OSI SYSTEMS INC quarterly report, Q2 FY2020

OSI Systems, Inc. — Form 10-Q Summary

Reporting period: Fiscal second quarter and first six months ended December 31, 2019. The filing describes these periods as Q2 fiscal 2020 and compares them with the corresponding periods ended December 31, 2018. The financial statements are unaudited.

Business Context

OSI Systems designs and manufactures specialized electronic systems and components for homeland security, healthcare, defense, aerospace and other critical applications. Its three reporting segments are Security, Healthcare, and Optoelectronics and Manufacturing.

Security: Inspection systems, detection products, related services and turnkey security-screening solutions.
Healthcare: Patient monitoring and diagnostic cardiology systems and services.
Optoelectronics and Manufacturing: Specialized electronic components, flex circuits and electronics manufacturing services for internal and external customers.

Financial Performance and Key Metrics

Metric	Three months ended Dec. 31, 2018	Three months ended Dec. 31, 2019	Six months ended Dec. 31, 2018	Six months ended Dec. 31, 2019
Net revenues	$303.2 million	$305.3 million	$569.5 million	$596.2 million
Gross profit	$110.3 million	$110.8 million	$206.3 million	$210.0 million
Gross margin	36.4%	36.3%	36.2%	35.2%
Operating income	$31.7 million	$32.9 million	$48.0 million	$57.8 million
Net income	$19.1 million	$21.0 million	$28.5 million	$41.7 million
Diluted EPS	$1.03	$1.12	$1.53	$2.22

Six-month segment revenue increased 9% in Security to $391.4 million, decreased 8% in Healthcare to $82.2 million, and increased 1% in Optoelectronics and Manufacturing to $122.6 million. Security represented approximately 66% of consolidated revenue, Healthcare 14%, and Optoelectronics and Manufacturing 20% of external revenue.

Six-month operating expenses declined to $152.2 million from $158.3 million. SG&A decreased 2.1%, while research and development increased 9.7% to $29.1 million. Restructuring and other charges changed from a $2.9 million expense to a $3.0 million net benefit, primarily because of insurance reimbursements for legal costs, partially offset by severance costs.

The six-month effective tax rate was 13.5%, compared with 23.0% in the prior-year period. The reduction primarily reflected discrete tax benefits related to equity-based compensation of approximately $6.9 million. Excluding those discrete items, the effective tax rate was 27.8%, compared with 28.2%.

Cash Flow, Liquidity and Debt

Cash flow from operations was $59.6 million for the six months ended December 31, 2019, compared with $40.8 million in the prior-year period.
Investing cash outflow was $15.6 million, including $11.6 million of capital expenditures and $3.9 million for intangible and other assets.
Financing cash outflow was $45.9 million, driven primarily by $27.0 million of share repurchases and $26.7 million of tax payments related to net share settlements of equity awards.
Cash and cash equivalents were $95.1 million at December 31, 2019, down from $96.3 million at June 30, 2019. Approximately 82% was held by foreign subsidiaries and subject to potential repatriation tax considerations.
The revolving credit facility has aggregate commitments of $535 million and matures in April 2024. Borrowings were $91.0 million, letters of credit were $53.7 million, and available borrowing capacity was $390.3 million.
The company had $287.5 million principal amount of 1.25% convertible senior notes due September 2022, with a carrying value of $261.1 million at December 31, 2019. The notes were not convertible during the reported quarter.
Total debt, including current and long-term portions, was approximately $354.2 million at December 31, 2019, based on the balance sheet carrying amounts.
Management stated that cash, operating cash flow and available credit facilities are expected to meet operational cash needs for the next 12 months and the foreseeable future. The company was in compliance with its credit-facility covenants.

Material Changes Versus the Prior Comparable Period

Revenue increased 1% in the quarter and 5% for the six-month period, led by Security products and services.
Healthcare revenue declined because of lower patient-monitoring-system sales; management noted that prior product-launch difficulties may continue to affect results.
Six-month gross margin declined 100 basis points because of an unfavorable Security revenue mix, with higher equipment sales relative to higher-margin services, and lower Healthcare revenue. Optoelectronics and Manufacturing margin improved through favorable mix and operational efficiencies.
Operating income increased 4% in the quarter and 21% for the six-month period, benefiting from lower SG&A and restructuring-related benefits.
Net income increased 10% in the quarter and 46% for the six-month period, with the year-to-date increase aided materially by discrete tax benefits.
Share repurchases totaled 266,874 shares, or $27.0 million, during the six months. The company had 295,833 shares remaining under its authorized repurchase program at December 31, 2019.
The company adopted ASC 842 lease accounting on July 1, 2019, recording approximately $26.9 million of operating lease right-of-use assets and $27.2 million of operating lease liabilities at December 31, 2019. Management stated that adoption did not materially affect operating results or cash flows.

Guidance, Outlook, Risks and Unusual Items

The filing does not provide a specific quantitative revenue or earnings forecast. Remaining performance obligations were approximately $189.2 million at December 31, 2019; management expected to recognize approximately 51% during the following 12 months.

The Mexican government turnkey security-screening contract, scheduled to expire in January 2020, was extended through May 13, 2020. Discussions regarding a potentially broader program were ongoing, but continuation and terms were uncertain.
Management cited risks from global economic uncertainty, Brexit, foreign exchange movements, trade policies and tariffs, government spending and procurement policies, healthcare-market conditions, customer acceptance timing, contract delays and product-market acceptance.
The company is involved in shareholder securities litigation and derivative litigation related to allegations in a 2017 short-seller report. The company believes the claims are without merit, but outcomes and potential losses could not be predicted or estimated.
The SEC and DOJ were investigating trading in company securities and related company operations and disclosures. The company could not predict potential actions, penalties or remedial measures.
Environmental investigations continued regarding historical soil and groundwater contamination at the Hawthorne, California facility. No loss contingency was accrued because an unfavorable outcome was not considered probable and reasonably estimable; an adverse resolution could be material.
Acquisition-related contingent payment obligations had a remaining maximum potential payment of $26.2 million, while the recorded contingent consideration liability was $16.7 million.
The company recorded net legal-cost reimbursement benefits of $3.5 million for the six months ended December 31, 2019, partially offset by $0.5 million of severance costs.

Investor Verification Checklist

Verify whether Security revenue growth and the mix between equipment and higher-margin services can support or restore gross margins.
Assess the recovery trajectory of Healthcare sales and the effect of prior product-launch issues.
Separate recurring earnings performance from the $6.9 million year-to-date discrete tax benefit.
Monitor renewal, expansion or termination of the Mexican SAT contract after May 13, 2020.
Review developments and potential financial exposure from the shareholder litigation, derivative actions, and SEC/DOJ investigations.
Evaluate liquidity accessibility given that approximately 82% of cash was held by foreign subsidiaries and that the company had substantial debt and letters of credit.
Track cash deployment, share repurchases, convertible-note maturity in 2022, and compliance with revolving-credit covenants.