Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

OSI Systems, Inc. (OSIS)

Q3 2008 Earnings Call Transcript

May 1, 2008 12:00 pm ET

Executives

Deepak Chopra – Chairman and CEO

Alan Edrick – EVP and CFO

Ajay Mehra – EVP and President, Rapiscan Systems

Victor Sze – EVP, Company Secretary and General Counsel

Analysts

Josh Jabs – Roth Capital Partners

Jeff Rosenberg – William Blair

Tim Quillin – Stephens Inc.

Josephine Millward – Stanford Group

Brian Ruttenbur – Morgan Keegan

Operator

Good day ladies and gentlemen and welcome to the OSI Systems third quarter for 2008 earnings conference call. My name is Jehaida and I will be your coordinator for today. At this time, all participants are in listen-only mode and we will be facilitating a question and answer session towards the ends of this conference. (Operator instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr. Alan Edrick, Chief Financial Officer. Please proceed.

Alan Edrick

Thank you. Good morning and thank you for joining us. I'm Alan Edrick, Executive Vice President and CFO of OSI Systems. I'm here today with Deepak Chopra, our President and CEO; Ajay Mehra, our President of the security division; Victor Sze, our General Counsel; and Jeremy Norton, our Vice President of Investor Relations.

Welcome to OSI Systems fiscal 2008 third quarter conference call. We would like to extent a special welcome to anyone who is a first time participant on our conference calls. Please also note that this presentation is being webcast and will remain on our Web site for approximately two weeks. Before discussing our financial and operational highlights, I would 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 non-GAAP financial 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 will also be filed with the SEC as part of our Form-8K.

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 obligation to revise or to update any forward-looking statements whether as a result of new information, future results or otherwise.

With that disclaimer out of the way, and before turning the call over to Deepak, I will provide a high level overview of recent accomplishments. As we've discussed on each of our conference calls over the past year, we have placed a major emphasis on specific initiatives to improve our profitability and we are pleased with the rapid progress we are making.

Our third quarter and YTD financial results demonstrated significant improvement over the respective periods last year and provide clear evidence that the significant initiatives we implemented in fiscal 2007 and have continued to build upon in fiscal 2008 are leading to sustainable, improved earnings performance.

Q3 highlights are as follows. First, we reported a 24% increase in third quarter sales with strong double-digit growth witnessed across all divisions. Second, the changes we have made throughout the organization including the successful cost rationalization efforts are clearly paying off, as our operating income excluding impairment, restructuring and other charges increased by approximately $10.5 million over the same period a year ago, resulting in a $25.6 million nine-month year-over-year increase. Each division reported a significant bottom line improvement.

Third, the combination of increased sales coupled with our reduced cost structure led to EPS of $0.39 for the third quarter. Excluding a one-time tax benefit as well as impairment restructuring and other charges, our Q3 EPS would be approximately $0.20, representing a $0.39 improvement in our normalized EPS compared to the prior year period when we lost $0.19 per share on a normalized basis.

In addition to the cost reduction initiatives that have improved our operational leverage, we have also invested in positioning the company for future growth, including substantial R&D investment. We opened our new healthcare manufacturing facility in China, which we anticipate will open new markets to our sales channel in addition to providing a low cost manufacturing environment.

Finally, we returned to generating positive free cash flow in the third quarter. We still have many challenges ahead of us as we continue to demonstrate improvement in our net margin, but we believe we are well situated to capitalize on our plan for both near-term and long-term earnings growth.

I'll be updating you further on the financial performance of the company. But first, let me turn the call over to Deepak.

Deepak Chopra

Thank you, Alan. Again, good morning and welcome to the OSI Systems third quarter fiscal 2008 earnings conference call. I'm going to provide you with a brief operational overview of the business before handing the call back over to Alan, who will go into greater detail on the financial performance of the company, after which we will open the call up to questions and answers.

The third quarter saw continued improvement in our financial results. Revenues for the quarter were $156.7 million, an increase of $30.2 million or 24% from $126.5 million reported in the third quarter of the previous fiscal year. The company reported net income of $6.9 million or $0.39 per diluted share. When excluding the impact of impairment, restructuring and other non-recurring items, of which Alan will discuss in greater detail, the net income for the third quarter of fiscal 2008 was approximately $3.7 million or $0.20 per diluted share compared to a net loss of approximately $3.3 million or $0.19 per share in the third quarter of the previous fiscal year. Backlog at the end of the third quarter was $219 million as of March 31, 2008, with continued strength across all divisions.

Let me go into the various segments. Security, our security division again reported solid revenue growth. Revenues for the quarter increased by approximately 14% to $51.4 million. YTD revenues have increased by approximately 26%. Bookings are expected to be strong in the fourth quarter given the current quotation activity providing us with good visibility heading into fiscal 2009. Backlog for the security business at the end of the third quarter was same in comparison to the backlog at the beginning of the period, again demonstrating a strong booking quarter for the business.

This quarter, we made the following announcements concerning the security division. In January, we announced the receipt of a $2 million order from our Chinese distributor for baggage and parcel inspection systems. These systems are intended to be installed in be installed around Beijing for use during the upcoming Olympics and Paralympic games, making Rapiscan Systems the primary western supplier of X-ray scanning equipment for the events. The order continues our longstanding relationship with the Olympic and Paralympic games and demonstrates the strides we are making in garnering market share in the rapidly expanding Chinese security market.

In March, we announced that we had received a $7.3 million contract award from the U.S. Army for multiple re-locatable gamma cargo inspection systems. These systems are going to be deployed internationally and used to detect a wide range of threat and contraband in challenging environments. The order highlights our continued relationship with DoD for cargo inspection products and underscores the breadth of the market opportunity for this product line.

Regarding R&D, we remain on track to showcase our new inline high-speed CT system for check baggage training. The real-time tomography systems as we have mentioned before will start being showcased in fiscal 2009. This product holds tremendous growth potential for the company while also rounding out our scanning portfolio to be the broadest in the scanning industry.

On the TSA front, we have started installing the new AT machines at check points all over U.S. airports. Our cost cutting efforts continue to be focused on the security division as we look to improve our overall operating performance. We expect to see improved operating results in the fourth quarter and in fiscal 2009 as the work we are doing progresses.

As mentioned before, the quotation pipeline continues to look strong both domestically and internationally, and we expect Q4 to be a strong booking quarter both domestically and internationally.

Healthcare, I'm very pleased to report another strong quarter for our healthcare division. For the quarter, revenues increased by approximately 18% to $63.6 million while our operating income increased to $2.3 million from a $3.4 million loss in the comparable quarter last year. We are proud of the dedication and hard work of our management and employees in implementing the changes necessary in fiscal 2007 and continuing in fiscal 2008 in order to achieve this turnaround.

This quarter, we made the following announcements concerning the healthcare division. In February, we announced the official opening of our new healthcare manufacturing facility in Suzhou, China. The manufacturing facility will initially be focused on developing and manufacturing products for the emerging markets, while also serving as the cornerstone for the company's emerging market activities, including R&D, aftermarket service, training, marketing and sales, and marketing support.

Once fully operational, we expect the facility will further improve gross margins for the division. The real impact we feel will be felt on the margin enhancement in fiscal 2009. The emerging market is a tremendous growth opportunity for the company, and in March, we announced a significant order in South America. This order from a major regional teaching hospital provides us with a foothold within the marketplace and a strategic reference sight from which we can center our marketing efforts within the region.

Finally in March, we announced that Spacelabs has been recognized by two independent survey companies as the number one aftermarket service provider in North America, replacing Philips Medical. This recognition is a tremendous achievement and underscores the company's commitment and dedication to our customers' needs.

We remain committed to R&D within this division. Our R&D spending year-to-date is greater than last year in absolute dollars as we look to accelerate a number of key projects we are working on. We expect to begin to see the results of this investment in fiscal 2009 as we look to launch a number of new products.

The business has been a tremendous success for us this fiscal year. While recent media reports have highlighted concerns within the market relating to the current credit crisis, we have not seen any signs of slow down but will continue to watch cautiously. We believe we can continue to grow this business both domestically and internationally.

The optoelectronic division announced strong revenue growth in the third quarter with revenues increasing by 44% to $53.4 million, positively impacted by the previously announced $46 million contract awards for electronic sub-assemblies from a large defense contractor. This quarter, we continued to wind down on our weapon simulation business. We remain on track to put this business behind us by the end of our fiscal year as we finish our obligations to our customers.

With that, I'm going to hand it back to Alan for financial details.

Alan Edrick

Thank you, Deepak. Consistent with our message from the last conference calls, our management team remains highly focused on driving operating margin improvement to significantly improve earnings in fiscal 2008 and beyond. I'll speak more about this shortly but first let me review the financial results of the third quarter.

As Deepak mentioned, net sales for the third quarter increased 24% to $157 million in fiscal '08 from $127 million in fiscal '07. On a divisional basis, our Opto group had an outstanding quarter, reporting a 50% increase in third party sales led by strong shipments on a contract associated with the U.S. government's MRAP troop transport program in addition to a 24% increase in inter-company sales in support of the growth of our healthcare and security divisions.

Our security division reported another solid quarter with 14% growth in sales or 26% growth on a year-to-date basis, highlighted by strong cargo sales. Our healthcare division reported its fourth consecutive strong quarter with year-over-year sales growth of 18% or $63.6 million in sales which was again largely driven by strong North American patient monitoring sales. Our bottom line for the third quarter in 2008 markedly improved, as we reported net income of $6.9 million or $0.39 per diluted share compared to $3.6 million or $0.21 per diluted share for the same period of '07. Excluding certain non-recurring items in both 2008 and 2007, including the impact of a one-time tax benefit and the reported impairment restructuring and other charges in 2008, and a one-time legal settlement and restructuring charges in 2007, net income for the third quarter of fiscal 2008 would have been approximately $3.7 million or $0.20 per diluted share compared to an approximate net loss of $3.3 million or a loss of $0.19 per diluted share for the comparable quarter of last year.

When you look at the contributors to our significant earnings improvement, we saw progress not only on the top line but also across the spectrum in terms of margin improvement. For the third quarter of fiscal 2008, our gross margin increased from 34.7% to 36% led by an approximate 200 basis point improvement in both our healthcare and Opto group gross margins.

We continue the margin expansion reported in the previous quarter in our healthcare division as a result of the economies of scale associated with increased sales as well as manufacturing cost savings from the substantial restructuring activities initiated in fiscal 2007.

Our security gross margin also improved even after factoring in strong cargo sales, which tend to carry lower gross margins than our other security products. While our gross margin will vary from quarter to quarter as a result of a number of factors including product mix, unit volumes, pricing, inventory reserves and capacity utilization, we expect to see overall improvements in the future.

During the quarter and the nine-month period, we experienced the operating leverage that the organization works so hard to achieve. Our SG&A expenses as a percentage of sales decreased by 470 basis points for the third quarter and 430 basis points for the first nine months of fiscal '08. For the quarter, SG&A expenses declined to 24% from 28.8% of sales compared to the same period in the prior year.

Looking at it from a slightly different perspective, despite a 24% increase in Q3 revenues, we increased SG&A expenses by only 4%. The impact of the cost savings initiatives is clearly materializing and we are able to better leverage our existing infrastructure.

To R&D, research and development expenses for our third quarter of '08 were $12.1 million or 7.7% of sales, compared to 9% of sales in the same period last year. And in absolute dollars, such costs increased by $0.7 million from that of the previous year. We are making significant investments across many technologies in both our security and healthcare product offerings. While much of this investment will not impact fiscal '08 revenues, we believe it positions the company to capitalize on major opportunities in the future which address large global markets.

During the third quarter, we recognized an income tax benefit of $2.6 million compared to income tax expense of $3.7 million for the same period last year. However, included within the current year's tax benefit is a net tax benefit of $4 million as a result of discrete items impacting the tax revision, the largest of which was a $4.31 million onetime tax benefit associated with the repurchase of the minority interest of Spacelabs Healthcare. Excluding the impact of these discrete benefits, our effective tax rate for the current year was 31.7% compared to 42.6% in the prior year. Our provision for income taxes is dependent on the mix of income from U.S. and foreign locations due to tax rate differences among such countries as well as due to the impact of permanent taxable differences.

Moving to cash flow, during the quarter, we generated operating cash flow of $4.7 million as a result of our higher profitability, which was aided by a 9 day reduction in DSO and a focus on inventory turns, which slightly improved on a sequential basis. As mentioned on the last conference call, we have invested significantly in inventory in anticipation of large near term contract manufacturing and securities shipments, each of which have relatively long production lead times.

In addition, during the transition of a plant closure in our healthcare division, we have built up some incremental inventory which we anticipate will reverse in the first half of fiscal 2009.

Capital expenditures were $2.9 million remaining below historical levels, while depreciation and amortization was approximately $5.1 million. Improving free cash flow as we move into fiscal 2009 continues to be a top priority.

Turning to an update on the progress of reducing our cost base, as we mentioned during our past few conference calls, we began a review of our global operations in order to integrate recent acquisitions and to rationalize our cost structure. In fiscal '07, we succeeded in achieving our goal of reducing our cost base at an approximate $17 million annualized run rate. We mentioned that the greatest impact of these changes would be evident in our healthcare division and we believe the year-to-date results demonstrate this.

Though we are pleased with our achievements in fiscal '08 thus far, we are by no means done. We continue to strive to be more efficient to improve bottom line performance. And in our Phase II review, we have identified an additional $8 million of pretax annualized savings, which as Deepak mentioned the majority of which will come out of our security division. A portion of these savings have been realized in fiscal '08 results. As we implement these changes, we will continue to report certain restructuring charges.

Now, I would like to discuss our fiscal 2008 annual guidance. Previously, we had provided top line guidance of $590 million to $605 million. Given the robust year-to-date revenues and continued strength in bookings, we anticipate that we will exceed the top end of this range. Since our policy is to refrain from providing quarterly revenue guidance, we will not provide a more specific comment on revenues.

With the strength of our bottom line performance for the first nine months and the positive outlook for the fourth quarter, we are reiterating our EPS guidance of $0.65 to $0.77 per share excluding the impact of impairment restructuring and other onetime charges, as well as the previously mentioned onetime tax benefit and any potential divestitures as we evaluate our portfolio of technologies. We view fiscal 2008 as an important year for OSI, as we transformed our financial profile from three consecutive years of losses to a year of meaningful earnings and created a sustainable organization that paves the path for significant future earnings power. Building long-term shareholder value through increased financial performance is our highest priority. There is no doubt that we have more work ahead of us, but we are optimistic about our future prospects and look forward to reporting our results in the coming months.

Thank you for listening in on this conference call. And at this time, I would like to open the call to questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Josh Jabs with Roth Capital. Please proceed.

Josh Jabs – Roth Capital Partners

Hi, guys, nice quarter. In looking at the cash flows, I think we expected inventories to come in a bit given the upside in Opto, so shipping out of the MRAP order. So, what's going on there and then more generally, can you provide a little more color on what drove the cash flows in the quarter given the jump in accounts payable?

Alan Edrick

Sure, Josh, this is Alan. With respect to the inventory, though we had significant shipments on the MRAP order in Q3, we will continue to have significant shipments in Q4 and moving into fiscal 2009. So, the inventory levels associated with that particular project remain relatively stable. So, as a result so did inventory. The real change in accounts payable was driven by the buyback of the Spacelabs minority interest that we completed in December, but actually the cash outlay occurred in Q3. So, as of the end of Q2, it was reported in accounts payable and we actually spent the cash to buy back the shares in Q3. What also helps contribute nicely to the improved operating cash flow is some greater focus and improvements in our day sales outstanding, which decreased nicely during the quarter.

Josh Jabs – Roth Capital Partners

Okay. So, I mean if we expect the accounts payable to normalize here in the June quarter, I guess that kind of sets them up for cash flows normalizing into fiscal '09.

Alan Edrick

That would be correct.

Josh Jabs – Roth Capital Partners

Okay. It looks like TSA is moving fairly aggressively on the checkpoint upgrade. Can you give a little more color there maybe from Ajay, and then what expectations do you have for this program given L-3 appears to have dropped out of contention, I think it's actually removed from the Web site recently?

Alan Edrick

I guess we've announced that the initial order that we got, we got around 50% of what TSA had let out a number of machines. They are going through an upgrade of several large major Category X airports. We are involved in it. We fully expect to get our share, like I said, previously had been 50% plus. And we are moving forward aggressively over the next few months starting to install these machines.

Josh Jabs – Roth Capital Partners

Ajay, going back to you, I guess, TSA announced recently a little more details on how they are going to approach their cargo screening mandate, a lot of it having to do with prescreening at the freight forwarders. I know those type of programs take a while to actually get put in place. But, how is the company's channel position to go after presumably a large number of freight forwarders?

Ajay Mehra

We are, as you know, we have a lot of our equipment out there with freight forwarders. We are one of the strongest players with freight forwarders. We have known them, dealt with them for a long time, and as far as TSA is concerned, their program – their cargo program, we are involved with it, we have certain equipment that they are looking at. So, we feel very good that going forward that we are going to be a part of it.

Josh Jabs – Roth Capital Partners

Okay, and then finally, I guess this question gets asked every quarter, but Deepak, can you give us an update on the L-3 litigation and how that's progressing?

Deepak Chopra

The better person to give you the update is Victor Sze.

Victor Sze

Hi Josh, so our litigation against L-3 is currently on appeal. The latest development is that we have a hearing date for the oral arguments, it's May 20. So, on May 20, we are going to go in with L-3 counsel and argue our case in front of the appellate panel. We have always said that we feel we have a solid case so we are looking forward to the argument.

Josh Jabs – Roth Capital Partners

And then, just typically I know every case is different, but is that then – from that point, is that a two-month process or is that a 12-month process, what are the expectations?

Victor Sze

I would expect that it's less than 12 months, but it's really up to the court. But, this is the last step before we get the decision.

Josh Jabs – Roth Capital Partners

All right. Thanks, guys.

Operator

Your next question comes from the line of Jeff Rosenberg with William Blair. Please proceed.

Jeff Rosenberg – William Blair

Hi, I just wanted to ask, looking at your EPS guidance kind of at the midpoint and even factoring in the revenues likely to come up as strong as you are talking about, it does seem like you are looking for a nice sequential improvement in operating margins, so Alan, I thought maybe you could give us some further color on, is it gross margin that you think incrementally expands from here or is it something else that helps you get there?

Alan Edrick

You are saying for the fourth quarter or going beyond into fiscal '09?

Jeff Rosenberg – William Blair

I was asking about the fourth quarter.

Alan Edrick

The fourth quarter, yes, I think we'll see some – we anticipate seeing some nice gross margin expansion in the fourth quarter, which has typically been a very strong sales quarter for us. We think we'll be able to continue to leverage the operating expenses to flow through some meaningful earnings.

Jeff Rosenberg – William Blair

And in terms of gross margin, is that just mix driven or is there something there that you carry-forward into '09?

Alan Edrick

I think you'd say it would be sustainable. I think we can carry it forward into '09. It will be partially mix driven, but really the changes we are making, some of the restructuring efforts and some of the things that we have put into place we believe will lead to improved gross margins, not only potentially in the fourth quarter, but into '09 and beyond.

Deepak Chopra

You mentioned about 2009. Keep in mind that the cost cutting that we've done, the rationalization of cost structures will continue to drive margin improvement. Secondly, in 2009, for the medical business, China production should come on line. That should have a positive impact in 2009 on the margin. And thirdly, as Alan mentioned, we see still growth continuing on our top line which leverages our fixed cost. So, all indications are that the gross margin will continue to improve.

Jeff Rosenberg – William Blair

Okay. Thank you.

Operator

Your next question comes from the line of Tim Quillin with Stephens Inc. Please proceed.

Tim Quillin – Stephens Inc.

Hey, good morning. Can you give us a sense of how much is left of the EDO order at this point?

Deepak Chopra

Well, the best way to answer is that, as Alan mentioned, the shipments will continue in Q4 and Q1. We continue to reload the pipeline. And there is lot of legs left into what we are hearing about from new procurement by IT&T.

Tim Quillin – Stephens Inc.

Is 3Q revenue levels, are they indicative of what we should expect in Q4 and Q1?

Deepak Chopra

Would you repeat that again?

Tim Quillin – Stephens Inc.

Are the revenue levels that we saw in Opto in 3Q indicative of what we might see in 4Q and 1Q?

Alan Edrick

I think maybe the best way to answer that is the revenue levels in Opto were very strong in Q3. However, we really don't give quarterly guidance on a divisional basis. But, I think you might be able to infer some thing as we do anticipate having a continued strong sales associated with that contract, particularly in Q4.

Tim Quillin – Stephens Inc.

Great. And then on a large cargo side, what kind of growth did you see specifically in large cargo in the quarter year-to-year?

Deepak Chopra

Well, again, we said on last conference call, we are reluctant of breaking down the security product lines. All we can say is that the pipeline for large cargo is very strong, both domestically and internationally. We have also mentioned that we believe that Q4 would be a very strong booking quarter. Needless to say, we can say that if all the bookings that we are predicting happen, there will be a positive net bookings growth in security.

Tim Quillin – Stephens Inc.

And there was a little over $12 million quarter-to-quarter decline in security revenue. Hw much is that is attributable to a drop off in large cargo revenue in the quarter?

Alan Edrick

I think you got to look at it from a where was the third quarter of last year and where we are this year. I mean, as you know, large cargo can be lumpy. But, from a sequential quarter, it's hard to measure it. We still feel very comfortable like we said, Q4 always is stronger than Q3. And overall, security business remains very robust for us.

Deepak Chopra

I think that when you read from last quarter, which was a very strong shipping quarter, you are always going to see some quarter-to-quarter changes. And you know that in this industry, especially in large contracts, you will get a very strong booking quarter and then there will be a bit of lull and then you'll get another strong quarter. And the lead times are such that you can't expect every quarter to continue to have booking increase because very soon, with the lead time in front of you, you'll have a tremendous problem of shipments if you continue to look at it that way. What you have to look at it is that we have different segments in the security business, some of them are inventory turns, you book and ship very fast, if not the same quarter, the next quarter; some of them are longer lead times. So we have a very strong shipping quarter in the July, August, September area; October, November, December was a little different; January, February, March will be different; and Q4, we expect to be a very strong quarter. We really feel uncomfortable breaking down how much are the bookings back and forth between cargo and the rest of the business.

Alan Edrick

But to give you some sense, though we don't break down the bookings, we did have about a 44% growth in cargo sales, so it was very robust in Q3.

Tim Quillin – Stephens Inc.

Okay, that's helpful. Ajay, can you kind of talk a little bit about the pipeline of opportunities you are seeing on security and where the bookings might come if you have a strong bookings fourth quarter?

Ajay Mehra

Are you talking about specifically on large cargo?

Tim Quillin – Stephens Inc.

Generally. But large cargo, maybe most importantly.

Ajay Mehra

As I mentioned before, when you look at large cargo, a lot of times people focus in on what's going on with ports and water crossings. Obviously, DoD is a big component for us as well, which we demonstrated with the $7 million order last quarter. I think what you are going to see is, obviously, most of the U.S. government procurement from CVP happens in our Q1, which is what ends in September. And that's where we've usually seen the bumps. Internationally, our activity remains very strong. We are seeing activity all over the place in all regions of the world. So from that standpoint, we see growth taking place. Non-cargo, I think we've talked about the TSA business, we've talked about other government agencies. And internationally as well, we see our conventional business very strong right now.

Deepak Chopra

Tim, just to add on to what Ajay was saying, keep in mind that the multi-view are high-speed non-U.S. check baggage systems are also in the conventional business now. And we are getting a lot of traction in that. And as Ajay mentioned and I said it in my conference call that the activity domestically and internationally looks as strong as we have seen before, especially in cargo, but even in the conventional business.

Tim Quillin – Stephens Inc.

It sounds great. Alan, do you expect to get close to free cash flow neutral for the full year or are you still going to be burning cash based on the timing that you talked about?

Alan Edrick

We expect to be free cash flow neutral or, frankly, positive for the second half of the fiscal year. But given some of the build up that took place in the first half of the fiscal year, for fiscal '08, for full-year basis, we will not be positive.

Tim Quillin – Stephens Inc.

And have you looked at it this way, as far as going forward, kind of normalized free cash flow generation relative to net income or some other way to look at what – how you expect to convert income into free cash?

Alan Edrick

Yes, we think we can really create some real meaningful free cash flow beginning in fiscal '09, with many of the changes largely behind us and the improved profitability and now, the focus on improved working capital management with inventory turns and days sales outstanding. While I can't give you a metric to look at it on a scale, we think we really do have the ability to start generating real meaningful cash flow in '09 and beyond.

Tim Quillin – Stephens Inc.

Okay. And then just lastly, relative to your 5% net margin target in fiscal '10, first of all, is that still viable and is that a goal for all of fiscal '10 or a goal by the end of fiscal '10? Thanks.

Deepak Chopra

I think when you think about the goals in the future, I think 2010 as a total year, we have a good goal of 5%. I mean obviously, we are not going to say to you each quarter is going to be X, but as a goal we are all working towards that focus, that 2010 we should approach the 5% goal.

Tim Quillin – Stephens Inc.

Great. Thank you.

Operator

Your next question comes from the line of Josephine Millward with Stanford Group. Please proceed.

Josephine Millward – Stanford Group

Good morning.

Alan Edrick

Good morning.

Josephine Millward – Stanford Group

Congratulations on a good quarter. Alan, in terms of restructuring, do you have a sense of what restructuring charges might be in Q4?

Alan Edrick

I think you'll see them be comparable to what you saw in Q3, would be probably the best guess at this point.

Josephine Millward – Stanford Group

And do you expect this to go into fiscal year '09?

Alan Edrick

Yes, we do anticipate there will be some continued charges, particularly in Q1 as some of the changes that we are making, particularly in international locations, will complete during the summer.

Josephine Millward – Stanford Group

So you think this might wrap up by Q1 or –?

Alan Edrick

I don't know if it will completely wrap up, as we are going to continue to focus on more opportunities for savings. But, with respect to the phase two that we announced, yes, we do anticipate it will wrap up by Q1.

Josephine Millward – Stanford Group

Okay. And I also have a security question for Ajay. The TSA chief has said he is going to buy more AT X-ray systems for Checkpoint this year. Do you expect to maintain your 50% market share or will there be a new competition for these additional orders? If you can give us a little more color on that?

Ajay Mehra

I think the best way – all of us have read the articles. We feel very good with what we've done in the past and we don't anticipate any surprises going forward. As far as we know, there are no additional people that have been qualified except for the two people that are in there. So we feel good about our prospects going forward.

Josephine Millward – Stanford Group

Okay. And you've talked about, I think it was Alan, that you've invested in inventory in anticipation for security shipments. Are you referring to orders you already have in the backlog or are you referring to the strong bookings that you are expecting in Q4?

Alan Edrick

I guess it's a combination. I mean, we are looking at – like we said, we have to anticipate some of the orders that are coming in. Cargo are long lead times for us. We try to bring those lead times down. And in some cases, we've built up on orders that we expect over there and in some cases, we have the bookings already.

Deepak Chopra

Josephine, just to add on to it, most of the stuff that we have are standard products.

Josephine Millward – Stanford Group

I'm just trying to get a better sense of what's driving growth in security. What's the fastest growth driver, is it cargo, is it Checkpoint? Just trying to get a better feel of the break down within your security business.

Deepak Chopra

Well, it's both. Cargo definitely is a very strong growth driver. So is conventional, especially, like I mentioned, the multi-view systems.

Josephine Millward – Stanford Group

The multi-view, you're referring to international?

Deepak Chopra

Well, also the AT Systems for TSA. There's a lot of growth in that front of it.

Josephine Millward – Stanford Group

Okay. And can you give us your – what you shipped in cargo for the year and your cargo backlog?

Deepak Chopra

I think we have stopped breaking down the backlog in various product lines of security for competitive reasons. All we can say is that the backlog was pretty flat between Q2 and Q3. And we think that, with the strong shipments in Q4, we are expecting the bookings in security to surpass the shipments, so that the backlog should go up at the end of Q4.

Josephine Millward – Stanford Group

Okay. So your security backlog was flat at the end of the quarter and you don't want to break it out?

Deepak Chopra

Correct. That's right.

Josephine Millward – Stanford Group

Okay. All right, well, thank you very much.

Operator

Your next question comes from the line of Brian Ruttenbur with Morgan Keegan. Please proceed.

Brian Ruttenbur – Morgan Keegan

Okay. Thank you very much. The first question I had was on R&D going forward, with the new inline CT machine launching in the next nine months or so in the UK, is R&D going to drop then at that point into fiscal '10 or will you replace it with something else, this R&D spend?

Deepak Chopra

Well, the R&D that we have, especially since you are asking that specific way, with the RTD, R&D [ph] is going to continue. Keep in mind that just because if we do launch some time in fiscal 2009, by the way you said nine months, I'm just saying to correct it, some time in fiscal '09, we will start show casing it. That's just the beginning. We will continue to put R&D dollars into it. We will continue to develop more products. So that it's not going to a stop. Same thing in the healthcare. I think what will happen is, as a percentage of revenue, I think that the percentage will start coming down as the top line grows. In absolute dollars, the R&D we believe will continue to grow, but not that much that the percent of revenue will grow.

Brian Ruttenbur – Morgan Keegan

Okay. And that is taking into account when you talk about a 5% net margin in 2010, right?

Deepak Chopra

Yes, R&D for 2010 takes into account that we will continue to invest wisely in R&D.

Brian Ruttenbur – Morgan Keegan

What is left to implement when you talking about the additional $7 million to $8 million of cost savings? Is that personnel related? Is that plant closing, physical plant closing? What all is left out there, when you talk about the $7 million to $8 million?

Alan Edrick

It's a combination of both of those items that you just mentioned. In order to comply with certain international labor regulations, there's certain notice periods that are required and as a result that's why some of the stuff will be going into the summer for a couple of our plant closures. So, what's left is the physical closing of those plants and downsizing that goes along with that.

Brian Ruttenbur – Morgan Keegan

Okay. And then last question on the L-3 litigation, because I just want to make sure I understand, it's in an appeals process and the judge still has not ruled on it and that should happen in the next couple of months, is that too much of a summary?

Victor Sze

What happens from here is that on May 20, we are going to go in front of an appellate panel of three judges and each side will make their arguments and answer any questions that the panel has. And then from there, the panel is going to take it under submission and consider the case. And at some point after that date, they will come out with their decision and their opinion. There is no hard and fast on how long after that hearing date.

Brian Ruttenbur – Morgan Keegan

What's the longest something like that could last, ones it goes in front of the three judges?

Victor Sze

It's very difficult to say.

Brian Ruttenbur – Morgan Keegan

I mean are we talking years or months?

Victor Sze

I doubt very much that it will be years. I would more expect that it's in months. But, this is a fairly complex case, so it really is up to the appellate panel.

Deepak Chopra

Just to add on to it, sitting today on May 1, we still do not know, neither us nor L-3, we do not know the names of the appellate panel. It will only come out a week before and then both sides will go and talk off their oral arguments. It's a very short couple of hours and then it's up to them when they make a decision. But like Victor said, definitely it can't be years. It will be in months.

Brian Ruttenbur – Morgan Keegan

Okay. Thank you very much.

Operator

At this time, we do not have any more questions in queue. I would like to turn the call back to Mr. Deepak Chopra for closing remarks.

Deepak Chopra

Thank you very much for attending the third quarter conference call. In conclusion, we are very pleased with our operating results for the third quarter of fiscal 2008. Although we continue to talk that we have more work ahead of us, operating income and net income for the quarter and year-to-date have been positively impacted by the cost rationalization program that we embarked upon in the past 18 months. All of our business segments have robust bookings pipelines, which will position the company for continued revenue and earnings growth in fiscal 2009. As Alan mentioned, we are building the company for predictable earnings growth and 2008 has been a good turnaround and we believe that the real story is 2009 and 2010 and beyond. Thank you very much.

Operator

Thank you for your participation in today's conference. This concludes the presentation and you may now disconnect. Good day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: OSI Systems, Inc. Q3 2008 Earnings Call Transcript
This Transcript
All Transcripts