OSI Systems, Inc. ($OSIS)

And I'm here with Alan Edrick at OSI Systems. Thank you for being here with us.

Thank you. Nice to be here.

So I'd like to start this fireside chat usually for the audience that sometimes is an industry audience. A little bit of a business overview. What do you guys do?

Yes. So big picture, we have an exciting company. We have 3 divisions. We have a Security division. We have a Healthcare division, and we have an Optoelectronics division, which sort of ties everything together. Really from a big picture perspective, roughly in rough order of magnitude, about 70% of our business is security, a little over 20% is optoelectronics and a little under 10% is our healthcare business. We find that most of the investors are primarily interested in our security business. We believe we're the leading security detection company in the world. And security detection means what we're doing is we're doing security at aviation, at airports, at ports and borders and critical infrastructure, at sporting events and the like. And over time, we've captured significant market share to become what we believe to be the #1 player in the world. In our optoelectronics space, we do sensors, we make sensors, detectors, other electronic components, and we're an OEM supplier. So we supply to the Fortune 500 in industrials, probably many of the companies who are here at this conference, in aerospace and defense, and medical and a number of other industries. But in addition, our optoelectronics supplies many of the key components that go into our security products and many of the key components are going to our healthcare products. So through that vertical integration, we're able to enhance the margin and control the supply chain, be a little faster and more responsive to our customer needs. And finally, our healthcare division, the smallest division that we have, we serve hospitals. We make products in patient monitoring and cardiology, and then we have a lot of recurring revenue through service, spare parts and consumables.

So you just touched base on that Opto business, and that is the synergies. When did you realize that it was important to have that vertical integration? And have you seen any needs to actually expand that vertical integration to actually manage your future and your supply chain?

Yes. So interestingly, we started out as an optoelectronics company, and we expanded into security, and we expanded into healthcare. So vertical integration has always been ingrained as part of our DNA. And the more stuff that we can bring in-house and capture that margin and control the supply chain, the better for us. And what we've been seeing through the course of the years is just that. We have brought more and more in-house. We've seen those intercompany sales expand over the years. And while those revenues are ultimately eliminated in consolidation, the margin remains in-house and helps our earnings per share.

So when you think about M&A, how much focus you have into expanding into like new opportunities versus actually managing down your supply chain?

Yes. So when we think about M&A, we look at the entire spectrum. We're looking at acquisitions that will fill a need for us, a channel need, a technology need, perhaps take out a competitor. We may look at stuff that will help on the supply chain side as well, but it's usually much more strategic from a business and a financial perspective.

Perfect. So now I'm going to switch gears to security that mostly about the SEDENA Mexico contracts because honestly, I don't know, 95% of the conversations I got over the last two years were related to these type of contracts. Right now, like in your top line, most of that risk is gone and you have been able to fill that risk. How should we think about from a top line revenue perspective, how much is the Mexico-related services and support revenue that will kick in?

Yes. So you're absolutely right. We've been getting a lot of questions on Mexico lately. Mexico has been a fantastic opportunity for us. We received three contracts totaling north of $800 million a few years ago. We've been fulfilling those in our fiscal '24, '25, this fiscal '26, continue a little bit into fiscal '27. And as we've had that, a lot of the questions from investors were fantastic winning the orders. But as you convert the backlog to revenue, is your backlog going to come down? Are you -- is your revenue is going to come down? And over the years, we had said no. We have a tremendous pipeline of opportunities. And we've seen just that. Our backlog, even as we've converted significant backlog to revenue, our backlog has gone up. We finished the last quarter at a record backlog, and we filled that hole very successfully. And really, the exciting thing for us as we move into our fiscal '27, which is only 1.5 months away because we're a June 30 fiscal year, is unlike fiscal '25 and '26, where we had very difficult comps and a big hole to fill, which we think we've done. In fiscal '27, we don't really have any sort of material headwind related to Mexico any longer. So while there will still be a few more product shipments to go there, it does transition primarily to service revenue and our service revenue is very strong revenue and strong margins. So we're excited. So it's kind of a much more minimum headwind in fiscal '27 than we've seen before.

The other piece of those contracts is the receivables though. It's taking longer to actually be able to bill those deliverables and actually collect that money. What is the latest there? And when do you expect to actually recover that money?

Yes. So first off, we've been dealing with Mexico for a couple of decades. And we're dealing with the Mexican federal government, in this case, the Army and the Navy. And over the years, we've had a number of contracts with Mexico. They've paid us every single dollar, every single peso they owed us, generally speaking, not necessarily on time or when it's due, but we've gotten every amount of money we've had. We finished up our last quarter, the March quarter with about a $350 million receivable more or less from our key customer in Mexico. Subsequent to quarter end, I think we mentioned in our last conference call, we collected about $70-plus million on that. So it's come down. What that means for us and what really, really excites us for this other $270 million roughly is we're going to have extraordinary, we believe, free cash flow here over the next 12 months. The exact timing of which we don't know. I mean we believe because we're owed right now past due is probably something in the neighborhood of about $170 million because some of it isn't billed or isn't due yet. But this is normal course. This is very, very normal course for our contracts in Mexico, and we expect to fully get paid here over the next 12 months, hopefully even sooner.

So once this volatility is out, what is a normalized free cash flow conversion for a business like yours?

Yes. So over the next year, I think our free cash flow conversion is going to be nicely north of 100%, absent other things maybe potentially taking place. But what we've seen traditionally in our business is our free cash flow conversion is pretty close to 100% of net income, sometimes a little higher, sometimes a little lower, but our free cash flow conversion is very strong.

And you mentioned right before that this is normal business for you to deal with these type of like size of contracts, international customers, international governments. How much can you do to prevent this type of volatility from a contractual point of view? And if not, how do you prepare financially to be able to afford these type of opportunities at the end of the day if they were to come?

Yes. The good news is we love these contracts in Mexico. If we were offered these contracts 10 more times, we would take them 10 more times. They're great economically. It may take us a little bit longer to collect our receivables, but that's built into our overall business model. We have a very strong balance sheet. We have low net debt. We're sitting on a good amount of cash. We have a big credit facility that's untapped for our revolver. So we have plenty of capacity in order to take on contracts like this. Now that being said, we don't often get $800 million in 3 contracts like that. But if we did, our balance sheet is so strong that we can afford it. And it's -- if you look at it from a true economic perspective, it's a fantastic business proposition for us.

Have you seen any competitive advantages just from the willingness of taking that risk versus others or...

Oh, sure. So the knowledge we get, the business that we get, the references. So when we win business like that, other countries and other potential customers take note of those wins. Some of these wins were expected to be split amongst multiple parties. And at the end of the day, we ended up sole sourcing this. And that says a lot about our technology, our service offering, our reputation, our ability to deliver. And in fact, we've delivered exceptionally well, we believe.

Perfect. And sticking to international opportunities, we have seen some come from Latin America lately and Mexico has been super strong. Where else in the world are you seeing most of the incoming opportunities from?

No. The international opportunities have been strong for us. Over the last 3, 4, 5 years, the international growth has really driven our overall growth as a company. And the funnel remains robust. And we really see that in most regions in the world, not just Latin America, but the Middle East has been strong for us. Europe has been strong. Asia has generally been strong, not China. We don't do a lot in China, but other parts of Asia. So it's really kind of the entire world that has been strong, and we see tremendous opportunity going forward as well.

So before we jump into domestic opportunities, you just mentioned the Middle East. And in the first quarter, you saw -- you started to see some disruption there. How large is that business? How much it represents? How are you thinking about the disruption in the near term and opportunities as this conflict evolves? I don't know.

Yes. I mean the good news for us is we are the largest player in the Middle East for security detection, and we're the largest player by far. So we do a lot of business in a number of countries there. And when the conflict broke out in really the last month of the -- of our fiscal third quarter or calendar first quarter and continues, that has some impact on us. As you can imagine, in a short-term basis, countries aren't necessarily awarding necessarily new contracts, so it impacts bookings a little bit. But the exciting thing for us is both medium and long term, when these type of conflicts end, it generally means a lot of new business for us. So we're quite excited about that. We hope the conflict ends sooner than later. Potential impacts near term just could be continued on the bookings as well as certain deliveries. Now we have a lot of ways that we're able to maneuver certain things, but with the Strait of Hormuz closed, certain shipments that may go into the Middle East could be impacted. But that was all kind of built into what we said on our last earnings call.

Perfect. So now moving the focus to the U.S. The one big beautiful bill funded like over $1 billion for nonintrusive inspection machines. And because of the shutdown, that money hasn't flowed through the system yet. What are your expectations there?

Yes. This is super exciting for us. This is the type of money that we're seeing from the one big beautiful bill funneling to CBP, Customs and Border Protection, which is part of the Department of Homeland Security is very, very exciting. We expect very large orders probably starting 6 months ago. And of course, the government got shut down in October. And even when the government was reopened, the Department of Homeland Security, by and large, has been closed most of the time until just about a couple of weeks ago. So as we look forward, we are extremely excited about our positioning to get significant business. You mentioned the $1 billion plus for NII, the nonintrusive inspection scanning equipment, which is exactly what we do. In past awards, the most recent past awards for some big IDIQs, we got north of 40% of that business. Our hope is that we continue to maintain a very, very significant share. Our understanding is that we continue to be a preferred supplier for CBP. Our delivery and service was outstanding on these past contracts, and we think that plays a nice role. So our hope is that we're going to see some significant awards coming from the one big beautiful bill as well as some of the leftover money from the past IDIQ contracts.

So you mentioned your performance has been outstanding, and this is really interesting to highlight because there are many reports that actually say that in general, there is a lot of these assets and equipment that hasn't been actually installed that everything is lagging where they should be. What makes you unique? What -- where are you differentiated from a performance point of view? And what is your, I don't know, fair share to win from this opportunity considering your unique approach to CBP?

Yes. So on the last big IDIQs, I think there were three parties who received the awards. Again, we got more than 40% of it. While we delivered on time and we were always ready, government wasn't always necessarily ready. So some of the sites were delayed. So consequently, the program shifted a little bit to the right, but our performance was always spot on. We understand that might not have been the case with some of the other awardees on the contract. And we think that might position us well on new contracts. So what is our right for a fair share to win? We, of course, think the maximum, but the government generally does not sole source awards. So if we can keep the same type of market share percentage or potentially even higher, we'd be very thrilled.

Perfect. So when we think about this international growth supporting the backlog and [indiscernible] really actually most of the growth, the domestic opportunities, this mix between products and services, what does that do to margins? How should we think about like margins 3, 5 years from now?

Yes. So our goal is always to couple top line growth with operating margin expansion. And if you look at what we've done over the past decade, that's generally been our formula. As we look forward, so the last couple of years, we've had very, very strong product revenue growth from a lot of these international sales. And when you sell the products, they generally come with a 1-year warranty, maybe a little bit longer. But as they roll off of warranty, now you get this great recurring service revenue. And to your question, our service revenue generally carries more than 10 percentage points higher of margin. So we've seen very significant service revenue growth throughout calendar '25, and we expect to see nice continued service revenue growth going forward. So when you look at that, when you couple increasing service revenues at higher margin, coupled with economies of scale on higher product sales, our goal is to continue to grow the operating margins for the foreseeable future.

So how is that split today, like the recurring services versus products? And when you target opportunities, what could be your target in the future?

Yes. So today, our recurring revenue is about 30% in the Security division. We see that we could take that to 40% or higher in the future. All that is also, though, dependent upon the level of product sales we have. So while we expect to see very significant service revenue growth, there may be very strong product revenue growth sort of simultaneous with that. So that percentage mix may take a little bit longer to get to, but overall, still leads to very significant operating margin expansion. And when I say very significant product revenues, the one big beautiful bill that you just mentioned as well as some big orders that we've gotten on RF for Homeland Defense, Golden Dome, if you will, and the like, which is mostly product revenue at the outset. So very exciting times for us.

Before we touch base on RF because I think that's really interesting and kind of like new to you. When I think about margins on pricing, is there any difference for like international customers or regions versus domestic? What are the dynamics there?

Yes. There's no real set way of saying it. So every product might have a different margin depending upon the region, depending upon the customer and the like. So it's hard to draw sort of across-the-board inferences. At times, there'll be significant margins or at times, margins may be a little bit more compressed and then you get the much larger recurring revenue for many years. So it's not really a great general rule of thumb related to that.

So now switching to RF. You acquired that business, what, like 1.5 years ago. It's performing well like almost like quarterly revenues are matching like the annualized revenues of the business you acquired not so long ago. You just got what is like $230-plus million contract for over-the-horizon sensors. You were selected for the Shield Golden Dome contract. How do you think about like opportunities there? And why have you been investing into increased capacity to be able to afford those?

Yes. So this is a very exciting acquisition that we did about 18 months ago, as you mentioned, this should be sort of a case study in doing acquisitions. It hasn't been a single or double or a home run. It's been a grand slam so far. And the outlook going forward is even stronger than the strong performance that we've shown to date. The over-the-horizon radar technology that we have, the team has an excellent reputation. So as we acquired the company, we took these great technologies and products, some of the strong relationships the incumbent management team had. We supplemented that with our own internal resources, which were a little bit stronger as a larger company and our balance sheet, and it has afforded us the opportunities to bid on bigger projects and to win some of these bigger projects. And as you just mentioned, most recently, we were awarded this up to $235 million deal with Homeland Defense, very exciting for us. And we don't believe that's the end. We think there's much further opportunity there. So to your question on expanding capacity, we kind of saw this coming, not necessarily the whole Golden Dome award, but just the expansion of the RF business say, 9 months ago. And we began to expand capacity. We brought on new facilities that we began moving into in November of 2025 that will be completed with this year. This expanded our capacity by 3 to 4x, which proved to be very fortuitous as we're getting these larger orders. There may be opportunities to further expand based upon the strong demand that we're seeing out there today.

So if I were to think -- I'm going to annualize your first quarter revenues and you're running at a $150 million revenue line for that business. How much capacity -- like to what extent you can actually produce with the capacity you just increased?

Yes. So without sort of quantifying that today because we're increasing it today, and we're mostly running on a single shift, but we can move to 2 shifts or 3 shifts. We believe there's adequate capacity to improve -- increase our revenues nicely from there. But there may be potential for taking on additional space and building additional capacity, too, based upon the very exciting level of demand that we're seeing out there.

Perfect. So that's a perfect tie to M&A and investments and expansions and capital deployment. How do you think about that as you think about like investing into these opportunities you have with your current businesses versus actually going after something like these type of businesses that is something adjacent where your, I don't know, scope can actually give you bigger opportunities. How do you see that in the pipeline?

The great -- really the great answer for us is that both of those things are not necessarily mutually exclusive. We think we can do both. With the strong balance sheet that we have, with the strong free cash flow that we expect to generate, we believe we can invest as much as we need, that's appropriate in our business, while simultaneously turbocharging our organic growth with inorganic growth. So we think both of those opportunities lie ahead for us.

Perfect. And within security, we haven't talked about airports. You are usually stronger in the cargo market, but you have been talking about like this renewal wave that is about to come in like three years from now, and you do have better products now. I'm interested about that. Like how do you think about the opportunities there? Do you see -- think the airports are actually getting like the funding to improve all this equipment? What could delay that or not? And then from a competitive dynamics perspective, a lot is going on, right? Smiths as a stand-alone business, Leidos merging with Analogic., How do you think about your positioning into these like evolving competitive dynamics?

Yes. So the aviation market is exciting to us. We've been growing it at a double-digit mark. It's not as big for us, as you mentioned, as the cargo market for ports and borders, where we're the #1 player. But in aviation, we are a big player, and the opportunities are exciting. Most of the opportunities that we've been pursuing have been international opportunities, and we've been doing quite well there. But as you mentioned, a big replacement cycle is expected to start in a few years here in the United States for check baggage. We have probably a 20% or 25% market share on check baggage outside the United States. Inside the United States, when these machines were purchased long, long ago, we didn't have a product back then for check baggage, so we don't have an installed base. But similar to Europe, where we also didn't necessarily have an installed base at the time and have taken a significant market share, we would hope to get a fair share of the market when this replacement cycle starts in a few years, which is expected to last for about 5 years or so and then the strong recurring revenue of services goes on top of that. So we think we're very nicely positioned for aviation. We're improving our products all the time. And we're excited about the aviation market, and we think there might even be some faster growth opportunities come a couple of years from now in that segment of the business.

Perfect. And from the competitive dynamics, are you concerned from a product perspective or pricing power perspective from these businesses actually refocusing on [indiscernible] where we see a lot of penetration from the Analogics of the world, international competitors, right?

Yes. So fundamentally, we don't think the changes that have taken place with one of our competitors in the U.K. being taken private by a sponsor and the combination, as you mentioned, of Analogic and Leidos. I mean, Leidos had all the products that -- most of the products that Analogic had on the aviation side, but Analogic has some nice products, too. Fundamentally, we don't see it really changing the landscape in any material way, but time will tell.

Perfect. And now the other piece and is more volatile is events. How is the opportunity that you have with the World Cup coming? How -- what are the leading like orders there? Like are those already in backlog or last-minute orders? And how do we think about the Olympics as well in a couple of years?

Yes. So one of the nice things is we have been -- seems to be the partner of choice for these key events. We've done things in the Super Bowl. We've done many of the Olympics. We've done many of the World Cups. So we tend to be well situated for those. So with the upcoming World Cup and the upcoming Olympics, we like to believe we're well situated for those as well. The Olympics -- Summer Olympics, I'm referring to in 2028, of course, those decisions will be made down the road. They happen to be in our hometown of Los Angeles, where we're headquartered. So that's nice for us to see. But both of these things are very exciting for us, partly from a marketing perspective and partly from a financial perspective as well. The Summer Olympics tend to be much larger type of events and require much more product services and generate more revenues than a Winter Olympics or a World Cup.

Perfect. So now I'd like to switch gears to Opto. Opto has also been performing really, really strong. How sustainable is this double-digit growth momentum? And what are the arenas that are actually driving this? Or like what are the end markets that are driving this?

Yes. Hats off to our business teams at Opto. They've really done an exceptional job. Double-digit revenue growth in Opto is not characteristic of this division, but we've seen just extraordinary demand. And we just finished a quarter where despite strong revenue growth, we had a 1.5 book-to-bill ratio, I believe, in Opto. So sitting at a very strong and healthy backlog in the Opto business as well. Typically, we look at this as kind of a mid-single-digit growth business that we look to have some operating margin expansion on top of that. Sometimes we'll try to turbocharge that as well with some M&A. But those are kind of the characteristics of this business. Overall, we've tended to kind of outperform that.

What is driving -- is there any specific end market that is driving that growth?

Yes. So our Opto business is extremely well diversified. There's no end market that we have a high level of concentration in or any customers with a high level of concentration. That being said, aerospace and defense has been very, very strong for us. And that's a segment that carries high margins as well. So we're really excited about that part of the business. But frankly, across the board has been generally pretty strong for us.

So I could imagine, especially defense was already like not related or like tied to China. But have you seen from the other end markets any demand for you guys to help these customers and industries diversify away from China?

Absolutely. And that's been a real initiative over the last few years. More and more multinational companies would prefer to move their supply chain away from China given some of the challenges there. And I think we've been a beneficiary of that. And that trend continues. It's not accelerating, but the trend continues. So much of it has already been done, but more is still taking place.

How much of your products at Opto are like produced in U.S. and North America versus abroad, Asia and other places?

So when we look at where we manufacture for Opto, we do manufacture in the U.S. and the U.K. and Canada, but we also manufacture in a lot of low-cost jurisdictions such as Indonesia, Malaysia, India, Mexico. From a percentage perspective, the majority is produced outside the United States. It's probably in excess of 2/3.

Perfect. Last, healthcare, new management team has been there for a while. That business has been a little bit disappointing in terms of -- you've made like a huge investment into having the right products. Now you have the right team, but like what is still like lacking? Like is it an opportunity thing? Is the market ready to actually buy these things? What is delaying the recovery of this?

Yes. So we're excited about the future of healthcare. So the new management team, a new President came in just over a year ago. And over the past 6 months or so, he's really built out the entire management team. So it's pretty new. And we're absolutely kind of heading in the right direction. I know the numbers may not show that over the past few quarters. Hopefully, they will this quarter and as we move into fiscal '27. The most exciting thing for us in the healthcare business is a new patient monitoring platform that we're developing and will be coming out. And it's probably more of a -- by the time it has an impact on revenues will not necessarily be fiscal '27, but probably more fiscal '28. But we expect to see the business stabilizing, growing. We're looking at some efficiency improvement initiatives. But we really think we're on the right track. We believe we have the best management team we've ever seen, not just at the president level but at the operations level and many other positions as well. So while it has been a little bit underwhelming over the recent past, it is a very small part of our business. We do believe the future can be bright, and it does have the strongest contribution margins in our entire business. So as the top line goes up, the operating margins can go up quite significantly.

Perfect. And one question about like that end market. Is this similar like hospitals were like aviation where you actually have like this replacement cycle for hospitals doing this? And what are the macro factors that could determine if that cycle is delayed or not?

Yes. So this is an essential part of all hospitals, and these products generally are out there for 7 to 10 years or so. So there's always a replacement cycle. There's, of course, new hospital construction and new wings where additional opportunities take place as well and then winning some competitive conversions. But yes, it's mostly a replacement cycle business for us on the patient monitoring side. Cardiology, a little bit as well. Interestingly, the cardiology part of our business is the highest margin part of our business in healthcare. It's also one of the highest margin businesses in all of OSI systems. And we do have a strong share in places like Germany and the U.K. where we tend to be #1. And we think if we can take that leading market share and bring it here to the United States and other locations, it's a real opportunity for the overall division.

Perfect. And I always like to close these conversations with the two questions. Number one, what excites you the most about the future? And on the other side, what -- what keeps you up at night in order to execute this? What is the main problem there?

Yes. So we couldn't be more excited about the future. I think the opportunities that lie ahead of us in our largest division, in particular, security are outstanding. We've had great growth in our international business for a number of years. We continue to see a very strong and robust pipeline internationally. But what we're now seeing in the United States is so exciting between the one big beautiful bill, between some of the stuff going on with the Shield program, as you mentioned, and the homeland defense projects that we're getting, we think the U.S. growth can be outstanding for a number of years. And then you layer on the aviation opportunities that are going to start to take place coming up as well, very exciting for us. That, coupled with just a continued strong steady as she comes optoelectronics business and an improving healthcare business, I think, really lead us to having good top line growth, great earnings power. Our balance sheet is in phenomenal shape. So we couldn't be more excited about the future. We're looking forward to our new fiscal year starting in about 1.5 months. In terms of what keeps me up at night, probably like many others say, the things within our control, we feel really good about. In the world today, there's all sorts of geopolitical changes that sometimes are outside of our control. So we respond to that, and we're nimble, we're agile, and I think we're -- we've been working through those pretty well.

Amazing. Thank you so much for spending time with us.

Thank you very much.