OSI SYSTEMS INC quarterly report, Q3 FY2018

OSI Systems, Inc. Form 10-Q Summary

Reporting period: Fiscal third quarter and nine months ended March 31, 2018, compared with the corresponding periods ended March 31, 2017. The request identifies “2017 Q3,” but the filing is the fiscal 2018 third-quarter Form 10-Q, filed April 27, 2018. Financial statements are unaudited and presented in thousands, except per-share data.

Business Context

OSI Systems designs and manufactures specialized electronic systems and components for security and inspection, healthcare, defense, aerospace and related markets. Its divisions are Security, Healthcare, and Optoelectronics and Manufacturing.

Security represented 63% of nine-month revenue, up from 57% in the prior-year period.
Healthcare represented 18%, down from 21%.
Optoelectronics and Manufacturing represented approximately 19%, down from 22%.
The July 2017 acquisition of Smiths Group’s explosive trace detection business contributed $17.6 million of third-quarter revenue and $59.0 million for the nine-month period.

Financial Metrics

Metric	Q3 FY2017	Q3 FY2018	YTD FY2017	YTD FY2018
Net revenues	$245.1 million	$267.3 million	$708.5 million	$802.0 million
Gross profit	$86.0 million	$97.6 million	$236.7 million	$290.5 million
Gross margin	35.1%	36.5%	33.4%	36.2%
Operating income	$19.7 million	$7.7 million	$30.5 million	$45.3 million
Net income (loss)	$14.0 million	$2.6 million	$19.5 million	$(34.2) million
Diluted EPS	$0.72	$0.13	$1.00	$(1.82)

Third-quarter revenue increased 9%, driven primarily by Security growth and acquisitions. Nine-month revenue increased 13%.
Third-quarter gross margin expanded 140 basis points, while the nine-month margin increased 280 basis points, reflecting favorable product mix, acquired businesses and operating improvements.
Third-quarter operating income declined 61% because higher SG&A and substantially higher impairment, restructuring, legal and settlement charges more than offset gross-profit growth.
Nine-month net loss was driven primarily by a $65.4 million income-tax provision, including approximately $56.2 million of discrete Tax Act-related expense. Excluding discrete tax items, the nine-month effective tax rate was 28.2%, versus 27.3% in the prior-year period.

Cash Flow, Debt and Liquidity

Cash and cash equivalents were $194.0 million at March 31, 2018, compared with $169.7 million at June 30, 2017. Nearly all cash was held by foreign subsidiaries.
Operating cash flow was $115.8 million for the first nine months, compared with $52.2 million in the prior-year period.
Investing cash outflow was $141.9 million, including $103.2 million for acquisitions and $36.4 million for property and equipment.
Financing cash inflow was $50.0 million, including $125.0 million of revolving-credit borrowings, partly offset by $59.7 million of share repurchases and $20.6 million of tax payments related to equity-award net settlements.
Revolving-credit borrowings were $228.0 million, with $33.3 million of letters of credit outstanding and $263.7 million available under the facility. The facility matures in December 2021, and the company was in compliance with its covenants.
Long-term debt, principally the 1.25% convertible senior notes due 2022, totaled $247.0 million, net of discount and issuance costs. Other foreign subsidiary credit lines had $60.3 million outstanding and $12.9 million available.
Management stated that available funds, credit facilities and expected operating cash flow should be sufficient for operating needs for the next 12 months and the foreseeable future.

Material Changes and Unusual Items

Security revenue increased 18% in the quarter and 24% year to date, supported by cargo and vehicle inspection systems, checkpoint products, related services and the ETD acquisition.
Healthcare revenue declined 12% in the quarter and 3% year to date. Management cited weaker patient-monitoring sales, product-launch difficulties and healthcare-market uncertainty.
The company acquired an electronics component designer and manufacturer in January 2018 for approximately $22 million, plus potential earnout consideration of up to $6 million.
Third-quarter impairment, restructuring and other charges rose to $14.1 million from $2.5 million. Current-quarter charges included $4.0 million of asset impairments, $5.8 million of estimated settlement costs, $3.8 million of legal and settlement costs, and acquisition-related costs.
Nine-month impairment, restructuring and other charges were $23.5 million, including $7.2 million of impairment charges and $13.9 million of legal and accrued settlement costs.
The company repurchased 972,481 shares during the quarter at an average price of $61.37 per share. A new authorization permits repurchase of up to one million additional shares.
The company entered into a new two-year Mexican government security-screening contract in January 2018 at reduced revenue and profit rates. SAT represented 11% of nine-month revenue.

Outlook, Risks and Contingencies

Management expects customer purchasing delays may continue because of global economic uncertainty, oil-market weakness, government-budget conditions and political factors.
Potential risks include delays in contract awards or customer acceptance, government spending changes, currency movements, tax-law changes, product-launch execution, contract and regulatory compliance, and the ability to convert orders into revenue.
The SEC commenced an investigation into FCPA compliance, and the Department of Justice indicated it intended to request information. The agencies are also investigating trading in company securities. The filing states that outcomes, penalties and remedial measures cannot currently be predicted.
The company and certain executives face securities and shareholder derivative litigation related to allegations in a December 2017 short-seller report. The company believes the actions are without merit, but cannot estimate potential losses.
An investigation into acquired AS&E’s historical discount practices and GSA contract compliance could lead to False Claims Act claims, including treble damages and civil penalties. Management states that an appropriate accrual has been provided.
Environmental matters at the Hawthorne facility have not been accrued because unfavorable outcomes are not considered probable and reasonably estimable; an adverse resolution could be material.
Contingent acquisition obligations had a recorded fair value of $16.7 million, with maximum potential payments of $30.3 million under agreements with caps.
Internal control disclosure controls were not effective because of a previously identified material weakness involving non-routine transactions, including business combinations. Remediation efforts were ongoing.

Important Facts to Verify

Whether provisional Tax Act accounting will be adjusted during the permitted measurement period and how future cash taxes and repatriation affect liquidity.
The ultimate outcome and financial exposure from SEC, DOJ, FCPA, trading, securities-litigation and GSA investigations.
Final purchase-accounting valuations for the ETD acquisition, which remained preliminary and could result in material adjustments.
The sustainability of gross-margin improvement after acquisition-related mix benefits and the effect of the reduced-rate Mexican contract.
Progress in remediating the material weakness in internal controls over non-routine transactions.
Debt levels, variable-rate exposure and continued share repurchases relative to operating cash flow and acquisition spending.