OSI Systems, Inc. (NASDAQ:OSIS) Q2 2023 Earnings Call Transcript

OSI Systems, Inc. (NASDAQ:OSIS) Q2 2023 Earnings Call Transcript January 26, 2023

Operator: Good day, and thank you for standing by. Welcome to OSI Systems, Inc. Second Quarter 2023 Conference Call. Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your speaker today, Alan Edrick, Executive Vice President and Chief Financial Officer. Please go ahead.

Alan Edrick: Thank you. Good morning, and thank you for joining us. I’m Alan Edrick, Executive Vice President and CFO of OSI Systems. And I’m here today with Deepak Chopra, OSI’s President and CEO. Welcome to the OSI Systems Fiscal ’23 Second Quarter Conference Call. We are pleased that you can join us as we review our financial and operational results. Earlier today, we issued a press release announcing our second quarter fiscal ’23 financial results. Before we discuss our results, however, I would like to remind everyone that today’s discussion will include forward-looking statements, and the company wishes to take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 with respect to such forward-looking statements.

All forward-looking statements made on this call are based on currently available information, and the company undertakes no obligation to update any forward-looking statement based on subsequent events or new information or otherwise. During today’s call, we will refer to both GAAP and non-GAAP financial measures when describing the company’s results. For information regarding non-GAAP measures and GAAP measures of the company’s results and a quantitative reconciliation of those figures, please refer to today’s earnings release. I will begin with a discussion of our Q2 financial performance and then turn the call over to Deepak for an overview of our business performance. We will then finish with more detail regarding our financial results and a discussion of our outlook for the overall fiscal year.

Our second quarter financial results were solid as we navigated the current economic environment, which continues to be impacted by supply chain delays and increased costs, disruptive geopolitical events, inflation and rising interest rates. Our bookings and book-to-bill ratio were very strong last quarter. And we were awarded some significant contracts, which we will discuss during this call. But let’s start with a high-level summary of our Q2 results. First, we reported Q2 revenues of $296 million. representing a year-over-year increase of 7%, driven by solid revenue growth in our Security and Opto divisions, which were in part offset by soft Healthcare division sales and an approximate $4 million unfavorable FX impact. Second, we reported Q2 adjusted earnings per share of $1.19, down from $1.28 in Q2 of the prior year as a result of a less favorable mix of sales, which was anticipated, and additional interest expense.

And third, our Q2 bookings were over $500 million, representing a book-to-bill ratio of approximately 1.7, leading to a record quarter end backlog of nearly $1.5 billion. Before diving more deeply into our financial results and discussing the fiscal ’23 outlook, I will turn the call over to Deepak.

Deepak Chopra: Thank you, Alan, and thanks to everyone joining us on today’s call. Our performance in Q2 of fiscal ’23 was solid as we grew the top line while continuing to successfully operate in a macro environment challenged by the multiple factors that Alan mentioned. Our Q2 bookings were very strong, resulting in a record quarter end backlog. We believe we are well positioned for the second half of fiscal ’23, and this also positions the Security division, especially really well entering for fiscal ’24. Let’s discuss each division’s performance, starting with Security. The Security division delivered Q2 revenues of $167 million, about 15% higher than Q2 in the prior year. We were pleased with the division’s profitability, expanding our operating margin to 12.9%.

Our Security bookings were very strong and resulted in a book-to-bill ratio of 2.3 for Q2 and 1.9x for the first half of fiscal ’23 for this division. We continue to deliver on the large existing U.S. customers border protection, CBP programs we announced in fiscal ’22. These CDP programs focus on improving Security at the U.S. borders by utilizing our cargo and vehicle inspection platforms, Search Can integration software and gatekeeper vehicle checkpoint lane control solutions. Search Scan is our proprietary software solution that helps manage inspection image data, traffic, vehicle identification and integrates with other systems at checkpoints to streamline and facilitate the inspection process. Search Scan is also comparable with third-party inspection systems, making it a versatile option in the marketplace.

Based upon CBP’s current timing, some pushout from Q3 to Q4 has happened from what was previously anticipated. While Q2 year-over-year Security division revenues were up double digits and operating margin expanded, we believe the most notable item of the quarter was an exceptional bookings highlighted by a $200-plus million international order that we received in December and announced shortly afterward quarter end in January. Our deliverables are expected to include a number of our cargo and vehicle inspection products and radiation portal monitors, along with the managing the civil works and providing operator training and ongoing maintenance in the coming years. We are not forecasting any significant revenues related to this award in fiscal ’23, but this contract provides strong visibility into fiscal ’24 Security revenues.

We are currently working on the schedule with this customer and expect to have more to share on future calls, though we will start some of the manufacturing production in fiscal ’23. During November and December, we were proud to support the Security efforts at the FIFA World Cup in Qatar as the primary provider of security detection products. This event was held at multiple stadiums around Doha, and our Orion 920 CX baggage and parcel inspection systems and Metor6X walk-through metal detectors were successfully utilized to provide screening for over 2.5 million ticket holders and their belongings. In addition, these products were also used at the primary airport, hotels and other venues throughout the city. This order was and will be a great showcase for Rapiscan products in Middle East for time to come.

In turnkey services, our projects in Albania, Puerto Rico and Guatemala continued to perform well. The initial planning phase is underwear for the new turnkey airport services multiyear contract, which we received earlier in fiscal 2023. As part of this contract, we expect to manage screening services at a European airport for the staff, airline crews and vehicles at perimeter entry points. Initially though, as we have said before, this is a small contract, but it’s a first in the aviation space. Looking ahead, we believe that Security with a strong backlog and visibility into other key opportunities in the pipeline is well positioned for the second half of fiscal 2023 and beyond. Shifting to Optoelectronics division, that had another great quarter as third-party Q2 revenues were $80 million, which represented a new quarterly record for the division.

This division achieved a solid operating margin in spite of continued supply chain cost pressures extra. Opto serves a diversified OEM customer base in aerospace, defense, health care and consumer technology, among others. In these markets, certain OEMs are seeking to reduce their exposure to China sourcing and further derisk their supply chains by transitioning to other viable manufacturing regions in the East. We believe we could benefit significantly from this given our global manufacturing footprint covering Malaysia, Indonesia, India, United Kingdom and the U.S. Looking ahead, with a strong Q2 ending backlog that is almost 20% higher than this time last year, Opto is well positioned. Moving to the Healthcare division. This was a disappointing quarter, but we believe and expect stronger second half of the fiscal year in this division.

We continue to significantly invest in developing new products to further strengthen our patient monitoring and cardiology portfolio. Subsequent to the quarter end, we bolstered the sales leadership in U.S. with talent that we believe will help drive stronger results and position the business to thrive. Going forward, we plan to maintain our focus on innovation and operational execution while staying flexible to handle the opportunities as markets can change quickly. Overall, we are pleased with the company’s fiscal 2023 second quarter performance as we grew our top line, achieved significant bookings that have resulted in a record backlog. In addition, with the record backlog and a strong pipeline of opportunities, we believe we are well positioned for the second half of fiscal 2023 and ’24.

I would like to thank our employees, customers and shareholders and look forward to the second half. I will now turn the call back over to Alan Edrick to further discuss our financial performance before we open the call for questions. Thank you.

Alan Edrick: Well, thank you, Deepak. Now I will review the financial results for our second quarter in some greater detail. As said, our fiscal Q2 revenues were up 7% compared with that of the prior year Q2. Q2 Security division revenues were up 15%, largely due to the growth in our cargo and vehicle inspection products and related service revenue. The Security division’s book-to-bill ratio was approximately 2.3%, positioning the division well for strong revenue growth in the second half of fiscal ’23 and into fiscal ’24. Opto sales increased 8% year-over-year with strength in third-party sales to a diversified customer base as well as intercompany sales to support the anticipated upcoming Security division revenue growth. Opto bookings were again solid, leading to a record Q2 backlog for the Opto division.

As Deepak mentioned, the Healthcare division, which is our smallest business unit, representing about 15% of our overall first half sales, reported a 17% reduction in year-over-year revenues in a more challenging marketplace and in part due to a tougher year-over-year comp given the prior year elevated demand during the COVID Omicron variant surge. The Q2 gross margin was 32.5%, which, while consistent with that of Q1, was about 3.6% below that of the prior year Q2. This year-over-year change was primarily driven by lower sales in the Healthcare division, which carries the highest gross margin of our three divisions; higher Opto sales as a percentage of total sales, which carries the lowest gross margin of the three divisions; and a less favorable mix in security division sales.

Our gross margin was also impacted by increases in certain component costs. In general, our gross margin will fluctuate from period to period based on revenue mix and volume, inflation and impacts of supply chain, among other factors. Based upon our forecasted conversion of backlog to revenue and pipeline of opportunities, we anticipate a stronger gross margin in the second half of fiscal ’23 compared to the first half of this year. Moving to operating expenses. We continue to work diligently across each of our divisions to improve efficiencies and to prudently manage our SG&A cost structure. Our Q2 results reflected these efforts. Q2 SG&A expenses were $54 million or 18.3% of sales compared to $54.9 million or 19.8% of sales in the prior year Q2.

While foreign exchange created a headwind for Q2 revenues, it did have a beneficial impact on our operating expenses again this quarter. Research and development expenses in Q2 of fiscal ’23 were $14.5 million, consistent with that of the first quarter and just below the prior year amount of $15 million. We continue to dedicate considerable resources to R&D, particularly in Security and Healthcare, as we remain focused on innovative product development, which we view as vital to the long-term success of our businesses. In Q2 of fiscal ’23, we recorded $2.3 million of restructuring and other charges compared to just under $1 million of such charges in Q2 of the prior fiscal year. Moving to interest and taxes; net interest and other expense in Q2 of fiscal ’23 increased to $5.2 million from $2.2 million in the same prior year period, primarily due to rising interest rates and the maturity of our 1.25% convertible notes on September 1, which carried a lower rate than our current bank borrowings.

We executed an interest rate swap during Q1, picks a portion of our floating rate bank debt. On the tax side, the reported effective tax rate at our GAAP was 19.5% in Q2 of fiscal ’23 compared to 26.3% in Q2 of fiscal ’22. In Q2 of this year, we recognized discrete tax benefits of $0.8 million as compared to a discrete tax expense of $0.3 million in Q2 last year. Excluding the impact of discrete tax items, our normalized effective tax rate in Q2 of fiscal ’23 was 23% compared to a normalized effective tax rate of 25% in Q2 of fiscal ’22. I will now turn to a discussion of our non-GAAP adjusted operating margin. Overall, our non-GAAP adjusted operating margin in Q2 of fiscal ’23 decreased to 10.7% from 12.0% in the same prior year period. This was primarily driven by the weakness in revenue in the Healthcare division, which carries the highest contribution margin of our 3 divisions, coupled with the reduction in the Opto operating margin due to a difficult prior year comp.

The adjusted operating margin in the Security division increased to 14.7% in Q2 from 14.2% in the prior year second fiscal quarter, driven by higher revenue and disciplined OpEx management. We expect to see sequential improvement in this division in Q3 and in Q4 on stronger revenues and a more favorable revenue mix. We were pleased with the adjusted operating margin in our Opto division of 13.1% in the second quarter of fiscal ’23, representing our second best result historically for this division. We believe Opto is also poised for second half year-over-year adjusted operating margin expansion. With lower revenues and a less favorable revenue mix, the adjusted operating margin of our Healthcare division decreased to 8.6% from 13.8% in the prior year.

We currently expect the Healthcare division to show significant Q3 operating margin improvement over Q2 driven primarily by revenue growth. Moving to cash flow; cash flow used in operations was $9 million in Q2 of fiscal ’23 compared to cash provided by operations of $14 million in the same prior year quarter. For the first half of fiscal ’23, our operating cash flow is ahead of where we were for the first half of fiscal ’22. That being said, we typically deliver much stronger operating cash flow. In the first half of this fiscal year, we have increased inventory to support the anticipated sales growth as well as to mitigate supply chain risks. In addition, we have an elevated level of DSO due to slower customer payments and have other working capital uses, including the timing of payments.

CapEx in the second fiscal quarter was $3.6 million, while depreciation and amortization expense in Q2 was $9.6 million. We continue to be active in our stock buyback program, during which we spent approximately $4.5 million to repurchase about 53,000 shares this past quarter. Our Board increased the buyback authorization earlier this fiscal year. And as of quarter end, 1.86 million shares were available to repurchase under the program. Our balance sheet is solid with net leverage of 1.8 and significant capacity for acquisitions and additional stock buybacks. The size from a little north of $7 million of annual required principal payments under our bank term loan, the bulk of our debt matures in fiscal ’27. Finally, turning to guidance; we are tightening our fiscal ’23 revenues range guidance by $10 million at the top end, primarily attributable to the softness we saw in the Healthcare division this past quarter.

However, we are reiterating our previous non-GAAP earnings per share guidance. This guidance implies revenue growth in the range of 8% to 12% and non-GAAP adjusted diluted EPS growth of 17% to 23% over the remaining six months of fiscal ’23. The non-GAAP diluted EPS range excludes potential impairment, restructuring and other charges; amortization of acquired intangible assets; and noncash interest expense and their associated tax effects; as well as discrete tax and other nonrecurring items. We currently believe this revenue and non-GAAP earnings guidance reflects reasonable estimates. The actual impact on the company’s financial results of disruptions and increased cost in the supply chain and inflation and interest rates is difficult to predict and could vary significantly from the anticipated impact currently reflected in our estimates and guidance.

Actual revenues and non-GAAP earnings per diluted share could also vary from the anticipated ranges due to other risks and uncertainties discussed in our SEC filings. We continue to remain focused on the growth of our businesses and proactive management of our cost structure. We believe our efforts in these areas will enable OSI to continue providing innovative products and solutions. We expect to continue to navigate through the current dynamic and challenging environment while gaining traction in key strategic growth areas and positioning the company to capitalize on certain improving end markets. We would like to take this opportunity to thank the global OSI Systems team for its continued dedication in supporting our customers and partners.

And at this time, we would like to open the call to questions.

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Q&A Session

Operator: And our first question comes from the line of Brian Ruttenbur with Imperial Capital. Your line is open.

Brian Ruttenbur: Yes. So first question is on the large — on the Security side, the large $200 million-plus international order. Can you talk a little bit about — you talked a little bit about timing. But what does the plus mean? Is that all on the maintenance side? How big can this contract get? And the timing, is it all going to get produced in fiscal — and delivered in fiscal 2024?

Deepak Chopra: Brian, this is Deepak here. All I can say that is that majority or a significant portion of the $200-plus million contract is equipment. There is some civil works and some maintenance. And regarding the manufacturing and delivery, we said it in our speech, there’s insignificant revenue in the rest of ’23. It’s all focused on 2024. Second thing that you answered is, long term, yes, there could be more potential add-ons. Definitely, service and support. This kind of equipment has 7-, 10-year plus life cycle, upgrades and stuff. So we’re very excited about it, and this is a significant win. And also, this was an international competition, and we got the majority of the business.

Brian Ruttenbur: Was it — that’s the first time I heard that the business was split between you and I assume your largest or one of your largest competitors. Is that correct?

Deepak Chopra: I can’t talk about what other competitors, but it was international competition. We got the significant majority of the business.

Brian Ruttenbur: Okay. And then moving on to pipeline on the Security side. This was a very large award that I wasn’t aware of you were bidding on. Are there other such large awards as in the couple of hundred million or $100-plus million that you’re working on? Can you discuss a little bit what’s in your pipeline? Because this was so significant. Are there other ones like that out there?

Deepak Chopra: Well, Brian, you know that we don’t talk about any specifics, but I think you already got the answer yourself. This is not the only one. It’s international. Our equipment is very much desired. It’s a marketplace which looks at security all over the globe, including U.S. So we have others in the pipeline. And this is in the cargo side, and there are also areas in the aviation side. So the pipeline continues to be quite strong.

Brian Ruttenbur: Great. Then just a couple of quick questions on the other divisions. Healthcare was weak. What do you anticipate — seasonally a little bit weak. What do you anticipate out of Healthcare coming up new products and what areas?

Deepak Chopra: Well, though, we’ve mentioned that before, and Alan also talked to you, our focus is primarily our products are patient monitoring and cardiology. Patient monitoring, we have a lot of innovative new products being developed. It takes time. We are developing a whole new product line, and we think it’s basically late to ’24, ’25 kind time line. We are also much — very much focused on home care, connectivity remote monitoring. So that we’re doing a lot of investment in expanding our reach in the patient monitoring stuff and on what we call cardiology in like patches and wireless and kelly kind of a thing.

Brian Ruttenbur: Okay. Very good. And then just last question on the Opto side. It doesn’t appear that there’s any slowdown in demand. Is the supply chain normalized enough for you guys moving forward? Or are there things that you can’t produce that if you had a proper supply chain or a normalized supply chain you’d be producing?