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The following segment was excerpted from this fund letter.
Masimo Corporation (NASDAQ:MASI)
We made a new investment in Masimo Corporation, a provider of high-end vital sign monitoring equipment and software. This is a special situation investment, as it is in the process of unwinding an unpopular consumer products acquisition, which we believe will unlock the value of the core health care business.
Masimo is a market leader in monitoring pulse rates, oxygen levels and perfusion, blood hemoglobin content and other key signs on a continuous basis. Studies have shown that Masimo’s higher-quality monitoring can save lives (and money) via higher accuracy and better warning capabilities. The base health care business produces revenues of about $1.3 billion (2024 company guidance), of which about 15% consists of non-recurring sensor hardware sales (what Masimo calls sockets) that are the razor in the business model analogy.
The remaining 85% of revenues come from disposable sensors that are the blades in the business model analogy. They produce recurring (and growing) revenue. Masimo can grow its health care revenues by introducing new products (including monitor networking and warning software), gaining new U.S. and international customers, and getting customers to buy more parameters (additional vital signs) for the existing sockets they have installed.
Currently, the company averages about $8 per socket in sensor revenues, but that has the potential to go to $100 per socket over time. While we don’t believe we will see a 12-fold increase in revenues, we do believe that revenues could double over the next seven years. At the same time margins should expand due to gross margin improvements with the completion of a new Malaysian manufacturing facility and operating leverage because its sales force is largely built out and it has a comfortable research and development budget. So, overall base business cash flow could double as well in six to seven years.
This is all overshadowed by Masimo’s $1 billion acquisition of Sound United in early 2022. Sound United designs and manufacturers high-end stereo equipment under brands like Marantz and Denon. Masimo is launching a smartwatch designed for higher-end vital sign monitoring (for health and consumer markets) than products like Apple and Android’s watches and bought the company for its sales and distribution assets.
But the acquisition added debt and the market viewed it as a distraction, far afield from its health care roots. Shares dropped nearly 70% by October 2023. We got involved after an activist started to push for the separation of the businesses. At the end of the first quarter, Masimo announced that it was exploring modalities to split the consumer and health care businesses, including a spin-off or JV structure. We think this is a great idea that will unlock value in the currently under-appreciated health care business.
In addition, Masimo is likely to retain a good portion the potential proceeds of a lawsuit against Apple alleging patent infringement related to vital signs on the Apple watch. While this could be worth hundreds of millions or more in ultimate value, we view it as just additional value optionality on the investment. All in, we believe we can double our investment from current valuation levels from Masimo’s cash flow growth and higher trading multiple that we believe will be justified for the cleaner health care structure that the company should achieve this year.
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