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OSI Systems, Inc. (NASDAQ:OSIS)

Q3 2010 Earnings Call

April 26, 2010 12:00 pm ET

Executives

Deepak Chopra – CEO

Alan Edrick – EVP & CFO

Ajay Mehra - President Security Division, Rapiscan Systems

Analysts

Tim Quillin - Stephens Incorporated

Brian Ruttenbur - Morgan Keegan

Rick Hoss - Roth Capital Partners

Josephine Millward – Benchmark

Michael Kim – Imperial Capital

Unspecified Analyst

Operator

Good day ladies and gentlemen and welcome to the third 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 Edrick

Good morning, and thank you for joining us. I'm Alan Edrick, Executive Vice President and Chief Financial Officer 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 third 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 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 officials on this call about future company performance as well as certain responses to questions posed to company officials about future operating matters.

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 our non-GAAP measures, the most directly comparable GAAP measures and a quantitative reconciliation of those figures, please refer to today’s press release regarding our third 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 company’s SEC filings.

Any forward-looking statements made on this call speak only as of the date of this call, and 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 will provide a high-level overview of our financial performance during our third quarter. We will again touch on several themes that we discussed during past conference calls.

We continue to execute on our core strategy of generating meaningful earnings growth and free cash flow through margin expansion, as we simultaneously invest in key sales markets and R&D initiatives, we anticipate seeing an acceleration of sales growth.

Highlights for our third quarter of fiscal 2010 are as follows. First, we returned to year over year sales growth, albeit very modest growth, following a period of declining sales primarily associated with the recent recession. Leading the way was our security division, which posted a 23% sales increase.

This strong growth was tempered by a continuing challenging environment in our healthcare business and the expected third quarter reduction in our opto sales. Second, we continued to leverage our improved cost structure leading to a 50% increase in diluted earnings per share excluding restructuring and other charges representing strong earnings growth in 11 out of the past 12 quarters.

Third, we reported positive free cash flow for the ninth consecutive quarter. For the quarter we generated approximately $11 million in free cash flow or $0.59 per diluted share. As a result we are now in a net cash position with total cash of $46 million and debt totaling $38 million.

Fourth, earlier in Q3 we announced a major contract win with the Puerto Rico Ports Authority. As mentioned in our previous conference call this represents an important new avenue for growth for our security division and services. We expect that this 10 year contract will generate a significant stream of revenue that will likely lead to operating and margin expansion in fiscal 2011.

Revenues related to this deal are not included in our backlog. In summary we are pleased with the strong earnings and cash flow performance. As the economy rebounds we believe we are well positioned for significant top line growth and operating margin expansion.

I will provide additional Q3 and year to date 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 again good morning and welcome to the OSI Systems earnings conference call for the third quarter of fiscal 2010.

We continued to deliver positive results for our shareholders, despite the continued challenging economic environment. As Alan pointed out our financial performance was again very strong in our Q3, highlighted by strong earnings growth and cash flow.

Going forward as sales growth accelerates we are well positioned for margin expansion primarily a result of the initiatives we have implemented to reduce our cost structure and improve our overall operating efficiencies.

I’d like to spend some time focusing on our business segments, security division, Rapiscan, our security division continues to perform well. Revenues increased 23% in Q3, a new record for the division, and our operating profit more than doubled demonstrating the leverage in our model.

Security backlog was $150.8 million, down sequentially when compared to the second quarter backlog of $163.9 million. Bookings this quarter were impacted by timing issues. As I’ve said previously, the level of market activity within this industry is currently unprecedented, both domestically and internationally.

The funnel of orders we are chasing is at an all time high. Internationally there has been increased focus recently on the body scanners. We are currently in discussion with a number of key international airports and aviation authorities regarding the body scanners following the TSA’s decision to deploy the scanners here domestically in the US.

This quarter we announced contract awards to deploy body scanners at the Manchester, and Heathrow International Airport, in Britain, additionally we also announced the receipt of a contract from the Government of Nigeria for body scanners.

This order from Nigeria obviously being quite significant given this is the way terrorists originated his journey in the failed terrorist incident on Christmas Day. We remain one of only two TSA qualified vendors for body scanners. While the body scanner market provides significant upside in the short and medium term, we remain very excited about the potential of the security business going forward especially as it relates to upcoming US government mandate for 100% inspection of air cargo.

The mandate calls for systems to be implemented by August, 2010. The global market for our cargo and vehicle inspection products, the US government mandate calls for all inbound containers to be inspected by 2012, the introduction of our scanning solutions business model for cargo and vehicle inspection and the high speed inline all baggage system and lastly, the replacement cycle for the upgraded machines at the checkpoint.

With that said, additional highlights for the quarter were as follows. In January we announced the receipt of a 10-year contract from the Puerto Rican Ports Authority to provide a complete turnkey solution resulting in the scanning of all containerized inbound cargo at the Port of San Juan.

Under the terms of the contract which includes two renewal options for an additional five years each, 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 turnkey solutions theme.

As more ports around the world implement US mandated cargo inspection processes we expect opportunities for our screening 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.

We are currently working very closely with the Port of San Juan and expect to start the operation this summer. In January we also announced the receipt of a $35 million contract for all baggage screening equipment in Mexico. The contract includes installation of over 20 systems in 10 airports in Central and North Mexico.

Rapiscan will act in a new capacity as a prime contractor managing and coordinating construction and [inaudible] associated with implementing the whole baggage screening systems with a state of the art baggage handling system.

We expect the majority of the revenue to be recognized for this project in fiscal 2011. In February we announced the receipt of a $25 million contract for the US government agency for cargo and vehicle inspection systems. Our activity level within the cargo business globally remains robust and we anticipate this will be one of the fastest growing segments of the business.

In February we also successfully completed the contract to provide security-scanning systems for the Vancouver Winter Olympics. This event continued a long tradition that Rapiscan systems has with securing major international sporting competitions.

Highlight events have included the Commonwealth Games of Malaysia, 1998, and Manchester, 2002, and Melbourne, 2006, the Asian Games, 2006 in [inaudible] as well as Olympic Games in Atlanta, 1996, [Negano], 1998, Sydney, 2000, and Sault Lake City, 2002.

Healthcare division, our healthcare division continues to encounter challenging sales conditions as some hospitals look to delay planned purchases. Sales for the quarter when compared to the prior comparable period declined by approximately 9%.

Despite these challenges during the fiscal 2010 we have achieved improved operating income primarily the result of the proactive measures we initiated in fiscal 2009 to improve our overall cost basis.

The sales pipeline remains strong and we anticipate that as sales grow our healthcare division will experience significant margin expansion. Just wanted to make an emphasis, to our knowledge we are not losing any business and there seems to be no significant reduction in the airspace.

Subsequent to the completion of the quarter we have announced the introduction of three new products, with our [patient market] product line we launched the Ultraview 2900 and the Ultraview DM3 Dual-Mode vital signs monitor while within our diagnostic cardiology product line, we launched the CardioExpress ECG monitor.

We remain committed to product development and expect these products to have a positive impact on the operating performance of the division going forward as market conditions improve.

Optoelectronics and manufacturing division, as we had previously discussed we had anticipated that sales with our optoelectronic and manufacturing would decline during the third quarter when compared to the prior comparable period. The decline primarily associated with timing of the long-term manufacturing contracts.

Looking to the fourth quarter we expect the division to achieve strong sales growth. We have commenced an additional initiative within the division to improve the overall cost structure in order to improve efficiencies and thus operating margins, the results of which should be reflected in our fiscal 2011.

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 for questions.

Alan Edrick

Thank you Deepak, as mentioned on each of our conference calls over the past couple of years, we continue to focus on operating efficiencies throughout the company in order to drive significant earnings growth and free cash flow.

We are pleased to have been able to deliver on these goals even without top line momentum. This provides us a great deal of excitement and confidence as we consider OSI’s earnings potential as sales rebound.

I’ll speak to our guidance shortly, but first let me review the financial results of the third quarter of fiscal 2010. Overall net sales for Q3 increased 1% to $145 million led by a 23% increase in our security division sales. Partially offsetting this growth was the continued softness in our healthcare business and the anticipated lower Q3 sales in our optoelectronics business as Q3 in FY09 was an unusually strong quarter in opto primarily associated with strong sales orders from a defense industry related customer.

Due to ongoing [lean] and global supply chain initiatives as well as the product mix our gross margin continued to improve. We achieved a 200 basis point improvement in gross margin during the quarter to 36.6% from 34.6% in the prior year.

We saw margin improvement in both our security division and our healthcare division. Our gross margin typically varies from quarter to quarter as a result of a number of factors including product mix, unit volumes, pricing, inventory reserves, and capacity utilization.

With strong cost discipline now imbedded in the culture of the organization, our SG&A expenses were essentially flat in Q3 versus Q2, and 6% lower for the first nine months compared to the prior year comparable period.

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 in the quarter increased 7% over the prior year to $9.1 million, or 6.3% of overall sales.

We believe these efforts enable the company to be well positioned to capture major opportunities in our core markets in the future. Our effective tax rate for the third quarter was 28.3% and 29.6% for the nine months of fiscal 2010.

Our provision for income taxes is dependent on the mix of income from US and foreign locations, due to tax rate differences among such countries, as well as the impact of permanent taxable differences. As a result of these margin improvement initiatives we reported a significant improvement in our Q3 net income resulted in diluted earnings per share of $0.33 per share compared to $0.15 in the prior year.

Excluding the impact of restructuring and other charges our non-GAAP normalized EPS for Q3 would have been approximately $0.36 per diluted share as compared to $0.24 per diluted share in the prior year. For the first nine months our normalized diluted EPS increased 49% to a record $0.91 per share.

Moving to cash flow, we generated operating cash flow of approximately $16 million during Q3 and $40 million for the first nine months of fiscal 2010 driven by our improved profitability as well as our continued focus on working capital improvement.

For Q3 capital expenditures were $5.5 million, which included initial equipment costs for the Puerto Rico project while depreciation and amortization was $4.7 million. As a result of the strong cash flow we have reduced our debt balance by $14 million in the first nine months of fiscal 2010 and we now have more cash than we do debt.

As mentioned in previous conference calls, generating strong cash flow continues to be a top priority and we are very pleased with the sustained progress we have made in this effort. Turning to our fiscal 2010 guidance, we are anticipating Q4 year over year sales growth of 10% to 20%.

Such guidance does not anticipate any material contribution in fiscal 2010 from the recently announced new security contracts with the Port of Puerto Rico or the airports of Mexico. With improving gross margins and our relentless effort focusing on managing our cost structure we anticipate further improvement in our ability to deliver strong earnings.

And as a result we are increasing our fiscal 2010 EPS guidance to $1.30 to $1.36 per share excluding the impact of restructuring and other charges. This range represent EPS growth of 43% to 50% for the year.

These amounts exclude for purposes of appropriate comparison the impact of restructuring and other charges net of tax. In fiscal 2009 and continuing into fiscal 2010 we undertook decisive and meaningful actions to right size our business in response to economic conditions.

These actions produced strong results in fiscal 2009 and through the first nine months of fiscal 2010 and position us for further earnings leverage. During the past few years we have transformed our company into a consistent performer in a difficult economic environment, we have been able to significantly improve both earnings and cash flow and have built a strong foundation for significant future earnings power.

Thank you for listening to this conference call and at this time we would like to open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Tim Quillin - Stephens Incorporated

Tim Quillin - Stephens Incorporated

Just a couple of questions, I guess one is in terms of the volume of body imaging market if L3, hypothetically let’s say if the next round of orders you get 100 unit order and L3 gets a 200 unit order, is that, do you kind of see that as catch up and then you’ve split the 400 total and maybe go forward you would split orders 50/50, or is there anything to be read if they were to get to larger percent of the next orders.

Deepak Chopra

Number one is we can’t comment on this order. We do know that there were 300 units that TSA let out, and we got 100, intent that is on their TSA site. If you add that to the previous order we got, we have close to 250 units, so we have the largest population and we don’t know what the future split is going to be.

But we are very confident that our technology is well received, our deployment is going well and we plan to actively look at building more and more enhanced features in it and capture our fair share of the business.

Alan Edrick

And I think just to add on, we feel very positive on this market going forward.

Tim Quillin - Stephens Incorporated

What are the puts and takes of the millimeter way versus the backscatter approach to that screening.

Deepak Chopra

There are two different technologies, both show an image. There are different image resolution and both have different ways that the data pick the image so fundamentally new technologies as the deployment goes forward there will be more data coming out which instances which works better.

Tim Quillin - Stephens Incorporated

And would you expect to ship the new 100-unit order by the end of June.

Deepak Chopra

Number one we only have an intent on the TSA website, our capacity and production is capable of handling whatever the TSA requirement is.

Alan Edrick

TSA or any other requirements, we have more than ample capacity to whatever anybody needs.

Tim Quillin - Stephens Incorporated

And just in general is the pipeline on the security side such that you feel comfortable that you’ll build backlog again in the fourth quarter or is it still uncertain at this point.

Deepak Chopra

The backlog went down by approximately 11 to 12 million, a record shipping quarter and the timing change from one quarter to the other, the pipeline activity is very robust, we are chasing a lot of orders both domestically and internationally. So we are very confident that its going to be a good quarter but we really can’t pin this down from quarter to quarter what the exact number is.

Alan Edrick

Depends on timing of some of the larger orders as well.

Tim Quillin - Stephens Incorporated

And then on the healthcare business is there any indications in the current quarter that there’s an improvement or are you seeing any improved order flow after the healthcare legislation was passed maybe providing a little clarity.

Deepak Chopra

Well Q3 as we have said to you before, is historically an weak quarter, Q4 inherently the stronger quarter. So we expect Q4 to be stronger than Q3. I think that we are watching it very carefully. We think its bottomed out. The important thing is that people have this feeling that others are doing better. We don’t have that. All indications we have, we are not losing any orders. There’s only SP erosion.

Most of the other companies like Philips and GE, they are bundle it in their total product line then they report the revenue. Its all bundled in, there’s no separation. We are looking carefully at the monitoring market both domestically and internationally and we feel that bottom has already happened.

Tim Quillin - Stephens Incorporated

And just one detail question, what’s you’re best guess with regards to the tax rate in 4Q.

Alan Edrick

I think you’ll see the best guess is in that 29% to 30% range, plus or minus.

Operator

Your next question comes from the line of Brian Ruttenbur - Morgan Keegan

Brian Ruttenbur - Morgan Keegan

I want to follow-up on some of Tim’s questions, in terms of revenue, on the medical and opto side there was a disappointment obviously this quarter and what Tim asked and I wanted to drill down a little bit more on the medical side, do you think that hospitals are holding off right now because of the healthcare legislation or is it just because they know that you’re going to just [inaudible] in the fourth quarter and have held off for that extra quarter, what do you believe has caused the dip in the third quarter especially when you talk about year over year.

Deepak Chopra

Number one, I’m sure there is something going on for our people up in the hospital procurement cycle, they are waiting. They are prioritizing what they want to buy. They’re watching the healthcare debate to see what’s going to come out of it. We have not seen any price erosion. As a matter of fact our gross margins continue to improve even with reduced revenue.

We think that the general feeling in the marketplace is that the worst is over, flattening out and future looks better.

Brian Ruttenbur - Morgan Keegan

Then why was medical down year over year in terms of revenue.

Deepak Chopra

The thing is to keep in mind that Q3 inherently is down and last year to this year some orders came in, some got delayed so generally speaking we sort of anticipated a weaker quarter but definitely it was worse than what we thought, but going forward we think that our gross margins are leveraging is well suited as the market comes back and we think Q4 will definitely be stronger than Q3, that we capture more profit.

Brian Ruttenbur - Morgan Keegan

How about medical and the fourth quarter can we anticipate flat or slightly up or slightly down, in terms of the medical. When are we going to start seeing I guess the net net is, what quarter how far out before we start seeing medical get flat to up in terms of revenue year over year.

Alan Edrick

We’re anticipating that for Q4 we will see growth in revenue both sequentially as well as year over year. So to your point we think we’ve seen the worst is behind us and we’re going to start seeing both sequential and year over year growth.

Brian Ruttenbur - Morgan Keegan

And how about the same kind of question same line of thought onto optical, are we going to see optical rebound in the fourth quarter in terms of year over year and I would assume sequentially but also most important is year over year comparison.

Alan Edrick

The same answer really holds for opto and I’m referring to third party sales, we’ll take intercompany out of the equation, but third party sales we are anticipating both growth sequentially and year over year for opto in the fourth quarter.

Brian Ruttenbur - Morgan Keegan

So going into beyond fourth quarter do we anticipate for optical and medical to continue to see year over year as you look out beyond the next 60 days.

Deepak Chopra

Well number one we have not built the 2011 model yet, which we plan doing it the end of the next conference call but we today, from what we see and anticipate, we think there’ll be growth definitely in 2011. Just to add onto it, I did say that on the opto side we continue in our endeavor to look at our cost structure in both areas, the healthcare and opto and over the next two to three quarters we are planning to cut down cost which we have started already by another, Alan do you want to comment on how much.

Alan Edrick

Sure, as we’re anticipating revenue growth we’re also working on our overall operating efficiencies and we’re targeting north of $5 million in additional cost savings on an annual basis to take out in Q4 and Q1.

Brian Ruttenbur - Morgan Keegan

And that would be roughly then $5 million of charges too or about half that, is that $5 million annually and can you give us some kind of idea on charges.

Alan Edrick

Sure, its $5 million plus on an annualized basis and the charges associated with that it would probably be closer into the million dollar plus range. But nowhere near 50% of that.

Brian Ruttenbur - Morgan Keegan

And then backlog for security, you may have mentioned it, I just missed it, what part of the backlog was security.

Deepak Chopra

Security backlog we announced was $150.8 million compared to sequentially $163.9.

Operator

Your next question comes from the line of Rick Hoss - Roth Capital Partners

Rick Hoss - Roth Capital Partners

Restructuring for Q4, what do you think the charge is going to be.

Alan Edrick

We anticipate it will be somewhere in the ballpark of $1 million plus or minus.

Rick Hoss - Roth Capital Partners

And then what about next year, is that a million as well, or you were just talking about a million for FY11.

Alan Edrick

The amount I was referring to was for the total savings of $5 million plus that we’re targeting, the total charges will be just over a million dollars. We anticipate most of that will be reported in our fourth quarter with some residual in Q1.

Rick Hoss - Roth Capital Partners

So you’re not really targeting a large restructuring charge then for fiscal 2011 at this point.

Alan Edrick

That is correct.

Rick Hoss - Roth Capital Partners

And then as far as the opto segment its been fairly quiet recently can you give us an appreciation for the opportunities that are out there.

Deepak Chopra

There are two segments, the contract manufacturing which is tied up to some large defense contracts. We have some opportunities in that, some good add-ons still coming in and some new opportunities. In the general opto electronic devices and components, its tied up to the economy and as the economy improves we continue to look at various segments, the segments we are strong in is medical and some [inaudible] equipment and in general purpose electronic devices.

So we think that there are great opportunities in the area. Its very diversified and our own customer base is showing signs of coming back and placing repeat orders.

Rick Hoss - Roth Capital Partners

But there’s still a lot of opportunity on the cost reduction side it appears, if you look at the first quarter of 2008 you have $1.3 million operating income versus this quarter which is kind of comparable so still a lot of work to be had in cutting and reducing the cost structure here.

Deepak Chopra

That’s true.

Operator

Your next question comes from the line of Josephine Millward – Benchmark

Josephine Millward – Benchmark

Can you give us a sense of how much you expect to ship on Puerto Rico in the coming fiscal year and if that’s, before we start seeing that in your, the first quarter of fiscal year 2011.

Alan Edrick

We intend to begin seeing revenues associated with that contract in our first quarter of fiscal 2011. Following the completion of the first quarter we’re likely to give a little bit more input on what the total revenue opportunity is associated with that. At this point in time we haven’t provided what we’re anticipating to be the overall revenues associated with that contract.

Deepak Chopra

Just to add onto it, there is no revenue in this Q4 from the Puerto Rico.

Josephine Millward – Benchmark

Can you talk about whether you expect to sign other, if you’re working on other deals like Puerto Rico and what’s in your pipeline.

Deepak Chopra

Definitely we are working with other folks, but more than that I can’t comment on.

Ajay Mehra

We’re definitely working on places, but from a competitive environment I’m really not going to say anything else on that.

Josephine Millward – Benchmark

On cargo [inaudible] you have two contracts under protest, one is with customs and border protection, the other one is with a state department, can you give us a little more color on how you envision these protests might be resolved.

Deepak Chopra

Well you know that and its always disappointing when this kind of stuff happens, but all we can talk about at this stage is its under protest and it will be unfair for us to comment on it because its an active protest.

Josephine Millward – Benchmark

Do you think we’ll have some kind of resolution in the coming quarter or I guess how long do you think this is going to take for us to have some answers.

Ajay Mehra

I think its an active protest, timing is not all up to us but as and when we have more information I’m sure we’ll provide that to you.

Josephine Millward – Benchmark

In terms of air cargo the deadline is coming up very rapidly in August, but you know, and you have the largest number of equipment on TSA’s qualified [inaudible] list, but we really haven’t seen any meaningful orders, can you talk about the pipeline there and what’s going on.

Deepak Chopra

This question was asked even last conference call, I just want to emphasize that there are 3000 freight forwarders all over America and they buy anywhere from single digit machines to double-digit quantity. So definitely we don’t announce every order and some of them maybe even below our radar screen of announcing.

All we can say is that we do have the maximum number of qualified products on the list and its been a pretty good market and growing for us. On your previous one I just want to make sure that I put it in the right perspective any protest order, things that we are enrolled in, it does not appear in our backlog.

Josephine Millward – Benchmark

It seems like you have received some orders for air cargo, can you just give us a sense of the magnitude, I know there are small orders and you don’t announce all of them, its very hard to quantify this market, if you can give us a range of the kind of business you’re doing in air cargo.

Deepak Chopra

Very difficult.

Ajay Mehra

I think that again for competitive reasons, we’re doing well, there are a lot of single quantity, double quantity orders and I think I’ll leave it at that at this point and maybe we’ll comment on it in subsequent quarters. But right now we are getting orders, we are shipping orders to freight forwarders for the air cargo market.

Deepak Chopra

Just to add on to it, I think this modeling of this business is very different from the [ports]. There are no significant large customers in this market and I don’t think there ever will be. There are 3000 freight forwarders, they are going to continue to buy quantity [inaudible]. There is going to be no one large buy.

Josephine Millward – Benchmark

Nice margin improvement on your security business, do you think that 10% operating margin is sustainable going forward.

Alan Edrick

I think it is on that type of revenue level. I think we’re clearly seeing more and more efficiencies. There will be ebbs and flows at different revenue levels but I think that clearly is the targets that we’re looking at.

Josephine Millward – Benchmark

In terms of R&D what do, do you expect the level to remain pretty steady in fiscal year 2011, how should we think about R&D going forward.

Alan Edrick

We’re going to continue to invest heavily in R&D. As we look to fiscal 2011 we’ll be providing our guidance on our next call but I think its fair to assume that it will probably go up a little bit in absolute dollars and down as a percentage of sales.

Operator

Your next question comes from the line of Michael Kim – Imperial Capital

Michael Kim – Imperial Capital

Just going back to expand on the air cargo side and maybe to ask it a little bit different way, are you seeing the level of aggregate bookings year to date consistent with meaning the type of, or the total activity you would expect to see by the August deadline or are you looking at a fairly substantial ramp here over the next month or two and I wasn’t sure what your lead times were for these systems.

Ajay Mehra

We have ramped up for these systems over the last six months or so and we continue to see activity and orders coming in, what’s going to happen between now and August your guess is as good as mine but at the end of the day we are seeing activity, we are shipping more orders and I think its something you want to continue to watch over the next three, four months.

Deepak Chopra

Just to add onto it, the products that are on that qualified list, we look at that in our standard product portfolio and we can book and ship in the same quarter quite easily. We treat it as standard kind of production environment, there’s no big challenge and as the requirements increase close to August deadline its very easy for us to fill those orders.

Michael Kim – Imperial Capital

And then turning on to the body imaging side, can you talk a little bit about where you’re seeing the strongest international opportunities beyond the TSA’s, is it primarily the Middle East, are you seeing other European opportunities, any color you can provide would be helpful.

Ajay Mehra

I think that obviously internationally we’ve talked about [inaudible] and Manchester, we’ve talked about Nigeria, I guess the best way for me to answer that is that we’re looking at Asia, Africa, Europe, and South America and America. So not to, all joking aside, we are looking at various different countries but really to comment any specifically from a competitive standpoint, I would do it.

Michael Kim – Imperial Capital

And then just looking from a broader perspective given your backlog and where you see bookings is most of the growth drivers for security coming from your cargo and vehicle side or do you see opportunities for conventional systems, how do you see that breaking out.

Ajay Mehra

I think that, we’ve always said that we are the broadest range product line out and as security grows we expect all our product lines to grow. We spent a lot of money in R&D on cargo, on the body scanners, as well as on some of the new products that are coming out, the real time tomography RTT.

So we think that we’re going to see different amounts of growth, maybe in different areas but we’re seeing growth across the board.

Michael Kim – Imperial Capital

And then just on that RTT system, should we expect to see certification within the year or do you have any visibility on how that plays out.

Deepak Chopra

I think that what we have said before there’s no guarantee of the certification but we are anticipating some time in this calendar year.

Michael Kim – Imperial Capital

And then with the award in Mexico are you looking at other prime opportunities, is that model you will be thinking about going forward or would you consider that a fairly unique situation.

Ajay Mehra

I think that we’re looking at other opportunities. Security, the environment is ever changing. There are more opportunities, more different type of opportunities coming up so we learn from what we get and see how we can replicate them going forward.

Michael Kim – Imperial Capital

And then just turning to healthcare in the past you’ve talked about international opportunities particularly with some lower cost solutions, are you seeing international bottoming out as well or is that at a different pace from the domestic market.

Deepak Chopra

Different areas have different levels, we still are very, very positive and boisterous about the emerging markets as those economies are bouncing back faster. Europe is more challenging just like US but we think that all markets are showing all indications are that in 2011 it will be a significant improvement over this year.

Michael Kim – Imperial Capital

And you’re still primarily marketing the lower cost solutions in a lot of the emerging markets.

Deepak Chopra

We’ve always had before we even came up with the lower cost products, we always were selling in the high end, all we have said is we’re going to continue to enhance it by our lower cost products. So, it’s a broad product line.

Michael Kim – Imperial Capital

And in terms of just the current weakness is most of the delayed purchasing on the part of hospitals from US hospitals and to a lesser extent Europe or is it pretty comparable.

Deepak Chopra

Its comparable.

Operator

Your final question comes from the line of Unspecified Analyst

Unspecified Analyst

Forgive my ignorance, is a known question or if its common knowledge concerning your company, but segment by segment the backlog that you have is it letters of intent or is it funded and if it is funded, are there are back out clauses in those contracts.

Alan Edrick

Our backlog consists of firm written purchase orders most of which is deliverable within 12 months. Sure certain contracts would have back out clauses, but historically we’ve seen very few of that so what we reported in our backlog tends to ship and materialize within 12 months.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

Deepak Chopra

In closing I would just like to reiterate the positive results we were able to achieve in the third quarter of fiscal 2010, significant improvement in non-GAAP EPS, $0.36 diluted share in the third quarter when compared to non-GAAP EPS of $0.24 per diluted share in the prior comparable period.

Continued strong cash flow with operating cash flow for the third quarter of $16.5 million. Year to date operating cash flow of $40 million. Company overall backlog of $230 million, up 13% since the beginning of the fiscal year. Increased non-GAAP EPS guidance for fiscal 2010, new range announced today of $1.31 to $1.36 per diluted share.

And improvement of approximately 44% to 50% when compared to non-GAAP EPS of $0.91 for fiscal 2009. Security, we look at continued growth. We think we are confident that Q4 healthcare will be better, 2011 we think that the healthcare will continue to grow. And we continue to make progress improving our gross margin as we’ve demonstrated it and as Alan mentioned we continue to look at taking some cost down in Q4 and Q1 both in the healthcare group and the opto group.

Thank you very much.

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Source: OSI Systems, Inc. F3Q10 (Qtr End 03/31/10) Earnings Call Transcript
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