedLine® brain function monitoring for pediatric patients (1-18 years of age). With this clearance, the benefits of Next Generation SedlLine® are available for all patients one year old and above in CE mark countries. SedLine® helps clinicians monitor the state of the brain under anesthesia with bilateral data acquisition and processing of four leads of electroencephalogram (EEG) signals.
In March 2019, we announced FDA 510(k) clearance of the Rad-67™ Pulse CO-Oximeter® with Spot-check Next Generation SpHb® monitoring technology and the rainbow® DCI®-mini Reusable sensor. Rad-67™ offers rainbow® noninvasive hemoglobin measurement (SpHb®) and Measure-through Motion and Low Perfusion™ SET® pulse oximetry in a compact, portable spot-check monitoring device. When used with the rainbow® DCI®-mini sensor, Rad-67™ provides spot-check monitoring with Next Generation SpHb®.
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 Note 3 to our accompanying condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information related to Cercacor.
Adoption of New Lease Accounting Standard
Effective December 30, 2018, we adopted Accounting Standards Codification (ASC) Topic 842, Leases (ASC 842). Our adoption of ASC 842 generally resulted in (a) the recognition of lessee right-of-use (ROU) assets for the right to use assets subject to operating leases; (b) the recognition of lessee lease liabilities for our obligation to make payments under operating leases; and (c) the acceleration of when we recognize certain revenue and costs as a lessor of equipment provided to end-user hospitals at no up-front charge under deferred equipment agreements with fixed multi-year sensor purchase commitments. See “Critical Accounting Policies and Estimates” below and Note 2 to our accompanying condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information related to our adoption of this new accounting standard.
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Results of Operations
The following table sets forth, for the periods indicated, our unaudited results of operations expressed as dollar amounts and as a percentage of total revenues (in thousands, except percentages). Certain amounts for prior periods have been reclassified to conform to the current period presentation, including certain previously reported selling, general and administrative expenses that have been reclassified as research and development expenses for the three months ended March 31, 2018.

| Three Months Ended
| March 30, 2019 |  | Percentage of Revenue |  | March 31, 2018 |  | Percentage of Revenue
Revenue: |  |  |  |  |  |  |
Product | $ | 230,548 |  |  | 99.5 | % |  | $ | 204,389 |  |  | 96.0 | %
Royalty and other revenue | 1,116 |  |  | 0.5 |  |  | 8,564 |  |  | 4.0 |
Total revenue | 231,664 |  |  | 100.0 |  |  | 212,953 |  |  | 100.0 |
Cost of goods sold | 80,022 |  |  | 34.5 |  |  | 69,292 |  |  | 32.5 |
Gross profit | 151,642 |  |  | 65.5 |  |  | 143,661 |  |  | 67.5 |
Operating expenses: |  |  |  |  |  |  |
Selling, general and administrative | 74,204 |  |  | 32.0 |  |  | 70,217 |  |  | 33.0 |
Research and development | 21,415 |  |  | 9.2 |  |  | 19,559 |  |  | 9.2 |
Total operating expenses | 95,619 |  |  | 41.3 |  |  | 89,776 |  |  | 42.2 |
Operating income | 56,023 |  |  | 24.2 |  |  | 53,885 |  |  | 25.3 |
Non-operating income | 3,886 |  |  | 1.7 |  |  | 1,647 |  |  | 0.8 |
Income before provision for income taxes | 59,909 |  |  | 25.9 |  |  | 55,532 |  |  | 26.1 |
Provision for income taxes | 10,587 |  |  | 4.6 |  |  | 9,902 |  |  | 4.6 |
Net income | $ | 49,322 |  |  | 21.3 | % |  | $ | 45,630 |  |  | 21.4 | %

Comparison of the Three Months ended March 30, 2019 to the Three Months ended March 31, 2018
Revenue. Total revenue increased $18.7 million, or 8.8%, to $231.7 million for the three months ended March 30, 2019 from $213.0 million for the three months ended March 31, 2018. 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 March 30, 2019 and March 31, 2018 (dollars in thousands):

| Three Months Ended
| March 30, 2019 |  | March 31, 2018 |  | Increase/ (Decrease) |  | Percentage Change
United States (U.S.) | $ | 156,668 |  |  | 68.0 | % |  | $ | 141,040 |  |  | 69.0 | % |  | $ | 15,628 |  |  | 11.1 | %
Europe, Middle East and Africa | 48,472 |  |  | 21.0 |  |  | 44,037 |  |  | 21.6 |  |  | 4,435 |  |  | 10.1 |
Asia and Australia | 18,118 |  |  | 7.9 |  |  | 12,915 |  |  | 6.3 |  |  | 5,203 |  |  | 40.3 |
North and South America (excluding the U.S.) | 7,290 |  |  | 3.1 |  |  | 6,397 |  |  | 3.1 |  |  | 893 |  |  | 14.0 |
Total product revenue | $ | 230,548 |  |  | 100.0 | % |  | $ | 204,389 |  |  | 100.0 | % |  | $ | 26,159 |  |  | 12.8 | %
Royalty and other revenue | 1,116 |  |  |  |  | 8,564 |  |  |  |  | (7,448 | ) |  | (87.0 | )
Total revenue | $ | 231,664 |  |  |  |  | $ | 212,953 |  |  |  |  | $ | 18,711 |  |  | 8.8 | %

Product revenue increased $26.2 million, or 12.8%, to $230.5 million for the three months ended March 30, 2019, compared to $204.4 million for the three months ended March 31, 2018. This increase was primarily due to higher sales of consumables and monitors, which was partially offset by the impact of approximately $3.0 million of unfavorable foreign exchange rate movements from the prior year period that decreased the U.S. Dollar translation of foreign sales that were denominated in various foreign currencies. Our adoption of ASC 842 did not significantly impact our total product revenue for the three months ended March 30, 2019. During the first quarter of 2019, we shipped approximately 63,700 noninvasive technology boards and monitors, an increase of 10,100 units, or 18.8%, from 53,600 units shipped during the first quarter of 2018.
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Product revenue generated through our direct and distribution sales channels increased $23.5 million, or 13.1%, to $202.4 million for the three months ended March 30, 2019, compared to $178.9 million for the three months ended March 31, 2018. Revenues from our OEM channel increased $2.6 million, or 10.2%, to $28.1 million for the three months ended March 30, 2019 as compared to $25.5 million for the three months ended March 31, 2018.
Royalty and other revenue consists primarily of royalties received from Medtronic plc (Medtronic.) related to its U.S. sales pursuant to the terms of our settlement agreement, and revenue from non-recurring engineering services for a certain OEM customer. For the three months ended March 30, 2019, royalty and other revenue decreased by $7.4 million, primarily due to lower royalties from Medtronic as a result of the expiration of their obligation to pay us royalties after October 6, 2018. We received our final royalty payment from Medtronic during the three months ended March 30, 2019.
Gross Profit. Gross profit consists of total revenue less cost of goods sold. Our gross profit for the three months ended March 30, 2019 and March 31, 2018 was as follows (dollars in thousands):

| Three Months Ended
| March 30, 2019 |  | Gross Profit Percentage |  | March 31, 2018 |  | Gross Profit Percentage |  | Increase/ (Decrease) |  | Percentage Change
Product gross profit | $ | 150,593 |  |  | 65.3 | % |  | $ | 135,271 |  |  | 66.2 | % |  | $ | 15,322 |  |  | 11.3 | %
Royalty and other revenue gross profit | 1,049 |  |  | 94.0 |  |  | 8,390 |  |  | 98.0 |  |  | (7,341 | ) |  | (87.5 | )
Total gross profit | $ | 151,642 |  |  | 65.5 | % |  | $ | 143,661 |  |  | 67.5 | % |  | $ | 7,981 |  |  | 5.6 | %

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 $10.7 million for the three months ended March 30, 2019, compared to the three months ended March 31, 2018, primarily due to higher product revenue. Product gross margins decreased to 65.3% for the three months ended March 30, 2019 compared to 66.2% for the three months ended March 31, 2018, primarily due to our adoption of ASC 842 during the current quarter, which accelerated revenue and cost of goods sold associated with leased equipment provided to customers under sales-type leases and negatively impacted gross profit by approximately $1.3 million. Royalty and other revenue gross profit decreased by $7.3 million for the three months ended March 30, 2019 compared to the three months ended March 31, 2018, due to lower royalties from Medtronic as a result of the expiration of their obligation to pay us royalties after October 6, 2018.
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 March 30, 2019 and March 31, 2018 were as follows (dollars in thousands):

Selling, General and Administrative
Three Months Ended March 30, 2019 | Percentage of Net Revenues | Three Months Ended March 31, 2018 | Percentage of Net Revenues | Increase/ (Decrease) | Percentage Change
$74,204 | 32.0% | $70,217 | 33.0% | $3,987 | 5.7%

Selling, general and administrative expenses increased $4.0 million, or 5.7%, for the three months ended March 30, 2019, compared to the three months ended March 31, 2018. This increase was primarily attributable to higher payroll-related costs of approximately $2.8 million and higher selling and marketing-related costs of approximately $0.8 million. Approximately $5.7 million and $4.0 million of stock-based compensation expense was included in selling, general and administrative expenses for the three months ended March 30, 2019 and March 31, 2018, respectively.
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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 March 30, 2019 and March 31, 2018 were as follows (dollars in thousands):

Research and Development
Three Months Ended March 30, 2019 | Percentage of Net Revenues | Three Months Ended March 31, 2018 | Percentage of Net Revenues | Increase/ (Decrease) | Percentage Change
$21,415 | 9.2% | $19,559 | 9.2% | $1,856 | 9.5%

Research and development expenses increased $1.9 million, or 9.5%, for the three months ended March 30, 2019, compared to the three months ended March 31, 2018, primarily due to higher payroll-related costs of approximately $1.1 million, higher engineering project costs of $0.2 million and higher occupancy costs of $0.2 million. Included in research and development expenses was approximately $1.5 million and $1.2 million of stock-based compensation expense for the three months ended March 30, 2019 and March 31, 2018, 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 March 30, 2019 and March 31, 2018 was as follows (dollars in thousands):

Non-operating Income
Three Months Ended March 30, 2019 | Percentage of Net Revenues | Three Months Ended March 31, 2018 | Percentage of Net Revenues | Increase/ (Decrease) | Percentage Change
$3,886 | 1.7% | $1,647 | 0.8% | $2,239 | 135.9%

Non-operating income increased by $2.2 million for the three months ended March 30, 2019, compared to the three months ended March 31, 2018. Non-operating income for the three months ended March 30, 2019 consisted of approximately $3.4 million in net interest income and $0.5 million of net realized and unrealized gains on foreign currency denominated transactions. Non-operating income for the three months ended March 31, 2018 consisted of approximately $1.1 million of net realized and unrealized gains on foreign currency denominated transactions and approximately $0.5 million of net interest income.
Provision for Income Taxes. Our provision for income taxes for the three months ended March 30, 2019 and March 31, 2018 was as follows (dollars in thousands):

Provision for Income Taxes
Three Months Ended March 30, 2019 | Percentage of Net Revenues | Three Months Ended March 31, 2018 | Percentage of Net Revenues | Increase/ (Decrease) | Percentage Change
$10,587 | 4.6% | $9,902 | 4.6% | $685 | 6.9%

For the three months ended March 30, 2019, we recorded a provision for income taxes of approximately $10.6 million, or an effective tax provision rate of 17.7%, as compared to a provision for income taxes of approximately $9.9 million, or an effective tax provision rate of 17.8%, for the three months ended March 31, 2018. The decrease in our effective tax rate for the three months ended March 30, 2019 resulted primarily from an increase 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 $0.3 million compared to the three months ended March 31, 2018.
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Liquidity and Capital Resources
Our principal sources of liquidity consist of our existing cash and cash equivalent balances, future funds expected to be generated from operations and available borrowing capacity under our credit facility. At March 30, 2019, we had approximately $729.1 million in working capital, approximately $412.9 million in cash and cash equivalents, approximately $180.0 million in short-term investments and approximately $149.9 million available borrowing capacity (net of outstanding letters of credit) under our credit facility. We carry cash equivalents at cost that approximates fair value.
As of March 30, 2019, we had cash totaling $85.0 million held outside of the U.S., all of which was accessible without additional tax cost. We currently have sufficient domestic funds on-hand and cash held outside the U.S. that is available without additional tax cost to fund our domestic operations.
Cash Flows
The following table summarizes our cash flows (in thousands):

|  | Three Months Ended
|  | March 30, 2019 |  | March 31, 2018
Net cash provided by (used in): |  |  |
Operating activities | $ | 42,468 |  |  | $ | 71,995 |
Investing activities | (188,003 | ) |  | (7,371 | )
Financing activities | 6,165 |  |  | (10,232 | )
Effect of foreign currency exchange rates on cash | (261 | ) |  | (225 | )
Increase (decrease) in cash, cash equivalents and restricted cash | $ | (139,631 | ) |  | $ | 54,167 |

Operating Activities. Cash provided by operating activities was approximately $42.5 million for the three months ended March 30, 2019, generated primarily from net income from operations of $49.3 million. Non-cash activity included stock-based compensation of $7.3 million and depreciation and amortization of $5.4 million. Additional sources of cash included a decrease in deferred costs and other contract assets of approximately $7.1 million and an increase in income taxes payable of approximately $5.6 million. These sources of cash were partially offset by other changes in operating assets and liabilities, including an increase in accounts receivable of approximately $8.5 million, primarily due to the timing of cash receipts, and decreases in accrued compensation and accounts payable of approximately $19.4 million and $6.1 million, respectively, primarily due to the timing of payments.
For the three months ended March 31, 2018, cash provided by operating activities was approximately $72.0 million. Net income from operations was $45.6 million, which was offset by non-cash activity, including depreciation and amortization of $5.2 million and stock-based compensation of $5.3 million. Additional sources of cash included a decrease in accounts receivable of $17.8 million, primarily due to the timing of cash receipts; increases in income taxes payable, accounts payable and accrued liabilities of approximately $6.3 million, $2.4 million and $2.2 million, respectively, primarily due to the timing of payments; an increase in deferred revenue and other contract-related liabilities of approximately $2.4 million; and a decrease in inventory of approximately $1.1 million. These sources of cash were offset by other changes in operating assets and liabilities, including a decrease in accrued compensation of approximately $11.1 million, primarily due to the timing of payments and an increase in deferred costs and other contract assets of approximately $5.7 million.
Investing Activities. Cash used in investing activities for the three months ended March 30, 2019 was approximately $188.0 million, consisting primarily of approximately $180.0 million for purchases of short-term investments, approximately $7.0 million for purchases of property and equipment and approximately $1.0 million of capitalized intangible asset costs related primarily to patent and trademark costs. Cash used in investing activities for the three months ended March 31, 2018 was approximately $7.4 million, consisting of approximately $3.8 million for purchases of property and equipment and capitalized intangible asset costs of approximately $3.6 million related to patent and trademark costs.
Financing Activities. Cash provided by financing activities for the three months ended March 30, 2019 was approximately $6.2 million, driven primarily by proceeds from the issuance of common stock related to employee equity awards of approximately $6.3 million. Cash used by financing activities for the three months ended March 31, 2018 was approximately $10.2 million, primarily driven by settlements of common stock repurchase transactions totaling approximately $18.5 million, which were partially offset by proceeds from the issuance of common stock related to employee equity awards of approximately $8.4 million.
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Capital Resources and Prospective Capital Requirements
We expect to fund our future operating, investing and financing activities through our available cash, future cash from operations, our credit facility and other potential sources of capital. In addition to funding our working capital requirements, we anticipate additional capital expenditures during fiscal year 2019, primarily related to investments in infrastructure growth. Possible additional uses of cash may include the acquisition of technologies or technology companies, investments in property and equipment and repurchases of stock under our authorized stock repurchase program. However, any repurchases of stock will be subject to numerous factors, including the availability of our stock, general market conditions, the trading price of our stock, available capital, alternative uses for capital and our financial performance. In addition, the amount and timing of our actual investing activities will vary significantly depending on numerous factors, including the timing and amount of capital expenditures, costs of product development efforts, our timetable for infrastructure expansion, stock repurchase activity and costs related to our domestic and international regulatory requirements. Despite these investment requirements, we anticipate that our existing cash and cash equivalents will be sufficient to meet our working capital requirements, capital expenditures and other operational funding needs for at least the next 12 months.
Off-Balance Sheet Arrangements
We do not currently have, nor have we ever had, any relationships with unconsolidated entities or financial partnerships, such as entities referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. In addition, we do not engage in trading activities involving non-exchange traded contracts. As a result, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we engaged in these relationships. As of March 30, 2019, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K promulgated by the SEC.
Critical Accounting Policies and Estimates
The discussion and analysis of our financial condition and results of operations is based on our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these condensed consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of net revenues, expenses, assets and liabilities. We regularly evaluate our estimates and assumptions related to our critical accounting policies, including revenue recognition, inventory and related reserves for excess or obsolete inventory, allowance for doubtful accounts, stock-based compensation, lessee right-of-use (ROU) assets and lease liabilities, goodwill, deferred taxes and related valuation allowances, uncertain tax positions, tax contingencies, litigation costs and loss contingencies. We base our estimates and assumptions on current facts, historical experience and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the recording of revenue, costs and expenses that are not readily apparent from other sources. Changes in judgments and uncertainties relating to these estimates could potentially result in materially different results under different assumptions and conditions. If these estimates differ significantly from actual results, the impact on our condensed consolidated financial statements and future results of operations may be material.
Effective December 30, 2018, we adopted ASC 842, the new accounting standard governing leases. See Note 2 to our accompanying 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. A description of our updated accounting policies impacted by ASC 842 are included below:
Revenue Recognition
We derive the majority of our product revenue from four primary sources: (i) direct sales under deferred equipment agreements with end-user hospitals where we provide 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 our 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.
We generally recognize revenue following 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 consideration to which we expect 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.
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Revenue related to equipment supplied under sales-type lease arrangements is recognized once control over the equipment is transferred to the customer, while revenue related to equipment supplied under operating-type lease arrangements is generally recognized on a straight-line basis over the term of the lease.
While the majority of our sales transactions contain standard business terms and conditions, there are some transactions that contain non-standard business terms and conditions. As a result, contract interpretation and analysis is required to determine the appropriate accounting, including: (i) the amount of the total consideration, including variable consideration, (ii) whether the arrangement contains an embedded lease, and if so, whether such embedded lease is a sales-type lease or an operating lease, (iii) how the arrangement consideration should be allocated to each performance obligation when multiple performance obligations exist, including the determination of standalone selling price, (iv) when to recognize revenue on the performance obligations, and (v) 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.
We enter into agreements to sell our monitoring solutions and services, sometimes as 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, we estimate 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, our pricing and discount practices, and other market conditions.
Sales under deferred equipment agreements are generally structured such that we agree to provide certain monitoring-related equipment, software, installation, training and/or warranty support at no up-front charge in exchange for the hospital’s agreement to purchase sensors over the term of the agreement, which generally ranges from three to six years. We allocate contract consideration under deferred equipment agreements containing fixed annual sensor purchase commitments to the underlying lease and non-lease components at contract inception. In determining whether any underlying lease components are related to a sales-type lease or an operating lease, we evaluate the customer’s rights and ability to control the use of the underlying equipment throughout the contract term, including any equipment substitution rights retained by us, as well as our expectations surrounding potential contract/lease extensions or renewals and the customer’s exercise of any purchase options. Revenue allocable to non-lease components is generally recognized as such non-lease components are satisfied. Revenue allocable to lease components under sales-type lease arrangements is generally recognized when the lease commences. Revenue allocable to lease components under operating lease arrangements is generally recognized over the term of the operating lease. We generally do not expect to derive any significant value in excess of such asset’s unamortized book value from equipment underlying our operating leases arrangements.
Revenue from direct sales of our products to end-user hospitals, emergency medical response organizations and other direct customers, as well as to distributors, is generally recognized either at the time of delivery or at shipment, based upon the terms of the contract or underlying purchase order.
Sales of integrated circuit boards and other products to our OEMs are generally recognized as revenue at the time of shipment. Revenue related to OEM rainbow® parameter software licenses is generally recognized upon shipment of the OEM’s product to its customers, as reported to us by the OEM.
We provide certain customers with various sales incentives that may take the form of discounts or rebates. We estimate and provide 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, we allow returns under certain circumstances. At the end of each period, we estimate and accrue for these returns as a reduction to revenue. We estimate 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.
Lessee ROU Assets and Lease Liabilities
We determine if an arrangement contains a lease at inception. ROU assets represent our right to use an asset underlying an operating lease for the lease term and lease liabilities represent our obligation to make lease payments arising from an operating lease. ROU assets and lease liabilities are recognized at the commencement date based on the present value of lease payments over the lease term. We generally estimate the applicable discount rate used to determine the net present value of lease payments based on available information at the lease commencement date. Many of our lessee agreements include options to extend the lease, which we do not include in our lease terms unless they are reasonably certain to be exercised. We utilize a portfolio approach to account for the ROU assets and liabilities associated with certain equipment leases. We have also made a policy election not to separate lease and non-lease components for our real estate leases and to exclude short-term leases with a
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term of twelve months or less from our ROU assets and lease liabilities. Rental expense for lease payments related to operating leases is recognized on a straight-line basis over the lease term.
Other Critical Accounting Policies
There have been no material changes to any of our other critical accounting policies during the three months ended March 30, 2019. For a description of these critical accounting policies, please refer to “Critical Accounting Estimates” in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the fiscal year ended December 29, 2018, filed with the SEC on February 26, 2019.
Recent Accounting Pronouncements
See Note 2 to our condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for a description of recently issued or adopted accounting standards.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market risk represents the risk of changes in the value of market risk sensitive instruments caused by fluctuations in interest rates, foreign exchange rates and commodity prices. We are exposed to various market risks that may arise from adverse changes in market rates and prices, such as interest rates, foreign exchange fluctuations and inflation. We do not enter into derivatives, including forward contracts, or other financial instruments for trading or speculative purposes.
Interest Rate Risk
Our exposure to market risk for changes in interest rates relates to the increase or decrease in the amount of interest income we can earn on our cash, cash equivalents and short-term investments, as well as the increase or decrease in the amount of interest expense we must pay with respect to our various outstanding debt instruments. We do not believe our cash, cash equivalents, and short-term investments are subject to significant interest rate risk due to their short term maturities. As of March 30, 2019, the carrying value of our cash equivalents and short-term investments approximated fair value. We currently do not have any significant risks associated with interest rates fluctuations related to interest expense. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. Therefore, declines in interest rates over time will reduce our interest income while increases in interest rates will increase our interest income. A hypothetical 100 basis point change in interest rates along the entire interest rate yield curve would increase or decrease our interest rate yields on our investments and interest by approximately $0.1 million for each $10.0 million in interest-bearing investments.
Foreign Currency Exchange Rate Risk
A majority of our assets and liabilities are maintained in the United States in U.S. Dollars and a majority of our sales and expenditures are transacted in U.S. Dollars. However, we also transact with foreign customers in currencies other than the U.S. Dollar. These foreign currency revenues, when converted into U.S. Dollars, can vary depending on the approximation of exchange rates applied during a respective period. In addition, certain of our foreign subsidiaries transact in their respective country’s local currency, which is also their functional currency. As a result, expenses of these foreign subsidiaries, when converted into U.S. Dollars, can vary depending on the approximation of exchange rates applied during a respective period.
We are exposed to foreign currency gains or losses on outstanding foreign currency denominated receivables and payables, as well as our foreign currency denominated cash balances and certain intercompany transactions. In addition, other transactions between us or our subsidiaries and a third-party, denominated in a currency different from the functional currency, are foreign currency transactions. Realized and unrealized foreign currency gains or losses on these transactions are also included in our statements of operations as incurred.
The balance sheets of each of our foreign subsidiaries whose functional currency is not the U.S. Dollar are translated into U.S. Dollars at the rate of exchange at the balance sheet date and the statements of comprehensive income and cash flows are translated into U.S. Dollars using an approximation of the average monthly exchange rates applicable during the period. Any foreign exchange gain or loss as a result of translating the balance sheets of our foreign subsidiaries whose functional currency is not the U.S. Dollar is included in equity as a component of accumulated other comprehensive income.
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Our primary foreign currency exchange rate exposures are with the Euro, Japanese Yen, Swedish Krona, Canadian Dollar, British Pound and Mexican Peso against the U.S. Dollar. Foreign currency exchange rates have experienced significant movements in recent years, and such volatility may continue in the future. During the three months ended March 30, 2019, we estimate that changes in the exchange rates of the U.S. Dollar, primarily relative to the Turkish Lira, Euro and British Pound, negatively impacted our revenues by $3.0 million when compared to foreign exchange rates from the prior year period. We currently do not enter into forward exchange contracts to hedge exposures denominated in foreign currencies and do not use derivative financial instruments for trading or speculative purposes. The effect of additional changes in foreign currency exchange rates could have a material effect on our future operating results or cash flows, depending on which foreign currency exchange rates change and depending on the directional change (either a strengthening or weakening against the U.S. Dollar). We estimate that the potential impact of a hypothetical 10% adverse change in all applicable foreign currency exchange rates from the rates in effect as of March 30, 2019 would have resulted in an estimated reduction of $11.7 million in reported pre-tax income for the three months ended March 30, 2019. As our foreign operations continue to grow, our exposure to foreign currency exchange rate risk may become more significant.
Inflation Risk
We do not believe that inflation has had a material effect on our business, financial condition or results of operations during the periods presented. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could have a material adverse effect on our business, financial condition and results of operations.
Item 4. Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, as amended (the Exchange Act), is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s (SEC) regulations, rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), as appropriate, to allow for timely decisions regarding required disclosure.
In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. As required by Rule 13a-15(b) or Rule 15d-15(b) promulgated by the SEC under the Exchange Act, we carried out an evaluation, under the supervision and with the participation of our management, including our CEO and CFO, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on the foregoing, our CEO and CFO concluded that our disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report on Form 10-Q.
During the quarter ended March 30, 2019, we implemented certain controls and processes relating to our adoption of the new lease accounting standard, ASC 842, as of December 30, 2018. Throughout our implementation, we evaluated the impact of the adoption of this new standard on our internal control over financial reporting and modified and enhanced existing controls, as well as created new control processes where necessary, to maintain the effectiveness of internal control over financial reporting in all material respects. There have been no other changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during our most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
The information set forth in Note 21 to our condensed consolidated financial statements under the caption “Litigation” included in Part I, Item 1 of this Quarterly Report on Form 10-Q is incorporated herein by reference.
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Item 1A. Risk Factors
Before you decide to invest or maintain an interest in our common stock, you should consider carefully the risks described below, which have been updated since the filing of our Annual Report on Form 10-K for the fiscal year ended December 29, 2018, filed with the Securities and Exchange Commission (SEC) on February 26, 2019, together with the other information contained in this Quarterly Report on Form 10-Q, and any recent Current Reports on Form 8-K. We believe the risks described below are the risks that are material to us as of the date of this Quarterly Report on Form 10-Q. Other risks and uncertainties, including those not presently known to us or that we do not currently consider material, may also impair our business operations. If any of the following risks comes to fruition, our business, financial condition, results of operations and growth prospects would likely be materially and adversely affected. In these circumstances, the market price of our common stock could decline, and you could lose all or part of your investment or interest.
Risk factors marked with an asterisk (*) below include a substantive change from or an update to the risk factors included in our Annual Report on Form 10-K for the fiscal year ended December 29, 2018, filed with the SEC on February 26, 2019.
Risks Related to Our Revenues
We currently derive the majority of our revenue from our Masimo SET® platform, Masimo rainbow SET™ platform and related products. If these technologies and related products do not continue to achieve market acceptance, our business, financial condition and results of operations would be adversely affected.
We are highly dependent upon the continued success and market acceptance of our proprietary Masimo SET® technology that serves as the basis of our primary product offerings. Continued market acceptance of products incorporating Masimo SET® will depend upon us continuing to provide evidence to the medical community that our products are cost-effective and offer significantly improved performance compared to conventional pulse oximeters. Health care providers that currently have significant investments in competitive pulse oximetry products may be reluctant to purchase our products. If hospitals and other health care providers do not believe our Masimo SET® platform is cost-effective, safe or more accurate or reliable than competitive pulse oximetry products, they may not buy our products in sufficient quantities to enable us to generate revenue growth from the sale of these products. In addition, allegations regarding the safety and effectiveness of our products, whether or not substantiated, may impair or impede the acceptance of our products.
Some of our products are in development or have been recently introduced into the market and may not achieve market acceptance, which could limit our growth and adversely affect our business, financial condition and results of operations.
Many of our noninvasive measurement technologies are considered disruptive. These technologies have performance levels that we believe are acceptable for many clinical environments but may be insufficient in others. In addition, these technologies may perform better in some patients and settings than others. Over time, we hope to continue to improve the performance of these technologies and educate the clinical community on how to properly evaluate them. If we are successful in these endeavors, we expect these technologies will become more useful in more environments and will become more widely adopted. Our product portfolio continues to expand, and we are investing significant resources to enter into, and in some cases create, new markets for these products. We are continuing to invest in sales and marketing resources to achieve market acceptance of these products, but are unable to guarantee that our technologies will achieve general market acceptance.
The degree of market acceptance of these products will depend on a number of factors, including:

• | perceived clinical benefits from our products;

• | perceived cost effectiveness of our products;

• | perceived safety and effectiveness of our products;

• | reimbursement available through government and private health care programs for using some of our products; and

• | introduction and acceptance of competing products or technologies.

If our products do not gain market acceptance or if our customers prefer our competitors’ products, our potential revenue growth would be limited, which would adversely affect our business, financial condition and results of operations.
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Our ability to commercialize new products, new or improved technologies and additional applications for Masimo SET® and our licensed rainbow® technology is limited to certain markets by our Cross-Licensing Agreement with Cercacor Laboratories, Inc. (Cercacor), which may impair our growth and adversely affect our business, financial condition and results of operations.
Since 1998, we have been a party to a cross-licensing agreement with Cercacor, (as amended, the Cross-Licensing Agreement), under which we granted Cercacor:

• | an exclusive, perpetual and worldwide license, with sublicense rights, to use all Masimo SET® technology owned by us, including all improvements to this technology, for the monitoring of non-vital signs parameters and to develop and sell devices incorporating Masimo SET® for monitoring non-vital signs parameters in any product market in which a product is intended to be used by a patient or pharmacist rather than by a professional medical caregiver, which we refer to as the Cercacor Market; and

• | a non-exclusive, perpetual and worldwide license, with sublicense rights, to use all Masimo SET® technology owned by us for measurement of vital signs in the Cercacor Market.

Non-vital signs measurements consist of body fluid constituents other than vital signs measurements, including, but not limited to, carbon monoxide, methemoglobin, blood glucose, hemoglobin and bilirubin. Under the Cross-Licensing Agreement, we are only permitted to sell devices utilizing Masimo SET® for the monitoring of non-vital signs parameters in markets where the product is intended to be used by a professional medical caregiver, including, but not limited to, hospital caregivers and alternate care facility caregivers, rather than by a patient or pharmacist, which we refer to as the Masimo Market. Accordingly, our ability to commercialize new products, new or improved technologies and additional applications for Masimo SET® is limited. In particular, our inability to expand beyond the Masimo Market may limit our ability to maintain or increase our revenue and impair our growth.
Pursuant to the Cross-Licensing Agreement, we have licensed from Cercacor the right to make and distribute products in the Masimo Market that utilize rainbow® technology for certain noninvasive measurements. As a result, the opportunity to expand the market for our products incorporating rainbow® technology is also limited, which could limit our ability to maintain or increase our revenue and impair our growth.
We face competition from other companies, many of which have substantially greater resources than we do. If we do not successfully develop and commercialize enhanced or new products that remain competitive with products or alternative technologies developed by others, we could lose revenue opportunities and customers, and our ability to grow our business would be impaired, adversely affecting our financial condition and results of operations.
The medical device industry is intensely competitive and is significantly affected by new product introductions and other market activities of industry participants. A number of our competitors have substantially greater capital resources, larger product portfolios, larger customer bases, larger sales forces and greater geographic presence, have established stronger reputations with specific customers, and have built relationships with Group Purchasing Organizations and other hospital purchasing groups (collectively, GPOs) that may be more effective than ours. Our Masimo SET® platform faces additional competition from companies developing products for use with third-party monitoring systems, as well as from companies that currently market their own pulse oximetry monitors. In addition, competitors with larger product portfolios than ours are engaging in bundling practices, whereby they offer increased discounts to hospitals that purchase their requirements for a variety of different products from the competitor, including products that we do not offer, sometimes pricing their competing products at a loss.
Rapid product development and technological advances within the medical device industry place our products at risk of obsolescence. Our long-term success depends upon the development and successful commercialization of new products, new or improved technologies and additional applications for our existing technologies. The research and development process is time-consuming and costly and may not result in products or applications that we can successfully commercialize. In particular, we may not be able to successfully commercialize our products for applications other than arterial blood oxygen saturation and pulse rate monitoring, such as for respiration rate, hemoglobin, carboxyhemoglobin and methemoglobin monitoring.
If we do not successfully adapt our products and applications both within and outside these measurements, we could lose revenue opportunities and customers. Furthermore, one or more of our competitors may develop products that are substantially equivalent to our U.S. Food and Drug Administration (FDA) cleared products, or those of our original equipment manufacturer (OEM) partners, in which case a competitor of ours may use our products or those of our OEM partners as predicate devices to more quickly obtain FDA clearance of their competing products. Competition could result in pressure from our customers to reduce the price of our products and place fewer orders for our products, which could, in turn, cause a reduction in our revenues and product gross margins, thereby adversely impacting our business, financial condition and results of operations.
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Some of the world’s largest technology companies that have not historically operated in the healthcare or medical device space, such as Apple, Alphabet, Samsung and others, have developed or may develop products and technologies that may compete with our current or future products and technologies. These companies have substantially greater capital, research and development, and sales resources than we have. If we are unable to successfully compete against them, our financial performance could decline.
We depend on our domestic and international OEM partners for a portion of our revenue. If they do not devote sufficient resources to the promotion of products that use our technologies, our business would be harmed.
We are, and will continue to be, dependent upon our domestic and international OEM partners for a portion of our revenue through their marketing, selling and distribution of certain of their products that incorporate our technologies. Although we expect that our OEM partners will accept and actively market, sell and distribute products that incorporate our technologies, they may not do so. Because products that incorporate our technologies may represent a relatively small percentage of business for some of our OEM partners, they may have less incentive to promote these products over other products that do not incorporate these technologies.
In addition, some of our OEM partners offer products that compete with ours and also may be involved in intellectual property disputes with us. Therefore, we cannot guarantee that our OEM partners, or any company that may acquire any of our OEM partners, will vigorously promote products incorporating our technologies. The failure of our OEM partners to successfully market, sell or distribute products incorporating our technologies, the termination of OEM agreements, the loss of OEM partners or the inability to enter into future OEM partnership agreements would have a material adverse effect on our business, financial condition and results of operations.
If we fail to maintain or develop relationships with GPOs, sales of our products would decline.
Our ability to sell our products to hospitals depends, in part, on our relationships with GPOs. Many existing and potential customers for our products are members of GPOs. GPOs negotiate pricing arrangements and contracts with medical supply manufacturers and distributors that may include provisions for sole sourcing and bundling, which generally reduce product purchasing decisions available to the hospitals.
These negotiated prices are made available to a GPO’s members. If we are not one of the providers selected by a GPO, the GPO’s members may be less likely or unlikely to purchase our products. If a GPO has negotiated a strict sole source, market share compliance or bundling contract for another manufacturer’s products, we may be prohibited from making sales to members of such GPO for the duration of such contractual arrangement. Shipments of our pulse oximetry products to customers that are members of GPOs represented more than 80% of our U.S. product sales for the three months ended March 30, 2019. Our failure to renew our contracts with GPOs may cause us to lose market share and could have a material adverse effect on our business, financial condition and results of operations. In addition, if we are unable to develop new relationships with GPOs, our competitive position would likely suffer and our opportunities to grow our revenues and business would be harmed.
Inadequate levels of coverage or reimbursement from governmental or other third-party payers for our products, or for procedures using our products, may cause our revenue to decline.
Sales of our products depend in part on the reimbursement and coverage policies of governmental and private health care payers. The lack of adequate coverage and reimbursement for our products or the procedures in which our products are used may deter customers from purchasing our products.
We cannot guarantee that governmental or third-party payers will reimburse a customer for the cost of our products or the procedures in which our products are used. For example, some insurance carriers have issued policies denying coverage for transcutaneous hemoglobin measurement on the grounds that the technology is investigational in the outpatient setting. Other payers are continuing to investigate our products to determine if they will provide reimbursement to our customers. These trends could lead to pressure to reduce prices for our current and future products, cause a decrease in the size of the market or potentially increase competition, any of which could have a material adverse effect on our business, financial condition and results of operations.
We do not control payer decision-making with respect to coverage and payment levels for our products. Additionally, we expect many payers to continue to explore cost-containment strategies (e.g., comparative and cost-effectiveness analyses, so-called “pay-for-performance” programs implemented by various public government health care programs and private third-party payers, and expansion of payment bundling initiatives, and other such methods that shift medical cost risk to providers) that may potentially impact coverage and/or payment levels for our current products or products we develop in the future.
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Outside of the U.S., reimbursement systems vary by country. These systems are often subject to the same pressures to curb rising health care costs and control health care expenditures as those in the U.S. In addition, as economies of emerging markets develop, these countries may implement changes in their health care delivery and payment systems. If adequate levels of reimbursement from third-party payers outside of the U.S. are not obtained, sales of our products outside of the U.S. may be adversely affected.
Consolidation in the healthcare industry could lead to demands for price concessions or to the exclusion of some suppliers from certain of our markets, which could have an adverse effect on our business, results of operations or financial condition.
Because healthcare costs have risen significantly over the past decade, numerous initiatives and reforms initiated by legislators, regulators and third-party payers to curb these costs have resulted in a consolidation trend in the healthcare industry to aggregate purchasing power. As the healthcare industry consolidates, competition to provide products and services to industry participants has become and will continue to become more intense. This has resulted in, and will likely continue to result in, greater pricing pressures and the exclusion of certain suppliers from important market segments as GPOs, independent delivery networks and large single accounts continue to use their market power to consolidate purchasing decisions for hospitals.
We expect that market demand, government regulation, third-party coverage and reimbursement policies and societal pressures will continue to impact the worldwide healthcare industry, resulting in further business consolidations and alliances among our customers, which may reduce competition, exert further downward pressure on the prices of our products and adversely impact our business, financial condition and results of operations.
Our customers may reduce, delay or cancel purchases due to a variety of factors, such as lower hospital census levels or third-party guidelines, which could adversely affect our business, financial condition and results of operations.
Our customers are facing growing levels of uncertainties, including variations in overall hospital census for paying patients and the impact of such census variations on hospital budgets. As a result, many hospitals are reevaluating their entire cost structure, including the amount of capital they allocate to medical device technologies and products. Such developments could have a significant negative impact on our OEM customers who, due to their traditionally larger capital equipment sales model, could see declines in purchases from their hospital customers. This, in turn, could reduce our board sales to our OEM customers.
In addition, certain of our products, including our rainbow® measurements such as carbon monoxide, methemoglobin and hemoglobin, that are sold with upfront license fees and more complex and expensive sensors, could also be impacted by hospital budget reductions.
States and other local regulatory authorities may issue guidelines regarding the appropriate scope and use of our products from time to time. For example, some of our noninvasive monitoring devices may be subject to authorization by individual states as part of the Emergency Medical Services (EMS) scope of practice procedures. A lack of inclusion into scope of practice procedures may limit adoption.
The loss of any large customer or distributor, or any cancellation or delay of a significant purchase by a large customer, could reduce our net sales and harm our operating results.
We have a concentration of OEM, distribution and direct customers. For example, sales to two just-in-time distributors each represented more than 10% of our product sales for the three months ended March 30, 2019. We cannot provide any assurance that we will retain our current customers, groups of customers or distributors, or that we will be able to attract and retain additional customers in the future. If for any reason we were to lose our ability to sell to a specific group or class of customers, or through a distributor, we could experience a significant reduction in revenue, which would adversely impact our operating results.
Our sales could also be negatively affected by any rebates, discounts or fees that are required by, or offered to, GPOs and customers, including wholesalers or distributors. Additionally, some of our just-in-time distributors have been demanding higher fees, which we may be forced to pay in order to continue to offer products to our customers or which may force us to distribute our products directly to our customers. The loss of any large customer or distributor, or an increase in distributor fees, could have a material adverse effect on our business, financial condition and results of operations.
Our royalty and other revenue has historically consisted primarily of royalties received from Medtronic plc (Medtronic) related to its U.S. sales, and more recently, revenue from non-recurring engineering (NRE) services for a certain OEM customer. However, Medtronic is not required to pay royalties to us for sales occurring after October 6, 2018. In addition, we have completed the majority of our contracted NRE services and expect to complete the remaining NRE services next year.
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We currently do not expect to replace this royalty and NRE services revenue with revenue from other sources, and such loss of revenue will have an adverse effect on our future results of operations.
Imitation Masimo sensors and third-party medical device reprocessors that reprocess our single-patient-use sensors may harm our reputation. Also, these imitation and third-party reprocessed sensors, as well as genuine Masimo reprocessed sensors, are sold at lower prices than new Masimo sensors and could cause our revenue to decline, which may adversely affect our business, financial condition and results of operations.
We believe that other organizations are manufacturing and selling imitation Masimo sensors. In addition, certain medical device reprocessors have been collecting our used single-patient-use sensors from hospitals and then reprocessing, repackaging and reselling those sensors to hospitals. These imitation and third-party reprocessed sensors are sold at lower prices than new Masimo sensors. Our experience with both these imitation sensors and third-party reprocessed sensors is that they provide inferior performance, increased sensor consumption, reduced comfort and a number of monitoring problems. Notwithstanding these limitations, some of our customers have indicated a willingness to purchase some of their sensor requirements from these imitation manufacturers and third-party reprocessors in an effort to reduce their sensor costs.
These imitation and reprocessed sensors have led and may continue to lead to confusion with our genuine Masimo products; have reduced and may continue to reduce our revenue; and, in some cases, have harmed and may continue to harm our reputation if customers conclude incorrectly that these imitation or reprocessed sensors are original Masimo sensors.
In addition, we have expended a significant amount of time and expense investigating issues caused by imitation and reprocessed sensors, troubleshooting problems stemming from such sensors, educating customers about why imitation and reprocessed sensors do not perform to their expectations, enforcing our proprietary rights against the imitation manufacturers and reprocessors, and enforcing our contractual rights under our customer contracts.
In response to these imitation sensors and third-party reprocessors, we have incorporated X-Cal® technology into certain products to ensure our customers get the performance they expect by using genuine Masimo sensors and that such sensors do not continue to be used beyond their useful life. However, some customers may object to the X-Cal® technology, potentially resulting in the loss of customers and revenues.
We also offer our own Masimo reprocessed sensors, which meet the same performance specifications as our new Masimo sensors, to our customers. Reprocessed sensors sold by us are also offered at a lower price and, therefore, may reduce certain customer demand for our new sensors. As a result, increased sales of our own Masimo reprocessed sensors may result in lower revenues, which could negatively impact our business, financial condition and results of operations.
Risks Related to Our Intellectual Property
If the patents we own or license, or our other intellectual property rights, do not adequately protect our technologies, we may lose market share to our competitors and be unable to operate our business profitably.
Our success depends significantly on our ability to protect our rights to the technologies used in our products. Our utilization of patent protection, trade secrets and a combination of copyright and trademark laws, as well as nondisclosure, confidentiality and other contractual arrangements, to protect our intellectual property afford us only limited protection and may not adequately protect our rights or permit us to gain or maintain any competitive advantage.
Our patents related to Masimo SET® algorithm technology began to expire in 2011. Certain other patents related to our ProCal sensor technology began to expire in 2015. Additionally, upon the expiration of other issued or licensed patents, we may lose some of our rights to exclude competitors from making, using, selling or importing products using the technology based on the expired patents. Furthermore, in recent years, the U.S. Supreme Court has ruled on several patent cases and several laws have been enacted that, in certain situations, potentially narrows the scope of patent protection available and weakens the rights of patent owners. There can be no assurance that we will be successful in securing additional patents on commercially desirable improvements, that such additional patents will adequately protect our innovations or offset the effect of expiring patents, or that competitors will not be able to design around our patents.
In addition, third parties may challenge our issued patents through procedures such as Inter-Partes Review (IPR). In many IPR challenges, the U.S. Patent and Trademark Office (PTO) cancels or significantly narrows issued patent claims. IPR challenges could increase the uncertainties and costs associated with the maintenance, enforcement and defense of our issued and future patents and could have a material adverse effect on our business, financial condition and results of operations.
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We also utilize unpatented proprietary technology and know-how and often rely on confidentiality agreements and intellectual property assignment agreements with our employees, OEM partners, independent distributors and consultants to protect such unpatented proprietary technology and know-how. However, such agreements may not be enforceable or may not provide meaningful protection for our proprietary information in the event of unauthorized use or disclosure or other breaches of the agreements, or in the event that our competitors discover or independently develop similar or identical designs or other proprietary information.
We rely on the use of registered and common law trademarks with respect to the brand names of some of our products. Common law trademarks provide less protection than registered trademarks. Loss of rights in our trademarks could adversely affect our business, financial condition and results of operations.
The laws of foreign countries may not adequately protect our intellectual property rights.
Intellectual property protection laws in foreign countries differ substantially from those in the U.S. If we fail to apply for intellectual property protection in foreign countries, or if we cannot adequately protect our intellectual property rights in these foreign countries, our competitors may be able to compete more effectively against us, which could adversely affect our competitive position, as well as our business, financial condition and results of operations.
If third parties claim that we infringe their intellectual property rights, we may incur liabilities and costs and may have to redesign or discontinue selling certain products.
Searching for existing intellectual property rights may not reveal important intellectual property and our competitors may also have filed for patent protection, which may not be publicly-available information, or claimed trademark rights that have not been revealed through our searches. In addition, some of our employees were previously employed at other medical device companies. We may be subject to claims that our employees have disclosed, or that we have used, trade secrets or other proprietary information of our employees’ former employers. Our efforts to identify and avoid infringing on third parties’ intellectual property rights may not always be successful. Any claims of patent or other intellectual property infringement against us, even those without merit, could:

• | be expensive and time consuming to defend and result in payment of significant damages to third parties;

• | force us to stop making or selling products that incorporate the intellectual property;

• | require us to redesign, reengineer or rebrand our products, product candidates and technologies;

• | require us to enter into royalty agreements that would increase the costs of our products;

• | require us to indemnify third parties pursuant to contracts in which we have agreed to provide indemnification for intellectual property infringement claims;

• | divert the attention of our management and other key employees; and

• | result in our customers or potential customers deferring or limiting their purchase or use of the affected products impacted by the claims until the claims are resolved;

any of which could have a material adverse effect on our business, financial condition and results of operations. In addition, new patents obtained by our competitors could threaten the continued commercialization of our products in the market even after they have already been introduced.
We believe competitors may currently be violating and may in the future violate our intellectual property rights. As a result, we may initiate litigation to protect and enforce our intellectual property rights, which may result in substantial expense and may divert management’s attention from implementing our business strategy.
We believe that the success of our business depends, in part, on obtaining patent protection for our products and technologies, defending our patents and preserving our trade secrets. We were previously involved in significant litigation to protect our patent positions related to some of our pulse oximetry signal processing patents that resulted in various settlements, most recently in 2016. In view of some of the new market entrants, we may be required to engage in additional litigation to protect our intellectual property in the future. In addition, we believe that certain individuals who previously held high level technical and clinical positions with us, misappropriated our intellectual property for the benefit of themselves and other companies. Our ongoing and future litigation could result in significant additional costs and further divert the attention of our management and key personnel from our business operations and the implementation of our business strategy and may not be successful or adequate to protect our intellectual property rights.
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Risks Related to Our Regulatory Environment
Our failure to obtain and maintain FDA clearances or approvals on a timely basis, or at all, would prevent us from commercializing our current or upgraded products in the U.S., which could severely harm our business.
Unless an exemption applies, each medical device that we wish to market in the U.S. must first undergo premarket review pursuant to the Federal Food, Drug, and Cosmetic Act (FDCA) by receiving clearance of a 510(k) premarket notification, receiving clearance through the de novo review process, or obtaining approval of a premarket approval (PMA) application. Even if regulatory clearance or approval of a product is granted, the FDA may clear or approve our products only for limited indications for use. Additionally, the FDA may not grant 510(k) clearance on a timely basis, if at all, for new products or uses that we propose for Masimo SET® or licensed rainbow® technology.
The traditional FDA 510(k) clearance process for our products has generally taken between three to six months. However, our more recent experience and interactions with the FDA, along with information we have received from other medical device manufacturers, suggests that, in some cases, the FDA is requiring applicants to provide additional or different information and data for 510(k) clearance than it had previously required, and that the FDA may not rely on approaches that it had previously accepted to support 510(k) clearance. As a result, we have experienced lengthier FDA 510(k) review periods over the past few years, which have delayed the 510(k) clearance process for our products.
To support our product applications to the FDA, we frequently are required to conduct clinical testing of our products. Such clinical testing must be conducted in compliance with FDA requirements pertaining to human research. Among other requirements, we must obtain informed consent from human subjects and approval by institutional review boards before such studies may begin. We must also comply with other FDA requirements such as monitoring, record-keeping, reporting and the submission of information regarding certain clinical trials to a public database maintained by the National Institutes of Health. In addition, if the study involves a significant risk device, we are required to obtain the FDA’s approval of the study under an Investigational Device Exemption (IDE). Compliance with these requirements can require significant time and resources. If the FDA determines that we have not complied with such requirements, the FDA may refuse to consider the data to support our applications or may initiate enforcement actions.
Even though 510(k) clearances have been obtained, if safety or effectiveness problems are identified with our pulse oximeters incorporating Masimo SET® and licensed rainbow® technology, patient monitor devices, sensors, cables and other products, we may need to initiate a recall of such devices. Furthermore, our new products or significantly modified marketed products could be denied 510(k) clearance and be required to undergo the more burdensome PMA or de novo review processes. The process of obtaining a de novo classification or PMA approval is much more costly, lengthy and uncertain than the process for obtaining 510(k) clearance. De novo classification generally takes six months to one year from the time of submission of the de novo request, although it can take longer. Approval of a PMA generally takes one to three years from the time of submission of the PMA, but may be longer.
We sell consumer versions of our iSpO 2® and MightySat® pulse oximeters that are not intended for medical use. Some of our products or product features may also be exempted from the 510(k) process and/or other regulatory requirements in accordance with specific FDA guidance and policies, such as the FDA guidance related to mobile medical applications. In addition, some of our products or product features may not be subject to device regulation pursuant to Section 520(o) of the FDCA, which excludes certain software functions from the statutory definition of a device. If the FDA changes its policy or concludes that our marketing of these products is not in accordance with its current policy and/or Section 520(o) of the FDCA, we may be required to seek clearance or approval of these devices through the 510(k), de novo or PMA processes.
The failure of our OEM partners to obtain required FDA clearances or approvals for products that incorporate our technologies could have a negative impact on our revenue.
Our OEM partners are required to obtain their own FDA clearances in the U.S. for most products incorporating Masimo technologies. The FDA clearances we have obtained may not make it easier for our OEM partners to obtain clearances of products incorporating these technologies, or the FDA may not grant clearances on a timely basis, if at all, for any future products incorporating Masimo technologies that our OEM partners propose to market.
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If we or our suppliers fail to comply with ongoing regulatory requirements, or if we experience unanticipated problems with our products, these products could be subject to restrictions or withdrawal from the market.
Our products, along with the manufacturing processes, labeling and promotional activities for our products, are subject to continual review and periodic inspections by the FDA and other regulatory bodies. Among other requirements, we and our suppliers are required to comply with the FDA’s Quality System Regulation (QSR), which governs the methods and documentation of the design, control testing, production, component suppliers control, quality assurance, complaint handling, labeling control, packaging, storage and shipping of our products. The FDA enforces the QSR through announced and unannounced inspections. We are also subject to similar state requirements and licenses.
In addition to the FDA, from time to time we are subject to inspections by the California Food and Drug Branch, international regulatory authorities, and other similar governmental agencies. The standards used by these regulatory authorities are complex and may differ from those used by the FDA.
Failure by us or one of our suppliers to comply with statutes and regulations administered by the FDA and other regulatory bodies or failure to adequately respond to any FDA Form 483 observations, any Food and Drug Branch notices of violation or any similar reports could result in, among other things, any of the following:

• | warning letters or untitled letters issued by the FDA;

• | fines, civil penalties, in rem forfeiture proceedings, injunctions, consent decrees and criminal prosecution;

• | import alerts;

• | unanticipated expenditures to address or defend such actions;

• | delays in clearing or approving, or refusal to clear or approve, our products;

• | withdrawals or suspensions of clearance or approval of our products or those of our third-party suppliers by the FDA or other regulatory bodies;

• | product recalls or seizures;

• | orders for physician notification or device repair, replacement or refund;

• | interruptions of production or inability to export to certain foreign countries; and

• | operating restrictions.

If any of these items were to occur, it would harm our reputation and adversely affect our business, financial condition and results of operations.
Failure to obtain regulatory authorizations in foreign jurisdictions may prevent us from marketing our products abroad.
We currently market and intend to continue to market our products internationally. Outside of the U.S., we can generally market a product only if we receive a marketing authorization and, in some cases, pricing approval, from the appropriate regulatory authorities. The regulatory registration/licensing process varies among international jurisdictions and may require additional or different product testing than required to obtain FDA clearance. FDA clearance does not ensure new product registration/licensing by foreign regulatory authorities, and we may be unable to obtain foreign regulatory registration/licensing on a timely basis, if at all.
In addition, clearance by one foreign regulatory authority does not ensure clearance by any other foreign regulatory authority or by the FDA. If we fail to receive necessary approvals to commercialize our products in foreign jurisdictions on a timely basis, or at all, our business, financial condition and results of operations could be adversely affected.
Modifications to our marketed devices may require new regulatory clearances or premarket approvals, or may require us to cease marketing or to recall the modified devices until clearances or approvals are obtained.
We have made modifications to our devices in the past and we may make additional modifications in the future. Any modifications to an FDA-cleared device that could significantly affect its safety or effectiveness or that could constitute a major change in its intended use would require a new 510(k) clearance or possibly a de novo review or PMA. We may not be able to obtain such clearances or approvals in a timely fashion, or at all. Delays in obtaining future clearances would adversely affect our ability to introduce new or enhanced products in a timely manner, which in turn would have an adverse effect on our business, financial condition and results of operations. For device modifications that we conclude do not require a new 510(k), we may be required to recall and to stop marketing the modified devices if the FDA disagrees with our conclusion and requires new clearances or approvals for the modifications, which could have an adverse effect on our business, financial condition and results of operations.
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Federal regulatory reforms may impact our ability to develop and commercialize our products and technologies.
From time to time, legislation is drafted and introduced in Congress that could significantly change the statutory provisions governing the clearance or approval, manufacture and marketing of medical devices. For example, in August 2017, Congress enacted the FDA Reauthorization Act of 2017 (FDARA). FDARA reauthorized the FDA to collect device user fees, including a new user fee for de novo classification requests, and contained substantive amendments to the device provisions of the FDCA. Among other changes, FDARA required that the FDA update and revise its processes for scheduling inspections of device establishments, communicating about those inspections with manufacturers and providing feedback on the manufacturer’s responses to Form 483s. The statute also required that the FDA study the impact of device servicing, including third party servicers, and creates a new process for device sponsors to request classification of accessory devices as part of the PMA application for the parent device or to request a separate classification of accessory devices.
In addition, the FDA regulations and guidance are often revised or reinterpreted by the FDA in ways that may significantly affect our business or products. Future regulatory changes could make it more difficult for us to obtain or maintain approval to develop and commercialize our products and technologies.
If our products cause or contribute to a death or serious injury, or malfunction in a way that would likely cause or contribute to a death or serious injury, we will be subject to medical device reporting regulations, which can result in voluntary corrective actions or agency enforcement actions, including recall of our products.
Under the FDA medical device reporting regulations, we are required to report to the FDA any incident in which a product of ours may have caused or contributed to a death or serious injury or in which a product of ours malfunctioned and, if the malfunction were to recur, would be likely to cause or contribute to death or serious injury. In addition, all manufacturers placing medical devices in the European Union (EU) are legally required to report any serious or potentially serious incidents involving devices produced or sold by the manufacturer to the relevant authority in those jurisdictions where any such incident occurred.
The FDA and similar foreign regulatory authorities have the authority to require the recall of our commercialized products in the event of material deficiencies or defects in, for example, design, labeling or manufacture. The FDA must find that there is a reasonable probability that the device would cause serious adverse health consequences or death in order to require a recall. The standard for recalling deficient products may be different in foreign jurisdictions. Manufacturers may, under their own initiative, recall a product if any material deficiency in a device is found or they become aware of a safety issue involving a marketed product. A government-mandated or voluntary recall by us or by one of our distributors could occur as a result of component failures, manufacturing errors, design or labeling defects or other deficiencies and issues.
We may initiate certain field actions, such as a correction or removal of our products in the future. Any correction or removal initiated by us to reduce a health risk posed by our device, or to remedy a violation of the FDCA caused by the device that may present a risk to health, must be reported to the FDA. If the FDA subsequently determines that a report was required for a correction or removal of our products that we did not believe required a report, we could be subject to enforcement actions.
Any recalls of our products or enforcement actions would divert managerial and financial resources and could have an adverse effect on our financial condition and results of operations. In addition, given our dependence upon patient and physician perceptions, any negative publicity associated with any recalls could materially and adversely affect our business, financial condition, results of operations and growth prospects.
*Promotion of our products using claims that are off-label, unsubstantiated, false or misleading could subject us to substantial penalties.
Obtaining 510(k) clearance permits us to promote our products for the uses cleared by the FDA. Use of a device outside its cleared or approved indications is known as “off-label” use. Physicians may use our products off-label because the FDA does not restrict or regulate a physician’s choice of treatment within the practice of medicine. While we may request additional cleared indications for our current products, the FDA may deny those requests, require additional expensive clinical data to support any additional indications or impose limitations on the intended use of any cleared product as a condition of clearance. If the FDA determines that our products were promoted for off-label use or that false, misleading or inadequately substantiated promotional claims have been made by us or our OEM partners, it could request that we or our OEM partners modify those promotional materials or take regulatory or enforcement actions, including the issuance of an untitled letter, warning letter, injunction, seizure, civil fine and criminal penalties. While certain U.S. courts have held that truthful, non-misleading, off-label information is protected under the First Amendment under certain circumstances, the FDA continues to take the position that off-label promotion is subject to enforcement action. It is also possible that other federal, state or foreign enforcement authorities may take action if they consider our communications, including promotional or training materials, to constitute promotion of an uncleared or unapproved use.
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If not successfully defended, enforcement actions related to off-label promotion could result in significant fines or penalties under other statutory authorities, such as laws prohibiting false claims for reimbursement. In any such event, our reputation could be damaged, adoption of our products could be impaired and we could be subject to extensive fines and penalties.
Additionally, we must have adequate substantiation for the claims we make for our products. If any of our claims are determined to be false, misleading or deceptive, our products could be considered misbranded under the FDCA or in violation of the Federal Trade Commission Act. We could also face lawsuits from our competitors under the Lanham Act alleging that our marketing materials are false or misleading.
The regulatory environment governing information, cybersecurity and privacy laws is increasingly demanding and continues to evolve.
Personal privacy and data security have become significant issues in the U.S. Europe and in many other jurisdictions where we offer our products. The regulatory framework for privacy and security issues worldwide is rapidly evolving and is likely to remain uncertain for the foreseeable future.
Certain U.S. laws govern the transmission, security and privacy of individually identifiable information that we may obtain or have access to in connection with the operation of our business, including the conduct of clinical research trials or other research studies that may provide us with access to sensitive health and other personal information. We may be required to make costly system modifications to comply with these data privacy and security requirements. In addition, if we do not properly comply with applicable laws and regulations related to the protection of this information, we could be subject to criminal or civil sanctions. Internationally, the General Data Protection Regulation (GDPR) has recently taken effect in the European Economic Area (EEA) and many EEA jurisdictions have also adopted their own data privacy and protection laws in addition to the GDPR. Furthermore, other international jurisdictions, including South Korea, China and Australia, have also implemented laws relating to data privacy and protection. Although we believe that we are complying with the GDPR and similar laws, these laws are still relatively new. Therefore, as international data privacy and protection laws continue to evolve, and as new regulations, interpretive guidance and enforcement information becomes available, we may incur incremental costs to modify our business practices to comply with these requirements. In addition, our internal control policies and procedures may not always protect us from reckless or criminal acts committed by our employees or agents.
Violations of these laws, or allegations of such violations, could subject us to cash and non-cash penalties for noncompliance, disrupt our operations, involve significant management distraction and result in a material adverse effect on our business, financial condition and results of operations.
*We may be subject to or otherwise affected by federal and state health care laws, including fraud and abuse laws, and could face substantial penalties if we are unable to fully comply with these laws.
Health care fraud and abuse laws potentially applicable to our operations include, but are not limited to:

• | the federal Anti-Kickback Statute, which prohibits, among other things, knowingly and willfully offering, paying, soliciting or receiving any bribe, kickback or other remuneration intended to induce the purchase, order or recommendation of an item or service reimbursable under a federal health care program (such as the Medicare or Medicaid programs);

• | the federal False Claims Act and other federal laws which prohibit, among other things, knowingly and willfully presenting, or causing to be presented, claims for payment from Medicare, Medicaid, other government payers or other third-party payers that are false or fraudulent;

• | state laws analogous to each of the above federal laws, such as state anti-kickback and false claims laws that may apply to items or services reimbursed by governmental programs and non-governmental third-party payers, including commercial insurers; and

• | the Physician Payments Sunshine Act (Sunshine Act), which requires medical device companies to track and publicly report, with limited exceptions, all payments and transfers of value to physicians and teaching hospitals in the U.S.

If we are found to have violated any such laws or other similar governmental regulations, including their foreign counterparts, that are directly or indirectly applicable to us, we may be subject to penalties, including civil and criminal penalties, damages, fines, exclusion of our products from reimbursement under Medicare, Medicaid and other federal health care programs, and the curtailment or restructuring of our operations. Any penalties could adversely affect our ability to operate our business and our financial results. Any action against us for violation of these laws, even if we successfully defend against such action, could cause us to incur significant legal expenses and divert our management’s attention from the operation of our business.
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Legislative and regulatory changes in the health care industry could have a negative impact on our financial performance. Furthermore, our business, financial condition, results of operations and cash flows could be significantly and adversely affected by health care reform legislation in the U.S. or in our key international markets.
Changes in the health care industry in the U.S. and abroad could adversely affect the demand for our products and the way in which we conduct our business. For example, the Patient Protection and Affordable Care Act (the ACA), enacted in 2010, required most individuals to have health insurance, established new regulations on health plans, created insurance-pooling mechanisms and reduced Medicare spending on services provided by hospitals and other providers. The ACA also imposed significant new taxes on medical device makers in the form of a 2.3% excise tax on U.S. medical device sales, as well as related compliance and reporting obligations. This medical device excise tax (MDET) has been temporarily suspended by Congress on a number of occasions, and most recently through December 31, 2019. The MDET may be reimposed on medical device makers beginning on January 1, 2020 if such suspension is not re-extended or the MDET is not permanently repealed.
Additionally, the long-term viability of the ACA, and its impact on our business and results of operations, remains uncertain. There have also been recent U.S. Congressional actions to repeal and replace the ACA, and future actions are expected. For example, the Tax Cuts and Jobs Act of 2017, among other things, eliminated the individual mandate requiring most Americans (other than those who qualify for a hardship exemption) to carry a minimum level of health coverage effective January 1, 2019. Although we cannot predict the ultimate content or timing of any healthcare reform legislation, potential changes resulting from any amendment, repeal or replacement of these programs, including any reduction in the future availability of healthcare insurance benefits, decrease the number of people who are insured, which could adversely affect our business and future results of operations.
Our medical devices and business activities are subject to rigorous regulation by the FDA and other federal, state and international governmental authorities. These authorities and members of Congress have been increasing their scrutiny over the medical device industry. In recent years, Congress, the Department of Justice, the Office of Inspector General of the Department of Health and Human Services, and the Department of Defense have issued subpoenas and other requests for information to medical device manufacturers, primarily related to financial arrangements with health care providers, regulatory compliance and marketing and product promotional practices. Furthermore, certain state governments have enacted legislation to limit and/or increase transparency of interactions with health care providers, pursuant to which we are required by law to disclose payments and other transfers of value to health care providers licensed by certain states.
We anticipate that the government will continue to scrutinize our industry closely, and any new regulations or statutory provisions could result in delays or increased costs during the periods of product development, clinical trials and regulatory review and approval, as well as increased costs to assure compliance.
Risks Related to Our Business and Operations
We may experience conflicts of interest with Cercacor with respect to business opportunities and other matters.
Prior to our initial public offering in August 2007, our stockholders owned 99% of the outstanding shares of capital stock of Cercacor, and we believe that a number of our stockholders, including certain of our directors and executive officers, continue to own shares of Cercacor stock. Joe Kiani, our Chairman and Chief Executive Officer (CEO), is also the Chairman and CEO of Cercacor.
Due to the interrelated nature of Cercacor with us, conflicts of interest may arise with respect to transactions involving business dealings between us and Cercacor, potential acquisitions of businesses or products, the development and ownership of technologies and products, the sale of products, markets and other matters in which our best interests and the best interests of our stockholders may conflict with the best interests of the stockholders of Cercacor. In addition, we and Cercacor may disagree regarding the interpretation of certain terms in the Cross-Licensing Agreement. We cannot guarantee that any conflict of interest will be resolved in our favor, or that, with respect to our transactions with Cercacor, we will negotiate terms that are as favorable to us as if such transactions were with another third-party.
We will be required to assign to Cercacor and pay Cercacor for the right to use certain products and technologies we develop that relate to the monitoring of non-vital sign parameters, including improvements to Masimo SET®.
Under the Cross-Licensing Agreement, if we develop certain products or technologies that relate to the noninvasive monitoring of non-vital sign parameters, including improvements to Masimo SET® for the noninvasive monitoring of non-vital sign parameters, we would be required to assign these developments to Cercacor and then license the technology back from Cercacor in consideration for upfront payments and royalty obligations to Cercacor. Therefore, these products and technologies would be deemed to have been developed or improved exclusively by Cercacor.
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In addition, we will not be reimbursed by Cercacor for our expenses relating to the development or improvement of any such products or technologies, which expenses may be significant. As a result of these terms, we may not generate any revenue from the further development of certain products and technologies for the monitoring of non-vital sign parameters, including improvements to Masimo SET®, which could adversely affect our business, financial condition and results of operations.
In the event that the Cross-Licensing Agreement is terminated for any reason, or Cercacor grants a license to rainbow® technology to a third-party, our business would be adversely affected.
Cercacor owns all of the proprietary rights to certain rainbow® technology developed with our proprietary Masimo SET® for products intended to be used in the Cercacor Market, and all rights to any non-vital signs measurement for which we do not exercise an option pursuant to the Cross-Licensing Agreement. In addition, Cercacor has the right to terminate the Cross-Licensing Agreement or grant licenses covering rainbow® technology to third parties if we breach certain terms of the agreement, including any failure to meet our minimum royalty payment obligations or failure to use commercially reasonable efforts to develop or market products incorporating licensed rainbow® technology. If we lose our exclusive license to rainbow® technology, we would lose the ability to prevent others from making, using, selling or importing products using rainbow® technology in our market. As a result, we would likely be subject to increased competition within our market, and Cercacor or competitors who obtain a license to rainbow® technology from Cercacor would be able to offer related products.
We may not be able to commercialize our products incorporating licensed rainbow® technology cost-effectively or successfully.
As a result of the royalties that we must pay to Cercacor, it is generally more expensive for us to make products that incorporate licensed rainbow® technology than products that do not include licensed rainbow® technology.
We cannot assure you that we will be able to sell products incorporating licensed rainbow® technology at a price the market is willing to accept. If we cannot commercialize our products incorporating licensed rainbow® technology successfully, we may not be able to generate sufficient product revenue from these products to be profitable, which could adversely affect our business, financial condition and results of operations.
Rights provided to Cercacor in the Cross-Licensing Agreement may impede a change in control of our company.
Under the Cross-Licensing Agreement, a change in control includes the resignation or termination of Joe Kiani from his position as CEO of either Masimo or Cercacor. A change in control also includes other customary events, such as the sale or merger of Masimo or Cercacor to a non-affiliated third-party or the acquisition of 50% or more of the voting power of Masimo or Cercacor by a non-affiliated third-party. In the event we undergo a change in control, we are required to immediately pay a $2.5 million fee to exercise an option to license technology developed by Cercacor for use in blood glucose monitoring. Additionally, our per product royalties payable to Cercacor will become subject to specified minimums, and the minimum aggregate annual royalties for licensed rainbow® measurements payable to Cercacor related to carbon monoxide, methemoglobin, fractional arterial oxygen saturation, hemoglobin and blood glucose will increase to $15.0 million, plus up to $2.0 million for other rainbow® measurements. Also, if the surviving or acquiring entity ceases to use “Masimo” as a company name and trademark following a change in control, all rights to the “Masimo” trademark will automatically be assigned to Cercacor. This could delay or discourage transactions involving an actual or potential change in control of us, including transactions in which our stockholders might otherwise receive a premium for their shares over our then-current trading price. In addition, our requirement to assign all future improvements for non-vital signs to Cercacor could impede a change in control of our company.
We may experience significant fluctuations in our quarterly and annual results and may not maintain our current levels of profitability in the future.
Our operating results have fluctuated in the past and are likely to fluctuate in the future. Many of the countries in which we operate, including the U.S. and several of the members of the EU, have experienced and continue to experience uncertain economic conditions resulting from global as well as local factors. In addition, continuing strength and growth in the U.S. economy has raised the probability of inflationary pressures and future interest rate hikes that have not been experienced in the U.S. for more than a decade. Our business or financial results may be adversely impacted by these uncertain economic conditions, including: adverse changes in interest rates, foreign currency exchange rates, tax laws or tax rates; inflation; contraction in the availability of credit in the marketplace due to legislation or other economic conditions, which may potentially impair our ability to access the capital markets on terms acceptable to us or at all; and the effects of government initiatives to manage economic conditions.
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In addition, we cannot predict how future economic conditions will affect our critical customers, suppliers and distributors and any negative impact on our critical customers, suppliers or distributors may also have an adverse impact on our results of operations or financial condition. Our expense levels are based, in part, on our expectations regarding future revenue levels and are relatively fixed in the short term. As a result, if our revenue for a particular period was below our expectations, we would not be able to proportionately reduce our operating expenses for that period. Any revenue shortfall would have a disproportionately negative effect on our operating results for the period.
Recent accounting changes related to our embedded leases within certain deferred equipment agreements have also resulted in the acceleration of the timing related to our recognition of revenue and expenses associated with certain equipment provided to customers at no up-front charge. Since we cannot control the timing of when our customers will request us to deliver such equipment, our revenue and costs with respect to leased equipment could vary substantially in any given quarter or year, which could further increase quarterly or annual fluctuations within our financial results.
Due to these and other factors, you should not rely on our results for any one quarter as an indication of our future performance. If our operating results fail to meet or exceed the expectations of securities analysts or investors, our stock price could drop suddenly and significantly.
Future changes in accounting pronouncements and tax laws, or the interpretation thereof, could have a significant impact on our reported results, and may affect our historical reporting of previous transactions.
New accounting pronouncements or taxation rules, and evolving interpretations thereof, have occurred and are likely to occur in the future. For example, in recent years, the Financial Accounting Standards Board (FASB) issued new accounting standards that impact our reporting of revenue and expenses, including Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers (ASC 606) and ASC Topic 842, Leases (ASC 842). Changes made by these new accounting standards not only apply prospectively, but depending on the method of adoption, may also recast previously reported results. In addition, the 2017 Tax Act, which took effect on January 1, 2018, included a number of changes to existing tax law impacting businesses including, among other things, a permanent reduction in the corporate income tax rate from 35% to 21%, a one-time transition tax on the “deemed repatriation” of cumulative undistributed foreign earnings as of December 31, 2017 and changes in the prospective taxation of the foreign operations of U.S. multinational companies. Moreover, Congressional leaders have recognized that the process of adopting extensive tax legislation in a short amount of time without hearings and substantial time for review is likely to have led to drafting errors, issues needing clarification and unintended consequences that will have to be reviewed in subsequent tax legislation or addressed in future tax regulations. We continue to evaluate the impact of ASC 606, ASC 842 and the 2017 Tax Act on our business, financial condition and results of operations. For additional information related to the impact of new accounting pronouncements and the 2017 Tax Act, please see Notes 2 and 20, respectively, to our consolidated financial statements included in Part IV, Item 15(a) of our Annual Report on Form 10-K for the fiscal year ended December 29, 2018, filed with the SEC on February 26, 2019.
Our results of operations could vary as a result of the methods, estimates and judgments that we use in applying our accounting policies.
The methods, estimates and judgments that we use in applying our accounting policies are, by their nature, subject to substantial risks, uncertainties and assumptions. Factors may arise over time that lead us to change our methods, estimates and judgments, the impact of which could significantly affect our results of operations. See “Critical Accounting Estimates” contained in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 29, 2018, filed with the SEC on February 26, 2019 and “Critical Accounting Policies and Estimates” contained in Part I, Item 2 of this Quarterly Report on Form 10-Q for additional information about these methods, estimates and judgments.
If we lose the services of our key personnel, or if we are unable to attract and retain other key personnel, we may not be able to manage our operations or meet our growth objectives.
We are highly dependent on our senior management, especially Joe Kiani, our CEO, and other key officers. We are also heavily dependent on our engineers and field sales team, including sales representatives and clinical specialists. The loss of the services of members of our key personnel or the inability to attract and retain qualified personnel in the future could prevent the implementation and completion of our objectives, including the development and introduction of our products. In general, our key personnel may terminate their employment at any time and for any reason without notice, unless the individual is a participant in our 2007 Severance Protection Plan, in which case the individual has agreed to provide us with six months’ notice if such individual decides to voluntarily resign.
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We are involved, and may become involved in the future, in disputes and other legal or regulatory proceedings that, if adversely decided or settled, could materially and adversely affect our business, financial condition and results of operations.
We are, and may in the future become, party to litigation, regulatory proceedings or other disputes. In general, claims made by or against us in disputes and other legal or regulatory proceedings can be expensive and time consuming to bring or defend against, requiring us to expend significant resources and divert the efforts and attention of our management and other personnel from our business operations. These potential claims may include but are not limited to personal injury and class action lawsuits, intellectual property claims and regulatory investigations relating to the advertising and promotional claims about our products and employee claims against us based on, among other things, discrimination, harassment or wrongful termination. Any one of these claims, even those without merit, may divert our financial and management resources that would otherwise be used to benefit the future performance of our operations. Any adverse determination against us in these proceedings, or even the allegations contained in the claims, regardless of whether they are ultimately found to be without merit, may also result in settlements, injunctions or damages that could have a material adverse effect on our business, financial condition and results of operations.
Changes to government immigration regulations may materially affect our workforce and limit our supply of qualified professionals, or increase our cost of securing workers.
We recruit professionals on a global basis and must comply with the immigration laws in the countries in which we operate, including the U.S. Some of our employees are working under Masimo-sponsored temporary work visas, including H1-B visas. Statutory law limits the number of new H1-B temporary work permit petitions that may be approved in a fiscal year. Furthermore, there is a possibility that the current U.S. immigration visa program may be significantly overhauled. Any resulting changes to this visa program could impact our ability to recruit, hire and retain qualified skilled personnel. If we are unable to obtain work visas in sufficient quantities or at a sufficient rate for a significant period of time, our business, operating results and financial condition could be adversely affected.
The risks inherent in operating internationally, including the purchase, sale and shipment of our components and products across international borders, may adversely impact our business, financial condition and results of operations.
We currently derive approximately 30% of our net sales from international operations. In addition, we purchase a portion of our raw materials and components from international sources. The sale and shipment of our products across international borders, as well as the purchase of materials and components from international sources, subject us to extensive U.S. and foreign governmental trade regulations, including those related to conflict minerals. Compliance with such regulations is costly and we could be exposed to potentially significant penalties if we are found not to be in compliance with such regulations. Any failure to comply with applicable legal and regulatory obligations could impact us in a variety of ways that include, but are not limited to, significant criminal, civil and administrative penalties, including imprisonment of individuals, fines and penalties, denial of export privileges, seizure of shipments, restrictions on certain business activities, and exclusion or debarment from government contracting. Also, the failure to comply with applicable legal and regulatory obligations could result in the disruption of our shipping, manufacturing and sales activities. Any material decrease in our international sales would adversely affect our business, financial condition and results of operations.
In June 2016, the United Kingdom (UK) held a referendum pursuant to which voters elected to leave the EU, commonly referred to as Brexit. Although the long-term effects of Brexit will depend on any agreements the UK makes to retain access to the EU markets, Brexit has created additional uncertainties that may ultimately result in new regulatory costs and challenges for medical device companies and increased restrictions on imports and exports throughout Europe, which could adversely affect our ability to conduct and expand our operations in Europe and which may have an adverse effect on our business, financial condition and results of operations. Additionally, Brexit may increase the possibility that other countries may decide to leave the EU in the future.
In addition, our international operations expose us and our representatives, agents and distributors to risks inherent in operating in foreign jurisdictions. These risks include, but are not limited to:

• | the imposition of additional U.S. and foreign governmental controls or regulations;

• | the imposition of costly and lengthy new export licensing requirements;

• | a shortage of high-quality sales people and distributors;

• | the loss of any key personnel that possess proprietary knowledge, or who are otherwise important to our success in certain international markets;

• | changes in duties and tariffs, license obligations and other non-tariff barriers to trade;

• | the imposition of new trade restrictions;

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• | the imposition of restrictions on the activities of foreign agents, representatives and distributors;

• | compliance with foreign tax laws, regulations and requirements;

• | pricing pressure;

• | changes in foreign currency exchange rates;

• | laws and business practices favoring local companies;

• | political instability and actual or anticipated military or political conflicts;

• | financial and civil unrest worldwide;

• | outbreaks of illnesses, pandemics or other local or global health issues;

• | the inability to collect amounts paid by foreign government customers to our appointed foreign agents;

• | longer payment cycles, increased credit risk and different collection remedies with respect to receivables; and

• | difficulties in enforcing or defending intellectual property rights.

The U.S. government has recently initiated substantial changes in U.S. trade policy and U.S. trade agreements, including the initiation of tariffs on certain foreign goods. In response to these tariffs, certain foreign governments, including China, have instituted or are considering imposing tariffs on certain U.S. goods. In addition, the U.S. is negotiating or has entered into new trade agreements that could affect adversely us, including the United States-Mexico-Canada Agreement, which if ratified by each member country’s legislature, would replace the North American Free Trade Agreement. A trade war, trade barriers or other governmental actions related to tariffs, international trade agreements, import or export restrictions or other trade policies could adversely impact demand for our products, our costs, customers, suppliers and/or the U.S. economy or certain sectors thereof and, therefore, adversely affect our business, financial condition and results of operations.
The U.S. Foreign Corrupt Practices Act and similar worldwide anti-bribery laws in non-U.S. jurisdictions generally prohibit companies and their intermediaries from promising or making improper payments to non-U.S. officials for the purpose of obtaining an advantage to secure or retain business. Because of the predominance of government-sponsored health care systems around the world, many of our customer relationships outside of the U.S. are with governmental entities and are therefore subject to such anti-bribery laws. We have adopted policies and practices that help us ensure compliance with these anti-bribery laws. However, such policies and practice may require us to invest in additional monitoring resources or forgo certain business opportunities in order to ensure global compliance with these laws.
Our operations may be adversely impacted by our exposure to risks related to foreign currency exchange rates.
We market our products in certain foreign markets through our subsidiaries and other international distributors. As a result, events that result in global economic uncertainty could significantly affect our results of operations in the form of gains and losses on foreign currency transactions and potential devaluation of the local currencies of our customers relative to the U.S. Dollar.
While a majority of our sales are transacted in U.S. Dollars, some of our sales agreements with foreign customers provide for payment in currencies other than the U.S. Dollar. These foreign currency revenues, when converted into U.S. Dollars, can vary depending on the approximation of the exchange rates applied during a respective period. Similarly, certain of our foreign subsidiaries transact business in their respective country’s local currency, which is also their functional currency. In addition, certain production costs related to our manufacturing operations in Mexico are denominated in Mexican Pesos. As a result, expenses of these foreign subsidiaries and certain production costs, when converted into U.S. Dollars, can vary depending on average monthly exchange rates during a respective period.
We are also exposed to foreign currency gains or losses on outstanding foreign currency denominated receivables and payables, as well as cash deposits. When converted to U.S. Dollars, these receivables, payables and cash deposits can vary depending on the monthly exchange rates at the end of the period. In addition, certain intercompany transactions may give rise to realized and unrealized foreign currency gains or losses based on the currency underlying such intercompany transactions. Accordingly, our operating results are subject to fluctuations in foreign currency exchange rates.
The balance sheets of our foreign subsidiaries whose functional currency is not the U.S. Dollar are translated into U.S. Dollars at the rate of exchange at the balance sheet date and the statements of operations and cash flows are translated into U.S. Dollars using an approximation of the average monthly exchange rates applicable during the period. Any foreign currency exchange gain or loss as a result of translating the balance sheets of our foreign subsidiaries whose functional currency is not the U.S. Dollar is included in equity as a component of accumulated other comprehensive income (loss).
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We currently do not hedge our foreign currency exchange rate risk. As a result, changes in foreign exchange rates could have a material adverse effect on our business, financial condition and results of operations. For additional information related to our foreign currency exchange rate risk, please see Quantitative and Qualitative Disclosures about Market Risk in Part I, Item 3 of this Quarterly Report on Form 10-Q.
*We currently manufacture our products at several locations and any disruption to, expansion of, or changes in trade programs related to our manufacturing operations could adversely affect our business, financial condition and results of operations.
We rely on manufacturing facilities in California, New Hampshire, Mexico and Sweden that may be affected by natural or man-made disasters. Earthquakes are of particular significance since some of our facilities are located in earthquake-prone areas. We are also vulnerable to damage from other types of disasters, including power loss, attacks from extremist or terrorist organizations, epidemics, communication failures, fire, floods and similar events. Our facilities and the manufacturing equipment we use to produce our products would be difficult to replace and could require substantial time to repair if significant damage were to result from any of these occurrences.
If one of our manufacturing facilities was affected by a natural or man-made disaster, we would be forced to rely on third-party manufacturers if we could not shift production to our other manufacturing facilities. Furthermore, our insurance for damage to our property and the disruption of our business from casualties may not be sufficient to cover all of our potential losses and may not continue to be available to us on acceptable terms, or at all. If the lease for any of our leased facilities is terminated, we are unable to renew any of our leases or we are otherwise forced to seek alternative facilities, or if we voluntarily expand one or more of our manufacturing operations to new locations, we may incur additional transition costs and experience a disruption in the supply of our products until the new facilities are available and operating. Additionally, we have occasionally experienced seasonality among our manufacturing workforce, and if we continue to experience such seasonality or other workforce shortages or otherwise have issues retaining employees at our manufacturing facilities, we may not be able to meet our customers’ demands.
Our global manufacturing and distribution are dependent upon our manufacturing facilities in Mexico, and the expedient importation of raw materials and exportation of finished goods between the U.S. and Mexico. Undue delays and/or closures of the proximal cross-border transit facilities may adversely affect our ability to fulfill orders to customers and to source raw materials in a timely manner. In April 2019, U.S. Customs and Border Patrol discussed the re-assignment of resources, which could impact timely processing of cross-border traffic. In addition, announcements have also been made by the U.S. federal administration about completely closing the U.S.-Mexico border, which could significantly restrict the movement of any goods across the border. Accordingly, delays in U.S.-Mexico cross-border traffic or an abrupt closure of U.S.-Mexico border may significantly impact our ability to supply our healthcare provider customers with essential replenishment supplies and may impact the continuity of their care to patients, as well as adversely impact our business, operating results and financial condition.
In addition, our manufacturing facilities in Mexico are authorized to operate under the Mexican Maquiladora, or IMMEX program. The IMMEX program allows us to import certain items from the U.S. into Mexico duty-free, provided that such items, after processing, are exported from Mexico within a stipulated timeframe. Maquiladora status, which is renewed periodically, is subject to various restrictions and requirements, including compliance with the terms of the IMMEX program and other local regulations. Failure to comply with the IMMEX program regulations, including any changes thereto, could increase our manufacturing costs and adversely affect our business, operating results and financial condition.
If we do not accurately forecast customer demand, we may hold suboptimal inventory levels that could adversely affect our business, financial condition and results of operations.
If we are unable to meet the demand of our customers, our customers may cancel orders or purchase products from our competitors, which could reduce our revenue and gross profit margin. Conversely, if product demand decreases, we may be unable to timely adjust our manufacturing cost structure, resulting in excess capacity, which would lower gross product margins. Similarly, if we are unable to forecast demand accurately, we could be required to record charges related to excess or obsolete inventory, which would also lower our gross margin.
If we are unable to obtain key materials and components from sole or limited source suppliers, we will not be able to deliver our noninvasive patient monitoring solutions to customers.
We depend on certain sole or limited source suppliers for key materials and components, including digital signal processor chips and analog-to-digital converter chips, for our noninvasive patient monitoring solutions. Manufacturing problems may occur related to these and other outside sources if these suppliers fail to develop and ship products and components to us on a timely basis, or provide us with products and components that do not meet our quality standards and required quantities.
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In addition, from time to time there have been industry-wide shortages of certain components that we use in our noninvasive blood constituent patient monitoring solutions. We may also experience price increases for materials or components, with no guarantee that such increases can be passed along to our customers, which could adversely impact our gross margins.
If any of these problems occur, we may be unable to obtain substitute sources for these products and components on a timely basis or on terms acceptable to us, which could harm our ability to manufacture our own products and components profitably or on time.
If we fail to comply with the reporting obligations of the Securities Exchange Act of 1934 and Section 404 of the Sarbanes-Oxley Act of 2002, or if we fail to maintain adequate internal control over financial reporting, our business, results of operations and financial condition and investors’ confidence in us could be adversely affected.
We are required to prepare and disclose certain information under the Securities Exchange Act of 1934 in a timely manner and meet our reporting obligations in their entirety, and our failure to do so could subject us to penalties under federal securities laws and regulations of The Nasdaq Stock Market LLC, expose us to lawsuits and restrict our ability to access financing on favorable terms, or at all.
If we fail to maintain adequate internal controls over financial reporting, we may not be able to conclude on an ongoing basis that we have effective internal control over financial reporting in accordance with the Sarbanes-Oxley Act. Moreover, any failure to maintain compliance with the requirements of Section 404 of the Sarbanes-Oxley Act or any material weakness in our internal control environment could result in the loss of investor confidence in the reliability of our financial statements, which in turn could harm our business, negatively impact the trading price of our stock, and adversely affect investors’ confidence in our company and our ability to access capital markets for financing.
Changing laws and increasingly complex corporate governance and public disclosure requirements could have an adverse effect on our business and operating results.
Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), the California Transparency in Supply Chains Act, the UK Modern Slavery Act and new regulations issued by the SEC and The Nasdaq Stock Market LLC, have and will create additional compliance requirements for us. To maintain high standards of corporate governance and public disclosure, we have invested in, and intend to continue to invest in, reasonably necessary resources to comply with evolving standards.
For example, the Dodd-Frank Act includes provisions regarding “conflict minerals” (generally tin, tantalum, tungsten and gold) that are mined in the Democratic Republic of Congo and adjoining countries (the DRC region), and in June 2016, the EU adopted its own regulation on conflict minerals that covers the sourcing of conflict minerals from anywhere in the world. The provisions of the Dodd-Frank Act require us to undertake comprehensive due diligence to determine whether conflict minerals used in our products, including any portion of our products manufactured by third parties, financed or benefited armed groups in the DRC region. The rules also require us to file conflict mineral reports with the SEC annually. We have incurred, and expect to continue to incur, additional costs to comply with these rules, including costs related to determining the source of origin of conflict minerals used in our products. Given the complexity of our supply chain, we may face difficulties if our suppliers are unwilling or unable to verify the origin of all conflict minerals used in our products.
In addition, stockholder litigation surrounding executive compensation and disclosure of executive compensation has increased with the passage of the Dodd-Frank Act. Furthermore, our stockholders may not continue to approve our advisory vote on named executive officer compensation that is required to be voted on by our stockholders annually pursuant to the Dodd-Frank Act. If we are involved in a lawsuit related to compensation matters or any other matters not covered by our directors’ and officers’ liability insurance, we may incur significant expenses in defending against such lawsuits, or be subject to significant fines or required to take significant remedial actions, each of which could adversely affect our business, financial condition and results of operations.
If product liability claims are brought against us, we could face substantial liability and costs.
Our products are predominantly used in patient care and expose us to product liability claims and product recalls, including, but not limited to, those that may arise from unauthorized off-label use, malfunctions, design flaws or manufacturing defects related to our products or the use of our products with incompatible components or systems. In addition, as we continue to expand our product portfolio, we may enter or create new markets, including consumer markets, that may expose us to additional product liability risks. We cannot be certain that our product liability insurance will be sufficient to cover any or all damages for product liability claims that may be brought against us in the future. Furthermore, we may not be able to obtain or maintain insurance in the future at satisfactory rates or in adequate amounts to protect us against any product liability claims.
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Additionally, the laws and regulations regarding product liability are constantly evolving, both through the passage of new legislation at the state and federal levels and through new interpretations of existing legislation. For example, in February 2017, the Washington Supreme Court determined that, under the Washington Product Liability Act, medical device manufacturers have a duty to warn hospitals of any potential risks posed by their products. As the legal and regulatory landscape surrounding product liability change, we may become exposed to greater liability than currently anticipated.
Any losses that we may suffer from product liability claims, and the effect that any product liability litigation may have upon the reputation and marketability of our technology and products, together with the corresponding diversion of the attention of our key employees, may subject us to significant damages and could adversely affect our business, financial condition and results of operations.
Future acquisitions of businesses could negatively affect our business, financial condition and results of operations if we fail to integrate the acquired businesses successfully into our existing operations or if we discover previously undisclosed liabilities.
We have acquired several businesses since our inception and we may acquire additional businesses in the future. Future acquisitions may require debt or equity financing, which could be dilutive to our existing stockholders or reduce our earnings per share. Even if we complete acquisitions, there are many factors that could affect whether such acquisition will be beneficial to our business, including, without limitation:

• | payment of above-market prices for acquisitions and higher than anticipated acquisition costs;

• | issuance of common stock as part of the acquisition price or a need to issue stock options or other equity to newly-hired employees of target companies, resulting in dilution of ownership to our existing stockholders;

• | reduced profitability if an acquisition is not accretive to our business over either the short-term or the long-term;

• | difficulties in integrating any acquired companies, personnel, products and other assets into our existing business;

• | delays in realizing the benefits of the acquired company, products or other assets;

• | regulatory challenges;

• | cybersecurity and compliance related issues;

• | diversion of our management’s time and attention from other business concerns;

• | limited or no direct prior experience in new markets or countries we may enter;

• | unanticipated issues dealing with unfamiliar suppliers, service providers or other collaborators of the acquired company;

• | higher costs of integration than we anticipated;

• | write-downs or impairments of goodwill or other intangible assets associated with the acquired company;

• | difficulties in retaining key employees of the acquired business who are necessary to manage these acquisitions;

• | negative impacts on our relationships with our employees, clients or collaborators;

• | litigation or other claims in connection with the acquisition; and

• | changes in the overall financial model as certain acquired companies may have a different revenue, gross profit margin or operating expense profile.

Further, our ability to benefit from future acquisitions depends on our ability to successfully conduct due diligence, negotiate acceptable acquisition terms, evaluate prospective acquisitions and bring acquired technologies and/or products to market at acceptable margins and operating expense levels. Our failure in any of these tasks could result in unforeseen liabilities associated with an acquired company, acquiring a company on unfavorable terms or selecting and eventually acquiring a suboptimal acquisition target. We may also discover deficiencies in internal controls, data adequacy and integrity, product quality, regulatory compliance and product liabilities that we did not uncover prior to our acquisition of such businesses, which could result in us becoming subject to penalties or other liabilities. If we do not achieve the anticipated benefits of an acquisition as rapidly as expected, or at all, investors or analysts may not perceive the same benefits of the acquisition as we do.
If these risks materialize, our stock price could be materially adversely affected. Any difficulties in the integration of acquired businesses or unexpected penalties or liabilities in connection with such businesses could have a material adverse effect on our business, financial condition and results of operations.
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We may incur environmental and personal injury liabilities related to certain hazardous materials used in our operations.
Certain manufacturing processes for our products may involve the storage, use, generation and disposal of certain hazardous materials and wastes, including silicone adhesives, solder and solder paste, sealants, epoxies and various solvents such as methyl ethyl ketone, acetone and isopropyl alcohol. As a result, we are subject to certain environmental laws, as well as certain other laws and regulations, that restrict the materials that can be used in our products or in our manufacturing processes. For example, products that we sell in Europe are subject to regulation in the EU markets under the Restriction of the Use of Hazardous Substances Directive (RoHS). RoHS prohibits companies from selling products that contain certain hazardous materials in EU member states. In addition, the EU’s Registration, Evaluation, Authorization, and Restriction of Chemicals Directive also restricts substances of very high concern in products. Compliance with such regulations may be costly and, therefore, we may incur significant costs to comply with these laws and regulations.
In addition, new environmental laws may further affect how we manufacture our products, how we use, generate or dispose of hazardous materials and waste, or further affect what materials can be used in our products. Any required changes to our operations may increase our manufacturing costs, detrimentally impact the performance of our products, add greater testing lead-times for product introductions or have other similar effects.
In connection with our research and manufacturing activities, we use, and our employees may be exposed to, materials that are hazardous to human health, safety or the environment. The risk of accidental injury to our employees or contamination from these materials cannot be eliminated, and we could be held liable for any resulting damages, the related liability for which could exceed our reserves. We do not specifically insure against environmental liabilities. If an enforcement action were to occur, our reputation and our business and financial condition may be harmed, even if we were to prevail or settle the action on terms favorable to us.
We rely significantly on information technology and any failure, inadequacy, interruption or security lapse of that technology, including any cybersecurity incidents, could harm our ability to operate our business effectively.
Increased global cybersecurity vulnerabilities, cybersecurity threats, and sophisticated and targeted cybersecurity attacks pose a risk to the security of Masimo’s and our customers’, partners’, suppliers’ and third-party service providers’ products, systems and networks, including the confidentiality, availability and integrity of any underlying information and data. Our ability to effectively manage and maintain our internal business information, and to ship products to customers and invoice them on a timely basis, depends significantly on our enterprise resource planning system and other information systems. Portions of our information technology systems may experience interruptions, delays or cessations of service or produce errors in connection with ongoing systems implementation work. In addition, interfaces between our products and our customers’ computer networks could provide additional opportunities for cybersecurity attacks on us and our customers. The techniques used to attack computer systems are sophisticated, change frequently and may originate from less regulated and remote areas of the world. Cybersecurity attacks in particular are evolving and include, but are not limited to, threats, malicious software, ransom ware, attempts to gain unauthorized access to data and other electronic security breaches that could lead to disruptions in systems, misappropriation of confidential or otherwise protected information and corruption of data. As a result, there can be no assurance that our protective measures will prevent or detect security breaches that could have a significant impact on our business, reputation, financial condition and results of operations.
The failure of these systems to operate or integrate effectively with other internal, customer, supplier or third-party service provider systems and to protect the underlying information technology system and data integrity, including from cyber-attacks, intrusions or other breaches or unauthorized access of these systems, or any failure by us to remediate any such attacks or breaches, may also result in damage to our reputation or competitiveness, delays in product fulfillment and reduced efficiency of our operations, and could require significant capital investments to remediate any such failure, problem or breach, all of which could adversely affect our business, financial condition and results of operations.
From time to time, we may carry out strategic initiatives that could negatively impact our business, financial condition and results of operations.
We expect to continue to carry out strategic initiatives and investments that we believe are necessary to grow our revenues and expand our business, both in the U.S. and abroad. For example, we have continued to invest in international expansion programs designed to increase our worldwide presence and take advantage of market expansion opportunities around the world. Although we believe these initiatives and investments continue to be in the long-term best interests of Masimo and our stockholders, there are no assurances that such initiatives and investments will yield favorable results for us.
Accordingly, if these initiatives and investments are not successful, our business, financial condition and results of operations could be adversely affected.
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Our credit agreement contains certain covenants and restrictions that may limit our flexibility in operating our business.
Our credit agreement dated December 17, 2018 (Credit Facility) with JPMorgan Chase Bank, N.A., as Administrative Agent and a Lender, and Bank of the West, a Lender, contains various affirmative covenants and restrictions that limit our ability to engage in specified types of transactions, including:

• | incurring specified types of additional indebtedness (including guarantees or other contingent obligations);

• | paying dividends on, repurchasing or making distributions in respect of our common stock or making other restricted payments, subject to specified exceptions;

• | making specified investments (including loans and advances);

• | selling or transferring certain assets;

• | creating certain liens;

• | consolidating, merging, selling or otherwise disposing of all or substantially all of our assets; and

• | entering into certain transactions with any of our affiliates.

In addition, under our Credit Facility, we are required to satisfy and maintain specified financial ratios and other affirmative covenants. Our ability to meet those financial ratios and affirmative covenants could be affected by events beyond our control and, therefore, we cannot be assured that we will be able to continue to satisfy these requirements. A breach of any of these ratios or covenants could result in a default under our Credit Facility. Upon the occurrence of an event of default, the Lenders could elect to declare all amounts outstanding under the Credit Facility immediately due and payable, terminate all commitments to extend further credit and pursue legal remedies for recovery, all of which could adversely affect our business and financial condition. As of March 30, 2019, we had no outstanding draws and $0.1 million of outstanding letters of credit under our Credit Facility and were in compliance with all applicable covenants. See Note 15 to our accompanying condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information on our Credit Facility.
*We may experience conflicts of interest with respect our CEO’s role in the Patient Safety Movement Foundation.
Joe Kiani, our Chairman and CEO, founded the Patient Safety Movement Foundation in 2012 with the aim of eliminating preventable deaths caused by medical errors. Conflicts of interest issues may arise between our business and customers and the objectives of the Patient Safety Movement Foundation. For example, one of the objectives of the Patient Safety Movement Foundation is to request that hospitals implement Actionable Patient Safety Solutions to overcome some of the leading patient safety challenges that hospitals currently face. Some hospitals and other healthcare providers may disagree with the Patient Safety Movement Foundation’s recommendations or may determine that these steps and other actions encouraged by the Patient Safety Movement Foundation may not be practicable or may be too costly or burdensome to implement. Although Mr. Kiani’s role in the Patient Safety Movement Foundation is separate from his role as our President and CEO, hospitals and healthcare providers that do not agree with the actions or recommendations of the Patient Safety Movement Foundation may nonetheless disfavor Masimo products, which could adversely affect our business, financial condition and results of operations.
Risks Related to Our Stock
*Our stock price may be volatile, and your investment in our stock could suffer a decline in value.
There has been and could continue to be significant volatility in the market price and trading volume of equity securities. For example, our closing stock price ranged from $102.78 to $138.28 per share from December 29, 2018 to March 30, 2019. Factors contributing to our stock price volatility may include our financial performance, as well as broader economic, political and market factors. In addition to the other risk factors previously discussed in this Quarterly Report on Form 10-Q, there are many other factors that we may not be able to control that could have a significant effect on our stock price. These include, but are not limited to:

• | actual or anticipated fluctuations in our operating results or future prospects;

• | our announcements or our competitors’ announcements of new products;

• | the public’s reaction to our press releases, our other public announcements and our filings with the SEC;

• | strategic actions by us or our competitors, such as acquisitions or restructurings;

• | new laws or regulations or new interpretations of existing laws or regulations applicable to our business;

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• | changes in accounting standards, policies, guidance, interpretations or principles;

• | changes in our growth rates or our competitors’ growth rates;

• | developments regarding our patents or proprietary rights or those of our competitors;

• | ongoing legal proceedings;

• | our inability to raise additional capital as needed;

• | concerns or allegations as to the safety or efficacy of our products;

• | changes in financial markets or general economic conditions, including the effects of recession or slow economic growth in the U.S. and abroad;

• | sales of stock by us or members of our management team, our Board of Directors (Board) or certain institutional stockholders; and

• | changes in stock market analyst recommendations or earnings estimates regarding our stock, other comparable companies or our industry generally.

Therefore, you may not be able to resell your shares at or above the price you paid for them.
Concentration of ownership among our existing directors, executive officers and principal stockholders may prevent new investors from influencing significant corporate decisions.
As of March 30, 2019, our current directors and executive officers and their affiliates, in the aggregate, beneficially owned approximately 11.5% of our outstanding stock. Subject to any fiduciary duties owed to our other stockholders under Delaware law, these stockholders may be able to exercise significant influence over matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, and will have some control over our management and policies. Some of these persons or entities may have interests that are different from yours. For example, these stockholders may support proposals and actions with which you may disagree or which are not in your best interests. The concentration of ownership could delay or prevent a change in control of us, or otherwise discourage a potential acquirer from attempting to obtain control of us, which in turn could reduce the price of our stock.
In addition, these stockholders could use their voting influence to maintain our existing management and directors in office or support or reject other management and Board proposals that are subject to stockholder approval, such as amendments to our employee stock plans and approvals of significant financing transactions.
Our investors could experience substantial dilution of their investments as a result of subsequent exercises of our outstanding options, vesting of outstanding restricted stock units (RSUs) and performance stock units (PSUs), or the grant of future equity awards by us.
As of March 30, 2019, approximately 11.5 million shares of our common stock were reserved for issuance under our equity incentive plans, of which approximately 5.6 million shares were subject to options outstanding at such date at a weighted-average exercise price of $47.22 per share, approximately 2.8 million shares were subject to outstanding RSUs, approximately 0.4 million shares were subject to outstanding PSUs and approximately 2.6 million shares were available for future awards under our 2017 Equity Incentive Plan. Over the past 24 months, we have experienced higher rates of stock option exercises compared to many earlier periods, and this trend may continue. To the extent outstanding options are exercised or outstanding RSUs or PSUs vest, our existing stockholders may incur dilution. We rely on equity awards to motivate current employees and to attract new employees. The grant of future equity awards by us to our employees and other service providers may further dilute our stockholders.
Future resales of our stock, including those by our insiders and a few investment funds, may cause our stock price to decline.
A significant portion of our outstanding shares are held by our directors, our executive officers and a few investment funds. Resales by these stockholders of a substantial number of such shares, announcements of any proposed resale of substantial amounts of our stock or the perception that substantial resales may be made, could significantly reduce the market price of our stock. Some of our directors and executive officers have entered into Rule 10b5-1 trading plans pursuant to which they have arranged to sell shares of our stock from time to time in the future. Generally, these sales require public filings. Actual or potential sales by these insiders, including those under a pre-arranged Rule 10b5-1 trading plan, could be interpreted by the market as an indication that the insider has lost confidence in our stock and reduce the market price of our stock.
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We have registered and expect to continue to register shares reserved under our equity plans pursuant to Registration Statements on Form S-8. All shares issued pursuant to a Registration Statement on Form S-8 can be freely sold in the public market upon issuance, subject to restrictions on our affiliates under Rule 144. If a large number of these shares are sold in the public market, the sales could reduce the trading price of our stock.
Our corporate documents and Delaware law contain provisions that could discourage, delay or prevent a change in control of our company, prevent attempts to replace or remove current management and reduce the market price of our stock.
Provisions in our amended and restated certificate of incorporation and amended and restated bylaws may discourage, delay or prevent a merger or acquisition involving us that our stockholders may consider favorable. For example, our amended and restated certificate of incorporation authorizes our Board to issue up to 5.0 million shares of “blank check” preferred stock. As a result, without further stockholder approval, our Board has the authority to attach special rights, including voting and dividend rights, to this preferred stock, including pursuant to a stockholder rights plan. With these rights, preferred stockholders could make it more difficult for a third-party to acquire us. In addition, our amended and restated certificate of incorporation provides for a staggered board of directors, whereby directors serve for three year terms, with one-third of the directors coming up for reelection each year. A staggered Board will make it more difficult for a third-party to obtain control of our Board through a proxy contest, which may be a necessary step in an acquisition of us that is not favored by our Board.
We are also subject to anti-takeover provisions under the General Corporation Law of the State of Delaware. Under these provisions, if anyone becomes an “interested stockholder,” we may not enter into a “business combination” with that person for three years without special approval, which could discourage a third-party from making a takeover offer and could delay or prevent a change in control of us. For purposes of these provisions, an “interested stockholder” generally means someone owning 15% or more of our outstanding voting stock or an affiliate of ours that owned 15% or more of our outstanding voting stock during the past three years, subject to certain exceptions as described in the General Corporation Law of the State of Delaware.
We may elect not to declare cash dividends on our stock, may elect to only pay dividends on an infrequent or irregular basis, or may elect not to make any additional stock repurchases. As a result, any return on your investment may be limited to the value of our stock. In addition, the payment of any future dividends or the repurchase of our stock might limit our ability to pursue other growth opportunities.
Our Board may from time to time declare, and we may pay, dividends on our outstanding shares in the manner and upon the terms and conditions provided by law. However, we may elect to retain all future earnings for the operation and expansion of our business, rather than paying cash dividends on our stock.
Any payment of cash dividends on our stock will be at the discretion of our Board and will depend upon our results of operations, earnings, capital requirements, financial condition, business prospects, contractual restrictions and other factors deemed relevant by our Board. In the event our Board declares any dividends, there is no assurance with respect to the amount, timing or frequency of any such dividends.
In July 2018, our Board approved a stock repurchase program, authorizing us to purchase up to 5.0 million additional shares of our common stock over a period of up to three years (2018 Repurchase Program). Any repurchase of our common stock under the 2018 Repurchase Program will be at the discretion of a committee comprised of our CEO and Chief Financial Officer, and will depend on several factors, including, but not limited to, results of operations, capital requirements, financial conditions, available capital from operations or other sources and the market price of our common stock. Therefore, there is no assurance with respect to the amount, price or timing of any such repurchases. We may elect to retain all future earnings for the operation and expansion of our business, rather than repurchasing additional outstanding shares. As of March 30, 2019, 5.0 million shares remained available for repurchase pursuant the 2018 Repurchase Program. For additional information related to our 2018 Repurchase Program, please see Note 17 to our accompanying condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.
In the event we pay dividends, or make any stock repurchases in the future, our ability to finance any material expansion of our business, including through acquisitions, investments or increased capital spending, or to fund our operations, may be limited. In addition, any repurchases we may make in the future may not prove to be at optimal prices. Our Board may modify or amend the 2018 Repurchase Program, or adopt a new stock repurchase program, at any time at its discretion without stockholder approval.
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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
During the three months ended March 30, 2019, we satisfied certain U.S. federal and state tax withholding obligations due upon the vesting of performance share units by withholding 1,163 shares of our common stock, with an aggregate fair market value on the date of vesting equal to the tax withholding obligations, from the shares of our common stock actually issued in connection with such award.
Shares repurchased by us or withheld to satisfy tax withholding obligations for the three months ended March 30, 2019 and March 31, 2018 were as follows (in thousands, except per share amounts):

|  | Three Months Ended
|  | March 30, 2019 |  | March 31 2018
Shares repurchased or withheld |  | 1 |  |  | 2 |
Average cost per share |  | $ | 105.52 |  |  | $ | 86.08 |
Value of shares repurchased or withheld |  | $ | 123 |  |  | $ | 168 |

Item 5. Other Information
Effective as of May 6, 2019, our Board appointed Bilal Muhsin as our Chief Operating Officer, and our former Chief Operating Officer, Anand Sampath, became our Executive Vice President, Operations and Clinical Research. Upon commencement of his appointment, Mr. Muhsin assumed the duties of our principal operating officer, which he will hold until such time as his successor is appointed, or until his earlier resignation or removal. There are no reportable family relationships or related party transactions (as defined in Item 404(a) of Regulation S-K) involving us and Mr. Muhsin.
Mr. Muhsin has served as our Executive Vice President, Engineering, Marketing and Regulatory Affairs since March 2018. In May 2015, Mr. Muhsin became Executive Vice President, Engineering after having served as Vice President, Engineering, Instruments and Systems since April 2012. Prior to this, Mr. Muhsin held other Director and Manager level positions within the Company since June 2000. Mr. Muhsin’s technical, product and overall leadership skills have helped Masimo bring revolutionary new products to the marketplace, including Masimo’s Patient Safety Net, Radical-7®, Root® and various significant software products. Mr. Muhsin holds a B.S. in Computer Science from San Diego State University.
Mr. Muhsin’s annual base salary was increased from $447,784 to $550,000 and he will continue to be eligible to receive an annual performance bonus under our 2017 Executive Bonus Incentive Plan. Additionally, effective as of May 9, 2019, we granted Mr. Muhsin an option to purchase 50,000 shares of our common stock (the “Option”) under our 2017 Equity Incentive Plan. The Option will vest, subject to Mr. Muhsin’s continued employment with the Company, over a five year period, with 20% of the shares subject to the Option vesting on each anniversary of the grant date.
Mr. Muhsin is also a participant in our 2007 Severance Protection Plan (the “Plan”), which provides, among other things, that (a) if Mr. Muhsin’s employment is terminated by us without Cause (as defined in the Plan), he will receive a Basic Severance Benefit (as defined in the Plan) equal to his annual salary and (b) in the event of a Change in Control, 50% of Mr. Muhsin’s unvested and outstanding stock options or other equity-based awards will immediately vest and (i) if Mr. Muhsin’s employment is terminated on the date of a Change in Control specifically because his current job, or similar job, is not offered to him on the date of such Change in Control, the remainder of his unvested and outstanding stock options or other equity-based awards will immediately vest and he will receive a Change in Control Severance Benefit (as defined in the Plan) equal to the sum of his annual salary and his average annual bonus over the last three years or (ii) if Mr. Muhsin’s employment is terminated by us without Cause or if he terminates his employment with us for Good Reason upon or within 36 months after a Change in Control, other than for the reason set forth in clause (i) above, the remainder of his unvested and outstanding stock options or other equity-based awards will immediately vest and he will receive a Change in Control Severance Benefit equal to the sum of two times his annual salary and one times his average annual bonus over the last three years. Additionally, in each case, Mr. Muhsin and his COBRA qualifying beneficiaries will be entitled to COBRA continuation coverage at our expense for a period of 12 months and we will make life insurance coverage for the first twelve months following Mr. Muhsin’s termination available for purchase. The Company has also entered into an indemnification agreement with Mr. Muhsin in the same form entered into by the Company and its other executive officers.
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Item 6. Exhibits

EXHIBIT INDEX
Exhibit Number |  |  |  | Description of Document
3.1 |  | (1) |  | Amended and Restated Certificate of Incorporation (Exhibit 3.2)
3.2 |  | (2) |  | Amended and Restated Bylaws adopted on October 20, 2011 (Exhibit 3.2)
4.1 |  | (1) |  | Form of Common Stock Certificate (Exhibit 4.1)
4.2 |  | (1) |  | Fifth Amended and Restated Registration Rights Agreement made and entered into as of September 14, 1999, between Masimo Corporation and certain of its stockholders (Exhibit 4.2)
4.3# |  | (3) |  | Masimo Retirement Savings Plan (Exhibit 4.7)
10.1* |  |  |  | Amendment No. 1 to Credit Agreement, dated as of March 8, 2019, among Masimo Corporation, the Lenders party thereto and JPMorgan Chase Bank, N.A. as Administrative Agent
21.1* |  |  |  | List of Registrant’s Subsidiaries
31.1* |  |  |  | Certification of Joe Kiani, Chief Executive Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, as amended
31.2* |  |  |  | Certification of Micah Young, Chief Financial Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, as amended
32.1* |  |  |  | Certification of Joe Kiani, Chief Executive Officer, and Micah Young, Chief Financial Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, as amended
101.INS* |  |  |  | XBRL Instance Document
101.SCH* |  |  |  | XBRL Taxonomy Extension Schema Document
101.CAL* |  |  |  | XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF* |  |  |  | XBRL Taxonomy Extension Definition Linkbase Document
101.LAB* |  |  |  | XBRL Taxonomy Extension Label Linkbase Document
101.PRE* |  |  |  | XBRL Taxonomy Extension Presentation Linkbase Document

Attached as Exhibit 101 to this report are the following formatted in XBRL (Extensible Business Reporting Language): (i) Condensed Consolidated Balance Sheets as of March 30, 2019 and December 29, 2018, (ii) Condensed Consolidated Statements of Income for the three months ended March 30, 2019 and March 31, 2018, (iii) Condensed Consolidated Statements of Comprehensive Income for the three months ended March 30, 2019 and March 31, 2018, (iv) Condensed Consolidated Statements of Cash Flows for the three months ended March 30, 2019 and March 31, 2018, and (v) Notes to Condensed Consolidated Financial Statements.
_____________________________

(1) | Incorporated by reference to the exhibits to the Company’s Registration Statement on Form S-1 (No. 333-142171), originally filed on April 17, 2007. The number given in parentheses indicates the corresponding exhibit number in such Form S-1, as amended.

(2) | Incorporated by reference to the exhibit to the Company’s Current Report on Form 8-K filed on October 26, 2011. The number given in parentheses indicates the corresponding exhibit number in such Form 8-K.

(3) | Incorporated by reference to the exhibit to the Company’s Registration Statement on Form S-8 filed on February 11, 2008. The number given in parentheses indicates the corresponding exhibit number in such Form S-8.

# | Indicates management or compensatory plan.

* | Filed herewith.

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

|  |  |  | M ASIMO C ORPORATION
Date: May 6, 2019 |  |  |  | By: |  | /s/ J OE K IANI
|  |  |  |  |  | Joe Kiani
|  |  |  |  |  | Chief Executive Officer and Chairman
Date: May 6, 2019 |  |  |  | By: |  | /s/ M ICAH Y OUNG
|  |  |  |  |  | Micah Young
|  |  |  |  |  | Executive Vice President, Finance and Chief Financial Officer

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