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OSI SYSTEMS INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Overview We are a vertically integrated designer and manufacturer of specialized electronic systems and components for critical applications. We sell our products and provide related services in diversified markets, including homeland security, healthcare, defense and aerospace. We have three operating divisions: (a) Security, providing security and inspection systems and turnkey security screening solutions; (b) Healthcare, providing patient monitoring, diagnostic cardiology and anesthesia systems; and (c) Optoelectronics and Manufacturing, providing specialized electronic components for our Security and Healthcare divisions, as well as to third parties for applications in the defense and aerospace markets, among others. Security Division. Through our Security division, we provide security screening, threat detection and non-intrusive inspection products and services worldwide, and provide turnkey security screening solutions. These products and services are used to inspect baggage, cargo, vehicles and other objects for weapons, explosives, drugs, radioactive material and other contraband as well as to screen people. Revenues from our Security division accounted for 49% of our total consolidated revenues for fiscal 2014. 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. Currently, the U.S. federal government is discussing various options to address sequestration and the U.S. federal government's overall fiscal challenges and we cannot predict the outcome of these efforts. While we believe that national security spending will continue to be a priority, U.S. Government budget deficits and the national debt have created increasing pressure to examine and reduce spending across many federal agencies. We believe that the diversified product portfolio and international customer mix of our Security division position us well to withstand the impact of these uncertainties and even benefit from specific initiatives within various governments. However, depending on how future sequestration cuts are implemented and how the U.S. federal government manages its fiscal challenges, we believe that these federal actions could have a material, adverse effect on our business, financial condition and results of operations. On December 5, 2013, we were notified by the U.S. Transportation Security Administration (TSA) that a delivery order that we had received on September 26, 2013, for baggage and handling inspection systems was being terminated for default. The termination resulted from the use of an upgraded X-ray generator component. While the component had been vetted by our Security division's internal quality assurance, we had not met the contractual requirement of obtaining the TSA's approval in advance. The upgraded X-ray generator component has since been approved for use by the TSA. As a result of this termination for default, we were referred to the U.S. Department of Homeland Security (DHS) for further review. Although the results of this review cannot be determined at this time, among other consequences, we could be barred from conducting future business with the U.S. Government for a period of time. We are continuing to work to complete the review process with DHS, but the timing of the completion of this process and the ultimate outcome are currently unknown. Healthcare Division. Through our Healthcare division, we design, manufacture, market and service patient monitoring, diagnostic cardiology and anesthesia delivery and ventilation systems worldwide 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 51 -------------------------------------------------------------------------------- Table of Contents be at the patient's bedside, in another area of the hospital or even outside the hospital. Revenues from our Healthcare division accounted for 24% of our total consolidated revenues for fiscal 2014. 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. In addition, there is continued uncertainty regarding the ongoing debates related to the U.S. budget, the debt ceiling and the Affordable Care Act, any of which may impact hospital spending, third-party payor reimbursement and fees to be levied on certain medical device revenues, any of which could adversely affect our business and results of operations. In addition, hospital capital spending appears to have been impacted by strategic uncertainties surrounding the Affordable Care Act and economic pressures. We also believe that the economic slowdown has caused some hospitals and healthcare providers to delay purchases of our products and services. During this period of uncertainty, sales of our healthcare products may be negatively impacted. Although there are indications that a general economic recovery is underway, we cannot predict when the markets will fully recover or when the uncertainties related to the U.S. federal government will be resolved 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. Optoelectronics and Manufacturing Division. Through our Optoelectronics and Manufacturing division, we design, manufacture and market optoelectronic devices and provide electronics manufacturing services globally 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, gaming systems and consumer products. We also provide our optoelectronic devices and electronics manufacturing services to original equipment manufacturers, as well as our own Security and Healthcare divisions. Revenues from external customers in our Optoelectronics and Manufacturing division accounted for approximately 27% of our total consolidated revenues for fiscal 2014. Consolidated Results Fiscal 2014 Compared with Fiscal 2013. We reported consolidated operating profit of $81.3 million for fiscal 2014, a $6.9 million or 9% improvement over the $74.4 million operating profit reported for fiscal 2013. This improved profitability was driven primarily by a 13% increase in sales, which resulted in a $14.6 million increase in gross profit. This increase was partially offset by a $7.1 million increase in SG&A expenses to support our growth and a $4.0 million increase in impairment, restructuring and other charges. Fiscal 2013 Compared with Fiscal 2012. We reported consolidated operating profit of $74.4 million for fiscal 2013, an $8.5 million or 13% improvement over the $65.9 million operating profit reported for fiscal 2012. This improved profitability was driven primarily by a 2.3% improvement in our gross margin, which resulted in a $21.8 million increase in gross profit which was partially offset by a $6.7 million or 3% increase in operating expenses to support our growth initiatives and by a $6.6 million increase in impairment, restructuring and other charges. Acquisitions. Historically, an active acquisition program has been an important element of our corporate strategy. Over the past three years, each of our acquisitions has not been considered materially significant, either individually or in the aggregate. We continue to believe that an active acquisition program supports our long-term strategic goals and we intend to look to acquisitions to strengthen our competitive position, expand our customer base and augment our considerable research and development programs. Through such efforts we aim to accelerate innovation, improve earnings and increase overall stockholder value. 52 -------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates The following discussion and analysis of our financial condition and results of operations is based on our Consolidated Financial Statements, which have been prepared in conformity with accounting principles generally accepted in the United States. Our preparation of these Consolidated Financial Statements requires us to make judgments and estimates that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. As a result, actual results may differ from such estimates. Our senior management has reviewed these critical accounting policies and related disclosures with the Audit Committee of our Board of Directors. The following summarizes our critical accounting policies and significant estimates used in preparing our Consolidated Financial Statements: Revenue Recognition. We recognize revenue from sales of products when title and risk of loss passes, and when terms are fixed and collection is probable. Generally, this occurs upon shipment but there are instances when customer acceptance occurs at our factory where the product is held at the customer's request. In these instances, when we are able to bill our customer and payment is probable, we recognize revenue. Revenue from services includes after-market services, installation and implementation of products, and turnkey security screening services. The portion of revenue for the sale attributable to installation is deferred and recognized when the installation service is provided. In an instance where terms of sale include subjective customer acceptance criteria, revenue is deferred until we have achieved the acceptance criteria. Concurrent with revenue recognition, we accrue estimated product return reserves and warranty expenses. Critical judgments made by management related to revenue recognition include the determination of whether or not customer acceptance criteria are perfunctory or inconsequential. The determination of whether or not customer acceptance terms are perfunctory or inconsequential impacts the amount and timing of revenue recognized. Critical judgments also include estimates of warranty reserves, which are established based on historical experience and knowledge of the product under warranty. Revenue from turnkey services agreements is included in revenue from services. In certain agreements, revenue is recognized based upon proportional performance, measured by the actual number of hours incurred divided by the total estimated number of hours for the project. The impact of changes in the estimated hours to service the agreement is reflected in the period during which the change becomes known. We recognize revenues from out of warranty service maintenance contracts ratably over the term of the contracts. For services not derived from specific maintenance contracts, we recognize service revenues as we perform the services. Deferred revenue for such services arises from payments received from customers for services not yet performed. Advances from Customers. On occasion, we receive advances from customers associated with certain projects. In fiscal 2012, we entered into an agreement with the Mexican government to provide a turnkey security screening solution along the country's borders, and in its ports and airports. Associated with the agreement, we were provided an advance totaling $100 million. We are obligated to provide a guarantee until the advance has been earned. The obligation under this advance is $75 million as of June 30, 2014. Such advances are classified in the consolidated balance sheets as either a current or long-term liability dependent upon when we estimate the corresponding amortization to occur. Allowance for Doubtful Accounts. The allowance for doubtful accounts involves estimates based on management's judgment, review of individual receivables and analysis of historical bad debts. We monitor collections and payments from our customers and we maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We also assess current economic trends that might impact the level of credit losses in the future. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances could be required. 53-------------------------------------------------------------------------------- Table of Contents Inventory. Inventory is stated at the lower of cost or market. Cost is determined on the first-in, first-out method. We write down inventory for slow-moving and obsolete inventory based on assessments of future demands, market conditions and customers who may be experiencing financial difficulties. If these factors were to become less favorable than those projected, additional inventory write-downs could be required. Property and Equipment. Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets and taking into account their estimated salvage value. Amortization of leasehold improvements is calculated on the straight-line basis over the shorter of the useful life of the asset or the lease term. Leased capital assets are included in property and equipment. Amortization of property and equipment under capital leases is included with depreciation expense. Income Taxes. Our annual tax rate is based on our income, statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we operate. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Significant judgment is required in determining our tax expense and in evaluating our tax positions including evaluating uncertainties. We review our tax positions quarterly and adjust the balances as new information becomes available. Deferred income tax assets represent amounts available to reduce income taxes payable on taxable income in future years. Such assets arise because of temporary differences between the financial reporting and tax bases of assets and liabilities, as well as from net operating loss and tax credit carryforwards. We evaluate the recoverability of these future tax deductions by assessing the adequacy of future expected taxable income from all sources, including reversal of taxable temporary differences, forecasted operating earnings and available tax planning strategies. These sources of income inherently rely on estimates. To provide insight, we use our historical experience and our short and long-range business forecasts. We believe it is more likely than not that a portion of the deferred income tax assets may expire unused and therefore have established a valuation allowance against them. Although realization is not assured for the remaining deferred income tax assets, we believe it is more likely than not that the deferred tax assets will be fully recoverable within the applicable statutory expiration periods. However, deferred tax assets could be reduced in the near term if our estimates of taxable income are significantly reduced or available tax planning strategies are no longer viable. Business Combinations. Under the acquisition method of accounting, we allocate the fair value of the consideration paid for the businesses to the tangible and identifiable intangible assets acquired and liabilities assumed based on their estimated fair values. We record the excess of purchase price over the aggregate fair values as goodwill. We engage third-party appraisal firms to assist us in determining the fair values of assets acquired and liabilities assumed for larger transactions. These valuations require us to make significant estimates and assumptions, especially with respect to intangible assets and the fair value of contingent payment obligations. Critical estimates in valuing purchased technology, customer lists and other identifiable intangible assets include future cash flows that we expect to generate from the acquired assets. If the subsequent actual results and updated projections of the underlying business activity change compared with the assumptions and projections used to develop these values, we could experience impairment charges. In addition, we have estimated the economic lives of certain acquired assets and these lives are used to calculate depreciation and amortization expense. If our estimates of the economic lives change, depreciation or amortization expenses could be accelerated or slowed. Impairment of Long-Lived Assets. Goodwill represents the excess purchase price of net tangible and intangible assets acquired in business combinations over their estimated fair value. Goodwill is allocated to our segments based on the nature of the product line of the acquired business. The carrying value of goodwill is not amortized, but is annually tested for impairment during our second quarter and more often if there is an indicator of impairment. Intangible assets other than goodwill are amortized over their useful lives unless these lives are determined to be indefinite. 54-------------------------------------------------------------------------------- Table of Contents We assess qualitative factors of each of our reporting units to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill. Such assessments indicated that it is not more likely than not that the fair value of each reporting unit is less than its carrying amount, including goodwill. Thus, we have determined that it is not necessary to proceed with the two-step goodwill impairment test. There was no goodwill impairment for each of the three fiscal years ended June 30, 2014. We evaluate long-lived assets with finite lives for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Impairment is considered to exist if the total estimated future cash flows on an undiscounted basis are less than the carrying amount of the assets. If impairment does exist, we measure the impairment loss and record it based on the discounted estimate of future cash flows. In estimating future cash flows, we group assets at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows from other asset groups. Our estimate of future cash flows is based upon, among other things, certain assumptions about expected future operating performance, growth rates and other factors. Although we believe the assumptions and estimates we have made in the past have been reasonable and appropriate, different assumptions and estimates could materially impact our reported financial results. More conservative estimates of the anticipated future benefits from these businesses could result in impairment charges, which would decrease net income and result in lower asset values on our balance sheet. Stock-Based Compensation Expense. We account for stock-based compensation using fair value recognition provisions. Thus, we record stock-based compensation as a charge to earnings net of the estimated impact of forfeited awards. As such, we recognize stock-based compensation cost only for those stock-based awards that are estimated to ultimately vest over their requisite vesting period, based on the vesting provisions of the individual grants. The process of estimating the fair value of stock-based compensation awards and recognizing stock-based compensation cost over their requisite vesting period involves significant assumptions and judgments. We estimate the fair value of stock option awards on the date of grant using the Black-Scholes option-valuation model which requires that we make certain assumptions regarding: (i) the expected volatility in the market price of our Common Stock; (ii) dividend yield; (iii) risk-free interest rates; and (iv) the period of time employees are expected to hold the award prior to exercise. We estimate the fair value of restricted stock and restricted stock unit awards on the date of the grant using the market price of our Common Stock on that date. In addition, we are required to estimate the expected impact of forfeited awards and recognize stock-based compensation cost only for those awards expected to vest. If actual forfeiture rates differ materially from our estimates, stock-based compensation expense could differ significantly from the amounts we have recorded in the current period. We periodically review actual forfeiture experience and revise our estimates, as necessary. We recognize the cumulative effect on current and prior periods change in the estimated forfeiture rate as compensation cost in earnings in the period of the revision. As a result, if we revise our assumptions and estimates, our stock-based compensation expense could change materially in the future. Certain shares of restricted stock and restricted stock units vest based upon the achievement of pre-established performance goals. We estimate the fair value of performance-based awards at the date of grant and the probability that the specified performance criteria will be met, adjusted for estimated forfeitures. Each quarter we update our assessment of the probability that the specified performance criteria will be achieved and adjust our estimate of the fair value of the performance-based awards if necessary. We amortize the fair values of performance-based awards over the requisite service period adjusted for estimated forfeitures for each separately vesting tranche of the award. See Note 7 to the Consolidated Financial Statements for a further discussion of stock-based compensation. Legal and Other Contingencies. We are subject to various claims and legal proceedings. We review the status of each significant legal dispute to which we are a party and assess our potential financial exposure, if any. If the potential financial exposure from any claim or legal proceeding is considered probable and the amount can be reasonably estimated, we record a liability and an expense for the estimated loss. Significant judgment is required in both the determination of probability and the determination as to whether an exposure is reasonably estimable. 55 -------------------------------------------------------------------------------- Table of Contents Because of uncertainties related to these matters, accruals are based only on the best information available at the time. As additional information becomes available, we reassess the potential liability related to our pending claims and litigation and revise our estimates accordingly. Such revisions in the estimates of the potential liabilities could have a material impact on our results of operations and financial position. Net Revenues The table below and the discussion that follows are based upon the way we analyze our business. See Note 13 to the Consolidated Financial Statements for additional information about business segments. % of % of % of 2012-2013 2013-2014 2012 Net Sales 2013 Net Sales 2014 Net Sales % Change % Change (Dollars in millions) Security $ 391.8 49 % $ 372.2 46 % $ 440.4 49 % (5 )% 18 % Healthcare 235.6 30 % 231.3 29 % 222.3 24 % (2 )% (4 )% Optoelectronics / Manufacturing 165.6 21 % 198.5 25 % 244.0 27 % 20 % 23 % Total Net Revenues $ 793.0 $ 802.0 $ 906.7 1 % 13 % Fiscal 2014 Compared with Fiscal 2013. Net revenues for fiscal 2014 increased $104.7 million, or 13%, to $906.7 million from $802.0 million for fiscal 2013. Revenues for the Security division for fiscal 2014 increased $68.2 million, or 18%, to $440.4 million, from $372.2 million for fiscal 2013. The increase was primarily attributable to a $52.0 million increase in revenue from our turnkey screening services in Mexico as the program ramped up in fiscal 2014, and due to growth in the sales of cargo equipment, which increased $33.5 million, including the partial fulfillment of a large Foreign Military Sale to the U. S. Department of Defense. These increases were partially offset by a decrease in the sales of baggage and parcel inspection equipment of $20.2 million. Revenues for the Healthcare division for fiscal 2014 decreased $9.0 million, or 4%, to $222.3 million, from $231.3 million for fiscal 2013. The decrease was primarily attributable to an $8.7 million, or 5%, decrease in our patient monitoring product line sales mainly in our North American region as certain hospitals have delayed capital spending. Revenues for the Optoelectronics and Manufacturing division for fiscal 2014 increased $45.5 million, or 23%, to $244.0 million from $198.5 million for fiscal 2013. $28.0 million of this increase was attributable to businesses we acquired during the fiscal year. The remaining $17.5 million organic growth, or 9%, was driven by a $25.1 million increase in contract manufacturing sales primarily to customers in the consumer products and industrial businesses, partially offset by a $7.6 million decrease in commercial optoelectronics sales mainly caused by reduced aerospace and defense industry spending. Fiscal 2013 Compared with Fiscal 2012. Net revenues for fiscal 2013 increased $9.0 million, or 1%, to $802.0 million from $793.0 million for fiscal 2012. Revenues for the Security division for fiscal 2013 decreased $19.6 million, or 5%, to $372.2 million, from $391.8 million for fiscal 2012. In fiscal 2012, we recognized $94.7 million in revenues related to a single large contract where we served as a prime contractor and hardware systems integrator that was substantially completed in the fourth quarter of the prior year. Excluding the impact of this program, the Security division's sales increased by $69.2 million, or 23%, primarily attributable to the growth of our turnkey screening services business. Revenues for the Healthcare division for fiscal 2013 decreased $4.3 million, or 2%, to $231.3 million, from $235.6 million for fiscal 2012. The decrease was primarily attributable to a $3.8 million, or 16%, decrease in our 56-------------------------------------------------------------------------------- Table of Contents anesthesia product line revenues and a $1.4 million, or 5%, decrease in our cardiology product line revenues partially offset by a $1.2 million, or 1%, increase in our patient monitoring product line sales with increases in our North American and Asian regions. Overall, increases attributable to new product offerings within our patient monitoring product line were offset by sluggish markets. Revenues for the Optoelectronics and Manufacturing division for fiscal 2013 increased $32.9 million, or 20%, to $198.5 million from $165.6 million for fiscal 2012. This increase was primarily attributable to a $43.5 million, or 50%, increase in our contract manufacturing sales, as a result of an expanded customer base as we have made new manufacturing services available to such customers, partially offset by a decrease in commercial optoelectronics sales of $10.6 million, or 14%, primarily as a result of reduced sales volumes to customers in the solar energy and healthcare industries, as well as an underperforming European market. Gross Profit % of % of % of 2012 Net Sales 2013 Net Sales 2014 Net Sales (Dollars in millions) Gross profit $ 268.6 33.9 % $ 290.4 36.2 % $ 305.0 33.6 % Fiscal 2014 Compared with Fiscal 2013. Gross profit increased $14.6 million, or 5%, to $305.0 million for fiscal 2014, from $290.4 million for fiscal 2013 and was attributable to the 13% increase in sales. Our gross margin during the period decreased to 33.6% from 36.2% for the prior-year period. The decrease was attributable to: (i) the impact of increased revenue from our Optoelectronics and Manufacturing division, which grew faster than our other two divisions, and which historically generates the lowest gross margins across the three division; (ii) the impact of product mix within our Optoelectronics and Manufacturing division, as a higher proportion of sales occurred in the contract manufacturing business, which carries lower gross margins than the optoelectronics business; (iii) the impact of a reduction in revenues in our Healthcare division, which historically generates the highest gross margin across the three divisions and (iv) increased depreciation associated with the ramp up of turnkey operations in our Security division. These factors were partially offset by improvements in margins in the cargo equipment business within our Security division, primarily as a result of more efficient manufacturing processes and economies of scale. Fiscal 2013 Compared with Fiscal 2012. Gross profit increased $21.8 million, or 8%, to $290.4 million for fiscal 2013, from $268.6 million for fiscal 2012. Our gross margin during the period increased to 36.2% from 33.9% for the prior-year period. The increase was primarily attributable to: (i) increased revenue from our turnkey screening services in our Security division, which provided higher margins than product sales and (ii) the impact of lower than average margin related to the single large contract in our Security division where we served as a prime contractor and hardware systems integrator in the prior-year period. These improvements were partially offset by: (i) the impact of the reduced revenue in our Healthcare division, which has historically generated the highest gross margin across the three divisions and (ii) the impact of the increased revenue from our Optoelectronic and Manufacturing division, which has historically generated the lowest gross margin across all three divisions. 57 -------------------------------------------------------------------------------- Table of Contents Operating Expenses % of % of % of 2012-2013 2013-2014 2012 Net Sales 2013 Net Sales 2014 Net Sales % Change % Change (Dollars in millions) Selling, general and administrative $ 151.7 19.1 % $ 159.8 19.9 % $ 166.9 18.4 % 5 % 4 % Research and development 49.6 6.3 % 48.2 6.0 % 44.8 4.9 % (3 )% (7 )% Impairment, restructuring and other charges 1.4 0.2 % 8.0 1.0 % 12.0 1.3 % 471 % 50 % Total operating expenses $ 202.7 25.6 % $ 216.0 26.9 % $ 223.7 24.7 % 7 % 4 % Selling, General and Administrative SG&A expenses consisted primarily of compensation paid to sales, marketing and administrative personnel, professional service fees and marketing expenses. Fiscal 2014 Compared with Fiscal 2013. For fiscal 2014, SG&A expenses increased by $7.1 million, or 4%, to $166.9 million, from $159.8 million for fiscal 2013. This $7.1 million increase was primarily attributable to increased costs to support our 13% revenue growth and increased professional fees primarily in our Security division. As a percentage of revenue, SG&A expenses were 18.4% for fiscal 2014, compared to 19.9% for the comparable prior year period. Fiscal 2013 Compared with Fiscal 2012. For fiscal 2013, SG&A expenses increased by $8.1 million, or 5%, to $159.8 million, from $151.7 million for fiscal 2012. This $8.1 million increase was primarily attributable to: (i) an increase of $6.6 million of SG&A expenses related to our turnkey screening solutions business; and (ii) an increase of $2.1 million in our Optoelectronics and Manufacturing division in support of our 20% external revenue growth. As a percentage of revenue, SG&A expenses were 19.9% for fiscal 2013, compared to 19.1% for the comparable prior year period. Research and Development Our Security and Healthcare divisions have historically invested substantial amounts in R&D. We intend to continue this trend in future years, although specific programs may or may not continue to be funded and funding levels may fluctuate. R&D expenses included research related to new product development and product enhancement expenditures. Fiscal 2014 Compared with Fiscal 2013. For fiscal 2014, R&D expenses decreased by $3.4 million, or 7%, to $44.8 million, from $48.2 million for fiscal 2013. As a percentage of revenues, R&D expenses were 4.9% in fiscal 2014, compared to 6.0% in fiscal 2013. The decrease in R&D spending in fiscal 2014 was mainly a result of reduced spending related to products that are nearing completion as well as resources moving from R&D activities to support newly developed products in our Security division. Fiscal 2013 Compared with Fiscal 2012. For fiscal 2013, R&D expenses decreased by $3.4 million, or 3%, to $48.2 million, from $49.6 million for fiscal 2012. As a percentage of revenues, R&D expenses were 6.0% in fiscal 2013, compared to 6.3% in fiscal 2012. The decrease in R&D spending in fiscal 2013 was driven mainly by a decrease in spending in our Security division. Impairment, Restructuring and Other Charges For the past several years we have endeavored to align our global capacity and infrastructure with demand by our customers and fully integrate acquisitions, thereby improving our operational efficiency. These activities 58-------------------------------------------------------------------------------- Table of Contents included reducing excess workforce and capacity, consolidating and relocating certain manufacturing facilities and reviewing the value of certain technologies and product lines. The overall objectives of the restructuring activities were to lower costs and better utilize our existing manufacturing capacity. During fiscal 2012 through 2014, we continued these efforts to further increase operating efficiencies, although we implemented fewer changes than those made in prior fiscal years. Our efforts have helped enhance our ability to improve operating margins, retain and expand existing relationships with customers and attract new business. We may utilize similar measures in the future to realign our operations to further increase our operating efficiencies. The effect of these efforts may materially affect our future operating results. Fiscal 2014 Compared with Fiscal 2013. During fiscal 2014, we incurred $12.0 million of impairment, restructuring and other charges as follows: (i) $2.3 million in our Security and Optoelectronics and Manufacturing divisions for employee termination costs and costs related to facility consolidations; (ii) $2.0 million in our Healthcare division related to our move into a new building to serve as the division's headquarters and primary manufacturing facility; (iii) $5.8 million of costs incurred within our Security division related to contract issues with the U. S. federal government; (iv) $1.3 million in our Corporate segment for debt restructuring costs related to the amendment of our credit agreement that was completed in the fourth quarter of fiscal 2014 and (v) $0.6 million of professional fees associated with defending a class action complaint that was filed against the Company and recorded in our Corporate segment. See description of costs incurred in fiscal 2013 in the section below. Fiscal 2013 Compared with Fiscal 2012. During fiscal 2013, we incurred $8.0 million of impairment, restructuring and other charges primarily related to headcount reductions and facility consolidation, and in conjunction with our agreement with the Transportation Security Agency (TSA) related to the Rapiscan Secure 1000SP Advanced Imaging Technology system and associated Automated Target Recognition software and our related agreement with the U.S. Department of Homeland Security (DHS). Of this amount, $2.4 million was recorded within our Healthcare division, $5.0 million was recorded within our Security division, and $0.6 million was recorded within our Optoelectronics and Manufacturing division. During fiscal 2012, we incurred $1.4 million of restructuring and other charges primarily related to headcount reductions and facility consolidation. Of this amount, $0.2 million was recorded within our Healthcare division, $0.3 million was recorded within our Security division, and $0.9 million was recorded within our Corporate segment. Interest Expense and Other Income, net Interest expense and other income, net includes interest expense related to our credit facility and other debt, the impact of foreign currency forward contracts that were not treated as cash flow hedges and other non-operating expense and income items. Fiscal 2014 Compared with Fiscal 2013. In fiscal 2014, our interest expense and other income, net was $5.4 million, compared to $5.0 million in fiscal 2013. This increase was primarily due to the prior-year favorable impact of the gain related to the performance of foreign currency forward contracts. The net interest expense in fiscal 2014 associated with borrowings and the utilization of the letters-of-credit facility were similar to fiscal 2013. Fiscal 2013 Compared with Fiscal 2012. In fiscal 2013, our interest expense and other income, net was $5 million, compared to $4 million in fiscal 2012. This $1.0 million increase was due to increased borrowings under our revolving credit facility to fund the investment in the Mexican turnkey services program, higher utilization of the letters-of-credit facility and the new mortgage debt associated with the acquisition of a building. This was partially offset by a gain related to the performance of foreign currency forward contracts, which were not treated as cash flow hedges. 59-------------------------------------------------------------------------------- Table of Contents Provision for Income Taxes The effective tax rate for a particular period varies depending on a number of factors including (i) the mix of income earned in various tax jurisdictions, each of which applies a unique range of income tax rates and income tax credits, (ii) changes in previously established valuation allowances for deferred tax assets (changes are based upon our current analysis of the likelihood that these deferred tax assets will be realized), (iii) the level of non-deductible expenses, (iv) certain tax elections and (v) tax holidays granted to certain of our international subsidiaries. Fiscal 2014 Compared with Fiscal 2013. In fiscal 2014, our income tax expense was $28.0 million, compared to $25.3 million for fiscal 2013, resulting in an effective tax rate of 36.9% in fiscal 2014 and 36.4% in fiscal 2013. Included within the fiscal 2014 expense was a non-cash tax charge of $7.6 million as a result of electing to accelerate the tax depreciation of certain fixed assets related to our turnkey screening solutions program in Mexico. This election resulted in cash tax savings of approximately $21 million in fiscal 2014. Similarly, included in the fiscal 2013 expense was a non-cash tax charge of $6.8 million as a result of electing to accelerate the tax depreciation of certain fixed assets related to our turnkey screening solution program in Mexico. This prior year election resulted in cash tax savings of approximately $26 million. However, in both fiscal 2014 and 2013, portions of the tax bases of the underlying assets were forfeited resulting in a non-cash tax charge in the year the election was made. Excluding the impact of these charges, our effective tax rate would have been 26.8% in fiscal 2014 and 26.6% in fiscal 2013. Effective for tax years beginning January 1, 2014, the election to accelerate depreciation is no longer available in the Mexican tax code. Therefore, a similar election is not expected to be made in future years. Fiscal 2013 Compared with Fiscal 2012. In fiscal 2013, our income tax expense was $25.3 million, compared to an income tax expense of $16.4 million for fiscal 2012, resulting in an effective tax of 36.4% in fiscal 2013 and 26.5% in fiscal 2012. The tax expense and effective tax rate for fiscal 2013 was impacted by the tax charge discussed in the previous paragraph. Excluding the impact of this charge, our effective tax rate for fiscal 2013 would have been 26.6%. Liquidity and Capital Resources Over the past several years our principle sources of liquidity have been our cash and cash equivalents, cash generated from operations and our credit facility. Cash and cash equivalents totaled $38.8 million at June 30, 2014, an increase of $4.1 million, or 12%, from $34.7 million at June 30, 2013. During fiscal 2014, we generated $129.2 million of cash flow from operations. The majority of the proceeds were used for the following: $54.6 million invested in capital expenditures, $35.0 million in the repayment of bank lines of credit, $17.6 million for the acquisition of businesses and other assets and $20.6 million for the repurchase of our Common Stock, including net share settlement of equity awards. If we continue to net settle equity awards, we will use additional cash to pay our tax withholding obligations in connection with such settlements. We currently anticipate that our available funds, credit facilities and cash flow from operations will be sufficient to meet our operational cash needs for the foreseeable future. In addition, without repatriating earnings from non-U.S. subsidiaries, we anticipate that cash generated from operations will be able to satisfy our obligations in the U.S., including our outstanding lines of credit, as accounting earnings in the U.S. are not necessarily indicative of cash flows since earnings are generally reduced by non-cash expenses including depreciation, amortization, and stock-based compensation. The changes in our working capital and cash and cash equivalent balances are described below. 2012-2013 2013-2014 2012 2013 2014 % Change % Change (Dollars in millions) Working capital $ 322.5 $ 244.9 $ 269.3 (24 )% 10 % Cash and cash equivalents 91.5 34.7 38.8 (62)% 12 % 60 -------------------------------------------------------------------------------- Table of Contents Working Capital During fiscal 2014, working capital increased by $24.4 million or 10%. The most significant increases in working capital were due to: (i) the reduction in our borrowing under our bank lines of credit of $35.0 million; (ii) the increase in the level of current deferred tax assets of $31.9 million; (iii) the increased level of inventories of $27.9 million and (iv) a $22.6 million decrease in the level of accounts payables. Partially offsetting these increases in working capital were: (i) an increase in deferred revenue of $42.5 million; (ii) a decrease in accounts receivables of $21.0 million; (iii) a $19.3 increase in other accrued expenses and current liabilities and (iv) a $6.8 million reduction in prepaid expenses and other current assets. During fiscal 2013, working capital decreased as we utilized cash on-hand and drew down on our revolving credit facility to fund capital spending in preparation of our turnkey screening solutions program in Mexico and partially for the purchase of a new building to serve as the headquarters and as a manufacturing facility for our Healthcare division, as well as building improvements for this new facility, which were partially offset by our positive net earnings. 2012-2013 2013-2014 2012 2013 2014 % Change % Change (Dollars in millions) Cash provided by (used in): Operating activities $ 120.6 $ 58.7 $ 129.2 (51 )% 120 % Investing activities (81.2 ) (167.9 ) (72.2 ) 107 % (57 )% Financing activities (1.7 ) 51.1 (54.3 ) NM NM Cash Provided by Operating Activities Cash flows from operating activities can fluctuate significantly from period to period as profitability, tax timing differences and other items can significantly impact cash flows. Our largest source of operating cash flows is cash collections from our customers following the sale of our products and services. Our primary uses of cash for operating activities are for purchasing inventory in support of the products that we sell, personnel related expenditures, facilities costs and payments for general operating matters. Fiscal 2014 Compared with Fiscal 2013. Cash generated by operating activities in fiscal 2014 was $129.2 million, an increase of $70.5 million, or 120%, from fiscal 2013. This increase was primarily due to changes in working capital in the current-year period when compared to the prior-year period, including: (i) a $79.7 increase in the change in cash flow from accounts receivables due partially to the increased level of focus on improving our days sales outstanding and collecting delinquent receivables from our turnkey program in Mexico; and (ii) a $46.2 million increase in the change in cash flow from deferred revenue as well as due to the $32.9 million increase in net income for fiscal 2014 after giving consideration to non-cash operating items including depreciation and amortization, stock-based compensation and deferred taxes among others as compared to the prior-year period. These favorable changes in cash flow were partially offset by the following unfavorable changes in working capital: (i) a $66.6 million decrease in the change in cash from accounts payable and (ii) a $16.1 million decrease in the change from prepaid expenses and other current assets. Fiscal 2013 Compared with Fiscal 2012. Cash generated by operating activities in fiscal 2013 was $58.7 million, a decrease of $61.9 million, or 51%, from fiscal 2012. This decrease was primarily due to changes in working capital in the current-year period when compared to the prior-year period, including: (i) a $109.8 million decrease in the change in cash flow from advances received from customers; (ii) a $36.2 million decrease in the change in cash flow from accounts receivables as average days sales outstanding increased in the current year; and (iii) a $13.8 million decrease in the change in cash flow from deferred revenue as deferred revenue as of the prior-year end was earned in fiscal 2013. These unfavorable changes in working capital were partially offset by the following favorable changes in working capital: (i) a $53.4 million increase in cash from accounts payable as days 61-------------------------------------------------------------------------------- Table of Contents payments to vendors increased compared to the prior year; (ii) a $27.0 million increase in net income for the twelve months ended June 30, 2013, after giving consideration to non-cash operating items including depreciation and amortization, stock-based compensation and deferred taxes, among others; and (iii) a $21.5 million increase in cash from changes in prepaid expenses and other current assets. Cash Used in Investing Activities The changes in cash flows from investing activities were primarily related to capital expenditures as well as the acquisition of businesses and other assets to support our growth plans. Fiscal 2014 Compared with Fiscal 2013. Net cash used in investing activities was $72.2 million in fiscal 2014, a decrease of $95.7 million, or 57%, as compared to the $167.9 million used in fiscal 2013. During fiscal 2014, we invested $54.6 million in capital expenditures as compared to $157.4 million in the comparable prior-year period. This decrease was primarily a result of the timing of capital expenditures in support of our turnkey screening program in Mexico. During fiscal 2014, we also used cash of $17.6 million for the acquisitions of businesses and other assets as compared to $10.5 million in the comparable prior-year period. Fiscal 2013 Compared with Fiscal 2012. Net cash used in investing activities was $167.9 million in fiscal 2013, an increase of $86.7 million, or 107%, as compared to the $81.2 million used in fiscal 2012. During fiscal 2013, we invested $157.4 million in capital expenditures primarily in our Security division related to the fulfillment of our large turnkey screening services program in Mexico and the acquisition of land and building which is now serving as our Healthcare division's new headquarters, as compared to $68.5 million invested during fiscal 2012 mainly in initial preparation of our large turnkey screening services program in Mexico. Cash Provided by (Used in) Financing Activities The changes in cash flows from financing activities primarily relate to (i) borrowings and payments under debt obligations; (ii) the issuance of and/or repurchase of Common Stock and (iii) employee stock plan activities. Fiscal 2014 Compared with Fiscal 2013. Net cash used in financing activities was $54.3 million in fiscal 2014, compared to net cash provided by financing activities of $51.1 million in fiscal 2013. In fiscal 2014 we paid down our outstanding bank lines of credit by using $35.0 million as compared to receiving $59.0 million in the comparable prior-year period. In fiscal 2014, we repurchased $20.6 million of our Common Stock including net settlement of equity awards compared to $22.4 million for the comparable prior-year period. In addition, cash provided by financing in the prior year period included a new term loan of $11.1 million for our new headquarters in our Healthcare division. Fiscal 2013 Compared with Fiscal 2012. Net cash provided by financing activities was $51.1 million in fiscal 2013, compared to net cash used in financing activities of $1.7 million in fiscal 2012. In fiscal 2013, $59.0 million in cash was provided from our bank revolving credit facility primarily to fund our capital spending. In fiscal 2013 we also financed the acquisition of land and building through an $11.1 million term loan. Finally, in fiscal 2013, we used $22.4 million to repurchase shares of our Common Stock under our stock repurchase plan and settle tax obligations arising out of our stock plans as compared to $6.4 million in fiscal 2012. Borrowings Outstanding lines of credit and current and long-term debt totaled $37.3 million at June 30, 2014, a decrease of $34.2 million from $71.5 million at June 30, 2013. See Note 6 to the Consolidated Financial Statements for further discussion. 62-------------------------------------------------------------------------------- Table of Contents The following is a summary of our contractual obligations and commitments at June 30, 2014 (in thousands): Payments Due by Period Less than After Contractual Obligations Total 1 year 2-3 years 4-5 years 5 years Total debt $ 37,255 $ 26,819 $ 4,910 $ 3,707 $ 1,819 Operating leases $ 20,191 $ 9,581 $ 8,616 $ 1,994 $ - Purchase obligations $ 45,505 $ 45,178 $ 327 $ - $ - Defined benefit plan obligation $ 8,006 $ 162 $ 384 $ 1,083 $ 6,377 Total contractual obligations $ 110,957 $ 81,740 $ 14,237 $ 6,784 $ 8,196 Other Commercial Commitments-letters of credit $ 124,718 $ 22,059 $ 3,070 $ 96,567 $ 3,022 We anticipate that cash generated from our operations, in addition to existing cash borrowing arrangements and future access to capital markets should be sufficient to meet our cash requirements for the foreseeable future. However, our future capital requirements will depend on many factors, including future business acquisitions, capital expenditures, litigation, stock repurchases and levels of research and development spending, among other factors. The adequacy of available funds will depend on many factors, including the success of our businesses in generating cash, continued compliance with financial covenants contained in our credit facility and the health of capital markets in general, among other factors. Cash Held by Foreign Subsidiaries Our cash, cash equivalents, and investments totaled $38.8 million at June 30, 2014. Of this amount, approximately 83% was held by our foreign subsidiaries and subject to repatriation tax considerations. These foreign funds were located primarily in Malaysia and the United Kingdom, and to a lesser extent in Mexico, India, Singapore, China, Germany and Canada amongst others. We intend to permanently reinvest a significant portion of our earnings from foreign operations, and we currently do not anticipate that we will need this cash in foreign countries to fund our U.S. operations. In the event that funds from foreign operations are needed to fund operations in the United States and if U.S. taxes have not been previously provided on the related earnings, we would provide for and pay additional U.S. taxes at the time we change our intention with regard to the reinvestment of those earnings. Stock Repurchase Program Our Board of Directors authorized a stock repurchase program under which we may repurchase up to 4,000,000 shares of our Common Stock. During fiscal 2014, we repurchased 165,845 shares under this program. As of June 30, 2014, 1,219,195 shares were available for additional repurchase under the program. Upon repurchase, the shares are restored to the status of authorized but unissued shares and we record them as a reduction in the number of shares of Common Stock issued and outstanding in our Consolidated Financial Statements. Off Balance Sheet Arrangements As of June 30, 2014, we had no off balance sheet arrangements, as defined in Item 303(a)(4) of Regulation S-K, other than those previously disclosed. New Accounting Pronouncements For information with respect to new accounting pronouncements and the impact of these pronouncements on our Consolidated Financial Statements, see Note 1 to the Consolidated Financial Statements. 63-------------------------------------------------------------------------------- Table of Contents Related-Party Transactions In 1994, we, together with an unrelated company, formed ECIL-Rapiscan Security Products Limited, a joint venture organized under the laws of India. We own a 36% interest in the joint venture, our Chairman and Chief Executive Officer owns a 10.5% interest, and our Executive Vice President and the President of our Security division owns a 4.5% ownership interest. Our initial investment was $0.1 million. For the years ended June 30, 2012 and 2013, our equity earnings in the joint venture amounted to $0.4 million and $0.1 million respectively. There was no equity earnings in the joint venture recognized for the year ended June 30, 2014. We, our Chairman and Chief Executive Officer and our Executive Vice President and the President of our Security division collectively control less than 50% of the board of directors voting power in the joint venture. As a result, we account for the investment under the equity method of accounting. The joint venture was formed for the purpose of the manufacture, assembly, service and testing of security and inspection systems and other products. Some of our subsidiaries are suppliers to the joint venture, which in turn manufactures and sells the resulting products. Sales to the joint venture for fiscal 2012, 2013 and 2014 were approximately $5.8 million, $5.7 million and $5.2 million, respectively. Receivables from the joint venture were $0.3 million and $0.6 million as of June 30, 2013 and 2014, respectively. We have contracted with entities owned by our Chief Executive Officer and/or his family members to provide messenger services, auto rental and printing services. Such costs in fiscal 2012, 2013 and 2014, were approximately $79,000, $76,000 and $31,000, respectively. UNAUDITED QUARTERLY RESULTS The following tables present unaudited quarterly financial information for the four quarters ended June 30, 2013 and 2014 (in thousands, except per share data): Quarter Ended September 30, December 31, March 31, June 30, 2012 2012 2013 2013 (Unaudited) Revenues $ 181,694 $ 194,049 $ 198,409 $ 227,895 Costs of goods sold 120,339 123,961 126,571 140,750 Gross profit 61,355 70,088 71,838 87,145 Operating expenses: Selling, general and administrative 39,925 36,829 37,752 45,255 Research and development 11,316 11,858 12,386 12,680 Impairment, restructuring and other charges - 2,723 2,286 2,978 Total operating expenses 51,241 51,410 52,424 60,913 Income from operations 10,114 18,678 19,414 26,232 Interest and other expense, net 1,097 1,386 1,341 1,200 Income before provision for income taxes 9,017 17,292 18,073 25,032 Provision for income taxes 2,678 4,872 4,544 13,185 Net income $ 6,339 $ 12,420 $ 13,529 $ 11,847 Basic earnings per common share $ 0.32 $ 0.62 $ 0.68 $ 0.59 Diluted earnings per common share $ 0.31 $ 0.60 $ 0.66 $ 0.58 64 -------------------------------------------------------------------------------- Table of Contents Quarter Ended September 30, December 31, March 31, June 30, 2013 2013 2014 2014 (Unaudited) Revenues $ 206,274 $ 236,408 $ 203,956 $ 260,104 Costs of goods sold 138,328 155,469 133,449 174,496 Gross profit 67,946 80,939 70,507 85,608 Operating expenses: Selling, general and administrative 42,214 45,556 39,399 39,700 Research and development 11,020 11,175 10,579 12,018 Impairment, restructuring and other charges 4,239 2,179 2,507 3,119 Total operating expenses 57,473 58,910 52,485 54,837 Income from operations 10,473 22,029 18,022 30,771 Interest and other expense, net 1,470 1,503 1,370 1,097 Income before provision for income taxes 9,003 20,526 16,652 29,674 Provision for income taxes 2,609 5,953 11,851 7,548 Net income $ 6,394 $ 14,573 $ 4,801 $ 22,126 Basic earnings per common share $ 0.32 $ 0.73 $ 0.24 $ 1.11 Diluted earnings per common share $ 0.31 $ 0.71 $ 0.23 $ 1.07 |