OSI Systems Inc (OSIS) 2007 Q4 法說會逐字稿

Welcome to the fourth quarter 2007 OSI Systems earnings conference call. My name is Bill and I will be your conference coordinator for today. At this time all participants are in a listen-only mode. We will conducting a question-and-answer session towards the end of today's presentation. (OPERATOR INSTRUCTIONS) As a reminder, today's conference is being recorded for replay purposes.

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

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 with Deepak Chopra, our President and CEO; Victor Sze, our General Counsel; and Jeremy Norton, our Director of Investor Relations. Welcome to the OSI Systems 2007 fourth quarter conference call. We'd like to extend a special welcome to anyone who is a first time participant on our conference calls. 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'd like to read the following statement. In connection with this conference call the Company wishes to take advantage of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 with respect to statements that may be deemed to be forward-looking statements under the Act. Such forward-looking statements could include general or specific comments by Company officials on this call 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.

With that disclaimer out of the way our fourth quarter financial results were encouraging on several fronts. Highlights include a 22% increase in sales, led by a record top line for both our security and our healthcare divisions and the completion of the previously announced fiscal '07 cost cutting initiatives resulting in approximately $17 million of annualized cost savings. The combination of increased sales coupled with our reduced cost structure and a favorable tax benefit led to Q4 earnings per share of $0.24 compared to $0.04 in the prior year period. In addition we were free cash flow positive for the second consecutive quarter after nine consecutive previous quarters in the other direction. Finally, we ended the quarter maintaining a record backlog. As a result, we entered fiscal '08 with a tremendous amount of momentum though we still have several challenges ahead of us as we continue to improve operating margins. 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. Welcome to you all to OSI Systems fourth quarter conference call. I'm going to provide you with a brief operational overview of our three business segments before handing the call back over to Alan who will go into greater detail on the financial performance of the Company. After which we will open the call up to the questions and answers.

As Alan mentioned the Company reported record revenues for the fiscal year of $532.2 million, an increase of $79.6 million, or 18% from $452.7 million recorded in fiscal 2006. In addition to achieving record revenues the Company was able to maintain its record backlog level of $209 million heading into the fiscal 2008. For the fourth quarter, revenue was a record $152.8 million an increase of 22% from $125.6 million a year ago.

2007 can be called a transition period for the Company. We have been saying for the last three quarters that the changes were necessary in the Company's way of doing business to improve its bottom line performance. We initiated a global review of our cost structure across all divisions and announced previously that we had identified approximately 15 million to $17 million of cost savings. We moved aggressively in the second half of 2007 to implement these cost savings, and I'm happy to announce that the end of the fiscal year concluding June we were able to implement almost all of this 15 million to $17 million of cost reductions. Most of these cost savings came out of cost of sales. We laid off approximately 8% of our workforce worldwide, and consolidated five manufacturing facilities. We continue to be aggressive in identifying and implementing cost savings wherever possible, and to that end, in July we announced an additional 2 million to $3 million of savings which we have started implementing it and would be done by the second half of fiscal 2008.

Let me touch on the divisional performances and what's happening in the business. The security division. The division reported record revenues for the fiscal year of $186.6 million, an increase of $51.4 million or 38% from $135.1 million recorded in fiscal 2006. Backlog as of 6/30/2007, stood at $117 million. The growth for the year was primarily driven through increased cargo sales, during the year we announced a number of significant orders both internationally and domestically. The market finally started growing during fiscal 2007 and we feel very good that 2008 the momentum would continue in the cargo business.

As we have said previously, this being the government year end for U.S., we continue to be very excited about booking some additional business in our security product line the next 30 to 45 days, especially in cargo. The other highlights, we introduced our first product in the automated all baggage screening market in December. We announced that we had received a significant order from an international airport to replace their existing HBS, all baggage screening system. This order was significantly significant that we replaced an incumbent vendor while providing us with the opportunity to develop a reference site from which we can base our future marketing efforts.

Our business in the MVX [Monteview] product line in automated HBS, non certified by the U.S. government but specifically for the other marks, has done very well. We are sitting on a very strong backlog, and we think that two that 2008 we will capture more additional businesses. Obviously being a new product, as you start shipping a new product initially, the cost structure is such because you have a lot of engineering rolled into it, so our margins for that product line initially are low but we're very confident that as we start shipping in volume production, it will improve.

There are positive industry trends heading into fiscal 2008. We believe that we will see the division to grow at rates ahead of other divisions, significant amount of activity currently is ongoing with the U.S. government as we have announced recently, an indefinite delivery, indefinite quantity received of an order for 80 Checkpoint systems, it was quite well covered in U.S.A. Today yesterday. We have also received an IDIQ order for testing and deployment of back scatter body scanners. As you know, that we've had had multiple systems working in terminal 4 in Heathrow, and it's been very well received. We are very excited that the TSA finally in the U.S. is looking at deploying and testing these back scatter body scanners at check points.

These projects are highly sensitive and we appreciate your understanding that we do not have the ability to expand on the status or nature of these products -- projects outside of what has been disclosed publicly, especially during the question-and-answer period we would appreciate it as we are in the end of government year spending, and we are chasing some of those dollars, we might not be able to be very forthcoming in answering your question very directly.

We continue to be committed to investing significant amount of money in R&D in fiscal 2008. Our R&D spend for security for this product will go up in 2008. The project that we are working on is the high-speed in-line certifiable CT system for automated all baggage screening. We continue to make progress in this program. Our target date for beta testing of this product is in late fiscal 2008 to early fiscal 2009.

Healthcare. Revenues were up 6% to $233.2 million versus $220.6 million. Excluding revenues attributable to Del Mar Reynolds, acquired in July [2006], underlying revenues decreased by approximately 6% compared to fiscal 2006. All the production in the base revenue was due to weakness in the patient monitoring sales in North America in the first half of fiscal 2007. We are happy to announce that the second half bounced back and Q4 was significantly stronger entering into next year with very strong backlog in patient monitoring bookings.

At the end of first quarter, we moved quickly to implement a broad range of changes within the healthcare segment. These changes led to an improved operating performance of the remainder of the fiscal year. Most of the cost savings that we have announced achieving 15 million to $17 million came out of the healthcare group. In the last 12 months, the division has been honored twice by Frost & Sullivan for North America patient monitoring company of the year for both 2006 and 2007, Excellence in Technology award.

Just like security we are committed to R&D. We have increased our R&D spending in the fiscal year by approximately $6 million within this division. We continue to work aggressively for the next generation platform launch. During this year we resulted in a number of new products being launched in this year like advanced anesthesia system Blease Cyrus and Ultraview SL perioperative monitoring suite in the North American market. We also introduced our first vital signs monitor targeted specifically at the day surgery centers and low acuity markets and the emerging markets, the M-care 300.

The Company expanded its presence in the emerging markets. We have opened approximately 50,000 square-foot manufacturing facility in China. The facility is expected to begin operations in the second half of fiscal 2008. We are committed in this healthcare sector to increase our manufacturing gross margins and in doing that the Company has focused that we will continue to move more and more production both to the Chinese manufacturing facility as it comes on-line and our Indian research and development center of software.

Optoelectronics division. The division reported record revenues for the fiscal year of $186.6 million, an increase of $51.4 million or 38% from $135.1 million recorded in fiscal 2006. Despite revenue growth, the weapon simulation business which accounts for a very small portion of revenue of the optoelectronics division had an operating loss pretax of approximately $4.6 million for the year with $1.6 million of that in Q4. We are looking to focus on our core operations moving forward and to that and we are reviewing strategic options for our weapon simulation business to eradicate the losses experienced in the past fiscal year. We are committed to look at this division very aggressively and this portion of the business definitely will be strategically planned what to do so that we can put it behind us. With that, I'm going to hand it over to Alan to talk in detail about the financials.

Thank you, Deepak. As we continue to grow the top line our management team is highly focused on driving operating margin improvement. To significantly improve earnings in 2008 and beyond. I will speak more about this shortly but first let me review the financial results of the fourth quarter.

For the fourth quarter we reported net income of $4.3 million, or $0.24 per diluted share, compared to $0.7 million, or $0.04 per diluted share for the same period of fiscal 2006. The bottom line results include a favorable tax benefit of $1.3 million. Assuming a normalized effective tax rate and excluding impairment restructuring and other charges of $3.69 million inclusive of losses attributable to our weapon simulation business, our diluted EPS is comparable to reported earnings. Net sales for our fourth quarter increased 22% from $125.6 million in fiscal '06 to $152.8 million in fiscal '07.

Our security division continues to experience strong top-line growth reporting a 36% increase in sales for the quarter, 38% for the year, led by improved cargo sales which grew 93% over the comparable period last year. Our baggage and parcel inspection, checked baggage screening and people screening systems also reported growth of 15% over the prior year quarter. As you know, and as Deepak mentioned our healthcare division had a challenging first nine months of the year, but rebounded strongly in the fourth quarter. We are very pleased to report a record top line for healthcare in the fourth quarter with a year over year Q4 sales increase of approximately 17%, of which approximately 12% was related to the acquisition of a diagnostic cardiology business in the first quarter of fiscal '07.

Optoelectronics and manufacturing division third party sales continue to show nice progress increasing approximately 11% over the prior year. For the fourth quarter of '07 our gross margin declines at 37% from 41% in the prior year period, primarily due to a change in the product mix, as well as continued losses incurred in our previously mentioned weapon simulation business included in our optoelectronics and manufacturing division. In addition, the gross margin was impacted by the product mix in our security division which included increased sales of our cargo inspection products and multiview x-ray checked baggage systems which generate lower gross margins as we make the initial shipments of the first units which include heavy engineering costs up-front. While our gross margin will vary from quarter to quarter, as a result of a number of factors including product mix, unit volumes, pricing, inventory reserves and capacity utilization, we do expect to see overall improvements in the future.

Our SG&A expenses as a percentage of sales decreased 4.7% for the 2007 fourth quarter from 30% to 25.3% of sales compared to the same period in the prior year. The impact of the cost savings initiative is materializing and we are able to better leverage our existing infrastructure. In addition we experienced a reduction in legal expenses due to the successful conclusion of several costly lawsuits. I'll speak a bit more about the progress in our cost rationalization plans later on this call.

R&D expenses for Q4 '07 were $11 million or 7.2% of sales compared to $9.6 million or 7.6% of sales in the prior year. As Deepak mentioned we are making significant investments across different technologies in our security product offering. In addition, we continue to invest significantly in next-generation product in our healthcare division. We anticipate that our fiscal '08 R&D expenses as a percentage of sales will continue at similar or slightly higher rate to that of fiscal '07 which was 8.2% of sales. Interest expense decreased on a sequential basis primarily due to the third quarter receipt of $15 million from GE as the final resolution of a working capital dispute dating back to the acquisition of Spacelabs but increased from the prior year due primarily to the additional borrowings associated with the acquisition of Del Mar Reynolds back in July '06. We recorded an income tax benefit of $1.3 million due primarily to the recognition of the benefit of previously disallowed foreign losses and to an increase in R&D credits.

Moving to cash flow, as I've mentioned on each of the conference calls this year we have placed significant emphasis on generating free cash flow. This focus is paying off. Q4 marked the second consecutive quarter of generating positive free cash flow which we define as operating cash flow less capital expenditures. As you may recall, Q3 represented the first quarter in the past nine quarters that we generated positive free cash flow. This was achieved over the past six months by managing our working capital better including increasing our inventory turns despite a buildup in cargo inventory in our security division to meet the increasing backlog in that business, increased focus on customer collections as well as the improved operating performance of the Company.

In the fourth quarter we generated $6 million in operating cash flow as compared to using approximately $1 million, or $0.8 million in the same quarter last year. Capital expenditures were approximately $4.4 million. Depreciation and amortization was approximately $3.9 million and stock-based compensation expense was approximately $1.1 million in the quarter. We are pleased to have ended the year maintaining our record high backlog of approximately 209 million led by continued strength in security with its backlog of $117 million.

Turning to an update on the progress of reducing our cost base, as we mentioned during our past two conference calls we began a review of our global operations in order to integrate recent acquisitions and to rationalize our cost structure. This review resulted in plans to achieve approximately 15 million to $17 million of pretax annualized cost savings. As of the end of the fourth quarter we are pleased to report that this first phase was completed with annualized savings reaching the upper end of the range of approximately $17 million. The full benefit is expected to be realized in fiscal '08. The greatest impact of these changes will be evident in our healthcare division for which we have completed in excess of $10 million of annual savings. Most of these savings will materialize through the cost of goods sold line item while other savings will move through the SG&A line item.

In addition we are continuing to review our cost base and in July announced plans to achieve an additional 2 million to $3 million of pretax annual savings which we expect to implement before the end of this calendar year. Subsequent to year end we entered into a new credit facility for approximately $90 million replacing our previous $67 million domestic credit facilities. The new credit facility includes a $45 million term loan and a $45 million revolving line of credit with the ability to increase the overall facility to $100 million. The new larger credit facility replaced two separate facilities and provides additional borrowing capacity, improved financial covenants, and offers a slightly lower interest rate depending upon our leverage ratio.

Now let's discuss the Company's guidance. For fiscal 2008 we are providing top line guidance of 580 million to $595 million, representing growth of 9 to 12% over fiscal 2007. Although we are well into the first quarter of fiscal '08, it remains too early to provide precise earnings guidance for the quarter. What. we are able to say, is that we expect net sales to be between 125 million and $130 million and we expect to report a loss for the quarter. But we do expect there will be significantly less than that of the first quarter of fiscal '07.

As Deepak mentioned the U.S. government's fiscal year ends this month and our security business forecast can be greatly impacted during this season. As a result we expect to have greater visibility following the conclusion of our first quarter. 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 optimistic about our future prospects and look forward to reporting our results in the coming months. Thank you for listening in on this conference call and at this time I would like to turn the call over to questions.

Thank you very much, sir. (OPERATOR INSTRUCTIONS) Our first question comes from the line of Josh Jabs of Roth Capital.

You mentioned some of the changes going on in the opto side. Sounds lake a possible spinoff of the defense simulation business. Can we get any more color on the timing of what that event would be, and can we start looking at that as a discontinued operation? Any color there?

Josh, we're looking at all options. I think what internally because sensitive issue because most of the business is to other prime subs in the U.S., and we want to be still very sure what we say and what we do, but one thing we are committed to do that we want to put this behind us. We are looking at various options, whether that's strategic partnership, could be spin-off, it could be absorbing or moving the operations into California from Florida. All the options are being looked at. Timing-wise we are determined to get this behind us before calendar 2007, '08.

All right. And then looking at Spacelabs, obviously there's been some changes going on within that business. You have mentioned over the last couple quarters that you've had some stabilization in North America. As you look at your backlog in that business right now, how much visibility do you have heading into this next fiscal year? Looks like quite a bit of seasonality is playing into the September quarter, and I'm just wondering how much confidence you have in that business looking at the rest of the fiscal year '08.

Number one, that business is inventory turns business. It really doesn't work on backlog practically. As you said, one of the reasons that we have this all the time, the quarter is never over till midnight end of that quarter. In that business. Because we build a lot of parts to standard. Fortunately, we entered this quarter with a very good backlog, which will reflect that we should have a good Q1 and obviously, as you know, Q2 is historically the strongest and Q4 is also very strong. So we do have better visibility, but we think that the actions that we have taken not only are top-line driven but also cost reductions, gross margins, and as I mentioned in my review, that manufacturing focus to move to lower cost operation in China and India is a must. We must increase our manufacturing gross margin not just focus on the top line and healthcare, because that's such a highly leveraged business, our target is that we -- we ended the year at somewhere in the high 40s. Our internal target is that we want to get into mid-50s in manufacturing gross margin for the healthcare business. Not going to happen overnight, but that's what our plan is. That's what we are focusing on.

Then looking at gross margins I understand that you're shipping new product on the security side, that carries with it lower gross margins, some of that is in the backlog right now, but if I look at the gross margins for fiscal year '08, can we get back to maybe where we were in fiscal year '06? Is that -- is that type of gross margin achievable, or what's kind of the target there?

Josh this is Alan. I think in fiscal '06 we reported a gross margin of 39%. Based on some of the changes that we are making we are aiming to get back to that, that sort of range. We think it is indeed possible.

Just to add on to it for you what you said about the MVX product, we had a good backlog of that. As we start shipping sale number 5, 6, 7, 8, 9, 10, 11, whatever, the costs associated with manufacturing costs, associated with that, will start coming down, because the first couple of units definitely have more engineering wrapped into it. We are ramping that up very fast. Some of the cost is based upon very fast ramp-up. So as we get more organized in that product line it automatically would start showing better margins.

Are you -- specifically looking at that product line are you referring to the costs associated with some of the professional services that go around with kind of tweaking the new units for the customer?

Absolutely. That plus expediting the vendors to ship product out. I mean, if we had planned to ship ten and if you're now going to ship 30 obviously it has some impact on expediting but that's a good problem to have.

All right. Great, thanks.

Thank you very much, sir. Ladies and gentlemen, your next question comes from the line of Jeff Rosenberg of William Blair & Company.

Good morning. If we look at your Q1 expectations on the top line and I think about what normal seasonality looks like, I mean, that gets you some of the sequential reduction that you're guiding for in terms of revenue but can you talk a little bit about it appears that security is going to come down pretty significantly quarter on quarter as well, and is that the effect of some lumpy positive benefits in the fourth quarter, or given the strength in backlog, I just thought maybe you could give some color on the near term trends in security? Thanks.

Well, let me see how -- what you're saying. Definitely Q1 seasonality the revenue will come down, both in security and in healthcare. As the revenue comes down, definitely the margin will get affected in healthcare anyway because that's a leveraged product line. In security, it it depends on the mix, Jeff, that ships out, whether it is more cargo, whether it's more conventional. But overall we think that Q1 definitely will have a loss. It will have a lower margin compared to Q4 but it will be better than Q1 last year. And with the cost cuts that we have done, it should start impacting positively. Keep in mind that Q2 historically is a very strong quarter for health, and it will be a very strong quarter for security just being driven by the backlog that we he have, and depending on what other intake we take from the U.S. government on the year end, in the next 30 to 45 days, Q2 could be a very good quarter, both for revenue and for margin.

Okay. That's helpful, but the one thing you touched upon that I was looking to understand better was given the strength of the backlog, I'm trying to remember the source of seasonality in the security business in the September quarter or is it just more a function of the inherent unevenness of the business that we saw real good growth in Q4 and then a fall-off in Q1?

Well, there is not that much seasonality and security as in healthcare but there is some just practically speaking that Europe shuts down. So that some of the people who are going to give orders are on vacation, but otherwise, I think there is not much seasonality into it. It is just driven by the backlog. Just driven by backlog what you get in, and since we have a strong backlog, I think that your first quarter would be better than the previous quarters, but Q4 was a very strong shipping quarter for security and I want to emphasize Q2 will also be because of the way the backlog is.

Okay. So it's just a timing issue is what you're saying and I guess could you provide any specificity as to what really was the source of strength in Q4, the orders that -- or the equipment, any color on what orders really benefited the fourth quarter?

Well, it's backlog. The last couple of quarters we've been sitting on record backlog, and the lead times are such in cargo -- with very heavy cargo shipments for Q4. So you ship a lot of cargo from the backlog, and now we're building up the next wave, so it takes some time. So depending upon when they get accepted, when they get shipped, we think that you ship a lot in Q4 cargo. Now we're building in Q1 and it might not make it in Q1 or into Q2.

What was the absolute number in cargo this quarter?

The absolute number was about 21.5 million.

Thanks. And then on the SG&A, if we think about you within your range, let's call it 10% type revenue growth for fiscal '08, what sort of growth should we think about you will be able to maintain in SG&A if that's the sort of revenue growth that you ultimately achieve?

Certainly. We are expecting to continue to leverage that SG&A infrastructure and we expect to see SG&A as a percentage of sales continue to decline although in absolute dollars there will probably be a slight increase.

Last question I had is what sort of tax rate should it makes sense to assume for the for forward quarters?

Always a challenge with the tax rate with OSI Systems but we are expecting that we can be in the 30s this year, somewhere probably in the mid-30s.

Thanks a lot, Alan.

Thank you very much, sir. Ladies and gentlemen, your next question comes from the line of Tim Quillin of Stephens, Inc.

Just real simply, I guess, in terms of the earnings guidance or lack thereof, when you say a loss significantly less than the first quarter of fiscal '07, I mean, can you narrow that down? Is that essentially saying anywhere from a loss of $0.30 to breakeven, or where should -- how should we be thinking about the first quarter?

Well, I expected you to ask that question. It's definitely significantly less than $0.36, and it definitely is not breakeven, otherwise we would say it's breakeven. It's a loss. Because if you look at the revenue, Tim, you look at the margins, you look at the SG&A, you look at the R&D, it's pretty much going to be difficult to give a range because it still is early but I would say that somewhere in between is where it's going to end up, close to that. Very difficult for me to give you any answer better than that. It's a revenue driven. If you just look at historically Q1 has been always weak.

Okay, and just the other question is that it seems like or it feels like that you're not intending to cut SG&A cost, which is a little bit disappointing, but are hoping to grow into your current overhead. Is that something that would change if revenues don't come on board like you're planning?

Number one, that's not a true statement. Out of the 15 million, 17 million, Alan mentioned is on the top range, and we identified another 2 or 3 million, so if you add up the total number it's about 19 million to 20 million. The majority of that came from cost of scales but a big chunk of that came from SG&A. So it's definitely working on SG&A and we continue to look at that area, and we also made a comment most of -- the majority of the costs were healthcare related, and there was a big chunk in SG&A that got cut as we combined the new acquisition Del Mar Reynolds into Spacelabs he we had two organizations, we had two back offices, we had two sales organizations, service organizations, buildings, we did attack that SG&A. What Alan was trying to say is that we -- one, we continue to look at it. And if you look at over the last -- 2007, going into 2008, from 2006 to 2008, your revenue is going to grow by about $150 million, and your SG&A will be down in absolute dollars. So we definitely are attacking SG&A, no question about it.

Okay. Just one last question. One point you had been talking about potentially getting to a 5% net margin. That something that you're thinking about for fiscal '09 or is that something further out?

I think that I can confidently say with all the things that we are doing, obviously we want to make sure that the healthcare and the security continues, but there is no reason why 2009, with all the stuff that we are doing that we cannot do much better than 5% operating income.

Okay. I guess I was referring to 5% net.

Alan, you want to put color on it?

Tim, we are certainly striving to get to a 5% margin and are making all efforts to do that through top-line growth, through gross margin improvement, and through leveraging the infrastructure of our SG&A. We believe we can get there in terms of the timing by year. I think as we said all along we don't think we can be there in fiscal '09 from a full year perspective, a run rate perspective by the end of the year.

Okay. Thank you.

Thank you very much, sir. Ladies and gentlemen, your next question comes from the line of Brian Ruttenbur of Morgan Keegan.

Thank you very much. The first question I have on revenue growth in 2008, can you give us what that revenue, out of the 580 to 595 how much of that would be security?

We haven't done that, Brian, but we have said it, that the momentum of the security continues to be strong compared to the other divisions and we think that what happened in 2007, 2008, security would continue to be very healthy growth.

So that would be 20% security growth would be realistic, is that right?

I think so.

Then what does that mean that medical and optical combined would be growing kind of low single digits?

That's about right.

Okay. The other question is about first quarter. It sounds like on the securities side first quarter is going to be not what fourth quarter levels were but higher than what third quarter '07 levels were. Third quarter '07 was $45 million, fourth quarter was $56 million. Is that fair to say, somewhere in between those two numbers?

Yes.

Okay. The next question is about EPS. On the year. I know that you've given no guidance on the year but I'm just trying to understand a little bit about where revenue will break out on the year and then how EPS will also break out. First quarter we know what that's going to be. It's going to be a loss and 125 million to 130 million, then the December period should have a big ramp-up maybe to not quite fourth quarter levels but something shy of that. Is that what you're thinking?

I think that Q2 could be in line to Q4 or even higher.

Okay.

Q3 would go down. Q4 could be as high as this Q4 or even more.

So would the earnings -- would there be something that would cause you to make less in earnings in like the Q2 number versus the Q4 number? Let's just say that in Q2 you reported $153 million roughly. Would your earnings be at the same levels, or is there something seasonally that causes Q4 earnings to be even higher?

Well, the way to look at it, you've got to put the revisal of the mix. It's important because there's a major difference in the gross margins between security, medical, and optoelectronics. But with all the initiatives that we've got going and with Alan's comment that we continue to improve the gross margin, I think that if the revenue mix comes favorable in Q2, there should be no reason why the earnings should not be better than even Q4 this year.

Okay. Very good. And then to try and understand, there were some questions on SG&A and R&D, I'm just trying to understand how much SG&A is going to be on the year. You did $150.3 million in 2007, $139 million in 2006. The comment was around -- that you're going to be flat, maybe slightly higher from '06 -- excuse me, '07 levels, which was $150 million. Is that what I heard, and is that correct?

That is correct, Brian.

Okay. And then -- but as a percentage, because you're going to be growing revenue, it's going to be lower. Why is there not more leverage? I think that's come up on the SG&A line. Why couldn't you -- since there were all these cuts, it seems like SG&A would automatically be going down while your revenue is growing, even as a total dollar amount instead of holding flat.

Keep in mind that the cuts that we made, a big chunk of that reflects in cost of sales. There is a certain amount of SG&A especially in healthcare in marketing and sales.

So the selling part as you grow your top line has to grow with that.

Well, there's a commission involved into it. Keep in mind the two portions to it. There's something SG&A marketing and sales, your distribution channel and stuff and there's some commissions.

Okay. That's fair enough.

And the other thing is on the securities side as revenue line picks up we are not adding SG&A. That business it will not add anything. So on the average as a percentage of revenue it will start coming down. It's maybe flattening out right now.

Then on the R&D line, you did $43 million last year, $35 million the year before. Is that going to be flat or up? It sounds like you've started some new initiatives, so it's going to be up year-over-year in 2008.

Well, firstly, to correct it, there are no new initiatives. We basically are continuing two major programs of R&D and the security as you know we're developing the automated high-speed certifiable CT scanner, and as a result some milestones continue to be met, we keep increasing that cautiously. So it's not a new initiative. We just have -- we are doing it by phases. In the healthcare sector we are aggressively working towards launch of a new platform, and we've been at it for the last couple of years, and we will continue for the next couple of years, and as we get more closer to it we continue to increase R&D.

Okay. Can you then give me some perspective on R&D as it relates to 2007, 2008? Is it going to be higher or lower?

We think it will, on a percentage of sales basis, be similar, if not slightly higher, and it was 8.2% of sales in fiscal '07 so therefore with the increase in sales on an absolute dollar basis we would anticipate it's going to increase.

Okay, so dollar amount is going up but it shouldn't be over 8.1, 8.2. It should be holding around the 8's, rate?

Yes.

And then the tax rate you mentioned was mid 30s, is that correct?

Yes, that's our best estimate.

Okay. Nobody has asked the question yet but what is the status of the L3 litigation? I think there was an appeal process going on.

Victor?

This -- the current status of the L3 litigation is that both sides have filed our opening briefs and there's one further round of briefing that's going to happen in the next few weeks here. After that, we're looking to the court to set a date for the oral argument and naturally beyond that, as far as any potential discussions between the parties, we can't really go into that. That's all confidential.

So we're looking at probably another couple months before this appeals process is over; is that correct?

Well, the appeals process meaning the active part of it. Once the oral arguments are done, we're going to be looking to the court to give us their decision.

Okay. So do you anticipate a decision then by calendar year end?

That's always really hard to say. We've been told that historically the second circuit takes something within a matter of six months to render their decisions, but case by case it it's really difficult to say.

Okay. And is it anticipated that, assuming you come out smelling pretty or positive on this appeal, that L3 will be that much more compelled to negotiate with you? Or is there more things that they can appeal after this?

Well, we can't read their mind, Brian. They have tried it two times. They struck out. They'll try another time. They'll strike out. But then maybe common sense will prevail but I can't read their mind.

Okay. And then just trying to get the military opto revenue was, what, 5 million a year? How much was it that was produced in a year for you guys?

Roughly 7 to 8 million.

7 to 8 million. And that 7 to 8 million lost 4.6 million. What's going on with that business that it's losing so much money on such a small revenue base?

Well, there's some impairment, some inventory cost overruns, all of the above, and we basically at year end took a look at it, with the completion and impairment is going to be and we took a conservative view. Now we basically just trying to get this completed in the next couple of months, and after that to make a decision what we do with that product line. It's not a core business. It's like you say, it's a very small portion of our revenue, and I think long term we definitely don't have too much interest in it.

Okay. Very good. That's all my questions. Thank you.

Thank you very much, sir. Ladies and gentlemen, your next question comes from the line of Steve Emerson of Emerson Investment Group. Please proceed.

Gentlemen, I'm trying to get a little better color on your 580 million, $595 million guidance range. To what extent is this a ultra or very conservative range, and perhaps if you could address to what extent these possible orders that you said you may have been selected for are in these estimates?

Steve, one of the reasons that we have said that we are in that period right now with the coming year end, and obviously everybody is trying to chase some year-end government money, I wouldn't call it that our range is conservative or optimistic. That's, from where we sit right now, that's what we think it is. I think we will be able to give a little better color where it's going to be after the government year end of the year funding is done. If you remember last year we were in the same mode and we did get a big chunk of the money from the government. So I think after the -- at the first quarter conference call we should have a better idea. So I don't want to call it conservative or optimistic. That's the best that we know right now.

Thank you.

Thank you very much, sir. Ladies and gentlemen your next question comes from the line of Matthew McKay of Jefferies & Company.

Good morning, guys.

Good morning.

Wanted to kind of focus on the SG&A line a little bit here. First of all, just kind of -- it doesn't sound like you -- obviously what you've been focused on is cutting out a lot of the cost of goods line here. On the SG&A line just kind of curious how you're structuring the overhead supporting each of the businesses. So for example, are you -- how many kind of systems do you have back there? Are you trying to consolidate it down on to two or three systems, or is it more than that? Just kind of what the strategy is to clean up the back office a little bit here.

I'll take that, Matt. This is Alan. We are making great efforts in order to reduce the ERP systems, as you mentioned. From a lot of legacy systems from acquisitions we had about 11 systems at the beginning of last fiscal year. We got down to six which is an enormous accomplishment by our IT department this past year. Our ultimate goal is to get to two. Because it would be just too difficult to integrate the healthcare ERP system into the OSI one. So we're continuing that regard. The way we are structured is highly decentralized between the different divisions which creates probably some incremental SG&A. So as we go forward and look to become increasingly efficient there will be some opportunities to further streamline the back office, centralize certain more functions that will have the opportunity to leverage that structure and bring down SG&A as a percentage of sales even further.

That's helpful. So to get down to two systems, -- when do you think you'd get down to two systems?

I'd say within the next -- I'd say we'd probably be down to three systems within the next -- a good chance by this point next year.

Then it it sounds like this turnaround that you're going through you've kind of gone to a new level here where 2007 was really about capacity rationalization and improving the efficiency end of the business and now it seems to be moving more strategic question, do we keep the weapons portion of the optoelectronics business, for example, or the healthcare business. Is there any way that you can kind of put what the scope is right now in terms of the turn around that you're looking at and what maybe is viewed as more strategic or less strategic?

Well, this is Deepak here. If you really look at it there are some things that we have learned with the initiative we were doing. Healthcare for example, is a leveraged business. We combined Del Mar in aggressive manner, we cut 10, 12 million out of costs, then we look at it and say, going forward, though the top line is going to grow, but it's in a single digit growth, gross margin becomes very important to increase. So we've looked at it and made a strategic decision to move to China, some of the manufacturing, so we can increase the gross margin. As I mentioned, we ended the year in the high 40s, and we want to work towards the mid-50s. Might not happen in 2008, but we definitely will start achieving that towards that side as the China operation comes on line. It's very focused.

There's some SG&A area that we are looking at tin healthcare but it's not easy, because that historically, and if you look at the comps out there in the same businesses we are, the SG&A runs in the mid 30s, in that area, because of marking costs, your commissions, and your spread all over the world so that you have infrastructure that is difficult to consolidate into OSI. You look in the security side of the business, again margins become very important as we start shipping multiple units we have to continue to look at margins. You look at SG&A, it's a little bit more easier to manage that SG&A and to focus consolidation but a lot of that also is needed because you have a broad product line, and you're spread all over the world. Your business is expanding all over the world, so your revenue will take care of some of that stuff into it, and we think that we are optimized quite well in that area.

Opto is one area where you have two distinct businesses. Contract manufacturing and optoelectronics OEM business, and we are about six, seven plants and we continue to look at that area and Alan, as he mentioned, we're trying to put together back office systems aggressively and at the same time make decisions where certain product lines do we want them or do we spin them off or to combine with other product lines. So definitely 2007 was a first shot cut the cost as fast as possible, execute it, which we have done, in eight months we've took down that much cost out, and now we're looking at strategically which areas we want to keep, which areas we want to move around, and it will be an evolving exercise. Definitely there is no reason why the consolidation gross margins do not start approaching 39 to 40, 41%, and if you can keep our SG&A or maybe reduced a little bit, with a little bit extra R&D there's no reason why we cannot go into 2009 with a very strong capacity to make bottom-line earnings.

That's helpful. As an example, could we eventually see the optoelectronics business get absorbed into various other portions of the business, and then maybe one key spun out of the remaining piece of the optoelectronics business?

I wouldn't go that far but we can look at simplifying that product lines into it and maybe consolidating into one or two more -- reduction of plants and combining some of the businesses. It's very difficult to put into one or the other product line of security or healthcare because they have inter-company sales of 30 plus million but they also have $100 plus million of external business, and it's quite profitable.

Then you said -- healthcare you said gross margins you want to get into the mid-50s. What are the gross margins for security and optoelectronics right now?

Well, it's difficult to break it down into that. I think we have sort of talked about in broad ranges that optoelectronics means OEM business, runs in the mid 20s. The security business, depending upon whether it's conventional, cargo, new start-up, the MVX product line, it's very difficult to do that, but our target is that we need to be in the mid to high 30s.

Okay. And then just one last question. On interest expense, is using the interest expense that you reported this quarter, is that sort of a fair level to use going forward given that you've got the new credit facility in place now?

Yes, I would say that would be in all material respects a good indication.

Okay, great. Thanks a lot, guys.

Thank you very much, sir. (OPERATOR INSTRUCTIONS) We do have a question from the line of Sara Phillips of Stephens, Incorporated.

I just have two quick questions for you. I'm just wondering with the benefit of hindsight do you guys have any information for the weakness in the North American patient monitoring market earlier in the fiscal year?

Well, hindsight is 20/20. I think in one of the conference calls we did say, we had a very good 2006 and then we changed our fiscal year of that product line from December where all the other companies have it to June, to match OSI. Since most of the commissions of sales people are tied up, exponentially goes up as they come more closer to their target so we had a weakness and that reflected in the last June quarter which was very strong. But the other thing is that I think that management maybe got a little too confident with such good success of 2006, that they took the eye off the ball in the first half, which we immediately rectified it, and it reflected what happened in the second half. In Q4 we not only had a very strong patient monitoring sale but we also ended up going into this year with a very strong backlog.

Great. Very helpful. And then my second question is, if you have an update on the RTT CT, basically any next milestones that you anticipate?

Would you repeat your question again.

On your (inaudible) CT development do you guys expect any milestones for this coming up?

Well, we continue to have internal milestones as we mentioned that our increased R&D is cautiously being done by looking at incremental milestones that that group is reaching. So there is no one big milestone that's out there. There are incremental milestones that we continue to monitor.

Okay. Thank you very much.

Thank you very much, ma'am. And we have no further questions in queue. I'd like to turn the call back over to our speakers for any closing remarks they may have.

Thank you very much for attending the conference call. I know we've taken a lot of time. 2007 in summary I call it a transition year. 2008 we're building on the momentum of the initiatives we started. We are in good product lines, security is showing a lot of visibility both domestically and internationally. We have patiently waited for the cargo, we have invested very wisely, some of those results are now panning out. In healthcare we continue to look at increasing gross margins.

Definitely work is still left. We continue to look at our SG&A. We have not given it up. Our whole focus is to make bottom line grow. At the same time, we can't ignore the top line. We are enjoying good growth. We continue to manage those businesses, but we are going to put the defense systems business behind us, do strategically whatever we have to do so we can look forward to the two product lines and the optoelectronics business aggressively going forward. Thank you very must have.

Thank you very much, sir. Thank you, ladies and gentlemen, for your participation in today's conference call. This concludes your presentation for today and you may now disconnect. Have a good day.