OSI Systems Inc (OSIS) 2006 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Q3 2006 OSI Systems earnings conference call. At this time, all participants are in a listen-only mode, and we will conduct a question-and-answer session towards the end of this conference. (OPERATOR INSTRUCTIONS).

I would now like to turn the call over to Mr. Victor Sze, General Counsel. Please proceed, sir.

Thank you very much and good afternoon. With me on the call today are OSI Systems Chairman and CEO, Deepak Chopra; the President of the OSI Security (technical difficulty), 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 10-K filed with the SEC.

For a limited time, we will make the webcast replay of this presentation available on the investor relations section of our website. Our website address is www.osi-systems.com.

Please note that the date of this conference call is May 15, 2006. 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 reporting, reproduction or rebroadcast of this conference call without the express written consent of (technical difficulty) is prohibited.

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

Thank you very much, Victor. Before I go into the quarter, I want to mention that I am speaking from New York City, where I'm currently participating in our trial with L-3 Communications. The trial has just entered the third week, and is expected to last for approximately four weeks. As you can respect, I am unable to comment or answer any questions (technical difficulty) or potential possible outcome of the trial until its conclusion. I thank you very much for your understanding and patience regarding this matter.

For the third quarter of fiscal 2006, the Company recorded revenues of 108.1 million, with diluted earnings per share of $0.06 after stock-based compensation expense of $1.5 million or $0.09 per diluted share. Anuj Wadhawan, who is currently in Los Angeles, will discuss the financial highlights in further detail at the conclusion of my operational review, and then we will open it up to questions.

Overall, we are pleased with the operating performance for the Company as a whole in all its three operating segments. We are particularly pleased with the security segment recording record revenues of 36.7 million and returning to profitability, which we said in our last conference call. We expect this performance to continue into the fourth quarter of this fiscal year.

The revenue growth and operating income performance for the security business was primarily led by the strong performance of our cargo and vehicle product line and continued robust revenue stream from our people and parcel scanning conventional business. Year to date, we have announced in excess of 28 million in new cargo orders from both international and domestic customers. The backlog for the cargo product stands at approximately 44 million to 43 million at the end of the quarter, with the total security business's backlog to be at a very healthy level.

We continue to see increased traction for the product line globally, especially cargo, led by the US government, and strong performance should continue into the fiscal 2007. The security business will continue to be committed to R&D, both for its cargo product line and the automated hold baggage screening market, although we did say in the last conference call that the R&D going forward for the cargo line is relatively lower and reducing, and the R&D for the whole baggage screening line is increasing.

We also introduced our first-quarter offering in the hold baggage market in this quarter. A major focus of our R&D spending will be on the commercialization of the Rapiscan RTT1000 CT system for automated hold baggage inspection. As told before, the system utilizes our proprietary real-time tomography technology for the automated inspection of hold baggage. The system is electronics-based without any moving parts that by design will increase baggage throughput, from the present machines doing approximately 500 to 600 bags per hour to increased throughput to approximately 1,500 bags per hour. We believe the system will radically reduce installation and ongoing maintenance costs, which, associated with the current systems, is a big problem in the market.

This quarter, we announced $7 million order with the Manchester Airport Group, which was one of the original group to go towards CT scanner technology for automatic hold baggage. If all the customer options are exercised, the order could be worth approximately $40 million. We are expecting to deliver the product in fiscal 2008, and we are at present ramping up R&D towards what we call scaling it in size and to continue to work out the various subsystems of the system.

The third quarter of our healthcare business, as we had mentioned, is seasonally weaker when compared to the businesses, and especially the second quarter ending December and the fourth quarter ending June. Despite the seasonal factors, our monitoring and anesthesia business continues to show year-on-year order book growth. For the first nine months of the fiscal year, monitoring order book growth globally has increased by 18%. The growth has been led by the continued strength and strong performance in the US market, which is the biggest market for the monitoring products. The business has and remains focused on recapturing our replacement cycle business. Published industry growth rates show the market growing at approximately 3 to 5% in the US, similar number in Europe and about 10% in Asia-Pacific. Our order book growth clearly indicates that we are achieving our internal goal of recapturing our installed base, while also capturing market share from our competitors.

Gross margins for the healthcare business continue to improve, and have approached 48% versus 46% over the first three quarters as a whole over the fiscal year. The improvement is attributable to the introduction of new products in the patient monitoring line and the achievement of efficiencies in the manufacturing process in our monitoring and anesthesia product lines and the growth in our revenue. The business, although, is facing a challenge in the UK and German markets, primarily due to the government spending cycles, a challenge that we are not alone, but us and all our competitors are also facing.

This quarter, the Company also reached a settlement with Masimo regarding our Dolphin I digital pulse oximetry products. Under the terms of the settlement, we agreed to discontinue the product line of Dolphin I digital pulse oximetry. The financial impact of this is expected to be minimal and immaterial. Big focus of that product line is in our original equipment manufacturing relationships for continuing to make oximetry products for other patient monitoring companies and supplying products under the name TruLink or Spacelabs.

The healthcare business is focused on organic growth in all the product lines, and we are looking to introduce new technologies and products, while also focusing on the introduction of the anesthesia product line into the US market sometime in fiscal 2007. We continue to look at acquisitions globally; it is part of our strategy. We internally have said that we would target the healthcare business to approach approximately $0.5 billion in revenue over the next two to three fiscal years, combination from acquisitions and from internal organic growth. Any acquisition we look in that product line, we target towards making it accretive to both Spacelabs and OSI in a very short period.

The optoelectronics business continues its great performance in fiscal 2006. The business has benefited not only from the general pickup in the economy, but also the improved performance in our security and healthcare businesses. This quarter, we achieved record intercompany sales of $7.6 million. This has helped in pushing the operating income for the business for the quarter.

This quarter, we also announced the resignation of Deloitte & Touche as our independent accountants. We had been with Deloitte & Touche for the past 15 years, and thank them for their service. We welcome our new auditors, Moss Adams, and looking forward to a long, solid relationship with respect from both sides. The resignation, as we have discussed, of Deloitte & Touche was primarily due to relationship issues, and not in any way associated with financial reporting procedures of the Company.

For the six months ending June 30, 2006, we expect revenues to be between 231 and 236 million, an increase of approximately 18% when compared to 196 million achieved in the second half of fiscal 2005. We will be profitable, and expect that operating income will be significantly higher in Q4 when compared to Q3. Overall, we are well-positioned to finish the year on a strong note, setting us for a successful growth-oriented 2007.

With that, I will hand it over to Mr. Anuj Wadhawan to give the detailed financial information.

Thanks, Deepak, and good afternoon, everyone. Financial highlights for the three and nine months of fiscal 2006 -- our revenues for the third quarter of fiscal 2006 increased by 13.9 million or 15% to 108.1 million compared to 94.2 million for the third quarter of last year. Revenues for the first nine months of fiscal 2006 increased by 42.8 million or 15% to 327.1 million from 284.3 million for the first nine months of fiscal 2005.

Net income for the third quarter of fiscal 2006 was 1 million, compared to a net loss of 2.9 million for the third quarter of last year. Net loss for the nine months of fiscal 2006 was 3.1 million, compared to net income of 840,000 for the first nine months of last year.

Diluted income per share for the quarter was $0.06, compared to diluted loss per share of $0.18 for the third quarter of last year. Diluted share for the first nine months was $0.20, compared to diluted income per share of $0.05 for the first nine months of last year.

Due to the adoption of FAS 123(R) in the first quarter of fiscal 2006, we recorded a stock-based compensation expense of 1.5 million in the third quarter and 4.1 million in the first nine months of fiscal 2006.

I will give you the breakdown of revenues. On the securities side of our business, revenues increased by 7.4 million or 26% to 36.4 million this quarter, compared to 29 million for the last year's third quarter. The increase was primarily due to an increase in revenues of 4.8 million or 101% in our cargo and vehicle inspection products and 2.6 million or 11% in our conventional base business, which comprises of baggage, parcel and people scanning products.

For the first nine months of fiscal 2006, the security group revenue increased by 2.8 million or 3% to 93.8 million from 91 million. The increase was primarily due to increase in revenue in our conventional base business of 7.2 million or 10%, and was partially offset by a decrease in revenues of our cargo and vehicle inspection products.

On the healthcare side of our business, the revenue increased by 1.6 million or 3% to 49.4 million in the quarter, compared to 47.8 million in the last year's third quarter.

For the first nine months of fiscal 2006, revenue increased by 17.2 million or 12% to 161.8 million, compared to 144.6 million in the first nine months of fiscal 2005. The increase in revenues in the quarter and nine months were primarily due to increased revenues from our monitoring and anesthesia systems.

On the optoelectronics side of our business, external revenue increased by 28% to 22.2 million in the third quarter, compared to 17.3 million in the last year's third quarter. External revenues for nine months increased by 22.8 million or 47% to 71.5 million from 48.7 million in the last year's nine months. The increase in revenues in the quarter and nine months was primarily due to an increase in revenues of both commercial optoelectronics and higher contract manufacturing levels. In addition, during the quarter, we reported intercompany revenues of 7.5 million, compared to 5 million in the third quarter of fiscal 2005 and 5.4 million in the second quarter of fiscal 2006, which got eliminated in the consolidation.

Our gross margin for the quarter increased to 39.8%, compared to 35.2% in the last year's third quarter and 38.5% in the second quarter of fiscal 2006. Our gross margin for the nine months increased to 38.3%, compared to 36.4% for the last year's nine months. The increase in gross margin was primarily due to favorable change in product mix an all of our three businesses.

SG&A for the third quarter was 33.8 million, compared to 30.2 million for the last year's third quarter and 33.5 million for the second quarter of fiscal 2006. The increase in SG&A in the third quarter compared to last year's third quarter was primarily due to increased legal fees of approximately 1.9 million associated with the ongoing litigation of L-3 and SAIC, and the inclusion of approximately 1.2 million in stock compensation expense and higher administrative costs to support the growth of our businesses. The increase was partially offset by the impact of an increase in bad debt reserve of 2.5 million in the three months ended March 31, 2005.

SG&A for the first nine months of fiscal 2006 was 100.7 million, compared to 80.6 million for the last year's nine months. The increase in SG&A was primarily due to increased legal and professional fees of 5.2 million, higher administrative costs of 2.2 million, inclusion of stock-based compensation expense of 3.4 million, 2.7 million due to inclusion of full nine months of Blease SG&A, higher sales and support costs of 7.2 million to support the growth of our three businesses and foreign currency translation losses. The increase was partially offset by the impact of an increase in bad debt reserve of 2.5 million in the three months ended March 31, 2005.

R&D for the third quarter of fiscal 2006 was 8.9 million, compared to 7.3 million in the third quarter of last year and 8.7 million for the second quarter of fiscal 2006. R&D for the first nine months of fiscal 2006 was 26.3 million, compared to 21 million in the first nine months of fiscal 2005. The increase in R&D spending was due to increased R&D spending by our healthcare group for the development of next-generation products and increased R&D spending for the development of our automated hold baggage screening and cargo and vehicle inspection systems by our security group.

We had an income tax benefit of 820,000 for the third quarter of fiscal 2006, compared to a tax benefit of 2 million in the third quarter of fiscal 2005. For the nine months of fiscal 2006, we recorded a tax benefit of 1.8 million, compared to a tax benefit of 602,000 for the last year's nine months. Our tax rate is dependent on the mix of income from the US and foreign locations, due to tax rate differences. Our effective tax rate has increased due to inclusion of incentive stock options expense and the total stock compensation expense, which does not qualify for tax deductions. We expect our tax rate in the fourth quarter will be impacted as we adopt SFAS 109-2 to repatriate our foreign earnings. We are currently evaluating the impact of this.

In the first nine months of fiscal 2006, we used approximately 10 million of cash in operating activities, primarily for working capital to support the growth of our businesses. Our total backlog remained strong at the end of March of approximately 131 million. Our cargo backlog at the end of March was approximately 43 million.

We reiterate our revenue guidance for the second half of fiscal 2006 to be in the range of 231 million to 236 million, and expect revenues and operating income be higher in the fourth quarter when compared to the third quarter of fiscal 2006.

With that, I will open it up for questions.

(OPERATOR INSTRUCTIONS). Brian Ruttenbur, Morgan Stanley.

This is Brian Ruttenbur with Morgan Keegan. I don't get paid like the guys at Morgan Stanley. A couple of quick questions for you. On the tax rate, you expect it to be up significantly from third-quarter levels? Are we talking 45, 50%? Are we talking 35%? What range are we talking?

If you look at third quarter, we had a benefit, income tax benefit. In the fourth quarter, we are -- [as you said], are going to be [cost stable]. But there are various different variables out there, in that one is a stock compensation expense and repatriation. The tax rate is going to be higher. It is going to be over 50 to 70% range.

So on a GAAP basis, it would be over 50%?

Yes, it will be between 50 to 70%.

And then, legal fees you mentioned in the quarter was 1.9 million, I believe, is what I call it. What kind of legal fees do you anticipate in the quarter we are currently in, given the trial and everything?

Just to clarify, 1.9 million is the increment over the prior year's third quarter.

How much legal fees did you actually have in the third quarter?

Approximately $2.7 million.

Okay, so you had 2.7. What do you anticipate in this current period?

Well, let me try to answer that question, because I am in New York. Very difficult for us to come up with a number. We definitely think that the best estimate we can give you, it would be higher than Q3. But at the same time, it will drastically go down by the end of this quarter, by the end of this month.

The other outstanding large, I guess, litigation is -- the only one that I am aware of is SAIC. Is that the big one out there? Is there anything else major besides that?

No, those really are the two that are sort of the larger part of our legal fees. The others are more minor.

And then let me just talk about gross margins. You had good gross margins in the period, in the third quarter. And over the last, I guess, six or seven quarters, that is your highest gross margin overall. Can you maintain that 40%? Is that the goal?

I think that a lot depends on the security shipments, and as we have said, that both quarters would continue to show growth compared to Q3. So there is no reason why the gross margin should not continue to tick upwards, approaching the 40% plus number.

On SG&A, just going down through the income statement for the next period, it's certainly very heavily weighed to Q4. I assume that is because of bonuses and salary increases and everything that take place in the fourth quarter. Is that the case?

I don't know. Maybe, Anuj, you want to take it. I think that the bonus accrual goes all through the whole year, and there are no raises or something that come into fourth quarter. I think it's more like the hourly people get reviewed in August and the exempt get reviewed in September. So I don't think so that's true. Anuj, you want to add onto it?

Yes. The fourth quarter -- another fact that kicks in is the professional fee associated with the [actuary] testing on Sarbanes and coming from the auditors. That's another variable coming into it. And another variable comes with the commission of our internal sales force. In the healthcare business, their compensation is based on the revenues; they have their sales targets. As we come to fiscal year end and they approach their sales targets, there are commissions on that.

So seasonally, the fourth quarter is much heavier, even as a percentage of revenues? That's what it has been, at least. Is that fair to say, this year?

If you take it as a percentage of revenue, I don't think that it's going to increase significantly. It all depends upon -- other variable is legal, as Deepak mentioned, is going to be higher. But if you exclude that, our SG&A is very much in the level where we are.

On R&D, it sounds like it's going to be up in the fourth quarter versus the third quarter. Did I hear that right?

That's true.

Can you give us a range? Is it going to be up by 1 or 2 million, or what?

Ajay, you want to comment on it? Because the only area that is going to be up is not medical but your RTT automated baggage claim.

Obviously, you are ramping up with the R&D there. It's going to be up -- but I would say it will be up by less than $1 million quarter to quarter.

And everything else should be down or flat, beyond that, for the rest of the Company? Is that right, Deepak?

I think the answer is flat is a better answer than down. But just to complete your first sentence on the SG&A, I was just thinking about it, what Anuj was saying. As a percentage of revenue, I don't think so that your SG&A is going to be higher in Q4 compared to Q3, because if you look at our guidance, Q4 revenue is going to be significantly higher than Q3.

That makes sense. I just want to understand a little bit more on the security side what all is going out there from a macro environment? What is up for bid right now? Where is the big action? Is in the US, is it in Europe, is it Asia? Where are the big large cargo and other contract awards expected?

Ajay, you want to take that?

Yes. I think, on the large cargo side of things, we are seeing activity both internationally and domestically. We are actively talking to, participating in various government agencies over here. Internationally, again, it is very strong activity, very strong, stronger than what we have seen it, in fact, ever before. On the [conventional] side, our people in the parcel scanning business, we continue to see growth. Anuj mentioned that we were at 10%, 11% higher than previous quarters. We are seeing growth there. We are looking at newer markets that we're entering overseas. And the automated hold baggage screening, that is just a market that we have started. We are obviously looking at customers that have been with us at different airports; they are the same customers. So we think that we're going to get some good traction there as well, going forward. So really, all three areas of our business are looking very strong.

Navid Malik, Collins Stewart.

In terms of your revenue (technical difficulty) from patient monitors, you are signaling that the growth in the global market for the order intake was 18%. How long do you think this growth can continue for, given the market's growing sort of low single to mid single digits? And where do you see particular inflection points in terms of new products coming through?

Number one, that is very true. Our growth, what we had said to you for the last four, five, six quarters that we have been talking about, we continue to see double-digit growth. Our US business, surprisingly, has been very strong in monitoring order intake, which basically says that not only are we capturing our lost market share, but we are also taking business away from our competitors.

Definitely non-US, we have some challenges still. As you know, that area was started when the Company separated from GE, from scratch. And we are still building our sales force. We are still building our relationships. In the Asia-Pacific, we continue to make progress. We have new products in line. The closest one is the [low acuity] monitor, specially geared up for the low-cost market to go after the [outer] clinics and the Asia-Pacific area.

Our major launch for a whole new platform is not scheduled until late 2007/2008. But the other initiative is, as you know, that we have 510k approval for anesthesia machines in US, and we are right now in our final strategic plans of launching the anesthesia product line into US.

So there's a lot of activity happening in that area. Answer to your question, how long can we continue this double-digit growth? We have said it that for the next foreseeable future we will continue to see this double-digit growth, and we don't see any slowdown in the short period. Where it will end up in the inflection point, I think, is still four, six, eight quarters out.

And just on the anesthesia business, do you think that given the strength of that business in the rest of the world, that you could see a pretty confident launch in the US? What are your expectations or preparations for launch of anesthesia products in the US?

Well, keep in mind that US is the biggest market for the anesthesia products, so it is a huge market. But we're also coming in -- you can appreciate it that Draeger-Siemens and Datex-Ohmeda/GE are there. We plan to launch it, but we have always said to you we're going to get one shot in US. So we are very careful. We are doing all our analysis. And that is why we are very cautious and we are going to think it very carefully when we launch. But when we launch, we are going to launch it very aggressively, and we have high hopes for it that will capture a good share of the market.

On the margins, on the healthcare side, hit 48%. Do you think that there is sort of reasonable headroom for further margin expansion in the final quarter and then going into fiscal 2007? Are you able to rationalize some of your costs in your [low-cost] centers such as China and India?

The answer is yes. We have told before that we think that we can cross the 50% mark. We might miss it by a quarter or so, but we are on the right track. And we believe that as our monitoring business continues to grow, it automatically has a higher margin. And we continue to look at manufacturing in other areas to increase our efficiency. So it is absolutely true that we continue to move towards the 50% margin in the near future.

Jeff Rosenberg, William Blair & Company.

Back to the gross margin. I wanted to ask, given that I understand you're seeing improving gross margins in all of the segments, and that is obviously having the most predominant effect, but I was surprised, given the mix shift moving away from healthcare this quarter sequentially versus the cargo business, that gross margins still went up. So can you provide a little color there in terms of -- it sounds like the security gross margin was up particularly strongly. So maybe a little bit of specific commentary on the improvement there?

Well, I'll answer the healthcare side, and Ajay can maybe take on the security. On the healthcare side, firstly, we did mention to you that this was going to be a weaker quarter, revenue-wise, compared to Q2. But even then, because the monitoring sales, especially in the US, were so strong, which inherently has very high margins -- so that pushed the margin, even with the revenue being down. And our optoelectronics business has performed very well in its margin, and continues to do well. And we think it will continue.

Ajay, you want to comment on the security side?

Yes. I think, if you look at the security side, the margins have improved, both if you look at growth in the conventional. We said that as these sales go up, your related expenses don't necessarily go up the same amount. So we have been able to leverage our margins as the sales volume has gone up. And the same thing is happening with the cargo side. The other thing we're doing on the cargo side is, if you remember, nine months ago, a year ago, we were doing a lot of one-offs. As we become more familiar with some of the products, our margins have improved there as well.

We went through before all the different line items on the P&L. But it sounds like what you are pointing toward is the best operating margin in this fourth quarter that you have seen in some time, but there's a lot of moving parts here. Can you give us a flavor for it? Do you think you can achieve a mid-single-digit operating margin this quarter? Or how should we -- because it seems like the gross margin should have another nice step up, with the mix shifts will be more favorable. And obviously, there's continued leverage there. And with good revenue growth, you'll see some improvement in operating expenses. So can you give us a feel for what that turns out on the operating margin line?

Well, let me try to answer that. You have asked a pretty tough question for us. Our revenue is going to be significantly up in Q4 compared to Q3. We've also said security will continue to be strong. And we have also said Q4 will be stronger than Q3 in healthcare. Basically, you're absolutely right that all these factors lead to that the gross margins should be up. The problem we have is that we don't know where the legal is going to fall. And like I said, we are in an active lawsuit right now. We have also the moving parts where Anuj mentioned about our tax rate and our Sarbanes-Ox expenses which start coming up in the Q4.

So what we are trying to say is that, if we take out some of this one-off kind of things that are happening, the operating income line will be significantly higher compared to Q3, but very difficult for us to project beyond that for this quarter. But on the operational side, the revenue is going to be up, all segments will be profitable and the operating income line will be significantly higher than Q3.

Anuj, you want to add some more flavor to it?

No. You have said it pretty much on that, Deepak.

Well, maybe I am being too short-term-oriented in looking at the fourth quarter. If we look at 2007, the legal expenses are much more normal, and you have got a gross margin that is north of 40%. Can we expect you to get back to the 6% operating margin in 2004? Or maybe just some sense of what your targets are, now that you have had some chance to really drive some improvement and get some scale back in the security business. Where do you think we should look to when we look out to the next fiscal year?

I think that you have modeled it quite well. If you reduce the legal expenses going into 2007, and as Ajay says, the activity is quite strong, and we can do growth in healthcare, there is no reason why we should not return back to some overall company margins in the 40% plus or north of it and a return back to at least single-digit operating income, just keeping with one proviso, that Ajay is saying that we are increasing our R&D spending in the automated baggage scanning business. But your analysis is right.

And you have given us in the past the absolute dollar number of shipments on the cargo side. Is that the number that -- I think you just talked in terms of incremental year-over-year growth. Last quarter, I think you said that large cargo was only about $5 million. Does that improve quarter on quarter?

In this quarter, we shipped about $9.5 million in large cargo, compared to about 4.5, 4.7 million in last year's third quarter, and about 4.7 million in the second quarter of fiscal 2006.

You're talking about the kind of double-digit growth you're seeing in the patient monitoring business, but the overall healthcare business was up less. So can you talk about where the business has been weaker, in terms of what is dragging the overall growth down of the revenue in the healthcare group?

Well, one of the things is that the European sector, especially in UK and Germany, definitely is a challenge for all of us, because of their healthcare spending. And the other thing is that our medical data, our clinical trial business, is weak. And that is dragging the growth down. On the other hand, monitoring, which inherently has very high margin, continues to be strong.

So overall, we are quite happy. And keep in mind the oximetry business, I'm sure you know, has been in sort of a state of flux with this Masimo-Nellcor, which is part of Tyco, fight going on. It doesn't have any impact on us presently or even in the future, but they are definitely -- everybody you saw was sitting on the sideline, seeing what these two guys are going to battle it out. We didn't have enough to lose, so we decided to just not even push forward with our digital oximetry business. So, once sort of that whole environment gets settled down, we continue to be a believer in the rest of the oximetry business to continue.

So I take that to mean that when I look at the significant jump that you're expecting in the fourth quarter sequentially in terms of overall revenue, there is not anything unusual? There will be a seasonal recovery in healthcare, but that's not enough to get to your guidance. So you have got visibility into, I would take it to be, a much stronger shipment quarter in terms of cargo in this June quarter. And maybe Ajay, you could talk about, given the overall lumpiness there, what your comfort level is, if that happens.

Well, let me answer the vertical side. Definitely, Q4 seasonally -- and we have given guidance -- will be stronger than Q3. And on the security side, Ajay, you want to comment on it?

Yes. Cargo is lumpy. But sitting here today, like we have said, I do expect security to be a better quarter in the fourth quarter than the third quarter. So I think we'll leave it at that. It is positive, where we are in the third quarter.

Just to add onto it, we did say that cargo backlog [still stands] at about $43 million, even with shipments of 9 million plus. And we have also said that the total security backlog is quite healthy.

And it is just not cargo. We're seeing the growth in cargo as well as conventional.

Right. And I'm just saying that there's much more than a normal recovery seasonally, so to speak, in your numbers. I'm assuming it's a real stair-step up in the security business, is what we're looking for to make your guidance.

That's true.

Josh Jabs, Roth Capital.

Good quarter. In looking at the backlog, how much of the Manchester order went into the security backlog? Did you account for any of that?

Ajay, I don't know. Do you want to take it?

It's approximately, I think, $7 million of the total in that.

So from the Manchester order, kind of going forward in the backlog, there will be 7 million until you start shipping out of the CT?

That's correct.

And then, I guess, going back to the tax rate, you have had a little bit of fluctuation here. You have talked about repatriation and some of the stuff you have going on with some of the foreign income. Is this something that we expect to continue to fluctuate over the next year? When is this going to settle down?

This is just a onetime provision and the onetime opportunity we have. We can repatriate our foreign earnings. It expires on June 30, 2006.

And then what kind of rate, then, do you expect to get back to, then, after next quarter?

We have got a lot of variables in there -- as I mentioned earlier, mix of income, stock compensation expense, [ISOs] including in there. But if we exclude this repatriation, it will be somewhere in the neighborhood of 40 to 55%, somewhere in that neighborhood.

And Josh, just to add on to another thing, I just what to make sure what you asked about the Manchester backlog. Manchester backlog would be in the total security backlog, not in the large cargo backlog, which is at 43 million.

That's a good [plan]. And then, on the Dolphin settlement, you said that you didn't expect a significant impact there. Is there going to be any impact on the intercompany revenue? So is there an impact on the margin side?

No. Intercompany revenue in that particular product line would be to Spacelabs Healthcare for their TruLink oximetry product, which has nothing to do with Dolphin I or digital oximetry.

And then, I guess, finally, just going back to the R&D issue again, I understand that you're going to ramp R&D to get where you need to be on the hold baggage side. But you have talked about healthcare being sort of flattish, maybe a little down, and then the cargo is obviously coming back in.

So if you look at the R&D line, both from a percentage of revenue and also just from an absolute number, are we going to kind of settle in to the numbers that we're seeing now? Do you expect this to still come up within that million range that Ajay had said before? I think there has been some confusion there.

Let me try to answer. I don't think that we ever said that the healthcare R&D is going to go down. But as the revenues pick up as a percentage, it's pretty much where it is right now. In the security side, yes, the R&D is going to go up in the automated checked baggage business, but we also said the R&D in the large cargo is going to go down. What that impact is going to be, it's still a little bit too early. But one of the things that you should look at it is, because Q4 is going to be significantly stronger in revenue as a percentage, I don't think so R&D is going to go up. It might even go down. And on the healthcare, the only thing that has happened different is that we have been a little bit more efficient of the R&D engineering as we are doing in India. Compared to what we thought we were going to cost, it's costing us less.

(OPERATOR INSTRUCTIONS). Tim Quillin, Stephens & Co.

I apologize in advance. I wasn't able to listen to the earlier part of the call, so some of these are going to be redundant, but what do you expect the tax rate to be in the fourth quarter?

Anuj, you want to take it?

Yes. I mentioned in the earlier that a lot of variables are going to be there. One is a mix of income between our foreign and domestic locations, and then ISOs included in our stock-based compensation expense. This doesn't qualify for tax deduction. And in the fourth quarter, we are expecting that the tax rate is going to get impacted because of repatriation of our foreign earnings. That's currently we are evaluating. It definitely will increase our effective tax rate. The combination of all that -- it's a very broad range. It will be between somewhere between 50 to 70%.

But you also have said -- Tim, if you were not there in the early part of the call -- that this repatriation is a one-off item that we have to do it before June 30, 2006.

So 40 (multiple speakers) 55% in 2007?

Sorry?

40 to 55%, though, after this?

Yes.

And then, what was the total backlog?

Total backlog was about 133 million. Included in that, large cargo was about 43 million.

And what is the timing on the 43 million? What is the expected timing of shipments?

Ajay, you want to take it?

Yes. A vast majority of that is going to be -- again, it's going to be within the next 12 months. They are obviously -- we are shipping some fourth quarter, Q1, Q2 -- it's going to be shipping over the next 12 months. So new orders we get in take anywhere from four to nine months to ship. Some of the older orders we are shipping. We shipped some in Q3. We're going to ship some in Q4 and Q1.

And can you talk about the pipeline a little bit, Ajay, especially with regard to cargo screening? I notice that there is a fair amount of funding in the pending supplemental appropriations bill for container screen. Is that something that is applicable to OSI?

Yes, it is. I mentioned earlier, if we look at our pipeline, if you look at activity out there, it's very, very strong, stronger than have ever seen it, both internationally and domestically. As you know, with the government it's a matter of some of these budgets passing and getting some of the funds appropriated. But we feel very good about what we are seeing out there right now.

Just to add on to it, as you know, we did announce some time ago an IDIQ holder -- indefinite quantity, indefinite delivery. We have multiple products of large cargo qualified in that program. And, as the budget gets finalized and goes into the next year, starting October time period onwards, we definitely think that our products are needed for national security.

So is it your understanding that this $200 million plus of funding for container screening that CBP has would be spent under the IDIQ?

I think it would be inappropriate for me to answer that question. All I can tell you is that they have chosen different vendors. We are one of them under the IDIQ. Where they spend that 200 million, whether it's all on the IDIQ or some of it, that is a question better asked to the US government. I don't want to answer for them.

But maybe, Ajay, you can give some color relatively. Last year, the total number available to them was significantly smaller than what they are trying to put through this year.

That's correct.

So that sort of gives you an indication that if we got some input in our order intake from last year, this year as the number goes significantly up that they are asking for, that maybe there will be more available.

I like the sounds of that. On the operating margin side, I was a little bit surprised in the composition. You touched on this a little bit, but the healthcare margins were maybe a little bit lower than I would have anticipated, granted in a seasonally weaker quarter. But the opto margins were outstanding. Is there any trade-off between the intercompany work there, or is that all eliminated out? Is that all outside business margin that opto is getting, or is there some kind of trade-off on who gets the savings from in-house manufacturing that the opto is doing for healthcare?

Let me try to answer that. Firstly, we have always practiced arm's-length transaction between the opto group in a fair way to the divisions. The external sales are higher. That increases their margin. And as they ship more intercompany, they do ship with margin. So when you add the two things together, definitely optoelectronics group generates very healthy operating income. And we have said that before. But I would not go as far as saying, is there some kind of a monitoring that we just divide a little bit here, a little bit there, or whatever? It's very well [thought out], arm's-length transaction with what the fair pricing is between the manufacturing component group of optoelectronics and the two divisions, security and the healthcare.

That's helpful. Have you talked about what the legal costs have been year to date?

Victor or Anuj, would you like to take a shot at it? Or if you don't, if somebody can make a good estimate?

It's approximately 4.9 to $5 million.

And this quarter, the current quarter, it's still pretty hard to estimate where your legal costs are going to end up?

Well, we did say, I think, that if you were there on the call or not, that we cannot estimate, but as a best guesstimate, we are in a four-week trial as we speak, so we think that Q4, which is June ending, the legal costs will be higher than Q3, which Anuj mentioned was approximately $2.7 million. But it should go down after that, significantly.

And other than the legal costs, is there any initiatives that might lower SG&A? Or do you expect estimate costs to stay relatively flat in fiscal 2007, excluding the legal costs?

Well, if you really looked at it, one of the things that has happened -- we definitely want to emphasize that we continue to look at our SG&A costs. But the new variable that has entered into it is this stock compensation expense that wasn't there before, and now it is in there. And that is having an impact in there, and the R&D is up.

So I think, as I know that you continue to ask, as a percentage of revenue, as the revenue line picks up, the SG&A as a percentage of revenue should start coming down, especially if you take the big element out of the legal. And even after taking legal out, I think as the revenue line continues to grow, excluding the legal, the percentage SG&A should start coming down.

Anuj, do you want to add something?

No, I think you said it well.

Okay. I was just looking at excluding stock option expense and excluding legal expense, you did about $30 million in SG&A in the third quarter. And what I am trying to figure out is, can I kind of extrapolate that as a good run rate that you don't need to grow much in fiscal 2007? And as your legal costs run off, maybe that would be a good run rate that we should think about?

I think that that is a fair statement. Again, Anuj, would you have a comment on it?

No. That is pretty much -- that will be pretty much in that range.

And then, the management retention bonus -- do we have one more quarter of that? Is that done?

It has already been done.

It's done?

Yes.

And you may have touched on this. And if you have, don't repeat yourself, please. But can you talk about the situation with the auditor and why there was a severing of the relationship?

Well, the issue basically was that I think the relationship was the major issue. After 15 years of marriage, I think fatigue was showing from both sides. And our biggest complaint had been that we just didn't get the respect or [call the priority]. And we were eight hours late on our year end. We were a couple of days late on the quarter. And after Q2, it was pretty obvious that both sides were not being in a happy mode.

So we actually had started dialogue even before Deloitte & Touche resigned, or started talking to and interviewing various potential. But our plan was to look at a point after the third quarter. But Deloitte & Touche surprised us by resigning eight days to the quarter left. And then we had to actually aggressively go forward. And we had multiple choices. We had even choices, in the end, between big four and going to a smaller, regional firm.

And there was a lot of debate inside the Company, and we basically did our analysis and said what really was our biggest complaint was our respect and our ability to be on the front side of the priority to get the answers. And we thought that we would be better served with a regional firm. And it so turned out that Moss Adams had their headquarters in Seattle. They had offices in Los Angeles. And basically, we are very happy with what we have seen, and you can see the results that we were very worried about the timing. And in that motion, we can tell you that we have not filed a Q yet, but we are timing the Q to be any day, and we think it's in the next couple of days. And we think that if we were with a big four, this would have been very difficult; we would not get to this.

It has been a great four weeks. It has been midnight oil burning from both the auditors and inside. But we are very happy with the service we are getting.

And was there any specific accounting issue that brought the shaky marriage to an end with Deloitte?

No. When they resigned, there was no item that was open. Q2 had already been signed off. Q3 they had not even started, so it was in between, with no open issues left.

In fact, I think you can even add to it that Deloitte was very helpful and very instrumental in our bringing aboard the new audit firm, and they expressed some very positive sentiments about us, and did say that it was just a business relationship issue, and beyond that they had no real concerns about us.

Just to add onto it that internationally, which [are independent] offices, I think in Asia-Pacific -- Anuj, and, what, Malaysia and Singapore, or where?

Malaysia and Singapore, both.

Malaysia and Singapore, Deloitte & Touche is still our auditors.

And all the open items which were there -- not open, but to all the significant efficiencies and material weaknesses, those we had, we have already disclosed in our 8-K.

There are currently no questions in queue.

With that, I would like to end it. I want to thank you very much for this late evening, at quarter to seven on the East Coast. We appreciate your time. We believe that we are poised for a good 2007. We continue to look at all our segments, and we are very comfortable in saying that in Q4, revenues would be stronger than Q3, operating income will be significantly stronger, and all three segments will be profitable. Security will have a good Q4, better than Q3. Going into 2007, we are looking at a growth, and we are looking at a positive movement to get towards profitability. Our margins continue to improve, and we are looking forward to ending one of the litigation this quarter, so that we could go start the new year with one less litigation. Thank you.

Thank you for your attendance in today's conference. This concludes the presentation. You may now disconnect. Good day.