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Analogic (NASDAQ:ALOG)

Q2 2014 Earnings Call

March 06, 2014 5:00 pm ET

Executives

Mark Namaroff - Director of Investor Relations & Corporate Marketing

James W. Green - Chief Executive Officer, President and Director

Michael L. Levitz - Chief Financial Officer, Senior Vice President and Treasurer

Analysts

Jason Wittes - Brean Capital LLC, Research Division

Lawrence Solow - CJS Securities, Inc.

Jan David Wald - The Benchmark Company, LLC, Research Division

Jiwon Lee - Sidoti & Company, LLC

Operator

Good afternoon, and welcome to Analogic Corporation's Second Quarter Conference Call for Fiscal 2014. The following corporate officers are present: Mr. Jim Green, President and CEO; Mr. Michael Levitz, Senior Vice President, CFO and Treasurer; and Mr. John Fry, Senior Vice President and General Counsel.

I'd like to remind everyone that a supplementary presentation will be used during today's call. If you have not already downloaded that presentation, you can do so at any time at investor.analogic.com. Again, that is investor.analogic.com. That presentation will remain available until April 6, 2014.

I'd like to now turn the conference over to Mark Namaroff, Director of Investor Relations. Sir, please begin.

Mark Namaroff

Good afternoon, everyone, and welcome to Analogic's second quarter conference call for fiscal 2014. I'm sure all of you have downloaded our press release issued earlier today describing our results for our second quarter. If not, you could do so via our website at investor.analogic.com.

[Operator Instructions] And now before I turn the call over to Jim Green and Mike Levitz to review our second quarter results, I'd like to remind everyone that today's call may be -- may include forward-looking statements, such as comments about our plans, expectations and projections. For more information on risks and other factors that could cause our actual results to differ significantly from our forward-looking statements, please refer to our most recent Form 10-K and 10-Q reports on file with the SEC.

Also, on today's call, we will be discussing certain financial measures not prepared in accordance with Generally Accepted Accounting Principles or GAAP. We believe that using non-GAAP metrics provide investors a more thorough understanding of our business. An explanation and a reconciliation of our non-GAAP financial measures are provided at the end of the presentation and in our second quarter press release.

And now I'd like to turn the call over to Jim Green, our President and CEO.

James W. Green

Thanks, Mark. Good evening, everybody. Let's move to Slide 4 of the presentation. We'll get started. The usual, I'll start with taking a quick high-level look at the latest quarter. And then we'll look at each of the 3 primary reporting segments, and within each segment give a clear view of how we see the market environment around us.

Let me start by saying, and to fully understand Analogic, it's important to keep focus on the underlying core revenues of the company as representative of our underlying health and our outlook. Our stated strategies rely on developing our own technologies and product platforms where we control our destiny and drive profitable growth. So you'll hear Mike and I increasingly reference product revenues separate from customer-funded engineering revenues, which sometimes cloud our underlying trends.

So now looking to the quarter. In the quarter, we had total revenue of $141 million. That's up 2% from last year. Importantly, we saw solid growth in our core product revenues. Our total revenues include the exit of patient monitoring and certain nonstrategic OEM ultrasound probes.

We also saw lower customer-funded engineering that Mike and I will describe in more detail in a few minutes. Gross margin improved to 43%. That's up 3 points, supported by higher margin mix as the higher shifts to ultrasound and security.

Our GAAP operating measured 9%. That's down 1 point from last year, with a 1.5 point impact of severance and acquisition-related charges. Non-GAAP operating margin came in at 13.5% and did include a 1-point charge for severances.

GAAP earnings per share measured $1.53%. That's up $0.75, but it did include a $0.69 one-time tax benefit. Our non-GAAP EPS improved to $1.17 a share. That's up $0.12. And remember that both our GAAP and non-GAAP EPS included severance-related charges in the quarter.

Finally, our operating cash flows were over $14 million.

Move to Slide 5. We'll take a look at the business highlights. Ultrasound revenue was roughly flat, though we continued to shift to our direct sales, which were up mid-teens from prior year. North America was very strong, came in at 24% growth year-over-year. However, our direct European sales were down 18% on challenges in the European healthcare market.

China direct was up strong. Now the big drag we've had in overall ultrasound has been in OEM probe sales, which we expected based on our direct sales focus for the business. Probes are down 50%, and they include the exit from some nonstrategic legacy lines. The good news is the drag annualizes and stabilizes in our next quarter. And the probe revenue is now under 15% of our total Ultrasound segment.

I'm excited to announce that we've submitted to the FDA for U.S. sales clearance of our new breakthrough realtime handheld ultrasound technology and product called the Sonic Window. This represents a market need for technology that we hope to prove provides better outcomes with lower overall costs and a lower cost setting. And we plan to launch the product this summer.

Security sales were up 25%. We saw increased demand across both medium and high-speed applications. And we're also pleased to see that the U.S. Department of Defense expects to make some decisions about Rapid DNA this summer, and we think our system was in a real good position.

We move on to Slide 6 and onto Medical Imaging. Medical Imaging revenue recovered from last quarter despite challenges in the market. We saw mid-single digit revenue -- mid-single digit product revenue growth across all 3 imaging technologies. We did experience a year-over-year drag from the exit of the legacy patient monitoring. Now that's going to annualize as we get through the finish of this year.

We also include a measurable reduction in external engineering funding. Let's not forget that leveraging our platforms supports our growth, improves our pricing and our margin opportunities.

Now, I want to take a minute and talk about what's happening in the market environment. We don't -- we operate inside of a market with less of effects in a number of places where we had exposure. In the U.S., the U.S. healthcare market still remains uncertain. And the Affordable Care Act, in time, it's expected to add more insured lives and eventually, help grow procedures that requires our products.

The European healthcare markets are still struggling from various austerity measures, and emergency markets are growing slower. As an example, Russia has dropped dramatically. And some countries such as France, seem to have delayed or deferred their annual tenders for a substantial portion of Medical Imaging equipment.

Large OEM medical companies are signaling similar near-term healthcare market challenges in Diagnostic Imaging in both Europe and emerging markets, with CT being especially hit hard.

In the U.S. medium-speed security market, the pace of recapitalization is slower than TSA originally signaled.

So we've seen some delays in airport tenders for large high-speed systems. We're very excited about the long-term growth of the high-speed international segment. To mention, some upcoming examples include Heathrow, Singapore and France, where between them, they represent over 200 high-speed systems that should come in to tender process here in the near future.

Okay. With that, I'll turn it over to Mike to go through some of the details on the financials. Mike?

Michael L. Levitz

Thank you, Jim, and good evening, everyone. I'm going to walk you through the financial performance in the second quarter, beginning with the performance highlights on Slide 7 of our online presentation. As Jim mentioned, our revenues in the second grew 2% from the same period last year to $141 million. That was on 5% net growth in product revenue. And that included a 3 percentage point unfavorable impact of the exit from our legacy patient monitoring product line. This strong product revenue growth was offset by lower engineering revenue in the quarter, which I will describe to you in a bit more detail shortly.

We were pleased to deliver a 3-point improvement in gross margin in the second quarter to 43% on a GAAP basis and 44% on a non-GAAP basis. This improvement was driven by a more favorable mix of sales through our direct channel, favorable pricing, as well as cost improvements, including the benefit of increasing volume at our manufacturing facility in Shanghai.

Due largely to the lower customer funded engineering revenue, during the second quarter, we proactively reduced our headcount, which resulted in a severance charge of $1.2 million in the quarter. This charge was not defined as restructuring-related and is included in both our GAAP and non-GAAP results. We expect this and related cost reductions to reduce our run rate spending by approximately $4 million annually.

On a GAAP basis, our operating income and operating margin decreased slightly in the quarter. And on a non-GAAP basis, our operating income and margin were both roughly consistent in the quarters compared to the same period last year at approximately $19 million and 13.5%, respectively.

If you would turn to Slide 8 and our P&L for the quarter. As you can see in the revenue section, our product revenues increased 5% in the second quarter. Again, this is net of a 3 percentage point unfavorable impact of our exit at the beginning of this fiscal year from our legacy patient monitoring product line. The growth in product revenue was also offset by a reduction in engineering revenue. And that's largely a result of the completion of key projects as of the end of last fiscal year, where those products that were being engineered will be introduced into production in a future period, as well as our increased focus on leveraging technologies and product platforms across our business.

The impact of the lower customer funded engineering not only resulted in a reduction to revenues, but also a corresponding increase in operating expenses, as our engineering team focused on internal initiatives, and the cost of this work is therefore reflected within our research and development expense in OpEx.

Our overall operating expenses also increased in the quarter as compared to the same quarter last year due to the cost of Ultrasonix operations included following the acquisition of Ultrasonix this past March. We expect operating expenses to be lower in the second half of this year as we complete and begin to see savings related to the closure of our manufacturing operations in Denver and Vancouver as part of our previously announced ultrasound manufacturing consolidation, as well as due to a lower cost following the headcount reduction we've taken in the second quarter.

During the second quarter, we also recorded favorable tax benefits that resulted in a net P&L income tax benefit as reflected in our GAAP result. This included an $8.8 million nonrecurring discrete tax benefit, primarily related to a reduction in taxes expected to be paid in the future, following a change in brands classification for one of our Canadian operation. We excluded this benefit from our non-GAAP results.

In addition, we closed out an IRS audit during the second quarter and recorded a related discrete tax benefit of $900,000. And that has been included in both our GAAP and non-GAAP results consistent with similar discrete items in prior period.

Together, we expect these activities to provide ongoing tax savings, with expected P&L savings of approximately $1 million each year going forward.

And we now expect our effective tax rate for the remainder of this year to be lower than we've signaled before and before discrete items to be between 28% to 29%.

Now turning to Slide 9 and our year-to-date results. For the first half of the year, we saw a 1% growth in product sales, and that included the 3 percentage point unfavorable impact from exiting the legacy patient monitoring product line.

However, the product revenue in the first of the year was offset by lower engineering revenues, as we described for the second quarter. At the same time, we saw strong 2-point improvement in gross margin on this transition to higher gross margin product revenues from engineering revenues, as well as favorable pricing, product mix and the benefit of cost reduction. With the cost reductions that we've taken in the second quarter, we expect operating margin to continue to improve in the second half of this fiscal year.

Now if you would turn to Slide 10, I'll discuss our operating performance by segment. Our Medical Imaging segment revenue totaled $80 million in the quarter. That was up $20 million from the first quarter this fiscal year, but down 1% from the same quarter last year.

Product revenue in this segment grew 1%, as compared to the same quarter last year, our mid-single-digit growth in our core product lines of CT, MRI and mammography, offset by a 6% point unfavorable impact on this segment of the exit of our patient monitoring business. The product revenue growth was offset by lower customer-funded engineering. At the same time, our non-GAAP operating margin improved 2 points to 16.6% due to the favorable pricing mix and cost reductions, including the benefit from the continued ramp-up of our Shanghai facility.

Our Ultrasound segment revenue was roughly flat in the second quarter with the same quarter last year, as solid double-digit sales growth in our direct channel was offset by a significant reduction in sales of our OEM ultrasound probes, which we believe has now stabilized at just below 15% of our ultrasound revenues.

The solid double-digit growth in our direct channel sales reflected double-digit growth in North America and China, including sales of products obtained as part of our acquisition of Ultrasonix last March, offset by a significant reduction in our European sales due to challenging market local conditions, local market conditions as Jim described.

Our ultrasound operating margin decreased compared to last fiscal year as we continue to invest and fund the transition of this segment towards expansion of our direct channel business. It's in line with our strategy for longer-term increased growth and profitability. Our results in the second quarter continued to reflect the cost of redundant manufacturing operations in Denver and Vancouver. That said, we successfully closed the Denver facility on schedule, towards the end of the second quarter, and we remain on schedule to close our manufacturing operations in Vancouver by the end of this fiscal year. We expect to benefit of these facility reductions to begin to be realized over the next 4 quarters.

As part of this transformation towards the direct business, our comps also include an investment in our point-of-care sales force as we expand our presence in that market. We expect the operating result in Ultrasound segment to improve further as these sales reps, many of which were hired in the last 6 -- 6 to 9 months to continue to progress towards quota.

Finally, our Security business grew 25% due to strong product sales of both medium and high-speed checked baggage scanners, partially offset by lower engineering revenues as our newer products move into production. Our non-GAAP operating margin in this segment increased 2 points to 16% in the second quarter as compared to the same period last year on the growth in sales and favorable mix.

Please turn to Slide 11, where you can see our working capital and cash flow. Our cash balance grew $6 million to $111 million at the end of the second quarter on $14.5 million in operating cash flows and lower capital spending as compared to last year as we continue our plan to increase in free cash flows.

In summary, the second quarter of fiscal 2014 was a solid recovery from the first quarter of this fiscal year, with above-market underlying product revenue growth, continued investment in our future and favorable tax. We delivered a strong increase in gross margin in line with our strategy for profitability expansion. And we took action to mitigate the unfavorable impact of lower customer-funded engineering with the cost reductions we made during the second quarter. We delivered strong cash flows, continue to have a strong balance sheet and remained focused on performance over the full fiscal year and beyond, driving growth and managing cost.

Thank you very much. And now, Jim will walk you through the fiscal 2014 outlook.

James W. Green

Thanks, Mike. So move to Slide 12 and look -- in summary, let me just say, in spite of a tough Q1 and market headwinds, we -- as we look at the business and we look at our underlying product revenues, we still see solid underlying growth in these product revenues throughout the remainder of the year.

Looking at each segment, starting with Medical Imaging. For the year, we see an upper mid-single digit decline as the recovery is now not expected to overcome the weak Q1. When I look inside Medical Imaging, our core product revenues, they still grow in the mid-single digit region through the second half. Now our growth in this space will be impacted by the exit of patient monitoring and lower funded engineering.

And we continue to invest, our investment in new platforms that launch later this year, are going to drive growth late in the fiscal year and support our long-term growth plans.

So look to Ultrasound. We continue our expansion strategy, delivering solid double-digit growth for the year. Our expanded surgery, urology and point-of-care sales reps continue to move to quota. Our projected growth is in spite of the drag from lower sales of OEM probes, which thankfully is going to annualize as we get to next quarter.

And we continue to invest in new-generation guidance technologies and are incredibly excited about the new Sonic Window product.

Security is expected to be roughly flat, impacted by reduced funded engineering and timing in some of the delays on various airport tenders that are upcoming.

The international high-speed segment continues to develop with several large airport tenders in process. We expect slower U.S. replacement with modest incremental growth in the mid-speed shipments here in the near term.

It's nice to see that Rapid DNA is entering the early stages of adoption, and we are really excited about the long-term growth opportunities in this new space.

To summarize, with solid underlying product revenue growth and exciting new products launching, we remain bullish on our long-term profitable growth strategy and trajectory. However, in this year, while our Medical Imaging business recovered from a difficult first quarter, and with the headwinds in our markets, we now expect fiscal 2014 total revenue and operating margin to be roughly flat with fiscal 2013.

Now we'll open the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Jason Wittes with Brean.

Jason Wittes - Brean Capital LLC, Research Division

Just want to kind of quickly run through the divisions and get a little bit of color. First off, with Medical Imaging, I know that you do have several, I would say, big-ticket products hitting this year, I think, almost full gantry systems. Are they -- is that kind of the driver in the second half that you're talking about, are those going to be -- have a minimal impact on 2014?

James W. Green

I see those -- these new higher content systems as having not much impact in 2014, but we do expect to start to shift in production late in 2014. But they really become an underpinning for our growth as we look forward.

Jason Wittes - Brean Capital LLC, Research Division

And then in terms of just the general macro environment, do you have any expectation as to how long that -- its apparent down-cycle might run through and impact the Medical Imaging business?

James W. Green

Yes, we look at it and we listen and work pretty close with our big OEM providers who have also substantial exposure worldwide. And the general belief is that on the -- there's a number of things that are going to shake out over the next 12, maybe 18 months, with the Affordable Care Act here in the States. Most of us feel that it's fairly stable now, but we don't expect to see growth in the U.S. because there's just a lot of unknown there. But as the insurance does start to expand across the 30 or so million people that are still expected to now become part of the insured lives, that should start to give us an overall growth factor. But that's certainly going to be -- that's going to play out over the next few quarters. Europe has been through a lot with the austerity situation. And we all saw from our side, we saw something like an 18% downturn in the European business of ours. And we heard very clearly from the big players who have, again, a lot of exposure there that they all saw pretty steep, from our perspective, dropoff in orders in Europe. Now some of that's Russia, some of that we know in certain countries like France. And in some of the Benelux countries, we're seeing just a dramatic delay in when they author -- when they offer the tenders. And we also saw in a couple of southern European countries where the tenders were offered, the deals were sold or the deals were accepted, but then the government's decided not to -- to delay funding on some of it. So Europe, there's some headwinds there a little bit and certainly, some unknown there. So I think from our perspective, as we look at Medical Imaging and the Diagnostic Imaging space, we expect that to be pressured for a while. Now what helps us is as we expand with our R&D investment, we're adding new products, growing share and expanding to help at least tread water in that space. That's why we're saying our underlying product revenues is there, we continue to see growth in that space, though not substantial growth like we see in some of our other spaces like Ultrasound. But certainly, that's going to be an issue for a little while.

Jason Wittes - Brean Capital LLC, Research Division

Okay, that's clear. And then on Security, my understanding last quarter was that the TSA had kind of already signaled they were delaying the replacement cycle. It sounds like you've gotten more data and, I guess, you're saying there's a little more delay even than you thought on the first quarter or am I misreading that?

James W. Green

Well, I think we've been looking at this in the longer run as being a great opportunity for some real incremental growth when you look at just the number of sockets and the number of units that are going to go through replacements. But with the government shutdown, certainly, that caused -- it doesn't -- it's not a linear delay of day-for-day. When they shut down, it takes a while for them to get back together. But certainly, the pressures with the government budgets is they're trying to see if they can delay adopting new systems as they can. Now we know that as these systems reach a certain age, they're going to have some extended life potential, but they're going to have to go through replacement. But any way you look at it, we're just expecting that, that ramp is going to be a little slower than they had told us in the past. I think it's just prudent planning. We do expect it to be incremental growth for us, but we're not expecting it to be substantial here in the short term.

Jason Wittes - Brean Capital LLC, Research Division

Okay, that's clear. And then I -- just real quick on the OE, and I'll jump off. The OEM probes -- basically, you're assuming that, that business stabilizes in Q3. And I know that was somewhat of planned obsolescence on your part given your shift towards more direct sales?

James W. Green

Yes, that's right. If you go back even a few years, the OEM probes could have -- was rough. It could have been 30% -- 25%, 30% of the ultrasound total revenues. That's now dropped as we expected and planned down to under 15%. So it's much less of a drag. And again, since it annualizes, it stabilizes and we won't see it as a year-over-year, quarter-over-quarter drag. It becomes just a lower consistent part of our revenue stream.

Jason Wittes - Brean Capital LLC, Research Division

Do you guys have any kind of estimate in terms of what the drag was for this year related to the OEM probe business?

James W. Green

I don't know. Mike, do you have a rough feel on that?

Michael L. Levitz

I guess the way I describe it is that we've seen the growth in direct business now that we've moved forward with Ultrasonix. That is at least offset that. So it really accelerated our transition from the OEM side to the direct. And so -- and as we replace lower margin products with much better higher margin products at a better sale price and a sale point, you know that conversion really helps drive not just the growth, but profitable growth. And now with the stabilization of probes, we're not going to see that drag going forward.

Operator

Our next question comes from Larry Solow, CJS Securities.

Lawrence Solow - CJS Securities, Inc.

Just taking a step back. Just globally, it sounds like a lot of the things qualitatively you've already discussed, but it looks like the macro environment has gotten somewhat worse just on the medical side in Europe and the deceleration in emerging markets. And then it sounds like the customer-funded engineering revenue, although you had signaled it was going to be lower, sounds like it's even lower than you thought, which drove you -- make some corresponding cost cuts. Is that fair to say?

James W. Green

Yes, it is. And also, I think there were some funded projects that we decided not to take. And some funded projects that, from a timing perspective, just didn't come in exactly the same time. But in general, it is absolutely following the trajectory that we had expected. And if you look at the company 7 or 8 years ago or 6 years ago, the funded engineering, which I would call almost more like engineering services, were somebody would pay us to do something and build one of them or to build just in it would be limited to their sale. It wasn't a good, strategic leveraging type of capability for us. And so as a percent of our total revenue, it was, and you go back a few years, it was probably north of 10% of total revenue. Now it's a much, much smaller number, and it's down to just -- it's something that we can manage around now. But we did need to take some cost reductions because our plan is when this kind of deals do come in because they're lumpy and they can hide underlying trends for us to work toward a more variable structure where we could bring in temporary type of support or contract to handle those and not have it cause such ups and downs in our base numbers.

Lawrence Solow - CJS Securities, Inc.

Okay. So it sounds like then the real change is not really engineering revenue, but more just because you already expected that, more the macro environment and more Europe and emerging markets because I thought of the U.S. you already thought was going to be sort of flat right this year?

James W. Green

That's right, that's right. And in fact, we had thought with Q1, we had a pretty harsh Q1 in Medical Imaging, and I think we were down maybe $20 million or so. But we had expected that into some -- because we do look through to our -- see the demand from our customers. We expected that to push into the next 3 or 4 quarters, but -- and it did, but as you would -- but what we didn't expect is with the downturn in Europe, with what's happening in Russia and some of these countries, that underlying expected growth there dropped enough to -- so that we couldn't make it all back in the year. So that's why Medical Imaging, we're suggesting we're going to be down from flat to maybe down 6%, 7% in that segment. But of course, that does include the products that we shifted out of, for instance, patient monitoring. I think if you take out patient monitoring and some of the things we've obsoleted, the underlying pure product revenues are still growing.

Lawrence Solow - CJS Securities, Inc.

Right. And on that note, I think at the Analyst Day, you thought maybe Medical Imaging could sort of return back to a mid to high single-digit growth, more along with the procedures, or are we seeing mid-single digit growth looking out over '15, '16. Are you a little bit more weary of that? And the follow-on to that is some of the -- you expect mid-single digit growth in the back half of the year, but not helped new product launches. Are some of those launches being delayed more that you expected some to come in '14 or was that already in your expectations?

James W. Green

I think your point is exactly right. We had thought and felt that just the underlying fundamental market that we should be in that kind of mid-single digit growth. But with what's going on recently, it's probably more near term in our thoughts as far as some of the potential impacts there. But again now, if you look at the underlying growth rate and you take out the one-times and what we designed out of, we're not far off of that number now anyway. So we're roughly kind of running at that mid-single on a product revenue basis. So I think that, at least in my perspective, that's a fair target expectation for that market. We don't see it as a big growth market. We do see it as at least kind of an underpinned slower growth market. And our big growers are in our direct Ultrasound and in our Security long-term business.

Lawrence Solow - CJS Securities, Inc.

Right, right, okay. And then just on the positive side, the PocketSonics filing, I guess, that was in January. So you're expecting an approval and launch, I guess, it sounds like, by the summer. Are you incorporating any sales in that or do you think it's going to be sort of a slow launch as you educate the market with a completely new technology?

James W. Green

Yes, well, it's starts on a -- at a point 0. So from there, we certainly see -- we have very high expectations for this. And it will be what I would expect to augment our growth trajectory in the ultrasound space. That will be the primary side. So that -- it will add to our growth rate not so much in this year. It'll start at a fairly low level in '15, but that's where we expect some very nice acceleration. But given the size that we have, it -- but it will. We do expect it to be enough to move at least the growth vector and the slope of that curve.

Lawrence Solow - CJS Securities, Inc.

Right. And that would be beginning in fiscal '15?

Michael L. Levitz

That's right. Beginning fiscal '15, we start to really see the numbers growing there.

Lawrence Solow - CJS Securities, Inc.

Okay. And then just lastly, on the Rapid DNA and a decision expected by the government. Is the decision sort of your product versus a competing product or is it sort of just to move ahead on the whole Rapid DNA expansion within the U.S.?

James W. Green

Yes, well, there's a couple of pieces to the Rapid DNA. One is GE is already repping this product for police stations for use in policing-type operations. Now the government that's being -- that is looking at the product separately through our partner, who's developing a direct contract with the government, and that's with Department of Homeland Security and Department of Defense, they're looking at it in a slightly expanded and different way. And that's what was in the USA Today article that we referenced. And that's a kind of a runoff of a couple or, I don't know the exact number, 2 or 3 maybe different companies that are trying to vie for that business. We believe that our product is very, very well positioned to win this. Now probably, the bigger unknown is with the government comes the timing. But we do expect to see this starting to sell here as we get to this -- into our fiscal. Even this year, we're already starting to sell some in small quantities. But as things start to pick up, and we look forward, there's just a very big potential market for this if it can clear legal and social and other types of hurdles.

Lawrence Solow - CJS Securities, Inc.

And the GE product, that is your product, right? That's a product you're in?

James W. Green

Yes, it is. We've teamed with NetBio and its repped and as a private label with GE.

Operator

Our next question comes from Jan Wald, Benchmark Company.

Jan David Wald - The Benchmark Company, LLC, Research Division

I guess, I have a few questions left after all the ones that had been -- that you've had to take already. My sense is your visibility is pretty good into the next 3 months and not much worse for the next 6 -- for the next 3 months, but then it degrades over time. So were you surprised by what happened? In other words, do the OEMs that you -- are building your estimates for sales on -- surprise you in the last 3 months? Or have you seen anything for the next 3, 6, 9 months that surprised you?

James W. Green

I would say that they surprised us some. We expected -- we knew the timing issue with Q1 because the demands, we were in the middle of a number of deals that were going through. And with large ticket items, they can move the needle. But when the underlying growth vector dropped, and we saw why, and that was a bit of a surprise. And when something significant happens like in the -- we wouldn't have expected entire countries in Europe to delay or defer their annual or semiannual tender offerings. That -- I mean, that had a pretty substantial effect, and it certainly did on our big OEM customers. But we saw it directly with our direct sales in Europe because that's -- we have substantial direct sales operation for our Ultrasound business in Europe. Now thank god we don't have substantial growth in North America to more than offset it, but that really hit everybody pretty straightforward and immediate. So yes, I mean, that was a surprise now. So we've readjusted that. We've looked at and talked with our customers. We're paying very keen attention to what they're saying and seeing in their order outlook, in their order book, and then in what they're saying about the marketplace. And everybody's playing -- pays a lot of attention to the timing of tenders with these large single buyers in many countries outside the U.S.

Jan David Wald - The Benchmark Company, LLC, Research Division

And, I guess, this is an unfair question to ask, but do you feel like -- do you expect to be surprised more or do you think you've got a handle on what the market's going to look like at least for the rest of this calendar year?

James W. Green

Well, I think we're -- we took our expectation down pretty hard for this calendar year. And I'd say that we're pretty confident for this calendar year, but as we get out much past that, we're all crossing our fingers and hoping that a couple of things really do stabilize, namely the Affordable Care Act starts pulling people in. That should start to drive upward, bend the curve growth up. And Europe should stabilize. At least what we're hearing on the broad economic side of Europe is that things are stabilizing, and then it's just a matter of time now how and when that transitions into the medical equipment side of the marketplace.

Jan David Wald - The Benchmark Company, LLC, Research Division

Okay. And I guess, shifting gears a little bit. You had lower customer-funded engineering this quarter. And it sounds as if you expect that to continue and maybe even want it because of the -- your strategy to go higher -- to provide higher value capability to the OEMs. How do we understand that? I mean, do we -- are we -- should we expect to see lower customer-funded engineering in the future and R&D go up because of that and margins be affected? How do we understand that? Or is this just a short-term phenomenon?

James W. Green

That's a great question. And that's why we're trying to give a better underlying view of the product revenues because that's the real measure of the health. Our engineering revenues, if you go back a few years there, they were $25 million, $30 million a year. Now we're probably closer to $10 million a year. So it's not such a big number that it becomes a big drag. But strategically, when we design the product ourselves and then we know if we get full rights to leverage it across multiple OEM customers, that's part of why you see our gross margins moving up so strongly. I mean, we were at 43% gross margin this quarter and we expect to stay at higher levels like this. So that's part of what makes that happen. We get better pricing. We maintain better gross margins and then, of course, turns into better operating margins. And if I can lever across multiple OEM customers, then I can get much more exposure worldwide and not be -- have such limitations to a particular customer in their particular segment. So expect that to stay down. Maybe it will drop -- move up or down a little bit, but I don't expect it to grow. But also, you noticed that we're taking cost actions because I can't carry a higher cost basis with that, and I shouldn't. Our targets have been to be down around maybe 11% of revenue for R&D. And then when a lump of a new project does come in, if we choose to have it funded externally, I'd like to have that be more variable, the cost side of that, and look to get some contracts in place to bring on temporarily help to do that as opposed to hire and fire.

Jan David Wald - The Benchmark Company, LLC, Research Division

Okay. And, I guess, one last question. Just in the Ultrasound business, I guess, I wasn't surprised as to what happened in the Medical Imaging portion of your business in Europe, especially. But in the Ultrasound business where you're not necessarily selling into capital -- well, you're not necessarily selling to hospitals that have a capital requirement and hurdle that you have to get over, you could sell into individual practices and stuff. You still saw a decline. Do you think -- or did you see a decline in that part of your business? And if so, do you think that'll be short term or a long-term trend?

James W. Green

Yes. Well, first of all, to clear that up, it is a capital purchase. It is to primary acute care centers. So it does, as far as the initial products sell, it is into that same market. We don't do -- our sales into physician offices is actually quite low. We are primarily at high-end hospitals, and we do have exposure worldwide. And the down -- the drag we saw this quarter in Europe with some of our customers, we saw it ourselves very clearly. I mean, I said we had an 18% drop in revenue in that segment for Europe. So now we do expect that's going to come back. Our outlook and expectations is set, the tenders that we responded to where we got the deals that they're going to come through, that they're going come through, that they're going to take the equipment and they're going to pay us. But we do expect that there could be some lumpiness and delays in that. And we also expect that countries like France will start buying equipment. They're not going to let it -- the companies want it, doctors want it, hospitals want it. And if they get through -- as they get their funding straightened out, that's not going to stop. That's going to come back. And again, this is more on timing.

Operator

[Operator Instructions] Our next question comes from Jiwon Lee, Sidoti & Company.

Jiwon Lee - Sidoti & Company, LLC

Jim, answered my question on the gross margins. So I just wanted to talk a little bit about your sort of a goal or expectations for the operating margin in terms of the dollars for the second half, with the mix that you're anticipating now.

Michael L. Levitz

So Jiwon, it's Mike. So the guidance that Jim gave is that we expect that the revenues and operating margins will be roughly flat with last year.

James W. Green

Yes, and I think that what you can take out of that, if you do math, with Q1 being so harsh, you would expect, and we expect the second half to be strong. We expect that there's solid underlying product revenue growth, and there is significant operating leverage on that revenue -- on that higher revenue stream and on that growth. And you also noticed, in the meantime, we took further cost of reducing our overall cost of infrastructure with the shutting down of the Denver facility. Those costs are going -- also continue to help improve our operating leverage in the second half and going forward.

Jiwon Lee - Sidoti & Company, LLC

Okay. So staying on the R&D side then, with the new product initiatives and other things going on, it's kind of spiked up. Is that sort of kind of the expectation because that's kind of how the math work out, if you're maintaining that gross margin goal and the operating expenses goal. Did I read that correctly?

Michael L. Levitz

Yes, Jiwon, one of the things to keep in mind is when we get lower funded, customer funded engineering, those costs -- let's say we keep headcount flat as an example. The cost of those engineers moved from being up in revenue with the cost of revenue to being back in our R&D line. And so when we get lower funded engineering, it looks like our R&D spending is going up even when our R&D spending may very well be flat. And so that was one of the reasons why, and in fact, one of the key reasons why we took the cost reductions that we did, as I mentioned a little bit earlier, is when that funded engineering came down. And again, we're not just going to take funded engineering that doesn't fit within our strategy for growth and profitability. And so when that came down, we took action to reduce that spend. So we do expect the R&D expenses to continue to move towards our targets that we've talked before towards 11% of revenue. And that's for the self-funded R&D. But there's a timing and component to how quickly those costs go down relative to the level of funded R&D. But we are focused on continuing to drive operating margin, improvement in line with the targets that we've talked about in the past.

Jiwon Lee - Sidoti & Company, LLC

That's right, my bad. And just kind of moving onto the ultrasound, then. How much of an operating margin from that segment alone can you expect, with the consolidation going on and, hopefully, the revenue ticking up in the second half?

James W. Green

I think just in general with ultrasound, certainly, it's our best gross margin product line and segment. And as the costs continue to come down, the only reason for that area, for that division not to become dramatically more profitable is as we bake investments in some of the new products, but more in our distribution structure. We spent quite a bit to build out our distribution channel. But most of that's in pretty good shape now. I'm not -- I don't see major expansions required at this point. It's more maintenance. But certainly, that market or that segment is going to continue to become more and more profitable as we look forward. And in the past, we've said that a technology like this certainly should be shooting well into the teens, if not high teens as we look to the long run in that segment.

Operator

There are no further questions at this time. I will now turn the call back over to Mr. Green for closing comments.

James W. Green

Let me say thank you for dialing in and listening to our quarterly statement. Thank you for your interest in Analogic. And we invite you to call in again in June when the company will review our third quarter fiscal 2014 results. Thank you, and have a good evening.

Operator

Thank you. For listeners who may have come in late, this call has been recorded. You can access the telephone replay by dialing 1 (877) 919-4059 or for international callers, 1 (334) 323-7226 and entering pass code 83477396. The telephone replay will be available at that number beginning 2 hours from now and running through midnight Eastern Time, Sunday, April 6, 2014. The webcast replay will be available on the Investor Relations page of our website at www.analogic.com, beginning about 3 hours from now and will be available through Sunday, April 6, 2014. Thank you for joining Analogic Corporation's Second Quarter Earnings Conference Call. You may now disconnect.

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