This conference call transcript was computer generated and almost certianly contains errors. This transcript is provided for information purposes only.EarningsCall, LLC makes no representation about the accuracy of the aforementioned transcript, and you are cautioned not to place undue reliance on the information provided by the transcript.
spk20: Good day, and thank you for standing by. Welcome to OSI Systems, Inc. Second Quarter 2023 Conference Call. At this time, all participants are in a listen-only mode. After the speaker's 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. You will then hear an automated message advising your hand is raised. To withdraw your question, please press star 1 1 again. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Alan Edrick, Executive Vice President and Chief Financial Officer. Please go ahead.
spk09: Thank you. Good morning, and thank you for joining us. I'm Alan Edrick, Executive Vice President and CFO of OSI Systems, and I'm here today with Deepak Chopra, OSI's President and CEO. Welcome to the OSI Systems Fiscal 23 Second Quarter Conference Call. We are pleased that you can join us as we review our financial and operational results. Earlier today, we issued a press release announcing our second quarter fiscal 23 financial results. Before we discuss our 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 on subsequent events or new information or otherwise. During today's call, we will refer 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. I will begin with a discussion of our Q2 financial performance and then turn the call over to Deepak for an overview of our business performance. We will then finish with more detail regarding our financial results and a discussion of our outlook for the overall fiscal year. Our second quarter financial results were solid as we navigated the current economic environment, which continues to be impacted by supply chain delays and increased costs, disruptive geopolitical events, inflation, and rising interest rates. Our bookings and book-to-bill ratio were very strong last quarter, and we were awarded some significant contracts, which we will discuss during this call. But let's start with a high-level summary of our Q2 results. First, we reported Q2 revenues of $296 million, representing a year-over-year increase of 7%, driven by solid revenue growth in our security and opt-out divisions, which were in part offset by soft healthcare division sales and an approximate $4 million unfavorable FX impact. Second, we reported Q2 adjusted earnings per share of $1.19, down from $1.28 in Q2 of the prior year as a result of a less favorable mix of sales, which was anticipated, and additional interest expense. And third, Our Q2 bookings were over 500 million, representing a book-to-bill ratio of approximately 1.7, leading to a record quarter and backlog of nearly 1.5 billion. Before diving more deeply into our financial results and discussing the fiscal 23 outlook, I will turn the call over to Dibak.
spk04: Thank you, Alan, and thanks to everyone joining us on today's call. Our performance in Q2 of fiscal 23 was solid as we grew the top line while continuing to successfully operate in a macro environment challenged by the multiple factors that Alan mentioned. Our Q2 bookings were very strong, resulting in a record quarter end backlog. We believe we are well positioned for the second half of fiscal 23 And this also positions the security division especially really well entering for fiscal 24. Let's discuss each division's performance starting with security. The security division delivered Q2 revenues of $167 million, about 15% higher than Q2 in the prior year. We were pleased with the division's profitability, expanding our operating margin to 12.9%. Our security bookings were very strong and resulted in a book-to-bill ratio of 2.3 for Q2 and 1.9 times for the first half of fiscal 23 for this division. We continue to deliver on the large existing U.S. Customs and Border Protection CBP programs we announced in fiscal 22. These CBP programs focus on improving security at the U.S. borders by utilizing our cargo and vehicle inspection platforms, SurgeScan integration software, and Gatekeeper vehicle checkpoint lane control solutions. SurgeScan is our proprietary software solution that helps manage inspection image data, traffic, vehicle identification, and integrates with other systems at checkpoints to streamline and facilitate the inspection process. Search scan is also compatible with third-party inspection systems, making it a versatile option in the marketplace. Based upon CBP's current timing, some push out from Q3 to Q4 has happened from what was previously anticipated. While Q2 year-over-year security division revenues were up double digits and operating margin expanded, We believe the most notable item of the quarter was our exceptional bookings highlighted by a $200-plus million international order that we received in December and announced shortly afterward quarter end in January. Our deliverables are expected to include a number of our cargo and vehicle inspection products and radiation portal monitors along with the managing the civil works and providing operator training and ongoing maintenance in the coming years. We are not forecasting any significant revenues related to this award in fiscal 23, but this contract provides strong visibility into fiscal 2020 in the 24 security revenues. We are currently working on the schedule with this customer and expect to have more to share on future calls, though we will start some of the manufacturing production in fiscal 23. During November and December, we were proud to support the security efforts at the FIFA World Cup in Qatar as the primary provider of security detection products. This event was held at multiple stadiums around Doha and our Orion 920CX baggage and parcel inspection systems and Metro 6X walk-through metal detectors were successfully utilized to provide screening for over 2.5 million ticket holders and their belongings. In addition, these products were also used at the primary airport, hotels, and other venues throughout the city. This order was and will be a great showcase for rapid scan products in Middle East for time to come. In turnkey services, our projects in Albania, Puerto Rico, and Guatemala continue to perform well. The initial planning phase is underway for the new turnkey airport services multiyear contract, which we received earlier in fiscal 2023. As part of this contract, we expect to manage screening services at a European airport for the staff, airline crews, and vehicles at perimeter entry points. Initially, though, as we have said before, this is a small contract, but it's a first in the aviation space. Looking ahead, we believe that security with a strong backlog and visibility into other key opportunities in the pipeline is well positioned for the second half of fiscal 2023 and beyond. Shifting to optoelectronics division, that had another great quarter as third party Q2 revenues were 80 million, which represented a new quarterly record for the division. This division achieved a solid operating margin in spite of continued supply chain cost pressures extra. Apto serves a diversified OEM customer base in aerospace, defense, healthcare, and consumer technology, among others. In these markets, certain OEMs are seeking to reduce their exposure to China sourcing and further de-risk their supply chains by transitioning to other viable manufacturing regions in the east. We believe we could benefit significantly from this given our global manufacturing footprint covering Malaysia, Indonesia, India, United Kingdom, and the U.S. Looking ahead, With a strong Q2 ending backlog that is almost 20% higher than this time last year, Opto is well positioned. Moving to the healthcare division, this was a disappointing quarter. But we believe and expect stronger second half of the fiscal year in this division. We continue to significantly invest in developing new products to further strengthen our patient monitoring and cardiology portfolio. Subsequent to the quarter end, we bolstered the sales leadership in US with talent that we believe will help drive stronger results and position the business to thrive. Going forward, we plan to maintain our focus on innovation and operational execution while staying flexible to handle the opportunities as markets can change quickly. Overall, We are pleased with the company's fiscal 2023 second quarter performance as we grew our top line, achieved significant bookings that have resulted in a record backlog. In addition, with the record backlog and a strong pipeline of opportunities, we believe we are well positioned for the second half of fiscal 2023 and 24. I would like to thank our employees, customers, and shareholders and look forward to the second half. I will now turn the call back over to Alan Edrick to further discuss our financial performance before we open the call for questions. Thank you.
spk09: Well, thank you, Deepak. Now I will review the financial results for our second quarter in some greater detail. As said, our fiscal Q2 revenues were up 7% compared with that of the prior year Q2. Q2 security division revenues were up 15%. largely due to the growth in our cargo and vehicle inspection products and related service revenue. The security division's book-to-bill ratio was approximately 2.3, positioning the division well for strong revenue growth in the second half of fiscal 23 and into fiscal 24. Opto sales increased 8% year-over-year, with strength in third-party sales to a diversified customer base, as well as intercompany sales to support anticipated upcoming security division revenue growth. Opto bookings were again solid, leading to a record Q2 backlog for the opto division. As Deepak mentioned, the healthcare division, which is our smallest business unit, representing about 15% of our overall first half sales, reported a 17% reduction in year-over-year revenues in a more challenging marketplace, and in part due to a tougher year-over-year comp given the prior year elevated demand during the COVID Omicron variant surge. The Q2 gross margin was 32.5%, which, while consistent without a Q1, was about 3.6% below that of the prior year Q2. This year-over-year change was primarily driven by lower sales in the healthcare division, which carries the highest gross margin of our three divisions, higher opto sales as a percentage of total sales, which carries the lowest gross margin of the three divisions, and a less favorable mix in security division sales. Our gross margin is also impacted by increases in certain component costs. In general, our gross margin will fluctuate from period to period based on revenue mix and volume, inflation, and impacts of supply chain, among other factors. Based upon our forecasted conversion of backlog to revenue and pipeline of opportunities, we anticipate a stronger gross margin in the second half of fiscal 23 compared to the first half of this year. 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 Q2 results reflected these efforts. Q2 SG&A expenses were 54 million or 18.3% of sales compared to 54.9 million, or 19.8% of sales in the prior year Q2. While foreign exchange created a headwind for Q2 revenues, it did have a beneficial impact on our operating expenses again this quarter. Research and development expenses in Q2 of fiscal 23 were 14.5 million, consistent with that of the first quarter, and just below the prior year amount of 15 million. 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 Q2 of fiscal 23, we recorded $2.3 million of restructuring and other charges compared to just under $1 million of such charges in Q2 of the prior fiscal year. Moving to interest and taxes. Net interest and other expense in Q2 of fiscal 23 increased to $5.2 million, from $2.2 million in the same prior year period, primarily due to rising interest rates and the maturity of our 1.25% convertible notes on September 1st, which carried a lower rate than our current bank borrowings. We executed an interest rate swap during Q1 to fix a portion of our floating rate bank debt. On the tax side, the reported effective tax rate under GAAP was 19.5% in Q2 of fiscal 23, compared to 26.3% in Q2 of fiscal 22. In Q2 of this year, we recognized discrete tax benefits of $0.8 million as compared to a discrete tax expense of $0.3 million in Q2 last year. Excluding the impact of discrete tax items, our normalized effective tax rate in Q2 of fiscal 23 was 23%, compared to a normalized effective tax rate of 25%, in Q2 of fiscal 22. I will now turn to a discussion of our non-GAAP adjusted operating margin. Overall, our non-GAAP adjusted operating margin in Q2 of fiscal 23 decreased to 10.7% from 12.0% in the same prior year period. This was primarily driven by the weakness in revenue in the healthcare division, which carries the highest contribution margin of our three divisions, coupled with a reduction in the opto-operating margin due to a difficult prior year comp. The adjusted operating margin in the security division increased to 14.7% in Q2 from 14.2% in the prior year second fiscal quarter, driven by higher revenue and disciplined OpEx management. We expect to see sequential improvement in this division in Q3 and in Q4 on stronger revenues and a more favorable revenue mix. We were pleased with the adjusted operating margin in our Opto division of 13.1% in the second quarter of fiscal 23, representing our second best result historically for this division. We believe Opto is also poised for second half year-over-year adjusted operating margin expansion. With lower revenues and a less favorable revenue mix, the adjusted operating margin of our healthcare division decreased to 8.6% from 13.8% in the prior year. We currently expect the healthcare division to show significant Q3 operating margin improvement over Q2, driven primarily by revenue growth. Moving to cash flow. Cash flow used in operations was $9 million in Q2 of fiscal 23 compared to cash provided by operations of $14 million in the same prior year quarter. For the first half of fiscal 23, our operating cash flow is ahead of where we were for the first half of fiscal 22. That being said, we typically deliver much stronger operating cash flow. In the first half of this fiscal year, we have increased inventory to support anticipated sales growth, as well as to mitigate supply chain risks. In addition, we have an elevated level of BSO due to slower customer payments and have other working capital uses, including the timing of payments. CapEx in the second fiscal quarter was $3.6 million, while depreciation and amortization expense in Q2 was $9.6 million. We continue to be active in our stock buyback program, during which we spent approximately $4.5 million to repurchase about 53,000 shares this past quarter. Our board increased the buyback authorization earlier this fiscal year, and as of quarter end, 1.86 million shares were available to repurchase under the program. Our balance sheet is solid, with net leverage of 1.8, and significant capacity for acquisitions and additional stock buybacks. Aside from a little north of $7 million of annual required principal payments under our bank term loan, the bulk of our debt matures in fiscal 27. Finally, turning to guidance. We are tightening our fiscal 23 revenues range guidance by $10 million at the top end, primarily attributable to the softness we saw in the healthcare division this past quarter. we are reiterating our previous non-GAAP earnings per share guidance. This guidance implies revenue growth in the range of 8% to 12% and non-GAAP adjusted diluted EPS growth of 17% to 23% over the remaining six months of fiscal 23. The non-GAAP diluted EPS range excludes potential impairment restructuring and other charges, amortization required intangible assets, and non-cash interest expense and their associated tax effects as well as discrete tax and other non-recurring items. We currently believe this revenue and non-GAAP earnings guidance reflects reasonable estimates. The actual impact on the company's financial results of disruptions and increased costs in the supply chain and 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. We continue to remain focused on the growth of our businesses and proactive management of our cost structure. We believe our efforts in these areas will enable OSI to continue providing innovative products and solutions. We expect to continue to navigate through the current dynamic and challenging environment while gaining traction in key strategic growth areas and positioning the company to capitalize on certain improving end markets. We would like to take this opportunity to thank the Global OSI Systems team for its continued dedication in supporting our customers and partners. And at this time, we would like to open the call to questions.
spk20: As a reminder, to ask a question, please press star 11 on your telephone and wait for your name to be announced. To withdraw your question, please press star 11 again. Please stand by while we compile the Q&A roster.
spk19: And our first question comes from the line of Brian Ruttenberg with Imperial Capital.
spk20: Your line is open.
spk13: Yes, thank you very much. So first question is on the large, on the security side, the large $200 million plus international order. Can you talk a little bit about, you talked a little bit about timing, but what does the plus mean? Is that all on the maintenance side? How big can this contract get? And the timing, is it all going to get produced in fiscal and delivered in fiscal 2024?
spk04: Brian, this is Deepak here. All I can say that is that majority or significant portion of the 200 plus million dollar contract is equipment. There is some stable works and some maintains. And regarding the Manufacturing and delivery, we said it in our speech, there's insignificant revenue in the rest of 23. It's all focused on 2024. Second thing that you answered is long-term, yes, there could be more potential add-ons. Definitely service and support. This kind of equipment has seven, 10-year plus life cycle, upgrades and stuff. So we're very excited about it, and this is a significant win. And also, this was an international competition, and we got the majority of the business.
spk13: Was it – that's the first time I heard that the business was split between you and I assume your largest – or one of your largest competitors. Is that correct?
spk04: I can't talk about what other competitors, but it was international competition. We got the significant majority of the business.
spk13: Okay. And then moving on to pipeline on the security side, you know, this was a very large award. that I wasn't aware of you were bidding on. Are there other such large awards as in the couple hundred million or a hundred plus million that you're working on? Can you discuss a little bit, you know, what's in your pipeline? Because this was so significant. Are there other ones like this out there?
spk04: But Brian, you know that, you know, we don't talk about any specifics, but I think you've already got the answer yourself. This is not the only one. It's an international Our equipment is very much desired. It's a marketplace which looks at security all over the globe, including U.S. So we have other in the pipeline. And this is in the cargo side. And there are also areas in the aviation side. So the pipeline continues to be quite strong.
spk13: Great. Then just a couple quick questions on the other divisions. Healthcare was weak. you know, what do you anticipate, you know, seasonally a little bit weak, what do you anticipate out of healthcare, you know, coming up, new products in what areas?
spk04: Well, David mentioned that before, and Alan's also talked to you. Our focus is primarily our products of patient monitoring and cardiology. Patient monitoring, we have a lot of innovative new products being developed. It takes time. We are developing a whole new product line. And we think it's basically a 2020, late 2024, 2025 kind of timeline. We are also very much focused on home care, connectivity, remote monitoring, so that we're doing a lot of investment in expanding our reach in the patient monitoring stuff and on what we call cardiology in like patches and going wireless and tele kind of a thing.
spk13: Okay, very good. Thank you very much for that answer. And then just last question on the opto side. It doesn't appear that there's any slowdown in demand. You know, is the supply chain normalized enough for you guys moving forward? Are there things that you can't produce that if you had a proper supply chain or a normalized supply chain you'd be producing?
spk09: Brian, this is Alan. Good question. And while we see some signs of the supply chain improvement, there's still certain challenges. And you're right. There's certain backlog that we have that we'd be able to convert to revenue at an accelerated basis if not for those final missing components that are still supply chain challenged. So, yes, we still see nice, strong demand. We've got a heck of a backlog. And as the supply chain issues begin to ease up, that should help as well.
spk04: Brian, this is Deepak, just to add on to what Alan said, that it's been a very good success. Kudos to the team. But I said in the last October call also, there is a big focus on the OEM customers who are trying to get away from dependence on China. And our facilities in Batam, Indonesia, Malaysia, our new facilities expansion in India, We have a lot of opportunity to work with our customer base who are happy with us and feel confident that we can be there longer term for them. That's been a big growth story, and we think that will continue.
spk11: Great. Thank you.
spk20: Thank you. One moment for our next question. And our next question comes from Larry Solo with CJS Securities. Your line is open.
spk06: Great, thanks. Good morning or good afternoon. Just a couple of follow-ups. On the large deal, it doesn't sound like you have great 100% visibility on timing and all, but it does sound like it'll be pretty much a few-quarter type of a delivery. I'm just curious that the maintenance part or the service part, How should we look at that? I know your service revenue today is like 25% of your total revenue, but is this more like a recurring piece? Would it be like a 10% to 20% type range? Any way to just kind of think of that? And then the second part of that question, is this a government customer? I suppose a private.
spk09: Hey, Larry, this is Alan. Good questions. This is a sovereign customer, so we like that aspect of it. Um, we're working with the customer currently on the, you know, the anticipated timing and we'll have, uh, we'll have a better feel probably by the time of our, of our next conference call as to what that rollout may look like, but it will begin in fiscal 24 and expected to be a substantial, um, while. Deepak mentioned that it's predominantly product sales and civil works. Uh, there is a service element of it too. Uh, and you're right, you know, as the, as the initial.
spk06: service contract ends and warranty period ends there's always a um a nice recurring revenue that comes with service and spare parts uh thereafter so we are looking that for that to be a nice recurring revenue base for us okay and is this i mean i know it's not you know it's not full turnkey um there are missing aspects that sort of somewhat quasi turnkey um but is it could we assume this is a better margin than sort of your normal product sales um
spk09: Yeah, so Larry, this is not turnkey. This would be sort of a typical product sale except on quite a large scale. As you know, we don't go into margins on specific programs, but we do like the economies of scale and benefits that we get when we produce products in volume, so that's usually beneficial to our margins.
spk06: Okay, that's fair. And speaking just on service revenue on that topic, you had a nice little bump this quarter. I think service revenue grew like close to 10% and I didn't look back, but it certainly was like the last, you know, eight quarters, maybe more than that. So was there something, you know, I know you're sort of ramping up maybe a little bit more in Guatemala than you have or what, was there anything specific that driven that?
spk09: Really, some of our products rolled off of warranty and came onto service contracts that they accelerated some of the service revenue for us. And we think that's, So as we look forward, we expect to have, you know, continued strong service revenues.
spk06: Okay. No, fair enough. And then just on security, you mentioned, you know, margins were, you guys said you were, you know, pleased and you thought, you know, performance was good there. So it just seems like it's predominantly a mixed issue there. I know they're up a little bit sequentially and even year over year, but if you look back the last couple, you know, the back half of last year, I know margins were, quite stronger. I just want to clarify, you kind of expect that same, it feels like that same kind of cadence this year?
spk09: Yeah, Larry, this is Alan. We do expect the operating margins for security to be much stronger in the second half than we saw in the first half. You know, as Deepak mentioned, a few pushouts were a little bit more weighted to Q4 than Q3. And we would, you know, we would expect strong operating margins in each of those quarters.
spk00: Okay.
spk06: And just to follow up on Brian's question, on the healthcare, sort of on the patient monitor side, 24-25, would that be like a whole next generation, a whole swap out, or would that just be partial? Or any more color on that?
spk04: Well, there's deeper care. It's not like an overall push-out kind of a thing. You add on to your products, that's more applications, more connectivity, better results, more reliability, uh, and more features or that it will be, it'll start coming in late 24 and 25. Uh, but when you do that, you basically are looking at what we call it. That's why there's significant R and D investment. It's a significant, what we call it upgrade to the next generation for the next 10 years, the next generation of the whole system.
spk06: Okay. Great. Last question. Just on free cash flow, Alan, you mentioned it was up a little bit on the first half year over year, but basically pretty close to flat the last two years in the front half. And usually I think the front half is a little bit better for you guys historically. So what's your thoughts sort of in the back half of this year for cash flow and then even going forward just from a high level over the next few years? Thanks.
spk09: Yeah, great question, Larry. And we're really excited about we're moving to fiscal 24. In fiscal 23, Outside of this new large contract, we would say the opportunity for strong operating and free cash flow in the second half would be extremely robust. That being said, with this large contract and prepping for it for fiscal 24, there's likely going to be a substantial investment in inventory as we begin to produce and manufacture these products. So we'll probably see a little bit more muted cash flow than we've historically seen in fiscal 23. with the opportunity for very strong cash flow in fiscal 24 slash 25.
spk06: Great. Thanks for all the call and everything. Appreciate it.
spk20: Thank you. One moment for our next question. And our next question comes from Christopher Glenn with Oppenheimer. Your line is open.
spk10: Thank you. Good morning or afternoon, I guess, depending on where you are. So I had a couple of questions also on, you know, this kind of convergence of two large projects, the CDP and the New International Win, just addressed one on the free cash flow side. But I'm curious, as you have these two large programs set to, you know, both be materially active and fiscal 24, curious about your capacity? And are you walking away from any, you know, nice margin kind of 50 cent pieces of business to execute on these $10 bills?
spk04: Well, this is Deepak here, absolutely not. We have the capacity, we have facilities in England, we have facilities in US, we have facilities to help, and this is the thing that we've been saying all along that differentiates us from our competitors. We also have what we call intercompany relationship, so that when we want to expand the cargo product line or the detection product line in Rapperskand, we have the ability to go to the vendor base that's friendly to us, plus expand our own intercompany manufacturing of optoelectronics division which supplies key componentry to these areas. So, no, we're not going to pass any business just for this. This was planned. And we are very much focused, and that's one thing that Alan said, that this is a significant win, but we've handled these things before. And we're going to start manufacturing. Yes, there's the inventory increase. Yes, there'll be more production, pressure. in fiscal 23 or towards 24, but we are capable of it. Alan, do you want to add anything?
spk08: No, I think that summarized it quite nicely. I agree.
spk10: My follow-up was on O&M segment. You know, it's kind of in and around the electronics area, which is starting to see a lot of destocking. You've noted consistently you're expanding scope with existing and adding new because of your fulfillment capabilities and great global presence. Just from an end market point of view, I was curious. I think you're kind of insulated there, too. Maybe two-thirds of your business is defense, healthcare, and automotive certainly hasn't overshot from a cyclical perspective. Do you feel you're kind of insulated from the you know, so-called electronic cycle that's clearly, you know, rolling in some areas?
spk04: Well, very good question. The good news for us is we are so diversified. We have such a broad customer base that no one industry or no one specific area affects us up and down. They're very broad. Our marketplace, as you mentioned, aerospace, defense, medical, automotive, It's a very broad portfolio. And that's been our success story. And that has been very well done. And at the same time, I've emphasized again and again that for the time to come, this big focus on our customer base looking to get less dependent on China, makes the big plus long-term investment with their vendors. And if we are a good vendor, we have a long-term relationship to keep expanding, and we can have the ability to talk to our customers. Do you want us to manufacture in India for the Indian market? Do you want to manufacture in Malaysia, Indonesia? We can do all that, and that's been a very big plus story, and we look at that as a broad base, not dependent on any one specific thing or customer or industry.
spk18: Great. Thanks for the color.
spk19: Thank you. One moment for our next question.
spk20: And our next question comes from Jeff Martin with Roth Capital Partners. Your line is open.
spk02: Thanks. Good morning, Deepak and Alan. Hope you're doing well. I wanted to get a sense, because the large international carbon vehicle inspection order was a competitive bid. Chase, what factors do you believe ultimately led to you winning the award?
spk03: I can't understand the question.
spk09: The question was, what were the competitive factors that led us to win the $200 million plus deal?
spk04: Sorry, not very clear. Basically, we have said that before. You know, we consider ourselves one of the top performers in the cargo space. Our customers rely on us, we have a very good reputation. And being a vendor and a good supplier to CBP also is a big plus as a good reference. So that all over the world, we are considered and we always say that if there is going to be a dinner party, we definitely get invited. If there's a dance, we get invited. And then we feel proud about it that our dancing steps are good. We don't trip over each other. And our technology is good. Search scan software is a unique thing. Our product base is very broad. We have what we call the broadest product portfolio to offer to the customer, transmissive, backscatter combination. So all I can say is that our competition advantage is that we have the product base. We are well-regarded, and we have very good reputation to deliver the product and to maintain our credibility long-term. Alan?
spk09: Sure. The product quality, the service organization, the reputation, all of those really factored in, in addition to all the areas that Deepak mentioned.
spk02: Okay, great. With respect to your anticipated improvement in the healthcare division for the second half of the year, are there any specific factors that come into play there, and is the challenges you've had in the first half, how much of that do you think is internal factors versus external market factors?
spk09: Jeff, this is Alan. So good questions. Some of the reasons why we have a bit more confidence in this second half as we enter Q3 compared to the first half really is based on the pipeline of opportunities that we're looking at. We're seeing some more sizable opportunities than were available in the first half. You talk about, you know, why were we softer in the first half? Part of it was indeed the marketplace. You know, the hospital market has been a bit more challenged, their own financials at hospitals. And then some of it, you know, was a little bit self-inflicted as well from a timing perspective on some of our products as well. So a little bit of a combination of both. But we do feel better. for the second half and with a very strong contribution margins, you know, as our revenues go up from what you saw in Q2, there's a big pull-through to operating income and operating margin.
spk02: Yeah, okay. And then my question for me is with the, you know, FIFA equipment, you know, on display at the event in Qatar, you mentioned that, you know, opportunities in the Middle East with show thinking and equipment, I'm curious if there's near-term opportunities, if that's a longer-term expectation.
spk04: Well, Deepak here, you know, what I meant was it's a great showcase. It's been very well received. A lot of kudos, a lot of exposure to various people in Middle East. I would say, and we don't comment on it, there are opportunities all over the world. Middle East has always been a strong pipeline opportunity. And we continue to look at it, but I don't want to comment on anything specific that's there, Alan. It's just a broader application, and it's out there, and we feel that it's very good for us to be a showcase as what happened, and it's a very successful event.
spk02: Great. Thanks for your time.
spk20: Thank you. And as a reminder, to ask a question, please press star one one on your telephone. And if you wish to withdraw, please press star one one again. And our next question comes from Josh Nichols with the Riley Finn. Your line is open.
spk15: Yeah, thanks for taking my question. Just kind of to extrapolate a little bit further, clearly the company is positioned for a pretty strong second half given what we're seeing with the backlog and the order flow. On the gross margin front, I think last year you were doing 35%, 36% gross margin. Do you expect that that's kind of achievable in the second half of this year given that you're targeting kind of 10-ish percent top line growth in the back half?
spk09: Josh, this is Alan. Very good question, and we do expect to see stronger gross margins in the second half than the first half, and I think the numbers you alluded to are not unreasonable by any means.
spk15: Just for cash flow, understandable, right? There's some upfront investment for these big orders, a lot of which it seems like are going to be coming through next fiscal year. Fair to assume that the free cash flow cadence is going to be let's call it maybe comparable to last year, but next year likely to be, you know, in excess of the hundred or so million you've kind of historically achieved as some of the revenue materializes?
spk09: Yeah, Josh, I think there's, you know, fantastic opportunity for next year in fiscal 24 and 25 for extremely strong cashflow, kind of getting back to, you know, historical levels and then some. Um, that being said, you know, perhaps there's other new large opportunities as well that, that, that could factor into that as well. But yeah, big opportunities for 24 and 25 based upon the, what we see today for cashflow.
spk15: Perfect. And then last question for me, um, just trying to figure out the timing a little bit. So of the $200 million or so of CBP orders, um, I know you've been delivering on that, but like How much is left and how much of that is going to be coming in in the back half versus next year? I assume the majority will come next year, but any clarity you can provide on that would be helpful.
spk09: Sure. Josh, this is Alan. Yeah, we do expect significant CBP revenues in the second half of this fiscal year, more than we saw in the first half. And we do expect substantial CBP revenues in fiscal 24 as well. We don't quantify by the dollar amount, but We do see a big uptick happening here in the second half and into fiscal 24 as well. Great. Thank you.
spk20: And at this time, I'm showing no further questions.
spk04: Thank you all again for participating in our conference call. I want to thank specifically our employees and our stockholders. supporting us. We continue to focus on the product line, manufacturing, challenges with supply chain, and working with our customers' needs. And we look forward to speaking with you at our next earnings call. Thank you very much and have a good day. Bye.
spk20: And this concludes today's conference call. Thank you for participating. You may now disconnect.
spk12: The conference will begin shortly. To raise and lower your hand during Q&A, you can dial star 1 1. The conference will begin shortly. To raise and lower your hand during Q&A, you can dial star 1 1. you Thank you.
spk01: Thank you.
spk19: Good day, and thank you for standing by.
spk20: Welcome to OSI Citizens, Inc. Second Quarter 2023 Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 11 on your telephone. You will then hear an automated message advising your hand is raised. To withdraw your question, please press star 11 again. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Alan Edrick, Executive Vice President and Chief Financial Officer. Please go ahead.
spk09: Thank you. Good morning, and thank you for joining us. I'm Alan Edrick, Executive Vice President and CFO of OSI Systems, and I'm here today with Deepak Chopra, OSI's President and CEO. Welcome to the OSI Systems fiscal 23 second quarter conference call. We are pleased that you can join us as we review our financial and operational results. Earlier today, we issued a press release announcing our second quarter fiscal 23 financial results. Before we discuss our 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 on subsequent events or new information or otherwise. During today's call, We will refer 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. I will begin with a discussion of our Q2 financial performance and then turn the call over to Deepak for an overview of our business performance. We will then finish with more detail regarding our financial results and a discussion of our outlook for the overall fiscal year. Our second quarter financial results were solid as we navigated the current economic environment, which continues to be impacted by supply chain delays and increased costs, disruptive geopolitical events, inflation, and rising interest rates. Our bookings and book-to-bill ratio were very strong last quarter, and we were awarded some significant contracts, which we will discuss during this call. But let's start with a high-level summary of our Q2 results. First, we reported Q2 revenues of $296 million, representing a year-over-year increase of 7%, driven by solid revenue growth in our security and opto divisions, which were in part offset by soft healthcare division sales and an approximate $4 million unfavorable FX impact. We reported Q2 adjusted earnings per share of $1.19, down from $1.28 in Q2 of the prior year, as a result of a less favorable mix of sales, which was anticipated, and additional interest expense. And third, our Q2 bookings were over 500 million, representing a book-to-bill ratio of approximately 1.7, leading to a record quarter and backlog of nearly 1.5 billion. Before diving more deeply into our financial results, and discussing the fiscal 23 outlook, I will turn the call over to Dibak.
spk04: Thank you, Alan, and thanks to everyone joining us on today's call. Our performance in Q2 of fiscal 23 was solid as we grew the top line while continuing to successfully operate in a macro environment challenged by the multiple factors that Alan mentioned. Our Q2 bookings were very strong resulting in a record quarter end backlog. We believe we are well positioned for the second half of fiscal 23 and this also positions the security division especially really well entering for fiscal 24. Let's discuss each division's performance starting with security. The security division delivered Q2 revenues of $167 million about 15% higher than Q2 in the prior year. We were pleased with the division's profitability, expanding our operating margin to 12.9%. Our security bookings were very strong and resulted in a book-to-bill ratio of 2.3 for Q2 and 1.9 times for the first half of fiscal 23 for this division. We continue to deliver on the large existing U.S. Customs and Border Protection CBP programs we announced in fiscal 22. These CBP programs focus on improving security at the U.S. borders by utilizing our cargo and vehicle inspection platforms, search scan integration software, and gatekeeper vehicle checkpoint lane control solutions. SearchScan is our proprietary software solution that helps manage inspection image data, traffic, vehicle identification, and integrates with other systems at checkpoints to streamline and facilitate the inspection process. SearchScan is also compatible with third-party inspection systems, making it a versatile option in the marketplace. Based upon CBP's current timing, Some push out from Q3 to Q4 has happened from what was previously anticipated. While Q2 year over year security division revenues were up double digits and operating margin expanded, we believe the most notable item of the quarter was our exceptional bookings highlighted by a 200 plus million dollar international order that we received in December and announced shortly afterward quarter end in January. Our deliverables are expected to include a number of our cargo and vehicle inspection products and radiation portal monitors, along with the managing the civil works and providing operator training and ongoing maintenance in the coming years. We are not forecasting any significant revenues related to this award in fiscal 23, but this contract provides strong visibility into fiscal 2024 security revenues. We are currently working on the schedule with this customer and expect to have more to share on future calls, though we will start some of the manufacturing production in fiscal 23. During November and December, We were proud to support the security efforts at the FIFA World Cup in Qatar as the primary provider of security detection products. This event was held at multiple stadiums around Doha, and our Orion 920CX baggage and parcel inspection systems and METOR 6X walk-through metal detectors were successfully utilized to provide screening for over 2.5 million ticket holders and their belongings. In addition, these products were also used at the primary airport, hotels, and other venues throughout the city. This order was and will be a great showcase for rapid-scan products in Middle East for time to come. In turnkey services, Our projects in Albania, Puerto Rico, and Guatemala continue to perform well. The initial planning phase is underway for the new turnkey airport services multiyear contract, which we received earlier in fiscal 2023. As part of this contract, we expect to manage screening services at a European airport for the staff, airline crews, and vehicles at perimeter entry points. Initially though, as we have said before, this is a small contract, but it's a first in the aviation space. Looking ahead, we believe that security with a strong backlog and visibility into other key opportunities in the pipeline is well positioned for the second half of fiscal 2023 and beyond. Shifting to optoelectronics division, That had another great quarter as third party Q2 revenues were 80 million, which represented a new quarterly record for the division. This division achieved a solid operating margin in spite of continued supply chain cost pressures extra. AAPTO serves a diversified OEM customer base in aerospace, defense, healthcare, and consumer technology, among others. In these markets, certain OEMs are seeking to reduce their exposure to China sourcing and further de-risk their supply chains by transitioning to other viable manufacturing regions in the East. We believe we could benefit significantly from this given our global manufacturing footprint covering Malaysia, Indonesia, India, United Kingdom, and the U.S. Looking ahead with a strong Q2 ending backlog that is almost 20% higher than this time last year, AAPTO is well positioned. Moving to the healthcare division, this was a disappointing quarter. But we believe and expect stronger second half of the fiscal year in this division. We continue to significantly invest in developing new products to further strengthen our patient monitoring and cardiology portfolio. Subsequent to the quarter end, we bolstered the sales leadership in U.S. with talent that we believe will help drive stronger results and position the business to thrive. Going forward, we plan to maintain our focus on innovation and operational execution while staying flexible to handle the opportunities as markets can change quickly. Overall, we are pleased with the company's fiscal 2023 second quarter performance as we grew our top line, achieved significant bookings that have resulted in a record backlog. In addition, with the record backlog and a strong pipeline of opportunities, we believe we are well positioned for the second half of fiscal 2023 and 24. I would like to thank our employees, customers, and shareholders and look forward to the second half. I will now turn the call back over to Alan Edrick to further discuss our financial performance before we open the call for questions. Thank you.
spk09: Well, thank you, Deepak. Now I will review the financial results for our second quarter in some greater detail. As said, our fiscal Q2 revenues were up 7% compared with that of the prior year Q2. Q2 security division revenues were up 15%, largely due to the growth in our cargo and vehicle inspection products and related service revenue. The security division's book-to-bill ratio was approximately 2.3, positioning the division well for strong revenue growth in the second half of fiscal 23 and into fiscal 24. Opto sales increased 8% year over year, with strength in third-party sales to a diversified customer base, as well as intercompany sales to support anticipated upcoming security division revenue growth. Opto bookings were again solid, leading to a record Q2 backlog for the opto division. As Deepak mentioned, the healthcare division which is our smallest business unit, representing about 15% of our overall first half sales, reported the 17% reduction in year-over-year revenues in a more challenging marketplace, and in part due to a tougher year-over-year comp given the prior year elevated demand during the COVID Omicron variant surge. The Q2 gross margin was 32.5%, which, while consistent without a Q1, was about 3.6% below that of the prior year Q2. This year-over-year change was primarily driven by lower sales in the healthcare division, which carries the highest gross margin of our three divisions, higher opto sales as a percentage of total sales, which carries the lowest gross margin of the three divisions, and a less favorable mix in security division sales. Our gross margin was also impacted by increases in certain component costs. In general, our gross margin will fluctuate from period to period based on revenue mix and volume, inflation and impacts of supply chain among other factors. Based upon our forecasted conversion of backlog to revenue and pipeline of opportunities, we anticipate a stronger gross margin in the second half of fiscal 23 compared to the first half of this year. Moving 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 Q2 results reflected these efforts. Q2 SG&A expenses were 54 million, or 18.3% of sales, compared to 54.9 million, or 19.8% of sales in the prior year Q2. While foreign exchange created a headwind for Q2 revenues, it did have a beneficial impact on our operating expenses again this quarter. Research and development expenses in Q2 of fiscal 23 were 14.5 million, consistent with that of the first quarter and just below the prior year amount of $15 million. 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 Q2 of fiscal 23, we recorded $2.3 million of restructuring and other charges, compared to just under $1 million of such charges in Q2 of the prior fiscal year. Moving to interest and taxes. Net interest and other expense in Q2 of fiscal 23 increased to 5.2 million from 2.2 million in the same prior year period, primarily due to rising interest rates and the maturity of our 1.25% convertible notes on September 1st, which carried a lower rate than our current bank borrowings. We executed an interest rate swap during Q1 to fix a portion of our floating rate bank debt. On the tax side, The reported effective tax rate under GAAP was 19.5% in Q2 of fiscal 23 compared to 26.3% in Q2 of fiscal 22. In Q2 of this year, we recognized discrete tax benefits of 0.8 million as compared to a discrete tax expense of 0.3 million in Q2 last year. Excluding the impact of discrete tax items, our normalized effective tax rate in Q2 of fiscal 23 was 23% compared to a normalized effective tax rate of 25% in Q2 of fiscal 22. I will now turn to a discussion of our non-GAAP adjusted operating margin. Overall, our non-GAAP adjusted operating margin in Q2 of fiscal 23 decreased to 10.7% from 12.0% in the same prior year period. This was primarily driven by the weakness in revenue in the healthcare division, which carries the highest contribution margin of our three divisions, coupled with a reduction in the opto-operating margin due to a difficult prior year comp. The adjusted operating margin in the security division increased to 14.7% in Q2 from 14.2% in the prior year's second fiscal quarter, driven by higher revenue and disciplined OPEX management. We expect to see sequential improvement in this division in Q3 and in Q4 on stronger revenues and a more favorable revenue mix. We were pleased with the adjusted operating margin in our Opto division of 13.1% in the second quarter of fiscal 23, representing our second best result historically for this division. We believe Opto is also poised for second half year over year adjusted operating margin expansion. With lower revenues and a less favorable revenue mix, the adjusted operating margin of our healthcare division decreased to 8.6% from 13.8% in the prior year. We currently expect the healthcare division to show significant Q3 operating margin improvement over Q2, driven primarily by revenue growth. Moving to cash flow. Cash flow used in operations was $9 million in Q2 of fiscal 23 compared to cash provided by operations, of 14 million in the same prior year quarter. For the first half of fiscal 23, our operating cash flow is ahead of where we were for the first half of fiscal 22. That being said, we typically deliver much stronger operating cash flow. In the first half of this fiscal year, we have increased inventory to support anticipated sales growth, as well as to mitigate supply chain risks. In addition, we have an elevated level of BSO due to slower customer payments, and have other working capital uses, including the timing of payments. CapEx in the second fiscal quarter was $3.6 million, while depreciation and amortization expense in Q2 was $9.6 million. We continue to be active in our stock buyback program, during which we spent approximately $4.5 million to repurchase about 53,000 shares this past quarter. Our board increased the buyback authorization earlier this fiscal year, and as of quarter end, 1.86 million shares were available to repurchase under the program. Our balance sheet is solid, with net leverage of 1.8 and significant capacity for acquisitions and additional stock buybacks. Aside from a little north of 7 million of annual required principal payments under our bank term loan, the bulk of our debt matures in fiscal 27. Finally, turning to guidance. We are tightening our fiscal 23 revenues range guidance by 10 million at the top end, primarily attributable to the softness we saw in the healthcare division this past quarter. However, we are reiterating our previous non-GAAP earnings per share guidance. This guidance implies revenue growth in the range of 8 to 12% and non-GAAP adjusted diluted EPS growth of 17 to 23% over the remaining six months of fiscal 23. The non-GAAP diluted EPS range excludes potential impairment restructuring and other charges, amortization required intangible assets, and non-cash interest expense and their associated tax effects, as well as discrete tax and other non-recurring items. We currently believe this revenue and non-GAAP earnings guidance reflects reasonable estimates. The actual impact on the company's financial results of disruptions and increased costs in the supply chain and 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. We continue to remain focused on the growth of our businesses and proactive management of our cost structure. We believe our efforts in these areas will enable OSI to continue providing innovative products and solutions. We expect to continue to navigate through the current dynamic and challenging environment while gaining traction in key strategic growth areas and positioning the company to capitalize on certain improving end markets. We would like to take this opportunity to thank the Global OSI Systems team for its continued dedication in supporting our customers and partners. And at this time, we would like to open the call to questions.
spk20: As a reminder, to ask a question, please press star 11 on your telephone and wait for your name to be announced. To withdraw your question, please press star 11 again. Please stand by while we compile the Q&A roster. And our first question comes from the line of Brian Ruttenberg with Imperial Capital. Your line is open.
spk13: Yes, thank you very much. So first question is on the large, on the security side, the large $200 million plus international order. Can you talk a little bit about, you talked a little bit about timing, but what does the plus mean? Is that all on the maintenance side? How big can this contract get? And the timing, is it all going to get produced in fiscal and delivered in fiscal 2024?
spk04: Brian, just to be clear, all I can say that is that Majority or significant portion of the 200 plus million dollar contract is equipment. There is some civil works and some maintenance. And regarding the manufacturing and delivery, we said it in our speech, there's insignificant revenue in the rest of 23. It's all focused on 2024. Second thing that you answered is, Long term, yes, there could be more potential add-ons. Definitely service and support. This kind of equipment has 7, 10 year plus life cycle, upgrades and stuff. So we're very excited about it. And this is a significant win. And also, this was an international competition. And we got the majority of the business.
spk13: Was it, that's the first time I heard that the business was split between you and I assume your largest, or one of your largest competitors. Is that correct?
spk04: I can't talk about what other competitors, but it was international competition. We got the significant majority of the business.
spk13: Okay. And then moving on to pipeline on the security side, you know, this was a very large award. that I wasn't aware of you were bidding on. Are there other such large awards as in the couple hundred million or a hundred plus million that you're working on? Can you discuss a little bit, you know, what's in your pipeline? Because this was so significant. Are there other ones like this out there?
spk04: But Brian, you know that, you know, we don't talk about any specifics, but I think you've already got the answer yourself. This is not the only one. It's an international Our equipment is very much desired. It's a marketplace which looks at security all over the globe, including U.S. So we have other in the pipeline. And this is in the cargo side. And there are also areas in the aviation side. So the pipeline continues to be quite strong.
spk13: Great. Then just a couple quick questions on the other divisions. Healthcare was weak. you know, what do you anticipate, you know, seasonally a little bit weak, what do you anticipate out of healthcare, you know, coming up, new products in what areas?
spk04: Well, David mentioned that before, and Alan's also talked to you. Our focus is primarily our products for patient monitoring and cardiology. Patient monitoring, we have a lot of innovative new products being developed. It takes time. We are developing a whole new product line. And we think it's basically a 2020, late 2024, 2025 kind of timeline. We are also very much focused on home care, connectivity, remote monitoring, so that we're doing a lot of investment in expanding our reach in the patient monitoring stuff and on what we call connect cardiology in, like, patches and going wireless and tele kind of a thing.
spk13: Okay. Very good. Thank you very much for that answer. And then just last question on the opto side. It doesn't appear that there's any slowdown in demand. You know, is the supply chain normalized enough for you guys moving forward? Are there things that you can't produce that if you had a proper supply chain or a normalized supply chain you'd be producing?
spk09: Brian, this is Alan. Good question. And while we see some signs of the supply chain improvement, there's still certain challenges. And you're right. There's certain backlog that we have that we'd be able to convert to revenue at an accelerated basis if not for those final missing components that are still supply chain challenged. So, yes, we still see nice, strong demand. We've got a heck of a backlog. And as the supply chain issues begin to ease up, that should help as well.
spk04: Brian, this is Deepak, just to add on to what Alan said, that it's been a very good success. Kudos to the team. But I said in the last October call also, there is a big focus on the OEM customers who are trying to get away from dependence on China. And our facilities in Batam, Indonesia, Malaysia, our new facilities expansion in India, We have a lot of opportunity to work with our customer base who are happy with us and feel confident that we can be there longer term for them. That's been a big growth story, and we think that will continue.
spk11: Great. Thank you.
spk20: Thank you. One moment for our next question. And our next question comes from Larry Solo with CJS Securities. Your line is open.
spk06: Great, thanks. Good morning or good afternoon. Just a couple of follow-ups. On the large deal, it doesn't sound like you have great 100% visibility on timing and all, but it does sound like it'll be pretty much a few-quarter type of a delivery. I'm just curious that the maintenance part or the service part, How should we look at that? I know your service revenue today is like 25% of your total revenue, but is this more like a recurring piece? Would it be like a 10% to 20% type range? Any way to just kind of think of that? And then the second part of that question, is this a government customer? I suppose a private.
spk09: Hey, Larry, this is Alan. Good questions. This is a sovereign customer, so we like that aspect of it. Um, we're working with the customer currently on the, you know, the anticipated timing and we'll have, uh, we'll have a better feel probably by the time of our, of our next conference call as to what that rollout may look like, but it will begin in fiscal 24 and expected to be a substantial, um, while. Deepak mentioned that it's predominantly product sales and civil works. Uh, there is a service element of it too. Uh, and you're right, you know, as the, as the initial. service contract ends and warranty period ends, there's always a nice recurring revenue that comes with service and spare parts thereafter. So we are looking for that to be a nice recurring revenue-based force.
spk06: Okay. And I know it's not full turnkey. There are missing aspects that are sort of quasi-turnkey. But could we assume this is a better margin than sort of your normal product sales?
spk09: Yes. Yeah, so Larry, this is not turnkey. This would be sort of a typical product sale, except on quite a large scale. As you know, we don't go into margins on specific programs, but we do like the economies of scale and benefits that we get when we produce products in volumes, so that's usually beneficial to our margins.
spk06: Okay, that's fair. And speaking just of service revenue on that topic, you had a nice little bump this quarter. I think service revenue grew like close to 10% and had a tie, and I didn't look back, but it certainly was like the last, you know, eight quarters, maybe more than that. So was there something, you know, I know you're sort of ramping up maybe a little bit more in Guatemala than you have, or was there anything specific that had driven that?
spk09: Really, some of our products rolled off of warranty and came onto service contracts. They accelerated some of the service revenue for us, and we think that's So as we look forward, we expect to have, you know, continued strong service revenues.
spk06: Okay. No, fair enough. And then just on security, you mentioned, you know, margins were, you guys said you were, you know, pleased and you thought, you know, performance was good there. So it just seems like it's predominantly a mixed issue there. I know they're up a little bit sequentially and even year over year, but if you look back the last couple, you know, the back half of last year, I know margins were, quite stronger. I just want to clarify, you kind of expect that same, it feels like that same kind of cadence this year?
spk09: Yeah, Larry, this is Alan. We do expect the operating margins for security to be much stronger in the second half than we saw in the first half. You know, as Deepak mentioned, a few pushouts were a little bit more weighted to Q4 than Q3. And we would, you know, we would expect strong operating margins in each of those quarters.
spk00: Okay.
spk06: And just to follow up on Brian's question, on the healthcare, on the patient monitor side, 24-25, would that be like a whole next generation, a whole swap out, or would that just be partial? Any more color on that?
spk04: Well, there's deeper care. It's not like an overall push-out kind of a thing. You add on to your products, that's more applications, more connectivity, better results, more reliability, uh, and more features or that it will be, it'll start coming in late 24 and 25. Uh, but when you do that, you basically are looking at what we call it. That's why there's significant R and D investment. It's a significant, what we call it upgrade to the next generation for the next 10 years, the next generation of the whole system.
spk06: Okay. Great. Last question. Just on free cash flow, Alan, you mentioned it was up a little bit on the first half year over year, but basically pretty close to flat the last two years in the front half. And usually I think the front half is a little bit better for you guys historically. So what's your thoughts sort of in the back half of this year for cash flow and then even going forward just from a high level over the next few years? Thanks.
spk09: Yeah, great question, Larry. And we're really excited about moving to fiscal 24. In fiscal 23, You know, outside of this new large contract, we would say the opportunity for strong operating and free cash flow in the second half would be extremely robust. You know, that being said, with this large contract and prepping for it for fiscal 24, there's likely going to be a substantial investment in inventory as we begin to produce and manufacture these products. So, we'll probably see a little bit more muted cash flow than we've historically seen in fiscal 23. with the opportunity for very strong cash flow in fiscal 24 slash 25.
spk06: Great. Thanks for all the call and everything. Appreciate it.
spk20: Thank you. One moment for our next question. And our next question comes from Christopher Glenn with Oppenheimer. Your line is open.
spk10: Thank you. Good morning or afternoon, I guess, depending on where you are. So I had a couple of questions also on, you know, this kind of convergence of two large projects, the CDP and the New International Win, just addressed one on the free cash flow side. But I'm curious, as you have these two large programs set to, you know, both be materially active in fiscal 24, curious about your capacity? And are you walking away from any, you know, nice margin kind of 50 cent pieces of business to execute on these $10 bills?
spk04: Well, this is Deepak here, absolutely not. We have the capacity, we have facilities in England, we have facilities in US, we have facilities to help, and this is the thing that we've been saying all along that differentiates us from our competitors. We also have what we call intercompany relationship, so that when we want to expand the cargo product line or the detection product line in RappiScan, we have the ability to go to the vendor base that's friendly to us, plus expand our own intercompany manufacturing of optoelectronics division which supplies key componentry to these areas. So, no, we're not going to pass any business just for this. This was planned. And we are very much focused, and that's one thing that Alan said, that this is a significant win. But we've handled these things before. And we're going to start manufacturing. Yes, there's the inventory increase. Yes, there'll be more production pressure in fiscal 23. towards 24, but we are capable of it. Alan, do you want to add anything?
spk08: No, I think that summarized it quite nicely. I agree.
spk10: My follow-up was on O&M segment. You know, it's kind of in and around the electronics area, we're starting to see a lot of destocking. You've noted consistently you're expanding scope with existing and adding new because of your fulfillment. capabilities and great global presence. Just from an end market point of view, I was curious. I think you're kind of insulated there, too. Maybe two-thirds of your business is defense, healthcare, and automotive certainly hasn't overshot from a cyclical perspective. So do you feel you're kind of insulated from the so-called electronic cycle that's clearly rolling in some areas?
spk04: Well, very good question. The good news for us is we are so diversified. We have such a broad customer base that no one industry or no one specific area affects us up and down. They're very broad. Our marketplace, as you mentioned, aerospace, defense, medical, automotive, it's a very broad portfolio. And that's been our success story. And that has been very well done. And at the same time, I've emphasized again and again that for the time to come, this big focus on our customer base looking to get less dependent on China makes the big plus long-term investment with their vendors. And if we are a good vendor, we have a long-term relationship to keep expanding, and we can have the ability to talk to our customers. Do you want us to manufacture in India for the Indian market? Do you want to manufacture in Malaysia, Indonesia? We can do all that, and that's been a very big plus story, and we look at that as a broad base, not dependent on any one specific thing or customer or industry.
spk18: Great. Thanks for the color.
spk19: Thank you. One moment for our next question.
spk20: And our next question comes from Jeff Martin with Roth Capital Partners. Your line is open.
spk02: Thanks. Good morning, Deepak and Alan. Hope you're doing well. I wanted to get a sense, because the large international carbon vehicle inspection order was a competitive bid. Chase, what factors do you believe ultimately led to you winning the award?
spk03: I can't understand the question.
spk09: The question was, what were the competitive factors that led us to win the $200 million plus deal?
spk04: Sorry, not very clear. Basically, we have said that before. You know, we consider ourselves one of the top performers in the cargo space. Customers rely on us. We have a very good reputation and being a vendor and a good supplier to CBP also is a big plus as a good reference so that all over the world we are considered and we always say that if there is going to be a dinner party, we definitely get invited. If there's a dance, we get invited. And then we feel proud about it that our dancing steps are good. We don't trip over each other. And our technology is good. Search scan software is a unique thing. Our product base is very broad. We have what we call the broadest product portfolio to offer to the customer, transmissive, backscatter combination. So all I can say is that our competition advantage is that we have the product base. we are well regarded, and we have very good reputation to deliver the product and to maintain our credibility long term. Alan?
spk09: Sure. The product quality, the service organization, the reputation, all of those really factored in, in addition to all the areas that Deepak mentioned.
spk02: Okay, great. And then, with respect to your anticipated improvement in the healthcare division for the second half of the year, are there any specific factors that come into play there, and is the challenges you've had in the first half, how much of that do you think is internal factors versus external market factors?
spk09: Jeff, this is Alan. So good questions. Some of the reasons why we have a bit more confidence in this second half as we enter Q3 compared to the first half really is based on the pipeline of opportunities that we're looking at. We're seeing some more sizable opportunities than were available in the first half. You talk about, you know, why were we softer in the first half? Part of it was indeed the marketplace. You know, the hospital market has been a bit more challenged, their own financials at hospitals. And then some of it, you know, was a little bit self-inflicted as well from a timing perspective on some of our products as well. So a little bit of a combination of both. But we do feel better. for the second half and with a very strong contribution margins, you know, as our revenues go up from what you saw in Q2, there's a big pull-through to operating income and operating margin.
spk02: Yeah, okay. And then my question for me is with the, you know, FIFA equipment, you know, on display at the event in Qatar, you mentioned that, you know, opportunities in the Middle East with show thinking and equipment, I'm curious if there's near-term opportunities, if that's a longer-term expectation.
spk04: Well, Deepak here, you know, what I meant was it's a great showcase. It's been very well received. A lot of kudos, a lot of exposure to various people in Middle East. I would say, and we don't comment on it, there are opportunities all over the world. Middle East has always been a strong pipeline opportunity. And we continue to look at it, but I don't want to comment on anything specific that's there, Alan. It's just a broader application, and it's out there, and we feel that it's very good for us to be a showcase as what happened.
spk21: And it's a very successful event.
spk03: Great.
spk02: Thanks for your time.
spk20: Thank you. And as a reminder, to ask a question, please press star one one on your telephone. And if you wish to withdraw, please press star one one again. And our next question comes from Josh Nichols with the Riley Finn. Your line is open.
spk15: Yeah, thanks for taking my question. Just kind of to extrapolate a little bit further, clearly the company's positioned for a pretty strong second half, given what we're seeing with the backlog and the order flow. On the gross margin front, I think last year you were doing 35%, 36% gross margin. Do you expect that that's kind of achievable in the second half of this year, given that you're targeting kind of 10-ish percent top line growth in the back half?
spk09: Josh, this is Alan. Very good question, and we do expect to see stronger gross margins in the second half than the first half, and I think the numbers you alluded to are not unreasonable by any means.
spk15: Just for cash flow, understandable, right? There's some upfront investment for these big orders, a lot of which it seems like are going to be coming through next fiscal year. Fair to assume that the free cash flow cadence is going to be let's call it maybe comparable to last year, but next year likely to be, you know, in excess of the hundred or so million you've kind of historically achieved as some of the revenue materializes?
spk09: Yeah, Josh, I think there's, you know, fantastic opportunity for next year in fiscal 24 and 25 for extremely strong cashflow, kind of getting back to, you know, historical levels and then some. That being said, perhaps there's other new large opportunities as well that could factor into that as well. But yeah, big opportunities for 24 and 25 based upon what we see today for cash flow.
spk15: Perfect. And then last question for me, just trying to figure out the timing a little bit. So of the $200 million or so of CBP orders, I know you've been delivering on that, but like How much is left and how much of that is going to be coming in in the back half versus next year? I assume the majority will come next year, but any clarity you can provide on that would be helpful.
spk09: Sure. Josh, this is Alan. Yeah, we do expect significant CBP revenues in the second half of this fiscal year, more than we saw in the first half. And we do expect substantial CBP revenues in fiscal 24 as well. We don't quantify by the dollar amount, but We do see a big uptick happening here in the second half and into fiscal 24 as well. Great. Thank you.
spk20: And at this time, I'm showing no further questions.
spk04: Thank you all again for participating in our conference call. I want to thank specifically our employees and our stockholders. supporting us. We continue to focus on the product line, manufacturing, challenges with supply chain, and working with our customers' needs. And we look forward to speaking with you at our next earnings call. Thank you very much and have a good day. Bye.
spk20: And this concludes today's conference call. Thank you for participating. You may now disconnect.
Disclaimer