Welcome to the Q3 2013 OSI Systems Earnings Conference Call. My name is Richard, and I'll be your operator for today's call. [Operator Instructions] Please note that this conference is being recorded. I will now turn the call over to Mr. Alan Edrick. Mr. Edrick, you may begin.

Good morning, and thank you for joining us. I'm Alan Edrick, Executive Vice President and CFO of OSI Systems. And I'm here today with Deepak Chopra, our President and CEO; Ajay Mehra, President of our Security division, Rapiscan Systems; and Victor Sze, our General Counsel. Welcome to the OSI Systems Third Quarter Fiscal 2013 Conference Call. We'd like to extend a special welcome to anyone who is a first-time participant on our conference calls. Earlier today, we issued a press release announcing our third quarter fiscal 2013 financial results. Before we discuss 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 officers on this call about future company performance, as well as certain responses by company officers to questions posed about future operating matters. 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 or its officers. 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 new information, subsequent events, future results or otherwise. During today's call, we may refer to both GAAP and non-GAAP financial measures of the company's operating and financial results. For information regarding non-GAAP measures and comparable…

Thank you, Alan, and again, good morning, and welcome to OSI Systems' earnings conference call for the third quarter of fiscal 2013. As Alan mentioned, in spite of a couple of soft revenue quarters, OSI achieved year-to-date revenue growth of 3% and leveraged this modest top line growth to a very strong EPS growth, which Alan discussed earlier and will provide additional details shortly. We entered the year aware of a very tough revenue comparison in the second half related to last year's $98 million integrated products contract by our Rapiscan Security division. We believed that despite the tough comps, we would be able to grow with a strong pipeline of opportunities. The impact of delayed U.S. spending in security and hospital purchases, as well as continued weakness in the European government sector, has caused a reduction in our revenue. Although our current revenue guidance for the full fiscal year is about $65 million lower than our initial estimates at the midpoint, our team's ability to expand margins has been superb, providing us confidence in our ability to meet the earnings goals we set out at the beginning of the fiscal 2013. This performance is a testament to our team's ability and agility in its planning and execution and response to changes in the marketplace. In Q3, our revenues were $198 million, and we delivered an operating margin of 10.9%, excluding the impact of restructuring and other charges. We now have had 2 consecutive quarters of double-digit operating margin, a first for the company since 2003. We continue to maintain a robust product development and opportunity pipeline and manage for the long term while retaining the ability to withstand the global macro dynamics currently in effect. So even during flat demand in some regions, we continued to make market share…

Thank you, Deepak. Our focus on higher-margin growth initiatives and operating improvements throughout the company has succeeded in delivering significant earnings growth. As our fiscal '14 is only about 2 months away, we are very excited about the prospects for both top line and bottom line growth, as we transition past the challenging second half comp. I will speak to our fourth quarter guidance shortly, but first, let me review in more detail the financial results for the third quarter. Net revenues in the third quarter of fiscal '13 were down 5% versus Q3 last year. As we said, revenues from our Security division decreased 11% in the third quarter. Though as we previously discussed, this was primarily due to the impact of the U.S. Army integrated products contract. Again, excluding the prior year impact on revenues from this program, our Security division sales increased by 41%. Our opto division continued the double-digit revenue growth momentum from the first half by delivering 10% sales growth as a result of continued success in broadening our customer base. And finally, as Deepak discussed, our Healthcare division revenues dipped by 9% in Q3 with some general global softness. We do believe this division is primed for a very strong sales in Q4. The Q3 gross margin of 36.2% was very encouraging, up by a significant 300 basis points from the same quarter last year. This increase was mainly attributable to a better mix of revenue in our Security division, including increased turnkey sales. As we move to OpEx, our Q3 SG&A was up just $700,000 despite incremental costs in our Security division related to supporting our turnkey screening services. And we continue to invest significant resources in R&D to enhance both our Security and our Healthcare product offerings. Our R&D spending as a…

Yes?

We will open the call to questions.

[Operator Instructions] Our first question online comes from Tim Quillin from Stephens Inc.

In terms of your guidance for the fourth quarter, could you just characterize the level of visibility that you have now relative to that guidance compared to the type of visibility you would have at this time in the quarter in previous times? If there's some way to quantify that, that would be great.

Sure, Tim. This is Alan. As we're 3.5 weeks or so into the quarter, I think our visibility for the remainder of the fiscal year, which is now just a few months away, is stronger than it typically would be for when there's a longer period in time. We have very strong visibility, particularly into our Security and opto business. Our Healthcare business, as you can imagine after 2 disappointing quarters, has been thoroughly vetted for the fourth quarter. And although it's not a backlog business like Security and opto, we feel that our funnel of opportunities has frankly never been stronger. We believe that coming into the second half of the fiscal year that it was heavily loaded to the June quarter, though we are anticipating that March would have been stronger. But we do feel good overall. So overall, we feel very good about the visibility that we have and the guidance that has been provided.

And just want to make sure I understand on the Healthcare side that you think there's the potential for growth in revenue year-over-year in the Healthcare segment in the fourth quarter?

Yes, Tim, it's Alan. There certainly is that potential. Q4 last year was a very strong quarter for us. Clearly sequentially, the Q4 in June will be much, much stronger than March, but we do believe there is the potential for year-over-year growth in addition to sequential growth.

Got it. Got it. And then, Deepak, it was great to hear that you've gotten at least one order for RTTs in Europe. If you could talk about maybe the size of that and what the pipeline looks like just in Europe for RTT?

Thanks, Tim. For competitive reasons, again, I don't want to talk about the size of the order except it is for multiple units, and it's at a very healthy margin. We are very, very happy about it, and the pipeline, not just in Europe but internationally, looks as strong as ever. Obviously, as we have said in the previous conference calls, with all these turmoil that's going on, there is always the tendency for customers to push. But they are approaching the red lines, and we are very, very confident that we will score this as a big home run. And we had mentioned before that we were confident of booking our first orders by the end of our fiscal year, and we are happy to announce that we did it in Q3, so very, very happy with that.

Yes, that's a good news for sure. I know that -- I don't think you mentioned in your prepared script and haven't really wanted to talk too much about it, but there was -- the Department of Defense put out a formal notification to Congress on the potential foreign military sale to Iraq. And there was very specific quantities discussed in there, and at least a dollar amount that I know is maybe more of a ceiling amount. But it's a big potential order, and so I just want to understand how you're thinking about that in terms of the timing or what is the remaining process before you get to an order or orders there?

Tim, this is Ajay. I think that you've all read what the DoD announcement was, and we continue to work with them and the Iraqis. But at this point, it would be really inappropriate for us to even comment any further. When we have more information, when we have -- when and if we book the order, we'll talk about it.

Tim, this is Deepak. Just to add onto what Ajay's saying, you know our policy that until we actually book the order, we don't talk about it. This was a news by the DoD, not by the company. We obviously are excited. We are working on both sides, the Iraqis and the Americans. And until it happens, we don't want to talk about it.

Okay. Now can you just confirm whether this would be funded by the U.S. government in any way and thus, subject to sequester?

I think we're not going to go into how it's getting funded, et cetera, but we don't anticipate the sequester to affect us.

Okay. And then just last detail questions and I'll let others step in. But Alan, and you may have said this, but what was the depreciation and amortization for the quarter? And what do you expect that to be on a full run rate once you're done with the capital expenditures related to the Mexico project?

Sure, Tim. Our depreciation and amortization for Q3 was a little bit north of $7 million. It will increase significantly as we move further along in the project. We don't guide to D&A as a specific line item level, but you'll start to see it in Q4 and Q1. You'll start to see a real ramp up in that depreciation and amortization number, leading to very, very strong EBITDA for the company.

Yes. And how about the remaining CapEx? What kind of 4Q CapEx do you expect?

We'll continue to have some significant CapEx in Q4, but it's going to moderate from the levels that we have seen previously, and as we head into fiscal '14, even further.

Our next question online comes from Matt Dolan from Roth Capital Partners.

So I first wanted just touch on the operating margins. They're obviously trending higher especially on the Rapiscan side. Should we expect these gains to at least be maintained? Or is there room for additional expansion from here? I know you gave some commentary on '14 but maybe you can just directionally help us out.

Sure, Matt. This is Alan. Yes, we're very pleased with our operating margins and our gross margins in Q3. We do believe that there's opportunities for those margins to continue to improve. Our core business in Rapiscan has been improving the margins. And certainly, the turnkey screening solutions part of our business has really been contributing nicely. And as that ramps up, it could lead to even higher operating margin expansion. So we are encouraged by that, and we do expect to see operating margin expansions going forward as well. So we think the rate you saw in Q3 can be improved upon.

Okay. And then following up on the Healthcare side, I know in the U.S. earlier this year, utilization at the hospital level has been a little choppy. Is this something that you're seeing pockets of softness? Or is this more of a national general trend that you're seeing with that side of the business?

Matt, this is Deepak here. I think the better way to answer that is that since November, December, January, February, there's been what I call a drag. Everybody just basically went into what I call hibernation. The hospitals at the top level sort of put their orders on hold. We haven't lost any, and I'm sure you're talking to the other companies. Everybody's been sort of in a holding pattern, but we believe that just like what [indiscernible] was saying, what Alan said, I think people are just settling down, and it's going to open up. And we are very comfortable that Q4 will be as strong, if not, better than last year's.

So just maybe to follow up on that, I think previously, you talked about getting towards a double-digit growth rate for Healthcare. Is that still a goal that's realistic for you over time?

The answer is yes, especially with the economy improving both here before in the rest of the world and this uncertainty going away and our extra benefit of the new product launch.

Our next question online comes from Yair Reiner from Oppenheimer. Yair Reiner - Oppenheimer & Co. Inc., Research Division: So first, I just wanted to follow up on the margin question. If we look specifically at the Security business, I think x some of the impairment costs and so forth, the margin is around 18%. Is there any reason to believe that, that is not the right base level to model for that segment going forward?

Yair, this is Alan. Yes, your numbers are right, and it was a terrific quarter. And you're seeing the impact of turnkey increasing. There's always a different mix of business from a quarter-to-quarter perspective, so based on that revenue level and the contributions from different businesses, will play into effect what will happen to our operating margins in Security. But we do believe as a general nature that the operating margins are going to be significantly higher than we've historically seen in that business based on the business model changes that we've made and has been part of our strategy. Yair Reiner - Oppenheimer & Co. Inc., Research Division: Got it. And then in terms of the cash flows, you said they're going to be significant going forward. Is the right way to think about that is if free cash flow equal to or greater than adjusted income starting in the fourth quarter? Or if not, how should we quantify significant in this case?

Yes, so what we do believe even beginning in this quarter, the June quarter, there's the opportunity for significant free cash flow, which could exceed the net income levels. A lot of factors go into that in terms of timing of collections and payments and the like. We expect to have a little bit more commentary on free cash flow as we head into fiscal '14. But we do believe that this quarter and future quarters is going to -- can generate some real significant free cash flow, which will result in a nice yield. Yair Reiner - Oppenheimer & Co. Inc., Research Division: Got it. And then a follow-up on RTT, I realized that maybe you can't start naming all of your prospects. But can you maybe give us an idea of what should we think about as the bogey for the contribution for RTT in FY '14? What would be a reasonable expectation for you internally in terms of what that new product can bring to the company next year?

Well, this is Deepak, Yair. Again, for competitive reasons, looking into 2014, difficult to go back and pin an actual number or the number of people we're working with. But we've always maintained that this is regulatory driven. It's a replacement cycle. And as the economies get stabilized in Europe and other places, we believe that this is a very big game changer for Rapiscan. There are a lot of potentials, and as we start putting the units out there, more and more people will get comfortable with it. So -- and I think we also said in the previous conference calls, it's not going to be a floodgate opening. I know people will try 1 unit, 2 units, multiple units, and then go look at it. And secondly, the other thing we want to caution everybody is the sales cycle and the install cycle is very different from a normal machine because you're integrating these complicated systems in the baggage handling system at airports. So we believe that 2014 will be a great start for us, and the ramp-up will start. And we look at it as a significant revenue and margin driver for the company. Yair Reiner - Oppenheimer & Co. Inc., Research Division: Great. And then just one more if I could. This one's probably for you, Alan. You've had to revise your forecast here for a couple of quarters in a row. And so I was just wondering maybe you can give us a little primer on the methodology that OSI uses to build its forecast and its guidance, and whether in light of the changes here over the last couple of quarters, whether you've seen a need to go back and revisit the way that process is working or should work going forward?

Sure, Yair. It's a fair question in light of the changes the last couple of quarters. As we look back historically, we've had a pretty strong process and compiling our revenue forecast and our earnings forecast and then translating that into guidance. And in the past, there have been some quarters where we haven't made the revenue number as a consensus from the street, but we've made that earnings number. Certainly in light of the last couple of quarters, we have revisited our process because we've seen the -- we've seen some significant comedowns in the revenue guidance, as Deepak had alluded to, from the start of the year. Some of it, outside of our control. We did not anticipate the level of delayed spending both by the U.S. government and by hospitals. So as we look to do guidance going forward, we'll certainly compile our numbers and provide some -- probably some added conservatism in it. And we expect that, as we enter fiscal '14, the guidance that we'll provide for revenues and earnings will be significant yet achievable.

[Operator Instructions] Our next question comes from Brian Ruttenbur from CRT Capital Group.

First question is on the body scanners. Is that issue 100% behind us? Have you gotten the final letters? What's left if anything?

Well, it's Deepak here, Brian. As we mentioned in the last conference call, we have resolved our agreement with TSA, and we are working diligently with TSA to redeploy these units at other government agencies. And the other thing is that the other area that we said in the last conference call with the DHS, there's no change from last conference call. We continue to work with them, and there is no progress of any conclusion on it.

Okay. And then one -- a couple of other questions on timing of certification. I think that you had talked about at previous conference call that you think that this calendar year, it's realistic or a potential for realism on certification from the TSA for the RTT. Is that still going down the correct path for the timing?

That's true, Brian. To the best of our knowledge, we continue to work with them, and I did mention in my thing that we're still targeting before the end of the calendar year.

Okay. So along those same lines, I think that in terms of Mexico-type business, you were targeting 1, maybe 2 new wins this calendar year. Is that still the case?

Brian, I just want to correct it. I never said 1 or 2. What I did say specifically is we are in active discussions with multiple customers. And we are feeling very good and confident that before the calendar year is over, we will have some more good news.

Okay, very good. And then in terms of the RTT, can you talk at least the size of the order? Is it 1 customer, 2 customers? Is it 3 units, 1 unit? Can you give us some kind of guidance there?

You know my answer already. I'm not going to give you the amount, but I will answer to that question that it's one customer, and it's for multiple units.

Okay. And there's competition out there, as I understand, for high-speed units, from Smith and others that are going into this area. Is anybody else getting traction, getting orders from that same customer or different customers that you're aware of?

This is, as we've said before, we are very, very happy that there is competition because as you go look at the new product, this is a revolutionary product, high speed, and it's good to have competition. We encourage our competition. And I'm not going to comment on it whether with the same customer we got the order, whether there's any traction from the other side. I'm sure that they are as active as we are looking at various potential customers. We are aware of them. We are happy to see them. We believe that in a side-by-side test, we still think that price to performance and ownership, we have the best solution.

Okay, very good. Last question on Mexico, can you tell us how many sites are up and how many sites in total are going to be up by the end of June? Give us some kind of -- or percentages if you don't want to talk number of sites. You have 20% up or 50% up. Can you give us something along those lines?

Sure, Brian. It's Alan. Yes, as we described before, we're not allowed to disclose the number of sites by our customer, very sensitive information. But we do believe that from a revenue perspective, we'll be -- we'll probably be recognizing somewhere close to 3/4 of the run rate in the fourth quarter thereabouts. So we're making great progress, and by the end of the calendar year, we expect to be, if not fully, nearly fully operational.

So does that mean that the next quarter, the September period, then you would be at 90% or 100%. Is it the percent in terms of revenue recognition?

Yes, it would be above where we'd be in June. So it'll be -- it will be climbing up, not necessarily the 90% or 100%, but it will be climbing up.

Our next question online comes from Josephine Millward from Benchmark Company.

Deepak, did you say Security bookings were $80 million for the quarter?

That's true, Josephine. And that booking number is non-any-turnkey business.

Right. Can you give me your Security funded backlog?

Our Security backlog overall, Josephine, from -- excluding turnkey services increased from the same quarter, from basically from the December quarter. We're up about 5%.

Okay, that's helpful. So looking ahead in fiscal year '14, you're going to have a much easier comp without the army contract. You have Mexico ramping. Do you think you can return to double-digit growth in Security?

Definitely.

So -- and I know you're not entirely -- you're not done with your planning for fiscal year '14, Deepak. But can you just talk about what you see as key drivers in '14?

Well, Josephine, yes, in the Security area, we have maintained that we have multiple products. The key drivers that we are focused in are these turnkey screening service, the RTT product line, the cargo product line expansion and continuing to move forward with our new products, the Trace and the Radiation. In the Healthcare, we are very excited about the Arkon anesthesia ramp-up. We are also on the other new product launches, the XPREZZON, the qube and the other products. In the opto, we continue to look at gaining traction with new customers and with our global footprint in manufacturing continuing to work what we call a strategic way to look at our customers in the opto area where we carry them from fast turnaround prototyping in stateside U.S. to high-volume production without -- seamlessly without them having to go -- to look at a different vendor. So these are the main drivers. We continue to look at it. And as Alan has mentioned, besides the drivers to the top line, we continue to focus and continue to improve our operation efficiency to continue increase our margin expansion.

Just a follow-up, the Department of Energy had a solicitation for Radiation Detection through a program called the Second Line of Defense last year. Can you give us an update on where we stand on that program and whether you view that as an opportunity in the coming year?

I think we're going to get more clarity on that program probably in next fiscal year. There has been delays on that program, but we are actively working with them with the current program that we have.

Do you think there's going to be a new solicitation, Ajay? And can we see that before the end of this calendar year?

You know what, I think a lot just depends on what happens in Washington. I will be guessing, so I would leave it at that. When we have more information, we'll provide that to you.

And Alan, can you give me a tax rate for '14? What do you think we should use?

Little bit too early to say for '14. We'll be providing our guidance on our next conference call.

Okay. But for '13, I think -- you think we should use roughly 27% for the full year, right?

Yes. I think we said 27% and change.

We have a follow-up question online from Tim Quillin from Stephens Inc.

You announced an expansion of your stock repurchase plan. I'm just wondering how you're thinking about buybacks and more generally capital allocation now that you should start to generate a lot of free cash flow, and you still have a very clean balance sheet.

Sure. Tim, this is Alan. Yes, we did announce an expansion of 1 million shares to our stock repurchase program. We had -- we still had about 400,000 and change of shares, and now we have over 1.4 million. As we are generating free cash flow and we're -- we look at our valuation, we certainly think that it could be an attractive time to continue buying back shares. So we'll go in opportunistically from time to time and execute on the program.

Okay. And would you expect to be -- when your window opens up a couple of days up from now, would you expect to be buying the stock?

We really don't comment on the timing of when we repurchase shares.

Okay. The Optoelectronics margins were a little bit lower than I expected even excluding out the restructuring charge. I know it ebbs and flows a little bit there. But was there anything of note in the margins?

Yes. Tim, it's Alan. The main driver really was the mix of business. We had higher sales in our, what we call, our OSI Electronics, some of the electronic manufacturing services. Those inherently carry a bit lower margin, so it was really attributed to that.

And what kind of margin would you think that you would have or what kind of mix would you expect to have in the fourth quarter and as we think about fiscal '14?

I think in the fourth quarter, it'll still be a little bit more shifted towards that, our OSI Electronics business. But as we head into fiscal '14, I think some of the core Optoelectronics that generate some of the higher margin will be a bit stronger. I think that's probably the best way of characterizing it.

Right, okay. On the Arkon product, you mentioned a couple of times -- I wonder if you can just talk about what a typical sale looks like on Arkon in terms of number of units and kind of rough order of magnitude, what the average selling price of a single unit is and how it might ramp up kind of the pace of ramping up that business.

Tim, the typical -- there's no typical sale. It can change from one machine to multiple machines. The typical ASPs, depending upon the options that the customer asks for, is about at $55,000 to $60,000. So it's a pretty healthy number with good margins. And the marketplace basically is pretty big, and we think of it that the marketplace is very anxious to get another competitor compared to the Stalwarts, like the Datrix Sumida [ph] and the Drägers of this world. So -- and it goes in hand in hand. We call on the same customers as the monitors. So this was just [indiscernible] natural for us. And we think that this product will generate a lot of sales. And it's not like a monitor that you can just book and ship. This will have a little bit extra time, but it'll still be able to book and ship in the same quarter.

Okay. And would you be hoping to get to a 5% market share over the next couple of years? Do you have market share targets?

Well, we are hoping to do better than 5%. We've always said that we would like to get up to 10% market share, and it's a market where it's a nascent market, we are starting from ground 0. Obviously, the challenge is to go after the incumbents, but with the opening and the relative reception that we have got and the features we've got built into it -- and keep in mind that this unit was designed from bottoms up where all the imports over a 2-year period was taken from the user. So we've got rave reviews, and I think we are targeting at a 10% market share ultimately when we get completely launched.

Okay. And then on the turnkey services business, I've kind of conceived of this or thought about the fact that you have a half dozen or so pipeline opportunities at various stages. But how is that pipeline growing? So you've executed well on a couple of different projects. I know there's a lot of interest around the world. Is the pipeline expanding or the number of opportunities you're working on growing?

I think, Tim, we've always said to you that we consider ourselves to be pioneers in this conversion from sale to a turnkey by a manufacturer. So the first thing we have said in many times in our previous conference calls, every potential large cargo customer, buying customer can be also a customer for a turnkey. So there's not a number of -- number of half a dozen or 6 or 2 opportunities. It's on a multiple front. Just like we talk to people buying multiple units for cargo to buy, we continue to work with them potentially to look at it, any of them can be converted to a turnkey. And we said in the last conference call and we said it again today, we are in active discussions with multiple turnkey potential customers. And we feel better today than we felt in the last conference call of closing these deals before the calendar year.

That would be great. And just last detail, Alan. The stock compensation for the quarter?

The stock compensation expense for the quarter was about $4 million.

[Operator Instructions] And at this time, I'm showing no further questions.

Ladies and gentlemen, thank you once again for attending our conference call. We're looking forward to finishing fiscal 2013 on a high note and speaking with you all once again next quarter. We are very, very confident looking at the optimistic 2014. We have an excellent employee staff. We have good products, and with this uncertainty behind us, we look forward to a strong 2014. Thank you.

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.