OSI Systems, Inc.
Q4 2008 Earnings Call Transcript

Published: 27 Aug 2008

[Operator:]

Welcome to the fourth quarter 2008 OSI Systems earnings conference call. (Operator Instructions) I will now like to turn your presentation over to Alan Edrick, Chief Financial Officer.

[Alan Edrick:]

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, President of our Security Division, Rapiscan Systems; Victor Sze, our General Counsel; and Jeremy Norton, our VP of Investor Relations. Welcome to the OSI Systems 2008 fourth quarter and year-end conference call. We’d like to extend 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 our website for approximately two weeks. Before discussing our financial and operational highlights, I’d 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 measures, the most directly comparable GAAP measures and quantitative reconciliation of these figures, please refer to today’s press release regarding our fourth quarter results. The press release will also be filed with the SEC as part of a Form 8-K. 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 of overview of recent accomplishments. As highlighted on each of our conference calls over the past year, we have placed significant emphasis on specific initiatives to improve our profitability; and we continue to be pleased with the rapid progress we are making. Our fiscal year 2008 financial results demonstrated significant improvement and provide clear evidence that the changes we embarked upon in fiscal 2007 and continue to build upon in fiscal 2008 are leaning to sustainable improved earnings performance. Q4 and fiscal year highlights are as follows

[Deepak Chopra:]

This has been a very good year for the company. 2008 was a challenging year. We committed to you the people over the last couple of quarters that we are focused to grow our top line wisely and bring more emphasis on the bottom line. We are happy to announce, as Alan has mentioned, that year-on-year revenue increased by 17% to a record $623 million. While excluding the impact of impairment restructuring and other one-time charges, operating income improved by approximately $29 million to an operating profit of $24 million versus a loss for the year before; and earnings per share improved by approximately $1.04 resulting to $0.74 per diluted share on a normalized basis from last year earlier. On a divisional basis, all three businesses finished the year on a very positive note. Security

[Alan Edrick:]

Consistent with the message from each of our calls this past year, our management team remains highly focused on driving earnings and cash flow improvement. I’ll speak more about this shortly, but first let me review the financial results of the fourth quarter. As previously mentioned, net sales for the fourth quarter increased 12% to a record $171 million in fiscal ’08 from $153 million in fiscal 2007. On a divisional basis, our Security Group reported another solid quarter with 10% growth in sales coming off a strong Q4 in the prior year, leading to 21% for the full growth. Our Opto Group had another outstanding quarter reporting a 45% increase in third party sales led by strong shipments on a contract associated with the U.S. Government’s MRAP Program, as Deepak mentioned. As expected, our Healthcare Division reported Q4 sales in line with the prior year’s strong performance and for the full year saw a 10% top line growth. Our bottom line for the fourth quarter in 2008 markedly improved as we reported net income of $5.5 million or $0.31 per diluted share compared to $4.3 million or $0.24 per diluted share for the same period in fiscal 2007. Excluding certain non-recurring items in both ’08 and ’07, primarily impairment restructuring and other charges and normalizing the tax provision, net income for the fourth quarter of fiscal 2008 would have been approximately $6.4 million or $0.36 per diluted share compared to net income of approximately $2.8 million or $0.16 per diluted share for the comparable quarter of last year. For the fourth quarter of fiscal ’08, our gross margin decreased 220 basis points, primarily due to significant growth in our Opto Group sales. As our Opto Division reported a 45% increase in sales, which inherently carry a lower gross margin than our other two divisions, our consolidated gross margin is adversely impacted. 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 do expect to see overall improvements in fiscal 2009. During the fourth quarter and fiscal 2008, we realized the operating leverage that the organization worked so hard to achieve. Our SG&A expenses, as a percentage of sales, decreased by 360 basis points for the fourth quarter and 410 basis points for all of fiscal 2008. For the quarter, SG&A expense declined to 21.7% of sales form 25.3% compared to the same period last year. Looking at it from a slightly different perspective, despite a 12% increased in Q4 revenues, we actually decreased SG&A expenses by 4% in absolute dollars compared to the same period last year. Research & Development

[Operator:]

(Operator Instructions) Your first question comes from Joshua Jabs - Roth Capital.

[Joshua Jabs- Roth Capital Partners LLC:]

So if I look at the cost savings impact, operating expenses actually came right in line with our expectations for the quarter. I know the improvements on the gross margin that take a little longer to materialize, but can you give us a little color on where the margins are currently between other divisions and where that’s likely to go over time, maybe excluding the impact of the MRAP orders?

[Alan Edrick:]

Josh, while we don’t give gross margin detail by division, let me kind of give you some high perspectives. I think as we look forward, I think we could anticipate that we could see up to 200 basis point improvement in fiscal ’09. We think that can be generated by a number of initiatives. One, as Deepak mentioned, the pure closure of the weapon simulation business which was a drag on our gross margin will clearly help in fiscal ’09. We couple that with the growth in our business that we’re projecting for next year is highly focused to Security and Healthcare, which have higher margins than the Optoelectronics business, so this year’s gross margin was dragged down a little bit by the strong sales in our contract manufacturing group within Optoelectronics, which while they provided nice operating margin and a nice contribution to our earnings per share, adversely impacted our gross margin. So we think those things coupled with some supply initiatives that we’re doing, the closures of certain facilities in Healthcare, which currently while we’re operating multiple facilities while the closure is taking place negative impact our gross margin on the short-term will all contribute nicely. Those closures are essentially done now. So as we move into fiscal ’09, we feel pretty confident that we’re going to see some nice gross margin improvement.

[Joshua Jabs- Roth Capital Partners LLC:]

Then on the backlog, you finished at $212 million which looked pretty good given the revenue beat, but you’ve had some pretty orders here the first part of this quarter. Where does the backlog stand today?

[Deepak Chopra:]

It’s in the middle of the quarter, but approximately it’s end of July, the backlog was close to $240 million, and the big increase is in Security. Keep in mind that this is the quarter where it’s not over yet and this is a very important quarter for the Security and we believe that Security backlog at the end of the quarter would be higher than it was at the end of June significantly.

[Joshua Jabs- Roth Capital Partners LLC:]

Last one here

[Alan Edrick:]

Sure, maybe kind of you give a broad sense. Overall from a headcount perspective year-on-year, we’re down 2% compared to last year. If you kind of look at it on a security division basis with some of the cost savings that we did this year, we’re down about 6%, Opto we’re down about 4%, and Healthcare we’re up slightly given the new manufacturing facility that we opened in Suzhou.

[Joshua Jabs- Roth Capital Partners LLC:]

With the dual facilities running that you had close them down, will that number come down on the Healthcare side?

[Alan Edrick:]

Yes, we anticipate it will.

[Deepak Chopra:]

Just to add on it, one of the other things that you should look at it is not just the headcount but where the headcount is. Obviously the headcount in the western world, in United States, cost more money than the same comparable headcount in China or India. So as we move those little people around, the total payroll cost maybe a much bigger impact than the headcount reduction.

[Joshua Jabs- Roth Capital Partners LLC:]

Then Deepak, I guess one last question for you. I know there’s some diversification going on. Any chance we get on a funnel plan there?

[Deepak Chopra:]

I have been talking to Victor. The answer is yes. I think the first time you dive into it, it’s more difficult. Keep in mind that I’m still the largest stockholder and over the last couple of years my holdings have not sort of changed. I’m not running to the knock to the hills.

[Joshua Jabs- Roth Capital Partners LLC:]

I think that’s a good, should get rid some of the noise there.

[Operator:]

Your next question comes from Brian Ruttenbur - Morgan Keegan.

[Brian Rottenbur:]

Where was backlog in Q407?

[Deepak Chopra:]

$209 million.

[Brian Rottenbur:]

Litigation with L3, is that dead? Is that something that’s just totally in the past now and just pressing on?

[Victor Sze:]

The court of appeals has remounted the case for [inaudible] proceedings at trial level and that’s where it stands right now.

[Brian Rottenbur:]

So that does mean that you’re going to have more expenses and how much do you expect in 2009 in terms of legal?

[Victor Sze:]

It’s sort of in between proceedings right now and it’s [inaudible] pending litigation and it’s difficult as you can expect for us to make any firm comments on that, but we’re got all options open to us.

[Brian Rottenbur:]

So is the automatic appeals, I mean what all are you going to have to consult outside legal advice for?

[Victor Sze:]

So where it stands right now is that the second circuit has made its initial ruling. We filed a petition for rehearing. Obviously we disagree with their results, so that is a petition that’s pending right now. But as I mentioned earlier, the initial ruling was to remount the case.

[Brian Rottenbur:]

On a worse case scenario, what does that mean for you guys?

[Deepak Chopra:]

Business as usual.

[Brian Rottenbur:]

So I mean do you pursue tings on a worse case and ask for a retrial or what?

[Victor Sze:]

Like I said earlier, it is life pending litigation and you’re asking for some strategic questions here, but it’s different, as you can imagine, for us to make any firm statements on life pending litigation.

[Deepak Chopra:]

Brian, just to add on it, we’re looking at all our options, but we don’t think about it. WE got a business to run and our focus is of running the business, but this is one of those things that will continue and we look at it as the next hand is dealt to us.

[Brian Rottenbur:]

Can you talk a little bit about, maybe this is for Alan, cash generation in 2009, what the plan is? You’re at roughly $49 million of debt. Is the plan to generate – - can you talk about what kind of cash you expect to generate to the balance sheet in 2009 since you give revenue and earnings guidance.

[Alan Edrick:]

Yeah, we don’t give cash flow guidance, but what I can say, Brian, is coming off of five straight years of generating negative free cash, were very optimistic. I think the plans that we’ve been putting in place for the better profitability and greater focus on working capital initiatives such s DSOs and inventory turns is going to lead - - we’re optimistic it’s going to lead to positive free cash next year. We think the Q4 and even Q3 was some indication of that, so we’re very positive on our operating cash flow sort of projections, internal projections for next year in free cash overall, but we don’t give free cash flow guidance.

[Brian Rottenbur:]

Maybe you can tell us capex expected in 2009.

[Alan Edrick:]

I think it’ll be with sort of our historical run rates which tend to be in that 15 to 17 million range.

[Brian Rottenbur:]

Let me just back into cash flow. We’re expecting operating, according to your guidance, operating income or even net plus DNA, you’re talking about 20 to 30 million of, I probably used a broader brush there, 20 to 30 million kind of cash flow and then you subtract out capex. Is there anything else that I should be looking at in there that I’m missing in terms of cash flow? Is there something else going on?

[Alan Edrick:]

I think you’re in the ballpark. I mean I think as we grow particularly within the Security Division there’s different inventory requirements that take place, but I think generally speaking it’s in the ballpark.

[Brian Rottenbur:]

Then the last question is target model, as you stand now kind of two to three years out from now, you expect to grow your top line at a, what, 7% to 8% total revenue and gross margin should go 100 basis points up a year and net should go up 100 basis points. Can you give us some kind of broad brush on business model where it should go and over what period of time?

[Deepak Chopra:]

One of the things is that we’ve been so focused onto the bottom line for the last couple of quarters. 2008 has been a challenging year. We focused on 2009 and frankly speaking all through the company. Bottom line is more important than top line, not that top line is not improvement. But I think that our internal targets are close to the double digit growth, continue to improve a point or so in the gross margin as we move production over, as we look at repeat orders in cargo and in other things and continue to look at that the SG&A to keep it down. R&D spend wisely, and that famous thing for Tim Quillin, that 5% net is the 2010 target. That’s the target we’re working towards.

[Operator:]

Your next question comes from Michael Kim - Imperial Capital.

[Michael Kim:]

In regards to the Security Division, can you talk a little bit about the sales mix in the quarter, the fourth quarter and the relative growth for between cargo and vehicle and other Security products, the baggage, parcel, and people products?

[Ajay Mehra:]

I think what you’re seeing really everybody talks about cargo. We’re seeing growth over there from a sales standpoint. Obviously we’ve always said that depending on when the product ship, it’s going to make a difference. So we’ve had some very good bookings. We expect to have good sales. I think on the conventional side, we’ve also seen very strong sales, not just for the quarter but for the year as well, and we’re looking at double digits on both sides.

[Michael Kim:]

Just based on the commentary, it sounds like you’re starting to see a stronger momentum on the cargo side, or would you still characterize it as pretty much across the board?

[Ajay Mehra:]

Well I think cargo side is definitely very strong for us, but we’re seeing growth in other areas as well, so there might be a little different in terms of what percentage growth we’re seeing, but we’re seeing good growth in the entire security product line.

[Deepak Chopra:]

Just to add on to it, keep in mind that the ticket for cargo is much bigger number. So as those systems get shipped out, the numbers start looking very big. So we think that both areas will continue to grow, but we also want to emphasize that longer term, not this year, but longer term we also have the check baggage product line coming on line. We already have the MVX systems, the R&D systems hopefully we’ll start generating revenue in 2010/2011. So we look at it that all sectors we can look at very significant growth. But right now you’re absolutely right; cargo is driving much faster than the other sector.

[Michael Kim:]

In terms of the margins with cargo tracking higher, would you expect that from a mixed perspective to drive margin along the lines with the progress we’ve seen in the last number of quarters?

[Deepak Chopra:]

The answer is yes. As production repeat orders get shipped out, we continue to look at improved margin in cargo. One of the things that we’re trying to put a model together, it’s not just the gross margin of a product line that we look at. It’s what the net contribution to the bottom. Cargo might have a lower margin than some of the other products, but they also might require less R&D. They might require less support, so might drop significantly the same or better to the bottom line.

[Michael Kim:]

Switching gears on the Healthcare Division, can you talk a little bit about the contribution from international growth in the quarter versus domestic and also your expectations for the growth in newer products versus sort of existing products? It sounds like you’re pretty excited about the entry level products going into next year, if you think that’ll drive the majority of the growth for ’09?

[Deepak Chopra:]

Well for 2008, all three sectors are, Alan also mentioned, the emerging markets, the Western Europe, and United States all had increases. The elance or the new product launch of the lower cost products, specifically for the emerging markets, has zero contribution today in 2008. In 2009, it will start showing some contribution, and we believe that since that sector’s economies are growing faster than the rest of the world that we will see more growth coming out from that product line, keeping in mind that has nothing to do with our other R&D for the next generation launch of our higher end products which will start coming online somewhere in the near future. We can’t give you a date for competitive reasons. The other contribution is from the anesthesia product line and the cardiology product lines. They’ve all shown significant growth in all sectors geographically.

[Operator:]

Your next question comes from Josephine Millward - Stanford Group.

[Josephine Millward:]

How much of the bookings for MRAP in Opto have you shipped, and do you expect additional orders from ITT in the future?

[Deepak Chopra:]

I mentioned that our booking to date is about $65 million and, yes, we expect more bookings. Regarding shipments, I don’t think so we have an exact number, but, Alan, would you take a macro level whether it’s 20% shipped, 30% shipped, 40/50% shipped?

[Alan Edrick:]

Yeah, I would venture to say just it’s roughly two-thirds of that amount was shipped fiscal ’08 with the balance to be shipped in fiscal ’09.

[Josephine Millward:]

Alan, you talked about the 200 basis point improvement in gross margin driven by a change in your product mix, are you also planning on more cost cutting initiatives? Can you give us more color on what to expect in terms of one-time charges and what areas you’ll be focused on?

[Alan Edrick:]

As you know, Josephine, over the past two years we have been highly focused on some of the efficiency programs and some of the cost rationalization efforts. While that will always be a continuing process, I think a lot of the heavy lifting is behind us and now it becomes more fine tuning of the business operations focusing more on some supply chain initiatives and continuing to optimize sort of our product portfolios and manufacturing methods. So as a result, I don’t believe we are anticipating at this point the impairment restructuring charges to be as significant. We will see them going on for at least the first few quarters of fiscal ’09, particularly within the Healthcare Division where some of the closures of a facility that we’ve been in process gets completed and due to just accounting rules, we couldn’t accrue for that all in fiscal ’08. So we will see them, but we believe the magnitude will be less than fiscal ’08.

[Deepak Chopra:]

Just to add on to it, Josephine, that as we introduce the new product line, new R&D initiatives with the launch of the new products, they command higher margins. So that’s another variable that should help us in getting our margins better as the new products come online.

[Josephine Millward:]

Deepak or Ajay, can you talk more about the TSA air cargo opportunity? Do you expect the TSA to pilot your event x-ray system for that sometime soon or is that in the works already?

[Ajay Mehra:]

I think you’re all aware, you’re aware what TSA is doing. They’ve had some hearings [inaudible] talked about their cargo. We are involved with TSA. We are involved with talking to them. We have some products they’re looking at and really for me to comment any further would be inappropriate at this time, but we are definitely involved with the TSA and working with them closely.

[Operator:]

Your next question comes from Tim Quillin - Stephens Inc.

[Timothy Quillin:]

I apologize, I missed the first part of the call, but I know you don’t give quarterly guidance, but I think you’ve had a loss in the first quarter in the past over the past couple fiscal years. Could you just comment on whether you expect to be profitable in the first quarter of fiscal ’09?

[Alan Edrick:]

You’re right, we don’t have quarterly guidance and the trend you see in the past is that the first quarter’s generally been our lightest quarter. That being said, all the changes that we’ve been making, our goal and our intent is to be profitable in each and every quarter of the year, which includes Q1 as well.

[Operator:]

You have a follow-up question from Joshua Jabs - Roth Capital.

[Joshua Jabs- Roth Capital Partners LLC:]

Alan, just to follow-up here on the tax rate, what are you looking at for a consolidated tax rate going forward.

[Alan Edrick:]

Really depends a lot on the mix of where our profits are generated, Josh. But I think what we are using as a model is roughly 35%. We think we might be able to do a little better than that next year, but 35% is about where we’re going.

[Joshua Jabs- Roth Capital Partners LLC:]

How big do you think that range is based on mix? Have you looked at that?

[Alan Edrick:]

Yeah, it really can be plus or minus as much as 4%. I would say not so much the plus but through some tax strategies it could actually be less. But we would 35% is probably a pretty good number to use and we would hope to do a little better than that.

[Joshua Jabs- Roth Capital Partners LLC:]

Just looking at the way that you reported the pro forma, it’s $0.36 for Q4. If I just run the number straight through without the tax adjustment and take out the one-time costs, I get $0.38 so that sort of starts to back into that tax adjustment, but that also means I guess if you’re getting the $0.74 for the year that some of the prior quarters would have been bumped up a little bit.

[Alan Edrick:]

It may just be a little bit of a rounding issue between quarters when you look at the whole annualization, but I think you’re on target.

[Operator:]

Your next question comes from John Zoro - BCN.

[John Zora:]

I have a quick question, and I missed part of the call, so if it’s already been asked I apologize. The manufacturing cost savings, just over and above sort of closing duplicate plants and things like that, can you talk about that? I know when I had met with you before, you had talked about implementing some new manufacturing, new people in the manufacturing side and a potential cost savings there.

[Alan Edrick:]

Certainly. I think the manufacturing opportunities for us are really multifold. One as we’ve introduced the Suzhou, China, factory, we think that will help. As we finalize the closure of our U.K. based Healthcare facility, that will certainly contribute because as of Q4, we were still operating two manufacturing facilities in that regard and that is ending in Q1 more or less. In addition to that, we have brought on some new talent throughout the organization on the manufacturing side that we think will greatly improve the supply chain, the manufacturing processes themselves. That really will allow us to expand the margin and expand our ability to manage our working capital as well. So we’re optimistic in that regard, and that’s across the board from Security, Healthcare, and Optoelectronics.

[Operator:]

We’re currently showing no more questions in queue at this time.

[Deepak Chopra:]

Thank you, everybody. In conclusion and summary, we think that 2008 was a very good for us. The management, the employees of the company worked very hard. We focused very much over the last couple of quarters of delivering predictable results to the Street. We’re going into 2009 with a very good visibility. Our backlog is up. Security, Healthcare, Opto all feel very good for the year. Obviously we have to put up a visor, though we have not been impacted yet by the economy, we continue to look at it both domestically, internationally. But we will rise to the challenge. Our focus is to grow wisely the top line, but keeping in mind that predictable earnings is very important. So we continue to do it and hope to talk to you next quarter. Thank you.