OSI Systems Inc (OSIS) 2007 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second quarter 2007 OSI Systems earnings conference call. At this time, all participants are in a listen-only mode. We will be facilitating a question and answer session towards the end of today's conference. If at any time during the call you require audio assistance (OPERATOR INSTRUCTIONS). As a reminder, this call is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr. Alan Edrick, Chief Financial Officer. Please proceed, sir.

Thank you very much. Good morning and 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; Victor Sze, our General Counsel; and Jeremy Norton, our Director of Investor Relations.

Welcome to the OSI Systems 2007 second quarter 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 ended December 31, 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 will 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 again, good morning and welcome to the conference call. I'm going to be very brief on this conference call to talk about the three business segments, and then Alan will go into detail on the financial side and we're going to leave more time for questions because I'm sure you guys have a lot of questions this time.

We had a record revenue of $137.5 million, an increase of 17% from the $117.1 million reported in the second quarter last year. Also, the major highlight is that our backlog is at an all-time high of $197 million in spite of an increase, a significant increase, in shipments even compared to the last quarter. The most important thing in that backlog is also that in spite of the security [books] revenue being up 46% to $44.4 million, the backlog remained at $115 million, [pretty] flat compared to the last quarter, meaning thereby that if you remember the last conference call, we had a record booking of $87 million in that quarter, so that we were able to book and there's enough strength and momentum in the marketplace that even at $44.4 million, our backlog stood at about $115 million.

In the security sector, which Ajay is going to talk more in your question/answers, just quick bullets. We have a very strong performance in all the groups. Backlog is pretty strong in people and parcel screening and cargo, and even in the Hold Baggage Screening and the new product introduced, the MBX.

We continue to invest in our CT based real-time tomography product line. We continue to look at, both globally and domestically, at all various agencies of U.S. and abroad, the activity of quotation continues to be very strong. I can almost say that we have seen for the last quarter and continuing going forward, the activity of quotation and interest in security equipment has never been as strong as it is today. That doesn't mean that the competition is not there. We have competition. At the same time, I think we are a much stronger company.

Our Rapiscan 600 series, the new Windows-based machine has been very well-received. Our Hold Baggage Screening, the major win at one key airport international which, for competitive reasons, we don't want to disclose, but to knock off an incumbent in the marketplace is a major success for us and we want to build on the momentum into that product line. Cargo and vehicle inspection, we have a very healthy backlog as mentioned in the last conference call. We finally have some production products, repeat production, which can make us look at cost-cutting, look at our supply chain, and both activity in the U.S. government agencies and international has been quite strong, although CBP, which is potentially the largest customer for these kind of products, have not even kicked in yet.

Health-care -- definitely we've had weakness in the first half Q1, Q2, primarily due to the patient monitoring product line in the U.S. Just to put it in the right perspective, we bought the Company in March, 2004. We have had very good success for about eight quarters. The first time the business went down was in first quarter this year. We took precautions. We have cut and streamlined the operation. We have aggressively started the synergies and integration of Del Mar Reynolds. In this business, it's not easy to do changes that fast because of the regulatory reasons and because of the long-term commitments that you have at facilities, especially international.

Management of the Company has risen to the occasion. Approximately out of a $15 million to $17 million cost reduction that the Company announced, approximately $10 million of that is from the health-care group. We have reorganized the total organization of the health-care group, not only just for cost reduction and streamlining, but also to identify to make sure that the global company that we have and the strategy that we have, that we manage those areas for the products that the customers want, with the result that we have reorganized the top management into groups which is North America, emerging markets which is Asia-Pacific, Latin America and the European continent. That way, we can address and identify the needs of the customers better, design the products better, and be more closer to the customers. We are very confident that that strategy as we execute will be successful.

Although the business in North America for the first half was down, we are very encouraged with the bookings in the North America patient monitoring in November/December time period. As a matter of fact, the bookings for that quarter was a record in the history of the Company in the last five years.

Non-U.S., the rest of the business, is performing to budget. Our introduction of the anesthesia machine in the U.S. in October has been very well-received. Our integration of the Del Mar Reynolds is going as planned. Our clinical trial business, which although small, has increased its bookings by almost 100% from a year ago. We have a lot of confidence that going forward, that business will continue to grow on a significant pace.

Optoelectronics continues to perform to budget. External revenues have increased 18% from $25.8 million to $33 million. External revenues [were] primarily as mentioned in the last conference call, are driven by the commercial sector, especially in medical in the CT scanner arena. Intercompany revenue, which is part of our strategy, continues to grow. [As a matter of fact it] increased 72% from $5.4 million to $9.3 million, driven primarily both by shipments to the health-care growth and also to the security group.

Overall, we are in a much better shape. We have embarked on this total revamping and sizing the Company not only just in health-care, but in security and optoelectronics, corporate, in every segment that there is, and as I mentioned that Alan will tell more details into it.

All I want to say is, the Company is at the right size where we have critical mass in all groups which we did not have before, and this allows us, especially with a healthy backlog, that we can plan our production, we can plan predictable cost reduction, supply chain issues, management, facilities, so that it has given us the opportunity where maybe for the last couple of years we were trying, especially in the health-care, to stabilize and build confidence to the customer base. Now we are trying to size the business properly, put the right R&D investment into place, so that we can come forward in 2008 in a much stronger position.

With that, I'll hand it over to Alan.

Thank you, Deepak. As Deepak mentioned, the second quarter was characterized by record sales, strong bookings, the initiation of cost-cutting initiatives throughout the Company, and the recording of certain non-cash charges as we reviewed our overall product portfolio. While we continue to gain considerable traction on the topline, we are internally focused on driving operating margin improvement to generate significant earnings potential as we head towards fiscal 2008. Simultaneously, we are putting measures in place to improve free cash flow, such as improving inventory turns and reducing days sales outstanding.

I'll speak more about this shortly, but first, let me review the financial results of the second quarter. For the second quarter, we reported a net loss of $20.6 million or $1.23 per diluted share compared to essentially a breakeven quarter for the same period of fiscal '06. During Q2, as part of a review of our product portfolio, we assessed the viability of certain product lines and related technology, which resulted in total pretax charges of $31.8 million, which include a $21.5 million charge associated with the impairment of certain fixed and intangible assets and the recording of additional inventory reserves of $10.3 million. These changes were primarily recorded in our Security division and related to older technology and/or technology with less certainty as to future revenue streams.

Net sales for our second quarter increased 17% from $117 million in fiscal '06 to $137 million in fiscal '07. Our Security and Optoelectronics divisions continued to experience strong topline growth while our Healthcare division, as Deepak mentioned, reported disappointing results. Our Security division reported a 46% increase in sales in the second quarter led by improved cargo sales which grew 58% 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 44% over the prior quarter. Our Optoelectronics and Manufacturing division again had a strong quarter, recording Q2 external sales of $30.3 million, representing an increase of 18% over the second quarter of fiscal '06. This combined 33% increase in our Security and Optoelectronics businesses was partially offset by the performance of our Healthcare division which, while up 3% overall inclusive of the Del Mar Reynolds acquisition in July 2006, was down approximately 10% organically, excluding this acquisition.

The health-care downturn was most prevalent in our North America patient monitoring business in which sales declined approximately $7 million from that of the prior-year quarter. However, there are encouraging signs of recovery in the health-care business as patient monitoring bookings increased 31% compared to the prior-year quarter, paving the way for a stronger second half.

For the second quarter of fiscal '07, the gross margin declined to 28.6% from 38.5% in the prior-year period. This was primarily due to the $10.3 million charge in recording of additional inventory reserves as we previously discussed. Excluding these charges, our gross margin would have been 36.1%, representing a 2.4% decline. This decline was primarily associated with reduced health-care sales, which carry higher gross margins than our consolidated margin; the increased sales of cargo inspection products by our Security division, which inherently carry lower gross margins; and the growth in sales of our Optoelectronics and Manufacturing division, which generally carry lower gross margins than our other divisions.

While our gross margin will vary from quarter to quarter, we expect to see improvements in the second half of this fiscal year. Our SG&A expenses as a percentage of sales decreased 1% for the 2007 second quarter compared to that of the prior year. Excluding approximately $3.7 million of SG&A expenses in support of the Del Mar Reynolds acquisition in absolute dollars, our SG&A expenses were essentially flat compared to last year despite a 17% increase in sales as we have begun to implement certain cost savings initiatives to leverage the existing infrastructure. I'll speak a bit more about the cost rationalization plans later on this call.

R&D expenses for Q2 were $11.2 million or 8.1% of sales including approximately $1 million related to the DMR acquisition compared to $8.7 million or 7.4% of sales in the prior year. We continued to invest in our Healthcare division for next generation products. In addition, we are making significant investments across different technologies in our security product offerings.

Interest expense increased from approximately $400,000 last year to $1.3 million this year due to the additional borrowings associated with the acquisition of Del Mar Reynolds in July and to fund working capital requirements, as well as to the general rise in interest rates. With respect to taxes, our projected annual effective tax rate is approximately 39%, though due to certain international losses, we were limited in the amount of this benefit that we could recognize in the first half and as such, the benefit amounted to 36% of pretax loss. This is an improvement from the earlier projected effective tax rate of 42%.

In the second quarter, we generated $1 million in operating cash flow after using approximately $13 million in Q1. Capital expenditures were approximately $5.3 million while depreciation and amortization was stable at approximately $5 million. The amortization expense is expected to decrease approximately $1.3 million annually as a result of the impairment charges previously mentioned. As we look to the balance of fiscal '07 and beyond, generating free cash flow is a top priority of our management team and we will place a great deal of focus on achieving this result. We are pleased to have ended the quarter with a record high backlog of approximately $197 million led by continued strength in security bookings.

Now, turning to our plans to lower our cost base. As we mentioned in our press release, we commenced a review of our global operations in order to integrate recent acquisitions and to rationalize the cost structure. This review has resulted in plans to achieve approximately $15 million to $17 million of pretax annualized cost savings, including a reduction of approximately 8% of the global workforce along with the consolidation of multiple facilities. These cost-cutting measures have commenced across all divisions with the goal of implementing these reductions by the end of the current fiscal year.

The greatest impact of these changes will be evidenced in our Healthcare division, for which we have targeted $10 plus million dollars of savings. These measures are expected to positively impact the fourth quarter of fiscal '07, net of anticipated severance and related charges, with the full benefit expected in fiscal '08.

Now, let's discuss the Company's guidance. We have previously provided fiscal '07 topline guidance of $535 million to $545 million in net sales representing growth of 18% to 20% over fiscal '06, which we continue to reiterate. Given the cost-cutting initiatives that will continue throughout fiscal '07 and associated charges for severance and early lease terminations among others, which are difficult to predict, we will not be providing bottom-line guidance for the remainder of fiscal '07. However, we can say that due to the strong backlog, particularly in the Security division, our fourth quarter is expected to 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 we are very enthusiastic about our future prospects and look forward to reporting our results in the coming months. Again, thank you for listening in on this conference call, and at this time, I'd like to open the call to questions.

(OPERATOR INSTRUCTIONS) Brian Ruttenbur, Morgan Keegan & Co., Inc.

Couple of questions. First of all, R&D going forward, it was pretty high this quarter at 11.2. I assume the trend will be to bring that down over time?

Brian, as we had mentioned to you that we are involved in R&D in both the health-care and the security area, I think for the short-term for the next couple of quarters, I would maintain that you should model it as if the R&D would be pretty much constant to where you see in this quarter, or as in absolute dollars; but as a percentage of revenue, it should come down because the second half has higher revenue any way compared to the first half.

And then, maybe switching over to plans for inventory reductions and accounts receivable reductions. What are the plans, in fact?

Yes, certainly there's a great deal of focus and emphasis being placed across all divisions with respect to each of those because I view it as a significant opportunity to improve our working capital management. There has been a lot of focus placed on that and I think we've actually seen some realizations of those benefits, particularly in our Security and Optoelectronics divisions in Q2, with further opportunities in Q3 and Q4. I think the greatest opportunity now resides in our Healthcare division, which actually has some rising DSO in the past quarter and we are instituting similar changes and focus through the supply chain and through focus collection efforts in order to improve -- to reduce the DSO and to improve the inventory turns.

So, DSOs, the goal would be 40 days? What's realistic that you can get to over the next 12 months?

Difficult to say and we really have -- given our business, we really have a very different mix of type of customers, so I think it's a little premature at this point is say what our DSO target is, but what we can say is we, on a consolidated basis, do look to further reduce our DSO quarter over quarter each quarter.

That's one of your main things that's going to help cash flow? Is that your plan?

That's certainly the case. Yes.

And then, can you talk a little bit about your plans for operating cash flow, either you wouldn't give earnings per share, but maybe next quarter can you talk operating cash flow? I assume it's going to be better than the December period. Can you at least talk in those kind of general terms and maybe even next year or any kind of terms that you can give me on that?

Yes, we don't really give forward-looking guidance with respect to cash flow, per se. I can say this is the first quarter in awhile that we actually generated positive operating cash flow. So that was certainly an encouraging sign. It's a little bit more difficult to predict in Q3 and Q4 as we take certain charges, and some of those will be cash charges associated with severance and the like as we're doing the cost rationalization plans. So, we would hope to be in a position in the near-term that we might be able to give such guidance, but at this point I think it's a little premature to give cash flow guidance.

Just to add on to what Alan was saying, I think that at the Q3 conference call, when we are looking at Q4 where some of these major things that we're doing are implemented and executed, I think we'll have a better idea. But generally speaking, [either you want us to answer] the question for 2008 and onwards, definitely with all the cost-cuttings, with all the DSOs, inventories and other area that would -- that although the revenues have gone up, we are maintaining the inventory which will improve the inventory turns, and as we are looking deeper into it, all the signals are that 2008 should be positive cash.

Should I look for, excluding cash charges, that you would remain operating cash flow positive? Is that a fair statement?

That is our goal. Yes.

And then, one or two more questions and I'll jump off and let somebody else ask some questions. Are you looking at additional cost savings outside of the ones you've announced? And those cost savings that you've announced, where does that take you? In terms of a net margin?

We are always looking at additional cost savings, and I think this was a very aggressive plan that we put together and recently announced. We're not done. We'll always be looking at the Company at continuing to optimize our cost structure and our cost base, and those plans will continue. And as we do those plans, we'll get a better sense of where our operating and net margins can eventually fall out. Again, probably a little bit premature to say at this point where we would hope our net margin will go.

Just to add on to it, you're very astute. Basically, as we move forward, we are looking at, especially now into what I call the supply chain manufacturing side, we have the ability to move around product from here to Far East Asia, we have plans there, so that the first focus has been on this $15 million to $17 million, but there is no doubt in our mind that as we execute it, there are more areas we can look at it and definitely this is an ongoing exercise.

Josh Jabs, Ross Capital.

You mentioned, I guess, in the press release that revenues and bookings are expected to be stronger in Q3 and Q4 on a health-care side and you do have some seasonality in that business. Can you just give us a little bit more of an idea of how that's likely to play out?

Well, number one, if you look at it that our bookings, even in patient monitoring, the weak area for the first half, November/December was a very strong booking month with results that our Q2 quarter as a whole was the strongest in five years history of the Company. Second thing is that, we made a change last year, to change the Spacelabs' year end from December, which is historically the year end for all health-care companies, which we changed that to June to coincide with the OSI.

And there was an impact that relatively last year the fourth quarter, April, May, June, was quite strong, and we think that that will repeat again this year. So we believe that going into Q3, we had strong bookings in November/December. We think that Q3, Q4 would be stronger than Q1, Q2. We think that more focus is there. These changes that have happened, the streamlining, the reorganization, all point towards that we are more focused on it.

One other item, which is almost like a reversal, all of Q1 and Q2 were weak for patient monitoring in North America. Q1 and Q2 performed to budget or maybe slightly ahead in the rest of the world in patient monitoring, which was not the story before. As we have said in the previous conference call, when we bought the business, U.S. sales and marketing organization was really robust and untouched by the various gyrations of ownership of Spacelabs, but we started from scratch in March 2004 building up the sales and marketing organization in the rest of the world. So we've had below par performance because we were just building that organization.

For the first time, Q1 and Q2, the rest of the world performed to budget. Unfortunately, that was a distributor model in many countries, so that margin is lower than the margin in North America; although they performed to budget, when North America went down, the total margin went down. So we believe that if that trend continues and we have no reason why not, what we are building towards as North America gets into Q3, Q4, it will build up the momentum and we're just more focused. And again, I'm going to emphasize Q4 will be stronger compared to Q3.

So you still expect to have the same sort of seasonality that you've had in the past with March being weaker and June being stronger?

Well, that's true, but remember we used to talk about it, that December is the strongest quarter; the second strongest quarter is April/May/June. The next one is January/February/March, and the weakest is July/August/September. Well, that's still there except with us changing the year end, there's a little bit more that we will have two strong quarters October/November/December and April/May/June.

Fairly bullish comment, I think, coming out of one of your competitors on the future of CT and security, and then obviously some changes in that space as a result of the G.E. and Smith partnership. How do you see it impacting your opportunities as you roll out your own product? And does that change your strategy at all for that space?

Would you repeat that? What bullish statement from one of our competitors in the CT?

One of your competitors [was] out with a fairly bullish comment as to the future of CT in the airports, both within baggage and also at the checkpoint, and then obviously, there's been some changes in the space as a result of Smith's partnership. How do you see that impacting your opportunities going forward or any of your plans for entering that space?

Well, entering that space it's a given. We've been investing money in our real-time tomography product line and keep in mind in the check baggage space, we also have launched our high-speed non-U.S. system the MBX and we've had a fantastic reception and traction in that marketplace. We believe that this thing, by the way, the deal is not done yet between Smith and G.E., and there's going to be some issues on that especially on the trade side, but hypothetically, we make an assumption that if it's done, definitely it creates a big competitor, but keep in mind we were competing with the Smiths of this world before and the L-3's of this world before. So we do compete against big giants, so this definitely changes the landscape.

We are on the right track. Our strategy is intact. We continue to spend wisely on our product line, but we also continue to look at the possibilities of making strategic alliances in the industry for other kind of products to compete against this formidable competitor that has happened. Ajay, you want to comment on it?

I think it's -- we've been competing against all of the people; just the mix has changed a little bit and like Deepak said earlier, I remain very confident where the security business is going.

Finally, Alan, can you repeat what the amortization stock-based comp charges were in the quarter?

The stock compensation charges for the quarter were roughly $1.5 million, and depreciation and amortization was roughly $5 million.

Josephine Millward, Stanford Financial Group.

Can you tell me what your -- what was the number for security bookings for the quarter?

Well, the backlog was $115 million. It was $115 million last quarter (multiple speakers)

If I back into it, it's about 44, is that right?

Approximately, yes.

Can you also give us an update on your cargo backlog?

It's relatively flat from last quarter. I think last quarter was 48. We're right around the same number.

Can you give us an update on your outlook for cargo in terms of timing of the anticipated orders from the CBP?

Well, I think if you look at cargo, just to broaden that question, the activity level in what we're looking at both domestically and internationally remains very strong. As far as CBP is concerned, I think that they're looking to make a decision within the next couple of months for last year's money, and let's not forget other agencies as well. There are a lot of other agencies within the U.S. that are buying cargo equipment as well. So like I said, I remain very bullish on what's going on there and we should have our decision hopefully within the next two, three months.

On that point, can you just give us, expand on that point a little bit? When you say other agencies within the U.S. government, what other opportunities are you looking at for Cargo and Vehicle Inspection?

Well, you know, without going into details, there are obviously opportunities in DOD and other agencies and I would for competitive reasons, not go into specifics, where we're talking to and who we're talking to.

Just to add on to Ajay's, all we can say is that we've been very successful in the last two quarters in our bookings from the U.S. government and international in cargo. And you already know that CBP hasn't even kicked in yet. So obviously, there's a lot more activity in other agencies of the U.S. [government] and OSI has been very successful in that area.

Can you talk about what's driving the demand in the international market for cargo inspection? And what regions are you seeing the strongest demand?

I think you're seeing the demand pretty much across the world. And whether it's Europe, whether it's Asia, Middle East, the reason I think is straightforward; whatever is happening in the U.S., the rest of the world is following and they want to make sure with CSI or other initiatives, nobody gets caught flatfooted and the demand for equipment, for security purposes has increased tremendously.

Just to add on to it that we have a very large presence internationally, as you know. We have announced in the last quarter orders in Hungary. We have had orders in the other parts of the world and we believe that as the whole world starts looking at cargo inspection, we are quite well-placed, and as AJ mentioned before, the quotation activity is very strong and we believe that we are well-placed internationally as well as domestically to capture this demand.

One last question. I think your breakeven for cargo security is about 30 million for the year. What would you consider a normalized level where you can achieve a normalized margin and what would that target be?

Difficult question because it depends on the mix. There are products gamma, there are products in large x-ray, there are VEDS. There are different kinds of products and they have different margins. I think the other way also to look at that is we also have some grant money. So, it's difficult to say at what level that if we could look at a breakeven operation, but I think if you look at the generalized statement, somewhere into the mid 30s, 40s, you can get there and then after that, a lot depends upon the kind of mix that you get.

Keep in mind that as the time rolls on, there is also a service content with it. So even if initially the sale might not have good margin, which we all know that cargo has relatively lower margin compared to the other product lines, but there's a service content that continues to build, with each year at more and more installments, installs are being done, our service revenue will continue to increase, which will also continue to enhance the margin.

Tim Quillin, Stephens, Inc.

Can you give us a little bit of an update on the development of your Hold Baggage Screening in the UK?

What would you like to know?

Well, I think the technical issue was scaling up your system or -- and so, where are you? Are there any milestones between where you were and where you want to be and how do we stack up right now?

Well, the way we would like -- we have to be very careful for competitive reasons because obviously this is an R&D program. We continue to watch that development very carefully with milestones which are very specific inside (indiscernible) [driven] because keep in mind that the R&D spend in one case we are watching very carefully because the total number is going higher and higher. On the other hand, we want to not overspend or underspend so we monitor them on a regular basis on milestones and all we can say right now is that we are quite encouraged. We are not out of the challenge. We still have challenge and we continue to make progress. More than that, I'll be uncomfortable to say. All we can say is that we have not reached any milestones of that kind that makes us rethink that it will not work. There are definitely challenges still ahead of us.

And also, on the air cargo side, give me an update on what you're doing, both in regards to the PFNA system and also other potential technologies that you might use to solve that inspection problem.

As far as the Houston system is concerned, we said it -- we are waiting for some additional funding from the U.S. government. Hopefully, we should have that shortly. It is, we've said, the only system out there that can look at air cargo, containerize air cargo without breaking out and looking through [break bulk] cargo. With the emphasis with the new Democratic Congress, I think air cargo has again become a top topic of discussion, and we are looking at various other technologies when it comes to break bulk.

I don't think there's one technology they're going to use depending on the type of cargo. It might be X-ray, CT, or other kinds of technology that we have and as we are working closely with the government, getting specifics into it, I don't want to do that for competitive reasons, but I think going back to Houston, that is the -- from what I'm aware of, that is really the only R&D project out there to look for containerized air cargo. I think over the next three, four months, we're going to know a lot more on what the government thinking is and then keep you updated.

Just to add on to it, the Company has not changed its stance what we shared with you people a year ago. If there is any development going forward on the PFNA system, we will entertain it, but OSI Systems is not going to put any amount of our own money into it.

Do you have an update on the L-3 lawsuit?

Yes. We're right now just awaiting a ruling from the Judge on L-3's post-trial motions. As you know, the hearings took place in December, and we're just waiting for the Judge to rule.

We basically continue to wait. Hopefully one of these days, we will get a notification that the Judge has decided to rule something. Right now we're waiting. On the other subject, SAIC, basically it's done with. It's behind us, and we continue to aggressively move forward, building up our product line and aggressively quoting it and we have backlog. We are looking at cost reduction. We continue to look at some R&D development for the next generation products. As you know, that we just announced last week, another advanced technology development contract which combines high-energy and weapons of mass destruction kind of devices, so we continue to move forward in that whole product line.

What was the revenue from large cargo inspection systems in the December quarter?

I think it was approximately somewhere between $7 million and $8 million; I think $7.5 million.

That's helpful, which I guess points to substantial strength in the rest of the security business, and is there any pockets that you can talk about that might be [dry] or anything that we should think about that might not be sustainable a year from now? And I'm specifically thinking about wartime support.

I think we're seeing the security business really strong across the board. So, at least for the next six, nine months, the next two, three quarters looking forward, we see some very strong growth. Keep in mind even the cargo we've said that Q3 and especially Q4 we're starting to ship this stuff. That's when you're going to see some shipments happen there. On the other hand, we are -- activity remains very strong, so we are anticipating some strong bookings there as well. So, really from the standpoint of where I can see for the relatively near-term, two, three, four quarters, I mean things look good.

And just to add on to it, I think with whatever you're hearing in Washington, Democrats, we believe, are going to be more looking at protecting the borders to be serious about the terrorist threat, so that war or no war, I think long-term prospects for cargo have never looked better today than before. We think that this will continue. The backlog reflects it. The quotation activity reflects it, as Josephine asked, there are some things happening that CBP finally are going to start going forward.

There are a lot of initiatives going forward in the House and the Senate, so we believe that for the next couple of years, it will continue to look and what I call planning is going to happen and as straight increases, as stability comes in, decisions come in on the U.S. side making the procurement in cargo, I think some of the trading partners will continue to also increase their procurement.

I think, specifically, if you'll look at the President's budget, DOD, I think it was somewhere around, what, $725 billion. I'm not sure Congress will leave that intact, but if you look at the specifics in terms of force protection/others, I think those will continue to stay in place and continue to grow in other areas. As far as DHS is concerned, Congress has talked about a mandate looking at 100% port security screening and other air cargo, et cetera. So I think your DHS funding is going to continue to grow. So from that standpoint, your question about wartime, some of that funding might come down, but I think in terms of force protection and screening equipment, that's going to remain in place for the foreseeable future.

And then on the opto side, is there some -- should I expect some fluctuations in revenue there? Is it as relatively, what I thought a relatively strong quarter looks like on the contract manufacturing side, is $30 million a good run rate going forward or would you expect to come off that level a little bit in the next couple of quarters?

I would say opto inherently is a little bit less volatile than some of our other divisions. While there are fluctuations from a quarter to quarter perspective, that run rate is probably fairly indicative of the future.

Just to add on to what Alan said, in the opto area, there is contract manufacturing and there is what we call proprietary optoelectronic devices that we make. In the proprietary optoelectronic devices area, it's very predictable. It's quite strong, although it's tied up to the economy. If the economy goes down in the next couple of years, it will have an impact, but all signs are with large time contracts, that that area is very strong.

Contract manufacturing in the opto area has the smallest growth margin because you're doing assembly work of value added. So that business is going to fluctuate, but from the bottom line, we are not as susceptible to the contract manufacturing side. Revenue might be, but as security ships more, as health-care ships more, our intercompany revenue also will continue to increase. Our commercial, especially in the medical area, continues to do well.

Contract manufacturing is more opportunist; contract manufacturing is a relationship with customers, and even in that area, we continue to monitor how we can increase the gross margin by shifting product from U.S. and Europe to international, especially Malaysia and Indonesia and now India. So we continue to look at how we can continue to make the operation more productive.

On the cost savings, the $15 million to $17 million in cost savings, I'm trying to figure out how to think about a base level for that and how to measure your progress from here, and so, in terms of gross margin, is 36% gross margin in SG&A of $38 million, is that the base that we work off of or are we already seeing part of that $15 million to 17 million??

Well, a little of that has been realized in Q2, very little. Most of it is coming in Q3, and then a little further in Q4. So as you're looking out modeling towards the future, the full $15 million to 17 million, I would suspect you could put in really effective July 1.

Through the second half of the fiscal year, we will realize a positive impact. We expect that we may have P&L charges in the neighborhood of $3 million to $4 million in the second half associated with the rationalization of facilities and headcount, but we'll also have realized cost savings in excess of that. So, if you're looking at what the net impact is on the second half of the fiscal year, it should be a positive net impact in the $3 million range, plus or minus.

But emphasize more towards Q4 than Q3.

Correct.

And just lastly, Alan, on the tax rates, so is 39% a good tax rate for the next two quarters? And then what should we be thinking about for a tax rate in fiscal '08?

39% is a good rate for fiscal '07. That is what we're looking at. Though, given our mix, which is largely -- fluctuates significantly between international and domestic as well as certain tax planning initiatives, it can fluctuate. And as we look forward, we are actually looking for that tax rate to come down. We are looking to -- we think there's some significant tax planning strategies for us that as we move into fiscal '08 and fiscal '09, that we can get more towards the mid 30s rather than that 39%, 40% range.

(OPERATOR INSTRUCTIONS). Matthew McKay, Jefferies & Co.

Just kind of taking a step back on the security side for a second here, and with the strength you're seeing within cargo, I'd love to get your perspective on what you see changing there and why we're starting to see that pick up the way it is. Is it just simply critical mass of dollars? Is it people have finally cracked the nut on the operational flow of commerce? Is it more removal of some political hurdles or what's going on there, do you think?

I think it's a little bit of all of the above. If you look at it from Rapiscan OSI standpoint, we've been, over the last couple of years, actively developing a lot of different products, and finally we've had products, we've sent some in the field that people can actually look at. Keep in mind, these are not X-ray machines you see at airports. People have to actually touch and feel these things and you get a reputation on how things are going. So I think internationally, people are seeing similar systems out there. They are impressed with the systems out there and we are seeing a lot more activity.

In terms of what's going on domestically, I think that we all talk about it, that when is port security going to go to the next level? We've heard the 5% scanning right for a long time for containers coming into the U.S. I think one of the things that hopefully going forward is going to change things is that the Congress has said that they are looking at port security. They want to see 100% screening; whether they achieve that 100% level is a separate issue, but you are going to see increased activity.

Last year, Customs CBP actually went out and did trials of certain equipments. Ours, they looked at our Gamma, our VEDS as well as our X-ray equipment, and we were chosen as one of the vendors and they gave us an ID IQ. So they've got some of that equipment, they've tested some of that equipment, and I think their funding for this year was increased from last year and they're looking to see what they're going to do the next two to three months. I think from that standpoint internationally and domestically, it's starting to come together.

Just add on to it is, this industry is still evolving. I mean this is a new industry, and we think that the big push hasn't happened yet, and as it moves forward, everybody's been talking about it. So some of that talk is now resulting into actual orders. Keep in mind, one thing we continue to tell everybody, in the best of times, cargo will still be a very lumpy business. From quarter to quarter, it will be very lumpy.

Okay, and then just kind of following up on that then, are you getting the feeling, again, this could all change in six months, but are you getting the feeling that the U.S. government in particular is starting to settle on at least what technology to use and what specific scenarios? Or are we still kind of, well, we'll try this for a little while and then maybe back off and try another type of technology to see if that works any better? I guess is, the maturation of the industry, how is that coming along just in terms of what technology to use?

Are you talking about cargo or are you --?

Yes, still on cargo.

You know, I think the trend on cargo is definitely towards high-energy X-ray mobiles. So I think we've seen that trend. Obviously that's one of the products that we provide as well. But you've got to look at it from the government's standpoint as well. It's an evolving -- there's a lot of evolving technology, they're always looking for new next generation items. We announced a three point -- what is it, $3.5 million contract recently to look for really the next generation, again, X-ray system, but we're looking to see if we can look at nuclear threats, dirty bonds, et cetera, all in one system and that will be deployed within the next year or so. So I think they're always looking at the next generation and we're always looking and working closely with the government to see what else we can add on to the equipment we have.

Fundamentally, it's the mobile kind of units that they want, and all o the advancement and development will continue to enhance, put more and more bells and whistles, more and more testing capability. Fundamentally, the platforms are going to be mobile. That's the way the government is looking at it.

And then, just kind of on, just follow up to a couple of previous questions, on the operating margin, just with the cost-cutting that you're going through and the rationalization of everything, what would be a decent operating margin goal just from the cost-cutting?

And then, as a second phase to that, what would be an operating margin goal assuming that you start producing some returns off of the investment spending that you're doing?

We think the cost-cutting will certainly have a very favorable impact on our operating margins. We are not ready at this point in order to provide what those goals are. Clearly we're going to be targeting close to a double-digit operating margin for us. But --

Is that just from the cost-cutting?

Cost-cutting and growth initiatives. Absolutely.

Ladies and gentlemen, this does conclude the question-and-answer portion of today's conference call. I would like to turn the presentation back over to Mr. Chopra for any closing remarks.

Thank you very much. To summarize it, this has been a challenging first half. The total company is focused towards -- definitely the topline is important, but we are very much focused into making money. That is the strategy of the Company and we have not finished doing all the analysis and there is more opportunity, but we are taking a breath. We're going to execute it. It's already started. Q4 will be a good representation. I think at the next conference call we'll have a little bit more visibility. We are building both the health-care and the security group towards strength and to capitalize in 2008 all of the initiatives that we have done. Thank you very much.

Ladies and gentlemen, thank you for your participation in today's conference call. This does conclude your presentation and you may now disconnect. Have a great day.