Good day, ladies and gentlemen, and welcome to the OSI Systems second quarter 2018 conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions]. As a reminder, this call is being recorded. I would now like to introduce your host for today's conference, Mr. Alan Edrick, Chief Financial Officer. You may begin.

Thank you. 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 the OSI Systems second quarter fiscal 2018 conference call. Earlier today, we issued a press release announcing our second quarter fiscal year 2018 financial results and an 8-K. Before we discuss our 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 under the securities laws. 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 the expected financial and operational performance of the company and its operating divisions; expected revenues, earnings and growth; and expectations regarding the effects of new tax legislation. Please be advised that actual results could differ materially from our forward-looking statements due to numerous factors, including factors 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 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 subsequent events or new information 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…

Thank you, Alan. And thank you to everyone joining us on today's call. As Alan has mentioned, we had an excellent quarter and first half of fiscal 2018, having achieved strong sales, adjusted earnings growth and cash flow. Each of our three divisions – Security, Healthcare and Optoelectronics – contributed to this quarter's performance. Before continuing and discussing the divisions in detail, I would like to address a matter that we disclosed earlier today. In December, a short seller launched an attack on our stock. Their reports are misleading and are based on several false assumptions. Following the publication of their initial report, we were notified by the SEC and the DOJ that they are looking into matters contained in the short seller's report. Separately, the SEC and DOJ are looking into trading in OSI stock by executives, directors and employees. In relation to the subject of investigation, the company has taken action with respect to a senior employee. As you can appreciate, these are pending legal matters and we cannot comment any further. The company takes compliance and our policies on anticorruption and securities trading very seriously and we take a great deal of pride in our compliance efforts in those areas. Reviewing the Q2 performance and highlights for each division, beginning with Security. Q2 revenues in the Security division were $172 million, a 23% increase from the prior-year. This includes $20 million in revenues from our recently acquired explosive trace detection business, which has come out of the gates very strong since the acquisition in July 2017. We have made substantial strides in integrating the trace product line into our overall Security sales and operation infrastructure. Our core Security business is performing well, with strong sales bookings and improved margins. The growth was nicely distributed across our various…

Thank you, Deepak. Now, let's review the financial results for the second fiscal quarter in greater detail. As mentioned previously, our revenues in Q2 of fiscal 2018 increased by 14%. Q2 revenues in the Security division increased by 23% and were driven by strong performance across much of our product portfolio as well as the explosive trace detection acquisition. Revenues in the Healthcare division increased 13% in Q2 on an organic basis, led by strong US patient monitoring sales and growth in our international diagnostic cardiology business. Overall, the Opto division sales were up 5% as intercompany sales to support the growth of the Security segment significantly increased. External revenues in the Opto division grew by 2%. Each of our divisions contributed to a large gross margin expansion to 36.7%. The greatest impact was attributable to the Security and Healthcare divisions as it had favorable product and channel mixes as well as economies of scale resulting from higher revenues and operational efficiencies. As mentioned on previous calls, our gross margin will fluctuate from period to period based on product mix, amongst other factors. Moving to operating expenses, in Q2 of fiscal 2018, SG&A was up $8.5 million, primarily due to acquisitions in the Security division and in support of the growth of the division. We also saw additional corporate overhead as the company grew. We continue to be focused in all of our divisions on increasing efficiencies and prudently managing our cost structure. R&D expenses in Q2 were $15.1 million, up from $12.9 million and also primarily due to the Security division acquisitions and increased investment to enhance our product portfolio. We remain focused on innovative product development, which we view as vital to the long-term success of our business. Impairment, restructuring and other charges were $8.3 million in Q2…

[Operator Instructions]. Our first question comes from Brian Ruttenbur with Drexel Hamilton. Your line is now open.

Yes, thank you very much. Very good quarter, by the way. So, jump right into understanding cash flow. You had an extremely strong cash flow quarter. Was there anything one-time in nature that happened in this period? Was there pull forwards of revenue? I'm just trying to understand going forward because it was way above average cash flow.

Yeah. Brian, good questions. Thank you. This is Alan. Cash flow was outstanding for us in the quarter and really probably resulted from two primary things. Just the general strong profitability of the company, better working capital management and some customer advances that we received that also aided. You're also right that there was some revenues that came forward a little bit from Q3, not of a significant amount, but some that also helps contribute to a strong quarter and strong cash flows.

Okay. So, we should see cash flows drop a little bit just because of that from quarter to quarter and also the seasonality of healthcare in the March period, right?

That's correct.

Okay. And then, in terms of security revenue, just trying to model this new contract because it kicks in – this quarter is the first quarter it kicks in. We should have a drop in revenue from the December period to the March period, is that right? Because of Mexico.

Yes. Brian, good question. And we, of course, provide guidance on an annual basis, but, generally speaking, that would be correct. We generally see that the Q2 period is a bit stronger than Q3 due to some seasonality. And then, as you mentioned, there's a change from the new Mexico contract that was factored into our guidance. And you're right. So, generally speaking, our fourth quarter is stronger than our third quarter.

And then, if I could talk – it wasn't mentioned, but if I could bring up RTT and give us an update on your win rate and what's going on, number of airports you're in roughly and what's going on there because it appears that you had a couple of good wins in Europe this period.

Brian, this is Deepak here. Obviously, specifically, we don't talk about it except what we have already announced. Yes, the pipeline is very robust. As we said on many, many calls for the last couple of times, ECAC's requirement of a deadline is coming closer. So, a lot of the airports in Europe continue to look at it. Our win in Panama is what I call as a very strategic win for us because as Latin America starts revamping their airports to meet new standards, it helps that you already have a presence in one of the large airports. All in all, I can't comment for competitive reasons of what our percentage take is, but I would be quite confident in saying that we are maybe considered the biggest intake and successfully that has happened in the last couple of quarters.

And you mentioned Latin America with the RTT. So, it's a $2 billion opportunity roughly in Europe. And you seem to be winning above your share or at least your share and then some. Is something going on with South America and Latin America that is making them respond to the 2020 deadline in Europe?

Well, two-sided question. Obviously, the total pipeline is there worldwide. And yes, all the airports in Europe are pushing towards it. Some of the smaller ones can ask for exceptions. Latin America doesn't have a requirement as such. But anybody who is going to upgrade their airports, they want to get the best because the lifetime of these kind of products are 8, 10, 15 years, so they want to get the best product that's out there and we just want to make sure that not only Latin America, Asia, Middle East that we are looking at all those areas as potential growth opportunity with our product.

Okay. And then just last question, addressing the FCPA issue, have you had any – I've followed you guys forever, it seems like, but I don't recall that you've ever had any issue in the past – that's going off of memory. I haven't gone back and searched all the documents. Has there been anything in your history on that?

No. And we are very proud of our ethics policy, our FCPA policy, training. And this triggered by the short seller and we are cooperating with them, working with open dialogue.

Okay, thank you very much.

Next question comes from Larry Solow with CJS Securities. Your line is now open.

Great. Thanks. Good afternoon. Deepak, I realize the ethics investigation is a sensitive issue. Can you maybe just take 30 seconds just to review the factual history real briefly of the Albania contract? If I'm not mistaken, wasn't that already reviewed by a court in Europe, so that was already somewhat looked? Can you comment on that?

Larry, basically, that's true, what you've said. We went through two government changes and we in an open tender. It was a competitive bid. And we won fair and square. We have a very satisfied customer. When the government changed, basically, the new government coming in had some hesitation. They stopped the contract. We went into an arbitration in Vienna. And we prevailed. And we negotiated what I call a renewed contract and it's been going well. So, the answer to you is that it has been – what I said before, it has gone through two government, the changes. It's been working very well. And not only that, but it's a showcase where a lot of customers internationally have looked at it and it's getting a lot of attention and we are very proud about it. We are very proud to be part with the Albanian government.

And if I may, the short seller – there's sort of two parts. I guess, bribery which sounds like – from what you just described, it sounds like, it's hard to believe there is any of that, but also that there is some issues with the way you're accounting for it. Can you just give any rebuttal to that?

Larry, this is Alan. We, of course, don't go into point by point with the short seller report. What we can tell you is we're comfortable with the accounting as is the auditing firm who audits our financials.

Okay. Let's move on. And I appreciate still the insight. I know it's a sensitive situation. Obviously, a great quarter. But just – as Brian said, and it does sound like there's maybe a little bit of pull forward in Security. Doesn't seem like it's a significant amount. But just on that subject, your margins in Security year-to-date are – operating margin are about 16%, somewhat above – back to where the levels they were, even a little bit above in 2014 and 2015. Are these sustainable? I know one piece of the business that had been hurt was – hurting you guys was the RTT piece. Has that recovered? Is that back to corporate average or its Security segment average? I know you don't guide for the quarters for the segments, but how should we view sort of margins in this segment as we look out over the next two years?

Larry, this is Alan. Good questions. You're right. Our operating margins on an adjusted basis for Security have been very strong in the first half of the fiscal year. We don't really provide guidance on operating margins going forward. That being said, an increasing beneficial mix in our products with the acquisition, for instance, of the trace business, with the ramp up in RTT and improved margins as we've been talking about over the past few years, we've seen the margins improve in that product. All of those things will have favorable impacts. Of course, reduced revenues associated with the Mexico contract – we've been talking about for a while – plays a role in that too. And all of those things factor into what we believe to be the strong guidance that we provided for fiscal 2018 that we recently increased.

Got it. Just last question on your increased guidance. Was there – I know you did say that the statutory rate was coming down from 35% to 28% at least for the – I guess for the six months of the year, in the back half of the year. Can you sort of give us what the full effective rate for the year is expected now versus what it was and how much that is benefiting the EPS guidance?

Sure, Larry. So, our guidance was unchanged relative to taxes. As you know, a good portion of our profits take place overseas. So, our effective tax rate that we're estimating for the year is approximately 28%, which is consistent with where it was even before tax reform. There's an opportunity for it to benefit further in fiscal 2019 as we get the full benefit of the reduction to 21%. But being that we're a fiscal year and not a calendar year company, half of our year is based on – from the US perspective is based on 35% and half is based on 21%, which coincidentally is also about 28%.

Got it. So, purely higher revenues and maybe a little better operating profit is driving it. There's nothing below the line?

That's correct.

Got it. Great. Excellent. Thank you very much. I appreciate it.

Our next question comes from Sheila Kahyaoglu with Jefferies. Your line is now open.

Good evening. It's actually Greg on for Sheila. Just wanted to follow up on free cash flow. Is there any type of free cash flow guide for the year and how should we think about that, given lower volumes for Mexico?

Greg, this is Alan. Good question. We're very pleased with our free cash flow so far in the first half of the year. Free cash flow is not a metric that we provide guidance on. We see volatility from a quarter-to-quarter perspective, but with our strong profits comes good free cash flow. Of course, with growth, there sometimes is a usage for working capital. So, we're happy with where we're at on a year-to-date basis.

Thanks. And then, one of your competitors had mentioned that there was some weakness on the US government side. Some of that just related to the CR. Have you been seeing any of that?

No. This is Deepak here. Unless you're asking on specific product line, we don't see any general weakness. We're very optimistic about our US intake.

Thanks. And then just last, you had mentioned some lumpiness in the Healthcare margins, heavily dependent on volume. When we look at the margins you did in the quarter, I think they're the definitely the highest for quite some time. How should we think about that going forward?

This is Alan. Good question. The Q2 margins were very strong in Healthcare, as we saw an increase on the top line, but also, as I think I might have mentioned, it was strong US patient monitoring sales, which generally carries a higher gross margin for us as well as strong international cardiology sales, which also carries a strong contribution margins for us. So, we'll see that fluctuate from time to time, but we're very pleased with the quarter's operating profits in that business.

Thank you.

Our next question comes from Austin Drake with B. Riley FBR. Your line is now open.

Yeah. Good afternoon, guys. Just real quickly. When did you receive the inquiry for the FCPA investigation?

I think we have said it subsequent, but more than that we would rather not talk about it.

Okay. And then, could you characterize the current operating environment across the different business lines? And could you talk about maybe some of the larger opportunities you think the company could capitalize on over the next, like, 6 to 12 months?

Maybe the first portion, Alan, you want to take it?

The general operating environment?

Yeah.

Yeah. The general environment, we're seeing a strong funnel of opportunities in the Security business. Our Opto team has done a real nice job and we've seen – in our Healthcare business, we've seen – over the last four quarters, we've seen 7%, 7%, 10% and 13% organic growth. So, I think our outlook is bright in the general environments that we operate.

And just to add on to your second part of the question is, our opportunities are very broad. I said in my opening statement. We have a very broad product line with the ETD acquisition that we did in July. And we are proud to say that we have the broadest product portfolio in security in the scanning, so that we look at opportunities in cargo, in turnkey services, in trace detection, in HBS, RTR, we have a TRS (tray return systems), and what we call an integrated solution in all these. And now that I've also mentioned that we are embarking upon this new initiative, what we have said in the sporting events, we think that we have a great opportunity to continue to grow this product line. And with the CertScan proprietary software for our cargo, which is one of the biggest selling point in our turnkey services, we are very, very optimistic about the growth prospects in all our security. And Alan mentioned in your healthcare. And in the Optoelectronics, which has a big component in medical, we think there's good growth opportunity. And with the military funding being talked about in Washington, has a big prospect for us in growth in the aerospace and defense industry.

Okay, got it. That's great. And how should we think about D&A and CapEx for the remainder of fiscal year 2018?

This is Alan. We would expect that D&A will decrease over the remainder of fiscal 2018 as there was a significant portion of our contract with Mexico that became fully depreciated in the month of January. So, I would expect to see D&A decline in both Q3 and Q4 from where it was at the Q2 level. There was a second part of your – oh, CapEx. From a CapEx perspective, we are not currently today anticipating any significant CapEx over the second half of the fiscal year, unless we win new turnkey programs, which, of course, is very positive for us.

Got it. Okay. And then, just lastly from me, is there any more detail to give on the SG&A increase in the quarter or is that just simply support for the growth of the company?

Yeah, it really is support for the growth of the company including the acquisitions that we did.

Thank you.

And our next question comes from Jeff Martin with ROTH Capital Partners. Your line is now open.

Thanks. Good afternoon, guys.

Hi, Jeff.

Hi, Jeff.

I just was curious if you could shed some light, the trace detection business benefited in the first half by the international flight mandate to put additional screening in. Ha that run its course or you see some medicinal benefit from that in the second half of the year?

Well, again, very difficult to speculate. An incident or an event can change things. I think in the last conference call, Alan did say that our first half was stronger than the second half with respect to the trace. That's baked into our numbers. But at the same time, we are pursuing a lot more opportunities. And the whole strategic reason of buying that business was that we have a broader structure, we have a better sales channel, we have a much broader reach, we are in 147 countries and we have integrated the product line into our standard security business and we hope to pull some more sales.

Okay. And then, in the large patient monitoring contract for Healthcare, was there benefit to that in the second quarter or is that mainly a second half or even first half of 2019 benefit?

Jeff, this is Alan. Yeah, my understanding is it was partially shipped in the second quarter and will be partially shipped subsequent to that.

Okay. And then, in terms of the tax-related charge, what's the cash related portion of that? I assume it's not all pure cash.

You're correct, Jeff. Very little of it is cash. We also have NOL carryforwards and certain tax credits that would offset it. And as you may know, any resulting cash is also payable over eight years. But the expected cash outlay on that charge is actually quite minimal for us based on our expectations today.

Okay, great. That's all I had. Thanks.

At this time, I'm showing no further questions. I'd like to turn the call back over for closing remarks.

Thank you. Thank you everybody. Ladies and gentlemen, once again, thanks for participating in our conference call. We look forward to the second half and speaking with you at the next earnings call. Good day, everyone. Thank you very much.

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program. You may now disconnect. Everyone, have a great day.