OSI Systems Inc (OSIS) 2006 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to your fourth quarter and year end 2006 OSI Systems' earnings conference call. [OPERATOR INSTRUCTIONS] At this time I'll turn the call over to your host, Mr. Alan Edrick.

Good morning and good afternoon to those on the East Coast and thank you for joining us. I'm Alan Edrick, Executive Vice President of Finance of OSI Systems. I'm here today with Deepak Chopra; our President and CEO; Ajay Mehra, President of our Security Division, Rapiscan Systems; Dave Tilley, President of our largest health care division, Spacelabs medical; and Victor Sze, our General Counsel. Welcome to the OSI Systems' 2006 fourth quarter and year end conference call.

We'd like to extend a special welcome to anyone who is a first time participant on our conference calls. If you are at a computer, you can visit our Website at www.osisystems.com. Click on "Investor Relations," then press "Releases" and view a copy of the press release of our financial results that we issued this morning for the quarter and year ended June 20, '06. Please note also that this presentation is being Webcast and will remain on our Website for approximately two weeks.

Before discussing our financial and operational highlights, I'd like to read the following statement. In connection with this conference call, the Company wishes to take advantage of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, with respect to statements that may be deemed to be forward-looking statements under the Act.

Such forward-looking statements could include general or specific comments by Company officials about future Company performance, as well as certain responses to questions posed to Company officials about future operating matters. The Company wishes to caution participants on this call that numerous factors could cause actual results to differ materially from any forward-looking statements made by the Company. These factors include the risk factors set forth in the Company's SEC filings.

Any forward-looking statements made on this call speak only as of the date of this call and the Company undertakes no obligation to revise or to update any forward-looking statements, whether as a result of new information, future results or otherwise. I'll be updating you further on the financial performance of the Company but first let me turn the call over to Deepak.

Thank you, Alan, and welcome to OSI's year end fourth quarter conference call. 2006 has been a good year for the Company. It's achieved record revenues of $453 million. All three business segments, namely security, health care, and electronics grew at a strong performance, especially in Q4. Operating income improved significantly in Q4 compared to a year ago and also grew healthily for the full year. Gross margin for the Company improved to 20 basis points to 39% for the year and 41% for Q4.

On the L-3 lawsuit, it was decided in our favor with a judgment of approximately $125 million, although we have not received the money yet. L-3 is intending to appeal. And Victor will talk a little bit more about it. The Company also ended the year with a record backlog of $147 million, especially a very strong backlog in the security division. Alan will talk about the financial highlights in more details. I'm going to jump into talking about the three business segments.

Healthcare, we just ended a conference call for the Spacelabs Healthcare about an hour ago. We had a very good year, business grew about 13% to $220 million from a year ago. Gross margins improved by 2 percentage points. Operating income grew by 75%. We completed the acquisition of Del Mar Reynolds in August from the Ferraris Group plc. And for that acquisition we used and leveraged Spacelabs' Healthcare's balance sheet by debt instead of using stock or new equity. Our strategy and vision for the healthcare business is sound and is being executed to plan.

In simple terms, our strategy is top line growth between 8% to 10% organically, continue to leverage our infrastructure worldwide both from manufacturing perspective and the sales and marketing and distribution. Look at strategic acquisitions to broaden our reach in both product offerings to our customers and our global reach. Specifically, grow the clinical trial business. Although this business only accounted for approximately $5 million in revenue for the year, we believe that this will be a good growth opportunity. And although the business did not grow from a year ago, we entered the new year with doubling of the backlog.

With the Hertford cardiology group in the UK, which is a similar business, it was part of the Del Mar Reynolds business, will approximately double our revenue in the clinical trial business and make us have a presence in both U.S. and European sector. Which in turn, makes us a better vendor to the international pharma companies for their clinical trials business.

We have achieved approximately 48% gross margin for the healthcare group. We continue to strive and make progress in improving it. And we believe that by the end of 2007 we should be approaching the 50% gross margin mark. Especially, as we achieve and squeeze synergies by combining the Spacelabs business with the new acquisition, Del Mar Reynolds. In summary in the health care business, we are quite buoyant for the 2007 year, both in the top line growth and bottom line growth.

Optoelectronics, we continue to grow external sales and improve our global reach. Our primary products in this area go into the medical, defense, and semiconductor sector. Inter-Company revenue also continues to grow, which is one of our fundamental strategies that we look at when we look at acquisitions. As inter-Company revenues grow, so does the operating margin. This business is very important to us, as it allows us to look at a very broad industrial base from inside view, which gives us an insight of what business products or product lines we want to jump in as end product manufacturers and sellers. Like what happened in the security group and the healthcare group.

Security group, business grew year-over-year. Fourth quarter was especially strong. Also one of the highlights, which we said in the last conference call, that Q3 was profitable, Q4 would be profitable. We are entering 2007 with a strong backlog overall in the security group. The three segments in that area are people and parcel scanning, which is the general purpose machines at check points, at cruise lines, freight forwarders, and the metal gates and our famous Body Scanner Secure 1000 product. We believe that 2007 that business will continue to grow and that business especially, since we are vertically integrated, has the best margins both in the security group and also leaves margin behind in the optoelectronics group.

In the cargo business, where it's been a big challenge for the last four to six quarters, we have had losses before, we turned the corner in Q3. Q4 was good, shipments. We're entering the year with a good backlog. We believe that with the new initiatives, which Ajay can talk in question and answer about, the government's initiatives for the CBP and other budget things.

We are very excited and positive about Q4. We started shipping our high-speed non-U.S. product called the MVX multi-view system, which we got the sign-off from DfT, Department of Transport, in UK in December 2005. Our first shipments have started. We believe that 2007, we will start making some headway in that area. And that product compared to the other products have a relatively better margin.

Our investment for our high-speed CT, under the name real time tomography system, continues. As we have said before to all of you, that 2007, there is no revenue, late 2008 is what we are targeting towards. We believe that that investment in that product line is wisely spent. We think that that market, the next big wave for development and installation of machines would be -- which will happen over the next three to four years, will continue to look at high-speed as one of the qualities and requirements of those systems. With that, I'll turn it over to Alan for the financial highlights.

Thank you, Deepak. Let's start off by a review of our Q4 operating results and conclude with a discussion of forward-looking financial guidance. Net sales for our 2006 fourth quarter increased 25% from 100.7 million in '05 to 125.6 million in '06. For the year, net sales increased 18% from that of '05. Each of our business segments experienced sizable top line growth.

Our security division witnessed a 28% increase in the fourth quarter, led by strong cargo sales, which grew 75% over the comparable period last year. Similarly, our healthcare divisions' Q4 sales increased 15%, led again by strong patient monitoring growth of approximately 20%. Lastly, our optoelectronics and contract manufacturing division recorded a Q4 sales increase of 46%.

With this growth in sales, we witnessed solid gross margin expansion, from 37.9% in the fourth quarter of '05 to 41% in the current year. Our gross margin for the year was 39%, representing a 220 basis point improvement over that of the prior year. This improvement occurred across all three of our division as we leveraged our fixed cost structure to realize economies of scale and achieve supply chain efficiencies.

Looking forward, we anticipate our gross margin will improve. Though, from a quarter to quarter perspective, we expect to see fluctuations, as a result of the impact of further changes in our product mix, seasonality and the volume of sales. Our SG&A expenses as a percentage of sales decreased 5.4% for the 2006 fourth quarter. Although on an absolute dollar basis, such expenses increased due to approximately 2.7 million in litigation costs, primarily associated with the L-3 trial in May. Which culminated, as Deepak mentioned, in a $125 million verdict in our favor. And also 1.1 million in non-cash stock option compensation expenses due to the adoption in fiscal '06 of FAS 123R and thus, no such expense was recognized in the prior year.

For the whole year, such costs as a percentage of sales was comparable to fiscal '05. So on an absolute dollar basis, they also increased due to the litigation costs described above, the inclusion of stock option compensation expense, and increased accounting fees. Each segment's SG&A cost decreased as a percentage of sales. Although again, in absolute dollars, they increased to support the overall growth of the applicable businesses.

From a research and development standpoint, these expenses were 9.6 million in the fourth quarter, which was consistent with that of the prior year. For fiscal '06, R&D expenses as a percentage of sales was also consistent with that of the prior year, as we continued to invest in our healthcare division for next generation patient monitoring products. As well as the inclusion of a full year's worth of R&D expenses associated with the Blease acquisition in fiscal '05.

In addition, we continue to make significant investments across different technologies in our security product offering. We expect an increase in R&D in fiscal '07 as we continue to invest in our promising next generation of DT technology in our security group. As such, we anticipate that our R&D as a percentage of fiscal '07 sales for OSI overall will fall between 7% and 9%.

For fiscal '06, we recorded income tax expense of 1.1 million or 216% of pretax income, as compared to an income tax benefit of 5.3 million or 68% of pretax loss for last year. This unusually high effective tax rate was primarily attributal to the inclusion of compensation expense related to incentive stock options due to the adoption of FAS 123R in fiscal '06, which does not qualify for a tax deduction. As well as the repatriation of dividend income from overseas to take advantage of a one-time reduced tax rate, but had the effect of increasing our overall tax rate, which was discussed on the last conference call.

These items were partially offset by the successful conclusion of an IRS audit and the release of an associate reserve. Although our effective rate is difficult to predict, due to the mix of income from U.S. and foreign locations and permanent differences, which can greatly affect the rate in our pretax income; we do anticipate that our fiscal '07 effective tax rate may fall between 40% and 50%.

These strong results contributed to a solid increase on the bottom line. Operating and net margins showed significant improvement. Operating income for the 2006 fourth quarter increased approximately 12 million, as we went from a $7.4 million loss to a $4.2 million of operating income. Net income for the fourth quarter of '06 was 0.7 million or $0.04 per diluted share, compared to a net loss of 3.2 million or a loss of $0.20 per share for the fourth quarter of fiscal '05.

The fourth quarter results included stock-based compensation expenses of 1.3 million or $0.06 per diluted share due to the adoption of FAS 123R in fiscal '06, as previously discussed. For the fiscal year ended June 30, '06, we reported a net loss of 2.4 million or $0.17 per diluted share, compared to a similar net loss of 2.4 million or $0.15 per share for the fiscal year ended 2005. 2006 results include stock-based compensation expense of 5.4 million or approximately $0.25 per diluted share, whereas no such costs were recognized in the prior year.

In the fourth quarter, we used 1 million in operating cash flow. Capital expenditures were 5.3 million. And depreciation and amortization was approximately 4.2 million. As we looked to fiscal 2007 and beyond, we will seek to generate significant free cash flow and we'll place a great deal of emphasis on achieving this result. We ended the year, as Deepak mentioned, with a record-high backlog of approximately 147 million led by the strong increase in security booking.

Now, let's turn to discussing the Company's guidance. The Company will begin, with this conference call, to provide enhanced financial guidance. For fiscal '07, we are providing top line guidance of 535 million to 545 million in net sales, representing growth of 18% to 20% over fiscal '06. Our earnings guidance for the year is $0.35 to $0.45 per diluted share, compared to a loss per share of $0.17 in fiscal '06. Although, we are over 2/3 of the way through the first quarter of fiscal '07, it still remains too early to provide precise guidance for the quarter.

What we are able to say, is that we expect net sales to be between 112 and 116 million, representing a 10% to 14% increase over Q1 last year. And we expect to report a loss for the quarter but we expect it will be less than that of the first quarter of fiscal '06. Please note, that such guidance does not include any in-process R&D associated with the DMR acquisition pending the final purchase price allocation or any unanticipated one-time charges. Lastly, we have filed for the automatic extension to file our 10-K. And we expect that we will file this document well within the deadline.

Building long-term value through increased financial performance is our highest priority. We are very enthusiastic about our prospects for fiscal 2007 and look forward to reporting our results in the coming months. This time, let me turn it back over to Deepak.

Thanks, Alan. I'll open it up for questions.

[OPERATOR INSTRUCTIONS] We have a question from Drew Johnson from Morgan Keegan.

Good morning, guys. Can we get an update on litigation you guys have outstanding?

It's Victor Sze. On L- 3, we did get a jury verdict in our favor for 125 million. It was a long time coming. We're very pleased with the outcome. We always felt very strongly about our case. And the jury agreed with us on our claims. Currently, it's in post-trial. There's some post-trial motions pending. We hope to have those decided within the next few months. And we'll keep you updated on that.

I know the other major item that people are aware of is the SCIC litigation. The wheels are turning pretty slowly on that one. There are some motions pending before the court right now including cross motions for summary judgment. And we're just going to have to wait for the outcome of those.

Okay. And so as far as litigation expense, probably going to be down pretty significantly from this quarter but still relatively high? $1 million, something like that?

Yes, on both of those the litigation expenses will continue. But we can't expect them to be down.

Thank you.

Maybe just to fill it up, Victor, do you want to talk about GE also?

On GE, as many of you know, we do have a working capital adjustment claim into GE for the Spacelabs acquisition back in 2004. The current status, the claim is outstanding. We hope to have that resolved as soon as we can. We can't get into the substance of it obviously, it's confidential. But we do hope to bring that to resolution soon.

Thank you.

[OPERATOR INSTRUCTIONS] And we have a question from Michael Bartlett of William Blair & Company.

Good morning, guys. I was hoping you could give us the specific backlog for the cargo division -- or the cargo part of security?

The backlog, on the last conference call, approximately was about 43 million.

It sounds about right.

Backlog at the end of June, out of 147 for cargo was approximately 38 million. And we don't know, middle of the quarter, what we can talk about specifically. The only thing I can comment on is that middle of the quarter, which is not a very accurate idea, but end of August Company's backlog is even higher compared to 147 million. And we believe that because of the government's year-end in September, that by the end of September, going at the end of this quarter, the backlog will be even higher.

Okay.

And we believe that most of the backlog increase in August and September, relatively will be into the security division.

All right, thank you.

[OPERATOR INSTRUCTIONS] And we have a question from Josephine Milar of Stanford Washington.

Hi, good morning. What was your operating cash flow for the quarter?

Our operating cash flow for the quarter was approximately 1 million on the negative side.

Okay. Since you expect to return to profit for fiscal year '07, do you have a target for operating cash flow the the coming year?

Yes, we're certainly analyzing our free cash flow and looking at certain operating cash flow targets. But we are not providing guidance and the cash flow perspective.

Can you also talk a little bit about your first quarter guidance? Why you're expecting a loss excluding one-time charges?

One other thing is that healthcare business is the weakest in the [third] quarter. To give you an idea, Q2 December is the strongest, June is the next strongest, and then into March, this happens to be the weakest quarter. And with the business leverage, meaning that the gross margin is so high, that with the revenue going down for this quarter, it's going to have a big impact on the overall Company.

Second thing is that first quarter also happens to be loaded heavily by the expenses for both the Sarbanes 404 and the year-end audit. So as both those things hit in the first quarter, it is going to be the reason for the loss. And obviously the revenue is down. On the other hand, Q2 happens to be historically the strongest quarter for the Company, especially for health care.

But this year we also expect that it will be quite strong for the security because of the strong backlog. Q2 will be the complete opposite to Q1, will be very strong. And we are also saying that Q2, Q3, Q4 will be strong enough so that the year-end is between $0.35 to $0.45 after allocating the losses of Q1.

That's great. Thank you.

We have a question from Drew Johnson, Morgan Keegan.

Just a quick follow-up. Do you guys have a feel as far as EBIT for 2007? With the fluctuations and tax rates kind of tough to pin down EPS, do you guys have any sort of guidance you're giving out for EBIT, as well?

Alan, you want to take ate shot at it?

Certainly. Yes, we certainly have our targets on a EBIT basis but we felt it most appropriate to give top line guidance and EPS guidance. Recognizing that with some fluctuations in the raising interest, it certainly could affect that. But at this point we're getting top line and bottom line guidance.

Just to add on to Alan, one of the reasons why the taxes have fluctuated so much, obviously one is the place where the income or loss is generated. Because the total income was so small that it sort of enhances the -- it makes exaggeration of the fluctuation, the tax rate. And as Alan mentioned, we believe in 2007, as we become more and more profitable, the tax rates should go into the normal range, which is about 40% to 50%.

Thank you.

And we have a question from Josh Jabs of Roth Capital.

Hi, good afternoon. Deepak, can you talk a little bit about the introduction of Blease into the U.S. and when you expect revenues to become meaningful from that effort?

Well, I can't give you a precise date because in in business everybody is very competitive and secretive. I think what we have made a statement this morning and we made it very specific. But we said we will introduce the anesthesia Blease product line in the U.S. in the first half of the fiscal 2007, which started in July, ends in December. So, we are now sitting in September. So that means definitely it's some time in Q2. I don't want to be more specific than that.

The thing is that in this business, also because it's medical and we're entering a market where it's dominated by the GE's and the [Greger's] of this world. But we don't expect a step function revenue increase but we do expect some success. We are expecting that 2007 this year is going to be revenue increase, obviously you're starting from 0. But we're not expecting and planning a huge jump.

I think 2008 is more likely as we start getting out there and trying to combine and leverage our sales force out there. But it's going to be a well-planned launch. We are very excited about it. Our initial review from our customers where we have show it around has been very positive. And we believe that it will be a successful launch and it sort of rounds up our product line much better.

In addition to the Blease anesthesia machine, we've also in August introduced a new ventilator product line. And that has received very good reviews, both domestically and internationally. And we believe that the OEM business for Blease products, especially ventilators, will also be a positive mode for us. And we think we'll see healthy growth in that area.

All right. And then in switching gears here a little bit, looking at the security side of the business. You've been out there for a little while now with the international hold baggage offering, what are you seeing in that market? Is that something we can expect to pick up here in this fiscal year?

Ajay, you want to handle it?

Yes, I think as Deepak mentioned, that we've introduced our MVX-R, which was multi-view but that has been okayed to proceed by Department for Transport back in September of 2005, sorry -- yes, 2005. We've -- obviously, we're going to start -- we started shipping that product. I think, I said at the last conference call, as well, we think Q3, Q4 is where we're going to have more of an impact on that product. Keep in mind this is not like our conventional x-ray sales because we obviously have to book it and airports have to be ready to receive it. And it takes a few months to get into backlog and ship it.

But we feel that we're going to start seeing some sales in Q3, Q4. We've already got some bookings. And really, I think you're going to see a bigger increase in '08. But you will see an impact this year, but the the latter part of this year.

Josh, maybe to add onto it. As you know, that that marketplace is dominated by L-3 with the Perkin-Elmer [X-Vivid] product line. We think that's very exciting about it. And we think the great opportunity is that most of the machines out there, and, Ajay, there are about what 1,000 machines out there? And about 600 to 700 of them are quite old, looking to be replaced. They are what is called single-view technology. And the EU came up with the new guidelines that any replacement or new machines in that marketplace have to be multi-view. Have to be multi-view.

So obviously, L-3 has the better chance. They are the incumbents. But our technology has received very good favorable response. Obviously, [Smith Holter] has a product. But we're not going to be able to say that we are displacing the incumbent. But we think if we can capture 10% or 20% of their marketplace in the near future, it's a huge growth opportunity for us. And the ASP's on these product lines are anywhere between 200,000 to 400,000 and the margins are relatively good.

All right. And then, Ajay, looking sort of longer term, there are a number of announcements over the last couple months on the [CARS] and the ASP programs. What do you -- how do you guys view those programs? What's their relevance, especially with some maybe some increases in port funding coming here in the last part of this year?

Well, there's several programs out there. We're involved in serval programs and CARS is not one of them. But we are involved in what I will call a complementary program, that offers a very good solution to U.S. ports and overseas ports. Keep in mind, we're only participating through CBP. We have an IDIQ, so we're already participating in that market. So, you're going to see a lot of programs I think over the next 12 to 18 months. You're going to see different programs come into place and funding for those programs. As far as the -- I think on the port, are you talking about the Port Security Bill? the 400 million?

It looks like theres -- it's not a huge bump but it looks like there's maybe a 25% bump in inspection, equipment spending. And then there's also a 400 million in general grant money that's kind of hanging out there that hasn't been passed yet but looks like as of yesterday it's probably going to come through.

Keep in mind, the 400 million general grant, it's a general grant, it's not an appropriations bill, so there's no actual funding that's gone into it. What the Senate is saying is this is what we would like to do. What's really relevant in that Bill, I think from our standpoint is, it for the first time calls for a minimum standard for inspection equipment that the CBP has to establish for containers coming into the U.S. And keep in mind we already have an IDIQ with the CBP, so we think that's very positive because that's been one of the weaknesses in the cargo market, there's no standard that has been set. It also has three pilot programs that they're going to look at for overseas ports in there.

But, again, like I emphasized there's really no funding associated with it. On the appropriations side, I don't know the exact numbers offhand, but I believe the House was around 90 million and the Senate was around 300 million for scanning equipment. Obviously, they have to reconcile that Bill because they're pretty far apart. Once they reconcile it, the number hopefully is going to fall somewhere in between and we'll have more clarity.

Just to add on to it. Whatever happens, as I mentioned to you earlier, the government took almost a year last year to look at all the products applicable for ports and borders. And they narrowed it down and gave IDIQ's to a couple of companies for their products. We are very excited about it that we got the maximum number of products into the IDIQ. We an x-ray product, we got an gamma product, we got a DNA based product. So, we think as they move forward and start deploying and making their decisions, we hope to capture a good portion of it.

And then, Alan, just a couple of quick follow-up questions here on the bookkeeping side. I just missed these. What was the litigation expense in the quarter? And can you repeat what the D&A was?

Sure, the litigation expense in the quarter was roughly 2.7 million. And depreciation and amortization was 4.2 billion.

All right, great, thank you.

[OPERATOR INSTRUCTIONS] I'm showing no questions at this time, I'll turn the call back over to the presenters for closing remarks.

Thank you very much. 2006, in our opinion, has been a turning point. We have invested heavily in the past in the cargo business. We have a broad product line. We believe that we're entering 2007 with a healthy backlog of prospects in the U.S. Procurement is better than before. And as cargo ships, we think that the security group will be profitable for the whole year. But we continue to invest also in the checked baggage arena.

Healthcare business, we have a sound strategy of growth. At the same time, we continue to look at strategic acquisitions and enter into selected markets. Electronics business continues to perform as planned. And with more capturing more inter-Company revenue, it will continue to do better and better year-over-year. We do have work cut out for us.

I know everybody looks at it, SG&A is a challenge. Alan has taken that as a first priority to continue to look at how we can leverage our SG&A. We continue to look at it. We have work to do but we believe we are on the right track, our strategy is sound, we are building a strong Company for the long-term. Thank you.