OSI Systems, Inc. (OSIS) Q4 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2013 OSI Systems Earnings Conference Call. My name is Lisa, and I'll be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Mr. Alan Edrick, Chief Financial Officer. Please proceed, sir.

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; and Victor Sze, our General Counsel. Welcome to the OSI Systems Fourth 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. Please note that this presentation is being webcast and will remain on our website for approximately 2 weeks. Earlier today, we issued a press release announcing our fourth quarter fiscal '13 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 and expectations, as well as certain responses by company officers to questions posed about future financial and 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 quarterly report on Form 10-Q and other prior and future 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 conference 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 financial measures and comparable GAAP measures and a quantitative reconciliation of those figures, please refer to today's press release, which has been furnished to the SEC as an exhibit to a current report on Form 8-K. Before turning the call over to Deepak to discuss the business in more detail, I'm going to provide a high-level overview of our financial performance. We will, again, touch on several themes that we discussed during past conference calls. Highlights for our fourth quarter of fiscal '13 are as follows: First, we again reported record earnings as we experienced significant margin expansion leading to earnings per diluted share of $1.02, excluding restructuring and other charges and a noncash tax charge related to our turnkey screening solution program in Mexico. This marks the 16th straight quarter in which we have generated double-digit year-over-year non-GAAP EPS growth. Second, the record earnings were particularly noteworthy, given that Q4 sales were down slightly as compared to Q4 '12 due to a difficult comp. Last year's Q4 sales were driven in large part by a $47 million in sales from our U.S. Army Entry Control Point Systems Integration Contract. Excluding the impact from this large contract, sales increased 20% in the fourth quarter of fiscal '13. Third, after a couple of difficult quarters for revenues, our Healthcare division bounced back with its second highest revenue quarter of all time, representing 41% sequential growth. With disciplined cost controls, this top line performance resulted in a record quarterly operating margin for Healthcare of 18%, excluding restructuring and other charges. Fourth, our Optoelectronics and Manufacturing division continued the strong revenue momentum, achieving both record revenue and record backlog with a solid Q4 book-to-bill ratio. Operating profits were impacted by the mix of business and approximately $2 million of bad debt expense and inventory reserves. And finally, our Security division's turnkey program in Mexico continues to track to the approximate time lines discussed in our last call. With the large majority of the initial project CapEx investment already in place, we expect this program can generate a significant free cash flow in fiscal '14 and beyond. We are pleased to report another strong quarter of bottom line performance and remain very enthusiastic about our future. Over the past 5 years, we have focused on expanding our operating margins, and the results of fiscal '13 showed continued success on this goal. With a solid backlog and the challenging sales comps of the past 2 quarters behind us, we are poised for strong sales growth in this coming year. I will provide additional financial details and will discuss our fiscal '14 guidance. But first, let me turn the call over to Deepak.

Thank you, Alan, and again, welcome to the OSI Systems earnings conference call. As Alan discussed, in the fourth quarter, we delivered higher profitability on slightly lower revenues when compared to the prior year quarter. Q4 2013 was a tough revenue comp quarter in Security and Healthcare, primarily due to a large systems integration security contract and the fact that our Healthcare division had a record quarter in Q4 2012. Overall, revenues for the year were $802 million, 1% higher than fiscal 2012, and we entered fiscal 2014 with good momentum, strong backlog and a robust growing pipeline of opportunities. Throughout the year, we invested in each of our divisions to strengthen their foundations for profitable growth. We look forward to the opportunities in 2014 as we continue to leverage our performance and position in each core market with an expanded solution offering. Let's spend some time to discuss each business in more detail, starting with our Security division Rapiscan, where revenues were $372 million for the full fiscal year, about 5% lower than prior year, with an operating margin exceeding 13%. The strong profitability resulted from a favorable product mix towards higher-margin products and services. Basically, higher revenues from turnkey services and equipment, which largely replaced a large systems integration Army contract, which Alan has mentioned earlier. Excluding this contract, Rapiscan achieved 23% growth from the prior fiscal year and finished the year with a strong, healthy backlog. Going over some of the highlights in Security. During the fourth quarter, we received European ECAC approval for the large tunnel Real Time Tomography 110 screening system for all baggage. The newly improved RTT 110 and the earlier approved RTT 80 can screen bags significantly faster than the CT systems currently installed at airports. Airports that rely on ECAC-certified systems worldwide now have the ability to select the right mix of RTT models to optimize baggage handling, while achieving the highest levels of security. We continue to work with the TSA to receive certification for RTT at U.S. airports and are still hopeful for certification by calendar year. We are also working with TSA on new opportunities in aviation checkpoint security. Having one of the widest portfolios in the industry allows us to participate in numerous opportunities to provide security screening solutions. The cargo scanning market remains a fast-growing segment for us. We captured new opportunities in cargo with a broad set of customers throughout the year, primarily with the Eagle series mobile and fixed inspection systems. These systems continue to be favored for their comprehensive detection of threats and rugged operation, especially in harsh environments. Turning to turnkey services. We continue to ramp up, making strong progress in Mexico. As we have discussed in prior calls, we have strategically focused on building upon the momentum from Puerto Rico and Mexico turnkey service projects and have been actively engaged with potential customers in several regions of the world. We enter fiscal 2014 with a strong backlog and a growing pipeline of domestic and international opportunities. As we've seen with recent events in the world, infrastructure security is of paramount importance, and we are very proud of our role in helping our customers develop and implement their security strategy. Rapiscan has numerous exciting, new products in development. Moving to the Healthcare division. Spacelabs achieved sales of $72 million for the quarter, slightly below revenues in the prior year quarter which, as I mentioned earlier, were an all-time record and delivered an operating margin of 18%, a new record, excluding restructuring and other charges. Compared to the March quarter sequentially, we saw improvement in most regions and thus are optimistic about the future. As you may recall, there was general softness in certain regions in the past couple of quarters, so we are very positive about the future in Healthcare after reaching the second highest-ever quarterly revenue in Q4 2013. We mentioned in our call earlier in the year that we have acquired a new state-of-the-art Spacelabs headquarters and manufacturing facility in Washington state and expect it to improve productivity while reducing overall occupancy costs. I'm proud to announce that we have substantially completed the relocation to this 176,000 square foot facility, which allow for future expansion as the business grows and improve productivity. In 2014, we expect to aggressively gain share with new products, utilizing our GPO relationships and direct sales force. We will also continue to drive the expansion of the opportunity pipeline by engaging new customers in growing regions. Specifically, we are very optimistic about capturing market share with the state-of-the-art anesthesia system, Arkon, and expect to continue to gain sales traction after the launch earlier this year. Moving to Optoelectronics. The fourth quarter, the Optoelectronics division generated revenues of $70 million, a 24% increase from the prior year. New programs from existing and new customers contributed to the outstanding growth in the quarter and throughout the year. Exposure to multiple markets also allowed Opto to have access to a wide pool of opportunities, driving top line growth. Overall, we are really excited about our prospects and look forward to delivering growth in OSI revenues and profits in the coming year. With that, I'm going to hand the call back over to Alan to talk in detail about our financial performance and guidance before opening the call for questions. Thank you.

Thank you, Deepak. Our continued focus on driving higher-margin growth initiatives and operating improvements throughout the company has succeeded in delivering significant earnings. As we start our fiscal '14, we are excited about the prospects for both revenue and earnings growth. I'll speak more to our guidance shortly. But first, let me review in more detail the financial results for the fourth quarter. Net revenues in the quarter were down 3% versus Q4 last year. Revenues from our Security division decreased 18% in the fourth quarter, primarily due to the impact of the U.S. Army integration contract I mentioned earlier. Excluding the prior year impact on revenues from this program, Security division had robust sales growth. Our Opto division continued its strong top line momentum, with 24% sales growth for the quarter as a result of continuing success in broadening our customer base. And finally, though our Healthcare division revenues dipped by 2% in Q4 year-over-year, it was up 41% sequentially, as we mentioned earlier. The fourth quarter gross margin of 38.2% was very encouraging, up by a significant 380 basis points from the same quarter last year. This increase was mainly driven by our better mix of revenue in our Security division, including increased turnkey security sales. The margin expansion is particularly noteworthy since our lowest gross margin division, Opto, experienced significant sales growth, which places pressure on the overall company gross margin. Moving to OpEx. Q4 SG&A saw only a modest increase over the prior year despite the ramp up in Mexico and additional bad debt expense. All divisions have done an admirable job increasing efficiencies and managing the cost structure. We continue to invest significant resources in R&D to enhance our Security and Healthcare product offerings. Our R&D spending as a percentage of revenues was 5.6% in the fourth quarter of fiscal '13, which was just slightly lower than the comparable quarter in '12. We focus our efforts on innovative products and technologies to add value to our Security and Healthcare product offerings and to enhance future growth. We are seeing the results of these efforts in a number of new products that are being released. Restructuring and other charges were $3 million in the quarter, primarily related to the move to our new Healthcare headquarters which, as Deepak mentioned, not only will facilitate growth but is expected to result in substantial cost savings over many years. Please note this move was completed in 2 phases, the first of which occurred in our fourth quarter and the second of which will be completed in our first quarter of fiscal '14. We are currently anticipating restructuring and other charges of approximately $3 million in connection with the second phase of the move and the consolidation of one of our Opto facilities. These charges are excluded from our non-GAAP EPS. Our effective tax rate for fiscal '13 was 26.6%, excluding the impact of a noncash tax charge of $6.8 million. This charge was incurred as a result of electing to accelerate the depreciation for tax purposes of certain fixed assets related to our Mexico turnkey program. Mexican tax law afforded us the opportunity to save approximately $26 million of taxes in fiscal '13 by accelerating the depreciation of fixed assets. By making this election, portions of the tax basis of the underlying assets were forfeited, resulting in a noncash tax charge in the year the election is made. In addition to saving cash taxes in the near term, this election to accelerate depreciation was made fairly obvious because the tax lives of the underlying assets exceed the 6-year initial term of the program by up to 14 years, thus potentially resulting in the forfeiture of a large portion of the cost of the fixed assets. Including this noncash tax charge, our effective tax rate was 36.4%. Our provision for income taxes is dependent on the mix of income from U.S. and foreign locations, due to tax rate differences among countries, as well as the impact of permanent taxable differences and valuation allowances, among other items. Gross margin expansion, coupled with solid cost management, led to Q4 earnings per share of $1.02 as compared to $0.79 in the comparable prior year period, excluding restructuring and other charges, as well as the noncash tax charge noted previously, which represents a 29% increase. The GAAP EPS, including these restructuring and other charges and a noncash tax charge, was $0.58. Moving to cash flow. As we mentioned on recent quarterly calls, we expected to see significant volatility in cash flow in fiscal '13, primarily as a result of the Mexico turnkey program. Our cash flow from operations in fiscal '13 was $59 million. This operating cash flow was used to partially fund our capital expenditures, which totaled $157 million for the year. This is consistent with our previous guidance that CapEx would be significantly higher than historical norms in support of our Mexico turnkey program. Our year end DSO increased over the prior year as a significant portion of 2012 Q4 sales were collected in the same quarter prior to year end, whereas a larger portion of our Q4 '13 sales have already been or expected to be collected in Q1 of '14. Partially offsetting the rise in DSO was a corresponding increase in days payables. In addition, we repurchased approximately 12 million in stock during fiscal '13. We expect the current business to lead to solid cash flow in the future as we generate significant cash, with most of the initial CapEx spending on Mexico behind us soon. Finally, turning to our fiscal 2014 guidance. With the solid outlook for each of our businesses, our revenue guidance for fiscal '14 is $870 million to $895 million, which represents 8% to 12% year-over-year growth. As you know from past calls, we provide overall company guidance. Rather than by division or program. We anticipate diluted earnings per share of $3.22 to $3.38, excluding impairment, restructuring and other charges, which represents 17% to 22% growth on a non-GAAP basis over fiscal '13. This range factors in increased investments in R&D and a higher effective tax rate. We are working on and investing in a number of new innovative R&D programs, which we will share at the appropriate time in the future. With this, we expect such costs to rise somewhat in proportion to our sales growth in fiscal '14. During the past few years, we have transformed our company and as a result, we have consistently delivered a strong bottom line along with significant operating cash flow. The investments we have made have enabled us to be the leader in turnkey screening solutions and strengthened our other businesses, allowing the company to perform well despite a challenging worldwide economic environment. We believe we are well positioned for continuous strong growth in the coming years, and we look forward to sharing our progress on upcoming calls. Thank you for listening to this conference call. And at this time, we'd like to open the call to questions.

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

The questions I have, can you give us an update on FMS? Where we are? And then maybe talk about Mexico. Are you 80% done with Mexico? And when you will you be 100% done?

Brian, regarding your question of FMS, you know that we are very careful if and when there's anything active going on. We refrain from talking about any specifics. All we can say is we continue to work with both sides, the Iraqi government and U.S., and we are feeling good about it, and that's about it.

And Brian, it's Alan. With respect to Mexico, yes, we have made substantial progress. At year end, we were roughly 3/4 of the way through being fully ramped up. And we believe that during fiscal '14, we'll be -- we should be 100% ramped up or very, very close thereto.

Okay. So by third or fourth quarter, you should be near 100% in recognizing near 100% revenue. It will be a year or 2 before you're hitting peak margins in Mexico?

I think the margins throughout fiscal '14 should be very strong for us, and we'll be close to that rate.

Okay. And then just one other question. On the TSA testing, has that kicked back in? Or did it ever stop on the RTT? And what's the status of that?

An answer to your question, it never stopped. We continue to work with TSA, not only just with the check baggage program RTT but also with the checkpoint. We are still hopeful, we are in test cert [ph]. We are still hopeful that we get through by the end of calendar year. But like I said, this is a long process, and we continue to work with them. It never stopped.

Your next question comes from the line of Tim Quillin with Stephens Inc.

So the -- I'm not sure I heard you right in terms of the turnkey pipeline, but did you mention domestic and when you're talking about that pipeline?

Tim, we have said all along that we continue to look at all opportunities. And it's true, we are actively pursuing both domestic and international.

Okay. Now would that -- so I think that's a little bit of a new wrinkle from my perspective, anyway. So would the domestic opportunities be federal or some other entity?

Well, Tim, for competitive reasons, I think I will rather not say it, except that we continue to look at all opportunities, and we are working with the customers. And one of the things we've always said, every large sale of cargo can be converted into a turnkey thing. So as we get more traction with Puerto Rico and Mexico and more and more people get comfortable with it, we think that there's also domestic need. I'm not going to go any further or which side of the domestic business.

Okay. And is it accurate to say at this point that your turnkey pipeline in terms of the number of opportunities is bigger than it was 3 months ago?

Absolutely true. We are getting a lot of traction. And as we expected, with the success of Puerto Rico and Mexico, they are live sites. People are more comfortable and references a good point. And definitely, our pipeline is quite strong. We have increased our sales penetration and people in -- just for the services business worldwide.

And what's your comfort level in winning an additional turnkey contract before the end of the calendar year?

Well, we are very optimistic, let's say, and we continue to work on it. But again, Tim, these are some of the things that we have a policy that we don't want to talk much detail until the eagle has landed.

Right. No, that's fair. That's fair. And when I look at your guidance for fiscal '14, are you including anything in the guidance from an additional turnkey when -- or from equipment orders from the government of Iraq?

Tim, this is Alan. So our guidance incorporates a number of factors. Of course, a new turnkey win always takes into account that there'll be a significant time lag for ramping up the revenues, so there wouldn't be any significant revenues embedded in our guidance for fiscal '14 associated with the new turnkey win. That would most likely impact us to a much greater extent in fiscal 2015, similar for FMS.

Right. Any update on the RTT pipeline in Europe, what your expectations are for order flow for that product?

We continue to work, as we had mentioned in the last conference call, Tim. Whenever you are not the incumbent, there's lots of concern the way customers look at it. We said in the last conference call that we have won multiple orders in that part of the world. We are happy to announce that we've already won additional orders internationally, and we continue to pursue many, many other opportunities. Regarding the shipping, just like Alan mentioned on the FMS and on any turnkey, it's not a simple book and ship. It takes a little time, so we are expecting some revenue latter part of -- on this year. But it's a real ramp-up in our opinion, contribution will be next year.

Okay. And then just finally and I'll step back in the queue. But can you give us an update on what you're seeing in terms of demand for the Arkon anesthesia delivery system?

Very well received. Again, new product. We are testing the customers, got rave reviews wherever we have shown it. And again, it's going to be a slow start, and we think that it's going to really make us a player in the anesthesia industry, but it'll take some time to get there. But it definitely has started in this fiscal year. Alan, you want to add something?

I think that captures it well. We've seen a modest amount of revenues thus far through the end of fiscal '13. And I expect we'll see a modest amount of revenues in the first half of fiscal '14, picking up steam from there.

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

Could you give us a sense in terms of your guidance on what kind of relative assumptions, whether they're modest or nonexistent, in terms of RTT in your fiscal '14 guidance and then also for FMS?

Sure, I'll take that, Jeff. Within our guidance, as you know, we've won some orders on RTT so that is embedded in our guidance and maybe a small increment from there. But as Deepak mentioned, it is really primarily -- though we'll expect to see some nice bookings in fiscal '14, we think that the revenues would follow in fiscal '15. FMS, we think the biggest proportion of the revenues would also likely be in fiscal '15 if we were so fortunate as to win that contract.

Okay. But nothing embedded in the guidance on that?

Nothing significant.

Okay. And then could you touch on the bad debt reserve for Opto? Is that something you typically have a certain degree of? Is that tied to some credit issues at a customer? What caused that? It seems somewhat material.

Yes. We have a pretty good track record of having a very, very low bad debt write-offs or expense, if you will. We had 1 particular customer, and really 2 customers, but 1 of a bigger nature that frankly just sort of went belly up in the fourth quarter. We started seeing signs of it in the third quarter, and there were some reserves taken there as well. But the fourth quarter really became a challenge for them. So we believe it was -- in accordance with GAAP, it was most appropriate to expense the receivable that we had on our books. They didn't represent a significant amount of revenues in fiscal '13 so as we look forward, it's not of a material impact to us going forward.

Okay. And then could you characterize or quantify the annual cost savings from the restructuring and lease termination activities that have happened in Q4 and expect to happen in Q1 of '14?

Yes. We're very excited about our new facility for our Healthcare division, and we think that will result in $2 million plus of annual pretax cost savings to the company from fiscal '14 forward.

And you had some off of some smaller restructuring charges for Opto and Security. Does that have an annualized savings tied to that as well?

Yes. The additional restructuring charges that we had, most notably in Security, will also result in probably a 7-figure cost savings for us going forward as well.

[Operator Instructions] Your next question comes from the line of Yair Reiner from Oppenheimer. William Lee - Oppenheimer & Co. Inc., Research Division: This is Will for Yair. So if we're going -- thinking about the RTT product, I understand that Smiths was able to get their machines certified first from the TSA. Does that create any wrinkles to your certification process? And are you still targeting certification by end of this calendar year?

This is Deepak here. It has no bearing on our process of certification. At any time, at TSA, they have multiple units being tested. And we think that the long term, there is no problem in us versus Smiths has already got certification. The business climate is very healthy. And when the procurement decisions are made, it's made mostly on multiple vendors. William Lee - Oppenheimer & Co. Inc., Research Division: Right, right. And in terms of timing, are you still targeting something at the end of this year? Or I guess, has there been any indications that, that timing may be shifted to the right a little bit? Or is it still the same?

It's very difficult to pin it down. We continue to work with it. We perform what we know today. We continue to feel very good about it, that we will complete the certification process. And by the way, it's multiple steps. Smiths is now into the next step of what is called the OTE, Operational Test Readiness. We go from pre-cert to the next stop, and we feel good about it, but it can slip. I mean, unfortunately, this is one of those things. We've been talking about it for some time. It's a blind test. And people take multiple iterations to do it. We feel good about it and continue to work diligently with TSA. William Lee - Oppenheimer & Co. Inc., Research Division: Right. And one last thing. Can you just remind me how much revenues was from the Army system integration contract in the first quarter of this year? Was anything meaningful?

This is Alan. No, it was not meaningful. Really, the bulk of that $98 million contract was shipped in fiscal '12, so the amount in Q1 of fiscal '13 was relatively very small.

Your next question is a follow-up from the line of Tim Quillin with Stephens, Inc.

These are mostly detail questions. And so Alan, do you have in front of you the more precise backlog number? I know you said $1 billion in the press release.

Yes. It rounded up to $1 billion, Tim. It was in the upper 9s.

And do you have a number for the Security backlog? Or can you give us some sense of what Security bookings were in the quarter?

Security bookings in the quarter were about $74 million, and the backlog was about $800 million.

So $74 million, a pretty sizable number, given where the U.S. government order flow was. Do you have any early read on bookings expectations for the September quarter?

Well, Tim, as you know that everybody from the past historically looks at that as a government year end big booking kind of a thing. We have -- we are working with some year end monies. But I won't call it that our expectation is as high as previous year's. But our booking prediction for the rest of the world is quite strong.

Yes. It seems like things are going well outside of the U.S.

Just to add on to your question, we are very, very happy with the Q4 backlog -- the bookings. That is very, very healthy, especially with what's going on and what you have seen from the other companies in our space. And that's basically our strength is very global, very geographic and a very broad product line.

Absolutely. Do you have CapEx -- specific CapEx plans for 2014? And/or how much capital expenditures are left for the Mexico project?

Sure, Tim, this is Alan. We don't provide a guidance on the CapEx line item. But what we would say is that the bulk of the spending on Mexico was behind us in -- by the end of June. There is still some more spending to go, but the large majority of that is behind us. So as we look at fiscal '14, while we have some more Mexico, we have our normal business. And then, of course, we would hope to get a new turnkey business, which will factor into that as well.

Got it. Do you have, Alan, in front of you what depreciation and amortization was for the fourth quarter?

$9.6 million.

And stock compensation expense?

1 second. $4.9 million.

And then in terms of the depreciation and amortization for 2014, obviously, a lot of that will be determined by the way you depreciate equipment in Mexico. And I wasn't -- I'm not exactly clear how the accelerated depreciation might factor into that. But maybe if you can give us just a sense of how, first of all, what -- how we should think about depreciation and amortization for fiscal '14 and how you're depreciating equipment for Mexico and how the acceleration plays into that?

Sure, Tim, it's Alan. Yes, we would expect the depreciation and amortization for fiscal '14 to be substantially higher than fiscal '13, given the ramp-up in Mexico. We tend to depreciate Mexico over the term of the contract. The accelerated depreciation has no bearing whatsoever on how we book depreciation. That is purely a tax concept, so it's what we file on our tax returns, but not what you see as depreciation in accordance with GAAP. So you sort of take that off the table. It won't impact the way you're thinking about it. But we have not been a company that, historically, has talked about EBITDA as D&A is something that is significantly ramping up. And when you start to take a look at EBITDA, we are expecting significant, significant growth in fiscal '14.

There are no additional questions at this time.

This is Deepak here. I would like to thank everyone for joining our call and want to, again, thank all the stockholders, thank our employees, thank customers. It's been a good finish to a year where we had some challenges, and we look forward to speaking with you again on our next call, and we are very excited about our future with new products, old divisions, old portal and continuing penetration into our turnkey businesses and RTT. Thank you very much.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.