MASIMO CORP - Quarter Report: 2008 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 27, 2008

OR

For the transition period from              to             

Commission File Number 001-33642

Masimo Corporation

(Exact Name of Registrant as Specified in its Charter)

(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  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Indicate the number of shares of each of the issuer’s classes of common stock, as of the latest practicable date:

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MASIMO CORPORATION

FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 27, 2008

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PART 1. FINANCIAL INFORMATION

MASIMO CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

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

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MASIMO CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except share information)

(unaudited)

The following table presents details of the stock based compensation expense that is included in each functional line item in the condensed consolidated statements of income above (in thousands):

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

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MASIMO CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

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)

Masimo Corporation, or the Company, is a global medical technology company that develops, manufactures and markets non-invasive patient monitoring products that improve patient care. The Company invented Masimo Signal Extraction Technology, or Masimo SET, which provides the capabilities of Measure-Through Motion and Low Perfusion pulse oximetry to address the primary limitations of conventional pulse oximetry. The Company markets a family of non-invasive blood constituent patient monitoring solutions that consists of a monitor or circuit board and their proprietary single-patient use and reusable sensors and cables. Since 2005, the Company has introduced a variety of new non-invasive measurements expanding the capability of the Company’s Masimo Rainbow SET platform. The Company sells to hospitals and the emergency medical services, or EMS, market through its direct sales force and distributors, and markets its circuit boards containing the Company’s proprietary algorithm and software architecture to original equipment manufacturer, or OEM, partners. The Company considers both the pulse oximetry device and its consumable sensors and cables to be products as defined in its statements of income.

Basis of Presentation

The accompanying condensed consolidated balance sheet as of September 27, 2008, the condensed consolidated statements of income for the three and nine months ended September 29, 2007 and September 27, 2008, the condensed consolidated statements of cash flows for the nine months ended September 29, 2007 and September 27, 2008, and other information disclosed in the related condensed consolidated notes are unaudited. The condensed consolidated balance sheet as of December 29, 2007 was derived from the Company’s audited consolidated financial statements at that date. The accompanying 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, 2007, filed with the U.S. Securities and Exchange Commission, or SEC, on March 4, 2008.

The accompanying condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the 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, or GAAP, have been condensed or omitted pursuant to such rules and regulations. The 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, which include only normal recurring adjustments, necessary to state fairly the Company’s consolidated financial position as of September 27, 2008, consolidated results of operations for the three and nine months ended September 29, 2007 and September 27, 2008, and consolidated cash flows for the nine months ended September 29, 2007 and September 27, 2008. The results for the three and nine months ended September 27, 2008 are not necessarily indicative of the results to be expected for the fiscal year ending January 3, 2009 or for any other interim period or for any future year.

Fiscal Periods

The Company follows a conventional 52/53 week fiscal year and fiscal 2007 was designated as a 52 week year. Under a conventional 52/53 week fiscal year, a 52 week year includes four quarters of 13 fiscal weeks while a 53 week fiscal year includes three 13 week quarters and one 14 week quarter. Under the Company’s fiscal year policy, each quarter and the year end will end on the Saturday corresponding to either the 13 or 14 week quarter. As a result of the adoption of the 52/53 week convention in fiscal 2007, the Company’s first, second and third quarters ended on Saturday, March 31, June 30 and September 29, 2007, respectively, and its fiscal year ended on Saturday, December 29, 2007. In fiscal 2008, the Company is on a 53 week fiscal calendar in which its first, second and third quarters ended on Saturday, March 29, June 28 and September 27, 2008, respectively. The Company’s 2008 fiscal year will end on Saturday, January 3, 2009. For fiscal 2008, the first three quarters are 13 week quarters and the fourth fiscal quarter is a 14 week quarter.

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Principles of Consolidation

The condensed consolidated financial statements include the accounts of Masimo Corporation and Masimo Laboratories, Inc., which has been consolidated pursuant to FIN 46(R), “Consolidation of Variable Interest Entities—an Interpretation of ARB No. 51.” In addition, these condensed consolidated financial statements include the accounts of Masimo Corporation’s wholly-owned subsidiaries, Masimo Americas, Inc., Masimo Europe Ltd., Masimo Japan, Masimo Canada ULC and Masimo Australia Pty. Ltd. All intercompany accounts and transactions have been eliminated in consolidation.

Comprehensive Income

SFAS No. 130, “Reporting Comprehensive Income,“ establishes requirements for reporting and disclosure of comprehensive income and its components. Comprehensive income includes foreign currency translation adjustments and other items that have been excluded from net income and reflected in stockholders’ equity.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management 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: determination of accounts receivable allowances, inventory reserves, warranty reserves, rebate reserves, valuation of the Company’s common stock, stock options, distributor channel inventory, royalty revenues, property tax and income tax contingencies. Actual results could differ from those estimates.

Reclassifications

Certain amounts in the condensed consolidated financial statements for prior periods have been reclassified to conform with current period presentation.

Fair Value Measurements

Effective December 30, 2007, the Company adopted Statement of Financial Accounting Standard No. 157, or SFAS 157, “Fair Value Measurements“. SFAS 157 defines fair value, establishes a framework for measuring fair value under GAAP and enhances disclosures about fair value measurements. In February 2008, the Financial Accounting Standards Board, or FASB, issued FASB Staff Position No. FAS 157-2, “Effective Date of FASB Statement No. 157“, which provides a one year deferral of the effective date of SFAS 157 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed in the financial statements at fair value at least annually. Therefore, effective December 30, 2007, the Company adopted the provisions of SFAS 157 with respect to its financial assets and liabilities only.

SFAS 157 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, which are the following:

The estimated fair values of the Company’s financial instruments, which include cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities, income taxes payable and long-term debt, approximate their carrying values due to their short maturities and because the weighted average borrowing rate of the long-term debt approximates the current market rates for similar borrowings. These items are classified as either Level 1 or Level 2 inputs. Cash equivalents consist of highly liquid investments, with a maturity of three months or less at the date of purchase, including U.S. Treasury bills and money market funds.

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Effective December 30, 2007, the Company adopted SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities,” or SFAS 159. SFAS 159 allows an entity the irrevocable option to elect 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 the fair value option under this statement as to specific assets or liabilities. Therefore, through September 27, 2008, the Company has not recognized the net change in fair value of their U.S. Treasury bills.

The Company records U.S. Treasury bills at cost and continues to carry those amounts at cost, which approximates, but does not equal fair value. The fair value of the U.S. Treasury bills at September 27, 2008, excluding accrued interest, was $103.9 million as compared to a cost of $103.8 million. The fair value is based on quoted market prices in active markets for identical assets, level 1 input.

The Company records money market funds at cost and continues to carry those amounts at cost which equals fair value. The fair value is based on quoted market prices in active markets for identical assets, level 1 input. As of September 27, 2008, the cost and fair value of our money market funds was equal to $11.9 million.

Revenue Recognition and Deferred Revenue

The Company recognizes revenue pursuant to the requirements of American Institute of Certified Public Accountants, or AICPA, Statement of Position, or SOP, 97-2, “Software Revenue Recognition,” as amended by SOP 98-9, “Software Revenue Recognition, With Respect to Certain Transactions,” Financial Accounting Standards Board, or FASB, Emerging Issues Task Force, or EITF, Issue No. 03-5, “Applicability of AICPA Statement of Position 97-2 to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software,” and other authoritative accounting guidance.

The Company recognizes revenue when: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or services have been rendered, (iii) the price is fixed or determinable and (iv) collectability is reasonably assured. The Company enters into agreements to sell pulse oximetry and related products and services as well as multiple deliverable arrangements that include various combinations of products and services. While the majority of the Company’s sales transactions contain standard business terms and conditions, there are some transactions that contain non-standard business terms and conditions. As a result, contract interpretation is sometimes required to determine the appropriate accounting including: (i) whether an arrangement exists; (ii) how the arrangement consideration should be allocated among the deliverables if there are multiple deliverables; (iii) if fair value can be determined for each deliverable based on vendor specific objective evidence, or VSOE; (iv) when to recognize revenue on the deliverables; and (v) whether undelivered elements are essential to the functionality of the delivered elements. Changes in judgments on these assumptions and estimates could materially impact the timing of revenue recognition.

The Company’s sales under long-term purchase contracts are generally structured such that the Company agrees to provide up-front and at no charge certain monitoring equipment, installation, training and ongoing warranty support in exchange for the hospital’s agreement to purchase sensors over the term of the agreement, which ranges from three to six years. The Company does not recognize any revenue when the monitoring and related equipment is delivered to the hospitals and installation and training is complete. The Company recognizes revenue for all of the delivered elements, on a pro-rata basis, as the sensors are delivered under the long-term purchase commitment. The cost of the monitoring equipment initially placed at the hospitals is deferred and amortized to cost of goods sold over the life of the underlying long-term sensor contract.

In situations where VSOE does not exist for undelivered elements, the contract product revenue and corresponding cost of goods sold are deferred until either the element is delivered or VSOE is established. For the three and nine months ended September 29, 2007, $888,000 and $3.5 million, respectively, of contract product revenue was deferred. During the three and nine months ended September 29, 2007, $2.0 million of previously deferred revenue was recognized related to the delivery of an upgrade which occurred during the third quarter of 2007. Deferred costs associated with this revenue aggregating $718,000 were expensed in the same 2007 periods. For the three and nine months ended September 27, 2008, $672,000 and $3.1 million, respectively, of contract product revenue was deferred. During the three and nine months ended September 27, 2008, $2.6 million of previously deferred revenue was recognized, including $1.9 million related to an agreement in which VSOE was established as a result of a contract amendment providing the Company the option to substitute a deliverable with VSOE in place of a deliverable with no VSOE and $683,000 related to the collection of cash for sales which had been deferred due to uncertainty over collectability. Deferred costs associated with this revenue aggregating $852,000 were expensed in the same 2008 periods. Pursuant to the Company’s revenue recognition policy, it expects to continue to defer revenue and the related costs of goods sold, and recognize previously deferred revenue in future periods as required under applicable accounting guidance.

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The Company’s distributors purchase primarily sensor products which they then resell to hospitals that are typically fulfilling their purchase obligation to the Company under the end-user hospital’s long-term sensor purchase commitments. Upon shipment to the distributor, revenue is deferred until the Company’s commitment to their end user consumer is fulfilled, which occurs when the sensors are sold by the distributor to the end-user hospital. The Company also provides certain end-user hospitals with the ability to purchase sensors under rebate programs. Under these programs, the end-user hospitals may earn rebates based on their purchasing activity. The Company estimates and provides allowances for these programs at the time of sale as a reduction to revenues and an increase to deferred revenues.

Product Warranty Expense

The Company provides a warranty against defects in material and workmanship for a period ranging from six months to one year, depending on the product type. In the case of a long-term sales agreement, the Company typically warranties certain products for the term of the agreement, which usually ranges from three to six years. In traditional sales activities, including direct and OEM sales, the Company establishes an accrual for the estimated costs of warranty at the time of revenue recognition. Estimated warranty expenses are recorded as an accrued liability, with a corresponding provision to cost of sales. In end-user hospital contracts, revenue related to extended warranty is recognized over the life of the contract, while the product warranty costs related to the end-user hospital contracts are expensed as incurred.

Changes in the product warranty accrual for the nine months ended September 29, 2007 and September 27, 2008 were as follows (in thousands):

Net Income Per Common Share

Basic net income per common share is computed by dividing net income attributable to common stockholders for the period by the weighted average number of common shares outstanding during the period. Net income attributable to common stockholders is calculated using the two class method under Emerging Issues Task Force, or EITF, Issue No. 03-6, “Participating Securities and the Two-Class Method under FASB Statement No. 128.” EITF No. 03-6 establishes standards regarding the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder of such securities to participate in dividends and earnings of the Company. Pursuant to EITF 03-6, the two-class method of computing basic earnings per share is required when an entity has participating securities.

Dividends must be calculated for the participating security on undistributed earnings and are a reduction in the net income attributable to common stockholders. The Company’s previously outstanding Series A through G preferred stock were participating securities because they had the right to dividends should dividends be declared on common stock. Assumed dividends on undistributed earnings are allocated as if the entire net income were distributed and are based on the relationship of the weighted average number of common shares outstanding and the weighted average number of common shares outstanding if the preferred stock were converted into common stock.

Upon closing of the Company’s initial public offering on August 13, 2007, all of the outstanding convertible preferred shares were converted into common shares. Therefore, subsequent to this stock conversion the Company uses the if-converted method under SFAS No. 128, “Earnings Per Share” to calculate earnings per share. Accordingly, for the three months ended September 29, 2007, the Company calculated net income per share using the two-class method for the first 43 days of the period and the if-converted method for the remaining 48 days of the period. For the nine months ended September 29, 2007, the Company calculated net income per share using the two-class method for the first 224 days of the period and the if-converted method for the remaining 48 days of the period. Income was allocated between these periods on a straight-line basis over the number of days of the respective periods. The Company calculated net income per share for the three and nine months ended September 27, 2008 using the if-converted method for the entire periods.

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Diluted net income per common share is computed by dividing the net income attributable to common stockholders for the period by the weighted average number of common and potential common shares outstanding during the period, if the effect of potential common shares is dilutive. Potential common shares include incremental shares of common stock issuable upon the exercise of stock options.

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

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New Accounting Pronouncements

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141(R), or SFAS No. 141(R), “Business Combinations“. SFAS No.141(R) provides greater consistency in the accounting and financial reporting of business combinations. It requires the acquiring entity in a business combination to record all assets acquired and liabilities assumed at their respective acquisition-date fair values and changes other practices under SFAS No. 141. SFAS No. 141(R) also requires additional disclosure of information surrounding a business combination, such that users of the entity’s financial statements can fully understand the nature and financial impact of the business combination. SFAS No. 141(R) is effective for fiscal years beginning after December 15, 2008. If the Company consummates any acquisitions on or after January 4, 2009, the purchase accounting treatment could result in a material difference from current accounting treatment.

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 160, or SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements“. SFAS No. 160 amends Accounting Research Bulletin No. 51, “Consolidated Financial Statements“, to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS No.160 is effective for fiscal years beginning after December 15, 2008. The Company does not expect the adoption of this statement to have a material impact on its consolidated financial statements.

In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, or SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133”. SFAS No. 161 enhances the disclosure requirements for derivative instruments and hedging activities and thereby is designed to improve the transparency of financial reporting. SFAS No.161 is effective for fiscal years beginning after November 15, 2008. The Company does not expect the adoption of this statement to have a material impact on its consolidated financial statements.

In May 2008, the FASB issued Statement of Financial Accounting Standard No. 162, or SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles”. SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles. SFAS No. 162 will become effective on November 15, 2008. The Company does not expect the adoption of this statement to have a material impact on its consolidated financial statements.

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The Company’s total comprehensive income is as follows (in thousands):

Masimo Laboratories, Inc., or Masimo Labs, is an independent entity spun off from the Company to the Company’s stockholders in 1998. The Company is a party to a cross-licensing agreement with Masimo Labs, which was amended and restated effective January 1, 2007, or the Cross-Licensing Agreement, that governs each party’s rights to certain of the intellectual property held by the two companies.

Pursuant to FASB Interpretation No. 46(R), or FIN 46(R), “Consolidation of Variable Interest Entities—an Interpretation of ARB No. 51,” Masimo Labs is consolidated within the Company’s financial statements for all periods presented. Accordingly, all royalties, option and license fees and other charges between the Company and Masimo Labs have been eliminated in these consolidated financial statements. The Company may discontinue consolidating Masimo Labs in the event it is permitted under FIN 46(R).

As of December 29, 2007 and September 27, 2008, the Company had amounts due from employees of $598,000 and $230,000, respectively. As of December 29, 2007 and September 27, 2008, these amounts are classified in other current assets and other assets in the accompanying condensed consolidated balance sheet.

The Company’s Chief Executive Officer has been a member of the board of directors of Saba Software, Inc., a human capital development and management solutions provider, since 1997. The Company has paid Saba Software $22,000 and $81,000 during the nine months ended September 29, 2007 and September 27, 2008, respectively, for various software products and services.

The royalty receivable of $13.9 million as of December 29, 2007 represents the amount received in February 2008, for the three months ended December 29, 2007. The royalty receivable of $11.4 million as of September 27, 2008 represents the Company’s estimated amount due for the three months ended September 27, 2008. Pursuant to the settlement agreement with Nellcor Puritan Bennett, Inc. (currently Covidien Ltd., or Covidien), the royalties are paid to the Company based on sales of Covidien U.S. based pulse oximetry products. The Company recognizes royalty revenue based on the royalty rate per the settlement agreement multiplied by its estimate of Covidien’s sales for each quarter. Any adjustments to the quarterly estimate are recorded prospectively in the following quarter, when the Company receives the Covidien royalty report, which is generally 60 days after the end of each quarter.

Inventories are stated at the lower of cost or market. Cost is determined using a standard cost method, which approximates FIFO (first-in, first-out) and includes material, labor and overhead. Inventory valuation allowances are recorded for materials that have become obsolete or are no longer used in current production and for inventory that has a market value less than the carrying value in inventory.

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Inventories consist of the following (in thousands):

Long-term debt, excluding capital leases noted below, consists of the following (in thousands):

As of September 27, 2008, the Company had one arrangement, which allows for the financing of the equipment placed with hospitals in connection with the related long-term sensor purchase agreements. This agreement provides for an equipment line whereby draws are collateralized by (i) equipment and (ii) either a future revenue stream associated with the long-term sensor purchase agreement or a defined repayment schedule associated with the long-term sensor purchase agreement. The related equipment securing these borrowings is recorded on the Company’s condensed consolidated financial statements as deferred cost of goods sold and is depreciated on a straight-line basis over the life of the sensor contract to which they are related. The financing arrangement is non-recourse to the Company. In the event the hospital was unable to continue performing under the terms of the long-term sensor agreement, the Company would be required to write-down the remaining deferred cost of goods sold and the related financing obligation reflected in long-term debt. As of September 27, 2008, no hospitals have defaulted under this program.

At September 27, 2008, the carrying value of the equipment collateralizing the borrowing was $64,000. During the nine months ended September 27, 2008, the Company repaid $26.7 million, or the entire amount owed, on a previous arrangement plus $168,000 in prepayment fees which are included in other non-operating income (expense). As of September 27, 2008, principal and interest payments under the remaining financing agreement were $52,000 per month based on an average interest rate of 7.1% per year.

The Company currently has seven capital leases related to office equipment. These leases have interest rates ranging from 5.2% to 8.8% per year and mature on various dates from December 2009 through April 2013. As of September 27, 2008, the total future remaining interest cost was $27,000. Not including this interest expense, the capital lease obligations consist of the following (in thousands):

In March 2006, the Company declared a cash dividend of $3.365 per share, in the aggregate amount of $171.8 million, to holders of the Company’s common and preferred stock, assuming the conversion of all outstanding shares of preferred stock into an aggregate of 34,612,503 shares of common stock. During the year ended December 31, 2006, $171.4 million of this declared dividend had been paid.

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In December 2006, the Company declared an additional cash dividend of $0.725 per share, in the aggregate amount of $37.1 million to holders of the Company’s common and preferred stock, assuming the conversion of all outstanding shares of preferred stock into an aggregate of 34,612,503 shares of common stock. Of the total cash dividends declared in both March and December 2006, the Company paid in aggregate $37.2 million in the first six months of 2007 and $180,000 in the third quarter of 2007. No dividends were declared or paid in the fourth quarter of 2007, or the first or second quarters of 2008. In the third quarter of 2008, the Company paid $13,000 in dividends. The total outstanding dividends payable balances as of December 29, 2007 and September 27, 2008 were $183,000 and $170,000, respectively.

In April 2004, the Company adopted the 2004 Incentive Stock Option, Nonqualified Stock Option, and Restricted Stock Purchase Plan, or the 2004 Plan, which initially provided for the issuance of options to purchase up to 3,000,000 shares of the Company’s common stock, plus any shares available under the prior year stock option plans, including shares that become available due to forfeitures at prices not less than the fair market value of the Company’s common stock on the date the option is granted, as determined by the Board. The options granted under the 2004 plan generally vest annually over five years using the straight-line method, unless otherwise provided, and expire ten years from the date of grant. The Board approved increases in the number of shares available for grant under the 2004 Plan to 4,500,000 shares on February 6, 2006, 6,000,000 shares on November 1, 2006 and 7,500,000 shares on May 24, 2007.

On August 7, 2007, in connection with the Company’s initial public offering, the 2007 Stock Incentive Plan, or the 2007 Plan, became effective. Under the 2007 Plan, 3,000,000 shares of common stock are reserved for future issuance, plus any shares available under the prior year stock option plans, including shares that become available due to forfeitures at prices not less than the fair market value of the Company’s common stock on the date the option is granted. In addition, the 2007 Plan includes an “evergreen” provision which automatically increases the number of shares reserved for issuance on the first day of each fiscal year by 3% of the shares outstanding on last day of the immediately preceding fiscal year. However, on February 7, 2008, the Company’s Board of Directors amended the Company’s 2007 Plan to decrease the number of shares reserved under the plan by 1,640,748 shares of common stock, the exact amount automatically added to the share reserve effective December 30, 2007, pursuant to the “evergreen” provision.

The options granted under the 2007 Plan generally vest annually over five years using the straight-line method, unless otherwise provided, and expire ten years from the date of grant. The number and weighted average exercise price of options issued and outstanding under all stock option plans, at exercise prices ranging between $1.33 and $41.51 per share, are as follows:

The weighted-average fair value of options granted was $13.88 for the nine months ended September 27, 2008.

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The Company applies the provisions of Staff Accounting Bulletin, or SAB, No. 107 “Share-Based Payment” and SAB No. 110, “Share-Based Payment“ in its application of SFAS No. 123(R), “Share-Based Payment.” The fair value of each option is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for grants:

In accordance with SFAS 123(R), the Company recorded stock-based compensation expense of $944,000 and $2.2 million during the three and nine months ended September 29, 2007, respectively, and $2.0 million and $5.7 million during the three and nine months ended September 27, 2008, respectively.

The aggregate intrinsic value of options outstanding as of September 27, 2008 was $167.1 million. The aggregate intrinsic value of options exercisable as of September 27, 2008 was $88.8 million. The aggregate intrinsic value of options exercised during the three months ended September 27, 2008 was $19.1 million. The aggregate intrinsic value is calculated as the difference 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 unrecognized stock based compensation as of September 27, 2008 was $43.3 million related to unvested options granted after January 1, 2006. The weighted average remaining contractual term of options outstanding as of September 27, 2008 was 7.2 years. The weighted average remaining contractual term of options exercisable as of September 27, 2008 was 5.2 years. The total fair value on the respective vesting dates of all options vesting during the three months ended September 27, 2008 was $6.6 million.

In February 2007, the Company repurchased 11,640 shares of common stock at an average price of $13.56 per share totaling $158,000 from a former employee. The difference between the repurchase price and the original option exercise price totaled $134,000 and was recorded as operating expense during the three months ended March 31, 2007. In May 2007, the Company repurchased another 30,000 shares of common stock at an average price of $14.09 per share, totaling $423,000, from another former employee. The difference between the repurchase price and the original option exercise price totaled $283,000 and was recorded as operating expense during the three months ended June 30, 2007. All these shares were recorded in treasury stock and are available for reissue. Since these events occurred prior to the Company’s initial public offering, no public announcement regarding stock repurchase was made. No shares were repurchased during the three months ended September 29, 2007.

Leases

The Company leases its facilities in North America, Europe and Asia under operating lease agreements expiring at various dates through August 2014. Certain facilities leases contain pre-determined price escalations. The Company recognizes the lease costs using a straight line method based on total lease payments. As of December 29, 2007 and September 27, 2008, rent expense accrued in excess of the amount paid aggregated $625,000 and $375,000, respectively, and is classified in other liabilities. The Company also leases automobiles in Europe and Japan that are classified as operating leases and expire at various dates through October 2010.

Future minimum lease payments under operating and capital leases for each of the following fiscal years ending on or about December 31 are (in thousands):

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Rental expense related to operating leases was $560,000 and $1.6 million for the three and nine months ended September 29, 2007, respectively, and was $842,000 and $2.5 million for the three and nine months ended September 27, 2008, respectively.

Employee Retirement Savings Plan

The Masimo Retirement Savings Plan, or the Plan, is a 401(k) plan covering all of the Company’s full-time U.S. employees who meet certain eligibility requirements. The Company contributes to the Plan on a discretionary basis. The Company contributed $251,000 and $710,000 to the Plan for the three and nine months ended September 29, 2007, respectively, and $287,000 and $864,000 to the Plan for the three and nine months ended September 27, 2008, respectively.

Employment Agreements

As of September 27, 2008, the Company had an employment agreement with one of its key employees that provides for an aggregate annual base salary of $686,400, plus other benefits, with annual increases at the discretion of the Board of Directors. The agreement with the Company also provides for an annual bonus based on the Company’s attainment of certain objectives and goals. The agreement automatically renews on a daily basis and terminates three years from the date either party gives notice of termination to the other party.

As of September 27, 2008, the Company had an additional employment agreement with one of its key employees, which provides for an annual base salary of EUR €150,000 (approximately $219,000 as of September 27, 2008). The agreement also contemplates an annual bonus based on the attainment of certain revenue, gross margin and operating income milestones. The agreement also contains a non-compete provision. If the Company enforces the non-compete provision following the employee’s termination of employment, the employee would be entitled to receive a lump sum payment equal to 50% of his annual base salary as of the date of his termination, which must be paid in equal installments over the term of the non-competition period.

Severance Agreements

On January 11, 2008, the Company entered into a severance plan participation agreement with three of its executive officers. The participation agreements, or Agreements, are governed by the terms and conditions of the Company’s 2007 Severance Protection Plan, or Severance Plan, which became effective on July 19, 2007. Under an Agreement, the 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 terminates his employment for good reason under certain circumstances.

Purchase Commitments

Pursuant to contractual obligations with vendors, the Company had $16.9 million of purchase commitments as of September 27, 2008. These purchase commitments were made for certain inventory items to secure better pricing and to ensure the Company will have materials on hand to meet anticipated demands for inventory.

Concentrations of Risk

The Company is exposed to credit loss for the amount of cash deposits with financial institutions in excess of federally insured limits. As of September 27, 2008, the Company had $6.9 million of bank balances of which $6.5 million was in excess of the Federal Deposit Insurance Corporation limit. The Company invests its excess cash deposits in U.S. Treasury bills and money market accounts with major financial institutions. As of September 27, 2008, the Company had $103.8 million in U.S. Treasury bills which are backed by the U.S. federal government. Also, as of September 27, 2008, the Company had $11.9 million in money market accounts, of which $6.9 million was covered under the U.S. Treasury Department Temporary Guarantee Program for Money Market Funds effective on September 19, 2008.

While the Company and its contract manufacturers rely on sole source suppliers for certain components and contract manufacturing services, management believes that steps have been taken to minimize the impact of a shortage or stoppage of shipments, such as maintaining excess inventory and designing products that may be easily modified to use a different component. There can be no assurance that a shortage or stoppage of shipments of the materials or components or services that the Company purchases will not result in a delay in production, or adversely affect the Company’s business.

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The Company’s ability to sell its products to U.S. hospitals depends in part on its relationships with Group Purchasing Organizations, or GPOs. Many existing and potential customers for the Company’s products become members of GPOs. GPOs negotiate pricing arrangements and contracts, sometimes exclusive, with medical supply manufacturers and distributors, and these negotiated prices are made available to a GPO’s affiliated hospitals and other members. During the three and nine months ended September 29, 2007, shipments of the Company’s pulse oximetry products to U.S. hospitals that are members of GPOs amounted to $24.4 million and $72.9 million, respectively. In the three and nine months ended September 27, 2008, shipments to U.S. hospitals that are members of GPOs were $35.4 million and $99.1 million, respectively.

For the three months ended September 29, 2007, no customers represented over 10% of the Company’s total revenue. For the nine months ended September 29, 2007, one customer represented 10.6% of the total revenue. For the three and nine months ended September 27, 2008, one customer represented 10.3% and 11.7% of the total revenue, respectively.

At December 29, 2007, two customers represented 8.4% and 5.3% of accounts receivable. At September 27, 2008, one customer represented 5.2% of accounts receivable.

Litigation

In May 2002, the Company filed a lawsuit against Tyco Healthcare (currently Covidien), in the United States District Court for the Central District of California, alleging damage to the Company’s business as a result of the anti-competitive business practices of Tyco Healthcare. Specifically, the Company alleges that it had incurred damages as a result of a series of illegal exclusionary and anti-competitive acts by Tyco Healthcare that were designed to maintain its monopoly in the pulse oximetry market in violation of federal antitrust laws.

In March 2005, a jury found that Tyco Healthcare’s use of sole-source contracts, product bundling, market share-based compliance pricing contracts and co-marketing agreements with patient monitoring companies were unlawful restraints of trade and exclusionary dealing arrangements and, as a result, violated federal antitrust laws. The jury awarded the Company $140 million in damages. Under the antitrust laws, if the jury verdict is sustained in whole or in part, all damages are trebled. Tyco Healthcare filed post-trial motions requesting that the District Court either override the jury decision or grant a new trial. In March 2006, the District Court upheld a portion of the jury verdict and vacated the remaining verdict. In addition, the District Court vacated the jury’s damages award and granted Tyco Healthcare a new trial on damages. As a result, the Company may not receive any damages in this lawsuit. The District Court held an evidentiary hearing in October 2006 to re-try the damages. On January 25, 2007, the District Court issued a preliminary ruling which did not set damages, but resolved some issues of dispute about damages, and ordered another evidentiary hearing on issues still undecided by the District Court. The District Court held this evidentiary hearing in March 2007. On July 2, 2007, the District Court entered its final judgment awarding the Company damages which were trebled to $43.5 million and denying the Company’s request for a permanent injunction with respect to Tyco Healthcare’s business practices found to be anti-competitive. The Company and Tyco Healthcare have each filed a notice of appeal from the judgment. The Company filed its opening brief on December 17, 2007 with the United States Court of Appeals for the 9^th Circuit. On December 27, 2007, the Consumer Federation of America and Medical Device Manufacturers Association filed an Amicus brief supporting Masimo. Tyco filed its opposition and appeal brief on March 3, 2008 and a group of law professors filed an Amicus brief supporting Tyco on March 10, 2008. Even if the Company is ultimately awarded damages in this litigation, the amount will be subject to a 50% legal fee contingency agreement, in which case the Company would receive 50% of the net (of costs) proceeds from the award. Even though most of the legal expenses to date have been on a contingency basis, the Company expects to incur expenses related to the appellate work, which will be reported as operating expense within the Company’s statements of income.

The Company believes the jury verdict it received in the Tyco Healthcare antitrust litigation has been important in its efforts to increase its market share among certain large hospital systems and GPOs that were formerly closed as a result of Tyco Healthcare’s anti-competitive conduct. See “Risk Factors” for a description of the risks related to the Company’s litigation against Tyco Healthcare.

On July 24, 2007, Shaklee Corporation filed suit against the Company in the United States District Court, Central District of California, alleging that the Company’s pulse oximeters incorporate patented calibration methods that are licensed to Shaklee. NIR Diagnostics, Inc., the original licensee of the patents, was originally named as a defendant, but then agreed to become a plaintiff in the action. Shaklee and NIR sought an injunction and damages against the

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Company. On August 27, 2008, the Company settled all pending litigation brought by Shaklee and NIR against the Company. Pursuant to the settlement, Shaklee and NIR dismissed all outstanding claims against the Company with prejudice, and the Company dismissed all outstanding claims against Shaklee and NIR without prejudice. The settlement was reached without the Company incurring any liability to either Shaklee or NIR.

On February 19, 2008, the Company filed a lawsuit against Respironics, Inc. for breach of contract, breach of the covenant of good faith and fair dealing, and interference with prospective economic advantage, based on a January 16, 2006, contract between Respironics and the Company. On April 7, 2008, Respironics filed a demurrer seeking to dismiss the lawsuit on the grounds that the Company’s complaint fails to state sufficient facts to constitute valid claims. The court subsequently denied Respironics’ demurrer. On July 16, 2008, Respironics answered the Company’s complaint and filed a cross-complaint. The Company answered the cross-complaint on August 15, 2008, denying all material allegations. There is no guarantee that the Company will prevail in this suit or receive any damages or other relief if it does prevail.

From time to time, the Company may be involved in litigation relating to claims arising out of its operations in the normal course of business. The Company believes that it currently is not a party to any 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.

Voluntary Recall

On July 31, 2007, the Company initiated a voluntary recall of its Rad-9 pulse oximeter, a standalone bedside pulse oximeter product, sales of which represented less than 0.2% and 0.3% of the Company’s product revenue in the three and nine months ended September 27, 2008, respectively. In accordance with its original design and similar to other pulse oximeter devices, the Rad-9 gives a visual alarm if there is a sensor fault; under other circumstances, the Rad-9 gives both a visual and audio alarm. In late 2006, the Company sent notice to owners of the Rad-9 that a free upgrade was available to add an audio alarm to the Rad-9 when a sensor fault is detected. Although the Company received notification from the U.S. Food and Drug Administration, or FDA, that recall of its Rad-9 was not mandatory, the Company decided to voluntarily recall the Rad-9 and implement this upgrade. The Company does not believe that a non-upgraded Rad-9 poses a significant risk to health or would cause serious injury or death. The Company decided to voluntarily recall the Rad-9 because it believes it has the possibility of improving the care of patients. This decision follows a customer report that an elderly patient, who may have damaged her pulse oximeter sensor, had died after removing her tracheostomy tube. Based on what is currently known, the Rad-9 appears to have been operating in accordance with its specifications. The Company had originally estimated that the total costs resulting from this voluntary recall would be approximately $300,000, although this was an estimate and the actual costs could differ. The Company incurred this charge in the quarter ended September 29, 2007. As of September 27, 2008, the Company had incurred actual upgrade costs of approximately $292,000 and does not expect to incur any additional costs in the future related to this recall. Any other future recalls could result in a diversion of management resources, substantial cost and negative publicity, all of which could adversely affect the Company’s business, financial condition and results of operations.

The Company’s chief decision maker, the Chief Executive Officer, reviews financial information presented on a consolidated basis, accompanied by disaggregated information about revenues by geographic region for purposes of making operating decisions and assessing financial performance. Accordingly, the Company considers itself to be in a single reporting segment, specifically non-invasive 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 United States and are not allocated to any specific region. 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.

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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):

Sales to customers located in the United States were $40.5 million and $110.7 million for the three and nine months ended September 29, 2007, respectively, and $50.0 million and $140.0 million for the three and nine months ended September 27, 2008, respectively.

In July 2006, the FASB issued Interpretation No. 48, or FIN 48, “Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109,“ which became effective on January 1, 2007. FIN 48 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. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The adoption of FIN 48 on January 1, 2007 resulted in an increase to the Company’s accumulated deficit of $618,000. As of September 27, 2008, the balance of the gross unrecognized tax benefit was $3.5 million, of which $2.3 million (net of federal benefit on state taxes), if recognized, would affect the effective tax rate. It is reasonably possible that the amount of unrecognized tax benefits will decrease in the next 12 months by $242,000 primarily related to certain timing differences.

Interest and penalties related to unrecognized tax benefits are recognized in income tax expense. For the three and nine months ended September 27, 2008, the Company accrued $68,000 and $195,000, respectively, for interest.

The Company conducts business in multiple jurisdictions, and as a result, one or more of the Company’s subsidiaries files income tax returns in the U.S. federal, various state, local and foreign jurisdictions. Due to the existence of net operating loss carryforwards, all years since 1994 are open for examination by major taxing authorities.

The provision for income taxes was $6.9 million and $20.4 million, or an effective tax rate of 39.7% and 40.3% for the three and nine months ended September 29, 2007, respectively. The provision for income taxes was $7.6 million and $20.0 million, or an effective tax rate of 36.6% and 38.1% for the three and nine months ended September 27, 2008, respectively. The effective tax rate differs from the statutory U.S. federal income tax rate of 35.0% primarily due to state taxes and other permanent differences between pre-tax income for financial reporting purposes and taxable income.

This quarterly report on Form 10-Q contains “forward-looking statements” as defined in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, 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; statements concerning new products,

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technologies or services; statements related to future capital expenditures; statements related to future economic conditions or performance; 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,” 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 Form 10-Q and in our other SEC filings, including our Annual Report on Form 10-K for the fiscal year ended December 29, 2007, which we filed with the SEC on March 4, 2008. 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.

Overview

We are a global medical technology company that develops, manufactures and markets non-invasive patient monitoring products that improve patient care. We invented Masimo SET, which provides the capabilities of Measure-Through Motion and Low Perfusion pulse oximetry to address the primary limitations of conventional pulse oximetry. Pulse oximetry is the non-invasive measurement of the oxygen saturation level of arterial blood, or the blood that delivers oxygen to the body’s tissues, and pulse rate. Conventional pulse oximetry is subject to technological limitations that reduce its effectiveness and the quality of patient care. In particular, when using conventional pulse oximetry, arterial blood signal recognition can be distorted by motion artifact, or patient movement, and low perfusion, or low arterial blood flow. Low perfusion can also cause the failure of the conventional pulse oximeter to obtain an accurate measurement. Conventional pulse oximetry readings can also be impacted by bright light and electrical interference from the presence of electrical surgical equipment. Published independent research shows that over 70% of the alarms were false outside the operating room using conventional pulse oximetry. Our Masimo SET platform has significantly addressed many of the previous technology limitations. The benefits of Masimo SET have been validated in over 100 independent clinical and laboratory studies.

We market a family of patient monitoring solutions which incorporate a monitor or circuit board and consumables, including both proprietary single-patient use and reusable sensors and cables. In addition, we offer a remote-alarm/monitoring solution, software and other accessories. Although our Masimo SET platform is only operable with our proprietary sensors, our sensors have the capability to work with certain competitor pulse oximeters through the use of our adapter cables. In 2005, we launched our Masimo Rainbow SET Pulse CO-Oximetry platform utilizing licensed Rainbow technology from Masimo Laboratories, Inc., or Masimo Labs, which enables the non-invasive measurement of not only arterial blood oxygen saturation level and pulse rate, but also carboxyhemoglobin, or carbon monoxide levels in the blood, and in 2006, methemoglobin saturation levels in the blood. Most recently, in May 2008, we received clearance from the FDA for SpHb, our non-invasive measurement of total hemoglobin levels in the blood, and in August 2008, we received FDA clearance of our Single Patient Adhesive Rainbow SpHb sensors. In September 2008, we began shipments of SpHb on a limited basis to select customers. Along with the release of our Masimo Rainbow SET Pulse CO-Oximetry products, we have developed multi-wavelength sensors that have the ability to monitor multiple measurements with a single sensor.

We are continuing the research and development of products for the non-invasive measurement of other measurements based on the Masimo Rainbow SET platform. Included in this development are products for acoustic respiratory monitoring (ARM). Although we plan to continue to research, innovate and develop new technologies and products, we are unable to predict which potential measurements can be achieved, the time and cost to complete development, and ultimately whether we will have any additional measurements approved by the FDA or other regulatory agencies.

The building of our installed base of pulse oximeters, Pulse Co-Oximeters and circuit boards generates recurring sales of our consumables, primarily single-patient use sensors. A user of one of our pulse oximeters or our OEMs’ pulse oximeters can obtain the benefit of the Masimo SET or Masimo Rainbow SET only by using our proprietary sensors that are designed for our system. We estimate that our worldwide installed base was approximately 540,000 units as of September 27, 2008, up from 448,000 units as of September 29, 2007. We estimate our installed base to be the number of bedside pulse oximeters and circuit boards that we have shipped in the prior seven year period.

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We currently manufacture bedside and handheld pulse oximeters, a full line of single-patient use and reusable sensors and patient cables. We use third-party contract manufacturers for some of our products and components that can be more efficiently manufactured by these parties, primarily circuit boards, cables and plastics for instrument housings. We perform incoming inspection, final assembly and testing of any products or subassemblies manufactured by third-party contract manufacturers to assure quality control.

Masimo Laboratories

Masimo Labs is an independent entity spun off from us to our stockholders in 1998. We are a party to a cross-licensing agreement with Masimo Labs, which was amended and restated effective January 1, 2007, or the Cross-Licensing Agreement, that governs each party’s rights to certain of the intellectual property held by the two companies.

Under the Cross-Licensing Agreement, we granted Masimo Labs an exclusive, perpetual and worldwide license, with sublicense rights to use all Masimo SET owned by us, including all improvements on this technology, for the measurement of non-vital signs measurements and to develop and sell devices incorporating Masimo SET for monitoring non-vital signs measurements in any product market in which a product is intended to be used by a patient or pharmacist rather than a professional medical caregiver, which we refer to as the Labs Market. We also granted Masimo Labs a non-exclusive, perpetual and worldwide license, with sublicense rights to use all Masimo SET for the measurement of vital signs in the Labs Market.

We exclusively license from Masimo Labs the right to make and distribute products in the professional medical caregiver markets, or the Masimo Market, that utilize Rainbow technology for the measurement of carbon monoxide, methemoglobin, fractional arterial oxygen saturation, and total hemoglobin, which includes hematocrit. To date, we have developed and commercially released devices that measure carbon monoxide and methemoglobin using licensed Rainbow technology. We also have the option to obtain the exclusive license to make and distribute products that utilize Rainbow technology for the measurement of other non-vital signs measurements, including blood glucose, in product markets where the product is intended to be used by a professional medical caregiver.

Pursuant to FASB Interpretation No. 46(R), or FIN 46(R), “Consolidation of Variable Interest Entities—an Interpretation of ARB No. 51,” Masimo Labs is consolidated within our financial statements for all periods presented. Accordingly, all royalties, option and license fees and other charges between us and Masimo Labs have been eliminated in the consolidated financial statements. We anticipate that we will continue to consolidate Masimo Labs pursuant to the guidance set forth in FIN 46(R); however, we may discontinue consolidating Masimo Labs in the event it is permitted under FIN 46(R).

Results of Operations

The following tables provide a comparison of our earnings per share calculated under Emerging Issues Task Force Issue No. 03-6, or EITF 03-6, “Participating Securities and the Two-Class Method under FASB Statement No. 128“, and SFAS No. 128 or SFAS 128, “Earnings per Share“, in accordance with GAAP and the non-GAAP if-converted method based solely upon SFAS No. 128. The non-GAAP if-converted method assumes conversion of all shares of our preferred stock into common stock as of December 31, 2006.

Upon closing of our initial public offering on August 13, 2007, all of the outstanding convertible preferred shares were converted into common shares. Therefore, subsequent to this stock conversion, we use the if-converted method under SFAS 128 to calculate earnings per share.

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We believe that the following non-GAAP earnings per share information for the three and nine months ended September 29, 2007 is relevant and useful information that can be used by analysts, investors and other interested parties to assess our performance on a comparable basis to the three and nine months ended September 27, 2008 and future reported earnings per share. Accordingly, we are disclosing this unaudited information to permit additional analysis of our performance (in thousands, except share data):

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