OSIS - NASDAQ

Good day and thank you for standing by. Welcome to the OSI Systems, Inc. Second Quarter 2024 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, CFO. Please go ahead.

Well, thank you. Good morning 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, OSI's President and CEO. Welcome to the OSI Systems’ fiscal ‘24 second quarter conference call. We are pleased that you can join us as we review our financial and our operational results. Earlier today, we issued a press release, announcing our 2024 fiscal year second quarter financial results. Before we discuss our results, however, I'd 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 such forward-looking statements. All forward-looking statements made on 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. During today's call, we will refer both to GAAP and non-GAAP financial measures when describing the company's results. For further 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 with a high-level summary of our financial performance for the second quarter of fiscal '24 and then turn the call over to Deepak for a discussion of our business and operational performance. We will then finish with more detail regarding our financial results and a discussion of our outlook for fiscal year of 2024. We mentioned on the last earnings call that we expected to see accelerated growth beginning in Q2, and that was indeed the case. Our second quarter financial results were very strong with the Security Division again generating double-digit revenue growth and significant year-over-year operating margin expansion. The Opto division performed solidly, while the Healthcare division experienced a challenging quarter. We anticipate significant overall revenue and earnings growth for the balance of fiscal ‘24, and we are encouraged by the momentum in the business. Let's start with a summary of our fiscal 2024 Q2 results. First, revenues increased 26% year-over-year to a Q2 record of $373 million, driven by the performance in our Security division where revenues were up 49% year-over-year. Second, the strong revenue growth coupled with gross margin expansion led to record Q2 non-GAAP adjusted earnings per share of $2.21, up 86% from Q2 of the prior fiscal year. Third, bookings were solid with a book-to-bill of approximately 1, and we ended the quarter with a backlog of nearly $1.8 billion. This strong backlog provides outstanding visibility for the full fiscal year. Before diving more deeply into our financial results and discussing the fiscal ‘24 outlook, I'll turn the call over to Deepak.

Thank you, Alan, and thank you to everyone joining us today. I'm happy to report a record breaking second quarter for fiscal 2024 with revenues reaching $373 million, representing 26% growth year-over-year, and operating income growing 105% over the same period from last year. This exceptional performance was driven by relentless execution in security, complemented by solid results in the Optoelectronics and Manufacturing division. Our backlog, as Alan mentioned, and opportunity pipeline remains extremely healthy, providing confidence for strong performance in the second half of ‘24 and beyond. Let's discuss each division's performance starting with Security. The Security division delivered Q2 revenues of $250 million, representing 49% growth year-over-year from last year. Then double this profitability in the same period. The adjusted operating margin expanded significantly to 22.7%, reflecting a favorable mix of higher gross margin sales, efficient operations and robust market demand. Bookings were also solid, despite the sizable conversion of backlog to revenue in the quarter. The security division's backlog at the end of Q2 was comparable to the start of the fiscal year, given a book-to-bill ratio of approximately 1.0 in the first half of fiscal 2024. Q2 marked the commencement of revenue recognition on our recent major cargo programs announced earlier with SEDENA, the Mexican Defense Agency, as well as continued momentum on the cargo program with a large international customer previously announced. We continued to expand our presence for potent border solutions and secured significant recent new contracts Shortly after the quarter end, we announced a $59 million contract that we received in Q2 from an EMEA region customer for various cargo and vehicle inspection platforms, including our Eagle Series and car view systems. Furthermore, we are expected to integrate these inspection systems into a national command center through our proprietary CertScan integration platform, which has been gaining traction with port and border custom agencies worldwide, and allows us to differentiate our offering from our competitors. During the quarter, we also announced a $5 million award from a Latin American customer for port security solutions, including installation and integration support for the Eagle P60 High Energy Drive-through Cargo and Vehicle Inspection

Well, thank you, Deepak. So let's review in greater detail the financial results for our fiscal ‘24 second quarter. Again, our fiscal Q2 revenues were up 26% with the second quarter of the prior fiscal year. Q2 Security division revenues were up 49%, largely the results of sales growth of our cargo and vehicle inspection products. We also had double-digit revenue growth in our aviation and checkpoint products and related services. Q2 revenues included continued shipments from the $200 million plus cargo contract announced in January ‘23, and initial revenues from the $500 million plus cargo contract announced in March ‘23. Opto sales were down approximately 1% year-over-year. Strong intercompany Opto sales to support anticipated Security division growth were partially offset by reduced third-party revenues as certain Opto customers decreased inventory levels or are experiencing program delays, which we anticipate will continue to impact us for another quarter or so. The Healthcare division sales decreased 4% year-over-year with growth in recurring revenues of SaaS, service, supplies and accessories, along with growth in cardiology product revenues. These increases though were outweighed by a decrease in revenues reported for our largest product family, patient monitoring, in the challenging hospital CapEx environment. The fiscal ‘24 Q2 gross margin of 37.9% was up over 500 basis points from the 32.5% gross margin in Q2 last year. While the gross margin expanded in each division, the most notable improvement was seen in the security division, which experienced a favorable mix of sales along with strong operational execution. Our gross margin will generally fluctuate from period to period based on revenue mix and volume, inflation and impacts of changes in supply chain costs amongst other factors. Moving to operating expenses. We continue to work diligently across each of our divisions to improve efficiency and to prudently manage our SG&A cost structure. Q2 SG&A expenses were $71.6 million or 19.2% of sales compared to 18.3% of sales in Q2 of the prior year. The year-over-year increase was driven by higher compensation costs, including incentive compensation linked to our significant sales growth, increased professional fees, and a higher level of bad debt expense than in the prior year Q2. We expect to leverage our SG&A for fiscal ‘24 where such expenses are expected to decline as a percentage of sales on a full-year basis, implying a lower SG&A run rate in the second half of the 2024 fiscal year then we reported in Q2. Research and development expenses in Q2 of fiscal ‘24 were $16.4 million or 4.4% of sales, compared to $14.5 million or 4.9% of sales from the prior year quarter. We continue to dedicate considerable resources to R&D, particularly in security and healthcare, as we remain focused on innovative product development, which we view as vital to the long-term success of our businesses. We recorded $1 million of restructuring and other charges in Q2 of fiscal 2024, compared to $2.3 million of such charges in Q2 of the prior fiscal year. Moving to interest and taxes. Net interest and other expenses in Q2 increased to $6.5 million in fiscal year ‘24 from $5.2 million in fiscal year ‘23, primarily due to increased interest rates on a higher level of borrowings. We executed an interest rate swap during Q1 of fiscal ‘23 to fix a portion of our floating rate bank debt. Our reported effective tax rate under GAAP was 20.2% in Q2 of fiscal ‘24 compared to 19.5% in Q2 of fiscal ‘23. In Q2 of fiscal ‘24, we recognized a discrete tax benefit of $2.5 million compared to $0.7 million in Q2 of the last fiscal year. Excluding the impact of discrete tax items, our normalized effective tax rate in Q2 of fiscal ‘24 was 25.7% compared to a normalized effective tax rate of 23% in Q2 last year. I will now turn to a discussion of our non-GAAP adjusted operating margin. Overall, our non-GAAP adjusted operating margin in the second quarter of fiscal ‘24 increased to 15.5% from 10.7% in Q2 of fiscal ’23, driven by strength in the Security division. The non-GAAP adjusted operating margin in the Security division expanded to 22.1% in Q2 of this year from 14.7% in Q2 of last year, primarily due to a favorable sales mix and operational improvements. The adjusted operating margin in our Opto division was again solid, increasing to 13.4% in the second quarter of fiscal 2024 from 13.1% in last year's Q2. The Healthcare's division's adjusted operating margin was negligible with the reduction in the division sales. Moving to cashflow. As mentioned on past calls, we expected to invest significant amounts in working capital associated with the anticipated strong growth in security. In Q2, cash used in operations was $23.5 million, primarily due to increases in accounts receivable associated with the revenue growth and inventory increases in preparation for program deliveries under the two large security division contracts announced last year. CapEx in the second quarter was $3.5 million, while depreciation and amortization expense was $10.3 million. Our balance sheet is solid with, modest net leverage of under 1.4x, and significant capacity for investments, acquisitions, and stock buybacks. Aside from $7.5 million of annual required principle payments under our bank term loan, the bulk of our debt matures in fiscal 2027. Finally, turning to guidance. We are increasing both our fiscal ‘24 revenues and non-GAAP diluted EPS guidance. We currently expect our fiscal 2024 revenues to increase more than 19% over revenues in fiscal ‘23, and we anticipate our fiscal 2024 non-GAAP diluted EPS to grow more than 29% over our non-GAAP diluted EPS in fiscal ‘23. This non-GAAP diluted EPS guidance excludes potential impairment restructuring and other charges, amortization of inquired intangible assets and their associated tax effects, as well as discrete tax and other non-recurring items. We currently believe this guidance reflects reasonable estimates. The actual impact on the company's financial results of timing changes on expected revenues, disruptions and increased costs in the supply chain and inflation and interest rates is difficult to predict, and could vary significantly from the anticipated impact currently reflected in our estimates and guidance. Actual revenues and non-GAAP earnings per diluted share could also vary from the guidance indicated above due to other risks and uncertainties discussed in our SEC filings. We continue to remain focused on the growth of our businesses and proactive management of our cost structure. We believe our efforts will enable OSI to continue providing innovative products and solutions. We would like to take this opportunity to thank the global OSI Systems team for its continued dedication in supporting our customers and partners. And at this time, we'd like to open the call to questions.

[Operator Instructions] Our first question comes from the line of Josh Nichols from B. Riley.

Great to see such strong results, particularly from the Security division. I think you highlighted on the call, but you've had pretty strong award wins this year as well too, year to date, including that $59 million award out of the EMEA region. One, fair to assume that's not a backlog because it happened after quarter end. And then two, are you seeing other opportunities in this region or others with things like the conflict in Israel that are going on that could offer some large contract wins later this calendar year?

As I mentioned in my call, the pipeline in security looks very strong to us and in basically all regions. The only place that there is a little bit of slow down and everybody on hold is in U.S. because of what's going on in Washington. But all over the world, the pipeline is very strong and we believe that we are very well poised to win some other strong big contracts all over the globe. Not only just in cargo, but even in aviation.

And then just since you touched on the U.S. I know, we don't have a budget yet. But if you're looking here, there's clearly a lot of focus on the southern border. You've had some very nice large award winds there. Could you talk about some of the opportunity that could come to fruition later this year on that front? Because there's still some good amount of availability under the IDIQs, or even later potentially, if we look at like a TSA refresh next calendar year or something like that.

Again, good question on the southern border, definitely there's a lot of interest and even in the temporary budgets that are being talked about it, there's lots of interest from both sides of the house for enhancing the border security. And we've said that before, we are very well poised for it. And the CVP itself has an IDIQ out there, which still has a lot of capacity and we are very much favored as a strong partner in that space. On your second half of the question, aviation, definitely the airport -- air traffic is increasing all over the globe, and we believe that we are very well poised for it, both domestically and internationally. And we've announced some orders internationally that there is a lot of growth opportunity and definitely there is some uncertainty with the Middle East, what's going on in the Ukraine. But we also look at it, and we've said it in a couple of times before, sooner or later, as this thing settle down and I keep praying that it does, all the areas around that area where there's conflict, all those countries will need security equipment. And we again, are very well poised for it.

Thanks. The last question for me. One, impressive that the company's maintained this $1.8 billion backlog, despite what's been a pretty high conversion for the security with record 2Q revenue. I presume the visibility into not just this year, but fiscal ‘25 has to be improving as well with these new awards. Like, how much of the backlog do you think you're going to have for next year, and how much visibility do you have and confidence that you're going to be able to grow the top line, not just this year, but next year as well too?

Well, again, very good question. As we have said that, our backlog, even after the -- what you just mentioned, after a strong Q2 in revenue, still is very strong. Pipeline seems strong, and we think that it'll continue into the next years, not just ’25, into ‘26 and beyond. But as you know that, we already said that historically, it's a lumpy business. Some customers push it out, some people want it even accelerated into it, so that can happen. We don't want to give any specific numbers, but all we are saying is that we are sitting very pretty with a very strong backlog and a very strong pipeline, and the economy is looking good. The interest rates hopefully will come down, traffic is increasing, freight has to be moved around, and we think that all of that looks like good for the next coming years. Alan, you want to add something?

No, I think that sums it up quite nicely. Strong visibility for the remainder of this year and into coming years. So we think we're quite well positioned.

Our next question comes from the line of Christopher Glynn from Oppenheimer.

Question on healthcare. It sounds like a little better second half, most likely little seasonal help, right? And perhaps, it'll still be a little below normalized and maybe, if you can just work with that construct a little bit, how do we think about natural market normalization or progression beyond this year, the pandemic growth is maybe more digested, perhaps that's still an overhang or is the market just become a bit more of a street fight?

Well, again, you sort of answered it to yourself. During the pandemic, we got a little, I would call it a great tailwinds, and that's definitely slowing down. And if you read it everywhere, healthcare section is a challenging section. The hospitals are having a tough time. But at the same time, we believe that we have approached some new technology and products that we are looking at it. And one of the things that we are very much excited about it is, besides selling monitors, which is one of our primary businesses, that because of the shortness of capital and stuff, we believe the subscription model looks like a good catchall for medium to small hospitals. And we are very proud to announce that we actually have, what I said, a startup of what we call is a remote telemetry. People are sitting in a control room away from the hospital. We get a contract with the hospital and we give services to them. And anytime there is a vital sign event, the technician sitting in a control room far away from the hospital, they call up, we talk to the technicians, we tell them, hey, go look at patient number 14. And that is caught on. And it's a subscription model, it's a paying model. And with our Rothman Index also into it, we are sort of differentiating ourselves from our customers. But overall, it is a challenging business, and we are spending a lot of money for the last couple of years and will continue, hopefully with the success of a brand new platform in the coming year.

And then on the security margins, you called out a mix a couple times and it occurs to me, I wanted to ask, I think, different phases of these large projects might have different mixes. So should we regard the mix dynamic as kind of optimized in the second quarter relative to what's probable in most quarters as you execute these projects?

A good question. It was indeed a favorable mix in the second quarter. That being said, a number of the projects that we have in our backlog and in our pipeline of opportunities appear to be strong margins as well. So while it may not carry the same gross margin profile that we saw in Q2, we still expect it to be very, very solid as we move forward. But it was a very favorable mix in Q2. You're exactly right.

And last one, no surprise on the slightly negative year to date free cash flow, I know, it's timing and obviously you have the projects and overall revenue ramp. But should we assume continue pretty, pretty tight next year and more harvest time in fiscal ‘25?

Although we don't really provide cash flow guidance, I think directionally what you're saying is correct. We'll continue to invest in some working capital associated with these big contracts in the near term. And then there's an opportunity to harvest an awful lot of free cash flow going forward as we have in years in the past. So, we're excited about this. This is what we like to put our balance sheet to work with.

Our next question comes from the line of Larry Solow from CJS Securities.

A couple follow-ups. Most of my questions been answered actually. Just on the margins, I know you don't get specific guidance out, but obviously in the security piece, I think it was a good 250 points above your previous record high. Curious, anything in there that would or going forward that would make this an unusual number or why can't we kind of sort of sit in, at least in this low 20s range as I look at just from the near fact that of a big bump in revenue, it looks like the last couple times you've gotten kind to this revenue level. You've also had margins sort of in that high 19s or over 20. So just trying to par out, is there anything that should kind of make this margin not sustainable?

Yes, Larry, this is Alan. Good questions. And we don't disagree with you. Again, as we don't provide guidance on an operating margin level. But what you're talking about in the past seeing 19 and low 20s at these type of revenue levels, there's every reason to believe that those things are sustainable. There'll always be changes associated with the different mix in the like, but yes, we do believe that there's every opportunity to sustain and even increase those type of margins over time.

Okay. In terms of sort of the order queue or the funnel not so much orders, but I guess, potential orders. As you look out, obviously, it sounds like most areas are still doing really strong. But can you just kind of give us a feel qualitatively where in terms of -- are you still seeing a lot of vehicle inspection demand? Is it cargo inspection at ports? What are sort of the bigger drivers, if you will?

This is Deepak here. Good question. It's a very broad. What I said in my statement, both in borders and port security and even in aviation, all that area, is a lot of demand and lot of interest, not only just for expansion, but also to replace the old technology with the new technology. And every customer is more conscious about to make it more efficient. And one of the things that we are very proud about it is because of our success turnkey multi-year contracts that have been very successful with happy customers, they make a very good reference point as a selling tool for customers that are not even thinking about going to a turnkey solution and best buying equipment. But they look at that and that expands into it. So our presence, and we can be very, very confidently say, we consider ourselves number one in this space. But I look at this as a growing business with the economy there and with people more security conscious and border security everywhere, people are more conscious and we have the right equipment. It's now no one area. It's broad all over the world.

Okay. And just switching gears real fast and just on Opto, you mentioned, I guess a couple of things there. Just a little more color on the sort of the flattish quarter, but it sounds like you feel like this is temporary, were there specific -- you mentioned some program delays. I guess, were there a couple specific larger sort of delays that impacted the quarter and what kind of gives you the encouragement going forward? And then secondly, if you could just elaborate a little bit more, I guess you said, you're opening up a new facility in Mexico. Is that the case?

So on the Opto side, there were no large programs to any significant magnitude that were delayed. It was just a number of programs from customers who probably overbought inventory a little bit during the pandemic times for risk mitigation and are now are right size in their inventory levels to a more optimum level and maybe some of their own programs have experienced some delays. So just a little bit of that kind of stuff that led to the relatively flat Opto sales. And as I said in sort of my remarks as well, that that could continue for another quarter or so, offsetting that to some extent going forward. We did open up a new facility in Mexico that we're excited about. It's gaining traction and we think it's going to be a big contributor to us in fiscal ’25 and beyond.

Just to add on to it. I did say that, and we've been saying that and we're seeing that. In this Opto space, this China-centric manufacturing customers are very concerned about it. They want to go broaden their portfolio with vendors who can deliver away from there. We are very well placed into it in Indonesia and Malaysia and India, and now with this Mexico facility open up, it gives us a broader reach to go to our OEM customers and cater to a bigger, bigger part for them to look at us.

[Operator Instructions] Our next question comes from the line of Jeff Martin from Roth MKM.

Wanted to touch on the markets in general. Where you think you are in terms of those being growth markets or whether you're gaining share, how that kind of parses out? And then specifically on security, what percentage of contracts now have CertScan? Are they all CertScan? That seems like a huge differentiator that could become kind of a self-fulfilling win rate as countries need to communicate across their systems and identify threats that can be helpful for prevention?

A very broad question. Definitely, I can't say CertScan is in everything, but we believe longer term, the two things that differentiate us from, in the security field from other competitors, we have a very broad product portfolio, high energy, medium energy, low energy, and we have demonstrated that we can integrate it together with the CertScan software and we can do it remote monitoring and stuff like that. All that stuff does help. But I won't go back to say that every unit or every contract we have has CertScan built into it. We do try to push that and we have seen success and I've said that where initially it might not have it, but then it results into the next add-ons and stuff like that. Regarding where position? I'm still very confident about it that I can say proudly that at least in the borders and sports security cargo, we are very, very confident that we are number one products portfolio, very good reputation, and we are very well liked by both domestic U.S. and international customers. Aviation, I don't think so that I can probably say we are number one, but we are number two and three, and we are catching ground, but we are also in that space, very good. In the air cargo space, we have a very broad portfolio and a very large install base, and we think that's another growth opportunity for us. And even in that space, we have started doing what is called remote monitoring for employee screening and stuff like that, where we are doing it from a remote control screen.

Great. And if I could just ask one more on a longer term, we look through more of a longer-term lens here. Could you help us understand where some of the bigger replacement cycles are throughout the world? I think in the U.S. you're going to see a passenger screening replacement cycle some point in the next several years here. But what other markets there might be replacement cycles upcoming, not necessarily in the next 12 months, but maybe in the next three to five years?

Well definitely replacement cycle for the check baggage is coming in U.S. in the next couple of years, if there's been some delay. Passenger screening, more AI, more automation is definitely going to happen. And internationally, there's not one specific area. Just look at it. Wherever there is passenger traffic, wherever you think that passenger traffic is going to increase, tourism or business related, all of them need the space for increasing their security. For example, one of the things everybody's talking about it, India has a huge potential growth opportunity. They're expanding in infrastructure. They're making like 20, 30, 40 new airports. We are very well positioned there. So those are the kind of places where we think, but there's no one specific area. It's all over, Mexico, Latin America, Middle East, Asia, even Africa, everywhere there is growth potential.

Great. And then just one more if I could. Latches onto what you just mentioned. Are there technologies where you feel like you've got some internal development to do. You do spend a lot on R&D, you mentioned AI in airport screening. Just curious if there's technologies out there that you see as a significant opportunity to continue to differentiate?

Well, the technology advancement will continue. In the cargo space, we are very well focused into it. We keep spending good money into it. We are integrating, like for example, CertScan and some other automation into the cargo space. In the aviation space, our checkpoint -- our RTT for check baggage is very well received. We are putting some AI into it. In the passenger screening and what I call the metal gates and the stuff, definitely there is technology out there for higher throughput, more technology to do better resolution stuff. We are working, developing it ourselves, plus also partnering with some new technology platforms to integrate our products.

At this time, I would now like to turn the conference back over to Deepak Chopra, CEO, for closing remarks.

Thank you all for participating in our call, and I want to again, thank our employees and our customers and all our stockholders supporting us. It's been a great quarter and we look forward to again talking to you and we feel very good and confident about our strong second half and the year beyond. Thank you.