Good day, ladies and gentlemen, and welcome to the Third Quarter 2012 OSI Systems Earnings Conference Call. My name is Shauntelle, and I will be your facilitator for today's call. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today's call, Mr. Alan Edrick, Chief Financial Officer of OSI Systems. Please proceed, sir.

Thank you very much. Good morning. Thank you for joining us. I'm Alan Edrick, Executive Vice President and CFO of OSI Systems. I'm here today with Deepak Chopra, our President and CEO; and Victor Sze, our General Counsel. Welcome to the OSI Systems Third Quarter Fiscal '12 Conference Call. We'd like to extend a special welcome to anyone who is a first-time participant on our conference calls. Please also note that this presentation is being webcast and will remain on our website for approximately 2 weeks. Before discussing our financial and operational highlights, I'd like to read the following statement. In connection with this conference call, the company wishes to take advantage of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 with respect to statements that may be deemed to be forward-looking statements under the act. Such forward-looking statements could include general or specific comments by company representatives on this call about future company performance, as well as certain responses to questions posed to company representatives about future operating matters. During today's conference call, we may refer to both GAAP and to non-GAAP financial measures of the company's operating and financial results. The company's earnings release has been filed with the SEC as an exhibit to a current report on Form 8-K. The company wishes to caution participants on this call that numerous factors could cause actual results to differ materially from any forward-looking statements made by the company. These factors include the risk factors set forth in the company's last annual report on Form 10-K and other SEC filings. Any forward-looking statements made on this call speak only as of the date of this call, and the company undertakes no obligation to revise or to update any forward-looking statements, whether as a result of…

Thank you, Alan. And again, good morning, and welcome to the OSI Systems earnings conference call for the third quarter of fiscal 2012. All our 3 business segments, Security, Healthcare and Optoelectronics, delivered strong top and bottom line growth as we achieved revenue growth exceeding 19% and delivered an operating profit growth of 54% over the prior quarter. We ended the quarter with a record backlog of approximately $1.1 billion. This is the highest backlog in a quarter at any time in the company's history. Without a doubt, the major contributor of the increase was the result of a landmark 6-year agreement to provide turnkey operations in Mexico for their security. Let us review highlights for each division, beginning with our Security division. Rapiscan, where the sales were up 27% to $112 million in the quarter. Other highlights for Rapiscan in the quarter and early Q3, we announced the initial award value of turnkey services agreement with Mexico's tax and customs authority to be approximately $400 million and stated at that time that this agreement could have higher value as the program scope is finalized. Later in the quarter, the value of the award was expanded to approximately $900 million. The terms remain at 6 years. Under this agreement, Rapiscan would provide ongoing operations of a comprehensive x-ray screening program, which will include technology, staffing and maintenance support at locations controlled by Mexico's customs authorities, such as ports of entry, as well as inland checkpoints and some airports. We expect to leverage our experience from prior infrastructure and systems integration effort at Puerto Rico to fully optimize our efforts in Mexico. In anticipation of this agreement and the overall tremendous organic growth potential at Rapiscan, we have increased the depth of our Rapiscan management team by adding senior leaders in…

Thank you, Deepak. Our relentless focus on growth initiatives and operating improvement throughout the company has succeeded in delivering significant sales and earnings growth. With the strong momentum across each of our division, coupled with our $1.1 billion backlog, we are well positioned for continued strong top line growth and further margin expansion. I'll speak to our updated guidance shortly, but first, let me review the financial results for the third quarter of fiscal '12. As we said earlier, net sales were up 19% on an overall basis. Our Security division led the way with 27% growth in Q3, as mentioned earlier. For the first 9 months of fiscal '12, Security bookings totaled over $1 billion, which represents a 4x increase over the first 9 months of fiscal '11. The strong Rapiscan sales growth was witnessed across many product lines and spearheaded by delivery of entry control point inspection systems from the contract won earlier this year. Our Healthcare division had an outstanding quarter, returning to double-digit revenue growth. After multiple quarters of flat or declining revenues during the height of the U.S. recession, we have now reported our fifth consecutive quarter of growth in the Healthcare division. This quarter's growth was led by U.S. sales with some softness experienced in Europe, which was anticipated. We leveraged this 10% sales growth to more than double our operating income, demonstrating that our focus on improving operating efficiencies, coupled with high contribution margins, are continuing to produce measurable results. Given Healthcare's recent and upcoming product launches, in addition to the previously mentioned signing of a new long-term Group Purchasing Organization contract, we believe the future is very bright for our Healthcare business. External sales in our Opto division were also again solid, increasing 13% for the third quarter, with both our commercial…

[Operator Instructions] Your first question comes from the line of Brian Ruttenbur of CRT.

A couple of questions. First of all, very good quarter. Can you talk about Puerto Rico, the ramp, what's going on there, and talk about profitability, how much revenue was recognized in the quarter? And maybe now that you ramped, you can talk about profitability at that facility -- those facilities, excuse me.

Brian, this is Deepak here. Alan can tell you a little bit about the margins and the profitability. With the third site turned on, as Alan said in the last conference call, that brings us approximately close to about 85% of the total revenue. There's a fourth site, which we -- a smaller site, which will bring us to that total 100% number, much smaller, which will go live sometime in this quarter or early first -- it doesn't matter. It's a smaller site. It's right on plan. It's performing very well, receiving very good kudos. We've shown and developed customers. I want to let Alan talk about the profitability margins.

Sure. Brian, for Q3, with the 2 sites, it was not a material contribution to the overall OSI sales or profit. The margins are where we were internally expecting. They are quite significant. This final quarter, as we went live about 2 weeks ago, we should get a significant amount of revenues related to our overall projected revenues for this contract. So as we said before, we'd like to see a full quarter's worth of operations before we provide further clarity. But I'll tell you, it really is going according to plan. We're very excited. And we do think we'll have that fourth site up and running in the first half of fiscal '13.

So is the plan for roughly $4 million or $5 million per revenue -- per quarter of revenue, is that the plan?

Well, as you know, we've never shared what the -- what our revenues will be from this project. Different analysts have estimated that. It might be in the neighborhood of $15 million to $20 million on an annual basis. And we don't think they're far off in those guesstimates.

And then in terms of -- switching over to Mexico, you talked about advances in the quarter. Were those related to Mexico, the majority of those?

Yes. Brian, this is Alan. While we can't speak to specific customer advances from specific customers, we did have, in total, about a net of $95 million of customer advances from various customers. You can probably surmise where the largest one will come from.

Okay. And then in terms of expenses in Mexico, you're going to have, obviously, expenses that you just incurred this last quarter and in the next couple of quarters. Then those expenses, well, are they onetime in nature? Are they training expenses? Are they bringing on new people? Can you talk about the -- what you're doing there and how that's working?

Certainly, Brian, yes. We've really made great progress in a very short period of time since signing this agreement. What we're now doing in terms of what some of those startup costs consist of are the general overhead you might imagine as we begin to ramp and do some of the hiring, some of the training, some of the planning, et cetera. So in the past quarter, in Q3, that contributed to about a $0.05 hit to our EPS. So in other words, the $0.65 that we reported might have been closer to $0.70 without that. And as you mentioned, those will continue over the next couple of quarters. In fact, it'd probably be a little bit higher as we continue to create the infrastructure down in Mexico. So we would anticipate that for the next couple of quarters, which is a good thing. Everything is moving along very nicely.

So those are primarily people expenses and travel expenses rather than actual infrastructure expenses, right?

Yes. The costs that we build in terms of infrastructure are capitalized and are part of our PP&E.

Okay. And then last question, in terms of the gross margin drop in the quarter kind of a year-over-year, and that was because of the Security and Opto having lower year-over-year margins because of the mix of the type of business that you were -- you recognized in the quarter, is that right?

Yes. It was 2 things. One is Security and Opto growing faster than Healthcare, even though all 3 grew in double digits. Security and Opto, which had faster growth, had lower gross margins than that of -- than at Healthcare. So when you combine the things, you put some impact on the overall consolidated margin. And then you're right, the mix within the divisions was a little less favorable as well, which resulted in a margin that we reported. We do anticipate, as we move into fiscal '13, that we'll be seeing increasing margins again.

Next question comes from the line of Tim Quillin of Stephens, Inc.

Alan, do you have the more precise backlog numbers in front of you, both the overall backlog and the Security backlog?

Sure. You don't like the numbers rounded to the nearest 10th of a billion?

I like what that implies in terms of how big the backlog is, but I like precision.

Sure. No problem. Our overall backlog was $1,101,000,000.

$1,101,000,000?

Exactly, yes.

And the Security backlog?

The Security backlog was north of $250 million compared to slightly higher than that at the end of December, excluding Mexico, of course.

So $250 million, excluding Mexico. And the impact, how much of the $900 million Mexico contract did you take into backlog?

Roughly $0.75 billion is in the backlog today.

And what are the puts and takes as far as putting the entire $900 million in there? Are there still some uncertainties in terms of the run rate of that contract?

Tim, as you know, we always try to be a bit conservative. And really, it's just related to the various start times of the sites coming online. We feel very confident on the overall program. And as we get a little more clarity, we anticipate that, that $0.75 billion will actually increase. But we're just being very conservative on the start times at the moment.

Right. And then as we think about the run rate on that contract, is it right for us to guesstimate that $900 million over 6 years implies a $150 million run rate? Is that kind of the right neighborhood?

Yes, yes. After the initial startup, that is essentially the right way to think about it.

And when does that -- when does the time start ticking on that 6-year time frame?

Tim, this is Deepak here. The total contract started sometime end of January. So the 6-year clock started. And what Alan is saying is that the reason we've been conservative of the number, depending on when will new sites get online, it then starts producing revenue. But it's a 6-year total contract, which is just a fixed amount of time. So depending on how fast we can get the sites up and running, the revenue will change. But we've taken a conservative view what it will take us to get the site started. But overall, as the total contract starts rolling, Alan is right, approximately $150 million annualized is the right number.

Right. So if I understand you correctly, then the revenue per site and kind of the revenue run rate is well understood. But the total, excluding startup cost, the term of the -- of when you take the revenue could be different, and so you can have a conservative view of when that started out. But the run rate is not going to -- it does not have a lot of uncertainty around it, is that right?

Absolutely right.

Okay, okay. And then in terms of -- what kind of CapEx should we expect for the -- in rough ballpark terms? What kind of capital expenditures would be associated with Mexico?

Tim, we anticipate it will be a little bit north of $150 million for the contract.

And how will you depreciate that? Over what term?

It's a little bit premature to say in terms of everything we're doing, but it's a 6-year contract. And we're anticipating -- depreciating that over the life of the various assets.

Right, right. And I know it's even early to talk about the margins on your contract in Puerto Rico, but in general terms, how should we think about margins on the contract in Mexico?

In general terms, we would anticipate that the margins will be significantly above the operating margins that we report for Rapiscan overall or even OSI overall. So it will be a significant enhancement to the operating margins of both the division and the overall company.

Would you expect -- is there anything different about Mexico in terms of the margin structure versus Puerto Rico?

Well, the only maybe one difference is, as you know, in Puerto Rico, some of the delays were related to the Puerto Rico handing over the sites to us to do the very basic infrastructure. We said in Mexico, we were going to take control of that. So as a result, we're doing that basic infrastructure, which is leading to the higher CapEx number, which is all priced into the model and our own pricing. But as a result, the margin that you would obtain on that might be slightly less than you would get in Puerto Rico. But overall, both of the deals have very, very significant margins and will make a meaningful difference to OSI results [ph].

I think just to add on to it, one of the other differences are, the reason why Puerto Rico was never going to get booked into our backlog, that it's based on the containers that they're inspecting. As far as Mexico is concerned, it's a fixed number per site, per month.

Right, right. That's fair. And then on the RTT product, how should we think about EU certification versus TSA certification in the total market opportunity? In other words, how big a part of your revenue opportunity would be the EU countries or those that follow the standards versus the TSA opportunity?

Tim, I mean, obviously, there's no some fixed numbers. But to give you an idea, most of the CT scanner and checked baggage machines were installed post-9/11. So they are coming to about a 10-year cycle of replacement, both here and in Europe and everywhere else in Asia. In U.S., it's a pretty given that you have to have TSA certification for getting any socket. In Europe, it is the ECAC standards and the Level 3 standards that we just announced out of the latest standards, meaning that by 2014, European airports must adhere to Level 3 standards, period. That's the present law. So the machines that are there, they need to be changed, whether they are 10-year-old or 5-year-old or whatever. By 2014, they have to meet the new standards. And then the rest of the world follows one way or the other, whether it's the TSA certification or whether it's the ECAC standard. So we look at this, that the total number of sockets, we've said it before, is about 3,000, without any expansion, between U.S. and the rest of the world. But if you look at it about $1 million plus, north of $1 million machines, it's a $3 billion plus market. And everybody in Europe, obviously, with the turmoil that's taking place, everybody's sort of waiting and seeing, but 2014 is driving it. So we believe that the opportunity is great. Obviously, the U.S. market, we're still waiting for. And we are very confident, especially after the certification from EU. That's just a matter of time before we get the TSA. The rest of the world, we got the certification. Now we are going to aggressively market it and hope that we are very confident that we have been waiting for a long time that in 2013, 2014, it's going to be a very good product line for us and a revenue getter.

Right. And long ago, you had received an order from Manchester Airport that was contingent on getting certification. Can you start shipping against that order now?

Unfortunately, Tim, on that particular airport, we basically had contractually a certain date for certification. And since we never got it by that time, the decision was made by the company that we are going to part friendly between the 2 sides because we just never made the certification in time, and we were not ready to go back and expose the company for manufacturing.

Got it. Got it. Okay. So that ship has sailed. And just one last question, if you would allow. So on the Army contract, it's $100 million integration contract. It's a big, big deal that you're executing against right now. Are there other -- but it's finite in nature. Are there other opportunities that you see after that contract ends? Or should we think about that coming to an end sometime in your fiscal '13?

Well, the answer is definitely, we are spring boarding and leveraging what we have successfully achieved. And by the way, the customer is very happy. We are working on other opportunities. At this stage, it definitely looks like that we will have more business. But we can't say whether the business volume will be the same amount or there'll be multiple contracts equal to that. But we are definitely a player in that infrastructure market. And on your previous question, I just want to make a clarification, on the Manchester thing, that got taken out of the backlog. So it is not in our backlog that Alan gave you the numbers.

Your next question comes from the line of Jeff Martin of Roth Capital Partners.

I was just curious if you could walk us through the process of RTT from the point of getting the European approval to, say, taking your first purchase order. What needs to be done? How long is the evaluation period? And what kind of timeline should we expect for it to generate first revenue from?

Jeff, this is Deepak here. It's a difficult sales cycle. Before the certification, it was difficult for us to even talk to any airports. And now we know, we have a list, we already have the list of the airports which are interested. We've been talking to them for the last couple of years. And now we're going back and actually saying we have the certification. And we are talking to them. But it's not just an equipment sale. It's -- you've got to work with the baggage handling systems. So we will now start talking to baggage handling people, start looking at designing with them in conjunction for what the airports need. So it's a cycle that we personally think that late 2013 -- second half of our fiscal 2013, we expect to generate revenue.

Okay. And then what are your thoughts on pricing? Have you decided if you're going to try the premium price, if you're going to price it aggressively? Some color there would be helpful.

Well, as I mentioned before, that these units sell for north of $1 million. We have not decided specifically. Obviously, we are going to look at each customer, each opportunity, but it's the cost to ownership. Price is a little secondary thing. It includes warranty. It includes service. It includes uptime. It includes how it integrates with the baggage handling system, how complex it is. And one of the big advantages we offer, with the speed same as 1,800 bags an hour as the present conveyors go in Europe, we think that the installation cost and the support cost will be much less than the present incumbent units that they are used to. So we have not sort of shown our hand yet. It'll depend on site to site, customer to customer. We do expect that we will not down-sell it. That, we can tell you.

Now taking the 3,000-unit addressable market or -- I forget what term you used before, but let's say there's 3,000 sites to locate these at. Is your addressable market smaller than 3,000 because your throughput is higher? Should we -- how should we think about the addressable market for RTT relative to the current size of the market?

Well, number one, I just want to make sure that we did say it, half-and-half, approximately half of that is in U.S. We do not have TSA certificate yet, though we are very confident that we're going to get it soon. The other half, obviously the market size hasn't gone down. As a matter of fact, in some ways you can look at it, that it can increase the size of the market, not only are you replacing what is called Level 3 machines. You can be replacing the whole system of Level 1, 2 and 3, which right now has a high-speed, lower-cost machine in the front end, and a couple of those lines go in and feed a Level 3 kind of a machine. In our case, we can make that obsolete and go to just one machine. So the sockets are not going to get less, plus new construction, plus the expansion slots, as the economy improves. We think that the addressable market is there. It doesn't mean that we're going to get all. There are limitations of changes or replacement. So at this -- it's too early to look at what the addressable market is. The size of the market is very big, and it's going to go on for the next couple of years. 2014 is not that far away. So there's going to be a big mad rush for the airports to redesign their systems, and we are going to participate very aggressively because I think our solution is better than anything out there.

Great. That sounds like a wonderful opportunity for you. Could you -- you mentioned strategic acquisitions. Could you -- I assume that's in Rapiscan. If you could provide some broad detail on what the strategy is there.

Well, obviously, for competitive reasons, we're not going to tell you the strategy except that we have gone on record. We like both product lines. We like all 3 product lines, but specifically, both in Security and Healthcare. And as everybody knows, with the defense, with what's happening, that -- there is consolidation out there. There are some non-core assets being shed by the large defense contractors. We are very focused into it, and we do continue to look at very carefully. We are very savvy buyers but both in the Security and in the Healthcare area. Both are very good if you just look at the results. The margins are tremendous. The leverage is tremendous in Healthcare. And the U.S. has started coming back to life. We are very, very excited about it. And Security, we continue to look at it. And now obviously, the new area opening up in the infrastructure side, we'll also look at services in the infrastructure area.

Okay. Great. And then final question, could you give us some detail on some of the hires that you've made for Rapiscan? Are these high level? Or are they more infrastructure and support people? Some detail there would be helpful.

I think we are beefing up our total leadership in operations and quality, in supply chain, in engineering, in R&D, service. So it's in all disciplines.

[Operator Instructions] Your next question comes from the line of Jonathan Richton of Imperial Capital.

I just wanted to maybe follow up quickly on the acquisitions side. In terms of how you guys are looking, I know in this space, you've spoken out to kind of a small space, and everyone knows everyone. Is the strategy more to look at new smaller companies that are really like good value at this point and where you can either get into new customers? Or are you still more focusing on an area where you're going to just broaden your product offering? Which angle are you guys favoring in terms of the potential strategy?

I think you've said it very well, all of the above. We will look at geographic advantage to increase our reach geographically, product expansion, customers that we would like to look at it, all of the above. And obviously, the size-wise is pretty standard. We are not going to look at a $1 billion company. We're going to look into the hundreds or smaller.

Okay. And then just following up on the previous comments in terms of the Mexico contract versus Puerto Rico and how they're structured all differently, I guess what was the reason for that? Was that the choice of having the government in Mexico wanting to structure it versus more on a monthly fee versus a per scan basis. And what are you seeing in terms of the customers that you're talking to going forward? Are they favoring that type of contract? Or it's kind of either/or?

Well, firstly, the first answer to your question is, obviously, the customer chooses. We supply a solution. The customer chooses which model they like. Our Puerto Rico model is a little different than Mexico. Regarding all the other opportunities, we are looking at it, all of the -- both kinds.

All right. Are you seeing a preference by the customers you're talking to? Or is it too early to tell?

No, there's no preference to it. I think both of them are very viable models. Both of them, as Alan has mentioned, have significantly higher margins than our present sales. So we look at that as opportunity. That's going to depend from country to country, customer to customer. Ultimately, the end of it is the same. It's an inspection services solution that we provide.

Okay. And quickly on the SG&A side, is the significant improvement there mostly coming from your Healthcare side, from Spacelabs, where you have the leverage? Or was there modest improvement also on the Rapiscan side?

Jonathan, it's Alan. We saw improvement throughout all 3 of our divisions in actuality.

Your next question comes from the line of Josephine Millward of The Benchmark Company.

Can you talk about what's the speed or number of bags per hour on those checked baggage x-rays machines in Europe right now? And how does that compare to the speed for other conveyor belt systems?

Josephine, as you know, that the European airports are designed for speed for throughput. For the front line, what is called Level 1 is what is called the multiview systems, which are not TSA certified or the ECAC Level 3 certification. They run between 1,500 to 1,800 bags an hour. And then they go through what is called a Level 2 inspection. And then if the bag has a potential suspicion, then it goes to Level 3, which is a slow-speed CT scanner anywhere between 600 to 800, 900 bags an hour. So our system from day 1 was designed to make it simple. Otherwise, with all these different speeds, you have to put a spaghetti of infrastructure in the baggage handling conveyors, which then cause a lot of service problem and throughput problem, and frankly, space and cost. So because the European system conveyors are already designed for 1,800 bags an hour in the front end, our approach is to take one of those machines out and slap one of the EU Level 3 certified to the newest standard machine. And it just simplifies all the conveyor systems. So you have the ability to simplify an airport baggage handling system with this new high-speed certified to Level 3. And like I mentioned before in the conference call, right now, 2014 is the deadline for all European airports to have Level 3 certification, and we provide that now with the certified at the high speed. There is no other company who has that high speed.

Right. That's very interesting. That's why I asked that question. Clarification on the EU mandate. I thought it was -- they have until 2022 to swap all the machines to meet Level 3 EU certification, is that right? It's starting in 2014, but they have 6 years to do it.

Well, yes. But they're pushing for it, and there's obviously so much political turmoil right now. Some countries are pushing it. But right now, they got to start doing it 2014. And I think the other way you have to look at the market, once there is a product available that can do these things, the people who are sitting on the sideline or making a decision of what they want -- people are afraid to buy a machine which becomes obsolete in 2 years or 3 years, so that if this technology is available, whether they start in 2014 and go to 2020 or they need a replacement now anyway for a 10-year machine, do they get cheapest machine at a slower speed in 2012 and then look at something else in 2014, '15? Or do they buy at a premium discounted machines which can do the job properly and don't have any obsolescence in it?

That's very helpful. Deepak, can you give me a sense of your current market share in Europe for checked baggage x-rays? Trying to get a sense of your installed base in terms of the existing sockets in Europe.

Josephine, the good news and the bad news. The bad news is we don't have a very large installed base with multiview. And the good news is that opens up a great opportunity of whatever we sell as a percentage increase.

At this time, there are no further questions in the queue. And I would like to turn the conference back over to Deepak Chopra, Chief Executive Officer, for closing remarks. Please proceed, sir.

Thank you very much. I again want to thank all of you, especially all the analysts that we've been talking about it for the last 3, 4 years about the RTT product. We are very excited about this development. We continue -- we're going to continue to pursue it in the near future. Mexico and Puerto Rico are great wins and basically authenticates our strategy in the security market. With the cost controls and our leverage that we have, we think that the year is going to end very strong, and we continue to believe that 2013, '14 is going to be very exciting for OSI. I want to also thank all the employees of the company for making this thing happen. Thank you very much.

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a wonderful day.