OSI Systems Inc (OSIS) 2007 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the OSI Systems 2007 first quarter earnings conference call. My name is Latesha and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. [OPERATOR INSTRUCTIONS] As a reminder, this conference is being recorded for replay purposes.

At this time, I will now turn the presentation over to Mr. Alan Edrick, Chief Financial Officer. Please proceed, sir.

Thank you. Good afternoon. Thank you for joining us. I'm Alan Edrick, Executive Vice President and CFO of OSI Systems. I'm here today with Deepak Chopra, our President and CEO, Ajay Mehra, President of our Security Division, Rapiscan Systems, and Victor Sze, our General Counsel.

Welcome to the OSI Systems 2007 first quarter conference call. We would 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.osi-systems.com, click on Investor Relations, then press releases, and view a copy of the press release of our financial results that we issued this afternoon for the quarter ended September 30th, 2006. Please also note that this presentation is being webcast, and will remain on our website for approximately two weeks.

Before discussing our financial and operational highlights, I would 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 on the financial performance of the Company, but first let me turn the call over to Deepak.

Good afternoon to all of you, and once again welcome to the OSI Systems first quarter fiscal 2007 earnings call. Our revenues for the quarter were 115.5 million, with a loss of $0.36 per share. As mentioned earlier on our year-end conference call, the first quarter is the weakest quarter for the Company, especially for the Healthcare group. The Healthcare revenues, especially in U.S., were quite weak, and the losses for the quarter are primarily attributable to the softness in the Healthcare revenue.

Both the other segments, Security and Opto, had revenue growth, but tend to have relatively lower gross margins compared to the Healthcare products, with the result that even though we made the revenue guidance of $115 million, the gross margin was down by approximately 3 percentage points.

The Healthcare sector, though had a weak performance in the U.S., the international sector met its budget, and we continue to gain traction overseas. We believe that the second quarter Healthcare revenues will be up compared to the first quarter, both domestically and internationally, and as we have said before, historically, second quarter is a strong quarter, especially in U.S.

Spacelabs Healthcare also launched its advanced anesthesia assistance in North America on October 14th at the American Society of Anesthesiologists in Chicago. It was a very successful launch but a very strong lead generation and all indications are that the product was well-received. North America happens to the biggest market for anesthesia products and we expect to gain a foothold in this market in the near future. This market is dominated by GE and Siemens [Drager,] but we are very optimistic that we will be able to grow this business in conjunction with our strong presence and large install base, patient monitoring product line. Although one should expect 2007 to be a launch year with some revenues from this product line, but we believe the real increase in revenue will materialize in 2008.

We also completed the acquisition of Del Mar Reynolds from The [Ferraris] Group in July 2007, and have started the integration process aggressive. Initially, when we were doing our due diligence on this acquisition, we made some assumptions of the cost synergies that we expected to achieve. We are happy to report that our estimates were quite conservative, and we believe that the actual cost synergies that we will realize are significantly higher. Our execution is on plan, and we expect that the financial performance from these synergies will be positively felt in the second half of this fiscal year, with the full impact in fiscal 2008.

Our strategy for the healthcare business is sound, and we plan to continue to grow our healthcare product portfolio and leverage our infrastructure, both in manufacturing and in sales and marketing. Ultimately, our goal is to balance our revenues globally, and achieve critical mass so we can leverage our infrastructure to generate predictable, positive operating income. During the integration process of Del Mar into Spacelabs Healthcare, we have instituted the process of looking at our total healthcare business in its entirety to make it more efficient.

Security segment. Revenues are up for the group with increases both in the both product lines, that is the people and partial screening and large cargo. The group, although lost money for the quarter, it is making progress. Security group had a record booking quarter, with $87 million of new bookings. The backlog is at an all-time high of approximately $115 million, which gives us very good visibility going forward. We have succeeded in getting strong bookings, both domestically from various U.S. government agencies, as well as from the international customers in Europe, Asia Pacific and Middle East. Our challenge now is to manage our supply chain and increase our productivity, which in turn should increase our operating income for the group, especially in the second half. We should see significant growth in revenues and operating income with fourth quarter being a very strong both in revenues and operating income for the Security group.

Internally, we have initiated a similar process to the Healthcare group to analyze the various product lines and manufacturing processes and facilities in order to improve productivity and to increase and improve on the manufacturing gross margin, especially for the cargo product line. We have got this opportunity, in our opinion, for the first time in the cargo group as we have backlog of multiple products in decent numbers, so we can address the production cost issues. In the past, as we have mentioned before, we had a great deal of engineering to absorb in one of product models which have reduced our production efficiency. Q1 still had some of these problems, which brought the group down into a loss situation, but we think that some of these problems are behind us, and we look at that in the upcoming quarters, especially Q3 and Q4, both the topline and operating income would improve for the group.

In the checked baggage product line, our multi-view MVXR continues to gain momentum in the overseas market, and we are quite optimistic of this product family. We continue with our real-time tomography development project in U.K. and are watching its progress very cautiously.

We have also received numerous grants from the U.S. government for ongoing development in various product lines, both in cargo and people and partial screening. Activity continues to be very strong both domestically and internationally. September was one of the strongest booking months for the group, especially from the U.S. government.

Optoelectronics and Contract Manufacturing segment. This segment continues to perform very well, with good growth both in top line revenue and operating income. Inter-Company revenues also are growing as shipments to both Security and Healthcare group continues to grow. In this segment of our business, commercial sector is very strong, defense electronics is holding its own, but external contract manufacturing is somewhat weak. The strongest performer in this group in the commercial sector is for the medical electronics subsystems where the business is significantly up year-over-year. We are also looking at improving our manufacturing efficiencies in this sector, especially by moving more and more products to the low cost manufacturing facilities that we own in India and Far East.

With that, I will hand it over to Alan to cover the financials, after which we will open for questions, and then I will come back to conclude with a summary. Thank you.

And thank you, Deepak. Let's start off by building on the financial review that Deepak just provided by looking at our operating results and will conclude with a discussion of forward-looking financial guidance. For the first quarter, we reported a net loss of 6 million, or $0.36 per diluted share, compared to a net loss of $4.2 million or $0.26 per share for the first quarter of fiscal 2006. The higher than anticipated loss was primarily due to the softness experienced in our Healthcare division as Deepak just described, an unfavorable change in the product mix, which included a higher percentage of certain low margin product sales, and a lower than expected tax rate, which though beneficial for the whole year, adversely impacted the first quarter as we reported losses.

In addition, in connection with the acquisition of Del Mar Reynolds, we recorded a $0.6 million charge for in-process research and development.

Net sales for our first quarter increased 13% from 101.9 million in '06 to 115.5 million in fiscal '07, which was at the upper end of our guidance of 112 to 116 million for the quarter. Our Security and Optoelectronics divisions experienced strong top line growth while our Healthcare division witnessed a slowdown.

Our Security division reported a 52% increase in sales in the first quarter, led by improved cargo sales, which grew 214% over the comparable period last year. Our conventional security product sales, which consists of baggage and parcel inspection, checked baggage screening and people screening systems, also reported significant growth of 26% over the prior year.

Our Optoelectronics and Manufacturing division, as Deepak described, once again had a strong quarter, recording Q1 external sales of 26.3 million representing an increase of 12% over the first quarter of '06.

The combined 33% increase in our Security and our Optoelectronics businesses were partially offset by the weakness in sales of our Healthcare division, which was down approximately 16% organically, and 6% overall, inclusive of the Del Mar Reynolds acquisition in July. The downturn was most prevalent in our U.S. healthcare business, in which sales declined approximately $8 million from that of the prior year quarter. Note the prior year quarter did recognize a windfall in Healthcare revenues associated with Hurricane Katrina. Although sales increased, our gross margin declined from 36.3% in the first quarter of '06 to 33.3% in the current year. This decrease primarily resulted from lower U.S. Healthcare sales, which carry higher gross margins than our consolidated gross margin, as well as increased sales of cargo inspection products by our Security division, which inherently carry lower gross margins.

Looking forward, we anticipate that our gross margin will improve. However, 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.

Moving to expenses. Our SG&A expenses as a percentage of sales, decreased 1.4% for the 2007 first quarter compared to that of last year, excluding approximately $2.6 million of SG&A expenses absorbed as part of the DMR acquisition. In absolute dollars, our SG&A expenses were essentially flat compared to last year even though our sales increased as we have begun to implement certain cost saving initiatives to leverage the existing infrastructure. As Deepak mentioned we are aggressively integrating the recently acquired DMR businesses and anticipate the realization of certain cost savings in the second half of this fiscal year.

Research and Development expenses for the first quarter were 10.3 million, or 8.9% of sales, compared to 8.6% of sales in the prior year. We continue to invest in our Healthcare division for our next generation products. In addition, we are making significant investments across different technologies in our Security product offerings.

Our interest expense increased from approximately 0.5 million in the prior year to $1 million this year, due to the additional borrowings associated with the acquisition of Del Mar Reynolds, which was about $25 million in borrowings, and to fund our operation. For the first quarter of '07, we recorded an income tax benefit of 3.2 million, or 32% of pretax losses as compared to an income tax benefit of 2.9 million, or 41% of pretax loss for the comparable prior year period.

Our projected annual effective tax rate is approximately 42%, though due to certain international losses, we were limited in the amount of this benefit that we could recognize if the first quarter, and, as such, the benefit amounted to 32% of pretax loss.

In the first quarter, we used $14 million in operating cash flow. Capital expenditures were 2.5 million, and depreciation and amortization was approximately 5 million. As we look to fiscal '07 and beyond, generating significant free cash flow is a top priority, and we will place a great deal of emphasis on achieving this result. We are pleased to have ended the quarter with a record high backlog of approximately 196 million, led by the substantial increase in Security bookings as Deepak alluded to earlier.

Now let's discussion the Company's financial guidance. As we discussed on the last conference call, it is our intention to provide annual financial guidance. We had previously provided fiscal '07's upline guidance of 535 to $545 million in net sales, representing growth of 18 to 20% over fiscal '06. Our earnings guidance for the year was $0.35 to $0.45 per share, compared to a loss per share of $0.17 for fiscal '06. At this time, we are reiterating the previously announced guidance. Please note that as described previously, 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. Due to the strong backlog, particularly in the Security division, we do anticipate that our fourth quarter will be the strongest quarter of this fiscal year. Building long term shareholder value through increased financial performance is our highest priority. There is no doubt that we have a lot of work ahead of us, but are very enthusiastic about our future prospects and look forward to reporting our results in the coming months.

Thank you for listening in on this conference call. At this time, I'd like to open the call to questions.

And thank you for the presentation. [OPERATOR INSTRUCTIONS] And your first question comes from the line of Tim Quillan with Stephens Incorporated. Please proceed.

Good afternoon.

Good afternoon, Tim.

With the fact that you're maintaining your sales guidance, is -- does that reflect a reduction in your revenue expectations in the Healthcare segment offset by strength in the Security business? Can you just talk about how you're looking at your Healthcare business for the rest of the year?

Well, number one, the Healthcare business basically has some seasonality, but definitely the first quarter, we have said would be weak, but it was relatively weaker than what we thought, but all indications are that frankly a couple of our competitors have reported the same thing, all indications are that the second quarter will be definitely stronger than first. We are not really sure or confident that it will be as strong to offset the weakness for the first quarter, but right now, it looks like that for the whole year, we are still quite optimistic about the total revenue of Healthcare, maybe given some -- some range of 5, 6, 10, up or down, whereas the Security side is going to have a very strong growth, especially in the cargo area, and, also, in the people and parcel scanning, and most of the growth is what we call good margin product because of U.S. government.

And obviously with the caveat that you know ,Tim, that there's always revenue definition issues from one quarter to the other from, especially in the Security. So overall, reiterating the guidance of definitely Security is much more stronger than we anticipated, and we think that there is some softness in the Healthcare group, so at this stage, we don't think there's any business model change as such.

Okay. But just to -- just to -- if you could just discuss what you're seeing in the Healthcare business in North America, in particular, in a little more detail, and what -- what does or doesn't give you confidence that it's a short term issue? I mean, what would suggest that we're going to see a rebound there?

I think Q2, when we finish Q2, would be a better indication. Like I said, that many companies have a very large portion of the yearly revenue come in the second quarter. But the other thing that's giving us indication of feeling a little bit more comfortable is a strong funnel, what we call the pipeline, as we have mentioned to you that the Healthcare business in a way, you have very strong pipeline indication of where the business is going to come from, subject to obviously whether the hospital is going to make the wing or not, going to be delay or not, but at least you know where all it is.

So some of the orders that we were expecting were pushed out, and we continue to watch it. We've had -- we've had no indication of any ASP pressure. We have no indication that we are losing to any competitors. It seems to be just out of the last eight quarters, we've had one weak quarter, which we, by the way, anticipated, because we did caution everybody. It just was weaker than what we thought, but Q2 gives us a little bit more comfort, and by the time we're on the next conference call, we'll have a pretty good indication what the year looks like.

The other thing, just to make a comment, though U.S. was weak, internationally, they were on budget, with the result that where before U.S. had been ahead, and the international sector was weak, which we have been saying that as we get the infrastructure in place, as we get the sales people on the ground, as we fill the pipeline with products and distributors, and that is paying off to our strategy at internationally we are getting more predictable revenue, and we've had eight strong quarters in the U.S. With one quarter, it could be an anomaly. It could be just push out. Right now, we are not changing any of our, any of our items.

Okay. That's helpful and I just have a couple, few details here. One is what -- what revenue was generated on the large cargo side in the quarter?

Ajay, you want to comment on it?

Do we usually break that down?

Yes, we do.

Okay. We had approximately 11.5 million.

And how much of the backlog did large cargo represent?

Do you have the numbers, Alan? By the way, this is Deepak, to add on, that 11 million includes some grant in the cargo area, and the backlog -- what's the backlog?

The backlog was at a little over 48 million for the large cargo.

48 million. Okay. And then Alan, could -- do you have the stock option expense, the FAS 123 expense, by line item that in cost of services and SG&A and R&D in front of you by any chance?

I do. The total amount was roughly 1.4 million, of which about 100,000 went through cost of goods sold. 1.2 million went through SG&A, and the remainder went through R&D.

And what was the after tax impact of stock options expense? Do you have that?

It was $1 million.

Okay. That's helpful. And I missed, you went through the cash flow items, and I got 5 million D&A, 2.5 million CapEx. What was cash from operations?

About 14 million, cash used in operations was about 13.7 million.

13.7 used. Okay. Thank you guys very much.

And your next question comes from the line of Jeff Rosenberg with William Blair. Please proceed.

Hi, first on a follow-up. Ajay, you said that the large cargo backlog was 48 million?

That's correct.

So that's up about, I think, $10 million quarter on quarter and with --

That's right.

-- the bookings you recorded, so the bookings are heavily weighted towards people and parcel. Is that the right conclusion there?

The bookings in large cargo are very strong, but you're absolutely right, in people and parcel, they're very strong as well. We had a defragmation. We booked 87 million during the quarter, which was a record quarter for us.

Right, and I'm thinking you shipped about a flat amount in large cargo, and saw $10 million in increase in backlog so that's like $70 million plus in people and parcel bookings. Is that, am I missing something there?

I don't have the exact breakdown in front of me what we booked, but large cargo was very strong, and I don't think you're missing anything. Security and conventional was very strong as well.

Could you talk a little bit about -- obviously a lot of the attention about demand is around more the cargo related stuff. Can you talk a little bit more about what's happening on the people and parcel, because that seems like that's even stronger.

Just to clarify it, we should look at the number. I think that -- I don't think so that's true that out of $87 million, 70 million was people and parcel screenings, and $17 million was cargo. I think the number was maybe more bookings in cargo than 17, but definitely out of the 87 million, a big chunk was in people and parcel scanning.

It still seems though like it was heavily weighted towards people and parcel, is that true? The majority of it came from there?

Yes, it is. The thing to be looking at the large cargo kept on doing very well. The security and conventional, one of the things that I've said last time is we are looking at a lot of other territories, especially international, whether it's Asia, whether it's Africa, whether it's Middle East, eastern Europe, where we really were not involved in a year ago. We built up the infrastructure. We're starting to see a lot of sales come out of those areas, as well as South America and China, and the U.S. government business is very strong there, as well. So you're really seeing an increase in really all segments of the business over there.

And is that as dominated by the airline sector as it has been historically, or in terms of the U.S. government?

No, it's a combination. We did well in the airline sector with TSA and overseas as well, but the parcel screening and baggage screening, it's getting more and more diversified. Used to be a lot more aviation, but as people become more conscious about security, we're finding the market is getting a lot broader than it used to be.

Okay. That's interesting. I guess one question on guidance. know you're not giving quarterly guidance, but the past couple of quarters, you have sort of given us whether you expect to make a profit or a loss in the in the upcoming quarter. Do you care to say for the December quarter, whether you expect to be in the black?

Yes, this is Alan. Our expectation is to be profitable in Q2.

Okay. And when you look at your gross margin for the quarter, obviously mix played a big role, but it sounds like there was some disappointment above and beyond the shift away from Healthcare. Is it possible to delineate how much of the decline we should have expected because of the weakness in Healthcare, and how much of it was because of the incremental difficulties on the gross margin front?

Well, Alan, maybe you want to comment, but I think if you really look at it, Healthcare group has such a high gross margin, especially material margin is so big, that whenever you have 4, 5, $6 million, there's a significant chunk, and we had expected weakness, but definitely it was weaker than we expected, and keep in mind, also, it had two months of Del Mar Reynolds into it, and Del Mar Reynolds we have said is in the initial stages, to have some -- some, what I call, time element limit that will wash out. So overall, I would say that the significant majority of the loss can be attributable to the Healthcare group.

I would just further add to that, that's exactly right. With the Healthcare group, there are significant economies of scale, and when there's a little bit of weakness in certain segments, it does -- it can dramatically affect the overall Company's consolidated margin, which we saw manifested here by a 3 percentage point reduction, so that was primarily due to the Healthcare.

Okay, and when I look at the full year, it looks to me like we're going to have a revenue mix for the entire year that's more weighted towards Security than it was in '06, just given the shrink you're seeing there. How should I think about that relative to gross margin? My assumption would be gross margins will be down for the full year, or continue to be down year-over-year maybe the better way to look at it, exclusive of Q1. If that's right, do you expect that you can get gross margins back up above 40% at some point during the year?

Well, I -- Alan can give you maybe a little bit better flavor of it, but I'll make a general comment on it. The Healthcare, definitely, if the Healthcare revenues are up, in the gross margins are better because from the average of the Company, Healthcare has more margins, but there's another thing that's coming into play. As Security groups start shipping good margin cargo products repeat production orders where we can identify, look at costs, which is the first time we've had an opportunity.

When you look at in the total Company for the year, as we ship more production oriented cargo, and more people and parcel screening from the previous year, there should be a plus point on the margin. Second thing is that Del Mar Reynolds's business tends to be even a higher margin than monitoring sales, with the result that overall the gross margin would tend to have a balancing act, and for practical purposes, it might be in line to the same as what we have said in the past, because there are so many moving parts. Alan?

Yes, I would add to that as well. I I think you're right. When you look at the slice of the pie, the Security and the Opto groups are growing at a faster rate than that of Healthcare which has traditionally had the highest margin aspect of the business.

That being said, we are looking at a lot of margin improvement initiatives within the Security group, and there's economies of scale associated with that group as well that will contribute to greater gross margin. The Opto group is growing at a nice rate, too, and their margins are improving. So the Healthcare, with the addition of Del Mar Reynolds which does carry margins in the neighborhood of 70%, which will slightly offset some of those reductions that we've seen in sort of the core patient monitoring businesses and the like, will help us approach the gross margin targets that you were talking about.

Okay. Thanks.

And your next question comes from the line of Brian Ruttenbur with Morgan Keegan. Please proceed.

Yes. A couple quick questions. As I calculate it, your new guidance for earnings on the year, $0.35 to $0.45, would have you making $0.70 plus for the remaining three quarters on your, as you define operating earnings, which is basically GAAP plus excluding one-time items? Is that correct?

That's right.

Okay, and it's going to be weighted proportionately. Second quarter is going to be profitable, you already said, and is it going to be heavily weighted to the fourth quarter kind of like it was the year before, or I mean third quarter, excuse me?

Well, I I think what we have said is that Q4 should be a very strong quarter, just because of timing, because keep in mind that $85 million of new bookings happened in the first quarter, with a very strong September. So by the time it relates into shipments, especially in cargo, conservatively, we are looking at the Q4. The Q2 would hardly have any impact from those. Q3, Q4, you'll start seeing it. So definitely Q4 is leading towards that.

And also on the Healthcare, next to Q2, Q4 is the strongest, and last year Q4 was very strong. So I think that your estimate is right, that to get to $0.75 approximately, whatever number, you've done the math, all three quarters would be profitable, and what we are just saying the guidance being, just giving you some heads up that Q4, it's skewed towards Q4. Not for any other reason, because the backlog is that way.

Okay, and just so I understand the guidance. The one time items, you had 600,000 in R&D, in process R&D. Do you anticipate a similar charge going forward, or is that the only thing that will be backing out of the guidance, so that I can understand the guidance better?

Well, on Del Mar Reynolds, from what we know right now, that's the only one that we can come up with, but it's very difficult to project, especially we are conducting an all divisional, all segment sector detailed analysis now that we have the visibility of back log, and what we are learning from the integration of Del Mar that whatever original estimates we had, we were conservative, and they're significantly better. We have taken that to go to all of the divisions and see if there are some areas which are not performing, so we have to move them around in facilities and stuff. I can't comment on it, Brian, that we won't have some other place to look at.

Okay. But right now, that -- basically that $0.70 to $0.75 of GAAP earnings, it will be GAAP earnings for -- unless there's some kind of one-time hit of restructuring or something like that, for the next three quarters?

That's a true statement.

Okay. Perfect. Moving on. Tax rate assumptions for the next three quarters. I know you were talking about a tax rate on the year, but it's kind of confusing when you get a big tax credit. Should we be looking for like a 40, 45% on taxable earnings for the next three quarters?

It does get a bit complex, but, yes, I think what we're looking at is in that 40 to 45% range for an effective rate the whole year. There may be, there could be a quarter that could actually be a little bit less than that because of this 32% for this particular quarter which can get flipped, but overall, if you project a 40 to 45%, you should be in line with what we are projecting at this point.

Okay, and then another follow-up on the gross margin. You did 39% gross margin last year. In that guidance, do you anticipate that or worse or better than that level?

I think in the similar area, and I think if you do the math to get to our guidance that we have given for the remaining three quarters, we've got to get up into that area, and we feel good about it.

Okay. Then going on to that math. SG&A then should be -- and R&D should be dropping from the first quarter levels for the next couple of periods, or remaining flat?

In absolute dollars or -- ?

In absolute dollars. You're at 37.1 million, or 2, something like that, in SG&A. Should we be saying to try to get to that number flattening or down?

I think it would probably be more on the flattening side.

Okay. And the same thing with R&D?

With R&D, we're looking at lot of different initiatives, but I think as a percentage of sales, it should be fairly comparable with some opportunities to potentially, as the sales increase, to potentially drop it as a percentage of sales.

Okay, is that comparable as in first quarter, or comparable as in last year? It was 8.9% first quarter and it was 7.9% on the year last year.

I think it's going to be probably more comparable to last year.

Okay. Great. A couple of other quick follow-ups. On the Security side, you obviously lost money. Is this because of the competition? Are you competitively bidding? Is it not controlling costs on the manufacturing side? What's causing you to lose money on the Security side? I just maybe try to get a better -- or a clearer picture on that.

I think, first of all, Brian, you've got to compare it, the first quarter usually is the weakest quarter for us. And if you look at our Q1 the last year to now, it will give you an idea. There is -- there is a little bit more in R&D spending that we had there compared to last year's quarter. The other thing, really, is that, as Deepak mentioned, we had some shipments in cargo which really had a lot of NRE engineering which were there from about a year, year and a half ago in the backlog, we're finally shipping it. So -- but looking forward, we think that the margins are definitely improving. In terms of expenses, besides R&D, I don't think there really was any skew in expenses per se.

Okay, and then can you give us an approximate one year shippable backlog? You have 196 million in backlog. Can you tell us what is shippable within 12 months?

I -- I think a large portion of that backlog is shippable within 12 months, and that's --

Like 80%, something like that?

I don't have the number in front of me. I think it's a large portion.

Brian, just to add on to it, keep in mind there are three segments into the product line. We did say that the backlog is at a record high not only for the whole Company, but for Security, 115 million. A big majority of that 115 million is all shippable in Security, with the caveat that as you know in this game, quarter to quarter, we might end up at June 30th, and something is not ready on the other side to receive it, so it might get pushed into it.

Whereas for the rest of the product line, in the medical area, it's all shippable, but in the Opto area, which has also had a very strong bookings, some of them are -- are contracts which extend for 12 months, and with 9 months left to go, there might be. But I would say that on 196 million, the way historically we talk about it is, it is significantly up by 40-plus million, $50-plus million from the last quarter conference call, and we are feeling very confident that all of this stuff is not multi-year contracts, but it's all shippable in the near future, in the next three quarters or maybe will go into the fourth quarter.

Okay, very good. And then two more quick questions. These are simple. The debt 56.8 million. I think I've calculated that correct. What's your capacity?

Our current capacity right now is in the neighborhood of about 80 million.

Okay. Are there plans to take that up higher?

There are, yes.

Okay. And then last question, finally. PF&A. Give us an update and what's going on on the deployment, and I believe it was Houston for the PF&A, and are you going to lose money in that deployment?

I guess just to clarify what Alan said, yes, we are looking to get more debt head room, but it's all senior debt, all like a revolver. It's all bank debt. We are not -- I don't want you to read into the line that suddenly we are doing some kind of an instrument or something. It's only what is the capacity of the present balance sheet.

Okay. That's how I interpreted it. That's good.

Okay. Ajay?

What was the question?

On PF&A.

What is the status, or do you plan to lose money on this deployment? Is it a loss leader, in other words?

I guess the best way to describe it, we said it the last time as well, we should have some result by early part of next quarter, but we've said it before, we've got certain amount of government funding. OSI does not intend to put in anymore money into this project, unless it's funded by the government.

So do you make money, break even, or lose money on this deployment?

Well, hopefully whatever we're going forward, it's going to be funded by the government at that point, so you don't make money, but you don't lose any money, except for there might be some non-allowable expenses or that sort of thing I'm over looking.

Okay, so you're running it more as a break-even for this first deployment as I understand it, is that correct?

That's what we would like to do and any, if there are overruns et cetera, we would like to get that government, funding from the government.

Okay, how much of that revenue will you book in this coming period?

It's insignificant.

Oh, insignificant. Great. Thank you very much.

And your next question comes from the line of Josephine Millward with Stanford Washington Research Group. Please proceed.

Good afternoon, Deepak. How are you?

I'm fine. Good afternoon.

You might have provided this information already. Can you give me the revenue and operating income breakdown by product line?

I think the segmentation result is there. By division?

Right. Revenue and operating income.

Did you mean by segment, Security, Healthcare, and Opto?

Exactly, by segment.

Well, it's there. Alan, do you want to give the numbers?

Hang on, you know what, I have it. That's okay. Don't worry about it. Now, do you typically announce orders when they're received because -- ?

Well, the answer is yes and no. For example, on this one, we've integrated some math, we announced approximately $53 million of orders. In reality, we've booked significantly higher than that. So we tried to announce, but in many cases if it's a competitive reason that we don't want to announce -- Or it's sensitive, we wouldn't do it, or if the customer doesn't want to announce it, we won't.

So we do not announce every order, but we sort of every quarter conference call, we sort of give an indication in backlog that sort of says this time around, it was an unusual situation because, one, we booked $87 million in Security. That's a huge number. I don't think so that we have come even close to that. I think the previous quarter high was maybe about 38, 40 million. So it's double that number, and for the whole Company, also, the backlog for the last two quarters have significantly gone up from just -- and that's the reason. But we don't announce every order.

Okay. Looking at your Security bookings, it looks like about 20-plus was cargo related, so the rest, you mentioned the rest of your bookings are coming from parcel and people inspection. Can you just give us a little more color on what type of customers and where are you seeing demand for parcel and people?

I think -- this is Ajay -- it's pretty much all over the place. I mean, you look at -- we've seen it in the aviation sector like I've mentioned with the U.S. government, TSA. We've also set up an infrastructure over the last year, year and a half, in places where we were not present, whether it's parts of Asia, China, South America, eastern Europe, Africa, Middle East. We've really seen a pick-up from all sectors, and as I mentioned previously, the market has broadened as well, so there are more and more customers that are coming in that were not there before.

The acceleration you're seeing overseas, is that from multi-view, or is it from carry-on X-ray inspection systems?

What we're talking right now really is the carry-on inspections. Deepak, I think, mentioned we have entered check baggage market and multi-view, and we're seeing a lot of opportunities there, and we've had some success, but the majority of this right is now from carry-on.

Okay.

Just to add on to it, the present backlog, I would say, is all derived towards not much contribution from MVXR, but we think that going forward we've got some very good opportunities, and we think that we will book some good business in that area, in addition to what we've already got.

Okay. So just to clarify, out of the 196 million in your total backlog, did you say 115 of that is in Security?

That's true.

Okay. Deepak, can you talk a little more about the new government grants that you have received R&D type of work that you're doing in cargo and people and parcel screening?

There's a lot of different grants that we have in cargo and cargo screening, and, you know, I really don't want to talk about it, what we're doing, what we're not doing, for competitive reasons.

Okay. Well, let me -- let me ask the question differently, then. As you know, the Department of Homeland Security, or DOD recently awarded a next generation radiation detection R&D contract, the cars program. I'm just -- and Rapiscan was actually not selected for this -- for this contract. I'm just trying to get a sense of what your technology road map is for radiation detection in the cargo space going forward.

As I mentioned in the last conference call, you're absolutely right. We're not part of it, but there are other grants that we have that we feel the technology that we're working on, again these are government grants, will look at not just scanning, but RADCU capabilities as well.

Also, as I mentioned, we do have an IDIQ contract with the U.S. Customs. As we speak, they've bought some systems on that. And we talk to them on a regular basis and what improvements, et cetera, they would like to have. Cars is something that it's going to be development contracts, they're going to look at procurement maybe three, four years down the road, and a lot of other programs that are coming into place, and I think the government is going to pick and choose whatever is best out there.

Just to add on it to what Ajay said, I think we said it in the last conference call, we feel quite confident that if there is long-term procurement of launched cargo with radiation add-ons kind of thing, we will be able to participate with our technology that we are developing, and we actually have products in our backlog even now that has these kind of products in it.

Which we're working with the government.

Okay. All right. Thank you.

And your next question comes from the line of Matthew Mackay with Jefferies and Company. Please proceed.

Good afternoon, guys. Question just on the internal initiative that was started to raise profits here. Just if you could give a little bit of color on the scope of what you're doing there, and possibly even quantify how much savings potentially could come of it.

I'll answer the latter one easier. We don't have any number, specifically. Obviously we do have internal targets that we are talking about, but obviously we're not able to talk about it, but the first one, it's an elaborate process. I think it basically started with, firstly, we need to get cash flow improved, and Alan has talked about it, we are putting initiatives in place. We're trying to improve our DSOs. Medical group has taken the first lead with the Del Mar Reynolds acquisition, where we had a plan in place to integrate that business into Spacelabs, and we felt the opportunity to do it on an accelerated mode, where we have looked at not just Del Mar Reynolds, but by combining with Spacelabs, what does it do to the total business, including facilities, people, geographic locations, sales and marketing, manufacturing, supply chain, vendor relationships, so it's like an across the board. And to give you an idea of the mechanism, we have about mini task forces and a project manager managing all of the staff for us together to look at every aspect of that business where we can benefit by leveraging.

So we've taken that step and now we've gone back with Alan's heading it up to look at the other groups in the Security for the first time we have a backlog to support, especially in cargo, which we have said for the last couple of -- almost for the last four quarters, that the biggest challenge we've had is one of lot of R&D, every product is different, and then we have to support it not only by production, and then basically work with vendors, and then go to the installation site and send people to go back and do these one-ups. We're trying to streamline the product line. We're trying to work with standardization in that area. We're trying to see whether we need multiple sites of development and centers of excellence. We're looking at every aspect of it. And in the Opto area, it is primarily how fast we can move more and more production to lower cost area to increase the margin.

Okay. Now with all that said, and given the growing backlog with a lot of it expecting probably to come in the fourth quarter of the fiscal year, does this internal disruption that's going on in the Security, is there a heightened risk here that some of that backlog may not get realized until the next year, just because of this disruption, outside influences aside?

Go ahead.

Well, first of all, I would not call it disruption. I mean, I would call it improving efficiencies, and if anything, it should help us get out the backlog. I mean, to give you an example, something that we've already done, is you look at our facilities overseas in England, we used to have four different locations for the Security group. We're down to one, and that's really improved our efficiencies and what we can get out, and help us realize and meet our backlog needs. So from a disruption standpoint, that's not what we're worried about.

I think just to add on to it is that we are watching it carefully. We are -- our capacity to ramp up, especially in the people and parcels screening, I think we are better off than any other Company in this space, because we are vertically integrated, and our revenue model, our manufacturing model is such that we can leverage the production facilities not only just in the U.S., but in U.K. and Malaysia. In the cargo space, like I mentioned, we've never had a production line. And we finally have some traction, hoping that we're going to get more traction in the next couple of months to come, and as we do repeat production, definitely we can improve our efficiencies and we continue to look at where else we can look at to increase our efficiency.

Okay. So -- I don't want to get too fine on this, but so just as an example, you're moving from facility A to facility B, or moving two facilities into one facility. Like how long does it take to actually go through that process, and do you overlap processes to ensure there's no disruption? I'm just a little -- it seems like if you're going to be switching facilities that there would be -- maybe it's minimal, but there would be some stuff that goes on there.

We watch it very carefully, and in many cases, we are fortunate especially in Security, we have multiple facilities anyway. So basically we look at it very carefully, and as I said, the exercise that's going on the Healthcare side is a very well thought out exercise with a lot of people involved into it, and we are doing it step by step in a very organized manner.

Does it also involve consolidation of some of the ERP systems?

The answer is yes.

Would that potentially cause a rise in DSO over the next couple of quarters?

Alan?

No, we don't think so. If anything, it should help promote a reduction in DSO as we bring greater focus and attention to that very metric.

Okay. Okay. All right. Well, good luck, and thanks, guys.

Thank you.

And your next question comes from the line of [Alex Taft] with UBS. Please proceed.

Hello. I -- most of my questions were also around this internal initiative, so most of them have been answered. But I was just wondering, is there a reason why we wouldn't want to quantify what type of savings can come from these initiatives over the long term?

It's very preliminary. I think the closest answer I gave in my presentation that in the Healthcare area, when the business that we bought, Del Mar Reynolds, had a trailing revenue of about $30 million, approximately, $35 million, and it had an infrastructure in place that we did some analysis of, $2 million of looking at our synergies, and I said that after we got into it and started digging deeper into it, the number is maybe double that. Obviously, it's going to take time to get to the end. It's not going to happen overnight. We think the second half we'll start seeing some progress.

Obviously the more we go into it time-wise, the better it gets. So Q3 will be some, Q4 will be even more. But whatever we can get to Q4, if you annualize that number, if it's doubled $2 million on a yearly basis, that's a huge number. Any other groups that we have looked at it, it's been too early, and we just haven't got the analysis done up to where we can reach to. Like I said, this is the first opportunity we've had to look at it with a strong backlog and a visibility that we can start working on.

It would be great to have updates on this in future calls then.

Point well taken.

Thank you.

And your next question comes from the line of Josh Jabs with Roth Capital. Please proceed.

Good afternoon. Deepak, given some of the weakness in Healthcare in North America this quarter, what gives you confidence kind of as we look out to the rest of this fiscal year that you can get that business back on track? And as a follow-up to that, does that change any of your plans for the -- for the -- as far as looking at the Blease strategy?

Well, number one, keep in mind, if you want to emphasize to people, after 8 quarters, we've had one weak quarter of Spacelabs missing what we internally had budgeted for. So that doesn't mean that the business has significantly changed. Obviously we are watching it very cautiously. We think that what gives us confidence, and why we are reiterating into it, is look at the backlog that we've got. We've got a $196 million backlog. So we can plan and be more predictable, and then we put our plans together. On the other hand, Blease strategy, absolutely, I said it, our strategy in Healthcare is very sound and straightforward. We said we're going to launch it in the U.S. in a very cautious manner. We took the time. We launched it in Chicago last month. Very well-received.

We built up the momentum, and we think that 2007, next couple of quarters, don't expect great revenue increases, because we're going to be demo-ing them, we're going to be trying to show it off as much, putting them together with our monitoring, but we think that the world needs, and especially U.S., another alternate to the GEs and the Dragers the of this world, and we plan to be that alternate, so we think that combined with our big install base in Healthcare and monitoring and our sales and service organization, definitely we will be a viable alternate to the GEs and the Dragers of this world.

Like we said, we are not changing out strategy and we continue to want to build a critical mass, Josh, as we've talked about it. In the Healthcare business, it's very important to reach a certain critical mass, because your SG&A costs are pretty high, and Del Mar proves itself. Del Mar proves our strategy is sound, how much we can squeeze out in our synergies on a $35 million trailing 12-month revenue as we put it together on to the Spacelabs Healthcare product line.

All right, and then switching gears, looking at Security, and this may have already been discussed here, but on the -- looking at in the whole baggage opportunity internationally, how much sort of -- as we look at your guidance, how much of the -- I guess how much is assumed coming out of the whole baggage opportunity versus what you're seeing in the backlog?

Ajay?

I think I mentioned on the last conference call that the whole baggage really -- it's not one of these things that it's a turnaround, quick turnaround. We basically, when airports are built, they're looking at several models, it takes several months, so from a real standpoint for this year, I think you might see some sales in Q3, maybe in some in Q4, but it's primarily 2008 and beyond is what we're looking at, so it's not a significant amount of what we're talking about in this year.

Josh, just to add on to it, in the whole baggage area, we have a product which is today being offered to sell internationally in the multi-view sector. The other one is a little bit farther out, and what Ajay is saying is true. In the present backlog, in our present numbers, in our present plan for this year, old baggage doesn't even play a picture.

Okay, so if we see news coming out on that side, we should consider that sort of upside to what's already been discussed?

The answer is yes.

Okay. Great. Thank you.

And your next question comes from the line of [Tom Lair] with Mulholland Capital. Please proceed.

Good afternoon everybody. I had just a few things I wanted to kind of follow up on, just to clarify. Are you then saying that the guidance that -- for this fiscal '07, does not really include any of the cost containment efforts that you're ramping up, apart from maybe the Del Mar Reynolds that you've clarified and you can identify, and even that, you can't identify too closely?

Well, I wouldn't go as far, because it's a continuing process we work all the time. All we are saying is that this time around, with backlog being strong, especially in cargo, which has been a very low gross margin product for us, we've had a big challenge for the last couple of years in that product line, and we are saying that we are now putting initiators in place to squeeze some out of -- to get better manufacturing costs, better margins. So I wouldn't say that it's like coming from the left field. It is built into it. But most of the stuff that we're talking about that we can identify very closely, it's the Del Mar Reynolds integration into Spacelabs.

Okay, just going on. Can you give us any update on the legal front, as far as the L3 progress, on that side, or GE? Can you say anything about that?

Sure. Victor, you want to take that?

Sure. Tom, L3 we've got the post trial motions pending, and we're hoping to schedule a hearing in the near future, hopefully before year end, calendar year end. On GE, that matter is under confidentiality at the moment. In the past, it was in the courts in Delaware. It's no longer in the courts, so it's currently in a confidential process so I can't say too much about it.

Can we read into that that there might be some settlement there, and is that fair thing to say, or just that you're talking or -- ?

Can't say, but we -- we don't want to --

Can you remind us on the L3, what the hearing, the parameters are as far as where we go once we have the hearing and the appeal process?

Yes. On L3, the post trial motions right now have been filed by L3. They're asking the judge basically to lower or reverse the $126 million verdict that was reached back in May, and as far as what goes on after the post trial motions are decided, we can't say. We'll cross that bridge when we come to it.

Just to add on to what Victor was saying, anytime that you get away from courts into talking to each other, that's progress. So with GE, it's a fair assumption on your part that the parties are now talking, and it's an arbitration that we are going forward with. More than that, we can't talk about it, but I think initially, we have said it before in a couple of conference calls, we think that before this fiscal year is over, June, we would like to bring both these things to a conclusion.

Okay. Going back to the Blease and the introduction here, can you, Deepak, maybe, just give us a sense of what the size of that market is here domestically, and what a sensible if you were to pick up 5, 10% of that market, what kind of revenue targets we're talking about?

Okay. The total market, we look at that anesthesia market, as between 700 million to about 900 million. That's the total market. 70% is what people say in the anesthesia world in the U.S. It's the biggest market. So you're looking at about a $0.5 billion market. Of a $0.5 billion market, it's basically owned -- it's like owned by GE and Drager, Siemens. So we believe that if we are able to achieve even miniscule increases, we are starting from zero. Initially, we'll look really good. It will show 100% increases, 200% increases, but 2008, I think if we can get to even 5% of that market, that's very good. It will be a great plus, because 5% of that $500 million market is about $25 million that we didn't have, and right now we have zero.

And it goes right through existing distribution.

Absolutely. In addition to that, Blease also has introduced a family of OEM products that other companies use worldwide, and we also are trying to aggressively push that. So we believe that Blease will start having some big potential upside for us in the coming years as U.S. gets launched, as new products get launched.

Because keep in mind that the biggest problem that small device manufacturers have in healthcare, they have good margins, but their distribution is not there. We happen to have a good distribution network, both domestically and internationally, that we can leverage and piggyback these acquisitions like Del Mar and Blease that we've done.

Okay, let me, last thing I wanted to touch on, again back on the Security and the product development. Can you guys say anything about the efforts along on PF&A, whether the government would likely go forward, or can you have any read of that, whether that'll fund forward development? And, also on the -- the multi-view -- I guess it's not the X-ray, the more revolutionary product for the whole baggage, can you say anything as far as progress in that development, or just -- ?

Let me talk about PF&A. I just talked about it a little while ago, that I don't know what the government is going to do or not do, but we have basically said that Rapiscan OSI is not going to fund that product going forward.

Yes, I understand that you guys --

I think -- I think hopefully in the next two or three months, we'll get a better feel of what the government wants to do. In terms of -- in terms of the CXR, we're going through that development, we're watching it very carefully, and -- and really, like we said, it's something that we're looking at on a quarter by quarter basis, and that's really all we have to say at this point.

Well, just to add on to what Ajay said. On the PF&A after the El Paso development, we did say to all of you that OSI Rapiscan is not going to put any more money, except the 4 million that we have invested in he Houston contract. And we are supposed to hand over at some time in the beginning of 2007 how it will perform and work. A lot of that depend upon what the expectations are from both sides.

Keep in mind that there are products -- there are products that come under cargo, air cargo, that there is no technology that exists today that can inspect that except PF&A, so there's a lot of hope into it, but we have no idea how it will work, but we've also said to all of you that even if it is super good, it takes so many years to put together a product that long -- long term, it's going to have a great benefit. Short term, it's not going to do anything for anybody.

Okay. Okay. That's fine. Thank you.

[OPERATOR INSTRUCTIONS] And your next question is a follow-up from the line of Tim Quillan with Stephens Incorporated. Please proceed.

I'll catch you offline at a different time, but I would like to congratulate Ajay on a great quarter.

Thanks.

Thank you.

Thank you very much, Tim.

And at this time, there are no further questions. I will now turn the call over to the Chairman and Chief Executive Officer, Mr. Chopra, for closing remarks.

Thank you, everybody, and I really appreciate the people on the East Coast. It's getting a little late. We are very excited about the Company. We have a very high backlog. Our challenge right now is to improve the bottom line, and to ship the products out. We have initiated various things in the Company in all divisions. We're looking at addressing it. We think that some of the one-time things that we've been doing in the Rapiscan area, hopefully in Q2, Q3, Q4, cargo will start producing some positive numbers to the bottom. We look forward to in the Healthcare, we're trying to aggressively integrate Del Mar into the Healthcare, and the U.S. Healthcare area, we're watching it very carefully. And in the Opto area, we continue to make progress and we continue to see ways how we can improve the efficiency. Thank you very much.

Thank you for your participation in today's conference. Ladies and gentlemen, this conclude the presentation. You may all disconnect and have a good day.