Ladies and gentlemen, thank you for standing by. And welcome to the OSI Systems Incorporated First Quarter 2020 Conference Call. At this time, all participants’ lines are in a listen-only mode. After the speaker’s presentation, there will be a question-and-answer session. [Operator Instructions]. I would now like to hand the conference over to your speaker today, Mr. Alan Edrick, Chief Financial Officer. Sir, please begin.

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 fiscal 2020 first quarter conference call. We would like to extend a warm welcome to anyone who is a first-time participant on our conference calls. We are glad that you can join us. Earlier today, we issued a press release announcing our fiscal year 2020 first quarter financial results. Before we discuss our results, I would like to remind everyone that today's discussion will include 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; including the company's expected revenues, earnings and growth. Undue reliance should not be placed on our forward-looking statements as actual results could differ materially from our forward-looking statements due to numerous factors, including but not limited to 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. For information…

Thank you, Alan and good afternoon to all of you. We started the fiscal 2020 with record revenues and EPS in the first quarter. All three divisions grew their revenues from the prior year first quarter and delivered nice profitability. Getting into each division’s performance starting with the security division, where we reported revenues of approximately $189 million, an increase of 11% over the prior year period. The security division continues to see an expansion of its opportunity pipeline in most product categories, both internationally and domestic U.S; although some orders that we anticipated in Q1 and the security growth have pushed to the right. Backlog continues to be strong specifically in the RTT and cargo solution equipment where we have clear visibility through fiscal 2020. A few examples of Q1 activities in our key end markets starting with ports and borders. During Q1, we continue to support the U.S. government on its initiatives to strengthen Border Security to prevent contraband illegal drugs, and people smuggling entering the country. A few of our products utilized for these critical efforts are our cargo and vehicle inspection systems, both fixed and mobile X-ray portals, explosive trace detection units for our drug detection, and baggage and parcel inspection X-ray systems. We are nearing the completion of the build out phase for that that turnkey service projects at the ports in Guatemala and in Asia, and look forward to both becoming operational in the next few months. The Middle East integrated service project continues to make progress. Our existing programs in Mexico, Puerto Rico and Albania are continuing to perform well and our check points have resulted in numerous seizures, and interdiction of illegal cargo shipments. On the Mexico turnkey program, we are in active discussions with the customer for an extension to the…

Thank you, Deepak. Now I will review the financial results for our 2020 first fiscal quarter in greater detail. As mentioned previously, our revenues in Q1 of fiscal 2020 were up 9% year-over-year. Revenues in the security division reached a record Q1 level of $189 million, an increase of 11% from Q1 of fiscal 2019, driven primarily by growth in the cargo and RTT product lines. The Opto division continued its impressive performance, with revenues increasing 4% year-over-year to a new Q1 record of $74 million. This increase was driven by 6% in external revenues, partially offset by a reduction in intercompany revenues. Our health care division posted solid revenue growth of 5% driven by U.S. demand, which was leveraged to significant growth and profits. The Q1 gross margin of 34.1% was down from 36% in the same quarter last year. Though we saw gross margin expansion in our Opto and health care divisions, reduced gross margin in the security division, due to the mix of revenues resulted in the overall reduction. With respect to the security mix, security product revenues were up 24% while security service revenues were down 5%. Security product sales tend to have lower gross margin than security service sales, thus resulting in a reduced overall gross margin. As mentioned on previous calls, our gross margin will fluctuate from period to period, based on a revenue mix among other factors. Moving operating expenses, SG&A expenses were up slightly by 0.8% year-over-year. However, as a percentage of sales, SG&A expenses decreased to 21.4% in Q1 of fiscal 2020 from 23.2% in Q1 of the prior year, which evidences our diligent efforts across all of our divisions to improve efficiencies, and prudently manage our cost structure. R&D expenses in Q1 were $14.2 million up 4% from Q1 of…

[Operator Instructions]. Our first question comes from the line of Larry Solow from CJS Securities. Your line is open.

Great, good afternoon. Thanks for taking my questions. Just on the security piece, can you just give us a little more color, a little bit of light on the orders in terms of your visibility? It sounds like there are some specific orders that were shifted a little bit to the right. Do you still expect those to happen this year? It sounds like it's pure -- more timing than anything else?

Good question. This is Deepak here. Yes, I did say that, and this business, especially globally, the pipeline is very strong. We have a lot of opportunities out there, but as you're chasing these orders, a lot of these orders depend upon the readiness of the customer even while placing the orders. And as you get into both the cargo equipment orders, and if you are looking at the RTT orders globally, some of them got pushed to the right, but our total pipeline continues to be very strong. We have said it before in the previous calls that as the deadlines are approaching in Europe, 2022, 2021, airports continue to move forward. There is a lot of activity in the U.S. I'm sure you've seen a lot of press on what's happening on the southern border. There is a lot of activity; we are very well placed, so we are very confident about the orders.

Okay, so customers haven't necessarily gotten more hesitant on a macro level, it is just more -- or, I mean is that something that you don't know or you know..?

This is mostly timing related. None of them have gone away, because they need those products.

Right.

What happens is that, if the airport's terminal is not ready, if they don't have the baggage handling system in time, they've got to get their construction looked at, and it changes the timing of it. We've said it not only just for the order placement, but it also has an impact on the actual shipments. That's why some of the revenues also move from one quarter to the other.

Right, and pretty impressive on the product revenue being up 24% year-over-year. There was no acquisition there or anything else. I guess that is somewhat on the timing side, and then the flip side question to that is, what drove the service piece down 5%?

Basically, it's interrelated, again, to the mix and it can also, what we say is as the 24% increase and the equipment sales have gone up, remember, our business, when the equipment is placed it requires a lot more service people, installation and stuff. That consumes a lot, and then it has service later on, after the warranty period. So, as we are shipping a lot of product, and Alan mentioned this quarter was quite heavy in the equipment sales, and that required lot more support work in the service personnel, too.

And then some of that on that product side, was some of that helped by the initial start from some of the -- I know you had a couple of sort of quality turnkey deals that I think were beginning now, if I'm not mistaken. Did that contribute all this quarter?

Yes. This is Alan. The actual turnkey deals were not part of Q1 yet, they'll be coming here in the next few months. The one that was kind of a hybrid deal, we have recognized some revenues associated with that, so that has been helpful for us.

Okay, and then just switching gears real fast on the healthcare side, obviously Q1 is usually, in terms of profitability, a down quarter or barely profitable. You know, 7%, obviously it's only a couple of million dollars. But it seems like hopefully you should be for the full year, I know you don't guide per segments, but perhaps in the double digits this year on an operating margin level? is that something to target or shoot for this year?

Larry, this is Alan. You're right, we only provide guidance on the overall OSI Systems, and we think there are nice opportunities in healthcare to expand margins, with it being our highest contribution margin division, so it becomes very sensitive to the topline.

Okay, great. Thank you very much.

Thank you. Our next question or comment comes from the line of Aman Gulani from B Riley, FBR. Your line is open.

Hey guys, thanks for taking my question and congratulations on another solid quarter. So yes, nice to see some lift in the Opto margins. If you can provide a bit more color on what's driving the improved margins there? Is it like a particular end market that's driving the margins a little bit higher?

Sure, this is Alan. I'll take a shot at that. Yes, we are real pleased with the Opto division's performance. The operating margins, we thought were outstanding. What was really driving it was sort of an improved mix. We have gotten more into the flex circuit business over the past several years. We did a few acquisitions a couple of years ago, and those businesses are higher margin in general, and they have continued to perform outstanding. That coupled with the strong performance in our core optoelectronics and our core contract manufacturing has really helped. Over the time, we've shedded some customers that were either low margin or no margin, so overall, the mix has just improved, leading to much stronger operating margins for the group.

Got it. Thank you. And then any color on the European checked baggage conversion? Last quarter you said you were about 30% to 40% through that. Has that gone up from the prior quarter?

This is Deepak here. It continues, I've said in my remarks we won some contracts in Europe and in Asia. It continues to get more installed base out there, but I still believe strongly that the heavy lifting and the big numbers are going to be in the later part, late in 2020 and 2021 as they come closer to the deadline.

Got it. Thank you. And then last question for me, I know you've been talking about securing a client in the Middle East for integrated services. You did mention that was progressing smoothly. When do you think you could start generating meaningful revenues from that contract?

This is Alan. I think we'll see some meaningful revenues from that contract in this fiscal year, fiscal 2020, so I think we're on track for that.

There is a Deepak. Just to add on to what Alan said, we have said it and we've been very careful in saying it's an integrated services contract. We have also said in previous calls that it is going to go through phases, Phase 1, Phase 2, Phase 3, Phase 4, so it can continue to expand, depending upon the performance and the satisfaction to the customer. We feel very good about it. To us, that looks like there'll be a continued long-term growth and a good, profitable contract long term in that area.

Okay, thank you. I'll pass it on.

Thank you. Our next question or comment comes from the line of Jeff Martin from Roth Capital Partners. Your line is open.

Thanks, good afternoon Deepak and Alan, how are you?

Hi Jeff, fine.

Deepak, I was wondering if you could expand a little bit on the competitive positioning that you've got in aviation. Passenger and cargo, you mentioned higher throughput and better image quality. I was wondering if you could just elaborate on that?

Yes. This is Deepak here Jeff, good question. We have always maintained that our RTT has some very significant advantages over what we call the rotating gantry, less moving parts. It has fundamentally higher speed, image quality is very good, and it has caught on very well with the cargo carriers who want to increase the throughput of package inspection, and they want to do better imaging of the packages. So that has become a big success story for us and we continue to focus on it, and we are spending a lot of R&D money to optimize their requirements, and that continues to see growth. On top of that, in the aviation checked baggage sector also, we've got a lot of progress made. We continue to ship more machines and as the deadline in Europe comes closer, we continue to see more action. On top of that, we have said in the last couple of conference calls, we have also started focusing on what we call Checkpoint CT, outside the U.S. And that has gotten a lot of traction, there is a lot of interest, we are doing a lot of demos with various customers, especially in Asia and in Europe. We think that long term, that growth market is also going to be there in what we call the Checkpoint 920CT for the Checkpoint. So all-in-all, both in cargo and in checked baggage and now in the Checkpoint CT, we look at the next couple of years, the growth momentum will continue.

Okay. And then could you repeat your comments around the radiation monitoring opportunity? This is a market you've been in for some time. You mentioned 15,000 units, but I didn't capture if that was the addressable market or if that's your installed base?

Thanks, good question. I want to clarify. There are two different things I said. One, we have shipped our radiation monitors to some places for inspection, and we are in that business for a long time. It's not a big business, but you got confused. The second sentence I said is our installed base worldwide for our baggage, for our Checkpoint DPI machines globally -- that's the X-ray machines, not the radiation portals and such -- and we think that machine, that quantity might be more than 15,000 installed base. So there are two different things. Sorry for the confusion.

Okay, I appreciate that. And then final question, if you hadn't had these orders pushed to the right, what would your book-to-bill, have been in security?

Well, obviously, north of one.

Okay, great nice quarter guys.

And Jeff, just to clarify that again. We've said that before. You've followed us for a long time. This business is lumpy, both in bookings and in the shipments. None of them have disappeared or anything else, just pushed, and we continue to look at it. Some of these bookings also become a little bit more lumpy the bigger the size of it. Because when you're selling one or two, versus if you want to sell the airport 12 machines, it becomes a big difference, and it takes a longer time to predict when.

Great point. Thanks, Deepak.

Thank you. Our next question or comment comes from the line of Sheila Kahyaoglu from Jefferies. Your line is open.

Hey, good afternoon guys and thank you for the time. I was wondering if you could give a little bit more comment on the security, just what you're seeing on a global basis. Are you seeing any impact from China trade or Brexit with this business? And then, any end market color that you have as well within, whether it's aviation or stadiums or what's driving some of the product strength? Thank you.

I'll take that. This is Deepak here, Sheila. We have said it before, we continue to monitor it. We have had no impact from any of the China tariffs, at all. At the same time, as we have said before, more turmoil in the world, more requirement for security. So we continue to see a very robust pipeline, continues to be very, very proactive and though it takes a long time, we have said it but our pipeline for turnkey businesses continues to grow, with long cycles. Some of them are difficult to predict when, but there is a lot more interest. The more we talk, the more we succeed, the more we take our customers to the places. I've said in the last couple of conference calls, we are very fortunate that we are going to have a turnkey project in Asia. We're going to have a turnkey project, we already know, in Puerto Rico. We have one in Albania, we have one in Middle East, we have one in Latin America and Mexico. So all those become what I call a showpiece for the customers of that region to come and look at it, and it's catching on quite well. So we think that there is no what I call a show stopper, for the continuous growth of the security business, as well as the new applications that have come out into the air cargo area or the checked baggage. The European airports have to get to a deadline. Now they are talking about the Checkpoint CT, add a checkpoint, all the new applications, so the growth continues. We are not impacted, but we are watching it carefully.

Got it. And then is there any color that you could give? Is the services business in turnkey about a quarter of the portfolio? Is that still the case?

Sheila, this is Alan. It would be less than that. It was a higher percentage under the initial Mexico contract, when the Mexico revenues were larger and before the rest of our business grew so significantly. So, turnkey is a very nice part of our program, but it's not as large as that.

Okay. And so turnkey and services you would bucket into one?

We classify turnkey as part of services.

Okay, got it.

If you're talking about turnkey and services together, then yes, that represents a far more substantial part of our portfolio.

Okay. And then Alan, just on the free cash flow, a good quarter in terms of $25 million. Is that sort of the run rate we should be thinking about? And I guess, how do you think about capital deployment from here, given that you've lowered your leverage quite a bit?

Sure. Yes, we were real pleased with our free cash flow, our operating cash flow and our free cash flow. I wouldn't necessarily say that's a run rate on each quarter. I think you'll see some quarters where it will be larger than that, and I think you'll see some quarters where it may be significantly below that. A lot of it would be reflective of our need to build inventory and the timing of collections. But overall, we're very pleased with where our cash flow is. How we look to deploy our capital allocation, with our strong cash and low net leverage, is first and foremost, we like winning these new turnkeys and they require some CapEx, which had nice returns on investment for us. We also look at M&A. As you know we've been active throughout our history, and any residual cash we use for opportunistic stock buyback, as well as paying down any debt that we might have.

Great, thank you for the color.

Thank you [Operator Instructions] I'm showing no additional questions in the queue at this time. I'd like to turn the conference back over to management for any closing remarks.

Thank you. I want to thank everyone for joining our call. I look forward to speaking to you on the next quarter call. And again, I want to thank all the employees for a good deliverance and execution for the quarter. Thank you.

Ladies and gentlemen, thank you for participating in today’s conference. This concludes the program. You may now disconnect. Everyone, have a wonderful day.