How activist Politan Capital may find an opportunity to trim costs, build value at Masimo

Business: Masimo is a global medical technology company that develops, manufactures and markets a variety of noninvasive monitoring technologies and hospital automation solutions. Their core business is measure-through-motion and low perfusion pulse oximetry. They sell highly technical pulse oximeter devices to hospitals and operate in a duopoly with 60% market share. Nellcor controls the other 40% market share.

Stock Market Value: about $8.2B ($155.72 per share)

Percentage Ownership: 8.4%

Average Cost: $143.73

Activist Commentary: Politan Capital Management was founded by Quentin Koffey. Most recently, Koffey led the activism strategy at Senator Investment Group. Prior to that, he led the activist practice at D.E. Shaw and before that he was at Elliott Management. Koffey is operating Politan more like a private equity fund than a traditional long-short equity hedge fund, as it can draw down locked up capital to give it enough time to accomplish its goals through active engagement with boards and management teams to improve governance, operations or strategic direction. Politan looks for (i) high quality businesses that underperform their peers or potential, (ii) where there is a clear fix and (iii) a clear pathway to implement that fix.

Masimo has a solid core pulse oximetry business for hospitals. This is a high technology business that uses decades of studies to convince hospitals that their devices get more accurate readings and healthier outcomes. As a result, it is a very sticky business with high barriers to entry. This is a razor/razor blade business model with the devices using single-use sensors pursuant to five-year contracts resulting in 80% recurring revenue for Masimo. While Covid temporarily helped them in 2020, by the end of 2021 the bump had subsided. They now have secular tailwinds in a trend to use devices like pulse oximeters instead of nurses as the nursing population is declining. Further, more demand for pulse oximeters in hospitals is anticipated as they open up for more elective surgeries after Covid.

Masimo was founded in 1989 by chairman and CEO Joe Kiani (who owns 8.5% of the company’s stock). He built a solid business and kept a small circle with a five-person board. However, Masimo has become a public company run like private company by a visionary founder. This worked fine for a while as he successfully built the pulse oximetry business, but now the milk is starting to spoil as Kiani pursues pet/science projects. While some of these projects like hospital automation businesses and brain function monitoring could be reasonable extensions of their core business, it has become obvious that the company needs a more objective board to oversee the discipline of R&D spending.

For example, after meeting with Masimo about integrating its technology into the Apple Watch, Apple began hiring Masimo employees, including its chief medical officer. In the fall of 2020, Apple introduced the Series 6 watch, which can measure arterial oxygen saturation. Masimo sued Apple for allegedly stealing trade secrets and using Masimo’s inventions, which isn’t unreasonable. But, now Masimo has launched its own W1 watch to compete with Apple. This feels more personal than fiduciary.

Moreover, on Feb. 15, it was announced that the company entered into an agreement to acquire Sound United LLC, a consumer speaker business, for $1 billion. At eight times EBITDA, reasonable minds can differ whether they overpaid for this acquisition or not by a couple of hundred million dollars, but news of the acquisition sent the stock into a nosedive from $228 per share on Feb. 15 to $144 per share the following day. That is a loss of $4.6 billion in market cap for a $1 billion acquisition. Clearly, the market was concerned with the lack of strategic discipline at a company being run by its founder.

This is a story as old as activism itself – a founder/CEO making a great product and using the cash flow to fund pet projects. Kiani seems capable of running the core business, but he has an empire-building mentality that needs to be reined in by the board. With a refreshed board that institutes discipline, operating margins should be in excess of 40%, and the stock could double in three years’ time.

This is a company in desperate need of shareholder representation on the board. But don’t expect to see any public fight letters from Politan — that is not their style. They will work quietly and behind the scenes with the Masimo to try to get one or two seats on the board. With only five directors, Masimo could easily add two Politan directors and still have a very manageable board of seven.

As board members, Politan could be very helpful to both management and shareholders in pursuing strategic projects. They will listen to management with an open mind, and if they agree with a project their support would give management cover with other shareholders to pursue it. However, at the end of the day they are economic animals and will do what is best for shareholders — if management cannot justify a project, Politan will be there to protect shareholder value.

If Masimo does not settle, Politan would not be able to nominate directors until January and then could only nominate two directors to the staggered board. But that is OK with Politan – they are patient investors with money locked up for more than four years. They will even go through multiple years and multiple proxy fights if that is what is necessary. Quentin Koffey won five of 14 board seats at Centene, as well as three of nine board seats at CoreLogic when he was at Senator. He also had various activist campaigns at D.E. Shaw and Elliott. Moreover, there is some evidence of shareholder discontent at Masimo. At the 2022 annual meeting, incumbent directors Adam Mikkelson and Craig Reynolds received 20.3% and 30.3% votes against them, respectively. But maybe the biggest thing in Politan’s favor is that Joe Kiani is up for election in 2024. If the firm wins a proxy fight in 2023, it would be like the Sword of Damocles for him. Clearly, it would be better for everyone to resolve this amicably.

Ken Squire is the founder and president of 13D Monitor, an institutional research service on shareholder activism, and he is the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments. Squire is also the creator of the AESG™ investment category, an activist investment style focused on improving ESG practices of portfolio companies.