OSI Systems, Inc. (OSIS) Q3 2015 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Q3 2015 OSI Systems' Earnings Conference Call. My name is Whitley, and I'll be your operator for today. [Operator Instructions] As a reminder, this call 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.

Thank you. 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' third 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 in our Web site, located at www.osi-systems.com, for at least two weeks. Earlier today, we issued a press release announcing our third quarter fiscal year 2015 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 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 measures and comparable GAAP measures, and a quantitative reconciliation of those figures, please refer to today's press release regarding our third 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 third quarter of fiscal 2015 are as follows: First, we reported record third quarter revenues of $215 million, a 6% year-over-year increase, 8% excluding the impact of FX. The top line growth was primarily driven by our healthcare division, both organically as well as through the impact of an acquisition completed earlier this year. In addition, revenues in our security division continue to increase, albeit at a slower rate than we had been expecting. We will touch more on this later in the call. Second, we reported record Q3 non-GAAP diluted earnings per share, excluding restructuring and other charges of $0.78, which represents an 11% year-over-year growth. This marked the 22nd quarter out of the last 23 that we achieved double-digit non-GAAP EPS growth. Third, we generated strong Q3 free cash flow of $23 million, and achieved a record nine-monthly cash flow of $78 million. We concluded the quarter with a solid balance sheet. And finally, the opportunity for pipeline for RTT is strong. Recently we announced the largest RTT order in our history at one of Europe's most iconic airports. Before jumping into additional financial details and updated guidance, let me turn the call over to Deepak.

Thank you, Alan, and again, good morning and welcome to the OSI Systems' earnings conference for the third quarter of fiscal 2015. Through the first three quarters of this fiscal year, as Alan has mentioned, OSI achieved year-to-date revenue growth of 7%, and adjusted EBITDA growth of 16%. We look to finishing the year as we build further momentum for fiscal '16. In quarter three, our revenues were $215 million, 6% higher than the prior year, and we delivered an operating margin of 10%, excluding the impact of restructuring and other charges. During the quarter, we kept our focus and managed to work through challenging international markets marked with significant local currency fluctuations. We continued our efforts to seek out new customers for profitable revenue growth, and to leverage our technologies and expand our global presence in each business segment; all the while, we maintain our momentum to drive essential improvement initiatives throughout our organization. Now let's review the highlights for the quarter for each division, starting with our security division, Rapiscan. Quarter three sales were $99 million, or about 4% higher than the prior year. Historically, Rapiscan's Q3 has been a tough quarter for top line growth, however the Q3 non-turnkey book-to-bill ratio of one-to-one coupled with recently announced deals after the quarter ending, and a robust pipeline of opportunities provide optimism for the future. Here are the highlights for the quarter for Rapiscan; our traction with our new RTT real-time tomography product offering continues to grow as we announced during the quarter an international order for approximately $11 million, and after the quarter is closed another $27 million order, the largest RTT to-date for Rome's -- Italy's primary airport. Both of these orders are for the RTT110, the large tunnel explosive detection system. We see the overall momentum building in the marketplace with international airports and air cargo customers striving to meet the latest screening requirements. We also see a growing number of RFPs, Request for Proposals, in this space, especially in Europe as airports get ready to meet the latest standards by 2020. We are actively involved in various multi-machine tenders, especially in the European sector. In U.S., we achieved certification from the TSA for the RTT80, the 80 centimeter tunnel size, a significant milestone and accomplishment of which we are very proud of. As has been the case in Europe, we believe the market in the U.S. will also trend in favor of the larger tunnel requirement that the RTT110 serves, and we expect to submit the RTT110 for TSA certification testing in fiscal 2016. The RRT110 employs the same underlying technology as the RTT80, but offers a larger tunnel size, and thus is capable of screening larger items. As our customer demand has increased for the RTT110, we have started ramping up production in our U.K. facility for this larger tunnel size RTT machine. During the quarter, we continued to execute well on the Iraq border military sales order for cargo equipment, and are proud to have completed the shipments of all units for this order that we received last June. There is still a service portion of the FMS order for which we expect to continue to recognize a small amount of quarterly revenues. We believe there are further opportunities in Iraq, and we look forward to the potential to assist with additional requirements as they come available, and are well-placed and liked by the customer. During the quarter, our Mexico and Puerto Rico screening services contracts continued to successfully perform well to our satisfaction. The potential opportunities available in screening services give us confidence in our ability to grow this side of our business, but as mentioned earlier, the actual sales cycle is difficult to predict. Our international pipeline remains very strong for Rapiscan products and screening services. Specifically, we've seen expanding opportunity pipeline in cargo systems, airport systems, and screening services. On the other hand, we also see increased difficulty in predicting the timing of orders. There are many factors that seem to be contributing to the scenario. We think that the strong dollar, Middle East turmoil have had a noticeable impact here, at least in potentially delaying the decision-making process from some customers. Overall, we believe the favorable macro trends we are seeing in the market, such as increasing number of commercial partners in global trade, continuing opportunities for infrastructure expansions, and border security in the critical regions such as Middle East, and implementation by international airports to meet the latest requirements for airport, passenger, and baggage screening will create an environment for continuing long-term growth in the security division. Moving to the healthcare division, Spacelabs' revenue grew by 14% in the third quarter to $59 million. We are pleased with this growth as it reflects a mix of improved organic growth, coupled with revenue generated by our recent Automated External Defibrillator, AED product acquisition. We see good demand across certain markets, including the U.S., which remains our largest market, and many of the emerging market regions. In the U.S., hospital spending continues to firm up, albeit at a measured pace as customers are learning to live with the new norm under the Affordable Care Act environment. During the quarter, we announced a new group purchasing contract with Premier, Inc., a leading healthcare improvement company with one of the largest group purchasing organizations in the U.S. The contract covers our patient monitoring and connectivity solutions, and provides us access to Premier's members, which number in the thousands. We also continued to gain new customers for our anesthesia workstation, Arkon. Arkon sales were at a record high as a percentage of our total sales in healthcare. We expect that Arkon will be a notable contributor to our future growth in healthcare. During the quarter, we also continued to integrate the AED acquisition, and remain confident in the long-term potential of this business in the international markets. On the product development side, we introduced the AriaTele transmitter, a slim, lightweight, state-of-the-art telemetry transmitter incorporating a specialized graphic display of real-time cardio and blood oxygen data. We have other exciting data monitoring products releases planned for the near future, which we believe will contribute to sales growth. Moving to our optoelectronics and manufacturing division; total revenues declined by just under 2%, while operating income grew by approximately 47% in absolute dollars. We had a significantly higher profit on a similar level of revenues for the quarter, and are very pleased with these results. As we mentioned over the last several quarters, we're focused on improving the operating metrics for this division, and in certain cases have phased out some lower profit generating revenue area. In addition, we are nearing completion of our Opto facility plant consolidation efforts in the U.S. More importantly, these actions make us more focused, and therefore a stronger supplier to our customers. We continue to believe that an ongoing rebalance to a more favorable sales mix, and the impact of our operational initiatives will create plenty of opportunity for further margin expansion at Opto. To sum it all, based on what we see in the short-term, including the FX impact, we are adjusting our revenue and earnings estimate guidance for the fiscal year. Alan Edrick will go into this in more detail. As always, I would like to thank our employees, customers, and stockholders for their continuing support. With that, I'm going to turn the call back over to Alan to talk in detail about our financial results before opening the call for questions, thank you.

Thank you, Deepak. We continue to strive for revenue and earnings growth and capitalizing on operational efficiencies. Let's review the financial results for the third quarter of the fiscal year in greater detail. Our revenues in the third quarter of fiscal '15 increased 6% over Q3 of fiscal '14. Excluding the impact of FX, primarily due to the strengthening dollar on our Euro and British Pound-denominated sales, the growth rate was 8%. This was primarily due to a 14% increase in sales of our healthcare division, driven by stronger organic growth, and additional revenues generated by the cardiology business we acquired in our first quarter. Healthcare sales in the emerging markets continue to be strong, and we saw a top line growth in North America, while European markets were softer than anticipated. Based upon our backlog and opportunity pipeline, we are poised for further growth in Q4 in the healthcare division, compared to the prior year. Sales in our security division increased 4%, driven by deliveries on the Iraq FMS contracts, which was partially offset by the timing of bookings and deliveries of other cargo opportunities. And as expected, our Opto division revenues, while down 2%, were stronger than our first half performance, with greatly improved operating margin, which we will discuss in more detail later. Our Q3 gross margin came in at 33.7%, compared to 34.6% in Q3 of the prior year. Gross margin expansion in our Opto division, as a result of operational improvements and a favorable product mix were offset to a greater extent by a less favorable sales mix in the security and healthcare divisions. As mentioned on previous calls, the margin will fluctuate from period-to-period based on the revenue mix, among other items. Moving to OpEx. In Q3 of fiscal '15 SG&A as a percentage of sales decreased to 17.6% from 19.3% in the prior year. We continue to manage costs closely, and in absolute dollars SG&A decreased on a year-over-year basis by $1.4 million, or 4%. This was aided by the strengthening dollar in many countries in which we have local operations. We remain committed in all of our divisions to increasing efficiencies and managing our cost structure prudently. Our goal continues to be to hold the SG&A growth rate below the rate of sales growth, though results in individual quarters may vary. We continue to invest significant resources in R&D to enhance both our security and our healthcare product offerings. Our R&D spending of $12.6 million in Q3 was up approximately 19% from the prior year, primarily due to increased spending to support our next generation of products in our security division. As mentioned on previous calls, we expected 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 25% for Q3, and 27.2% for the first nine months 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 Q3 GAAP diluted EPS was $0.64, compared to $0.23 last year. The Q3 non-GAAP earnings per diluted share, which excludes restructuring and other charges was $0.78, compared to $0.70 in the comparable prior year period. Let's now turn to a discussion of our operating margin, which excludes restructuring and other charges. The Q3 adjusted operating margin was 10.2%, slightly above the 10.1% we recorded in the prior year. The security division reported an operating margin of 15.5%, which is down from last year due to substantial increase in R&D as well as the changes to the gross margin previously mentioned. As discussed in my previous calls, we've been working diligently to improve the Opto division's operating margins. These efforts continue to yield results, as the operating margin increased from 5.6% in Q3 last year to 8.4% this year, a 280 basis points improvement. This margin increase was driven both by a favorable product mix as well as results from solid execution on operational initiatives. Finally, in healthcare we saw a slight uptick in operating margin from 7.8% last year to 7.9% in Q3 this year. And as we entered Q4, which is historically the largest sales quarter for our healthcare division, we optimistically received both sequential and year-over-year operating margin expansion. For the company overall, adjusted EBITDA margins for Q3 increased year-over-year from 18.3% to 19.3%. As we strive to become more efficient, we look for planned consolidation opportunities and other cost savings items. We are in the process of consolidating one of our facilities in the Opto Group, which is expected to be completed this quarter. This initiative coupled with cost reductions in our healthcare and security divisions is expected to yield savings of over $5 million on an annualized basis. Close to the full impact of these changes is expected to be realized as we begin our fiscal '16. Moving to cash flow, for Q3 of fiscal 2015 we reported operating cash flow of about $27 million. Capital expenditures totaled $4 million in the quarter, while depreciation and amortization was $13.4 million. Day sales outstanding or DSO was 70 days in Q3, fiscal '15, compared to 64 days last year. Our level of DSO fluctuates from period-to-period due to the timing of sales and collections. Our balance sheet is strong, and our leverage ratio remains well below one. Our credit facility continues to provide us with flexibility to execute our business plan and respond to opportunities. Finally, turning to the update of our fiscal 2015 guidance; as Deepak described, with international security orders taking somewhat longer than previously anticipated, the consolidation on Opto facility which might have a short-term impact on revenues and the FX headwind on overall sales in the strong dollar, we are currently expecting fiscal '15 revenues to be between $950 million and $975 million. It is important to note that in the fourth quarter of fiscal '14, our security division generated an incremental $23 million of revenues from the Iraq FMS contract, and as Deepak described, just a small amount of FMS revenues anticipated for Q4 this year. Excluding the impact of the FMS contract on Q4 revenues, our guidance suggests Q4 revenue growth of approximately 9% to 18%. We anticipate non-GAAP earnings per diluted share of $3.42 to $3.60 for fiscal '15, excluding the impact of impairment, restructuring, and other charges. This range incorporates a less favorable margin mix of expected sales in our security division in Q4. We currently believe the sales and earnings guidance reflects reasonable estimates. However, actual sales and earnings could vary from this range because of the risks and uncertainties applicable to our businesses in the industries in which we operate. 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 and then allowed us to introduce innovative products and services to the market. We look forward to sharing our progress in the 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] Our first question comes from the line of Brian Ruttenbur with Sterne Agee. Please proceed.

Yes thank you very much. A couple of quick questions; on the RTT certification, can you talk a little bit about the market and what's going on with the U.S. federal market, now that you have gone through the very difficult certification process? And the competition out there, who's already certified, and a high-speed machine, maybe lay that out for us?

Thanks, Brian. Yes, you said it; it's taken us a long time. Basically, our focus -- and we said in the last conference call also, the big focus is there is a big demand in Europe for the 2020 that all new procurement between now and the future, the airports must buy the newest standard ECAC for any new procurement. There are active tenders out there as we speak, lot of airports are now getting into that mode for buying. As we said that the Rome airport was a big success, it's a great big win for us and gives us an anchor. As you know, we won Oslo a year and half ago. And we believe that the continued momentum for the next 2015-2016 is in the international sector. Not to ignore the U.S. side, we are happy that we got the RTT 80 certification; it's taken longer than we all expected, and I know that all of you were asking on the call [ph] -- on every conference call. And we've gone back and focused ourselves that now that we've got the technology validation that we are putting in this calendar year the 110 big size machine into TSA for also getting certification. Over the next '15, '16, the focus and demand is bigger and more driven towards the international sector than U.S. Regarding competition, the Rome was an international hub competition, we are very proud that we got selected. We are very, very confident that we are a great product, and especially their airports demand high throughput and seamless integration in their present HBS systems, we have an edge [ph] on it.

Yes. So who is the competition out there? There's Smiths, Leidos, who else is certified with the CT machine? And do they have a high-speed machine?

Well, all the same players. You said Leidos, yes; Smiths, yes; Morpho Detection, yes; L3, yes. Some of them have also high-speed of what we call the half-a-meter per second machine at 18 [ph] bags an hour. And some of them have slightly lower speed. Only the machine that we know of that is high-speed certified to the same speed as we have it that we know of is the Smiths.

Okay. Thank you. Just moving on to a couple other questions; on the cash flow side, Alan, can you talk about -- you've generated, I believe, it was $173 million in the first nine months. What are you projecting in your estimates to be cash from ops for fiscal '15?

Yes, thanks, Brian. Cash flow from operations for our first nine months was $87 million. Our free cash flow was about $77 million. We don't provide guidance on cash flow, but we are very pleased with our cash flow throughout the fiscal year.

Okay. And then turnkey, I can't let that one go. What's the status of new wins? Is everything delayed out there? And is it still kind of South America, and Middle East, and Eastern Europe that still are looking at this?

Well, Brian, I won't use the word "delay." We've always said that, that it's a long cycle and we are actively perusing multiple potentials both in Latin America, Middle East, and even in Europe. When they will consummate is a little unpredictable, but these things tend to be that you start working early, like I said before, and I'll again repeat it, the cargo sales versus a turnkey go hand-in-hand, and we continue to monitor that, and we still feel very good about it. We have a focused team working on it, and we believe that we will succeed.

Great. Last question, just on the Healthcare side; are you still looking for long-term growth in low to mid-single digits? And is this going to be driven by anesthesia, or is this going to be driven by patient monitoring?

Well, we are definitely looking for growth, and we are not limiting our sights to a single-digit. We are limiting our sights to double-digit. And, yes, anaesthesia is a focus, so is the defibrillator product line, international, and our patient monitoring continues to it. And as we have said, as the U.S. markets shifts over from the electronic medical records, last year December 31, money spent on it, now, big hospitals are focused on these extra patients that have entered the pool that they have to now provide extra CapEx to get more beds ready for these more people who are entering the insurance pool.

Great. Thank you.

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

Good morning, guys.

Good morning.

First of all, Deepak, congratulations on the RTT. It's great news.

Thank you.

I was wondering if you can give us more color on your guidance, the $25 million range for Q4. Is it very much driven by security? Should we -- are we more likely to hit the low-end or the high-end? Can you give us more color?

Sure, Josephine, this is Alan. We believe the $25 million range based on what we know today is an appropriate range. Typically, what would draw us to the higher end of that range or lower end of that range would be revenues from both our security division and our healthcare division, and the Opto tends to be a bit more predictable. So it's difficult for us to say whether we'll be at high end of the range or the low end of the range, but we feel very confident that we should be somewhere within that range.

Do we expect growth in Security in Q4, given that you have shipped most of your Iraq order?

Our security in Q4 had an outstanding Q4 last year, as you know, providing a difficult comp. So we believe that a good portion of the revenue growth in Q4 of this year will be driven by our healthcare division.

That's helpful. Alan, can you give us a more detailed breakdown of your backlog? I'm trying to reconcile your security book-to-bill ratio of one, versus the $600 million backlog compared to $700 million last quarter.

Yes, so each of those numbers as you've described are rounded numbers, our total backlog at the end of last quarter was about $660 million, and our total backlog at the end of this quarter is about $630 million. So when you exclude turnkey and take rounding into consideration, the book-to-bill ratio is about 1.0. So I think maybe that helps with your numbers a little bit.

Thank you. And a follow-on on RTT opportunities; Deepak, can you talk about what the opportunities look like in Asia and the Middle East, now that you have U.S. TSA certification? Does it significantly help your competitive positioning there?

The answer is yes, Josephine, but keep in mind that we have said that the big requirement, what I call "priority one," is Europe. Because of the deadline of 2020, and the size of the airports, and the replacement cycle, we are focusing that the number one priority for us, and I am not sure the competitors feel the same way, is the European sector for the HBS replacement cycle. The answer to your other question, yes, Middle East and Asia, and even Latin America do have requirements. And most of the focus that we want to make on and we want to emphasize is, though we have certification for the RTT80 from the TSA. Our feeling is that, given the choice and the price difference being insignificant, the RTT110 will be a preferred product than the RTT80, and also if our volume is more towards the RTT110 we think that product, in our opinion, is the one that we will capitalize on, compared to the RTT80.

When are you expecting a TSA certification for RTT110?

We are submitting the RTT110 platform before this calendar year is over, and obviously we have learnt a lot and feel better for it, and hopefully you're one of the ones who have been asking for many, many quarters, this will be a faster than the RTT80.

Great. Thank you very much.

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

Thanks. Good morning, Deepak and Alan.

Good morning.

Deepak, could you give us a sense of how much of the international market is on the RTT side, is CT-based, based on your best guess? In other words, how much of the replacement cycle is completed and compliant to this point?

Jeff, on the different base to answer it, let me understand it what you're asking. Just the European sector, the replacement for the HBS to the new requirement are more than 1,000 machines. And then you add on to the international, it can be Latin America, in Asia Pacific, and the ex-Soviet block, you can and another 500, 600, 700 machines or more. By the term -- the way will talk about it the total market worldwide is more than 3,000 machines. So it's a huge market, and then you're going to -- you can look at it, the replacement cycle is not going to happen at the same time all over the world. But Europe is the focus that we're looking at it, because they have a finite deadline, and a finite requirement of the ECAC-certified machines to be bought.

Okay. That makes sense. You mentioned a lot of RFP activity. How do you feel that you're positioned on an RFP versus your competitors?

Well, we are feeling good after the big successful win at this large airport in Rome. There are other large tenders out there actively being pursued. Anything more than that, as you know is the company policy, we won't say it, but we think we are well positioned. And people like our product. We have some unique improvements over it. We burn less power. Our footprint makes less noise. And it has no moving parts. So we have some very positive things to offer to the customer.

Okay, great. And then, Alan, could you quantify the currency impact both on a revenue and an operating income basis for the quarter?

Yes, the revenue impact, Jeff, for the quarter was approximately 2%, $45 million from the FX in Q3. On the bottom line, we actually had a slight benefit due to FX, as a lot of our costs are based in those same currencies.

Okay. And in your 2014 10-K, it mentions under the currency section a 10% strengthening of the dollar would benefit operating income about $12 million. Does that same relationship apply in today's mix of business?

Yes, it certainly changes a little bit based on today's mix, as you're mentioning. But at the end of the day, when the dollar strengthens, we do benefit on the bottom line, and we have some headwinds on the top line. In Q4, we're expecting an even further escalation on the top line, which is partly embedded in the new guidance where our continued sales, in particularly in the Pound and the Euro, but also in other currencies as well where the dollar has strengthened against has some adverse headwinds.

Okay. And then to switch gears to Healthcare, you mentioned some record revenue on Arkon. I was just curious what your expectations for anesthesia for the next several quarters are, if you're expecting that to really ramp up, and if you could give some insight into the dynamic of how that is playing out in the market?

Well, as you know that we don't break it down. Basically what we're saying is that as a percentage of the total revenue of the Healthcare, we are quite confident that the Arkon products line is just well-settled, and people like it, and it will continue to gain momentum.

So if you were to break down the things you're most enthusiastic about for Healthcare, where -- how would those rank out?

I think the patient monitoring and the new product introduction, the AriaTele, and some of the other products, and the Arkon are the primary drivers. And then, we also feel that as we assimilate the AED product line into an international distribution channel we should start seeing some more positive growth.

Okay, great. Thanks for taking my questions.

There are no further questions in the queue at this time.

Ladies and gentlemen, thank you once again for attending our conference call. We look forward to speaking with you all once again in August for our Q4 and year end. Thank you.