OSI Systems Inc (OSIS) 2008 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the OSI Systems First Quarter 2008 Conference Call. My name is [Jahida] and I will be your operator for today. (OPERATOR INSTRUCTIONS.) And now, I would like to introduce Mr. Alan Edrick, Chief Financial Officer. Please proceed.

Thank you. Good morning and thank you for joining us. I'm Alan Edrick, CFO of OSI Systems. I am joined on this call today by 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 Fiscal 2008 First 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 obligations to revise or to update any forward-looking statements, whether as a result of new information, future results, or otherwise.

With that out of the way, our first quarter financial results demonstrated significant improvement over the same period last year and provide added evidence that the significant changes we implemented in fiscal '07 and are continuing to build upon in fiscal '08 are leading to improve bottom line performance. I will discuss both fiscal '08 and longer term financial targets later on this call, but let's start off by reviewing the Q1 highlights.

First, we reported a 13% increase in sales led by a strong top line in both our Security and Healthcare Divisions, which grew 19% and 17%, respectively.

Second, following up on last year's successful cost rationalization strategy, we continued these efforts and identified an additional 7 to 8 million of savings, which we expect to be nearly fully realized in the next fiscal year.

Third, the changes we made in our Healthcare Division are paying off, as we restored top line momentum and turned an operating loss of 4.3 million in Q1 last year to operating income of 1.1 million in Q1 of '08. As you recall, Q1 is historically a comparatively soft quarter in our Healthcare business.

Fourth, the combination of increased sales coupled with our reduced cost structure led to a 24% improvement in our EPS for Q1 of '08 compared to the prior year period.

Fifth, during the quarter we entered into a new credit facility providing added capacity with improved terms.

And finally, we ended the quarter with a record backlog. Thus, we believe we are well situated to capitalize on our plan for both near term and long term earnings growth though we still have several challenges ahead of us as we continue to demonstrate improvement in our net margin. I'll be updating you further on the financial performance of the Company, but first, let me turn the call over to Deepak.

Thank you, Alan. And again, good morning and welcome to the OSI First 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 then go into greater detail on the financial performance of the Company, after which we will open the call up to questions and answers.

Company Overview. Highlights. Improved operating performance in the first quarter. Revenue of 131 million, up 13% from 115 million for the first quarter of the previous fiscal year. Operating loss of 2.1 million, or $0.12 per diluted share, compared to an operating loss of 6 million, or $0.36 per share, in the first quarter of the previous fiscal year. Backlog at the end of the quarter increased by approximately 15 million to 224 million from 209 million, an increase of 9%.

As Alan will discuss further, the Company continues to pursue initiatives and cost-cutting in order to improve our operating efficiency and profitability.

I want to emphasize before I go into the detailed business segments that though the top line of the Company is important, we as a Company are committed to enhance and improve our profitability. I am personally involved in every element of that, and leading the charge together with Alan Edrick. And all the Divisional Presidents are 100% committed on this ongoing process.

Let's talk about the segments. Security Division. Security Division continues to achieve strong revenue growth with strong bookings. This quarter we announced a number of significant contract wins, including but not limited to the TSA Advanced Technology Program for the Checkpoint. We won a $9.3 million contract award from the TSA for our new Rapiscan 620AT baggage and parcel inspection systems.

I'm extremely proud of our [managing] and manufacturing teams for successfully tendering and securing this IDIQ for the Company. Out of a total 250 machines let out, we are proud to say that we garnered half of it. This contract enables us to maintain our leadership position in this market in the U.S.

Cargo. This quarter was another strong quarter for revenues and for the bookings. We announced approximately $30 million in contract awards from various U.S. Government agencies. These orders again highlight our strong leadership position in this market. As we have said in the last conference call, we were very anxiously waiting for the government year-end and it came through, and we are very, very happy to work with the U.S. Government. Not only our bookings were strong domestically with the U.S. Government, but also in the international sector. Even after the strong revenue, the Security backlog went up from the last quarter from $117 million to $122 million.

Body Scanners. This quarter we also announced an IDIQ from the TSA for our proprietary body scanner. We are pleased to be working closely with TSA on this program, as you know that we've had our body scanners working for the last couple of years in Terminal Four at Heathrow.

Going forward, we expect to see continued strong bookings for our new Rapiscan 620AT, both domestically and internationally. We continue to see increasing cargo sales, both domestically and internationally. The activity continues to be strong internationally worldwide. We continue to invest in our R&D programs. As we have mentioned in the last conference call, we have increased our R&D spending and it will continue to go up during the fiscal 2008 into 2009 as we develop our real-time tomography CT scanner. Just to again emphasize, no guarantees of revenue short term. It is from what we know the only high speed certifiable 1,800 bags an hour scanner that is being developed. We are very excited. And in small batches with some key customers we have started talking about it.

We also look to see an improvement in the operating performance of this division. Even though revenue has continued to grow, we believe our focus will continue to be more focused on the operating performance on this growth. A lot of initiatives have been undertaken and we would expect these to see a positive impact in our operating income as the year progresses.

Healthcare. That has been a fantastic turnaround story. Healthcare Division, which as you know, had a tough 2007, it's performance has continued to improve from the fourth quarter of last year. Revenues in Q1 were up 17% compared to prior fiscal year - 56.6 million versus 48.2 million - primarily driven by continued strength in Europe, Asia Pacific, and what we have said was a weakness for inpatient monitoring in North America has bounced back now for two quarters in a row.

Cost-cutting initiatives that were undertaken last fiscal year, though very painful, have begun to have an impact on the operating income. We continue to look for additional cost-cutting across the whole group this fiscal year, and expect to continue the positive performance in the first quarter and to continue for the remainder of the year. As we mentioned last time, to go towards long term improvement in manufacturing gross margins, we have set up a factory in China. We think that by the latter part of this fiscal year it will continue to come online and the real impact will be felt in 2009. Our internal target is that in 2009, 2010 we can look at 3 to 4% gross margin improvement in the manufacturing products that we are able to move to China. R&D spending in the group increased this quarter as we looked to accelerate the time to market some of the new programs that we are working on.

Optoelectronics Division. Good bookings quarter to start the fiscal year for our Opto group, led by a $22.1 million order for electronic sub-assemblies for our Optoelectronics Contract Manufacturing Group from a major U.S. defense contractor. This was further followed up after the quarter was over with another award for $14 million. This brings the total bookings from this defense contractor in three phases of $5 million, $22 million, and $14 million. All 22 and 14 million are shippable this fiscal year. Our operating income year-on-year, however, was down for this division, as the product mix changed significantly in this quarter, especially with the losses from the Weapons Simulation group.

As mentioned in the last conference call, our Weapons Simulation business is not a core business. We have identified it. We lost approximately $4.5 million in fiscal 2007. The operating loss for this quarter was approximately 400,000. As mentioned previously, once we have completed the current programs, we will look at strategic alternatives for this business, including the possibility of exiting the business or strategically partnering with somebody or absorbing it into our Optoelectronics business.

Across the board, we have also begun a review of all operations within this segment of our business to decide which businesses are core and which are non-core. In addition, we are aggressively moving production from the U.S. facilities for this division to our Far East manufacturing, which will further improve our operating margin.

With that, I'm going to hand it over to Alan to talk in detail about the financials.

Thank you, Deepak. As I said on the last conference call, as we continue to grow the top line, our Management Team is highly focused on driving operating margin improvement to significantly improve earnings in fiscal 2008 and beyond. I'll speak more about this shortly. But first, let me review the financial results of the first quarter.

For the first quarter, our bottom line markedly improved as we reported a net loss of 2.1 million, or $0.12 per diluted share, compared to a net loss of 6 million, or $0.36 per diluted share for the same period of fiscal '07. Net sales for Q1 increased 13% to 131 million in fiscal '08 from 115.5 million in fiscal '07.

Our Security Division continues to achieve strong top line growth, reporting a 19% increase in sales led by a 69% increase in cargo sales.

Our Healthcare Division followed up with record fourth quarter sales with a 17% year-over-year increase in Q1 sales led by strong patient monitoring and anesthesia equipment sales.

Our Optoelectronics Manufacturing Division third party sales decreased 2% over the prior year, as Q1 last year was particularly strong. In addition, the Opto Division has significantly increased its intercompany manufacturing to accommodate the growth in our Security and Healthcare Divisions.

Sales in the Opto Division are expected to be strong in the second half of fiscal '08, led by our Contract Manufacturing group, for which we have recently announced $36 million in new contracts, as Deepak mentioned.

For the first quarter of '07, our gross margin increased--excuse me--for the first quarter of '08, our gross margin increased to 33.7% from 33.3% in the prior year period. The increase in gross margin was primarily attributable to improvement in our Healthcare Division as a result of economies of scale associated with increased sales, as well as manufacturing cost savings from our restructuring activities initiated last year.

The improvements in the Healthcare gross margin were partially offset by (1) increased Contract Manufacturing revenues in our Opto Division, which generally carry lower gross margins than our other businesses, (2) lower gross margins in commercial optoelectronic products, due to the change in volume, and (3) a change in the product mix in our Security Division with a higher proportion of sales of cargo products, which have to date carried a lower margin than our conventional products.

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 nicely - 3.9% for the first quarter of fiscal '08 - to 27.6% from 31.5% compared to the same period in the prior year. The impact of the cost savings initiatives is materializing and we are able to better leverage our existing infrastructure. As a result, despite a 13% increase in revenues, such costs have decreased in absolute dollars, and therefore significantly declined as a percentage of sales. I'll speak a bit more about our phase two cost rationalization plan later on this call.

R&D expenses for Q1 '08 were 9.7 million, which was a reduction of 1.1 million from that of the prior year. We are making significant investments across different technologies in our Security and Healthcare product offerings. While much of this investment will not impact fiscal '08 revenues, we believe it positions the Company to capitalize on major opportunities in the future, which address large markets. Though R&D expenses were below that of the prior year in the first quarter, we anticipate that such costs for the full fiscal year on an absolute dollar basis will increase slightly over fiscal '07.

Our income tax benefit was 1.1 million, which translates to an effective tax rate for the first quarter of fiscal '08 of 35.1%. Our provision for income taxes is dependent on the mix of income from U.S. and foreign locations due to tax rate differences among various countries, as well as due to the impact of permanent taxable differences.

Moving on to cash flow. As mentioned on each of the conference calls this year, we have placed significant emphasis on generating free cash flow, which proved successful in the second half of fiscal '07 by increasing our inventory turns and reducing our DSO, coupled with the improved operating performance. In the first quarter, net cash used in operations was 3.6 million, representing a $10.1 million improvement as compared to the 13.7 million used in the comparable prior year period, even after a $14 million increase in inventory, primarily in anticipation of heavier shipments in the Security business, which require longer lead times.

Capital expenditures were 2.6 million and depreciation and amortization was 4.5 million. As Deepak mentioned, we are pleased to have ended the quarter with a record high backlog of approximately 224 million led by continued strength in Security with a backlog of 122 million.

Turning to an update on the progress of reducing our cost base, as we mentioned during our past few conference calls, we began a review of our global operations in order to integrate recent acquisitions and to rationalize our cost structure. In fiscal '07, we succeeded in achieving our goal of reducing our cost base at an approximate $17 million annualized run rate. We mentioned that the greatest impact of these changes would be evident in our Healthcare Division as we integrated a recent acquisition of a diagnostic cardiology group, and we believe the Q1 results are quite reflective of this improvement.

Though we are pleased with this achievement in fiscal '08, by no means are we done. We continue to strive to be more efficient and to improve bottom line performance. And in our phase two review we have identified an additional $7 to $8 million of pre-tax annualized savings, inclusive of the $2 to $3 million we announced in September. As we implement these changes, we will report certain restructuring charges, which at this point would be premature to quantify.

Now, let's discuss the Company's fiscal '08 annual earnings guidance and longer range plans. We are introducing our fiscal '08 earnings guidance. We anticipate fiscal '08 diluted EPS of $0.60 to $0.75 per share, excluding the impact of impairment, restructuring, and other one-time charges, or any potential divestitures as we evaluate our portfolio of technologies. We view fiscal '08 as an important transition year for OSI as we transform our financial profile from three consecutive years of losses to a year of meaningful earnings that paves the path for significant near term earnings power.

As we continue to grow the top line, drive operating margin improvement through efficiencies, economies of scale, and cost reductions, we are striving to move from a negative net margin to approximately 5% by fiscal '10, which we believe will generate significant value to our investors.

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. We also at this point continue to reiterate our previous revenue guidance.

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

(OPERATOR INSTRUCTIONS.) Your first question comes from the line of Josh Jabs with Roth Capital. Please proceed.

Hey. Good morning, guys.

Good morning.

You mentioned the 7 to 8 million in cost savings that you're targeting over the next year. I know this is 5 million in addition to the 2 to 3 million that you had previously announced. The timing--you kind of mentioned that the 7 to 8 million in total is going to be a 12-month target. Is there any change in that 2 to 3 million coming out by the end of this calendar year?

Hey, Josh. This is Alan. The 2 to 3 million in the first half of our fiscal year, or as you mentioned, in this calendar year, it continues to be on track. The additional 5 million is more long term in nature, as it includes certain closure of different facilities, including certain international locations, which require a longer lead time. So we would anticipate that the majority of the incremental 5 million is going to be done really in the second half of this fiscal year continuing slightly into next year.

Okay. But no change to the 2 to 3 million coming out?

That's correct.

All right. And then, backlog--you mentioned the backlog. As of September 30, you've had a few fairly big announcements since that time. Given what appears to be a pretty obvious impact on revenues this year, how should we be thinking about the drawdown from the backlog? Typically, you've had seasonality in the December quarter--seemingly strong December quarter followed by a little softness in the March quarter. Is that going to be kind of smoothed out this year?

Yes, Josh, we really do anticipate seeing a sort of a smoother stream of both revenues and earnings than we've experienced in the past. As you know, Q2 and Q4 have typically been our strongest quarters with a little downturn in Q1 and Q3 from a seasonality factor. The way the backlog is shaping up, we would anticipate that we're going to see a ramp up in our earnings as we move through Q2--through Q4 and through--through Q3 and Q4. And we would anticipate that the revenues in the weighted backlog is going to play out. We'll be strong in Q2, but not without necessarily the drop off that we've seen in the past in Q3. We think it will be a closer more comparable number as we move forward.

Just to add onto it, Josh--it's Deepak here--that Alan is absolutely right. On top of that, keep in mind that Healthcare definitely has a seasonality of Q2. So as you add those two things together, Q2 would be strong--frankly, it would be still the strongest quarter. But we won't see the dip back down in Q3, and Q4, obviously, the other strong quarter. But on top of that keep in mind that Security still has the lumpiness issue that things might move from one quarter to the other, but at this stage we have the best visibility that we have ever had in the history of the Company.

Okay. I guess that goes back to the real question here and that you have some big Security orders sitting there. Should we be--looking at those as more likely - if we want to be conservative - more likely March quarter versus December quarter?

I think it's fair to say that, yes.

Okay. And then, finally, R&D was actually down pretty significantly versus our expectations in the quarter. Anything one-time in nature there? Should we expect that number to come back up?

Yes. We would--we had some--we would expect for the full year that it will be greater on an absolute dollar basis than it was last year. So though it was a little bit lighter in this particular quarter, we think that number will ramp back up as we're aggressively moving through some of our programs the remainder of the year.

Well, just to add on to what Alan was saying, the reason it was down was just timing, some of the (inaudible) being filled out, both in the Security development and especially in the Healthcare are just timing issues. But as Alan mentioned, we have said it on every conference call, that 2008 R&D in absolute dollars would be higher than 2007.

Okay, great. Thanks, guys.

Your next question comes from the line of Tim Quillin with Stephens, Inc. Please proceed.

Good morning.

Good morning.

You mentioned that the Security and I think in particular large cargo shipments might come more in the third quarter. How about the $36 million in components for bomb jammers? How will that be shipped over the next couple of quarters?

We anticipate we'll see a certain level of shipments in Q2, but we'll see a much higher proportion of that order in Q3 and continuing into Q4 as well.

Okay. With regards to gross margin--so there was a nice bounce back in the Healthcare business, but gross margin stayed relatively static and Security profits still aren't there. How does that--how does the Security business progress to profitability over the next couple years to get you to your 5% overall net margin target in fiscal '10?

Tim, this is Deepak here. Basically, the way you should look at it, that one is obviously the consolidated margin is going to be driven because of the heavy shipments from the Optoelectronics group of contract manufacturing for this jamming subcomponent that we ship, which inherently has low margins somewhere in the low teens, so that the consolidated margin might get affected. But when you look at the Security business as a whole, cargo, as you know inherently has lower margin compared to the rest of the business, so as those shipments bump up it could have some impact on the gross margin, but some of these things of what Alan mentioned, the $5 million additional cost reduction we are looking at, it's Company-wide and this time it is being focused a little more carefully into the Security group. So hopefully, that should have some impact on profitability and gross margin enhancement.

Alan, do you want to add something?

Yes, I think Deepak's exactly right. In order to hit our target, I think the way we will see operating margin improvement within our Security Division will be from a few areas. One will be some economies of scale; two will clearly be some cost reductions that we are carrying out; three will be some improved manufacturing efficiencies; and some focus on the supply chain. So I think those areas, coupled with leveraging the existing infrastructure, are going to lead to a nice turnaround within the Security division.

Okay. What was--did you have these numbers in front of you - the revenue from large cargo systems in the quarter? I think you said it was up 69%. And then, what of the $122 million of Security backlog, what portion of that is large cargo?

Well, we tend not to try to breakout the revenues specifically. We have backlog. And backlog at September 30 for cargo was 63 million.

63 million, okay. And the $5 million of additional cost savings, what exactly is that?

It's a combination of a number of factors. It includes additional rationalization of the work force, rationalization of facilities, and other overhead items as well.

Okay.

Tim, just to--because you have been driving that on every conference call. I just want to emphasize what Alan said. All items up to $5 million have actually been identified, so it's a real number.

Okay. And in terms of trying to model--I mean, there's a lot of things happening, obviously, in terms of your mix of revenue and some big shipments that will go through over the next couple quarters. So you're not giving quarterly--specific quarterly EPS guidance yet, but it sounds like kind of based on what you're saying on a ramp up from 2Q--or 2Q to 3Q, 3Q to 4Q, that we could have relatively low EPS in 2Q. I guess, how should I think about 2Q earnings?

Well, while we are only providing annual guidance, we would say that we do continue to expect that we will have a significant improvement in the reported EPS for Q2 of '08, compared to Q2 of '07.

Just to add on to what Alan was saying, that if the first thing that we said was that the additional savings are going to take some time to mature because of some of the international organizations involved, it's a fair statement that the bigger impact of that would be felt relative to Q2 into Q3 and Q4. And the bomb jamming shipment that Alan mentioned is more skewed towards Q3 and Q4.

Okay. And I guess more specifically, I think on the last conference call, Deepak, you said that Q2 could approach the levels that we saw in 4Q of '07, which is around $0.24. So maybe now we're looking at a slightly lower number.

I think so. I think a lot depends upon some of the revenue to happen, and as you know, with the holiday period into it and revenue recognition issues. I think if you also remember the same conference call we said that we would feel more comfortable in giving specific guidance in this conference call because there are a lot of moving pieces, which is why we came out this time and Alan gave a yearly guidance. My feeling is that in the old days Q1 used the be the weakest, Q2 was the strongest, and then you would get into some Q3 weaker, Q4 stronger. With the backlog the way it is, we feel more comfortable that you guys should model towards Q2, Q3, Q4 with less dip in Q3 than historically has been there.

Okay. And Alan, what kind of tax rate should we be modeling for the rest of the year?

We believe that it's going to be in the mid-30s. We projected about 35% for the year, which is reflected in the Q1 effective tax rate. That as you know historically at OSI can move around a bit, depending upon the mix of income and other items. But I think if you go with the mid-30s, that's our best estimate at this point in time.

Okay, thank you.

Your next question comes from the line of Josephine Millward with Stanford Group. Please proceed.

Good morning.

Good morning.

Hi. Can you tell us what bookings were for the quarter?

Well, one way to look at it, what the backlog of the Company was in the last conference call, look at the backlog now and the shipments, and that should give some indication of what the bookings were.

Right, I can figure that out. Thank you. I was just hoping you would confirm that. I wanted to go back to the issue of profitability in Security. Now, Security revenue has been very strong and you've seen a healthy ramp in cargo. I understand the conventional X-ray portion of this business is relatively profitable and cargo has been an issue. And we have seen a very healthy growth in cargo. I'm just trying to figure out why this is still incurring losses and how we're going to get to profitability.

Well, let me start out by saying to your first statement, definitely relatively cargo has lower gross margins than the conventional business, but conventional business also has different mixes in it in that product line. But primarily, the way we want you to model it, remember that data--it's a significant amount of R&D being spent, especially in the real-time tomography product line, which has no contribution to revenue for the next couple of years.

Can you give us a sense of how much R&D you are spending on Security?

I can't give you how much for competitive reasons, but we can give you an idea. In 2008, the Security R&D as a whole is approximately half of what the total R&D of the Company is, which is about $50 million.

So relatively compared to any other company in the space, we are spending a lot of money in R&D for the future. As Alan mentioned in his commentary, that we are spending this towards 2009, 2010. But at the same time, we continue to look at initiatives and I, of course, answered to Tim's question about the $5 million more that we have identified, the majority of that this time is identified in the Security growth. Just for the specific thing that you are asking, we want--now we have the backlog, we have repeat production orders in our product line, and we are emphasizing and focusing the management of that growth towards supply chain and rationalizing the cost structure in all aspects of Security.

Deepak, I understand why you are so focused on developing a computer tomography technology. However, is the TSA actually evaluating your CT technology? Because they're currently evaluating next generation CT machines by your competitor. Do you know if they have started to evaluate your system?

Number one, I'm not going to comment on where we stand with TSA for competitive reasons. We do know that TSA is looking at next generation technology. From all indications that we have--and it's only our views--we are quite ahead in the concept that we have chosen. There is no product that we know of--and we've said in the last conference calls--that we know of that with high speed certifiable that anybody's in the same arena as we are talking about. That's why we are so excited about it. And we are--we don't want to talk about the stage at which we are. Let's just say that we are more confident now than we were a year ago, than six months ago. And that's the reason and the rationalization of increasing the R&D spend on this project.

Okay. Now, in terms of cargo, my understanding was that once you reached the $40, $45 million annual run rate, that that's a breakeven annual run rate for your cargo business. Is that correct or--and do you--are you currently breaking even in cargo, based on the existing volume?

Again, I--for competitive reason, we won't tell you the detail, because there's a lot of overlap. But we can say that we are very happy with the progress that cargo has made and definitely we can at least say that in the quarter cargo was not a negative contributor.

Okay, that's fine. Can you give us an update on the L3 issue, whether--I think the last time we spoke you were expecting a court hearing in November. Is that still on track? And what can we expect next?

I'm going to let the General Counsel handle that. Victor?

Yes. Hi, Josephine.

Hi, Victor.

Hi. The status of L3 is that all briefing has been completed and we're awaiting a hearing date for oral arguments and haven't gotten it yet. Given the timing, I'm not sure when that's going to be--whether that will be in November or not. There's always questions about settlement, and as you can appreciate, that is a confidential topic. But suffice it to say that on [reasonable] terms we feel that it's always wiser to settle a case rather than continue for the litigation.

Do you think we'll have a hearing date before the end of the year?

Yes, that's really up to the court.

Okay.

I would hope so, but that's really up to the court.

Thank you, Victor. I'll let somebody get in. Thank you very much.

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

Yes, thank you very much. Nice guidance. The 5% net after-tax in '10--2010, that's for the entire year, is that right Alan?

Yes, that is what our target is.

Okay. And where do you think that you can get to eventually with this business?

Well, we think we can get north of 5% clearly. We're a little reticent at this early stage of going through all the changes to give longer term projections than that. But we're pretty optimistic about the real earnings power inherent in this model as we're able to leverage the infrastructure, the operating expense line items, grow the top line, have some gross margin improvement, not to mention particularly big cash inflows and other things that can come in that can change that picture. So while it's a little bit early to say where we go past that, I think suffice it to say, we do believe we can get north of that.

Brian, just to add on to Alan, keep in mind that there are three segments of the business. And though we are looking at the consolidation, we have an active program for the last 12 to 14 months of looking at all aspects as it relates to each segment. And we don't want to--the reason why Alan and I are saying difficult to talk about long term beyond 2010 is because there is also rationalization that is being done in the business of what belongs in the company.

Okay. What other cuts need to be made--magnitude? Do you see another 5 million coming down between now and the next 12 to 24 months, or how big of cuts do you see happening in order to get to that 5% goal?

Yes, I think, Brian, we'll continue to announce them as we identify them and move forward. Last year, 17 million, and this year, we've announced like 7 to 8 million. It's going to be an ongoing process. And I think we can continue to become more efficient and leaner throughout the organization. And we'll certainly keep you abreast as the progress develops.

Just to add on to that is--Brian, this is an iterated long--it's an ongoing thing. It's like guessing in the future what kind of business we're going to get. So we look at it and there is a constant review process with the divisions and corporate to be looking at ways to become more efficient, what can be combined, what kind of hand is going to be dealt, and what kind of future products we're going after. So it's not that we have like fixed bogies to hit. This is an ongoing iterated program supported wholeheartedly from top to bottom.

Okay. And then, the other question is do you have to wait until you get to that 5% before you potentially divide up the company, or has there been talk about increasing shareholder value by dividing the company into maybe a pure play security division or a pure play healthcare before that time?

You already know my answer. I can't tell you anything. We continue to review all alternatives.

Okay. And then, last question is the profitability of the backlog now versus the profitability last year. Is it dramatically up? And can you--if it is, then can you give me some kind of parameters to say how much more profitable this year's backlog is versus last year's?

Yes, Brian, it's Alan. While I can't quantify how much more, I can tell you with quite a lot of confidence that the profitability in the backlog is indeed stronger now than it was at this point last year.

But just to also add on to it, as you look at the cost cutting going across the Company, the profitability changes. So to (inaudible) pick a number, we don't analyze the profitability of the backlog a year ago or now. We look at a cost structure that we need and can rationalize with the backlog we have and what we are expecting to book more and the product mix. So I'm back again to it's that all focus--though we are not ignoring the top line, all focus is to continue to increase the profitability of the Company.

Great. Thank you very much.

And your next question comes as a follow up from Jeff Rosenberg with William Blair and Company. Please proceed.

I just wanted to ask you, Deepak, on the contract manufacturing ramp that you're expecting, can you talk a little bit strategically about what attracted you to this particular opportunity of growing it as much as you have relative to experiences you've had in the past with contract manufacturing type sub-assembly--electronic sub-assembly business that was lower margin? And it seems like you've been in and out of that business periodically over the years, and maybe a little color there as to what drew you to be in this one.

Well, number one, we have not been in and out of the business. We've always been in that business. Keep in mind that the reason we have contract manufacturing to begin with, it has large strategic reasons--manufacturer of intercompany products especially if they are for (inaudible) or their delivery times are accelerated or (inaudible) the divisions back and forth. If you look at the elimination, the intercompany revenue from this group continues to increase as the Security and the Healthcare revenues go up. So we've always been in this business.

Now, what happens is that as we go have the intercompany as the focus, we're also looking at external revenue. And since we have the factory--factories to be exact, we took on more business and we continue to look at selectively what businesses we want to look at. Definitely, they are lower gross margin, Jeff. But as you know, they also have a relatively low SG&A R&D kind of expenses below [line], so that if--your gross margin is still low. And if you notice the last couple of years in the segmentation results, the Optoelectronics group, which contract manufacturing is part of it, has been very healthy in profitability. Although it's down now because of Defense Systems, which we are addressing it as we wind down the programs.

But it's a business that is very much integrated into the support of the two main businesses that we have. And it gives us a tremendous amount of flexibility. Like we say in our conference calls, that in the Healthcare group, the quarter is not over until the quarter is over. That means that--don't take me literally to it, but if we booked the business at 11:00 p.m., one hour before the quarter is over, we can ship the product out. And that's because of some of the flexibility we have in the supply chain, including the integration and cooperation between the contract manufacturing group of the business and the main users of Security and Healthcare.

Okay. All right. Thanks for the color.

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

Matthew McKay. Great. Good morning, guys.

Good morning.

Just a couple follow up questions first of all. Just to be perfectly clear, the 5% net margin in fiscal 2010, does that assume any divestitures or is it the business as a whole right now?

No, Matt. This is Alan. That is the business as a whole right now. Any divestitures could certainly impact that number. Absolutely.

Okay, great. And then, just on looking at the gross margin in the second fiscal quarter, just kind of high level, do you expect that to grow or improve on a year over year basis?

We would anticipate that we will see some margin improvement on a year-over-year basis. Yes.

At the gross margin level?

Yes.

Okay. And then, given the Healthcare business had pretty strong growth--revenue growth this quarter, on the last conference call you said that you expected that business to grow overall for the year around 5%. Should we expect the Healthcares business to be flat top line for the next couple quarters? Or is it going to grow it to greater than 5% for the full year?

We do anticipate it growing at a great than 5% rate for the whole year. We haven't broken it down necessarily by each of our divisions. But we would anticipate Healthcare will grow at a faster clip than 5%.

Okay. And then, on the Optoelectronics side, given the recent awards that you have received, again, in the last conference call, I think you said 5% top line growth for Optoelectronics. It sounds like you're getting a little bit more bullish in that segment, at least on top line growth. Is that one also going to grow at greater than 5% now?

We would anticipate that Opto will grow at a faster rate than that as well, yes.

Okay. Which then kind of raises the question here--the last piece is Security business. Backlog improved quite a bit in that business year over year. It seems like you still remain quite bullish on it. Any reason why you're just keeping guidance where you're keeping it as opposed to relative to what you said prior?

Well, as we go through all the changes in the Company and are driving significant improvement, we think it appropriate at this point to reaffirm the guidance, though as you point out, we've certainly had some nice bookings over the recent past couple of months.

Okay, thanks.

Just to add on to it is bookings are good. We are looking at it. But keep in mind, especially in Security, there is always that concern of revenue recognition and lumpiness from one quarter to the other. So we are holding our top line revenue guidance, being a conservative company.

Okay, fair enough. And then, just lastly, on the cost savings with the $5 million, where--you've talked about rationalizing facilities and headcount. But I'm curious to sort of hear where the focus is in terms of which business segment. Last year, it was primarily Healthcare. Are you still focused primarily in Healthcare or have you moved on to Security or Optoelectronics? Just a little bit more color on that would be helpful.

Yes. I would say the greater focus for this year is going to be on Security, and then it will include Opto as well, although I'd also say we're also looking at Healthcare. But I'd say the greatest focus at this moment lies in our Security division in order to improve the financial profile of this division.

Yes. And is that primarily just improving the efficiencies of the business, or is there some back office systems that you can rationalize as well?

It's certainly across the board. It really goes across all sectors.

Okay, great. Thanks a lot, guys.

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

All of my questions have been answered. Thank you.

Okay. Your next question comes from the line of Tim Quillin with Stephens, Inc. Please proceed.

Yes, just a few more questions. But on the gross margin side--and Deepak, I think you touched on this a little bit on the last call. But some of this--your gross margin targets eventually in 2010 are going to depend on mix, I understand. But what kind of gross margin would you be looking at in 2010, and kind of a rough gross margin by segment, where you would be targeting?

Well, I think that if you talk about a target, I think to get to 5% net target in 2010, you can just look at it--if your gross margin (inaudible) approaching close to 39, 40%, but then with that you've got to look at if there's any divestitures that happened depending on how the various businesses grow. But all in all, if we succeed and we 100% hope we will, that China comes online and we are able to move a lot of product from the U.S. and U.K. to China in the Healthcare, that means--we've already said that--that we're looking for 3 to 4% target for gross margin improvement in Healthcare. We look at Security, as cargo comes on, it definitely and historically has lower gross margin, but we are addressing, as Alan has said, looking at the supply chain. Look at the way we do business. And we as look at that area, I think we can improve and we are going to continue to improve the gross margins.

Contract Manufacturing Optoelectronics is a little different animal. We have good margins in our base business for (inaudible), but contract manufacturing generally in sub-assembly - [PC] bolts and stuff like that - have low teens margin. Depending upon where the total mix comes into it, it can have--continue to have an impact on the gross margin side. But I will emphasize that at a certain point the gross margin in various divisions are not directly related that you can look at what's going to get to the bottom line, because even if you make in low teens in the Optoelectronics, it doesn't have the same baggage of SG&A and R&D compared to the other growth. So that you can still go down and get to that--Alan's target that we are talking about of 5% net in 2010.

So you've got to look at this as very complicated though simple. Each division has different requirements. Each division--supply chain is very important. Manufacturing is important. So is R&D. So is (inaudible).

I don't know if you have this in front of you, but do you have a breakdown of Optoelectronics between contract manufacturing and sensors and value-added systems?

We do certainly have that breakdown, Tim, but we don't break down on a public basis any segment within Optoelectronics.

Okay. And then, on the Opto business, with this $36 million order that you're going to be shipping this year, should we think of that as a business that will be down in fiscal '09, or is there some way you can avoid negative comparisons next fiscal year?

It's too early. There might be follow-on, there might be similar products into it. Keep in mind, we are also looking at some core and non-core businesses in the Optoelectronics group. Definitely Defense Simulation, which can have an impact on the top line, too, depending on what we do.

Okay. And SG&A, do you expect that now to be flat or down with '07--versus '07?

Yes, we're--Tim, we're giving just overall bottom line EPS guidance. We're not going to be giving it on a particular line item basis.

Okay, fair enough. And then, lastly, where is your ownership stake in space labs right now? Thank you.

We repurchased a few more shares during the first quarter and we currently own 84%.

Thanks.

Your next question comes from the line of Josephine Millward with Stanford Group. Please proceed.

Hi. Alan, can you just give us a sense of what kind of restructuring and impairment charges we might see this coming year?

Yes. Hi, Josephine. As I mentioned in sort of the opening remarks, at this point as we're moving forward it's a bit early to quantify what those restructuring charges will in fact be. But we'll give you more information as we move forward throughout the process.

At this time there are no more questions and I would like to turn the call over to Mr. Deepak Chopra, CEO. Please proceed.

Thank you very much for attending this conference call. I want to emphasize that 2007 definitely was a very challenging year. 2008 is a year we are focused into building the Company towards 2009, 2010. We definitely have it in our blood. [What] people need to understand is that we have revenue, we have backlog, we now have the ability--and also have this ability to look at long term view of the Company. Cost cutting is going to happen. We are addressing each and every item in the Company. There are no sacred cows.

And I want to emphasize that with each quarter we are building towards a better way to report and this is the first step up for many years that the Company has given a full year guidance in EPS, which most of you were crying for. We hope to continue to educate you more on the business segments. We want to look at our core and non-core businesses. Both Security and Healthcare are very important to us. And we will continue to leverage wherever we can.

With that, I thank you very much.

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