OSI Systems, Inc. ($OSIS)

Ladies and gentlemen, thank you for standing by. At this time, I would like to welcome everyone to the OSI Systems, Inc. Third Quarter 2026 Conference Call. [Operator Instructions] I will now turn the conference over to Alan Edrick, Chief Financial Officer. You may begin.

Thank you. Good afternoon, and thank you for joining us. I'm Alan Edrick, Executive Vice President and CFO of OSI Systems, and I'm here today with Ajay Mehra, OSI's President and CEO. Welcome to the OSI Systems Fiscal '26 Third Quarter Conference Call. We are pleased that you can join us as we review our financial and our operational results. Before we discuss these results, I would like to remind everyone that today's discussion will include forward-looking statements, and the company wishes to take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 with respect to such forward-looking statements. All forward-looking statements made on this call are based on currently available information, and the company undertakes no obligation to update any forward-looking statement based upon subsequent events, new information, or otherwise. We will also reference both GAAP and non-GAAP financial measures. Applicable reconciliations are available in today's earnings release. We delivered solid third quarter financial results, setting fiscal Q3 records across multiple metrics, despite facing the most challenging year-over-year comparison of fiscal '26, primarily driven by our Mexico contracts. The company's revenues reached a fiscal Q3 record of $453 million, and non-GAAP earnings per diluted share set a fiscal Q3 record of $2.60. Importantly, excluding revenues generated by the large Mexico security contracts in both periods, Security revenues grew 25% year-over-year. Our Optoelectronics and Manufacturing division also performed well, posting 10% growth and a Q3 record for that division. Bookings were strong, with a 1.3x book-to-bill ratio driven by both Security and Opto, resulting in a record backlog, highlighted by the previously announced homeland defense award, about which Ajay will provide more information shortly. On the cash side, we generated $14 million in fiscal Q3 operating cash flow, despite limited collections in the quarter on the receivables in Mexico. Shortly after quarter end, we collected approximately $74 million of the largest Mexico receivable, a strong start to Q4 cash flow. Before diving more deeply into our financial results and discussing our outlook for fiscal '26, I will turn the call over to Ajay for our business and operational discussion.

Thanks, Alan, and thank you, everyone, for joining us today. I'm pleased to be here to discuss our third quarter results for fiscal 2026. We delivered another quarter of solid execution and ended the quarter with a backlog of approximately $1.9 billion, the highest in the company's history. We remain focused on execution, leveraging our strengths in key markets, and utilizing our global operating model as we finish Q4 and head into fiscal 2027. Let's turn our businesses to discuss Q3 performance in more detail, starting with Security. As expected, Q3 performance was up against difficult year-over-year comparisons, primarily due to our Mexico programs transitioning from significant product sales to long-term related service and support revenues. Despite that, Security performed well with solid bookings, top line growth, and operating margin expansion. Furthermore, we continue to be very active with customers across aviation, ports and borders, and defense-related applications. Bookings were highlighted by a sizable award from homeland defense of an Undefinitized Contract Action, or UCA, with a not-to-exceed value of approximately $235 million for the production and integration of a homeland defense over the horizon radar transmit subsystem. We continue to build strong traction with our RF-engineered solutions and are hopeful that there may be additional opportunities in this area for future business. In addition, these capabilities position us well to further support Golden Dome, the U.S. initiative to create an integrated missile defense system. As you know, we are a participant in the $151 billion SHIELD IDIQ, which we announced last quarter, and we look forward to the opportunities that may arise from this initiative. During Q3, we also received several international awards for cargo and vehicle inspection systems and airport screening solutions. In addition, we were an integral part of the security at the Milan Winter Olympic Games, providing our products to screen participants, officials, fans, as well as their baggage and cargo. Towards the latter half of Q3, we began to see initial impacts from conflict in the Middle East. Certain programs' activities have been delayed by factors such as logistic constraints, travel restrictions, and heightened security protocols. Certain customers in the region are facing pressure from disruptions tied to the conflict. If the situation persists, we could see further impact on the timing of order intake and project completion time lines. That said, once the region stabilizes, we could potentially see even stronger demand for our Security solutions. In the U.S., the order activity for Security products was impacted during the quarter by the shutdown at DHS, which delayed the procurement of our products and services to support U.S. border initiatives. Now that the shutdown has ended, we are hopeful for order patterns to normalize over the coming weeks and months. And I want to emphasize here that these are timing-related dynamics rather than changes in the underlying demand. In the U.S., we're also excited about the potential of our Security solutions for high-profile upcoming events, such as the FIFA World Cup '26 soccer tournament and the 2028 Olympics. Furthermore, in the U.S., the roughly $1 billion outlined in the One Big Beautiful Bill for NII equipment remains a significant growth opportunity. And, of course, during the shutdown, the spending resulting from this bill was delayed in Q3. Turning to Optoelectronics and Manufacturing. Q3 performance was again strong as revenues increased 10% year-over-year with the book-to-bill ratio well exceeding 1. In March, Opto received a $40 million award for the electronic subassemblies from a medical OEM, a significant award in a division where most orders are under $5 million. Customers continue to value our vertically integrated model and global manufacturing footprint as they diversify supply chains and launch new products. Our global Manufacturing footprint across Malaysia, Indonesia, India, Canada, Mexico, the U.K., and the U.S. allows us to offer customers attractive combinations of value and scalability. Opto's backlog remains at record levels, providing great long-term visibility across aerospace, defense, medical, industrial, and other end markets. And finally, our Healthcare division, which continues its path of improving operations and focusing on new product development. In Q3, Healthcare was adversely impacted by order timing, most notably in the U.S., resulting in lower sales and profitability. On the flip side, we did see growth in the EMEA region during the quarter. As you may know, Healthcare's products generally carry the highest contribution margins at OSI. So even modest revenue growth has an outsized impact on profitability. Looking at OSI Systems overall. Our financial position remains strong. The robust and growing backlog, year-to-date cash flow generation, and a healthy balance sheet give us continued confidence in the company's prospects. In addition to large program opportunities highlighted earlier, we remain focused on increasing our mix of recurring revenues through expanded service and support agreements. As always, I would like to thank our employees, customers, and stockholders for their continued support and dedication. With that, I will turn the call over to Alan to discuss our financial results in more detail before we open the call for questions. Thank you.

Well, thank you, Ajay. Now let's review in greater detail the financial results for Q3. Let's begin with a look into our revenues by division. Security division revenues in Q3 came in at $319 million, driven by higher service revenues, an increased contribution from the RF business, which has been effectively integrated into our overall operations, and increased aviation product revenues. As expected, revenues from our large Mexico Security contracts decreased to $11 million in Q3 fiscal '26 from $69 million in Q3 of the prior year. Excluding the Mexico contracts, Security's revenues surged 25% year-over-year, reflecting healthy growth across the broader Security portfolio. Fiscal Q4 is expected to experience a reduced revenue impact from Mexico in comparison to Q3, with the magnitude of this headwind expected to largely roll off as the company enters fiscal '27. Our Optoelectronics and Manufacturing division had another excellent quarter. Opto sales, including intercompany, increased 10% year-over-year to $111 million, a new Q3 record for this division. This was driven by sales growth across our diversified product and customer portfolios. And as described earlier, Healthcare division sales were soft. Our Q3 fiscal '26 gross margin was 33%, slightly down from the same quarter in the prior year, as a less favorable revenue mix on product sales outweighed an increase in gross margin from higher service revenues. Our margins can fluctuate based on product and service mix and volume, supply chain cost, FX, tariffs, among other factors. Moving on to operating expenses. SG&A expenses in the 2026 third fiscal quarter were $71.5 million, down 2% from the prior year fiscal Q3 and representing 15.8% of sales compared to 16.5% of sales in Q3 last fiscal year. We continue to work diligently across all divisions to manage our SG&A cost structure efficiently. R&D expenses in Q3 were $19.5 million, or 4.3% of revenues, up from $18.6 million, or 4.2% of revenues in the same quarter last year. This increase stems from our commitment to investing in innovation, resulting in market-leading offerings in Security and positioning OSI well for the future. We expect to continue our heightened R&D efforts to advance key initiatives. Even with these R&D investments, our combined SG&A and R&D expenses as a percentage of sales have decreased annually for each of the past 8 years, underscoring our ability to drive operating efficiencies while still funding growth initiatives. Now moving below the operating line. Interest and other expenses, net, in fiscal Q3 was $4 million, down from $8.2 million in the same quarter the prior year, primarily due to reduced borrowing costs. Our effective tax rate under GAAP was 18.3% in this Q3 versus 14.3% in Q3 last year. Excluding discrete tax items, our normalized effective tax rate, which is the rate used in calculating non-GAAP EPS, was 23.6% in Q3 this year compared to 23.7% in the same prior year quarter. On a non-GAAP basis, our Q3 '26 adjusted operating margin of 14% was comparable on a sequential basis from Q2 and slightly below the prior year third fiscal quarter. The Security division's adjusted operating margin expanded from 18.1% in Q3 last year to 18.3% in Q3 of fiscal '26, driven by growth in higher-margin Security service revenues combined with reduced operating expenses. This, though, was offset by the other 2 divisions. The Opto adjusted operating margin decreased to 13.5% in Q3 this fiscal year from 14.0% in last year's fiscal Q3 on a less favorable mix of revenues. The adjusted operating margin of our Healthcare division was negligible due to the sales level. As Ajay mentioned, we expect margin recovery as Healthcare performance improves. Moving to cash flow and the balance sheet. We generated $14 million in Q3 operating cash flow despite limited collections in the quarter on our largest receivable in Mexico. However, as mentioned earlier, not long after quarter end, we received a payment of approximately $74 million from our largest Mexico customer, providing a strong start to our Q4 cash flow. Operating cash flow for the first 9 months of fiscal '26 was just shy of the amount for all of fiscal '25. DSO increased 7% from fiscal Q2. Current expectations are that DSO will decrease by fiscal year end. We expect substantial cash inflows in Q4 and into fiscal '27 as we continue to collect on the Mexico receivables, which should lead to sizable operating cash flow and strong free cash flow conversion. CapEx in Q3 was $8 million, while depreciation and amortization expense was $9.5 million. Our balance sheet remains solid. We ended the quarter with $345 million in cash. Our net leverage at the end of Q3 fiscal '26 was approximately 2.2x, as calculated under our credit agreement. Now turning to our guidance. We are maintaining our fiscal '26 guidance for revenues and non-GAAP earnings per share. The recent shutdown of the Department of Homeland Security and the conflicts in the Middle East have impacted short-term bookings and could impact near-term Q4 revenues, but looking out further, resolution of each of these matters, one of which has just been done, could potentially represent future opportunities for the company. We note that our fiscal '26 non-GAAP diluted EPS guidance excludes any impact of potential impairment, restructuring, and other costs, amortization of acquired intangible assets and their associated tax effects, and discrete tax and other nonrecurring items. We currently believe this guidance reflects reasonable estimates. The actual impact on the company's financial results of timing changes on the expected conversion of backlog to revenues, new bookings, timing of cash collections, tariffs, the recent DHS shutdown, the conflicts in the Middle East, and supply chain disruptions, among other factors, is difficult to predict and could vary significantly from the anticipated impact currently reflected in our guidance. Actual revenues and non-GAAP EPS per diluted share could also vary from the guidance indicated above due to other risks and uncertainties discussed in our SEC filings. In summary, we delivered a record fiscal Q3, driven by our 2 largest divisions, a record backlog, providing multiperiod visibility, and we also made a meaningful cash collection in the beginning of Q4 that further enhances our balance sheet. We remain committed to operational excellence as we grow our businesses and deliver innovative products and solutions to our customers. We aim to invest in key strategic areas with the goal of driving long-term value for our shareholders. Once again, we thank the entire global OSI team for their dedication to supporting our customers and partners. Their efforts are what make our results possible. And at this time, we'd like to open the call to questions.

[Operator Instructions] Your first question comes from the line of Larry Solow with CJS Securities.

I guess the first question, we know Mexico is going to be pretty slow. So the 25% growth you've seen outside Mexico, where is that coming from, I guess, geographically? And just on the product mix, is most of that still ports and borders, vehicle inspection? I'm just trying to figure out if you could parse out -- give us a little color on the origin of the growth.

Larry, this is Alan. Good question. We're seeing the growth in a bunch of different areas. First off, geographically, we're seeing most of the growth internationally. As we look forward with the ending of the DHS shutdown, we foresee the U.S. picking up steam significantly as we enter fiscal '27. But to date, most of the growth has been driven internationally. And we're seeing it across a wide variety of our areas. We're seeing our service revenues increase nicely. We're seeing our aviation revenues increase nicely. We're seeing our RF revenues increase nicely. And that's predominantly what's driven most of the growth that we're seeing outside of Mexico, as we mentioned.

And the RF contract that you got, the Golden Dome contract that you announced, you announced at the end of April, but I guess it was in your -- was it actually obtained before the end of the quarter? Is that -- because it sounds like that order is clearly in the backlog and the book-to-bill for the quarter, correct?

Yes, it came in -- this is Ajay -- came in at the end of March.

And I guess you were just delayed because of the government shutdown, or any reason why the release wasn't put out?

Larry, it just takes a little bit of time to go through the various sequences in order to get a press release out and get the appropriate approvals to do so.

And just on the government shutdown or delays and whatnot, it sounds like it certainly has impacted your bookings a little bit to date, maybe a little bit more Q4. And has it impacted revenue at all to-date? It sounds like maybe no, but there is potential in Q4. Is that kind of what I hear?

So I think that what I pointed out earlier was, yes, it's impacted some bookings. But really, it's a timing issue. I mean, that's really what it is. So we think that those bookings and, like I said, the $1 billion Big Beautiful Bill is still sitting there. So yes, it did. I think in Q4, we're hoping things start loosening up for the next few weeks to a few months. And it may have a slight impact, but we'll wait and see.

Your next question comes from the line of Christopher Glynn with Oppenheimer.

Just want to ask about the services revenue. So I know it wasn't going to be totally linear, but it was about 5% growth and had been consistently strong double digits. And my understanding was following significant sustained backlog growth for a few years that this would probably be double-digit grower compound pretty consistently. Is that still an appropriate view? Or should we view it as maybe stepping down to the single-digit profile going forward for services?

This is Alan. Good question. What we saw throughout calendar '25 for 4 straight quarters was very strong double-digit growth in service revenues as our installed base increased significantly. In this particular quarter, we had mid-single-digit growth in our service revenue coming off of a little bit more difficult comp, and it also has to do with some of the timing of some of the installations that were done in prior quarters versus this quarter. As we look forward, we continue to expect to see very strong service revenues. I think there'll be certain periods where we'll see good double-digit growth. There'll be other periods where it's single-digit. But overall, we expect to see nice growth in our service revenues, which is nice because it inherently carries a higher margin associated with it.

Okay. So, Alan, it sounds like you expect it generally over the next 1 year or 2 years to be outgrowing equipment. Is that right?

It can be. It all depends. So for instance, as we begin to...

I get it. It can be a little nebulous, yes. Yes, not trying to pin you down.

And we expect strong product revenue growth as well. And with the strong product revenues we're expected to have as well.

Okay. And then on Security margins, you've effectively run down the Mexico revenues, which you've described as really efficient production runs. And so should services be in a pretty consistent margin expansion trajectory from here?

Is the question, will the service margin continue to increase from here?

Yes. Now that you've had a couple of years where it's been flat to down slightly as you've wound down the Mexico revenue, which you have described as very efficient production runs. And if that's all taken out of the base period and you continue scaling, just wondering if there's any reason why we shouldn't expect consistent margin expansion at Security from here.

The goal in Security is always to couple top line growth with operating margin expansion, and that's what we look to do over the long term. There will be certain quarters or periods where based upon the mix of the revenues, particularly the mix of the product revenues, may not necessarily lead to that end result. But over a longer-term basis, that's absolutely the goal and the intent of the company.

Your next question comes from the line of Josh Nichols with B. Riley.

Great to see the record backlog and book-to-bill yet again. And despite the DHS shutdown, now that that's back open again, just curious, are there any specific mechanisms by which the CBP procurement resumes post shutdown? Or do you expect there to be a relatively quick uptick in order activity between now and your fiscal year end at the end of June?

This is Ajay. I think it's going to be relatively quick over the next few weeks, maybe some months. But there's really no restriction that we can see that they can't resume stuff. It's just people coming back in, takes some time to get everybody working. And concentrating on [ letting out ] orders instead of where the funding is going to come from. So we feel good about it. But I think over the next few weeks, time will tell, but we are very encouraged that the shutdown is over.

And then I wanted to touch on, I guess, 2 things from my last 2-part question. One, this $235 million homeland defense contract, I think that's much larger than anyone was anticipating. You touched on SHIELD. Do you see any other large opportunities within that piece of potential business that you think the company is in good position to secure? And lastly, just, Alan, maybe for you, a question on post this $74 million Mexico account receivable that you guys got, how would you characterize the Mexico-related AR levels today?

I'll take the first part. We obviously are very happy and proud of this contract we got. It basically demonstrates our technical expertise out there, some of the products we have out there were well considered by the government and other customers. Yes, there are opportunities out there. I'm not going to sit here and try to quantify them. It's a very new market. We're all looking at it. But I think by the size of the order and what the future holds, we'll wait and see over the next few quarters. But it's a great start, and we feel very good about it.

And this is Alan. So the second part of your question, Josh, on the Mexico receivable, with the recent receipt of the $74 million, it certainly reduces the Mexico receivable balance. That being said, there's ample opportunities for significant cash flow as we collect on this receivable over the coming months and quarters. So we would expect the free cash flow conversion to be quite outstanding here over the foreseeable future.

Your next question comes from the line of John Godyn with Citi.

This is Bradley Eyster on for John Godyn. So I just want to take a step back and look at the bigger picture on the opportunities you're seeing, particularly around the airport security demand side, and I appreciate that you touched upon the potential supply chain challenge that you're seeing given the dynamic macroenvironment. But that same school of thought with the reduction of flight capacity to various degrees, concerns over jet fuel cost/availability, I know it's still early days, but have you guys seen any impact to the demand for these services? Or is there any timing impacts [ creeping ] up from this?

I mean, it's a great question. I think overall, after a conflict ends, unfortunately, being in the security business, it's always that things tend to pick up. Are there some temporary disruptions in the Middle East, et cetera, because of aviation? Yes. But I think we've got to look at it from an overall standpoint that as and when this gets put behind us, we think we'll see not just aviation, but overall, we think we'll see an uptick potential in our business.

I just want to touch upon the opportunities on Golden Dome and SHIELD that you're pursuing. So I'm just curious, more in the medium to longer term here, potentially. So how would you measure off the competitive landscape here for the RF protection side specifically. Just curious what kind of update you can provide on any kind of traction in interest you're getting from customers here would be helpful.

I think that we've been talking about it for several quarters. Like I said, we're -- this initial contract has been very good for us. We announced smaller contracts last quarter. We think there's a lot of momentum going forward. But honestly, I think there's a limited amount what we can talk about because of what type of contracts these are. But I think the future looks good. The timing, we'll just have to wait and see.

Your next question comes from the line of Seth Seifman with JPMorgan.

This is [ Rocco ] on for Seth. Should we think about the homeland award and possible similar awards in the future as supporting the longer-term growth in the Opto segment? And how should we be thinking about the top line growth in 2027 following the low double-digit pace this year? Could it be one of the faster growers next year?

First of all, this is in the Security segment, the Golden Dome, that's where it falls. On the Opto side, we think that, yes, there is room for potential growth as we go forward. We've talked about it before. There's definitely a movement away from China. And with our capabilities, like I mentioned in my remarks, all over the world, not just in Asia, but in Europe and the U.S., from a Manufacturing basis, we provide a lot of flexibility to our customers. So we feel good as we move forward. Obviously, there are always a little bit of ups and downs there. But overall, I think Opto is in a good position.

[Operator Instructions] Your next question comes from the line of Jeff Martin with ROTH Capital.

I wanted to dive into the RF business a bit more. Are you able -- Alan, are you able to give us the revenue number from that business for the quarter? And then, I believe you were ramping up additional production facilities there. Curious where you're at today in production capacity relative to the homeland defense contract.

I can go through the actual numbers. But we started ramping up the production capabilities and moved into new facilities over the last several months, but we made that decision a while ago. And frankly, it looks like a very good decision. And so we've ramped up that capacity. We'll keep on ramping it up. Like I said, we're in a new facility, and we feel good about what we could do and offer the government in terms of being able to turn around product a lot faster than we were able to maybe 1 year or 2 years ago. You want to take the second part, Alan?

Sure. Yes, we were pleased, Jeff, with the revenues in the RF business. I believe it was a new record for us. We did about $38 million in the quarter. So the run rate of that business has significantly increased since the time of acquisition 18 months or so ago. So we're very pleased with the trajectory.

I know you're not in a position to really give any guidance beyond this year, but just curious qualitatively, how you're thinking about growth and your growth prospects in fiscal '27 and '28.

This is Alan. So good question. And you're right, we'll be giving our guidance for fiscal '27 on our next call in August. That being said, we're optimistic for growth as we move into our new fiscal year, just 2 months from now. So we're excited to close out Q4 and fiscal '26. But with the strong backlog and robust opportunity pipeline that we have out there, fiscal '27 could be a very, very exciting year for us.

And last one for me is, you've been historically a very value-oriented buyer on the M&A front. A lot of those have produced very good returns. I think the RF business is a case in point. Just curious if you're seeing other opportunities out there that are similarly interesting? And are there areas from either a market expansion standpoint or a technology expansion standpoint that you're looking at that could move the needle over the next couple of years here?

We're always looking at opportunities. I mean, that's just part of it. And as Alan has pointed out before, we have a lot of dry powder available for us. And I think we look at, from a technology standpoint, obviously, we want to make sure that 1 plus 1 everybody says 3, I always say maybe more. But there are opportunities. I really don't want to get into specifics, but we're always actively looking. But we're not going to do anything unless we feel it really makes a difference from a strategic as well as from a business perspective as we move forward.

There are no further questions at this time. That concludes the Q&A session.

Once again, thank you all for attending our conference call. We look forward to speaking with you during our next earnings call following the completion of our fiscal year. Thank you.

Ladies and gentlemen, that concludes today's call. Thank you all for joining, and you may now disconnect.