OSI Systems, Inc. — Form 10-Q Summary
Business context and reporting period
OSI Systems designs and manufactures specialized electronic systems and components for homeland security, healthcare, defense, aerospace and related markets. Its reporting segments are Security, Healthcare, and Optoelectronics and Manufacturing. This filing covers the three months ended September 30, 2017, the first quarter of fiscal 2018, compared with the three months ended September 30, 2016, the first quarter of fiscal 2017. The financial statements are unaudited.
Financial performance and liquidity
- Revenue: $257.1 million, up 16.4% from $220.9 million. Product revenue increased to $165.7 million from $153.5 million, while service revenue increased to $91.5 million from $67.4 million.
- Gross profit: $91.3 million, compared with $68.1 million. Gross margin improved to 35.5% from 30.8%, primarily due to favorable mix in Security, including AS&E and ETD, and in Optoelectronics and Manufacturing.
- Operating income: $19.4 million, compared with $2.1 million. Operating margin increased to approximately 7.5% from 1.0%.
- Net income: $10.2 million, compared with $0.7 million. Diluted earnings per share increased to $0.52 from $0.03.
- Interest and other expense: $4.2 million, compared with $1.2 million, reflecting higher borrowings and $1.8 million of non-cash interest expense associated with the convertible notes.
- Cash flow: Operating cash flow was $35.1 million, compared with cash used of $1.9 million in the prior-year quarter. Investing cash outflow was $108.5 million, including $83.6 million for acquisitions and $23.7 million for property and equipment. Financing cash inflow was $95.4 million, primarily from $111.0 million of revolving-credit borrowings.
- Cash and liquidity: Cash and cash equivalents were $192.0 million at September 30, 2017, up from $169.7 million at June 30, 2017. Approximately 99% of cash, cash equivalents and investments was held by foreign subsidiaries and subject to potential repatriation tax considerations.
- Debt: Revolving-credit borrowings were $214.0 million, with $33.1 million of letters of credit outstanding and $277.9 million available under the facility. Net long-term debt, after discount and issuance costs, was $245.7 million, including $240.9 million related to the convertible notes.
- Balance sheet: Total assets increased to $1.35 billion from $1.23 billion at June 30, 2017, primarily reflecting the ETD acquisition. Inventories increased to $271.3 million from $248.5 million.
Material changes versus the prior comparable period
- Security revenue increased 31% to $162.2 million and represented 63% of consolidated revenue, compared with 56% previously. The increase reflected AS&E, acquired in September 2016, and $21.7 million of ETD revenue following its July 2017 acquisition.
- Healthcare revenue was essentially unchanged at $45.5 million. Excluding the prior-year divestiture of a non-core European cardiology business, management stated that Healthcare revenue increased 10%.
- Optoelectronics and Manufacturing revenue increased 3% to $58.9 million, driven by commercial optoelectronics, partially offset by lower North American contract manufacturing revenue.
- SG&A increased 28% to $55.7 million and research and development increased 21% to $15.1 million, largely due to acquisitions and increased Security investment.
- Impairment, restructuring and other charges declined to $1.1 million from $10.0 million. The prior-year period included a $5.4 million impairment charge related to an abandoned Security product line.
- The ETD acquisition was completed on July 7, 2017 for estimated consideration of $80.5 million. Preliminary purchase accounting included $33.8 million of goodwill and $30.0 million of intangible assets. ETD contributed $21.7 million of revenue and $4.0 million of pretax income during the quarter.
Outlook, risks, contingencies and unusual items
- Management stated that available funds, credit facilities and operating cash flow are expected to meet operational cash needs for the next 12 months and the foreseeable future. No specific revenue or earnings guidance was provided in the filing.
- The Mexican SAT turnkey screening contract represented approximately 13% of quarterly revenue and was scheduled to expire in January 2018. Non-renewal, reduced scope or unfavorable revised terms could materially affect results and could impair assets dedicated to the contract.
- Management cited global economic uncertainty, U.S. dollar strength, weak oil markets, delayed customer purchasing, healthcare industry uncertainty, government budget and procurement changes, contract timing, customer acceptance requirements, foreign exchange and regulatory or compliance matters as significant risks.
- AS&E remained subject to a GSA investigation concerning historical discount practices and compliance with GSA contract pricing provisions. Management stated that an appropriate accrual had been recorded, but potential False Claims Act exposure could include treble damages and civil penalties.
- The company is investigating historical soil and groundwater contamination at its Hawthorne, California facility. No environmental liability was accrued because management did not consider a loss probable and reasonably estimable; an adverse resolution could be material.
- Contingent acquisition consideration had a fair value liability of $13.9 million at September 30, 2017, with maximum future payments under capped arrangements of $26.4 million.
- Management disclosed a material weakness in internal control over non-routine transactions, including business combinations. Disclosure controls and procedures were therefore concluded to be ineffective, although management stated that the financial statements fairly presented the company’s financial position and results under GAAP. Remediation efforts were underway.
- Tax expense included a $5.3 million increase in the valuation allowance against deferred tax assets, partially offset by a $4.3 million tax benefit for equity compensation. The reported effective tax rate was 32.9%; excluding discrete items, it was 28.3% versus 28.0% in the prior-year quarter.
Key facts investors should verify
- Whether the Mexican SAT contract was renewed, and on what scope, pricing and terms.
- The final purchase-price allocation for ETD and any resulting changes to goodwill, intangible assets, liabilities or earnings.
- Progress in remediating the material weakness in internal controls over non-routine transactions.
- The status and potential financial exposure of the GSA investigation involving AS&E.
- Debt levels, interest costs, covenant compliance and remaining borrowing capacity after acquisitions and capital expenditures.
- Whether the strong Security revenue and margin performance is sustainable after accounting for acquisition contributions and RTT product order timing.
- The availability and repatriation constraints of foreign-held cash, including potential tax costs if funds are moved to the United States.