OSI Systems, Inc. (OSIS) Q1 2027 Earnings Report, Transcript and Summary

Good day, and thank you for standing by. Welcome to the OSI Systems, Inc. First Quarter Fiscal 2027 Earnings Conference Call. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Alan Edrick, Chief Financial Officer. Sir, please go ahead.

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 Ajay Mehra, OSI's President and CEO. Welcome to the OSI Systems Fiscal '27 First Quarter Conference Call. We are pleased that you can join us as we review our financial and our operational results. Today's discussion will include forward-looking statements, and the company wishes to take advantage of the safe harbor provision of the Private Securities Litigation Reform Act of 1995 with respect to such statements. All forward-looking statements made in this call are based on currently available information, and the company undertakes no obligation to update any forward-looking statement based on subsequent events or new information or otherwise. We will also reference both GAAP and non-GAAP financial measures. Applicable reconciliations are available in today's earnings release. On our August call, we told you three things about fiscal '27, that we have built our guidance factoring in the situation in the Middle East, that we expected growth to be strongest in the second half, and that we expected free cash flow to exceed net income. These three factors will frame our discussion this quarter. First quarter revenues were $403 million, representing a Q1 record, up 5% year-over-year. And adjusted earnings per diluted share grew to a first quarter record of $1.66, up 17% year-over-year. Operating cash flow, $37 million, more than doubled the same prior year quarter; and free cash flow, which is operating cash flow less capital expenditures, was approximately $30 million, about 120% of GAAP net income. Q1 bookings were strong. Our book-to-bill ratio was 1.4, and our backlog increased to a record $2.1 billion from approximately $1.9 billion at June 30. I also want to be direct about certain reported figures for the first fiscal quarter. A meaningful part of our EPS growth this quarter came from below the operating line with lower net interest expense and a lower share count, and I'll quantify those for you later in this call. Margins were impacted by our revenue decline in the Healthcare division and the mix of revenues in Security, both of which Ajay and I will address. But before diving more deeply into our financial results and discussing our outlook for fiscal '27, I'm going to turn the call over to Ajay.

Thank you, Alan, and thanks to all of you for joining us today. As Alan mentioned, we achieved record fiscal first quarter revenues and earnings per share. Order activity was strong, resulting in a book-to-bill ratio of 1.4, which increased our backlog to a record $2.1 billion. The first quarter played out largely as we outlined on our last call. Bookings were strong. Backlog grew to a new all-time high, and we remain on-track for a stronger second half of fiscal 2027. Now let me turn to our 3 divisions, starting with Security. Q1 revenues were $264 million, up 4% year-over-year despite a challenging geopolitical environment, including the conflict in the Middle East, which continues to affect activity in the region. We continue to work closely with our customers there to support their ongoing needs. As anticipated, the transition of our Mexico program affected year-over-year comparisons, consistent with our initial fiscal '27 outlook. That said, Security bookings were strong and the division ended the quarter with a record backlog. Let me share a few highlights from the quarter. During the quarter, we announced two 5-year IDIQ contracts awarded by U.S. Customs and Border Protection, one with a ceiling of approximately $200 million for our relocatable Rapiscan passenger vehicle inspection systems, and a second with a ceiling of about $85 million for van-mounted mobile X-ray inspection systems. We have received initial delivery orders totaling approximately $21 million under these contracts and expect more orders as we start delivering. To be clear, only firm orders rather than ceiling values are included in our backlog figures. Our RF business is performing exceptionally well. We continue to execute on our Homeland Defense Over-The-Horizon Radar contract that was awarded last fiscal year, which has a not-to-exceed value of approximately $235 million and is our largest RF award to-date. Together with our participation in the SHIELD IDIQ, which supports a number of golden dome-related initiatives, this award positions us well to compete for additional contracts in the future. In Q1, we announced further bookings in this business line totaling approximately $90 million. Also, customer engagement across our RF portfolio remains at very high levels. Growing recurring revenues remains a priority. We continue to expect strong double-digit service revenue growth in fiscal 2027 with growth accelerating throughout the year. Given the size of our installed base, we expect service to become a larger part of our revenue mix over time, which should support margin expansion. While Security margins can vary from quarter-to-quarter with product and program mix, our long-term objective continues to focus on pairing growth with margin expansion as higher-margin service revenue becomes a larger part of our business. We are also preparing for a role as official physical screening and security technology, hardware, software solutions provider of the LA28 Olympic and Paralympic Games and an official supporter of Team USA. This is expected to be the largest sporting event in history. Furthermore, our experience at the FIFA World Cup, the Paris Olympics, and Milan Winter Olympics, among many other global events is vital to our success here. And we also see LA28 as a platform to showcase our offerings and compete for future large venue and event security opportunities. Turning to our Optoelectronics and Manufacturing division. Opto delivered another strong quarter. Revenues, including intercompany sales, were at a first fiscal quarter record of $120 million, up 9% year-over-year, with sales to third-party customers up even higher at 16% year-over-year. During the quarter, revenue growth was paired with operating margin expansion. Bookings were robust across our EMS, flex circuit, and Optoelectronics product lines, and the division closed the quarter with its highest quarter end backlog. Our long-standing OEM relationships, vertically integrated model, customized offerings and global manufacturing footprint across North America, Europe, and Southeast Asia continue to serve customers well in aerospace, defense, healthcare, and industrial markets, particularly as they further diversify their supply chains. Finally, Healthcare faced a challenging quarter. Revenue declined 14% year-over-year, primarily due to lower patient monitoring sales as hospitals continue to manage capital spending carefully. We remain focused on supporting our installed base, improving operational efficiency and completing the development of our next-generation monitoring platform. We expect Healthcare to return to growth in the upcoming quarters. In summary, our demand remains robust with a 1.4 book-to-bill ratio, a well-diversified $2.1 billion backlog, established CBP contract vehicles, promising additional U.S. government opportunities, a growing RF pipeline and continued expansion in our Optoelectronics division. Looking forward, we are focused on disciplined execution, converting our backlog into revenue, improving healthcare, and driving margin expansion across our business. I want to thank our employees, customers, and stockholders for their continued support. With that, I will turn the call back over to Alan, to discuss our financial results and updated fiscal 2027 guidance in more detail, before we open the call for questions.

Thank you. Thank you, Ajay. So let's begin with our revenue performance. Product revenues grew 5% year-over-year to $290 million, and service revenues grew 4% to $114 million. By division, as Ajay mentioned, Opto grew 9%, including intersegment sales and 16% to external third-party customers. Security grew 4% and Healthcare declined 14%. We said on the last call that we expected the Mexico program transition would be a headwind of less than $25 million in fiscal '27, concentrated in the first half. In the first quarter, that headwind was approximately $8 million, consistent with that outlook. And we anticipate in Q2, this amount to be approximately $11 million. And although service revenue growth was modest in Q1, but in line with our expectations. As Ajay said, we expect strong double-digit growth in fiscal '27 service revenues, led by the Security division, driven by a significant number of products rolling out warranty, aviation service, SaaS, and increasing RF business, among other items. Our Q1 fiscal '27 gross margin was 30.7% compared to 32.0% in the first quarter of last year. The variance was primarily driven by the decline in Healthcare division sales, which carried the highest gross margin of our 3 divisions. In addition, the strength of Opto division sales, which carry the lowest gross margin in the 3 divisions, though operating margins are solid impact us and a less favorable mix of revenues this quarter within the Security division. As we noted in the past, our margins can fluctuate based on product and service mix, volume, supply chain costs, foreign exchange, tariffs and other factors. We expect gross margin to increase over the balance of the year on higher overall revenues, including greater growth in higher-margin service revenues. Moving on to operating expenses. We continue to work diligently across all divisions to manage our SG&A cost structure efficiently. In Q1, SG&A was $69 million or 17.0% of sales compared with 17.4% of sales a year ago. R&D expenses in Q1 were $19.4 million or 4.8% of revenue. We continue to invest substantial resources consistent with our commitment to innovation and positioning OSI well to the future. Total operating expenses, excluding restructuring and other costs, declined to 21.8% of sales in Q1 this year from 22.7% in the same quarter of the prior year. Now moving below the operating line. Net interest and other expenses in fiscal Q1 were $3.3 million compared with $7.4 million in the same quarter of the prior year. This $4.1 million improvement was primarily due to reduced borrowing costs, coupled with increased investment income on higher cash and short-term investment balances. Our effective tax rate under GAAP was 18.8% in Q1 of fiscal '27 compared to 19.9% in Q1 last year. Excluding discrete items, the normalized effective tax rate, which is the rate we use in calculating non-GAAP EPS, was 22.9% in Q1 compared to 23.3% in the same prior year quarter. On a non-GAAP basis, our Q1 fiscal '27 adjusted operating margin was 9.5% compared to 10.3% in the prior year first fiscal quarter. By division, non-GAAP operating margin was 12.6% in Security, 12.1% in Opto, and negative 1.8% in Healthcare. While we saw adjusted operating margin expansion in the Opto division, the operating loss in the Healthcare division and less favorable Security division mix drove the consolidated change. We anticipate stronger operating margins for the balance of fiscal '27 in each division and for OSI overall. Moving to cash flow and the balance sheet. We generated $37 million of operating cash flow in Q1 this year compared to $17 million in last year's Q1. Accounts receivable at September 30 were $18 million lower than at June 30, given Q1 revenues are historically lighter than Q4, while unbilled receivables rose $34 million as we recognize revenue on certain Security contracts ahead of billing milestones. The receivable balance from our largest customer in Mexico slightly declined from June to September as collections modestly outpaced revenue following significant Q4 collections. We continue to expect this receivable to decrease significantly by the end of fiscal '27, contributing to expected strong annual free cash flow conversion. Inventories increased $48 million during the quarter to $463 million to support strong second half scheduled deliveries from our backlog. CapEx in the first quarter was $7.7 million, while depreciation and amortization in the quarter was $9.0 million. During Q1, we repurchased approximately 306,000 shares at an average price of about $204 for approximately $62 million. Our Board, in August, increased the authorization for stock repurchases by an additional 1 million shares. And at the end of Q1, approximately 773,000 shares were available under the repurchase program. Our priorities remain organic investment, strategic acquisitions, opportunistic repurchases, and maintaining a strong balance sheet. Q1 diluted shares were 16.3 million compared with 17.5 million a year ago, a 7% reduction, reflecting the repurchase and retirement of shares over the past year. Our balance sheet remains solid, providing us with significant flexibility. We ended the quarter with $236 million in cash and cash equivalents and $66 million in short-term investments, approximately $302 million in total, with total debt of approximately $1.0 billion and no amounts drawn under our bank lines of credit. With the capital returned to shareholders during Q1 through stock buybacks, net leverage under our credit agreement was approximately $2.3 million. Over 90% of our debt is at fixed rates, which limits our borrowing cost sensitivity to higher short-term interest rates. Now turning to our guidance. We are raising our fiscal 2027 non-GAAP EPS guidance while reaffirming our fiscal '27 revenue guidance of $1.875 billion to $1.930 billion. We now expect non-GAAP EPS of $11.28 to $11.64, representing 9% to 12.5% year-over-year growth. The expected increase primarily reflects the favorable impact to EPS of stock repurchases made in Q1. As we said in August, we continue to expect revenue growth to be strongest in the second half of the fiscal year. We expect second quarter revenues to be modestly down year-over-year as Q2 represents the toughest Middle East comp with sizable revenues in the prior year period before the conflict began, along with the Mexico impact previously discussed. H2 revenue growth is underpinned by the timing of the expected conversion of our sizable backlog and a healthy funnel of new opportunities, coupled with the significant year-over-year growth expected in Security service revenues that we have previously discussed. We also continue to expect free cash flow to exceed net income for the full fiscal year. Our guidance excludes potential impairment, restructuring and other costs, amortization of acquired intangible assets and their associated tax effects and discrete tax and other non-recurring items. Actual results could vary from guidance due to the timing of backlog conversion, new bookings, cash collections, tariffs, the conflicts in the Middle East, U.S. government funding and procurement timing, interest rates and supply chain disruptions, among other factors discussed in our SEC filings. In summary, we began fiscal '27 with record first quarter revenues, strong bookings, a record backlog and cash generation running ahead of last year. We thank the entire global OSI team for their dedication. At this time, we'd like to open the call to questions.

[Operator Instructions] Our first question is going to come from the line of Josh Nichols with B. Riley Securities.

Great to see the backlog well above $2 billion for the first time with a strong book-to-bill. EPS obviously moving up higher. I know you're reiterating the top line revenue guidance. But just with the backlog increase, I was just curious, is part of that just being some conservatism given that there's already a second half weighting to the outlook? Or is this something that you think these new orders that you got are really just going to increase visibility for the company when you think about like fiscal '28, '29 and the timing of those deliveries?

Josh, this is Alan. Great question. And we're really pleased with the record level of backlog that we have. Going into our guidance, with still conflicts going on in the Middle East and other geopolitical events, we just thought it prudent to maintain that revenue guidance at this time. Certainly, there is upside, and it sets us up quite nicely as we enter fiscal '28 and beyond as well.

Yes. And then just for a little bit more context, I'm guessing probably not, but was any of those Middle East orders that caused the onetime hiccup in last quarter, was any of that shipped? Or are you still expecting that to come in, in the second half? And is there anything else that you guys have been working on that you expect may come to fruition in terms of the order pipeline generally?

Yes. Another good question, Josh. It's Alan. So yes, we mentioned last time there was roughly $50 million pushed out of our fourth quarter. During our Q1, we shipped and recognized revenue about $8 million of that. I think last time we said we expected the balance to mostly be in the second half of this year and even into fiscal '28, and that's still currently our expectation.

Yes. Just -- this is Ajay. Just to add on in terms of orders, we -- even with the Middle East situation, we had a great book-to-bill ratio. Orders are materializing in other places. And as I said, I think, previously as well, as hopefully when the conflict ends, usually, in the long run, it's an opportunity for us to get a lot more orders as people become more and more conscious of security around infrastructure and military facilities.

Yes. I appreciate that. That's a good point we're taking note of. Good to see the progress there.

Our next question will come from the line of John Godyn with Citigroup.

I wanted to just talk a little bit about or hope you can elaborate a little bit on what's going on with services revenues. I think everybody is excited on the growth there, what it means for margins over time. It seems like there was a little bit of a blip, but you guys are confident that that mix is going to improve through the balance of the year in the Security division. Any color you could provide would be great.

Sure, John. This is Alan. Good question. Yes, while our service revenue growth was modest at around 5% in Q1, we see a significant pickup year-over-year in each of Q2, Q3, and Q4. And that's really underpinned by looking at the rollout of our products that we've installed coming off of warranty. That's a big part of it. Some of the aviation service revenue that we're doing. some of the SaaS revenue such as CertScan, some increasing revenue with our RF business and some various other items. So we actually have some very good visibility into the service revenue growth, which gives us a high degree of confidence for that strong double-digit growth in service revenue commencing really this quarter in Q2 and getting even stronger in the second half.

Great. That's very helpful. And if I could ask one more on the Middle East. Just reflecting what's out there in the news, there is this concern of an escalation after the midterms. I just was hoping to think through that with you guys. If there was a dramatic escalation event, how might that impact your thinking? How might you guide investors to kind of think through the impact on the business?

So I think, as I said, in the long run, obviously, any -- unfortunately, any conflict does benefit us with increased security requirements. I think in the -- we've taken into account as much as possible what we think is going to happen. But obviously, we don't have a crystal ball like anybody else. So we'll wait and see. But from what we know right now, we feel confident in what we think is going to happen over the next 3 quarters.

Our next question will come from the line of Christopher Glynn with Oppenheimer & Co.

I want to ask a little bit about the RF business. You talked about growing RF pipeline and notwithstanding the large bookings you've had. I know there's a lot of classified work you do there, but curious if you could talk about the competitive landscape, a little bit more about the differentiation that's winning. How unique is the offering? And how dependent are the Serve programs on you guys singularly?

So this is Ajay. As we said previously, yes, it's a kind of business we're pretty restricted in what we can say or not say. But I will tell you that our offerings are regarded very favorably by customers. We have some very unique products that others do not have. And in certain areas, we definitely do dominate the market. So I think that without getting into specifics, we feel very good about our prospects going forward. And as I said in my prepared remarks, we are definitely very much talking to customers and discussing opportunities as we move forward.

Great. And just in terms of those large orders, the $235 million and the $90 million, curious how that's pacing to orders. I think it's a little more upfront than the CBP orders, but just kind of curious.

Chris, this is Alan. Yes. So it's exciting for us. We are recognizing revenue on that $235 million contract as we speak. So we saw some nice revenues for that in Q1, and we'll continue to see it through the balance of this fiscal year. The new orders that we got for $90 million, we'll see some contribution this year and more contributions in out years as well.

Yes. It gives us great visibility in '27 and beyond.

Our next question will come from the line of Larry Solow with CJS Securities.

I guess questions just on the backlog composition of the backlog. It sounds like most things are United -- U.S.-focused, right? You got a couple of big orders in August and then the $90 million on the on the RF side. I guess that's mostly U.S. Is that -- no Middle East this year in your guidance on sales and I'm sure on bookings. But is the majority or vast majority of bookings you expect this year domestic? Or is there some international stuff in the queue or close in the queue?

So this is Ajay. I mean, bear in mind that we do business in 150 countries. So international business, we expect to continue. Obviously, Middle East is a blip right now, and hopefully, that turns around. And we have domestic orders as well. So it really depends on a quarter-by-quarter, whether it's domestic or international.

All right. And I guess the other question I have really is more importantly, just in the U.S., is there any risk -- we're always looking over our shoulder on the Middle East and Iran. Just curious, the U.S., the reconciliation bill, Reconciliation 3.0, I guess, they call it. I guess I have to -- midterms, that's supposed to be hopefully hashed out before year-end. But is there a funding risk, particularly on Golden Dome and maybe even -- I don't think -- I think that that's a separate funding for them, right? There's no actual funding in the traditional appropriations there. So I'm just curious, is that something you guys are watching, particularly on Golden Dome, but just obviously, we had a government shutdown last year that impacted stuff for quite a while. So any thoughts on that would be great.

So a lot of this is out of our control, obviously. But keep in mind, with the Big Beautiful Bill, a lot of the funding for DHS as well as the Golden Dome programs was already there. So that will continue, and we're still waiting for CCP and others for that funding to be awarded. They started the programs, but there's still a long ways to go. So I think that really from the original reconciliation bill, we're still waiting for orders to be released. I think that -- as far as the future is concerned, we feel even on the RF business that a lot of the funding is already there. Obviously, everybody looks for future funding. So we'll see what happens. But at this point, the programs we're in, in the near-term to short-term, we feel pretty good.

Great. Lastly, just from my take, just summarize, it sounds like, obviously, Q1 is a light quarter and top line or mix -- top line was fine. Mix was a little bit light that hurt your margins a little bit. But it doesn't sound like, from an operating standpoint, much has really changed for your outlook this year. The increase in guidance is more because of your share buyback than anything else. Is that kind of fair to say?

Yes, Larry, this is Alan. That would be a fair statement at this point in time, yes.

And one moment for our next question, which will come from the line of Seth Seifman with JPMorgan.

I wonder, you gave us some helpful commentary about the revenue in Q2, just so we're all kind of properly calibrated in terms of how we get to the year. How do we think about the mix evolving in Q2? I think you mentioned a recovery in services' growth and the degree of sequential margin expansion that we might think about.

Yes, Seth, this is Alan. So you're correct. We tried to give some color for modeling purposes for Q2 that we give annual guidance. We do see service revenue accelerating meaningfully in Q2, probably that type of growth doubling, if not more than doubling in Q2, with continued acceleration in the second half of the year as well. So we would anticipate that that will contribute nicely to expanding margins throughout the balance of the year.

And then maybe I guess as you think about capital deployment, we saw some good share repurchase this quarter, kind of the way we should think about that going forward, still with good cash on the balance sheet and nice conversion this year. Are there interesting things to look at in M&A right now? Is that part of the outlook? Is it kind of more focused on executing this kind of growing backlog that you have and maybe we'll see some more share repurchases? Maybe just some updated thoughts on capital deployment.

Yes. So we're -- this is Ajay. We're always looking at organic growth. That's always our #1 priority, and we think there are a lot of opportunities out there. So it's not that we absolutely need an acquisition, but we obviously look at acquisitions. We've done them in the past. And we need to look at an acquisition that's strategic, that builds on our momentum and then really increases our market penetration or gives us some complementary markets that we're going after. And we're always looking at -- always opportunistic about share repurchases. So there's no set rule here or there, but we look at all three opportunities, and we still are.

[Operator Instructions] And our next question will come from the line of Jeff Martin with ROTH Capital Partners.

Wanted to dig into how you're thinking about future investment in the RF business with the success that you're having. I know that you've built out overseas manufacturing. Are we -- do we have significant capacity at this point? Or are you going to have to look to expand capacity? And then could you also touch on either R&D or future investment in -- further in the RF business?

So great question. And obviously, we want to make sure, and I'll address the R&D first, that we start and keep on investing in future products. You obviously want to invest when times are good. And we're actively looking at opportunities there. In terms of expansion, I think we mentioned before, we moved into a new facility. We've actually moved into a second new facility. We feel that we have a very robust pipeline that we can meet with the current requirements that we have, and we can always go into a second shift and meet it. And as we actively talk to customers, that's one of the things we're able to demonstrate that, yes, we have the ability to get more orders and grow and get them in, in a timely manner. And really, if necessary, it's a kind of business that if you have to add another facility, it will be fairly straightforward for us to do.

I think that's the first time I've gotten a great question out of you, Ajay.

I'm showing no further questions at this time. And I would like to hand the conference back over to Ajay, for any closing remarks.

Once again, thank you all for joining our call. We look forward to speaking with you during our next earnings call following the completion of our fiscal 2027 second quarter. And hopefully, all of you have an upcoming great holiday season. Thank you very much.

This concludes today's conference call. Thank you for participating, and you may now disconnect. Everyone, have a great day.