OSI Systems, Inc. ($OSIS)

Good afternoon, everyone. Welcome back to the aerospace and defense track here at the JPMorgan Industrials Conference. I'm Seth Seifman, the aerospace and defense equity analyst here. And we are very grateful to have with us OSI Systems. And we're here with CFO, Alan Edrick. And Alan is going to talk with us about the company. We're going to do a fireside chat, a little bit of Q&A, and we'll ask in the audience for some questions as well. But Alan, thanks very much for coming. I appreciate it.

Thank you. Thank you for having us.

Cool. Maybe stepping back before we get into the detailed questions, if you just kind of want to set the scene in terms of where things stand for the company this year, the growth prospects that you see, kind of what you guys are excited about?

Yes. It's been a great year for OSI Systems. We are a June 30 fiscal year, so we reported half of our year and coming up on our 3-quarter mark right now. Over the last few years, we've experienced very strong growth, both on the top line and the bottom line, and that has continued into this year with strong revenues, strong bookings and strong profits. So we're excited and the prospects ahead of us are very exciting. We've been growing quite a bit internationally. And while those prospects still remain very, very robust, we think the next few years, the U.S. growth is going to really be outstanding for us. So exciting times for OSI.

Excellent. Excellent. And maybe we'll start off talking about the security business. You mentioned U.S. growth ahead. There was a good amount of money in the reconciliation bill last year for border security equipment. Have we seen -- but we've also had some friction. We had the government shutdown for a period at the end of last year. The Department of Homeland Security still doesn't have funding for fiscal '26. Have you started to see some of the contract activity get going?

Yes, we've certainly seen a lot of RFIs and RFPs. The outlook for us, we believe, with some of the funding coming from the One Big Beautiful Bill and the like is superb. And we think it's going to really set us up nicely for the next few fiscal years for us. So we're very excited about that. We think the orders are on the come there for us and hopefully not in the too-distant future. You're right, the shutdown of the government back in October and November impacted some things from a timing of bookings. It didn't impact our fiscal year because these were bookings that would generate revenues, we believe, in '27, '28, maybe '29. And even though the government has been opened, as you mentioned, the DHS is still shut down, though we still continue to work with many of the key parties within the government. So we're very excited and are very optimistic about the outlook there.

Okay. Excellent. And when we think about that, I think it was something in the low $1 billion range, $1 billion and change that was in the reconciliation bill for border security equipment?

Yes, there are several categories. And the first category is just over $1 billion for nonintrusive inspection scanning equipment, which is exactly what we do with CBP, Customs and Border Protection. And then there were some other funding in a few other agencies and then additionally, some funding for the Olympics and the World Cup. So all told, it's a very significant and sizable sum that we're trying to play a meaningful role in.

Right, right. And I guess some of that -- I mean, there's a time line attached to some of that. The World Cup funding needs to be coming soon if it's going to happen. So I guess that part of it we can look for in the nearer term. And then when we think about the company's share of that, I know in terms of port and border security equipment, OSI is the global leader. Would we think about the company getting at least half of what's out there?

Well, we're hopeful it will be a very sizable award. The last CBP awards that were given of a sizable nature, I believe we got around 40% to 45% of the awards. We continue to be a very strong provider and have an excellent relationship with CBP. So when the awards come, we're hopeful that we can maintain that share or even grow it. So we are optimistic about that.

Okay. Okay. Excellent. And then on the airport side of the business, I gather there are some opportunities coming as well. How do we think about when those opportunities show up and also the scale of those opportunities versus what's available on the ports and border side?

Yes. Aviation is a very important part of our business. We're larger on the ports and borders and critical infrastructure side and have a higher market share, but we also have a strong market share in aviation. And for the last several years, the biggest part of our aviation business has been international. And I think over the next couple of years, it's going to continue to be outside the United States. But there'll be a big replacement cycle coming for check baggage in a few years, starting here in the United States. that will likely be roughly a 5-year replacement cycle. And that will all be incremental business for us because when these checked baggage machines were first put out in the United States or installed, we didn't have a product back then. And we then developed the industry's first check baggage machine specifically for security applications. And it's been a great success for us. We've had some great wins outside the United States and some good market share. And we would hope to do the same right here in the United States when that replacement cycle starts here, too.

And is that something where you'd expect awards kind of late in the decade and then for that 5-year cycle to kind of start from there?

I think that's probably a very reasonable time frame. And the timing couldn't be more perfect for us because we believe we'll have some significant awards for -- with CBP and ports and borders and some other government agencies as well. So as those maybe start to wind down a little bit and move more into service, the aviation will kick in, as you mentioned, towards the end of the decade and then beyond.

And then on the international side, what's the demand picture like internationally, both for airports, I guess, and for ports and borders?

Well, unfortunately, the world doesn't get a whole lot safer as we see in the news every day, but it kind of plays well into the business that we participate in. So we continue to see robust activity in our funnel. We're excited about it on the ports and borders and critical infrastructure, but as well as aviation. So all of those areas are very strong opportunities for us. Of course, the most recent conflict in the Middle East could create some medium- and long-term opportunities for us as well. So it's not necessarily always great for certain things going on, but it tends to play well into the business that we're in.

All right. And are there particular regions that seem more promising in terms of demand?

Yes, there are. I mean, in addition to the United States, the Middle East, we look at it as very fertile territory. We have very strong market share in the Middle East. But we also see strength in Latin America, Asia, not China, but other parts of Asia would be notable. And of course, we do business throughout the EU as well. But I'd say between the U.S. and the Middle East and some parts of Latin America, that's probably our strongest growth opportunities.

And what's the competitive environment like these days when you go out to try to win business internationally?

Yes. So on an international basis, the competitive landscape hasn't changed a whole lot. We tend to be, we think, one of the strongest players internationally. Our largest competitor has recently announced that this particular division is -- the Security division is being divested and is being sold to a private equity player that's supposed to close sometime later in 2026. But the competitive landscape is largely the same, both internationally and the United States, same main competitors that we have that are all good companies, but we seem to compete well and favorably with.

I think one of the interesting things that I learned about the business when I started following the company was there's obviously equipment that you guys sell, but you also sell services. And there's a support aspect to the equipment and okay, that makes sense. There's a lot of equipment that companies sell where there's an aftermarket. But also that you will almost provide the service -- so can you tell us about that offering and how penetrated that is within your sales base right now?

Yes. So maybe I'll talk about sort of service in general, including the aspect you're referring to. But service for us is very exciting. Throughout calendar '25, we saw strong double-digit growth, I think, each quarter on our service revenues. And that's important for us because it can really expand margins. Our service margins are at least 10 percentage points higher than our product margins on a general basis. So as the service revenue becomes a bigger part of our overall mix or a percentage of our overall revenues, that can lead to nice operating or EBITDA margin expansion. So very, very favorable for us. And within our service revenues, we really have 4 main areas. We have our field service and maintenance, which is the largest area for us in service revenues, where we have a very high adoption rate where we fulfill the service for our customers. So after we sell the product and let's say, it has a 1-year warranty, if it's out there for 7 to 10 years, we tend to get annual renewal contracts for very strong margin service revenue. In addition to that, we pioneered a new business model, which you were alluding to that we call turnkey or a different version of SaaS, Security as a Service, where instead of selling the product, we manufacture the product, we place it at the customer location, but it sits in our balance sheet. We own it. We enter into a long-term contract with customers up to 15 years. They've ranged from 6 years to 15 years. We staff it up with our people, our employees, and then we charge a fee per scan or a fee per site per month. Thus a great source of recurring revenue at strong margins. So it's been a great area for us, primarily focused in the international markets. And from that, we developed a proprietary software called CertScan, which we now are taking out as a stand-alone true SaaS-based product, Software as a Service, which is exciting for us. We're beta testing it with some real orders here in the United States, but we've also gotten some significant orders outside the U.S. for this. So exciting. We're in the very early innings, but we think it can grow substantially at high SaaS-like margins, which is great for us. And then the final area of service for us is training revenue. So we're doing more and more training initiatives. So these 4 things, we think can contribute to nice size service revenue growth. And again, the service revenues carry substantially higher margins than our product revenues.

Okay. When you take on the operation of the equipment, and this is -- for your customers, this is kind of an important national mission. What kind of risk does the company take on in those cases?

Yes. So we're very careful to, of course, not absorb any additional risk that we need to. So in most of these cases, sitting side-by-side with us when we're doing the operations is a member of the government. And the member of the government makes the final adjudication or decision whether to pass the truck or the car through. We might provide a recommendation, but they make that final decision. So as a result, we have not seen any particular liability associated with this.

Not something that the company is exposed, correct. Okay. Excellent. One of the things, I guess, as we've seen the service portion of revenue grow in recent quarters, we haven't seen an accompanying expansion of the margin. And so why is that? And when do you think that might become -- that service contribution might become more observable?

Sure. So the service revenue growth that we've seen over the last 12 months has led to nice incremental margins on the service side. But on the overall blended side, we had some tough comparisons. So over the past couple of years, we've been fulfilling 3 major contracts that we won in the country of Mexico, totaling about $800 million. And as we deliver those products, because we are making the same product over and over and over again, there was quite a bit of efficiencies, which led to higher product margins than we would otherwise normally have. So over the last few quarters with that tough comp, as we've replaced the Mexico product revenues with other customer product revenues, it's been at a little bit lower margin. So overall, our margins have been pretty strong, but because the service revenues have kind of offset the change in the product margins. All that being said, the last quarter where we have a more challenging comp on the product revenue side related to Mexico is this quarter in March, which we've outlined in the past. So as we move forward into kind of our June quarter and then into our next fiscal year as we start July 1 and beyond, those tough comps are gone and should lead to an opportunity for nice operating margin expansion.

Right. Okay. And how does the -- when the growth in the business becomes a little bit more U.S.-focused and CBP focused, does that have an impact on the margin mix?

It may. Sometimes margins have been favorable in the United States. It all depends as the bids go out and the like, but that should be very helpful. It should also be very helpful from a working capital perspective as the U.S. government tends to be a faster payer than many international locations.

That's probably a good segue to the cash flow topic. So we'll talk about that now, and then we'll go on and talk about a few other things as well. But I know that waiting for the payments from this $800 million of work in Mexico has dragged on your free cash flow in recent years. Can you talk about where that stands? What kind of remains to be collected? And what's kind of the visibility on when that can arrive?

Yes. So the country of Mexico and the many agencies that we work with the country of Mexico have been long-standing customers of ours for the past couple of decades and have been very, very reliable payers. They paid us every single dollar or peso that they owe us, not always on time, but they always pay us everything they owe us. So the current large contract that we have outstanding is with the Mexican Army, a group called SEDENA, very -- it's part of the federal government, so as a result, we feel very confident in collecting all the cash as we have with every contract that we've had in Mexico. It's been slower than we would like. There's always some bureaucracies that take place and the like. So they have been paying us. I just -- we wish it would be a little bit faster. But what that means for us that we think over the next 12 months, our free cash flow has the opportunity to be simply outstanding and the free cash flow conversion can be very, very strong.

Okay. Okay. Is there -- I guess, if we looked at the an unbilled receivable or something like that, that would kind of show what the magnitude of that excess cash?

Yes, really both looking at the unbilled receivable and the billed receivable because each of those balances is substantial. The unbilled receivable is coming down and converting the billed, which then means it can be paid, but the billed receivable itself is significant as well. So we're excited about that. It means we're going to be -- we should be generating very, very significant free cash flow here over the next 12 months.

Okay. Excellent. I guess when we step back and we think about the security business and having a strong market position and demand both domestically and internationally, what's the right growth algorithm to think about for that business?

Yes. It's difficult to put a pure algorithm on it because there are times when we get these outsized contracts, such as the 3 large Mexico contracts. Today, we sit on big opportunities here in the United States with the One Big Beautiful Bill, things like Golden Dome and the like. So there's times where the growth can be very outsized and then the service revenue comes along with it. But on a big picture scheme, we think on a long-term basis, it's kind of a -- it could be like an upper single-digit type growth business where -- with many years being in the double digits. Yes.

Okay. Okay. And then within that, how do you think about the margin opportunity in a business where you're growing. So there's -- I'm sure there's some leverage. There's a growing service component and a growing installed base. There's also right now, maybe some elevated domestic demand on the OEM side, on the new equipment side. Does that create a path to margin expansion?

No, we think so. I think you just hit on the key elements. As service revenues become a bigger proportion of our overall mix, that drives operating margins. Economies of scale associated with higher revenues and leveraging that fixed cost structure also does. The mix of where the revenues may occur in one country versus another, one product versus another. And all 3 of those type of things, we think, can lead to nice operating margin expansion.

Okay. I'm glad you mentioned Golden Dome, and I'm glad you did because people generally think about security products, and we've talked about ports and borders, and we talked about airports and not necessarily thinking about the company in a military context. Can you talk about what you guys do in radars and how that's relevant to missile defense?

Sure. So about 18 months ago, we completed an acquisition of an RF and a radio frequency solutions company. At the time we did the acquisition, I'm not sure the words Golden Dome existed. So it certainly wasn't part of the underwriting of our acquisition. And this is an acquisition that's performed incredibly well for us out of the gate over the past 18 months, where we've had significant revenue growth, significant bookings. So we took basically their strong products and technologies, and we put it in and combined it with our larger sales channel, our larger balance sheet and the like, and we've seen just tremendous momentum. I think in the September quarter, we had, I think, a 3.3 book-to-bill ratio in this business, strong bookings again in the December quarter and all this being very exciting. So the business is doing great. Now we layer on Golden Dome, which came in, we're part of the $151 billion IDIQ, along with numerous other companies. But we believe we are extremely well positioned for it using our over-the-horizon radar products. These are classified programs, so we can't go deep into exactly what we do. But I would say, suffice it to say, we think we're extremely well positioned for Golden Dome and would anticipate we'll be seeing some nice orders in this business, which should be very, very favorable for us. In that regard, we increased capacity, manufacturing capacity in this business. We moved into -- we began to move into new facilities in November of '25, and we'll be continuing that move throughout calendar '26, and we'll be out of our current facilities by the end of this year. And the timing couldn't have been better. I mean we needed the extra capacity just for our own existing business even before Golden Dome. But with Golden Dome, it provides even more room for us to grow in a significant way.

And is that something where the company is selling directly to a military customer? Or are you part of a team with a prime contractor?

The answer is both avenues are available to us. So we do have direct talks directly with the U.S. government, and we also have discussions with prime contractors.

Okay. Okay. And the growth that you've seen in that business thus far has been mainly domestic. It's with the U.S. DoD?

So it's been a combination. We've seen domestic growth, but we also sell to a number of countries as well. So we've seen broad-based global demand, which is one of the things I think OSI Systems kind of brought to the table being with our global footprint. So the U.S. opportunities are very robust, but international opportunities are nice, too, that we've won and continue to pursue.

When you sell those products internationally, RF and over-the-horizon radar products. Are those foreign military sales? Or can those be direct commercial sales to the customer?

Yes, they have not been part of the FMS program. They are direct sales.

Sales -- very -- I would imagine then very -- profitable.

They are. They are very much in line with our overall security margins, which are nice and strong.

Right. Right. Okay. Okay. And we talked a little bit earlier, you mentioned the demand around the World Cup. When we see events like that, is that something that ever kind of -- we ever would see in the quarterly results? Or is it something that just kind of is in the numbers and part of the business, and we don't -- there's often events going on, and we wouldn't necessarily recognize it.

It depends on the event. We've been very strong winning many of the Summer Olympics, many of the Winter Olympics, many of the World Cups, Super Bowl, things like that. Oftentimes, they're nice revenues, but it won't move the needle in a quarter, but it's great from a marketing perspective and otherwise. But then there'll be other events such as the Summer Olympics, which can be very meaningful. And we anticipate the '28 Olympics could be meaningful if we're to win that. We recently did the past Olympics in Paris and the like. So great from a marketing perspective, nice from a profit perspective. But in terms of moving the needle, Summer Olympics will probably move it more than other events.

Okay. Okay. I think for most investors, I kind of think about the security products business as kind of the core of the company, but there are 2 other segments within OSI. Maybe you can give us an update on Optoelectronics and prospects for that business.

Yes. We couldn't be more proud and excited of what our Optoelectronics team have done. In Opto, we serve a variety of customers in aerospace and defense, medical, automotive, industrial, technology and the like with no customer concentration. And in addition to serving all these Fortune 500 type companies, we also supply many of the key components that go into our security products and into our health care products, which is how everything is sort of tied together. So through that vertical integration, we end up enhancing the gross margin, control the supply chain, we could be a little bit more responsive to our customers. Our Opto team has just done a great job. I think in the first 2 quarters of the fiscal year, we grew 11%, 12%, which is fantastic. It's a business that we show a little bit of operating margin expansion mostly on a year-over-year basis, generates very strong free cash flow. The team has done a great job getting new business in a variety of ways. One is, we serve numerous very, very large companies and oftentimes in a program or 2, just mining new business out of those very, very large companies, and the team has done a good job of that. Second is, of course, attracting new customers. And then the third is there's a number of companies who have had China as part of their supply chain where there's a desire to move away from China. And we have a footprint globally. So if they want to remain in Asia, we have operations in Malaysia, Indonesia and India. If they want to nearshore, we have Mexico in addition to U.S., Canada and the U.K. So the team has done a really great job getting new business, having strong bookings, good book-to-bills and have really just been delivering quarter after quarter.

You mentioned aerospace and defense is one of the key end markets for Opto, and we see the growth that's been in the defense budget, growth that could be ahead of us in the defense budget. Is that something that moves the needle in that business?

Yes. We're very focused on the aerospace and defense business. A lot of the high rail or high reliability products go into that, which while smaller dollars carry a nice margin and the like. So we look at that as a big opportunity, particularly in today's landscape.

Yes. And that's -- if I recall that, that's a fairly global business in terms of the footprint. And so do you -- I mean do increasing European defense budgets create an opportunity for the Opto business or in Asia?

You're absolutely right. We're seeing quite a bit of activity in Europe in addition to the U.S. We don't see quite as much out of Asia, but the EU is a very fertile territory for us there.

Right. Okay. And the -- and I assume there's no -- you have U.S. operations on the defense side that can be completely separate. And so even though it's part of a global business, there's no issue with supplying for U.S. military?

No issue whatsoever.

Yes. Okay. Okay. Excellent. Maybe we'll take a brief pause to see if there's any questions in the room. But we can also continue to talk about the third segment, which is Healthcare. And I guess you guys made an effort to kind of retool that business starting maybe towards the -- I guess, towards the end of '24 or so. Can you talk about the progress there?

Yes. Yes, we're very excited about the progress. We brought on a new President just about a year ago in this business. Over the past 6 or 7 months, he's really retooled his team and brought on a number of new senior management personnel. We think we probably have the highest quality team that we've ever had in a number of different disciplines. And we're seeing that beginning to yield dividends for us. The excitement for this business is as we launch our next-generation patient monitoring platform, which we hope to launch the first phase towards the end of this calendar year or so, and it's a multiphase approach. But we think that can really get the top line engine going quite nicely. And this business has the highest contribution margins of any of our divisions. So even though it's a small business, under 10% of our revenues and even a smaller percentage of our profits, for every incremental dollar we sell, more drops to the bottom line than any of our other businesses. So we're excited about the future prospects.

Right. Okay. And how long do you think it will take to get a sense of how that's working out?

Yes, it's a good question. I mean I think we'll gain confidence as time goes on. But I think as we get into calendar 2027, we'll start to have a feel for that. But in the meantime, even before the next-generation patient monitor launches, some of the initiatives that are being put into place, we think will drive better results over the next 4 quarters and the like. So we're excited about the business.

Excellent. I guess when you think about cash flow, you talked about the benefits that should be coming from collections from customers in Mexico. When we think about CapEx, a fair amount of growth ahead. Is there a need to step up capital investment in the coming years?

Yes. I guess the good news for us is we're fairly light from a capital intensity perspective. So when you look at our CapEx sort of year-over-year, it's not too significant. Where it can increase and increase in a good way, and we wish this happens more and more is when we do the turnkey programs or the security-as-a-service because as we place the equipment out there and it sits in our balance sheet, that is treated as CapEx. And that's what we actually want to have happened. Absent that, we don't think there's a massive need for additional capital as we grow. We think we have ample capacity. We'll continue to invest, but CapEx is just not overly significant for OSI as we sit here today.

Right. Okay. Okay. When you -- when we think about some of the strong cash flow that's ahead of us, how do you think about what to do with that cash? What are your capital deployment priorities?

Yes. So kind of from a capital allocation perspective, we kind of look at 3 things principally. And we don't look at these 3 things as necessarily being mutually exclusive. At times, we can do all 3. But the first is M&A. We think we have tremendous organic growth ahead of us. So by no means do we feel compelled to do any acquisitions. But we've always done acquisitions over the last couple of decades, and the acquisitions have contributed very nicely. We're a very disciplined buyer and the like. But I would envision that M&A, particularly in our Security and Opto divisions, will continue to be a part of our overall growth strategy. Second, we do stock buyback. So we bought back some significant stock in November, a few months ago. And I would imagine that we'll continue to buy back stock over time. And then any excess cash we have, we sometimes use to pay down debt.

Okay. When you look at M&A, when we think about your position in ports and borders, you're the #1 provider and maybe in airports, #2. So leading market position. Is there -- do you think there is an opportunity from a concentration and regulatory perspective for the company to do M&A?

We do think there's a real opportunity. We think there's opportunities to fill channel needs, technology needs, maybe take out a competitor. Of course, we'd always sort of look at antitrust, but we can also look at natural adjacencies, a little bit like the RF business that we bought in 2024 that might not have been straight down the middle of the fairway, but made total sense using a similar customer base and allowing us to greatly expand their business. So we think there's kind of great opportunities for us to continue to pursue M&A and Security.

Okay. And when you -- when things come across your desk that you see, I think in a lot of areas in the A&D space, the sense is that valuations are quite high. Is that something that you've observed as well?

We've always observed that over time. I mean there's always a disconnect between the buyer -- what the buyer thinks it's worth and maybe what the seller thinks it's worth. And it takes time to have a meeting in the minds and sometimes bridging that with contingent consideration like earn-outs and the like. But we're a company that historically has been disciplined, and we're willing to wait it out for the right valuation. And because we have such strong organic growth, we believe, ahead of us, we don't feel compelled to do an acquisition for the sake of growth or for the sake of anything else. So we'll continue to be disciplined in that approach.

What's the right level of leverage for the company?

Yes. So now we're -- I think we're levered just over 2x, which I think most would -- net leverage would be considered very, very modest. We're traditionally more conservative. But for the right acquisition and with the ability to rapidly delever, we would lever up to 3.5 or more times if we saw a path to delevering. We did that when we took out a publicly traded company called American Science and Engineering a few years back, which has been not just a home run, probably a grand slam acquisition for us. And we did just that. I think we levered up to the mid-3s. And within 2 years, we were levered back to approximately where we are today. So we would consider that for anything that we thought was very strategic and value creating for our shareholders.

Excellent. Excellent. Maybe moving back to another topic, which is the top line. We'll be looking out for the orders from Department of Homeland Security. Are there other international opportunities on the horizon that you would point to in the near term that people should be looking out for?

There's a number of opportunities on a global basis outside the United States. However, they just usually are not well known or public. So the sort of the first time investors or the sell side can become aware of them might be the time they're announced because they're just -- they're private -- they're tenders that don't become public until the deal is already done.

Based on what's out there, I mean one of the things that I found kind of -- actually kind of impressive over the last couple of years, we've seen sales grow significantly. I think the backlog has been fairly steady in that $1.8 billion range over a couple of years now. Do you see exiting this year or at some point during '27 seeing sufficient demand to bring that backlog higher?

Yes. So I know some of the concern a couple of years ago was when we won the big Mexico contracts, and we converted that backlog into revenue that our backlog would come down and our revenues would come down. And we said we didn't think that would be the case over this period of time, which has proven to be true. So to your question, yes, we think as we go out through this calendar year, we think there's great opportunities through some of the bookings that we may get to continue to expand the backlog and give us even greater visibility towards the future.

Right. Okay. Okay. Excellent. Well, we're down under 30 seconds here. So I just want to make sure, is there anything we didn't cover that you think we should highlight?

I think you covered all the main things. And with the big game tonight, I'll say go USA in the World Baseball Classic.

Yes. Yes. Okay. Excellent. Very good. Well, Alan, thanks so much for being here. Really appreciate it. Thanks, everyone.

Thank you.