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OSI Systems Inc  (NASDAQ:OSIS)
Q3 2019 Earnings Call
April 30, 2019, 4:30 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good afternoon, ladies and gentlemen and welcome to the OSI Systems, Inc. Third Quarter 2019 Conference Call. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at the time. (Operator Instruction). As a reminder, this conference call is being recorded. I would now like to turn the conference over to your host, Alan Edrick, Chief Financial Officer. Mr. Edrick, the floor is yours.

Alan Edrick -- Executive Vice President and Chief Financial Officer

Thank you. Good afternoon and thank you for joining us. I'm Alan Edrick, Executive Vice President and CFO of OSI Systems. Now I'm here today with Deepak Chopra, our President and CEO. Welcome to the OSI Systems fiscal 2019 third quarter conference call. We would like to extend a welcome to anyone, who is a first time participant on our conference calls.

Earlier today, we issued a press release announcing our fiscal 2019 third quarter and nine month financial results. Before we discuss the results, I'd like to remind everyone that today's discussion contains forward-looking statements. 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 under the securities laws. These forward-looking statements are based on management's current expectations and are subject to uncertainties, risks, assumptions and contingencies many of which are outside the Company's control. Such statements include without limitation, information regarding the expected financial and operational performance of the Company in its operating divisions including the Company's expected revenues, earnings and growth. Undue reliance should not be placed on forward-looking statements as actual results could differ materially from any forward-looking statements due to numerous factors including factors described in the Company's periodic reports filed with the SEC from time-to-time. All forward-looking statements made on this call are based on currently available information and speak only as of the date of this call and the Company undertakes no obligation to update any forward-looking statement that becomes untrue because of subsequent events or new information or otherwise.

During today's conference call, we may refer to both GAAP and non-GAAP financial measures of the Company's results. For information regarding non-GAAP measures and comparable GAAP measures and a quantitative reconciliation of those figures, please refer to today's press release regarding our fiscal 2019 third quarter results which has been furnished to the SEC as an exhibit to a current report on Form 8-K. Before turning the call over to Deepak to discuss the Company's general business and operations, I will provide a high level financial overview of the third fiscal quarter. First, we reported third quarter revenues of $304 million a 14% year-over-year increase. This represents an all time record for the Company driven by solid performance across our three divisions. In Security, we reported record Q3 revenues of $193 million representing 14% year-over-year growth. The Opto division sales increased 7% including contributions from our recent acquisitions.

Our Healthcare division returned to growth mode delivering a 12% Q3 year-over-year sales increase. Second, we reported record Q3 GAAP diluted earnings per share of $1.5 compared to $0.13 in the same prior year period. Non-GAAP Q3 EPS which exclude certain specified items was a record $1.17 per diluted share compared to $0.86 in Q3 of fiscal '18 as we leveraged the record revenues to accelerate earnings growth.

Third, our Q3 cash flow from operations was $46.9 million up 51% over the same period last year. Also subsequent to quarter end, we amended our credit facility to improve the interest rate terms, extend the maturity through April 24 and increase the size to $535 million as well as various other improvements that we believe provide us with additional operational and financial flexibility.

Before diving more deeply into our financial results, and discussing our updated fiscal 2019 guidance. Let me turn the call over to Deepak.

Deepak Chopra -- Chairman, President and Chief Executive Officer

Thank you, Alan. And again good afternoon and welcome to the OSI Systems earnings conference call for the third quarter of fiscal 2019. All three divisions Security, Healthcare and Optoelectronics fired on all cylinders and contributed to record revenue and non-GAAP and GAAP earnings for the quarter.

Q3 revenues grew by 14% and represent an all time record for any quarter in the Company's history. Alan will provide more detail on the financial performance on it. Reviewing the highlights with the three divisions beginning with the security, where revenues were $193 million also an all time record revenue record was 14% higher than the prior year of Q3. We saw strengths demonstrated at both aviation and cargo during the quarter. We experienced robust growth in RTT110 sales, the Real Time Tomography explosive detection systems internationally and with a broad offering in cargo and vehicle inspection system globally had a very good quarter.

During the quarter, we announced RTT orders with two key European airport customers totaling approximately $18 million. Also shortly after the quarter end, we announced a $10 million follow on RTT order from a prominent international airport in Europe. For the checkpoint CT, we are getting traction with the 920 CT internationally. The overall opportunity pipeline at airports and cargo facilities is quite strong and our sales and operations team is ramping up what expected increased demand as we move into fiscal '20. Given our worldwide presence, we are focused on leveraging our service and logistics capabilities to capture additional opportunities especially as our installed base continues to grow significantly. During the quarter, we announced a contract valued at $12 million for operations and maintenance services from the NATO Support and Procurement Agency. Under this contract, we are responsible for operating and continuing service of Rapiscan Systems and AS&E cargo, vehicle, parcel, and personnel explosive and contraband detection systems.

On the integrated services and turnkey front, as we mentioned on our last call, we entered into a 10 year contract to provide a complete turnkey screening solution for the Port of Santo Tomas de Castilla in Guatemala, for which we are in the process of constructing civil works. In the near future, we expect to install our cargo screening systems at this port, integrate our proprietary CertScan image management and analysis software and be ready for operations later this calendar year. The Guatemala contract along with the existing Mexico, Puerto Rico and Albania turnkey screening service contracts are all going well and they provide a nice showcase of our capabilities to potential new turnkey customers.

We look forward to continued success in cargo systems as we help our customers protect borders and ports and prevent the movement of illegal drugs and contraband. As an example, our cargo screening equipment is utilized on both sides of Mexico US border. During Q3, Customs and Border Protection announced the largest fentanyl drug bust in US history near Nogales, Arizona. In March, we served as a title sponsor for the second year in a row for the Rapiscan Systems Classic at PGA Champions Tour event in Biloxi, Mississippi.

At this event, we provided security for the safety of players, attendees and other service providers. In addition, we held several industry workshops that were focused on the topics of air cargo and airport security. All event attendees had the opportunity to see a demonstration of a product portfolio for people, baggage and parcel screening. It was a great opportunity to broaden awareness of our brand. Q3 was an excellent quarter for the Security division and while certain bookings got pushed to future periods, we have already landed some key orders in April and the pipeline continues to be robust both internationally and domestic US toward a strong fiscal 2020.

Moving into the Healthcare division, Spacelabs showed significant improvement as revenues were 12% higher than in the prior year's Q3 and resulted in significant operating income growth. The change in leadership and organization has improved performance and the overall progress and execution at this division. We saw strong bookings and sales in the US for patient monitoring and also growth in the cardiology product line which is mostly sold in Europe. During the quarter, we announced three significant orders from the US hospitals totaling $19 million for patient monitoring. These large orders are a sign of effective execution by the division sales team and a positive indication of the overall market health. We look forward to continuing the momentum in Q4 and into fiscal 2020. Moving to our Optoelectronics and Manufacturing division, Q3 overall revenues were $71 million up 7% including inter-company from the prior year with a strong operating margin.

We see ample opportunities for growth with OEMs across numerous industries. We also continue to seek acquisitions that help us strengthen our position in the marketplace and broaden our product offering in this division. In summary, we enter in Q4 with a healthy backlog and great visibility in our pipeline and expect to deliver a strong finish to this fiscal year. As always, I would like to thank our employees, customers and stockholders for the continued support. With that, I'm going to turn the call back over to Alan to talk in more detail about our financial results before we open the call for questions. Thank you.

Alan Edrick -- Executive Vice President and Chief Financial Officer

Thank you, Deepak. Now, I will review financial results for the third fiscal quarter in some greater detail. As mentioned previously, our revenues in Q3 of fiscal '19 were up 14% year-over-year. Q3 revenues in the Security division increased by 14% driven by growth in both the cargo and vehicle inspection and RTT product lines.The Opto division continued its steady performance growing external revenues 16% year-over-year. About half of that growth due to the performance of a recent -- a recently acquired business and the balance due to strong sales in our core Optoelectronics business. The growth in external revenues was partially offset by Opto's reduced intercompany sales during the quarter due to improvements in inventory management in our other divisions resulting in a 7% increase overall in the Opto division revenues compared to the same period last year. And as Deepak mentioned, we were pleased to see Spacelabs post 12% revenue growth driven by strong US patient monitoring sales and more modest growth in cardiology and supplies and accessories revenue. The Q3 gross margin of 36.6% was comparable to the 36.5% in Q3 of last year. We saw gross margin expansion in our Opto and Healthcare divisions with a slight year-over-year reduction in the Security division gross margin. As mentioned on previous calls, our gross margin will fluctuate from period to period based on revenue mix among other factors.

Moving to operating expenses. SG&A expenses were up $7.5 million in Q3, over the same period of the prior year, due to the growth of the Company including the impact of fiscal 2019 acquisitions.

We worked across all of our divisions to improve efficiencies and prudently manage our cost structure. R&D expenses in Q3 were $13.7 million down approximately $2 million from Q3 of the prior year due to reduced costs in our Security division for ongoing engineering projects and in our Healthcare division. We remain focused on innovative product development which we view as vital to the long term success of our business. Impairment, restructuring and other charges were a net benefit of $1.8 million in Q3 of fiscal '19 as compared to $14.1 million in charges in Q3 of fiscal '18. The current year amount reflects the net insurance reimbursement of certain legal costs.

Moving to taxes. Excluding the impact of discrete tax items, the Company's effective tax rate was 28.6% in Q3 of fiscal '19, compared to 28.2% in the prior fiscal year third quarter. During the three months ended March 31, '19, we recognized a discrete tax benefit of approximately $700,000 resulting in a reported effective tax rate of 26%. During the three months ended March 31, '18, we recognized a discrete tax benefit of approximately $300,000 resulting in a reported effective tax rate of 18.1%.

Let's now turn to a discussion of our non- GAAP adjusted operating margin which excludes impairment, restructuring and other charges and acquired amortization expense. The Company's non-GAAP adjusted operating margin improved to 11.2% in Q3 of fiscal '19 from 9.7% in Q3 of fiscal '18. This increase was driven by operating margin expansion in all three divisions. This growth was most notable in the Healthcare division in which operating margins increased to 11.1% from 2.9% year-over-year primarily driven by revenue growth and effective operating expense management.

Moving to cash flow, in Q3 of this year, we generated $46.9 million in operating cash flow compared to $31.1 million in Q3 of last fiscal year. The strong cash flow is driven by increased profits and improvements in working capital. Collections were strong as days sales outstanding decreased from 74 days in Q3 of fiscal '18 to 65 days in Q3 of fiscal '19. And with strong Q3 sales and improved inventory management, inventory declined significantly on a sequential basis. Capital Expenditures in the quarter were $8.3 million which included investment for previously announced turnkey projects while depreciation and amortization was $14.1 million. Our balance sheet remains strong. We ended the quarter with net leverage of approximately 1.5 (ph) as calculated under our recently amended revolving credit facility.

Finally, turning to guidance. We are raising our fiscal year 2019 sales guidance to a range of $1.165 billion to $1.19 billion and increasing our fiscal year 2019 non-GAAP earnings per share guidance to a range of $4.10 to $4.30. Note, this guidance factors in anticipated start-up costs associated with our new turnkey projects as well as not quite as favorable expected margin mix in the Security division. This non-GAAP diluted EPS range excludes potential impairment, restructuring and other charges, amortization of acquired intangible assets and non-cash interest expense and their associated tax effects as well as any discrete tax items.

Additionally, we continue to evaluate the impact of tax reform on our effective tax rate which contains complex provisions. The effective tax rate is subject to significant volatility and will be updated as more analysis and information is available. We currently believe the sales and non-GAAP earnings guidance reflects reasonable estimates, actual sales and non-GAAP earnings however could vary from the anticipated ranges due to the risks and uncertainties specifically affecting our business and generally affecting industries in which we operate. These risks and uncertainties include items beyond our control such as site readiness or product installations, evolving government trade policies, customer acceptance of our products and the timing of orders in each division and other risks and uncertainties discussed in our SEC filings. We have continued to grow our business while investing in product development and making selective strategic acquisitions. These investments enable OSI to continue our leadership role with innovative products and solutions across our various industries. Thank you for participating in this conference call. And at this time, we would like to open the call to questions.

Questions and Answers:

Operator

(Operator Instructions) Our first question comes from the line of Larry Solow from CJS Securities. Your line is open.

Stefanos Crist -- CJS Securities -- Analyst

Hey guys, congrats on the quarter. This is Stefanos Crist calling for Larry. First question. So Jim Green joined OSI just about a year ago and the year under his belt. Can you discuss some of the initiatives in healthcare that's really driving the return to revenue growth

Deepak Chopra -- Chairman, President and Chief Executive Officer

Yeah this is Deepak here. Fundamentally during the last couple of calls, that we focused on -- what you call, focus focus focus on what we are known in the industry for, what is our real focus on the products and that's patient monitoring. So we deemphasized a money losing operation -- product line in the anesthesia area. Also we got out of a channel in some part of the world where it was not being very profitable. And we basically met or managing our cost focus execution.

And Jim Green has done a very good job of focusing Company back to its core competency and patient monitoring, connectivity, Telemetry, supplies and accessories and cardiology product line. And that's what's happening.

Stefanos Crist -- CJS Securities -- Analyst

Thank you so much. And just one more question. Could you talk more about the opportunities on the US Mexico border in terms of the wall?

Deepak Chopra -- Chairman, President and Chief Executive Officer

Okay let me try to answer that. I think we said it in the last conference call also. The budget for non-intrusive equipment has gone up in the Congress. And Customs and Border Patrol which is responsible for looking after the borders is a very good customer of ours. We are working diligently with them to do more at the southern border. And as I mentioned it, we have equipment on both sides of the border also. We are a very good relationship with them and we look at it that the opportunities continue to be very robust and we'll continue to grow.

Obviously, we have a policy that till anything specific happens, we don't talk more than that.

Stefanos Crist -- CJS Securities -- Analyst

Got it. Thank you and congrats again.

Deepak Chopra -- Chairman, President and Chief Executive Officer

Thank you.

Operator

Our next question comes from the line of Sheila Kahyaoglu with Jefferies. Your line is open.

Sheila Kahyaoglu -- Jefferies -- Analyst

Good afternoon and thank you all for the time. I guess, Deepak, in terms of the healthcare margins. How do we think about -- reducing cyclicality of that business as you focus on patient monitoring. What do we think about the potential runway of margins from here?

Alan Edrick -- Executive Vice President and Chief Financial Officer

Sheila this is Alan. I'll take that question. So we do see some seasonality in the healthcare business in general but what we see is that the healthcare business has the highest contribution margins. So our -- as our revenues increase there is a -- there's a major contribution to the operating income and the operating margin level. So our operating margins are highly reflective of what's going on our top line. Our sales are -- the majority of our sales are in the US which is also our highest margin area within healthcare. So we believe that as we continue to grow the top line, there is ample room for continued operating margin expansion as we go forward.

Sheila Kahyaoglu -- Jefferies -- Analyst

Okay. Thank you. And then I was wondering if you could expand upon the potential for the services offering, you guys mentioned in the prepared remarks, how do we think about that and just -- the incident you guys mentioned in Arizona, have that potential of driving your business. Thank you.

Deepak Chopra -- Chairman, President and Chief Executive Officer

Sheila, this is Deepak, here. One of the things we've said for the last couple of years and we continue to talk about it. We are very, very positive on what we call integrated services and turnkey business model that basically is what we are, what we announced for the Guatemala, that's what we have in Mexico, that's what in Puerto Rico, that's with Albania. And as more of those are being showcased to other customers from those regions, people are beginning to get more confidence that this concept and operational mode is a successful, viable, economic partnership with the customer and a vendor. Regarding the catch, yes it was a actual catch to our equipment, it was published on TV by the CBP and there's been other catches. So couple of months ago there was a catch in Albania going into Italy for a very large cash there. So it's getting more publicity, we think that the services models and the integrated services is catching on and we are very proud about one fact that we have a very broad product portfolio and without proprietary CertScan software, it also plays very well into training the customer into making more software enhancements to be specific to various things that at the border they want to catch and the most important thing is that we have the products, we have a good brand name and we have the software.

Sheila Kahyaoglu -- Jefferies -- Analyst

Great, thank you.

Operator

Our next question comes from the line of Jeff Martin from Roth Capital. Your line is open.

Jeff Martin -- Roth Capital -- Analyst

Thanks, good afternoon. Nice quarter, guys.

Deepak Chopra -- Chairman, President and Chief Executive Officer

Thank you.

Alan Edrick -- Executive Vice President and Chief Financial Officer

Thank you.

Jeff Martin -- Roth Capital -- Analyst

I'm wondering, if you could elaborate on the prepared remark for staffing up for increased demand in 2020 and are there specific areas you can highlight both from a product perspective and a geographic perspective.

Deepak Chopra -- Chairman, President and Chief Executive Officer

This is Deepak here, basically with the growth that we have seen over the last couple of quarters in security especially both in the cargo product line and in the RTT, we are ramping up production capability both in the cargo facility in Boston and in England (ph) in both the RTT facility and the cargo facility because as you know the timeline or the production, equipment, the inventory and all that stuff take some time. So plus also manpower. So we are -- we are ramping up or we have increased production and in some cases just an example without giving any more information there was some products in Billerica that we were doing one a month, now we are doing five a month, so we have really increased the capacity.

Jeff Martin -- Roth Capital -- Analyst

Yeah, that's encouraging. Could you also elaborate on the comment regarding some order push outs from Q3, is that into Q4, is that beyond fiscal '19?

Deepak Chopra -- Chairman, President and Chief Executive Officer

Well especially in the cargo business, as you know, you've followed the Company for some time. It can change from a month to next month for the quarter for the next one depending upon their international tenders, sites not readiness, customer changing the specification and stuff. So I would say that it's pushed toward Q4, some we already booked, some will come into the next -- early part of next year. But I did make a comment that we are projecting right now .Though we have not given any guidance that we look at the opportunity in a pipeline for a strong fiscal 2020, is in the making.

Jeff Martin -- Roth Capital -- Analyst

Great. That's it for me. Thanks, guys.

Operator

(Operator Instruction) Our next question comes from the line of Aman Gulani from B. Riley. Your line is now open.

Aman Gulani -- B.Riley -- Analyst

Hi guys. Congratulations on the quarter and thanks for taking my question. I just wanted to get an update on the replacement cycle in Europe. What percentage of the way to the conversion do you think you are roughly?

Deepak Chopra -- Chairman, President and Chief Executive Officer

As we have said before that 2020, '21 are the deadlines. There's a lot of activity in Europe. We have also said in the last conference call and some of the orders we announced, we have been quite successful on getting some orders in the European sector. Basically can't -- becasue we don't know the data, but if you have to guess or estimate about 30%, 35% had been bought. So there is still lot of activity coming up in the next 12 months. On top of that we've also said in the conference call, the last couple of conference calls that it's not just Europe though there are deadline requirements in Asia and Latin America and Middle East. But they're also upgrading their airports. So the demand continues to be quite strong in all -- all -- in all over area -- geographical.

Aman Gulani -- B.Riley -- Analyst

Got it. Very helpful. Last question from me regarding the IDIQ contract for $450 million. Have you seen much activity on that front and just trying to get a feel for if it could be a material contributor in the near term?

Deepak Chopra -- Chairman, President and Chief Executive Officer

Well we did -- we did clarify it last year. Firstly itself, it's a customer we've had before. We've done an IDIQ before and it going to emphasize is that all it basically says is that it's a license to participate, to bid and to be asked by the customer at the hospital to ask for our products. And there is no guarantee that any specific dollar amount would be spent but that's like a maximum limit that they can spend on the products they want to buy and there are one or two other companies also who -- also have the same IDIQs, so that it's basically a focus that the government has this vehicle called indefinite delivery, indefinite quantity. This is just the max limit on which you can spend

Aman Gulani -- B.Riley -- Analyst

Got it, thank you. I will pass it on.

Operator

There are no more question at this time. Presenters, you may continue.

Deepak Chopra -- Chairman, President and Chief Executive Officer

Well thank you very much. Appreciate and we want to wish everybody Happy Easter. And looking forward to getting the next year -- of year end call in August. Thanks for everybody's support.

Operator

Ladies and gentlemen, this concludes today's conference. Thank you for your participation and have a wonderful day. You may all disconnect.

Duration: 30 minutes

Call participants:

Alan Edrick -- Executive Vice President and Chief Financial Officer

Deepak Chopra -- Chairman, President and Chief Executive Officer

Stefanos Crist -- CJS Securities -- Analyst

Sheila Kahyaoglu -- Jefferies -- Analyst

Jeff Martin -- Roth Capital -- Analyst

Aman Gulani -- B.Riley -- Analyst

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