Earnings Call Transcript - OSIS Q2 2022

Operator, Operator

Good day, and thank you for standing by. Welcome to the OSI Systems, Inc., Second Quarter 2022 Conference Call. At this time, all participants are in a listen-only mode. After the presentation, there will be a question-and-answer session. To ask a question during that session, please follow the Operator Instructions. Please be advised that today's conference is being recorded. If you require any further assistance, please follow the Operator Instructions. I will now like to hand the conference over to OSI Chief Financial Officer, Alan Edrick. Please go ahead.

Alan Edrick, CFO

Good morning and thank you for joining us. I'm Alan Edrick, Executive Vice President and CFO of OSI Systems. And I'm here today with Deepak Chopra, our President and CEO. Welcome to the OSI Systems fiscal 2022, second quarter conference call. We are pleased that you can join us as we review our financial and operational results. Earlier today, we issued a press release announcing our second quarter fiscal year '22 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 in this call are based on currently available information, and the company undertakes no obligation to update any forward-looking statement based on subsequent events or new information, or otherwise. During today's call, we will refer to both GAAP and non-GAAP financial measures when describing the company's results. For information regarding non-GAAP measures, and GAAP measures of the company's results, and a quantitative reconciliation of those figures, please refer to today's earnings release. I will begin with a discussion of our financial performance for the second quarter of fiscal '22, and then turn the call over to Deepak for an overview of our business performance. I will then finish with more detail regarding our financial results and a discussion of our outlook for the 2022 full fiscal year. We are pleased with our results this quarter, despite global marketplace challenges, including heightened impacts from COVID, with the emergence of the Omicron variant, increasing supply chain delays, and logistics costs. As we continue to work through this environment, a top priority at OSI Systems remains to deliver on commitments to our customers and to our partners and position the company for long-term success while preserving the safety of our employees. Now, we will go through a high-level summary of our financial results. Q2 revenues of $277 million were comparable with that of the prior year Q2. Increased sales in the Opto division along with a slight increase in sales in the Security division were mostly offset by a 4% reduction in year-over-year Healthcare division sales as expected. Q2 non-GAAP earnings per share were $1.28, down 5% from Q2 of fiscal '21, due primarily to increased R&D, higher supply chain costs, and a change in product mix. For the first half of fiscal '22, we reported record non-GAAP diluted EPS of $2.44 per share, up 5% year-over-year. Bookings were a bit softer in the second quarter of fiscal '22, following a Q1 book-to-bill of 1.6. The Q2 book-to-bill ratio was 0.9, resulting in the fiscal '22 first-half book-to-bill exceeding 1.2. We ended the quarter with a backlog of over $1.2 billion, a 12% increase since the beginning of the fiscal year. Lastly, in December, we amended our credit facility, increasing the capacity from $535 million to $750 million, extending the term to a fresh five years, and maintaining the very favorable pricing, which as of quarter end was Libor plus 100. This has increased optionality as our convertible notes come due in September 2022. Before diving more deeply into our financial results, I will now turn the call over to Deepak.

Deepak Chopra, CEO

Thank you, Alan, and thanks to everyone joining us on today's call. We had a good second quarter and first half of fiscal 2022 while working to a challenging macro environment that was significantly impacted by the rapid spread of the Omicron variant. This latest COVID surge continues to hamper our supply chain, logistics, and business-related travel. Security has been the most impacted, while Opto Electronics and healthcare were less affected and performed to our expectations. We ended the quarter with a backlog of over $1.2 billion and enter the second half of fiscal 2022 with confidence in our ability to execute in a tough environment. Taking onto each division's performance in the quarter, starting with Security. The Security division delivered Q2 revenues that were slightly higher than Q2 in the prior year, and revenues in the first half that were 5% higher than the first half of fiscal 2021. In Q2, the Omicron variant impacted a pandemic-challenged environment, especially for the aviation security market, as certain airports prolonged their equipment upgrade, replacement, and service cycles. Local travel restrictions in certain regions of the globe also affected timing for installation, test, and acceptance phases by the customer of our aviation board and border security products. Discussing some of the highlights in the unit quarter and the first half, the security team captured several key booking opportunities during the quarter. We announced one of these wins valued at about $29 million from an international customer to provide cargo and vehicle inspection systems, baggage and parcel inspection systems, related training, and maintenance services. At the end of the quarter, previously we announced $200 million in orders that were received near the end of Q1 from U.S. Customs and Border Protection under two indefinite delivery, indefinite quantity contracts called IDIQs, that collectively have a ceiling value totaling approximately $870 million. As CBP further strengthens its border security to intercept contraband and illegal drugs hidden in cargo and vehicles, we believe that there are opportunities for additional orders under these IDIQs to support the customer's non-intrusive cargo and vehicle inspection programs for which we have one of the broadest solution offerings in the industry. As we have mentioned before, shipments on this contract will be more towards Q4 and into 2023. Internationally, we are currently working on several projects to upgrade and maintain existing rapid scan and AS&E cargo and vehicle inspection systems and new installations. Our ZBV mobile backscatter vans, Auto Sixties, high-energy and multi-energy configurations for drive-through portals, and G60 fixed-gantry configurations, among others, are utilized at one or more of these projects to provide customs clearance of goods at ports and border crossings. On some projects, we are also incorporating our proprietary software called CertScan, which is cyber-secure and helps manage inspection image data, travel, vehicle identification, and integrate with other IT systems at cargo and vehicle inspection checkpoints, thereby streamlining and facilitating the inspection process. CertScan was designed to work with third-party inspection systems and can be sold as standalone software. We continue to gain traction with our CertScan software-as-a-service model, with potential customers that have inspection equipment from multiple vendors to utilize the software platform. As mentioned before, in our $200 million contract that we announced earlier, a good portion of the CertScan software is also included. In turnkey services, our projects in Albania, Puerto Rico, and Guatemala continue to perform well, and experience and capabilities derived from operating and managing these turnkey programs have been invaluable, allowing us to differentiate ourselves and win critical border security projects that involve equipment installation, civil works, system integration, and operating training, and in some cases, the CertScan software as well. During the quarter, we continued to work with third-party global logistics providers to support their infrastructure expansion efforts that require various solutions for parcel inspection and explosive detection. We have a broad set of solutions here that match well the requirements of these customers. They are very focused on capturing new opportunities in this growth area primarily driven by increased e-commerce goods flow. As mentioned before, air cargo has become a very good product portfolio for us, and we feel that we are best positioned with our broad product portfolio for that market. In Q2, security did a commendable job delivering to our customers while prudently managing the cost structure, dealing with the ongoing supply disruptions, travel bans, travel quarantines, and test and acceptance delays. Looking ahead, we believe that security, with a solid backlog and opportunity pipeline, is well positioned for a strong second half of our fiscal year. As Alan will talk later, definitely some of the revenue in Security got pushed from Q2 into Q3 and Q4. Moving on to our Optoelectronics division, we had a strong quarter by leveraging our global operational presence to deliver to our various OEM customers. Opto's third-party Q2 revenues of $78 million represented yet another new record for the division. Opto dealt with instances of material shortages, component price increases, and higher freight costs and still achieved record quarterly profit in an increasingly difficult macro environment. The Opto team has done well to anticipate potential supply chain constraints and plan workarounds as needed to maintain deliveries to OEMs in aerospace, defense, healthcare, automotive, and telecommunication industries, among others. During the quarter, we announced an order for approximately $6 million to manufacture sub-assemblies for a wireless critical communication provider. To support growth in Asia, especially for our medical products, we're expanding Opto's India operation as we transition to a larger facility shortly, which will come online in the second half of 2022. Looking ahead, with a record Q2 ending backlog, we anticipate Opto continuing to perform well in the second half of the fiscal year. I want to make an extra comment that our customers, OEM customers in the Opto business, have been extremely cooperative, and have assisted us in the supply chain. In some cases, we've been able to pass on the price increases over to them. Moving onto the healthcare division, we reported revenues of $52 million, a bit lower than the same period from a year ago, which was expected. Last year's Q2 revenues still had tailwinds from hospitals expanding their ICU capacity for the pandemic. During the quarter, we announced a couple of key wins totaling $9 million from U.S. hospitals in the Northwest and South regions. These hospitals ordered a wide array of patient monitoring solutions, including our Xhibit Central Stations, Qube transport patient monitors, and related accessories. During the quarter, we continued to significantly invest in developing new products for the patient monitoring and cardiology product lines to further strengthen our offering for the future. For cardiology, we have also invested in building out a U.S. sales channel that, together with new product launches, helped drive strong cardiology top-line growth in Q2 and the first half. While we have a significant portion of revenues in the U.S. for patient monitoring, we're just getting started establishing our U.S. presence for cardiology. Going forward, we plan to maintain our focus on operational execution and stay agile to handle additional demand that may arise from certain hospitals that need to increase capacity, currently being strained by the latest COVID variant. Overall, we are pleased with the company's fiscal 2022 first half performance considering the conditions that quickly arose due to the Omicron variant. We are hopeful that the overall impact from Omicron will dissipate as quickly as it started. There are already signs of that occurring. However, due to the ongoing challenges now exacerbated by the latest variant, we are revising our top-line guidance to a slightly lower range, while simultaneously feeling confident in increasing our earnings guidance with expected improvements in operating margins and product mix in the second half, alongside more security revenue, which Alan will go into more detail. Since the beginning of the pandemic, the company has proven its ability to maintain its focus on helping customers worldwide with their critical roles in providing public health, safety, and security. I would like to thank our employees, customers, and shareholders for their confidence in us, and I look forward to the second half of our fiscal year. I will now turn the call back over to Alan to further discuss our financial performance before we open the call for questions. Thank you.

Alan Edrick, CFO

Thank you, Deepak. I now will review the financial results for our fiscal second quarter in greater detail. As mentioned earlier, fiscal Q2 revenues were roughly the same as that of the prior-year Q2. Security division revenues were up slightly with increased service sales, but reduced product sales. As Deepak mentioned, the pandemic has impacted the timing of completion of certain projects and acceptance testing, which adversely affected security revenues this quarter. Opto sales, including intercompany sales, increased 5% year-over-year, continuing the momentum seen throughout fiscal 2021. Third-party Opto sales in the second quarter were up 3% year-over-year, while intercompany sales in the quarter were up 13% year-over-year to support the anticipated increase in security sales in the second half of fiscal '22. The growth in Opto and security sales was partially offset by a 4% reduction in year-over-year revenues in the healthcare division. This was anticipated given the elevated demand for the patient monitoring products in the earlier stages of the pandemic, creating difficult comparisons for the division in fiscal '22. While this dynamic related to patient monitoring sales is anticipated to continue during the remainder of the 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. Cardiology related sales increased significantly year-over-year in each of Q1 and Q2. The Q2 gross margin was 36.1% compared to 37% reported in Q2 of fiscal '21. Similar to last quarter, stronger revenue growth in our Opto division, which carries a lower gross margin than our other two divisions, and reduced healthcare division revenues, which carry a higher gross margin than our other two divisions, places downward pressure on the consolidated gross margin. The mix of product and service sales within the security division was also less favorable than the prior year's comparable quarter. Like many companies, we experienced increases in certain component and freight costs in each division, which impacted the gross margin as well. 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 again demonstrate the success of these efforts. Q2 SG&A expenses were $55 million or 19.8% of sales compared to $56 million or 20.3% of sales in the prior year Q2. Research and development expenses in Q2 were $15 million, representing a year-over-year increase of 9%. 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 Q2 of Fiscal '22, we recorded $0.8 million of restructuring and other charges as compared to a benefit of $0.2 million in Q2 of the prior fiscal year. Moving to interest and taxes, net interest and other expense in Q2 of fiscal '22 decreased to $2.2 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 eliminated the non-cash interest expense associated with our convertible debt. We note that adoption of this standard also resulted in increased debt on the balance sheet by eliminating the unamortized discount of approximately $10 million. On the tax side, excluding the impact of discrete tax items, our effective tax rate in Q2 of fiscal '22 was 25.0% compared to 27.5% in Q2 of fiscal '21. We recognized discrete tax benefits of $0.3 million in Q2 of each of fiscal '21 and '22, and as a result, the reported effective tax rate was 26.3% in Q2 of fiscal '22, compared to 28.8% in Q2 of fiscal '21 under GAAP. I'll now turn to a discussion of our non-GAAP adjusted operating margin. Overall, our adjusted operating margin decreased to 12% in Q2 of fiscal '22, from 13% in Q2 of fiscal '21, driven by the previously discussed factors related to gross margin, increased investment in R&D, and the reduction in revenues in our healthcare division, which tend to carry higher margins. We are pleased with the increase in the adjusted operating margin in our Opto division, which expanded to a record 15.4% in Q2 this year, driven primarily by gross margin improvement, as compared to 12.8% in the prior year second quarter. This Q2 record margin in Opto was offset by reductions in the other two divisions. The adjusted operating margin in our healthcare division was 13.8% in Q2 of fiscal '22, compared to 17.4% in Q2 last year. The decrease was driven by higher component and freight costs in this challenging supply chain environment, increased investments, and infrastructure to support future growth, and economies of scale associated with a higher level of sales during the onset of the pandemic. Similarly, our security division's adjusted operating margin decreased to 14.2% in Q2 this year from 15.7% in Q2 of the 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 Q2, cash provided by operations was $14.5 million. Cash flow was again impacted by our decision to increase inventory levels to mitigate certain supply chain challenges, and the timing of payments to vendors and collection from customers, as some parties have been delaying payments in the current business environment. CAPEX in the second fiscal quarter was $3.7 million, while depreciation and amortization in Q2 was $9.5 million. We were again active in our stock buyback program. During Q2, we spent approximately $29 million to repurchase 312,790 shares, leaving approximately 2.1 million shares available to repurchase under the current program. Our balance sheet is solid, with net leverage under 1.5, with significant capacity for acquisitions and additional stock buybacks. We have multiple options to satisfy our obligations under the convertible notes, which mature in September. Finally, turning to guidance. As Deepak described, challenges associated with the pandemic, including the impact on the aviation business and travel, which can impact the timing of product installation and acceptance testing in a more difficult supply chain environment, have led us to revisit the guidance. Additionally, a customer shifted their business to a consignment model. While this last change leads to increased gross margins, it decreases revenues. As a result, we are reducing our fiscal '22 sales guidance to $1.16 to $1.195 billion, from $1.19 to $1.225 billion. However, we anticipate stronger operating margins. As such, despite expectations of reduced revenues, we are increasing the fiscal 2022 non-GAAP EPS guidance to a range of $5.75 to $6.02, from $5.72 to $6. Based upon our projected backlog delivery schedule, we anticipate increasing sequential revenues and non-GAAP EPS in each of Q3 and Q4. We currently believe this revenue and non-GAAP earnings guidance reflect reasonable estimates, and we've taken into account the anticipated impact of the COVID-19 pandemic and supply chain challenges in our guidance. Given uncertainties as to the duration and scope of the COVID-19 pandemic and supply chain disruptions, as well as other variables, however, the extent of the impact on the company's 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 in our SEC filings. In the face of these challenging times, we continue to remain focused on the growth of our businesses and continued management of our cost structure. We believe our efforts in these areas will enable OSI to continue our leadership in providing innovative products and solutions. We delivered solid first half results in an ever-changing environment and continue to navigate effectively through uncertainty while gaining traction in key strategic growth areas and positioning the company to capitalize on improving end markets. Finally, we'd 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. At this time, we'd like to open the call to questions.

Operator, Operator

And thank you. Our first question is from Brian Ruttenbur with Imperial Capital. Your line is open.

Brian Ruttenbur, Analyst

Thank you very much. The first question is for Alan. Can you discuss your expectations for operating cash flows this year, considering the inventory build and other factors? How do you view these elements as being one-time occurrences, and what is your outlook for recovery in fiscal '23?

Alan Edrick, CFO

Hi, Brian, it's Alan. Yes, good question. As you know, we've been a strong generator of operating cash flow in each of the past many years here. In fiscal '22, we've made some strategic decisions that will affect our working capital metrics. We are increasing inventory significantly as you've seen on the balance sheet to mitigate some of that supply chain risk, also to prepare for the strong sales that we're anticipating in the second half and then continuing into fiscal '23. Simultaneous with that, although we're increasing the inventory, we're paying our vendors a little bit faster as well, which is impacting cash flow given some challenges there. Finally, on the receivables side, our DSO is a little bit elevated. So your question is on point and that this year is a bit of an unusual year. We generated $14.5 million of operating cash flow in the second quarter. And while we don't provide guidance on cash flow, we are anticipating that our cash flow will be better in the second half of the fiscal year. And then as we move into fiscal '23 and beyond, it should bounce back to more historical levels and grow from there. We're expecting to be a strong cash flow generator as we enter our new fiscal year here in about five months.

Brian Ruttenbur, Analyst

Okay. Just as a follow-up on that. Historically, the ballpark and operating cash flow basis on the norm has been roughly $80 to $100 million, is that the right ballpark historically?

Alan Edrick, CFO

Yes. We might even comment that that's a little on the low side. If we look at fiscal '19 through '21, our operating cash flow was north of $100 million each year.

Brian Ruttenbur, Analyst

Okay. Great. Good. So the next question is on the competitive front. So maybe you can talk about book-to-bill. It was a little bit soft in the fourth quarter. Is that a seasonality issue or is that just everybody is slowing down and tapping the brakes because of Omicron? And I'm sure that Deepak will address this or you pass it off to Alan, Deepak?

Deepak Chopra, CEO

Brian, good question. It's a very broad question because you mentioned the word competitive in which product lines. So I presume that you are referring to security?

Brian Ruttenbur, Analyst

Yes.

Deepak Chopra, CEO

But going back first to the security thing, as you all know, because the government fiscal year is September ending, that's always a very strong quarter. And we did announce the big thing, over $200 plus million from the CBP, which by the way, we've said it, was the largest order and out of all the various competitors, we got the largest share. And there's a lot more runway still in that. This quarter, our security revenue definitely was down a little bit disappointing, but the reason was mostly with detection, where some of the orders got pushed out in the aviation side. But we still had a very strong booking overall. And our backlog is very strong. We haven't lost anything. And the other thing is that some of these big orders and stuff are acquired face-to-face, travel restrictions, the changes of our ability to visit the customer, to make the customers come and visit us, that all has become challenging, so it got pushed to the right. Good news is that the requirements have not changed. They still are looking very aggressively, and we are very well positioned. One other thing that we're very excited about is that as we launch more than more aggressively, not just in the U.S., but globally, our Certscan agnostic equipment software. That opens up more opportunities. Going on to the other two product lines, we have had very good strong bookings. Even in healthcare, it was expected some of the downturn, but still very strong, especially in the U.S. And we continue to see that for the next six months; both in Opto and healthcare, it will continue to be strong.

Brian Ruttenbur, Analyst

Great. Thank you very much.

Operator, Operator

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

Josh Nichols, Analyst

Thanks for taking my question. And really good to see the continued ongoing profitability here, strong operating margins despite some of those challenges already touched on. I guess the one thing I wanted to ask about is raising the EPS guidance, but taking the revenue guidance down a little bit. Considering that the backlog is still at these record levels, $1.2 plus billion, are these more like push outs and would you expect some of that revenue that you're trimming this year to maybe fall to next year, so that there's maybe not many changes to the out-year estimates given that your backlog really hasn't decreased at all?

Alan Edrick, CFO

Yes, Josh, this is Alan. It's a good question. You're right, our backlog remains quite strong. The timing of a little bit of that deliverables has pushed a little bit to the right, which has changed the revenue guidance, so it moves into fiscal '23, positioning us nicely for next year. We do have good visibility into the second half of fiscal '22 for that revenue guidance, particularly in security and in optoelectronics where we have a very, very strong backlog, so the amount of bookings remaining to fill the gap is of a narrow amount. On the earnings side, we've been experiencing increased operating margins. In that respect, on lower revenues, we still anticipate that our profitability will actually improve and generate us higher operating margins as a company overall, which really positions us well as we move forward to leverage the growth in sales in future years.

Josh Nichols, Analyst

Thanks. And then I think I might have missed it. I know you mentioned maybe part of the reason for the reduction was a shift with one of the Opto customers. What exactly is going on there and could you quantify how much of the revenue estimate update was related to that versus what's going on in the Security division?

Alan Edrick, CFO

Sure, Josh, thanks. This is Alan again. So we had a customer in the Opto who shifted to what's called a consignment model. So rather than us building a product from scratch, securing all the components and selling it with that markup, in this case, some of the more difficult to find items that had been resulting in large purchase price variances. The customer has taken over that responsibility to find the items and then provide it to us at no cost, and then we sell it back, and of course, we can't get a markup on the customer consigned material, so we get the markup on the value-add. In the end, it actually ends up being really good for us. Our operating margins are stronger, our gross margins are stronger. We don't necessarily need to carry the inventory, so the working capital metrics are better. But what we do see is lower revenue as a result. But really not much of a change in the operating profit, so just a better operating margin. Probably $10 to $15 million of the change in the revenue guidance was associated with that shift. And because that shift doesn't really have an impact on the bottom line is another reason why we were able to increase the earnings guidance despite reducing the revenue guidance.

Deepak Chopra, CEO

This change in inventory management has led to improved working capital metrics. However, we are experiencing lower revenue as a consequence. Fortunately, there has not been a significant alteration in operating profit, resulting in a better operating margin. It's estimated that around $10 to $15 million of the adjustment in the revenue guidance is related to this shift. Since this change does not significantly affect the bottom line, it is another factor that allows us to raise the earnings guidance while lowering the revenue guidance.

Josh Nichols, Analyst

Thanks for the clarity.

Deepak Chopra, CEO

This is Deepak here, just to add on to what Alan said. The other thing is we have said it, in the second half, the mix is going to change. We're just going to be stronger in the Security side compared to the Opto which carries a lower margin. We think that with the mix changing also could be a big help. Just to add to what Alan's saying, it's very important: our customers in the Opto area had to be one of those consignment models. They are large companies, and they have a better way of getting product. They can get their raw materials better than we can. They take over that, our risk goes away. They provide that because they desperately need their parts. They can buy it for any price they want. And we just do the value-add. To us, it's a very good model.

Josh Nichols, Analyst

Thanks. And then the last question for me, and then I hope to get a chance to ask something. Clearly, so the notes are coming due, no issues. You have a ton of liquidity, very easy. Assuming you'd probably use your available liquidity to pay that off and just the fact that you upsize the facility also, I'm just kind of curious, expectations as far as potential M&A. Are there a lot of opportunities that you're seeing today? Are you farther down the pipe with one or two potential acquisitions where we might see something like this fiscal year or are you just really expanding that capacity, so you're ready to act if something does come about, but nothing that's really exceptionally close to being completed at this time?

Deepak Chopra, CEO

Well, it's a good observation, but you already know our answer. It's got to be very vague. We look at every opportunity we can, and definitely, this strengthens us. We're well positioned, and we're going to capitalize on it. Whether it's in acquisitions, whether it's in stock buyback, whether it's in inventory or whatever we can, we are well positioned. Alan?

Alan Edrick, CFO

No, I agree. We thought it was an opportune time to amend the credit facility, to extend the tenure, to increase the liquidity. That gives us lots of options for all those items that Deepak just described and more, and we are always looking at M&A to your question.

Josh Nichols, Analyst

Yes, makes all sense, obviously, a lot more than plus 100, right? So that's it from me. Thanks, guys, I appreciate it.

Operator, Operator

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

Larry Solow, Analyst

Thank you, and good afternoon, Deepak and Alan. I have a few follow-up questions regarding Brian's inquiry about the bookings. I understand the near-record backlog the company has. However, when it comes to security, while the recent orders from CBP were encouraging, I hope there will be more. If we exclude that large order, it appears your book-to-bill ratio may actually fall below one in Q1 and also decrease this quarter. Are there any concerns about that? I'm trying to assess the overall situation, and it seems the potential pipeline for additional orders is stronger than ever. However, if we disregard the one significant order, the last couple of quarters show some pressure. Any insights on this would be appreciated.

Alan Edrick, CFO

Larry, this is Alan. I'll take a shot at it. So by nature of our security business, we always have one-off type orders, some larger, some smaller, so it's always difficult for us to ever exclude certain orders. Our overall bookings level has been strong for the first half. But what we have seen is a slowdown in bookings on the aviation side that Deepak was describing earlier in his prepared comments, as we've seen an intensification of COVID, first with Delta and then with Omicron. So the little bit lighter bookings that we've experienced are principally on the aviation side. But to put it all together, we still have a book-to-bill in security in the first six months of about 1.4, which we feel pretty optimistic about.

Deepak Chopra, CEO

To add to what Alan mentioned, the government fiscal year ends in September, which tends to be a slow period. This year, however, we received a significant order along with several others from the Department of Defense and the State Department. A challenge we face is that bookings on the aviation side, along with some international orders, have been delayed. This delay does not indicate a loss of interest; rather, these bookings require customer interaction, travel, and site visits, which have been hindered by travel restrictions. Despite these challenges, the demand remains intact, and we expect these opportunities to reemerge as travel and customer engagement improve.

Larry Solow, Analyst

Okay. Now, that's clear, and again, by no means do I mean to discount the large orders for vehicle screening at Customs and Border Patrol. And on that subject, you mentioned there's over $800 million total IDIQs, and I think less than half of that's obviously been ordered already, so it does sound like you have more coming. What about additional IDIQs from other agencies outside of the CBP? Is that something that you guys talk to other agencies? Do you expect others to pick up this product, maybe within the U.S. and maybe also internationally?

Deepak Chopra, CEO

There is certainly significant interest out there, even in aviation. IDIQs give the government the right to place an order, and the better you perform, the more orders you receive. This applies to various departments such as DOD, State Department, and DOE, among others. While they may not refer to them as IDIQs, similar concepts exist internationally. You can receive a Phase one order and then progress to a Phase two order. Once you obtain a Phase 1, you can expect to get Phase 2 and Phase 3. This progression is quite natural, especially in the security sector.

Larry Solow, Analyst

I have a question about the margins. It seems that the mix and supply chain challenges have significantly impacted your performance in Security. If I analyze the revenues either sequentially or year-over-year, they appear to be relatively stable. This suggests that the margin issue is not primarily related to operating or absorption levels, but rather the mix. However, upon closer inspection, I noticed that service revenues have actually increased. Typically, service revenues yield higher margins compared to product revenues. While this might be a generalization, I would have expected your margins to benefit from improved service performance. Service revenue seems to have risen by 5% year-over-year, so I suspect that the drop in new product revenue is about that same percentage. I'm trying to understand this better because there's a significant drop in margin, with a decrease of 200 basis points year-over-year and 150 basis points sequentially just within security. I'm curious whether you anticipate this level to persist for a few quarters or if you expect a rebound. Thank you.

Alan Edrick, CFO

Sure, Larry. So I think you really have pointed out some of the reasons why the operating margins dropped for security in the second quarter, but as we move forward into Q3 and Q4 on the stronger revenues, the economies of scale associated with that, we are expecting operating margin expansion in security through the balance of the fiscal year.

Deepak Chopra, CEO

I would like to add that there are also supply chain issues affecting security. The supply chain and freight have both had an impact. As these issues improve, we can expect the margin to also improve.

Larry Solow, Analyst

I may be generalizing, but historically, I've thought that service revenues carried a higher margin. Is that not the case?

Alan Edrick, CFO

That is true. Service revenues do carry a higher margin compared to product revenues.

Larry Solow, Analyst

Okay. Switching topics briefly to the Opto side, there's clearly been significant margin improvement year-over-year, and your margins have consistently been in the low double-digits. Do you think the mix contributed to the 300 basis points increase, or is there a portion of that improvement that you believe may be sustainable?

Alan Edrick, CFO

Well, it was certainly a great quarter for Opto and on the operating margin. It's been down the last 10-12 quarters have been quite solid for Opto. I would say it was a very favorable environment on the margin side for Opto in Q2. We would anticipate good strong margins in Q3 and Q4, but not necessarily to the same level as we saw in Q2, but should represent year-over-year improvement in each of Q3 and Q4.

Larry Solow, Analyst

Okay. Lastly, regarding healthcare, could you provide insight into the increase in the sales force? Most of this business, particularly in cardiology, was primarily in Europe or specifically the UK. We're essentially starting to build this business from the ground up. How many sales representatives do you plan to add? How many have you already added, and could you give us an update on your progress or maybe a percentage? Will the sales force be larger than it currently is in the UK?

Alan Edrick, CFO

Larry, this is Alan. It's a good question. Our cardiology business historically had been extremely strong in the UK and in Germany, and then we've sold in other parts of the world as well. In the U.S., which is a good strong market, hadn't been a primary focus. We use a different sales force selling cardiology than we do for patient monitoring, although they do share leads because it's a different type of sale. We began really building out that sales force in earnest over a year ago. New sales leader, who has got a tremendous track record, as well as the team. It's not a sales force that's going to be the size of patient monitoring anywhere in the near term because it's a different target that we're going at. But we do believe that we're basically fully ramped on our U.S. sales force today, and that has led us to see good strong double-digit growth in each of the first quarter, the second quarter, and we anticipate that to continue. With cardiology representing our highest contribution margins, not only in healthcare, but in all of OSI Systems, that can really have a nice flow-through effect on the overall bottom line.

Larry Solow, Analyst

Great. Thanks. I appreciate all the color there.

Operator, Operator

Thank you. Our next question is from Jeff Martin with ROTH Capital Partners. Please go ahead.

Jeff Martin, Analyst

Thanks. Good morning, Deepak and Alan. Nice job getting through a really challenging environment there.

Deepak Chopra, CEO

Thank you.

Jeff Martin, Analyst

I wanted to understand your experience with travel, particularly regarding the acceptance of security installations during the Delta variant. Did travel ever return to normal levels in terms of acceptance? I'm trying to gain insight into how we might see travel resume, especially for OSI concerning the Omicron variant.

Deepak Chopra, CEO

Good question, Jeff. I would say that maybe there's a stuck in the last quarter, we were looking at things getting better and then the Omicron comes in, travel is restricted, and we use travel in a very broad sense. We look at travel two ways. One is, you can see customers, or customers can't come to you. The second thing is you have to do installations. Many of our products need a sign-off by the customer after installation or some of the other support that has to be built, civil works, other things. Because of all this activity restriction, which has become a problem. Just to give you an idea, if we have to go back to, let's say, an Asian country or to a Middle East country to install it, we have to send a person from England; that person has to be quarantined for a couple of days, and then they go back and they want to get the installation done, and then they find out that the customer has COVID, so the customer is not there. Then they come back to the hotel, then they are quarantined again, and then they come back to England, they get quarantined again. By the time you finish, it's a very inefficient system. That has put some cost structures in it, and some of the revenues have been pushed out. That thing isn't going to change. Your guess is as good as mine. Every indication is Omicron is at its peak; it's going to come down, that should open up. There's a lot more positive, encouraging news. Just hope that there is not another variant that comes in. Customer interaction is very, very important, especially in the international sector. It has also happened in the U.S. Some U.S. customers are also having a tough time visiting our sites or us being able to go back and sign off. All that stuff is really under the name of travel. That has been a big issue, and hopefully, as it gets better and Omicron peaks down, we will again end up getting a lot of successes and sign-ups with the customers.

Jeff Martin, Analyst

That's helpful. Thanks, Deepak. Wanted to also focus on Certscan a bit more. Could you help us understand what the typical contract looks like in terms of maybe an average revenue size and duration, how many years? And then also, what kind of feedback you're seeing in the sales channel from potential customers on Certscan? It'd be helpful to have that perspective.

Deepak Chopra, CEO

Good question. We ask all these questions to our team all the time. Basically, firstly, it's an agnostic software, think of it, which can interface and connect from one equipment to another, from one central station to another equipment, to another site, to another central station, and to be able to be accessible by all centralizing in order to make it more efficient data flow. And it's agnostic; it doesn't matter whether it's our rapid scan system or our competitors’ system or whatever. The customer is very interested and excited about it. The way the revenue comes in, is one is the first sale. To even the person who's, again, a competitor, if their system is going and getting integrated into it, they got to get the software from Certscan to use that. Customer interacts with it, and then we do training. As the customer long-term uses it, what we call more seats, we get a licensing fee. All that stuff adds up to become typical, I call it, like a Microsoft model or whatever; as we go forward, it will start having recurring revenue and tends to be higher margin revenue. That's the model, and it's not just in the U.S. We are integrating and doing some of the stuff internationally. The most important challenge that we think, and I think it's logical, just think about it, how efficient the world will become if various trading countries can interact with each other and pass the data back and forth under the secure software platform, then that will make the efficiency of cargo movement much better.

Jeff Martin, Analyst

Right. And how long do you target for the average contract? Are we talking five to seven-year contracts, are they one-year contracts with a couple of built-in extensions? How are those initially targeted?

Deepak Chopra, CEO

It's too early to tell, but think about it this way: For the software business, once the customer is onto it, all the add-on options, accessories, and once the platform is established, you'll get multiyear contracts, renewable.

Jeff Martin, Analyst

Right. Okay. And then thinking a bit more longer-term here, I know there's an upcoming replacement cycle in the U.S., particularly with passenger screening. What other things are on the longer-term horizon that you're excited about, particularly within the security segment?

Deepak Chopra, CEO

Well, you said it. One is obviously the replacement cycle to the aging equipment in passenger screening. There's been updates and there is the new certification model; everybody is going to get to baseline level. Everybody has to get certified. That's a big opportunity. In my mind, the cargo side or integration of all the checkpoints in borders and ports and stuff is the biggest opportunity, and we will continue to expand and grow because as you know, at one time many years after 9/11, Congress took a 100% inspection. And some people said, well, it's 5%, and up to 5-7 years, it got stopped. Somewhere in between, it's going to continue to grow. As it grows, it requires more product, more integration, and that's what I think is the greatest opportunity. The third one, which we have said on our conference calls and we're having a lot of success, and we think about it, is e-commerce and air cargo. That has been a dormant area for us, which also requires a lot of security. They need even more integration and stuff, and that becomes a big play. We are very well placed. We have said before that that's been one of the biggest growth opportunities for us in the air cargo space.

Jeff Martin, Analyst

Great. Thanks, Deepak. Appreciate the color, very helpful.

Operator, Operator

Thank you. We have a question from Sheila Kahyaoglu with Jefferies, your line is open.

Sheila Kahyaoglu, Analyst

Hi, good afternoon. Deepak, Alan. Thanks for the time. So I want to go back to Opto. Performance is really good in the business. And you seem to indicate that this is a sustainable level, maybe for Opto, but as well as the rest of the business. How do we think about inflation, raw material costs, and pricing overall? Is this the business that has the most leverage to pricing? I previously thought it had the lift.

Alan Edrick, CFO

Hi, Sheila. This is Alan. In the Opto business, what we tend to see more so than Opto businesses, when there is inflation or input cost increases, this is the area where we're dealing with OEMs, and that's where there's the biggest opportunity to pass it on to the customer. We typically have seen that, which is one of the reasons why we haven't had a degradation of our operating margins. In fact, we've had an improvement in both our gross and our operating margins as customers clearly understand what's going on in the supply chain, and nobody wants to pay more money. They understand when we show them that our costs have gone up, that we need to pass that cost on to them.

Sheila Kahyaoglu, Analyst

Okay. Got it. And then on securities, could you go back to the business? How do you think about the growth trends given the bookings, about the deceleration we saw in the quarter? If you could touch upon the different end markets and what sort of growth you saw in Q2; I think you mentioned cargo was a particular standout. If you could elaborate on the different end markets you serve.

Deepak Chopra, CEO

Sheila, this is Deepak here. I want to make sure that we emphasize to explain. No business has gone away. It's pushed to the right. We've had some business that at the last month, last week, last day could not get onto a ship or to get freight there. In some cases, the customer was not there. The site was not ready. It got pushed to the right. So we believe that is not a deceleration. It's just pushing to the right, and it will be there; the backlog is still there; the pipeline is very strong, and that will continue. Now, Alan mentioned and I mentioned that the aviation side really took a big sudden dive. Everybody was expecting after Q1, up to the Delta variant that passenger travel was going to increase. Then Omicron comes in, pushing everything to the right. Ultimately, air travel will increase and go back to normal, and people need to invest in airports, upgrades, and stuff that it will happen. Same thing with air cargo; it could continue to grow as there is more demand. As long as there is demand, as long as there is travel, as long as there is security needed, this business will continue to grow; it just got pushed to the right.

Christopher Glynn, Analyst

Thank you. Good afternoon and good morning. I think most of my questions have been asked, but I did want to ask about security, backlog pricing versus cost to execute. Cost to execute is certainly in flux. Backlog pricing comes in when you get bookings. How does this impact the volatility in future margins? Or are there provisions?

Deepak Chopra, CEO

Well, and maybe you want to make it, Alan.

Alan Edrick, CFO

Sure. Chris, this is Alan. Good question. Generally, when you take an order, you're right, you lock in price. It's pretty difficult after that period of time to get customers to increase that price in the security business. While we have had some increases in our supply chain that we sometimes had to absorb on orders that we had taken many months or many quarters ago, and we certainly factor that into all of the new bookings that we have in place. That being said, and we put it all together, our outlook looks good for what we have in the backlog, which is why we believe we'll see increased operating margins in the second half of the year for the security business.

Christopher Glynn, Analyst

Is that comment sequential or year-over-year comment or growth as far as the back half of security margin?

Alan Edrick, CFO

It's definitely on the sequential side. It would probably be year-over-year as well, but I was thinking sequentially.

Operator, Operator

All right. We're not showing any further questions in the queue at this time.

Deepak Chopra, CEO

Well, thank you very much. I want to thank all the employees, and also our patients, for our customers, and the support of the stockholders. It's been a challenging time. We're not going to say that it was easy. At the same time, we are also saying we are confident about the second half. Our backlog is strong, but there's uncertainty there. We're well positioned. Supply chain is a challenge; freight is a challenge, but we are well positioned. One of the things that I want to again emphasize, we distinguish ourselves from our competitors. We had a vertically integrated country with manufacturing operations in Asia, Europe, Latin America, and the U.S. So we have a lot of flexibility to cater to our customers' needs and to be flexible. That has been a big strength for us. I want to thank everybody and talk to you after the third quarter. Thank you again for your support. Goodbye.

Operator, Operator

And with that, ladies and gentlemen, we thank you for participating in today's conference. You may now disconnect. Have a wonderful day.