Masimo: Doing Well by Doing Good - Intrinsic Investing (2024)

In January 2017, we wrote a post on the opportunities and threats of investing in healthcare stocks over the next decade.

To recap, over the prior 20-year period, the U.S. healthcare sector outperformed the S&P 500 by nearly two percentage points per year, on average. Many companies reaped the benefits of a highly inefficient U.S. healthcare system, where prices surged without delivering proportionate value to patients.

We continue to believe this is unsustainable. Whether it’s through government action or market forces, changes are on the horizon for the U.S. healthcare industry to better align costs with outcomes.

As such, we demand two things when looking at new healthcare companies:

• Do these products and services improve patient outcomes?
• Do this company’s products and services help reduce system-wide costs?

Frankly, we have not found many companies that fit both criteria. Yes, there are many technological advances occurring in healthcare. In fact, PwC expects healthcare to have the most R&D spending in absolute dollar terms of any industry by 2020.

Unfortunately, innovation in healthcare doesn’t always translate into improved outcomes and lower system costs.

To illustrate, here’s what the Congressional Budget Office wrote in a 2008 study:

The added clinical benefits of new medical services are not always weighed against the added costs before those services enter common clinical practice. Newer, more expensive diagnostic or therapeutic services are sometimes used in cases in which older, cheaper alternatives could offer comparable outcomes for patients.

We think one of the intrinsic problems is that, because it’s the incumbents – i.e. the primary beneficiaries of an inefficient system – doing the bulk of the innovation spending, there’s little incentive for them to change the status quo.

California-based Masimo piqued our interest because it takes an outsider’s approach to finding healthcare solutions. Indeed, the company’s mission statement is “Improving patient outcomes and reducing the cost of care.” A natural fit.

But this isn’t just marketing spin. The company’s founders, Joe Kiani (current Chairman & CEO) and Mohamed Diab were electrical engineers by trade and started Masimo in 1989 after working with early versions of pulse oximeters that used sensors to measure oxygen levels in the blood.

Those early pulse oximeters were particularly unreliable when the patient was in motion – think premature babies, emergency situations, etc. Medical professionals would either use invasive procedures (via syringe) to get a more accurate reading or assume the reading from the sensor was correct and risk misdiagnosis.

We’ll get into more details in a moment, but fast-forward to today and Masimo’s pulse oximetry sensors are the standard of care in most of the country’s operating rooms, NICUs, and ICUs.

From our recent trip to Masimo’s headquarters for an investor day, we confirmed that the company’s engineering-first spirit remains a key differentiator in Masimo’s corporate culture. Each solution starts with first principles and a blank sheet of paper rather than starting with the status quo.

Put another way, Masimo is a technology company pursuing better solutions in the healthcare industry, rather than a healthcare company using technology as an avenue for higher-priced solutions. We consider Joe Kiani to be a Visionary-Outsider leader of a company that’s running circles around incumbents with eroding moats.

Okay, let’s take a step back. How does Masimo fulfill our first criteria to improve patient outcomes?

Starting with Masimo’s core business – Signal Extraction Technology (SET). With FDA approval in 1998, Masimo’s proprietary SET was the first platform to accurately measure pulse ox when the patient is in motion (common in emergency situations) and low perfusion (low levels of oxygen).

With the use of LED sensors and encrypted algorithms, Masimo sensors obtain vital information in a non-invasive manner. In non-medical terms, it shoots a known quantity of light from one sensor and gets a reading based on the amount of light it receives on the other end. These are similar principles to how your Apple Watch or FitBit operate.

Impressively, SET’s alarm reliability during motion and low perfusion settings remains generations ahead of the other major player in pulse oximetry, Nellcor (now owned by Medtronic). One study showed that while Masimo SET had 3% missed true alarms and 5% false alarms, Nellcor’s N-600 sensors had 43% and 28%, respectively.

Despite such a wide lead in performance, Masimo announced at their investor day that they had made their SET even more accurate.

We think this speaks volumes of the company’s culture. With that type of lead, most medical device companies would declare victory, drop R&D spending, and harvest higher cash flows. Instead, Masimo pushes further. One false alarm is too many.

Now, even though Masimo’s technology has long been superior, it’s taken more than a decade to win half the pulse oximetry market share. This speaks to the switching costs involved in pulse oximetry.

It’s a classic razor-and-blade business model. The company sells technology boards that go into both Masimo-branded monitors and OEM-branded monitors. This equipment typically gets replaced every 10-12 years, so it’s a slow product cycle. Masimo then sells disposable sensors with a 5-7 year contract. About 80% of its sensors are single-patient use (one-week life), with the rest being reusable silicon sensors (six-month life).

Even after the hospital decides to make a change, new monitor integration takes another 1-2 years start to finish, which further adds to switching costs. On this point, Masimo boards already have all the various readings (SET and rainbow) installed and it’s up to the hospital to “turn on” various components.

Even though winning share is a slow process, once Masimo wins the business, it’s typically locked in. The company boasts a 98% customer renewal rate.

Though the SET patents have expired, Masimo successfully defended them over the past decade, winning a $265 million settlement plus royalties from Nellcor in 2006, followed by a 2016 settlement with Philips that resulted in a $300 million cash payment plus a multi-year business partnership to sell Masimo boards in Philips monitors. Philips has a 50-60% market share in the U.S. high acuity monitoring market, so this is a massive opportunity for Masimo to extend its installed base and establish more presence on the general floor of hospitals. (More on that in a moment.)

Masimo’s SET algorithms are also proprietary and encrypted, which will make it challenging for upstarts to match its current performance.

Finally, Masimo has smartly reinvested its SET cash flows in new products that leverage its expertise in sensors and monitors.

Masimo’s rainbow technology, for example, uses an upgraded sensor to provide medical professionals with a portfolio of critical health metrics. Among these additional readings are hemoglobin, carbon monoxide, and acoustic respiration rate.

Rainbow patents have 10-15 years remaining, which will help Masimo defend its lead over competitors in monitoring sensors.

Put simply, we think Masimo is generations ahead of its competition in non-invasive sensors. The other major players have shown more interest in milking their sensor business for cash flow rather than reinvesting in innovation. Upstart competitors will need to run the gauntlet of regulatory approvals and slow product cycles before they can go head-to-head with Masimo’s current offerings. So by the time they get into the arena, we think Masimo will have further extended its technology lead.

Masimo has already fully penetrated the critical care beds in U.S. hospitals, where patients’ vital signs are continuously monitored. But this isnot the case on the general floor – yet. Only 10% of general floor beds in the U.S. use continuous monitoring.

If you’ve ever been in a general floor bed yourself or assisted a loved one, you know the routine. The nurse comes in every few hours to check your vitals. He or she might jot them down on a tablet or laptop – but often it’s pen and paper.

This can result in transcription errors and may miss sharp, unexpected changes in a patient’s health, such as an opiate addict’s breathing capacity crashing in between nurse visits. Through Masimo’s Patient SafetyNet platform and sensors, the hospital gets real-time, non-invasive, and continuous patient monitoring solutions on the general care floors. This is a win-win-win for patients, nurses, and hospitals.

Rather than doing spot checks, nurses can monitor patient vitals 24/7 from a screen at the nurses’ station. If a patient’s reading turns from green to yellow or red, it’s time to check in on the patient. This saves the nurses time and allows them to spend more time with the patients who need the care.

For hospitals, continuous monitoring reduces liability risk. Why would you want to risk a patient crashing in between spot checks and deal the subsequent lawsuits that would surely follow? When you start from first principles, there’s no reason why hospital patients shouldn’t be monitored from the time they’re admitted until the time they go home.

Change at hospitals can be frustratingly slow, but we consider many of Masimo’s solutions to be inevitable.

I could write thousands of more words on Masimo’s innovative products – brain function monitoring, automating operating rooms, etc. – but I’ll discuss one more innovation.

Last year, Masimo announced it was one of eight companies (out of more than 250) selected by the FDA for expedited approval of a system designed to detect respiratory problems related to opioid overdose.

As I began to run some numbers on the market opportunity, I couldn’t believe the data I was seeing. Among them:

• In 2017, there were 191 million opioids prescriptions written in the U.S.
• 92 million U.S. adults used a prescription opioid in 2015.
• In 2017, there were 47,600 opioid overdose deaths in the U.S.; 17,029 deaths related to prescription opioids.

Those numbers are staggering.

One of the key risks of opioid use is respiratory depression where your brain is deprived of oxygen and you run the risk of cardiac or respiratory arrest. The scary thing is that people typically do not know beforehand how they will react to opioids.

Masimo knew from its hospital-based patient monitoring systems that its sensors could greatly reduce the risk of respiratory depression in patients prescribed opioids. So, it created Opioid SafetyNet: a take-home, direct-to-consumer monitoring system that connects to a smartphone and alarm to alert the patient, caregiver, and emergency services when respiratory depression is occurring.

Masimo believes it has a market opportunity of over $4 billion with Opioid SafetyNet, even under the assumption that opioid prescriptions are reduced by 30% as a preventative measure.

Beyond the market opportunity, the system has the potential to save thousands of lives – the benefits from which cannot be fathomed from a personal, familial, and societal standpoint. The Opioid SafetyNet product is currently pending FDA approval.

Okay, so we’ve seen how Masimo’s products are dramatically improving patient outcomes. How are they reducing systemwide costs?

First and foremost, the high accuracy of Masimo’s non-invasive sensors relieve doctors and nurses from having to extract blood via syringe, often while the patient is in motion, to get patient data. These invasive procedures raise the risk of infection and potential liability to the doctors, nurses, and the hospital. It’s also a win for the patient, of course, who doesn’t get stuck with more needles than necessary.

Second, Masimo’s sensors and monitors greatly reduce the number of false alarms and are more accurate with true alarms. False alarms are a waste of time for the medical professionals who rush into the room (at the expense of other patients) and do unnecessary procedures, which increase the cost of care.

Finally, by streamlining patient monitoring in all hospital settings, Masimo’s products help hospitals run more efficiently. Decluttering operating rooms, shortening patient time in ICU beds, and accelerating surgery times benefits everyone involved. Again, a win-win-win for medical professionals, the hospital, and the patient.

Medical devices have long been an attractive segment of the market – steady demand, long product cycles, high returns on invested capital, and so on. Indeed, since 2009, the iShares U.S. Medical Device ETF (IHI) has significantly outperformed the S&P 500 ETF (SPY).

Despite medical equipment being an attractive industry as a whole, we think most of the industry fails to achieve both of our investment criteria – improve patient outcomes and reduce system costs. Masimo does both and does it in a unique way – by starting with first principles when developing a product and relentlessly innovating in pursuit of a higher standard. We think the innovative culture at Masimo will lead to unpredictable value creation – new products and services we can’t currently measure.

In short, we believe Masimo is doing well by doing good. Naturally, they’re profit-motivated like any business, but we also think the company has a rare intrinsic motivation to save lives and solve big problems. Kiani sets the tone for Masimo’s culture. During our visit to headquarters, we noted that there was a “founder’s pedigree” among the employees we met – someone who, like Kiani, is dedicated to saving lives, creating step-change products, and out-innovating stodgy competition.

And that, in itself – beyond the switching cost and intangible asset-based moat sources – could be Masimo’s most important moat source.

All images come from Masimo’s website and investor presentations, unless otherwise noted.

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