OSI SYSTEMS INC annual report, FY2020

OSI Systems, Inc. — Fiscal 2020 Form 10-K Summary

Reporting period: The supplied filing is the annual report for the fiscal year ended June 30, 2020, filed August 21, 2020. The request metadata references “2019 Q4,” but the filing is a full fiscal-year 2020 Form 10-K, not a quarterly filing.

Business context

OSI Systems designs and manufactures specialized electronic systems and components for homeland security, healthcare, defense, aerospace, medical and industrial applications. Its three operating divisions are Security, Healthcare, and Optoelectronics and Manufacturing. Security represented approximately 64% of fiscal 2020 revenue, Healthcare 16%, and Optoelectronics and Manufacturing 20%.

• Security revenue was $742.0 million, including inspection systems, turnkey screening solutions and related services.
• Healthcare revenue was $185.3 million, primarily from patient monitoring, diagnostic cardiology and connected care systems.
• Optoelectronics and Manufacturing revenue was $238.7 million, including external OEM and electronics manufacturing activity.
• International shipments represented approximately 57% of revenue in fiscal 2020.

Key financial metrics

Metric	Fiscal 2020	Fiscal 2019	Change
Revenue	$1,166.0 million	$1,182.1 million	Down 1.4%
Gross profit	$420.6 million	$430.6 million	Down $10.0 million
Gross margin	36.1%	36.4%	Down 0.3 percentage points
Income from operations	$104.9 million	$107.8 million	Down 3%
Operating margin	9.0%	9.1%	Down 0.1 percentage points
Net income	$75.3 million	$64.8 million	Up 16.1%
Diluted EPS	$4.05	$3.46	Up $0.59
Cash flow from operations	$129.2 million	$119.1 million	Up $10.1 million

Net margin improved to approximately 6.5% from 5.5%, primarily reflecting a lower income tax provision. The fiscal 2020 tax provision was $10.9 million, compared with $21.4 million in fiscal 2019; the effective tax rate was 12.6% versus 24.8%. Excluding discrete tax items, the effective tax rate was 27.3% versus 28.9%.

Cash flow, liquidity and debt

• Cash and cash equivalents were $76.1 million at June 30, 2020, down from $96.3 million.
• Operating cash flow was $129.2 million. Investing cash outflows were $42.7 million, including $20.4 million of capital expenditures, $8.9 million for acquisitions and $13.4 million for intangible and other assets, primarily internal-use software development.
• Financing cash outflows were $104.7 million, including $29.2 million of net debt repayment and $76.3 million for share repurchases and taxes related to net share settlements of equity awards.
• Total debt was $327.0 million, down from $346.6 million. This included $59.0 million outstanding under the revolving credit facility and $267.1 million of long-term debt.
• The revolving credit facility provides total commitments of $535 million, with $429.5 million available after borrowings and letters of credit. The company was in compliance with its debt covenants.
• The company has $287.5 million principal amount of 1.25% convertible senior notes due September 2022. The notes were not convertible during fiscal 2020 under the stated conditions.
• Management stated that cash, credit facilities and operating cash flow should be sufficient for operational needs over the next 12 months and the foreseeable future.

Material changes versus fiscal 2019

• Revenue declined modestly as COVID-19 disrupted aviation, cargo, contract manufacturing and commercial optoelectronics activity, particularly late in the third quarter and during the fourth quarter.
• Security revenue declined 1%, primarily because of lower service revenue and the June 2020 expiration of the Mexican SAT turnkey screening contract, partly offset by stronger cargo and vehicle inspection sales.
• Healthcare revenue declined 2% because of lower patient-monitoring equipment sales and the exit from a product line, despite increased demand for certain monitoring products related to COVID-19.
• Optoelectronics and Manufacturing revenue declined 3% because of lower contract manufacturing and commercial optoelectronics sales, partly offset by a February 2020 acquisition.
• Gross margin decreased because the mix shifted away from higher-margin service revenue toward equipment sales.
• SG&A declined 4% due to cost containment, lower travel and lower commissions. Research and development increased 1% to $57.3 million.
• Impairment, restructuring and other charges increased to $6.5 million from $3.8 million. Fiscal 2020 included $5.5 million of asset impairments, $4.2 million of employee termination and facility closure costs, and a $3.6 million net recovery of certain legal costs from insurance reimbursements.
• Backlog was approximately $861 million at June 30, 2020, down from $911 million. Approximately $274 million was not reasonably expected to be fulfilled in fiscal 2021.
• Shares outstanding declined to approximately 18.0 million from 18.2 million, reflecting repurchases and equity award settlements. A new repurchase authorization was increased to 3.0 million shares in August 2020.

Guidance, outlook, risks and unusual items

The filing does not provide specific fiscal 2021 revenue, earnings or margin guidance. Management expects continued uncertainty from COVID-19, global economic conditions, government budgets, trade policies, tariffs and sanctions.

• COVID-19 reduced airline passenger traffic and demand for certain airport security products, delayed customer orders and deliveries, limited manufacturing capacity at some facilities and increased risks of customer defaults, contract modifications and supply-chain disruption.
• Healthcare demand for patient monitoring products increased during the pandemic, but management cautioned that elevated 2020 purchases could reduce future capital purchases as customers become more heavily equipped.
• The European deadline for airports to meet ECAC Standard 3 hold-baggage screening requirements was moved from September 2020 to September 2021. OSI’s RTT product had passed the Standard 3 threat-detection requirement.
• The Mexican SAT turnkey security contract expired in June 2020. Continuation and terms remained uncertain.
• Material risks include dependence on government and international spending, lengthy sales and acceptance cycles, contract cancellations or nonrenewals, competition, foreign exchange, supply-chain concentration, cybersecurity, regulatory compliance, medical-device recalls, environmental remediation and execution of the company-wide ERP implementation.
• The company continues to investigate soil and groundwater contamination beneath its Hawthorne facility and has not accrued a loss contingency because management does not consider an adverse outcome probable and reasonably estimable.
• OSI and certain executives face consolidated securities and shareholder derivative litigation related to allegations in a 2017 short-seller report. The SEC and DOJ are also investigating trading in the company’s securities and related operations and disclosures. Outcomes and potential losses could not be reasonably predicted or estimated, and no related loss accrual was recorded.
• The company adopted ASC 842 lease accounting in fiscal 2020, recognizing approximately $27.9 million of operating lease right-of-use assets and $28.3 million of operating lease liabilities. The adoption did not materially affect operating results or cash flows.

Investor verification points

• Verify the effect of COVID-19 on fiscal 2021 orders, manufacturing capacity, aviation and cargo demand, customer payment performance and margins.
• Monitor whether the Mexican SAT program is renewed and the financial effect of any revised terms.
• Reconcile backlog conversion, including the $274 million not expected to be fulfilled in fiscal 2021, with actual revenue and cash collections.
• Assess liquidity ahead of the $287.5 million convertible-note maturity in September 2022, including conversion or repurchase obligations.
• Review the status and potential exposure from the SEC and DOJ investigations, securities litigation, derivative actions and related legal costs.
• Evaluate inventory valuation and obsolescence risk; inventory was $241.2 million and was identified by the auditor as a critical audit matter.
• Track foreign-currency exposure, with management estimating that a 10% appreciation or depreciation of the U.S. dollar would change fiscal 2020 operating income by approximately $5.8 million in the opposite direction.
• Confirm the company’s ability to maintain debt-covenant compliance, access its revolving facility and manage the planned transition away from LIBOR.