OSI Systems, Inc.

Hello. Thank you for standing by, and welcome to the OSI Systems, Inc. Fourth Quarter 2022 Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question and answer session. To ask a question during the session, you will need to press Star 1-1 on your telephone. Please be advised that today's conference may be recorded. I would now like to hand the conference over to your speaker today, Alan Edrick, Chief Financial Officer. Please go ahead.

Well, thank you. Good afternoon and thank you for joining us. I'm Alan Edrick, Executive Vice President and CFO of OSI Systems. Deepak Chopra, our President and CEO, could not join the call today due to an unavoidable last-minute conflict. Welcome to the OSI Systems Fiscal 22 Fourth Quarter Conference Call. Let's review our business performance, financial and operational results. Earlier today we issued a press release announcing our fourth quarter and fiscal year 22 financial results. Before we discuss the results, however, I would like to remind everyone that today's discussion will include forward-looking statements and the company wishes to take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 with respect to such forward-looking statements. All forward-looking statements made on this call are based on currently available information. and the company undertakes no obligation to update any forward-looking statement based upon subsequent events or new information or otherwise. During today's call, references will be made to both GAAP and non-GAAP financial measures when describing the company's results. For information regarding non-GAAP measures and GAAP measures of the company's results and a quantitative reconciliation of those figures, please refer to today's earnings release. Let's begin with the discussion of our financial performance for the fourth quarter of fiscal 2022, provide an overview of our business performance, and then let's finish up with more detail regarding our financial results and the discussion of our outlook for fiscal 23. We are pleased with our results last quarter, particularly given the macroeconomic challenges we faced, including supply chain delays and logistics costs, disruptive geopolitical events, the COVID-19 pandemic, inflation, and rising interest rates. As we manage the current environment, we continue to prioritize delivering on commitments to our customers and partners and positioning the company for long-term success. Now let's go through a high-level summary of our financial results. First, we reported record Q4 revenues of $337 million, a 1% year-over-year increase driven by record Security Division sales. The strength in security sales was partially offset by a slight reduction in year-over-year opto sales, mainly due to certain supply chain constraints, and a small reduction in healthcare division sales. Second, we reported record Q4 adjusted earnings per share of $1.96, up 27% from Q4 of the prior year, driven by productivity improvements, a favorable sales mix, tighter cost controls, a lower tax rate, and a reduced share count, which outweighed higher supply chain logistics and labor costs. Third, bookings were solid, with a book-to-bill ratio of just above 1 for Q4 and 1.13 for the full fiscal year. We concluded the fiscal year with a record Q4 backlog of over $1.2 billion, a 15% increase over the backlog at the end of fiscal 21. And finally, Operating cash flow for the fourth quarter was strong, as we generated approximately $22 million, while capital expenditures were approximately $5 million. We spent approximately $15 million in our stock buyback program in the fourth fiscal quarter. Before diving more deeply into our financial results and discussing the fiscal 23 outlook, let's provide more detail of our business performance by division, starting with security, where Q4 and fiscal 22 revenues increased 4% and 5% respectively year over year. Security's Q4 book-to-bill ratio of 1.0 was solid, given record sales in the quarter. The security division ended fiscal 22 with a backlog 10% higher than the end of fiscal 21. Q4 was highlighted by robust performance, important border security-related products and services, with some notable bookings for these products, particularly with international customers. We previously announced a few of these wins. a $12 million international contract to provide Eagle P60 ZVX drive-through cargo and vehicle inspection systems and related products and follow-on services, another $12 million international award for Eagle M60 mobile high-energy cargo and vehicle inspection systems, along with follow-on service and support, and a $29 million international order to provide several cargo and vehicle inspection systems in various mobile and fixed configurations. As international travel restrictions are gradually dissipating, we're capitalizing on opportunities where face-to-face sales and customer support are crucial. In the U.S., we began to deliver on the significant awards received earlier in fiscal 22 under the indefinite delivery, indefinite quantity contracts, or IDIQs, from the U.S. Customs and Border Protection in Q4. These programs not only utilize our cargo and vehicle inspection platforms, but also our CertScan software and vehicle checkpoint lane control solutions from Gatekeeper, a business we acquired in the second half of fiscal 22. We anticipate recognizing most of the revenue from these delivery orders over the next three years, which is somewhat longer than originally expected, mainly due to customer readiness timing. These were the first orders under the five-year IDIQs and there is opportunity to receive additional orders during this timeframe as CBP continues to work towards their goals at the U.S. southern border. We continue to see traction with large U.S. customers for CertScan, our proprietary software platform that is cyber secure, can manage inspection image data, integrates with other IT systems at checkpoints, and facilitates the automation of inspection activity. We're also working on international opportunities that would rely on CertScan as a key component where equipment installation, image data management, systems integration, and training are required. Our turnkey service programs continue to perform well in Puerto Rico, Albania, and Guatemala, and we are actively pursuing additional turnkey services opportunities. Our revenue growth in ports and border security was offset to some degree by the lower revenues in our aviation-related business. Within this sector, There were bright spots during the year as we worked with global logistics carriers such as DHL and FedEx to address their demands for air cargo screening as passenger aviation related sales were more modest. We anticipate that we could see an overall improvement in the aviation sector in calendar 23 and forward as demand at international airports is anticipated to increase for servicing and upgrading passenger and baggage inspection infrastructure. I should note that while aviation is an important market for us long term, it accounted for under 10% of the total company revenues in fiscal 22. These percentages will fluctuate year to year based on upgrade and replacement cycles, among other factors. Looking ahead, with a significant backlog and a strong pipeline of opportunities, the security division enters fiscal 23 in a good position to drive revenue growth. Moving on to optoelectronics. The optoelectronics and manufacturing division generated total revenues, including intercompany, of $367 million for fiscal 22, representing a 5% increase over revenues in the prior fiscal year and a new record for the division. The opto division has strong bookings, finishing the fiscal year with a book-to-bill ratio of 1.2 and a record year on backlog. Opto continues to support a wide variety of OEMs in aerospace, defense, healthcare, test and measurement, automotive, and consumer technologies. Supply chain constraints, longer lead times, and rising input costs adversely impacted us in fiscal 22 and continue to adversely impact us today. We have been proactive, however, and increased our inventory of certain materials to help mitigate the impact of supply chain disruptions and continuing to serve our customer base while adjusting our pricing to reflect the increased material costs in this division. During fiscal 22, we brought in our global operational footprint and improved our ability to handle heightened demand with the addition of a new Indian manufacturing facility that is now nearly fully operational and has necessary regulatory approvals and customer acceptance, particularly from healthcare customers. We also further vertically integrated our flexible circuit manufacturing operations by adding a wet-edge processing operation, reducing our reliance on outsourcing to an already constrained global electronic supply chain, which is expected to increase operating margins as well. Opto started fiscal 23 with a large backlog and a global customer base that continues to rely on suppliers like Opto that can execute in a tough environment. We believe that we are well-positioned in the Opto division for a strong year, although supply chain constraints are expected to push certain planned Q1 revenues into a subsequent quarter. Moving to healthcare. The healthcare division's fiscal 22 revenues were 3% below fiscal 21, as expected. The lower revenue level in fiscal 22 resulted primarily from reductions in pandemic-related healthcare spending. we continue to invest significant resources in R&D in our healthcare division to enhance our core offerings and to develop new products in patient monitoring and diagnostic cardiology that align well with the trend in the marketplace for enhanced digital connectivity to enable hospital to home patient care. Looking ahead in the healthcare division, we will focus on the continued growth of our cardiology and remote monitoring business and also drive recurring services, supplies, and accessories revenues to counter the drawdown of the elevated purchases of patient monitoring products during the pandemic. Now let's go through the financial results for our fourth quarter in greater detail. So as mentioned, Q revenues were up 1% compared with that of the prior year Q4. Fiscal fourth quarter security division revenues were up 4% on a very challenging comp, given the divisional's exceptional performance in Q4 fiscal 21. This increase was primarily driven by our cargo and vehicle inspection offerings. While both product and service revenues increased, we saw a more notable increase in service revenues. Aviation-related sales were again down year over year. However, we are seeing increased activity levels in this area. OPTO third-party sales decreased 1% year over year for the quarter. while Opto's total sales, including intercompany sales, decreased 2% year over year. Though we entered Q4 with a then record Opto backlog and now enter fiscal 23 with a new record Opto backlog, supply chain constraints have led to delays in production and shipments of certain orders. The healthcare division reported a 3% reduction in Q4 year over year revenues. While patient monitoring and cardiology sales decreased in the quarter, There was an increase in services, supplies, and accessory sales, which tend to be recurring in nature. The fiscal 22 Q4 gross margin was 36.4%, compared to 35.5% reported in Q4 fiscal 21. The increase was driven primarily by a 9% increase in service revenues, which tend to carry a better gross margin than product sales, as well as the mix of sales within the security and opt-in divisions. The small reduction in healthcare division sales, which has the highest gross margin among the three divisions, partially offset the increases just noted. We also experienced increases in certain component and freight costs in each division. These increased costs are expected to impact overall gross margin in fiscal 23. Our gross margin will fluctuate from period to period based upon revenue mix and volume, among other factors. Moving to operating expenses. We continue to work diligently across each of our divisions to improve efficiencies and to prudently manage our SG&A cost structure. Our Q4 results again demonstrate the success of these efforts. Q4 SG&A expenses were 66 million, or 19.5% of sales, compared to 68 million, or 20.5% of sales in the prior year Q4. Research and development expenses in Q4 of fiscal 22 were 14.6 million, representing a year-over-year increase of 5%. We continue to dedicate considerable resources to R&D, particularly in security and healthcare, as we remain focused on innovative product development, which we view as vital to the long-term success of our businesses. In Q4 of fiscal 22, we recorded 2.7 million of restructuring and other charges, as compared to $2.2 million in Q4 of the prior fiscal year. Over to interest and taxes. Net interest and other expense in Q4 of fiscal 22 decreased to $2.4 million from $4.1 million in the same prior year period, primarily due to the adoption of the accounting standard ASU 2020-06, which eliminated the non-cash interest expense associated with our convertible debt, as we previously discussed. Our cash interest expense increased approximately 17% in Q4 of fiscal 22 compared to Q4 the prior year. I will further discuss interest expense in the context of our fiscal 23 guidance later on this call. On the tax side, a reported effective tax rate under GAAP was 9% in Q4 fiscal 22 compared to 12.9% in the prior year Q4. In Q4 of fiscal 22, we recognized a discrete tax benefit of $4.9 million as compared to $4.0 million in Q4 of last year. Excluding the impact of discrete tax items, our effective tax rate in Q2 of fiscal 22 was 22.3% compared to an effective tax rate of 26.3% in Q4 of fiscal 21. I will now turn to a discussion of our non-GAAP adjusted operating margin. Overall, Our adjusted operating margin in Q4 of fiscal 22 increased 150 basis points to 13.7% compared to 12.2% in the same prior year period. This operating margin expansion was driven by an improved gross margin highlighted by increased service revenues and strong SG&A expense management. We were particularly pleased with the increase in the non-GAAP adjusted operating margin in our security division which expanded to 19.7% in the last quarter of fiscal 22 from 18.0% in the prior fiscal year fourth quarter, driven by increased service gross margin and lower operating expenses. We were also delighted that the adjusted operating margin in our Opto division increased to 12.7% in Q4 of the 2022 fiscal year from 11% in the prior fiscal year fourth quarter, despite slightly lower revenues due in part to gross margin expansion on a favorable product mix. And with lower revenues and a less favorable revenue mix, the adjusted operating margin of our healthcare division decreased to 8.9 percent from 11.8 percent in the prior year. Moving to cash flow. Cash flow provided by operations was 22 million in Q4 fiscal 22 compared to 8 million in the same prior year quarter, driven by higher profits and certain working capital improvements. CapEx in the fourth quarter was $4.6 million, while depreciation and amortization expense in Q4 was $9.7 million. We continue to be active in our stock buyback program in the quarter, during which we spent approximately $14.8 million to repurchase 177,336 shares, leaving approximately 1.25 million shares available to repurchase under the current authorized share repurchase program. Our balance sheet is solid. with net leverage under 1.5 and significant capacity for acquisitions and additional stock buybacks. Our convertible notes mature next month. We increased our credit facility in December of 2021 in contemplation of retiring the convertible notes. We expect to utilize 100 million from our delayed draw term loan and 142 million from our revolver to retire the approximately 242 million of convertible notes outstanding. we anticipate having over $300 million available under our credit facility following the retirement of the convertible notes, including the outstanding letters of credit. In this rising interest rate environment, we anticipate our borrowing cost will approximately double in fiscal 23 at the current level of debt outstanding. Finally, turning to guidance. For fiscal 23, the company anticipates revenues in the range of $1,240,000,000 to $1,275,000,000 in adjusted earnings per diluted share in the range of $6.02 to $6.25. The non-GAAP diluted EPS range excludes potential impairment, restructuring, and other charges, amortization of acquired intangible assets and non-cash interest expense, and their associated tax effects, as well as discrete tax and other non-recurring items. Given the current rising interest rate environment, the adjusted EPS guidance reflects an impact of approximately 30 cents per diluted share of expected increases in interest expense, resulting from the utilization of our credit facility to retire our maturing low interest rate convertible notes, as well as higher costs on the existing outstanding borrowings. Our earnings guidance also contemplates increased costs associated with certain products already in DACLOG, which we do not expect to pass on to customers, most notably in the security division. In fiscal 22, our performance was heavily weighted to the fourth fiscal quarter. Based on what we are currently seeing from our backlog and pipeline of opportunities and factoring in customer timeline preferences for deliveries and supply chain limitations, we currently anticipate revenues and adjusted operating income will be strongest in fiscal quarters two through four in fiscal 23. We currently believe this revenue and adjusted earnings guidance reflect reasonable estimates. The actual impact on the company's financial results of the pandemic, supply chain disruptions and increasing costs and rising inflation and interest rates is difficult to predict and could vary significantly from the anticipated impact currently reflected in our estimates and guidance. Actual revenues and non-GAAP earnings per diluted share could also vary from the anticipated ranges due to other risks and uncertainties discussed in our SEC filings. In the face of these challenging times, we continue to remain focused on the growth of our businesses and continued management of our cost structure. We believe our efforts in these areas will enable OSI to continue providing innovative products and solutions. We delivered solid results throughout fiscal 22 in a dynamic and challenging environment. We continue to navigate effectively through uncertainty while gaining traction in key strategic growth areas and positioning the company to capitalize on improving end markets. We'd like to take this opportunity to thank the global OSI Systems team for its continued dedication in supporting our customers and contributing to the creation of value for our stockholders and other stakeholders. And at this time, we'd like to open the call to questions.

Thank you. As a reminder, to ask a question, you will need to press star 1 1 on your telephone. Please stand by while we compile the Q&A roster. Our first question comes from Brian Ruttenberg with Imperial Capital. You may proceed.