Ladies and gentlemen, thank you for standing by and welcome to the OSI Systems Inc., Second Quarter 2020 Conference Call. [Operator Instructions] I would now like to hand the conference over to your speaker today, Alan Edrick, Chief Financial Officer. Thank you. Please go ahead, sir.

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 Fiscal 2020 second 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 second quarter fiscal year 2020 financial results. Before we discuss our results, I'd 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 and earnings. Undue reliance should not be placed in 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…

Thank you, Alan, and thanks to everyone for joining us on today's call. For the second quarter of fiscal 2020, we again achieved record sales and earnings and delivered robust cash flow. Let's review the Q2 performance and highlights for each division beginning with the security. Q2 revenues in the security division were $202 million, a 7% increase from the prior year achieving record sales for any quarter in our history. We saw strong sales of cargo and vehicle inspection systems for port and border applications and checkpoints solutions and service for air cargo and airport security applications. We continued to see sustainable future growth in these areas of the marketplace. Security bookings in the quarter were strong at $234 million representing an approximate 1.2 book to bill ratio. We continued to gain traction with the port and border customers. We expect to begin our turnkey programs in Guatemala and Sri Lanka in the near future. We announced last week the extension of the MSAT program in Mexico until May 2020. We are actively engaged with Mexico's government on a broader long-term program. As you know, we've had a successful eight years ongoing program and we believe that we are very well positioned. As you can understand, we cannot comment any further on this matter. With respect to the U.S., it is fairly well known and we have said it in the previous calls that the U.S. government's focus on the Southern border with Mexico is heightened. It's leading to significant increased funding for non-intrusive security equipment. As you know, we have a lot of cargo scanning equipment at the border on the U.S. side. Although, there have been some order push outs, the opportunity pipeline continues to look very, very robust. We have had several other wins during the…

Thank you, Deepak. Now I will review the financial results for our 2020 fiscal second quarter in greater detail. As mentioned previously, our revenues in Q2 of fiscal 20 were 305 million. Revenues in the security division reached a record Q2 level of 202 million a year-over-year increase of 7% driven primarily by growth in cargo equipment and checkpoint inspection sales. In addition, security service revenues also increased year-over-year. Opto division sales increase modestly as strong intercompany sales to support the security division were countered by a reduction in external sales. And as Deepak pointed out, our healthcare division struggled with sales down markedly. While the healthcare backlog remained strong, up 26% as compared to the end of Q2 in the prior fiscal year. The timing of certain deliveries as requested by customers has pushed out. Our Q2 gross margin of 36.3% was comparable with the same prior year, quarter and up sequentially from 34.1% recorded in Q1 of fiscal 20. As mentioned on previous calls, our gross margin will fluctuate from period to period based on revenue mix among other factors. Moving to operating expenses. SG&A expenses were well-managed and decreased 5% year-over-year. As a percentage of sales, SG&A expenses decreased to 20.9% in Q2 of fiscal 20 compared to 22.1% in Q2 of the prior year. We worked diligently across each of our divisions to improve efficiencies and prudently manage our cost structure. In this quarter's performance in this area was another good example of these efforts. R&D expenses in Q2 were $14.9 million up 16% from the same quarter of the prior year. Each division incurred more R&D costs, but the increase was largely driven by investments in the security division. We remain focused on innovative product development, which we view as vital to the long-term success…

[Operator Instructions] Our first question is from Jeff Martin from ROTH Capital Partners. Your line is now open.

Thanks. Good afternoon, guys.

Good afternoon.

Hi, Jeff.

I was wondering if you could elaborate on the order push outs, are those essentially tied to the customers in border related work you're getting.

Yes. This is Deepak here. As you know, we have said it in the previous calls that the budget for the non-interest of equipment has significantly increased over the last year for Customs and Border Patrol group and some of the execution of reducing those orders and stuff have become a little bit more challenging because of the significant increase of their budgets. We feel very confident about it. We are actively involved. We have a lot of equipment at the border both sides, both on the U.S. side and the Mexico and we feel good about it. The pipeline continues to be strong, but the real sort of thing is when they get ordered and when they are ready to receive it.

Right. Okay. And then the Healthcare related push outs seemed more out of your control one-time in nature. Any idea of when those might hit or are they going to be in the second fiscal half of the year? What is exactly included in your guidance in terms of --

Well, on that particular one. Basically there's a little bit of change in the marketplace as you know there's so much consolidation going on in the hospital space. And as the IDM groups or the purchasing groups get bigger, they have lots of hospitals to work with, construction delay, receiving of these equipment, changes from one side to the other. And that has really become a little bit more difficult to predict. And one of the things that as Alan mentioned, I mentioned that the backlog looks good, but some of the actual shipping and acceptance is a lot depended upon the readiness of the customer to receive it.

And Jeff, this is Alan. Just to add a little bit more color, based on what we are hearing from some of the customers some of those push outs will move into Q4 and into our next fiscal year.

Great. That's helpful. And then, I wanted to touch on your comment where the robust pipeline, especially in the U.S., in previous calls you really focused more on international as being the stronger of the two. Is that a shift in what you are seeing in the marketplace in terms of near-term plans?

Just to clarify, both sides look very robust. And that's why we also set our book-to-bill is very strong at 1.2 in the security group. The reason I wanted to just emphasize that shot-term there is a lot of activity on the U.S. side and these are finite products. We already have the equipment and some of that stuff. So, there is no shortage or change in the robust pipeline both international and domestic and we continue to pursue the opportunities all over the globe.

Great. Thanks for taking my questions.

Thank you.

Thank you. Our next question comes from the line of Larry Solow from CJS Securities. Your line is now open.

Great, thanks. Good afternoon, guys. Just to clarify on the U.S. security side and sort of what was contemplated in your guidance. It sounds like, Deepak, maybe you had a little bit more expectations for maybe some sooner sales on the Southern border. But, it sounds like overall that may be pushed out a little bit. But, the opportunity seems like it's actually growing even more than -- maybe not by the expectation, but it sounds like it's a short-term issue on the growth, sounds like it will be there. Is that a good way to summarize that?

Absolutely. I couldn't have said it better. It's exactly what we feel. The pipeline very strong and the budget is significantly increased. We are well positioned. We have a lot of equipment. We have good relationship with the customer. And again, I want to emphasize that both sides of the border. And we feel that the pipeline continues to be very robust and we expect to be quite successful.

And on the Mexico side, I know you can't comment too much, but it sounds like you mentioned potentially a broader deal going forward. So, I assume that would be, I guess, more on the border patrol side, but maybe even more broader based on that, right? And other areas too. Is that fair to say?

Well, the less we talk the better.

Okay.

It's been appreciated, but all I can say is it's all inclusive.

Okay, fair enough. And do you expect some -- I know that's sort of a four-month extension. I don't know that's a standard or you guys sort of negotiate just to add four months. But do you expect maybe to have a new contract before that or is that something that may not happen until toward the end?

Well, the thing is that they do it their way. And basically we are in active discussions and hopefully by the end of May, we should have a broader program, but there is no guarantee.

Okay. And on turnkey, the Guatemala and then Sri Lanka, I thought those were set to start a quarter or maybe two quarters ago and did they get delayed a little bit? And are you incurring some costs ahead of that?

Well, the thing is always these kind of programs, the starting actual date is little unpredictable. We have done everything, we are ready. The equipment is there, they've been tested and everything else and now it's just a question of starting to start doing the scanning. And we are quite excited about it. And yes, we had announced it before, we are expecting now and we want to say it carefully in near future.

Got it. And then, just on the book-to-bill, you guys usually sort of refer to that, the non-turnkey, but I guess this number is sort of bookings versus your total revenue, right? So that's sort of encompassing at least turnkey revenue, I don't know if there was any turnkey orders, probably not, right?

Larry, this is Alan. Yes. This was for the company overall and the division overall.

Right.

There were some turnkey orders in there.

Okay.

Yes.

All right. Okay. Just lastly, anything you can -- just a little more color on the new President in the Healthcare division. I think you said, he just came in last quarter, if I'm not mistaken.

Well, we are quite positive about him. He is a very detail-oriented guy, comes from the medical industry from Philips and some of the other big boys, based in Seattle, very much focused. We are looking at a cost rationalization, looking at more focus on product development. As we've said in the last call, we are focusing, focusing very much on patient monitoring and cardiology. We have exited the anesthesia business and this guy is very much focused on it and working with us. Alan, do you want to add something?

Yes. We're very pleased with the work that our new President is doing. He has energized the team and they're moving in the right direction and we're very hopeful and confident that we're going to see some nice progress.

Great. Excellent. Thank you. Appreciate it.

Thank you. Our next question comes from the line of Josh Nichols from B. Riley, FBR. Your line is now open.

Yes. Thanks for taking my question. I did want to ask, there has been a nice up tick over the last few years in direct sales to the U.S. government, and it sounds like despite a couple of push outs, that's likely to continue. Could you help frame how big of an opportunity you see within the U.S. regarding the company's RTT 110 now that's been certified and you have this approaching February 2021 deadline where everything is going to have to be processed?

This is Deepak here. Good question. Firstly, I want to focus on it that the up tick in the U.S. side of the business up till now has mostly been in cargo. As you know that there is not procurement actively going on for checked baggage in the airports. Our new endeavor of using the RTT into the air cargo space has been very well received. We are working with large logistics carriers both international and domestic and have had a very good success rate in it and we feel that growth will continue. So we feel that the 2021, 2022, when the deadlines come and the new certs and requirements come, we are well positioned and we believe that the total pipeline, both in the aviation, air cargo and cargo border will continue to be growth for the next couple of years, especially in U.S., but also international.

Thanks. And then, I want to hit on, the company has had some really strong operating cash flow for the first half of this year, $60 million with good expense and working capital management. What are the expectations in that regard for the back half of the year, Alan?

Sure. Good question, Josh. We expect to continue to generate nice operating cash flow. Cash flow is not a metric that we provide guidance on overall, but we're going to continue to focus on strong working capital management and increased profits and the two of those should combine to generate good cash flow for us in the back half of the year as well.

And could you provide a little bit of update, we've talked about before about the progress regarding the integrated service contract in the Middle East and how that's been coming along?

Well, we are making progress and we are hoping to go live in the near future. Obviously in some of those places, political climates change and we continue to look at it, but remain very positive. Lot of interest and -- the interesting thing is that there has been no lack of interest. And as we get more and more progress and people get used to and we said it before, that the integrated service is catching up. We have a very broad marketing group working globally to look at that area and we continue to look at various opportunities, not just in Middle East, but in Asia and Latin America, and frankly even in U.S.

That's great. And I'll hop back in the queue. Thank you.

Thank you. [Operator Instructions] And our next question comes from Greg Konrad from Jefferies. Your line is now open.

Good evening. So, just to touch on the last question. I mean, I know you provided some numbers in the past. I mean, is there any way to think about how far we are through the European upgrade cycle and kind of how that filters into potential U.S. requirements?

Good question, again. I think a couple of calls ago, somebody did ask, I'll be guessing, but I would say that maybe half done, about 45%, 50%, and we have said it that we've been quite successful and we continue to pursue more aggressively as they go forward for the remainder of the year to the deadline.

Thank you. And then, just in Healthcare, I was hoping to get a little bit more color. You talked about a lengthened sales cycle and larger buying groups. I mean, one, has there been any change in the competitiveness of the market? And two, I think that business has always been -- had margins that are maybe most sensitive to volume. Is there any reason to not think that that relationship would hold kind of when volumes come back in terms of incrementals?

Good question. And I think you've answered yourself. Good. There is no ASP erosion that we've seen. Margins remain very healthy. And yes, the nature of the beast is that it's very much tied to the revenue. So as the revenue comes back up, the margin contribution to the bottom line will be significant. Alan, you want to add something?

No. Well said. The Healthcare business is our highest contribution margin business, which is very sensitive to the top line. So as revenues go up, there's a big pull through to operating margins, and of course, the inverse is true as well.

Thanks. And then, just last one for me. I mean, it seemed like you mentioned five or six things that are kind of driving the growth in Security. One of them were services for airport security. I mean, any color or notable around kind of the regional perspective or is that fairly broad based?

I would say, it's pretty broad based. Again, I want to emphasize not just the airports and stuff, border crossings, ports, sporting events, cruise lines, border police, air logistics, air cargo, we feel is a very good growth opportunity and we are very well placed in that.

Thank you.

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

Ladies and gentlemen, thanks once again for participating in our conference call. We look forward to the second half and speaking with you at the next earnings call for Q3 in April. Good day. Thank you everyone.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.