OSI SYSTEMS INC quarterly report, Q3 FY2015

OSI Systems, Inc. — Form 10-Q Summary

Reporting period: The filing covers the three and nine months ended March 31, 2015, representing fiscal third quarter 2015. The request metadata identifies “2014 Q3,” but the filing’s current reporting period is March 31, 2015, with March 31, 2014 comparatives.

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. The company operates internationally and provides products, services, turnkey security screening solutions and electronics manufacturing services.

Financial Performance

Metric	Three months ended March 31	Change	Nine months ended March 31	Change
Net revenues	$215.4 million	6%	$691.6 million	7%
Gross profit	$72.6 million	3%	$236.1 million	8%
Gross margin	33.7%	Down from 34.6%	34.1%	Up from 33.9%
Income from operations	$18.5 million	2%	$61.2 million	21%
Net income	$13.2 million	175%	$42.7 million	66%
Diluted EPS	$0.64	Up from $0.23	$2.08	Up from $1.25

Quarterly operating margin was approximately 8.6%, compared with 8.8% in the prior-year quarter. Nine-month operating margin improved to approximately 8.8% from 7.8%.

Revenue mix: In the quarter, Security revenue rose 4% to $99.2 million, Healthcare revenue rose 14% to $59.4 million, and Optoelectronics and Manufacturing revenue declined 2% to $65.3 million before intersegment eliminations.
Year-to-date mix: Security revenue increased 17% to $349.6 million, Healthcare increased 10% to $176.7 million, and Optoelectronics and Manufacturing declined 7% to $199.9 million before eliminations.
Operating expenses: Quarterly SG&A declined 4% to $38.0 million, while research and development increased 18% to $12.6 million. Nine-month SG&A increased 2% and R&D increased 17%.
Taxes: The quarterly effective tax rate was 25.0%, compared with 71.2% in the prior-year quarter. The prior-year rate included a $7.6 million non-cash tax charge related to accelerated depreciation for the Mexico turnkey screening program. The nine-month effective tax rate was 27.2%, compared with 44.2%.

Cash Flow, Debt and Liquidity

Cash and cash equivalents were $49.0 million at March 31, 2015, compared with $38.8 million at June 30, 2014.
Operating cash flow was $87.7 million for the nine months, down from $123.8 million. The decline primarily reflected working-capital usage of $24.1 million versus a $17.5 million source in the prior-year period.
Investing cash outflow was $30.1 million, including $10.1 million of capital expenditures and $14.7 million for business and other asset acquisitions.
Financing cash outflow was $46.3 million, including $18.0 million of repayments on bank lines and $30.4 million of common-stock repurchases and net share settlements.
Total outstanding lines of credit and current and long-term debt were $17.8 million at March 31, 2015, down from $37.3 million at June 30, 2014.
The company had a $450 million revolving credit facility maturing in May 2019. At March 31, 2015, $6.0 million was drawn and $85.4 million was outstanding under the letters-of-credit sub-facility. The company reported $24.2 million available under foreign credit facilities, with no foreign debt outstanding.
Approximately 71% of cash, cash equivalents and investments were held by foreign subsidiaries and may be subject to additional U.S. tax upon repatriation.
Management stated that available funds, credit facilities and operating cash flow should be sufficient to meet operational needs for at least the next 12 months.

Material Changes Versus the Prior Comparable Period

Revenue growth was led by Security, including deliveries under a U.S. Department of Defense Foreign Military Sale contract for Iraq, and Healthcare, including Latin American and Asian growth and a European cardiology acquisition.
Optoelectronics and Manufacturing revenue declined because of lower contract-manufacturing sales, partially offset by stronger commercial optoelectronics activity.
Quarterly gross margin declined because of product and geographic mix in Healthcare and product mix in Security. Year-to-date gross margin improved because of operational efficiencies and product mix in Optoelectronics and Manufacturing.
Operating income and net income benefited from higher sales, lower interest expense, a substantially lower tax rate and reduced year-to-date restructuring charges.
Foreign currency translation produced an $8.9 million year-to-date loss in other comprehensive income, compared with a $2.0 million gain in the prior-year period.
Inventories increased to $265.4 million from $234.1 million at June 30, 2014, while accounts receivable declined to $165.4 million from $185.8 million.
The company completed acquisitions that were not material individually or in aggregate; Healthcare completed a small European cardiology acquisition.

Guidance, Outlook, Risks and Unusual Items

No specific quantitative revenue or earnings guidance is provided in the filing. Management expects available liquidity and cash generation to support operations for at least the next 12 months.
Key risks include delays or cancellations of domestic and international government contracts, government budget and sequestration actions, customer program delays, foreign exchange movements, international political and economic conditions, healthcare capital-spending pressure, regulatory and export-control compliance, and market acceptance of new products.
The company is subject to a securities class action and two shareholder derivative actions concerning alleged disclosures about automated threat-recognition software, unapproved parts in baggage-scanning systems and related stock sales. The company believes the claims are without merit but cannot predict the outcome or estimate any potential loss.
The Hawthorne, California facility has historical soil and groundwater contamination. Monitoring and investigations continue; no environmental liability has been accrued because a loss is not considered probable and reasonably estimable. An adverse resolution could be material.
Contingent acquisition consideration had a maximum potential future payment of $57 million, with $20.8 million of contingent payment obligations recorded at March 31, 2015.
A $100 million advance from the Mexican government for a turnkey border and airport screening project had $56.3 million remaining to be amortized at March 31, 2015.
The TSA terminated a delivery order for default following use of an upgraded X-ray generator without advance TSA approval and asserted a compensation claim. The matter was resolved by mutual agreement in April 2015, after the reporting date; the filing text does not provide the settlement amount.
Restructuring and other charges were $3.6 million in the quarter and $6.4 million year-to-date, including costs related to TSA and foreign-government contract matters, facility consolidations, employee reductions and legal defense costs.
The company had no significant off-balance-sheet arrangements and reported effective disclosure controls with no material changes in internal control over financial reporting.

Investor Verification Items

Verify the amount and accounting impact of the TSA settlement reached in April 2015.
Monitor the securities class action, derivative litigation and any related legal fees or settlements.
Assess the potential exposure from the Hawthorne environmental investigation and the $57 million maximum contingent acquisition payments.
Evaluate the sustainability of Security growth, the Healthcare acquisition contribution and the decline in contract-manufacturing revenue.
Review working-capital trends, particularly the increase in inventories and the reduction in operating cash flow.
Consider foreign-currency sensitivity: management estimated that a 10% appreciation or depreciation of the U.S. dollar against local currencies would change quarterly operating income by approximately $3.0 million in the opposite direction.
Confirm the effect of foreign cash holdings and potential repatriation taxes on U.S. liquidity.