OSI Systems (OSIS) is a global player in security screening with its Rapiscan System, used at airports, borders, ports, and other key infrastructure points. While security is the core business of OSI, it is active in more areas.
The company has long reported steady sales growth, while it has started to improve margins to acceptable levels as well. This progress was halted in recent quarters as the company no longer benefited from a large military contract which got fulfilled last year. Furthermore, other parts of the business came under some pressure as well.
These operational challenges had a big impact on the bottom line of the business, triggering a 40% sell-off from the 2015 highs. While such a pullback looks attractive, I would like to see a further retreat before I am a buyer of the shares. This follows the fact that valuation levels are not extremely attractive yet. Another reason is the acquisition of AS&E, a much smaller competitor which has its own challenges as well.
A Quick Glance At The Business
OSI has subdivided its activities across three segments. While OSI is best known from its security division, which makes up half of total sales, it has two other segments as well.
The healthcare segment focuses on patient monitoring, diagnostic cardiology, and defibrillators, among others. The optoelectronics and manufacturing segment provide solutions used by aerospace and defense business as well as inspection services. Each of these segments generate roughly a quarter of overall sales.
With exception of some small deals, OSI has relied largely on organic growth in order to expand the business. The company doubled its sales in the period 2006-2015, as revenues grew towards $958 million last year. Operating margins have expanded from essentially a break-even result in 2006 to the point where margins have come in around 9% in recent years.
The organic growth trajectory has resulted in a "clean" balance sheet which reveals that OSI operates with just a very modest amount of net debt. The long term positive trends pushed earnings up to a record of $65 million in 2015, equivalent to $3.17 per share on a GAAP basis.
Investors jumped on the bandwagon last year, being impressed by margin gains and continued growth. At a high around $95 per share in November of 2015, investors have pushed up the valuation multiples to roughly 30 times earnings.
Ever since shares of OSI peaked at $95 in November of last year, a significant correction has taken place. Shares have nearly been cut in half, now trading in the low-fifties. This is quite a big move for what is essentially an unlevered business.
The major shock came at the end of January of this year when the company released its second quarter results. The company reported that its revenues fell by 23% on an annual-basis. GAAP earnings were entirely wiped out, as adjusted earnings fell from $0.96 per share to just $0.40 per share. OSI´s revenues fell by $60 million in actual dollar terms to just $197 million for the quarter. Most of the sales shortfall can be explained by the fact that the second quarter of the year before did include a large $39 million military order which did not recur.
Excluding that order, sales were still down by 8% as the company faced some challenges in other parts of the business as well. This includes the decision within the optoelectronics segment to improve margins by rationalizing the client base. In that light it was comforting to see that third quarter sales fell by just 2% on an annual basis.
That does not mean that the company has completely solved its issues. The fourth quarter sales guidance of $230 to $255 million in sales suggests that revenues are seen down by 4 to 14% on an annual basis. Earnings are seen at $0.45 to $0.70 per share, as margins come under pressure amidst the sales declines.
The Pro-Forma Outlook
Based on the fourth quarter outlook, OSI is expected to post sales of roughly $850 million in 2016. GAAP earnings are seen at $1.45 to $1.70 per share, although these numbers are impacted by large restructuring charges. Excluding these costs as well as impairments, earnings are seen at $2.00-$2.25 per share.
The company is now trading at $53 per share, valuing equity at $1.06 billion given that there are 20 million shares outstanding. The net debt load of OSI is very modest at just $37 million, equivalent to roughly 0.2-0.3 times EBITDA.
The $1.1 billion enterprise valuation values OSI at 1.3 times sales. based on the non-GAAP earnings outlook, OSI trades at 23-26 times earnings. It should be said that these earnings are very depressed. Based on 2015 non-GAAP earnings of around $3.50 per share, the earnings multiple comes in at just 15 times.
The Purchase Of American Science & Engineering
Despite some of the operational headwinds in the core business, OSI decided that now is the right time to engage in dealmaking, potentially to rejuvenate reported growth numbers.
The company will acquire American Science and Engineering (ASEI) for $37 per share, valuing that business at $187 million net of net cash holdings being acquired. AS&E owns X-ray technologies which are complementary to existing operations, creating a strong position in Cargo and general Aviation security screening.
The trouble is that AS&E has serious issues of its own. The company posted record sales of $279 million in 2011, accompanied by operating profits of $64 million. The great operational momentum was driven by the US military involvement in Iraq and Afghanistan at the time.
Ever since, the business has deteriorated significantly. Sales have fallen to just $103 million over the past year, as the company posted an operating loss of $5 million. While these trends look outright detrimental, AS&E has a solid commercial business as well. Other good news is that OSI expects to generate very sizable synergies resulting from the deal. Over time, costs savings are anticipated to come in at $18 million per year!
The company believes that the deal should be accretive. In the year 2018, GAAP earnings per share should increase by at least 10% as a result of the transaction. Assuming that normalized earnings of OSI come in around $3 per share, 10% accretion translates into $0.30 per share, or to $6 million in actual dollar terms. That earnings per share number is realistic if the very ambitious synergy targets are achieved.
The net debt load of the business will slightly exceed the $240 million mark, for a leverage ratio of 1.5 times EBITDA. Leverage ratios are seen even a bit lower if one takes into account the anticipated synergies.
While AS&E has its challenges, investors like the fact that OSI is buying a company for merely 10 times the expected costs synergies alone. That fact has probably been the key driver behind the roughly 6% gains in OSI's share price following the deal. That move added some $70 million to the market valuation of the firm.
OSI has been a long term steady growth story. The company has doubled its operations over the past decade, while it managed to expand its margins. These positive developments were followed by an abrupt reversal in 2016.
While the company has not used much debt, and shares have fallen by more than 40% from 2015 highs, shares are not necessarily very cheap. Even if I use non-GAAP earnings, the multiple still arrives at a steep 23-26 times earnings. With the purchase of AS&E, OSI is buying a troubled competitor, not fixing the organic growth issues.
While the purchase price is not very cheap at around 1.8 times trailing sales, AS&E might be close to stabilization. If that is the case, the purchase price can easily be justified given the large costs and revenue synergies.
That being said, the +10% planned accretion in earnings per share might not be enough to account for the risks. This includes the fact that AS&E is currently posting losses and synergies look ambitious. To account for these risks, I would like to see a slightly further retreat in the shares, before I get enthusiastic on the shares.
Working with a $3 earnings per share number for 2017/2018, I only see compelling reasons to buy shares at a 14-15 times multiple, two years ahead of time. This translates into a targeted entry level of around $45 per share, some 15% below today's levels. I think that these levels offer sufficient risk-reward to initiate a long term position, if shares ever fall to these levels.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.