Osi Systems Inc Q4 FY2023 Earnings Call

Good day, everyone. Thank you for standing by and welcome to the OSI Systems, Inc. Fourth Quarter and Fiscal Year 2023 Conference Call. It is now my pleasure to turn the call over to the Chief Financial Officer, Alan Edrick.

Well, thank you. Good morning and thank you for joining us. I am Alan Edrick, Executive Vice President and CFO of OSI Systems and I am here today with Deepak Chopra, OSI's President and CEO. Welcome to the OSI Systems fiscal 2023 fourth quarter and year end conference call. We are pleased that you can join us as we review our financial and operational results. Earlier today, we issued a press release announcing our 2023 fiscal year fourth quarter and full year financial results. Before we discuss these 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 further 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 press release. I will begin with a discussion of our financial performance for the fourth quarter of fiscal 2023 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 fiscal year 2024. Our fourth quarter financial results were excellent, with all three divisions producing double-digit revenue growth and significant growth in our overall operating income. We are pleased about the strong finish to the fiscal year and are even more excited about our prospects for the new fiscal year. I will start with a high level summary of our Q4 results. First, we reported record Q4 revenues of $412 million, representing a year-over-year increase of 22%, driven by revenue growth of 29% in our Security division, 11% in the Opto division and 18% in the Healthcare division. Second, we reported record Q4 non-GAAP adjusted earnings per share of $2.66 and up 36% from the $1.96 in Q4 of the prior fiscal year, as strong operating results significantly overcame the negative impact of approximately $0.15 per share of additional interest expense associated with higher interest rates in the fourth quarter of fiscal 2023 versus fiscal 2022. Third, we ended the year with a record year-end backlog of just over $1.8 billion. The book-to-bill ratio in Q4 was 1.8%, led by the extremely strong performance of the Security division. This record backlog provides exceptional visibility as we enter fiscal 2024 and demonstrates the strong momentum across our businesses. Before diving more deeply into our financial results and discussing the fiscal 2024 outlook, I will turn the call over to Deepak.

Good morning, everyone. And thank you very much for joining us today as we discuss the OSI Systems' strong performance for the fourth quarter and fiscal year 2023. In fiscal 2023, all three of our divisions enhanced operations to efficiently capitalize on their respective opportunity pipelines. We saw our revenues grow year-over-year by 22% in the fiscal 2023 fourth quarter and 8% for the full year 2023, while delivering strong profitability. We ended the fiscal year with a record reported backlog of $1.8 billion, which is 46% higher than our backlog the previous fiscal year-end, providing the company with excellent visibility as we enter the new year. We dive into the highlights now. Our Security division delivered excellent results in the fiscal 2023 fourth quarter, with revenues increasing 29% year-over-year. We experienced sales growth across our major Security product categories with particularly robust growth in our cargo and vehicle inspection products. Our book-to-bill ratio was 2.4 for the fourth quarter. Most notably in Security in April, we booked one of the largest awards in the history of our industry. This approximately $500 million net of VAT award was received from Mexico's Secretaría de la Defensa Nacional referred as SEDENA. Under the Security program, we are slated to provide a range of inspection systems including the Eagle high energy and low energy cargo inspection portals, the Carview Vehicle Inspection System and our proprietary CertScan Multisite Integration Platform for inspecting trucks, buses and cars at Mexico's Northern and Southern border checkpoints. We also expect to provide civil works, training and follow-on service as part of this important Security initiative by the Mexican Government. We anticipate the contract ramp-up should begin in the second quarter of this fiscal year 2024. Near the end of the last quarter, we commenced delivery on the other large cargo win of over $200 million from an international customer that we announced in the third quarter. We anticipate further revenue in 2024 with ramp-up accelerating in our second fiscal quarter of the year. We expect to provide further updates on timing of the revenues for both of these large programs in future earnings calls. Throughout the fourth quarter of 2023, we completed several domestic and international Security projects at ports, borders and airports driving substantial revenue growth. Additionally, increased activity at airports boosted service revenue from the aviation segment of our business. We strive to enhance service revenue growth across all product areas, including aviation. It is particularly gratifying to see this growth in our service activity at multiple airports after the slowdown during the pandemic. During the last quarter, we announced approximately $21 million in awards from international airport customers from our RTT 110 Real Time Tomography explosive detection systems for checked or baggage screening. We are pleased with the expansion of the footprint of our RTT system, a platform which has been widely adopted with several 100 systems already operating at international airports and global logistics hubs at air cargo carriers. We are very happy to announce that we have reached approximately 500 units of our RTT systems installed worldwide, which is a great achievement. Recently, we were informed of our selection as the primary security detection provider for the 2024 Paris Olympic Games in France. While revenue for this project is likely to be recognized primarily in fiscal 2025, this is expected to be an excellent opportunity to demonstrate our broad range of Security solutions at a major venue and build upon our success as the leading Security provider at the FIFA World Cup games in Qatar held during fiscal 2023, as just like SYI, we did the London Olympics also in the past. This is a good achievement and is a very good project for us. It was a competitive bid and we scored the best. Earlier this month, we received notification that the Itemiser 5X Trace Detection system has been qualified for addition to the TSA Air Cargo Screening Technology List, ACSTL, authorizing its use for air cargo screening in the U.S. This development further strengthens our ACSTL approved offering portfolio that includes a diverse range of X-ray inspection platforms suitable for both small and large parcels, advanced trace detection for explosives and a broad selection of related supplies and accessories. As we have mentioned before in our calls, air cargo has been a very good customer base for us and continues to grow. As we look to the future in our Security division, our focus remains on product innovation, operational excellence and expanding our market presence. With a record year backlog and a robust opportunity pipeline, we are extremely excited about the division's growth. Our turnkey services projects in Puerto Rico, Albania and other parts of the world continue to perform very well. Over to the Optoelectronics group. The Optoelectronics and Manufacturing division achieved a significant milestone with record Q4 revenues of crossing $100 million, including intercompany sales 11% growth over Q4 2022. Furthermore, our Opto sales surged to $387 million for the full fiscal year, a 6% increase over sales in the last fiscal year. Opto continued to engage throughout the fiscal year with potential customers, keen on establishing supplier partnerships as an alternate to China. In addition, Opto has benefited from partnering with leading OEMs that are well positioned in their market segments. Furthermore, Opto's vertically integrated structure has become a strong advantage in the marketplace as it provides greater flexibility and optionality in supply chain management. Our extensive operating infrastructure spanning the U.S., U.K., India, Indonesia and Malaysia also offers flexibility in meeting these customer demands. As we transition into fiscal 2024, we anticipate Opto to uphold the consistency in performance we have come to expect. Following a challenging third quarter in fiscal 2023, the Healthcare division posted a strong fourth quarter performance with an 18% year-over-year revenue increase, despite continuing volatility in the CapEx spending by hospitals the Healthcare division team secured significant wins. During the quarter, we announced a noteworthy order of approximately $12 million from a major U.S. hospital for a wide range of patient monitoring, innovative clinical workflow and connectivity solutions. The Healthcare team also worked diligently to integrate the acquisition of the Rothman Index-based predictive analytics software into our business operations. In fiscal 2024, we expect to integrate this clinical analytics solution into our SaaS platform, SafeNSound, aiming to enhance clinical insights and workflows for patients of various acuities and ages. In addition, the Healthcare division is focused on developing innovative new business models and solutions such as leasing and subscription programs centered around the needs of hospitals operating in today's challenging environment. Looking ahead, we are confident about our company's future. Thanks to our strong market position and compelling solutions and the dedication of our excellent team. We are extremely excited about our fiscal 2024 and anticipate significant growth on both the top line and bottom line which Alan will discuss shortly. In closing, I would like to thank all our employees and customers and business partners. With that, I am going to turn the call over back to Alan to talk in more detail about our financial results and fiscal 2024 guidance before we open the call for questions. Thank you.

Well, thank you, Deepak. Now let's review the financial results for our fourth quarter in some greater detail. Again, our fiscal Q4 revenues were up 22% compared with that of the fourth quarter in the prior year. Q4 Security division revenues were up 29%, largely due to the growth in our cargo and vehicle inspection products and related service revenue. This included our first shipments from the $200 million plus cargo contract announced in January and continued strength in deliveries on the two significant U.S. Customs and Border Protection awards received in fiscal 2022. Aviation related revenues increased as well. Opto sales were up 11% year-over-year, with 8% growth in third-party sales to a diversified customer base, supplemented by strong intercompany sales to support the anticipated Security division growth. And the Healthcare division finished the year on a high note, reporting 18% Q4 sales growth, highlighted by a significant competitive conversion win at a prominent U.S. hospital that Deepak just mentioned and that we announced in May. The Q4 gross margin of 34.7% was up sequentially over the 34.3% in Q3, though approximately 1.6% below that of prior year Q4. The year-over-year gross margin in the Opto division continued to expand and the Healthcare division reported a comparable gross margin to that of the prior year's fourth quarter. However, a less favorable mix in Security division sales, coupled with certain supply chain cost increases resulted in an overall reduced year-over-year Q4 gross margin in Security and the company overall. Our gross margin will, in general, fluctuate from period-to-period based on revenue mix and volume, inflation and impacts of changes in supply chain costs, among other factors. Moving to operating expenses. We continue to work diligently across each of our divisions to improve efficiency and prudently manage our SG&A cost structure. Our fiscal 2023 Q4 results again reflect these efforts. Q4 SG&A expenses were $67.2 million or 16.3% of sales, compared to $65.5 million or 19.6% of sales in the prior year Q4. As a result, SG&A expenses increased 2% on a 22% increase in sales. Research and development expenses in Q4 of fiscal 2023 were $15.5 million, up from $14.6 million in the same prior year quarter. We continue to dedicate considerable resources to R&D, particularly in Security and Healthcare as we remain focused on innovative product development, which we view as vital to the long-term success of our businesses. In Q4 of fiscal 2023, we recorded $3.2 million of impairment, restructuring and other charges, compared to $2.7 million of such charges in Q4 of the prior fiscal year. Moving over to interest and taxes. Net interest and other expense in Q4 increased from $2.4 million in fiscal 2022 and to $5.7 million in fiscal 2023, 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 of fiscal 2023 to fix a portion of our floating rate bank debt. On the tax side, the reported effective tax rate under GAAP was 17.6% in Q4 of fiscal 2023, compared to 9% in Q4 of fiscal 2022. In Q4 of fiscal 2023, we recognized a discrete tax benefit of $2.2 million, compared to $4.9 million in Q4 of the last fiscal year. Excluding the impact of discrete tax items, our effective tax rate in fiscal 2023 was 21.9%, compared to an effective tax rate of 22.4% in Q4 of fiscal 2022. I will now turn to a discussion of our non-GAAP adjusted operating margin. Overall, our adjusted operating margin increased from 13.7% in Q4 of fiscal 2022 to 15.6% in the fourth quarter of fiscal 2023, driven by strength across each of our three divisions. The adjusted operating margin in the Security division remained solid, though declining slightly to 19.3% in Q4 of 2023 from 19.7% in Q4 of 2022, primarily from the mix of sales and supply chain impact mentioned earlier. We were pleased with the adjusted operating margin expansion in our Opto division, which increased to 13.8% in Q4 of fiscal 2023, compared to 12.7% in last year's Q4 due to strong sales and a favorable mix of revenues. And with the strong sales growth in the Healthcare division, this segment's adjusted operating margin expanded to 12.1% from 8.9% in Q4 of the prior year. Moving to cash flow. Cash provided by operations was $22 million in Q4 of fiscal 2023, which was comparable to the prior year's fourth quarter. We anticipate building inventory during upcoming quarters in preparation for program deliveries under the two large Security division contracts announced in fiscal 2023. CapEx in the fourth quarter of 2023 was $3.1 million, while depreciation and amortization in Q4 was $9.7 million. Our balance sheet is solid with modest net leverage of under 1.5 and significant capacity for investments, acquisitions and stock buybacks. Aside from $7.5 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 initiating our fiscal 2024 revenues and non-GAAP diluted EPS guidance. We currently expect our fiscal 2024 revenues to increase more than 18% over revenues in fiscal 2023 and our fiscal 2024 adjusted EPS to grow more than 25% over adjusted EPS in fiscal 2023. We typically provide a range for such guidance. However, as we continue to work with certain large customers on the timing of deliveries and our supply chain partners on the timing of component deliveries, we believe the guidance provided is more appropriate at this time. We expect first quarter revenue growth to be at a modest level with significant revenue growth for the remainder of the year. The expected adjusted EPS growth factors in increased interest expense given the change in the rate environment over the past year. This guidance also contemplates a higher effective tax rate due to rate increases in the U.K. and a higher tax rate in Mexico than throughout much of the world. This fiscal 2024 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 guidance reflects reasonable estimates. The actual impact on the company's financial results and timing changes on expected revenues, 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 guidance anticipated above 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 will enable OSI to continue providing innovative products and solutions. 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.

Thank you. Our first question comes from Larry Solow with CJS. Please proceed.

Great. Thanks. Good morning or good afternoon. I guess just a couple of clarifications. So it just feels like on the revenue growth side, Alan, maybe you could just help me with this. So the CBP contracts are obviously well in earnest and probably this will be their biggest year or maybe last year and this year is the biggest two, but international contract sounds like it's just starting to ramp, Mexico is more like a Q2 start, but probably be bigger next couple of years. I am just trying to get a little better frame of sort of the revenue growth outlook over the next two years, three years as the kind of put all these large contracts together, maybe if you can help me with that?

Sure, Larry. Good question and you are right. The Mexico contracts, we expect to really start showing the significant revenue beginning in Q2 in earnest and going on from there. And the revenue from these large contracts that we announced in fiscal 2023, our multiyear revenue opportunity. So we are excited about that. The high watermark for our CBP revenues from the IDIQs, the two IDIQs that we got in fiscal 2022, were in fiscal 2023. So we had significant revenues in fiscal 2023. We will continue to have nice revenues in fiscal 2022 and fiscal 2024, but at a level probably about half of where we were in fiscal 2023. So a really nice position to be in and we are quite excited about the outlook for fiscal 2024 and beyond.

And on the CBP contract, now that you have kind of gone through some of that because I know it was a little bit slower first and I believe there's also some remaining IDIQ dollars out there. So what's sort of the outlook for that contract or additional dollars from the CBP or other U.S. organizations or perhaps internationally, without get into specifics, do you feel like you will have other opportunities that go out over the next few years?

A very broad question, Larry. Good question. On the CBP, as we have announced, the total IDIQs, on the two IDIQs in 2022, we announced the total number was more close to $800 million. Out of that, we got about a $200 million contract which we are delivering. As Alan mentioned, a big chunk of that revenue out in 2023, but it will continue in 2024 and 2025. We are well positioned, though, there's no guarantee, we are well positioned for getting more contracts from CBP. We can't say anything about the timing. But invariably, these IDIQs customers give you that, but there's more potential, and if you do good with a customer, they give you more business. We are very well positioned into it and we are very, very close and working very well together with our customer. Regarding the international contracts, we continue to have a very broad funnel. There are all kinds of orders floating around all over the world. We can't talk about timing and one of the things we have always said to you in that regard, the bookings also come not in a very consistent way. It comes in ups and downs, but we are very much excited about it. And the second thing is obvious, as we get more successful in these large contracts, we continue to gain more momentum and we can very confidently say that we are eminently the largest supplier in the cargo side of the business, at the same time, have the broadest product portfolio and happy customers.

Great. If I could just ask one more question about margin, it seems like there are some inefficiencies and component shortages, and you are ramping up very quickly. Do you think that, over time, you will be able to achieve significant margin improvements given the fast revenue growth from contracts? Thanks.

Our goal is to show operating margin expansion as we increase our productivity with these contracts. We expect to achieve this while also benefiting from certain economies of scale. Some contracts will naturally have higher margins than others, but we aim for continued expansion of operating margins.

And this is Deepak here. I just want to add on to it. The other side of it. Definitely when you ramp up very fast, supply chain becomes a challenge and we are continuing to work with that. Good news is that we are very much working together with our vendor base, but that's always going to be a challenge, especially when you ramp up very, very fast.

Excellent. Great. I appreciate all color. Thanks, guys.

Thank you. One moment for our next question, please. And it's from the line of Josh Nichols with B. Riley. Please proceed.

Yeah. Thanks for taking my question and great to see the very healthy double-digit growth forecast for fiscal 2024. I think just to kind of in pointed a little bit or how to think about the model for 2024 but also beyond? You have this record $1.8 billion backlog, any approximation for what guidance implies and how much of that backlog is going to extend beyond this fiscal year, but more 2025, 2026?

Josh, this is Alan. So it's a good question. Based upon what we are seeing out there right now of that $1.8 billion, we would expect about roughly $1 billion of that to be deliverable in fiscal 2024. So quite a bit of it still to be delivered beyond fiscal 2024. So a good position to be in.

No. That's great to hear. And then you had a pretty nice improvement in cash flow for fiscal 2023 despite some of these investments. I know you mentioned you are going to have to make some more inventory investments at least while you are ramping up for the first couple of quarters. Is the expectation that cash flow is going to be up year-over-year as well back to kind of like the normal $100-plus million cadence or a little bit lower given some of the inventory investments you are going to be making this year?

Hey, Josh. It's Alan again. Although we don't provide cash flow guidance. Directionally, our cash flow is expected to be impacted by the growth in inventory and accounts receivable, as you are mentioning, associated with the large international cargo contracts, the timing from those. And as you are also saying, we do currently believe there will be some H1 investment in this regard. But suffice it to say that, we do expect cash flow to be very, very robust for this as we begin these deliveries and start collecting from our customers on some of these large orders.

So is it fair to say probably up significantly in the back half, right, where the front half was just having a little bit more investment for inventory specifically?

I think that's fair to say.

Yeah. And then I just want to hit on, Deepak, you talked about it briefly. How should we think about the company's opportunities to expand service revenue? I know a lot of these large awards are on the products front, but you have had some success with CertScan and other offerings you do and how should we think about the service revenue growth expectations for fiscal 2024 and the opportunities on that front?

Well, again, very good question. As you know, most of these products that we supply, their lifetime is of 10 years, 15 years. So as our installed base gets bigger and bigger, it has more and more service revenue and that has been very well taken care of and we continue to look at it. In addition to that, we have been very much focused on the CertScan software and that continues to be a success all over and also we keep talking about it, the turnkey solutions. So that as you combine all these functions, the bigger the installed base, more successes we have globally, the better long-term we look at recurring revenue in service and the turnkey models.

Yeah. Thanks. I will let someone else take the turn.

Thank you. One moment please for our next question. And it comes from the line of Jeff Martin with ROTH MKM. Please proceed.

Hey. Thank you. Hi, Deepak. Hi, Alan. How are you doing?

Hey, Jeff.

Thank you.

Congratulations on achieving the TSA certification. Could you share how important this development is for the cargo screening business? I understand that you have already been performing well in this sector, but does this certification present a significant opportunity for additional growth?

This is Deepak here. Again a good question. This is quite important to us, because as you can understand it, for the air cargo business, not only do they need X-ray machines, they also need distress detection systems. So now that we have got certification into it, we can offer a broader portfolio of products and service to our customer base in air cargo and that goes very well together. And on top of that, this product is coming at the right time that there is a revamp of what we call a new product, new technology, new instruments that the air cargo people want to buy and with us getting the certification and already a very broad-based with our RTT machines, with our normal BPI checkpoint machines this gives us a bigger portfolio. And not to forget that also as we get to a broader portfolio in that, we continue to focus on a services model and the CertScan model. So this helps very much together our broader product base.

Great. Thanks for the detail. And then one, international cargo and vehicle inspection has been a significant driver of your growth over the past several years. I was just curious outside of the large contract wins, which could be strong visibility into fiscal 2024. How do you look at maybe fiscal 2024 and fiscal 2025 in international cargo and vehicle inspection relative to the past couple of years, is there still significant room for growth there?

The answer is yes. Obviously, we continue to look at it. But, again, our focus is not only just to sell equipment, but to sell a services model, to sell an integrating solution. So that means that as the business model goes up there worldwide, we are depending upon not just sales of equipment like in the past, but an integration model, which gives us much more capacity to grow and each one of them that we do, it has a long-term tail of service recurring revenue.

Great. Can you tell me if the changes you're making to enhance customer value in the subscription or lease model for Healthcare are something you've done before, or is this a new approach for that division?

No, I would say that is a new model. However, it's important to note that we have been using this kind of model in our Security business, which gives us a lot of experience. As we look to expand this into the Healthcare business, we need to educate our customers on its efficiency for patient health and its cost-effectiveness. We believe this model has strong potential for growth, but it will require time and education. We are actively working on this, and we do have a solid foundation of experience to build on.

Very helpful. Thank you.

Thank you. Our next question comes from Christopher Glynn with Oppenheimer. Please proceed.

Thanks. Good morning or good afternoon depending on your location, and congratulations on the success. I wanted to ask about the outlook for Healthcare revenue specifically. The strong performance in the fourth quarter will affect the full year comparison, and it seems there was a bit of a concentration in your discussions about the new patient monitoring platforms ramping up beyond fiscal 2024. I'm interested in understanding how we should consider the ongoing base run rate of that business in the meantime as we plan for 2024.

The Healthcare business typically experiences mid-single-digit growth. It operates on a book and ship model, which isn't reliant on backlog, as was the case in Q4. As mentioned in the previous Q3 call, some contracts were delayed until Q4, and we fulfilled those in that quarter. Therefore, we anticipate continued single-digit growth in this model. There are challenges in the Healthcare industry, with hospitals facing difficulties. However, we believe that with our investments in R&D, the new platform we are introducing, and the new service models like subscription and leasing, there is potential for growth in our Healthcare business.

Okay. Great. Thanks for that. And then I was just curious, when you talk about these nice content and reference wins around Olympics or FIFA, which happens to that equipment after these kind of large events?

It varies from customer to customer. In some instances, it's just rental equipment, which we can sell afterwards. In other cases, customers purchase the equipment and then donate it to various organizations. The approach really depends on the specific country and customer. The key point I wanted to highlight is that it’s a significant accomplishment and a great branding opportunity for us to be recognized as the service provider for globally recognized events like the Olympics and FIFA. This enhances our image and brand reputation. We are particularly proud of this contract, which was won through a competitive international bidding process that selected us as the primary security supplier.

What was the usage or adoption of security equipment like yours about five years ago? You can choose a different reference point if needed. Is it becoming more standard in just the last few years?

I would say it's been like that for a long time. But the answer to your question about how big or something, just think about it at the FIFA game, every hotel, every venue, every airport, everything in Qatar has Rapiscan products. So it's significant, but like I said, revenue is not the important model in this, we look at this as a buildup, what I call the trade name and our reputation. Alan, do you want to add something?

These are really notable successes for us. While they do contribute positively to our revenues and profitability, the real advantage lies in the brand recognition and its overall impact in the marketplace.

Thank you. Appreciate the color.

Thank you, sir. And I am not showing any further questions in the queue.

Well, thank you all once again for attending our conference call. Again, I want to thank our employees, our customers, our investors, our analysts and everybody. It's been a great year finish to it and we are excited about 2024 and beyond and we look forward to speaking with you on our next call following the completion of our fiscal 2024 first quarter. Thank you again.

Thank you all for participating and you may now disconnect.