OSI Systems - Great Business, Limited Appeal After Multi-Year Momentum

Sep. 3.14 | About: OSI Systems, (OSIS)


OSI Systems continues to grow at an impressive pace.

As earnings have been stagnant recently, the valuation multiples have increased thanks to continued share momentum.

Despite the growth and the strong balance sheet, I am cautious at 25 times forward GAAP earnings.

Investors in OSI Systems (NASDAQ:OSIS) have nearly recovered the steep losses which the stock faced at the start of the year.

The conglomerate consisting out of its security business, the healthcare operations and the optoelectronics business has demonstrated healthy growth over the past decade, spurring strong momentum in recent years.

Fourth Quarter Headlines

Back in August, OSI Systems posted fourth quarter sales of $260.1 million, a 14.1% increase compared to the year before.

On the back of the reported growth in topline sales, earnings have enjoyed a big boom as well. Net earnings came in at $22.1 million, a nearly 87% improvement compared to the year before.

Amidst a flattish outstanding share base, earnings improved to $1.07 per share.

A Look At The Performance

CEO Deepak Chopra was happy with the sales growth which was led by the security business and strong bookings related to Foreign Military Sales contract from the US Department of Defense.

The security group business posted sales of $141.7 million which is a very steep increase of more than 45% compared to last year. At the same time operating margins fell to 13.1% of sales which is down some 170 basis points compared to the year before.

The optoelectronics and manufacturing segment posted sales of $70.5 million, not even a percent increase compared to the year before. Operating margins fell slightly to 6.2% of sales which was down some 40 basis points versus last year.

The healthcare group was the weakest link, posting a more than 15% fall in sales to $61.2 million. Margins have been under pressure as well, being down 330 basis points to 11.7% of sales.

The shift in the relative performance of the separate segments had a big impact on the overall margin profile of the company. OSI reported gross margins of 32.9% of sales which is down significantly from the 38.2% margins reported last year. This was offset by very strong cost control in operating expenses which totaled 21.1% of sales, down 560 basis points compared to the year before.

Overall, operating margins saw a modest boost from these shifts as net earnings saw a big boost from an effective tax rate which fell to 25.5% of operating income. This came after last year's excessive effective tax rate of 52.7%.

Another Year Of Growth Predicted

For the upcoming fiscal year of 2015, sales are seen between $960 and $985 million.

Significant sales leverage is anticipated with earnings seen 12-20% higher on a per share basis, as earnings are forecasted to come in between $3.50 and $3.75 per share. This guidance excludes one-time items including restructuring charges and is a non-GAAP earnings metric.

Note that for 2014 OSI posted net earnings of $47.9 million on adjusted earnings of $64.3 million. Applying the similar 25% discount to non-GAAP earnings would result in anticipated GAAP earnings of $2.70-$2.75 per share for 2015.

Solid Balance Sheet, What About The Valuation?

At the end of the quarter, OSI held some $39 million in cash and equivalents while it has a similar amount outstanding in debt. This results in a rather flattish net cash position.

With 20.6 million shares outstanding, which are now trading at nearly $70 per share, equity in the business is valued at $1.44 billion.

For the entire past fiscal year the business posted sales of nearly $907 million on which it has posted earnings of nearly $48 million.

This values operations at around 1.6 times annual sales and 30 times GAAP earnings. Based on the outlook for the upcoming year and my estimates for the discrepancy between GAAP and non-GAAP earnings, shares trade at 25 times forward GAAP earnings.

History Of Growth

Over the past decade, OSI Systems has managed to display spectacular revenue growth as it has grown the business from just $250 million in sales in 2004 to more than $900 million over the past year. This translates into average annualized sales growth in the 13-14% region.

While the business posted modest losses between 2005 and 2008, the company has structurally improved its earnings although they have stagnated in the $40-$50 region over the past three years. The company has increased its total outstanding share base by about a third over this time period, resulting in real dilution of about 3% per annum over this time period.

For a long time this growth has not really been recognized by the market with shares trading in a $10-$30 range between 2005 and 2009. Ever since the market has recognized earnings growth and sales growth which has actually pushed shares to highs of $80 in 2012. Ever since shares have traded in a $50-$80 range.

Note that shares are susceptible to significant volatility at times. Shares fell from $70 to a low of $47 in the matter of days back in December of last year after the US Transportation Security Administration terminated the order components in the AT-2 detection systems. Shares quickly recovered and have risen some 30% this year as performance was solid and the company booked many new orders.

Final Implications

OSI's business model is not the most preferred among investors. The reliance on big one-time orders of selected clients can result in chunky results and anxiety among investors who worry about cancellations and the stream of future contracts.

The company's security business, being represented by the Rapiscan Systems generates roughly half of total sales with its X-ray imaging used for people and goods screening. This business has seen structural tailwinds since 9/11 but is volatile at times, the reason why the company also operates a healthcare and optoelectronics business.

This provides a bit of stability for the business which has a strong growth profile, yet also carries a premium valuation of 30 times current earnings and 25 times forward GAAP earnings after multi-year momentum. Solid growth is anticipated, yet shareholders have seen no dividends and limited dilution over the past years. Overall, this creates little appeal actually in my eyes. For now I remain very cautious amidst the observations made above, yet share might offer especially on big dips such as the one witnessed last year.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.