OSI Systems, Inc. (OSIS) Q2 2015 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Second Quarter 2015 OSI Systems' Earnings Conference Call. My name is Tahisha, 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.

Good morning and thank you for joining us. I'm Alan Edrick, Executive Vice President and CFO of OSI Systems and I am here today with Deepak Chopra, our President and CEO. Welcome to the OSI Systems' second quarter fiscal 2015 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 is expected to remain on our website, located at www.osi-systems.com, for at least two weeks. Earlier today we issued a press release announcing our second quarter fiscal year '15 financial results. Before we discuss our financial and our 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 during this call that may be deemed to be forward-looking statements under the Act. Forward-looking statements relate to the company's current expectations, beliefs, projections and similar expressions and are not guarantees of future performance or outcomes. Forward-looking statements involve uncertainties, risks, assumptions and contingencies, many of which are outside the company's control that may cause actual results or outcomes to differ materially from those described in or implied by any forward-looking statement. Such statements include, without limitation, information provided regarding expected revenues and earnings in fiscal 2015 and statements regarding the expected overall financial and operational performance of the company and its operating divisions. The company wishes to caution participants on this call that numerous factors could cause actual results to differ materially from these forward-looking statements. These factors include the risk factors set forth in the company's last annual report on Form 10-K and other risks described in documents subsequently filed by the company with the SEC from time to time. All forward-looking statements made on this call are based on currently available information and speak only as of the date of this call. And the company undertakes no obligation to update any forward-looking statement that becomes untrue because of new information, subsequent events 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 financial measures and comparable GAAP measures and a quantitative reconciliation of those figures, please refer to today's press release regarding our second quarter results which has also 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 will provide a high level review of our financial performance. We will again touch on several themes that we have discussed during past conference calls. Financial highlights for our second quarter of fiscal ‘15 are as follows: First, we reported record second quarter revenues of $258 million, a 9% year-over-year increase. The growth was driven by another solid quarter in our security division, which grew 29% as a result of strong equipment sales, including partial fulfillment of the Foreign Military Sales contract to the U.S. Department of Defense. Second, we reported record Q2 non-GAAP diluted earnings per share, excluding restructuring and other charges, of $0.96, which represents 23% year-over-year growth. This marks the 21st quarter out of the last 22 that we achieved double-digit non-GAAP EPS growth. And third, we generated strong Q2 free cash flow of $26 million resulting in a record first half free cash flow of 54 million. We concluded the quarter with a very solid balance sheet. Before jumping in to additional financial details, let me turn the call over to Deepak.

Thank you, Alan. And again good morning, and welcome to the OSI Systems' earnings conference call for the second quarter of fiscal 2015. We are now halfway through our fiscal year and are pleased to announce that we have delivered record revenue and earnings for the first half. The security division continues to lead the way delivering excellent revenue growth and higher profitability. Alan will go into the financials of each division in more detail, but first I like to discuss a few of the second quarter highlights by the division. Let’s start with the security division. During the quarter, as Alan has mentioned, we continued to execute well on the Department of Defense Foreign Military Sales contract where we provide security inspection equipment to Iraq. These FMS deliveries contributed to the security division achieving revenues of $137 million, representing a growth of 29% for the quarter. We continue to make headway with the real-time tomography or advanced CT hold baggage solution. Shortly after the quarter end, we announced a $5 million order from an international customer to provide multiple RTT110 units, which are certified under the European Union Standard III requirements for hold baggage screening. We see a growing pipeline of potential RTT customers internationally and expect to continue capturing wins going forward. We are at present actively involved in multiple international hold baggage screening tenders. As you may know from listening to previous calls. The RTT is in certification process at the DSA, though our book-to-bill ratio was a little soft for the quarter, we are very optimistic and confident about our near-term opportunities. The international sales pipeline for our broad product offering continues to grow in all regions. In turnkey services, which as you know, had a long sales cycle, we are in discussions with several customers internationally. These potential customers benefit from being able to review the demonstrative successes of present existing turnkey programs. During the quarter, we were honored to be selected as a winner at the Government Security News Magazine’s 2014 Homeland Security Awards in the detection product category with our CounterBomber system, a radar-based standoff threat detection solution. CounterBomber can identify concealed person, borne threats such as suicide vests and can do that at a standoff distance. The initial feedback from the marketplace gives us confidence that CounterBomber addresses a growing threat in certain hotspots around the world and we will seek to capture these opportunities. Cargo products continue to be one of the fastest growing product lines as we see potential demand from new customers and from an expansion of existing relationships. In the passenger aviation and air cargo markets, we continue to place inspection systems at checkpoints and hold baggage areas with both conventional and real-time tomography systems at airports and at air cargo facilities. Our innovation and leadership in developing new solutions has really benefited us as we deliver leading technology solutions to our customers. The ample activity we’ve seen during the last few quarters, size of the opportunity pipeline and existing backlog give us confidence in our ability to deliver continued strong results from the security division. Moving onto healthcare division, Spacelabs revenues were $69 million, an increase of 10% from the prior year. The overall healthcare market for medical equipment continues to recover albeit slowly. Spacelabs’ revenues growth in the quarter was favorably impacted by the recent Automated External Defibrillator, AED acquisition. But the division’s operating margins was somewhat unfavorably impacted by the same. We continue to integrate the AED business into our medical product line. Our innovative anesthesia platform Arkon contributed to the top line growth during the quarter as we gained share in a market segment in the U.S. that is relatively new to us. We continue to grow our anesthesia delivery market share and expect Arkon to become a meaningful contributor to the division's performance in the future. During the quarter, we also expanded our presence with group purchasing organizations in U.S. These organizations continue to increase their importance in the hospital spend for equipment, supplies and accessories. To that end, we recently announced that we were awarded a three year group purchasing contract from Premier, Inc. one of the largest GPOs to provide outpatient monitoring systems including our flagship XPREZZON product. We now have patient monitoring contracts with all the leading GPOs. Looking ahead, we anticipate improvement in sales growth and profitability at Spacelabs, as we shift forward a more favorable product and geographic mix and fully integrate the recent AED acquisition. Moving to our optoelectronic division which had revenues of 66 million in the quarter, a 14% lower than prior year. A couple of factors contributed to lower growth which we are expected, planned and previously communicated. We had a difficult comp in this quarter because in the prior year, we had significant sales to an international customer that ordered well above its normal demand pattern to stock inventory for a newly created channel. We are also rationalizing the customer base, choosing to end certain contracts with marginal profitability. In addition, we strengthened the operations improving the operating margin. I should note here that the stronger inter-company sales did help to reduce the effect from these factors. At Opto division we continue to gain traction with new customers and programs. As an example during the quarter we announced a $7 million order from an OEM serving the defense and aerospace high-performance computing market to provide electronic sub-assemblies. We also saw increased order demand for optical components from customers in the defense and communication industries. Our products are utilized by a variety of end customers. As an example we are truly proud that our optical sensors were utilized in the guidance system of Rosetta, a spacecraft launched by the European Space Agency in 2004. Recently Rosetta became the first spacecraft to land on a comet. So in Q2 at Opto, we took the opportunity to initiate rationalization of our manufacturing footprint and continue the shift to a greater focus on opportunities that enhance profitability. We expect to further see the benefit of these efforts in the future. Overall, we are pleased with our performance in this quarter and look forward to a very successful second half. I would like to thank our employees, customers and shareholders for this continued support. With that I'm going to turn the call over to Alan to talk in detail about our financial performance before opening the call for questions. Thank you.

Thank you, Deepak. Our ongoing effort to deliver meaningful revenue and earnings growth through higher margin growth initiatives and operating improvements continues to prove successful. Let's review in greater detail the financial results for the second quarter of this fiscal year before discussing our updated fiscal 2015 guidance. Our revenue in the second quarter of fiscal '15 increased 9% over Q2 of last year. This was primarily due to 29% revenue growth in the quarter at our security division resulting from deliveries on the FMS contract entered into in June of 201, the strength in our equipment services business and new product introductions. Revenue on our healthcare division increased 10%, resulting as Deepak described, primarily from the acquisition of a cardiology business in our first quarter. Sales in the emerging markets were quite strong. While sales in the higher margin North America and European markets were lighter than anticipated. Based upon our backlog in our opportunity funnel, we head into Q3 in the healthcare division in the stronger position than in past years. And as expected, our Opto division’s revenue decreased 14%, as a result of lower contract manufacturing sales given a tough comp due to factors that Deepak just discussed. Our Q2 gross margin came in at 34.6%, an increase of 40 basis points as compared to Q2 in the prior year. This improvement was driven by a number of factors, most notably the impact of operational improvements in the Opto division coupled with a decrease in revenue in this division which typically carries the lowest gross margin of the company's three divisions. These improvements were partially offset by the adverse impact of product and sales channel mix within our healthcare division. As mentioned on previous calls, the margin will fluctuate from period-to-period based upon revenue mix amongst other factors. Let's move to OpEx. In Q2 of fiscal '15, SG&A as a percentage of sales decreased to 18.6% as compared to 19.3% in the prior year. In absolute dollars, the increase in SG&A of 2.3 million supported the 9% sales growth. Our goal continues to be to hold the SG&A growth rate below the rate of sales growth, though individual quarters may vary from this. We remain committed in all of our divisions to increasing efficiencies and managing our cost structure prudently. We continue to invest significant resources in R&D to enhance our security and our healthcare product offerings. Our R&D spending of $13.2 million in Q2 was up 19% from the prior year, primarily due to increased spending to support our next generation of products in our security division. As mentioned on our last call, we expect an elevated level of R&D spending in fiscal '15 as we developed innovative technologies to broaden our product offerings and enhance future growth. Our effective tax rate was 27.7% for Q2 of fiscal '15 and 28.1% for the first half of this fiscal year. 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, tax selections and valuation allowances, among other items. Moving down the income statement, our Q2 GAAP diluted EPS was $0.89, a new record. The Q2 non-GAAP earnings per diluted share, which excludes restructuring and other charges was $0.96, also another new record, compared to $0.78 in the comparable prior year period, which represents 23% growth. Let's now turn to a discussion of our operating margin, excluding restructuring and other charges. The Q2 adjusted operating margin was 10.9% compared to 10.2% in the prior year. The security division reported an operating margin of 16.2%, improving from 15.8% in Q2 last year. As mentioned in my previous calls, we expected to see a sequential increase in Opto's operating margin. This again, proved to be true, as Opto's adjusted operating margin increased from 6.5% in Q1 to 6.8% in Q2. Finally, in healthcare given the change in the geographic and product mix and the impact from the integration of the acquisition, the healthcare division's operating margin declined from 14.6% to 10.8%. We are cautiously optimistic that we will see operating margin expansion in the healthcare division during the second half of this fiscal year with a more favorable product and geographical mix. For the company overall, adjusted EBITDA margins for Q2 increased year-over-year from 18.1% to 18.8%. Moving to cash flow, for Q2 of fiscal '15 we reported operating cash flow of $29.5 million, capital expenditures totaled $3.4 million in Q2 while depreciation and amortization was $14.3 million. Day sales outstanding or DSO was 65 days in Q2 compared to 63 days last year. Our level of DSO frequently fluctuates significantly from period-to-period and we used approximately $4.5 million for our share repurchase program including net settlements during the quarter. Our balance sheet is strong and our leverage ratio remains well below one. Our credit facility continues to provide the company with flexibility to execute our business plan and respond to opportunities. Finally, turning to our fiscal '15 guidance; we are increasing our revenue guidance to be between $975 million and $998 million for fiscal '15. We are slightly increasing our guidance for fiscal '15 non-GAAP diluted earnings per share which excludes the impact of impairment restructuring and other charges to $3.54 to $3.76. We currently believe the sales and earnings guidance reflects reasonable estimates. However actual sales in earnings could vary from this range because of the risks and uncertainties applicable to our business and industries. During the past few years we have built a strong foundation for growth and have consistently delivered a strong bottom-line along with significant operating and free cash flow. Our investments have enabled us to become the leader in turnkey screening solutions that allowed us to introduce innovative products and services to the market. 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.

Thank you. [Operator Instructions]. Your first question will come from the line of Tim Quillin from Stephens, Inc. Please proceed.

Hi, good morning. Alan as much as I appreciate the backlog in billions of dollars, would you be able to provide the backlog numbers in millions of dollars for this quarter and last quarter if you have that information available?

Tim as we've been reporting over the last several quarters or last several years actually we've been reporting in billions. I don't have the actual amounts. The number didn't in fact around to $700 million from a rounding perspective. I believe the number was just shy of that.

Okay, so I guess what I would hope to get out at this that the last quarter was $0.8 billion. This quarter was $0.7 billion, was there really a full $100 million reduction in backlog quarter-over-quarter.

Sure yeah. Tim, the change in backlog predominantly was a result of the normal recognition of revenue on the Mexico contract. The FMS contract with which we recognized significant revenues. And then as Deepak described, our bookings were little bit soft in this past quarter, Rapiscan though the outlook looks extremely strong for the second half.

Okay and what were the bookings for Rapiscan for the quarter.

The non-turnkey book-to-bill ratio was a little bit north of 0.5.

Little north of 0.5, okay. And then what was the FMS deliveries during the quarter, the revenue contribution from the FMS order?

The FMS revenues were strong this quarter; they were a little bit more than double than they were last quarter. I believe last quarter 17 million on equipment, the equipment deliveries were a little bit north of double at this quarter.

Little north of 34, okay. And then what is the expected timing of a potential follow-on order from Iraq?

Tim as you know that we are in discussions and normally never make a comment of the timing but we are hopeful that we will have some good results in the next quarter or so.

And I know this is a little bit hard to do but when you think about that opportunity, is it something that’s relatively certain where that follow-on is necessarily, necessary to complete the project they have started or is it relatively uncertain?

Well you know that we as a company we never comment on it. Nothing is written in stone till it happens. We are working with the government both with the U.S. side and the Iraqi government. They are happy and once they start a program obviously we have an advantage and the units are well received. We are installing the units and deploying them as we speak.

Okay. And then what was the contribution from the Defibrillator acquisition in the quarter?

Tim, the December quarter is typically the strongest in this business as we understand it, very new in our portfolio but the contribution was north of 6 million.

Got it. And then just last question or I’ve actually two questions, but one question is around the EPS guidance which I don’t think you’ve narrowed the range yet so far this year so there’s a fairly wide range on the EPS guidance where does that variability come from and then last question is around your CapEx plans for the year, I think you’ve only had 6.5 million year-to-date is that kind of the run rate we should think about for the rest of the year? Thank you.

Sure Tim, its Alan. I’ll answer both of those questions in inverse order. On the CapEx side of the equation, CapEx has been a little bit lighter in the first half of the year. We do expect CapEx to pick up a bit in the second half of the year. Certainly it’s well down from the past couple of years as we've rolled out FMS, FMS -- as we have rolled out Mexico which was a highly capital intensive project. Of course we hope to win new turnkeys which could kick up that CapEx again in the future, but we do anticipate the number to increase in the second half. From earnings per share perspective we have a range of $0.22 and when you equate that into dollars and cents, it’s not as wide of a range as that sounds. So it’s a lot of the variability that can take place in all three of our divisions but namely in security and healthcare we think that’s a prudent range and based on various factors we’ll see how it ends up turning out.

All right. Thank you.

Your next question will come from the line of Brian Ruttenbur from CRT Capital. Please proceed.

Yes thank you very much. I did not catch the book-to-bill even though you said it twice, what was the book-to-bill ex-Iraq FMS?

We gave a book-to-bill ex-turnkey which was a little bit north of 0.5. If we exclude FMS, the number would be significantly higher.

Okay. And you expect the book to bill to get back up to one on a year, the fiscal year?

Well Brian, this is Deepak here. Our pipeline is very, very robust and strong both in the cargo and the RTT area and we expect the bookings to be up much stronger in the second half.

And Brian this must revenue for Rapiscan not OSI overall.

Great. And then next question I had was a buyback, did you have any buybacks in the quarter?

We did Brian we bought back little bit under $5 million of buyback activity.

What was the average price?

It would have been in the, the average price would have been in the high 60's I believe.

Okay. And your plan for additional buybacks is I think you still have what $46 million authorized?

Yeah Brian we have actually our number authorizes is a bit above that and we certainly look at it from time to time with competing priorities.

Okay do you know how much you have authorized still?

I'd want you to ask -- if you have any other questions I’ll get to that answer.

Okay yeah I’ll keep asking other questions you can look that up and if you don’t have it right off we can just circle around later. The reason for the weakness in the bookings and in the period was there anything seasonal involved?

Well Brian it’s always is. Basically you’re chasing cargo and the RTT tenders and some of them get delayed. We haven’t lost any. Our pipeline continues to be very strong and it always has been, basically it goes from the quarter to the next quarter.

Brian its Alan. So your earlier question on the buyback we have 880,000 shares authorized still which would equate to roughly $60 million.

Okay. And then can you give us -- always the same question somebody has to ask it, status of the RTT certification?

Yes, well I did say it in my opening that we are still at the third certification testing at DSA and keep in mind that we do have certification ECAC in Europe and most of the activity that we have talked about and addressing it and the strong pipeline and the active tenders that we are involved in are all ECAC European based certification.

Okay. And then last question in terms of cash flow on the year, core to your guidance as I back into it you should generate north of $100 million of free cash flows, does that seem reasonable still?

That certainly seems in the ballpark depending upon how things play out for working capital requirements, CapEx requirements, but that's not a bad proxy.

Okay, thank you.

And your next question will come from the line of Josephine Millward from Benchmark Company. Please proceed.

Hi Deepak, hi Alan.

Hi Josephine.

Deepak can you expand on what droves your guidance increase it seems like you are more confident on healthcare, you did better macros or the new TPO relationship, can you just talk about that?

Would you repeat the question again Josephine I am sorry I didn’t understand it.

Sure just trying to get a better sense of what drove the guidance increase. It seems like you are more confident on healthcare, if you can talk about why the higher confidence in healthcare is it macros, the new TPO or anesthesia or all of the above?

All of the above, but keep in mind that we are also very optimistic about the continued strength in our security business, if we are also feeling a little bit more comfortable as the economy improves in the Optoelectronics business in the Opto side where we see the defense and the aerospace sector and the healthcare sector in our OEM business also looking positive, but primary our guidance, confidence of increasing is to do with the healthcare, but lot of various things we are pursuing in the RTT and the cargo area.

Great. On RTT the $5 million order that you received recently, is that for Western European airport or is it outside of Europe?

Well, all I can tell you as you know that you already know the answer, it’s international.

Okay. Can you give us an update on Albania if there is an update?

We are actively still pursuing our rights working with the government, and more than that we don’t want to talk about it hopefully it will be a positive conclusion.

Great, thank you.

[Operator Instructions]. Your next question will come from the line of Jeff Martin from ROTH Capital Partners. Please proceed.

Thanks, good morning.

Good morning, Jeff.

Deepak could you characterize the cargo pipeline on a geographic basis I know you talked about Middle East in prior calls and does the decline in oil have any impact on the sales cycle with potential customers in the Middle East?

Our cargo pipeline continues to be robust in all geographies and we haven’t seen any impact on the oil side yet.

Okay. And then could you characterize what kind of some of the swing factors are for next year in terms of growth I mean not asking you to quantify a growth rate for next year but obviously an FMS follow on order is a big swing factor what other areas do you see being impactful to supporting a growth year in the mid-single-digit to low double-digit revenue?

Jeff, this is Deepak here, not in the same priority, but just generally answering your question. We see a tremendous amount of opportunities in RTT in the HBS product line in cargo, in healthcare and in turnkey. And obviously we are optimistic about the FMS. But the focus, as I said that in my presentation before, we are actively involved in multiple multi-machine international tenders in RTT. As Europe moves towards the deadlines approaching for their requirement to go to the next technology, there is a lot more activity in the international sector for buying RTT HBS products. Cargo, we've also said to you is a huge pipeline for us and cargo and turnkey are next to each other, have turned together.

Okay, great. And then can you help us understand, you get a $5 million order from two international customer for RTT, what kind of roll-out should we expect? Will that hit in one quarter and if so which quarter do you expect that?

We have other orders too in the backlog. We have started shipping RTT products and we'll continue to ship them in the second half though the big, big increase would be in next year and we have started ramping up production.

Okay, great. And then with the GPO relationship with Premier. How should we think about the roll-out and impact of that too to healthcare in terms of timing and magnitude?

GPO's, we are in all the GPO's almost, now and they buy product as their partners, as their hospitals ask them to and they are basically consolidating their orders so that the average size of the order has become bigger for the same time the timing becomes a little bit more longer.

Okay, great and then Alan, is there additional seasonality in the Defibrillator business that we should be aware of in terms of modeling out healthcare for the balance of the year?

No, we don't believe so. What we've seen from looking at cash trends before we bought the company, was that the December quarter tended to be the highest but a little less seasonal in the March-June quarters.

Okay.

Jeff, just to add on to it. We are not going to be talking about in the future as a separate product line. It is part of -- they are integrating it into a product line in healthcare. So the seasonality will be less meaningful and our real excitement is we plan to take that product and put it into Spacelabs' international distribution channel, so we can capture more business. So that it will not be reported as a separate because we don't break it up for competitive reasons after separation going forward.

That's helpful. Thanks guys.

We have no more questions in the queue. I would like to turn the call back over to Mr. Deepak Chopra. You may proceed with final remarks.

Ladies and gentlemen, thanks once again for attending our conference call. We look forward to an exciting second half and speaking with you at the next earnings call. Thank you very much.