Osi Systems Inc Q1 FY2026 Earnings Call

Good day, and thank you for being here. Welcome to the OSI Systems, Inc. First Quarter 2026 Conference Call. Please note that today's conference is being recorded. I will now turn the call over to your speaker today, Alan Edrick, Chief Financial Officer. Please proceed.

Thank you. Good afternoon, and thank you for joining us. I'm Alan Edrick, Executive Vice President and CFO of OSI Systems. And I'm here today with Ajay Mehra, OSI's President and CEO. Welcome to the OSI Systems Fiscal 2026 First 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 fiscal '26 first quarter financial results. Before we discuss these 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 will be discussing the company's results using both GAAP and non-GAAP financial measures. For more details on these non-GAAP measures, their comparable GAAP measures and a quantitative reconciliation of the two, please refer to today's earnings release. I will begin with a high-level summary of our financial performance for the first quarter of fiscal '26 and then turn the call over to Ajay for a discussion of our business and operational performance. We will then finish with more detail regarding our financial results and a discussion of our increased guidance for fiscal year '26. We delivered strong first quarter financial results, setting multiple Q1 records across key metrics, and we are excited by the momentum across our businesses. Now for the high-level summary of our Q1 results. First, revenues increased 12% year-over-year to a Q1 record of $385 million. Each of our 3 divisions achieved double-digit top line growth, highlighted by a 13% increase in revenues in the Security division. This top line performance is especially noteworthy given that the prior year Q1 included substantial revenue from major security programs in Mexico. Excluding contributions from those Mexico contracts and revenues generated by businesses acquired in fiscal '25, our underlying consolidated revenues grew roughly 26% in Q1, highlighting robust organic demand across our core businesses. Second, the solid revenue growth led to record Q1 non-GAAP adjusted EPS of $1.42. And third, Q1 bookings were strong. And with a book-to-bill ratio of approximately 1.1 in the quarter, we finished with a record Q1 backlog approaching $1.9 billion. This backlog, coupled with a robust pipeline of opportunities, provides good visibility as we continue into Q2. Before diving more deeply into our financial results and discussing our outlook for fiscal '26, I will turn the call over to Ajay.

Thank you, Alan. Good afternoon, everyone. I want to start by recognizing the outstanding performance of our global OSI team in delivering a record-breaking first quarter. Our results this quarter reflect the strength of our diversified business model and our relentless focus on innovation, operational excellence and customer satisfaction. As Alan mentioned, we achieved 12% revenue growth with solid earnings. Furthermore, our service revenues grew 23% during the quarter as many of our product installations over the last few years are now generating recurring revenue from ongoing service and support. We closed the quarter with a record Q1 backlog and feel confident about the future outlook. Let's jump into the performance and key highlights across our 3 divisions for the first quarter, starting with our Security division. Q1 revenues in this division were $254 million, a solid 13% year-over-year growth. Bookings were strong, resulting in a record Q1 security backlog, setting a strong foundation for continued growth. During the quarter, we continued to successfully perform on our port and border security contracts with Mexico. However, as Alan will elaborate shortly, the impact of these contracts on our overall business has moderated. It has been more than offset by robust growth across other areas of our diverse security portfolio. This dynamic was evident in Q1, where revenues from our aviation, cargo and RF detection offerings, including service, drove double-digit overall growth. Our customers have witnessed our proven expertise in system integration, maintenance, operator training and long-term support, all of which optimize the performance of our inspection equipment during its lifecycle. We've also effectively built our turnkey offerings to strengthen our position in global equipment tenders for ports, borders and airport security. As I noted earlier, our bookings remained robust with a book-to-bill ratio of 1.1 in the Security division, supported by several significant wins, some of which we announced recently. We announced approximately $75 million in nonintrusive inspection product and integration orders and more than $60 million in RF product orders that we received during Q1. These orders reflect our growing momentum in critical areas such as cargo and vehicle inspection and advanced RF detection technologies. More importantly, they reinforce the stability and depth of our relationships with our customers. Driven by factors like geopolitical conflicts, terrorism and crime, governments worldwide are investing heavily in advanced systems to enhance detection, deterrence and response capabilities. These escalating global threats are being addressed by increasing focus on technology innovation and in turn, shifting policy priorities supported by targeted funding. During the quarter, we also announced an award of a 5-year contract from CBP for its NII Common Integration Platform program, also referred to as SIP. The SIP program is designed to enhance national border security by enabling sufficient screening and strengthening collaboration among CBP, the Department of Homeland Security and other stakeholders. We are providing our CertScan platform to support CVP's strategic goals by modernizing its inspection capabilities. Therefore, as part of the SIP program, we will support various integration efforts, not only on our platforms, but also with inspection technologies and solutions from other providers. This SaaS-based offering is expected to increase annual recurring revenues over time. We're also gaining significant traction in our RF product line and anticipate further momentum from opportunities tied to Golden Dome-related expenditures highlighted in the one big beautiful bill. Once the government resumes full operations, we anticipate heightened demand for a number of our core offerings. The successes in Q1 instill great confidence in our robust growth prospects as we advance through the remainder of fiscal 2026 and beyond. Turning now to our Optoelectronics and Manufacturing division. Opto delivered record Q1 revenues, including intercompany sales, while achieving strong profitability. We experienced notable strength and expansion across our product lines in North America, where many of our customers are leading OEMs in their industries. Our operations in Mexico continue to play an important role amid ongoing global tariff uncertainties. We fielded numerous inquiries from both existing and prospective OEMs seeking to realign their supply chains toward the U.S. and nearshore options. Our robust global manufacturing footprint spanning North America, Europe and Southeast Asia positions us as a compelling alternative for capitalizing on this potential supply chain shift. Finally, turning to our Healthcare division. Q1 sales rose a solid 10% year-over-year. As we've discussed on prior calls, we're executing on the improvement plans we put in place under a new leadership team and beginning to see tangible benefits in both sales and operations. That said, while this Q1 performance reinforces that we are on a good path, we still have considerable way to go before meeting our high-performance standards. Looking ahead, we'll continue to drive product innovation in health care with continued R&D investments while advancing operational efficiencies to enhance profitability. In summary, OSI Systems has tremendous momentum. We are a thriving business with a diverse and substantial backlog and a robust balance sheet that supports both organic growth and strategic investments. We remain disciplined in managing our cost structure. We expect to generate strong cash flow this year, which combined with our ample credit capacity affords us significant flexibility in capital allocation. I want to thank our employees, customers and shareholders for their continued support. With a strong foundation and expanding opportunities, we are well positioned to deliver long-term value. With that, I will turn the call over to Alan to discuss our financial performance and updated guidance in more detail before opening the call for questions. Thank you.

Thank you, Ajay. I will now provide a detailed review of our financial results for the first quarter and discuss our updated guidance for fiscal year 2026. In the first quarter, our revenues increased by 12% compared to the same period last year, with solid performance across all three segments. The security division generated revenues of $254 million in Q1, reflecting a 13% year-over-year increase. This growth was supported by higher service revenues, strong sales of aviation and checkpoint products, and increased revenues from the RF business we acquired in Q1 of fiscal 2025. As anticipated and consistent with last quarter's trend, revenues from our large Mexico security contracts fell to $25 million in Q1 of fiscal 2026, down from $70 million in the same quarter of the previous fiscal year. Excluding growth from acquisitions and the Mexico contracts, security revenues soared by 39% year-over-year, clearly demonstrating strong demand across our overall security offerings. Meanwhile, the Optoelectronics and Manufacturing division had another outstanding quarter, with optoelectronic sales, including intercompany, growing by 12% year-over-year to $110 million, marking a new record for Q1 within this division, driven by growth across our diverse product and customer portfolio. After a challenging Q4, healthcare division sales rebounded, primarily due to international revenue activities, achieving 10% year-over-year growth. Our gross margin for Q1 was 32%, down from the same quarter last year, as a less favorable revenue mix on product sales outweighed an increase in gross margin from higher service revenues. Our margins can fluctuate due to a variety of factors, including product and service mix, volume, supply chain costs, foreign exchange rates, and tariffs. Regarding operating expenses, in the first quarter of fiscal 2026, selling, general, and administrative expenses were $67 million, or 17.4% of sales, compared to $72.2 million, or 21% of sales, in Q1 of the previous year. This reduction was supported by more favorable foreign exchange rates this year compared to last. We continue to diligently manage our SG&A cost structure across all divisions as we grow. Research and development expenses in Q1 reached just over $20 million, or 5.3% of revenues, up from $17.8 million, or 5.2% of revenues, in the same quarter last year. This increase reflects our commitment to investing in innovation, leading to market-leading products, especially in security, positioning OSI well for the future. We plan to maintain this heightened focus on R&D to advance key initiatives throughout the remainder of fiscal 2026. Despite these investments, our combined SG&A and R&D expenses as a percentage of sales have decreased annually for the past eight years, a trend we expect to continue through fiscal 2026, highlighting our ability to drive operating efficiencies while funding growth initiatives. Moving below the operating line, net interest and other expenses in Q1 were $7.4 million, consistent with the same quarter last year. Our effective tax rate under GAAP was 19.9% in Q1 of fiscal 2026, compared to 21.9% in Q1 of the previous year. Excluding discrete tax items, our normalized effective tax rate used for calculating non-GAAP EPS was approximately 23.3% this quarter, down from 24.0% in the prior year. On a non-GAAP basis, our adjusted operating margin for Q1 fiscal 2026 was 10.3%, consistent with the same quarter last year. The adjusted operating margin for the security division was 13.5% in Q1, compared to 14.4% a year ago. While we saw strong growth in high-margin security service revenues, this was offset by a less favorable mix of product sales and increased R&D expenses. The adjusted operating margin for Opto was 11.9%, similar to last year's Q1 margin of 12.0%. However, we anticipate efficiencies in our new manufacturing facility to contribute to expanding margins in the second half of the fiscal year. Finally, the adjusted operating margin for our healthcare division improved by 260 basis points, partly due to revenue growth. Regarding cash flow and our balance sheet, our operating cash flow improved year-over-year in Q1, although there's potential for it to have been significantly larger. We received partial payments from a major security division customer in Mexico during the quarter, which is encouraging progress. We expect substantial cash inflows in fiscal 2026 as we continue to collect outstanding receivables, leading to strong operating cash flow this fiscal year and robust free cash flow conversion. Capital expenditures in the first quarter of 2026 were $7 million, while depreciation and amortization expenses were $10.3 million. Our balance sheet remains strong. At the end of the quarter, our net leverage was approximately 1.9 times, as calculated under our credit agreement. We amended our credit facility during Q1 to extend the maturity date to July 2030 and increase the borrowing capacity to $825 million, enhancing our liquidity and financial flexibility. Now, regarding our updated guidance, we are raising our fiscal 2026 guidance for both revenues and adjusted earnings per share. We now expect year-over-year revenues to be between $1.825 billion and $1.867 billion, representing a growth rate of 6.5% to 9.0%, an increase from the previous range of 5.4% to 8%. This updated guidance takes into account a projected 60% headwind from reduced revenues in our Mexico contracts for fiscal 2026 in the security division. We are also increasing our non-GAAP adjusted earnings per diluted share guidance from a range of $10.11 to $10.39 to a range of $10.20 to $10.48, reflecting a 9% to 12% year-over-year growth. It is important to note that this fiscal 2026 non-GAAP diluted EPS guidance excludes the impact of potential impairment, restructuring, other charges, amortization of acquired intangible assets and their related tax effects, and any discrete tax and other non-recurring items. We believe this guidance reflects reasonable estimates. However, actual impacts on the company's financial results can vary significantly due to timing changes in backlog conversion to revenues, new bookings, timing of cash collections, tariffs, the government shutdown, and other factors. In summary, we are dedicated to achieving operational excellence as we continue to grow our businesses and provide innovative products and solutions to our customers. We are pleased with the strong start to fiscal 2026 and look forward to building momentum throughout the year. We expect to generate robust cash flow and maintain the financial strength necessary to invest in key strategic areas that will drive long-term value for our shareholders. Once again, we thank the entire global OSI team for their commitment to supporting our customers and partners. Their dedication is what makes these results possible. We would now like to open the call for questions.

Our first question comes from Josh Nichols with B. Riley.

Good to see the guidance bump. I know fiscal 1Q is usually a little bit slower for the security business, but bucking the trend with a healthy book-to-bill ratio. I was wondering, could you provide just a little bit more granularity on what products and markets or geographies are really driving that strength, particularly since 1Q is usually a little bit slower, particularly in Europe?

Sure, Josh. Great question. Thank you. Yes, we were really pleased with the performance in our Security business, both on the revenue side and the bookings side and operational as well. We saw both on the revenues and the bookings side throughout the regions when we were looking at the EMEA region, looking at the Americas and even Asia Pacific, strength, whether it be in revenues or bookings across the board. Service revenues, of course, were exceptionally strong for us. It's nice. We're receiving this new era of much higher recurring revenues at higher margin on the service side. We had the contribution for a full quarter worth of the RF products versus a partial quarter in the prior fiscal year. And we saw our aviation products doing quite well as well. So all that contributed to really a great quarter for the Security division.

And then just one follow-up question. I mean you mentioned that you now had several quarters, right, the services revenue growth north of 20% here again. When you look at the guidance, the top line guidance for this year, you're guiding to around 8% growth. But I would assume that the services revenue growth would be significantly higher than that. Any kind of additional detail you could provide around that to help us kind of model the growth rate that you may be expecting for that piece of the business this year?

Yes, Josh, when it comes to our guidance, you're correct, though we don't provide guidance on service versus product specifically, directionally, you're absolutely right. We're expecting faster growth than our recurring service revenue in this particular year. Product revenues will be quite strong as well. But remember, we're coming off of a very difficult comp with heavy Mexico product revenues in fiscal '25. So we expect to see very solid revenue growth, both on product and service, but at a more accelerated rate on the service side in this fiscal year.

Just last follow-up for me, and I'll pass it to since you mentioned it. Tough comp for Mexico, but the business is still growing very healthy. And just thinking about longer term and next year, the comps are going to get easier against Mexico. I think you might have mentioned it before, but revenue contribution for this year for Mexico, should that be around $100 million type level? Or what are you targeting for this year?

That's a good estimate, probably just slightly below that.

Our next question comes from Jeff Martin with ROTH Capital Partners.

Great to see the results. Congratulations. I wondered if you could follow up with additional detail on your comment about governments worldwide are investing heavily. Has that been in your sights for quite some time now? I know you've talked about a robust and expanding pipeline for quite a while. But is this a newer phenomenon? Because I don't think you've really phrased it that way in the past.

I think this is Ajay. We've observed growth in the past, but there's definitely a marked acceleration happening now. With the significant bill we've discussed and opportunities in the Golden Dome, our service business has not only accelerated, but we are also offering integration services with our CertScan, which we recently announced with CVP. We're operating in nearly 20 different countries and see strong capabilities there. The government recognizes not just our ability to integrate NII platforms but also various technologies to transform data into actionable information. Given the ongoing trade issues, they can integrate U.S. CVP with their data, enhancing efficiency and making tariff declarations less burdensome. Furthermore, the geopolitical situation with Ukraine, Gaza, and others continues to create opportunities for us. So yes, we believe there’s an uptick, and we are optimistic about the opportunities, both in the U.S. and internationally.

Great. And then nice to see the uptick in the guidance even in light of the federal government shutdown here. I was wondering if you could touch on what you're seeing to date in terms of affected activities from the government shutdown.

So from our standpoint, we've had very limited impact. I mean we are in industries such as with CBP, others where it's considered essential. We have to provide our systems, service, keep the borders, the airports open. So I think one of the things maybe things get delayed a little bit in terms of some of the orders coming in. But really, it's not going to affect us in '26. So from our standpoint, so far, so good. It's really not a big deal.

Okay. And then I have two clarifications, if I could. The reference to the 26% growth, excluding acquisitions in Mexico, that was to total company revenue. And then on the security side, it was 39%. Did I hear those correctly?

Jeff, this is Alan. Yes, you've interpreted it exactly right.

Okay. And then you said there's a headwind of 60% from Mexico. I assume you mean $60 million year-over-year.

Effectively, a 60% reduction in revenues of Mexico revenues in fiscal '25 versus fiscal '26.

I think just to comment on that, I would look at that as a positive because we've been more than able to cover those headwinds with the tailwinds we've got in the rest of the product lines.

Our next question comes from Mariana Perez Mora with Bank of America.

So my first question is on Mexico. You mentioned some partial payments and improvement there and also a significant reduction on the revenue side. How should we think about the level of unbilled receivables so far? And how are those unbilled receivables progressing? What are the key milestones we should be looking at when we think about the timing of those payments along the next 9 months of the fiscal year?

Mariana, good question. Really some good progress on the unbilled receivables. We've seen the unbilled receivables in Mexico at September 30 come down nicely from June 30, and we expect to see that continued progress throughout the fiscal year. And the nice part is, of course, as it moves from unbilled into billed, we can then start collecting the cash. So as we look at fiscal '26, we expect some very significant cash flow from Mexico specifically, but from overall business more generally as well, which will lead to very strong free cash flow conversion.

And then when you think about free cash flow and the position you'll have, you have a lot of, I don't know, a deeper pocket to pursue different capital deployment activities. How is the M&A pipeline? What are you looking at when you look at that, especially after the radio frequency product line has been performing so strongly? How is that pipeline? And what type of capabilities are you looking at?

So this is Ajay. We're always focused on expanding our capabilities, not only in recurring revenue services but also in technology and complementary technologies that can help us reach deeper into government and other customer segments with the products we offer. I've always referred to this as a solution. We're entering a larger arena as we move forward. I've mentioned before that any acquisition we pursue will be thoroughly evaluated. We want to ensure that any combination yields significant benefits. We plan to balance cash collection with paying down debt and considering stock buybacks. We're exploring all three options, and the good news is we are in an excellent position to assess our next steps and identify the right acquisition opportunities as they arise.

And last one from me on the government shutdown. Are you waiting for any meaningful awards that have been delayed by the extended government shutdown? And how do you think about the risk as you think about the rest of the year from that?

So I think that we're working with the agencies during the government shutdown. Like I mentioned in my remarks, we're not as concerned about '26. Really some of the orders we're looking at are for beyond '26. You might have a little bit of delay here or there, but it's more on getting some orders in. It's really nothing significant that should affect our fiscal year.

Our next question comes from Seth Seifman with JPMorgan.

I wanted to ask about the profitability, especially in Security since some of the mix items you talked about offset the increase in the services mix. And so margin was down year-on-year. At what point do you see margin being able to expand again in the security business and kind of reset itself as the Mexico revenue kind of gets to a level where it's stable?

Yes, Seth, this is Alan. Good question. And really the final quarter of the difficult Mexico comps when it comes to a margin perspective, particularly is this upcoming quarter, the December quarter, which is, of course, built into our guidance and much more akin to what we've been seeing in the last couple of quarters. So as we get past the end of this calendar year and move into January, the comps get much more normalized from a Mexico perspective. And we believe that there's ample opportunity to start showing margin expansion again. There'll be quarters where it's very robust and quarters where there might be a different mix going the opposite direction as well. But really, as we move into the next calendar year and beyond, we should be in good shape to start focus on margin expansion again.

Okay. Excellent. And one follow-up regarding the funding in the reconciliation bill. We've observed that money on the defense side has been slow to be allocated. This delay might be partly due to the shutdown, but the process involved in accessing these funds may also be a factor for the customers. I'm curious about your experiences so far in discussions surrounding those contracts.

So this is Ajay. I think I mentioned this last time as well. We're expecting that funding to come in probably towards the second half of our fiscal year, and we are still anticipating that. It could have possibly arrived in December, but from our perspective, that's when we are expecting and planning for it. Regarding the funding itself, it’s significant, and there are priorities to consider. I believe one of the most critical priorities is border funding, which we think will not be delayed. We are confident that it will come in as we expect. Anything can happen, but we currently feel very positive about it. So that’s the best way to approach it.

Our next question comes from Larry Solow with CJS Securities.

Just a couple of follow-ups. Most of my questions have been answered. Can you just give us, Al, the specific number that the RF sensor business contributed in the quarter? I think it was $17 million last Q1 last year on a partial. So if you can give us that number. And then just more from a higher level, just thoughts on the Golden Dome, just time lines from a higher level, not specific, but when we might see that? Is that like quarters? Or is that years away? And how big of an opportunity could it potentially be for this business?

Larry, I'll take the first part of the question, and I think Ajay, the second part. In terms of the RF, we bought that business in September of 2024. So we had 3 or 4 weeks of operations last year. So last year, we did about $4 million in revenues from that business. And this past quarter, we did about $19 million of revenues. It is, generally speaking, a little bit of a seasonally slower quarter, and we expect that to pick up over the balance of the year.

Yes. So the question on the Golden dome, obviously, with our RF technologies, especially in this case, over the horizon radar, we feel that we're well positioned. Everybody is talking about the program being in the billions and billions or tens of billions of dollars. We think we have a pie in there. What it's going to be and how it's going to come across because it's not just the prevention, but it's obviously looking at missiles and missiles and other things. So I think we'll know in the next 2, 3 quarters, like I said before, but we feel good about where we are in the process.

Okay. Great. I have a question about the gross margin in Security. Alan, you mentioned that the product mix varies quite a bit. However, this quarter, the gross margin on products was significantly lower than what I have observed over the past several years. Was there anything unusual beyond just the mix, or was it simply a lower margin mix this quarter?

It really did come down to just being a lower margin mix this quarter on the product side, not necessarily reflective of what we would anticipate going forward. It just happened to be the mix of product sales in this particular quarter. Nice part was we made it up on volume to still have very, very nice profitability, but we would expect that that product margin to be better in the future.

And then just lastly on the cash flow, the free cash flow, I know you get this question a lot, but it sounds like you remain confident in a good year. And I guess my question would be Mexico has kind of been the biggest impact. And now that your revenues from Mexico are very modest. As we look out over the next few quarters, assuming even if they're a little bit late, I got to imagine by the end of this year, a lot of that, hopefully, Mexico delayed payment and AR specifically should come down a lot, almost normalized. So I mean, is it possible that we have a free cash flow drop-through conversion rate close to net income this year?

Good question. Yes, we would expect the Mexico cash flows to be very strong over the next few quarters and will position us extremely well. In terms of looking at free cash flow to net income, I think you're right. You might even be conservative. I believe we can exceed 100% of net income and possibly by a significant amount. So it could be a very, very nice free cash flow year for us.

And I'm not showing any further questions at this time. I'd like to turn the call back to Ajay for any further comments.

Okay. Well, I want to thank those in attendance for joining our call. We're excited about the opportunities ahead and look forward to speaking with all of you at our next call. Thank you very much.

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.