OSI Systems Inc (OSIS) 2017 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the OSI Systems, Inc. Fourth Quarter and Fiscal Year 2017 Conference Call. (Operator Instructions) As a reminder, this conference call is being recorded.

I'd now like to introduce your host for today's conference, Mr. Alan Edrick, Chief Financial Officer. Sir, you may begin.

Thank you. Good afternoon, and thank you for joining us. I'm Alan Edrick, Executive Vice President and CFO of OSI Systems, and I'm here today with Deepak Chopra, our President and CEO. Welcome to the OSI Systems Fourth Quarter and Fiscal Year-end 2017 Conference Call. We'd like to extend a warm welcome to anyone who is a first-time participant on our conference calls.

Please note, this presentation is being webcast and is expected to remain on our website located at www.osi-systems.com for at least 2 weeks.

Earlier today, we issued a press release announcing our fourth quarter and fiscal year 2017 financial results.

Before we discuss our results, I would like to remind everyone that today's discussion contains forward-looking statements. 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. These forward-looking statements are based on management's current expectations and are subject to uncertainties, risks, assumptions and contingencies, many of which are outside the company's control. Such statements include, without limitation, information regarding expected revenues, earnings and growth and statements regarding the expected financial and operational performance of the company and its operating divisions. The company wishes to caution participants on this call that numerous factors could cause actual results to differ materially from these forward-looking statements. These factors are described in the company's periodic reports filed with the SEC from time to time. All forward-looking statements made on this call are based on currently available information and speak only as of the date of this call, and the company undertakes no obligation to update any forward-looking statement that becomes untrue because of subsequent events or new information or otherwise.

During today's call, we may refer to both GAAP and non-GAAP financial measures of the company's operating and financial results. For information regarding non-GAAP measures and comparable GAAP measures and a quantitative reconciliation of those figures, please refer to today's press release regarding our fourth quarter and fiscal year-end '17 results, which has been furnished to the SEC as an exhibit to our current report on Form 8-K.

Before turning the call over to Deepak to discuss the general business and operations, I'm going to provide a high-level financial overview of the fourth quarter and fiscal year.

First, we reported fourth quarter revenues of $252 million, a 14% year-over-year increase. This increase was primarily driven by our Security division, which reported record Q4 revenues of $147 million, up 33% from revenues in Q4 of fiscal '16, and it included $23 million of revenues from the operations of American Science and Engineering, which we acquired in the first quarter of fiscal '17. Excluding AS&E's revenues, our Security division revenues were up by 12%. Our Healthcare division revenues were up 7% on an organic basis, which excludes the impact of the Q3 divestiture of a non-core business. Total revenues in our Opto division were down 5%, which is relatively in line with our expectations.

Second, we report a Q4 GAAP diluted earnings per share of $0.08. On a non-GAAP basis, Q4 EPS was $1.02, up 76% from Q4 of last year. Non-GAAP EPS excludes the impact of impairment, restructuring and other charges, amortization of acquired intangible assets, noncash interest expense and the gain from the sale of a business, all net of related tax effects. It also excludes the $2.4 million tax benefit from the initial adoption of a new accounting standard, ASU 2016-09, related to employee share-based payment accounting. Each of our 3 divisions reported operating margin expansion, excluding the applicable items just mentioned.

Third, operating cash flow was $11 million for the quarter and $63 million for the full fiscal year and capital expenditures were $5 million for the quarter and $17 million for fiscal '17.

Fourth, our non-turnkey Q4 book-to-bill ratio was 1.4. Our total backlog, including turnkey as of June 30, 2017 was approximately $738 million, up 18% from the backlog figure at the beginning of the fiscal year.

Lastly, on July 10, 2017, which was subsequent to our fiscal year-end, we announced the completion of the acquisition of the former Morpho explosive trace detection business from Smiths Group. This business is an excellent strategic fit and is expected to further enhance our already broad Security product portfolio and product development capabilities for fiscal 2018 and beyond.

Before diving into the numbers and discussing fiscal 2018 guidance in more detail, let me turn the call over to Deepak.

Thank you, Alan. And again, welcome to the OSI Systems earnings conference call for Q4 and year-end.

During fourth quarter and throughout fiscal 2017, the team worked to make changes to create sustainable advantages in the marketplace. We were proactive in growing market share in the Security division; strengthening the core of our Healthcare division; and in Opto division, continuing to execute on a strategy to create a strong, profitable business.

Talking in more detail about each division, starting with the Security division, where revenues were $555 million for the full fiscal year, 35% higher than the same period, year before. Revenues in the division in Q4 were up 33% from the prior year. Security division bookings were $198 million for the quarter and $554 million for the year, which represents a non-turnkey book-to-bill ratio of 1.7 and 1.2, respectively.

Obviously, these numbers include AS&E acquisition. The revenue growth resulted from a mix of organic growth and the acquisition activity. The AS&E acquisition, which was completed in September 2016, benefited us through most of the fiscal year in both revenues and profits. Alan will discuss a little bit in more detail the AS&E impact on both revenue and profits.

From a strategic perspective, we are very pleased with the acquisition as we are able to now go to market with a broader cargo-scanning solution base and provide more options to meet our customers' specific needs. We can proudly say that in our peer group in the Security business, we have the broadest product portfolio in the space.

We also strengthened our aviation security portfolio with our acquisition of the former Morpho explosive trace detection, ETD, business from Smiths. This acquisition enhances our position with airports and critical infrastructure customers around the globe that seek safety from the explosive threats.

Some of the highlights for Q4 for the Security division. On the checked baggage front, our efforts to improve our production efficiencies for the Real Time Tomography, RTT, our high-speed CT, have resulted in lower costs and improved margins.

During the fourth quarter, we announced an RTT order valued at approximately $23 million from a major European airport group, a great success for us. European airports are increasingly active, as we have said in the past, in adopting ECAC Standard 3 technology to meet the 2020 deadline. Numerous major international airports also in Asia are similarly upgrading their security inspection systems to follow the overall global trend towards standardizing around CT-based checked baggage solutions meeting the new standards.

The U.S. market, which is preparing for the next major replacement cycle, will continue to remain on track for the RTT 110 DSS certification. As the U.S. replacement cycle approaches and European airports strive to meet the 2020 deadline for ECAC Standard 3, we expect to see new opportunities to expand our RTT footprint and installed base.

The airport checkpoint market also remains active. During the quarter, we announced a multiyear contract valued at approximately $7 million to provide Rapiscan baggage and parcel inspection systems, including follow-on maintenance and support services to a prominent international airport authority.

Going into the cargo inspection side of the business, we won several U.S. and international strategic wins during the quarter. We have experienced a growing opportunity pipeline in this space as we announced approximately $63 million of awards for cargo products during the quarter. The continued growth of the installed base of our products is also leading to continued growth in opportunities for maintenance and services.

During the quarter, we announced a foreign military sale contract from the U.S. Department of Defense for approximately $23 million to provide training, service and logistic support for car -- Rapiscan cargo and vehicle inspection systems and an additional $20 million order to provide spare parts to support AS&E Z Backscatter cargo and vehicle inspection systems. Overall, it was a strong booking quarter for cargo products.

Turning to turnkey services. Our current programs in Albania, Mexico and Puerto Rico continue to perform well. As we have mentioned in the past, the potential customers that are seeking to buy cargo product or turnkey service model options are increasingly overall and we continue to look at moving from one to the other.

We have been spending a fair amount of time demonstrating the strengths of various hybrid options. To that end, earlier this month, we announced an international customer contract valued at approximately $40 million to implement a countrywide security scanning program that includes high-energy cargo and vehicle scanning systems. Our turnkey screening service business, S2 Global, will provide the design and construction of the inspection sites and a command and control center, utilizing its global integration platform, CertScan, and training operations personnel as well as providing a comprehensive maintenance and service support program.

We are actively working with the Mexican authorities on a multiyear renewal of our MSAT contract. Our fiscal 2018 guidance includes a multiyear contract for Mexico at a lower rate of revenue. The capital expenditures required for this renewal are expected to be minimal as the present installed equipment will continue to be deployed in its current state. As you can appreciate, we cannot comment any further on this.

We also used our strong balance sheet to continue to make strategic acquisitions, especially in the Security group. During Q4, we announced our intent to acquire the global explosive trace detection, ETD, business of Morpho Detection for approximately $80 million in cash, subject to certain adjustments, and announced the completion of this transaction shortly after the fiscal year-end. The acquired ETD business is now part of Rapiscan Systems and is expected to be accretive to fiscal 2018 EPS on a non-GAAP basis, which excludes amortization of acquired intangible assets and any restructuring or other charges.

This acquired business is a leader in trace detection with a current worldwide installed base of approximately 10,000 units. We are very excited about this acquisition for a couple of key reasons. It allows us to leverage the acquired ETD business existing customer base and product pipeline and gives us an opportunity to offer a full suite of products to aviation and non-aviation checkpoints alike.

For aviation checkpoints, we believe the trend is towards an integrated checkpoint where screening machines for carry-on baggage and people, trace equipment for explosive detection and automated tray return systems will work in a cohesive manner, creating a more efficient and pleasant passenger experience. The acquisition of the trace business and the prior acquisition of a tray return systems company in October 2016 further strengthens our checkpoint offering for airports and allow us to develop innovative hardware and software solutions, thereby moving us further along the integrated checkpoint path.

Looking ahead, we are excited about our growth opportunity in the Security business. The recent acquisitions, both AS&E and the trace business in the Security space, have created growth catalysts for ports, borders, airport and critical infrastructure protection.

I'm very proud of the team's achievements to-date, but I also realize that we need to continually review our organization and make the necessary changes to keep the business on its extended path. We recently realigned our Security division so that the cargo and solutions group focuses on cargo and vehicle inspection and the detection group on checkpoint security systems and security detection instruments. Earlier this month, we appointed a new President of the detection group, Mal Maginnis. Mal comes to us with 35 years of experience and is well-regarded in the defense, safety, security and technology industries. We welcome Mal to the team and are looking forward to his contributions. Ajay Mehra continues to lead the cargo and solutions group that has been a leading innovator in that space. Both of these groups together make us a broad, integrated product company in a growing global security market.

Moving to Healthcare. Spacelabs sales were $54 million in Q4 or about 7% higher year-over-year after adjusting for the AED divesture. Q4 also showed the profitable trend, almost 9.6% of operating income, that this business is capable of. Fiscal 2017 was a difficult year for Spacelabs, but we began to see positive momentum in the second half, which we expect to carry into fiscal 2018.

Our management team work to improve operations to better serve our customers and provide a first-rate customer experience in transitioning to a newer, higher performance technology key product portfolio. In the second half, we upgraded the operations, supply chain and engineering leadership and have begun experiencing benefits from these changes. The new Healthcare division leadership team has built a foundation in the division on which we can return to revenue growth and improved profitability in fiscal 2018.

Moving to the Opto division. In the fourth quarter, the Optoelectronics and Manufacturing division generated total revenues of $60 million, which was a 5% decrease from the same period in the previous year. We have been very selective in growing this division with a more favorable product mix. To that end, the non-GAAP operating margins improved to 14.1% for the fourth quarter, a record, compared to 9.9% in Q4 of the prior year. Looking ahead to fiscal 2018, we believe we can grow the top line of the Opto division, particularly for the second half of the fiscal year, in a similarly strategic manner.

It has been an excellent year by many measures. We have made strategic decision on acquisitions, investments, customer interaction and personnel. Each of those decisions requires a willingness to focus on the company's long-term objectives.

Overall, I'm very proud of the employees and the group, what we have accomplished in fiscal 2017 and look forward to a strong performance in fiscal 2018.

With that, I'm going to hand the call back over to Alan to talk more in detail about our financial performance and guidance before opening the call for questions.

Thank you, Deepak.

So now let's review the financial results for the fourth quarter in a little bit greater detail. As mentioned previously, our revenues in Q4 of fiscal '17 increased by 14% on a year-over-year basis. Revenues in the Security division increased by 33% year-over-year primarily as a result of $23 million of revenues generated by AS&E, growth in our conventional equipment sales and an increase in service revenues.

Revenues in the Healthcare division increased 7% on an organic basis led by stronger performance in our patient monitoring business, primarily in the North American market. This 7% increase excludes the impact of the AED product line that we divested in February of 2017. This marks the second consecutive quarter of a return to organic growth for our Healthcare division.

Opto external revenues were down by 7% as compared to the prior year, while intercompany Opto sales were up 15% due to increases in sales to each

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The Q4 gross margin was 34.4%, up 240 basis points from the 32% reported in the Q4 the prior year. This was primarily due to increased margins in our Opto division as a result of a favorable product mix and improved operating efficiencies; improved margins in our Healthcare division due to the product and channel mix; and gross margin expansion in our Security division, which leveraged economies of scale and the inclusion of AS&E, which was accretive to the overall gross margin. As mentioned on previous calls, our gross margin will fluctuate from period-to-period based on product mix, among other factors.

Moving to operating expenses. In Q4 of fiscal '17, SG&A as a percentage of sales decreased to 19.0% compared to 19.8% in Q4 of fiscal '16. In absolute dollars, SG&A spending was $48 million, which was up by $4.1 million over the same prior year period. This increase was primarily driven by the inclusion of AS&E, a company that we acquired in September. As noted on previous calls, we remain focused in all of our divisions on increasing efficiencies and prudently managing our cost structure.

R&D expenses in Q4 were $11.1 million compared to $11.9 million in the prior year. This year-over-year decrease in expenses was mainly due to lower R&D costs in our Healthcare division, but we continue to make significant investments in research and development in our Healthcare division as well as in our Security division to enhance our product portfolios. We remain focused on growth platforms in innovative product development, which we view as vital to the long-term success of our business. With the inclusion of the trace business, we anticipate R&D as a percentage of sales in fiscal '18 will be roughly comparable to fiscal '17.

We previously announced the goal of $18 million of cost synergies related to the AS&E acquisition over a 2-year time frame. We aggressively, but prudently, pursued such cost reduction and are pleased to say we have reached the annualized target ahead of the original schedule. Our estimated benefit in these efforts is approximately $11 million for the 2017 fiscal year.

Impairment, restructuring and other charges were nearly $25 million in Q4, which includes approximately $17.5 million for the impairment of assets related to our Mexican turnkey program, which I'll expand on further; $4 million of impairment related to the abandonment of product lines within our Security business, which were made redundant as a result of the AS&E acquisition; and $3 million of costs related to facility consolidations, employee severance and transaction costs related to our recent acquisition activity.

As it relates to the Mexico charge, we relocated and we reopened certain sites during Q4 due to changes in customer operational requirements. Approximately $11 million of the impairment relates to infrastructure costs that could not be relocated. The remaining $6 million or so relates to capital assets for sites in Mexico, which we believe are permanently impaired and have not produced any revenue.

The company's effective tax rate was 27.6% on a full year basis compared to 26.3% in fiscal '16. This rate does not include the $2.4 million tax benefit from adopting ASU 2016-09 in the current quarter. As a reminder, this benefit from the additional adoption was excluded from our non-GAAP earnings. Our provision for income taxes is based upon the mix of income from U.S. and foreign jurisdictions and tax rate differences among countries as well as the impact of permanent taxable differences, tax selections, equity vesting and exercises and valuation allowances, among other items.

So let's now turn to a discussion of our non-GAAP operating margin, which excludes the items mentioned earlier in the call. As would be expected with an increase in sales and profitability, the company's adjusted operating margin improved in Q4 of '17 on a year-over-year basis, coming in at 11.9% compared to 7.1% in the prior year period.

Due to the solid revenue growth in Security and the impact to the profitability from AS&E sales and related synergies, the adjusted operating margin was, again, strong in the Security division, improving both year-over-year to 15.2% from 9.8% in Q4 of last year and sequentially.

Our Opto division also saw significant adjusted operating margin expansion with an increase to 14.1% from the prior year Q4 level of 9.9%. The Opto operating margin in the fourth quarter was the highest that has been this decade, demonstrating the continued success this division has had in capturing operating efficiencies as it relates to product and customer mix.

We also saw noteworthy year-over-year fourth quarter improvement in our Healthcare division, climbing to near double-digit operating margin at 9.6% from 6.9% for the prior year period as costs were well-managed and the product mix tilted to growth in patient monitoring sales in North America, which generally features relatively high margins.

Moving to cash flow. In Q4 of fiscal '17, our cash flow from operations was $10.6 million, capital expenditures were $5.1 million in the quarter, while depreciation and amortization was $19.2 million. Days sales outstanding or DSO was 74 days for the fourth quarter of fiscal '17 as compared to 58 days last year. The increase was a result of strong June sales and some slower customer payments that were collected subsequent to fiscal year-end.

Continuing the trend from Q3 of fiscal '17, our days inventory for Q4 came in at 137, down by 16 days sequentially from the third quarter of fiscal '17 and down by 28 days from the Q4 fiscal '16 level of 165 days. In absolute dollars, inventory decreased to approximately $19 million on a sequential basis from the end of Q3.

Our balance sheet remains strong. We ended the quarter with net leverage of approximately 1.4 as defined under our revolving credit facility for pricing purposes.

And finally, turning to guidance. We anticipate 8% to 12% growth in fiscal '18 with sales approximating $1,040,000,000 to $1,080,000,000. In addition, we anticipate 12% to 20% growth in non-GAAP earnings per diluted share to $3.35 to $3.60, which excludes impairment, restructuring and other charges and amortization of acquired intangible assets as well as noncash interest expense.

We currently believe that sales and earnings guidance reflects reasonable estimates. Actual sales and earnings, however, could vary from this range because of the risks and uncertainties that affect our business and industries generally, including items not within our control such as site readiness or product installations, customer acceptance and the timing of orders in each division.

Over the long-term, we have a track record of producing sales and earnings growth with strong cash flow generation while simultaneously investing in product development and innovation for the future in conjunction with strategic acquisitions. We believe these efforts have served us well. Our investments have enabled us to continue our leadership role in the turnkey screening solutions market space and have allowed us to introduce innovative products and solutions to the market across our industries.

Thank you for participating on this conference call. And at this time, we'd like to open the call to questions.

(Operator Instructions) Our first question comes from Brian Ruttenbur from Drexel Hamilton.

Let me just start off with the basics. First of all, on your cash and debt, you have roughly $169 million in cash and debt at $344 million. I assume that does not include the Morpho of roughly $80 million. And will that come out of cash or be addition to debt?

Yes, Brian. So this is Alan. Good question. You're correct, that does not include Morpho, which was -- the Morpho trace business, which was acquired subsequent to year-end. That $80 million predominantly came out of our line of credit as most of the cash that we have is offshore.

Okay. So if I take the $344 million and add $80 million plus whatever cash you're going to generate, that's how I should look at your debt, correct?

That's correct.

Okay. That was easy. Next question is on Mexico. Okay. So we know that you've been generating roughly $120 million in the ballpark from Mexico. What is it that you're assuming in your projections going forward? And are you assuming a similar profit number or profit margin with Mexico in your guidance that you're giving us?

Brian, this is Deepak here. I have said that very specifically that we are not going to talk more about this as we are in the final stages of negotiations, which we feel very confident will result into a multiyear -- reduced revenue multiyear contract. And since the capital expenditure will be minimal, obviously the revenue will be much lower. Alan, do you want to add anything more to it?

No. I think that captures it well. And the guidance we gave for fiscal '18 incorporates our thoughts on what that renewal will look like, though we're not -- though we can't comment further on it while these discussions are taking place.

Okay. Understood. And then, the impairment that you took related to Mexico, I didn't catch them all. I apologize, but I'm traveling. So Mexico impairment, there was $11 million. Can you run down through those real quick? What was related to Mexico on your impairment charges?

Sure. So the customer in Mexico asked us to relocate certain sites towards the end of our fiscal year. And as we relocated those sites, we were able to move the equipment into a new location, but the civil works that were associated with the past sites, those, of course, don't have any value really ascribed to them any further. So the majority of that impairment related to the write-off, so to speak, the civil works of those sites that were relocated. The relocated sites are up and producing revenue for the company.

Okay. And how much was that in total?

The impairment was about $17 million.

$17 million. Were there other components? Or was it just a straight $17 million? I don't know if I heard something else in the conversation.

Yes. Related to Mexico or the impairment restructuring charges overall?

No, just related to Mexico. So out of the $24 million of charges, $17 million was related to Mexico. Is that correct?

Yes, that's correct. So about $11 million was what I just described and the remaining part were for certain sites that never got going and never produced any revenue, though we invested it into cash. And as a result, for those sites, those were written off. So they were never part of that $120 million in revenue that you referred to.

Okay. That's helpful. And then, in terms of the turnkey project, are you referring to it as a turnkey project because it's not a traditional turnkey project, the one that you announced, that $40 million? Can you give us a little more color on this? What you're doing that's different in this type project than you were or are in Mexico or Puerto Rico?

Yes. Brian, this is Deepak here. I think the last words are very accurately described. The project is somewhere similar between Puerto Rico, Albania, Mexico, all mixed in together. Some of them have training, some of them will have more of the command control center, some of them have image processing, so those with what we call a total solution. And as we move forward, these turnkey businesses can result into what we call the Mexico style or the Puerto Rico style or Albania style, but they are all sale of equipment or leaving of the equipment, plus maintenance, plus training, plus image analysis.

Okay. When did this start, this project?

I would say by the later part of this year. Alan, do you want to comment on it?

Yes. It could be up and running in our fourth quarter of this fiscal year. You could see some revenues, but you'll probably see more of it beginning in the following fiscal year.

Okay. So we're talking next summer, this will be up and operational. And can you tell us, is it Eastern Europe or is this Middle East or South America? Can you narrow down the region of the world?

You named all the regions. So for confidentiality, it's in one of these regions. But Brian, I also want to emphasize that the minute we do these kind of programs, which has maintenance, training, command control center, this can lead into a longer-term relationship with the customer for multi years.

Okay. I'll just wrap it up with -- can you give us some kind of a vision for 2018? Revenue by division, what you expect? You gave a total revenue, but do you expect Opto to grow at 3% and Security to grow at 10%? Can you give us some kind of numbers? Or should we be looking at historical numbers and looking for that same kind of growth going forward in '18?

Yes. Brian, this is Alan. So our company practice has always been to provide guidance just on overall OSI Systems level. That being said, our guidance does suggest that all 3 of our divisions will grow in fiscal '18 on the top line with the greatest growth occurring within our Security division.

Okay. And the Security division will obviously have growth because of the acquisition. And how much is Morpho going to add? Roughly $75 million? Is that correct?

Yes. Well, we aren't necessarily describing the exact amount of revenues for any particular deal or acquisition. What we can say is we're sizing the trace business to be running on a, call it, a $60 million-plus annual revenue run rate.

And our next question comes from Andrew D'Silva from B. Riley & Co.

Just a couple additional here. Just to start off, maybe we can focus on the Healthcare segment. I was actually surprised with how you did there in a good way because of everything that was going on with the Affordable Care Act. Do you guys feel like once that's cleared or at least hospitals are figuring out what's going on there that, that should benefit you in a way? Or do you get any sense of what's going on from a CapEx standpoint within healthcare as there's a lot of turmoil right now?

Well, this is Deepak here. Definitely, there's turmoil, but we look at the Affordable Care Act, the focus is our business has done well in North America. And we continue to look very optimistic going forward and the pipeline looks strong. Our customer satisfaction is well received. Our challenge is, and we've said it before. Alan has said it. I have said it. Latin America, Asia, Middle East, all of that is pretty challenging. And we see some signs of improvement, but our focus, North America, will do well next year.

Okay. Great. And then as we look at the U.S. cycle that's coming up in the 2020s, is there anything in particular that we should be focused on as that could be headwinds as in near-term TSA budget changing year-over-year? Or do you feel like as long as that guidance for them to change over new systems is in place, you're in pretty good shape as we head into the next few years?

The answer is yes. Their procurement cycle for replacement is in 2020, 2022 on the TSA side. We are very much focused on the European side. We have had a great success. We just announced -- we said there's another major order for $23 million to one airport group in Europe. There's a lot more activity there because they are working towards the deadline much faster. Some of the international Asian airports have also started looking at it. So we believe that over the next couple of years, the checkpoint TSA style definitely will start getting growth, but the major action for the next couple of years is, I would say, is Europe.

Okay. Great. And just 2 more quick questions. Just first off on turnkey, are you seeing opportunities to add some of the AS&E and trace detection technologies that you acquired into some of those bundled packages with either existing or new customers? Is that kind of the strategy right there in turnkey or is it kind of more legacy as in prior years?

Well, obviously, we have a broad product line so that we could cater to customer-specific needs in a better sense, both in a sale and a turnkey. Primarily, the turnkey tends to be more cargo-related. And yes, AS&E is a big asset because they are very strong and have a great brand for what I call the low energy, the backscatter. Rapiscan is a very strong tradename for the high energy. But in many applications, in a turnkey or a broader security thing, you need all of them. Regarding your question about the trace side, the trace business is going to be a very integrated part of a checkpoint solution, together with our X-ray machines, together with our tray return systems, together with our metal gates. So that you combine all those technologies, what we are seeing is a happy experience at an airport is if you can integrate all these. And that's what we did the strategic acquisition for that it gives us a total solution to be able to provide to the customer.

Okay. Great. And last question just staying with trace. Smiths originally before they were forced to have to divest the business had some pretty big operating efficiency numbers they thought they could obtain through the acquisition was around $10 million. But obviously, they had a fairly similar business line. Is there any sort of operating efficiencies that you guys are expecting through this acquisition? And any other types of synergies that you could expound upon would be great as well.

Well, [I think that makes] a two-pronged question, I'll give you some of the high level and Alan can tell a little bit more detail. Basically, this was a strategic acquisition not based on synergies, not like AS&E. AS&E was a synergistic way that we did business, and it has done very well for us. This is a strategic business. We needed it. We had a product gap. This filled up our product back. So we don't look at it as a strategic for a synergies thing, but you can call it synergistic. We have the same sales pipeline. We have the same HR. We have the same IT structure. We have the same supply chain, manufacturing. Yes, there will be some synergies, but we are counting on this as a strategic to pull more revenue for our X-ray machines by trace customers happy that we can bundle it together. Alan, you want to add some?

Yes, I would just add really on the -- kind of on the medium and the long-term perspective, we think that the real type of cost synergies we could see would really be supply chain-driven, really on the material cost and leveraging our supply chain. So that -- those aren't things that happen overnight, but those are things that definitely can happen in the medium and long term, which we think can have a nice impact for us.

And our next question comes from Larry Solow of CJS Securities.

Just had a couple of just quick follow-ups. Just sticking with the -- on the trace detection side. I know you don't want to give specific guidance for units or acquisitions, but fair to assume that, that's immediately accretive?

Yes. Larry, this is Alan. I would say that it is fair to say that it's immediately accretive on a non-GAAP basis.

Okay. And any more color? Is it similar margin profile to you guys? Any thoughts on accretion on that front?

Yes. So Larry, this was a carve-out in nature. And while we continue to get our arms around it, it is a deal that we think will be margin accretive to us overall. So we're excited about it. We'd hesitate on giving too much color around it just yet until we get a little bit more experience under our belt.

Okay. But the margins are at least similar to yours, if not better, in the long run?

Yes, we believe so.

Okay. And then just -- go ahead, I'm sorry.

Just to add on to the first half of the question is, basically, we bought this business now just a couple of months. And because of all the changes in the regulations and there's more focus on the laptop thing that's happening at airports, I'm sure you've heard about it.

Yes, that's my next question, go ahead, yes.

There's been a very strong demand for the trace product line products at the -- especially at the international airports where the flights have to leave from. And we are very well capable of catering to that, and we are very much focused. So the trace business has started on a very strong footing.

Okay. Yes, that was sort of my -- my next question was sort of the bump up in these ETD requirements. So in theory, maybe that $60 million run rate in sales could be higher in the short term? Is that without -- is that a fair assessment?

I think at this stage, I would say Alan's numbers are right. We can look at it just as a bump in the road. We look at longer-term view. We think this is a good product line. And like I emphasized, it's part of a strategy for bundling the total at the checkpoint with our X-ray machines and our tray return systems.

Okay. Great. And then just lastly, just one more on Mexico. With the -- I know you don't want to get into details, but I guess, can we assume that assuming it does renew, I know you had -- there was a capital expenditure for both the equipment side, which you were depreciating and then the upfront cost for -- the infrastructure cost and whatnot, which I guess will not repeat itself. So fair to assume there'll be no depreciation as well?

Larry, the 2 sides of the equation, the civil works you are referring to, you're correct, will be predominantly fully depreciated as of the end of the initial contract term. The equipment side has had a life longer than the initial 6-year contract, so there'll be continuing depreciation associated with the equipment. But your overarching question, will depreciation go significantly down related to this contract, the answer would be yes.

And our next question comes from Joan Tong of Sidoti & Company.

I understand that you guys don't provide quarterly guidance, but if you can just give us some sort of like color and direction on how should we think about like 2018, maybe the first half versus the back half, taking into consideration like the Mexico renewals could be, I believe, is in the third quarter.

Joan, this is Alan. Yes, we certainly appreciate your question. It has been our practice really over the past decade that we really only just provide annual guidance without giving specific color on a quarterly basis. But you could clearly suggest that the first half, we should be coming out of the gate very strong. And while the second half, we're anticipating a nice second half, too. The Mexico renewal takes place at that point in time, so there'll be some impact there.

Okay. Got it. And then in terms of RTT, like you guys mentioned Asia, Middle East and other parts outside U.S. and you're looking at like some of the stuff there, different airport. I assume that those are mostly replacement versus new buys, right? Can you just give us a little bit in terms of the market size, like replacement versus new airport? And perhaps talk about the timing, like how soon that you can see those turning into bookings and revenue growth?

Good question. The answer to your first question is, it's not a real true statement that they're only replacement. There's a lot of activity for growth in Asia, especially. In some places, they are putting new airports. In some cases, it's a replacement of older technology, which is not CT-based, what is called the Multiview, the older units. As they come out, they get replaced by a newer technology, more expensive CT systems. The answer to your second question, timing-wise, basically, there is no such requirement, like in Europe, of a certain standard and a timing, but as the -- more trade goes in, more passengers go in, as a threat which is universal for these things, I think the bigger airports all over the world, especially Asia Pac, Asia Pacific, they are very progressive. So they want to put the best technology upfront so that as they're going to replace it for the next 10-year cycle, they look at the best technology, even though their standards might not require it. So we believe that over the next 5 years, there will be continued growth for these kind of equipment in all over the world.

Okay. Got it. And then, Deepak, you mentioned like the operating productivity improvement, the cost-reduction initiatives on the RTT side is benefiting you guys in terms of margin expansion. Are we going to see more incremental margin like opportunity in 2000 -- going into 2018? And is there a way to sort of like quantify it?

Joan, this is Alan. Yes, a very good question. Yes, the team has worked hard to really improve the margin profile of RTT, and we've been doing that throughout fiscal '17. Really, the bigger impact of that will indeed occur in fiscal '18 because many of the units that we sold in '17 and installed were earlier units that were made under the higher cost structure. So yes, we do believe that there's nice margin expansion opportunity in fiscal '18 and potentially beyond for RTT. And while we haven't said what those margins are in RTT, the delta is pretty significant, so we're excited about that.

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Inspection side and I think you mentioned about over $60 million cargo inspection this particular quarter. And obviously, when -- the last couple of months, there are a lot of budget news and especially like back in May, the proposed 2018 budget for different agencies, we all know who they are, they looked pretty good. So I'm just wondering, like all the strength that you are seeing in the cargo side and just by talking to your customers, the elevated interest level, is this sustainable like going into next year also into 2000 -- the back half of 2018?

Well, again, very astute question. Yes, the budgets look quite positive from our product line, especially on the cargo side, and we have announced some very big wins. We continue to monitor it. We think that over the next 2018, definitely, the cargo products and the aviation products will continue to be in demand.

Okay. Okay. Finally, I wanted to talk a little bit about Healthcare. Very strong margin, edging back to almost to the double-digit rate. I know that this is like a division that is very leveraged to volume, but is there anything on the product mix side that stood out this particular quarter? And just want to gauge the sustainability going forward.

Joan, this is Alan. The mix was highly focused on patient monitoring and, in particular, U.S. patient monitoring, which tends to carry some of the higher contribution margins for our overall Healthcare business. So that, coupled with the cost structure that's been put in place, led to significant operating margin expansion. And you're right, with Healthcare being the highest contribution margins in the overall OSI portfolio, as revenues increase going forward, there's really nice opportunity to further expand on those margins and profitability profile.

Okay. So there's no -- there was no like sort of onetime or anything that in terms of product mix that stood out, might not be sustainable going forward?

No. It was very regular run rate type of business.

And our last question comes from Greg Konrad of Jefferies.

Just a couple of questions. I think most of my questions have been asked. But just when we think about the recent acquisitions to bring up revenue synergies, are there certain customers maybe that you weren't able to have conversations with that the bigger portfolio you find it easier to kind of get in and have conversations about maybe future business?

Well, the answer is yes. When you're dealing with government in other parts of the world, the bigger you are, the bigger product line that you have, more credibility you get, and that does benefit. But I would say that most of the players in our space are like 2, 3, 4, they are all in the same size now. So I mean, we would say that we have narrowed down the gap. We consider ourselves maybe at #2 as far as the revenue of the security products are and compared to our competitors. So it does give you some benefit. But I think more important than the size is the breadth of the product line. So we have now a very broad product line so we could go to an airport. If the airport is needing X-ray machines, but they also need trace, we have both. If they need also an integrated tray return system, we have that, too. They need metal gates, we have that. If you go to cargo, if they need integrated product line, low energy, medium energy, high energy, integration, training, we have all that. So definitely, it helps.

I mean, when you kind of list out all those capabilities, I mean, where it stands today, are there any gaps that maybe you can fill through internal R&D or another [fashions]?

There's always gaps to be filled by both internal development and what all we can strategically acquire. We continue to look at it. But at this stage, we are quite content with the product lines that we've got, but we continue to look at it. We have been very focused to grow that business.

And then just last on the Opto business. I mean, should we expect an ongoing shift where maybe more of that capacity is used internally? You mentioned that the eliminations were up quite a bit in the quarter versus kind of external sales.

This is Alan. No, that will fluctuate. So clearly, as the Healthcare business grows and the Security business grows, the intercompany sales that Opto has can grow along with it. It's balanced sometimes by inventory reduction initiatives by certain divisions. But it wouldn't be a diversion of capacity away from selling to third-party customers. We have plenty of capacity to fulfill both our internal requirements and our third-party requirements. So we're actively looking to grow both.

All right. I see no further questions in the queue at this time. I'd like to turn it back to the speakers for closing remarks.

Thank you very much. I again want to thank you for taking the time to listen to. We are very, very happy with our 2017, and we are excited about it. We are entering the 2018 with a strong backlog. We have given a very strong guidance upwards. And we believe that this business will be great for us. Thank you. Talk to you soon. Bye.

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program, and you may all disconnect. Everyone, have a great day.