Welcome to the OSI Systems Inc. Third Quarter 2017 Conference Call. [Operator Instructions]. As a reminder, today's conference is being recorded. I would now to introduce your host for today's conference call, Mr. Alan Edrick, Chief Financial Officer. You may begin, sir.

Good afternoon, 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. Welcome to OSI Systems Third Quarter Fiscal 2017 Conference Call. We would like to extend a warm welcome to anyone who may be a first-time participant on our conference calls. Please note this presentation is being webcast and is expected to remain on our website located at www.osi-systems.com for at least 2 weeks. Earlier today, we issued a press release announcing our third quarter fiscal year 2017 financial results. Before we discuss the results, I would like to remind everyone that today's discussion contains forward-looking statements. 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. These forward-looking statements are based on management's current expectations and are subject to uncertainties, risks, assumptions and contingencies, many of which are outside the company's control. Such statements include, without limitation, information regarding expected revenues, earnings and growth, and statements regarding the expected 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 are described in the company's periodic reports filed with the SEC from time to time. All forward-looking statements made on this call are based upon information that's currently available 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 subsequent events or new information or otherwise. During today's…

Thank you, Alan. And again, good afternoon, and welcome to the OSI Systems Earnings Conference Call for the third quarter of fiscal 2017. We are pleased to deliver nice quarterly performance led by our Security Division. Our Healthcare Division continued to improve its overall operation, while optoelectronics delivered double-digit profitability in the quarter. Overall, our revenues grew 16% and we ended the quarter with a very strong backlog of $686 million, approximately. Turning to review the highlights for the quarter for each division, starting with our Security Division, which includes the performance of American Science & Engineering. In addition to strong Security sales, as Alan mentioned, our Security bookings during the quarter were approximately $132 million, about 80% higher than the level achieved in Q3 of the prior year, but this quarter included the AS&E products also and about 20% higher sequentially from Q2. Few other additional business highlights for the Security growth. We continued to make great strides with our Rapiscan Real Time Tomography explosive detection system for the old baggage inspection product line, as we saw a number of new tenders in this space. As we get closer to the 2020 deadline for the European airports to comply with the new ECAC checked baggage screening standards, the RTT tender activity is expected to increase. We believe RTT continues to be well positioned against other offerings in the marketplace, and this has been demonstrated by numerous wins at various European and other international airports. During the quarter, we further penetrated key markets with significant international wins for both cargo and our conventional product lines. With the AS&E acquisition completed in September 2016, we have a broader product portfolio with enhanced global service and support infrastructure, thereby increasing our big success rate, as we can be more versatile in offering…

Thank you, Deepak. So let's review the financial results for the third quarter in greater detail. As mentioned previously, our revenues in Q3 of fiscal '17 increased by 16% on a year-over-year basis. Revenues in the Security Division increased by 31%, primarily as a result of the inclusion of $28 million of revenues generated by AS&E and continued strong growth in sales of our RTT checked baggage systems to international customers. Revenues in our Healthcare Division increased 7% on an organic basis, led by stronger performance in the U.S. market and improved year-over-year international sales. Opto external revenues were comparable with the prior year, while intercompany Opto sales were down in part due to continued rightsizing of inventory in the other 2 divisions. The Q3 gross margin was 35.1%, up from 33.3% in the prior year due to increased margins in our turnkey screening services, due to cost efficiencies in the strength in dollar, a favorable product mix within the Opto division and a strong quarter by AS&E, which carries higher margins than those of our businesses generally. As mentioned on previous calls, our gross margin will fluctuate from period to period based on product mix among other factors. Moving to operating expenses. In Q3 of fiscal '17, selling, general and administrative expenses as a percentage of sales increased to 20.2% compared to 18.6% in Q3 of fiscal '16. In absolute dollars, SG&A spending was $49.4 million, which was up by $10 million over the same prior year period. The increase was primarily driven by the impact of acquisitions as well as increased costs to support the growth in our Security Division. As noted on previous calls, we remain focused in all of our divisions on increasing efficiencies and prudently managing our cost structure. R&D expenses in Q3 were $14.4…

[Operator Instructions]. Our first question come from Brian Ruttenbur with Drexel Hamilton.

Just a couple of quick questions. First of all, on the guidance. It was all because of the -- was there anything else happening besides the divestiture of the one Healthcare Division and what kind of impact did that have to earnings?

Brian, this is Alan, I'll take that question. Yes, the revenue guidance was updated both to reflect the divestiture of the AED product line or the Healthcare Division as you mentioned, and our latest expectation is based upon the timing of certain awards. After adjusting for the divestiture, we narrowed the range with the bottom end of the range increasing and the top end of the range decreasing. From an earnings perspective, the divestiture of that business had a minimal impact.

Okay. And then you said certain awards have some security. Are Healthcare awards gotten pushed off to the right? Or am I reading something into that because you said besides the Healthcare divestiture? I was just trying to see if there was anything else going on besides the Healthcare divestiture and the change in numbers?

Nothing significant, Brian. There were a couple of awards and a couple of shipments that were expected in our second half from our backlog that based upon when the customer has desired it. Looks like it will be happening in the first half of the fiscal '18 rather than the second half of fiscal '17. That's a small amount, but that accounted for part of the change.

Okay. Very good. And then RTT, it looks like you're getting really good traction in Europe. I believe that you had a $7 million win from a European airport. Can you talk about number of airports you are in right now or have had sales to in Europe? And what do you see as your market share now? I know it's relatively new. It's kind of the Wild West there, but can you give us something to point to?

Brian, this is Deepak here. Specifically, we don't talk about specific unless what we've already announced. It's been -- it's definitely not Wild West, it's wild Europe, and we are getting a lot of success. Tender activity is up, and we have a very strong funnel. And as it comes more closer, as I said in my speech, as it's coming more closer to 2020, there's a lot more activity going on.

Can you maybe tell us just the number of airports that you've sold into in Europe? Not where they are located, just number.

Double digit is the best way I can answer. But without naming it, I mean, if you travel there, you can maybe see it. But we are in some of the very large airports.

Okay. Very good. And then in terms of just staying on the RTT, status of any certification of the -- I think it's the RTT 110 with the TSA, there's any update there? Are things still moving along?

Brian, I know this is the area you've been hearing us say that. We are actively in the test protocol, and it's going through it. We feel that we'll get some kind of a data and feel confident about it by the end of calendar year. But how it's been there, it's a speculation.

Okay. And then couple minor questions on adjusted EBITDA. What was it in the quarter? I didn't catch that.

Brian, just before Alan -- Alan is looking at the answer, just to make sure, if I emphasize, our ability to book business for RTT in Europe is not dependent upon RTT certification.

Absolutely, yes, because you're already good to go in Europe and in the U.S. to get traction once it starts, you'll need to get certification on the 110, is that correct?

That is true. On the other hand, we've said that before that the procurement cycles with the new standards at TSA is not imminent short-term.

Brian, this is Alan. The adjusted EBITDA for Q3 was $45.3 million.

Perfect. And then SG&A, I think that there is going to be some cost synergies. I assume some of that will be in SG&A. Should I be looking for SG&A to drop from Q3 to Q4? Seasonally, it rises, but because there is cost synergies going on with AS&E and other things, divestitures, should we see a drop in SG&A from Q3 to Q4?

Brian, I think it'll be relatively comparable. You're right. There will be some more synergies, but you're also right that it being a stronger sales quarter, particularly in the Healthcare business, oftentimes there is more variable costs on the compensation line there.

Okay. And then the last question. Margins in turnkey, you said, had an uptick in the quarter, I believe, or will remain high. Can you maybe elaborate or give a little more color on that?

Yes, Brian, in explaining I think we have about 180 point -- basis point improvement on our gross margin year-over-year from Q3 last year to Q3 this year. Part of that was due to turnkey. The turnkey margins were a little bit stronger this year. The dollar was stronger compared to some of the currencies that we deal with in Q3 of this year versus last year, which was helpful in overall margin. And we're always looking to get more efficient at the same time as well.

Our next question comes from Andrew D'Silva with B. Riley and Company.

Just a couple of quick questions here. First off, maybe you can give me a little bit of color on how some of these turnkey projects look after you go through your second cycle once they're renewed. Would you expect that you would use existing equipment in places internationally? Or would you anticipate that you'd have to actually purchase or create new equipment and take it over there? And if it is the former, maybe give a little insight on how pricing might change so we can maybe think about some model adjustments down the road?

This is Deepak here. I'm not following the question, I'm sorry. Maybe Alan, you can.

Andrew, are you referring to a renewal or are you referring to a brand-new win?

No, renewal. Would you have to purchase new equipment in any capacity, and then if you don't, how does pricing with the turnkey project change with the renewal?

Okay. So one of the way to answer is, it depends upon the contract to contract. It all depends on the timing, it depends on the age of the equipment, it depends upon, are there any other additional requirements being put by the customer. One of the things that we have said is that now that we have the AS&E portfolio in our product line in cargo, we look at maximizing the performance to what the customer needs are and as the renewals or replacements happen, we look at all kinds of efficiencies in their model. So there is no specific way it happens.

Yes. Okay, that's great color. Staying with the Security side of the business. Obviously, you're talking about tenders ramping up due to the 2020 deadline in Europe. Could you give us a sense of maybe what percent of the overall market is actually converted to date? Is it 25% to 30%? Or is it even less than that?

I don't have a specific number, but I would say that it's definitely a very small portion that has been converted and if I have to make a guess, calculated guess, 25% to 30%. So the rest of the stuff is still there to be converted.

Okay, got it. And with the ramp-up in tenders that have taken place, do you see it more of a sense of urgency from realization that if some of these airports don't actually pull the trigger in the next year or so that they maybe won't be able to meet that deadline. Historically, Europe's been somewhat laissez-faire in these situations, and I'm wondering if there is a sense of urgency based on some of the macro catalysts that have been taking place lately?

Well, definitely, there is -- with each month going by, there is more urgency because the airports have to not only look at our equipment, but they also have to look at the baggage handling systems, civil works, construction, especially the larger airports. Definitely, the urgency is there. And 2018, it will get more accelerated. But at the same time, these kind of standards basically go in together with the politics of it and is going to move around little bit time wise, country-by-country, I'm sure it will happen.

Okay, perfect. And then last question, just moving over to the Healthcare side of the business. It's been a pretty tumultuous calendar year '17 in the Healthcare industry from a regulatory standpoint. Have you noticed any sort of change in spending habits? Are people tightening their purse strings a little bit at hospitals from what you're seeing right now?

We've said it in a couple of conference calls already that one of the ways the U.S. model has changed the business is that there's been so much consolidation in the hospital market that they are what used to be a smaller order, faster predictable deadline, now it's little bigger orders and little bit more unpredictability because they are bigger GPOs, bigger hospital groups. So there is definitely little change into it, but are they tightening the thing? I think they all need more equipment, but definitely there is some uncertainty around this whole marketplace that's going on between Obamacare and Trumpcare and whatever the new name is. On the international side, we've said it before. Definitely, the whole marketplace is more challenging in it, but that it's a requirement. Everywhere, they want more equipment.

Our next question comes from Larry Solow with CJS Securities.

Just on the guidance. Basically it sounds like the divestiture is pretty much a wash on the bottom line. So you are essentially just narrowing your range a little bit close to the bottom end, but, I guess, since we're already through 3 quarters that probably was the assumption anyhow. Is that fair to say?

Yes. Larry, it's Alan. You're right. The divestiture did not have a big impact on the earnings guidance. And you're right, we narrowed the range by increasing the bottom end of the range and reducing the top end of the range.

Right. It looks like at least based on if our [indiscernible] analysts have any clue what's going on, we were all sort of towards the bottom half anyhow. Okay, just in terms of -- on the Security Division. You had 6% organic growth in the quarter, and I think that's probably in line with the [indiscernible] that's been trending this year. Not jumping the gun on next year's outlook, but how do you feel about that based on what your book-to-bill is year-to-date? I know you did mention that the backlog is up 10%. How is the book-to-bill looking? And are you comfortable sort of as you look out the next few quarters that we'll continue to get growth?

It's little bit early. We start looking at later part of the Q4, we start planning the next year. But right now from the backlog, from what the funnel looks like, and what 2020 is going to do to Europe for the RTT, the cargo, that the pipeline of AS&E products, we feel that 2018 will be a good year.

Great. And Deepak, you mentioned the increased tenders. Could you give us an idea what -- not the exact numbers, but tenders outstanding today versus last year? Are they up double digit? Not what you guys have won, but what's outstanding today?

I don't know how to put it in the perspective of that kind, but what I would say that is that our bid and tender activity is significantly up. We have increased the staffing in the bids and proposals area, and in anticipation of what's happening in Europe, and there is a significant amount of interest in the cargo product line all over, especially, when you see unrest in Middle East and you see things happening in Africa, there is a lot of demand for the cargo. Obviously, some of these places, they have to figure it out where the money comes from, but there is no lack of demand. And I would say generally, from last year to now, our bid proposal and our funnel is up.

Okay. How about on the turnkey side, not to beat a dead horse over the head. Any concrete things you could discuss? I know it's a long process. Has the funnel -- is the funnel growing? Are customers more engaged? And then second part of that question is, in terms of Mexico, when would we maybe expect to hear something on a potential renewal for next year?

Well, I mean, I understand from your tone, dead horse. No, you can ask. The thing is that this is a longer cycle. It is a longer cycle. Our activity and I said it in the last couple of conference calls, we've got a focused marketing and sales staff, and AS&E product lines make our product portfolio even better for turnkey solutions to tune it for the customers' needs. When that actually happens, specifically, it's very difficult to predict. We are very optimistic. We are working on multiple fronts. And we continue to look at it. Regarding the second part of the question on the renewal, it's a little bit too early. And all we can say is that we are engaged.

Okay, that's fine. And how about just on the AS&E. It sounds like, obviously, clearly, your cost-cutting efforts are on target, even ahead or even ahead of schedule and maybe eventually even get more synergies than you originally thought. How about on the top line? Some of these new business wins, I don't think any of that was included in the revenue for this quarter, but you still would like to trend at least sort of like at a $110 million rate versus I was more looking at like a $100 million rate without these new contracts -- these new business wins. What's your thought there going forward?

Well, the thing is that, some of the wins we have announced it. We think that first half of next year will be strong for AS&E, some of the big wins that they had, but this is again one of the things that we are going to start doing it. The AS&E product line and the Rapiscan cargo product lines are mingled together, and they'll be managed together. And we need to start talking about the cargo in general. And it's a lumpy business. And we feel that the first half of 2018 will be relatively strong because of the bookings and the backlog we got.

Got it. And obviously, the AS&E acquisition helped you. It's -- we could say it's starting to help the segment margin. Maybe a question for Alan. You had some nice improvements sequentially in the last few quarters and relative to last year. Looks like you're closing on 15%, and I think was probably the numbers you guys did in '14 and '15. Is this a number we can surpass over time, especially as RTT really starts to ramp up?

Larry, this is Alan. It's a good question and it's really going to be depend upon the mix of our business as we have more turnkey business that tends to be more favorable. RTT is hopeful in the long-term, as Deepak has mentioned in the past several calls, in the shorter-term they may not necessarily be as accretive to the operating margins. So it's really going to depend upon the mix of business and the product portfolio that comes in.

Got it. And then just switching gears real quick. On the Healthcare side, obviously, it's been a rough few quarters. It looks like at least top line, we're starting to see some growth. Anecdotally, it was nice to see a big order from that one hospital group. And I know it's sort of highly leveraged segment to fixed cost. So it sounds like you guys are optimistic that we can -- that this one quarter growth is not an aberration and maybe top line could -- can start generating growth and then we would see that in the bottom line as well. Is that a fair observation?

The answer is yes.

Okay. Last question, you guys, obviously, did convert. Seems like for not just to pay down some of your variable debt but also maybe to clear your balance sheet a little bit to give you little more liquidity. Anything out there on the horizon? In terms of M&A activity, was that one of the reasons why you did convert?

You already know the answer. We're not going to comment on anything.

Our next question comes from Sheila Kahyaoglu with Jefferies.

I guess just picking up where the last few questions left off. Can you just give us an update on Healthcare and the turnaround there and where you are with XTR product a little bit more?

Sheila, this is Deepak. Yes, we are very much focused on to it. Alan has maybe talked to you about it. We have a very strong new management. We have new President who will just be turning 1-year into it. We have new operations people, R&D people. So we're very much focused on it. We think that most of the heavy lifting is behind us. And fortunately, we have said it, and we are very proud about it that we haven't lost any significant orders anywhere. Customers like our products. We are very much focused on to making sure that whenever we leap that we are focused with the customer needs and have the support network there. So all in all, we are very optimistic. And we believe that the major problem got behind us.

Got it. So the sales force is sort of soft-launching the new product right now or -- just to get an idea.

Yes.

Okay. And within Security, is there any delineation you could give in terms of the organic growth that was up 6%, whether domestic or international, kind of an idea what led the growth?

Most of the growth is international. And obviously, with all the turmoil you see today happening in U.S., we believe that the infrastructure department of Homeland Security, border protection all that will be well funded. So we are very optimistic about positive, beyond what was last year. But this business is cyclical a little bit in a way. Right now that growth -- the 2 growth paths that we are focused on and we are very well placed, one is obviously the cargo product line with a broad product line with AS&E and Rapiscan; and secondly, RTT. There is a lot of demand and there is a certification standards needed in Europe, especially, with the deadline. So we believe that for the next couple of years, there's going to be a lot more activity, and we are well placed.

Okay. And then just one last one on Healthcare. I'm sorry, on Security and profitability. Adjusted margins were up about 20 bps. Would it be possible to bridge that, just solid organic growth? I would assume turnkey was a big benefit. Was there any offsets? I mean, the margins were great, but just looking at it, if there is any bridge you could provide?

This is Alan. Just sort of big picture Sheila, you kind of hit most of them. Turnkey was operating margin accretive for us in the quarter, as was the acquisition of AS&E. The RTT, which we're having more sales on at this point probably went the other direction for a little bit and as the gross margins on that product line are improving, we would expect that to change in future years.

[Operator Instructions]. Our next question comes from Jeff Martin with Roth Capital.

Alan, can you provide some update on RTT manufacturing margins? I know that's something that you laid out as an expectation would be initially a drag-on on blended gross margins, but wondering where you are in that process and what your expectation is for the quarter?

Yes, Jeff, it's Alan. Good question. You're absolutely right. In our fiscal '17, the RTT gross margins are lower. We've actually made substantial improvements in it, and our margins going forward are much higher. You won't begin to see the impact of that until fiscal 2018 because what we've sold in Q3 and what we sold in Q4 had been manufactured under our prior cost structure. And we'll still have a few more units of that into fiscal '18 as well. But we have significantly improved the cost structure of our overall RTT, which that will be reflective in margins in the future.

Okay, great. And then on the integration of AS&E, that 20% that's remaining in terms of the cost synergies, what are the elements that need to be completed before you achieve that final 20%?

Without going into great detail, I'll give you some highlights. IT, so things like integration of ERP systems and other type of IT applications are things that just take longer. So that would kind of be an example and a few others that we have to do as well. But those are little bit longer in horizon.

Got it. Okay. And then are you able to talk about your win rate for specifically cargo or anything that might be Rapiscan and AS&E combined in terms of the increased appeal to the customer base win rate recently versus pre-AS&E?

Well, there's no specific thing, but obviously, we're not competing with each other. As you combine the 2 product lines, one of the things we are very, very much proud about it and the strategy of buying AS&E was, Rapiscan was very strong in high energy, AS&E was very strong in low energy and medium energy. So you combine them together, we can offer a portfolio, which is much broader than any other competitor. So now instead of us trying to upsell or downsell or trying to compromise a customer's needs, we don't have to do it. We have all the products. And even in the turnkey way when we look at it, for example, at a border crossing, we don't have to put just a high-energy truck or a gantry. We can offer a high energy. But for better throughput for car scanning, we can put a low energy. So definitely, we have a better appeal to it, better financial benefit to the customers and we have a broad product line. Definitely helps.

So maybe better way to characterize that is greater contract capture percentage versus necessarily a win rate, is that accurate?

Yes. Better funnel, more broader product line, and hopefully better capture rate.

Right, right. Got it. And then last question on the Healthcare side. You typically have a significant uptake seasonality in Q4. Wondering if you believe the business is positioned again to see that in this year's fourth quarter?

Jeff, this is Alan. So as you know, we -- our guidance is generally speaking by the company overall, but from a big picture perspective, our guidance does include a sequential improvement in Healthcare given the historical trends that we've always seen in the past, besides fiscal '16 when we had the launch issue.

And I'm not showing any further questions at this time. I'd like to turn the call back over to our host.

Ladies and gentlemen, thank you once again for attending our conference call. We look forward to speaking to you all in August, when we will discuss our fourth quarter and full year fiscal performance. Thank you very much to all of you.

Ladies and gentlemen, this concludes today's presentation. You may now disconnect. And have a wonderful day.