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

All right. Wonderful. I'm Dave Chen at Morgan Stanley, and I'm really, really pleased to have Alan Edrick, Chief Financial Officer of OSI Systems.

Thank you for having us.

Alan is a veteran of OSI, celebrating actually his 20th anniversary. So is it your just extreme loyalty or you just couldn't find another job?

Maybe a bit of both.

Okay. All right. So let me just -- for important disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. So look, Alan, great to have you back at the Morgan Stanley TMT. And just like -- maybe just step back for those of you who may not be familiar with OSI, just give us a sense for the company today, the 3 different markets and kind of your competitive position.

Sure. Happy to do so, and thank you for having us back. At OSI Systems, we think we have a really exciting and compelling story. OSI Systems is made up of 3 divisions: a Security division, a Healthcare division and an Optoelectronics division. The Security division is by far our largest. It represents over 2/3 of our revenues and even a higher percentage of our profits. Our brand is called Rapiscan. We are the largest security detection company in the world. We principally focus in cargo and vehicle inspection at the ports and the borders, as well as in aviation, and now in a new field called RF. It's a business that's been growing quite significantly for us. We've seen significant revenue growth, operating margin expansion. We've got a great backlog and a great funnel of opportunities. So very, very exciting for us. We have a healthcare business called Spacelabs Healthcare. It's the smallest part of our overall business, representing under 10% of our revenues. We sell into hospitals, where we sell patient monitors and cardiology products. And then, about half of our revenue in this business is recurring through service, supplies and accessories. And what ties everything together is our third division, Optoelectronics, where we sell sensors, detectors, electronic components. And unlike Security and Healthcare, where we sell to the end customer, in Opto, we sell to the Fortune 500 predominantly in a variety of industries such as aerospace and defense, technology, medical, automotive, industrial and the like. But in addition to selling to the Fortune 500, our Opto division supplies many of the key components that go into our Security products and many of the key components that go into our Healthcare products. And through that vertical integration, we end up enhancing the company's overall gross margin. We can control the supply chain better, and we can be a little bit faster and more responsive to our customer needs.

Yes. And just kind of rough split of revenues across the 3?

Yes. So roughly 2/3 is our Security business, roughly 25% is our Opto, with the remainder being our Healthcare.

Healthcare?

Yes.

Okay. All right. So, as usual, I'd love to start with Security. So yes, just remind us just like the core pillars of your product platform within Security. I'm going to get to RF and maybe just the core business.

Yes. So sort of the core business of our Security -- most people know us for our aviation business because we all go to airports. Our brand is called Rapiscan. We sell products at the checkpoint where you put your carry-on bags through, your laptop through. We sell products for checked baggage. We do trace instruments as well and walk-through metal detectors. A nice business for us. We have market share estimated probably between 20% and 25% in the business. It's been growing very nicely for us, primarily internationally, though we think there are some great domestic opportunities coming up in the next few years. But the biggest part of our overall Security business is what we call cargo and vehicle inspection, where we are the #1 player. We have the largest market share. We sell into ports and borders and critical infrastructure. We have the broadest product portfolio in the industry. We integrate that with some proprietary software that we developed called CertScan. And together, it's enabled us to really differentiate ourselves from the competition, which has allowed us to capture significant share. And we have a variety of different business models that we go to market with in this particular part of our business.

Yes. You have some core subsegments that you just mentioned, checked baggage. How has the relative market shares over the last decade have changed for OSI in those subsegments?

Yes. So when we think really the subsegments, if we look at cargo and vehicle inspection, over the last decade, we were a pretty small player. We were -- we only had single-digit market share. Today, we believe we have north of 50% market share. Our team has just done an outstanding job gaining new customers with this broad portfolio of products and service offerings. We have another model that we go to market with called turnkey or a different version of SaaS that we coined Security as a Service, where we can get recurring revenues entering into long-term contracts, which has been quite nice for us. On the aviation side, I'd say our market share has been more stable. We've kind of grown with the market over time. But the big, big increases that we've seen in our Security business, our revenue growth has principally been driven by the cargo side of our business and the related service, which has been nice for us because it's very strong recurring revenue at substantially higher margin.

How much of it is -- what's driven the leadership? So it sounds like it's a service, but also is it just product excellence? Is it kind of go-to-market focus?

Yes. I think it's a great job by our leadership team in our Security business who decided that rather than some of our competitors, who focused on a particular technology, we really try to bring in all technologies. So we don't have to push a single technology on a customer, but we can see what is right for the customer and sell them that particular product. Our sales team has done an outstanding job in this respect. Our service team has, again, with the different business models of selling the product or doing it through a Security as a Service offering. It provides choices and options. Our service team provides best-in-class service. We all hope our machines never break down. But of course, when they do, how do you respond? And our teams have really done a terrific job there, giving us a big global advantage.

Yes. Obvious question is, just given global conflicts and the geopolitical climate, how has that translated to your pipeline?

Yes. So big picture, what's not great for the world tends to be good for our business. It's hard to turn on the TV these days or any days over the past several years and not see something happening in the world. And while that's unfortunate for the world, it tends to provide some tailwinds for us. And when some of the conflicts die down, it generally results in increased opportunity pipeline and sales for us, even maybe what's taking place here as we sit here today as well. So it's generally been good for our business. Sometimes there can be pressures on defense budgets, but security overall as a percentage of defense is extremely small, and very few places in the world want to be without security. So it's been somewhat immune overall, which is why we've seen such great growth.

Anything specific or that you would point to in terms of the government regulations or new spending proposals that directly hit you or kind of you just benefit generally from the halo of heightened geopolitical?

A little bit of both. We definitely benefit from the heightened halo. But here in the United States, of course, most recently, there's been the One Big Beautiful Bill. And the One Big Beautiful Bill has established significant funding for areas that play straight down the middle of the fairway for what we do, principally with CBP, which is Customs and Border Protection, part of the Department of Homeland Security, where the funding levels they're talking about are at a whole different clip than we've seen over recent years, and this is exactly what we do. So we're extremely excited about it. In addition, there's funding for things such as the Golden Dome which, again, by a way of an acquisition that we did about 1.5 years ago, again, fits squarely into what we do, and we think we're extremely well positioned there. So a lot of different things are coming together, which could prove very beneficial for us.

Can we just unpack both of those really super-interesting, very recent things? So can you just give us a sense for just the One Big Beautiful Bill, what's in it and kind of how does it impact OSI?

Yes. So if we're talking particularly about border funding, there's 4 principal areas within the One Big Beautiful Bill on the borders that we play in. The first is that they allocated somewhere between $1 billion and $1.1 billion to what's called NII, or Non-Intrusive Inspection, scanning equipment at the borders. That's exactly what we do. In past procurements, we've fared very, very well and gotten a nice percentage of those orders, and we would certainly hope to get that again. They've allocated additional money to border patrol sort of between the checkpoints, and that could be very beneficial for us as well. Certain amount of funding also to some biometrics and facial recognition, which we play nicely. And lastly, there's also money allocated to the World Cup and the upcoming Olympic Games in 2028. We've been one of the companies that has been very successful. We did the most recent Paris Olympics and the World Cup in Qatar amongst many, many other sporting events.

That's great. All right. And the Golden Dome?

And Golden Dome, Golden Dome is extremely exciting for us. We're part of the $151 billion IDIQ together with many, many other companies. But the technologies that we have fit squarely for what they're looking at with, we believe, limited competition. So while some folks are skeptical about when that funding may occur, we believe that where we're playing in, we're going to see some near-term funding this calendar year, and we might be the beneficiary of some significant orders for Golden Dome. And it plays extremely well into what we did for -- when we did this acquisition about 18 months ago, it was a smaller business that -- we took their tremendous technologies, put it -- combined it with our sales channel -- they had a good sales team, but combine it with our sales channel, our reach, our balance sheet, our government contacts, we've seen some extraordinary success. In our September quarter, we had a book-to-bill ratio north of 3 for this product line. We followed it up in the December quarter with a strong book-to-bill as well. And even before the concept of Golden Dome even occurred, we were seeing tremendous growth, leading us to increase our capacity, which has proved fortuitous as we're now looking at upcoming Golden Dome initiatives. So we started increasing the capacity in November of 2025. That will go on throughout 2026. But it's going to put us in a very strong position in order to be able to capture awards and deliver on those awards.

Two questions on that. So first, just drill into the actual product of the company you bought. And then, second, how does it relate or integrate with the rest of the Security portfolio?

Yes. So the product is RF-based, radio frequency-based using over-the-horizon radar. In addition, it has VLF, very low frequency and ultra-low frequency for communications with submersibles, submarines and the like. We work on quite a few classified programs, but the customer set is very, very similar to the customer set that we at Rapiscan, our Security division has worked on for years. So taking our strong relationships and feeding this great product profile and similarly taking some of the relationships that the acquired business have and using it with our products has been very, very synergistic. So we're off to a tremendous start. It's been a tremendous acquisition for us, fits very, very nicely into what we do. It might not be considered straight down the middle of the fairway, but it is a very, very nice adjacency and performing extremely well for us.

Got it. Right. Let's zoom back out to the geographic split of your business, and in particular, what's been in the headlines with you on a quarter-to-quarter basis is Mexico. So maybe just step back and just like -- when did your relationship with Mexico start? Why did they first choose you? How much business have you done with them? And then, kind of over time outlook for the future.

Yes, great question. We've been doing business with Mexico for a few decades. We had some very, very substantial contracts with Mexico that we performed, we believe, exceptionally well on. It led to some new RFPs a few years ago. And we ended up capturing 3 very major contracts: one for $500 million, one for $200 million and one for $100 million. So $800 million of orders over roughly kind of a 1-year period. And from that, we saw a significant spike in our backlog. And there had been some concern that as we converted the backlog into revenue, that our backlog would come down and it would be more difficult to replace that revenue. And we had said at the time, we didn't believe that would be the case, and that has proved to be absolutely true. So, as we saw a very big spike in our revenues in fiscal '24 and fiscal '25 associated with Mexico, we didn't see any reduction in our backlog at all as our sales team continued to capture significant opportunities, primarily outside the United States, during this period of time. So we've kept our backlog, and we've been seeing a nice increase in our revenues. Over the course of this year, we've been saying that it's going to be a very difficult comp from a Mexico perspective because we had such significant revenues last year but that we would overcome them once again. And that's exactly what we've been doing through the very, very strong revenues that we have really throughout the world, both in our cargo lines and in our aviation lines. And the beautiful thing about all this is, now, as we get this bigger installed base, we have much more recurring revenues as these products roll off of warranty on service. So if you look throughout calendar '25, we were growing at a strong double-digit clip on our service revenues. And that's exciting for us because it's great recurring revenue at substantially higher margin. So it could lead to some very nice operating margin expansion for us in the future.

Okay. Great. So yes, so let's touch on that. I think you've mentioned that recurring can get to -- you can actually move from like 30% to maybe 40% of overall.

Yes, we firmly believe so over time.

So like maybe just step back, and actually, I think Mexico was one of the first to adopt one of your SaaS or your turnkey.

Yes, they were the second customer, exactly right.

Second one. So like just what's the state of play with the industry? Like are -- is the entire industry going through a SaaS transition? Or is it kind of more case by case? Like what's the particular demand setup when you might have, when you might not have that situation?

Yes, it's a great question. And you might say, well, why would somebody choose to have this type of SaaS model versus buying the products? And there might be some customers either that don't have the money or the capital to buy the equipment upfront, or if they do, they might not have the operational expertise to do the whole thing. So we can come in with this great model where we can offer them 100% security with effectively nothing -- no out-of-pocket costs upfront. We enter into a long-term deal. We've done deals as little as 6 years and as much as 15 years. And then, we get this great recurring revenue at a nice margin for us. So that's kind of the customer profile. We'd love to see more and more customers go this way. We do have an upfront CapEx investment, but there's a nice return on that investment for us. But there will be certain customers that this is ideal for, and there'll be other customers that want to buy the product and do the operations themselves. So we haven't -- we've seen a nice adoption, but we don't see the industry going this way in totality by any means.

We're probably going -- there's definitely an upward trend in terms of turnkey or SaaS throughout the industry.

We think there's that real opportunity. Absolutely.

It doesn't get to, I don't know, majority probably.

I don't believe that.

All right. And then, like, just unpack for us like, you started with turnkey and then you have CertScan. Can you just describe the 2?

Yes. So when we developed our turnkey models, at the same time, we worked hard on developing a proprietary software. We've called that CertScan. And it's a command and control center that's given us a clear product differentiation, not just for our turnkeys, but sometimes when we do an actual product sale itself. For instance, the $500 million sale that we had in Mexico, originally, we thought that might be split 3 ways, and we would have been thrilled to get $150 million or $200 million contract. But as the customer started to look more into it and did customer reference checks and then also learned about the CertScan software, they decided to give us the 100% of the business, which has been outstanding for us. And from that, we have now taken the CertScan software out onto a traditional SaaS model, Software as a Service. So we're in the very, very early innings of that, but we've gotten some great feedback. We've had a number of wins in that regard, but again, very, very early. And then, we'd hope to get SaaS-like margins for this business as well.

Can they -- do they coexist? Do you do turnkey and SaaS? Or do you do one or the other?

So when we do turnkey, the CertScan is included within that. But we can sell SaaS as a stand-alone product to those who have our...

On-premise or they...

Exactly.

They buy it. Okay. Got it.

Exactly.

Okay. Great. Going back to the -- on the checked baggage side, there is kind of a natural cadence to -- like how long does one of these machines last? Just give us a sense for that.

Generally speaking, we think they last close to 10 years.

10 years. Okay.

Here in the United States, it's gone on a lot longer than that.

I've noticed that.

So many of these machines were put in not long after 9/11. So they've been out there sort of a couple of decades, which is costing the TSA some tremendous amounts in service. We believe there'll be a new procurement coming a few years from now. It will probably run for about 5 years. It will be an outstanding opportunity for us because when the original procurement took place, we didn't have a checked baggage product. We then developed one of the industry's first CT systems, designed specifically for security applications that we call RTT. And we've had great success with that product everywhere in the world outside the United States. So the United States, when the next replacement cycle occurs beginning a few years from now, that's all sort of virgin territory for us, and we're very excited about that opportunity.

Okay. Is there a similar opportunity -- what about the cargo side? What's the kind of lifespan there? And is there a replacement cycle there as well?

Yes. So unlike aviation, where every airport has systems -- and cargo, it's an emerging area. So it's an unregulated market compared to the aviation market. So the cargo products typically also last for about 7 to 10 years. But unlike aviation, which is today is primarily a replacement market, unless there's new airport construction or a new terminal, on the cargo, both at ports and borders, yes, there's replacements. But there are so many opportunities throughout the world at both ports and borders where there is no security scanning right now. So it represents more...

The growth driver there is more just greenfield.

That's exactly right. That's exactly right.

Whereas on the checked baggage side, I'm sure there's greenfield, but we should think about the refresh opportunity as a big growth driver perhaps in the next couple of years?

We believe that. It will start in a few years from now and go on for about 5 years.

Okay. And then, just what about just the overall product development road map for the entire Security division? Can you just give us a sense of what you [indiscernible] publicly and [ direction of travel ]?

Yes. So we invest a considerable amount of R&D for OSI Systems overall. The vast proportion of that goes into Security, though we do quite a bit in Healthcare and smaller percentage in Opto because it's often customer-funded. But within Security, we're always looking to obsolete ourselves. So there's a good amount of attention placed on brand-new products, but quite a bit on software development and the algorithms and using AI in some of the algorithms. And we always want to be ahead of the competition, state-of-the-art, and we think that's one of our clear differentiators. And we have an excellent engineering and R&D team who is coming out with some exciting things. We have not gone public and said what those are, but a number of exciting developments.

Okay. Excellent. Moving to Healthcare, okay, so it's about 10-ish percent of revenues. And so, just patient monitoring, just give a sense for the product and just like the -- maybe the market landscape in terms of like who you're selling into, who you're competing with, et cetera.

Yes. So in Healthcare, unlike Security, where we tend to be the #1 player, sometimes the #2 player in many of the markets, in Healthcare, we compete against some big boys. So we're not the largest player, which leads to our market share there. But in patient monitoring, what is patient monitoring? If you're at a hospital, sitting at your bedside is the monitor that will monitor your vital signs such as your blood pressure, your oxygen levels and others, which is then connected to a central station where a nurse can look at 16 rooms simultaneously, which is then often connected to telemetry products. So, as the patient moves around the hospital, they can be continuously monitored. We make all of those type of monitors. We've typically sold to medium and large hospitals, but we also sell into some small and rural hospitals as well. We are a -- our competitors are some big boys like GE and Philips. And we're not arrogant or naive enough to believe we're going to overtake them, but we believe we can take some additional market share. And we've been investing very significantly in a new patient monitoring product platform that will come out in multiple phases, the first of which will come out, we believe, sometime closer to 12 months from now. And that's going to be a very, very exciting growth opportunity for us. But in addition to that, we sell cardiology products. The cardiology products tend to be the highest-margin products in healthcare. They're also amongst the highest-margin products in all of OSI, so very, very high contribution margins. So, as our Healthcare business grows revenues with a very high contribution margins, there's a big -- very big pull-through down to our operating income and our EBITDA. So it's an exciting area for us. We've enhanced our leadership team there quite a bit. We brought on a new President about a year ago. He has brought on a number of new leaders over the last 6 months. So we think the business is in a better position than it's been in quite some time. So exciting for us, but the real growth driver is going to happen when we release our new patient monitoring platform.

Okay. All right. Last quarter, Healthcare was not the strongest performer.

Yes, it was a little disappointing in Q2. Of course, our Security business and Opto business did so well that it more than overcame the Healthcare thing. But we believe that was an aberration, and we're expecting the balance of this fiscal year to be much stronger than we saw in Q2. And as we move into our fiscal '27, we believe there'll be sort of accelerated growth with the new teams and some of these...

And new patient monitoring platform.

That's correct.

Yes. Okay. Great. And then, one final thing just on what -- how much of that -- your Healthcare business is actually services? Like a decent...

Yes, our recurring revenue in Healthcare is about 50%. We define that as our services and our supplies and accessories, which are continuously bought. So it's a very nice recurring revenue model.

Like a printer model?

Exactly.

That's actually a -- is that a larger mix than your Security business?

It is because in our Security business, it's about 30%. In Healthcare, it's about 50%.

Yes. That's great. Let's just round it out with Opto. So just, yes, some of the core products?

Yes. So Opto -- we're extremely excited about our Opto division and the performance of our Opto division. We sell sensors, detectors. What's a sensor? On the medical side, if you ever put your finger in a pulse oximeter to measure your oxygen level -- many of us got familiar with that during COVID. We're the world's largest manufacturer of the pulse oximeters on behalf of some of the largest OEMs in the world. But we make the sensors, detectors and electronic components that we sell to many companies that are here at this conference this past week, as well as many others throughout the world. It's a business that's done really well for us. In the first 2 quarters of our fiscal year -- we're a June fiscal year -- the business grew 11%, 12% in each of those quarters. But in addition to selling to third parties, we also sell to intercompany, which has been very helpful for us. We manufacture throughout the world. So if you want products made in the United States, we have that. But if you want a little bit lower cost, we manufacture in Malaysia, Indonesia, India, Mexico, and we can share some of those savings with our customers. Importantly, we do not manufacture in China, and many companies out there today are looking for alternatives to China. And with our Asian footprint outside of China, with our Mexico footprint, we provide a very, very nice alternative. So we've seen our team do a great job. We've mined more business out of existing clients, as well as getting brand-new clients, and it's really leading to kind of industry-leading growth and industry-leading margins in this business as well.

That's right. So just give me a sense for -- let's just zoom out, and now we've covered all 3. Maybe just some highlights from last quarter. And what did you like from the quarter?

It seems so long ago now last quarter [ when we ] think about this quarter. But the last quarter was exciting for us. We posted record revenues. We leveraged that to record earnings. Cash flow was pretty strong for us as well. Though the backlog remains solid, but we believe the bookings opportunities for us in the second half of this year are very exciting for us and as we move into fiscal '27. So we were very excited about our overall performance last quarter, but more excited about what's coming up in the future.

Yes. Every company is being asked this at this conference. So let's dive into it. Just like how is -- how are you using AI across your business? Whether it's within the company, or are you doing something interesting and transformational in terms of putting into the product for your customers?

Yes, it's a great question. And we're at, I'd say, a different stage for each of those. I'd say, our biggest focus today has been on the commercial side, both our Security and Healthcare teams on placing AI into our products and differentiating ourselves. In our Security business, we got a little head start on our competitors. We bought a company that was involved in AI about 5 years ago. So it gave us a little bit of a leap, and we've been embedding that in many of the products that we're selling or developing right now. So we think that's going to be a real competitive differentiator for us in Security. And we're doing a similar thing in Healthcare. Within our own business, like many companies looking to get more efficient, we kicked off that journey. I'd say, we're at the very early innings of that internally, but it's a primary focus of our leadership team here in calendar '26 and beyond. So exciting for us. We do think there'll be some transformational breakthroughs from a commercial standpoint, and we think there'll be some great opportunities from us from an internal standpoint.

All right. Great. I have a couple of questions left. So if anyone in the audience has a question for Alan? You mentioned earlier on the increased service mix. So when can we expect the pull-through into real margin expansion for the company?

Almost immediately. I mean, we saw -- over the last 4 quarters, we've seen a significant increase in our service revenues. That contributes to our margins very nicely. Countering that a little bit was, you mentioned Mexico, and we had more difficult Mexico comps and the like. The most difficult Mexico comp concludes this quarter here in March, and then we get into more normal comps thereafter. So I'd say really beginning in our June quarter and thereafter, the bigger service revenues, coupled with a more favorable mix. Exactly.

Better compare really. It's a clean compare starting you think in like...

In the June quarter. Yes, pretty close to that. Yes.

Kind of a good problem to have.

It's a great problem to have.

Given what Mexico has done for the company.

Exactly.

Yes. Any other questions? Yes.

[indiscernible]

So the question is, medium-term targets for free cash flow, sales, operating margins. We give annual guidance for revenues and earnings. So we haven't provided any targets beyond that. But big picture, our goal is the same as that we've shown over the last decade or so. We want to show good top line growth. We want to leverage our infrastructure to grow our earnings faster than our top line growth. From a free cash flow perspective, it's exciting for us. So we have a little bit of outsized working capital right now, which we think is going to normalize over the course of the next year or so, which should lead to substantial free cash flow generation, much higher than we've seen historically in the past, a conversion well north of 100% of our net income. So it's an exciting time for us.

On the capital allocation side, so your CapEx has remained relatively consistent. You've got a revolver. How do you balance kind of share buyback, acquisitions, et cetera?

Yes. So our capital allocation strategy is what you just described. We look at M&A. We look at stock buyback, any residual cash, maybe paying down a little bit of debt. We don't believe they're mutually exclusive. We've shown in the past that we can do acquisitions, while simultaneously buying back stock and paying down debt. We have very modest net leverage today. We did some significant stock buyback in November. But we're also an acquisitive company. And we've historically done some acquisitions that have filled the channel need, a technology need, maybe taken out a competitor, maybe moved into an adjacency that have created tremendous shareholder value. And although we believe that our organic growth opportunities are fantastic ahead of us, any opportunities that meet our criteria that could even turbocharge that organic growth, we certainly wouldn't be shy to act upon.

Great. Let's just end with -- you've been with the company for so many years. What's the outlook for the company, maybe like priorities for 2026 and beyond?

Yes. I mean, the outlook is fantastic. We're very excited as we move into our fiscal '27 here in about 4 months. The security outlook is tremendous with so many tailwinds at our back. Our Opto business continues to perform well. We believe our Healthcare is undergoing a nice turnaround. So we're excited to continue growing the company, and that's really what we're going to be focused on.

All right. Thank you very much, Alan.

Thank you.