OSI Systems, Inc.
Q2 2021 Earnings Call Transcript

Published: 28 Jan 2021

[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, our President and CEO. Welcome to the OSI Systems fiscal '21 second quarter conference call. We are pleased that you can join us as we review our financial and operational results and discuss our updated outlook for fiscal '21.

[Deepak Chopra:]

Thank you, Alan, and thanks to everyone joining us on today's call. During the second quarter of fiscal '21, as Alan has mentioned, we achieved record adjusted earnings and had strong cash flow, and we ended the quarter with a backlog in excess of $1 billion. With a healthy backlog and a solid overall first half performance, we enter the second half of fiscal '21 with confidence. Let's take look at each division's performance in the quarter. Starting with the security division.

[Alan Edrick:]

Thank you, Deepak. So let's review the Q2 financial results in some greater detail. Our revenues in Q2 of fiscal '21 were $276 million as compared to $305 million in the prior year Q2. Similar to Q1, we reported strong sales growth in the healthcare and Opto divisions, but a reduction in revenues in security due in part to the effects of the pandemic. Let's dive deeper, starting with the healthcare division, where, as Deepak mentioned, revenues increased 31% year- over-year with strength in many major geographic sales channels across our portfolio, including patient monitoring, supplies and accessories and service.

[Operator:]

Our first question comes from Jeff Martin, ROTH Capital Partners. Your line is open.

[Jeff Martin:]

Was curious if you could give us some additional insight into what you're seeing in the security segment in the second half relative to the first half? What are the key swing factors that give you confidence that you'll see an acceleration in the second half?

[Deepak Chopra:]

Good question, Jeff. This is Deepak here. One of the things as I mentioned, and Alan has mentioned, we're entering the second half with a very strong backlog. Our bookings have been very strong in Q1 and Q2 in security. And we expect that we will start shipping some of that stuff that has been challenged in the first half. Number two, all our indications are, our pipeline continues to be strong, both internationally and domestically. And I also mentioned that with the change of administration, in Washington, some of the bipartisan support is coming to reallocate some of the funding from the border wall into technology and nonintrusive equipment, which we are very well placed with and have a great relationship with DHS.

[Jeff Martin:]

Right. And along those lines, could you give us some relative perspective as to how much, say, in the last 12 months or last year the customs and border inspection in the U.S. contributed? I mean, are we talking about going from very little to potentially a significant amount over the next 12 to 18 months in perspective? That would be helpful.

[Deepak Chopra:]

Jeff, we don't break it down. But we have said in the previous conference calls already last year even DHS, CBP, their budgets have gone up quite a lot. And we think continued strength will remain in place to upgrade technology and to bring more technology-based platforms at the border for inspection.

[Jeff Martin:]

Okay. And then my second question is on the healthcare segment. Could you give us some relative perspective on what your expectation is for the second half of fiscal '21 in healthcare relative to the first half obviously, patient monitoring has been a nice contributor in the first half, and that may not be as strong in the second half, but cardio may pick up. Could just help frame for us whether you expect it to be flat up or down relative to first half?

[Alan Edrick:]

Jeff, this is Alan. Sure. I'll take that question. Of course, we provide guidance for the overall company of OSI Systems as opposed to by division. But kind of giving you a little color, we expect to see continued strength in the healthcare business here in our third quarter. There's so much uncertainty at this time given COVID and the pandemic that looking out beyond that, is difficult to say. But overall, we're seeing continued strength in our healthcare business, and we think that will continue. We're really pleased with the improvements made by our leadership team at Spacelabs and we expect that to reap dividends for us for the future.

[Jeff Martin:]

Okay. Great. And then last question. In terms of capital structure, you paid down roughly $30 million of debt in the quarter, cash was only down minimally just curious if we should anticipate continued debt reduction, how are you looking at capital allocation because you're generating significant free cash flow?

[Alan Edrick:]

Sure, Jeff. This is Alan. You're absolutely right. The cash flow has been excellent. Our capital allocation strategy is multifold. We look at acquisitions, we look at new turnkey projects, we look at stock buyback and we look at any residual paying down our debt. And the nice thing for us is we don't necessarily think they're mutually exclusive. In this past quarter, it was more on the debt pay downside. In the previous quarter, there was a small acquisition, coupled with significant stock buyback. We expect to continue to be a nice cash flow generator and be able to play in all of those areas that I just mentioned.

[Operator:]

Our next question comes from Larry Solow of CJS Securities. Your line is open.

[Larry Solow:]

Congrats on a good quarter. First question I have is on the security piece. So -- and I know you mentioned a little better mix benefited you this quarter, and you have mentioned cost cut in the last couple of quarters. Just trying to get my hands around the revenue declined about 30%, and you were -- as mentioned, able to keep your margin -- operating margin flat year-over-year, which is pretty remarkable. As revenue comes back, do you -- without giving us actual numbers, I suppose we should see operating margin continue to rise and reach perhaps significantly above where we are today. Is that fair to say?

[Alan Edrick:]

Larry, this is Alan. Good observation and good question. Absolutely, our team has done an excellent job maintaining margins with the change in revenue. And you're right, as margins move up, excuse me, as sales move up, we would expect margin expansion is our goal as well. And we think there's significant opportunity to do that. Of course, some of the changes that we made are more structural in nature and are permanent reductions. Others, like most companies, there's some temporary benefit for maybe some reduced travel savings and some things like that. But absolutely, we do believe there's opportunity for operating margin expansion in our security business and we're planning on that.

[Larry Solow:]

Okay. And you mentioned -- I know you had several contract wins recently. Have any of these contracts, any of these newer business wins contribute in the quarter? Or not? I don't know, on the security side?

[Alan Edrick:]

So the larger announcements that we made and that Deepak referred to will really be more in our second half and even somewhat into fiscal 2022. So this past quarter was principally for wins that we had before besides the smaller book and ship business.

[Larry Solow:]

Got it. And you mentioned Guatemala started to ramp is that any way to sort of characterize that? Is that -- have you sort of laid out cost ahead of the revenue? Should we start to see more rising contributions for that plus on the bottom line of the next several quarters?

[Alan Edrick:]

Yes. That's a correct statement. So we have been ramping up on our revenues for Guatemala and expect to be at near full run rate before the end of the fiscal year. And you are right, some of the costs that you put in are relatively fixed in nature so they come in advance of being at peak revenues. So yes, margins should increase relative to that project for us as volumes ramp up.

[Larry Solow:]

And the drop in service revenue this quarter sort of picked up a little bit relative to Q1. And I think service revenues were down mid-teens and overall revenue was only down in the high singles. Is that -- I assume, mostly from the security segment and I know partially related maybe to Mexico, but is that just utilization stuff and service stuff? Should we expect some of that to start to rebound as we look out?

[Alan Edrick:]

Yes. Good question again, Larry. The drop in service revenue is almost entirely related to Mexico. So that contract will lap in June. So as we move into fiscal '22, yes, we would expect to see a rise in our service revenues year-over-year, but we'll have another quarter or two of that same scenario relative to service revenues.

[Larry Solow:]

Okay. And you mentioned pretty significant growth in healthcare, the 30% number. And I think Q2 normally is a seasonally stronger quarter. Any way to sort of parse out the benefit from COVID? Do you -- it sounds like seems to be outweighing the cardio, the slowdown on cardio, but maybe not. Just trying to parse that out. And maybe you can help us, how much is cardiology roughly, can you tell us represent in terms of your segment revenue?

[Alan Edrick:]

So Larry, this is Alan. So cardiology, including some of the ancillary services, is about quarter of our revenue of our healthcare business overall.

[Larry Solow:]

Okay. And on the COVID benefit, do you see those continuing? Do we -- or is that something that may -- even with COVID continuing, I don't know, hospitals are they continuing to purchase monitors? Or will it become a point where they don't have so many beds for monitors, right?

[Deepak Chopra:]

So Larry, this is Deepak here. As Alan has mentioned, it's very difficult to predict it. We've had a very strong couple of quarters. And Alan has also mentioned, Q3 continues to show strength, difficult to read Q4. But all in all, we think that this is an ongoing, and it's not just in U.S., it's in Canada, it's in other parts of the world. And cardiology, we think, will pick up. So all in all, we think that the healthcare will continue to do well. But definitely, we are not saying in any shape or form that can continue with the 30% growth that we've seen. But -- on the other side, security, we think is going to do better in second half. And the Optoelectronics that Alan has mentioned continues to show very, very good performance.

[Larry Solow:]

Looking at healthcare, you don't think we're approaching any type of -- not a cliff, but where you might see a significant pullback from maybe perhaps customers on the hospital side don't buy for a few quarters. Is that something that you think is a risk or not necessarily?

[Deepak Chopra:]

We don't see any major pullbacks and stuff like that. At the same time, remember, we're also spending a lot of R&D money to develop new products, and those products will start being implemented in cardiology specifically in later in the second half. And as we go into the next years, the new platform that we are working on in monitoring should start seeing some big traction.

[Operator:]

Our next question comes from Christopher Glynn of Oppenheimer. Your line is open.

[Christopher Glynn:]

Yes. So I was curious about the cardiology commercialization process with the new products coming. I think there's a focus in North America. Wondering how the kind of channel conditioning is going, what your line of sight is on converting the commercial aspect independent isolating out the pandemic timing type dynamics?

[Alan Edrick:]

Chris, this is Alan. Really good question. Yes, we're really excited about the opportunities in cardiology. We brought on a new commercial team for North America for the United States specifically, as you're referring to. So we have a new Vice President of Cardiology sales who came on board and he's recruited some new members to his team, and the timing couldn't be more perfect. So as these new products begin to come out here, predominantly in our fourth quarter, fourth fiscal quarter and beyond. It's just a perfect time to start ramping up for cardiology. As Deepak mentioned, we expect some increasing levels of demand for some of the existing products. As we come out of the pandemic coupled with the new products, we expect this to lead to some significant growth in cardiology sales, particularly in the U.S., but really on a worldwide basis. And one of the nice things about that is cardiology represents our highest margin product in healthcare. Frankly, it's our highest margin product in all of OSI systems. So as cardiology sales ramp, there's a real nice pull-through to the bottom line both for the division and the company overall.

[Deepak Chopra:]

Just to add on to what Alan said, the other thing that there is a change happening in the marketplace that most people are looking at remote monitoring home monitoring, teleservices, our new products and stuff are based on cloud computing, and we are very much focused on to this new trend that's coming in there. People don't want to visit hospitals. People don't want to go there. So if they can do the monitoring from home, the doctors can go back and forth, we are very much engaged in that.

[Christopher Glynn:]

A quick question on inflation. Curious how you manage that, whether through hedges or pass-through and how backlog that's already booked fares when we have an inflation ramp in the economy?

[Alan Edrick:]

Yes. Chris, this is Alan. So we have not tended to see any material impact from inflation. While there can be some inflation, we -- our supply chain also does a good job managing cost reductions in other areas. So overall, we do not view inflation as really a significant impact to our company overall.

[Operator:]

Our next question comes from Josh Nichols of B. Riley. Your line is open.

[Josh Nichols:]

Commendable job specifically on the operating margin side, guess. Looking here, I did want to ask some of the questions I had have already been addressed. But looking at how strong the Opto division has been, we've been hearing a lot of things about shortages and high demand out of that area. Is there any elaboration that you could provide about specific areas of strength, whether it's like specific products and demand? And where is that feeding into from like a geographic region?

[Deepak Chopra:]

Good question. Definitely, yes, you're right. The reading right. There's a lot of people, we're having shortages and stuff. We don't see much about it. We are very fortunate that we are a vertically integrated company. The demand that we are seeing is in a very broad industrial platform. Obviously, the number one platform that's showing a significant demand is from our healthcare, we are very much into the healthcare OEM products in pulse oximetry and other areas that supply to other people. Aerospace depends. And the answer to your question is, in this particular case, it's pretty much move or there's a lot of demand from the U.S., there's a lot of demand in Asia. Even in Europe, yes, there are some challenges out there. But our product -- our customer base, one of the biggest trends we've always had in that Opto product line, we have a very broad customer base. And one of the other areas which are doing very well is in the automotive industry.

[Alan Edrick:]

And Josh, just to add on, our biggest strength has been out of our Asian operations. And the greatest growth is what Deepak just mentioned in automotive as well as in some of the defense business. So the broad-based nature of what we do has been extremely helpful for us.

[Josh Nichols:]

Some helpful detail on that front. I'm glad to hear that you guys are well situated as a vertically integrated player in that space. Is it fair to say now that you've had a couple of these turnkeys rollout also, right, and you're ramping up now that the services revenue is probably kind of bottomed in 2Q and probably going to start ramping up a little bit more as we move through the following back half of this year?

[Alan Edrick:]

Josh, this is Alan. Yes, that's generally a correct comment. I think what we're going to see -- where you'll see the growth in service tend to occur probably as we enter our fiscal '22 here in about 6 months. As we'll continue to have those tough year-over-year comps in service for Q3 and Q4. So we would expect the growth to begin starting fiscal '22.

[Josh Nichols:]

And then last question for me. I mean, I think you guys were cored in my model at least, like it looks like you're going to be under 1 time net debt-to-EBITDA levered, right, by the end of the year. So clearly, a lot of opportunities for you guys, whether that's share repurchases or looking at some strategic M&A as well. One of the things I think that people would like to see or be wondering about is what needs to happen? Or how could the company kind of potentially accelerate the top line growth, thinking more about next year on one over your pass those year-over-year comps kind of to like a a low double-digit revenue and get out of the mid, high single-digit growth category? And what's the opportunity to improve on that front?

[Deepak Chopra:]

Good question. I'm going to answer it in a broader sense and then maybe Alan can jump in basically, our focus is our backlog is very strong. Our pipeline is very strong, especially in security, and as what the pandemic settles down as the vaccination comes into place, more travel is started, we will start seeing some big infrastructure investment from airports and ports and stuff especially United States. So we think that's going to be the growth carrier in security. Opto will continue to do well as it's a very broad product line. And healthcare, as Alan has mentioned, though definitely, that kind of growth in patient monitoring might slowdown, but cardiology is there. And the most important thing is that as a company, we've also been very acquisitive. We look at acquisitions, and we'll continue to look at it with a strong balance sheet. Alan?

[Alan Edrick:]

Yes, I would echo what Deepak said, we have a strong funnel of opportunities ahead of us to drive good, solid organic growth, but sort of leveraging on your comment, Josh, we do have a very strong balance sheet with low net leverage. M&A, acquisitions have played a big part of our strategy over the last 10 or 15 years. And we'd like to bolster or supplement that organic growth with some acquisitions as well. So I think the combination of those two can get us to a more accelerated revenue growth, as you were suggesting.

[Operator:]

Our next question comes from Greg Konrad of Jefferies. Your line is open.

[Greg Konrad:]

We've talked a lot about new product development on the healthcare side. Is there any way to think about as these new programs roll out, how much is kind of replacement versus incremental opportunities and kind of expanding your total addressable market versus replacement products?

[Deepak Chopra:]

Okay. Good question. This is Deepak here. On both -- on the cardiology side, it's add-on products. It's cloud computing. It's tele products related. And those are going to start getting executed in the next couple of months. Regarding the patient monitoring side, we are investing largely for our new platform, and that's going to take some time. And that will go into both combination of replacement, and we also say where we call them conversions, where because of the good connectivity story, good partnership, better price performance, we think that we will get some replacement conversions also. So that will be the growth path.

[Greg Konrad:]

That's helpful. And then, I mean, you've always talked about healthcare being the highest contribution margin of the business, and I think 50%, 60% is the number that you guys have thrown out, and you've kind of seen that play out the last three quarters. Any reason to think that trend changes in terms of drop throughs? Or is that level kind of sustainable as we go forward?

[Alan Edrick:]

Greg, this is Alan. We believe that the contribution margins that you've seen in healthcare are indeed sustainable. It always depends upon the mix of revenues. But as you mentioned at the outset, it is our highest contribution margin business. So the incremental are significant for us.

[Greg Konrad:]

And then just last one. I mean, you talked a little bit upfront about the changes in administration and some of the benefits. But we also saw the FY '21 budget finally passed at the end of the calendar year. Any benefit or funding maybe that gets freed up by that bill passing?

[Deepak Chopra:]

Well, I specifically can't answer that. But as we have said before, both bipartisan administration, they all are looking at more technology, which will make it more efficient. We are very well placed to have a great relationship with DHS, DOD, CBP. Lots of our equipment is at the southern border. And we continue to think that all the things that are happening and what we are hearing will be positive for us.

[Operator:]

Our next question comes from David Mizrahi of Berenberg. Your line is open.

[David Mizrahi:]

You mentioned on the last call, you expect roughly half a billion dollar backlog to be converted into sales through the remainder of this fiscal year. Just given the difficulties you have in actually converting the backlog into sales, how has that changed for you guys so far?

[Alan Edrick:]

David, yes, good question. This is Alan. As we look at the remainder of the year, we continue to expect a little bit less than half of our current backlog to be converted into revenue through the rest of the fiscal year. We have pretty good visibility in working with our customers in terms of the timing of installations and the like. So we have a pretty high degree of confidence that it will be just a little south of half of our current backlog.

[David Mizrahi:]

Great. Okay. And then can you just give us a brief update on how the SafeNSound acquisition is going? And because I know that you're focusing with the remote patient monitoring market. And you mentioned a few calls ago that be roughly integrated in the next 12 months or so. So how is that progressing?

[Deepak Chopra:]

Good question. Well, and it's very much incremental and embedded into our development of the next platform. And we continue to move forward. It's very much part of the total R&D that we are doing to develop the next generation, especially remote monitoring, cloud computing and stuff, SafeNSound is very much part of that integral development.

[Alan Edrick:]

And in addition to that, as part of our new development, when we look at our current commercialization effort, it's been instrumental in winning certain new business. So it's been very helpful for our sales and commercial team to sell SafeNSound along with our existing patient monitoring products as a nice differentiator for us. So it's really been a big win for us.

[Operator:]

Thank you. I'm showing no further questions at this time. I'd like to turn the call back over to management for any closing remarks.

[Deepak Chopra:]

Ladies and gentlemen, thanks once again for participating in our conference call. We look forward to speaking with you at your next earnings call. I wish everybody a healthy, safe time. And again, I want to thank, once again, our total global employees of OSI Systems for a job well done. Very proud of them. Thank you.

[Operator:]

Thank you. Ladies and gentlemen, this does conclude today's conference. Thank you all for participating. You may now disconnect. Have a great day.