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Executives

Alan Edrick - EVP and CFO

Deepak Chopra - President and CEO

Analysts

Tim Quillin - Stephens Inc.

Brian Ruttenbur - CRT Capital

Josephine Millward - The Benchmark Company

Jeff Martin - Roth Capital Partners

Yair Reiner - Oppenheimer

OSI Systems (OSIS) F2Q 2013 Earnings Call January 24, 2013 8:00 AM ET

Operator

Good day ladies and gentlemen, and welcome to the Second Quarter 2013 OSI Systems Earnings Conference Call. My name is Derik, and I will be your operator for today. At this time all participants are in a listen-only mode. We shall facilitate a Question-and-Answer session at the end of this conference. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to Mr. Alan Edrick, Chief Financial Officer of OSI Systems. Please proceed.

Alan Edrick

Thank you very much. Good morning and thank you for joining us. I am Alan Edrick, Executive Vice President and CFO of OSI Systems. And I am here today with Deepak Chopra, our President and CEO; Ajay Mehra, President of our Security Division, Rapiscan Systems and Victor Sze, our General Counsel.

Welcome to the OSI Systems second quarter fiscal 2013 conference call. We’d like to extend a special welcome to anyone who is a first-time participant on our conference calls. Please note that this presentation is being webcast and will remain on our website for approximately two weeks. Earlier today, we issued a press release announcing our second quarter fiscal 2013 financial results.

Before we discuss financial and operational highlights, I’d like to read the following statement. 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 statements under the act.

Such forward-looking statements could include general or specific comments by company officers on this call about future company performance, as well as certain responses by company officers to questions posed about future operating matters. The company wishes to caution participants on this call that numerous factors could cause actual results to differ materially from any forward-looking statements made by the company or its officers. These factors include the risk factors set forth in the company’s last Annual Report on Form 10-K and other SEC filings.

Any forward-looking statements made on this call speak only as of the date of this call and the company undertakes no obligation to revise or to update any forward-looking statements whether as a result of new information, subsequent events, future results or otherwise.

During today’s call, we may refer to both GAAP and non-GAAP financial measures of the company’s operating and financial results. For information regarding non-GAAP measures and comparable GAAP measures, and a quantitative reconciliation of those figures, please refer to today’s 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 business in more detail including our recent agreement with the TSA, I will provide a high level overview of our financial performance. We will again touch on several themes that we discussed during past conference calls.

Highlights for our second quarter of fiscal ‘13 are as follows. First, we achieved record second quarter revenues of 194 million. Despite turbulent times, this represents our ninth straight quarter of top line growth leading the way was our Opto division, which grew third party revenues by 16% followed by our security division. After three strong quarters, our healthcare division struggled posting a 5% decrease in revenues due to soft international sales despite continued growth in United States.

Second, our strong EPS momentum continued as Q2 diluted earnings per share excluding the impact of restructuring and other charges increased 15% over the comparable period in the prior year to $0.70 per share. This marks the 14th consecutive quarter in which we have generated double digit year over year pro forma EPS growth. In fact our Q2 operating margin of 11% excluding impairment and other charges was a new record since we acquired Spacelabs back in 2004.

Third, our backlog of over 1 billion remained significant, and fourth, we generated 20 million of operating cash flow, a number that is eight times higher than last year’s Q2. This strong operating cash flow was used to continue to fund the significant CapEx associated with our Mexico turnkey program.

And speaking of our Mexico turnkey program, we were very excited to announce earlier this week that our initial scanning locations were certified as operational under our multiyear agreement in Mexico.

We are pleased to report another strong quarter of earnings and we remain very enthusiastic about our future. I will provide additional financial details and will discuss our fiscal 2013 guidance, but first let me turn the call over to Deepak.

Deepak Chopra

Thank Alan and again good morning and welcome to the OSI Systems earnings conference call for the second quarter of fiscal 2013. We are now halfway through our fiscal year and are pleased with the strong results thus far. For the first half, we achieved revenue growth of 8% and leveraged the top line growth to strong earnings per share. We also made substantial progress on our Mexico turnkey program and continued to implement key operational initiatives in each division.

In Q2, our revenues were 194 million a new company record at second quarter. We also delivered an operating margin of 11% excluding the impact of restructuring and other charges. Before discussing highlights for the quarter, I would like to update you on the status of our involvement in the TSAs, AIT, ATR program.

First as you know Rapiscan Systems received a show cause letter from the TSA in November. We believe we have clarified all of the questions in the show cause letter to TSA. The final resolution of the show cause letter is subject to final disposition by the Department of Homeland Security and the company is currently working diligently to complete that process.

We also recently reported that we have reached agreement with the TSA on the AIT-ATR contract. Rapiscan determined that the secure 1000 single post would not be ready to meet the next level of automatic threat recognition software ATR required by the congressionally mandated June 2013 deadline. Therefore we agreed to work with the TSA to redeploy these systems to other government agencies that already rely on the secure 1000 product line. As part of the agreement, the ATR development contract was terminated which allows us to stop the R&D spending on this program for which we saw a limited future beyond the TSA. We have had a close relationship with TSA and its predecessor agencies for the better part of two decades during which we have together pioneered many of the transportation security technologies in use today.

So I want to spend a few moments to provide some additional details about the AIT program and our initial role in this program. Before the attempted bombing of a US bound commercial flight on Christmas day 2009, TSA had tested and approved Rapiscan secure 1000 single post product and deemed its imaging technology capable of detecting the emerging threat of passenger borne explosives. As such, TSA and Rapiscan were already implementing countermeasures to stop underwear bomber type attacks. After the December 2009 attempted bombing, Rapiscan worked with TSA to quickly deploy more secure 1000 single post systems to provide better passenger screening at more US airports. Rapiscan was the first and for months, the only company able to provide an inspection system that met TSA's strict new requirements for detecting explosives on passengers.

Rapiscan work with TSA to quickly deploy these new systems on a fast track in order to address the emerging threat to our country’s security. We are truly proud of the role we played in bringing a dramatic improvement in commercial aviation security in the US.

We also continue to work very closely with TSA and Department of Homeland Security on multiple other programs demonstrating our unique capabilities and wide ranging knowhow in the security inspection system.

Beyond aviation, we have sold numerous secure AIT systems and continue to sell to customers with came accuracy to perceive privacy concerns.

Now, let’s review the highlights for the quarter. I will start with Rapiscan. Our broad portfolio of inspection solutions in people screening, baggage and parcel and cargo screening services continues to help us develop a robust pipeline of opportunities in aviation and non-aviation markets.

In air transportation, we have made progress with potential customers for our high speed RTT whole baggage screening system which has been approved for airports that follow the European ECAC standard. The RTT continues to be evaluated by the TSA and we are very confident that we will get TSA certification for our RTT product in this calendar year.

I know that we have said that on previous conference calls and yes we are late but it is an evolving process. We are working confidently with TSA and we feel that the product has very good possibility and opportunity of getting certified this year and in the European sector where we already got certification, we definitely will have bookings for the RTT product in our fiscal year. It might not result in any shipments but we will have bookings.

The pipeline for the RTT product line internationally continues to grow, it is very healthy, it’s in multiple hundred million dollars and although there is headwinds in Europe as you all read about it, we are very confident that we will be a big player in that market.

Regarding US business, it is a fact that US business has had an impact on Rapiscan’s booking in Q2. As you all know Washington is going through a challenging time to pass the budget. Till it is passed, the defense bookings will remain unclear. We are very fortunate compared to our competitors that we have a broad product line and a very healthy international pipeline, not to mention the two new products namely the RTT and Trace which will result into new bookings for these new two product lines.

We can assure you that we have not lost any U.S business except for the de-booking of the $5 million of the body scanner AIT program. We are confident that the RTT certification as I mentioned before, will happen this calendar year in U.S.

Regarding the turnkey businesses, we said in the last conference call, we are in active discussions with multiple potential customers internationally but this is a long cycle and the other thing is that as we go and improve and deliver successfully and complete the full installation and execution of Mexico, it will generate much more interest by other customers to come and look at it.

Let’s move to the healthcare division. After several quarters of double-digit revenue growth for this division, revenues declined 5% in the second quarter to $56 million yet through smart cost management control but division managed to generate an operating margin exceeding 12%. Much of the dip was a result of the non U.S economic environment especially Europe. With the election cycles behind us in U.S and the continued progress in the stabilization of Europe, we expect a return to growth in the healthcare industry and are projecting second half to be stronger than last year.

Namely UK as a March ending year, we have new launches of products. We have launched the Arkon anesthesia workstation and through our leveraging relationship with group purchasing organizations or GPOs, we expect second half to show growth. As Alan mentioned, U.S had an increase even in this Q2 quarter but we believe that because of the elections in November in US, the second half US can even show more growth.

In summary, Spacelabs had a challenging revenue quarter but still delivered double digit margins and we expect Spacelabs to have a stronger second half particularly in the international markets and the newly introduced product offerings and continued growth in the US market.

Moving to our Opto electronic division, which among our operating divisions had the strongest growth of the quarter, external revenues were 16% higher than the prior period and the operating margins approached 10%. Although Opto is impacted by the same general macroeconomic forces that effected the other two divisions, Opto has broad exposure from OEMs in various industries including medical, defense, test measurement and industrial and did a fantastic job. There is also a general trend of consolidation of the OEMs supply base in a few of these industries thus we are in a great position to capture new accounts and in fact did so as demonstrated this quarter with new customer in critical communications secure access control and tracking, automotive sensors and electronics gaming.

With our local to offshore design and manufacturing capabilities, Opto is well positioned as a valuable manufacture partner that can help our customers manage high efficiency manufacturing. So in Q2, the OSI team performed admirably under a scenario, but everything did not go exactly as planned. We grew the company stop line and delivered double digit operating margins and I am confident of our company’s abilities as we maintained an unwavering focus to continue to improve our processes, our product offerings and overall customer satisfaction.

I would like to thank our employees, customers and shareholder for their continuing support. We look forward to a strong second half of the fiscal year. with that I am going to handover the call back to Alan to talk in detail about our financial performance before opening the call for questions, thank you.

Alan Edrick

Thank you, Deepak. Our focus on growth initiatives and operating improvements throughout the company has succeeded in delivering significant earnings growth. One $1 billion backlog and the ongoing progress of our multiyear turnkey screening services agreement in Mexico position us well for further growth in margin expansion.

I will speak to our 2000 guidance shortly, but first let me review in more detail the financial results for the second quarter. Net revenues in Q2 of fiscal ‘13 were up 3% over Q2 last year on an overall basis. Revenues from our security division grew 3% in the second quarter. Heavy focus on the Mexico program, as well as delayed customer acceptance from December to January led to the push out on certain deliveries from Q2 to our second half. Our Opto division continued the double digit revenue growth momentum from the first quarter by delivering 16% external sales growth as a result of our continued success in broadening our customer profile.

In our healthcare division, the revenues dipped by 5% in Q2, we continue to deliver double digit operating margins. As Deepak mentioned, we believe we will see stronger healthcare revenues in the future. The Q2 overall gross margin for the company was 36.1% up by a 110 basis points from the same quarter last year. This increase was mainly attributable to increased revenue from turnkey screening services provided by our security division which generally provide higher margins than product sales. This improvement more than offset the impact of reduced revenues in healthcare which historically generates the highest gross margin across our three divisions as well as the impact of the double digit revenue growth in Opto which typically carries the lowest gross margins among our divisions. We anticipate our margins will continue to improve as our revenue mix changes with increased turnkey revenues from our security division.

Moving to OpEx, Q2 SG&A expenses as a percentage of revenue were flat at 19%. In absolute dollars, SG&A expenses were up year over year about $800,000 or 2% in support of the 3% revenue growth.

We continue to invest significant resources in R&D to enhance both our security and our healthcare product offerings, to this end our R&D spending increased 3% in the second quarter of fiscal 13 to 11.9 million with such incremental investment primarily focused on our security business. As a percentage of revenues, R&D expenses were 6.1% in the second quarter of fiscal ‘13 which was comparable to the same quarter last year. We believe our efforts will enable us to capture major opportunities in our core markets in the future. We continue to see the results of these efforts in a significant number of new products that have been released.

Our effective tax rate for Q2 was 28.2% and approximately 29% for the first half of ‘13, our provision for income taxes is dependent on the mix of income from US and foreign locations due to tax rate differences among countries as well as the impact of permanent taxable differences in valuation allowances among other items.

Top line growth coupled with gross margin expansion and solid cost management led to Q2 non-GAAP EPS of $0.70 per diluted share as compared to $0.61 per diluted share for the comparable prior year period. The company recorded an impairment restructuring and other charge of approximately $2.7 million associated with the TSA agreement that Deepak alluded to which reduced GAAP EPS to $0.60 per diluted share.

For the first half of fiscal ‘13 excluding the impact of an impairment restructuring and other charges, our non-GAAP EPS increased 19%.

Moving to cash flow, as we mentioned on our previous two calls, we expect to see significant volatility in cash flow in fiscal ‘13 largely as a result of the Mexico program. We generated a noteworthy 20.4 million of operating cash flow in Q2 and nearly $63 million for the first half of fiscal ‘13. This cash flow was used to partially fund our capital expenditures which totaled to $117 million in the first half of the fiscal ‘13 which as expected was significantly higher than historical norms in support of our Mexico program.

In addition, we repurchased approximately 3 million stock bringing our first half purchases to approximately 12 million inclusive of net settlements.

Depreciation and amortization was $5.9 million in Q2. Although we expect to experience greater than usual variability around free cash flow over the coming quarters, again due primarily to the Mexico project, we remain well positioned to meet future requirements with our cash on hand, cash flow from our ongoing operations and our $425 million credit facility.

Finally, turning to an update of our fiscal 2013 guidance, we are adjusting our sales guidance to be between 850 and 875 million. While this modifying range reflects solid 7% to 10% annual growth, the new range reflects some softness we saw in healthcare international sales, the de-booking of $5 million of orders related to the TSA agreement and a few other customer orders now expected to be booked later in fiscal ‘13 and shipped in fiscal ‘14.

On the other hand, with the significant progress being made in our Mexico project, and anticipated margin expansion, we are reiterating our non-GAAP EPS guidance including the impact of restructuring and other charges between $2.77 and $3 per diluted share, which represents an increase of 21% to 31% over fiscal ‘12.

During the past few years, we transformed OSI in to a company that generates good top line growth and has an organizational framework that position us for continued EPS growth. We believe we are well positioned for continued operating margin expansion in the coming years and we look forward to sharing our progress in upcoming calls.

Thank you for listening to this conference call. And at this time, we’d like to open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) And our first question is coming from the line of Tim Quillin from Stephens Inc.

Tim Quillin - Stephens Inc.

Alan, would you happen to have a detailed backlog numbers in front of you both for the overall company and for the security business?

Alan Edrick

I do have it Tim, from an overall company perspective. Our overall backlog is important. The backlog is about a $1 billion. Last quarter from a rounding perspective, it rounded up to 1.1 billion and this quarter from a rounding perspective it rounds to about 1 billion. As you know, our business is shifting more towards security turnkey revenues. So looking at changes in the backlog in the same way as in the past becomes a little bit less meaning as we’re building up long term backlog and then we deliver against those long term rewards. Further as you know, certain of our contracts like Puerto Rico never even entered the backlog.

Tim Quillin - Stephens Inc.

Right. I think in the first quarter backlog at the end of the first quarter was 1.053 billion, what was it at the end of December?

Alan Edrick

We had a book to bill ratio of a little bit less than one. So, it’s still over 1 billion, while I don’t have the precise number in front of me, it rounds down to 1 billion. As you said the 1.053 billion was just over 1.050 billion so it rounded up to 1.1 now it’s little bit under that, so rounds down to 1.0.

Tim Quillin - Stephens Inc.

Okay. And on the security backlog I thought we had discussed that last quarter, I thought the security backlog including Mexico was something like 943 million, at the end of September. Do you happen to know what that number is or what the book to bill was on the security side?

Alan Edrick

Yes, it’s slightly down for the reasons that Deepak mentioned. Our book to bill in security was a little bit under one as would be expected in this environment. So, it’s a little bit down, but meaningfully down.

Tim Quillin - Stephens Inc.

And so what at this point, what do you see in the pipeline right now? And Deepak, you had mentioned potential orders for RTT for instance. But what other things do you see in the pipeline that might suggest that those security bookings could pick up in the back half of your fiscal year.

Deepak Chopra

Tim, as I mentioned, there is ongoing growing pipeline in the security business especially internationally. As I mentioned, the three areas which are very strong are cargo pipeline continues to show very robust demand, definitely there is some push outs left and right, you’ve seen what’s happened in Middle East, you’ve seen what’s happened in Europe, it is definitely a little bit of what I would call a little uncertainty but the pipeline is super strong, that’s cargo.

Then you look at the RTT product line. As you know that the machines in Europe are getting pretty old. There is a huge demand for a replacement but we’ve said it before that again because of the turmoil in the European sector, there had been some push outs, airports are trying to push as much as they can to the future, but it’s a requirement and we are well placed into it and that pipeline I mentioned in my speech it’s more than couple of hundred million dollars and we think that it’s a great prospect for us and we are focused onto it, we’re working with multiple airports, and we are quite confident that we will book, we might not be able to ship it but we will book before our fiscal year is over.

The third area which we find it very exciting though it has a longer cycle, is the turnkey business, which primarily goes hand in hand with cargo customers, but there are other opportunities even in the non-cargo area that we are looking at. We are in active discussions; we have even taken some customers to our presence sides we are talking. But these kind of turnkey businesses they come in and not in a straight line and it takes some time to get them and we are very, very, very positive and boisterous about that growth business and frankly that’s what one of the reasons we have accelerated our Mexico launch.

Tim Quillin - Stephens Inc.

Right and so you sound very confident in terms of getting orders in Europe for RTT, within the fiscal year, you didn’t really set a timeline on additional turnkey opportunities and kind of mention a long sale cycle or is the timing of conversion of some of those discussions just still very uncertain right now?

Deepak Chopra

Well, you know the thing is it’s not a question of uncertain as we have said to you this business it takes a longer cycle and we have also said any cargo potential sale of any significant amount can also turn into a turnkey business, so it’s not a question of it is that it is a timing of this quarter or next quarter, we continue to work on it, we work parallel, it’s a concurrent parallel sales effort between a sale and a turnkey business and then the fourth item that we have said and we have said it, definitely that you’ve seen from your other companies you follow, US still the budget has passed is continuing to have that thing but we are actively talking to people in that pipeline too, so we have is, a very broad area in which we participated.

Tim Quillin - Stephens Inc.

Right, okay and just one last question, and I'll turn it over to others, but on the Mexico contract, is there anything you can, you started revenue you're pretty far along on this, can you give us some sense of what the overall capital expenditures are going to be? And then what is the level of expense going to be? How many employees are going to be working on the contract? What is this, now that you have a kind of better sense, you're further into it, what is this contract going to look like?

Alan Edrick

You know from a cap ex perspective what we said in the past is that we are anticipating it to be somewhere in that $175 million range, plus or minus and we still expect to be in that general range. For confidential purposes, you know just like in Puerto Rico, we're unable to say the number of employees, suffice it to say that there'll be a significant number of employees. But as we move forward we expect the Mexico program to generate significant revenue for us both in Q3 and Q4 and at a profit for each quarter.

Operator

Your next question is coming from the line of Brian Ruttenbur, CRT capital

Brian Ruttenbur - CRT Capital

First of all D&A, how much was depreciation and amortization in the quarter.

Alan Edrick

Brian, it was about 5.9 million,

Brian Ruttenbur - CRT Capital

5.9, perfect. Healthcare, what percentage of your healthcare is international? I think I recall it being around 20% is that right?

Alan Edrick

Brian, it's a little bit higher than that. Generally speaking it’s about two thirds tends to be US one third international broadly speaking.

Brian Ruttenbur - CRT Capital

So was it all just Western Europe that the slowdown was in the quarter?

Deepak Chopra

Majority of that was in Western Europe.

Brian Ruttenbur - CRT Capital

Is that because of the economy, is that because your product offering? Can you get any more specific? Did everybody see a slowdown in the industry, your competitors?

Deepak Chopra

It's definitely not the product line, it's the turmoil in Europe, and we think that it's going to get better. As a matter of fact we've seen signs it’s going to get better in the second half. UK for example as the year end and their spending is going to go up. We looking at the second half healthcare to have a growth compared to a year ago.

Brian Ruttenbur - CRT Capital

Okay and what kind of growth are you looking for in the second half in healthcare?

Alan Edrick

Well Brian we don’t provide guidance by division but we are in a single digit growth in healthcare in the second half of the year.

Brian Ruttenbur - CRT Capital

And then on the RTT certification, you have already been certified for a while now in Europe. Can you talk about any potential sales that you are getting or hence for sales on the RTT?

Deepak Chopra

Brian as you know the things we are working on, for competitive reasons we never talk frankly till we book, suffice to say, there are many-many airports both, big, big numbers and 1Z and 2Z, half a dozens, all over Europe and in middle East and in the CIS countries. So the pipeline continues to be strong and like I said there is a replacement cycle coming due and it’s like pushing from one quarter to the quarter, it’s going to happen, if you ask our competitors they will tell you the same thing. They have to replace that whole machines and there are about 1500 machines just in Europe.

Brian Ruttenbur - CRT Capital

So do you expect an award sometime this year from Europe, this colander year?

Deepak Chopra

We are counting on it, our sales funnel shows that we will book, not be able to maybe ship but book in second half in RTD.

Brian Ruttenbur - CRT Capital

Okay good and then last question on the slowdown in the US security business. Was that related to anything with the TFA or was that related to border patrol? Where was the slowdown, was there a specific agency that you saw the slowdown?

Deepak Chopra

The number one, we can categorically say there is no impact of the US business except for the AITD booking but we believe that everybody sort of playing too close to the chest in US till the budget is done, it’s all over that area, so no specific agency or so. But we are very much focused in to it as you know that we have complete office in Washington, we are up to speed and everything that is going on in Washington in our product line.

Operator

Your next question is coming from the line of Josephine Millward of Benchmark Company.

Josephine Millward - The Benchmark Company

Deepak and Alan, you had very strong growth in the second half of last year from the big army order. Now, and this year you have Puerto and Mexico ramping up. Do you still think we can see up digit growth in security in the second half and how do you get comfortable based on what we, because you have a very tough comp in the second half?

Alan Edrick

Our guidance for fiscal 2013 in the second half and the comparisons year-over-year of course imbed the fact that we do have very comps associated with the army orders in last year and you’re exactly right in that the Mexico and Puerto Rico are both coming on strong and of course are the higher operating margin than we saw with the army order. We don’t give guidance on a divisional perspectives, so we won’t talk about the growth rates reach division but overall, our overall guidance factored in the difficult comps related to the army orders and we feel very, very good about our guidance.

Josephine Millward - The Benchmark Company

Can you give us a sense of in terms of percentages of completion on Mexico by the end of say March and year end and if you anticipate the project to be fully operational something in fiscal year ’14.

Alan Edrick

Yes, we’re making substantial progress in our Mexico program and we expect to see significant revenues in the second half of fiscal ’13. We do expect that if not fully operational, very, very newly fully operational in fiscal ’14 as you suggest. So, we’re heading down right path.

Josephine Millward - The Benchmark Company

Okay. But do you think you guys will be 30 to 40% complete in terms of operational by the end of your fiscal year or can you give us a little bit of rough sense or 15% just so we have a feel of how does project is progressing?

Alan Edrick

Yes, our customer is very sensitive to the information we provide overall in the program but just to give you a greater comfort feeling, by the end of our fiscal year, we do think we will have made significant progress which allows us to make significant revenues in fiscal ’13 and as we head in to fiscal ’14 will be in a very, very strong shape.

Josephine Millward - The Benchmark Company

Okay. I had a follow up on RTT. You seem to have higher confidence on getting RTT certificated in the U.S. What’s changed because I know TSA doesn’t give you much feedback during the certification process? Is there anything new? I think the tone has really changed on you know getting certified this year which certainly very good news, I just like to get more color.

Deepak Chopra

Josephine, basically as you know that program is an evolving guest protocol. As we learn more we get more confident and obviously with our success and certification in Europe we feel more positive about the technology and you know we’ve been going through this process for some time as I mentioned before and we are late, but it happens. Some people have taken eight and nine attempts, but you’re absolutely right, our tone has changed to be more positive that we will get the certification in this calendar year.

Josephine Millward - The Benchmark Company

Great and in Europe, can you remind us of your current marketing shift for check baggage multi-view x-ray because I seem to remember it’s about 5%, you have some pretty well entrenched competitors there. Remind us why you know you think you’re well positioned in Europe?

Deepak Chopra

Josephine, number one is the RTT due to our present installed base is two different products.

Josephine Millward - The Benchmark Company

But I understand, certainly going to replace the x-ray products in Europe, so if you can give us a sense of your footprint in Europe right now?

Deepak Chopra

Well, we don’t have a footprint in the check baggage as you said, but it’s a different product. Answer to your question about why do we feel confident? We still maintain that we have the best price to performance and ownership of any product that exists there without RTT solution in the check baggage mode. So we feel very confident that as the airport, as the customers start looking at especially price versus service cost over the years, we think that we have the best solution and I think what’s going to happen is that when they make their decision and side by side comparison, we will come out on top and we continue to believe that we will get a significant share of that market and on the other hand Rapiscan has a great reputation for service and support because we happened to be at the airport with the checkpoint machines anyway. So even though we are not being incumbent it’s a new technology, its new product and ultimately it’s going to be the ownership cost.

Josephine Millward - The Benchmark Company

By the way Deepak I see Rapiscan machines everywhere in France, it’s very impressive because it’s very difficult to sell to the French.

Deepak Chopra

Thank you.

Operator

Your next question is from the line of Jeff Martin, Roth Capital Partners.

Jeff Martin - Roth Capital Partners

Alan, could you quantify the magnitude of the delay customer acceptance for Rapiscan in the quarter?

Alan Edrick

Sure Jeff, it was on the magnitude of around $10 million that pushed from Q2 to Q3 associated with that.

Jeff Martin - Roth Capital Partners

And has that product been shipped at this point?

Alan Edrick

It has.

Jeff Martin - Roth Capital Partners

Okay, and then could you characterize the budget driven delays in the US assuming we get a budget defined here pretty soon. How does that all of a sudden open up the market again?

Deepak Chopra

Well, there's no specific numbers but just a general feeling in Washington, till the budget gets decided everybody just playing close to their chest or whatever they want to buy, so I'm sure when you talk to your other companies you follow you'll get the same answer, so it's a watch and see game.

Jeff Martin - Roth Capital Partners

Okay, and then shifting that to Puerto Rico, did you see quite a ramp in transaction revenue there, since it is a per scan model? Did you see volumes pick up much there and where is that in terms of running at capacity today?

Alan Edrick

Yes we did see some nice year over year growth in Puerto Rico which was partially attributable to the gross margin expansion that you saw overall for the company. We continue to be nearly fully operational there with one more site to go, so we're running at let's call 85% or so of our projected run rate.

Jeff Martin - Roth Capital Partners

So the increase in volume is year over year, apples to apples.

Alan Edrick

It is, as you may recall we didn't have all the sites up and operational besides the one in Q2 of last year. So we have more sites operating this year compared to Q2 last year.

Jeff Martin - Roth Capital Partners

Okay, and then am I interpreting your commentary around gross margins that you expect gross margins to continue to expand from here or are we at a level, can I use for modeling for the next couple of quarters in Q2?

Alan Edrick

Our expectation is that there's always changes in the revenue mix that can impact it but overall with turnkey becoming a bigger portion of it, both Puerto Rico and Mexico that we would anticipate margins can continue to make some further progress.

Jeff Martin - Roth Capital Partners

And then with healthcare, if healthcare comes back a bit, that should help as well right?

Alan Edrick

Yes, healthcare has the strongest gross margins in our company, so as healthcare sales move up stronger it helps the overall margins.

Jeff Martin - Roth Capital Partners

Okay and then last question what's your remaining stock provision at this point?

Alan Edrick

Today, we still have about 550,000 shares authorized under our stock buyback program.

Operator

Your next question is coming from the line of Yair Reiner from Oppenheimer.

Yair Reiner - Oppenheimer

So, I just want to revisit the question about healthcare, if the third of the business is in Europe, it looks like that business might have been off 25% may be 30% in the quarter, I guess my question is what happened to change that market all of a sudden in the December quarter, obviously you know Europe has been a challenging market for some time.

Deepak Chopra

The first thing is, what Alan said was one third is at international business, not Europe but just to clarify Europe business is less than one third. Because we do have business in Latin America, we do have business Asia Pac. Regarding your second question, what happened is, there is definitely a turmoil and there is a credit crunch in Europe so that if the hospitals want to buy a new replacement monitors or whatever, they can delay it and that’s what happened in some other countries. In UK, we are very positive that with the elections normally, just like in US, at the yearend, they have more money left to buy so we think that January, February, March, UK will start buying more and I won’t say that is stable with the relative stability in the Europe than it was in October, November, December, our pipeline and our forecast is that Europe will bounce back.

Yair Reiner - Oppenheimer

I guess, I think we are aware of the credit crunch in Europe but we understand the economy is weak but if you look at the things sequentially, I don’t think anyone of us got the sense that Europe all of a sudden tumbled off a cliff in the last three months if anything. Things seems to have stabilized. So what again changed in the last calendar quarter of 2012 to change the trajectory of the business?

Deepak Chopra

Well not number one, we've always said in our conference calls that Europe has been challenging but if you really look at but the either thing I said was only US was up for the quarter, we think that the US could have been up even more if the elections were not there, if this was not an unusual year even in US because during October, November, December even in US, some customers froze to wait for the elections so though it is up, it could have been up more. So, if you combine that what we were forecasting and some of the prospect in Europe, it had an impact on Europe. On the other hand, if you really look at it, we talk about Europe; Middle East has had lot of (inaudible) too. So if you really look at it, the best way to look at it is our 33%, one third of business that Alan mentioned, defiantly had some push but that push has nothing to do with competiveness, has nothing to do with products. We believe that second half is bounce back.

Yair Reiner - Oppenheimer

Okay. And then just one quick question on RTT, in your original guidance you didn’t anticipate booking any revenue from that during this fiscal, is that correct?

Deepak Chopra

That’s true.

Operator

The next question is from the line of Tim Quillin from Stephens.

Tim Quillin - Stephens Inc.

But first did you book any revenue from the Mexico contract in the second quarter?

Alan Edrick

Tim, we did book some revenue in second quarter, we had also book some revenue in the first quarter as well.

Tim Quillin - Stephens Inc.

Right, I saw that. And what is the nature of the revenue that you booked in the first and second quarter.

Alan Edrick

This is related to our overall screening services program. As you know we generally don’t go into breaking out the piper revenues by program.

Tim Quillin - Stephens Inc.

Okay. What I mean was it up side that it was already up in generating revenue or just compensation for the build out of the program?

Alan Edrick

There were multiple factors that contributed to the overall revenue recognition related to the program and the nice progress that we’re making.

Tim Quillin - Stephens Inc.

Okay. Second question is, I know this is varies quite a bit from quarter to quarter but what percent of the security segment revenue comes from the U.S government?

Alan Edrick

Good question Tim and you’re right it does change from quarter to quarter. I mean there will be certain quarters where it’s significant percentage; there will be certain quarters where it’s a very insignificant percentage. It really, really varies based on the type of orders that we have in our backlog and what we’re shipping at that point in time.

The second quarter for fiscal ’13 had a low percentage of revenues from U.S government customers.

Tim Quillin - Stephens Inc.

Okay. But in terms of your future planning and thinking about growth would you assume that 20% of revenue would come from the U.S government?

Alan Edrick

We look it on a program by program basis and over different period times so we can’t quantify and assign different percentages because it really does vary from a quarter to quarter and year to year basis.

Tim Quillin - Stephens Inc.

Okay. And then in terms of Arkon the anesthesia delivery product. Do you have a sense now of when you might start to see first revenue there?

Alan Edrick

Yeah, begin marketing that product this month actually so our expectation as well we’ll see revenues for it in the second half of this fiscal year you know could be this quarter or next quarter. As Deepak alluded to earlier, we expect the revenue contribution in fiscal 13 to be modest but going forward we have a very, very high hopes for the product for fiscal 14 and 15, and the reason we expect to be more modest in fiscal 13 is that as hospitals begin buying this product, they usually try it out, they buy one or two and test it out for a few months, and then come bulk purchase thereafter so we’re really excited about their product, we think it has a great, great potential for us.

Tim Quillin - Stephens Inc.

Okay and then lastly and maybe a little philosophically but you’ve been growing earnings you know 20% plus here I guess probably really 25% plus over the several years, you’ve got this major contract with Mexico that’s starting to ramp up should be significantly bigger in fiscal 14 than fiscal 13. Would you think about a continuation you know that contract supporting a continuation of 25% earnings growth are being additive to that type of earnings growth rate, thank you?

Alan Edrick

Yeah, it’s him as Alan get us as you know we provide earnings guidance for our current fiscal year but not on a long term basis. Our plan is to continue to growth both the top line and bottom line on a significant basis, we look to leverage our top line growth to a much a faster earnings growth and as you mentioned we’ve been successful in doing that over the past many years here. The Mexico program is a very nice program for us both form a top line perspective and as we have said before it has a higher operating margin contribution in our corporate averages which will help us to sustain even faster earnings growth rate than our sales rate and a significant delta, so we’re very, very excited about their program and think from a long term perspective will be able to continue growth our earnings at a very, very healthy rate.

Operator

At this time, you have no further questions, thank you. I would like to turn the call back over to Mr. Deepak Chopra for any closing remark.

Deepak Chopra

Ladies and gentleman, now thanks once again for attending our conference call. We are looking forward to a terrific second half of the year and speaking with you all once again next quarter, thank you.

Operator

Ladies and gentleman that concludes today’s conference. We thank you for your participation. You may now disconnect. Have a great day.

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