OSI Systems, Inc. (OSIS) Earnings Call Transcript & Summary

Yes. Okay. We're a little delayed, but I'll just reiterate that we're here with OSI Systems and kicking off the aerospace defense track at the JPMorgan Industrials Conference. Alan Edrick, CFO of OSI Systems, is joining us. So thanks for being here, Alan.

And maybe we'll start off just maybe talking a little bit about the business and maybe familiarizing people a little bit with what you guys do. I think the thing that the people are probably most familiar with is at the airport and the Rapiscan systems that people will see to scan as they go through the checkpoint at the airport. But maybe tell us a little bit about your Security business and the different things that you do there.

Sure, sure. So our Security business is the largest of our businesses. It represents about 2/3 of our revenue. And as you correctly described, most people know us for our aviation business, what we do at the airports. Interestingly, people think that's the majority of our business. But the aviation and checkpoint type business is about 1/3 of our overall Security revenues. The biggest part of our business is actually ports and borders and critical infrastructure where we do scanning. And that represents the other 2/3 of our revenues. We have become the largest security detection company in the world. We surpassed the former #1, a little bit earlier last year. A nice part of our business is recurring in nature. So we sell products, and we have some great service revenues associated with it. But a very strong brand. We're quite a global company. More than half of our revenues in Security are outside the United States but the U.S. is quite an important geography for us as well. But we really get invited to all the major tenders out there, which are significant. And the world is not getting a whole lot safer as we see every day in the news, but it plays well into what we do.

Right. When you think about that port and border side -- and by the way, just for perspective, so the Security business overall is a little over $1 billion. So 2/3 of that $1 billion-ish is ports and borders. When you think about the level of -- and maybe let's start off with the checkpoint. I think about the checkpoint business as being fairly -- it's replacement that the world's major airports, for the most part, have security systems installed, and that's a business that is replacement. When you think about ports and borders, how much of that market is penetrated versus how much is still kind of open?

We like to think in the ports and borders that we're really still in the very early innings. So unlike aviation, where you correctly described that it's mostly a replacement market, though there are some new airports and new terminals being built. On ports and borders, we're really in kind of virgin territory where most of the times when we're installing security scanning solutions, it's not replacing existing equipment out there, it's where there was no security being done or it was not a high-tech security. It might be security such as dogs and the likes. So we think we're in the early innings of that game. It's the fastest-growing part of the business in the fastest-growing market. So it's the segment that we absolutely want to be in.

Right. All right. And you would say your -- how would you assess your market share in that part of the business?

We believe we're the #1 market share, that we have more than half the market. So we really believe we have kind of a dominant position in that area. And great for us on the product side and then that nice installed base that we have that continues to increase is really increasing our service revenues as well.

Okay. And when we think about the area that's open to further penetration, would you say is the domestic market pretty well penetrated and more of the open territories internationally? Or is it on both domestically and internationally?

Yes. The nice thing, it's really global. It's both domestically and internationally. Here in the U.S., of course, we're focused at the U.S.-Mexico border, where we have significant systems installed, but there's a lot more that needs to be installed both on the southern border as well as on the northern border. And then when we think about ports. Ports today, generally speaking, most cargo is not being scanned. So it represents a tremendous opportunity here in the United States. But outside the United States, we're seeing tremendous demand throughout all parts of the world, in the Middle East, in Europe, in Latin America, in Asia Pacific. So it's really growing at a nice clip.

Right. Okay. Okay. Excellent. And I guess when you think about meeting that demand, what's sort of a kind of realistic growth rate to think about for this market?

Hard to say because it can ebb and flow. Generally speaking, in this part of the market, folks tend to think that the growth rate over kind of a long-term period is high single digits or double digits -- lower double digits. We've been growing at a faster rate than that. And we think we have every reason to believe that we can continue to grow this business at a healthy rate, but that is the fastest growing part of the market.

Right. Okay. Okay. Excellent. And you mentioned the domestic market. I've heard the administration is rather focused on the border. So maybe if -- what have you seen so far in terms of plans from this administration that might affect your business in terms of creating more security infrastructure at the border?

We think there can be some very favorable tailwinds for us, both the current administration as well as Congress are highly focused on security, are highly focused at the borders, and they're highly focused on a technology solution in addition to the wall and the stuff. But the technology solutions, what we do, it's called NII or non-intrusive inspection scanning systems. And that's where we have the #1 share, and we think the backdrop is very favorable for us for increasing economics to come our way in this regard.

Right. And is that -- if we were to see something like that this year, would that be principally through the reconciliation bill that's being discussed in Congress?

Reconciliation bill would certainly be helpful. If it's a continuing resolution, we think there's parts of that can be favorable to us as well, looking at some of the similar funding levels as we may have had last year. But in a reconciliation bill or a new budget, there has been talks of allocating considerably more money to CBP, Customs and Border Protection and in particular, to the NII or non-intrusive inspection scanning systems that we play in. So yes, we do think that's an important element to get more dollars our way.

Right. Excellent. And then what would you say in terms of -- for customers, being the market leader in ports, what distinguishes your products, do you think, versus competitors?

Yes, great question. We think there's really a number of things. One, we have the broadest portfolio of products in the industry in this segment. We have high energy, we have low energy, we have medium-energy x-ray systems. We have combinational technologies. It comes in a variety of configurations. Many of our competitors have to push a particular technology solution on the customer. We have all the solutions. And thereby, we can see what's right for the customer and serve them well. Our customer service is outstanding. And then maybe one of the biggest differentiators for us is a software that we developed, a proprietary software called CertScan that we originally developed for a different business model that we have called turnkey but it clearly provides a big differentiator for us in other awards. For instance, we won a large award in Mexico a couple of years ago. It was a $500 million tender with the Mexican Army called SEDENA. And initially, we were thinking that this order may be split up 3 ways, and we might have gotten a $150 million or $200 million deal, which would have been a very nice deal for us. But after the customer did reference checks with select customers and just as importantly, after they learned about our CertScan software, they decided to sole-source the award, specifically to us. So this is clearly a differentiator for us, and we think will continue to be for a long time to come.

Excellent. I guess when we think about that contract, I know that's driven pretty fast growth in the Security segment over the past -- in fiscal '24 and into the beginning of fiscal '25. When you think about that work -- kind of getting through the initial phase of that work, and having the business kind of grow through the wind down of that particular project, is that a temporary headwind for growth? And is it possible to overcome it?

Yes. Yes, great question. And it was a question we were getting from a lot of folks, particularly last year as we started to generate significant revenues, and we had a strong backlog. So there was a concern from some out there that we'd start seeing a decrease in our backlog and ultimately, we were at a high of revenues and it will be coming down. And we said, no, that's not the case. This is our new baseline revenue level, and we're going to be growing from here, and we've seen just that. I think last quarter, our book-to-bill was nicely north of 1 in our December quarter. We ended the quarter with a record backlog despite converting a significant amount of those Mexico revenues that you're referring to -- Mexican backlog into revenues. So it really gives us tremendous visibility and an outlook into the future. And for our second half of the fiscal year, which based on our guidance, is expected to be larger than our first half in revenues that will contain a smaller proportion of Mexico revenues. So what that's meaning is that we are absolutely sort of filling that hole and getting some tremendous bookings and giving us great backlog and visibility. So as we move into fiscal '26 and beyond, our expectation is to continue to grow just as we always have been.

Right. Is there anything to highlight that came through that was particularly helpful in terms of filling that hole?

The nice part is it's -- they haven't been grand slam. So there's just been a series of singles and doubles and triples. A number of just nice-size orders, but to a very diverse customer base, principally outside the United States, not in Mexico, but principally outside the United States in places that have very fertile territory like the Middle East, other parts of Asia, not China, but other parts of Asia, Latin America and Europe. And we think the U.S. and the domestic market is going to be very, very strong for us in the future. It hasn't been as strong in the last couple of years, and we haven't needed it to be, with the strong revenue growth we have, but we think it's going to be much bigger for us going forward. So a nice position to be in.

Right. And when we think about the profitability of that work that's really been driving a lot of the growth recently, we've also seen some nice margin expansion in the Security business. When you think about evolving into a more kind of broad-based revenue set going forward, how -- what impact does that have on profitability?

Yes. So as we think about profitability going forward, one of the nice things we've had is as we get this bigger and bigger installed base out there, generally, there's a warranty for 1 year, sometimes a bit longer. And as the products roll off of warranty, for the next 8 or 10 years, while these systems are out there, we get the service revenue. And the service revenue on this cargo business, in particular, tends to generally carry maybe a 10-point or so differential on the gross margin between products and services. So we believe that our service revenue as a percentage of our overall Security division revenue will be increasing here over time and that can have a nice flow and pull-through effect to our operating margins.

Okay. And so be able to kind of maintain -- at least maintain and eventually expand the level...

Our goal is to continue to expand our margins. I mean there'll be a little bit of ebbs and flows in certain quarters. But overall, our goal is to continue to expand our operating margins.

Right. And when we think about that, you mentioned the service, and I think that's an important piece of this. The amount of -- what do you include in recurring revenue for the Security business?

So when we think about recurring revenue in Security, the biggest portion is our field service, which tends to recur year after year after year; our training revenue, which is a big initiative, and we think it's going to be growing significantly over time; our turnkey revenue, which are these long-term contracts that we have that come at substantially higher margins, generally speaking, which is great for us as well. And then kind of a newer thing that we're kicking off is our pure SaaS revenue on the proprietary software that we call CertScan. So all of those make up what we would consider to be recurring revenue in our Security segment.

And what -- when we think about Security now, how much of it is recurring revenue?

Today, it's about 30%. As we look forward, we think over the next several years, that number could approach 40% or beyond, again, with the bigger installed base that we have out there with hopefully some more new turnkey deals and with the rollout of our proprietary CertScan software.

Right. And the turnkey opportunity exists primarily with international customers?

Yes, it really does. I mean the turnkey opportunity is fantastic for a country or a location that either doesn't have the capital or money to buy the equipment upfront, or if they do, maybe they don't have the operational expertise. So it's ideally suited for that. We could do it well here in the United States, too. But due to certain dynamics, we think it's less likely to take off in the United States as swiftly as it has internationally.

Right. And when we think about kind of the field service opportunity, is that something where there's annual price?

Annual price increases?

Yes.

There are small annual price increases in most contracts.

Right. So let's say -- and my understanding, I guess, was if you had a certain size order, the -- and what's the kind of the life expectancy of the equipment?

Generally speaking, depending -- it's 7 to 10 years...

Right. So over that, let's say, over that 8, 9-year period, you would collect in service revenue, roughly the same as what was collected to install the equipment?

Yes, on the initial product sale, that's right...

With a higher margin.

With oftentimes a significantly higher margin. Yes.

Right, right. And then there's a small price opportunity through that 8-year period...

That's correct.

8, 9-year period.

That's correct.

Excellent. So we talked a lot about ports and borders. I guess, maybe tell us a little bit how you think about the airport market and what particular opportunities might be coming up there?

The airport market, the aviation market has been an exciting one for us as well. And we've been growing double digits in the aviation and checkpoint business as well. I think some of the more exciting opportunities are here in the United States. The checked baggage systems that we all use were installed long ago and are beyond their so-called economic useful life. There is a big replacement program slated to begin maybe as early as 2027, perhaps 2028, that will go on for about 5 years. We did not participate in the initial rollout of these, which happened not long after 9/11 because we did not have a product at that time for that. Because of the necessity driven by 9/11, they took medical CT and adapted them for security applications. We then became the first company to develop the industry's first security check baggage systems designed specifically for security. So rather than having a rotating gantry, like you might see it in a hospital, if you went for a CT scan, we have a stationary gantry aligned with a series of sensors that our Opto division makes. And with that, there's high throughput at lower false alarm rates and can be a lower total cost of ownership for the customer. So although we didn't participate in the initial rollout years ago, when we brought these out, we've been selling them very strong internationally. And we have them in leading airports like France, in Italy and many places in the Middle East and other parts of the world and we would expect to hopefully win our fair share here in the United States as well, which is all upside opportunity for us since we don't presently have an installed base in the U.S. for checked baggage machines.

Right. Is there an approximate dollar value that you attach to that? To the overall checked bagging -- checked baggage replacement?

We've seen folks kind of attach maybe $1 billion to $1.5 billion overall value. And likely, there'd be 3 or so companies that might share in that award over time. And then similar to the other products besides just selling the product, then when it's out there for the next decade, the service revenue is attractive.

Yes. Okay. Okay. And then I guess that kind of touches on the competitive landscape here. And it seems like kind of an interesting time in that I think our primary competitor in airport and checkpoint security is Smiths Detection. And the Smiths Group is in the process of a breakup that will see Smiths Detection become a stand-alone company. Do you see that changing in any way the market structure or the competitive dynamic in the market?

It remains to be seen. Smiths has announced publicly, they plan to sell or separate the business. So whether it becomes a standalone or part of another company, remains to be seen. And we know they're focused on one of their other divisions to divest first and then turn their attention to Detection is what they've announced publicly. We don't discount any competitor. Smiths has long been a great competitor and a leader in the industry. We're proud to have surpassed them in total size in 2024, but we don't stand on our laurels or take anything for granted. And maybe our successes had something to do with some of the changes that they're looking at. But we don't see any major change in that competitive dynamic if they were a stand-alone company.

Right. Okay. Okay. And then the other -- when you talk about 3 companies potentially competing in that checked baggage, the other one would be within Leidos?

Yes. Leidos is the other major player in the aviation market and really all the markets when we think about competition, Smiths and Leidos are our 2 biggest competitors. We tend to be the largest company followed by Smiths, followed by Leidos, but all formidable competition.

Right. Okay. Okay. I guess you mentioned -- when you talked about the products, you mentioned some of the -- what you make in your Opto division being part of your Security products. And so maybe let's talk about the Opto division for a second because we focused mainly on Security, which is the biggest and the most important segment. But OSI has 3 divisions, and one of them is Optoelectronics. So maybe tell us a little bit about what you do there, both the relationship between the Opto business and the Security business, but then also what the Opto business does independently?

Sure. So interestingly, Opto has formed the foundation of the company. It's where we started. So unlike...

That's the O in OSI?

That's the O in OSI. Yes. Unlike Security where we sell to the end customer, in Opto, we manufacture for the Fortune 500 and many of the leading OEMs. In fact, many of the companies who are at this conference over the next couple of days. In Opto, we make sensors, we make detectors, we make other electronic components. Much of the secret sauce that we do in our Security business is manufactured by our Opto division and through that vertical integration, we're able to enhance our overall company-wide margins. We can control the supply chain a bit better and be faster and more responsive to our customer needs. On a big picture basis, about 85% of our sales in Opto are to third-party companies and about 15% are intercompany. And of course, while those intercompany sales get eliminated in consolidation, the margin does remain in-house and part of our earnings. So it's been a big part of our success story.

Okay. And when you think about that Opto business and the opportunity there, we talked about growth in security. How do you think about the growth profile of those end markets for Opto and your opportunity to participate in the growth of those markets?

Yes. The nice thing about our Opto business is we participate in really diversified end markets. Yes, we're in aerospace and defense and in security, medical, gaming, technology, automotive, industrial, so a very diverse customer base, no customer concentration. No customer even coming close to approaching 10% of our sales from a third-party basis. And once we get engineered into a company's product, we tend to be there for a long time through the company's or the product's life cycle. Some companies and products we've been making for well over a decade. So although these Opto revenues don't maybe meet the classic definition of recurring revenue, we consider it repeat revenue because we have an extremely high rate of this revenue that just repeats over and over and over. And then our business development teams do really a fantastic job gaining new business out of existing customers as well as getting brand-new customers as well. So very important to us.

Maybe 2 kind of macro questions related to the Opto business. One is when you think about -- we heard a lot about slowing demand from airlines earlier today at the conference. The market seems to be telling us that risk of recession is increasing. When you think about the customers, the 85% or so, that's outside of the internal sales for Opto, how do you think about what happens to those sales in a softer economic environment?

Yes, it's interesting. We're actually kind of seeing a little bit of the opposite right now, which we feel fortunate about. Over the last 18 months or so, our Opto sales were a bit flatter as many of our customers had overbought inventory either during the pandemic and when there were supply chain concerns for risk mitigation measures. And over this period of time, they've been rightsizing inventory levels, more optimizing. And while that's not 100% complete, we believe it's largely complete. So we are actually expecting to see an acceleration of growth in our Opto revenues beginning as early as this quarter. All that being said, to your question, if the economy slows down and there's slowing demand for our customers' products, of course, that would impact us as well. But right now, we're actually seeing accelerating demand as opposed to a slowing down of demand.

Right. I mean I would guess it depends very much on the end market, too, if it's the A&D, building new aircraft, defense, those could be relatively protected.

Correct.

Okay. And then the other macro consideration is tariffs. And I think this is probably most relevant for Opto. And maybe you could even speak to it across the company. You have manufacturing locations all across the world, you sell to customers all across the world. How do we think about the impact of tariffs on OSI?

Yes. I mean we're all trying to kind of figure that out today. It changes on a on a regular basis quite dynamically. Big picture perspective, we don't view tariffs of having a meaningful impact on OSI. We -- in our Security business and in our third division, Healthcare, we don't do much in the countries that are projected to have more significant tariffs. In our Opto division, you're right, we do have a little bit of manufacturing in Mexico, a little bit in Canada, but kind of a rounding error when it comes to OSI overall. So although we're assessing what that might mean to us and to our customer base, we don't anticipate that to be anything of significance for us.

Right. Okay. And then maybe let's move on to the third segment. And so I guess, kind of like in Security, in the medical business, OSI sells products directly to the end customers. But maybe tell us a little bit about what you do in medical?

Yes. Yes. So in medical, our brand is called Spacelabs Healthcare. It's a well-recognized brand out in the hospital world. So we sell into -- principally into medium and large hospitals, though we'll also go into the more acute or rural setting. And what we principally focus on are patient monitoring products and cardiology products. So patient monitoring products are the monitor that you might see at the bedside of a hospital, monitoring all the vital signs, which is then connected to a central station, which we also manufacture and sell where a nurse can look at multiple rooms simultaneously, which is then connected into the hospital's electronic medical records, which we partner with the leading firms on. And then can also be connected through telemetry products, which we also make so the patient can be continuously monitored as they move around the hospital, for instance, if they had to go into an x-ray or just walking around the hospital. So that's the biggest part of what we do. It's a fully connected solution. And then we have cardiology products where we do ambulatory blood pressure and what they call Holter monitoring and the like. And the interesting thing about our cardiology is not only is it the highest margin products in our Healthcare division, it's the highest margin products generally speaking in all of OSI.

I think that's interesting because when we look at that division, there's been -- we've seen some sales declines in recent years. And as a result of those declines, kind of minimal earnings contribution and yet high gross margin. And so I know that the company has brought in some new leadership for that segment recently. And so it seemed like there was probably a need for that business to start to do more to contribute. And so how do you think about the recovery of that business going forward? What are the ways to increase sales, I guess, principally?

Yes, it's an exciting area for us, although it only represents 10% of our revenues. It is our highest contribution margin business. So as our revenues go up, an awful lot drops through to the bottom line. Unfortunately, the inverse can be true, too, if revenues are going down. As you pointed out, we brought on a new President, a President of this division on February 1, so just about 6 weeks ago. This individual, we believe to be of a significantly higher caliber than, frankly, we've ever had in the history of this division. Previously ran one of our competitors and tripled the patient monitoring business at one of our competitors under his tenure. Interestingly, he was also at Smiths when they had a medical division that they ultimately sold off as well. So bringing a whole new energy and a whole new way of looking at things. But what we think will really drive this business is a new suite of patient monitoring products that we're going to be bringing out. So we've been investing over the last several years, significant dollars in R&D to bring out the next generation of patient monitoring systems. And it will be a multiphase approach, but we believe the first phase will be released in the summer of '26. In the medical device world, that's not too far away now. So we're quite excited about that. But before that, we think under the new leadership and the new way of thinking, we think it can really help stimulate some of the commercial operations and probably get a little bit smarter in the way we run the business to contribute to a better bottom line.

Okay. Okay. No, that's very interesting. And so when we think about investment across the company, if we were to quantify the investment in kind of new health systems and think about that winding down, I assume, over the next year or so, does that -- is that cost that kind of goes away? Are there other investments that will be needed across the company to kind of fill in that hole?

Yes. We think we've been doing outsized spending on R&D in this division over the last several years, and we've got a few more years of that to go. But yes, that won't be -- we don't believe that to be a rate that will be there sort of over the long term. So as we roll out the products, yes, we think the overall R&D that we're spending will come down.

Okay. And when you think about overall investment over the next few years, R&D and CapEx, what's kind of the requirement for the company? And I guess, specifically, it seems like there is a very meaningful growth opportunity in ports and border security, are you capacitized to address the demand there?

Yes. So we have a number of plants throughout the world. We believe we have adequate capacity to continue our growth plans. So we don't think there's any new plants or major CapEx required in that regard. So our CapEx, we generally say should be somewhere in that kind of $25 million to $30 million a year range, where it can elevate, and this is for a really good thing, is if we win new turnkey contracts. And we expect to win new turnkey contracts. And as we do, there'll be an initial upfront capital requirement, but the paybacks on those are very strong indeed. So we'd like to have those happen. On the R&D side, on security, we'll continue to invest in next-generation technologies, which we think has helped us become the market leader, and we want to stay the market leader. But we try to grow our R&D investments at a pace that's a little bit slower than our growth in revenues overall, so we get that leverage effect on our operating and our EBITDA margins.

Okay. Okay. Let's talk about cash for a second. The SEDENA contract has been a real boon for the top line and driven a lot of growth. But cash conversion during the initial phases of that contract has been fairly low. So how do we think about cash conversion, I guess, kind of through cycle for the company? And then maybe particularly over the next several quarters, given kind of the low cash conversion we've seen recently?

Yes. So we've had some significant investments in working capital, namely in receivables and inventory associated with the SEDENA and a few other contracts. The exciting news is now that we're in 2025, as we look at calendar 2025 and beyond, we think we're going to be generating very, very significant free cash flow. So we think we'll have a very nice free cash flow to net income conversion. And we kind of think that starts now. So it's going to be a real positive time for us where we're generating perhaps outsized free cash flow for a while.

And would that carry through calendar '25?

We believe so. Yes.

And then as we look out in sort of to a normalized period, how would you think about conversion of net income?

We think 100% conversion is not unrealistic for us. Yes.

Okay. We talked about the management change in Healthcare, also had a management change in the CEO's office.

Yes.

Recently. A little bit different though. This is not someone who's new to the company. Ajay Mehra took over, but I think he's been at the company for over 30 years. So not a totally new face. But if you think about any changes that you've observed or expected changes, whether it's in emphasis, in capital deployment or strategy or anything like that with the change in leadership?

Yes. So our long-time CEO, Deepak Chopra, not the spiritual guru, but Deepak Chopra, he remains as our Chairman of the Board and will be instrumentally involved for the foreseeable future. Ajay stepping in, having been at the company for about 35 years and leading our Security division to the top position overall, I think, was a vote in continuity. The company has been doing real well, and I think it's a continued vote in that. So I don't think it's -- that we'll see a major change in direction. But I think with any new leader, there will always be some enhanced vision, and I think some opportunities to further build upon that and have some new ways of thinking. It's early days. It's only been about 2.5 months, but he's off to a fantastic start and really excited to see what's to come, especially as we start our planning for our new fiscal year here, beginning June 30, which just starts here in a few months.

Yes. Excellent. I think we're right about at time here. But if I could sneak in a last one, it would just be about capital deployment. And with the company, it hasn't generated a lot of cash in recent quarters but has a very strong balance sheet. And there's a lot of cash to be generated over the next several quarters. What are you going to do with it?

Yes. Yes, it's a great position to be in with the strong free cash flow that we're going to generate, really kind of 3 things we look at for our capital allocation, and we don't look at them as mutually exclusive. I think we can do all 3 of these. M&A, as has -- always been in our DNA. We did an acquisition earlier this year. That's off to a fantastic start for us, but we tend to do a couple of acquisitions each year. Sometimes smaller bolt-on acquisitions that will fill a channel need or a technology need or take out a competitor, but there could be larger ones as well. We've been active in stock buyback. In our first fiscal quarter, we bought back about $80 million of stock. And then lastly, although net leverage is not high, it's only 2.1, and we would expect it to continue to go down with our free cash flow, we would pay down -- any excess cash that we had, just pay down our revolver.

Okay. Okay. And with that, I think we'll wrap it up. But Alan, thanks so much for being here. Really appreciate it.

Thank you. I appreciate it as well.

Thanks.