Osi Systems Inc (OSIS) Q1 2022 Earnings Call Transcript

Ladies and gentlemen, thank you for standing by. And welcome to the OSI Systems Inc. First Quarter 2022 Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. Please be advised, that today’s program is being recorded. And I would like to introduce your host for today’s program, Alan Edrick, Chief Financial Officer. Sir, you may begin.

Thank you. Good morning and thank you for joining us today. I'm Alan Edrick, Executive Vice President and CFO of OSI Systems. And I'm here today with Deepak Chopra, our President and CEO. Welcome to the OSI Systems fiscal 2022 first quarter conference call. We are pleased to review with you our financial and operational results. Earlier today, we issued a press release announcing our fourth quarter and fiscal year 2021 financial results. Before we discuss our results, 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 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 the discussion of our financial performance for the first quarter of fiscal 2021, and then turn the call over to Deepak for an overview of our business. I will then return to finish with more detail regarding our financial results and a discussion of the outlook for fiscal 2022. Despite the continuing impacts from COVID, as well as supply chain and logistics challenges, the company performed well during our first quarter. Our priority at OSI Systems remains to deliver on commitments to our customers and our partners and position the company for long-term success while preserving the safety of our employees. Now let's cover some highlights. First, Q1 revenues increased 10% year-over-year, all organically driven by the strength of our security and Optoelectronics and Manufacturing divisions. Second, we achieved record Q1 non-GAAP earnings per share of $1.16, up 9% from Q1 of fiscal ’21 despite the volatile backdrop of travel restrictions, short term plant closures and supply chain constraints. And third, bookings were strong in the first quarter. The Q1 book to bill ratio was 1.6, leading to a 15% increase in backlog since the beginning of the quarter. Our backlog exceeded $1.2 billion for the first time. Before diving more deeply into our financial results, let me turn the call over to Deepak.

Thank you, Alan. And good morning to all of you. We are pleased with our fiscal 2022 first quarter performance, which showed strong revenues, bookings, and earnings. We delivered a strong first quarter despite an environment that included overseas plant partial shutdowns due to the pandemic and ongoing supply chain disruption. I am pleased with our disciplined execution which enabled us to navigate these challenges and capitalize on the ongoing recovery in certain of our end markets. As Alan mentioned, with a record backlog of over $1.2 billion, we are well positioned for the future. Talking about each division's performance in the quarter, starting with the security division, where first quarter revenues grew 11% year-over-year. The division saw significant bookings resulting in a book to bill ratio of 1.9. Shortly after the quarter end, we announced key wins that we achieved during Q1 with one of our major customers, U.S. Customs and Border Protection (CBP) to enhance border security infrastructure. Under the contract for the Low Energy Scanners (LEP) and Medium Energy Scanner (MEP), we received the largest orders to date, totaling approximately $200 million. As you know, the September quarter is also the government year, and we are very excited about this major win. We have the potential to receive another $65 million under this contract if CBP exercises its options. We expect to fulfill these orders over the next couple of years commencing in late fiscal 2022. We look forward to providing our CarView in-lane scanner, the Z Portal backscatter scanners, and our Eagle P60 ZBX Inspection Systems to support CBP’s target of achieving 100% screening at border crossings. In addition, a meaningful portion of order values are also for our proprietary search scan integration platform software for image analysis, data integration, and inspection. We believe that the CertScan software has potential to become a standalone platform-agnostic offering in the marketplace. Besides CBP, other customers around the globe are also looking at CertScan software. Our turnkey service operations in Puerto Rico, Albania, and Guatemala continue to do well as our customers rely on these programs to reinforce trade and tariff requirements. During the quarter, we successfully won orders with a number of key aviation and critical infrastructure customers and grew revenues from the prior year for baggage and parcel inspection systems and explosive trace detection systems. During the quarter, we announced an order for approximately $13 million to provide multiple units of our RTT 110 Real-Time Tomography Explosive Detection Systems for an Asia-Pacific International Airport. The air passenger traffic levels are improving but have not returned to pre-pandemic levels as you know, and thus, the demand for related products and services is recovering slowly. I should also note that the pandemic-related travel restrictions continue to complicate the process for scheduling site acceptance testing for new product installations in certain parts of the globe. We expect to continue dealing with these challenges in Q2 and going forward but expect the environment to improve thereafter. Although some unpredictability remains, the increasing security backlog demonstrates sustained and growing demand for our products and services setting up well as we continue through fiscal ’22 and move into fiscal ’23. And we look forward to serving our global customer base in aviation, air cargo logistics, border security, and critical infrastructure. One of the comments I made in the previous calls I want to emphasize again is that during this period, one of the areas in security that has been very successfully growing for us is logistics and air cargo. Customers like DHL and Federal Express are very much expanding their ability to deliver products, and we are integrated with our products. Moving to the Optoelectronic and Manufacturing division, Opto again delivered strong results with record Q1 revenues representing growth exceeding 15% over the prior year and maintaining double-digit adjusted operating margins, which is impressive given the supply chain shortages and cost increases in this pandemic environment. The division achieved record bookings and ended with record backlogs. Opto’s original equipment manufacturing customer base is exposed in multiple markets such as healthcare, defense in space, and automotive, among others. As we now have proven ability to deliver in a pandemic-challenged environment, these customers serving critical markets have remained loyal and, in many cases, collaborated with us to manage lead times and delivery schedules. Our team is working diligently to manage the other cost elements within our control and remain focused on execution. Finally, moving to the healthcare division. We finished Q1 with sales down slightly, about 2% lower than the prior year. This was expected; we had said that before, as some of the COVID-related tailwinds that we experienced a year ago have somewhat dissipated. Although demand in America, our largest revenue region, continues to be strong and growing, we did see some demand softening in the EMEA region. During the quarter, we announced an order valued at approximately $3 million to provide patient monitoring solutions and related accessories to a Midwestern U.S.-based hospital, where we expect to provide exhibit rental stations, expression patient monitors, and cube patient monitors. As information connectivity, ease of access, and portability become increasingly important in caring for patients, we continue to invest in advancing our key product platforms in patient monitoring and cardiology to take advantage of these trends. Moving forward, we have said before that cardiology is a focus for us to grow as it's the highest margin business in Spacelabs in the healthcare group. We are encouraged by the performance of the healthcare team as it has delivered consecutive quarters of double-digit adjusted operating margins. Overall, I'm pleased with our Q1 performance despite the continued challenges related to the pandemic. Our team remains focused on serving its global customer base. We have a significant backlog in security, a record backlog in Opto, and the healthcare division has been critical in continuing to serve the hospital customer base that is at the forefront of fighting the global pandemic. We are hopeful that the industry-wide supply chain disruptions and cost increases will normalize in the near future. However, we are prepared to continue operating in this environment and remain vigilant in finding opportunities to grow the top line and leveraging our operations and global presence in the marketplace. We look forward to the rest of fiscal ’22. With that, I will hand the call back over to Alan to talk in more detail about our financial performance before opening the call for questions. Thank you.

Thank you, Deepak. Now I will review the financial results for our fiscal first quarter in some greater detail. As we mentioned earlier, Q1 revenues were up 10% over the prior year driven by solid growth in each of the security and Opto divisions. Security revenues are up 11% year-over-year, driven by our cargo and vehicle inspection products and our checkpoint systems. The security division Q1 booked a bill, as Deepak mentioned, was 1.9, leading to significant backlog growth in the security division. Opto sales including intercompany sales increased 16% year-over-year, continuing the momentum that we saw throughout fiscal ’21. Third-party Opto sales in the first quarter were up 15%, while intercompany sales in the quarter were up 17% year-over-year. The Opto booked a bill was 1.4, resulting in record backlog for the division. The growth in security and Opto sales was partially offset by a 2% reduction in year-over-year revenues in the healthcare division, which was anticipated as Deepak mentioned. While patient monitoring sales are expected to be a bit more challenged this fiscal year, several initiatives surrounding our cardiology product line, including new product releases and building out the U.S. sales team, are beginning to pay off. For Q1, cardiology-related sales increased significantly year-over-year. The Q1 gross margin was 35.6% compared to 37.6% reported in Q1 of last year. This was driven primarily by the mix of revenues among our divisions and increasing component costs. Stronger revenue growth in our Opto division, which inherently carries a lower gross margin than our other two divisions, places downward pressure on the consolidated gross margin; the mix of products and sales within the security and Opto divisions was also less favorable than the prior year's comparable quarter. Offsetting these reductions was an increase in the gross margin in the healthcare division, driven by the growth in cardiology sales, which tends to carry a higher contribution margin. Like many companies, we experienced increases in certain component and freight costs, which impacted gross margin on a division and consolidated basis as well. As mentioned on previous calls, our gross margin will fluctuate from period to period based on revenue mix and volume, among other factors. Moving to operating expenses. We continue to work diligently across each of our divisions to improve efficiencies and prudently manage our SG&A cost structure. This quarter's results demonstrate the success of these efforts. Q1 SG&A expenses were $57 million or 20.5% of sales, compared to $59 million, or 23% of sales in the prior year's Q1. Research and development expenses in Q1 were $14.8 million, representing a year-over-year increase of 23%. We continue to dedicate considerable resources to R&D, particularly in security and healthcare. We remain focused on innovative product development, which we view as vital to the long-term success of our businesses. In Q1 of fiscal ’22, we recorded $2.5 million of impairment, restructuring, and other charges as compared to $8.4 million in Q1 of the prior fiscal year. Moving to interest and taxes. Net interest and other expenses in Q1 of fiscal ’22 decreased to $2 million from $4.2 million in the same prior year period, primarily due to the adoption of the new accounting standard ASU 2020-06, which eliminates the non-cash interest expense associated with our convertible debt. It also increases the debt on the balance sheet by eliminating the unamortized discount, which was approximately $10 million prior to adoption. On the tax side, excluding the impact of discrete tax items, our effective tax rate in Q1 fiscal ’22 was 25.4% compared to 27.5% in Q1 of fiscal ’21. We recognized discrete tax benefits of $2.1 million in Q1 of fiscal year ’22 compared to $0.3 million in the comparable prior year period. As a result, the reported effective tax rate was 15.9% in Q1 of fiscal ’22 compared to 25.3% in Q1 of fiscal ’21 under GAAP. I will now turn to a discussion of our non-GAAP adjusted operating margin. Overall, our adjusted operating margin decreased to 10.9% in Q1 of fiscal ’22, from 11.3% in Q1 of last year, driven by the previously discussed factors related to the gross margin, increased investment in research and development, and changes in healthcare. We were pleased with the increase in the adjusted operating margin in our Security Division, which expanded to a record 16.2% in Q1 this year, compared to 14.8% in the prior year first quarter. This Q1 record margin in security was offset by reductions in the other two divisions. Our healthcare division's adjusted operating margin was 12.1% in Q1 of this year, compared to 17.8% in Q1 of last year. The variance was driven by economies of scale associated with a higher level of sales in the prior year towards the beginning of the pandemic that boosted the fiscal ’21 margin, as well as increased R&D in the fiscal ’22 first quarter to support new product development, higher component costs in this challenging supply chain environment, and increased investments in infrastructure to support future growth that put downward pressure on the fiscal ’22 margin for healthcare. Aside from last year, the adjusted healthcare division operating margin for Q1 of fiscal ’22 was the strongest on record for Q1. Similarly, our Opto division’s adjusted operating margin decreased to 11.4% in Q1 of fiscal ’22 from 12.1% in Q1 of last fiscal year, primarily due to a less favorable mix of customer revenues and rising costs in the supply chain. Moving to cash flow, in Q1 cash used by operations was $11 million. This was driven in part by a decision to increase inventory levels to mitigate certain supply chain challenges and the timing of payments to vendors and collections from customers, as some parties have been delaying payments in the current business environment. CapEx in the first fiscal quarter was $3.5 million, while depreciation and amortization expense in Q1 was $9.7 million. We were active in our stock buyback program. During Q1 of fiscal ’22, we deployed approximately $16 million to repurchase 168,506 shares at an average price of approximately $96, leaving approximately 2.4 million shares available to repurchase under the current program. Our balance sheet is solid, with significant capacity for acquisitions and additional stock buybacks. Our convertible notes mature in September of 2022 and thus are now reflected as a current liability. Given the general strength of the balance sheet and liquidity through our credit facilities, we believe there are various favorable options available to us to satisfy our obligations under the convertible notes. Finally, turning to guidance. As Deepak described, although we are pursuing a number of opportunities that could potentially bolster our fiscal ’22 results, we are simultaneously cognizant of the current environment which we have seen, among other things, timing challenges associated with product installation and acceptance testing in our security division and headwinds in the supply chain. As such, we are reiterating that fiscal ’22 sales and non-GAAP EPS guidance previously provided while we manage through the pandemic and supply chain challenges. Based on our projected backlog delivery schedule, we anticipate the second half of the fiscal year to be stronger than the first half. We currently believe this revenue and non-GAAP earnings guidance reflects reasonable estimates. And we've included the anticipated impact of the COVID-19 pandemic and supply chain challenges in our guidance. Given uncertainties as to the duration and scope of each as well as other variables, however, the extent to which COVID-19 and supply chain may impact the company and its financial results 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 under SEC filings. In the face of these challenging times, we continue to remain steadfastly focused on the growth of our businesses through investment in product development, potential strategic acquisitions, and continued management of our cost structure. We believe our efforts in these areas will enable OSI to maintain its leadership in providing innovative products and solutions. We delivered strong first-quarter results and continue to navigate effectively through uncertainty while gaining traction in key strategic growth areas and positioning the company to capitalize on improving markets. Finally, we would like to take this opportunity to thank the global OSI Systems team for its continued dedication in supporting our customers and contributing to the creation of value for our stakeholders while maintaining a firm commitment to safety. And at this time, we'd like to open the call to questions.

Thank you. Our first question comes from Brian Ruttenbur with Imperial Capital. Your line is open.

Yes, thank you very much. First question on the big order with CBP. Can you talk about the timing? I think Deepak you mentioned that most of this is going to start shipping around the end of fiscal ’22. Should we expect that the majority of the $200 million will be shipped in fiscal ’23?

Deepak here. Yes, I said that. We expect that by the fourth quarter of this year, it will start shipping. The majority of it will shift next year and it's going to go into the next year following that too. But again, I want to emphasize that it could be a little earlier, it might have a little push to the right. It really depends upon the customer readiness and the ability to install and sign off. Alan, do you want to add some?

Yeah, Brian, I would echo what Deepak said. Very exciting order for us. Large order for us sets us up well as we move into fiscal ’23. And even ’24 we anticipate there could be just a modest amount of revenues towards the end of our fiscal ’22.

Brian, this is Deepak again. I just want to add on to that, since you know a lot about that marketplace. I did say that, but I want to emphasize that out of all the various people who got orders on the NII system at that time, we got the largest order. Our products are very well received. It's a very broad base. And not only it's the products, but it also has the CertScan proprietary software integration with it. So we're very excited about that. And we want to look forward to it. As you can imagine that as this goes forward, it has much more potential to become bigger and bigger. And not only just for CBP, but other places in the world will be watching how this progresses.

Great. In your backlog numbers, is that $200 million in that backlog?

Yes, it is. Brian, it's part of the September 30 backlog.

Okay, great. You mentioned some changes in gross margins due to the revenue mix, especially with a strong performance in Opto. Can you confirm whether the strong results in Opto for the first quarter are sustainable at those levels?

Brian, it's a good question though. Although we don't provide guidance by division, we believe the outlook for Opto is extremely strong. Record backlog, so even though we had record revenues, with a very strong book to bill ratio, it provides great visibility going forward. Now, of course, we'll have more difficult comps going forward in Opto as well because Opto had such a fantastic fiscal ’21 and each and every quarter. But on an absolute dollar basis, we feel very, very good about where Opto will be through the rest of the year. We won't see that. We don't anticipate seeing 15%-16% type year-over-year growth. But on an absolute dollar basis, very strong revenues going forward as well.

Great. And then just a couple other little things on SG&A and R&D. SG&A was down year-over-year. Is that a good number to look at? Or is there any aberrations? Because travel it appears is coming back in this fourth quarter going into the first quarter calendar. Is it travel related that is down or is it headcount reduction why is SG&A down?

Yeah. So we're really trying to manage our cost structure nicely and our team has done a great job in that regard. There was nothing particularly unusual of a significant nature in Q1. We did start to see travel begin to tick up in our first quarter in all 3 of our divisions, and we expect will probably pick up even a little bit further as the year progresses, as travel begins to open up even a little bit more. So we'll see that SG&A fluctuate from period to period. But there wasn't anything of a material nature that was super unusual in Q1.

Okay, and then R&D, It appears pretty dramatically year-over-year and even sequentially. Is there new projects going on? Is this something that just seasonally happened? I'm just looking back at your historicals, it just said $14.8 million looks historically pretty high for first quarter.

Brian, Alan again. You're right, it is high for a typical first quarter, but we felt those investments were quite prudent to make. And in both our security divisions, and in our healthcare division, we invested significantly in R&D in the first quarter for a number of new exciting projects coming out to fill demand in the global marketplace. And we really think this can make a difference for us going forward in the future. We'll continue to focus on R&D. We think it will be at a more elevated level than it was last year because we think that's so important to driving shareholder value going forward, but we wouldn't look for it to accelerate to any significant degree on a sequential basis.

Just to add on, Brian. For example, with this $200 million order from CBP. And I mentioned some of the products, the CarView in lane, the Z Portal systems, the P60s. Some of those are new systems. So the focus has been that as you go into new platforms and new products, it increases the R&D. Similarly in healthcare, as Alan has mentioned, we are investing quite a lot into the new platform in patient monitoring. And cardiology is a big focus for us because it's the highest margin product and we want to go forward to grow that business. The second thing is that people have to understand when they compare it to the year before, obviously, with the pandemic and the disruptions, interruptions, the travel restriction, the people working remote. Last year was relatively big, looking at it unusually low. And then when we come back into it, these are new products and new platforms. We are an innovation company. We're a technology company. And we're going to continue to focus on it, and the rewards will come in the years later.

That's good. Last question just real quick on working capital and cash flows. Obviously, you took inventory up, you already highlighted that. If you would expect positive cash flows for the second quarter, third quarter. When do you see that turning?

Brian, it’s Alan. Good question. Although we don't provide guidance for cash flow, generally. Let me kind of give you kind of directional. We expect that we'll have good strong, positive free cash flow for fiscal ’22 as we've shown in past years. Kind of in the near term with some of the supply chain items. We'll continue to invest prudently in inventory and manage our vendors appropriately to some of which require a little bit more timely payments than pre-pandemic. The nice thing is we have such a strong balance sheet, and we have such a strong credit facility that affords us the luxury and the opportunity to do what's best for the business on an overall basis. But we've always been a good strong free cash flow generating company, and we expect to continue to be just a few things from a timing perspective that could vary from a quarter-to-quarter basis.

Thank you. Our next question comes from a line of Jeff Martin with ROTH Capital Partner. Your line is open.

Thanks. Good morning, Deepak. And Alan, how are you?

Fine. Thank you.

Good, Jeff. Thanks.

Great. I was curious if you could elaborate on your comment that the opportunities are in front of you that can bolster 2022? I assume you're referring largely to the CBP contract. But are you alluding to other things that maybe we haven't heard much about yet? What specifically are those maybe by segment or by end market would be helpful?

Good question, Jeff. Deepak here. Definitely. Our products are very well entrenched in both healthcare and security globally, including the U.S. and other places. And, there's uncertainty. One of the things that Alan has mentioned in previous calls, we have some products already built, but we have just delivered them. So when we say what is opportunities in fiscal ’22 as the things open up as travel opens up as our ability to install units and sign off and stuff that can increase the revenue. But we just want to be cautious; we want to be conservative. Same way as in the supply chain. We all think it's going to get better, but there's going to be a challenge. And we have to manage it right. Our backlog in Opto, our backlog in security. Customers are eager for product. They want to get the product. Some customers are even helping us collaborate to get more material in, and in some places, we've been able to offset even the cost. So I look at this not just as the CBP opportunity, but as things open up as logistics open up air cargo—people want more products. Automotive, you'll hear it every day. We are very much involved in the automotive industry. And they're asking us to get the product.

Encouraging. I wanted to ask a question around CertScan. Alluding to you could sell it as a standalone product. I assume that to your fairly large installed base, existing install base. But would this retrofit into non-rapid scan equipment that's already out in the marketplace? Help us kind of shape how you're going about this opportunity? And how should we as an outside group think about it?

Good question. Good observation. I did make the statement. The platform we are developing, CertScan, is agnostic to the equipment that's very important. Yes, obviously, we are focused on getting the install base of the rapid scan and new products which have the integration of the software, but this software is agnostic. It can be used and is being used and tested by third-party products, so that it can be integrated into a central program for image analysis or inspection and data integration. We have focused on that and developing it as fast as possible, while doing education for customers to think about it as a standalone software.

Great. And then just wanted to ask a question around component and freight costs. What's your overlying thought process behind conceding some margin versus raising pricing or setting higher pricing? I would assume some of your existing contracts have the pricing already fixed in there where you can't necessarily go back and ask for adjustments on components and freight. But how should we think about when those pressures might need mitigating and what strategically you may do to offset some of those pressures?

Let me take a broader answer, and then Alan you can comment on it. There is no fixed time that this problem is going to go away. This is the challenge we have been facing. We are addressing it. The team is working well. We look at this compared to our competitors, we are in a better position. We are multinational manufacturing plants. We are all over the world: Malaysia, Indonesia, India, U.S., England. So we have a little bit better control of the freight and the ability to get components in those parts of the world depending on the customer's needs. One other consideration is that, as Alan has mentioned, we are increasing inventory by buying products that we know we need. We can take some risks with it. Because when the customer wants it, the person who can deliver has the order and gets it. In some cases, we've been able to pass on the material costs to customers who can understand it. In some cases, where there's been a fixed-price contract from before, it's difficult to do that. Freight is a big challenge. And it's not just the price, but the unpredictability of freight. Yet we think we are better positioned than our competitors. We have a broader, vertically integrated company intercompany between Opto, security, and healthcare, and so we can handle it better.

Yeah, Deepak stated it well, Jeff. But many of our customers, particularly our OEM customers, certainly understand the component cost increases. In many of those cases, we're able to pass on the increased cost to them. In other cases, particularly end customers, where there's been an order on the books for a long time and backlog, those would be more difficult. So it's a balancing act. We think we do what's most prudent for the company and the customer, and it's a balancing act.

Great. Much appreciate the insights and good luck with the balance of the year. Thank you.

Thank you. Our next question comes from the line of Larry Solow with CJS Securities. Your line is open.

Great. Good afternoon or good morning to you guys out in California. Couple of follow-ups. The first one is just on the large order from Customs and Border Patrol. If I’m not mistaken, this is for a screening of vehicles. There’s not much screening today on the borders, I believe it's below 5%. Could be the ultimate goal. And I don't know how many years that's over to sort of get this to like 75%. So it seems like there's a lot more opportunity just within the U.S. and the CBP. Is that a fair statement? I know you mentioned that hopefully other countries will adopt as well. But just within the U.S. borders, it seems like there's a much larger opportunity, multiyear opportunities. Is that fair?

Very well said. I think you answered it. Yes, there is a need for it. And there's a lot of what I call wishful expectations for 100% inspection. I don't think it’s 5%. I think it's more than that. But definitely, there is much more opportunity. But I want to emphasize even on that, besides just the equipment, just think about it that the integration of all the systems to a central station makes it more efficient. And that we think is important besides the new equipment and state-of-the-art products. If the integration is where we come back to CertScan. All the nations, all the border patrol, and all the countries ultimately for tariff reporting, they all need these kinds of products. The more one can centralize it, the more efficient it becomes. We think we are well positioned.

Okay. Switching gears, it seems that the focus in healthcare is on product development and rollout, particularly in cardiology. This appears to involve a combination of new products in the cardiology sector. From what I understand, most of the sales have historically occurred overseas, particularly in the UK and partly in Europe as well. So, should we view this as both product and geographical expansion in the cardiology area?

Number one, just to emphasize, our development for new products we said is also focused on patient monitoring, which is a majority of our sales. And they're also doing cardiology, which is a smaller portion of it. But we think that has better growth opportunity. So investing in both. Regarding the geographic thing, obviously, we look at all of it. Monitoring being significant in the U.S. is 70% plus. We can continue to look at that. And I did mention in my call, we're looking at connectivity, remote monitoring, home care, all kinds of stuff that is what everybody's looking at, especially during the pandemic. The development and research we're doing is to make our products more suitable for that. On the cardiology front, definitely, originally, it was more into the European sector. But we are also focusing and growing in the U.S. We have already started it. We believe that will continue in both Europe but primarily in the U.S. market, as it is a bigger market. So it's both. Alan, do you want to comment on something?

Yeah, well said, Deepak. But you're right, Larry. Historically, the strength of our cardiology business has been in Germany and the UK and some other selected international markets. We've been building up the U.S. sales and marketing team and infrastructure. We saw tremendous growth year-over-year in the U.S. in Q1 and expect that will continue to be a nice part of our growth through the balance of this year and for many years going forward. The increased R&D investment is in both cardiology and patient monitoring, but principally in patient monitoring for some new platforms that we'll have coming out in the future.

And switching gears onto the Opto side and the book to bill, the order trends seem to have improved sequentially the last couple of quarters. I know it seems to be coming from a lot of areas. But has anything changed over the last year or so? Are you seeing strength in any particular one or two areas more than others? I know you've kind of called out automotive before recently; is that where you're seeing a lot of the strength?

So hey, Larry, this is Alan. You're right. I mean, I think we've now had 7 straight quarters of tremendous book to bill ratios for the Opto division. While we're seeing broad-based strength in our Opto business, we think we've seen dominate a lot of those bookings has really been through our Asian operations. Yes, automotive is part of it, which has been great but also to a number of other types of industrial, medical, aerospace, defense, and even technology customers. So it's been a broad-based, strong demand led by our Asian operations, but our North American and UK operations have done extraordinarily well in bookings simultaneously.

To add to what Alan mentioned, besides sectors like automotive, defense, aerospace, and healthcare where we've consistently operated, we believe that if we had been able to supply more, our revenue would have surpassed expectations. As we anticipate ongoing growth, we are enhancing our Asian operations by opening a new factory in India. We are confident that the Opto business, along with our OEM sectors in healthcare, automotive, aerospace, and defense, will continue to expand. However, we want to highlight that supply chain challenges related to freight and logistics remain a significant concern.

Right. And then if I may just finish on that note, the supply chain obviously sounds like seeking seemingly worse; refer solely on a macro level. And it does seem like it's gotten worse a little bit worse for you guys too. With that said, Alan, it sounds like you expect free cash flow to sort of to certainly reaccelerate perhaps this quarter. Do you still think—I know you don't guide full year basis—but is it fair to say that free cash flow may be down some year-over-year? Last year, you had an amazing year and benefit, I think even from some working capital stuff. So that seemed like with a negative working capital, at least in the beginning of the year, and some excess inventory just to offset some of the supply chain issues, we will be down this year-over-year. But nothing really has changed in terms of your free cash flow generation capabilities.

Larry, this is Alan. Yeah, I think you said that. Long-term cash flow generation continues to be quite strong for us. Looking at fiscal ’22 specifically, some of the growth in the top-line and the investments that we're making in inventory in the sort of unique situation that we're in today. I think your overall assessment for cash flow this year is correct. And of course, as the situation improves going forward, there could be a nice bolus of cash flow as some of the working capital metrics on inventory turns, DSOs, and AP revert more back to mean. So some great opportunities there.

Thank you. Our next question comes from the line of Christopher Glynn with Oppenheimer. Your line is open.

Hey, good morning, guys. Sound great, nice job. Wanted to spend a little bit of time on healthcare and the margin opportunity. Couple questions, as diagnostic cardiology kind of continues to ramp, will we see a mixed tailwind as the year goes on and start to leverage higher investment, or is that more in the out years? How do you think about the kind of range of run-rate expansion really for the healthcare segment over the next couple of years as you're now live with cardiology and inching closer on monitoring?

Chris, this is Alan. Good question. The diagnostic cardiology and remote cardiology products for us do provide the highest contribution margin within the healthcare division. That being said, patient monitoring has nice contribution margins as well. But as we experience a greater growth rate in the near term in cardiology, relative to patient monitoring, we do think that provides some tailwind for on the gross margin side and leveraging that down to the bottom line. So we're excited about those growth opportunities in the near term in cardiology, and in the medium term, and longer term for patient monitoring.

Okay. And some of your GPOs, like you highlighted premiere last quarter with patient monitoring. Are those nice channel opportunities for the cardiology too, or is it really different?

No. Those represent real nice opportunities as well. And the team that manages our GPO relationships is in contact with each of those GPOs. We're on contract with some of them in cardiology and looking to expand further with the rest as the new products come out.

Chris, this is Deepak here. I just want to again, emphasize to say that the ratio between patient monitoring and cardiology is very much focused on the patient monitoring side. Cardiology is relatively small. So it might take some time for significant impact to happen. We look at that area growth-wise. And at the same time, we have to focus on the platform and the enhancement to the features of innovation monitoring which will continue. So just want to make sure that one realizes that the ratio between the two product lines is quite a lot; 70% of our revenue is from monitoring.

Yeah, I appreciate you highlighting those dynamics. And curious on security. There's been some real high-profile stuff there. But how would you characterize the sort of smaller project activity to kind of grab bag of venues things like that?

Well, good question. Again, I think most of the questions have been on the large order. But we have more than 20,000 installed base all over the world. So we sell many, many products in the $15,000 range, in $5,000 range to multimillion dollar ranges. We haven't given up or there is not just focus on one big contract. Pipeline of our activity remains very robust and strong, globally. As we have mentioned, and I'm sure you read about it, there's slow travel growth, passenger counts are slowly increasing, but there is still unpredictability. All the airports around it, they have to change their products. They still have to go get to the new ones. They're trying to do so. There are all kinds of courthouses, prisons, carnival cruises, all that stuff is there. And we have a very broad product line which caters to all of it.

Thanks again.

Thank you.

Thank you. Our next question comes from the line of Sheila Kahyaoglu with Jefferies. Your line is open.

Hi, good morning. Thanks for taking my question. Can we revisit the $200 million CBP order? Was it competitive? How should we interpret that? Should we consider the $200 million over the next two years? Are there any offsets to that?

Good question, Sheila. In different parts, I'll answer it. Number one, all these bids, these large ones that fall competitive. It's not like uniqueness we are very proud of that we got and multiple companies got what is called IDIQs, Indefinite Delivery, Indefinite Quantity orders. And then came the real orders, we're very proud to say we got the largest share. We think our product is superior. The answer to your second question is $200 million. This is a great win. And it's going to be spread over a little bit starting, as we said, in the fourth quarter, hopefully in this year going into 2023 and ‘24. But this is not the end. There are more rail scanners we are developing, and we've had some input in that; there are products all over. And then the other thing is, we are also very proud to say that we're also looking at software integration, which is what we call it agnostic. And we continue to go back and make that point. So that we think is a new endeavor, a new area for us to grow with a good margin product.

Okay, cool. No, that's how it will be packed. And is there anything that offsets that that was lost in the quarter, or this is all the new one?

Well, it's all add-on; nothing is lost. Some of the other orders are internationally got pushed out. We have not lost any. And we continue to look at in the air passenger area, in borders and patrol. And I want to emphasize again and again, I say that in many calls, air cargo logistics area, all this would you hear about increased shipments and stuff that has a benefit for us. Because our products are used by these logistics companies and air cargo companies.

That makes sense. And then you guys talked extensively about R&D being higher, given your investment in cardiology. Margins have been around 12% for the last 2 quarters. How long is the R&D cycle? How should we think about that investment laying on profitability?

Sure. Sheila, this is Alan. And again, the investment in healthcare and R&D is primarily on patient monitoring and cardiology as well. But the majority of it is in patient monitoring as we come out with a new platform. So the heightened R&D spending for healthcare will certainly be with us through the balance of this fiscal year and into next as we look to roll out these exciting new products.

Sheila, just to add on to it and emphasize that everybody talks about cardiology and patient monitoring. I did say we also have R&D in security. All these new products that we are coming up with, all the new innovations we are doing, that also has R&D on it. We continue to focus on that too.

Yes, okay, that makes sense. And then maybe the last one on Opto, you guys talked a lot about pricing and supply chain, a lot about supply chain. I think Opto is the most price-sensitive segment. Are you guys actually benefiting from price as inflation has hit in those shortages?

Well, I don't think I can say it in a positive way. I wouldn't say benefit; it's a challenge. What I want to say is that this whole thing, everybody's addressing it, everybody's looking at it, everybody's having some impact on it on the negative side. We're just monitoring it. We think that we are better positioned than some of our competitors across the product lines, but nobody's going to benefit from it. We are all looking at how we can minimize the impact.

Okay. Now, that's helpful. Thanks so much.

Thank you. Our next question comes from the line of Josh Nichols with B. Riley. Your line is open.

Yeah, hi. How’s it going? I just wanted to get a little bit of clarification. You mentioned a little bit of gross margin impact. But overall, the company has been navigating that pretty well. Given that Q1 is seasonally slower, how should we be thinking about that for the remainder of the year? You have some Opto expenses, but also, I would assume, like the higher revenue base as we work through the year should potentially help offset some of that. Is there expectation that the company's kind of gross margin gets back to like the 36% plus range or what's the thought there?

Josh, this is Alan. Good question. It'll certainly vary from quarter to quarter, depending upon the mix between the 3 divisions and the products within those 3 divisions. But you're absolutely right. As we get economies of scale, particularly weighted a bit more to the second half, where we indicated that we expect a higher second half revenues than first half revenues, there are opportunities to take the gross margins to those levels that you're talking about. And then as we begin to experience healthcare growth again, in future periods, healthcare carries the highest gross margin among the 3 divisions. So when you wait that all together, it can have a favorable impact on our consolidated gross margin.

Thanks. And then just hitting on the CBP awards. So $200 million, with another $65 million follow-on opportunity; but I mean, those 2 IDIQs were like close to $900 million in aggregate. Is there opportunity that like later this fiscal year we could—you could secure like another $100 million or so out of those orders? Or what's the upside opportunity beyond that $265 that we're at today?

Very good question. And very good data that you got. That's true. The 2 IDIQs for the LEPs and MEPs close to $800 million or $850 million, $900 million. They have not released all that. We got the biggest share. There is more opportunity as the years go by; they look at the products and we keep talking about CBP. There's DoD, the State Department. There are other areas in the government also using similar kind of equipment. So there is more opportunity in it. What I emphasize was that as these units can be deployed, as they look at and they fine-tune it, I'm sure they will ask for some changes and fine-tuning. Ultimately, this says that the companies who got these orders will continue to grow their install base as they progress to what CBP and DoD and others want. So there are more opportunities.

Got it, and then last question for me. You've talked about M&A; and the company's leverage has continued to decrease. You're deploying capital to buy back stock; but it's been a while since there's been a large acquisition. I think you guys now have the balance sheet to be able to do it, at least once you refi the convertible notes. But what's your thought process as far as key criteria that you're looking to do? Like, does the acquisition have to accelerate the company's growth, recurring revenue, profitability? And I guess I'd also ask like, what's your thoughts on like valuation framework considering that, right? A lot of assets are probably priced a little bit higher than they might have been a year or two ago.

My God, you said it. You already answered yourself. Exactly. I mean, it couldn't be put in better words. All of the above. We are very focused. A, we have done our acquisitions. We've said it many times. But at the same time, we just don't do an acquisition just for the sake of doing one. It must make strategic sense. It should either be a strategic to our product portfolio or its innovation technology that's out there. We are looking at all the aspects. But you're also right what you said; we are not going to do anything stupid to buy something at an overpriced asset, which makes no sense just to do one acquisition. Alan, do you want to add on it?

Yeah, I mean, you're absolutely right, Josh. We have a lot of dry powder available at our disposal with a strong balance sheet. We're always looking to do acquisitions that could fill a channel need, or a technology need, or take us in a new technology direction. We look for stuff that will accelerate our growth and will be accretive to our earnings. And as you rightly point out to, valuations and multiples are at different levels than they historically were. So we balance all that and are hopeful of being able to deploy some of our strong cash flow and balance sheet not just for stock buybacks, but to supplementing good organic growth with some acquisition growth.

Great, thanks.

Thank you. I'm showing no further questions in the queue. I would now like to turn the call back over to Deepak for closing remarks.

Thank you very much. And again, I want to thank all of you for your support. And I want to again thank and emphasize the employees of OSI Systems globally during all these challenging times. They have worked exceptionally for the betterment of the company, and at the same time satisfying a customer's needs. I want to thank them very much. Looking forward to the rest of the year. And we'll talk to you in late-January on the Q2. Thank you very much.

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.