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TMCNet:  OSI SYSTEMS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

[January 25, 2013]

OSI SYSTEMS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Statement This Quarterly Report on Form 10-Q contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward looking statements relate to expectations concerning matters that are not historical facts. Words such as "project", "believe", "anticipate", "plan,", "expect", "intend", "may", "should", "likely to", "could", " will", and "would" and small words and expressions are intended to identify forward-looking statements. Expectations described in the forward looking statements may prove to be inaccurate, and actual results may differ materially from those reflected in such expectations.



Important factors that could cause our actual results to differ materially from those expectations are described in this Quarterly Report on Form 10-Q, our Annual Report on Form 10-K and other documents previously filed or hereafter filed by us from time to time with the Securities and Exchange Commission. Such factors, of course, do not include all factors that might affect our business and financial condition. Although we believe that the assumptions upon which our forward-looking statements are based are reasonable, such assumptions could prove to be inaccurate and actual results could differ materially from those expressed in or implied by the forward-looking statements. All forward-looking statements contained in this Quarterly Report on Form 10-Q are qualified in their entirety by this statement. We undertake no obligation other than as may be required under securities laws to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Critical Accounting Policies and Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions and select accounting policies that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Our critical accounting policies are detailed in our Annual Report on Form 10-K for the year ended June 30, 2012.

Recent Accounting Pronouncements There are no recent accounting pronouncements that, if implemented, would impact us materially.

Executive Summary We are a vertically integrated designer and manufacturer of specialized electronic systems and components for critical applications, and provider of screening services. We sell our products and provide related services in diversified markets, including homeland security, healthcare, defense and aerospace. We have three operating divisions: (i) Security, (ii) Healthcare and (iii) Optoelectronics and Manufacturing.

19 -------------------------------------------------------------------------------- Table of Contents Security Division. Through our Security division, we design, manufacture and market security and inspection systems worldwide for sale primarily to U.S. and foreign government agencies, and provide turnkey security screening solutions.

These products and services are used to inspect baggage, cargo, vehicles and other objects for weapons, explosives, drugs and other contraband as well as to screen people. Revenues from our Security division accounted for 47% and 46% of our total consolidated revenues for the six months ended December 31, 2012 and 2011, respectively.

As a result of the terrorist attacks of September 11, 2001, and subsequent attacks in other locations worldwide, security and inspection products have increasingly been used at a wide range of facilities other than airports, such as border crossings, railway stations, seaports, cruise line terminals, freight forwarding operations, sporting venues, government and military installations and nuclear facilities. We believe that our wide-ranging product portfolio together with our ability to provide turnkey screening solutions position us to competitively pursue security and inspection opportunities as they arise throughout the world.

During our third quarter of fiscal 2012, our Security division won a six-year agreement with the Mexican government to provide a turnkey security screening solution along the country's borders, and in its ports and airports. We have begun recognizing revenue under this agreement reported as service revenues.

In November 2012, we received a "show cause" letter from the U.S. Transportation Safety Administration (TSA) regarding the Rapiscan Secure 1000SP Advanced Imaging Technology system and related Automated Target Recognition (ATR) software that were undergoing operational testing. We reached an agreement with the TSA under which we have agreed to assist the TSA in redeploying the Secure 1000SP units previously sold to the TSA and cease software development related to ATR. Our contract with the TSA for AIT systems will continue, though we did not sell systems to the TSA in fiscal 2012 and fiscal 2013. We recorded a $2.7 million impairment and other charges for the three months ended December 31, 2012 in connection with this agreement. Our agreement with the TSA regarding the issues raised in the show cause letter does not constitute final resolution of the matter, as the issues are also subject to U.S. Department of Homeland Security (DHS) disposition. We are working to complete the process with DHS.

Healthcare Division. Through our Healthcare division, we design, manufacture, market and service patient monitoring, diagnostic cardiology and anesthesia delivery and ventilation systems globally for sale primarily to hospitals and medical centers. Our products monitor patients in critical, emergency and perioperative care areas of the hospital and provide such information, through wired and wireless networks, to physicians and nurses who may be at the patient's bedside, in another area of the hospital or even outside the hospital. Revenues from our Healthcare division accounted for 29% and 30% of our total consolidated revenues for the six month periods ended December 31, 2012 and 2011, respectively.

The healthcare markets in which we operate are highly competitive. We believe that our customers choose among competing products on the basis of product performance, functionality, value and service. We also believe that the worldwide economic slowdown has caused some hospitals and healthcare providers to delay purchases of our products and services. During this period of uncertainty, we anticipated lower sales of patient monitoring, diagnostic cardiology and anesthesia systems products than what we had historically experienced, which negatively impacted our sales. Although there are indications that a recovery is underway, we cannot predict when the markets will fully recover and, therefore, when this period of delayed and diminished purchasing will end. A prolonged delay could have a material adverse effect on our business, financial condition and results of operations.

20 -------------------------------------------------------------------------------- Table of Contents Optoelectronics and Manufacturing Division. Through our Optoelectronics and Manufacturing division, we design, manufacture and market optoelectronic devices and provide electronics manufacturing services worldwide for use in a broad range of applications, including aerospace and defense electronics, security and inspection systems, medical imaging and diagnostics, telecommunications, office automation, computer peripherals, industrial automation, automotive diagnostic systems and renewable energy. We also provide our optoelectronic devices and value-added manufacturing services to our own Security and Healthcare divisions.

External revenues from our Optoelectronics and Manufacturing division accounted for 24% of our total consolidated revenues for both the six months ended December 31, 2012 and 2011.

Results of Operations for the Three Months Ended December 31, 2012 Compared to Three Months Ended December 31, 2011 Net Revenues The table below and the discussion that follows are based upon the way in which we analyze our business. See Note 9 to the condensed consolidated financial statements for additional information about our business segments.

Q2 % of Q2 % of (in millions) 2012 Net Sales 2013 Net Sales $ Change % Change Security division $ 89.0 47 % $ 91.8 47 % $ 2.8 3 % Healthcare division 59.2 32 % 56.1 29 % (3.1 ) (5 )% Optoelectronics and Manufacturing division 39.8 21 % 46.1 24 % 6.3 16 % Total revenues $ 188.0 100 % $ 194.0 100 % $ 6.0 3 % Total revenues for the three months ended December 31, 2012, increased $6.0 million, or 3%, to $194.0 million, from $188.0 million for the comparable prior-year period.

Revenues for the Security division for the three months ended December 31, 2012, increased $2.8 million, or 3%, to $91.8 million, from $89.0 million for the comparable prior-year period. The increase was primarily attributable to increased revenue from turnkey screening services. The increase was primarily attributable to increased revenue from turnkey screening services, partially offset by a decrease in equipment sales. The decrease in equipment sales resulted primarily from the fulfillment of a large contract in the prior year where we served as a prime contractor and hardware systems integrator.

21 -------------------------------------------------------------------------------- Table of Contents Revenues for the Healthcare division for the three months ended December 31, 2012, decreased $3.1 million, or 5%, to $56.1 million, from $59.2 million for the comparable prior-year period. The decrease was primarily attributable to decreased sales in our European and Middle Eastern region, which more than offset growth in our North American region. Among our product lines, the overall decrease included: (i) a $1.9 million decrease in anesthesia product revenue and; (ii) a $1.1 million decrease in patient monitoring product revenues.

Revenues for the Optoelectronics and Manufacturing division for the three months ended December 31, 2012, increased by $6.3 million, or 16%, to $46.1 million, from $39.8 million for the comparable prior-year period. This increase was attributable to an $8.1 million increase in contract manufacturing sales partially offset by a $1.8 million decrease in commercial optoelectronics sales.

Gross Profit Q2 % of Q2 % of (in millions) 2012 Net Sales 2013 Net Sales Gross profit $ 65.8 35.0 % $ 70.1 36.1 % Gross profit increased $4.3 million, or 7%, to $70.1 million for the three months ended December 31, 2012, from $65.8 million for the comparable prior-year period, primarily attributable to the 3% increase in revenue and favorable revenue mix. The gross margin increased to 36.1% from 35.0% for the comparable prior-year period. The increase was attributable to increased revenue from turnkey screening services within our Security division, which generally provide higher margins than product sales and more than offset the impact of the reduced revenue in our Healthcare division, which has historically generated the highest gross margin across the three divisions.

Operating Expenses Q2 % of Q2 % of (in millions) 2012 Net Sales 2013 Net Sales $ Change % Change Selling, general and administrative $ 36.0 19.1 % $ 36.8 19.0 % $ 0.8 2 % Research and development 11.5 6.1 % 11.9 6.1 % 0.4 3 % Impairment, restructuring and other charges - - % 2.7 1.4 % 2.7 NA Total operating expenses $ 47.5 25.2 % $ 51.4 26.5 % $ 3.9 8 % Selling, general and administrative expenses. Selling, general and administrative (SG&A) expenses consist primarily of compensation paid to sales, marketing and administrative personnel, professional service fees and marketing expenses. For the three months ended December 31, 2012, SG&A expenses increased by $0.8 million or 2%, to $36.8 million from $36.0 million for the comparable prior-year period. This $0.8 million increase was primarily attributable to the cost of supporting the 3% revenue growth. As a percentage of revenues, SG&A expenses were 19.0% for the three months ended December 31, 2012, compared to 19.1% for the comparable prior-year period.

22 -------------------------------------------------------------------------------- Table of Contents Research and development. Research and development (R&D) expenses include research related to new product development and product enhancement expenditures. For the three months ended December 31, 2012, such expenses increased by $0.4 million, or 3%, to $11.9 million, from $11.5 million for the comparable prior-year period. As a percentage of revenues, R&D expenses were 6.1% for both the three months ended December 31, 2012, and for the comparable prior-year period.

Impairment, restructuring and other charges. In conjunction with an agreement reached with the U.S. Transportation Security Administration, we incurred non-recurring impairment and other charges of $2.7 million in our Security division during the three months ended December 31, 2012. In the three months ended December 31, 2011 we did not incur any such charges.

Interest expense and other income, net. For the three months ended December 31, 2012, interest expense and other income, net, amounted to $1.4 million, as compared to $0.7 million for the same prior-year period. The increase in net expense was primarily due to higher utilization of the letters-of-credit facility and the new mortgage debt associated with acquisition of a new building.

Income taxes. For the three months ended December 31, 2012, our income tax provision was $4.9 million, compared to $5.3 million for the comparable prior-year period. Our effective tax rate for the three months ended December 31, 2012, was 28.2%, compared to 30.0% in the comparable prior-year period. Our provision for income taxes is dependent on the mix of income from U.S. and foreign locations due to tax rate differences among such countries as well as due to the impact of permanent taxable differences.

Results of Operations for the Six Months Ended December 31, 2012 Compared to Six Months Ended December 31, 2011 Net Revenues The table below and the discussion that follows are based upon the way in which we analyze our business. See Note 9 to the condensed consolidated financial statements for additional information about our business segments.

YTD Q2 % of YTD Q2 % of (in millions) 2012 Net Sales 2013 Net Sales $ Change % Change Security division $ 161.6 46 % $ 174.8 47 % $ 13.2 8 % Healthcare division 105.7 30 % 107.7 29 % 2.0 2 % Optoelectronics and Manufacturing division 82.0 24 % 93.2 24 % 11.2 14 % Total revenues $ 349.3 100 % $ 375.7 100 % $ 26.4 8 % Net revenues for the six months ended December 31, 2012 increased $26.4 million, or 8%, to $375.7 million, from $349.3 million for the comparable prior-year period.

Revenues for the Security division for the six months ended December 31, 2012 increased $13.2 million, or 8%, to $174.8 million, from $161.6 million for the comparable prior-year period. The increase was primarily attributable to increased revenues from turnkey screening services, partially offset by a decrease in equipment sales. The decrease in equipment sales resulted primarily from the fulfillment in the prior year of a large contract under which we served as a prime contractor and hardware systems integrator.

Revenues for the Healthcare division for the six months ended December 31, 2012, increased $2.0 million, or 2%, to $107.7 million, from $105.7 million for the comparable prior-year period. The increase was primarily attributable to increased sales in our North American region, partially offset by decreased sales in our European/Middle East/Africa region. The increase reflected a $3.7 million increase in patient monitoring product revenues and a $1.1 million decrease in anesthesia product revenues.

Revenues for the Optoelectronics and Manufacturing division for the six months ended December 31, 2012, increased $11.2 million, or 14%, to $93.2 million, from $82.0 million for the comparable prior-year period. This increase was attributable to an $18.0 million increase in contract manufacturing sales partially offset by a $6.8 million decrease in commercial optoelectronics sales.

Gross Profit YTD Q2 % of YTD Q2 % of (in millions) 2012 Net Sales 2013 Net Sales Gross profit $ 118.7 34.0 % $ 131.4 35.0 % Gross profit increased $12.7 million, or 11%, to $131.4 million for the six months ended December 31, 2012, from $118.7 million for the comparable prior-year period, primarily as a result of an 8% increase in revenue. The gross margin during the period increased to 35.0% from 34.0% for the comparable prior-year period. The increase was attributable to increased revenue from turnkey screening services within our Security division, which generally provide higher margins than product sales, and more than offset the lower level of growth in our Healthcare division, which has historically generated the highest gross margin among our three divisions.

Operating Expenses YTD Q2 % of YTD Q2 % of (in millions) 2012 Net Sales 2013 Net Sales $ Change % Change Selling, general and administrative $ 70.3 20.1 % $ 76.8 20.4 % $ 6.5 9 % Research and development 22.5 6.5 % 23.1 6.2 % 0.6 3 % Impairment, restructuring and other charges - - % 2.7 0.7 % 2.7 NA Total operating expenses $ 92.8 26.6 % $ 102.6 27.3 % $ 9.8 11 % 23 -------------------------------------------------------------------------------- Table of Contents Selling, general and administrative expenses. For the six months ended December 31, 2012, SG&A expenses increased by $6.5 million, or 9%, to $76.8 million, from $70.3 million for the comparable prior-year period. This increase was primarily attributable to the cost of supporting the 8% revenue growth. As a percentage of revenues, SG&A expenses were 20.4% for the six months ended December 31, 2012, compared to 20.1% for the comparable prior-year period.

Research and development. R&D expenses include research related to new product development and product enhancement expenditures. For the six months ended December 31, 2012, such expenses increased $0.6 million, or 3%, to $23.1 million, from $22.5 million for the comparable prior-year period. As a percentage of revenues, research and development expenses were 6.2% for the six months ended December 31, 2012, compared to 6.5% for the comparable prior-year period. The increase in R&D expenses for the six month period ended December 31, 2012, primarily resulted from an increase in R&D investment mainly in our Security division in support of multiple new product introductions.

Impairment, restructuring and other charges. In conjunction with our agreement with the U.S. Transportation Security Administration we incurred non-recurring impairment and other charges of $2.7 million in our Security division during the six months ended December 31, 2012. In the six months ended December 31, 2011 we did not incur any such charges.

Interest expense and other income, net. For the six months ended December 31, 2012, interest expense and other income, net, amounted to $2.5 million as compared to $1.5 million for the same prior-year period. The increase was primarily due to higher utilization of the letters-of-credit facility.

Income taxes. For the six months ended December 31, 2012, our income tax provision was $7.5 million, compared to $7.3 million for the comparable prior-year period. Our effective tax rate for the six months ended December 31, 2012, was 28.7%, compared to 30.0% in the comparable prior-year period. Our provision for income taxes is dependent on the mix of income from U.S. and foreign locations due to tax rate differences among such countries as well the impact of permanent taxable differences.

Liquidity and Capital Resources To date, we have financed our operations primarily through cash flow from operations, proceeds from equity issuances and our credit facilities. Cash and cash equivalents totaled $46.9 million at December 31, 2012, a decrease of $44.6 million from $91.5 million at June 30, 2012. The changes in our working capital and cash and cash equivalent balances during the six months ended December 31, 2012 are described below.

June 30, December 31, (in millions) 2012 2012 % Change Working capital $ 322.5 $ 241.2 (25 )% Cash and cash equivalents 91.5 46.9 (49 )% 24 -------------------------------------------------------------------------------- Table of Contents Working Capital. During the six months ended December 31, 2012, the Company utilized significant working capital to acquire a new headquarters and manufacturing facility for our Healthcare division and to prepare for our turnkey screening solutions program in Mexico. Specific fluctuations in components of working capital included: (i) a $44.2 million decrease in cash and cash equivalents; and (ii) a $38.6 million increase in accounts payable.

YTD Q2 YTD Q2 (in millions) 2012 2013 $ Change Cash provided by operating activities $ 12.5 $ 62.8 $ 50.3 Cash used in investing activities (14.1 ) (125.4 ) (111.3 ) Cash provided by financing activities 0.3 16.4 16.1 Cash Provided by Operating Activities. Cash flows from operating activities can fluctuate significantly from period to period, as net income; tax timing differences, customer collections, vendor payments and other items can significantly impact cash flows. Net cash provided by operations for the six months ended December 31, 2012 was $ 62.8 million, an increase of $50.3 million from the $12.5 million provided in the comparable prior-year period. This increase in net cash provided was primarily due to changes in working capital in the current-year period versus the prior-year period resulting in: (i) a $31.1 million increase in cash from changes in inventory, (ii) a $27.7 million increase in cash from changes in accounts receivables, (iii) a $15.5 million increase from changes in accounts payable and (iv) a $7.3 million increase in net income for the six months ended December 31, 2012, after giving consideration to non-cash operating items including depreciation and amortization, stock-based compensation and deferred taxes, among others. These favorable changes were partially offset by (i) an $18.1 million decrease in cash from changes in customer advances, (ii) a $8.3 million decrease in cash from changes in other accrued expenses and other current liabilities and, (iii) a $3.8 million decrease in cash from changes in accrued warranties.

Cash Used in Investing Activities. Net cash used in investing activities was $125.4 million for the six months ended December 31, 2012, compared to $14.1 million for the six months ended December 31, 2011. During the six months ended December 31, 2012, we invested $117.6 million in capital expenditures primarily in our Security division related to the fulfillment of a large turnkey screening services program with the Mexican government and the acquisition of a building, as compared to $9.1 million during the comparable prior-year period. During the six months ended December 31, 2012, we also used $5.8 million for the acquisition of businesses, as compared to $3.2 million during the comparable prior-year period.

Cash Provided by Financing Activities. Net cash provided by financing activities was $16.4 million for the six months ended December 31, 2012, compared to net cash provided by financing activities of $0.3 million for the six months ended December 31, 2011. During the six months ended December 31, 2012, $15 million in cash was provided from our bank revolving credit facility in support of our capital spending. During this period, we also financed the acquisition of a building through an $11.1 million term loan. In addition, during the six months ended December 31, 2012 we received $3.0 million in net proceeds from the exercise of stock options and the purchase of stock under our employee stock purchase plan compared to $2.2 million in proceeds from the exercise of stock options and the purchase of stock under our employee stock purchase plan in the prior period. Finally, during the six months ended December 31, 2012, we used $12.3 million of cash to repurchase shares of our common stock under our stock repurchase program and settle tax obligations arising out of our stock plans as compared to using $1.8 million of cash to repurchase shares of our common stock under our stock repurchase program and settle tax obligations arising out of our stock plans in the prior-year period.

25 -------------------------------------------------------------------------------- Table of Contents Borrowings Outstanding lines of credit and current and long-term debt totaled $28.5 million at December 31, 2012, an increase of $25.5 million from $3.0 million at June 30, 2012. See Note 4 to the condensed consolidated financial statements for further discussion.

Stock Repurchase Program Our Board of Directors authorized a stock repurchase program in March 1999 for up to 2,000,000 shares and in September 2004 increased the number of shares available for repurchase by 1,000,000 shares totaling up to 3,000,000 shares of our common stock. This program does not have an expiration date.

The following table presents the shares acquired during the period: Total number of Maximum number Total number of Average price shares purchased as of shares that may shares purchased paid per share part of program yet be purchased October 1, 2012 to October 31, 2012 - - November 1, 2012 to November 30, 2012 22,500 $ 69.40 22,500 December 1, 2012 to December 31, 2012 - - 22,500 $ 69.40 22,500 551,927 Dividend Policy We have never paid cash dividends on our common stock and have no plans to do so in the foreseeable future.

Contractual Obligations We presented our contractual obligations in our Annual Report on Form 10-K for the fiscal year ended June 30, 2012. See Note 7 to the condensed consolidated financial statements for further discussion regarding those obligations during the first six months of fiscal 2013.

26 -------------------------------------------------------------------------------- Table of Contents Off Balance Sheet Arrangements As of December 31, 2012, we did not have any significant off balance sheet arrangements as defined in Item 303(a)(4) of Regulation S-K.

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