OSI Systems Inc (OSIS) 2004 Q3 法說會逐字稿

Welcome to the OSI Systems third quarter results conference call. During the presentation, all participants will be in a listen-only mode. Afterwards we will conduct a question-and-answer session. At that time, if you have a question, please press the star, then the number one on your telephone. If you would like to withdraw your question, press the pound key on your telephone. As a reminder, this conference is being recorded, Thursday, April 29.

Your speakers for today are Mr. Anuj Wadhawan, Chief Financial Officer, Mr. Deepak Chopra, Chief Executive Officer and Chairman of the Board, Mr. Ajay Mehra, President of the Security Products Group, and Mr. Richard Atkin, President of Spacelabs Medical. I would now like to turn the conference over to Mr. Anuj Wadhawan. Please go ahead, sir.

Thank you very much. And good afternoon.

On the call today are OSI Systems Chairman and CEO, Deepak Chopra, the President of the Security Group, Ajay Mehra, and the President of Spacelabs Medical, Richard Atkins.

During our presentation, this afternoon, we will make forward-looking statements concerning upcoming events, our expectations regarding the company's financial performance. Each time we do, we will try to identify these statements with words such as expect, believe, anticipate, or other words that indicate potential events.

These forward-looking statements are subject to risks and uncertainties that may cause actual events to differ materially from those in the forward-looking statements. Please consider these risk factors contained in today's press release as stated during this conference call, as well as the risk factors described in our latest 10-K filed with the SEC.

For a limited time, we will make a Webcast replay of this presentation available on the Investor Relations section of our Web site. Our Web site address is www.OSI-systems.com.

Please note that today's date conference call is April 29, 2004. Any forward-looking statements we make today are based on assumptions that we believe to be reasonable as of today. We under take no obligation to update these statements as a result of future events.

Finally, this conference is the property of OSI Systems, and any recording, reproduction, or rebroadcast of this conference call without the express written consent of OSI Systems is prohibited.

I will turn the call over to our CEO, Deepak Chopra.

Thank you very much Anuj. Again, I want to welcome everybody to the OSI Systems third quarter 2004 conference call.

Revenue for the quarter was $61.5 million, and earnings per share on a fully diluted basis was 23 cents. Mr. Anuj Wadhawan, the CFO will go more into the details on the financial numbers.

This past quarter has been an extremely busy for the management. We enhanced our security portfolio by closing the acquisition of ARACOR, which makes the high energy mobile x-ray system under the name Eagle, which was developed together with the tutelage and guidance of U.S. Customs.

This, together with our material specific PFNA/DNA technology-based company, Ancore, broadens our product offering in the large cargo space for Homeland Security, customs, and narcotics interdiction at border crossings, airports, and seaports. We have the broadest product offering of any company in the world in this large cargo space.

Although the funding from the Department of Homeland Security for large cargo continues to be slow in coming, the activity, especially internationally, continues to be strong.

As reported in our last conference call, our new technology products for large cargo that we announced before, they will be delivered to the various government agencies within the next three to five months. Namely, the El Paso handover of Ancore's material-specific PFNA product is scheduled for Q1 2005. That is in the July, August, September time period.

ARACOR's large mobile x-ray Eagle system is scheduled to be handed over to the U.S. Customs within the next three to five months. In addition, Ancore's DNA-based bomb detection Vertical Explosive Detection Systems are scheduled to be delivered to the U.S. Air Force also in the next three to five months.

These are two systems, one is standard DNA technology-based system, and the other is a hybrid technology system which combines our proprietary TNA, and x-ray-combined technology. So although the funding from the Homeland Security is still slow in coming, our broad technology products will be online by Q1 2005, which is July, August, September of this year.

This should give us significant momentum and will enable us to show and tell to a variety of U.S. government agencies and customers from other countries.

As reported in our last conference call, TSA chose our XRD1000 Phantom system for trials to detect explosives for break bulk air cargo. We have provided the TSA with our XRD1000 unit and the testing is in progress as we speak.

This quarter, we are encouraged by our shipments in large cargo, which were over $10 million, and our conventional/parcel business continues to show strength. Our challenge from a year ago was to fill the hole created by a one-time $20 million order from Envision Technologies.

We had mentioned previously that we plan to fill this hole by growth both in the conventional parcel express scanning product line and large cargo. We are happy to report that we are on target.

We continue to increase R&D spending on security product line. We are making progress on our high-speed electronic computerized tomography carry-on and checked baggage scanner, and our target is to have beta site machines available for testing in Q3 fiscal 2005.

Opto Group companies had growth from last year's third quarter and from second quarter of 2004. Namely, OSI Electronics for contract manufacturing, and Laser Scan, for their laser range finder products for auto sense classification systems.

Although the economy is showing signs of improvement, we are still cautious and continue to monitor the progress, especially in the custom opto and the defense opto sector.

Medical group.

We have reached a major milestone in the medical group this quarter. We closed our Spacelabs Medical acquisition from General Electric on March 19.

This is a major step for the company. It enhances our medical product portfolio significantly. It gives us the momentum and the mass to build in this space just as we have demonstrated in the security space.

Our medical group revenues going forward will be similar to our security group revenues. It balances the company, and going forward, we have two very strong product lines with very good growth opportunities available to us.

I am not going to talk too much about the Spacelabs, as we have Mr. Richard Atkins, the President of Spacelabs on the conference call with us. I have asked Richard to give an overview on Spacelabs' products, and patient monitoring market in general for a few minutes after Mr. Wadhawan, the CFO, covers the financial highlights before we open it up for questions.

We at OSI are very excited about the future prospects of our medical group.

Before I hand it to Anuj, just to touch on the Dolphin Medical product line, as we had said, that has been an exciting product line, especially with the Nellcor Tyco patents coming off patent in October, November, 2003. Dolphin Medical signed ConMed, a public company, on NASDAQ as its exclusive U.S. distributor for Dolphin oximetry products.

As we mentioned earlier in our last conference call, that there is a very strong interest for the Nellcor compatible oximetry products, due to the expiration of these patents. I am happy to report that our business for this Nellcor compatible oximetry probes have grown significantly.

The ConMed relationship is proving to be a great success for us. We are ramping up production for these products, and the preliminary indications are that this will be a very good business for us long-term.

We again want to clarify and caution the street that the total revenue from this product line is still a small portion of OSI's overall business. In order to strengthen our long-term partnership for these products with ConMed, the company decided to sell 10% of Dolphin Medical to ConMed and long-term as we have said before, 2005 and beyond, we see a golden opportunity for good growth in this product line.

With that, I hand it over to Mr. Anuj Wadhawan for the financial highlights.

Thanks, Deepak.

Financial highlights.

The company's revenue for the third quarter of fiscal 2004 were $61.5 million, compared to $50.9 million for the third quarter of fiscal 2003, an increase of 21%.

Revenues from the security and inspection side of our business for this quarter were $33.8 million, or 55% of total revenues. Revenues from optoelectronics and medical side of our business were $27.7 million, or 45% of total revenues.

The net income for the quarter was $3.4 million, compared to $3.6 million for the third quarter of fiscal 2003.

Diluted earnings per share were 23 cents, compared to 24 cents for the last year's third quarter. Revenues for the nine months were $151.3 million, compared to $131.7 million for the prior year period, an increase of 15%.

Revenues from the security and inspection side of our business for the nine months were $86.5 million, or 57% of total revenues. Revenues from optoelectronic and medical side of our business were $64.8 million, or 43% of total revenues.

The net income for the nine months was $7.8 million, compared to $10.6 million for the prior year's nine months. Diluted earnings per share were 52 cents compared to 73 cents for the last year's nine months.

To give you the breakdown on the securities side of our business, revenues decreased 1% to $33.7 million this quarter, from $34.1 million from last year's third quarter. Revenues for nine months grew 1% to $86.5 million, from $85.9 million for the last year's nine months.

Revenues for third quarter and nine months of last year included shipments of $6.1 million and $17.1 million respectively from Envision, compared to zero in the third quarter, and $347,000 for the nine months of fiscal 2004. The decrease in Envision's revenues was offset by increased sales in conventional and large cargo business in the U.S. and international markets, and inclusion of ARACOR's revenues.

Excluding shipments to Envision, security revenue grew 21% and 26% in the quarter and nine months respectively compared to last year's third quarter and nine months. ARACOR is consolidated as a part of our large cargo business.

On the opto and medical side of our business, the revenues grew 65% to $27.8 million this quarter, from $16.8 million for the last year's third quarter. Revenues for the nine months grew 42% to $64.8 million compared to $45.8 million for the last year's nine months.

The increase in opto and medical side of our business was mainly due to acquisitions of OSI Electronics, OSI Defense, OSI Laserscan, and Spacelabs. These acquisitions revenue for the third quarter and nine months of fiscal 2004 were $13 million and $21.2 million respectively.

Gross margin for the quarter was 31.8%, compared to 31.6% for the third quarter of last year, and 28.6% for the second quarter of fiscal 2004. Our guidance for gross margin for third quarter was around 29%, which was based on inclusion of OSI Electronics revenue, which has lower gross margin.

The gross margin for the quarter was higher due to product mix in the security side of our business, and inclusion of Spacelabs shipments which has a higher gross margin.

As we include full quarter's revenue of Spacelabs, gross margin for the fourth quarter compared to third quarter of fiscal 2004 would be higher. We expect gross margin for the fourth quarter of fiscal 2004 to be in mid-30s.

R&D for the quarter was $3.5 million, or 5.6% of revenues, compared to $2.7 million, or 5.3% of revenues for the third quarter of last year. R&D for the nine months was $8 million, or 5.3% of revenues compared to $6.5 million, or 4.9% of revenues.

The increase in R&D was largely due to increased R&D spending on the securities side of our business, and inclusion of R&D spending of our recent acquisitions. We expect R&D to be significantly higher both in absolute dollars and as a percentage of revenues in the fourth quarter of fiscal 2004, as we include full quarter R&D costs of Spacelabs.

SG&A for the quarter was $12.4 million, or 20.2% of revenues, compared to $7.5 million, or 14.7% of revenues for the prior year's third quarter, and $8.2 million or 16% for the second quarter of fiscal 2004. The increase in SG&A compared to third quarter of last year was primarily due to increased headcount in sales and marketing and increased administrative expenses and inclusion of SG&A expenses of our recent acquisitions and higher legal costs necessitated with L-3 litigation.

And increase in SG&A compared to the second quarter of fiscal 2004 was primarily due to acquisitions and higher legal costs. Approximately $3.1 million of SG&A associated with recent acquisitions and $850,000 of legal costs were included in the third quarter of fiscal 2004.

We expect SG&A for the fourth quarter of fiscal 2004 to be substantially higher as we include full quarter's impact of Spacelabs' SG&A and continued higher legal costs. With the uncertainties of legal costs, and integration of Spacelabs and other acquisitions, we cannot provide more specific guidance for SG&A.

Our tax rate for the quarter was 17.9% compared to 28.4% for the third quarter of last year and 28.7% for the second quarter of fiscal 2004. The reduction in income tax rate was due to a favorable determination of a tax contingency.

Our tax rate is dependent on the mix of income from the U.S. and foreign locations, due to tax differences between countries. We expect our tax rate for the fourth quarter to be around 29%.

Our balance sheet has changed substantially with the consolidation of Spacelabs. Excluding Spacelabs' numbers, accounts receivables are up due to higher shipments. DSOs are approximately 78 days, compared to 85 days last year, and inventory is up due to large cargo projected shipments.

Our liquidity position remains very strong. We have approximately $65 million in cash and marketable securities. Sorry, $16 million in cash and marketable securities, and over $65 million in bank lines of credit.

Our backlog at the end of March, 2004, was over $92 million, including large cargo backlog of approximately $22 million and Spacelabs' Medical backlog of approximately $22 million.

Our guidance from the last conference call has been revenues for the year to be at approximately $200 million, we are revising our guidance for the year to approximately $243 million. Resulting fourth quarter revenue guidance to be approximately 92 to $93 million.

We expect a slight increase in earnings from operations in the fourth quarter compared to third quarter of fiscal 2004. Due to ongoing consolidation of Spacelabs Medical, we cannot provide specific earnings guidance. Additionally, our initial revenue guidance for fiscal 2005 is approximately $392 million.

With that, I will turn it over to Richard Atkins, President of Spacelabs Medical, to give you a brief overview of Spacelabs Medical.

Thank you Anuj, and good afternoon.

I'm very pleased to be here today as a member of the OSI senior management team, and I'd like to provide a brief overview of the Spacelab's history and background, and also a brief review of the current status of the business.

Spacelabs Medical was founded in 1958 to develop advanced medical monitoring products to support the NASA space program. One of our very first products is on display in the Smithsonian Institute.

The company has continued to focus on innovation and has built a strong reputation and a brand recognition by developing a significant number of firsts in the area of patient monitoring. Spacelabs Medical was the first to use ethernet technology for patient monitoring, to use open systems architecture and to develop connectivity solutions which enable flexible monitoring.

The continuous innovation of technologies and monitoring functionality such as a wireless capabilities and telemetry have enabled health care providers to use monitoring in many new locations. We also were the first to use clinical browsers to utilize Web capabilities in health care and to develop modular monitors, which enable health care providers to flexibly use their monitoring increasing efficiencies and reducing costs.

Many of these innovations have become the standards for medical monitoring worldwide. We have continued to focus the organization on developing these technologies and these capabilities and we have coming to market some very exciting new products from the internal R&D funnel and I will return to those a little later.

Historically, Spacelabs therefore has been extremely successful and we have filled a very large market share of installed base products with over 100,000 monitors worldwide, still in use.

During the '90s, Spacelabs sought to diversify its business and made a number of acquisitions in a noncore market area. Two of these businesses in particular added significant revenue but no operating profit.

These businesses were called Life Clinic and [Verdict]. At the peak, these noncore businesses added around 70 to $75 million of revenue to Spacelabs. But they significantly diluted the operating performance and defocused the organization.

The result, Spacelabs' revenues grew but it became loss making. With Spacelabs' loss making in late 2001, it was put up for sale, and that resulted in the acquisition of Spacelabs by Instrumentarium in July of 2002.

My involvement with Spacelabs began with that acquisition. And I was formally the President and CEO of Instrumentariums' North American businesses from 1998 to 2003, during which period we enjoyed a substantial growth in revenues, profitability, and market share.

At Spacelabs, my management team and I began the turn-around of the Spacelabs business. However, only five months later, in December, 2002, it was announced that GE was to acquire Instrumentarium.

That led to the divestment of Spacelabs and the acquisition of Spacelabs by OSI in March of 2004. As you can see, there was a period of over two and a half years of considerable uncertainty in the business. However, the Spacelabs management team continued to drive the turn-around program, which began in mid 2002.

For Spacelabs at the point of acquisition by OSI, that represents some good news and some bad news. On the down side, Spacelabs was combined within Instrumentarium to form efficiencies in the international businesses. But that had the effect of removing Spacelabs from direct sales in international territories.

On the plus side, we divested those noncore businesses, [Verdict] and Life Clinic, restructured the North American operations, sales and service and manufacturing, and placed a significant emphasis on improving customer service levels and customer satisfaction.

And we see that improvement reflected in the third party customer satisfaction surveys, and in the R&D pipeline which was significantly refocused on the core monitoring products. And I believe we also were able to significantly upgrade the management strength of Spacelabs.

Now, with the close of the acquisition by OSI, we believe Spacelabs has a clear direction for the future. It is leaner, it is more focused, and has new products to launch, both from its own R&D pipeline, and from the products and technology agreements which came as part of the divestment from GE.

Plus, an efficient OSI brings the anticipated advantage of technologies within the OSI group and manufacturing and cost synergies. Spacelabs' market position is that it is now the number three player globally in patient monitoring.

The market shares around the world in the major markets range between 5% and 15%. The market leader in patient monitoring is the Dutch group Phillips, following their acquisition of the former Hewlett Packard monitoring business.

Next comes GE. As a result of a series of acquisitions over the last four years, Marquette, CritiCom and then Instrumentarium.

Also in the marketplace, the German group Siemens last year combined their monitoring business with another German company, Drager, and also in the past year, a monitoring company inVivo purchased another monitoring company, MDE and then was in turn purchased by a health care service company, Intermagnetics.

As you can see from that list of changes, there have been significant number of acquisitions or changes of ownership in the past few years in patient monitoring. And in most cases, this has resulted in changes in the historical customer relationship and has, we believe created opportunities for companies with the right products, and the focus to benefit from these changes.

It is our experience that many, many health care providers who see health care as a vocation also perceive that the multi-billion dollar corporations are only in it for the dollars and cents, and that there is a significant need and desire from health care professionals to work with a progressive, flexible, responsive medical device company with a passion and dedication for health care and for customer service. It is our belief that Spacelabs is positioned to meet that need.

On the product side, in April of this year, and in May, we are launching a new range of monitoring products. These products have come from our internal product development pipeline, and are the range is called the Ultraview SL products.

We've also formed a number of significant partnerships recently in the technology and software area to enhance the product portfolio and also this month in April at the World Congress of Anesthesiologists in Paris, we launched the new anesthesia products that came from the OEM agreements with GE. These new products are being very well received by customers. So it is my view that Spacelabs is better positioned and in better shape than at any time in its history.

The customer reaction has been very positive. They've been very positive about the re-emergence of Spacelabs in a new competitive force in patient monitoring. The new approach and direction for Spacelabs is very positively received, and the new products are very well received.

Employee reaction is also very positive. Very positive about the re-emergence of Spacelabs as a monitoring company, and also very positive as Spacelabs being a part of the OSI group.

Today, the Spacelabs organization is north of 700 employees. The separation from GE and the incorporation of Spacelabs into OSI is ongoing. The management team and employees are very experienced and very talented group of people.

We have a very well structured and resourced organization, supporting and selling end customers in North America, with nearly 200 people in sales, service, and marketing in North America. We have also have a direct sales and service organization in the major European markets, in the U.K., France and Germany, and we have distributors representing Spacelabs in the rest of the world where they have either been retained as Spacelabs as distributors or recently appointed.

And I believe we also have a very strong channel in Asia-Pacific which will provide good upside opportunity for us in that region. So that's an overview and background to Spacelabs.

Thank you, Richard. With that, we open it up to questions.

Thank you. At this time, if you would like to register a question, please press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Please hold for your first question. Your first question is from the line of Tim Quillen with Stephens Incorporated.

Good afternoon. You raised guidance from $200 million to $243 million. Does that imply that Spacelabs is going to contribute $43 million in the fourth quarter?

The answer is no. The major significant portion of the upward guidance is from the full quarter of Spacelabs. But all of that is not from Spacelabs.

Got it. Should we look at Spacelabs as about $150 million annual revenue run rate and divide that by four to figure out what to put in fourth quarter?

Well, it's a little bit too early about it. We are still getting our hands around it. We have given the guidance for next year as a total company of about $392 million. The trailing 12 months unaudited numbers that we said before, Tim, for Spacelabs was about $150 million so we have not given that specific guidance next year yet for the various groups. But given a very preliminary guidance for the total year, for $392 million.

Okay. And Spacelabs in the reported quarter was roughly $5 million. Is that kind of ballpark right?

That's about the ballpark. Yes.

Okay. And do you plan in the future, do you plan to report a separate segment? Or how are you going to handle that?

We don't know yet. I mean we've been talking up till now, Tim, between security and nonsecurity, kind of.

Right.

But obviously, with Spacelabs being this big, we are going to again report security and nonsecurity, but I think that we are going to start breaking down at least what the medical, but keep in mind that besides Spacelabs, we have Dolphin Medical and [inaudible].

Right. Right that will confuse things a little bit for us but we'll figure it out. And I understand the difficulty in sorting out SG&A, but, you know, you're saying that earnings are going to be up from 3Q. What exactly, what earnings in 3Q? Is it the GAAP number or a pro forma number that we should expect you to be sequentially up from in the fourth quarter?

Tim, it would be from pro forma numbers would be what we're looking at, exclude on the gain of the sale of marketable securities and a favorable tax effect.

Okay. So you know, to be clear, about a 17 cent --

Income from operations.

Oh, income from operations. So about a -- okay, I gotcha. I gotcha.

And keep in mind, just to add it, Tim, that this will be the first quarter for the full quarter of the Spacelabs, and we are still consolidating, still getting our arms around it, and basically we don't have all the things, all our arms around the various aspects, and that's why we are in the mode of just developing a model.

Right. Well, we'll work with you on that. How about in the fourth quarter, do we, I think at one point, we had talked about potentially having another restructuring charge towards the end of the fiscal year. Is that still possible?

Well, the answer is yes, but you know, circumstances overtook us in a big way on this Spacelabs acquisition. And so we are relooking at it, and the consolidation of Spacelabs is on a much bigger scale. So that particular restructuring is being rethought through, as we look at the various segments.

Okay. That's fair. And how about legal costs? Is that going to be lumpy, you know, what should we expect in the fourth quarter, and when, if ever, will this be resolved?

Well, we are committed to the street that we will disclose the costs as you know last quarter was only about $100,000, this quarter is about $850,000, we are now in the discovery mode. Since we are in this litigation in this discovery mode, heading towards a trial, we don't want to talk any more. We don't know. Can't say it is lumpy. I think that it's a fair assumption that it's going to be higher than what was in Q2. Whether it will be in line with Q3 of $850,000, there about, we can't say because this is now in the main, we are in the center of the, what do you call it tornado, or whatever.

Right. Well it may become a rounding error within the rising SG&A with Spacelabs.

Well, just, finally, Richard, I appreciate the run down on the market. I found it very helpful. But I guess I'd like to put you on the spot a little bit and ask you how do you grow the company in, you know, what I perceive to be a saturated market with a lot of strong competitors, you know, what are your specific plans for, what do you think a realistic expectation for investors to have in terms of growth over the next few years?

Well, before Richard answers, one thing to comment on it, you know, we did, when we originally announced the Spacelabs acquisition, if you remember, we had given some numbers that Spacelabs has such a large install base, that just for the replacement, if you could sort of stabilize the company, and Richard can add on to it, there is a good growth opportunity to just what I call, if you can get a Ford customer to buy another Ford and not go to General Motors, there is enough growth opportunity for the next couple of years for Spacelabs.

Beyond that, as Richard mentioned, in his presentation, OSI brings a significant amount of manufacturing synergies, which will make Spacelabs more cost competitive, compared to some of the other players. Hopefully that can make them capture some more business.

And thirdly, his comment about that most other competitors in this space are large, multi-billion dollar companies with numerous acquisitions, and complications of getting organizations put together, we can carve out a fast nimble moving company, which is very pro-customer. With that, I will let Richard add more to it.

Well, yeah, that was essentially going to be my answer, in that the customers are looking of course for good products, good service, and to work with companies that they can develop relationships with. And we have been focusing on developing the Spacelabs product range over the past 18 months, and it's very fortunate would that we are now just launching that new product range, so we have new products coming to market.

We have spent a lot of time working on improved service and support. And we have seen improvements of that in customer satisfaction. And both the management team and the sales team that we've been able to put together as a part of the divestment is extremely experienced and has very, very good relationships with the health care providers. So I see the growth of the company coming from that combination of good products, good service, and good people.

Okay. Well, I guess I'm just trying to get at how quickly you can recapture some market share. Any kind of growth projections would be helpful.

I think that at this stage, you know, we are committing to the top-line for the total company, and giving you the trailing historical unaudited numbers for Spacelabs. And I think as we have said, Tim, as we get more into this, this is the first time that we have given almost a five quarter hence guidance in revenue, that means we are quite comfortable, and there is definitely growth in both sectors.

Okay. I will let somebody jump in. Appreciate it.

Hello? Hello?

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

Hi. Let's see. On the $22 million in backlog for large cargo, can you remind us what that number was last quarter?

Last quarter, end of last quarter, it was approximately $26 million. But we did ship about $10 million in third quarter.

And so that implies about $6 million in orders that you received during the quarter?

I believe if you do the math, yes.

Okay. And was there any contribution in the $10 million you shipped this quarter from ARACOR?

As we said in the past, ARACOR is --

The answer is yes. And including the backlog for last quarter of $26 million also included ARACOR backlog so we have sort of combined because they work in each other's products, they develop together, so we have said to the street that we are going to consolidate and report as one the total cargo.

Right. I was just looking at, if you look from the $6 million you shipped last quarter to the $10 million this quarter, how much of that growth was ARACOR.

I believe we -- do we have it handy? Maybe we can get back to him.

Approximately $4 million-plus.

Okay. So the balance of it was pretty steady quarter-to-quarter in the other large cargo products?

That's right.

Okay. Any TSA contribution this quarter? Did you finish out that project?

The -- this is Ajay, Jeff. The TSA, you know, like I mentioned last quarter is I think last quarter was a couple million on the TRX shipments, this quarter, is about $1 million on the TRX shipments. Obviously, we're talking to TSA, we've got some service revenue that we picked up, but the actual contract itself it's towards the tail end.

Just to add to it, Jeff, as you've seen from the numbers, even without the TSA contribution too much to the conventional shipments, the security conventional business has been quite strong, so the slow down in TRX on the end tail of TRX has been more than enough compensated by other businesses both domestic and international, and that's the reason why it has been such a healthy growth. The international business continues to be very good.

Okay. And just to sort of run through quick, and make sure that we're not way off here, if I, the pro forma number that we have for EPS would be around 18 cents per share in the quarter just reported, and then if we look at that being relatively flat with the revenue guidance you gave, that gives me an operating margin around 4% for the fourth quarter, and I know you're not giving specific guidance but I just want to make sure there's nothing significant I'm missing there in terms of how we arrive at again, getting a flat EPS quarter-to-quarter, just as a guess at what you think, a rough guess of how things are trending.

Well, our guidance for Q4 is better than Q3.

Okay.

On the operating level.

Okay. So we should look for obviously no scale as to how much better, but something better than that 4% number?

That's right. I mean we are basically saying that Q4, if you remember, originally, we had said that it's going to be, we had given guidance in revenue, and would what we are saying is with the Spacelabs addition, and we're still trying to go through consolidation, it's an accretive mode, and the earnings for Q4 would be better than Q3 on the operating level.

Okay. And you think it can be accretive before you embark on whatever consolidation efforts which obviously will take some time?

That's true. I mean if you read our comment in our press release, Q4 has none of the synergies that we originally had said, and that basically is an additional in the next, what I call six months from now, to 18 months to complete. So this Q4 guidance that we've given does not include any of the synergies.

Okay. And then one last question, just back to the backlog, you said $22 million of backlog from Spacelabs, so that gives me an apples-to-apples of 70 relative to the 80 from last quarter. Is that right?

That's correct.

Okay. Thanks a lot.

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

Yes, Brian Ruttenbur. Just wanted to get some clarification on a couple of things. You made some reference to SG&A expenses and R&D expenses going higher. And was just wondering if you could quantify that a little bit more, because it's hard for me to go substantially or, the type of words that you used to try and understand where these expenses are going. I know that this has been asked in some roundabout way before but I was wondering if you could give us a little bit more clarity.

Well, Brian, you know, basically what we are trying to say, if you look at the Q3 numbers, for SG&A and R&D, and keeping in mind that Spacelabs acquisition was only closed on the 19th of March, so already we have seen improvement in margin, we have given guidance for the margin from the original 29% to go to mid-30s. And on the other side, Spacelabs inherently from the historical product line in medical carries with it more SG&A and marketing expenses and more R&D.

Because it's new and this is the first quarter completely that it will be consolidated, it's very difficult for us to put specific numbers on it, and especially with the L-3 litigation which we have committed to you guys that we break it down every quarter. We are more comfortable at this stage to give a revenue guidance for the quarter, and an earnings kind of guidance, than to sort of breakdown the R&D and SG&A into more absolute dollars.

Okay. Let me ask a different question then about profitability. Can you talk about how profitable you guys would be in the March period, without Spacelabs and then if you had Spacelabs in there for the entire period?

Would you repeat that again?

How profitable would, what would your income statement look like if you had Spacelabs in for the entire period of March, for the entire quarter, and how would you look if you didn't have Spacelabs in there at all? I was wanting to know on a profitability basis, not on a revenue basis, but on a profitability basis how things would look.

There is no way we could even put our arms around it because firstly we didn't own Spacelabs before the 19th of March. Secondly, I think Tim asked the approximate revenue contribution from Spacelabs was about $5 million-plus, $5.5 million, and the respective R&D and SG&A which was again a carve-out. So it's impossible for us to sort of estimate, if it would have been for the total quarter.

I think Q4 would be a better indication as Spacelabs completely gets consolidated into the revenue and the SG&A and R&D, but even that, we are saying that that does not include any synergies that was one of the cornerstones for us, also, when we originally acquired Spacelabs, which we are saying is going to take some, what I call, time to get into it, but one thing we can give a comfort feeling to it, that the nonSpecelabs revenue and earnings was steady and positive.

It's not that we are trying to say that Spacelabs sort of covered the short fall. The rest of the business and I know have you some gross margin numbers just to give you and idea, nonSpecelabs, your margin was still improved.

Without Spacelabs our margin would have been approximately 30-plus percent.

And our guidance to the street was 29%.

Okay. Good. And then on a going-forward basis, when do you see Spacelabs becoming profitable to the bottom line at OSI?

Well, I don't think so we've ever said to you that Spacelabs was negative.

Okay. Very good. Well thank you very much.

Your next question is from the line of Steve Gish with Roth Capital Partners.

Good afternoon. First question, you had indicated expectations of a gross margin in the mid-30s this quarter. If that is primarily due to Spacelabs, is that sustainable as you take Spacelabs' product, which I believe is outsourced, and you bring that in-house?

Steve, you asked two questions. One, it's a true fact that as the fourth quarter Q4 of Spacelabs goes in, as Anuj just mentioned, we expect the gross margin to climb up from this quarter to the mid-30s.

That still does not have any of the manufacturing synergies by manufacturing Spacelabs' that they get from outside sourcing, that we will start bringing it in in the next couple of quarters, and our estimate right now is that in the latter part of next year, that means two quarters from now, that will be the third quarter from now, we will start seeing some of that synergies and contributing margin coming into it and we would think the full-out sourcing that we have identified to be approximately $25 million, on historical Spacelabs revenue, will kick in and contribute on an annualized basis after the 18-month period.

So to answer your question is, the margins would continue to improve as Spacelabs revenue gets consolidated, and as the manufacturing synergies kick in next year, the total operating margin and gross margin would improve further.

Now, does that mean with that consolidation, some of the growth in Spacelabs, we may not see on the revenue line, because of inter-company sales?

No, it's the complete opposite. The $25 million of manufacturing synergies are from them giving it to their vendors. Just like Rapsican gives to UDT, it gets eliminated but has no impact on the outside external revenue of Spacelabs, and like Rapsican.

Okay. And I'm just a little bit confused on your guidance for next year, $392 million. If you assume that the core businesses excluding Spacelabs are growing, you know, conservative 15%, it looks like you do expect some significant growth out of Spacelabs, or can you maybe just, what area of the company do you expect to see that growth.

Well, this was asked. I think that we are very comfortable at this stage that our next year number is about $392 million, which we haven't broken down into the product lines, but I guess it's a safe bet that both Spacelabs and the nonSpacelabs products are expected to grow.

You talked a little bit how the Department of Homeland Security has continued to be slow on their funding yet you're seeing increased or continued demand on the international market. What is driving that? Then, you know, if you exclude the backlog from Spacelabs, or the backlog contribution from Spacelabs this quarter, your overall backlog is slightly down this quarter, so what are you seeing that gives you that confidence that security will continue to grow?

Well, number one, a year ago, I think some of you were very concerned about the $20 million shortfall of the one-time Envision business, which we said very confidently that both groups, cargo, and conventional, will more than enough compensate that, which we're happy to report it happened. Secondly, our inventory turns business, which doesn't come into the backlog continues to show growth and we have demonstrated even without the TSA contributing much into it, we've been able to show growth.

Secondly, as I mentioned in my presentation, that we have in the first quarter of 2005, which is July, August, September, significant amount of new technology products coming online, namely the El Paso product, of the Eagle systems of ARACOR, for U.S. Customs, and the VEDS, Vertical Explosive Detection Systems to the U.S. Air Force so we should be able to do a show and tell and though the Homeland Security has not been very fast in coming, this seems to be continued to have interest, and we continue to get a lot of interest both internationally and domestically to look at our broad portfolio.

So based on that, we believe that both security and medical will both grow next year, and we are giving a guidance of $392 million.

Okay. And then at the El Paso site, is that also going to include the Eagle product?

Ajay, you want to comment on that?

Yeah, they're going to be doing some testing and yes, U.S. Customs had previously bought an Eagle product. It's an older model product, but they are going to be doing some side by side testing between x-ray, some other products, as well as PFNA.

But to just clarify, the present Eagle system that we have on order have nothing to do with El Paso.

And how is that revenue recognized? Is that a percent of completion or until it ships?

It's based on percentage of completion.

And is that the same for the ARACOR TNA system as well?

That's correct.

Okay. Thank you.

Ladies and gentlemen, as a reminder to register for a question, press star one. Your next question comes from the line of Tim Quillen with Stephens Incorporated.

Yeah, I just want to make sure that I understand exactly what you're talking about when you say that $25 million in outsource manufacturing will be brought in-house. Are you saying that they're paying their vendors $25 million for products and you'll get gross margin pickup on some of that? Or do you hope to actually get $25 million in gross margin savings because of insourcing?

Okay, well let me be very good that you asked because we tried to make it very clear in the press release.

I'm slow.

No, no, it is important because it is a major question. We, from our analysis, from our management, and with Spacelabs, they have identified out of the total procurement that Spacelabs does with their vendors, they have identified on an annual basis approximately $25 million can be manufactured by OSI companies.

So as we bring that $25 million, which right now Spacelabs gives it to their vendors, as we bring it in-house, there is some manufacturing gross margin that we will realize from that $25 million on an annual basis. So the gross margin out of that revenue will be our contributing margin, not $25 million. That's the revenue inter-company which will get eliminated but the contributing manufacturing gross margin that gets generated with that revenue will go to the bottom line.

And with that type of manufacturing business, would you capture a, you know, a 20% gross margin, a 15% gross margin? Just kind of in rough terms, what kind of pickup would you hope to see?

Well, you know, that's a difficult question to answer, but historically, if Spacelabs has been buying that from contract manufacturing vendors, you are in the right sweet spot of that's the kind of margin that a contract manufacturing should get. So you are very astute.

Okay. Great. That's, I just wanted to clarify that. Thank you.

Mr. Wadhawan, there are no further questions at this time. I will now turn the call back over to you. Please continue with your presentation or closing remarks.

Thank you very much. I'll turn it over to Deepak for closing comments.

Thank you very much.

In summary, this has been a great quarter for us. We have had record revenue. The company definitely is poised for growth.

We have two segments now, both what we think are very good opportunities for growth in security. Where we continue to broaden our portfolio in cargo, we have I think the world's broadest technology platform with PFNA, x-ray, TNA and hybrid technologies.

We have told the street and security, we will be a player in EDS, explosive detection systems, in both carry-on and checked baggage. We continue to invest with our own money for our electronic CT high-speed product line and our XRD 1000 deflection based phantom system.

With this Spacelabs acquisition, it gives us another breadth of dimension in the medical diagnostic instrumentation. With Dolphin, we continue to see with our ConMed relationship of revenue stream from the Nellcor compatible products.

And as the economy improves the opto product line will improve and it will leverage its manufacturing efficiencies by supplying inter-company both to Rapsican and to Spacelabs in the near future.

We are very excited about it. We are very excited to have the Spacelabs experienced management in our portfolio. And we look forward to growing both our businesses with strong balance sheet, our appetite will continue to increase. Thank you.

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your line.