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 measures.

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 press release which has been furnished to the SEC as an exhibit to our current report on Form 8-K.

Before turning the call over to Deepak to discuss the company's general business and operations, I'll take a few minutes to provide a high level financial overview of the second quarter results. First, we reported record second quarter fiscal 2020 revenues of $305 million a 1% year-over-year increase.

The key driver for the increased revenues was the strength of our security division sales, which was partially offset by healthcare division sales. Second, we recorded record Q2 GAAP diluted earnings per share of $1.12 compared to $1.03 in the same prior year period.

Non-GAAP EPS which excludes certain items specified in our earnings release and also referenced later on this call came in at a record $1.27 per diluted share for Q2 of fiscal 2020 compared to $1.19 per diluted share for Q2 of fiscal '19 as we leveraged higher revenues and strong expense management to generate earnings growth.

Third, our fiscal 2020 Q2 cash flow from operations was $35 million driven by record profits and improved inventory management. And finally, our Q2 2020 book to bill ratio was approximately 1.1 driven by strong security division bookings across multiple platforms.

Our backlog increased sequentially from $869 million at the end of Q1 to $886 million as of December 31, 2019. Before diving more deeply into our financial results and discussing our fiscal 2020 updated guidance, let me turn the call over to Deepak..

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 quarter with port and border customers.

We announced three of these plus a $15 million award by an international port authority to provide multiple units of the company's Rapiscan Eagle P60 high energy x-ray cargo and vehicle inspection systems where we would also construct civil works to support the installation of systems as well as provide training and follow on maintenance and support.

Two, an award by an international customer valued at approximately $14 million to provide multiple units of cargo and vehicle inspection systems and baggage and parcel inspection systems with the follow on maintenance service and support contract.

And the third, a $12 million award to provide operation and maintenance services for Rapiscan systems and AS&E security screening systems. In aviation, passenger and air cargo security, we continued to make good progress with our real-time tomography, RTT 110 explosive detection systems.

As an example of one of these numerous wins in the quarter, we announced a $15 million award for the RTT 110 from a global logistics provider for air cargo. This air cargo win builds upon the success we've achieved over the years since RTT 110s initial European certification in 2013.

This approval open up a pipeline of international airport customers seeking to comply with the European explosive detection standards ahead of the upcoming deadline.

Over the last few months, we have further enhanced our position in this marketplace by getting the RTT 110 certified to European Unions latest standard 3.1, which has more stringent requirements for the false alarm and threat detection accuracy.

The RTT 110 was also recently approved in the United States by the TSA for the air cargo standard ACTSL, which allows us now to offer this product to global air logistics companies. And finally, shortly after the quarter end, China's aviation authority, CAAC, notified us that the RTT 110 has been approved for use at China's airports.

Overall, we are very pleased with our performance and momentum in the security marketplace. The pipeline, as mentioned before, activity remains strong and we look forward to the second half of fiscal 2020 for this division. Moving to our optoelectronics division, the revenues for the quarter were a record $73 million for Q2.

Opto division expanded operating margins through a favorable sales mix and improved operational efficiencies resulting in the highest Q2 adjusted operating income in the division's history.

As we have mentioned before, we are focused in this division on the type of growth that helps to expand profitability through leveraging the existing channels and manufacturing infrastructure all through strategic acquisitions that would add to the core competencies of this division.

Moving on the healthcare division, which reported revenue of $42 million 19% lower than the revenue in the same period a year ago. We are disappointed by these results. The sales drop resulted partially from push outs of certain projects due to hospital readiness or construction schedule delays.

The overall sales cycle although has been lengthened as a result of group purchasing intermediaries. We've seen that trend resulting in a significantly higher backlog for the division.

The new healthcare division president who joined us in fiscal year Q1 is making strides and is focused on strengthening our market position and operations and cost rationalization. We are also working to enhance our core products and develop new offerings for patient monitoring and cardiology.

Looking ahead, the healthcare divisions, long-term market prospects remain favorable, and we will continue our efforts to improve the business. Overall, we are pleased to complete the first step in the robust opportunity pipeline.

The security division continues to see growth in opportunities from its end markets of transportation, cargo and infrastructure, especially in the U.S.

International customers are also increasingly seeking integrated solution offerings which include service, training, civil works, data analytics and management, which we are well positioned to provide. The opto division's ability to deliver strong profitability allows us to invest for growth organically and through strategic acquisitions.

Finally, the healthcare division's end markets of monitoring and cardiology are positioned in stable and addressable markets and thus operational execution and related improvements should translate to better financial performance in the future. I look forward to the second half.

I will now turn the call back over to Alan to further discuss our financial performance before opening the call for questions. Thank you all..

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 of our business. In Q2 of fiscal 20, we recorded a 0.9 million benefit in restructuring and other charges, due primarily through insurance recoveries compared to a 1.3 million benefit in Q2 of fiscal '19. Let's move to interest and taxes.

Interest and other expense in Q2 of 20 decreased to 4.8 million from 5.6 million in the same prior year period as a result of lower average borrowings due to the strong trailing year cash flow and lower average interest rates under our credit facility.

On the tax side, excluding the impact of discrete tax items, our effective tax rate in Q2 of fiscal 20 was 27.7% compared to 28.3% in Q2 of fiscal '19.

We recognized a discrete tax benefit of 0.7 million primarily for equity-based compensation in the most recently completed quarter compared to a 0.4 million tax benefit also for equity-based compensation in the same quarter last year.

As a result, we reported a tax provision under GAAP of 25.3% in Q2 of fiscal 20 compared to 26.8% in Q2 of fiscal '19. Let's now turn to a discussion of our non-GAAP adjusted operating margin, which excludes restructuring and other charges and amortization expense of acquired intangible assets.

The company's non-GAAP adjusted operating margin in Q2 of fiscal 20 increased to 11.6% from 11.4% in Q2 of fiscal '19. We saw a nice operating margin expansion in our security and our opto divisions partially offset by reduced operating margins in the healthcare division.

The security division's operating margin expanded to 15.7% in Q2 of this fiscal year from 15.3% in Q2 of last fiscal year. The opto division continued its momentum reporting a record Q2 operating margin of 13.5% in fiscal 20 compared to 12.9% in Q2 of fiscal '19. Moving to cash flow.

In Q2 of fiscal 20, we generated approximately 35 million in operating cash flow driven by strong profits and improved inventory management as days inventory on hand decreased to 118 days from 149 days in Q2 of the prior year.

This was partially offset by an increase in day sales outstanding to 77 days in Q2 of fiscal 20 from 68 days in Q2 of fiscal '19 as international sales involving longer average collection times represented a higher percentage of overall sales.

CapEx in the second fiscal quarter was 5.6 million while depreciation and amortization expense in the quarter was 13.4 million. We were active in our stock buyback program acquiring 140,823 shares during the quarter. As of December 31, 2019, 295,833 shares were available for additional repurchase under the current program.

Our balance sheet remains strong. We ended the second fiscal quarter with net leverage as calculated under our credit facility of under 1.4. And finally, turning to guidance.

For fiscal 20, we're reducing our sales guidance to a range of 1.205 billion to 1.240 billion the reduction reflects softness in the healthcare division coupled with some push outs of U.S. security orders that we continue to believe we are well positioned to receive.

Despite the sales change given stronger expected consolidated margins, we're slightly increasing our non-GAAP earnings per diluted share guidance to $4.63 to $4.85.

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, actual sales and non-GAAP earnings, however, could vary from the anticipated ranges due to the risks and uncertainties specifically affecting our business and generally affecting industries in which we operate.

These risks and uncertainties include items beyond our control such as site readiness for product installations, evolving government trade policies, customer acceptance of our products and the timing of orders and contract renewals in each division, and other risks and uncertainties discussed in our SEC filings.

We have continued to focus on the growth of our business while investing in product development, making selective strategic acquisitions and managing our cost structure. We believe these efforts will enable OSI to continue our leadership role in providing innovative products and solutions. Thank you for participating on this conference call.

And at this time, we would like to open the call to questions..

[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..