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OSI Systems, Inc. (NASDAQ:OSIS)

F2Q10 (Qtr End 12/31/09) Earnings Call

January 27, 2010 12:00 am ET

Executives

Deepak Chopra - President & Chief Executive Officer

Alan Edrick - Executive Vice President & Chief Financial Officer

Analysts

Tim Quillin - Stephens Incorporated

Rick Hoss - Roth Capital Partners

Brian Ruttenbur - Morgan Keegan

Josephine Millward - Dougherty & Co.

Operator

Good day ladies and gentlemen and welcome to the second quarter 2010 OSI Systems Earnings Conference Call. (Operator's Instructions) I would now like to turn the presentation over to your host for today's call, Mr. Alan Edrick. Please proceed, sir.

Alan I. Edrick

Good morning, and thank you for joining us. I'm Alan Edrick, Executive Vice President and CFO of OSI Systems. I'm 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 2010 conference call. We'd like to extend a special welcome to anyone who is a first-time participant on our conference calls. Please also note that this presentation is being web-cast and will remain on our website for approximately two weeks.

Before discussing our financial and operational highlights, I'd like to read the following statement. In connection with this conference call, the company would like 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 officials on this call about future company performance as well as certain responses to questions posed to company officials about future operating manners.

During today's conference call, we may refer to both GAAP and non-GAAP financial measures of the company's operating and financial results. For complete information regarding non-GAAP measures, please review our press release regarding our second quarter results. The press release has also been filed with the SEC as part of our Form 8-K. 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. These factors include the risk factors set forth in the SEC's filings.

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

Before turning the call over to Deepak, I'm going to provide a high level overview of our financial performance during our second quarter. We will again touch on several themes that we discussed during past conference calls.

Our core strategy of focusing on the generation of meaningful earnings and free cash flow, while simultaneously investing in key sales markets and research and development initiatives is paving the way for profitable sales growth. In spite of another challenging top line quarter, we were able to achieve far more in results that demonstrated the effectiveness of this strategy and our efforts.

Highlights for our second quarter of fiscal 2010 are as follows. First, with solid Q2 bookings we enter 2010 – calendar 2010 that is with an overall record backlog of approximately $240 million, and 18% increase from the beginning of our fiscal year. This was again led by our Security Division Rapiscan which finished the quarter with a new record backlog of $164 million, representing a 41% increase from June including numerous significant contact wins that Deepak will touch on shortly.

Given the strong backlog and visibility we are confident in predicting strong double digit sales growth in the second half of our fiscal year.

Second, although sales declined 5% for the quarter, we again reported a significant increase in earnings per share. Improved operating efficiencies, coupled with the cost containment initiatives drove both gross margin and operating margin expansion.

Third, we reported positive free cash flow for the eight consecutive quarter, leading to significant reduction on our net debt, and a leverage ratio well below one. For the quarter we generated approximately $8 million in free cash flow, or $0.41 per share.

Fourth, subsequent to quarter end, we announced a major contract win with the Puerto Rico Ports Authority. This represents an important new business model for Rapiscan. We expect this business to provide a longer term stream of revenues and to lead to further operating margin expansion in fiscal 2011. Revenues related to this deal which are expected to be significant, are not included in our published backlog.

Lastly, based on the strength of our backlog and our demonstrated operating leverage, we are increasing our fiscal 2010 earnings per share guidance. Although our top line was impacted by the global economic downturn, we are pleased with the Q2 earnings and cash flow performance. As the economy begins to rebound we believe we are well positioned for significant top line growth and operating margin expansion. I will provide additional Q2 and first half financial details and will discuss our fiscal 2010 guidance, but first let me turn the call over to Deepak.

Deepak Chopra

Thank you, Alan and good morning and welcome to the OSI Systems earnings conference call for the second quarter and first half of fiscal 2010. This has been a great quarter for us. We continue to deliver positive results for our shareholders despite the challenging economic environment. As Alan pointed out, our financial performance was again very strong in our Q2 highlighted by strong earnings growth, our record backlog and solid cash flow. These achievements are the direct result of our initiatives to implement organizational changes that have reduced our cost structure and improved our overall operating efficiencies.

I'm going to spend some time focusing on our business achievements by division and then Alan will go into more detail in the finances.

Security Division. Activity with Rapiscan remains very robust. Bookings for the first half were a company record $153 million, which equates to a book-to-bill ratio of approximately 1.4 times. This resulted in the division entering the second half with a record backlog of $164 million. Revenues for the quarter were down when compared to the prior comparable period, due primarily to the timings of shipments.

As we have mentioned many times before, security business is lumpy and especially as the size of the orders become bigger and bigger, the lumpiness will increase. We expect the security division to report outstanding revenue growth over the remainder of fiscal 2010 supported by a very strong backlog of $164 million.

I will touch on the whole body scanning which has been in the news all over. There has been a significant amount of media attention following the recent terrorist incident that occurred on Christmas day regarding the implementation of whole-body scanners for passenger inspection, both domestically and internationally. As a result we have seen a tremendous increase in interest for these products globally.

The facts as they stand are as follows: there are only two TSA qualified vendors for whole-body scanners. Prior to the Christmas incident, in October 2009, we received an initial production order for $25 million as part of a $173 million indefinite delivery indefinite quantity order. We have begun to deliver systems to the TSA for deployment domestically. As a result of the incident quotation (ph) activity internationally has also increased dramatically. We have booked orders internationally, but for competitive reasons we are not going to talk about them.

We've been asked many times the questions – we want to make it very clear that we have the production capacity to meet any increase in demand for this product without impacting our other customers and product lines in any shape or form.

We have begun work mostly with the TSA and other international aviation authorities to go into (inaudible) detail, deployment and additional enhancements. At this stage it is difficult for us to comment on any future plans of the TSA regarding this product. It is a well known fact that TSA is in active procurement mode for additional units. We will not comment on that in the question-answer period at all because it's an active procurement.

On the body whole-body scanner market provides significant upside, we remain very excited about the continuing potential of the security business going forward, especially as it relates to the U.S. Government mandate for 100% inspection of air cargo and inbound shipping containers. A global market for cargo inspection products, the introduction of our scanning solution business model like Puerto Rico that I will talk about a little bit more. The introduction of our high speed inline whole-baggage system targeted at both the international and domestic market.

Let me go into the detail of the Puerto Rico model. We announced a 10 year contract from the Puerto Rico Ports Authority to provide a complete Turn-Key Solution resulting in the scanning of all containerized inbound cargo at the port of San Juan. We've been talking about and focused on this model for the last couple of years and have invested in the infrastructure to move forward of trying to go beyond just selling the cargo scanners but to actually operate them.

Under the terms of the contract, which includes two renewal options for an additional five years each period, Rapiscan will provide cargo scanning services using multiple Rapiscan Eagle high energy x-ray systems at various locations at the port of San Juan. The cargo scanning initiative at the port of San Juan represents a new business model for the company and substantially expands the size of the market we address by opening new opportunities with customers who are not in the market for outright ownership of scanning equipment or are otherwise seeking the efficiencies and operational expertise offered by our Turn-Key Solutions team.

We are actively talking about other opportunities globally at this time. As more ports around the world implement U.S. mandated cargo inspection processes, we expect opportunities for a scanning solution business to grow. We believe this newly added business model will in the long run significantly enhance our opportunities and financial results in our Security Division. The other advantage of this thing is that the lumpiness in the cargo business which is inherent should get better because of this continued revenue from (inaudible) scan model.

We also expect the operating margins to be better in this business compared to outright sales. Again at this early stage we can talk in general, but it's very early to talk about operating margins specifically and revenue specifically attached to this contract. This is a 2011 model – we will start executing this by summer of this year, which will require some civil works some employee hirings, training testing and setting up the infrastructure in Puerto Rico.

The other major order that we booked just before the quarter ended was a $35 million contract for whole baggage screening in Mexico. This contract, for the first time for Rapiscan, includes the installation of our multi-view high speed systems in ten airports in Central and North Mexico. Rapiscan will act in a new capacity as a prime contractor managing and coordinating construction and civil works associated with implementing the HVS system with a state of the art baggage handling system. Again, a new add-on to just selling the scanning machines.

The installations and contract provide reference sites within a fast growing Latin American region for our marketing and sales effort of whole baggage screening total solution.

This fiscal year we have increased our focus and attention on the Latin America market, and this contract is a direct result of these initiatives. The majority of revenues from this contract is expected to be recognized in fiscal 2011. As Alan mentioned, just to emphasize, the Puerto Rico contract has no revenue in our backlog. On the other hand, the Mexican order is in our backlog.

We also announced the receipt of a contract from the Delhi Metro Rail Authority in India for the deployment of systems to inspect passengers baggage on the mass transit system in New Delhi. This contract is a significant win as it is our first major deployment within the Rail and Mass Transit industry globally.

In December we announced a contract to provide security scanning systems for the upcoming Vancouver Winter Olympics. Rapiscan Systems has a legacy of securing international sporting competitions such as the Commonwealth Games of Malaysia in 1998, Manchester 2002 and Melbourne 2006, the Asian games 2006 in Doha Qatar, as well as the Olympic Games in Atlanta, Nagano, Sydney and Salt Lake City.

As I've stated previously, the level of market activity within this industry is currently at an all-time high with our funnel building each day.

Healthcare Division, Spacelabs. Sales for our healthcare division declined in the second quarter by approximately 4% when compared to the prior comparable period. Due to proactive measures we undertook in fiscal 2009, despite the decline in sales the division was able to significantly improve operating income for the second quarter and first half of the fiscal year. We are beginning to see signs of improvement in the Healthcare market and maintain that as sales improve the division is well provisioned to experience strong operating margin expansion, as evidenced by the results announced today. We expect the second half of Healthcare to better than the first half.

During the quarter Healthcare division had a number of positive announcements, the highlights of which included: in November we announced that we had expanded our distribution channel in North America with the appointment of three manufacturer's representative organizations as Spacelabs distributors to broaden our reach in America. The three companies joined Spacelabs (inaudible) previously to presenting one of our major competitors in a similar capacity and does bring a lot of experience to Spacelabs sales and marketing. We look to leverage of their combined experience and market knowledge to continue to grow our market presence within the U.S. Healthcare market.

In October we announced the receipt of a $13.5 million indefinite delivery indefinite quantity order from the U.S. Government for the complete range of Spacelabs monitoring systems and consumable products. A one year IDIQ was awarded by the U.S. Defense supply center Philadelphia medical supplier operations directorate. Systems and products acquired under this IDIQ will be distributed nationally to all branches of the U.S. Armed Forces in addition to other U.S. Government agencies.

As previously discussed the ability for our Healthcare division to be highly profitable and operating cash flow positive during such (inaudible) economic conditions highlight the strength of the underlying business model.

Optoelectronics Manufacturing segment. Our Optoelectronics Manufacturing division continues to perform well in challenging economic conditions. Sales this quarter were relatively flat when compared to the prior comparable period, declining by approximately 2%. In December we announced the receipt of a further follow-on order for approximately $6 million from ITT for electronics sub-assemblies for the DOD mine resistant ambush protected vehicle program. With that I'm going to hand the call back over to Alan to talk in greater detail about our financial performance before opening the call up for questions.

Alan I. Edrick

Thank you, Deepak. As mentioned on each of our conference calls over the past few years, we remain focused on driving earnings and cash flow improvement. Our efforts continue to pay off, as reflected in our second quarter results providing a glimpse of the future earnings power we believe we can achieve. I will speak to our guidance shortly but first let's review our financial results of the second quarter of fiscal 2010.

Overall, net sales for Q2 decreased by 5% to $151 million. While there was top line softness, we are seeing encouraging signs pointing to robust sales in our Security Division in 2010 and significant second half year over year growth in our Healthcare Division.

Our Healthcare Division achieved an operating profit of $6 million, excluding restructuring charges, representing an 11% operating margin in Q2 the strongest in our company's history for this quarter. Our Optoelectronics business had a solid quarter with third party revenues increasing 7% while inter-company revenues were down, which was in directional alignment with the other divisions.

As revenues increase, we believe there is a significant opportunity to leverage our improved cost structure. Due to ongoing lean and global supply chain initiatives, as well as the product mix, our gross margin improved 320 basis points during the quarter, to 37.4% from 34.2% in the prior year. Our gross margin typically varies from quarter to quarter as a result of a number of factors, including the product mix unit volumes pricing inventory reserves and capacity utilization. Looking forward we anticipate our margins should improve from our prior year results due to the lower cost base as demonstrated in the first half as well as additional leverage resulting from revenue growth.

With strong cost controls remaining in place, our Q2 SG&A expenses decreased 3% from the comparable prior year quarter reflecting the impact of the actions we undertook earlier in 2009 and continued into fiscal 2010. For the first half of this year our SG&A expenses decreased 9% compared to the prior year comparable period.

Q2 R&D expenses were $10.4 million or 6.9% of sales which is consistent with the guidance we provided on our last call of higher sequential R&D spending. We continue to invest significant resources and technologies to add to and to enhance our security and healthcare product offerings. As a result of these programs we believe that the company is well positioned to capture major opportunities in our core markets in the future.

Our effective tax rate for the quarter was 30.6% and 34.4% for the first half of fiscal 2010. Our provision for income taxes in dependent on the mix of income from U.S. and foreign locations, due to tax rate differences among such countries as well as the impact determinant taxable differences (ph). As a result of these achievements we saw significant improvement in our Q2 net income, resulting in diluted earnings per share of $0.39 per share compared to $0.24 in the prior year. For the first half we reported a diluted EPS of $0.53 per share compared to $0.24 per share for the first half of 2009, or 120% improvement. However excluding the impact of restructuring and other charges EPS for Q2 would have been approximately $0.41 per diluted share as compared to $0.34 in the prior year.

Moving to cash flow. We generated operating cash of $13 million during Q2 and $23 million for the first half of fiscal 2010 driven by our improved profitability as well as our continued focus on working capital management. For Q2 capital expenditures were $5.4 million while depreciation and amortization was $4.3 million. Our debt balances continue to come down as payments reduced our total debt by approximately $6 million in the second quarter and $14 million in the first half. As mentioned in previous conference calls, generating strong cash flow continues to be a top priority, and we are very pleased with sustained progress we have made in this effort.

Finally, turning to our fiscal 2010 guidance. We are reiterating our previously announced sales guidance of $620-$640 million, which implies second half revenue growth of 19% - 26%. This guidance does not anticipate any material contributions in fiscal 2010 from the recently announced security wins with the port of Puerto Rico or the airports in Mexico as Deepak previously described.

With improving gross margins and our relentless focus on optimizing our cost structure, we believe our earnings outlook continues to improve and as a result we are increasing our fiscal 2010 EPS guidance to $1.23-$1.32 per share which represents EPS growth of 35%-45%. These amounts exclude, for purposes of appropriate comparison, the impact of restructuring and other fiscal charges.

In fiscal 2009 we undertook decisive and meaningful actions to rightsize (ph) our business in response to economic conditions. These actions have produced meaningful earnings performance in the first half of fiscal 2010 and position us for further earnings leverage. During the past few years we have transformed our company into a sustainable and consistent performer. In a difficult economic environment we have built a strong foundation for significant future earnings power. Given the operational improvements that we have implemented over the past two and a half years, coupled with the restructuring activities that have improved our cost structure, we believe we achieve significant operating margin expansion in the coming year.

Thank you for listening to this call, and at this time we'd like to open the call to questions.

Question-and-Answer Session

Operator

Thank you. (Operator's Instructions) Our first question will come from the line of Tim Quillan with Stephens, Inc. Please proceed.

Tim Quillan - Stephens, Inc.

Good morning. Can you talk at all – and I know you are not going to say where the opportunities are, but the pipeline for similar Turn-Key container screening solutions like you have in Puerto Rico?

Deepak Chopra

It's very difficult to – you said yourself for competitive reasons it's very difficult to answer that.

Alan I. Edrick

I think the only thing I'll say is that we are looking internationally and all over the place. It's not just one area.

Deepak Chopra

I think to add onto it is - the important thing to say is that Puerto Rico will become a very important site for everyone to look at because it's a first. We are going to make sure that it is a world class execution, because as we approach towards the decision making all over the world of how to handle cargo inspection, this changes the paradigm for them to have another alternative. Instead of buying the thing, leaving the thing, to actually have the same company which manufactures the equipment, which services the equipment and which installs the equipment can also be there to execute and do the (inaudible) scan. So that gives them the flexibility of the right product, no obsolescence and to be able to get the efficiencies of the people on the ground that are already servicing the equipment. We can also execute it we can do the billing. So the important thing is that there is no other one or two other sites that we are looking at. We have created a group which we created about a year ago. We are focusing on all the potential customers that are looking at procurement and this gives them and extra alternate.

Tim Quillan - Stephens, Inc.

This is a new business model for you, and so how confident are you in terms of your ability to estimate cost and to execute that margin. What are the uncertainties as you go into that line of business?

Deepak Chopra

Well, number one, we are very confident. This is a very well thought out thing. The important thing is the real cost or the big cost is to do with the equipment itself which whether we sell or service is the same in this model and the other model.

Regarding the actual risk, the risk basically could be the stability of the government at that place where this port is, the cargo flowing, the increase in cargo or reduction of cargo. I think those are the things that are normal, but that also is very good for us. Think of it this way, that we can move equipment from one place to the other so we can be very flexible. So I would think that this is a better model than an outright sale because of you are part of the team with the customer and you're looking at a customer's needs and you can be flexible so we're very confident about it.

Tim Quillin - Stephens Incorporated

That's fair. Can you give us an update on the status of RTT and what the next milestones are there?

Deepak Chopra

The next milestone which we have said is that sometime in early this year before our fiscal year is out we plan to get the units over to TSA.

Alan Edrick

That's correct.

Tim Quillin - Stephens Incorporated

Okay. And how comfortable are you that once you get it there that it can get certified?

Deepak Chopra

Well, the thing is that I'm sure that you know there are new specifications coming out so that everybody has to test and get certified to new specifications and we all are going to have the risk. We believe very confidently that with the resolution being better, with the speed being better, with less complications in the inline system because of the speed, we believe that we have a very good shot of being at the same level as anybody else. So at the end of the day this is going to be a bakeoff and it's a process and I'm sure that we will have some challenges, but we have an experienced team and we have a good product and we have been diligently working on it so we are very confident that we will succeed.

Tim Quillin - Stephens Incorporated

Sounds good. And just in general in the security business, I mean you're clearly looking for significantly accelerating growth in the back half of this year. Operating margin in fiscal '09 was a hair under 6% I think in the first half a hair under 6% as well. How much leverage are you going to have in that security business as growth accelerates and where can operating margins go for you?

Alan Edrick

Tim, this is Alan. I'll take a stab at that. We believe that we've made substantial progress in operating margins in the Rapiscan division and we continue to do so. As you mentioned, two years about we were about a 2% operating margin and last year just under 6%. We have accelerated that as you've seen in the second quarter results and as our top line grows in the second half of this fiscal year and into next year we believe that there continues to be substantial opportunities for operating margin expansion and we are targeting over the coming years to be in the double digits for operating margin for Rapiscan.

Tim Quillin - Stephens Incorporated

Okay, but we shouldn't necessarily expect that for fiscal '11?

Alan Edrick

We shouldn't not necessarily expect that for the complete year, correct.

Tim Quillin - Stephens Incorporated

Okay, thanks much. I'll let somebody else jump in. Great quarter.

Operator

And our next question will come from the line of Rick Hoss with Roth Capital Partners.

Rick Hoss - Roth Capital Partners

Hi. Good morning, gentlemen. A couple more questions on the Puerto Rican contract. Can you tell us how long you've been working on the negotiations surrounding that?

Deepak Chopra

No, I can't, but I will tell you that we have been talking about (inaudible) per scan concept for the last multiple years.

Rick Hoss - Roth Capital Partners

Okay. And then are you able to tell us the CapEx required for the initial placement in Puerto Rico?

Alan Edrick

Yeah. It can vary a bit, but I think our estimates, Rick, are going to range somewhere from $8-$12 million.

Rick Hoss - Roth Capital Partners

Okay. And then as far as payback periods go, and I actually view the payback for the Puerto Rican government as probably more important, have you guys discussed the potential tax revenue capture per container of what the average would be with the implementation of 100% scanning?

Deepak Chopra

Would you repeat that again?

Rick Hoss - Roth Capital Partners

I'm trying to find out the payback period for the Puerto Rican government by using your systems in order to scan 100% of the containers and how I would get there would be to assume some sort of average additional tax capture per container scanned. So say it would be $100 per scan and say you were charging 10 bucks to them then it would obviously be a very accelerated process for them as far as getting their money back and then profiting from having your systems on board.

Alan Edrick

Yeah, Rick. One of the beautifies of this business model, particularly for the customer, is that there's very little outlay. For instance, for the capital equipment we're investing in the capital equipment and really the payback goes to OSI in terms of the revenue coming so it's a beautiful business model of the Port of Puerto Rico. They don't necessarily need to look at payback analysis because there's very little upfront investment.

Rick Hoss - Roth Capital Partners

Right, but if they're paying say $10 a scan and they're able to increase their tax revenue from tax evasion by say $100 per container, then the argument for deploying additional systems for governments that don't currently scan 100% of containers would be compelling.

Alan Edrick

I think you're right. Specifics what they're looking at, et cetera, that is something that I'm sure the Puerto Rican government would look into and announce themselves, but Alan put it very well that their initial outlay is very insignificant.

Deepak Chopra

Well just to add onto it, keep in mind that the way the model is, the port or the customer does not invest any money. We as the operator invest the money, we charge by (inaudible) to the shipper which is an insignificant charge. So the shipper gets the charge, both get some revenue. We recover the rest for the operation and the depreciation and profit. So it's a perfect model made and whatever the internal analysis of capturing more duty and stuff like that, that's an internal analysis each customer would do and definitely you're very astute there is definitely some advantage. But keep in mind that each customer is going to have some additional requirement, but one requirement that starts the customer onto it is the container scanner initiative that they have to work towards inspection.

So it's going to be a necessary requirement, but the added benefit is duty evasion or capture of duty underreporting so that it's a win-win situation. That's why we are very excited about this model. As we execute it and other ports all of the world look at it, this is a perfect win-win situation and the manufacturer has finally entered into the business and we think that as a manufacturer we know the equipment, we know the limitations, we know the throughput, and we can size and match the right equipment to each application.

Rick Hoss - Roth Capital Partners

Okay. And then last question, as far as health care goes you've made some pretty important resizing over the last year or so, so are you done here and do you expect additional resizing? And then assuming that revenue is flat, would margins be flat or would they continue to expand?

Deepak Chopra

Well number one, we have been never done. We always keep looking at it, but we don't want to give you the idea that all we keep doing is downsizing it. We've invested in the manufacturing rep organization, for example, to increase our reach. In some other areas of the world we have increased sales and marketing and distribution relationship. We have moved around some R&D costs into the various regions. We're coming out with some new products and we continue to look at it.

And as we look at the challenges out there and the new additional products required by the manifesting rep organization which is a season organization that came from one of our largest competitors. We will continue to look at it so it's an evolving thing, both of wise investments at the same time continuing to look at where else we can make it more efficient. And we expect the margins to expand, and one of the things that we want to make a point is in Q2 even at the revenue that we did we increased the operating margin 11%. So that's what the capacity of this business is even in a flat revenue period and we expect the second half that the revenue will grow.

Rick Hoss - Roth Capital Partners

Okay. Thank you for taking my question.

Operator

And our next question will come from the line of Brian Ruttenbur with Morgan Keegan.

Brian Ruttenbur - Morgan Keegan

Yes, thank you very much. A couple of quick questions in here. First of all, R&D was up from quarter to quarter, can you talk about that level, what made it spike and do you expect that level to be at the $10.4 million going forward?

Alan Edrick

Sure. Hey, Brian, this is Alan. Yeah, as we mentioned on our Q1 conference call, the R&D was lower than what you would typically see for a variety of reasons and as we said at that time we expected it to cut back to more traditional levels which are what we're seeing here in Q2. So as we look forward we would anticipate that there'll probably some sequential dollar increase in R&D overall, but as a percentage of sales actually probably decline a little bit.

Deepak Chopra

Brian, just to add onto it. Definitely we are very focused in especially with the opportunities in the security area. There is some R&D increase in the security area and we are very excited about the R&D in that area.

Brian Ruttenbur - Morgan Keegan

Okay. And then the increase in earnings, I just have a question about that. You've also decreased the tax rate, how much of the increase in earnings was really due to the tax rate getting lowered versus most of our assumptions or really versus operational improvements or additional positive developments on the revenue side?

Alan Edrick

Sure, Brian. I'd say the increase in earnings is almost entirely attributable to operational improvements. We were in fact up 14% in our operating income. We also saw our interest expense decrease due to improved cash flow and better working capital management. The tax rate that we reported in Q2 was consistent with our Q1 though a little bit lower than I think the street was anticipating. That contributed a very small amount to the overall increase. It was primarily due to better operating income and lower interest expense.

Brian Ruttenbur - Morgan Keegan

Okay. And then the percent of revenue right now that you see coming from the DOD?

Alan Edrick

We're looking at all areas of governance. Specifically to break it down it's something that we've done in the past, but we are very bullish not just with DOD, but with other government areas that we're looking at as well.

Brian Ruttenbur - Morgan Keegan

Okay. Is it still 10%-15% in that range?

Alan Edrick

I'm not going to comment on what it is.

Brian Ruttenbur - Morgan Keegan

Okay. Will the surge in Afghanistan help you in that area?

Alan Edrick

Yes.

Brian Ruttenbur - Morgan Keegan

Okay, I'll leave it at that then. Thank you very much.

Operator

(Operator's Instructions) Our next question comes from the line of Josephine Millward with Stanford Group.

Josephine Millward - Dougherty & Co.

Good morning. I'm with Dougherty now, Stanford is no longer in existence (laughter). I wanted to talk about your pipeline in activities for air cargo. I know you have several technologies that have been qualified by TSA and I think to me the deadline for 100% screening by August of this year is going to get pushed back, but what do you think is the real potential addressable market here? And if you can talk about what you're seeing from the freight forwarders as well.

Deepak Chopra

Well, we can't talk specifics because you know it's not one customer, it's all over.

Josephine Millward - Dougherty & Co.

I haven't really seen any contract announcements and it seems to me you should be very active in this space. If you could just give us a little more color?

Deepak Chopra

Well number one to answer your question is we are the most active in that space because as you said, we have the broadest range of products on the TSA list. The reason you don't see news on that is these are freight forwarders. There are 3,000 freight forwarders in some shape or form all over America and they buy from 1-10 machines so it is difficult to keep tabs. We look at this business now as part of our normal business and there's a tremendous amount of activity and I don't know your comment that your sources that think the 2010 August is going to get pushed out. We can't comment on it, we don't know.

All we do know is that as we have said in the previous times, there was a big flurry of activity initially when there were pilot programs by TSA and then everybody has taken a deep breath and we expected that by January onwards as we get into 2010 the freight forwarders that were sitting on the sidelines are going to start making decisions and I think that the next couple of months, the flurry of activity in air cargo is going to increase because as you come more closer to the deadline whether that gets pushed or not, all freight forwarders need to act on it period.

Josephine Millward - Dougherty & Co.

Okay. So you're anticipating increased activity? Because my understanding is it's still a very small percentage of air cargo is being screened. Most of them are being sniffed by dogs right now so I think when you talk about 3,000 freight forwarders I think that market is still very — that the penetration is very limited. Is that correct?

Alan Edrick

I think it's a very new market. Specifically how it's going to get addressed through scanning or other methods, it's still in place.

Deepak Chopra

Well just to comment Josephine on that, the one thing I do understand is dogs can only do it for 30 minutes and then they need to take a rest and eat some dog food and do some other things.

Josephine Millward - Dougherty & Co.

You're absolutely right. Okay, that's helpful. And just a followup based on your first half results, security had to grow about 30%-40% in the second half for you to meet the low end of your guidance. Now since timing is always an issue with government customers, what gives you confidence that things might not slip to the right in the second half if you can help us think about the risks there?

Deepak Chopra

Well number one, we look at it every time we've broken down our backlog. Obviously there is lumpiness and some things can fall into this, but on the other hand you can also get some bluebirds in. We think that as the backlog is built and we definitely had some timing issues in Q2, especially with international, we think that the second half is achievable and we are very bullish about it and we think that the bookings even in this quarter as you know with a lot of activity going in Washington is going to be a very strong booking quarter.

Josephine Millward - Dougherty & Co.

Great. Can you also talk a little bit about health care because you have the same situation? We're going to need to see double-digit growth in health care in the second half for you to achieve your full-year guidance. We're seeing signs of recovery, what else is going on there that would drive this double-digit growth?

Deepak Chopra

I think that the same thing that everybody else is saying. I know you put out a nice report about Philips and GE, we're seeing the same thing. People with debt for capital equipment, the hospitals that were sitting on the sideline got to think about what Washington is going to do, have finally started thinking in their mind they got to move forward. They got a business to run, they got to look after the patients, they got to grow their revenues, and we feel that US has started showing positive confidence. We also feel that internationally as the wave has spread from last year from here to there people have now started taking the next breath to say okay let's get business going. And we think like you're seeing from your other companies you cover. We are not completely out of the woods. We're being very cautious, but we think that it's pretty much bottomed out. We think the second half is achievable and we're very confident about it.

Josephine Millward - Dougherty & Co.

Great, thank you. Final question, what tax rate should we use for the rest of the year?

Alan Edrick

Josephine, I would use a rate comparable to what you've seen in the first half of this year which is 30 and change.

Josephine Millward - Dougherty & Co.

Okay. Thank you very much.

Operator

And our next question is a followup question from the line of Tim Quillin with Stephens Incorporated.

Tim Quillin - Stephens Incorporated

Yes, thanks for taking a couple of quick detail questions. Stock price has done remarkably well up until today, but what fully diluted share count should we be assuming for the full year and over the next couple of quarters?

Alan Edrick

Sure, Tim. That will certainly depend upon how our stock price performs throughout the rest of the quarter and the next six months, but given the applications of the Treasury stock method, one might assume that it will go up in the neighborhood of 700,000-800,000 shares for Q3.

Tim Quillin - Stephens Incorporated

Okay. And then do you expect or plan any additional restructuring charges for the rest of the fiscal year?

Alan Edrick

I think as Deepak mentioned, we're always looking at ways we can continue to become more efficient so the likelihood is that we will see some, but probably not of a significant size.

Tim Quillin - Stephens Incorporated

And what was the $600,000 charge in the quarter related to?

Alan Edrick

It related to the closure of an additional facility and associated headcount.

Tim Quillin - Stephens Incorporated

In which business?

Alan Edrick

Primarily in the optoelectronics business and a little bit in health care.

Tim Quillin - Stephens Incorporated

Gotcha. Thanks much.

Operator

And at this time I show no further questions in the queue. I would like to turn the call back over to Mr. Deepak Chopra for any closing remarks.

Deepak Chopra

Thank you very much for your time today. In closing I would just like to reiterate the positive results we were able to achieve in the second quarter of fiscal 2010. Again to summarize it's significant improvement in EPS, non-GAAP from $0.41 diluted share when compared to $0.34 in the comparable period last year. Continued strong cash flow with operating cash flow for the first quarter of $13 million and free cash flow of $7 million, record backlog levels for our security division and the company overall of $164 million for security with $240 million for the company, increased EPS guidance for the fiscal 2010, new range announced today of $1.23-$1.32 per diluted share, and improvement of approximately 35%-45% when compared to $0.91 EPS for last year.

I want to emphasize that we continue to invest for the long term. We are very bullish for the second half in the security and the health care group. We think that 2011 with the kind of model that we have and the operating of (inaudible) model. Our new programs, our new products in health care to continue to look at sizing the operation properly and working on cash flow — we think we're going to have a great second half and we're going to have a great 2011 story. And as you know long term our target has always been to grow the business and we will continue to look at other opportunities including investments in new technology and acquisitions. Thank you very much.

Operator

Thank you for your participation in today's conference. This concludes your presentation. You may now disconnect. Good day, everyone.

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