Business Context and Reporting Period
OSI Systems, Inc. designs and manufactures specialized electronic systems and components for security, healthcare, defense, aerospace, and related markets. Its reporting segments are Security, Healthcare, and Optoelectronics and Manufacturing. This unaudited Form 10-Q covers the quarter and six months ended December 31, 2014, representing fiscal second quarter and first six months of fiscal 2015. Comparisons are primarily with the corresponding fiscal 2014 periods.
Key Financial Metrics
| Metric | Three Months Ended December 31 | Six Months Ended December 31 |
|---|---|---|
| Net revenues | $257.8 million, up 9% | $476.2 million, up 8% |
| Gross profit | $89.3 million; 34.6% margin | $163.5 million; 34.3% margin |
| Operating income | $26.1 million | $42.7 million |
| Net income | $18.2 million | $29.5 million |
| Diluted earnings per share | $0.89 | $1.44 |
| Operating cash flow | Not separately provided | $61.0 million |
Quarterly net income increased from $14.6 million to $18.2 million, while six-month net income increased from $21.0 million to $29.5 million. Quarterly operating margin was approximately 10.1%, compared with 9.3% in the prior-year quarter; six-month operating margin was approximately 9.0%, compared with 7.3%.
- Quarterly segment revenue was $137.0 million for Security, $69.5 million for Healthcare, and $65.5 million for Optoelectronics and Manufacturing, before intersegment eliminations.
- Six-month segment revenue was $250.4 million for Security, $117.3 million for Healthcare, and $134.6 million for Optoelectronics and Manufacturing, before intersegment eliminations.
- At December 31, 2014, cash and cash equivalents were $44.8 million, compared with $38.8 million at June 30, 2014.
- Total debt, including bank lines and current and long-term debt, was approximately $35.2 million at December 31, 2014, down from $37.3 million at June 30, 2014.
- The company had a $450 million revolving credit facility maturing in May 2019. Borrowings were $23.0 million and outstanding letters of credit were $90.7 million at December 31, 2014.
- Total assets were $1.057 billion and stockholders’ equity was $541.3 million at December 31, 2014.
- The effective tax rate was 27.7% for the quarter and 28.1% for the six months, compared with 29.0% for both prior-year comparable periods.
Material Changes Versus the Prior Comparable Period
- Security revenue increased 29% in the quarter and 23% for the six months, primarily from baggage and parcel inspection sales, new product launches, and partial fulfillment of a large Foreign Military Sale contract involving cargo and vehicle inspection systems for Iraq.
- Healthcare revenue increased 10% in the quarter and 8% for the six months, reflecting a European cardiology acquisition and stronger Latin American and Asian sales, partly offset by weaker organic sales in North America and Europe, the Middle East and Africa.
- Optoelectronics and Manufacturing revenue declined 14% in the quarter and 9% for the six months because of lower contract manufacturing sales, including reduced activity from two significant prior-year customers.
- Gross margin improved from 34.2% to 34.6% for the quarter and from 33.6% to 34.3% for the six months. Management attributed the improvement to operational gains in Optoelectronics and Manufacturing and its lower-margin revenue mix, partly offset by weaker Healthcare product and geographic mix.
- SG&A increased 5% for both the quarter and six months, while research and development increased 19% quarterly and 17% year to date, driven primarily by investment in next-generation Security products.
- Restructuring and other charges declined to $2.1 million for the quarter and $2.8 million for the six months, compared with $2.2 million and $6.4 million, respectively, in the prior-year periods. Current-period charges included TSA-related costs, facility consolidation costs, and legal fees related to shareholder litigation.
- Operating cash flow declined to $61.0 million from $75.0 million, primarily because working capital used $13.6 million of cash in the current period versus providing $15.9 million in the prior-year period.
- Investing cash outflow declined to $24.5 million from $54.3 million, primarily because capital expenditures fell to $6.4 million from $41.7 million. Acquisition spending increased to $14.7 million from $10.1 million.
- Financing cash outflow increased to $29.3 million from $16.5 million, primarily because common-stock repurchases and net share settlements totaled approximately $29.5 million versus $20.3 million in the prior-year period.
Guidance, Outlook, Risks, Contingencies, and Unusual Items
Management stated that available funds, credit facilities, and expected operating cash flow should be sufficient to meet operational cash needs for at least the next 12 months. The filing does not provide specific revenue or earnings guidance.
- Approximately 73% of cash and investments were held by foreign subsidiaries, subject to potential repatriation tax considerations. Management intends to permanently reinvest a significant portion of foreign earnings.
- Security operations remain exposed to delays in government contracts, sequestration, changes in government spending and procurement policies, contract compliance issues, and regulatory or enforcement actions.
- The TSA terminated a delivery order for default after the Security division used an upgraded X-ray generator without obtaining required advance approval. The government has asserted a compensation claim, and the matter remains under discussion. The Security division also agreed to extend its DHS Administrative Agreement by 24 months.
- The company faces a putative securities class action and two shareholder derivative actions alleging disclosure, contract-compliance, and fiduciary-duty issues related to Automated Threat Recognition software and unapproved baggage-scanning components. Outcomes and potential losses cannot presently be estimated, and no loss accrual was recorded.
- Contingent consideration obligations from acquisitions had a maximum potential future payment of $57 million; $23.7 million was recorded in other long-term liabilities at December 31, 2014.
- A $62.5 million customer advance remained outstanding under the Mexican turnkey security-screening agreement and is scheduled to be fully amortized by fiscal 2017.
- The company is investigating historical soil and groundwater contamination at its Hawthorne, California facility. No environmental liability was accrued because an adverse loss was not considered probable and reasonably estimable; a material adverse outcome remains possible.
- The company is exposed to foreign-currency risk. Management estimated that a 10% appreciation of the U.S. dollar against local currencies would increase second-quarter fiscal 2015 operating income by approximately $3.0 million, while a 10% depreciation would decrease it by approximately $3.0 million.
- No material changes to previously disclosed risk factors or market risks were reported. Disclosure controls were deemed effective, and no material changes to internal control over financial reporting were identified.
Important Facts for Investors to Verify
- Verify the timing, margin, and remaining revenue potential of the large Foreign Military Sale contract and its effect on Security growth.
- Assess whether the decline in Optoelectronics and Manufacturing sales reflects temporary customer timing or a sustained loss of contract manufacturing volume.
- Monitor working-capital trends, particularly the $29.8 million increase in inventories since June 30, 2014 and the decline in operating cash flow.
- Evaluate available borrowing capacity after considering $23.0 million of revolver borrowings and $90.7 million of outstanding letters of credit.
- Track the TSA claim, DHS compliance agreement, securities litigation, and related legal expenses or potential financial consequences.
- Review potential acquisition-related payments, customer advances, environmental exposure, and tax costs associated with foreign cash repatriation.
- Confirm that improved operating margins and lower restructuring charges are sustainable after adjusting for mix, acquisition effects, and unusual items.