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spk03: Thank you for standing by, and welcome to the OSI Systems Inc. Third Quarter 2023 Conference Call. At this time, all participants are in listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during this session, you'll need to press star 1-1 on your telephone. To remove yourself from the queue, simply press star 1-1 again. As a reminder, today's program is being recorded. And now I'd like to introduce your host for today's program, Alan Edrick, Executive Vice President and Chief Financial Officer. Please go ahead, sir.
spk07: Oh, 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 Third Quarter Conference Call. We are pleased that you can join us as we review our financial and our operational results. Earlier today, we issued a press release announcing our third 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 comparable 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 Q3 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 remainder of the fiscal year. Our third 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. We are excited about finishing the fiscal year strong and entering fiscal 24 with solid visibility given excellent backlog. I will start with a high-level summary of our Q3 results. First, we reported Q3 revenues of $303 million, representing a year-over-year increase of 4%, driven by solid revenue growth in our security, and opto divisions, which was in part offset by soft healthcare division sales and an approximate $4 million unfavorable FX impact compared to prior year rates. Second, we reported Q3 adjusted earnings per share of $1.49, up from $1.43 in Q3 of the prior fiscal year, despite the negative impact of approximately $0.16 per share of additional interest expense due to higher interest rates this year versus last year. Third, we generated strong third quarter operating cash flow of $65 million. And fourth, while our Q3 bookings were sound, perhaps the most notable item is that just after quarter end, we executed a contract for security booking of over $500 million net of that, representing one of the largest contracts in the industry, providing an excellent start to Q4 bookings and greatly enhancing the already strong visibility we have into fiscal 24. Before diving more deeply into our financial results and discussing the fiscal 23 outlook, I will turn the call over to Deepak.
spk14: Thank you, Alan, and welcome once again to the OSI Systems Earnings Call for the third quarter of fiscal 2023. As Anshu mentioned, we are pleased with our fiscal third quarter performance in which we grew revenues by 4 percent and adjusted operating income by 18% from the same period a year ago, while generating 68% more operating cash flow in comparison to Q3 of 2022. Our robust backlog not only instills confidence for Q4, but also positions us well for a very strong fiscal 2024. I will briefly touch on some key highlights from our third quarter performance across each division before turning back the call to Alan for more in-depth discussion of our financial results. Beginning with the security division, where revenues grew 13% in Q3 with significant operating margin expansion from the prior year's comparable quarter. Just before the quarter end, as Alan mentioned, we announced an award notification of a significant contract valued at approximately $600 million, which includes approximately 16% value-added tax from Mexico's Department of National Defense, SEDANA, for our cargo and vehicle inspection systems and related services. Under this award, We expect to provide multiple units of EGLE P60 high-energy drive-through cargo and vehicle inspection systems, Z-backscatter cargo inspection portals, Carview vehicle inspection systems, and a proprietary CertScan software multi-site integration platform. These solutions are planned to be utilized to inspect trucks, buses, and cars at customs border checkpoints increasing the safety and integrity of Mexico's borders. We are honored for our solutions to play a crucial role in facilitating the smooth flow of trade. I note, and I want to make it very focused clear, that even though we announced the Sedana Award in Q3, The related contract was executed early in Q4 and thus is not reflected in the Q3 bookings or quarter end backlog. Also want to mention that this was a competitive bid in which we were selected. This Mexico award followed another large $200 million international order that we received in Q2 and announced in early Q3. These exciting sizable deals enhance our visibility and provide confidence as we enter Q4 and approach the next fiscal year, 2024. These wins also bolster our market presence as we expand in key regions. Throughout Q3, we continue to deliver on our U.S. Customs and Border Protection CBP contracts. where we are supporting the enhancement of us border security infrastructure using various cargo and vehicle scanning platforms and the search scan integration platform these initial delivery orders valued at approximately 200 million dollars were received under the LEP and MEP indefinite indefinite quantity awards which had a combined potential award value of approximately $870 million. CBP has room under these IDIQs to issue additional delivery orders to one or more of the vendors that are qualified on these contracts. It is also important to highlight that the Mexico Sedena Award, as well as our ongoing efforts at CBP US, offer border and customs agencies across the Americas the opportunity to access comprehensive and integrated solutions. By incorporating CertScan software, our proprietary software solution that helps manage inspection image data, traffic and vehicle identification at checkpoints, we are able to unify platforms and cater to the unique needs of these clients. This would make the trade more smoother between Mexico and U.S. Our turnkey projects in Albania, Puerto Rico, and Guatemala have been operating as anticipated, and we continue through these projects to demonstrate our experience and capabilities in handling large-scale programs. As Alan mentioned, this contract, especially to CERNA, to our knowledge, was the biggest contract in the industry to anybody for equipment. On the aviation side, We continue to serve our airport customers and other critical transportation and public infrastructure customers worldwide. In Q3, we announced an order worth approximately $20 million from ANA Airport of Portugal. The order involves providing multiple units of our RTT, real-time tomography, explosive detection systems. These units are expected to be installed at various airports across Portugal. to enhance security by screening passengers' hold or checked baggage. Additionally, as part of this award, we are engaged to deliver ongoing maintenance service and support for these installations to ensure the system's reliable operation. During the quarter, we also received a $16 million service contract renewal from an OEM for checkpoint maintenance at U.S. airports. Looking ahead, We continue to see airport activity improving and anticipate that airport authorities will make prudent capital investments to continue upgrading security infrastructure for passenger safety. Moving on to our optoelectronics and manufacturing division, where we reported revenue growth of 2% in the third quarter, accompanied by strong operating margin expansion. We continue to experience some supply chain challenges for specific components, but we are actively implementing strategies to lessen the impact and maintain smooth operations. Opto Division continues to work with a broad base of customers, primarily technology OEMs, to provide components and sub-assemblies from our operations in US, UK, Canada, Malaysia, Indonesia, and India. Our backlog continues to be strong with a diversified OEM customer base, and we continue to position ourselves as an option for OEMs that seek offshore manufacturing partners as an alternative to China-based manufacturing. And finally, on to the healthcare division, where revenues were approximately 16% lower than in the prior years Q3. Disappointing. Apex spending in the hospital industry continues to be challenged by several elements, including elevated spending during the pandemic years and the current economic environment of constrained capital markets. During the quarter, we announced a $3 million order to provide patient monitoring solutions and support services to a Canadian-based hospital. This is a strategic win in a critical region for us. During Q3, We completed the acquisition of a small company called ParaHealth, a company that develops predictive enterprise software to alert clinicians and doctors to patient deterioration, helping to reduce in-hospital mortality, unplanned transfers to the ICU, and drive more timely decisions making for optimized patient care. The para health predictive solution, along with our existing safe and sound patient alarm management help us differentiate in the marketplace. During the quarter, we also added new talent to the sales and marketing leadership in the US. Q4 is typically a strong quarter for space labs. Based on seasonality and near-term visibility on certain opportunities, We believe that Space Labs has the potential to perform much better in Q4 than its recent performance of Q3. Overall, we are on track to finish Q2023 strong and continue our momentum into the next fiscal year. As always, I would like to thank our employees, customers, stockholders for their continued support. With that, I'm going to turn over the call back over to Alan to talk in more detail about our financial results and guidance before we open the call for questions. Thank you.
spk07: Thank you, Deepak. Now I'll review the financial results for our third quarter in a bit greater detail. Again, our fiscal Q3 revenues were up 4% compared with that of the prior year. Q3 security division revenues were up 13%, largely due to the growth in our cargo and vehicle inspection products and related service revenue. Opto sales increased 2% year-over-year, with modest growth in third-party sales to a diversified customer base, supplemented by strong intercompany sales to support anticipated upcoming security division growth. And as Deepak mentioned, the healthcare division, which is our smallest business unit representing approximately 15% of our nine-month sales, reported a 16% reduction in year-over-year revenues in a more challenging marketplace. The Q3 gross margin of 34.3% was approximately 1.1% below that of the prior year Q3. 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 and a less favorable mix in our 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 the supply chain cost changes, among other factors. Moving operating expenses. We continue to work diligently across each of our divisions to improve efficiencies and prudently manage our SG&A cost structure. Our Q3 results reflected these efforts. Q3 SG&A expenses were $53.7 million or 17.7% of sales compared to $57.8 million or 19.9% of sales in the prior year Q3. While foreign exchange created a headwind for Q3 revenues, it did have a beneficial impact on our operating expenses again this quarter. Research and development expenses in Q3 of fiscal 23 were 14.9 million, slightly down from 15.1 million in the same prior year quarter. We continued 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 Q3 of fiscal 23, we recorded $0.9 million of restructuring and other charges compared to $1.5 million of such charges in Q3 of the prior fiscal year. Moving to interest and taxes. Net interest and other expense in Q3 increased from $2.3 million in fiscal 22 to $5.7 million in fiscal 23, primarily due to rising interest rates and the maturity on September 1, 2022, of our 1.25% convertible notes, 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 23.8% in Q3 of this year, compared to 20.1% in Q3 of fiscal 2022. In Q3 of fiscal 23, we recognized discrete tax expense of $0.2 million as compared to a discrete tax benefit of $0.2 million in Q3 last year. Excluding the impact of discrete tax items, our normalized effective tax rate in Q3 of fiscal 23 was 23.2% compared to a normalized effective tax rate of 20.5% in Q3 of fiscal 22. I will now turn to a discussion of our non-GAAP adjusted operating margin. Overall, our non-GAAP adjusted operating margin increased from 11.4% in Q3 of fiscal 22 to 12.9% in the third quarter of fiscal 23, driven by strength in each of the security and opto divisions. The adjusted operating margin in the security division increased from 14.9% in Q3 of last year to 18.3% in Q3 of 23 due to higher revenue and lower operating expenses. We were also pleased with the adjusted operating margin expansion in our Opto division, which increased to 14.1% in the third quarter of fiscal 2023 compared to 12.9% in last year's Q3. These increases were partially offset by challenges in the healthcare division where the adjusted operating margin decreased to 5.4% from 14.7% in the prior year due to lower sales and a less favorable revenue mix. As Deepak mentioned, we currently expect the healthcare division to show significant Q4 operating margin improvement, both sequentially and potentially year-over-year due primarily to revenue growth. Moving to cash flow. Cash provided by operations was extremely robust. coming in at 65 million in Q3 of fiscal 23, compared to 38 million in the same prior year quarter, driven by strong collections and customer advances. We anticipate building inventory during upcoming quarters in preparation for program deliveries under the two large security division contracts announced last quarter. CapEx in the 2023 third fiscal quarter was 5.7 million, while depreciation and amortization expense in Q3 was $9.7 million. We were again active in our stock buyback program this past quarter, during which we spent approximately $13 million to repurchase approximately 138,000 shares. Our board increased the buyback authorization earlier this fiscal year, and as of quarter end, the program allowed for repurchase of up to 1.72 million shares. Our balance sheet is solid, with modest net leverage and significant capacity for acquisitions and additional stock buybacks. Aside from just over $7 million of annual required principal payments under our bank term loan, the bulk of our debt matures in fiscal 2027. And finally, turning to guidance. We are reiterating our fiscal 23 revenues and non-GAAP EPS guidance. The fiscal 23 non-GAAP diluted EPS guidance 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. 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 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.
spk03: Certainly. Once again, if you have a question at this time, please press star 11 on your telephone. One moment for our first question. And our first question comes from the line of Josh Nichols from B Reilly. Your question, please.
spk09: Yeah, thanks for taking my question and great to see the backlog here. So just to clarify here, so the 500 million net of the VAT award does not include in the current backlog. implying year-end backlog should be $2 billion plus, right, all-out SQL, and there's still opportunity for additional expansion with the CBP on top of the $200 million of awards you've already received. Is that a fair assessment?
spk14: Absolutely. There's deeper care. You've said it very well. I just want to add on to it that besides CBP add-ons, there are other opportunities that we continue to look at.
spk09: Thanks. And then the other thing I wanted to hit on, Alan, you talked a little bit about the EPS headwind from the higher interest expense. I mean, you've maintained EPS guidance this year, despite what's been a pretty significant rising rate environment. If you look here, EPS guidance for the year is up like 30 cents or so, and that probably excludes around 50 cents of headwind from those higher rates that we've talked about previously. So just if we were to extrapolate that into next year, I know you're not giving guidance for fiscal 24, but just that alone would apply around $7 a share in EPS next year if you were to have a similar kind of growth trajectory. And that really doesn't factor in all these additional large orders that you've seen, given that you probably expect growth to accelerate materially from the 6% that guidance implies for fiscal for this year and also without any margin expansion, which is also, I would assume, maybe likely. Is that also a fair assessment?
spk07: Well, Josh, you've summarized things quite nicely. Yeah, we have tremendous visibility as we sit here two months before the start of our next fiscal year into fiscal 24, which we're extremely excited about. You're also right about the interest expense. It was a significant headwind year over year for fiscal 23 compared to fiscal 22. even a headwind given what we expected at the time we came out with guidance in August as rates have steadily increased throughout the year. So we're really pleased with the overall performance on the bottom line in light of those headwinds. And you're right, while it's premature for us at this point to give guidance, as we typically do so following our Q4 call, or following our Q4, which will be our next call, we do anticipate there's tremendous opportunity to leverage the strong sales growth that we'll anticipate for next year into higher earnings growth.
spk09: Thanks. Last question for me. One is how much of the $200 million of orders from the CBP has been delivered or is going to be delivered this year versus rolling into next year? I know you also mentioned that the other $200 million award announced last quarter was effectively going to be almost all totally recognized in fiscal 24. Is that still the case?
spk07: This is Alan, Josh. A couple questions there. On CBP, as you know, we got off to a little slower start in the first half of this fiscal year as the customer had delayed certain deliveries and acceptance tests. We're really seeing that pick up. Our revenues were much stronger in Q3 for CBP and are anticipated to be in Q4 as well. And I think as we said on the last call or two, we expect CBP revenues to continue nicely into not only 24, but probably into fiscal 25 as well. So it positions us quite nicely. With respect to the large $200 million international order that we also announced at the beginning of last quarter, we haven't yet said what the timing of those revenues will be as we continue to work with the customer on that. But suffice it to say, we do expect, you know, very significant revenues from that contract in the next fiscal year.
spk09: Well, great, Alan and Deepak. Really looking forward to see how things shake out for next fiscal year, given the visibility and unprecedented backlog. I'll let someone else take a turn.
spk10: Thank you.
spk03: Thank you. Thank you. One moment for our next question. And our next question comes from the line of Brian Ruttenberg from Imperial Capital. Your question, please.
spk05: Great. Great quarter. First question I have is cash flow. It was very strong in the period. And maybe given all the build out that you're doing with these big contracts, can you talk about cash flows a little bit for the remainder of the year? And then where you see kind of cash flows going in 2024, I don't know how long this build-out is going to last as you probably have to stockpile some inventory for these big contracts.
spk07: Oh, Brian, this is Alan. Great question. Yeah, we were exceptionally pleased with the extremely strong free cash flow that we delivered in Q3. And as you correctly point out, with these two large contracts, the Sedana contract and the other large international contracts, we're going to be building inventory over the next several quarters for this contract. So it's a good issue to have. So as a result, we're not anticipating any significant cash flow necessarily in Q4 and maybe into early fiscal 24. But as we then begin to deliver the product, we expect there'll be a very rich amount of cash flow for us on an overall basis. So very excited about that. So probably some near-term cash flow headwinds and some medium and long-term significant cash flow generation.
spk05: Okay. Yeah, thank you very much. The interest expense also that was brought up by the previous analyst, can you talk a little bit about your plans maybe to lock in some long-term rates or are you going to continue to pay down debt? I noticed that you paid down some debt in the period. What are the plans there, and what is your current cost of capital?
spk07: Yeah, good questions. Brian, this is Alan again. So we did lock in the majority of our debt in Q1 of last year, so in the August-September timeframe through an interest rate swap. That swap was at 3.286%, so we feel good about that. We do expect to pay down debt as we generate cash flow, as we did this past quarter. And, you know, although we're always looking at other opportunities, that would be alternative uses of cash flow as well. So we feel good about that position overall.
spk05: Okay. And then maybe the last one is for Deepak, but Alan, please chime in if it's for you instead. It's about healthcare. Where do you see the future of the healthcare division? It's been several years since I've asked that question. They had a little blip here, and you expect to come back in the fourth quarter. But maybe you can talk a little bit about healthcare and where you see it going, Deepak.
spk14: Well, Brian, we are quite confident about the healthcare business. As Alan has mentioned, just keep in mind, we've said it before, it's the highest margin business. We are investing heavily, continue to do that. for R&D for the new platform that we're developing, which we have said it before, that it's going to change our whole platform. It's going to take a couple of years to do it. In the meantime, we remain confident, and for the disappointing Q3 specifically, especially when you also compare it with the COVID-related previous, what I call it, tailwinds. But at the same time, and maybe Alan can comment on it, this quarter Q3, we were expecting some significant size contract, which got delayed. We are told that it imminently will happen, so that we believe also normally seasonally Q4 is stronger than Q3 anyway, that Q4 will be a stronger quarter for it. And we are quite confident, and keep in mind that we've bought ParaHealth a couple of quarters ago, we bought Safe and Sound. We believe in that platform. We are looking at it in the connectivity story. Besides patient monitoring, we are looking at cardiology. We are trying to make it a services company in a way in some products. So all in all, we are quite excited about it. And as we have said it before, yes, it's disappointing. It's a bookend ship into it. So that as these contracts get delayed, it changes from one quarter to the other. But with the margin it is, with the connectivity that we're looking at, with the new change we have made in the sales management team of North America, we are very confident of the future of Space Labs. Alan, you want to add something?
spk07: Well, I think you said that well. Yeah, we were, you know, Q3 was a challenging quarter. As Deepak mentioned, had a contractor, too, that we were anticipating come in. It would have been a very different outlook. And we aren't anticipating that in Q4. And therefore, you know, we feel cautiously confident that we'll see a much different picture, financial picture in Q4 than we saw in Q3. And with the strong R&D programs that are taking place for some of the new patient monitoring platforms and cardiology products, you know, we think the future is going to be bright overall for the division.
spk05: Great. Thank you.
spk02: Thank you. One moment for our next question. And our next question comes from the line of Jeff Martin from Roth Capital.
spk03: Your question.
spk04: Thanks. Good morning, Alan. Deepak, hope you're doing well.
spk17: Hi, Jeff.
spk04: Alan, just an observation here. SG&A over really the last four years, if you extrapolate it through the end of this fiscal year, has declined every year. I know you're constantly evaluating efficiencies, but just was curious with respect to fiscal 24, you know, are we going to start to see SG&A expand again because the business is likely to see significant acceleration in revenue growth tied to these larger contracts?
spk07: Jeff, yeah, really good question. And we have, you know, we do monitor our costs quite judiciously. As we move into fiscal 24, we would expect SG&A as a percentage of revenues to decline, but on an absolute dollar basis to increase. consistent with seeing significant sales growth and some of the variable costs that come with that. So, yes, we would anticipate an absolute dollar increase in SG&A in our next fiscal year.
spk04: Okay. And then with respect to the USCBP contract or order, as we exit fiscal 23, where do you think you'll be in terms of percentage delivery against that contract? And, you know, on top of that, are you currently, you know, seeing activity or interest in follow-on orders or tack-on orders?
spk14: Jack, I'm going to ask a portion of it, and Alan can answer. We really can't break it down into specifics, into what percentage in this year, next year. What Alan has said is that it's been a little slow start, but Q3 was more shipments to CP than Q2. Q4 also is going to be more. but the contract, present contracts, will take it in 2025 and 26. But we also want to emphasize that the IDIQ, as I mentioned before, for the total two programs, put in about $800 million range to us and other vendors. Out of that, only $200 million was let out to us, a big portion of it. So there is still a lot of room as we move forward for CBP to put new orders on those IDIQs, which will continue into 25, 26, and beyond. And on top of that, we've said it before, one of the things that we are very much focused into it is not just selling the equipment, but the search scan software, which we continue to work, and we are very excited about it. And with the Sedana contract from Mexico, which we have said it, at the northern borders between Mexico and U.S., that's a very big plus point for longer-term cooperation between the two countries and to make the trade go simpler and faster. And we continue to say that as this thing is looked at it and people are happy with it, the customers are happy with it, this is a good selling point to the rest of the world wherever there is trade challenges there. to duplicate the same thing, and we are very well positioned for it. So we're very excited about it.
spk04: That's a great segue into my final question, Deepak. Is the coordination and integration between the U.S. and Mexico already in plan, or is that just in the initial stages of discussion, and was that a big part of the decision process for Sedena to go with RappiScan?
spk14: Well, number one, it was a competitive bid. And I think we've said it before, this was not based just on price. It was based on performance and the experience. But I can't say anything about the governments have to do whatever they have to do. But they have shared information in a way, well, that CBP was very complimentary and that could have, I don't know, that could have helped. But how they do it in the future, it all depends on politically. But what I look at it as is, we have said it before, and the other programs that we have in Guatemala and Puerto Rico and Albania, all of them have been very, very successful, and the customer is very happy. It does help in the trade, and we keep looking at it, that the whole world has to look at this, and with the efficient way of trade, it will help. But I can't say what they plan to do and what they are doing between the countries.
spk04: Got it. Thank you. Look forward to the fiscal 24 guidance next quarter.
spk03: Thank you. Thank you. Once again, if you have a question at this time, please press star 1-1. One moment for our next question. And our next question comes to the line of Larry Soto from CJS Securities. Your question, please.
spk00: Great.
spk08: Good morning. Quick question, just made a couple of follow-ups on the large awards you guys have been getting. And like you mentioned, it was a competitive bidding process in Mexico. What do you think? Do you think CertScan is your differentiator there? What do you think sort of is driving your fair share, if not the leading leader in most of this newer vehicle inspection and cargo inspection?
spk14: Good question. I would say CertScan is one of them, but there is a lot of other. We consider ourselves to be the preeminent technology provider in cargo in the world. We can say that confidently. multi-energy backscatter, our ability to interact with radiation portals, to interact with the license readers, integration, size of its service provider, I call it customer happiness, and the global presence. So all those factors do come into play. And one of the most important factors that come into play is the history of performance and execution. So I won't say just search scan, but it's a combination of all this innovation, upgrade of technology, new products, the ability to be able to perform and be flexible of customer demand. Alan, do you want to add something to it?
spk06: I think that summarizes it very well.
spk08: Got it. And then just for clarification, so the three contracts or whatever, they total, I don't know, five, six, seven, like 700, 800 million, 900 million. Is there... Can we expect, like, a reoccurring portion of that? I think these contracts, they're close to a billion, actually, if you add up all three of them. Would there be, like, a reoccurring portion that kind of is, like, 25% of this number, you know, which is kind of what your reoccurring service portion is today? Any sort of color on that?
spk14: Well, number one, you know, when you're trying to add it up, you're trying to add the CBP contract, the international contract and the Sedana. Yeah, if you add them together into it. But keep in mind, the CBP 200 million dollar contract is part of an IDIQ, which is 800 million. And not that all of that is going to go to us, but they can do whatever they want. But we are well positioned. Our customer is very happy. And the other side of the question, what you said is these contracts do include some service and maintenance anyway. And most of this lifespan of these equipments and stuff are more than 10, 12, 15 years. So there's a follow-on service and maintenance upgrading and stuff that continues. But on top of that, I want to say, yes, these are large contracts, but that doesn't mean that there are not other big potential contracts out in the rest of the world. And keep in mind, a couple of years ago, we had $750 million MSAT contract from Mexico Services. Puerto Rico long-term continues, and that's a big contract, so that there are other opportunities. We look at these as a very big stepping stone for us to be able to convince other parts of the world that these are great things to work together, and we are well equipped to manage and support the customers.
spk07: Alan? Yeah, Larry, one of the nice things about this, I think as you're alluding to, is as we get this bigger and bigger installed base out there, you get this nice recurring revenue through service, and the service revenue generally carries a nice, healthy margin associated with it as well. So it provides a steady stream of recurring revenue for many, many years to come.
spk08: Yeah, exactly. And your service revenue has kind of jumped up a little bit over the last few quarters, which is definitely helpful. And just for clarification, I know you said the international contract will begin in fiscal 2014. Sounds like you'll get a good portion of that, whether that's the majority or not. I don't think you're really clarifying there. But in terms of Mexico, do you also expect that to start driving contributions in this upcoming fiscal year?
spk07: Larry, this is Alan. So, you know, we're working with the customer on the timing of deliveries for that and revenue. But yes, the answer is yes, we do expect revenues to commence for the Mexico-Sedena contract in fiscal 24. we'll have more clarity on timing at our next call, but yes, we do expect revenues in fiscal 24.
spk08: Great. And then just, just lastly, just on opto, um, I think we, you know, it was, we, we, that this little slower growth this quarter on the top line, I think that was kind of, um, expected, but just, just in general, you know, backlog has been going up, you know, I think, I think it's at least as the last quarter, it won't be updated at this quarter, but it was up, I think 20% year over year. Um, what's sort of the disconnect between the 20% rise in backlog and sort of flattish sales? Is it just that most of these orders are longer term or is it timing related or any color on the grid?
spk14: Good question. Good observation. Keep in mind that business is a different business. And during the last year, especially with COVID and supply chain and issues like that, the customers placed orders just to put what I call their staking hand into that so that we have a longer-term backlog in that area. And some of the customers have now looked at it and see what their needs are and stuff and push and shove into it. But that backlog is what I call it is large contracts, and then it takes some time before the next ones come in. It's a longer-term play. Alan, maybe you can clarify a little bit more.
spk07: Yeah, that's the primary thing, just the timing of deliveries to customers, some of them who are adjusting their own inventory on hand requirements. Supply chain continues to play a role in that, too, where we might have 99% of the components, but we might be missing some small components that have delayed certain shipments. But that's the general area. So, yeah, the backlog in opto is very strong. Revenue, the conversion to revenue will be nice. And the productivity gains they've had have been really, really noteworthy, which has generated a lot of the operating margin expansion.
spk14: And just to add on to a little bit more broader, maybe a little bit of a broader thing, but I did say in my speech, one of the big things about that opto-business is our global presence. Manufacturing, whether U.S., whether it's in Canada, it's in England, it's in Malaysia, it's in Indonesia, India, That helps a lot because the OEM customers that we have who place orders, their other focus is supply chain issue, and the different parts of the world can supply different products, and everybody's looking at alternate to China. That's been a very big plus point long-term, and they continue to work towards that and use that effectively.
spk08: Great. And you just mentioned supply. If I could just slip one more question. What's this? significant ramp coming up in security. Is there any concern about your ability or the supply chain ability to kind of keep up with that pace in order to make these deliveries over the next two, three, four years?
spk14: Well, definitely. I mean, that's a big ramp up. But we are well positioned. Again, internal intercompany also is a big asset that we have between the upper group supplying the product, which our competitors don't have it. And we are basically very much focused into it. Won't say that's not a challenge. But at the same time, we feel that we are very much equipped. And we continue to look at it. We are working with the customer. We are working with our vendors. As Alan mentioned, there are definitely supply chain issues, cost issues. So we continue to look at it. But that's what our strength is. We continue to focus on it.
spk03: Great. Thanks. I appreciate all the call-in. Thank you. This does conclude the question and answer session of today's program. I'd like to hand the program back to Deepak Chopra for any further remarks.
spk14: Thank you all once again for attending our conference call. And I again want to thank our employees, our stockholders for their confidence in us, our worldwide employees all over. It's a very exciting time. We are focused on to it. And we'll again talk to you and have a better feeling In August, we're going to do the conference call for the year end for what the next year looks like. With a $2 billion backlog, we are very much focused and excited about it. Thank you very much.
spk03: Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day. you Bye. Thank you. Bye.
spk01: Thank you.
spk03: Thank you for standing by, and welcome to the OSI Systems Inc. Third Quarter 2023 Conference Call. At this time, all participants are in listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during this session, you'll need to press star 11 on your telephone. To remove yourself from the queue, simply press star 11 again. As a reminder, today's program is being recorded. And now I'd like to introduce your host for today's program, Alan Edrick, Executive Vice President and Chief Financial Officer. Please go ahead, sir.
spk07: Oh, 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 Third Quarter Conference Call. We are pleased that you can join us as we review our financial and our operational results. Earlier today, we issued a press release announcing our third 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 comparable 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 Q3 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 remainder of the fiscal year. Our third 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. We are excited about finishing the fiscal year strong and entering fiscal 24 with solid visibility given excellent backlog. I will start with a high-level summary of our Q3 results. First, we reported Q3 revenues of $303 million, representing a year-over-year increase of 4%, driven by solid revenue growth in our security, and opto divisions, which was in part offset by soft healthcare division sales and an approximate $4 million unfavorable FX impact compared to prior year rates. Second, we reported Q3 adjusted earnings per share of $1.49, up from $1.43 in Q3 of the prior fiscal year, despite the negative impact of approximately $0.16 per share of additional interest expense due to higher interest rates this year versus last year. Third, we generated strong third quarter operating cash flow of $65 million. And fourth, while our Q3 bookings were sound, perhaps the most notable item is that just after quarter end, we executed a contract for security booking of over $500 million net of that, representing one of the largest contracts in the industry, providing an excellent start to Q4 bookings and greatly enhancing the already strong visibility we have into fiscal 24. Before diving more deeply into our financial results and discussing the fiscal 23 outlook, I will turn the call over to Deepak.
spk14: Thank you, Alan, and welcome once again to the OSI Systems Earnings Call for the third quarter of fiscal 2023. As Anshul mentioned, we are pleased with our fiscal third quarter performance in which we grew revenues by 4% and adjusted operating income by 18% from the same period a year ago, while generating 68% more operating cash flow in comparison to Q3 of 2022. Our robust backlog not only instills confidence for Q4, but also positions us well for a very strong fiscal 2024. I will briefly touch on some key highlights from our third quarter performance across each division before turning back the call to Alan for a more in-depth discussion of our financial results. Beginning with the security division, where revenues grew 13% in Q3 with significant operating margin expansion from the prior year's comparable quarter. Just before the quarter end, as Alan mentioned, we announced an award notification of a significant contract valued at approximately $600 million, which includes approximately 16% value-added tax from Mexico's Department of National Defense, SEDANA, for our cargo and vehicle inspection systems and related services. Under this award, We expect to provide multiple units of EGLE P60 high-energy drive-through cargo and vehicle inspection systems, Z-backscatter cargo inspection portals, Carview vehicle inspection systems, and a proprietary CertScan software multi-site integration platform. These solutions are planned to be utilized to inspect trucks, buses, and cars at customs border checkpoints increasing the safety and integrity of Mexico's borders. We are honored for our solutions to play a crucial role in facilitating the smooth flow of trade. I note, and I want to make it very focused clear, that even though we announced the Sedana Award in Q3, The related contract was executed early in Q4 and thus is not reflected in the Q3 bookings or quarter end backlog. Also want to mention that this was a competitive bid in which we were selected. This Mexico award followed another large $200 million international order that we received in Q2 and announced in early Q3. These exciting sizable deals enhance our visibility and provide confidence as we enter Q4 and approach the next fiscal year, 2024. These wins also bolster our market presence as we expand in key regions. Throughout Q3, we continue to deliver on our U.S. Customs and Border Protection CBP contracts. where we are supporting the enhancement of U.S. border security infrastructure using various cargo and vehicle scanning platforms and the search scan integration platform. These initial delivery orders valued at approximately $200 million were received under the LEP and MEP indefinite quantity awards which had a combined potential award value of approximately $870 million. CBP has room under these IDIQs to issue additional delivery orders to one or more of the vendors that are qualified on these contracts. It is also important to highlight that the Mexico Sedena Award, as well as our ongoing efforts at CBP US, offer border and customs agencies across the Americas the opportunity to access comprehensive and integrated solutions. By incorporating CertScan software, our proprietary software solution that helps manage inspection image data, traffic and vehicle identification at checkpoints, we are able to unify platforms and cater to the unique needs of these clients. This would make the trade more smoother between Mexico and U.S. Our turnkey projects in Albania, Puerto Rico, and Guatemala have been operating as anticipated, and we continue through these projects to demonstrate our experience and capabilities in handling large-scale programs. As Alan mentioned, this contract, especially to Ceyana, to our knowledge, was the biggest contract in the industry to anybody for equipment. On the aviation side, We continue to serve our airport customers and other critical transportation and public infrastructure customers worldwide. In Q3, we announced an order worth approximately $20 million from ANA Airport of Portugal. The order involves providing multiple units of our RTT, real-time tomography, explosive detection systems. These units are expected to be installed at various airports across Portugal. to enhance security by screening passengers' hold or checked baggage. Additionally, as part of this award, we are engaged to deliver ongoing maintenance service and support for these installations to ensure the system's reliable operation. During the quarter, we also received a $16 million service contract renewal from an OEM for checkpoint maintenance at U.S. airports. Looking ahead, We continue to see airport activity improving and anticipate that airport authorities will make prudent capital investments to continue upgrading security infrastructure for passenger safety. Moving on to our optoelectronics and manufacturing division, where we reported revenue growth of 2% in the third quarter, accompanied by strong operating margin expansion. We continue to experience some supply chain challenges for specific components, but we are actively implementing strategies to lessen the impact and maintain smooth operations. Opto Division continues to work with a broad base of customers, primarily technology OEMs, to provide components and sub-assemblies from our operations in US, UK, Canada, Malaysia, Indonesia, and India. Our backlog continues to be strong with a diversified OEM customer base, and we continue to position ourselves as an option for OEMs that seek offshore manufacturing partners as an alternative to China-based manufacturing. And finally, on to the healthcare division, where revenues were approximately 16% lower than in the prior years Q3. Disappointing. Apex spending in the hospital industry continues to be challenged by several elements, including elevated spending during the pandemic years and the current economic environment of constrained capital markets. During the quarter, we announced a $3 million order to provide patient monitoring solutions and support services to a Canadian-based hospital. This is a strategic win in a critical region for us. During Q3, We completed the acquisition of a small company called ParaHealth, a company that develops predictive enterprise software to alert clinicians and doctors to patient deterioration, helping to reduce in-hospital mortality, unplanned transfers to the ICU, and drive more timely decisions making for optimized patient care. The para health predictive solution, along with our existing safe and sound patient alarm management help us differentiate in the marketplace. During the quarter, we also added new talent to the sales and marketing leadership in the US. Q4 is typically a strong quarter for space labs. Based on seasonality and near-term visibility on certain opportunities, We believe that Space Labs has the potential to perform much better in Q4 than its recent performance of Q3. Overall, we are on track to finish Q2023 strong and continue our momentum into the next fiscal year. As always, I would like to thank our employees, customers, stockholders for their continued support. With that, I'm going to turn over the call back over to Alan to talk in more detail about our financial results and guidance before we open the call for questions. Thank you.
spk07: Thank you, Deepak. Now I'll review the financial results for our third quarter in a bit greater detail. Again, our fiscal Q3 revenues were up 4% compared with that of the prior year. Q3 security division revenues were up 13%, largely due to the growth in our cargo and vehicle inspection products and related service revenue. Opto sales increased 2% year-over-year, with modest growth in third-party sales to a diversified customer base, supplemented by strong intercompany sales to support anticipated upcoming security division growth. And as Deepak mentioned, the healthcare division, which is our smallest business unit representing approximately 15% of our nine-month sales, reported a 16% reduction in year-over-year revenues in a more challenging marketplace. The Q3 gross margin of 34.3% was approximately 1.1% below that of the prior year Q3. 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 and a less favorable mix in our 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 the supply chain cost changes, among other factors. Moving operating expenses. We continue to work diligently across each of our divisions to improve efficiencies and prudently manage our SG&A cost structure. Our Q3 results reflected these efforts. Q3 SG&A expenses were $53.7 million or 17.7% of sales compared to $57.8 million or 19.9% of sales in the prior year Q3. While foreign exchange created a headwind for Q3 revenues, it did have a beneficial impact on our operating expenses again this quarter. Research and development expenses in Q3 of fiscal 23 were 14.9 million, slightly down from 15.1 million in the same prior year quarter. We continued 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 Q3 of fiscal 23, we recorded $0.9 million of restructuring and other charges compared to $1.5 million of such charges in Q3 of the prior fiscal year. Moving to interest and taxes. Net interest and other expense in Q3 increased from $2.3 million in fiscal 22 to $5.7 million in fiscal 23, primarily due to rising interest rates and the maturity on September 1, 2022, of our 1.25% convertible notes, 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 23.8% in Q3 of this year, compared to 20.1% in Q3 of fiscal 2022. In Q3 of fiscal 23, we recognized discrete tax expense of $0.2 million as compared to a discrete tax benefit of $0.2 million in Q3 last year. Excluding the impact of discrete tax items, our normalized effective tax rate in Q3 of fiscal 23 was 23.2% compared to a normalized effective tax rate of 20.5% in Q3 of fiscal 22. I will now turn to a discussion of our non-GAAP adjusted operating margin. Overall, our non-GAAP adjusted operating margin increased from 11.4% in Q3 of fiscal 22 to 12.9% in the third quarter of fiscal 23, driven by strength in each of the security and opto divisions. The adjusted operating margin in the security division increased from 14.9% in Q3 of last year to 18.3% in Q3 of 23 due to higher revenue and lower operating expenses. We were also pleased with the adjusted operating margin expansion in our Opto division, which increased to 14.1% in the third quarter of fiscal 2023 compared to 12.9% in last year's Q3. These increases were partially offset by challenges in the healthcare division where the adjusted operating margin decreased to 5.4% from 14.7% in the prior year due to lower sales and a less favorable revenue mix. As Deepak mentioned, we currently expect the healthcare division to show significant Q4 operating margin improvement, both sequentially and potentially year-over-year due primarily to revenue growth. Moving to cash flow. Cash provided by operations was extremely robust. coming in at 65 million in Q3 of fiscal 23, compared to 38 million in the same prior year quarter, driven by strong collections and customer advances. We anticipate building inventory during upcoming quarters in preparation for program deliveries under the two large security division contracts announced last quarter. CapEx in the 2023 third fiscal quarter was 5.7 million, while depreciation and amortization expense in Q3 was $9.7 million. We were again active in our stock buyback program this past quarter, during which we spent approximately $13 million to repurchase approximately 138,000 shares. Our board increased the buyback authorization earlier this fiscal year, and as of quarter end, the program allowed for repurchase of up to 1.72 million shares. Our balance sheet is solid with modest net leverage and significant capacity for acquisitions and additional stock buybacks. Aside from just over $7 million of annual required principal payments under our bank term loan, the bulk of our debt matures in fiscal 2027. And finally, turning to guidance. We are reiterating our fiscal 23 revenues and non-GAAP EPS guidance. The fiscal 23 non-GAAP diluted EPS guidance 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. 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 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 environment while gaining traction in key strategic growth areas and position 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.
spk03: Certainly. Once again, if you have a question at this time, please press star 11 on your telephone. One moment for our first question. And our first question comes from the line of Josh Nichols from B Reilly. Your question, please.
spk09: Yeah, thanks for taking my question and great to see the backlog here. So, just to clarify here. The $500 million net of the VAT award is not included in the current backlog, so implying year-end backlog should be $2 billion plus, right, all-out SQL, and there's still opportunity for additional expansion with the CBP on top of the $200 million of awards you've already received. Is that a fair assessment?
spk14: Absolutely, there's deeper care. You've said it very well. I just want to add on to it. that besides CBP add-ons, there are other opportunities that we continue to look at.
spk09: Thanks. And then the other thing I wanted to hit on, Alan, you talked a little bit about the EPS headwind from the higher interest expense. I mean, you've maintained EPS guidance this year despite what's been a pretty significant rising rate environment. If you look here, EPS guidance for the year is up like 30 cents or so, and that probably excludes around 50 cents of headwind from those higher rates that we've talked about previously. So just if we were to extrapolate that into next year, I know you're not giving guidance for fiscal 24, but just that alone would apply around $7 a share in EPS next year if you were to have a similar kind of growth trajectory. And that really doesn't factor in all these additional large orders that you've seen, given that you probably expect growth to accelerate materially from the 6% that guidance implies for this year and also without any margin expansion, which is also, I would assume, maybe likely. Is that also a fair assessment?
spk07: Well, Josh, you've summarized things quite nicely. Yeah, we have tremendous visibility as we sit here two months before the start of our next fiscal year. into fiscal 24, which we're extremely excited about. You're also right about the interest expense. It was a significant headwind year over year for fiscal 23 compared to fiscal 22, even a headwind given what we expected at the time we came out with guidance in August as rates have steadily increased throughout the year. So we're really pleased with the overall performance on the bottom line in light of those headwinds. And you're right, while it's premature for us at this point to give guidance, as we typically do so following our Q4 call, or following our Q4, which will be our next call, we do anticipate there's tremendous opportunity to leverage the strong sales growth that we'll anticipate for next year into higher earnings growth.
spk09: Thanks. Last question for me. One is how much of the $200 million of orders from the CBP has been delivered or is going to be delivered this year versus rolling into next year? I know you also mentioned that the other $200 million award announced last quarter was effectively going to be almost all totally recognized in fiscal 24. Is that still the case?
spk07: This is Alan, Josh. A couple of questions there. On CBP, as you know, We got off to a little slower start in the first half of this fiscal year as the customer had delayed certain deliveries and acceptance tests. We're really seeing that pick up. Our revenues were much stronger in Q3 for CBP and are anticipated to be in Q4 as well. And I think as we said on the last call or two, we expect CBP revenues to continue nicely into not only 24, but probably into fiscal 25 as well. So it positions us quite nicely. With respect to the large $200 million international order that we also announced at the beginning of last quarter, we haven't yet said what the timing of those revenues will be as we continue to work with the customer on that. But suffice it to say, we do expect very significant revenues from that contract in the next fiscal year.
spk09: Well, great. Alan and Deepak, really looking forward to see how things shake out for next fiscal year, given the visibility and unprecedented backlog. I'll let someone else take a turn.
spk10: Thank you.
spk03: Thank you. Thank you. One moment for our next question. And our next question comes from the line of Brian Ruttenberg from Imperial Capital. Your question, please.
spk05: Great, great quarter. First question I have is cash flow. It was very strong in the period. And maybe given all the build out that you're doing with these big contracts, can you talk about cash flows a little bit for the remainder of the year? And then where you see kind of cash flows going in 2024? I don't know how long this build out is going to last as you probably have to stockpile some inventory for these big contracts.
spk07: Oh, Brian, this is Alan. Great question. Yeah, we were, you know, exceptionally pleased with the extremely strong free cash flow that we delivered in Q3. And as you correctly point out, with these two large contracts, the Sedana contract and the other large international contracts, we're going to be building inventory over the next, you know, several quarters for this contract. So, you know, it's a good issue to have. So as a result, you know, we're not anticipating any any significant cash flow necessarily in Q4 and maybe into early fiscal 24. But as we then begin to deliver the product, we expect there'll be a very rich amount of cash flow for us on an overall basis. So very excited about that. So probably some near-term cash flow headwinds and some medium and long-term significant cash flow generation.
spk05: Okay. Uh, yeah, thank you very much. Uh, the, uh, interest expense also that was brought up by the previous analyst. Uh, can you talk a little bit about your plans maybe to lock in some long-term rates or are you going to continue to pay down debt? I noticed that you paid down some debt in the, in the period. What are the plans there and what, what is your current, you know, cost of capital?
spk07: Yeah, good questions, Brian. Uh, this is Alan again. So, uh, we did lock in, um, the majority of our debt in Q1 of last year. So in the August-September timeframe through an interest rate swap, that swap was at 3.286%. So we feel good about that. We do expect to pay down debt as we generate cash flow, as we did this past quarter. And although we're always looking at other opportunities, that would be alternative uses of cash flow as well. So we feel good about that position overall.
spk05: Okay. And then maybe the last one is for Deepak, but Alan, please chime in if it's for you instead. It's about healthcare. Where do you see the future of the healthcare division? It's been several years since I've asked that question. They had a little blip here and you expect to come back in the fourth quarter, but maybe you can talk a little bit about healthcare and where you see it going, Deepak.
spk14: Well, Brian, We are quite confident about the healthcare business. As Alan has mentioned, just keep in mind, we've said it before, it's the highest margin business. We are investing heavily, continue to do that for R&D, for the new platform that we're developing, which we have said it before, that it's gonna change our whole platform. It's gonna take a couple of years to do it. In the meantime, we remain confident, and for the disappointing Q3, specifically, especially when you also compare it with the COVID-related previous, what I call it, tailwinds. But at the same time, and maybe Alan can comment on it, this quarter Q3, we were expecting some significant size contract, which got delayed. We are told that it imminently will happen. so that we believe also normally seasonally Q4 is stronger than Q3 anyway. The Q4 will be a stronger quarter for it. And we are quite confident. And keep in mind that we've bought ParaHealth a couple of quarters ago. We bought Safe and Sound. We believe in that platform. We are looking at it in the connectivity story. Besides patient monitoring, we are looking at cardiology. We are trying to make it a services company in a way in some products. So all in all, we are quite excited about it. And as we have said it before, yes, it's disappointing. It's a bookend ship into it. So that as these contracts get delayed, it changes from one quarter to the other. But with the margin it is, with the connectivity that we're looking at, with the new change we have made in the sales management team of North America, we are very confident of the future of Space Labs. Alan, you want to add something?
spk07: Well, I think you said that well. Yeah, we were, you know, Q3 was a challenging quarter. As Deepak mentioned, had a contractor, too, that we were anticipating come in. It would have been a very different outlook. And we aren't anticipating that in Q4. And therefore, you know, we feel cautiously confident that we'll see a much different picture, financial picture in Q4 than we saw in Q3. And with the strong R&D programs that are taking place for some of the new patient monitoring platforms, and cardiology products, you know, we think the future is going to be bright overall for the division.
spk05: Great. Thank you.
spk02: Thank you. One moment for our next question. And our next question comes from the line of Jeff Martin from Roth Capital.
spk03: Your question.
spk04: Thanks. Good morning, Alan. Deepak, hope you're doing well.
spk17: Hi, Jeff.
spk04: Alan, just an observation here. SG&A over really the last four years, if you extrapolate it through the end of this fiscal year, has declined every year. I know you're constantly evaluating efficiencies, but just was curious with respect to fiscal 24, are we going to start to see SG&A expand again because the business is likely to see significant acceleration in revenue growth tied to these larger contracts?
spk07: Jeff, yeah, really good question. And we have, you know, we do monitor our costs quite judiciously. As we move into fiscal 24, we would expect SG&A as a percentage of revenues to decline, but on an absolute dollar basis to increase, consistent with, you know, seeing significant sales growth, and some of the variable costs that come with that. So, yes, we would anticipate an absolute dollar increase in SG&A in our next fiscal year.
spk04: Okay. And then with respect to the USCBP contract or order, as we exit fiscal 23, where do you think you'll be in terms of percentage delivery against that contract? And, you know, on top of that, are you currently – you know, seeing activity or interest in follow-on orders or tack-on orders.
spk14: Jack, I'm going to ask a portion of it, and Alan can answer. We really can't break it down into specifics, into what percentage in this year, next year. What Alan has said is that it's been a little slow start, but Q3 was more shipments to CP than Q2. Q4 also signifying going to be more, but the contract, present contracts, We'll take it in 2025 and 26. But we also want to emphasize that the IDIQ, as I mentioned before, for the total two programs were in about $800 million range to us and other vendors. Out of that, only $200 million was let out to us, a big portion of it. So there's still a lot of room as we move forward for CBP to put new orders on those IDIQs which will continue into 25, 26 and beyond. And on top of that, we've said it before, one of the things that we are very much focused into it is not just selling the equipment, but the search scan software, which we continue to work and we are very excited about it. And with the Sedana contract from Mexico, which we have set it at the Northern borders between Mexico and US, that's a very big plus point for longer term cooperation between the two countries and to make the trade go simpler and faster. And we continue to say that as this thing is looked at it and people are happy with it, the customers are happy with it, this is a good selling point to the rest of the world, wherever there is trade challenges there, to duplicate the same thing. And we are very well positioned for it. So we're very excited about it.
spk04: That's a great segue into my final question. Deepak, is Is the coordination and integration between the U.S. and Mexico already in plan, or is that just in the initial stages of discussion, and was that a big part of the decision process for Sedena to go with Rapiscan?
spk14: Well, number one, it was a competitive bid, and I think we've said it before. This was not based just on price. It was based on performance and the experience. But I can't say anything about the governments have to do whatever they have to do. But they have shared information in a way that CBP was very complimentary and that could have, I don't know, that could have helped. But how they do it in the future, it all depends on politically. But what I look at it as is, we have said it before, in the other programs that we have in Guatemala and Puerto Rico and Albania, all of them have been very, very successful and the customer is very happy. it does help in the trade and we keep looking at it that the whole world has to look at this and with the way the efficient way of trade it will help but i can't say what what they plan to do and what they are doing between the countries got it thank you look forward to the fiscal 24 guidance next quarter thank you thank you once again if you have a question at this time please press star one one
spk03: one moment for our next question. And our next question comes from Larry Solo from CJS Securities. Your question, please.
spk00: Great.
spk08: Good morning. Quick question, just a couple of follow-ups on the large awards you guys have been getting. You mentioned the competitive bidding process in Mexico. What do you think? Do you think CertScan is your differentiator there? What do you think sort of is driving, you know, your fair share, if not the leading leader in most of this newer vehicle inspection and cargo inspection?
spk14: Good question. I would say CertCan is one of them, but there is a lot of other. We consider ourselves to be the preeminent technology provider in cargo in the world. We can say that confidently. Multi-energy, backscatter, our ability to interact with radiation portals, to interact with the with the license readers, integration, size of its service provider, I call it customer happiness, and the global presence. So all those factors do come into play. And one of the most important factors that come into play is the history of performance and execution. So I won't say just search scan, but it's a combination of all this innovation, upgrade of technology, new products, the ability to be able to perform and be flexible of customer demand. Alan, do you want to add something to it?
spk06: I think that summarizes it very well.
spk08: Got it. And then just on the, for clarification, so the three contracts or whatever, they total, I don't know, five, six, seven, like 700, 800 million, 100 million. Is there, can we expect like a reoccurring portion of that I think these contracts, they're close to a billion, actually, if you add up all three of them. Would there be like a reoccurring portion that kind of is like 25% of this number, which is kind of what your reoccurring service portion is today? Any sort of color on that?
spk14: Well, number one, when you are trying to add it up, you're trying to add the CBP contract, the international contract, and the Sedana contract. Yeah, if you add them together into it. But keep in mind, the CBP 200 million dollar contract is part of an IDIQ, which is 800 million. And not that all of that is going to go to us, but they can do whatever they want. But we are well positioned. Our customer is very happy. And the other side of the question, what you said is these contracts do include some service and maintenance anyway and most of this lifespan of these equipments and stuff are more than 10 12 15 years so there's a follow-on service and maintenance upgrading and stuff that continues but on top of that i want to say yes these are large contracts but that doesn't mean that they are not other big con potential contracts out in the rest of the world Keep in mind, a couple of years ago, we had a $750 million MSAT contract from Mexico Services. Puerto Rico long-term continues, and that's a big contract, so that there are other opportunities. We look at these as a very big stepping stone for us to be able to convince other parts of the world that these are great things to work together, and we are well-equipped to manage and support the customers.
spk07: Alan? Got it. Larry, one of the nice things about this, I think as you're alluding to, is as we get this bigger and bigger installed base out there, you get this nice recurring revenue through service, and the service revenue generally carries a nice healthy margin associated with it as well. So it provides a steady stream of recurring revenue for many, many years to come.
spk08: Yeah, exactly. And your service revenue has kind of jumped up a little bit over the last few quarters, which is definitely helpful. And just for clarification, I know you said the international contract will begin in fiscal 24. It sounds like you'll get a good portion of that, whether that's the majority or not. I don't think you're really clarifying there. But in terms of Mexico, do you also expect that to start driving contributions in this upcoming fiscal year?
spk07: Larry, this is Alan. So we're working with the customer on the timing of deliveries for that and revenue. But yes, the answer is yes, we do expect revenues to commence for the Mexico-Sedena contract in fiscal 24. We'll have more clarity on timing at our next call, but yes, we do expect revenues in fiscal 24.
spk08: Great. And then just lastly, just on opto, I think this little slower growth this quarter on the top line, I think that was kind of expected. But just in general, the backlog has been going up. you know, I think it's up, at least as of the last quarter, I don't know if you updated it this quarter, but it was up, I think, 20% year over year. You know, what's, you know, what's sort of the disconnect between the 20% rise in backlog and sort of flattish sales? Is it just that most of these orders are longer term or what, you know, is it timing related or any color on the grid?
spk14: Good question. Good observation. You know, keep in mind that business is a different business. And during the last year, especially with COVID and supply chain and issues like that, the customers placed orders just to put their, what I call their staking hand into that so that we have a longer term backlog in that area. And, you know, some of the customers have now looked at it and see what their needs are and stuff and push and shove into it. But that backlog is what I call it is large contracts, and then it takes some time before the next ones come in. It's a longer-term play. Alan, maybe you can clarify a little bit more.
spk07: Yeah, that's the primary thing, just the timing of deliveries to customers, some of them who are adjusting their own inventory on hand requirements. Supply chain continues to play a role in that, too, where we might have 99% of the components, but we might be missing some small components that – have delayed certain shipments. But that's the general area. So, yeah, the backlog in opto is very strong. Revenue, the conversion to revenue will be nice. And the productivity gains they've had have been, you know, really, really noteworthy, which has generated a lot of the operating margin expansion.
spk14: And, you know, just to add on to a little bit more broader, maybe a little bit of a broader thing, but I did say in my speech, One of the big things about that opto business is our global presence. Manufacturing, whether US, whether it's in Canada, it's in England, it's in Malaysia, it's Indonesia, India, that helps a lot because the OEM customers that we have who place orders, Their other focus is supply chain issue, and the different parts of the world can supply different products, and everybody's looking at alternate to China. That's been a very big plus point long term, and they continue to work towards that and use that effectively.
spk08: Great. And you just mentioned supply. If I could just slip one more question. With this significant ramp coming up in security, is there any concern about your ability or the supply chain ability to
spk14: kind of you know keep up with that pace in order to you know make these deliveries over the next three two three four years well definitely i mean that's that's a big ramp up uh but we are well positioned again internal intercompany also is a big asset that we have between the upper group supplying the product which our competitors don't have it and uh we are basically very much focused into it won't say that's not a challenge But at the same time, we feel that we are very much equipped, and we continue to look at it. We're working with the customer. We're working with our vendors. As Al mentioned, there are definitely supply chain issues, cost issues. So we continue to look at it, but that's what our strength is. We continue to focus on it.
spk03: Great. Thanks. I appreciate all the call-in. Thank you. This does conclude the question and answer session of today's program. I'd like to hand the program back to Deepak Chopra for any further remarks.
spk14: Thank you all once again for attending our conference call. And I again want to thank our employees, our stockholders for their confidence in us, our worldwide employees all over. It's a very exciting time. We are focused on to it. And we'll again talk to you and have a better feeling In August, we're going to do a conference call for the year end for what the next year looks like. With a $2 billion backlog, we are very much focused and excited about it. Thank you very much.
spk03: Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.
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