OSI Systems' Management Presents at Morgan Stanley Technology, Media and Telecom Conference (Transcript)

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 |  About: OSI Systems, Inc. (OSIS)
by: SA Transcripts

OSI Systems, Inc. (NASDAQ:OSIS)

Morgan Stanley Technology, Media and Telecom Conference Call

February 26, 2013 8:00 pm ET

Executives

Alan Edrick – Executive Vice President and Chief Financial Officer

Analysts

David Chan – Morgan Stanley

David Chan – Morgan Stanley

Hi, great. I’m Dave Chan with Morgan Stanley, and we’re here with Al Edrick, CFO of OSI Systems. So Alan, once you just start with just a quick a couple of minute snapshot of the company, maybe kind of go into the three business units and the primary products that are sold within your three business units. Give us an intro.

Alan Edrick

Sure. Sure, so OSI systems, we do have three different divisions. We have a Security division, Healthcare division, and Optoelectronics. Our Security business is our fastest growing business. It represents about half of the company. We participate in really four major areas, what we call baggage and parcel inspection and these are the X-ray machines you see at the checkpoint for carry-on baggage, where we’re number one in that area.

Checked baggage which is a new area we’re moving into which has sizable market opportunities for growth. Cargo and vehicle inspection which is really in its infancy and we’re moving into a new model of a recurring revenue stream at a higher operating margin that we call turnkey services.

Our second segment is Healthcare division, it’s called Spacelabs Healthcare. We have three product lines, main product families, which is patient monitoring, anesthesia and cardiology, and each of these businesses has some nice opportunities for us as we’ve been refreshing the product line. And the third area which ties it all together is our Optoelectronics Group. It’s where the company was founded.

Unlike Security and Healthcare where we sell to the end customer, in Optoelectronics, we’re an OEM provider. We sell largely to the Fortune 500. It’s a nice business in and of itself. But it also supplies all the key components that go into our Security products and into our Healthcare products and that vertical integration really allows us to enhance our overall gross margins for the company and control our supply chain.

David Chan – Morgan Stanley

Thank you. You’ve been at OSI for…

Alan Edrick

Six years now.

David Chan – Morgan Stanley

Six years now and stock has certainly been an impressive run [over] the multiyear time period and one of the key reasons for that is the turnaround that has really happened over the last several years. Can you just give us a sense for what were some of the two, three, four things that you and Deepak really did to reinvigorate the company?

Alan Edrick

Sure. So as I joined the company, we were very strong at growing the top line. We had grown both organically and through acquisition. And we’ve done a number of acquisitions that we got very attractive valuations and made great strategic sense. What we weren’t so good at that point in time is post merger integration. So over a period of time, we’re showing we put a little hiatus on acquisitions for a while. We really start to integrate the companies that we acquired. We went through some cost rationalization programs, whereby we moved some excess manufacturing capacity. We moved to shared services operations. We just changed the whole lot of the cost structure that did involve in the growth opportunities, which is really the sales and marketing and the R&D.

So we instantly transform ourselves at that point from moving from a company that was losing money and bringing cash to a company that was generating significant earnings and generating significant free cash flow. So we all the while wanted to focus on strong top line profitable revenue growth, we really become a significant earnings player and significant free cash flow generator.

And we’ve been able to accomplish this through various economic cycles. And we are doing well in those 2007 and 2008 and when the recession hit. We still grow earnings at a substantial rate and then we’ve got a little tailwind coming out of the recession and our sales rebounded even stronger, and we continued the strong earnings growth and free cash flow generation. This year is a little bit of a hiatus in free cash flow that we’ve been investing in a major budget.

David Chan – Morgan Stanley

All right, thanks. That makes a lot of sense. Why don’t we just recap for everyone the December results? And just give us a sense for what do you think went well, and what perhaps you could have done better?

Alan Edrick

Well, it’s interesting. We view our December quarter as a pretty good quarter. The market didn’t necessarily react that way following our announcement. They are record earnings, the best quarter we’ve ever had in the history of our company for December quarter. Our Opto vision grew at a double-digit rate. Our Security division posted the strongest operating margin that had seen in some time.

Overall as a company, we posted our record operating margins in the December quarter. The area that was a bit light was our Healthcare business, where our sales were down 5%, mainly due to international sales primarily focused in Europe. So notwithstanding the decline in the Healthcare sales, overall as a company we still grow in the top line and we posted record earnings and continue to generate strong operating cash flow. So we actually think there was also – we’re very pretty good overall.

David Chan – Morgan Stanley

Great. And just drilling in on that Healthcare piece, so that was a weaker quarter than expected and that was largely due to European…?

Alan Edrick

Yeah, it was largely due to our European sales. And we would have been more concerned if the reason for the shortfall in the European sales was losing sales to our competitors. But that wasn’t the case at all. It’s just certain sales that we’re anticipating. There was a little bit of a diminished uncertainty in the part of Europe, whereby they just didn’t place those orders in the December quarter. And it’s not a sizable portion of our overall revenues for the few million dollars can make a difference between being a reasonable quarter in that area or software.

David Chan – Morgan Stanley

Okay, thank you. Going into 2013, you’re going to start and that’s looking better for the Healthcare?

Alan Edrick

Yeah, we really to believe that you can imagine when you’re a little light on the revenues there, we really thoroughly embedded our second half sales funnel and pipeline; and through that process, we feel much more confident about the outcome in the second half.

David Chan – Morgan Stanley

Okay. Now turning on to the Opto division, it actually put up some very, very strong numbers, 12% growth or $57 million above and sent us. So what was going on to drove that?

Alan Edrick

Opto division continues to outperform. I think was general marketing expectations are our sales team has really done an outstanding job, expanding our customer base. So we’ve been gaining more and more customers. The existing customers that we have, once you get engineered into the products, as long as you’re doing a pretty good job, you have those projects for years on a typical basis. But our sales team has really expanded the funnel of opportunities and the customer base.

And the nice thing about it is, they’re not just – saw that in the revenues in December, but also in new bookings, we landed a major new customer that we think can generate $10 million plus in annual revenues for Opto, which we’ll probably start towards the end of this fiscal year. So that just by itself gives five or so percent revenue growth for next year just on one customer and we’re continuing to do that. Our sales team has really done a nice job.

David Chan – Morgan Stanley

All right. Let’s jump into the Security business, and what is probably weighing on everybody’s mind is the March 1 sequestration deadline here. And so, just give us a sense for and there is probably something that a lot of companies here that (inaudible) are thinking about. So give us a sense for how you think it’s going to impact the business at OSI?

Alan Edrick

Sure. So sequestration, while we’re not immune to it by any means, we may not have as much exposure as some other companies do. Sort of good news and bad news for us is that, the bad news in the past was, we would always try to get into military business with the DoD and notwithstanding one nice army contracts we had last year. We weren’t all that successful in doing that. The good new is we just don’t have that much exposure to the military.

So where we believe a lot of the sequestration cuts will occur is in DoD and we’re generally not exposed to that as much, where we may have feel something like many companies under sequestration is just a little bit of uncertainty within the government, so there maybe, potentially could be delays in some of the government spending programs. But we don’t believe that the overall dollars that are going to our programs are going to be severely impacted.

David Chan – Morgan Stanley

All right, could be timing, but not the overall dollars.

Alan Edrick

Yes.

David Chan – Morgan Stanley

Okay, great. Okay, so let’s just get the TSA issue off the table here. So November 9, you received a show-cause letter maybe just kind of recap for everyone what issue was the – your reaction and then, how you resulted in kind of fee, any lingering issues in terms of resolution of the issue?

Alan Edrick

Sure. So one of our product lines is body scanners, a very highly controversy of product, since it’s been launched. We along with one other company have been two recipients of most of your just today. While we believe we have one of the best technologies for body scanners, we also believe, it’s not ideally suited for airports.

So if you go back for our last four or five conference calls, we’ve been telling everybody that with body scanners, we hadn’t sold any units over the last two years. So the great growth that we had in security in 2011 and 2012, lot of people thought it came from body scanners. It didn’t; we didn’t sell any units in those periods.

And we said further that we don’t expect to be selling any body scanners to the TSA going forward. And the primary reasons for that is, our product is about four seconds lower than our competitors and in airports four seconds is quite meaningful.

And then just certain things with safety issues and like, although it’s more of a perception standpoint than anything else. Our product is backscatter X-ray, which by definition has a very, very small amount of radiation, but it’s not zero. Our competitors’ product is zero. So for all these reasons, we didn’t view it as a great growth prospect for our company.

Notwithstanding that in November, we received as you mentioned a show-cause letter from the TSA. These letters are generally not made public and it just starts interaction between the government agency and the government contractor. Well, on this case, the letter became known by an Alabama Congress men, who basically went out and accused as a fraud, and our stock price suffered dramatically the very next morning.

There were congressional hearing that were talking place between the TSA and Congress unrelated to this topic. But of course, it came up and the TSA clearly stated that while products are in testing, there’s no way we could have been manipulating test data. But certainly, the damage was done as a result of that.

Subsequent to that period of time, we’ve worked with the TSA and we have an agreement with the TSA whereby we’re going to help them facilitate moving body scanners – our body scanners, the backscatter from the airports into other government agencies. So we agreed to do all that. We took a small charge for that in the December quarter and are now moving forward. Of course, final resolution whenever there is a show-cause letter rests with the DHS and it’s difficult to predict the timing of when you’ll get that.

David Chan – Morgan Stanley

And is there any kind of handicapping on the timing associated with the DHS process that you said publicly?

Alan Edrick

We’d certainly like to, but anytime we’re dealing with the federal government, it’s very difficult to predict the timing.

David Chan – Morgan Stanley

Okay. So Alan, you’ve talked a lot about kind of the U.S. government aspects of the business, but you’re doing something in international locations too. Specifically, you had a press release recently about the stuff you’re doing down at Mexico. Maybe you can talk about that specifically what you were doing there or you view the opportunity and the timing of that?

Alan Edrick

Yeah, good question. I mean, a large portion of our business is outside the United States and growing. So one of the areas that we’ve really been trying to grow is our turnkey business. So there has been two turnkey models that have been – two turnkey contracts that have been awarded in the world to-date and we’ve been the winner of both of them.

And while we don’t expect that will always about a 1,000 going forward, we think we have a good chance that winning more than our fair share deals. And what we mean by turnkey is our traditional model has always been to sell equipment and that we get recurring revenue through service, spare parts, and maintenance.

And we look to see how we can expand that revenue potential and how we can expand the operating margins from that as well. And we thought there might be a customer sit out there that would be interested in turnkey solutions whereby we manufacture the equipment. We place that at the customer site that we continue to own it. We staff up and then we charge a fee per scan or fee per site and these type of things.

So the first deal we won was in – it was in Puerto Rico. We’ve been ramping that up; we’re about 85% ramp today. It’s doing exceptionally well. And then the second deal we landed was in Mexico. It was a deal we landed last January and then it got upsized in February, really quite transformational for us, significant revenues that could be somewhere in the neighborhood of $150 million plus or minus on a full annual run rate at what we believe to be a significantly higher margins than our corporate averages. And the project is moving along on a nice pace right now and we feel very, very good about it.

So we’ll see – as we see more and more of these turnkeys, it gives us increased visibility from a long-term basis. Mexico is a six-year contract. Puerto Rico is a ten-year contract. So we’ve got increased visibility at higher margins. But you’re right; the international opportunities are clearly expanding.

David Chan – Morgan Stanley

But just in terms of the financial profile of these deals versus your standard deals, what’s the kind of the average gross margins profile of a turnkey contract versus just a standard, I deliver it to you product deal?

Alan Edrick

Sure. So we really try to focus a bit more in the operating margins than the gross margins. And while we haven’t shared what those operating margins specifically are, what we have said is, they are significantly higher than a quick product sale.

David Chan – Morgan Stanley

And then in terms of the Mexico contract, everyone who wants to kind of know what timing is the rollout and when do you see the lion share of revenues being recognized under that contract?

Alan Edrick

Yeah, so the rollout is going very, very well. In fact, we had nice revenues from it last quarter. We expect to see significant revenues from it this quarter and next. We think we might be as much as three quarters ramped by the end of our fiscal year, which is a June fiscal year and hope to be nearly, I hate to say, 100%, but let’s say, nearly ramped, and nearly fully ramped by the end of the calendar year. So that’s going to provide us calendar year 2013. So it’s really going much, much faster than Puerto Rico.

David Chan – Morgan Stanley

Yeah.

Alan Edrick

The lessons that we learned there, we applied, and so we expect to see a very, very sensible run rate in the very near future.

David Chan – Morgan Stanley

So in Puerto Rico, you have Mexico that are two big deals, it sounds like you have a 100% market share. But did you see a trend for customers that buy in this way and a big way and do you see how you are going to be a SaaS company over the next several years?

Alan Edrick

Well, we certainly like the model.

David Chan – Morgan Stanley

Yeah.

Alan Edrick

And we view any potential cargo customer or other products for that matter.

David Chan – Morgan Stanley

Yeah.

Alan Edrick

As potential turnkey customers. Some customers will prefer to continue to buy the equipment and we’re very happy to sell the equipment and then we’ll get service contracts with it. But there is a customer set out there that is in turnkey. So we’re pursuing additional turnkey opportunities. They’re generally longer sales cycles. But we’re working through those, some of those we’ve been working on for sometime, and I think we’re going to see some nice orders in the future.

David Chan – Morgan Stanley

All right. And one of the products in turnkey, I know you eluded a little bit more detail…

Alan Edrick

Yeah.

David Chan – Morgan Stanley

For the group here, Rapiscan RTT is kind of one of the products, maybe you can talk a little more about what is that – what’s the opportunities that just in turnkey standalone, how you think about that technology?

Alan Edrick

Yeah, so Rapiscan RTT is a very exciting product for us. This is where we’ve been spending a lot of our R&D dollars in our Security business over the last several years. RTT is a new check baggage system. It’s a high-speed check baggage system that would run at a significantly faster rate of throughput than what’s currently out there in the market.

It’s a different design concept of a fixed gantry system as opposed to rotating gantry system like we might see in a medical application. We believe it has a very attractive total cost of ownership profile and it’s got incredible opportunities both in the U.S and the EU. The U.S will be having a significant replacement cycle coming up here.

Most of the machines and many of the machines were put into place not long after 9/11. So they are coming up on end of life. So there is expected to be a significant replacement cycle here. And then with some of the changing regulatory requirements in Europe, primarily commencing in 2014, there is going to be a very, very large opportunity over there.

So, as we look at some of the biggest catalysts to our business going forward, RTT is clearly going to be one of them, turnkey and in cargo products as well. With RTT, we are going through the certification process in the U.S as we speak. And we do have a product certified in the EU already.

David Chan – Morgan Stanley

And then any comments on timeline for that certification process was normal any expectations?

Alan Edrick

Yeah, so it’s generally a long process you go through some interim process. You go through with the TSA. We’ve done it on many of our other products. On our last conference call, our CEO suggested that he was confident that we would see certification before the end of this calendar year.

David Chan – Morgan Stanley

And the EU certifications for the entire EU is not on a country-by-country basis.

Alan Edrick

Yeah with some exception.

David Chan – Morgan Stanley

Yes. Just go back to the TSA issues couple of some of my questions. One reaction to that is, does that mean that you have – there is a big backlog of sold products that you are having to take back after the TSA resolution?

Alan Edrick

Yeah, the answer will be no.

David Chan – Morgan Stanley

That’s the answer…

Alan Edrick

So we sold the product, it has been bought and paid for.

David Chan – Morgan Stanley

Yeah.

Alan Edrick

But governments used it very effectively for several years and all they are asking us to do is, as this maybe up better serve for the airports going forward is bring them into other government agencies where they would be provided to them likely free of charge, so it’s possible. We could get service contracts that will help us going forward. But it’s basically just moving the product from one place to another, there’s not any additional financial obligations from that.

David Chan – Morgan Stanley

Okay. And then in terms of the future roadmap for the body scanner market, do you see that as a big opportunity or do you just say that that was a big opportunity you leveraged historically and you’re going to move on?

Alan Edrick

So the way we thought, our body scanners has a small opportunity frankly. We sold them into prisons, military settings and we have the number one market share in those areas, but they’re small markets. We never viewed the aviation market as a substantial market opportunity for us. That being said, shortly after the underwear bomber, it became much more prevalent. So we have some nice sales for that in 2009 and 2010. But going forward, we really look at body scanners as a very, very small product of course.

David Chan – Morgan Stanley

I’ll just throw out one more questions and I assume I’ll open up to the audience here. Beyond the things that we talked about, Mexico and other things, what other geographies or where do you see the growth opportunities in the upside for the securities business? You guys have talked about Iraq in the past, things like that?

Alan Edrick

Yeah, so I mean, we think Middle East has very fertile territory. A lot of things have taken place in the Middle East right now. So of course, timing again is a little bit uncertain, but the opportunity set is significant. Latin America is significant. ASIA is really the whole world, I mean so many of the areas outside of airports, but so many of the areas are still very, very under penetrated. So it really represents sizable opportunities for us.

David Chan – Morgan Stanley

Great. Let me just open up to anybody in the room here. Anybody have a question?

Question-and-Answer Session

Unidentified Analyst

Has anything changed regarding your healthcare customers in Europe so far for the first two months of the year?

Alan Edrick

Yeah, so while we don’t generally comment on inter quarter basis, I can’t say that, it has been much stronger in the first two-thirds of this quarter than what we have seen in the previous quarter.

Unidentified Analyst

As you think about possibility for additional awards in the Security business, the turnkey type business, would you be surprised if you didn’t get another major piece of business before the end of 2013, or are you looking further out in that?

Alan Edrick

Good question. I think we would be surprised. I think based on the pipeline we have and the stages that discussions in the pipeline. I think we feel confident that we would see something in 2013 and would be surprised if we didn’t.

Unidentified Analyst

Can you just give us just an update on the competitive environment in the security…?

Alan Edrick

Yeah.

Unidentified Analyst

…arena across that, you opened for the couple of different, the way you have sliced nice to the market and certainly who are the key competitors in those different areas?

Alan Edrick

Sure.

Unidentified Analyst

And has there been any change?

Alan Edrick

Yeah, the competitive dynamic within Security has been largely unchanged here for several years. Few years ago there were few acquisitions that just consolidated the market a little bit. But overall, I mean our competitors such as baggage and parcel inspection we would view Smiths, which is the UK-based company as our largest competitor. They’re strong competitor to us as our way, but we seem to win our fair share.

In the cargo market, there is a few more competitors in addition to Smiths. We were competing against L-3, SAIC, the company called American Science and Engineering, so all of these are good companies that we compete with on a regular basis. We tend to be number one and number two in each of the markets we’re playing in security. On the people screening basis, again it would be an L-3. And on the check baggage, which is where we’re moving into with our RTT product, the key incumbents there would be saffron, which is the French conglomerate in L-3.

Unidentified analyst

Thanks. And just what’s the current backlog today and where do you see that going?

Alan Edrick

Yeah, so I mean we see the pipeline of opportunities is very robust. Our team is doing a solid job on that throughout the world. So we’re anticipating that as we head into fiscal 2014, things are going to look very strong for us.

David Chan – Morgan Stanley

And in closing, one last question, it’s just around the idea of the three different businesses and I know that you have suggested that Opto is what ties it all together. But can you just give us a sense for how, maybe a couple of examples how, they all kind of work together and how it works for you at the company?

Alan Edrick

Sure, so Opto is the key manufacturing partner of both security and healthcare. About 20% of Opto’s sales are to our sister companies. Lot of the internal product developments goes along with that. In addition for the three businesses, we of course employ a shared services concept for finance, IT, HR, legal, few other departments, which generally helps on a nice basis as well.

So it’s a strategy that worked very effectively for us. It has smoothed out our earnings profile. So if you look back over the last 16, 18 quarters or so, the trajectory you see is really only one direction. Sometimes all three divisions are firing in all cylinders and that’s fantastic, but that’s not always the case.

David Chan – Morgan Stanley

Yeah.

Alan Edrick

But if one isn’t firing in all cylinders, the other two are usually doing pretty well. So it’s really kind of kept us in a nice trajectory. The diversification has helped smooth things out.

David Chan – Morgan Stanley

Perfect. Any other questions now? Okay, good. Well, thank you very much.

Alan Edrick

Thank you.

David Chan – Morgan Stanley

Thank you.

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