Some Quick Thoughts on Masimo (MASI)

by Geoff Gannon

Quan here.

This post is to continue my discussion on 15 stocks I know. Today, I’ll talk about Masimo (MASI).


#6 Masimo (MASI)

Masimo makes products that continuously measure good and bad things in a patient's blood. Good things include oxygen and hemoglobin. Hemoglobin carries oxygen. Bad things include carbon monoxide. Too much carbon monoxide in blood causes poisoning.

Of course, too much of anything is a bad thing. Even oxygen levels have to be controlled. For example, too much oxygen can blind someone. This happened to a lot of premature babies in the past.

Masimo’s products have 3 advantages. One is that the measuring is done continuously. Two is that the measuring doesn’t require cutting the patient open. All that is required is that the patient wears the sensor on the outside of their body. Three is that Masimo measures important things in the blood. Oxygen is important in a good way. Carbon monoxide is important in a bad way. If a hospital fails to measure these levels, they could kill the patient. In any testing business the importance of what you are testing is critical.

Although Masimo has long been in blood measuring business, the way they measure blood has changed a little. Before 2008, Masimo measured oxygen level. Starting in 2008, Masimo was able to measure hemoglobin levels directly.


Profitable Razor and Blade Business Model

Masimo has a razor and blade business model. They sell drivers and sensors. Sensors are attached to patients. Drivers process information from sensors. 80% of drivers are included in multi-parameter monitors made by OEM partners. 20% of drivers are included in Masimo’s standalone system. Masimo usually provides their standalone system to end-customer free under a typical 5-year sensor sale contract. Customers can buy Masimo’s software to upgrade the driver so that the driver can process more measurements. But Masimo makes most money from selling sensors.

Masimo is protected by patents. Their much bigger competitor Covidien (COV) has been paying them a royalty for the infringement of Masimo’s patent. So, it’s not a surprise that Masimo’s 5-year average ROE is 35%.


Sustainability of Profit

I don’t think technological break-through is a big risk to Masimo. I think that when technology in a market gets to a certain threshold, people will put much less attention and R&D resources into the market. Especially when it takes more than 10 years for the market adopt new technologies in this business. So, I’m not concerned about technological break-through. But I do worry about how Masimo’s business after some of their patents starts to expire.

I don’t know exactly when Masimo’s patent for measuring oxygen level will expire. According to Adam Sues from Value Uncovered, the patent will expire in 2017. Let’s think about Masimo’s life after the patent expired.

Masimo’s customers are price conscious. OEMs want to reduce component costs of their multi-parameters. OEMs might want to produce their own drivers and some of them will have an edge over Masimo in distribution.

Their end users care a lot about price. Sensors are usually included in a package that gets reimbursed by insurers. End-users have the incentive to cut costs. Sensors are not cheap. The price ranges from $30 to over $1,000. And sensors are usually sold under a 5-year contract. The dollar amount of each contract is high. End-customers will negotiate hard and be open to other competitive products.

So what can protect Masimo?


Masimo’s Protection Against Generic Competition

The first protection is the razor and blade business model. 80% of drivers are put inside large, expensive multi-parameter monitors. These monitors have about 10-year field lives. End-customers will not switch to new expensive monitors simply for cheaper sensors. 20% of drivers are in Masimo’s standalone system. These systems have a 10-year useful life. But Masimo depreciate the system cost over 5 years as they realize revenue from 5-year sensor sale contracts. That means after 5 year, Masimo can renew sensor sale contracts at lower prices without reducing margin. However, the razor and blade business model doesn’t completely protect Masimo from generic competition.

The second protection is the upgradability of the driver. Having hemoglobin as a readily available measurement makes Masimo’s drivers more attractive to customers. Masimo’s patents for measuring hemoglobin will last for many years. But what happens when the patents eventually expire?

Phil Fisher would say the best protection is constant engineering improvements. Masimo has broad lines of sensors that are suitable for different patient conditions. For example, Masimo can reduce variability of performance between different patient settings, a weakness they faced with each new technology. Masimo can improve sensor designs to reduce cost for customers while maintaining gross margin. All these improvements can again be protected by patents.

I think there must be something other than just patents that explain Masimo’s success, becuase a long time market leader, Covidien, has actually violated Masimo’s patents since the late 1990s. At that time, Masimo was just a young company with no established sales organization. And not until 2000 did Masimo launch the first product. Yet, 10 years later, Masimo became the leader with 50% market share. I think constant engineering improvements explain Masimo’s success.


Still a Less Predictable Company

However, Masimo is only my sixth favorite stock out of the 15 I mentioned. Unlike Carnival, the disruptive technological risk to Masimo is real. I’m much more uncertain about Masimo’s future earnings. I don’t know how the business will change after their patents expire.

Masimo’s market is much bigger than Atrion (ATRI)’s niches. So Masimo’s product markets will get much more attention from competitors after the patent expirations. Although I think constant engineering improvement played a big role in Masimo’s success, I haven’t done enough scuttlebutt. So, I’m less certain about Masimo than about other companies I've discussed.

To be continued…

Talk to Quan about Masimo