OSI Systems Inc (OSIS) 2008 Q2 法說會逐字稿

Good day, ladies and gentlemen and welcome to the second quarter 2008 OSI Systems earnings conference call. My name is Dan and I'll be your coordinator for today. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session toward the end of this conference. (OPERATOR INSTRUCTIONS). As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today's call, Mr. Alan Edrick, Chief Financial Officer. Please proceed.

Good morning. And thank you for joining us. I'm Alan Edrick, CFO of OSI Systems. I'm here today with Deepak Chopra, our President and CEO, Ajay Mehra, President of our Security Division, Rapiscan Systems, Victor Sze, our General Counsel, and Jeremy Norton, our VP of Investor Relations. Welcome to the OSI Systems fiscal 2008 second 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. During today's conference call, we may refer to both GAAP and non-GAAP financial measures of the company's operating and financial results. For a complete information regarding non-GAAP measures, the most directly comparable GAAP measures and a quantitative reconciliation of those figures, please refer to today's press release, with our second quarter results. The press release will also be filed with the SEC as part of the form 8-K.

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 fort 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 overwise.

With that disclaimer out of the way, and before turning the call over to Deepak, I'll provide a high level overview of recent accomplishments. As we have discussed on each of our conference calls over the past year, we have placed a major emphasis on improving our financial results and we are pleased with the rapid progress we are making. Our second quarter financial results demonstrated significant improvement over the same period last year and provide added evidence that the significant changes we made in fiscal 2007 and are continuing to build upon in fiscal 2008 are leading to an improved bottom line performance. Q2 highlights are as follows.

First, we reported a 19% increase in sales, led by a strong top line across all divisions but particularly in Security, which grew 44%. Second, the changes we have made throughout the organization are clearly paying off as our operating income, excluding impairment, restructuring and other charges, increased by approximately $8 million over the same period a year ago, highlighted by our improvement in the Healthcare Division, where we turned an operating loss of $1.3 million in Q2 last year to operating income of $6.4 million in Q2 of '08. Third, the combination of increased sales coupled with our reduced cost structure led to earnings per share of $0.20 or approximately $0.27 without impairment, restructuring, and other charges, representing a $0.30 per share improvement in our normalized EPS for Q2 of '08 compared to the prior year period.

Fourth, following up on last year's successful cost rationalizations efforts, we continue these activities and we are on track to implement the previously announced $8 million of additional savings. Fifth, we completed the buyback of the remaining minority interest of our Healthcare Division, which was trading on the AIM market of the London Stock Exchange. In so doing, we eliminated duplicative company costs and the minority interest impact on the P&L associated with our Healthcare Division. Finally, although we had record sales in Q2, we ended the quarter with a record backlog as bookings continued to be strong, providing good visibility for the remainder of the year.

We still have many challenges ahead of us as we continue to demonstrate improvement in our net margin, but we believe we are well situated to capitalize on our plan for both near term and long-term earnings growth. 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 second quarter fiscal 2008 earnings 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. Quickly, giving you a brief financial overview highlights, improved operating performance in the second quarter with revenues up $164.2 million, an increase of $26.7 million or 19% from $137.5 million reported in the second quarter of the previous fiscal year. The company reported net income of $3.5 million, or $0.20 per diluted share, compared to a net loss of $20.6 million or $1.23 per share in the second quarter of the previous fiscal year. Excluding the impact of impairment, restructuring and other charges of $2.1 million, the company's net income was $4.9 million or $0.27 per diluted share. As mentioned by Alan, backlog at the end of the second quarter increased by approximately $8 million to a record $232 million from $224 million as of September 30th, 2007, an increase of approximately 4%.

Going into the business segments, Security. This quarter, our Security Division again reported very strong revenue growth. Revenues for the quarter increased by approximately 44%, to $63.9 million, compared to $44.4 million for the second quarter of our previous fiscal year, driven primarily by increased cargo shipments. As mentioned previously, we continue to look at improving our operating efficiencies globally within the Security Division, and to that end, in the second quarter, we made a number of organizational changes, including the consolidation of facilities and associated rationalization of headcount. We expect these changes will have a positive impact on the division going forward. Alan will touch on it in his detailed financial analysis. The majority of the impairment charge in this quarter was attributed to us looking at rationalization in the Security segment of our business.

During this quarter, our product development and engineering skills were showcased with the introduction of the Rapiscan and VXI, the new multi-view x-ray system, which is designed to expedite the inspection process of passengers' carry-on baggage at aviation checkpoints, which as all traveling public know is a big problem and we are very excited about the advantages of this machine. The product expands our portfolio of advanced x-ray systems for baggage and parcel inspection, an area of business which has been our core business for a number of years. In the first half of this fiscal year, we have announced two major contract wins for our new advanced multi-view x-ray systems for the baggage and parcel inspection area.

Firstly, in October, we announced receipt of $9.3 million contract from TSA for the Advanced Technology Program for our Rapiscan 620AT. We split this contract award 50/50 in quantity with Smiths and then in December we announced the receipt of a $5 million order from an international customer for multiple quantities of our new Rapiscan MVXI systems. These two systems we believe are the state-of-the-art and enhances the inspection process at a checkpoint.

The cargo business was again a strong performer this quarter, with record shipments. This is an area of the business that we expect will continue to be one of the fastest growing product segments within the Security Division. We do caution everybody that this business definitely is lumpy and will have bits and pieces sometimes higher shipments and then some quiet period and higher shipments again. Partition levels, both domestically and internationally, continue to grow to meet increased demand, especially in the cargo product line. This quarter we opened a new manufacturing facility in North Carolina. The facility primarily focused on the manufacture of our cargo, high energy x-ray systems, is expected to begin production towards the end of the fiscal year.

While sales continue to grow, we remain committed to the development of our new high speed inline certifiable solid state CT system for the inspection of checked baggage. To date, we are happy with our progress and are on track to begin showcasing the product in fiscal 2009. This product holds tremendous growth potential for Rapiscan while also rounding out our scanning portfolio to be the broadest in this industry. To summarize the changes that are taking place in the Security group and our continued effort to look at the bottom line, just to give an idea on the revenue of $63.8 million in the segment, the operating income before the impairment charges was about 4.3%.

Healthcare. I'm extremely pleased with the performance of our Healthcare Division in the second quarter of fiscal 2008. We achieved an operating margin in this division of approximately 9%, highlighting the positive impact of the changes initiated in fiscal 2007. Alan mentioned to you before, 2007 was a very challenging year for us. We embarked on a lot of initiatives, took down lot of costs, integrated the new acquisition that we bought in U.K., looked at consolidation of the facilities and we're very proud that the management of that group has done a tremendous job in achieving some of the targets we had set inside ourselves.

In December, we also completed the repurchase of the minority interest in this business, which was previously listed on the London stock exchange in October 2005. The repurchase is expected to be beneficial to the business, allowing management to focus on the operational side of the business, rather than being distracted with demands of managing a publicly listed company in the U.K. Additionally, the transaction is expected to be accretive to the overall financial performance of the company, as we have now eliminated the minority interest and duplicative public company expenses associated with the business. The growth in this revenue was primarily driven by continued strength in the patient monitoring North America, but we are very happy to report that not only North America, but Europe and Asia-Pacific all showed growth to the top line and continued improvement to the gross margin.

We remain on track to open our new 40,000 square foot facility in China this quarter. Initially, the facility will manufacture a portion of our anesthesia systems, which were previously manufactured in the U.K., along with our low acuity patient monitoring product line, which is primarily targeted at the daycare surgery centers and emerging markets. We believe that once the facility is fully operational, it should further improve gross margins for the Healthcare Division. Our internal analysis is that most of the consolidation and the layoffs and reorganizations in the Healthcare segment is done. It's behind us.

Our next challenge that we have embarked upon is to improve the manufacturing gross margin by moving the product from both U.K. and U.S. to China and to introduce a whole line of new patient monitoring product lines, geared up both at the low end for the emerging markets and on the high end for connectivity at hospitals. On that end, we remain committed to R&D within this division. Our R&D has gone up, as we have said before, and as we look to accelerate the time to market for a number of key projects that we are working on. 2008, late, second half of this year, and 2009 is going to be a very exciting time for our Healthcare Division with the launch of many new products.

Optoelectronic Division. The Opto Division showed strong bookings in the second quarter. Year-to-date, our Opto group has been positively impacted by large contract wins for electronic subassemblies from a large defense contractor. Subsequent to the completion of the second quarter, we announced a further $5.8 million order for electronic subassemblies from the same defense contractor. This brings the total bookings for this program to approximately $47 million over the past three quarters.

As mentioned in the last conference call, our weapons simulation business, which we have identified is not a core business going forward. In the second quarter, the business incurred an operating loss of $200,000 after losing approximately $400,000 in the first quarter of the fiscal year. Though this group continues to lose, we monitor it very carefully and the losses are coming down. Once we have completed the current programs that we are currently contracted for, we will look at strategic alternatives for this business, including the possibility of exiting the business or strategically partnering with a third party. We have mentioned earlier, we will definitely put this behind us before this fiscal year ends in June. In conclusion, all three business divisions are robust and continue to grow as evidenced by our record revenues and backlog announced today.

The backlog provides management with tremendous visibility into managing our company. We remain steadfast to our commitment to improve the bottom line and while we are seeing the positive impact of our efforts already, we expect that the significant impact of these initiatives we have started will be evident in fiscal 2009. With that, I'm going to hand it over to Alan to talk in detail about the financials before opening it up to questions.

Thank you, Deepak. Consistent with the message on the last conference call, our management team remains 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 second quarter. As Deepak mentioned, our bottom line markedly improved as we reported net income of $3.5 million or $0.20 per diluted share, compared to a net loss of $20.6 million or the loss of $1.23 per diluted share for the same period of fiscal '07. Excluding the impact of the reported impairment, restructuring and other charges, net income for the second quarter of fiscal '08 would have been approximately $4.9 million or $0.27 per diluted share, compared to an approximate net loss of $0.5 million or $0.03 per diluted share for the comparable quarter of fiscal '07.

Net sales for the quarter increased 19% to $164 million in fiscal '08 from $137.5 million in fiscal '07. As mentioned previously on a divisional basis, our security group continues to achieve strong top line growth, reporting a 44% increase in sales, led by a nearly three-fold increase in cargo sales. Our Healthcare Division reported its third consecutive strong quarter with record sales of $67.9 million, representing an 8% year-over-year increase led by strong North American patient monitoring sales. Our Optoelectronics and manufacturing division's third party sales increased 7% over the prior year, led by strong contract manufacturing sales as Deepak mentioned. In addition, the Optoelectronics group reported a 33% increase in intercompany sales in support of the growth in both our Healthcare and our Security Divisions. Such sales are eliminated in consolidation but positively impact our gross margin.

For the second quarter of '08, our gross margin was comparable to the prior year, excluding the impact of the prior year inventory writeoff. We realized a nice improvement in our Healthcare Division, as a result of economies of scale associated with increased sales as well as manufacturing cost savings from the substantial restructuring activities initiated in fiscal 2007. These improvements in the Healthcare gross margin were offset by one, increased contract manufacturing revenues in our Opto Division, which generally carry lower gross margins than our other businesses, two, lower gross margins in commercial Optoelectronics products due to a change in volume, and three, a change in the product mix in our Security Division with a higher proportion of sales of cargo products, which generally carry 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. Given the stronger than anticipated revenues in our lower risk contract manufacturing business, which inherently places pressure on our consolidated gross margin, we anticipate that our fiscal year 2008 gross margin will be approximately 35 to 37% of sales.

Moving to operating expenses. Our SG&A expenses as a percentage of sales decreased 4.1% for both the second quarter and for the first half of fiscal '08. For the quarter, SG&A expenses declined to 23.8% from 27.9% of sales, compared to the same period in the prior year. The impact of the cost savings initiatives are clearly materializing and we are able to better leverage our existing infrastructure. As a result, despite a 19% increase in sales, such costs have remained relatively stable in absolute dollars and therefore significantly declined as a percentage of sales.

Research and Development expenses for Q2 of '08 were $11.7 million, which represents an increase of $0.5 million from that of the prior year. We are making significant investments across many 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 on a year-to-date basis, R&D expenses were below that of the prior year, we anticipate that such costs for the full fiscal year on an absolute dollar basis will increase slightly over fiscal '07 but continue to decline as a percentage of revenues. Our income tax provision was $1.7 million, which translates to an effective tax rate for the second quarter of fiscal '08 of 35.2%. 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 to cash flow. During the quarter we invested significantly in inventory in anticipation of large Contract Manufacturing and Security shipments in the second half of the fiscal year, each of which have relatively long production lead times. As a result, net cash used in operations was $10.9 million, capital expenditures were $2.4 million and depreciation and amortization was $5 million. Improving cash flow continues to be a top priority. We are pleased to have ended the quarter as Deepak mentioned with a record high backlog of approximately $232 million. The Security backlog was approximately $110 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 2007, 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 and we believe the first half results clearly demonstrate those. Though we are pleased with our achievements in the first half of fiscal '08, we are by no means done. We continue to strive to be more efficient to improve bottom line performance and in our Phase II review, we have identified an additional $8 million of pretax annualized savings, a portion of which were realized in the first half of fiscal '08. As we implement these changes, we will continue to report certain restructuring charges.

Now let's discuss the company's fiscal 2008 annual guidance. Due to the strength in recent bookings, we are increasing our top line guidance by $10 million to 590 to $605 million in net sales. And given the strength of our first half performance and the positive outlook for the second half, we are tightening our range of earnings per share guidance by increasing both the lower and upper end of the range. As a result, we anticipate fiscal 2008 diluted earnings per share of $0.65 to $0.77, 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. Building long-term shareholder value through increased financial performance is our highest priority. There is no doubt that we have more 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'd like to open the call to questions.

(OPERATOR INSTRUCTIONS).

Your first question comes from the line of Tim Quillin from Stephens, Incorporated, please proceed.

Hey, good morning. Just a few questions. Number one, the Security business, as long as you've reported segment operating income has kind of treaded water near break-even and the restructuring charge sounds like is meant to address gross margins in that segment but do you also need to look at R&D and SG&A and I understand there's kind of some specific R&D you have right now, but what do you need to get to a decent operating margin? How do you define a decent operating margin? And what should we be thinking about for an operating margin target on that business in fiscal '09 and beyond.

This is Deepak here, Tim. The first thing is that definitely first part of your question, the restructuring addressed consolidation margin improvement and we also looked at some of the engineering areas. And we'll continue to look at it. The more important thing is that our R&D expenses are unusually higher compared to what it should be and the reason is that we are developing a whole new product line, the RTD real time Tomography. As you know, we are not in this business today. This is the only segment in the scanning product line that we don't have. And it's a great opportunity, especially with the new budget that President Bush is pushing. We are spending an accelerated R&D in that product line to get to the end goal which we have said is sometime in fiscal 2009.

As you also know, Tim, that that product tends to have a larger and higher gross margin. Cargo tends to have a lower gross margin. So as we go forward, there is two-prong attack of improving the gross margin. One is what we call the product line margin improvement. The second is continue to look at manufacturing efficiencies to increase the gross margin. Where we can target ourselves into it, we still try to work that issue out. This quarter, if you take the impairment out, as I mentioned, we have a 4.3% operating margin. We think that -- can we double that? I think in the future, as the CT product line, as the multi-view check baggage, as the secures, as new products come on line and what I call balance the revenue between cargo and non-cargo, I think we can get there. But it's not going to happen overnight. Alan, do you want to add something?

No, I think you put it very well. I mean, we're definitely looking at efficiencies within the Security group on the manufacturing side. But again, we've said it all along, we're spending a substantial amount on R&D and that number in the foreseeable future has affected us to our operating margins, but I think 2009 and beyond I think it's going to be a positive impact. Maybe Tim, just adding on to that, as you saw in fiscal '07, so much of our focus was on improving the operations of our Healthcare Division and the substantial changes that we made there are really being materialized right now in the numbers. We're really (inaudible) that same level of effort now within the Security Division to improve the operating margins within Security. So we think there's ample opportunity to continue to continue to improve the growth in the operating margins as we go forward.

It sounds like, should we be expecting high single digit operating margins in that business or is that really just kind of an interim step, because I don't think inherently it seems like a low margin or a single digit EBIT margin business. It seems like a business where you have some intellectual property and should be able to get higher margins over time. Is that fair? I mean, how -- where can you get to in two years?

Tim, we would agree with that assessment. Once we get to a steady state following the aggressive Research and Development that Deepak mentioned on the CT program and move back into a more normal state of Research and Development and come out with those new products, we would anticipate there is nice opportunity to move into the double-digit operating margin range.

Okay. Fair.

Just to again emphasize, one thing I think this last $8 million cost reduction target that Alan mentioned, majority of that is geared up into the Security area. We took the impairment charge in this quarter. The impact on the earnings hasn't started yet. So keep in mind that that $8 million in the latter part will annualize into your margin enhancement improvement into the Security group.

That's fair. Thank you. And then on the Opto business, what does the pipeline look like there in terms of backfilling the potential decline in revenue that you might see from the IED jam related sales?

Keep in mind that there are -- that's only one portion of our segment in the Opto business, I mean, the base business continues to grow, which I think we mentioned before, majority of that is in Healthcare and defense electronics related products. That continues to grow. And also, intercompany, I mean, keep in mind, both have a Healthcare and the Security business grows the top line, it automatically pulls in also the intercompany revenue, which eliminated, but margins still in the Opto group.

Okay. And just a couple detail questions. Alan, I missed your details on cash flows, but what was cash from operations? I think I got the D and A, was $5 million. What was CapEx in the quarter?

CapEx was 2.4 million in the quarter or $5 million on a year-to-date basis and cash flow with investment in the inventory we used about $10.9 million in operations.

Can that swing? What's that going to look like in the second half of the year and what -- are you still looking for positive cash flows for the full year?

We think there is a major opportunity that it will swing as the shipments begin to occur, both on the Optoelectronics business, the contract manufacturing, the large order that Deepak referred to, as well as in the Security business. So as the orders begin to ship, we'll see some absolute dollar reductions in inventory. You won't necessarily see that all manifest itself in Q3. I think you'll see that a bit more in Q4, then Q1 of the following fiscal year.

Okay. Very well. And just lastly, what was the backlog of large cargo?

We said it last time also. We -- for competitive reasons, we don't want to break it going forward, cargo, from non-cargo. I think Security backlog is a better way of looking at it. Competitive reasons, we would rather not talk about breaking it down into the cargo versus non-cargo.

Okay. That's fair. And so the Security backlog went down $12 million. Is it fair to say that the decline in backlog is mostly related to the shipments of large cargo?

Well, it's fair to say, because we did say it's very heavy shipments in cargo. You'll see that. Remember, this business is lumpy. You'll book a lot, and then you'll ship a lot. The good news is, we're very excited about it, that with record shipments, the backlog is holding and the activity is -- both domestically and internationally is very good.

Okay. Thank you. Good results. I appreciate that.

Your next question comes from the line of Brian Ruttenbur from Morgan Keegan. Please proceed.

Thank you very much. Great quarter, guys. Litigation update. Tell us what's going on with L3.

Hi, it's Victor Sze. Not much, frankly. We're sort of in a waiting game right now, waiting for a court hearing date from the second circuit when they'll be hearing our oral arguments. The briefing has been completed for a couple of months now, so we're waiting to hear from the court.

Okay. So this is their second appeal, L3's second appeal? Is that right? Or third?

This is actually their first appeal, technically. They did after the jury verdict, they did go back to the trial judge and ask the trial judge to reverse the jury verdict, to set it aside or to reduce it. They were unsuccessful at that stage. As you'll recall at that point the jury verdict was $125 million in our favor. They were unsuccessful in getting that set aside or reduced and they've now appealed the case to the second circuit.

Okay. So how long can the second circuit sit on this?

It's a very good question. I'm sure that they're extremely busy and very hard working judges and they'll get to it as soon as they can.

Okay. I mean, is this something that could drag on for years that they could sit on it or will it be heard within months, be decided, excuse me, within months?

I would think that it's within months.

Thank you. The next question is charges going forward, I think Alan you mentioned that there's potentially more charges as you find more potential fat to cut, that there could be additional charges; is that correct?

That is correct. Not just that. With some of the areas that we already identified, particularly in certain foreign locations with notification periods there will be charges that occur in Q3 and Q4.

Should we think of them in similar sizes to what happened in Q2?

I would think that for the second half of the fiscal year, it would be a similar size in total to what we saw in Q2.

Okay. Very good. And then the next question I have is on the Opto Division, you mentioned that you're going to get rid of the defense division one way or the other by June. Does that mean -- well, I won't even get into that. What I really want to know, is there any other divisions that you're looking at getting rid of?

We continue to look at across the board. Obviously, we are not going to talk about it before it's done. But let's just say that every non-core business, we are looking and addressing. All of them might not result into a restructuring charge. Some of them might get absorbed into other groups and divisions. This is a evolving process, Brian. We've been into it for about a year now and we continue to look at it.

The last question is about backlog. Seasonally at least historically you've had a dip in the December periods or somewhere around there, because you usually have a wave of awards late fall and then there's a dip, kind of a low period, at the end of the year, beginning of year, calendar year. Do you see that seasonality continuing? It's not showing up in your backlogs, which is very good. Maybe there's just no seasonality right now, maybe you can talk a little bit about that.

Well, generally speaking, because of the broad product line, the three segments together we've had a very good Opto bookings. We've had very good -- medical has been very good. If you remember, that is like inventory turns business, we book and ship. It's been very good. Security has been very, very strong. But you're right that late December and January and especially with the continuing resolution, Ajay, you want to comment on it?

Security, traditionally our June to September quarter tends to be the strongest, especially because a lot of the government orders, year end money is coming in there. Obviously last quarter we had some continuing resolutions which slowed things down but still internationally and otherwise we're seeing a lot of activity. So yes, there is always going to be some strength because of the way the U.S. orders are structured, but hopefully we can account for and offset some of that with what we're doing internationally.

That seems to be the big question and that seems to be stable is the Security side of the backlog. Going forward we should expect backlogs to be held around this level, give or take 5 or 10 million or 20 million or either side? Is that what you anticipate?

Well, I think, as long as you don't put your range into it, I think the backlog should maintain in that. But keep in mind, you know the best out of everybody, cargo will remain in backlog for some time and then there is a shipment out and you can't balance it and then you'll get some more backlog. It will come in waves. So we've had a record revenue going out of the door in the December quarter, especially cargo. We've said that. So $12 million down, it's a good assumption that most of that will be in cargo because we made some heavy shipments. On the other hand, we don't announce every order we book for competitive reasons. So we are very, very excited about the visibility and the continued strength in the backlog in all segments.

Okay. Thank you very much. Good quarter.

Your next question comes from the line of Jeff Rosenberg from William Blair & Company. Please proceed.

Good morning. Alan, what you were saying about gross margins, you made some cautious comments as it relates to how the growth in Opto will affect the electronics assembly there. It seems, having said that, your gross margin assumption for the second half would be flat to up from what you did in the second quarter. Could you elaborate a little bit on the effects of the change in mix with more electronic assembly but less cargo and where that net, net leaves you on the gross margin.

We think on a net net basis our gross margins will be somewhere between 35 and 37%. With the $40 million - plus of revenues associated in our Contract Manufacturing business, much of which will be flowing through Q3 and Q4 which inherently has a lower gross margin, so doesn't have much operating expenses to it so it has a high contribution margin, that lower gross margin will partially offset from a consolidated basis the improvements that we are seeing in our Healthcare gross margin which was evident in the first half of the year and we expect will continue to be evident in the second half of the year, as well as the improvements we're going to be seeing in the Security gross margin from any of the changes that we are making. We think that with those heavy Contract Manufacturing shipments it will adversely affect the gross margin to some extent though very much positively contribute to the bottom line.

Just to add --

sorry. Go ahead.

Just to add on to it. Keep in mind that our next focus in Healthcare is to continue looking at improving manufacturing gross margin, our focus in Security, continue to look at increasing the margins. So as the -- as Alan mentioned, but there's always this mix between the various segments of our businesses, but we feel very good about it with all the initiatives that are taking place in all divisions, that the margins will hold and maybe even improve.

I was going to say that I heard you on the 35 to 37 for the whole year but given what you had in the first half, you need to be sort of in the mid- to upper end of that range order to hold that for the whole year is what my math shows. I just question related to the near term and what you expected in gross margins. Do you see improvement in the second half versus the second quarter was my question.

We do see improvement in the second half versus the first half, of course, the second quarter was about 36%, which is right in the middle of the range that we are providing. The first quarter was about 33.7%. So you are correct in saying that gross margin in order to hit those numbers needs to improve in the second half of the fiscal year which we anticipate we'll do. We'll continue with momentum that we built in the Healthcare Division. We're now starting to build that same momentum in the Security Division and a little bit of that will be offset by the higher contract manufacturing orders but we are comfortable with improvements in the second half gross margin.

That helps. I think the other thing that I was just trying to see if I was right about, what your guidance implies is that you expect SG&A to be down pretty nicely from Q2 levels, maybe more like Q1 levels in the quarter in the back half. Is that the right way to think about that and is that something you achieved because of the mix and the relatively low operating expenses from the electronics assembly business or any color you could provide there.

Yeah, I think you've hit the nail on the head. You will see the SG&A always be a little bit higher generally speaking in the second quarter and the fourth quarter, when there may be slightly higher sales because you have some of the variable costs of commissions and the like. But I think you are correct in assessing that the Q3 SG&A levels will likely be below that of Q2 and maybe more in line with Q1, although slightly higher than that, probably and then Q4 we'll have a little bit of a spike back up.

Okay. Thanks a lot.

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

Good afternoon, everybody.

Good afternoon.

In looking at the Security spending on CT, looks like just looking at the budget that was submitted by Bush yesterday, that we could see a little bit of an acceleration in the funding there into fiscal '09 assuming all that gets passed. Looked like it's going to go from roughly $450 million this year to about $1 billion in fiscal '09. I assume you won't have the RTT out by then. Do you expect to be far enough long to influence the purchasing decisions by that point?

I think the best way to answer that, Josh, is we're obviously -- we obviously are communicating where we are with the TSA with our customers and really for me to comment on what we're talking to them or where we are, I'm really not comfortable from a competitive standpoint, but like we said before, that RTT in my mind is a great product and obviously gives us a lot of advantages in terms of speed, especially when you're looking at in line baggage and -- so I think I'll leave it at that. I really am not comfortable commenting any further than that.

Josh, this is Deepak. Just to add on, I did say in my presentation that we are going to showcase that right now, targeting, in fiscal 2009. That means that starting July to next June, somewhere in that period, we'll be, as long as we are in that mode, definitely like Ajay mentioned, we're talking to TSA and some of the international customers.

We're not giving exact timing.

Exact timing, we frankly don't know ourselves and we would rather not comment right now for competitive reasons. But let's just say that we are very excited about that product line and we believe that we will get recognition in 2009 from TSA in that. But there's international business and on top of that, we said it before, this is not a one year kind of a plan where if you miss the boat in 2008 or 2009, the story is all over. This is an ongoing, multi-billion dollar market. We think we still believe that this product will revolutionize the in-line baggage industry and we in this product line are ahead of everybody else that we know of and we believe that if we can deliver on our own projected specifications and everything we have heard and talked to customers and TSA, everybody is very excited about it, obviously the proviso is that we can deliver and get certified on that product.

Okay. Going back and looking at the opportunities with TSA, can you give us a little bit of an update on the AT program, how that initial roll-out has gone and kind of what you're looking at over the next 12 months.

I think -- I'll comment both on the AT programs and other programs working with TSA. We're moving forward. We've announced the order that Deepak mentioned. We got 50% of the initial quantity that TSA had given out. In terms of specific roll-outs, in terms of what we're doing, what we're working with them, again, I think this specifically for Security reasons with the TSA, we really can't comment. But everything is moving forward as we have planned.

Okay. Switching gears here a little bit, on the whole baggage side you had the big win over in Asia. Can you talk about what the pipeline looks like for that offering internationally?

First of all, that project is moving along very well for us. I think that, again, a little bit like cargo, that business tends to be a little lumpy but we are seeing a lot of activity in Middle East, as well as Asia and parts of eastern Europe and other places. So we still feel very good about that business, it's moving along well for us.

Okay. And then just over the last week or so there looks to be -- Pakistan announced a pretty extensive roll-out of explosives detection systems at different control points. Is there an opportunity for you in that market?

We're at a lot of different international markets. And Pakistan is one of them. Specifically, what we're doing with them, what we're not doing with them, again, I'm not going to comment on but we're always looking at various different markets all the time.

Sounds like we need to go back and bang on your partners there to squeeze some more information out of them. So you mentioned that the company did take the listing off the AIM. What were the recurring listing costs associated with the listing?

Alan, you want to comment on that?

Maybe more general way to answer that would be what are the associated public company costs just beyond the pure listing cost. We would anticipate us probably somewhere in the neighborhood of about $600,000 a year in ongoing public company costs.

Were there any meaningful legal fees associated with getting listing off?

There were not, no.

Okay. Last question here, additional opportunities on the large contract, you're working on the Opto side, given your visibility into that pipeline, are you expecting anything more in this fiscal year?

Well, again, looks like every business we're saying no comment, Josh, for competitive reasons. All I can say is since we got in three different waves, we are in good standing with our customers and it's an of ongoing program and we're very excited about it. We are working diligently. We are keeping our nose clean and we're keeping our customer happy. We are looking at other opportunities and keep in mind, the Opto business has a lot -- except for this large one, has lots and lots of opportunities as Contract Manufacturing and OEM customers in all various industries. So I mean, that's our bread and butter in that product line. We continue to look at other opportunities.

All right. Guys. Good quarter. Nice to see the cost savings coming through.

Your next question comes from the line of Matthew McKay from Jefferies & Company. Please proceed.

Great. Thanks, guys. Just a question on the seasonality. On the revenue, is Q2 kind of the strongest quarter now or is it going to be stronger than Q4 this year? And then maybe if you can just talk a little bit through, is this going to become more normal going forward or is it just as you said before, a little bit of lumpiness this year?

I think used to be that Q2 was the strongest because of the Healthcare. Now, we feel Q2, Q4 are comparable. Definitely, Q1 and Q3 are not as strong as Q2 and Q4. But the broader the product line becomes, the less the seasonality is coming in. But for example, for the second half, definitely Q4 will be stronger than Q3. But the difference between Q3 and Q4 might not be same as Q1 and Q2.

Given -- I would think that Q3 would do all right, just given the fact that you're working through these cargo orders through the pipeline. Is that a fair assessment, that Q3 is going to be all right, just from a top line perspective?

We do believe, Matt that Q3 will be strong in terms of revenues, highlighted by, yes, some cargo sales but even more importantly, some of the Contract Manufacturing sales that will be taking place.

So with with Q3 being relatively strong from cargo sales, just on a year-over-year basis it looks like Q4 is a little bit of a slowdown there. Is that -- you guys are just being conservative because you're not seeing it within -- a little bit further out on the time line or is there something out there in the three to six months that we should be aware of?

Well, I think the way you should look at it is, our guidance is look at Q3, Q4 together with the proviso, we believe Q4 will be stronger than Q3. It's very difficult to predict whether Q3 is going to be stronger in cargo or Q4. As you know, that that business has a tendency from one quarter to another. And we are putting the plan together. All we can say is the backlog visibility shows such that the second half will be comparable, if not a little better than the first half, but Q1, Q2 had significant differences in revenue. Q3 and Q4 will not be as significant differences, but Q4 definitely will be stronger than Q3.

Okay. Switching over to some of the accounting on RTT, when you produce a demo of the RTT product, how does that affect the accounting of it in terms of both R&D and potentially flowing through on the gross margin side?

I think we'll look at the accounting treatment of it. But to date, whatever we've been spending, and correct me if I'm wrong, Alan, basically we've been expensing it out as R&D.

That's correct.

And just to add on to that, as we actually have a purchase order.

Yeah, with Manchester, I believe. So when you deliver a demo to the TSA for them to tinker with, does it change how you're flowing it through R&D?

I don't think we ever said it, we're making a demo to the TSA.

Demo that will be demonstrated to someone.

We are making -- we have not ever said how many machines we are making. We are making some machines to deliver definitely to our customer Manchester. It's obviously making some extra. Like Ajay said, up to now, whatever we are doing we are expensing it out.

Okay. And then just in terms of the restructuring that you've done so far on the Security side, is there any way to quantify the square footage and maybe the people that were let go.

Very difficult. We have embarked upon, identified, we identified approximately $8 million of that, which majority of that is in Security group, combination of consolidation of facilities and people and I mentioned previously of some reorganization. All of that is lumped together. I don't think we feel comfortable in breaking down more detail in what we are doing.

Fair enough. Thanks a lot, guys.

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

Good morning.

Good morning.

Hello?

Good morning.

Good morning. Congratulations on a great quarter. Wanted to follow up on your cargo. Can you tell us how much you shipped during the quarter? Was it roughly 23, -- 22, $23 million?

Offhand, I don't have the number in front of me. Do you, Alan?

I think it's north of $20 million. Is that fair enough to say?

Yes.

So I'm in the right ballpark.

Congratulations. I hope that the baby is going to be good and healthy and you're going to be good and healthy.

Thank you, Deepak. I wanted to get your take on your outlook for cargo this year. When I look at CVP funding for non intrusive inspection equipment in fiscal year '07 it's actually going to be down more than 20%. If you can give me a sense of your cargo inspection outlook in the U.S., compare that to international I think that would be very helpful.

I think if you look at the CVP overall budget, it was close to $4 billion. What they end up actually spending on x-ray equipment, at least what I know so far is we don't know what that number is going to be. I mean, our best guess is, it's probably pretty much where it is or maybe up or down a little bit. So I don't think that that number has been really solidified. We're going to know more by Q4 or so. But from our standpoint, we feel very good about what next year looks like, not just in the U.S., and internationally we continue to have activity. We continue to go after business and look at new areas that -- and new territories that we were not in before. So I'm not sure where your data is coming from, but maybe you have more information than I do.

There was actually a specific line item for non intrusive inspection equipment. And my understanding is the majority of that will be going to operations and maintenance of the existing equipment due to the large purchase they made in '07. So we're looking at just over $100 million versus $136 million in '07. So I was hoping to get your take on what your thoughts were on that number.

Really, we don't know much more than that right now. But one of the things I think we want to emphasize is, cargo has beyond CVP, DOD, they also have a lot of international. We've been very successful in all three segments and we believe that the activity that we are in, negotiations in all these areas look very positive outlook for 2009. Keep in mind that depending on the mix in the cargo, the shipments can change from three months to six months to nine months and that basically will determine how the cargo shipments pan out to be. As far as the activity and the overall intake, I didn't mention about it. We believe and have focused that cargo will be the fastest growing segment for us, we believe, till RTD kicks in. Because then we think we have two good racehorses to propel our growth.

Deepak, can you talk a little bit about what you think is driving cargo inspection demand from the DOD? Is it because of the need in Iraq and Afghanistan and is that being funded by the supplemental, if you can give me a flavor of where that's coming from.

I think -- this is Ajay, it's a combination of things. First of all, you're seeing overall -- yes, you're seeing activity in the operational theaters. But force protection, you know, is not just in the operational areas. If you're looking at any base needs to be protected, whether here, overseas, any time you go on to the Navy area, any time you go onto a ship, needs to have protection. So it's a much broader market than just Afghanistan and Iraq.

What about in terms of international demand, where do you see that coming from and what's driving the demand?

I think the general paranoia in the world is driving that demand. Everybody internationally is looking at both from inspection criteria and from Security. Keep in mind, we always said it that internationally, some places it is driven by revenue loss of smuggling, anti-smuggling. So combination of both Security and general inspection for duty evasion is what's driving the demand, especially in Asia-Pacific where the trading -- the economies are doing good and trading internationally, export is a big number for them. So they want to get through inspection the fastest way and our scanners are ideally suited for it.

Okay. And you talked about how you expect cargo to continue to be one of your best growth drivers until your next generation EDS machine kicks in. So we're talking about until the end of fiscal year -- I mean, for at least two years or one and-a-half to do years? Is that the right way to think about it?

Would you repeat it again?

You said you expect cargo to be your best growth driver until CT kicks in. So are we talking about another year or two years? What's the time frame in terms of when you expect your next generation CDS machine to kick in?

Well, what we have said is that some time in fiscal 2009, we will start showcasing our electronic CT. Until that time, keep in mind, that we also have the non-certified high speed, non U.S. equipment in checked baggage, the MDX series which is doing very well. We believe that the best growth opportunity right now as a percentage increase is in cargo. We believe that going 2009 onwards, we will have two racehorses pushing for growth. We can't quantify it, but both markets are very large. Both markets are broad enough that it can propel the growth, which we've seen a fantastic growth in Security anyway, we did a 44% increase this year. So we have a lot of opportunity for growth in those two areas.

I think just the other thing I would add on there is the rest of the business of Security, we're introducing new products. We talked about our advanced technologies, which we anticipate doing well. You know, let's not forget, at least especially from a margin standpoint and from what we anticipate as a product base grows, our service revenues are going to go up as well.

That reminds me, congratulations on the AT x-ray win. Is there a reason why your x-ray machine -- you have 50% of the market share right now with Smith. Is there a reason why your machine is a lot cheaper than Smith's x-ray machine?

It's a different machine. You're talking about apples and oranges.

Okay.

TSA basically decided to buy apples and oranges. And they bought the same quantity of apples and same quantity of oranges. Bottom line is, it's two different technologies. TSA is trying to look at various options and how they perform and we believe that our option, which is cheaper, is a better solution.

Okay. And going forward, do you expect to maintain 50% of the replacement market share or how do you think that's going to shift as they continue to upgrade the rest of the Checkpoint x-ray machines in the country?

I think for me to comment on that would be totally inappropriate at this point. We continue to talk to TSA and move forward and I think that's -- I'm going to leave it at that.

Sure. Understood. But you knew I had to ask that question.

Fair enough.

Alan, when can we expect to see the full benefit of cost cutting in your Security Division? Would that kick in before the end of this fiscal year or do we have to wait until '09?

You'll see a portion of it in the second half of the fiscal year. In terms of the full benefit, by your question, you'll see that in fiscal '09.

Thank you very much.

(OPERATOR INSTRUCTIONS). Your next question comes from the line of Tim Quillin as a follow-up from Stephens, Incorporated. Please proceed.

Not only all my questions but I think all questions have been asked. Thank you.

Thank you.

At this time, there are no further questions in queue. I would now like to turn the call over to Mr. Deepak Chopra, CEO, for closing remarks.

Thank you very much. In conclusion, I want to emphasize that as I said in the last conference call conclusion, the total management of the company is committed and now you want to use the word excited about continued effort to increase the efficiency in all divisions. We continue to monitor it globally. We're looking at every aspect possible to increase our margin and increase our efficiency. Obviously watching our top line. We are not shirking from spending R&D money. We are focusing on it. We're putting milestones. We continue to look at broadening our portfolio. It has been a company strategy for a long time.

We want to be in Security, the broadest technology scanning platform company. In Healthcare, we do have competitors like the GEs and the Phillips. We are gaining ground. We continue to monitor it. Most of the cost cutting is behind us. Now we are looking at margin enhancement with China coming on line. We believe we have a great opportunity to look at a couple of percentage points improvement in the manufacturing gross margin, targeted towards 2009. We are excited about the new products that we're going to be introducing, both on the high end and on the low end in Healthcare.

We are very excited about our RTD product line. We think it's going to be a great product. We are very confident of showcasing them in fiscal 2009. Opto, we continue to monitor and reduce our losses in the Weapons Simulation. We have gone on the record that we put it behind us before this year is out. We look at all disciplines and we are very excited about the business. Want to thank all our stockholders in trusting us and we continue to thank for the great job done by the management and employees of the company. Thank you very much.

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