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MASIMO CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) 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 program; 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 28, 2013, which we filed with the SEC on February 14, 2014. 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. We provide our products directly and through distributors and OEM partners to hospitals, emergency medical service (EMS) providers, physician offices, veterinarians, long-term care facilities and consumers. Our mission is to improve patient outcomes and reduce the cost of care by taking noninvasive monitoring to new sites and applications. 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 monitoring, known as Masimo Signal Extraction Technology® (SET®) pulse oximetry. Pulse oximetry enables the noninvasive measurement of the oxygen saturation level of arterial blood, which delivers oxygen to the body's tissues. Pulse oximetry also enables the measurement of pulse rate, which when measured by an electrocardiography (ECG) is called heart rate. Pulse oximetry is one of the most common measurements taken in and out of hospitals around the world. Most pulse oximeter technologies work well when patients are well perfused and not moving. However, when either or both of these conditions occur, conventional pulse oximeters frequently do not provide any measurements, or provide inaccurate measurements. We invented Masimo SET®, which, for the first time, allows pulse oximeters to provide accurate measurements even during patient motion and low- perfusion conditions. The performance of Masimo SET® pulse oximetry is proven by more than 100 independent and objective studies and thousands of clinical evaluations. We believe that Masimo SET® is trusted by clinicians to safely monitor approximately 100 million patients each year and is used hospital-wide by eight of the top ten hospitals on the U.S. News & World Report Best Hospitals Honor Roll (2013-2014). Compared to other pulse oximeters during patient motion and low-perfusion, Masimo SET® provides measurements when other pulse oximeters cannot, dramatically reduces false alarms (specificity), and accurately detects true alarms (sensitivity) that can indicate a deteriorating patient condition. Masimo SET® pulse oximetry has also been shown to improve patient outcomes by helping clinicians reduce retinopathy of prematurity (ROP) in neonates, screen newborns for critical congenital heart disease (CCHD), reduce ventilator weaning time and arterial blood gas measurements in the intensive care unit (ICU), and save lives and costs while reducing rapid response activations and ICU transfers on the general floor. After introducing Masimo SET®, we have continued to innovate by introducing breakthrough noninvasive measurements that go beyond arterial blood oxygen saturation and pulse rate, and which create new market opportunities in both the hospital and non-hospital care settings. Our product offerings have expanded significantly over the years to also include noninvasive blood constituent, breath and brain-monitoring, including rainbow® Pulse CO-Oximetry, rainbow® Acoustic Monitoring, capnography and anesthetic agent monitoring, and SedLine® brain function electroencephalogram (EEG) monitoring. In addition, we have developed the Root® patient monitoring and connectivity platform and Patient SafetyNet™ remote patient surveillance monitoring system. 25-------------------------------------------------------------------------------- Table of Contents Our rainbow® Pulse CO-Oximetry utilizes both Masimo SET® and licensed rainbow® technology. We believe rainbow® Pulse CO-Oximetry includes the first devices cleared by the U.S. Food and Drug Administration (FDA) to noninvasively and continuously monitor multiple blood-based measurements using multiple wavelengths of light, which previously was only possible through intermittent invasive procedures. SpCO® provides noninvasive and continuous measurement of carboxyhemoglobin, or carbon monoxide levels in the blood. Carbon monoxide is the most common cause of poisoning in the world. When used with other clinical variables, SpCO® may help clinicians and emergency responders detect carbon monoxide poisoning and help determine treatment and additional test options. SpMet® provides noninvasive and continuous measurement of methemoglobin levels in the blood. Elevated methemoglobin in the blood leads to a dangerous condition known as methemoglobinemia, which occurs as a reaction to some common drugs used in hospitals and outpatient procedures. When used with other clinical variables, SpMet® may help clinicians detect methemoglobinemia and help determine treatment and additional test options. SpHb® provides noninvasive and continuous measurement of total hemoglobin. Hemoglobin is the oxygen-carrying component of red blood cells (RBC) and, along with oxygen saturation, determines the oxygen content of blood. Hemoglobin measurement is one of the most frequent invasive laboratory measurements in the world and is often measured as part of a complete blood count (CBC), which measures multiple other blood components. A low hemoglobin status is called anemia, which is generally caused by bleeding or the inability of the body to produce RBCs. SpHb® is available as a continuous monitor or a spot check measurement. Continuous SpHb® monitoring provides real-time visibility into the changes, or lack of changes, in hemoglobin, which can otherwise only be measured through intermittent, invasive blood testing. SpHb® has been shown to help clinicians reduce the number of RBC transfusions and, in multiple cases, has demonstrated its lifesaving ability in helping clinicians detect internal bleeding. Spot check SpHb® measurement, when used with other clinical variables, may help clinicians assess whether a patient's hemoglobin is lower or higher than may otherwise be assessed without any hemoglobin measurement which, in turn, may help determine additional test options. Available in both Masimo SET® and rainbow® SET® sensors, Pleth Variability Index (PVI®) provides for the noninvasive and continuous measurement of fluid responsiveness in patients whose breathing is controlled through mechanical ventilation, such as in the operating room or ICU. Fluid administration is critical to optimizing fluid status in surgery and critical care, but traditional invasive methods to guide fluid administration often fail to help clinicians assess fluid responsiveness. Newer methods are complicated and costly and considered appropriate only for the highest-risk patients. When used with other clinical variables, PVI® may help clinicians assess fluid responsiveness and determine treatment options. Our sound-based monitoring technology called rainbow Acoustic Monitoring™ (RAM™) enables noninvasive monitoring of respiration rate (RRa®). Respiration rate is the number of breaths per minute. A low respiration rate is indicative of respiratory depression and a high respiration rate is indicative of patient distress. Traditional methods used to measure respiration rate are often considered inaccurate, such as impedance pneumography, or are not well tolerated by certain patients, such as capnography. When used with other clinical variables, RRa® may help clinicians assess respiratory status and determine treatment options. RAM™ technology is available from the same circuit board as Masimo SET® and rainbow® Pulse CO-Oximetry measurements, which together we refer to as the rainbow® SET® technology platform. Our SedLine® brain function monitoring product measures the brain's electrical activity and provides information about a patient's response to anesthesia. SedLine® may help clinicians assess depth of anesthesia to optimize anesthesia and avoid over- or under-titration of anesthetics. Although not currently available for sale in the U.S., we received the CE Mark for respiration rate from the plethysmograph waveform (RRp™) in 2011. RRp™ enables monitoring of breathing status from a standard Masimo SET® pulse oximetry or rainbow® Pulse CO-Oximeter® sensor. The RRp™ measurement is determined by the variations in the plethysmograph waveform due to respiration, although the measurement is not possible in all patients or many conditions and may not immediately indicate changes in respiration rate. For patients requiring accurate and sensitive respiration rate monitoring, we believe that our RRa® measurement is better at detecting pauses in breathing than RRp™. The RRa® measurement also provides an important visual indication of breathing through the displayed acoustic waveform. Patient SafetyNet™ provides a patient surveillance or remote monitoring and clinician notification solution which includes Masimo SET® or rainbow® SET platform measurements at the patient's bedside along with a central assignment station and wired or wireless server. Patient SafetyNet™ wirelessly notifies clinicians caring for multiple patients in different rooms when one of their patients has an alarm, allowing them to become aware of changing conditions and intervene sooner, at times with life-saving support. Masimo SET®, along with Patient SafetyNet™, is proven to help clinicians avoid deaths while preventing ICU transfers, rapid response activations and preventable deaths on the medical/surgical floors of the hospital. Today, the majority of medical/surgical floors in the hospital are not continuously monitored. Halo Index™ can be used with our Patient SafetyNet™ to allow continuous global trending and assessment of multiple physiological measurements of a patient with a single number displayed on the Patient SafetyNet™ screen. Halo Index™ is CE marked, but not currently available for sale in the U.S. 26-------------------------------------------------------------------------------- Table of Contents Our universal "Board-in-Cable" pulse oximetry solution (uSpO2™) enables easier and faster integration of our products for OEM partners due to the ability to integrate Masimo SET® through software only. SpfO2™, a new parameter not currently available for sale in the U.S., has received the CE mark and allows for the noninvasive measurement of fractional arterial oxygen saturation. Previously, pulse oximeters could only measure and display functional oxygen saturation (SpO2), so when patients had elevated carboxyhemoglobin and/or elevated methemoglobin, the displayed functional oxygen saturation overestimated the actual oxygen saturation value. SpfO2™ allows more precise arterial oxygenation assessment in patients with elevated dyshemoglobins, common throughout the hospital and pre-hospital setting, compared to functional oxygen saturation. Our portfolio of capnography and gas monitoring products range from OEM solutions for external "plug-in-and-measure" analyzers and integrated modules to handheld devices. With multiple measurements delivered through either sidestream (ISA, AX+, OR+) or mainstream (IRMA) options, our customers can benefit from end tidal CO2, (EtCO2,), N2O, O2 and anesthetic agent monitoring in many hospital and pre-hospital environments, such as the operating room (OR), procedural sedation, ICU and EMS scenarios. In addition, our EMMA™ Capnograph with waveform display offers clinicians greater assessment of EtCO2 and respiration rate, as well as assists in recognition of return to spontaneous circulation, for a variety of clinical settings, including emergency medicine and transport, ORs, ICUs, patient rooms and clinics. EMMA™ fits in the palm of the hand, and we believe it is the smallest and most portable capnograph in the world. iSpO2® uses Masimo SET® technology for Measure-Through-Motion and Low-Perfusion performance to deliver measurements through a pulse oximeter cable and sensor with technology to an iPhone, iPad or iPod touch. The first version of iSpO2® allows consumers to use their iPhone, iPad or iPod touch to check their own arterial blood SpO2, pulse rate and perfusion index measurements. In the U.S., iSpO2® is available online for sports and aviation use only, and is not intended for medical use. In October 2013, iSpO2® was released in Japan for the iPhone, iPad and iPod touch. In December 2013, we received the CE mark on iSpO2® for the Android operating system, enabling functionality on select Android-based phones outside of the U.S. The iSpO2® Rx, the professional version for medical use, also received the CE mark in December 2013. The iSpO2® Rx product is not yet available in the U.S. but is available outside of the U.S. In June 2014, we announced FDA clearance for our Root® platform with capnography, wireless communication and Iris™ connectivity for third-party medical devices. Root® is a powerful new patient monitoring and connectivity platform that integrates our breakthrough rainbow® and SET® measurements with multiple additional parameters being made available through Masimo Open Connect™ (MOC-9™) in an integrated, clinician-centric platform. The first two MOC-9™ technologies for Root® were SedLine® brain function monitoring and Masimo capnography. Our third MOC-9™ technology for Root®, O3™ regional oximetry, provides for continuous and simultaneous measurement of tissue oxygen saturation (rSO2) and SpO2 to help detect regional hypoxemia that pulse oximetry alone can miss. O3™ regional oximetry has received the CE mark but is not currently available for sale in the U.S. Iris™ connectivity in Root® enables third-party devices such as intravenous pumps and ventilators to connect through Root® enabling display, notification and documentation to the electronic medical record through Masimo Patient SafetyNet™. In combination with a Radical-7® handheld device using rainbow® Pulse CO-Oximetry and rainbow® Acoustic Monitoring™, Root® will help clinicians instantly interpret a quickly changing display of multiple measurements, helping to simplify patient care workflows and empower caregivers to help make quicker patient assessments, earlier interventions and better clinical decisions throughout the continuum of care. In July 2014, we announced CE Mark clearance and limited market release of Radius-7™ for the Root® patient monitoring and connectivity platform, the first and only wearable, wireless monitor with our rainbow® SET® technology, enabling early identification of clinical deterioration while offering patients continuous monitoring with freedom of movement. With rainbow® SET® noninvasive measurements, Radius-7™ with Root® can alert clinicians at the bedside or remotely, through the Masimo Patient SafetyNet™ remote monitoring and notification system. Radius-7™ is not currently available for sale in the U.S. In August 2014, we announced CE Mark clearance in Japan, and limited market release of the rainbow® DCI-mini™, the first noninvasive hemoglobin (SpHb®) spot-check sensor for infants and small children (weight 3 to 30 kg). Paired with our handheld Pronto® device, the rainbow® DCI-mini™ sensors are designed to help clinicians quickly and easily spot-check hemoglobin levels in infants and small children, which may facilitate the identification of anemia. The rainbow® DCI-mini™ is not currently available for sale in the U.S. or Europe. We announced our new MX-5 OEM circuit board, a technology platform that utilizes approximately half the power of previously available rainbow® circuit boards to deliver breakthrough rainbow® Pulse CO-Oximetry noninvasive measurement performance, in September 2014. In addition to the lower power demands compared to previous rainbow® technology boards, the MX-5 adds dynamic power utilization to scale the MX-5's power draw based upon the combination of parameters being monitored to permit even longer battery runtimes. Our MX-5 OEM circuit boards offer full functionality of breakthrough rainbow® technology for noninvasive measurements of total hemoglobin (SpHb®), oxygen content (SpOC™), carboxyhemoglobin (SpCO®), methemoglobin (SpMet®) and acoustic respiration rate (RRa®), in addition to providing Measure- 27-------------------------------------------------------------------------------- Table of Contents Through-Motion and Low-Perfusion oxygen saturation (SpO2), pulse rate and perfusion index (PI) measurement capabilities of Masimo SET® pulse oximetry. Our pulse oximetry technology is generally contained on a circuit board which is placed inside a standalone pulse oximetry monitor, placed inside OEM multiparameter monitors or included as part of an external "Board-in-Cable" solution which is plugged into a port on an OEM or other device. All of these solutions use our proprietary single-patient use and reusable sensors and cables. We sell our products to end-users through our direct sales force and certain distributors, as well as our OEM partners, for incorporation into their products. In 2013, we also began selling our pulse oximetry products in the consumer market. As of September 27, 2014, we estimate that the worldwide installed base of our pulse oximeters and OEM monitors that incorporate Masimo SET® and rainbow® SET was approximately 1,289,000 units, excluding handheld devices. Our installed base is the primary driver for the recurring sales of our pulse oximeter and Pulse CO-Oximeter sensors, most notably single-patient adhesive sensors. Based on industry reports, we estimate that the worldwide pulse oximetry market is nearly $1.5 billion in 2014, the largest component being sensors. Our strategy is to utilize the accuracy and broad clinical benefits of our technologies to: (1) be the leading choice for pulse oximetry in traditionally monitored areas, in and out of the hospital; (2) expand the use of pulse oximetry beyond the critical care settings, including to the general floor of the hospital; (3) create demand for the use of breakthrough rainbow® measurements by our hospital customers; (4) offer rainbow® measurements to new markets such as EMS and physician offices; (5) penetrate existing noninvasive specialty monitoring markets such as capnography, gas, brain function, and other modalities with technologies that offer clinical and financial advantages; and (6) leverage the revolutionary Root® platform to provide open access to third-party developers for additional measurements, as well as connectivity to electronic health record systems and for third-party devices. Our solutions and related products are based upon our proprietary Masimo SET® and rainbow® algorithms. This software-based technology is incorporated into a variety of product platforms depending on our customers' specifications. 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 exclusively licensed from Cercacor Laboratories, Inc. (Cercacor) the right to OEM selected rainbow® technology and to incorporate selected rainbow® technology into our products intended to be used by professional caregivers, including, but not limited to, hospital caregivers and alternate care facility caregivers. Cercacor Laboratories, Inc. (Cercacor) Cercacor is an independent entity spun off from us to our stockholders in 1998. Joe Kiani and Jack Lasersohn, members of our board of directors, are also members of the board of directors of Cercacor. Joe Kiani, our Chairman and Chief Executive Officer, is also the Chairman and Chief Executive Officer 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. Under the Cross-Licensing Agreement, we granted Cercacor 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 monitoring 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 Cercacor Market. We also granted Cercacor a non-exclusive, perpetual and worldwide license, with sublicense rights, to use all Masimo SET® for the measurement of vital signs in the Cercacor Market. We exclusively license from Cercacor the right to make and distribute products in the professional medical caregiver markets, which we refer to as the Masimo Market, that utilize rainbow® technology for certain non-invasive measurements, including carbon monoxide, methemoglobin, fractional arterial oxygen saturation and hemoglobin. We also have the option to obtain the exclusive license to make and distribute products that utilize rainbow® technology for the monitoring 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. To date, we have developed and commercially released devices that measure carbon monoxide, methemoglobin and hemoglobin using licensed rainbow® technology. Additionally, we make and distribute products that monitor respiration rate via rainbow Acoustic Monitoring ™, which is not required to be licensed from Cercacor. In February 2009, in order to accelerate the product development of our hemoglobin spot-check measurement device, we agreed to fund additional engineering expenses of Cercacor. Specifically, these expenses included third-party engineering materials and supplies expense, as well as 60% of Cercacor's total engineering and engineering-related payroll expenses during 28-------------------------------------------------------------------------------- Table of Contents the three and nine months ended September 27, 2014 and September 28, 2013. For additional discussion of Cercacor, see Note 3 to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q and Part I, Item 1. "Business-Cercacor Laboratories, Inc." in our Annual Report on Form 10-K for the fiscal year ended December 28, 2013, filed with the SEC on February 14, 2014. For the foreseeable future, we anticipate that we will continue to consolidate Cercacor pursuant to the current authoritative accounting guidance; however, in the event that Cercacor is no longer considered a variable interest entity (VIE) under such accounting guidance, we may discontinue consolidating the entity. Stock Repurchase Program In February 2013, our board of directors authorized us to repurchase up to 6.0 million shares of our common stock under a repurchase program. The stock repurchase program may be carried out at the discretion of a committee comprised of our Chief Executive Officer and Chief Financial Officer through open market purchases, one or more Rule 10b5-1 trading plans, block trades and in privately negotiated transactions. We have paid for prior repurchases of stock with available cash and cash equivalents as well as borrowings under our revolving credit agreement. During the three months ended September 27, 2014, approximately 2.4 million shares were repurchased at an average cost of $21.95 per share, for a total repurchase price of $52.7 million. During the nine months ended September 27, 2014, approximately 4.4 million shares were repurchased, at an average cost of $23.01 per share, for a total repurchase price of $101.9 million. Of this amount, approximately $3.2 million was settled after September 27, 2014 and is recorded as an accrued liability as of September 27, 2014. As of September 27, 2014, approximately 0.6 million shares remained authorized for repurchase under the program. On October 23, 2014, our board of directors authorized us to repurchase up to an additional 3.0 million shares under this stock repurchase program bringing the total number of shares that remain authorized for repurchase as of such date to 3.6 million shares. Medical Device Excise Tax In March 2010, the U.S. Congress adopted and President Obama signed into law comprehensive health care reform legislation. Among other initiatives, these laws imposed taxes on medical device makers in the form of a 2.3% excise tax on U.S. medical device sales that took effect on January 1, 2013. During the three and nine months ended September 27, 2014, our medical device excise tax expense was $1.8 million and $5.0 million, respectively, which was recorded within our selling, general and administrative expenses. 29-------------------------------------------------------------------------------- Table of Contents 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): Three Months Ended Nine Months Ended September 27, % of September 28, % of September 27, % of September 28, % of 2014 Revenue 2013 Revenue 2014 Revenue 2013 Revenue Revenue: Product $ 137,142 95.2 % $ 124,522 94.7 % $ 402,868 94.8 % $ 382,725 94.5 % Royalty 6,976 4.8 6,925 5.3 21,988 5.2 22,086 5.5 Total revenue 144,118 100.0 131,447 100.0 424,856 100.0 404,811 100.0 Cost of goods sold 47,894 33.2 43,968 33.4 143,236 33.7 136,519 33.7 Gross profit 96,224 66.8 87,479 66.6 281,620 66.3 268,292 66.3 Operating expenses: Selling, general and administrative 62,064 43.1 53,090 40.4 179,533 42.3 159,536 39.4 Research and development 14,213 9.9 13,646 10.4 41,552 9.8 41,692 10.3 Litigation award and defense costs (2,321 ) (1.7 ) - - (10,331 ) (2.5 ) - - Total operating expenses 73,956 51.3 66,736 50.8 210,754 49.6 201,228 49.7 Operating income 22,268 15.5 20,743 15.8 70,866 16.7 67,064 16.6 Non-operating expense (566 ) (0.4 ) (676 ) (0.5 ) (43 ) - (3,240 ) (0.8 ) Income before provision for income taxes 21,702 15.1 20,067 15.3 70,823 16.7 63,824 15.8 Provision for income taxes 5,568 3.9 4,581 3.5 18,246 4.3 17,288 4.3 Net income including noncontrolling interest 16,134 11.2 15,486 11.8 52,577 12.4 46,536 11.5 Net (income) loss attributable to the noncontrolling interest (1,271 ) (0.9 ) 116 0.1 (1,280 ) (0.3 ) 2,532 0.6 Net income attributable to Masimo Corporation stockholders $ 14,863 10.3 % $ 15,602 11.9 % $ 51,297 12.1 % $ 49,068 12.1 % Comparison of the Three Months ended September 27, 2014 to the Three Months ended September 28, 2013 Revenue. Total revenue increased $12.7 million, or 9.6%, to $144.1 million for the three months ended September 27, 2014 from $131.4 million for the three months ended September 28, 2013. Product revenues increased $12.6 million, or 10.1%, to $137.1 million for the three months ended September 27, 2014 from $124.5 million for the three months ended September 28, 2013. This increase was primarily due to higher consumable product sales resulting from an increase in our installed base of circuit boards and pulse oximeters which we estimate totaled 1,289,000 units at September 27, 2014, up from 1,180,000 units at September 28, 2013. Total rainbow® product revenue increased $1.1 million, or 9.6%, to $13.2 million for the three months ended September 27, 2014, compared to $12.0 million for the three months ended September 28, 2013. Revenue generated through our direct and distribution sales channels increased $9.7 million, or 9.1%, to $116.1 million for the three months ended September 27, 2014, compared to $106.4 million for the three months ended September 28, 2013. During the three months ended September 27, 2014, revenues from our OEM channel rose by $2.9 million, or 15.9%, to $21.0 million from $18.1 million for the three months ended September 28, 2013. Our royalty revenue increased to $7.0 million for the three months ended September 27, 2014 from $6.9 million for the three months ended September 28, 2013. Cost of goods sold. 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 $3.9 million for the three months ended September 27, 2014 compared to the three months ended September 28, 2013 due to increased revenue. Our total gross margin increased to 66.8% for the three months ended September 27, 2014 from 66.6% for the three months ended September 28, 30-------------------------------------------------------------------------------- Table of Contents 2013. Excluding royalties, product gross margin increased to 65.1% for the three months ended September 27, 2014 from 64.7% for the three months ended September 28, 2013. This net increase in product margin was primarily due to the benefits from our continued product cost reduction efforts. We incurred $0.9 million and $1.3 million in Cercacor royalty expenses for the three months ended September 27, 2014 and September 28, 2013, respectively, which have been eliminated in our condensed consolidated financial statements for the periods presented. Had these royalty expenses not been eliminated, our reported product gross profit margin would have been 64.4% for the three months ended September 27, 2014 and 63.7% for the three months ended September 28, 2013. 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 increased $9.0 million, or 16.9%, for the three months ended September 27, 2014 compared to the three months ended September 28, 2013. This increase was primarily attributable to higher legal expenses of approximately $3.5 million, increased headcount costs of approximately $3.4 million and higher marketing-related expense of approximately $0.9 million. Approximately $2.2 million of share-based compensation expense was included in selling, general and administrative expenses for each of the three months ended September 27, 2014 and September 28, 2013. Also included in total selling, general and administrative expenses were $0.7 million and $0.6 million of expenses incurred by Cercacor for the three months ended September 27, 2014 and September 28, 2013, respectively. 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 increased slightly by $0.6 million, or 4.2%, for the three months ended September 27, 2014 compared to the three months ended September 28, 2013. This increase was primarily due to higher headcount related costs of approximately $0.9 million that were partially offset by lower engineering project related expenses. Included in research and development expenses for each of the three months ended September 27, 2014 and September 28, 2013 was approximately $0.3 million of share-based compensation expense. Also included in total research and development expenses were $0.8 million and $0.9 million of engineering expenses incurred by Cercacor for the three months ended September 27, 2014 and September 28, 2013, respectively. Litigation Award and Defense Costs. In July 2014, an arbitration panel issued a final award of $4.0 million to Cercacor, our VIE, in connection with the breach by a third party of a supply agreement, payment for which was received by Cercacor in August 2014. Cercacor recorded this award in the quarter ended September 27, 2014 as a reduction to operating expenses, net of approximately $1.6 million in related legal costs. We did not record any similar litigation award during the three months ended September 28, 2013. Non-operating expense. Non-operating expense consists primarily of interest income, interest expense and foreign exchange losses. Non-operating expense was $0.6 million for the three months ended September 27, 2014 as compared to non-operating expense of $0.7 million for the three months ended September 28, 2013. This net change of $0.1 million was primarily due to fluctuations in the amounts of net realized and unrealized gains and losses on foreign currency denominated transactions during the three months ended September 27, 2014 as compared to the three months ended September 28, 2013. Net realized and unrealized losses on foreign currency denominated transactions recognized during the three months ended September 27, 2014 were $0.5 million and resulted primarily from losses due to the strengthening of the U.S. Dollar against the Euro, Japanese Yen and British Pound Sterling, which were partially offset by gains due to the strengthening of the U.S. Dollar against the Swedish Krona. Net realized and unrealized losses on foreign currency denominated transactions recognized during the three months ended September 28, 2013 were $0.7 million and resulted primarily from losses due to the weakening of the U.S. Dollar against the Swedish Krona, which were partially offset by gains due to the weakening of the U.S. Dollar against the Euro. Provision for Income Taxes. Our provision for income taxes was $5.6 million, or an effective tax rate of 25.7%, for the three months ended September 27, 2014, compared to $4.6 million, or an effective tax rate of 22.8%, for the three months ended September 28, 2013. The significantly lower tax rate for the three months ended September 28, 2013 was primarily due to a discrete tax benefit recorded in such quarter related to the settlement of a prior tax audit. Our future effective income tax rate will depend on various factors, including changes in tax laws, changes in deferred tax asset valuation allowances, the recognition and derecognition of tax benefits associated with uncertain tax positions and the geographic composition of our pre-tax income. 31-------------------------------------------------------------------------------- Table of Contents Comparison of the Nine Months ended September 27, 2014 to the Nine Months ended September 28, 2013 Revenue. Total revenue increased $20.0 million, or 5.0%, to $424.9 million for the nine months ended September 27, 2014 from $404.8 million for the nine months ended September 28, 2013. Product revenues increased $20.1 million, or 5.3%, to $402.9 million for the nine months ended September 27, 2014 from $382.7 million for the nine months ended September 28, 2013. This increase was primarily attributable to higher consumable product sales of resulting from an increase in our installed base of circuit boards and pulse oximeters which we estimate totaled 1,289,000 units at September 27, 2014, up from 1,180,000 units at September 28, 2013. Total rainbow® product revenue increased $3.6 million, or 10.5%, to $37.6 million for the nine months ended September 27, 2014, compared to $34.1 million for the nine months ended September 28, 2013. Revenue generated through our direct and distribution sales channels increased $18.1 million, or 5.6%, to $340.5 million for the nine months ended September 27, 2014, compared to $322.5 million for the nine months ended September 28, 2013. During the nine months ended September 27, 2014, revenues from our OEM channel increased slightly by $2.1 million, or 3.4%, to $62.3 million from $60.3 million for the nine months ended September 28, 2013. Our royalty revenue decreased slightly to $22.0 million for the nine months ended September 27, 2014, from $22.1 million for the nine months ended September 28, 2013. Cost of Goods Sold. Cost of goods sold increased $6.7 million to $143.2 million for the nine months ended September 27, 2014 from $136.5 million for the nine months ended September 28, 2013 due to increased revenue. Our total gross margin approximated 66.3% for each of the nine months ended September 27, 2014 and September 28, 2013. Excluding royalties, product gross margin increased slightly to 64.4% for the nine months ended September 27, 2014 compared to 64.3% for the nine months ended September 28, 2013. We incurred $4.0 million in Cercacor royalty expenses for the nine months ended September 27, 2014 and $3.8 million for the nine months ended September 28, 2013, both of which have been eliminated in our condensed consolidated financial statements for the periods presented. Had these royalty expenses not been eliminated, our reported product gross profit margin would have been 63.4% for each of the nine months ended September 27, 2014 and September 28, 2013. Selling, General and Administrative. Selling, general and administrative expenses increased $20.0 million, or 12.5%, for the nine months ended September 27, 2014 compared to the nine months ended September 28, 2013. This increase was primarily attributable to higher legal expenses of approximately $9.0 million, approximately $4.6 million of additional costs associated with headcount growth, a one-time charitable donation to the Masimo Foundation for Ethics, Innovation and Competition in Healthcare of approximately $2.5 million and approximately $1.7 million of higher advertising and marketing-related costs. Approximately $6.3 million and $7.2 million of share-based compensation expense was included in selling, general and administrative expenses for the nine months ended September 27, 2014 and September 28, 2013, respectively. Also included in selling, general and administrative expenses were $2.4 million and $1.9 million of direct expenses incurred by Cercacor for the nine months ended September 27, 2014 and September 28, 2013, respectively. Research and Development. Research and development expenses were relatively flat at $41.6 million for the nine months ended September 27, 2014 compared to $41.7 million for the nine months ended September 28, 2013. Included in research and development expenses for the nine months ended September 27, 2014 and September 28, 2013 was approximately $1.1 million and $1.5 million, respectively, of share-based compensation expense. Also included in research and development expenses were $2.6 million and $2.9 million of engineering expenses incurred by Cercacor for the nine months ended September 27, 2014 and September 28, 2013, respectively. Litigation Award and Defense Costs. In July 2014, an arbitration panel issued a final award of $4.0 million to Cercacor, our VIE, in connection with the breach by a third party of a supply agreement, payment for which was received by Cercacor in August 2014. Cercacor recorded this award in the quarter ended September 27, 2014 as a reduction to operating expenses, net of approximately $1.6 million in related legal costs. We did not record any similar litigation award during the nine months ended September 28, 2013. In January 2014, an arbitrator awarded two of our former physician office sales representatives approximately $5.4 million in damages related to employment-related claims regarding our noninvasive hemoglobin monitoring products. As a result of this award, we took a charge of $8.0 million in the fiscal quarter ended December 28, 2013, which included $5.4 million in damages and $2.6 million in defense-related costs. We challenged the award in the U.S. District Court for the Central District of California, and on April 3, 2014, the District Court vacated the award. Accordingly, we reversed the previous $8.0 million charge in the first quarter of fiscal year 2014. We are unable to predict the final outcome of this matter; however, a reversal of the District Court's ruling could have a material adverse effect on our results of operations in the future. See Note 12 to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q. 32-------------------------------------------------------------------------------- Table of Contents Non-operating expense. Non-operating expense was less than $0.1 million for the nine months ended September 27, 2014 compared to $3.2 million for the nine months ended September 28, 2013. This net change of $3.2 million was primarily due to fluctuations in the amounts of net realized and unrealized gains and losses on foreign currency denominated transactions during the nine months ended September 27, 2014 compared to the nine months ended September 28, 2013. Net realized and unrealized gains on foreign currency denominated transactions recognized during the nine months ended September 27, 2014 were $0.1 million and resulted primarily from the strengthening of the U.S. Dollar against the Swedish Krona offset by losses due to the strengthening of the U.S. Dollar against the Euro, Japanese Yen and British Pound Sterling. Net realized and unrealized losses on foreign currency denominated transactions recognized during the nine months ended September 28, 2013 were $3.3 million and resulted primarily from losses due to the strengthening of the U.S. Dollar against the Japanese Yen and the weakening of the U.S. Dollar against the Swedish Krona. Provision for Income Taxes. Our provision for income taxes was $18.2 million, or an effective rate of 25.8%, for the nine months ended September 27, 2014, compared to $17.3 million, or an effective rate of 27.1%, for the nine months ended September 28, 2013. The higher tax rate for the nine months ended September 28, 2013 was primarily due to a $2.0 million charge related to the establishment of a valuation allowance against the deferred tax assets of Cercacor, which was partially offset by discrete benefits related to the settlement of a prior tax audit and for the retroactive reinstatement of the federal research tax credit back to fiscal 2012. Also contributing to the lower rate for the nine months ended September 27, 2014 was a change in the expected geographic mix of our fiscal year 2014 pre-tax income, which was partially offset by an increase in rate due to the expiration of the federal research tax credit at the end of 2013. Liquidity and Capital Resources Our principal sources of liquidity consist of our existing cash and cash equivalent balances, funds expected to be generated from operations, and funds available under our revolving credit agreement. At September 27, 2014, we had approximately $59.4 million in working capital and approximately $119.0 million in cash and cash equivalents as compared to approximately $168.0 million in working capital and approximately $95.5 million in cash and cash equivalents at December 28, 2013. We currently do not maintain an investment portfolio but have the ability to invest in various security holdings, types and maturities that meet credit quality standards in accordance with our investment guidelines. As of September 27, 2014, we had cash totaling $70.1 million held outside of the U.S. of which approximately $23.8 million was accessible without additional tax cost and approximately $46.4 million was accessible at an incremental estimated tax cost of approximately $13.9 million. In managing our day-to-day liquidity and capital structure, we do not rely on foreign earnings as a source of funds. We currently have sufficient funds on-hand and available under our line of credit to fund our domestic operations and do not anticipate the need to repatriate funds associated with our permanently reinvested foreign earnings. In the event funds that are treated as permanently reinvested are repatriated, we may be required to accrue and pay additional U.S. taxes with respect to any such repatriation. On September 29, 2014, we executed Amendment No. 1 to Credit Agreement (Amendment 1) with JPMorgan Chase Bank, N.A., as Administrative Agent and a Lender (JPMorgan), and Bank of America, N.A., as a Lender (BofA). Amendment 1 modifies our existing credit agreement dated April 23, 2014 with JPMorgan (the Credit Agreement and collectively with Amendment 1, the Amended Credit Agreement). The Amended Credit Agreement increases our current borrowing capacity by $125.0 million, bringing the total available borrowing capacity to $250.0 million, with an option, subject to certain conditions, to increase the aggregate borrowing capacity up to $350.0 million in the future. All unpaid principal under the Amended Credit Agreement will become due and payable on September 29, 2019. See Note 9 to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for additional information. During the three months ended September 27, 2014, we received $7.6 million from Covidien for royalties related to their U.S. sales pursuant to the terms of our amended settlement agreement. Based on the terms of such agreement, as of September 27, 2014, Covidien has the right to stop paying us royalties, subject to certain notice requirements. See "Covidien may seek to avoid paying any royalties to us, which would significantly reduce our royalty revenue and total revenues and adversely affect our business, financial condition and results of operations" under Part II, Item 1A - Risk Factors, in this Quarterly Report on Form 10-Q. 33-------------------------------------------------------------------------------- Table of Contents Cash Flows The following table summarizes our cash flows (in thousands): Nine Months Ended September 27, September 28, 2014 2013 Net cash provided by (used in): Operating activities $ 66,823 $ 48,210 Investing activities (69,626 ) (9,896 ) Financing activities 28,651 (18,915 ) Effect of foreign currency exchange rates on cash (2,326 ) 764 Increase in cash and cash equivalents $ 23,522 $ 20,163 Operating Activities. Cash provided by operating activities was $66.8 million in the nine months ended September 27, 2014 arising primarily from net income of $52.6 million, non-cash activity for depreciation and amortization of $9.5 million, share-based compensation of $7.8 million, and a provision for deferred taxes of $2.9 million. In addition, accrued liabilities and accrued compensation increased by $5.4 million and $1.2 million, respectively, all due to the timing of payments; and accounts receivable decreased by $3.2 million due to the timing of collections. These sources of cash were primarily offset by an increase in inventory of $6.3 million, an increase in deferred cost of goods sold of $3.6 million related to shipments of equipment to customers, an increase in other assets of $3.4 million primarily resulting from an increase in receivables for expected insurance recoveries, an increase in prepaid expenses of $1.9 million related to prepayments for insurance premiums and a decrease in accounts payable of $1.6 million due to the timing of payments. Cash provided by operating activities was $48.2 million in the nine months ended September 28, 2013 primarily from net income including noncontrolling interest of $46.5 million and non-cash activity for share-based compensation and depreciation and amortization of $9.0 million and $8.5 million, respectively. In addition, accounts payable increased by $11.1 million due to the timing of payments and accrued compensation increased by $3.5 million due to an increase in headcount. These sources of cash were offset by an increase in inventories of $12.1 million to meet the anticipated future demand for our products, an increase in prepaid income taxes of $6.4 million due to the prepayment of income taxes and an increase in deferred cost of goods sold of $9.1 million due to continued shipments of equipment to customers pursuant to long-term sensor contracts. Investing Activities. Cash used in investing activities for the nine months ended September 27, 2014 was $69.6 million, consisting primarily of $66.8 million for purchases of property and equipment, including $57.8 million related to the purchase of our new corporate headquarters, and $2.8 million of intangible assets related to capitalized patent and trademark costs. Cash used in investing activities for the nine months ended September 28, 2013 was $9.9 million, consisting of $6.9 million for purchases of property and equipment to support our manufacturing operations and $3.0 million for the increase in intangible assets related to capitalized patent and trademark costs. Financing Activities. Cash provided by financing activities for the nine months ended September 27, 2014 was $28.7 million, primarily resulting from borrowings under our Credit Agreement totaling $125.0 million offset by common stock repurchase transactions totaling $98.7 million. Cash used in financing activities for the nine months ended September 28, 2013 was $18.9 million, primarily due to repurchases of common stock totaling $19.8 million. Capital Resources and Prospective Capital Requirements As of September 27, 2014, we had an outstanding balance of $125.0 million under our Credit Agreement, and with the execution of Amendment 1 on September 29, 2014, had additional available capacity of $125.0 million under the Amended Credit Agreement. We also had an outstanding balance of $0.2 million resulting from capital leases related to office and computer equipment. We had no other debt obligations and are in compliance with all bank covenants. In February 2013, our board of directors authorized the repurchase of up to 6.0 million shares of our common stock under a repurchase program. During the three months ended September 27, 2014, approximately 2.4 million shares were repurchased at an average cost of $21.95 per share. During the nine months ended September 27, 2014, approximately 4.4 million shares were repurchased at an average cost of $23.01 per share. As of September 27, 2014, approximately 0.6 million shares remained authorized for repurchase under the current program. On October 23, 2014, our board of directors authorized us to repurchase up to an additional 3.0 million shares under this stock repurchase program bringing the total number of shares that remain authorized for repurchase as of such date to 3.6 million shares. 34-------------------------------------------------------------------------------- Table of Contents In the future, in addition to funding our working capital requirements, we anticipate our primary use of cash to be the equipment that we provide to hospitals under our long-term sensor purchase agreements. We also anticipate additional capital purchases related to renovating our new corporate headquarters as well as expanding our worldwide operations, including manufacturing, sales, marketing and other areas of necessary infrastructure growth. Possible additional uses of cash may include the acquisition of technologies or technology companies and/or additional stock repurchases. The amount and timing of our actual investing activities will vary significantly depending on numerous factors, including the timing of the acquisition, reconstruction and other costs related to our new corporate headquarters facility, product development efforts, our timetable for international sales operations and manufacturing expansion and both domestic and international regulatory requirements. Despite these investment requirements, we anticipate that our existing cash and cash equivalents and amounts available under the Credit Agreement 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 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 September 27, 2014, 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 and deferred revenue, inventory and related reserves for excess or obsolete inventory, allowance for doubtful accounts, share-based compensation, 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. For a description of our 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 28, 2013 filed with the SEC on February 14, 2014. There have been no material changes to any of our critical accounting policies during the nine months ended September 27, 2014. Recent Accounting Pronouncements See Note 2 to the condensed consolidated financial statements included in 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 investment portfolio and on the increase or decrease in the amount of interest expense we must pay with respect to our various outstanding debt instruments. Our risk associated with fluctuations in interest expense is limited to interest associated with our outstanding capital lease arrangements, which have fixed interest rates, and any borrowings under our Credit Agreement and any amendments thereto. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. We ensure the safety and preservation of our invested principal funds 35-------------------------------------------------------------------------------- Table of Contents by limiting default risk, market risk and reinvestment risk. We reduce default risk by investing in investment grade securities. A hypothetical 100 basis point change in interest rates along the entire interest rate yield curve would not significantly affect the fair value of our interest-sensitive financial instruments at September 27, 2014. Declines in interest rates over time will, however, reduce our interest income and expense while increases in interest rates will increase our interest income and expense. 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 average exchange rates 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 average 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 intercompany transactions. Realized and unrealized foreign currency gains or losses on these transactions are included in our statements of comprehensive income as incurred. Furthermore, 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 included in our statements of comprehensive income as incurred, and are converted to U.S. Dollars at the average exchange rates for a respective period. 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 the average monthly exchange rate 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. Our primary foreign currency exchange rate exposures are with the Euro, Japanese Yen, Swedish Krona, Canadian Dollar, British Pound Sterling and Australian Dollar, all relative to the U.S. Dollar. Foreign currency exchange rates have experienced significant movements recently and may continue to do so in the future. 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 a 10% change 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). 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's) regulations, rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the 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 Chief Executive Officer and Chief Financial Officer, 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 Chief Executive Officer and Chief Financial Officer 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. 36-------------------------------------------------------------------------------- Table of Contents There has been no change in our internal control over financial reporting during the quarter ended September 27, 2014 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. 37-------------------------------------------------------------------------------- Table of Contents |