“The best way for an investor to avoid popular delusions is to focus not on outlook but on value.”
- John Templeton
At Nintai Investments, we look for high-quality investments that we can hold for the long term and let value accumulate over time. A key component in maintaining quality in the portfolio is finding companies with excellent management with a long history of outstanding capital allocation. Warren Buffett's famous adage is that he always invests in companies an idiot could run because one day, one will. We agree with this. We also try to avoid such situations before said idiots rise to the top.
But even with the best planning, an investor can occasionally find themselves in a situation where a high-quality company’s management suddenly runs itself (and the company) right off the rails. In most cases, these are utterly unforced errors, with either the Board making a poor decision in hiring managers or senior executives falling prey to empire building and other poor capital allocation decisions. At Nintai Investments, perhaps nothing aggravates us more than when management suddenly alters course with a genuinely bone-headed decision that puts our entire investment thesis and valuation at risk.
Masimo: “A Brilliant Little Cash Machine”
In 2021, Nintai Investments initiated a position in Masimo (MASI), a medical device company specializing in measuring blood oxygenation levels. The company sells oximeters (the device the nurse clips on the end of your finger to measure your oxygen saturation rates), along with monitors and other technologies that support these measurement tools. Masimo first came to our attention in early 2010, and we first purchased shares in the former Nintai Partners Charitable Trust in May 2010.
When we issued our initial investment case, we summarized the company in the following manner:
“Masimo is a gem of a business. Positioned to take advantage of increasingly personalized healthcare and the move from the fee-for-service model, we see the company growing free cash flow by 12-14% annually over the next decade. The company has a clean balance sheet, high returns on assets, equity, and capital, and no debt. The management team has traditionally focused on organic growth funded by free cash flow.”
This is a company we look to hold for decades, if not forever. The company has an extremely deep moat with hundreds of patents protecting its core technology and market acceptance as the clear leader in its field. We greatly admired a management team conservative in its capital allocation seeking small bolt-on acquisitions and a focus on high capital return organic growth. We were pleased to own a company that kept a laser-like focus on its capital returns while dominating its niche market.
Sound United: “A Genius Move or Pure Madness”
Our investment thesis in Masimo was dramatically altered when the company announced in February 2022 that they were acquiring Sound United, a leader in consumer audio products. I will briefly go into our thoughts on the acquisition, but the markets were not pleased with the announcement. The stock dropped from $229/share on the day before the announcement to $144/share on the day of the announcement. Our thoughts were much the same. Our initial assessment of the deal centered on several core issues.
- It was tough to see how United Sound would play a role in the future growth of Masimo’s oximetry technology. Sound United states, “(The company) was founded in 2012 with a simple mission - to bring joy to the world through sound”. How bringing joy through sound was a fit with medical technology seemed quite a stretch.
- The company’s deal to buy Sound United for $1.03B means the company had to leverage the balance sheet. At the time of the announcement, the company had about $745M in cash, no debt, and generated roughly $230M in free cash flow. The company utilized approximately $500M of its cash and is expected to finance the remaining $500M with long-term debt.
- Sound United’s consumer audio business has nothing like the characteristics of Masimo’s oximetry business. It generates a far lower return on capital, return on assets, and far smaller gross and net margins. We estimate it has no moat. Our business valuation - taking into the SU acquisition and its effect on the company’s financials, margins, return on capital, etc. - has dropped by roughly 25%, reduced from $200/share in January 2022 to $155/share in June 2022.
A Very Poor Explanation
In general, we think management owes its shareholders a clear explanation when a transformative deal is announced. This includes what the acquisition brings to a company’s strategy and operations, how its products and services will add value, the estimated value generation of the deal in both the short- and long-term, and thoroughly explains the impact on the company’s financials. This is why we present each of our investment partners with a detailed investment case and valuation spreadsheet for every new holding that goes into our portfolios. We think Masimo’s management has done a terrible job explaining this deal to their shareholders. As an example, I include part of the latest quarterly earnings call. In it, analysts were eager to understand the Sound United deal better. I’ve included a small segment from the call where Mike Matson from Needham & Company asks Joe Kiani, CEO, about how the company expects Sound United’s and Masimo’s technology to compete with other competitors, in particular, Apple’s “Apple Watch”.
Mike Matson (Needham & Company)
“Yes, thanks for taking my question. I guess where I can start, with the consumer strategy and the smartwatch. Maybe you could talk about what you think it is about your smartwatch either the W1 or this upcoming brand watch, it's really going to kind of help differentiate you in the market versus some of the bigger companies out there like Apple or Samsung.”
Joe Kiani (Chief Executive Officer)
“Well, during this limited marketed release phase, I'll tell you what our customers are telling us. They have never had a product that allows them to do the things they've been wanting to do. So, for example, the continuous and accurate information on oxygen saturation and pulse rate. It's not been there. And whether it's used for sending patients home from hospitals, patients that are at risk that what that needs to be monitored remotely, or even athletes that use some of that information for better training, and better preparing for competition, they're telling us, it is different. It's unique. And it's compelling. And in addition, we have some unique new parameters that have never been released in a commercial watch before, for both healthcare and consumer wellness, which we're hoping to release with the launch of W1. And then as far as FREEDOM, I want to just tell you the things I said before are no more because of the competitive nature of this business. But we believe we have a compelling design, we believe with the addition of the Android features, and some unique features that, again, have never been made available before. We think we have a great product. So we think we have a product that should command 100% market share, which is what you want to have, what you want, for your team to feel. So the question is, do we have now the right distribution channel and the right salesforce, to hopefully make the most out of it? And time will tell, but we've never been better prepared. And we, I can tell you, the whole united Masimo team is excited. We're all grateful for the efforts that they have put into date. But we're going to have much work ahead of us. And I think it's revitalizing our team.”
This interaction gives me little confidence in the future integration of Sound United’s technology or how the acquisition will work with Masimo’s current product lines. I hear a lot of “it’s unique” and “it’s compelling,” but absolutely no clarity on why consumer audio will play an integral role in the future of oximetry technology. Mr. Kiani’s answer (and others on the call) provides no clear explanation as to how it impacts Masimo’s long-term strategy, how it will add to the company’s intrinsic value, nor was there any explanation of the impact on the company’s financials.
Where Do We Go From Here?
Management has outlined a path forward in which United Sound’s audio technology is integrated into Masimo’s consumer home-based products, such as their new watch and monitors. In addition, the company expects to utilize Sound United’s extensive retail direct-to-consumer sales and distribution channel. Masimo’s senior executives insist the future of personalized medicine (in their oximeter market) will be an integration of more traditional consumer-based electronics (such as Sound United’s audio products) integrated into traditionally hospital-based healthcare technology (such as Masimo’s oximeter monitors). Will this come true? It’s far too early to tell, but the company has done a pretty poor job laying out that future and its associated strategy to investors.
Masimo has a long history of improving its core oximetry technology and product lines. It has been extremely conservative with its balance sheet and produced excellent returns on capital. Over the past twenty years, management has earned my respect as savvy business leaders capable of outstanding capital allocation and a strong understanding of their core markets. Because of that, we will continue to hold our shares in our portfolios. That said, our confidence in Joe Kiani and his team has been shaken, and the leeway we give Masimo has certainly lessened.
Disclosure: I own Masimo in both Nintai Investment’s client portfolios as well as my own personal portfolio.
 I’ve often discussed how Nintai’s investment criteria limit us to roughly 150 -175 companies in the US and European markets. Many companies trading in the public markets don’t have the financial strength to meet our investment needs. It is rare to find a company with no debt, high returns on equity/capital, high free cash flow margins, a competitive moat, and trade at a reasonable discount to our estimated intrinsic value. These are the objective standards needed to meet our watch list requirements.