OSI Systems, Inc. Form 10-Q Summary
Business Context and Reporting Period
OSI Systems designs and manufactures specialized electronic systems and components for security, healthcare, defense, aerospace and industrial applications. Its reporting segments are Security, Healthcare, and Optoelectronics and Manufacturing. The filing covers the three months ended September 30, 2016, the first quarter of fiscal 2017, compared with the three months ended September 30, 2015.
The quarter included the acquisition of American Science and Engineering, Inc. (AS&E), completed September 9, 2016. AS&E contributed $14.2 million of revenue and $2.8 million of pretax income from September 10 through September 30, 2016.
Key Financial Metrics
| Metric | Q1 FY2016 | Q1 FY2017 | Change |
|---|---|---|---|
| Net revenue | $200.1 million | $220.9 million | +10% |
| Gross profit | $68.0 million | $68.1 million | Flat |
| Gross margin | 34.0% | 30.8% | Down 3.2 points |
| Operating income | $15.7 million | $2.1 million | Down 87% |
| Operating margin | 7.8% | 0.9% | Down 6.9 points |
| Net income | $10.8 million | $0.7 million | Down 94% |
| Diluted EPS | $0.53 | $0.03 | Down $0.50 |
| Cash flow from operations | $24.8 million provided | $1.9 million used | Down $26.7 million |
Revenue growth was led by Security, which increased 28% to $123.7 million, or 56% of consolidated revenue. Healthcare revenue declined 11% to $45.7 million, while Optoelectronics and Manufacturing revenue declined 1% to $51.5 million excluding intersegment revenue.
Operating expenses increased to $66.0 million from $52.3 million, including $10.0 million of impairment, restructuring and other charges. These charges included $5.4 million of asset impairment, $3.9 million of acquisition-related costs, and $0.7 million of employee termination and facility closure or consolidation costs.
At September 30, 2016, cash and cash equivalents were $123.0 million, compared with $104.4 million at June 30, 2016. Total debt, including bank lines and current and long-term debt, was $347.3 million, up from $133.8 million at June 30, 2016. The company had $339.0 million outstanding under its $450 million revolving credit facility and $33.2 million of letters of credit outstanding.
Approximately 93% of cash and cash equivalents was held by foreign subsidiaries and was subject to potential repatriation tax considerations. Management stated that available funds, credit facilities and expected operating cash flow should be sufficient for operational needs for the next 12 months and the foreseeable future.
Material Changes Versus the Prior Comparable Period
- Revenue increased $20.8 million, primarily from the AS&E acquisition, higher European RTT product sales, and increased turnkey screening services.
- Gross profit was essentially unchanged despite higher revenue, reducing gross margin from 34.0% to 30.8%. Management attributed the decline primarily to lower-margin RTT sales and lower Healthcare revenue.
- Operating income and net income fell sharply because of impairment, restructuring and acquisition-related charges, higher SG&A, and higher interest expense.
- Healthcare performance weakened because of challenging hospital spending and continuing issues associated with new product launches.
- Organic Optoelectronics and Manufacturing sales decreased 13%, primarily because of lower Asian sales, although reported revenue was substantially supported by prior acquisitions.
- Cash used in operations was $1.9 million versus $24.8 million provided in the prior-year quarter, mainly because working-capital changes used $29.1 million.
- Investing cash use increased to $191.5 million, including $186.9 million for acquisitions. Financing cash flow increased to $212.6 million, primarily from $214.0 million of revolving-credit borrowings.
- Goodwill increased from $122.8 million to $242.6 million and net intangible assets increased from $56.3 million to $129.3 million, largely due to the preliminary AS&E purchase accounting.
Guidance, Outlook, Risks and Unusual Items
The filing does not provide specific numerical revenue or earnings guidance. Management expects available liquidity, credit facilities and operating cash flow to fund operations, but notes that results may be affected by delayed customer purchasing and other uncertainties.
- Global economic weakness, particularly in China, a strong U.S. dollar and lower oil prices have delayed or deferred customer purchases.
- Healthcare product-launch issues may continue to adversely affect results.
- AS&E integration, acquisition financing, preliminary purchase-price allocations and additional amortization and interest expense create execution and financial risks. The AS&E valuation remains subject to adjustment during the one-year measurement period.
- The revolving-credit facility is secured, contains financial covenants, and its borrowing margin and commitment fee were scheduled to increase during the second quarter of fiscal 2017 because of higher leverage.
- The company has exposure to variable interest rates and foreign currency movements. Management estimated that a 10% appreciation or depreciation of the U.S. dollar against local currencies would change first-quarter operating income by approximately $3.0 million in the opposite direction.
- AS&E is subject to a GSA Office of Inspector General investigation concerning discount practices and compliance with its GSA Schedule contract. Potential False Claims Act consequences could include damages, civil penalties and legal costs; management states that an appropriate accrual has been recorded.
- Environmental contamination at the Hawthorne, California facility remains under investigation. No loss contingency has been accrued because management does not consider a loss probable and reasonably estimable, but an adverse resolution could be material.
- Shareholder derivative litigation is subject to a settlement term sheet that requires court approval.
- Approximately $15 million of property and equipment related to the Mexican turnkey security screening program was not in use at September 30, 2016.
- Management reported effective disclosure controls and no material changes to internal control over financial reporting. No material changes were reported to the risk factors in the prior Form 10-K.
Investor Verification Priorities
- Verify the final purchase accounting for AS&E, including goodwill, intangible assets, deferred tax liabilities and any measurement-period adjustments.
- Monitor leverage, covenant compliance, borrowing costs and available capacity under the revolving credit facility.
- Assess whether Security growth, including RTT and turnkey screening programs, offsets lower margins and Healthcare weakness.
- Track operating cash conversion and working-capital requirements following the acquisition.
- Review the status and potential financial exposure of the GSA investigation, derivative litigation and Hawthorne environmental matters.
- Evaluate the sustainability of reported results excluding the $10.0 million of impairment, restructuring and other charges and the partial-quarter contribution from AS&E.