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TMCNet:  MASIMO CORP - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

[February 15, 2013]

MASIMO CORP - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) You should read this discussion together with the financial statements, related notes and other financial information included in this Form 10-K. The following discussion may contain predictions, estimates and other forward-looking statements that involve a number of risks and uncertainties, including those discussed under Item 1A-"Risk Factors" and elsewhere in this Form 10-K. These risks could cause our actual results to differ materially from any future performance suggested below.



Overview We are a global medical technology company that develops, manufactures, and markets noninvasive patient monitoring products. Our mission is to improve patient outcomes and reduce cost of care by taking noninvasive monitoring to new sites and applications. We invented Masimo SET® which provides the capabilities of Measure-Through Motion and Low Perfusion pulse oximetry to address the primary limitations of conventional pulse oximetry. Pulse oximetry is the noninvasive measurement of the oxygen saturation level of arterial blood, or the blood that delivers oxygen to the body's tissues, and pulse rate. Pulse oximetry is one of the most common measurements made in and out of hospitals around the world. Masimo SET® has been validated in over 100 independent clinical studies and is the only pulse oximetry technology we are aware of that has been proven to help clinicians detect critical congenital heart disease in newborns, reduce retinopathy of prematurity in neonates, and decrease intensive care unit transfers and rapid response activations on the general floor.

Our products consist of a monitor or circuit board, and a recently introduced "Board-in-Cable" solution, for use with 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, and also sell some of our products to our OEM partners, for incorporation into their products. As of December 29, 2012, we estimate that the worldwide installed base of our pulse oximeters and OEM monitors that incorporate Masimo SET® was 1,088,000 units, based on an estimated 10 year field life assumption. Our installed base is the primary driver for the recurring sales of our sensors, most notably, single-patient adhesive sensors. Based on industry reports, we estimate that the worldwide pulse oximetry market was over $1 billion in 2012, the largest component of which was the sale of sensors.

After introducing Masimo SET®, we have continued to innovate by introducing breakthrough noninvasive measurements beyond arterial blood oxygen saturation level and pulse rate, which create new market opportunities in both the hospital and non-hospital care settings. In 2005, we launched our Masimo rainbow® SET platform utilizing both Masimo SET® and licensed rainbow®technology, which we believe includes the first devices cleared by the FDA to noninvasively and continuously monitor multiple measurements that previously required invasive or complicated procedures. Also, in 2005, we launched noninvasive carboxyhemoglobin, or SpCO®, allowing measurement of carbon monoxide levels in the blood. Carbon monoxide is the most common cause of poisoning in the world.

In 2006, we launched noninvasive methemoglobin, or SpMet®, allowing for the measurement of methemoglobin levels in the blood. 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. In 2007, we launched Masimo PVI®. Fluid administration is critical to optimizing fluid status in surgery and critical care, but traditional invasive methods to guide fluid administration often fail to predict fluid responsiveness and newer methods are complicated and costly. In March 2008, we debuted noninvasive hemoglobin, or SpHb ®, and in March 2009, we began full market release of SpHb®.

Hemoglobin is the oxygen-carrying component of red blood cells, and is one of the most frequent invasive laboratory measurements in the world, often measured as part of a complete blood count. A low hemoglobin status is called anemia, which is generally caused by bleeding or the inability of the body to produce red blood cells. In June 2010, we began a full commercial release of continuous and noninvasive monitoring of respiration rate, or RRaTM, via rainbow Acoustic MonitoringTM. Respiration rate is the number of breaths per minute. A low respiration rate is indicative of respiratory depression and high respiration rate is indicative of patient distress. Traditional methods used to measure respiration rate are often considered inaccurate or are not tolerated well by patients. In October 2010, we debuted the Halo IndexTM, which 69-------------------------------------------------------------------------------- Table of Contents allows continuous global trending and assessment of multiple physiological measurements of a patient with a single number displayed on the Patient SafetyNetTM screen. Halo IndexTM is pending FDA 510(k) clearance.

In July 2010, we began selling the SEDLine® monitor, which measures the brain's electrical activity and provides information about a patient's response to anesthesia. In January 2012, we received FDA clearance for the Pronto-7®, a product designed specifically for spot-checking hemoglobin, along with oxygen saturation and pulse rate. In December 2012, we released iSpO2™, a pulse oximeter cable and sensor with Measure-Through Motion and Low Perfusion Masimo SET® technology for use with an iPhone, iPad or iPod touch. We also offer a remote monitoring and clinician notification solution called Patient SafetyNetTM, which includes our which includes our Masimo SET® or rainbow ® SET monitors at the patient's bedside along with a central assignment station and wired or wireless server. Patient SafetyNetTM wirelessly notifies clinicians who are taking care of multiple patients in different rooms when one of their patients has an alarm, allowing them to intervene sooner and provide potentially life-saving support.

We offer Masimo SET® and rainbow® SET through our OEMs and our own end-user products, including the Radical-7®, Rad-87 ®, Rad-57TM, Pronto®, Pronto-7®, Rad-8 ®, Rad-5®, and Rad-5vTM. 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. As of December 29, 2012, we had 630 issued and pending patents worldwide. We have exclusively licensed from our development partner, Cercacor, the right to OEM rainbow® technology and incorporate rainbow® technology into our products intended to be used by professional caregivers, including, but not limited to, hospital caregivers and alternate care facility caregivers.

Antitrust Litigation Proceeds During the year ended January 1, 2011, we completed negotiations to resolve the merits of our antitrust litigation with Covidien. As a result, we retained a total of $30.8 million from two payments from Covidien following the Ninth Circuit Court of Appeals' October 2009 affirmance of a Federal District Court decision that Tyco Healthcare, now Covidien, violated the antitrust laws through anticompetitive business practices related to the sale of its pulse oximetry products. The gross payment amount from Covidien was $59.0 million, but excluding reimbursement of legal fees, costs and interest, the net amount was $43.5 million. Of this amount, we retained $30.1 million and the remainder was paid to the law firm that handled the trial for us. Subsequently, we received a second payment of $1.3 million from Covidien that related to our appeal attorneys' fees and related expenses. Of this second amount, we retained $0.8 million, with the remainder paid to our attorneys.

Dividend Payments Our board of directors continuously evaluates a variety of options to return value to shareholders, including acquisition opportunities, stock buy-back programs and dividends. In 2012 and 2010, after considering all available options at those times, the Board concluded that the best and most direct way to reward shareholders for their continued investment and confidence in Masimo was through the declaration of cash dividends. In February 2010, the Board declared a special dividend of $2.00 per share, or $117.5 million, which was paid in March 2010. In November 2010, the Board declared a second special dividend of $0.75 per share, or $44.5 million, which was paid in December 2010. In October 2012, the Board declared another special dividend of $1.00 per share, or $57.3 million, which was paid out on December 11, 2012 to stockholders of record as of the close of business on November 27, 2012. Both the 2012 and 2010 special dividends represented only a portion of our cash reserves, which the Board believed was sufficient to cover our current operational needs, and to fund continued research and development investments and current strategic initiatives.

Stock Repurchase Program In August 2011, our board of directors authorized the repurchase of up to 3.0 million shares of common stock under a repurchase program, which terminated pursuant to its terms in April 2012. The stock repurchase program 70-------------------------------------------------------------------------------- Table of Contents was carried out at the discretion of a committee comprised of our Chief Executive Officer and Chief Financial Officer through open market purchases under a Rule 10b5-1 trading plan. We paid for these repurchases with available cash and cash equivalents. During the year ended December 31, 2011, 1.8 million shares were repurchased, at an average price of $19.61 per share, totaling $36.2 million. During the year ended December 29, 2012, 1.2 million shares were repurchased, at an average price of $22.74 per share, totaling $26.3 million, which completed the stock repurchase program.

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, or the Cross-Licensing Agreement, which was amended and restated effective January 1, 2007, that 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, which we refer to as the Cercacor Market, rather than a professional medical caregiver.

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, referred to as the Masimo Market, that utilize rainbow® technology for the measurement of carbon monoxide, methemoglobin, fractional arterial oxygen saturation and hemoglobin, which includes hematocrit. To date, we have developed and commercially released devices that measure carbon monoxide, methemoglobin and hemoglobin using licensed rainbow® technology. We also have the option to obtain exclusive licenses 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.

In February 2009, in order to accelerate the product development of an improved hemoglobin spot-check measurement device, Pronto-7®, we agreed to fund additional Cercacor's engineering expenses. Specifically, these expenses included third-party engineering materials and supplies expense, as well as 50% of total Cercacor's engineering and engineering related payroll expenses from April 2009 through June 2010, the original anticipated completion date of this product development effort. Since July 2010, Cercacor has continued to assist us with product development efforts and charged us accordingly. Beginning in 2012, due to a revised estimate of the support required by us to complete the various Pronto-7 ® related projects, our Board of Directors approved an increase in the percentage of Cercacor's total engineering and engineering related payroll expenses funded by us from 50% to 60%. During the year ended December 29, 2012, and until both parties agree to end these services, Cercacor has and will continue to assist us with continuing productization efforts of the new handheld noninvasive multi-parameter testing device, that provides spot-check hemoglobin testing. During the year ended December 29, 2012, the total expenses for these additional services, material and supplies totaled $3.6 million.

Pursuant to authoritative accounting guidance, Cercacor is consolidated within our financial statements for all periods presented. This determination is based on our ability to direct the activities that most significantly impact Cercacor's economic performance, and our obligation to absorb Cercacor's expected losses. 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, or VIE, or in the event that we are no longer the primary beneficiary of Cercacor, we may discontinue consolidating the entity. For additional discussion of Cercacor, see Note 3 to the consolidated financial statements.

71 -------------------------------------------------------------------------------- Table of Contents SEDLine, Inc.

SEDLine, Inc., or SEDLine, a privately held entity that was formed in the fourth quarter of 2009, is a company that designs, manufactures, markets and sells brain function monitoring technology into the hospital marketplace. During 2009, we made loans to SEDLine totaling $3.0 million. These loans carried an interest rate of 7% and could be converted into equity upon certain predetermined conditions. Concurrently with the loans, we entered into a merger agreement with SEDLine, whereby we could acquire SEDLine at certain predetermined valuations.

Pursuant to authoritative accounting guidance, it was determined that SEDLine was a VIE and that we were the primary beneficiary during 2009 and the first six months of 2010. As a result, beginning in December 2009, we were required to consolidate SEDLine's assets, liabilities and equity as a VIE. On July 2, 2010, upon conversion of our $3.0 million note receivable and the related accrued interest due from SEDLine into 100% of the authorized common stock of SEDLine, SEDLine became a wholly-owned subsidiary of ours. For additional discussion of SEDLine, see Note 3 to the consolidated financial statements.

Spire Semiconductor Acquisition On March 9, 2012, we acquired substantially all of the assets of Spire Semiconductor, LLC, or Spire, a maker of advanced light emitting diode and other advanced component-level technologies. Masimo Semiconductor, Inc., or Masimo Semiconductor, a recently formed, wholly-owned subsidiary of ours, will operate the business going forward. Under the acquisition agreement, we paid $7.2 million and assumed $1.2 million of Spire's liabilities. Simultaneous with this asset acquisition, we entered into a lease agreement with a related party to Spire Corporation, to lease manufacturing and office space through March 2017.

The acquisition gives us an advanced ability to develop custom components, accelerate development cycles, and optimize future product costs. Masimo Semiconductor will specialize in wafer epitaxy, foundry services, and device fabrication for biomedical, telecommunications, consumer products and other markets. For additional information, see Note 4 to the consolidated financial statements.

Phasein Acquisition On July 27, 2012, we acquired PHASEIN AB, or Phasein, a developer and manufacturer of ultra-compact mainstream and sidestream capnography and gas monitoring technologies. The acquisition of Phasein's technologies complements our breakthrough innovations for patient monitoring with a portfolio of products ranging from OEM solutions for external "plug-in-and-measure" capnography and gas analyzers and integrated modules to handheld capnometer devices. With multiple measurements delivered through either mainstream or sidestream options, our customers can benefit from CO2, N2O, O2, and anesthetic agent monitoring in many hospital environments, such as operating rooms, procedural sedation and intensive care units.

We paid $30.5 million for all outstanding shares of Phasein. The final purchase price allocation resulted in $16.1 million assigned to goodwill, $12.6 million assigned to intangible assets, $1.4 million assigned to inventory, $2.4 million assigned to various other assets and $2.0 million assigned to various liabilities. Phasein's assets acquired and liabilities assumed, as well as its results of operations since the acquisition date, are included in our consolidated financial statements as of December 29, 2012. We funded the acquisition entirely with existing cash and cash equivalents.

72-------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth, for the periods indicated, our results of operations expressed as dollar amounts and as a percentage of revenue.

Year ended Year ended Year ended December 29, 2012 December 31, 2011 January 1, 2011 % of % of % of Amount Revenue Amount Revenue Amount Revenue (in thousands, except percentages) Revenue: Product $ 464,928 94.3 % $ 406,487 92.6 % $ 356,422 87.9 % Royalty 28,305 5.7 32,501 7.4 48,985 12.1 Total revenue 493,233 100.0 438,988 100.0 405,407 100.0 Cost of goods sold 166,982 33.9 144,854 33.0 119,825 29.6 Gross profit 326,251 66.1 294,134 67.0 285,582 70.4 Operating expenses: Selling, general and administrative 193,948 39.3 169,205 38.5 174,089 42.9 Research and development 47,077 9.5 38,412 8.8 36,000 8.9 Antitrust litigation proceeds - - - - (30,728 ) (7.6 ) Total operating expenses 241,025 48.9 207,617 47.3 179,361 44.2 Operating income 85,226 17.3 86,517 19.7 106,221 26.2 Non-operating income (expense) (1,405 ) (0.3 ) 14 - 1,348 0.3 Income before provision for income taxes 83,821 17.0 86,531 19.7 107,569 26.5 Provision for income taxes 21,883 4.4 22,478 5.1 34,164 8.4 Net income including noncontrolling interests 61,938 12.6 64,053 14.6 73,405 18.1 Net (income) loss attributable to noncontrolling interests 334 0.1 (353 ) (0.1 ) 125 - Net income attributable to Masimo Corporation stockholders $ 62,272 12.6 % $ 63,700 14.5 % $ 73,530 18.1 % Comparison of the Year ended December 29, 2012 to the Year ended December 31, 2011 Revenue. Total revenue increased $54.2 million, or 12.4%, to $493.2 million for the year ended December 29, 2012 from $439.0 million for the year ended December 31, 2011. Product revenues increased $58.4 million, or 14.4%, to $464.9 million in the year ended December 29, 2012 from $406.5 million in the year ended December 31, 2011. This increase was primarily due to higher consumable sales resulting from an increase in our installed base of circuit boards and pulse oximeters which we estimate totaled 1,088,000 units at December 29, 2012, up from 979,000 units at December 31, 2011. Contributing to the increase in our product revenue was our rainbow®technology product revenues, which increased $6.2 million, or 18.2%, to $40.3 million in the year ended December 29, 2012 from $34.1 million in the year ended December 31, 2011. Product revenue of $464.9 million during the year ended December 29, 2012 included $4.4 million and $3.1 million from the recently acquired Phasein and Masimo Semiconductor businesses, respectively. Revenue generated through our direct and distribution sales channels increased $53.3 million, or 15.6%, to $396.2 million for the year ended December 29, 2012, compared to $342.9 million for the year ended December 31, 2011. During the year ended December 29, 2012, revenues from our OEM channel increased $5.1 million, or 8.0%, to $68.7 million from $63.6 million in the year ended December 31, 2011. Included in this increase was $3.6 million from the recently acquired Phasein business.

Our royalty revenue decreased $4.2 million to $28.3 million in the year ended December 29, 2012 from $32.5 million in the year ended December 31, 2011. This reduction in revenue was primarily due to a reduction in the royalty rate from 13.0% to 7.75% of Covidien's U.S. pulse oximetry sales, which became effective on 73 -------------------------------------------------------------------------------- Table of Contents March 15, 2011. This rate reduction was the result of a second amendment to the original settlement agreement with Covidien, which we entered into on January 28, 2011.

Cost of Goods Sold. Cost of goods sold increased $22.1 million to $167.0 million in the year ended December 29, 2012 from $144.9 million in the year ended December 31, 2011. Our total gross margin decreased to 66.1% for the year ended December 29, 2012 from 67.0% for the year ended December 31, 2011. Excluding royalties, product gross margin declined to 64.1% for the year ended December 29, 2012 from 64.4% for the year ended December 31, 2011. This decline in product margin was primarily due to the incremental costs associated with the roll out of a new sensor technology, called X-CalTM, and the impact of lower product margins associated with the recently acquired Masimo Semiconductor and Phasein businesses. These declines were partially offset by decreased amortization costs associated with equipment placed at hospitals, selected inventory charge-offs related to product redesign and transition activities in 2011 that did not reoccur in 2012, and manufacturing efficiency improvements in 2012. Excluding Masimo Semiconductor and Phasein, our product gross margin would have been 65.2% for the year ended December 29, 2012. We incurred $5.0 million in Cercacor royalty expenses for both the year ended December 29, 2012 and December 31, 2011, which have been eliminated in our consolidated financial results for the periods presented. Had these royalty expenses not been eliminated, our reported product gross profit margin would have been 63.0% and 63.1% for the year ended December 29, 2012 and December 31, 2011, respectively.

Selling, General and Administrative. Selling, general and administrative expenses increased $24.7 million, or 14.6%, to $193.9 million for the year ended December 29, 2012 from $169.2 million for the year ended December 31, 2011.

Excluding Masimo Semiconductor and Phasein, selling, general and administrative expenses would have increased $21.6 million to $190.8 million for the year ended December 29, 2012. This increase was primarily due to a $9.8 million increase in payroll and related costs associated with increased staffing levels. In addition, total trade show, advertising and training expenses increased by $7.4 million, primarily due to additional trade shows attended, including a worldwide trade show in Q1 2012, which is only held once every four years. Also, legal fees increased $2.0 million due to increased litigation activity. Included in total selling, general and administrative expenses are $2.5 million and $1.9 million of direct expenses incurred by Cercacor for the year ended December 29, 2012 and December 31, 2011, respectively.

Research and Development. Research and development expenses increased $8.7 million, or 22.6%, to $47.1 million for the year ended December 29, 2012 from $38.4 million for the year ended December 31, 2011. Excluding Masimo Semiconductor and Phasein, research and development expenses would have increased $8.0 million, or 20.7%, to $46.4 million for the year ended December 29, 2012. This increase was primarily due to increased payroll and payroll related costs of $4.1 million associated with increased research and development staffing levels due to investment in research and development efforts. In addition, new project costs and engineering supplies increased $2.2 million related to new product development projects and additional clinical trial costs. Included in total research and development expenses are $3.7 million and $3.4 million of engineering expenses incurred by Cercacor for the year ended December 29, 2012 and December 31, 2011, respectively.

Non-operating income (expense). Non-operating expense was $1.4 million for the year ended December 29, 2012, as compared to non-operating income of $14,000 for the year ended December 31, 2011. This net change of $1.4 million was primarily due to the recognition of net realized and unrealized losses on foreign currency denominated transactions during the year ended December 29, 2012 of $1.6 million, as compared to the recognition of net realized and unrealized losses on foreign currency denominated transactions of $0.1 million during the year ended December 31, 2011. The net realized and unrealized losses recognized during the year ended December 29, 2012 resulted primarily from the strengthening of the U.S. dollar against the Japanese Yen, partially offset by the weakening of the U.S. dollar against the Euro. The realized and unrealized net losses on foreign currency denominated transactions recognized during the year ended December 31, 2011 resulted primarily from losses due to the strengthening of the U.S. dollar against the Euro, the British pound, the Canadian dollar and the Australian dollar, offset by gains due to the weakening of the U.S. dollar against the Japanese Yen.

Provision for Income Taxes.Our provision for income taxes was $21.9 million for the year ended December 29, 2012 compared to $22.5 million for the year ended December 31, 2011. Our effective tax rate increased to 26.1% 74-------------------------------------------------------------------------------- Table of Contents for the year ended December 29, 2012, compared to 26.0% for the year ended December 31, 2011. This increase in the effective tax rate was due primarily to the suspension of the federal research tax credit and increase in non-deductible items, which was offset by an effective tax rate decrease due to the income tax benefit resulting from the conclusion of a prior year tax audit, and the derecognition of uncertain tax positions due to the expiration of the statute of limitations. The American Taxpayer Relief Act of 2012, or the Tax Act, extended the research tax credit retroactively to 2012 and prospectively through the end of 2013. The effects of the change in the tax law will be recognized in the first quarter of fiscal 2013, which is the quarter when the law was enacted. If the Tax Act had been enacted as of December 29, 2012, the research tax credit would have reduced our 2012 effective tax rate by 1.2%. Our future effective income tax rate will depend on various factors, including profits (losses) before taxes, changes to tax law, the recognition and derecognition of tax benefits associated with uncertain tax positions and the geographic composition of pre-tax income.

Comparison of the Year ended December 31, 2011 to the Year ended January 1, 2011 Revenue. Total revenue increased $33.6 million, or 8.3%, to $439.0 million for the year ended December 31, 2011 from $405.4 million for the year ended January 1, 2011.

Product revenue increased $50.1 million, or 14.0%, to $406.5 million for the year ended December 31, 2011 from $356.4 million in the year ended January 1, 2011. This increase was primarily due to an increase in our installed base of pulse oximeter circuit boards and pulse oximeters to 979,000 units at December 31, 2011, from 855,000 units at January 1, 2011, based on an estimated 10 year field life assumption. Product revenue generated by our direct and distribution sales channels increased $59.3 million, or 20.9%, to $342.9 million for the year ended December 31, 2011 from $283.6 million in the year ended January 1, 2011, while revenues from our OEM channel decreased $9.2 million, or 12.7%, to $63.6 million for the year ended December 31, 2011 from $72.8 million in the year ended January 1, 2011. Our U.S. product revenue increased $30.1 million, or 11.7%, to $287.1 million for the year ended December 31, 2011 from $257.0 million in the year ended January 1, 2011. Additionally, our non-U.S.

product revenue increased $19.9 million, or 20.0%, to $119.4 million for the year ended December 31, 2011 from $99.5 million in the year ended January 1, 2011. Rainbow ® technology product revenues were $34.1 million and $32.9 million for the years ending December 31, 2011 and January 1, 2011, respectively.

Our royalty revenue was $32.5 million for the year ended December 31, 2011 and $49.0 million for the year ended January 1, 2011. This reduction in revenue was primarily due to a reduction in the royalty rate from 13.0% to 7.75% of Covidien's U.S. pulse oximetry sales, which became effective on March 15, 2011.

This rate reduction was the result of a second amendment to the original settlement agreement with Covidien, which we entered into on January 28, 2011.

These amounts were based upon actual royalties received for the first nine months of each year, and an estimate of Covidien's U.S. pulse oximeter sales for the last three months of each year, at the contractual royalty rate as prescribed by the 2006 settlement agreement and second amendment to the settlement agreement.

Cost of Goods Sold. Cost of goods sold increased $25.1 million, or 20.9%, to $144.9 million for the year ended December 31, 2011 from $119.8 million for the year ended January 1, 2011. Our gross margin decreased to 67.0% for the year ended December 31, 2011 from 70.4% for the year ended January 1, 2011. Excluding royalties, product gross profit margins decreased by 2.0% to 64.4% for the year ended December 31, 2011 from 66.4% for the year ended January 1, 2011. This decrease was primarily due to increased amortization costs associated with increased equipment placed at hospitals and selected inventory charge-offs related to product redesign and transition activities. We incurred $5.0 million in Cercacor's royalty expenses for each of the years ended December 31, 2011 and January 1, 2011, respectively, which have been eliminated in our consolidated financial results for the periods presented. Had these royalty expenses not been eliminated, our reported product gross profit margin would have been 63.1% and 65.0% for the years ended December 31, 2011 and January 1, 2011, respectively.

Selling, General and Administrative. Selling, general and administrative expenses decreased $4.9 million, or 2.8%, to $169.2 million for the year ended December 31, 2011 from $174.1 million for the year ended January 1, 75-------------------------------------------------------------------------------- Table of Contents 2011, which included $14.7 million of one-time marketing related expenses related to the establishment of the Masimo Foundation and various one-time grants and marketing initiatives. Excluding the impact of these one-time expenses, total selling, general and administrative expenses increased $9.8 million, or 6.1%, to $169.2 million for the year ended December 31, 2011 compared to $159.4 million for the year ended January 1, 2011. This increase was primarily due to an increase in commission and payroll costs of $8.0 million, associated with higher product sales and increased staffing levels. Also, expenses related to legal fees increased by $2.2 million due to additional legal activity and travel related expenses increased by $1.3 million. These increases in expense were offset by a decrease of $1.3 million in sample related expenses.

Included in these total selling, general and administrative expenses are $1.9 million and $2.7 million of direct expenses incurred by our VIEs for the years ended December 31, 2011 and January 1, 2011, respectively.

Research and Development. Research and development expenses increased $2.4 million, or 6.7%, to $38.4 million for the year ended December 31, 2011 from $36.0 million for the year ended January 1, 2011. The increase was primarily due to increased payroll and payroll related costs of $0.9 million associated with increased staffing levels, as well as $0.6 million in increased engineering supplies related to new product development. Also, contributing to the increase was an increase in depreciation expense of $0.3 million due to additional capital equipment purchased to support the growth of our business. Included in these total research and development expenses are $3.4 million and $2.0 million of engineering expenses incurred by our VIEs for the years ended December 31, 2011 and January 1, 2011, respectively.

Antitrust litigation proceeds. Antitrust litigation proceeds were $0 for the year ended December 31, 2011 as compared to net proceeds of $30.7 million for the year ended January 1, 2011. The $30.7 million received in the year ended January 1, 2011, was the result of payments from Covidien relating to the antitrust litigation following the Ninth Circuit Court of Appeals' October 2009 affirmance of a Federal District Court decision that Tyco Healthcare, now Covidien, violated the antitrust laws through anticompetitive business practices related to the sale of its pulse oximetry products.

Non-operating income (expense). Non-operating income was $14,000 for the year ended December 31, 2011, as compared to $1.3 million for the year ended January 1, 2011. This decrease of $1.3 million was primarily due to realized and unrealized net losses on foreign currency denominated transactions of $0.1 million recognized during the year ended December 31, 2011 compared to net gains of $1.0 million recognized during the year ended January 1, 2011. The realized and unrealized net losses on foreign currency denominated transactions recognized during the year ended December 31, 2011 resulted primarily from losses due to the strengthening of the U.S. dollar against the Euro, the British pound, the Canadian dollar and the Australian dollar, offset by gains due to the weakening of the U.S. dollar against the Japanese yen. The realized and unrealized net gains on foreign currency denominated transactions recognized during the year ended January 1, 2011 resulted primarily from gains due to the weakening of the U.S. dollar against the Japanese yen, partially offset by the losses due to the strengthening of the U.S. dollar against the Euro.

Provision for Income Taxes. Our provision for income taxes was $22.5 million for the year ended December 31, 2011, compared to $34.2 million for the year ended January 1, 2011. Our effective tax rate decreased to 26.0% for the year ended December 31, 2011 from 31.8% for the year ended January 1, 2011. This decrease in tax provision and effective tax rate was due primarily to the effect of electing the California single sales factor method for state apportionment, the change in geographic composition of pre-tax income in jurisdictions in which we do business and the decrease in uncertain tax liabilities as a result of an expiring statute of limitations. Our future effective income tax rate will depend on various factors, including profits (losses) before taxes, changes to tax law, and the geographic composition of pre-tax income.

Liquidity and Capital Resources As of December 29, 2012, we had cash and cash equivalents of $71.6 million, of which $32.0 million was invested in U.S. Treasury bills, $1.6 million was in money market accounts with major financial institutions and $38.0 million was in checking accounts. These U.S. Treasury bills are classified as cash equivalents since they 76 -------------------------------------------------------------------------------- Table of Contents are highly liquid investments, with a maturity of three months or less at the date of purchase. We carry cash equivalents at cost which approximates fair value.

As of December 29, 2012, we have cash totaling $28.0 million held outside of the U.S. A substantial portion of this cash held offshore is accessible without a significant tax cost. In managing our day-to-day liquidity and our capital structure, we do not rely on foreign earnings as a source of funds. We currently have sufficient funds for 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 to repatriate these funds.

In 2012, 2011 and 2010, we received $28.3 million, $37.4 million and $48.5 million, respectively, in cash receipts from Covidien for royalties pursuant to our settlement agreement. Through March 14, 2011, we received a royalty payment based on a rate of 13% of Covidien's U.S. pulse oximetry sales. On January 28, 2011, we entered into a second amendment to the settlement agreement with Covidien. As part of this amendment, which became effective as of March 14, 2011, Covidien agreed to pay us a royalty of 7.75% for its U.S. pulse oximetry revenue, as specifically defined in that second amendment, generated at least through March 15, 2014.

In August 2011, our board of directors authorized the repurchase of up to 3.0 million shares of common stock under a repurchase program. During the year ended December 31, 2011, 1.8 million shares were repurchased, at an average price of $19.61 per share, totaling $36.2 million. During the year ended December 29, 2012, 1.2 million shares were repurchased, at an average price of $22.74 per share, totaling $26.3 million, which completed the stock repurchase program. We paid for these repurchases with available cash and cash equivalents.

In October 2012, our Board declared a special $1.00 per share cash dividend, payable in December 2012, which totaled $57.3 million.

Cash Flows from Operating Activities. Cash provided by operating activities was $75.4 million in 2012. The source of cash consists primarily of net income including noncontrolling interests of $61.9 million, and non-cash expense for share-based compensation and depreciation and amortization of $14.1 million and $9.4 million, respectively. In addition, accrued compensation increased $4.8 million primarily due to higher staffing levels. These sources of cash were partially offset by an increase in accounts receivable of $10.1 million due to growth of our business, and an increase in benefit from deferred income taxes of $6.8 million due to timing differences of taxable income.

Cash provided by operating activities was $79.0 million in 2011. The source of cash consists primarily of net income including noncontrolling interests of $64.1 million, resulting from continued growth of our business. Also, non-cash expense for share-based compensation and depreciation and amortization were $13.7 million and $7.3 million, respectively, in 2011. In addition, accounts payable increased $5.2 million due to continued growth of our business and inventory purchases in anticipation of future demand for our products, and royalties receivable decreased by $4.9 million due to the decline in the royalty rate from Covidien. These sources of cash were partially offset by an increase in accounts receivable of $7.5 million due to the growth of our business, and an increase in deferred cost of goods sold of $4.5 million due to shipments of equipment to customers pursuant to long-term sensor contracts.

Cash Flows from Investing Activities. Cash used in investing activities for 2012 was $51.9 million primarily due to payments totaling $37.4 million for the acquisitions of Phasein and the Spire Semiconductor assets, net of cash acquired and excess liabilities assumed. Additionally, $10.8 million was used for purchases of property and equipment to primarily support our manufacturing operations. Cash used in investing activities for 2011 was $7.5 million primarily consisting of $5.1 million of cash to purchase property and equipment to support our manufacturing operations.

Cash Flows from Financing Activities. Cash used in financing activities for 2012 was $82.1 million primarily due to $57.3 million of dividend payments and $26.3 million in common stock repurchases. Cash used in financing activities for 2011 was $30.2 million resulting from $36.2 million in common stock repurchases and partially offset by $5.9 million of proceeds from the issuance of common stock associated with the exercise of stock options.

77-------------------------------------------------------------------------------- Table of Contents Future Liquidity Needs. 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 anticipate additional capital purchases related to expanding our worldwide international operations including manufacturing, sales, marketing and other areas of necessary infrastructure growth. Our focus on international expansion will also require both continuing and incremental investments in facilities and infrastructure in the Americas, Europe and Asia. We also anticipate possible uses of cash for the acquisition of technologies or the acquisition of technology companies. The amount and timing of our actual investing activities will vary significantly depending on numerous factors, such as the progress of our product development efforts, our timetable for international sales operations and manufacturing expansion, both domestic and international regulatory requirements and opportunities to acquire technologies and technology companies at prices we believe are favorable.

In February 2013, our Board of Directors authorized the repurchase of up to 6 million shares of our common stock. This stock repurchase program may be carried out through open market purchases, block trades, one or more trading plans adopted in accordance with Rule 10b5-1 of the SEC, and in privately negotiated transactions. The repurchase program will become effective in February 2013 and is expected to continue for a period of up to 36 months unless it is terminated earlier by our Board of Directors. In the event that we repurchase shares of stock, these repurchases will be subject to the availability of stock, general market conditions, the trading price of the stock, available capital, alternative uses for capital and our financial performance. Additionally, we expect to fund any potential stock repurchases through our available cash, future cash from operations, or other potential sources of capital.

Despite these possible capital investment requirements and any potential stock repurchases or dividend payments, we anticipate that our existing cash and cash equivalents will be sufficient to meet our working capital requirements, capital expenditures and operations for at least the next 12 months.

Current Financing Arrangements. As of December 29, 2012, other than capital leases, we did not have any other long term borrowings. The capital lease amounts represent principal and interest due on leased office equipment.

Contractual Obligations. The following table summarizes our outstanding contractual obligations as of December 29, 2012 and the effect those obligations are expected to have on our cash liquidity and cash flow in future periods (in thousands): Payments Due By Period Less than 1-3 3-5 More than 1 year years years 5 years Total Operating Leases(1) $ 5,491 $ 6,498 $ 2,758 $ 20 $ 14,767 Capital Leases (including interest)(2) 59 49 15 - 123 Purchase Commitments(3) 48,885 - - - 48,885 Total Contractual Obligations $ 54,435 $ 6,547 $ 2,773 $ 20 $ 63,775 (1) Facility, equipment and automobile leases.

(2) Leased office equipment.

(3) Certain inventory items under non-cancellable purchase orders.

Other obligation: As of December 29, 2012, the liability for uncertain tax positions, including interest, was $7.4 million. Due to the high degree of uncertainty regarding the timing of potential cash flows associated with these liabilities, we are unable to make a reasonably reliable estimate of the amounts and periods in which these liabilities might be made.

78-------------------------------------------------------------------------------- Table of Contents In addition to these contractual obligations, we had the following annual minimum royalty commitments to Cercacor, as of December 29, 2012 (in thousands): Payments Due By Period Less than 1-3 3-5 More than 1 year years years 5 years Minimum royalty commitment to Cercacor $ 5,000 $ 10,000 $ 10,000 (1 ) (1) Subsequent to 2017, the royalty arrangement requires a $5.0 million minimum annual royalty payment unless the agreement is amended, restated or terminated.

Cercacor is consolidated within our financial statements for all periods presented. Accordingly, all intercompany royalties, option and license fees and other charges between us and Cercacor have been eliminated in the consolidation.

For additional discussion of Cercacor, see Note 3 to the consolidated financial statements.

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 had engaged in these relationships.

Critical Accounting Estimates Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenue and expenses for each reporting period. Management regularly evaluates its estimates and assumptions. These estimates and assumptions are based on historical experience and on various other factors that are believed to be reasonable under the circumstances, and form the basis for making management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.

Inventory/Reserves for Excess or Obsolete Inventory Inventories are stated at the lower of cost or market. Cost is determined using a standard cost method, which approximates FIFO (first-in, first-out). Inventory valuation reserves are recorded for materials that have become obsolete or are no longer used in current production and for inventory that has a market value less than the carrying value in inventory. We generally purchase raw materials in quantities that we anticipate will be fully used within one year. However, changes in operating strategy and customer demand, and frequent unpredictable fluctuations in market values for such materials can limit our ability to effectively utilize all of the raw materials purchased and sold through resulting finished goods to customers for a profit. We regularly monitor potential inventory excess, obsolescence and lower market values compared to standard costs and, when necessary, reduce the carrying amount of our inventory to its market value.

We develop our inventory reserve based on an evaluation of the expected future use of our inventory on an item by item basis. We apply historical obsolescence rates to estimate the loss on inventory expected to have a recovery value below cost. Our historical obsolescence rates are developed from our company specific experience for major categories of inventory, which are then applied to excess inventory on an item by item basis. We also develop other specific inventory reserves when we become aware of other unique events that result in a known recovery value below cost. For inventory items that have been written down, either due to the inventory reserve analysis or due to a specific event, the reduced value becomes the new cost basis. The new cost 79-------------------------------------------------------------------------------- Table of Contents basis of an inventory item is not marked up in subsequent periods. Our inventory reserve was $6.0 million and $5.4 million at December 29, 2012 and December 31, 2011, respectively. If our estimates for potential inventory losses prove to be too low, then our future earnings will be affected when the related additional inventory losses are recorded.

Allowance for Doubtful Accounts We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. This allowance is used to state trade receivables at a net estimated realizable value. We rely on prior experience to estimate the amount that we expect to collect on the gross receivables outstanding, which cannot be known with exact certainty as of the time of issuance of this report. We maintain a specific allowance for customer accounts that we know may not be collectible due to customer liquidity issues.

We also maintain a general allowance for future collection losses that arise from customer accounts that do not indicate an inability, but may be unable, to pay. Although such losses have historically been within our expectations and the allowances we have established, we cannot guarantee that we will continue to experience the same loss rates that we have in the past, especially given the recent deterioration of the credit markets of the worldwide economy. A significant change in the liquidity or financial condition of our customers could cause unfavorable trends in our receivable collections and additional allowances may be required. Our accounts receivable balance was $67.9 million and $57.0 million, net of allowances for doubtful accounts of $2.0 million and $1.8 million at December 29, 2012 and December 31, 2011, respectively.

Share-Based Compensation Effective January 1, 2006, we adopted an accounting standard for share-based compensation using the prospective method, which requires us to expense the estimated fair value of employee stock options and similar awards based on the fair value of the award on the date of grant. To calculate the fair value of stock options, we use the Black-Scholes option pricing model which requires the input of subjective assumptions. These assumptions include estimating the length of time employees will retain their stock options before exercising them, the estimated volatility of our stock price over the expected term and the number of options that will ultimately be forfeited prior to meeting their vesting requirements. Pursuant to the prospective transition method, stock options granted prior to January 1, 2006 continue to be accounted for under the prior existing guidance for stock issued to employees.

We estimate the length of time in which stock options are expected to be outstanding based on both our specific historical option exercise experience, as well as expected term information available from a peer group of companies with a similar vesting schedule. The estimated volatility is based on historical and implied volatilities of our share price and historical and implied volatilities of a peer group of companies over the expected term of the option. As we obtain more historical data as a publicly traded company, we expect to rely increasingly on our specific information for our estimate of volatility.

We are required to develop an estimate of the number of stock options that will be forfeited due to employee turnover. Adjustments in the estimated forfeiture rates can have a significant effect on our reported share-based compensation, as we recognize the cumulative effect of the rate adjustments for all expense amortization in the period the estimated forfeiture rates were adjusted. We estimate and adjust forfeiture rates based on a periodic review of recent forfeiture activity and expected future employee turnover. Adjustments in the estimated forfeiture rates could also cause changes in the amount of expense that we recognize in future periods.

Share-based compensation expense was $14.1 million, $13.7 million and $12.3 million for the years ended December 29, 2012, December 31, 2011 and January 1, 2011. The fair market value of our stock may also increase the cost of future stock option grants. To the extent that the fair market value of our stock increases, the overall cost of granting these options will also increase. For further details regarding our share-based compensation see Note 12 of our consolidated financial statements.

80-------------------------------------------------------------------------------- Table of Contents Revenue Recognition and Deferred Revenue We follow the current authoritative guidance for revenue recognition. Based on these requirements, we recognize revenue when: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or services have been rendered, (iii) the price is fixed or determinable, and (iv) collectability is reasonably assured. We enter into agreements to sell pulse oximetry and related products and services as well as multiple deliverable arrangements that include various combinations of products and services. While the majority of our sales transactions contain standard business terms and conditions, there are some transactions that contain non-standard business terms and conditions. As a result, contract interpretation is sometimes required to determine the appropriate accounting, including: (a) whether an arrangement exists, (b) how the arrangement consideration should be allocated among the deliverables if there are multiple deliverables, (c) when to recognize revenue on the deliverables, and (d) whether undelivered elements are essential to the functionality of the delivered elements. Changes in judgments on these assumptions and estimates could materially impact the timing of revenue recognition.

In September 2009, the Financial Accounting Standards Board, or FASB, amended the accounting standards related to revenue recognition for arrangements with multiple deliverables. The new standard changes the requirements for establishing separate units of accounting in a multiple element arrangement and requires the allocation of arrangement consideration to each deliverable to be based on relative selling prices. The FASB also amended the accounting standards for revenue recognition to exclude software that is contained in a tangible product from the scope of software revenue guidance if the software is essential to the tangible product's functionality. We adopted these new standards on a prospective basis. Therefore, the new standards apply only to revenue arrangements entered into or materially modified beginning January 2, 2011. For revenue arrangements that were entered into or materially modified after the adoption of these standards, implementation of this new authoritative guidance had no significant impact on our reported revenue during either the year ended December 31, 2011, as compared to revenue if the related arrangements entered into or materially modified after January 2, 2011 were subject to the accounting requirements in effect in the prior year.

The new standards establish a hierarchy to determine the selling price to be used for allocating revenue to deliverables as follows: (i) vendor-specific objective evidence of fair value, or VSOE, (ii) third-party evidence of selling price, or TPE, and (iii) best estimate of the selling price, or ESP. VSOE of fair value is defined as the price charged when the same element is sold separately. VSOE generally exists only when the deliverable is sold separately and is the price actually charged for that deliverable. TPE generally does not exist for the majority of our products because of their uniqueness. The objective of ESP is to determine the price at which we would transact a sale if the product was sold on a stand-alone basis. In the absence of VSOE and TPE, we determine ESP for our products by considering multiple factors including, but not limited to, features and functionality of the product, geographies, type of customer, contractual prices pursuant to GPO contracts, our pricing and discount practices and market conditions.

A deliverable in an arrangement qualifies as a separate unit of accounting if the delivered item has value to the customer on a stand-alone basis. Most of our products in a multiple deliverable arrangement qualify as separate units of accounting. In the case of our monitoring equipment products containing embedded Masimo SET ® software, we have determined that the hardware and software components function together to deliver the products' essential functionality, and therefore, represent a single deliverable. In accordance with the new guidance, the revenue from the sale of these products no longer falls within the scope of the software revenue recognition guidance. Software deliverables, such as rainbow® parameter software, which do not function together with hardware components to provide the products' essential functionality, continue to be accounted for under software revenue recognition guidance. Our multiple deliverable arrangements may therefore have software deliverables that are subject to the existing software revenue recognition guidance. The revenue for these multiple-element arrangements is allocated to the software deliverables and the non-software deliverables based on the relative selling prices of all of the deliverables in the arrangement using the hierarchy in the new revenue recognition accounting guidance for arrangements with multiple deliverables.

Our sales under long-term sensor purchase contracts are generally structured such that we agree to provide up-front and at no initial charge certain monitoring equipment, software, installation, training and ongoing warranty support in exchange for the hospital's agreement to purchase sensors over the term of the agreement, which 81 -------------------------------------------------------------------------------- Table of Contents ranges from three to six years. The sensors are essential to the functionality of the monitoring equipment and, therefore, represent a substantive performance obligation. We do not recognize any revenue when the monitoring and related equipment and software is delivered to the hospitals and installation and training is complete. We recognize revenue for these delivered elements, on a pro-rata basis, as the sensors are delivered under the long-term purchase commitment. The adoption of the new guidance for revenue recognition did not change this pattern of revenue recognition for long-term sensor purchase contracts. The cost of the monitoring equipment initially placed at the hospitals is deferred and amortized to cost of goods sold over the life of the underlying long-term sensor purchase contract.

To the extent that the allocation of revenue to multiple deliverables under long-term sensor agreements depends on our estimated selling prices, there is uncertainty over the percentage allocation to equipment, sensors and software. A change in the factors we use to estimate selling price, the weighting we assign to different factors, or a change in our pricing and discounting strategy could result in a different allocation to the deliverables in an arrangement. However, because we recognize revenue as sensors are delivered over the term of the agreement, the total revenue recognized under long-term sensor agreements in any period is not dependent on the allocation to the deliverables. The total amount of revenue recognized under long-term sensor agreements in a period is dependent on the amount of sensors shipped in the period. Our long-term sensor agreements provide for a minimum annual purchase commitment by our customers, but the timing and amount of customer purchases may vary from period to period.

Accounting for Income Taxes As part of the process of preparing our consolidated financial statements, we are required to determine our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax expenses and assessing temporary differences resulting from recognition of items for income tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must reflect this increase as an expense within the tax provision in the statement of operations.

Management's judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We continue to monitor the realizability of our deferred tax assets and adjust the valuation allowance accordingly.

At December 29, 2012, we have $20.0 million of net operating loss carryforwards from our subsidiary in Sweden, which will carryforward indefinitely. We believe that it is more likely than not, that $9.3 million of such losses will not be realized. A valuation allowance has been provided on such loss carryforwards. We also have $0.4 million of net operating losses from various states, which will begin to expire in 2014, all of which will be recorded in equity when realized.

We have state research and development credits of $2.1 million which will carryforward indefinitely. Additionally, we have $0.5 million of investment tax credit on research and development expenditures from its operations in Canada which will begin to expire in 2019. We believe it is more likely than not that these deferred tax assets will be realized. In making this determination, we consider all available positive and negative evidence, including scheduled reversals of liabilities, projected future taxable income, tax planning strategies and recent financial performances. Our consolidated income tax provision or benefit and the net deferred tax assets include Cercacor's income taxes provision or benefit and deferred tax assets. For income tax purposes, Cercacor is not a member of our consolidated group and files its separate federal and California income tax returns.

On January 1, 2007, we adopted an accounting standard which prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. As of December 29, 2012 and December 31, 2011, the balance 82-------------------------------------------------------------------------------- Table of Contents of gross unrecognized tax benefits was $6.7 million and $8.4 million, respectively. The amount of unrecognized benefits which, if ultimately recognized, could favorably affect the tax rate in a future period was $5.7 million and $7.4 million as of December 29, 2012 and December 31, 2011, respectively. Both amounts are net of any federal and/or state benefits. It is reasonably possible that the amount of unrecognized tax benefits in various jurisdictions may change in the next 12 months due to the expiration of statutes of limitation or audit settlements. However, due to the uncertainty surrounding the timing of such events, an estimate of the change within the next 12 months cannot be made. Interest and penalties related to unrecognized tax benefits are recognized in income tax expense. At December 29, 2012, we had accrued $0.8 million for the payment of interest.

We conduct business in multiple jurisdictions, and as a result, one or more of our subsidiaries files income tax returns in the U.S. federal, various state, local and foreign jurisdictions. We have concluded on all U.S. federal income tax matters for years through 2008. All material state, local and foreign income tax matters have been concluded for years through 2005.

Recent Accounting Pronouncements In July 2012, the FASB issued Accounting Standards Update No. 2012-02, or ASU 12-02, Intangibles - Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment, to allow entities to use a qualitative approach to test indefinite-lived intangible assets for impairment. ASU 12-02 permits an entity to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If it is concluded that this is the case, then a quantitative impairment test that exists under current authoritative accounting guidance must be completed. Otherwise, the quantitative impairment test is not required. ASU 12-02 is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption of this update is permitted. We do not expect the adoption of this update to have a material impact on our consolidated financial statements.

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