OSI Systems Inc (OSIS) 2005 Q2 法說會逐字稿

Good day ladies and gentlemen and welcome to your quarter two 2005 OSI Systems Earnings conference call. My name is Jean. I'll be your conference coordinator. At this time I'll [inaudible] in a listen in mode and towards the end we'll be taking questions. If you ever need operator assistance please key star 0. At this time I'll turn the call over to your host, Victor [Zee], General Counsel.

Thank you very much and good afternoon. On the call today are OSI Systems Chairman and CEO Deepak Chopra, the President of the OSI Security Group Ajay Mehra, and OSI's Chief Financial Officer Anuj Wadhawan. During our presentation this afternoon we will make forward looking statements concerning upcoming events and 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 results to differ materially from those in the forward looking statements. Please consider the risk factors contained in today's press release and stated during this conference call as well as the risk factors described in our latest Form 10k filed with the SEC. 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 a quantitative reconciliation of these figures please refer to today's press release regarding our first quarter results. The press release will also be filed with the SEC as part of a Form 8k. For a limited time we will make the webcast replay of this presentation available on the investor relation section of our website. Our website address is www.osi-system.com. Please note that the date of the conference call is January 27, 2005. Any forward looking statements we make today are based on assumptions that we believe to be reasonable as of today. We undertake no obligation to update these statements as a result of future events. Finally, this conference call 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'll turn over the call now to our CEO, Deepak Chopra.

Thank you Victor, and once again I welcome everybody to the Q2 2005 Earnings conference call. Second quarter revenues were a record $102.5 million with earnings by diluted share of 15 cents after 4 cents charge related to Spacelabs amortization and retention expenses. Before the 4 cents charge, the earnings would be 19 cents by diluted share on a share count of 16.7 million shares. Mr. Wadhawan will cover the financial highlights.

I'm going to cover the various business segments of the company and the dynamics in these segments. As you know, last quarter, Q1 2005, was the first quarter where the company started segmenting the various business units. This quarter is a second quarter for us to show segmenting of our businesses. The Opto Group's external revenues for the quarter were $16.5 million verses $14.9 for Q1 2005. The inter-company revenues were $5.6 million verses $4.2 million for the Q1. Operating income increased to $1.9 million verses $1.7 for Q2. The commercial side of the Opto Electronics business increased while the defense Opto continues to be weak. Additionally, as mentioned previously, the inter-company sales especially to the medical group has increased sequentially quarter by quarter. Old factors increased external revenue and increased inter-company sales and contributed positively to the operating income increase.

Looking into the future, Opto business' challenge continues to be to expand its manufacturing intake from inter-company, especially from the medical group. We continue to consolidate and size our defense Opto business. During the next two quarters, this process will continue. Overall the Opto group has predictable revenue and operating income. Although defense Opto still has negative margin while commercial and inter-company have more than enough compensated towards the positive.

Healthcare group -- This group delivered very strong operating results and revenue. The revenue was $54 million with operating income of $4.9 million after retention and amortization expenses of approximately $900,000 in connection with the Spacelabs acquisition. As we had mentioned on the last quarter's conference call, that Q2 December ending will be a strong quarter for the medical group due to capital equipment spending cycle for U.S. hospitals. Revenues for the group of $54 million were a strong growth over Q1's revenue of $42.8 million. Profitability grew exponentially from $235,000 to approximately $4.8 million. Both of these numbers for Q2 and Q1 are after approximately $900,000 of charges for retention and amortization. Both product lines, Spacelabs Patient Monitoring and Dolphin Pulse Oximetry had strong revenue and profit growth sequentially from Q1 to Q2. As we had mentioned in the last conference call, especially Spacelabs Patient Monitoring business is highly leveraged with manufacturing gross margins in the mid-to-high 40's with the result that as revenue grows, operating income grows exponentially which was clearly demonstrated in this quarter.

This quarter is the third consecutive quarter in a row that medical group has delivered profitable results. The first half of 2005, that is Q1 and Q2, the revenues for this group was $97 million which makes it an annualized revenue rate of approximately $194 million. Although December was relatively a very strong quarter, we expect the second half of the healthcare to be almost in the same range, plus/minus a couple of million. This group will be profitable in both quarters, that is Q3 and Q4. Spacelabs continues to invest aggressively in R&D and has a long list of new products in the [inaudible] for the next 8 quarters. The challenge facing this group is in the international arena where we had to build our sales channels from scratch when we acquired the company from General Electric in March 2004.

Additionally, pulse oximetry under the trade name Dolphin continues to grow nicely through our prime U.S. distributor Conmed (ph) who, as mentioned previously, has done an excellent job for us. Our relationship with Conmed continues to be strong and healthy. We will also be launching our private label Nelcore (ph) Compatible Oximeter Probes under the Spacelabs name very shortly. This should add extra channels for the Dolphin oximetry products. We continue to look at additional strategic alliances to beef up our franchise in the healthcare group. The company also continues to look at strategic acquisitions to expand our healthcare portfolio both domestically as well as internationally. Our charter is to grow our healthcare group and the Spacelabs Patient Monitoring product line will be a central piece to that strategy.

Security group. Although the revenues increased to $32 million from $30 million for Q1, we incurred a loss of $1.2 million. The loss was attributable to the cargo inspection business. As we had mentioned in our previous conference call, there are two distinct segments to our security business. Namely, parcel and people inspection products which we also sometimes call conventional x-ray business and cargo inspection business. Of the $32 million revenue for the quarter, $23.6 million was parcel and people inspection business, while $8.4 million was from the cargo inspection business. The parcel and people inspection business consists of x-ray inspection machines for airports, small freight and packages, courthouses, embassies, prisons, etc. and metal gates and x-ray body scanners. This business continues to grow and is quite profitable. The large majority of the products are internally manufactured by the security group and the electronics and detectors, etc. are also supplied by the Opto group.

It's an inventory [inaudible] business and is approximately 70% of our total quarterly revenue of the security group. We have not seen any slow down in this product line. Our installed base continues to grow which in turn grows our service revenue. The margins are quite robust and the marketplace continues to show healthy growth. We are fully committed to this marketplace and as mentioned before, we have increased our research and development spending in this product line especially for the next generation explosive detection systems or aviation security. We are developing a broad line of products for this sector. For example, the multi-view high speed x-ray scanner and electronic computerized tomography scanners. No revenue is expected from this development in this physical year as we have mentioned before. In 2006 we expect that we'll start seeing revenue growth in that sector, although R&D spending continues at an accelerated rate.

The cargo inspection business has been and continues to be a big challenge for us. This business is still quite new with no standardization and lots of research and development is being spent. In addition, shipments for large cargo systems tend to be very lumpy from quarter to quarter. We as a company continue to develop a broad range of products, some completely internally funded by research and development paid by us and some with government developmental contracts with additional R&D investment from the company. These products also have a large outside procurement content which increases the material cost and increases inventory. Due to the above reasons these products inherently have lower manufacturing margins, especially in the early stages of development when a one of a kind system is being developed.

Although we remain committed to this marketplace, because we believe that the best growth opportunity for OSI in the future is in this product line, we are looking at continued losses from this product line until the time that these new technologies and products become repeat production orders. We have a very broad product agenda for this product line from high energy x-ray scanners, both mobile and relocatable to fixed, to gamma based systems to relocatable mobile x-rays scanners like Eagle to material specific [inaudible] neutron activation and thermal neutron activation based scanners. Ultimately we believe that the total logistics solution for cargo inspection at a port, a port of crossing, or an air terminal will happen but we cannot forecast when the government will decide to implement this. Our products are well received but no repeat large orders have materialized.

In summary, we continue to invest in this product line on a broad front. Our spending for the development far exceeds our intake of revenue, especially with positive margins. In light of our overall loss in the security group due primarily to the cargo inspection products we have implemented cost cutting in January 2005 in the security group which will result in an annualized savings of approximately $2 million starting in the fourth quarter of fiscal 2005. These savings will have no impact on Q3 due to the upfront costs associated with these changes. Old revenues and margins for large cargo inspection systems are below our original estimates for these products. Our overall strategy for the security group is to build a strong and broad platform of products for parcel and people scanning, explosive detection systems for checked baggage for aviation, and large cargo inspection systems with various technologies which will lead to total logistics solution for inspection.

In summary, a significant portion of our quarterly revenue from the security business is profitable, has always been profitable, but we are investing for the future by increasing our R&D and development spending for large markets, especially cargo inspection and explosive detection systems for checked baggage. All segments including Opto, healthcare, and parcel and people scanning for security group will be profitable for the second half of the year except large cargo inspection systems will continue to declare a loss. With that, I'll hand it over to Anuj Wadhawan to tell you the financial highlights.

Thanks Deepak. Good afternoon everyone. Financial highlights for the second quarter and 6 months of fiscal 2005. The company's revenues for the second quarter of fiscal 2005 were $102.5 million compared to $51.1 million for the last years second quarter, an increase of 101%. Revenues from the security side of our business for this quarter were $32 million, or 31% total revenues. Healthcare, $54 million, or 53% of total revenues. Opto, $16.5 million, or 16% of total revenues. The net income for the quarter was $2.5 million compared to $3 million for the second quarter of last year. Diluted earnings per share were 15 cents compared to 20 cents for the second quarter of last year. Excluding a pre-tax charge of $549,000 for [inaudible] bonus and $354,000 for amortization of intangibles and fixed assets relating to Spacelabs' acquisition in the second quarter of fiscal 2005, the diluted earnings for the quarter were 19 cents. Revenues for the 6 months were $190.2 million compared to $89.7 million for the last year's 6 months, an increase of 112%.

Revenues from the security side of our business for 6 months were $62 million, or 33% of total revenues. Healthcare $96.8 million, or 51% of total revenues, and Opto $31.4 million, or 16% of total revenues. The net income for the 6 months was $3.8 million compared to $4.3 million for the 6 months of last year. Diluted earnings per share were 23 cents compared to 29 cents for the last years 6 months. Excluding a pre-tax charge of $1.1 million for [inaudible] bonus and $708,000 for amortization of intangibles and fixed assets relating to Spacelabs' acquisition in the 6 months of fiscal 2005, the diluted earnings for 6 months were 31 cents.

On the security side of our business, revenues increased to $32 million in this quarter from $29 million for the second quarter of last year and $29.9 million for the first quarter of fiscal 2005. Revenues for 6 months grew 18% to $62 million from $52.7 million from the last year's 6 months. The increase in revenues in the quarter and 6 months for the last year's figures were primarily due to increased sales in parcel and people screenings and cargo inspection businesses and inclusion of ARACOR's revenue and was offset in part by lower sales to DSA (ph). The increase in revenues in the quarter compared to the first quarter of fiscal 2005 was primarily due to increased sales of parcel and people screening business and was offset in part by lower sales in cargo inspection business.

On the healthcare side of our business, the revenue grew $54 million this quarter from $3.3 million for the second quarter of last year and $42.8 million for the first quarter of fiscal 2005. Revenues for 6 months grew to $96.8 million from $6.6 million from the last year's 6 months. The increase in revenues over last year's second quarter were primarily due to the acquisition of Spacelabs and increase in sales of pulse oximetry business.

The increase in revenues from the first quarter of fiscal 2005 were primarily due to increased sales from our patient monitoring system, patient and pulse oximetry businesses. On the Opto side of our business, revenues decreased 12% to $16.5 million this quarter from $18.8 million for the last year's second quarter. The decrease in revenues in the quarter over last year's second quarter were primarily due to lower sales of defense optoelectronics. Revenues for 6 months grew to $31.4 million from $30.4 million for the last year's 6 months. The increase in revenues was primarily due to the acquisition of OSI Electronics and was offset in part by lower sales of defense optoelectronics. In addition, Opto captured inter-company revenues from security and healthcare groups of $5.7 million in the second quarter and $9.9 million for the 6 months compared to $4.5 million in the second quarter of 2004 and $7.2 million for the 6 months of 2004 respectively which have been eliminated in the consolidation. Gross margin for the second quarter was 35.6% compared to 28.6% for the second quarter of last year and 38.6% for the first quarter of fiscal 2005.

The increase in gross margins in the quarter over last year's second quarter was due to inclusion of Spacelabs shipments which has inherently higher gross margin and was offset in part by change in product makes in security business and lower sales of defense optoelectronics. The decrease in gross margin in the quarter compared to first quarter of fiscal 2005 was primarily due to change in product makes in cargo inspection shipments which had very little or no margin. R&D for the quarter was $7.1 million, or 6.9% of revenues compared to $2.4 million, or 4.9% of revenues for the second quarter of last year. R&D for 6 months was $13.7 million, or 6.9% of revenues compared to $4.4 million, or 4.6% of revenues. The increase in R&D spending in the quarter and 6 months was merely due to the development of cargo inspection products, explosive detection systems for aviation industry, and inclusion of R&D spending of Spacelabs. The R&D spending of Spacelabs was $3.2 million and $6.8 million for the quarter and 6 months of fiscal 2005, respectively.

SG&A for the quarter was $25.6 million, or 25% of revenues compared to $8.2 million, or 16% of revenues for the second quarter of fiscal 2005 and $24.8 million, or 28.3% of revenues for the first quarter of fiscal 2005. SG&A for 6 months was $50.4 million, or 26.5% of revenues compared to $15.7 million, or 17.5% of revenues for last year's 6 months. The increase in SG&A for the quarter and 6 months compared to last year's [inaudible] was primarily due to inclusion of Spacelabs SG&A and increased headcount in sales and marketing in our security business and was offset in part by lower legal and professional fees. The SG&A expenses of Spacelabs for the quarter and 6 months were $14.5 million and $28.2 million respectively.

Our tax rate for the quarter was 24.3% and for 6 months 26.9%. As mentioned in the last conference call, our tax rate for the quarter was lower due to retroactively including the R&D tax credits extended by Working Families Relief Act 2004. Also, our tax rate is dependent on the mix of income from the U.S. and foreign locations due to tax defenses between countries. Our total backlog at the end of December has increased to approximately $96.5 million compared to $92 million at the end of September 2004. Backlog for cargo inspection at the end of 2004 has also increased to approximately $23 million compared to $16.5 million at the end of September 2004. Our balance sheet remains very strong with over $29 million in cash and over $55 million in available lines of credits. We generated over $7 million in cash from operating activities in the second quarter of fiscal 2005. Our revenue guidance for the third quarter of fiscal 2005 to be $92 to $94 million with diluted earnings per share to be [inaudible] after Spacelabs' related retention and amortization expenses of 4 cents and our revenue guidance for the fourth quarter of fiscal 2005 to be $96 to $98 million with diluted earnings per share to be 8 cents to 10 cents after Spacelabs' related retention and amortization expense. With that, I will open it up to questions.

Ladies and gentlemen, if you'd like to ask a question key star 1 on your touch tone phone. If you'd like to withdraw your question, key star 2 and your questions will be taken in the order they are received by. And we'll take a question from Larry Hamivich of HMTC.

Good afternoon gentlemen. Very nice review of the operations. I'm new to the story and thank you very much for a detailed review. I want to focus a couple of questions on Spacelabs. Could you give us a little better breakdown of the revenue in the quarter and in the half between Spacelabs and pulse oximetry? You did mention both had shown good growth. I wonder if you could give us a little more color on that?

Well, we said last time on the conference call Spacelabs as we acquired it in March of 2004 basically had a couple of product lines. The bigger one was the patient monitoring, and then they had the ambulatory blood pressure monitoring and med data. We peeled off some of those product lines and made it into a healthcare solutions group together with a pulse oximetry and osteoporosis. So it's very difficult to set up a breakdown into the classic Spacelabs what it used to be. The way that we have moved forward is that we do a consolidated reporting of the healthcare group, but we have--last conference call did mention that the oximetry business which we have been monitoring as a separate so we can look at the growth of it, that has grown and proximately, the revenue for the oximetry product line approached about $5 million.

In the quarter?

In the quarter.

So roughly $50 or $49 million of the $54 million then comes out of Spacelabs?

Well, that's not true.

Okay.

The other product lines like osteoporosis and med data ABP [inaudible] but the vast majority of that $49 million is Spacelabs.

Okay. Very good. Any color on--any further color on your comments about strategic alliances, product line additions, and stuff like that? What would be some of the initiatives that would be interesting to you?

Well, obviously specifically we can't talk about it, but we did say that the acquisitions and strategic alliances we would look for in the medical area would be around the strong portfolio of patient monitoring of Spacelabs. More than that it's difficult to say and I would rather not comment on for competitive reasons.

How has the resuscitation, if you will, of Spacelabs gone? As you are very well aware, Spacelabs had been quite a stepchild for a while and had certainly suffered. It seems to be that you guys have done a very, very good job in making Spacelabs a stronger player. I wonder if you could give us a little flavor on that?

Well, the results speak for itself. We've had three consecutive quarters of profitability for the healthcare group which obviously Spacelabs is the major factor. We are very proud about it and it's like I said, it's a very leveraged business with very high margins in the high-to-mid 40's, so once you've crossed the breakeven point which a whole three quarters we have demonstrated it and this quarter especially with the revenues being at $54 million compared to about $43 million from last quarter, you can see the jump of operating income from $235,000 to about $4.9 million.

Yeah, so you've done very, very well. I'll ask you one more question and I'll jump back [inaudible] and that is you mentioned introducing a Nelcore Compatible Disposable Probe and I know there's been a lot of litigation in this area. I'm assuming that you're very comfortable in entering that market that you're not going to face litigation from Nelcore, but could you comment on that aspect of the product introduction?

Well, number one, we have been in Nelcore Compatible Pulse Oximetry under the Dolphin trade name for the last couple of years. We have kept our nose clean, we have tried to establish our brand recognition in countries where Nelcore did not have any patent protection, and the main patents, the key patents came loose in October, November of 2003 and since that time us, together with our distributor Conmed, have done a relatively good job, I believe, of growing into this marketplace. And we predicted it, but we are quite happily surprised the appetite that the customer base has for a Nelcore Compatible good quality Oximeter Probe and that's what we are seeing. And our growth has been very significant, and in addition we said today that we again emphasized from last time to now this time that we plan to introduce in the near future Nelcore Compatible brand name products under the Spacelabs name, especially for the Spacelabs install [inaudible].

And these are--this would not be in conflict with Nelcore's patents, because it sounds like you said that those patents are now--have expired?

That's true.

Okay, good. Okay thanks, because I know there has been a lot of litigation. I was just trying to get a flavor. Thanks very much.

We'll take our next questions from Steve Gish with Roth Capital. Please go ahead.

Hi. Good afternoon.

Good afternoon Steve.

Deepak or Anuj, you may have mentioned year-to-date revenues were $190.2 million and then you've issued guidance for Q3 to as high as $94 million and then as high as $98 million for Q4, which if my math is corrects gets me to $382 million with your previous guidance of $390 million, which--but your backlog was up this quarter. Could you please explain what you're seeing that makes you believe that revenue will come down more to the $380 million, $382 million?

Number one Steve, yes the math does add up. We had expected a much stronger second half in the cargo especially, and with the uncertainty of when the revenue product can be recognized, when the product actually ships from quarter to quarter has some uncertainty. Secondly, we were expecting some repeat orders and because we are sitting with 5 months left to go, we conservatively look at what we bought and what we ship historically has a time lag and we believe that what we predicted from our healthcare group which has annualized about $194 million is in line, the Opto is in line, people and parcel scanning business is in line, where we have a sharp fall is in the cargo business. And although we do have a higher backlog this quarter than quarter, most of that might not ship in the last--next five months and secondly, what we do have we are saying that they are one of--they are developmental, they are government grants, and they all tend to be not very rich in margin. And that's basically what's happening that we are suffering from repeat orders that have not materialized in the second half, and secondly what we have on the--on--is mostly developmental and one of a kind which consumes much more energy and engineering which is generating the margin pressure on the security group.

Okay, what about the progress of the [inaudible] site? Did that contribute to the margin pressure, whether--did something change dramatically there? Was a modification required?

Ajay, do you want to handle that?

What we're doing there right is I think is--I assume we're talking about El Paso?

Right.

We're basically fine tuning it. We expect to have that complete. Originally we were looking at this quarter. I think it is going to be sometime next quarter. But I think if you're looking at just adding to what Deepak had said, there are some repeat orders that we were looking at. For example, the Eagle product line which is the ARACOR product line. You might be aware, we've delivered three systems. One to Jamaica, one to port of Savannah in Georgia, another one to Baltimore, and what customs is doing is they go into some operational testing, etc. that's going to take several months and even if they get orders out on the road, we obviously can't deliver them fast enough so there have been some delays. Those are the kind of delays that we're talking about.

And just to add on to Ajay's comment, with the start of the Houston project we just have taken internally on ourselves that we want to make El Paso a showpiece and want to just do everything possible to make sure that the customer and the showpiece people we can show and tell would be happier with the performance. So we've just internally made the decision to delay it by a couple of months.

Okay, Anuj, what was the litigation expense this quarter?

Relating to L3 (ph)?

Correct.

Very minimum.

Same as last quarter. There has been no movement. We still are waiting for the judge's order.

Okay. And you had mentioned that $23.6 million in revenue came from conventional. Do you know what it was a year ago?

Of the top of the head we might not. Also, do you--how much [inaudible] was there. We can tell you from the last quarter.

Sequentially it was up from--

Sequentially it was up from $20 plus million?

First quarter was about $20 plus million and last year's second quarter was about $23 million but it had a significant portion of shipments to DSA.

Okay, thank you.

And we'll take our next question from Ben [Stuller] of HS Capital. Please go ahead. Mr. Stuller you are on the line.

Hi guys. Great quarter. All of our questions have been answered. Thank you.

And again, if you'd like to ask a question key star 1. And we'll take a question from Brian Ruttenbur at Morgan Keegan. Please go ahead sir.

Yes. A couple of quick questions about the launch in El Paso. Is it going to be April, May, June, is that the time frame that we're talking about right now?

Yes.

Okay. Do you have a month narrowed down on that?

I think one of the things that's going to make a clarification, there is a period of calibration. There is then a training of the customer, and then there is a handover to the customer to start doing their blind trials [inaudible] and so what we are saying is that calibration is eminent any time. Training can start at customer's convenience in the next four to eight weeks, and then somewhere in the April, May, June period the customer will start their blind trials with no accessibility to the [inaudible]. Ajay, you want to add--

I think that's right.

Okay. My next question is concerning ongoing revenue and earnings. It's kind of shocking to me how you guys go to break even and I'm just trying to understand, kind of, predictability of business going forward and I guess there's some extraordinary cost in the third quarter as you're restructuring things. If you back out these restructuring on current revenue guidance of let's say $92 to $94 million, how profitable would you be X any restructuring?

Number one, I think what Ajay touched on Brian, segmentation is pushing towards that we're trying to give you a better realization of the kind of makes and the products we have. There's [inaudible] that we can back off the costs. For example, we have the whole group, ARACOR, which is developing the Eagle system which had a BPA from the government. We delivered three systems. They are about $4 plus million dollars each and suddenly we find ourselves that the government has received them from all the imports we have got. They are very happy, but they want 6 months to try these systems before they want to add on or decide what they want to do. Now, we are in a predicament. What do we do? Do we take the whole group off? Do we reassign them? Do we look at some other alternatives? So we are sitting on that. That's one of the costs we have. That's an investment. We have got a lot of investment into that product line. You look at the BF&A system. We are fine tuning the El Paso to make sure it's a showcase. W have announced a contract for the Houston airport which has started, but we want to make sure that we finish El Paso and go to the next one. But if we are finishing El Paso and we are putting this extra effort onto that, we really can't jump the whole group over to the Houston. You look at what we are internally doing to the products which are the gamma systems. We have built systems. We are aggressively pushing them over and that's what we were banking upon that we could get some repeat business and we have them in inventory so we can ship it fast enough and it hasn't happened.

Okay. So the--

And the other thing is on the EDF system we have said for the last couple of quarters that we have aggressively started spending money on the R&D mode and that's what's showing up that it's no more a 7%, 8% R&D if you really count on the additional R&D around, we have almost doubled our R&D from last year. That's what's causing it and wherever we could find the ability for cutbacks from what we see without abandoning some of the investments and technologies that we have done and we still believe in doing, we have taken that shot and we've already done it. It's going to take this quarter to wash out the severance and some of the related costs and we are saying by Q4 it should start putting an impact which is what is showing up, but the real weakness we have, we just don't have enough repeat margin profitable products in large cargo.

Okay, so the reason for the break even is, I just want to make sure I understand is going from profitable to break even is primarily related to large cargo unprofitable business and it doesn't have anything to do with the medical side or really anything else, it's primarily large cargo, is that right?

The losses are primarily due to cargo.

Okay.

But the other thing that is coming into play from Q2, what you saw, a parcel and people scanning business of $23 million is quite profitable. You add $8.4 million dollars of cargo on top, which is government grants, which is one of, and all of the other stuff we are doing has significant losses for the quarter offset by the profit from the people and parcel scanning. [Inaudible] being $1.2 million approximate loss. Secondly, we had a very strong quarter in medical. You see that, we said December would be a very strong quarter. Obviously we are saying that the second half of the medical--for the medical, it's going to be the repeat of the first. So if you add the Q1 and Q2 into Q3, Q4, it spreads over so that what's going to happen is that your total profitability on a quarter by quarter for the medical group will not be the same as happened with the strength of the December quarter, especially Q3 because some of the changes we are making and have made will not come into play until Q4.

Okay, very good. Thank you very much.

And I'll take a question from Tim Quillin of Stephens, Inc.

Good afternoon.

Good afternoon Tim.

Deepak, I guess from a philosophical point of view you're taking a long term perspective on trying to build a business and particularly in large cargo and so you're making up front investments in R&D and also I would presume in your sales efforts, but yet the revenue is not there and it seems like it's been that story, not just this quarter but over the past several quarters or several years, and at what point do you start to focus more on profits and get the current returns and invested capital to a level that investors are comfortable with?

Good question Tim. One of the things--challenges, we've always had that cargo has been an enigma for all of us. I mean, except for one company and we all know, we feel that a certain agency chose them at the right time. They had a product and they're [inaudible] it, but if you look back a couple of quarters, four quarters ago, that same company for 14 quarters in a row, or 12 in a row, since 9-11 could not sort of put this together to make and continued to invest in the product line. I look at it that we really literally have a cargo product line which is almost like the repeat of a company which is waiting for the products to be accepted. Until that happens we just continue to invest and we continue to look at what added on developments we can--money that we can get from the government or other resources to add onto it. Regarding where we do go from here, and we don't have a timeline in sight where at a certain time we say we're going to abandon cargo, because as you all know, that cargo is the biggest growth opportunity that everybody says it, and we believe [inaudible] and there are enough line items. The unfortunate part is that U.S. government has not been able to make a decision on homing on to any specific standardization and we are hoping that with the El Paso, with the Houston kind of initiative, with the various Eagles that we have done there and with other people's technology, that some kind of a directive will come to buy. In the meantime, we look at it as a very positive step that by segmentation, if you look at every other group or product line we have in the company. They all have almost approached double digit operating income at these levels. And one segment of the business it's easy to say "well if that's the cancer, do we abandon it?" But we can't and we won't because that is the future growth segment unless someday somebody decides that cargo inspection is not needed anymore. Until that time we continue to invest in the future and it's unfortunate that we were not able to get a couple of orders and though the backlog is up, they are all one of a kind. Our backlog is significantly up from a year ago. I remember some of you were asking, "Well how are you going to deliver revenue with a backlog of $11 million?" Our backlog right now is $23 million in large cargo. So backlog is up, it's still one off's. I wish we could land a couple of gamma trucks which are very profitable for us. In a difference from quarter to quarter, one or two gamma trucks makes all of the difference.

I appreciate that, and maybe put another way, as I look back over the past five or six years, and maybe this is a case looking back further, but there's only been one year where you've had a 10% operating margin or better [tape cuts off] maybe at some point you focus on specific profitability targets or return invested capital or EVA or somehow target profitability as opposed to constantly building for the future but never really generating profits for shareholders. I mean, is there--is that type of thought process going on within the company right now?

Absolutely Tim. If you just reverse the clock back a couple of quarters, people asked us, "Why Spacelabs, what are we doing in medical?" You look at this quarter and Spacelabs performed much beyond any of your expectations, all of you. Now to me, it was the right decision. It's the right mix, it's the right way to expand, and it's the good acquisition we did. If the cargo business was either never on our plate or it had resulted into different kind of orders, it would be a different story. If you look at now by segmentation, every segment is very clear. Every segment has a profitable future and present profitable. What we are saying to you, look at it, that the security has two segments, and the investment that is going in, what was 4 quarters ago when nobody had any cargo revenue, of what people were saying about the other company, we have that situation in one product line called cargo. On the other hand, even now we could increase profitability by saying we don't want to be GDS. But as you know, that a broad enough portfolio, GDS cannot be ignored because it goes hand in hand with carry on baggage, it goes hand in hand of what the next generation of inline systems that are going to be bought and we continue--must invest in that to make the products.

Thanks Deepak. I appreciate the dilemma.

And we'll take a question from Ben [Stuller] of HS Capital.

Hi Deepak, it's Ben Stuller. How are you? [Inaudible] before [inaudible] a great quarter. I'm actually a little disappointed with the quarter, the revenue, and so forth. Looking at the process--the strategic process that's underway, I understand the segment reporting. You sound fairly beaten up. Is the strategic process still underway?

Would you ask the question again about beaten up? I didn't understand the question.

Well you sound like that you're a little depressed, a little beaten up by the quarter and about the different things that have come to light in terms of the different segments and how they performed, just in the tone of your voice that we've been accustomed to.

I wouldn't say that. Maybe I got up on the wrong side of the bed, but absolutely not. My view of this quarter is that we beat our revenue numbers. We beat beyond expectations of what the healthcare group could deliver where I think a lot of you people were disbelievers and we said, guys if we can get the revenue together, and December will be quarter, we predicted it, it performed beyond anybody's expectations. We believe that all our segments are performing well and what we are showing is that with the Eagle system, which is one of the biggest things we had invested into it, there is a lull. Government is testing them.

So we have the challenge in front of us to say, well we're going to make short term numbers so let's just clean house and get out of the business, and 6 months later the government comes back and says, "You know what, we really like the systems that you delivered, how soon can we build more?" and we say well we can't. We just got rid of that group. That's the kind of stuff, I don't think that [inaudible] beat up. We're trying to give more visibility of the various segments that are in there. And we projected a quarter ago of $97 to $99 million in revenue, 19 cents to 21 cents before retention and amortization and we delivered $102 million in revenue and 19 cents, and after a loss of $1.2 million from the security group, namely due to cargo. So then the cargo turns around and is able to deliver, it doesn't take a lot of energy to find out what is the possibility that we can get out of this product line. I do not agree that our tone is depressed.

Okay. That's what I heard from the early part of that call. Now in terms of the strategic--and I'm glad you clarified that for us. In terms of the strategic process that's currently underway, does it start and stop with segment reporting, or is it a process continue? Can you just talk a little bit about as well the consolidation and the industry and what you see going on right now in the industry as a whole?

Well, that process hasn't stopped. Segmentation was a first step. I think we have taken the next big step to dissect even in the segment to give view to you people even in the healthcare sector of the oximetry, of the monitoring--

Well, it's us, we're all shareholders. I look at it as all as a group, so--

And then we are looking at what the security various segments are. There is consolidation in the industry. We are looking at it, but we said it in the last conference call. We again repeat it. No decision has been done. At the same time we want to make sure that whatever we do and what's leftover is a viable product and we have said that the healthcare group needs a couple of quarters for that group to get a predictable track record and can erase what you earlier said, somebody, that it had a very checkered past, "How come you guys have turned it around so fast?" We want to make sure that people don't think that it happened as a fluke. 3 quarters in a row we have done consecutive profitability. We have always been profitable in our people and parcel scanning business. It continues to grow and we continue to--I look at the cargo as internally funding R&D together with whatever we can capture from other sources like government or whatever, all added contracts, to continue to develop the products that we believe long term will be needed in large cargo inspection products.

I understand that. Can you talk a little bit about the industry and what you're seeing out there in terms of being in the right space at the right time and so forth.

I think that large cargo is definitely a challenge for everybody and I am definitely aware of some of your-all of your feelings that how come company A is doing so well in cargo and we are not. Well they happened to have a product at the right time with the right place, got selected in a niche market. But keep in mind the big market in that area is cargo inspection or ports, borders crossings, and air cargo and we have development contracts, might not make money, developments contracts on the books for both border crossing and air cargo. We have the right products to compete with the highly mobile gamma systems, we have demonstrated successful installation of high energy [inaudible] systems worldwide. So we have all the product makes compared to any of our competitors as a broad enough product line. Unfortunately there is no question about it that we have not been able to capture in the funnel enough repeat orders to demonstrate profitability in the cargo segment.

Thank you. I will talk to you in the future. Thank you.

There are no more questions at this time. I'd like to turn the call back over to the presenters for closing remarks.

Thank you very much gentlemen. In summary I think the last question we answered it what our vision is. Segmentation is the step that we took. It was the right step to take. We are looking at each business unit. We are addressing the cargo losses. We have implemented a reorganization in the security group which will save us money by Q4. We are trying as hard to capture more business. At the same time we want to make sure that we invest for the long term because from a quarter to quarter, cargo business cannot be managed. It has to be managed with a longer tail and patience and perseverance and that's what we are demonstrating. Our healthcare franchise continues to demonstrate what we believed when we bought Spacelabs. Our oximetry product for which we have invested for the last couple of years is bearing fruit. Our Opto support business continues to capture inside [inaudible] manufacturing and all our businesses, all our segments, are producing profit and we believe that over the next couple of quarters as we can get some of the products into repeat in the large cargo, will demonstrate our investment is in the right place to develop those products and to perform profitably in that business. Thank you.

Ladies and gentlemen, thank you for joining us on the call. You may now disconnect.