OSI Systems, Inc. (OSIS) Q3 2020 Earnings Report, Transcript and Summary

Good afternoon. My name is Jerome, and I’ll be your conference operator today. At this time, I would like to welcome everyone to the OSI Systems, Inc. Third Quarter 2020 Conference Call. [Operator Instructions] Thank you. Mr. Alan Edrick, Chief Financial Officer. You may begin your conference.

Well, 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 third quarter conference call. We are glad that you can join us. We hope you and your families are safe and healthy as our country and the global community battle the many issues associated with the COVID-19 crisis. Prioritizing safety, we are exercising social distancing and are all not in the same location while conducting this call. Earlier today, we issued a press release announcing our third quarter fiscal year 2020 financial results. Before we discuss our results, I would like to remind everyone that today’s discussion will include forward-looking statements, and the company wishes to take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 with respect to all such statements. All forward-looking statements made on this call are based on currently available information and speak only as of today, and the company undertakes no obligation to update any forward-looking statement that becomes untrue because of subsequent events, new information or otherwise. During today’s call, we refer to both GAAP and non-GAAP financial measures when describing the company’s results. For information regarding non-GAAP measures and comparable GAAP measures of the company’s results and a quantitative reconciliation of those figures, please refer to today’s earnings release. I will begin by taking a few minutes to discuss what we are seeing as a result of the COVID-19 outbreak and follow with a brief overview of our third quarter results. I will then turn the call over to Deepak to discuss the company’s business before returning to discuss the third quarter results in more detail and also to provide our updated guidance. Our teams are successfully addressing many of the operational challenges that have arisen due to COVID-19 and related shelter-in-place government orders. We transitioned many of our employees to working from home and implemented changes in our work practices to promote the safety of those production employees who continue to come into the factories. Though there has been and will continue to be a financial impact to the company as a result of the pandemic, production in each of our operating divisions has been deemed essential, and we continue to work to fulfill demand for those essential products in a safe and healthy way. We believe we are well positioned to navigate these times and are relatively pleased with the outlook through the remainder of the fiscal year. On the demand side, we’ve seen increased global activity in our Healthcare division for patient monitoring products and supplies and accessories, and this is expected to positively impact our fourth fiscal quarter. In our Security division, we have experienced some delays on anticipated bookings as well as certain order requests from customers to push out delivery or an installation of products to a later date. This is most acute with respect to our aviation customers and our cargo customers as access to some locations is limited and certain government personnel are unavailable to perform final acceptance criteria. In our Opto division, we expect some adverse near-term impact on net revenues as we are seeing some changes in demand from certain of our OEM customers. We continue to work through their requirements as well as actively engage with our suppliers as we navigate this new landscape. While we have experienced intermittent facility closures and government-mandated limitations on our essential workforce, currently, all our manufacturing facilities are open, except for one small location in Mexico serving our Opto business. As the COVID-19 situation continues to evolve, we are monitoring the business environment for areas of concern. We are committed to delivering the products and services needed for our customers and to maintaining a safe and healthy workplace for our employees. In terms of our quarterly financial results, we reported Q3 revenues of $293 million, a 4% year-over-year decrease. Gross margin expansion, coupled with lower borrowing costs, led to a record GAAP diluted earnings per share of $1.06 and record non-GAAP diluted earnings per share of $1.20. Strong profits and working capital management led to solid operating cash flow of approximately $46 million in the quarter. Our balance sheet is strong, and we ended the quarter with net leverage as measured under our credit facility of approximately 1.4. With a $535 million revolving credit facility and a consolidated net leverage cap of 4.0, we believe we have ample liquidity for the foreseeable future. Before diving more deeply into our financial results and discussing our updated fiscal 2020 guidance, let me turn the call over to Deepak.

Thank you, Alan, and again, good afternoon, and welcome to the OSI Systems earnings conference call for the third quarter of fiscal 2020. As Alan mentioned, I’m going to start off commenting on the current environment. I’ll also discuss some of our third quarter highlights and then turn it back over to Alan to provide a further detail on our financial performance. First, I want to thank all of our employees across the world for working through the COVID-19 pandemic that has impacted everyday life and business activity. These times further crystallize our long-standing mission to make the world safer and healthier with our solutions and actions. As the COVID-19 virus spread around the world, our global team has been focused on executing through rapidly evolving government measures, all the while prioritizing the safety and the health of our employees. To accomplish this, we implemented significant measures to protect our employees, which have enabled the company to continue to operate effectively throughout this pandemic. I am truly proud of the organization that when challenged with these unprecedented conditions has continued to execute as we always do. Moving to the third quarter. As mentioned earlier, the company’s Q3 revenues were 4% lower than the Q3 in the prior year. Due to the global nature of our customers, many of our operations are impacted by the COVID-19 starting in late March. However, each business enhanced its communications internally and externally, moved into troubleshooting mode and responded well under the unforeseen circumstances. With strong execution, we delivered record Q3 EPS and strong cash flow. Bookings in each of our Opto and Healthcare divisions were strong. However, the timing of Security division bookings was impacted by COVID-19, leading to an overall book-to-bill of 0.9 and a backlog of $863 million. Let’s review each business, starting with Security, where revenues were $187 million or about 3% lower than the prior year Q3. During the quarter, we collaborated with our customers at airports, ports and borders to handle the change in business tempo and other short-term requirements that resulted from government actions in various regions to slow the virus spread. Yet, we also continued to support long-term infrastructure initiatives for these customers. We are also continuing to develop solutions that could help improve the checkpoint screening and overall passenger flow. We see potential for solutions, utilizing remote screening, automated tray return systems and artificial intelligence to lessen the burden on operators. Shortly after the quarter end, we acquired a small AI solution that utilizes deep learning and computer vision to assist with image analysis and threat detection on X-ray based detection platforms. We expect to utilize these AI tools across certain of our detection platforms for people, baggage and cargo. At ports and borders, our current projects and turnkey contracts continued through the quarter. We are currently in discussions with Mexico Government for the next agreement as the current agreements term end shortly in this quarter. You can understand that we cannot comment further at this time as we are in active discussions. Although the go-live for our recent turnkey programs for Guatemala and Sri Lanka have been delayed, for various factors, including COVID-19, we expect both of these programs to become operational in the next few months. Looking forward, we have adjusted our guidance somewhat downwards to reflect the expectation in our Security division that there will be some delays in the delivery of products to customers, most notably in aviation given the recent slowdown for travel as well as a delay in installation of certain contracts. The timing of revenue could also be impacted due to COVID-19 as we may experience potential delays in revenue recognition due to the difficulty of scheduling on-site customer acceptance for delivery or testing. Our pipeline continues to be robust all over the globe, especially also with the U.S. government. Moving to the Healthcare division. Spacelabs revenues were about 7% lower than the prior year’s Q3. Still, the division continued to improve operations and delivered operating margin expansion, resulting in comparable operating income to the prior year quarter. Towards the end of Q3, in late March, we saw increased demand for patient monitoring platforms. We expect that trend to continue in Q4 as healthcare facilities increase their bed capacity to handle growth in COVID-19 patient volume. We entered Q4 with a very solid backlog in this division that combined with overall order activity gives us confidence for a strong Q4 for Healthcare. Moving to our Optoelectronics and Manufacturing division. In Q3, overall revenues were $70 million, down 1%, including intercompany from the prior year with continued robust operating margin improvement. During the quarter, we made an acquisition of a provider of high-reliability transistors and optical sensors for defense and space applications. This small acquisition is consistent with our strategy to expand capabilities for high-rel electronic components for the space defense market segment. Given the geographic diversification of this division’s operations that are located in the U.S., Mexico, UK, India, Malaysia and Indonesia, we had to deal with various regional reactions to the pandemic that impacted the activity of businesses, but we remained mostly operational. We are proud that our customers relied on us as we came through the unforeseen challenges and delivered. Looking ahead in Q4, we expect our operational performance in Opto to be somewhat adversely impacted by the COVID-19 as certain facilities are not at full normal staffing levels due to government restrictions and being responsive to the timing of our evolving customer needs. We will continue to work tirelessly for our customers, and we will collaborate with local authorities to help take actions, to keep our employees safe in the areas where we operate. This division supplies subassemblies and components into the healthcare industry and defense and aerospace. In summary, we began our fiscal Q4 in a new world with challenges that we believe are transitory. The visibility that we do have compels us to adjust our fiscal 2020 financial guidance to a range reflective of the current environment. The solutions that we provide our customers in aerospace, defense, security and healthcare are crucial to each industry and the people it serves. As we deal with this challenging business environment, we will continue to focus on execution and remain agile to capture longer-term opportunities. As always, I would like to thank our employees, customers and stockholders for continued support. With that, I’m going to turn the call back over to Alan, to talk in more detail about our financial results before we open the call for questions. Thank you.

Thank you, Deepak. Now I will review the financial results for our 2020 third fiscal quarter in greater detail. As mentioned previously, our revenues in Q3 were $293 million. Revenues in the Security division were $187 million, a year-over-year decrease of 3%, in part driven by the impact of the pandemic on our aviation and cargo customers. Opto division sales were roughly flat on a year-over-year basis as increased intercompany sales to support the Security division were countered by a 3% reduction in external sales. While Healthcare division revenues of $46 million represented a sales reduction of 7% year-over-year, it did represent a 9% sequential sales increase and led to significantly improved Healthcare adjusted operating income in Q3 compared to Q2. Our Q3 gross margin of 37.3% was up 70 basis points from the same prior year quarter and up sequentially from 36.3% reported in Q2 of fiscal 2020. We saw margin expansion in each of our Security and Healthcare divisions due to a favorable revenue mix and operating efficiencies, partially offset by a small gross margin reduction in the Opto division, which experienced some operational disruptions late in the quarter due to COVID-19-related government restrictions. As mentioned on previous calls, our gross margin will fluctuate from period to period based on revenue mix and volume, among other factors. Moving to operating expenses. We have historically shown the ability to manage costs and this past quarter was no exception, as SG&A expenses decreased 3% year-over-year. We work diligently across each of our divisions to improve efficiencies and prudently manage our cost structure. R&D expenses in Q3 were $15.4 million, up 12% from Q3 of the prior year, driven to a large degree by increased investments in the Security division. We remain focused on innovative product development, which we view as vital to the long-term success of our business. In Q3 of fiscal 2020, we recorded a $4.5 million impairment restructuring and other charge. This charge was primarily related to reductions in our workforce and impairment of assets associated with the exit of a product line in our Healthcare division. Moving to interest and taxes. Net interest and other expense in Q3 of fiscal 2020 decreased to $4.7 million from $5.6 million in the same prior year period as a result of reduced average levels of borrowings under our revolving credit facility and lower average interest rates. On the tax side, excluding the impact of discrete tax items, our effective tax rate in Q2 of fiscal 2020 was 23.7% compared to 28.6% in Q3 of fiscal 2019. We recognized discrete tax benefits of $5.1 million compared to $0.7 million in the comparable prior year period. As a result, we reported a tax benefit under GAAP of 3.4% in Q3 of fiscal 2020 compared to a tax provision of 26% in Q3 of fiscal 2019. For the nine months ended March 31, 2020, our normalized effective tax rate, excluding discrete items, was 26.7%. Let’s now turn to a discussion of our non-GAAP adjusted operating margin, which excludes impairment, restructuring and other charges and amortization expense of acquired intangible assets. Each of our three divisions reported adjusted operating margin expansion in Q3. Adjusted operating margin in our Security division improved to 14.9% compared to 14.4% in the prior year, driven by gross margin expansion from a favorable mix of revenues and operational efficiencies. Our Healthcare division, adjusted operating margin, also driven by gross margin expansion as well as reduced OpEx, improved to 11.8% from 11.1% during the same period last year. And the adjusted operating margin in our Opto division grew to 12%, up 30 basis points year-over-year, representing the seventh consecutive quarter of year-over-year operating margin growth. Our corporate cost increased, however, primarily as a result of the recording of non-cash mark-to-market changes resulting from the Q3 stock market decline. This resulted in a slight overall reduction in the consolidated adjusted operating margin. Moving to cash flow. In Q3 of fiscal 2020, we generated $45.9 million in operating cash flow, driven by strong profits and well-managed inventory across each division as days inventory on hand decreased to 119 days in Q3 of fiscal 2020 from 140 days in Q3 of fiscal 2019. This improvement was partially offset by an increase in days sales outstanding to 80 days in Q3 of fiscal 2020, as some customers are stretching out payment cycles in the current environment. CapEx in the third quarter was $4.5 million, while depreciation and amortization expense in the third quarter was $10.8 million. Our cash flow conversion was strong. The ratio of operating cash flow less CapEx to net income for the quarter and nine months was 212% and 146%, respectively. We were active in our stock buyback program, acquiring approximately 296,000 shares during the quarter, which completed the previously announced buyback program. Our Board recently authorized a new program of up to one million shares. As mentioned earlier, our balance sheet is strong with conservative net leverage and no debt maturities until fiscal 2023. We have significant available borrowing capacity on our U.S. revolving credit facility. Finally, turning to guidance. For fiscal year 2020, we are reducing our sales guidance to a range of $1.165 billion to $1.185 billion. The reduction primarily reflects the expected adverse impact of the COVID-19 pandemic on our Security and Opto divisions, which we believe will be partially offset by increased demand in the Healthcare division. We are also updating our non-GAAP earnings per diluted share guidance to $4.45 to $4.65. This non-GAAP diluted EPS range excludes potential impairment, restructuring and other charges, amortization of acquired intangible assets and non-cash interest expense and their associated tax effects as well as discrete tax items. We currently believe the sales and non-GAAP earnings guidance reflect reasonable estimates, and we have reflected the anticipated impact of the COVID-19 pandemic in our guidance. However, given uncertainties as to the duration and scope of the COVID-19 pandemic as well as other variables, the extent to which COVID-19 may impact the company’s financial results is difficult to predict and could vary materially from the anticipated impact reflected in our estimates and guidance. Actual sales and non-GAAP earnings could vary from the anticipated ranges due to other risks and uncertainties discussed in our SEC filings as well. In the face of these unusual times, we continue to remain fully focused on the growth of our business while investing in product development, making strategic acquisitions and managing our cost structure. We believe these efforts will enable OSI to continue our leadership in providing innovative products and solutions. Finally, we would like to take this final opportunity to recognize and thank the entire OSI Systems’ team around the world for its focus on safety, dedication to supporting our customers and agility in the face of uncertainty, all of which helps to create value for our stakeholders. At this time, we will be happy to open the call to questions.

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

Good afternoon. Deepak and Alan, and hopefully good to hear your voices, and hopefully you and your family is doing relatively well. Just a couple of questions on the Security side, you mentioned, Alan, on the book-to-bill was, I think, 0.9 in the quarter. Do you happen to have like a trailing 12-month book-to-bill or an idea of what that is, just to give us sort of a better gauge of bookings over the last few quarters?

For the Security division specifically, Larry?

Yes, yes, yes.

Yes. For the Security division, over the past 12 months, it’s been just below 1.0. If you exclude turnkey, it would be a little bit higher, but just below 1.0.

Okay. So does that sort of portray sort of a flattish year-over-year? Or would you ex-corona, would you expect new orders? Is that more just a timing-related thing? Obviously, with corona coming on, we never know, but just excluding that.

Larry, this is Deepak here. The answer to your question, I think you answered it. We’ve said it before. Some of the orders have been pushed to the right, especially U.S. government, where everybody is working from home and everybody has to get together, but the pipeline and the requests continue to come very strong. Also, there are couple of orders of large airports that we have verbally got. But again, because of the sudden nature of the shutdown, it got pushed. So we don’t see long-term post-COVID any reduction in the pipeline or bookings in Security.

Okay. And you mentioned and sticking to that theme, you mentioned sort of I think even last quarter, there was appropriated dollars for the border, but it was just too soon – too much too soon. So it took a while and got pushed out a little bit. Is there the potential outside of logistics and COVID-related impacts, which who knows how long they go for but – go on for, but beyond the initial impact, how about in terms of government funding? It seems like there’s going to be a lot of areas that the U.S. government especially and other governments, too, of course, will have to sort of help basically bail out several industries and whatnot. Is there a possibility that some of the funding that was dedicated for Security could get a little bit pushed out because of that?

Obviously, nobody can give the answer. But all indications we are seeing is there is no shortfall. As a matter of fact, the challenge with the U.S. government has continued to be they have too much, and they don’t have enough people to release the orders. But at the same time, as the traffic goes back to normal, hopefully soon, some of these things are going to be necessary all over the world, and it will continue to grow.

Okay. And I remember a couple of years back or probably few years back now, when oil fell out of bed, some of these a lot of the energy-dependent economies had some issues and lowered securities expenses a lot or expenditures. Is that five years fast forward into today, do you have a large percentage of those kind of orders coming in? Or is it sort of a different mix today?

Well, whole world has different requirements. Yes, Middle East is very much oil dependent. Other places are more security dependent. Some other Asia Pacific and some other areas are more infrastructure investment to increase their manufacturing capability, like India and other places. So it’s all over the globe, and we feel very strongly over the last, take, even a decade, that’s going to be ups and downs from one year to the other, but we have never looked at it, as if oil industry or something globally has any impact negatively. It’s all positive.

Great. Okay. And just switching gears real fast. Just on the Opto segment. Again, beyond the sort of COVID temporarily impacts, if the economy goes into sort of a prolonged recession, whatever you want to call it, I would assume that would be the one segment that probably has some direct economic impact on it. Is that fair to say?

Well, again, there’s been no precedents. None of us know how it’s going to work. But the good news is that even in our Opto segment, we are very much respond to the healthcare industry, to the aerospace and defense industry. And all that industry, especially from the U.S. government and the western economies, they continue to have need for those products post-COVID-19.

Good. Okay, great. I appreciate that color there. Okay, great. Thanks again. Thanks a lot. I appreciate it.

Thank you.

Your next question comes from the line of Sheila Kahyaoglu of Jefferies. Your line is now open.

Hi, good afternoon, guys and thank you for the time. Maybe can you guys talk about Deepak, you referred to the slowdown in the aviation business, just given people are stuck working from home. How do you think about what percentage of your business is consumable? I think it’s part of the Morpho business you acquired. Or how do you kind of think about that business coming back? It would seem like the Security business comes back quickly, the consumables may be a little bit slower. And then whatever percentage of the business exposed to stadiums and concert sort of events is the last to come back. Can you talk about how you’re thinking about the aviation recovery? Security recovery, sorry?

Sure. Sheila, this is Alan. Let me take a stab at that. I think your thesis is right on point. However, for us, the consumable portion of our business in Security is really quite low. So the impact is pretty immaterial for us. And with respect to stadiums and the like, that’s really a small part of our business as well. So I think the thesis is right on point. But for us, from an overall Security business or overall OSI business, it’s quite small.

Sheila, just to add on to what Alan said, primarily, definitely in the aviation sector, with the passenger traffic down short term, that has an impact on any new additions that are being dealt that are getting pushed and delayed. But one of the bright spots in this business has been even during this time, and it was even there before COVID-19 and it’s going to continue, is cargo. Air cargo is a very big growing opportunity for it, and we are very much engaged with it even under these circumstances, of packages, delivery, more freight coming in has to be all done and done with automation and stuff. That’s what our expertise is. So that business has been very good for us.

Okay. And just on that point, Deepak, I think you mentioned you bought an AI company. How big was that? And kind of how does that flow into what you’re trying to do with putting less burden on actual people monitoring and screening and kind of automating this whole process?

Sheila, it’s insignificant cost wise. It was a strategic thing that we bought the right assets, patents and IP and other things that can help our division to put and to go faster into the machine language and artificial intelligence to make automation better. They have had some luck working with the government, which we will capitalize on it and put it on our machines and get faster to the end market.

Okay. Got it. And then just last one on Healthcare. I think you divested your healthcare ventilator business a while ago. You mentioned another divestment. Can you just touch upon what that is? And you also talked about patient monitoring seeing a demand uptick. Should we expect a return to growth pretty quickly for that business? How are you kind of thinking about healthcare?

Sheila, this is Alan. I’ll take that. So your first question, with respect to the product line that we got out of, we fully got out of the anesthesia product line. You might recall a year or so ago, we got out of a specific product called Arkon, which was our latest product in anesthesia. And following the final sales of some anesthesia products toward the end of Q2, in our third quarter, we fully got out of anesthesia. So we’re 100% out of that business today, and that’s what that charge related to. With respect to the increased demand that we’re seeing in patient monitoring, it’s real. And we would expect to see growth occurring immediately, as you just mentioned. So we expect to see some uptick in our fourth quarter as a result.

Sheila, just to add on to Alan’s about the patient monitoring growth, it’s global. We’re seeing a lot of demand increase in Asia Pac, in Latin America, in EMEA and in U.S. So it’s not just one region. It’s very global, and we think that it will continue beyond Q4.

And how big was the divestment? Was it a few points of growth or insignificant in terms of just the organic growth rate within Healthcare?

For fiscal 2020, it was insignificant.

I’ll turn back in the queue. Thank you guys very much.

[Operator Instructions] Your next question comes from the line of Jeff Martin of ROTH Capital Partner. Your line is now open.

Thanks, good afternoon, Deepak and Alan, I hope everything is going well. Was curious coming out of the work-from-home restriction, if you see potential for new technology implementation, new processes, integration with things, for example, the airport, checking temperatures and perhaps doing other testing, that would need to be integrated to your systems, would they be independent. And just broadly speaking, do you see opportunities coming out of this that might result in new product lines and new growth opportunities?

Very astute. Very good question. For competitive reasons, I won’t say it, but you’ve touched on it. Yes, we are looking at other add-on things during this challenging time because of our installed base and our service at airports. We continue to look at it. But beyond that, I would be uncomfortable to talk at this time.

Okay. And then I was curious what you’re hearing with regards to the customs and border inspection related work that the budget had increased fairly significantly over the course of 2019. Could you give us an update on what’s going on there? And if that remains an opportunity over the next six to 12 months or if you think that time line is pushed out and if the budget overall is impacted?

I think that was asked by Larry also before. That budget is there. The budget is quite significantly higher. And I’ve said that before, the challenge is that they need to find ways to spend it. It’s not going anywhere, and we are very well positioned. We are in active discussions on multiple programs. And we believe that as there’s more work, people come back to work, there is more continuity from this challenging time that the orders will start. We are very positive about it.

Okay. And then last question is relating to the feedback and the input you’re receiving with regards to scheduling of some of these orders that have been pushed. Are you getting any level of detail on rough time lines of when you might those might be rescheduled? Are they actually rescheduled on the calendar? Or is it just too dynamic of a situation still to really start to put dates on the calendar?

Well, that’s one of the things that what Alan has said. We have lowered our guidance, taking into account some of this uncertainty that we don’t know. Nothing has gone away. It’s just pushed to the right. And each country is different. Each day is different. We continue to look at it diligently, and we believe that all that stuff sooner or later will get done. And we are hoping there’ll be it will be sooner, but I can’t comment more than that, be more definite. Alan?

Maybe just to add on, Jeff. The vast majority of projects will continue on sort of the same time lines that we anticipated. But there are selected projects that will get pushed to the right and that’s what sort of changes a little bit the guidance and the stuff. But the vast majority continues uninterrupted is our current belief.

Very good, thank you very much.

[Operator Instructions] There are no further questions. You may continue, sir.

Ladies and gentlemen, thank you once again for attending our conference call. We look forward to speaking with you all in August when we will discuss our fourth quarter and full year fiscal performance. We wish you the most safest for you and your family. Be safe and look after yourself and your loved ones. Thank you.

This concludes today’s conference call. You may now disconnect. Thank you.