There? Oh, we got a—we need the—yeah, okay. We're a little delayed, but I'll just reiterate that we're here with OSI Systems and kicking off the Aerospace Defense Track at the JPMorgan Industrials Conference. Alan Edrick, CFO of OSI Systems, is joining us. Thanks for being here, Alan. Maybe we'll start off just maybe talking a little bit about the business and maybe familiarizing people a little bit with what you guys do. I think the thing that people are probably most familiar with is at the airport and the Rapiscan Systems that people will see to scan as they go through the checkpoint at the airport. Maybe tell us a little bit about your security business and the different things that you do there.
Sure, sure. Our security business is the largest of our businesses. It represents about two-thirds of our revenue. As you correctly describe, most people know us for our aviation business, what we do at the airports. Interestingly, people think that's the majority of our business. The aviation and checkpoint-type business is about a third of our overall security revenues. The biggest part of our business is actually ports and borders and critical infrastructure where we do scanning. That represents the other two-thirds of our revenues. We have become the largest security detection company in the world. We surpassed the former number one a little bit earlier last year. A nice part of our business is recurring in nature. We sell products, and we have some great service revenues associated with it. A very strong brand. We're quite a global company.
More than half of our revenues in security are outside the U.S. The U.S. is quite an important geography for us as well. We really get invited to all the major tenders out there, which are significant. The world's not getting a whole lot safer as we see every day in the news, but it plays well into what we do.
Right. When you think about that port and border side—and by the way, just for perspective, the security business overall is a little over $1 billion. Two-thirds of that billion-ish dollars is ports and borders. When you think about the level of—and maybe let's start off with the checkpoint. I think about the checkpoint business as being fairly its replacement. The world's major airports, for the most part, have security systems installed, and that's a business that is replacement. When you think about ports and borders, how much of that market is penetrated versus how much is still kind of open?
You know, we like to think in the ports and borders that we're really still in the very early innings. Unlike aviation, where you correctly describe that it's mostly a replacement market, though there are some new airports and new terminals being built, on ports and borders, we're really in kind of virgin territory where most of the times when we're installing security scanning solutions, it's not replacing existing equipment out there. It's where there was no security being done or it was not a high-tech security. It might be security such as dogs and the like. We think we're in the early innings of that game. It's the fastest growing part of the business in the fastest growing market. It's the segment that we absolutely want to be in.
Right. You would say your—how would you assess your market share in that part of the business?
We believe we're the number one market share that we have, more than half the market. We really believe we have a kind of a dominant position in that area. Great for us on the product side. That nice installed base that we have that continues to increase is really increasing our service revenues as well.
Okay. When we think about the area that's open to further penetration, would you say is the domestic market pretty well penetrated and more of the open territory is internationally, or is it on both domestically and internationally?
Yeah, the nice thing, it's really global. It's both domestically and internationally. Here in the U.S., of course, we're focused at the U.S.-Mexico border where we have significant systems installed, but there's a lot more that needs to be installed both on the southern border as well as on the northern border. We think about ports. Ports today, generally speaking, most cargo is not being scanned. It represents a tremendous opportunity here in the United States. Outside the United States, we're seeing tremendous demand throughout all parts of the world, in the Middle East, in Europe, in Latin America, in Asia-Pacific. It's really growing at a nice clip.
Okay, okay. Excellent. I guess when you think about meeting that demand, what's sort of a kind of realistic growth rate to think about for this market?
You know, hard to say because it can ebb and flow. Generally speaking, in this part of the market, folks tend to think that the growth rate over kind of a long-term period is high single digits or double digits, lower double digits. We've been growing at a faster rate than that. We think we have every reason to believe that we can continue to grow this business at a healthy rate. That is the fastest growing part of the market.
Right. Okay, okay. Excellent. You mentioned the domestic market. I've heard the administration is rather focused on the border. Maybe if you—what have you seen so far in terms of plans from this administration that might affect your business in terms of creating more security infrastructure at the border?
We think there can be some very favorable tailwinds for us. Both the current administration as well as Congress are highly focused on security, are highly focused at the borders, and they're highly focused on a technology solution in addition to the wall and the stuff. The technology solution is what we do. It's called NII or Non-Intrusive Inspection Scanning Systems, and that's where we have the number one share. We think the backdrop is very favorable for us for increasing economics to come our way in this regard.
Right. If we were to see something like that this year, would that be principally through the reconciliation bill that's being discussed in Congress?
The reconciliation bill would certainly be helpful. If it's a continuing resolution, we think there are parts of that that can be favorable to us as well, looking at some of the similar funding levels as we may have had last year. In a reconciliation bill or a new budget, there have been talks of allocating considerably more money to CBP, Customs and Border Protection, and in particular to the NII or Non-Intrusive Inspection Scanning Systems that we play in. Yes, we do think that's an important element to get more dollars our way.
Right. Excellent. What would you say in terms of for customers being the market leader in ports, what distinguishes your products, you think, versus competitors?
Yeah, great question. We think there's really a number of things. One, we have the broadest portfolio of products in the industry in this segment. We have high energy. We have low energy. We have medium energy X-ray systems. We have combinational technologies. It comes in a variety of configurations. Many of our competitors have to push a particular technology solution on the customer. We have all the solutions, and thereby we can see what's right for the customer and serve them well. Our customer service is outstanding. Maybe one of the biggest differentiators for us is a software that we developed, a proprietary software called Cert Scan that we originally developed for a different business model that we have called Turnkey. It clearly provides a big differentiator for us in other awards. For instance, we won a large award in Mexico a couple of years ago.
It was a $500 million tender with the Mexican Army called Sedena. Initially, we were thinking that this order may be split up three ways, and we might have gotten a $150 or $200 million deal, which would have been a very nice deal for us. After the customer did reference checks with select customers, and just as importantly, after they learned about our Search Scan software, they decided to sole source the award specifically to us. This is clearly a differentiator for us, and we think will continue to be for a long time to come.
Excellent. I guess when we think about that contract, I know that that's driven pretty fast growth in the security segment over the past in fiscal 2024 and into the beginning of fiscal 2025. When you think about that work, kind of getting through the initial phase of that work and having the business kind of grow through the wind down of that particular project, is that a temporary headwind for growth, and is it possible to overcome it?
Yeah, yeah, great question. It was a question we were getting from a lot of folks, particularly last year as we started to generate significant revenues and we had a strong backlog. There was a concern from some out there that we'd start seeing a decrease in our backlog, and ultimately we were at a high of revenues and it would be coming down. We said, no, that's not the case. This is our new baseline revenue level, and we're going to be growing from here. We've seen just that. I think last quarter, our book-to-bill was nicely north of one in our December quarter. We ended the quarter with a record backlog despite converting a significant amount of those Mexico revenues that you're referring to, Mexican backlog into revenues. It really gives us tremendous visibility and an outlook into the future.
For our second half of the fiscal year, which based on our guidance is expected to be larger than our first half in revenues, that will contain a smaller proportion of Mexico revenues. What that is meaning is that we are absolutely sort of filling that hole and getting some tremendous bookings and giving us great backlog and visibility. As we move into fiscal 2026 and beyond, our expectation is to continue to grow just as we always have been.
Is there anything to highlight that came through that was particularly helpful in terms of filling that hole?
You know, the nice part is they haven't been grand slams. It's just been a series of singles and doubles and triples, a number of just nice size orders, but to a very diverse customer base, principally outside the U.S., not in Mexico, but principally outside the U.S. in places that have very fertile territory like the Middle East, other parts of Asia, not China, but other parts of Asia, Latin America and Europe. We think the U.S. and the domestic market is going to be very, very strong for us in the future. Hasn't been as strong the last couple of years, and we haven't needed it to be with the strong revenue growth we have, but we think it's going to be much bigger for us going forward. Nice position to be in.
Right. When we think about the profitability of that work that's really been driving a lot of the growth recently, we've also seen some nice margin expansion in the security business. When you think about evolving into a more kind of broad-based revenue set going forward, what impact does that have on profitability?
Yeah, as we think about profitability going forward, one of the nice things we've had is as we get this bigger and bigger install base out there, generally there's a warranty for one year, sometimes a bit longer. As the products roll off of warranty, for the next eight or ten years while these systems are out there, we get the service revenue. The service revenue on this cargo business in particular tends to generally carry maybe a 10-point or so differential on the gross margin between products and services. We believe that our service revenue as a percentage of our overall Security division revenue will be increasing here over time, and that can have a nice flow and pull-through effect to our operating margins.
Okay. To be able to kind of maintain, at least maintain and eventually expand.
Our goal is to continue to expand our margins. I mean, there'll be a little bit of ebbs and flows in certain quarters, but overall our goal is to continue to expand our operating margins.
Right. When we think about that, you mentioned the service, and I think that's an important piece of this, the amount of what do you include in recurring revenue for the security business?
When we think about recurring revenue in security, the biggest portions are field service, which tends to recur year after year after year, our training revenue, which is a big initiative and we think is going to be growing significantly over time, our turnkey revenue, which are these long-term contracts that we have that come at substantially higher margins, generally speaking, which is great for us as well. Then kind of a newer thing that we're kicking off is our pure SaaS revenue on the proprietary software that we call Search Scan. All of those make up what we would consider to be recurring revenue in our security segment.
Right. When we think about security now, how much of it is recurring revenue?
Today it's about 30%. As we look forward, we think over the next several years that number could approach 40% or beyond, again, with the bigger installed base that we have out there with hopefully some more new turnkey deals and with the rollout of our proprietary Search Scan software.
Right. The turnkey opportunity exists primarily with international customers?
Yeah, it really does. I mean, the turnkey opportunity is fantastic for a country or a location that either doesn't have the capital or money to buy the equipment upfront, or if they do, maybe they don't have the operational expertise. So it's ideally suited for that. We could do it well here in the United States too, but due to certain dynamics, we think it's less likely to take off in the United States as swiftly as it has internationally.
Right. When we think about kind of the field service opportunity, is that something where there's annual price?
Annual price increases?
Yeah.
There are small annual price increases in most contracts.
Right. Let's say, and my understanding, I guess, was if you had a certain size order, what's the kind of life expectancy of the equipment?
Generally speaking, depending, seven to ten years, usually.
Over that eight, nine-year period, you would collect in service revenue roughly the same as what was collected to install the equipment.
Yeah, on the initial product sale. That's right.
With a higher margin.
With oftentimes a significantly higher margin.
Right. Right. And then there's a small price opportunity through that eight-year period.
That's correct.
Eight, nine-year period.
That's correct.
Excellent. We talked a lot about ports and borders. I guess maybe tell us a little bit how you think about the airport market and what particular opportunities might be coming up there.
The airport market, the aviation market's been an exciting one for us as well. We've been growing double digits in the aviation and checkpoint business as well. I think some of the more exciting opportunities are here in the United States. The checked baggage systems that we all use were installed long ago and are beyond their so-called economic use for life. There is a big replacement program slated to begin maybe as early as 2027, perhaps 2028, that will go on for about five years. We did not participate in the initial rollout of these, which happened not long after 9/11 because we did not have a product at that time for that. Because of the necessity driven by 9/11, they took medical CT and adapted them for security applications.
We then became the first company to develop the industry's first security checked baggage systems designed specifically for security. Rather than having a rotating gantry like you might see in a hospital if you went for a CT scan, we have a stationary gantry aligned with a series of sensors that our Optoelectronics division makes. With that, there's high throughput at lower false alarm rates and can be a lower total cost of ownership for the customers. Although we didn't participate in the initial rollout years ago, when we brought these out, we've been selling them very strong internationally. We have them in leading airports like France, in Italy, and many places in the Middle East and other parts of the world.
We would expect to hopefully win our fair share here in the U.S. as well, which is all upside opportunity for us since we do not presently have an installed base in the U.S. for checked baggage machines.
Right. Is there an approximate dollar value that you attach to that, to the overall checked baggage replacement?
We've seen folks kind of attach maybe $1 billion to $1.5 billion overall value. Likely there'd be three or so companies that might share in that award over time. Similar to the other products, besides just selling the product, when it's out there for the next decade, the service revenue is attractive.
Yeah. Okay. Okay. I guess that kind of touches on the competitive landscape here. It seems like kind of an interesting time in that I think the primary competitor in airport and checkpoint security is Smiths Detection. Smiths Group is in the process of a breakup that will see Smiths Detection become a standalone company. Do you see that changing in any way, the market structure or the competitive dynamic in the market?
It remains to be seen. Smiths has announced publicly they plan to sell or separate the business. Whether it becomes a standalone or part of another company remains to be seen. We know they're focused on one of their other divisions to divest first and then turn their attention to Detection, which is what they've announced publicly. We don't discount any competitor. Smiths has long been a great competitor and a leader in the industry. We're proud to have surpassed them in total size in 2024, but we don't stand on our laurels or take anything for granted. Maybe our success has had something to do with some of the changes that they're looking at, but we don't see any major change in that competitive dynamic if they were a standalone company.
Right. Okay. Okay. When you talk about three companies potentially competing in that checked baggage award, the other one would be within Leidos?
Yeah, Leidos is the other major player in the aviation market and really all the markets. When we think about competition, Smiths and Leidos are our two biggest competitors. We tend to be the largest company followed by Smiths, followed by Leidos, but all formidable competition.
Right. Okay. Okay. I guess you mentioned when you talked about the products, you mentioned some of what you make in your optical division being part of your security products. Maybe let's talk about the optical division for a second because we've focused mainly on security, which is the biggest and the most important segment. OSI has three divisions, and one of them is Optoelectronics . Maybe tell us a little bit about what you do there, both the relationship between the optical business and the security business, but then also what the optical business does independently.
Sure. Interestingly, optical has formed the foundation of the company. It's where we started.
OSI?
OSI, yes. Unlike security where we sell to the end customer, in optical, we manufacture for the Fortune 500 and many of the leading OEMs. In fact, many of the companies who are at this conference over the next couple of days. In optical, we make sensors, we make detectors, we make other electronic components. Much of the secret sauce that we do in our security business is manufactured by our optical division. Through that vertical integration, we're able to enhance our overall company-wide margins. We can control the supply chain a bit better and be faster and more responsive to our customer needs. On a big picture basis, about 85% of our sales in optical are to third-party companies and about 15% are inter-company. Of course, while those inter-company sales get eliminated in consolidation, the margin does remain in-house and part of our earnings.
It's been a big part of our success story.
Yeah. Okay. When you think about that optical business and the opportunity there, we talked about growth in security. How do you think about the growth profile of those end markets for optical and your opportunity to participate in the growth of those markets?
Yeah, the nice thing about our optical business is we participate in really diversified end markets. Yes, we're in aerospace and defense and in security, medical, gaming, technology, automotive, industrial. A very diverse customer base, no customer concentration, no customer even coming close to approaching 10% of our sales from a third-party basis. Once we get engineered into a company's product, we tend to be there for a long time through the company's or the product's lifecycle. Some companies and products we've been making for well over a decade. Although these optical revenues do not maybe meet the classic definition of recurring revenue, we consider it repeat revenue because we have an extremely high rate of this revenue that just repeats over and over and over.
Our business development teams do really a fantastic job gaining new business out of existing customers as well as getting brand new customers as well. So very important to us.
Maybe two kind of macro questions related to the optical business. One is when you think about we've heard a lot about we heard a lot about slowing demand from airlines earlier today at the conference. The market seems to be telling us that risk of recession is increasing. When you think about the customers, the 85% or so that's outside of the internal sales for optical, how do you think about what happens to those sales in a softer economic environment?
Yeah, it's interesting. We're actually kind of seeing a little bit of the opposite right now, which we feel fortunate about. Over the last 18 months or so, our optical sales were a bit flatter as many of our customers had overbought inventory either during the pandemic and when there were supply chain concerns for risk mitigation measures. Over this period of time, they've been right-sizing inventory levels, more optimizing. While that's not 100% complete, we believe it's largely complete. We are actually expecting to see an acceleration of growth in our optical revenues beginning as early as this quarter. All that being said, to your question, if the economy slows down and there's slowing demand for our customers' products, of course, that would impact us as well. Right now, we're actually seeing accelerating demand as opposed to a slowing down of demand.
Right. I mean, I would guess it depends very much on the end market too. If it's A&D building new aircraft, defense, those could be relatively protected.
Correct.
Okay. The other macro consideration is tariffs. I think this is probably most relevant for optical. Maybe you could even speak to it across the company. You have manufacturing locations all across the world. You sell to customers all across the world. How do we think about the impact of tariffs on OSI?
Yeah, I mean, we're all trying to kind of figure that out today. It changes on a regular basis quite dynamically. Big picture perspective, we don't view tariffs as having a meaningful impact on OSI. In our security business and in our third division healthcare, we don't do much in the countries that are projected to have more significant tariffs. In our optical division, you're right, we do have a little bit of manufacturing in Mexico, a little bit in Canada, but kind of a rounding error when it comes to OSI overall. Although we're assessing what that might mean to us and to our customer base, we don't anticipate that to be anything of significance for us.
Right. Okay. Maybe let's move on to the third segment. I guess kind of like in security, in the medical business, OSI sells products directly to the end customers. Maybe tell us a little bit about what you do in medical.
Yeah. Yeah. In medical, our brand is called Spacelabs Healthcare. It's a well-recognized brand out in the hospital world. We sell principally into medium and large hospitals, though we'll also go into the more acute or rural setting. What we principally focus on are patient monitoring products and cardiology products.
Patient monitoring products are the monitor that you might see at the bedside at a hospital monitoring all the vital signs, which is then connected to a central station, which we also manufacture and sell, where a nurse can look at multiple rooms simultaneously, which is then connected into the hospital's electronic medical records, which we partner with the leading firms on, and then can also be connected through telemetry products, which we also make so the patient can be continuously monitored as they move around the hospital, for instance, if they had to go into an X-ray or just walking around the hospital. That is the biggest part of what we do. It is a fully connected solution. We have cardiology products where we do ambulatory blood pressure and what they call Holter monitoring and the like.
The interesting thing about our cardiology is not only is it the highest margin products in our Healthcare division, it's the highest margin products, generally speaking, in all of OSI.
I think that's interesting because when we look at that division, we've seen some sales declines in recent years. As a result of those declines, kind of minimal earnings contribution and yet high growth margin. I know that the company has brought in some new leadership for that segment recently. It seemed like there was probably a need for that business to start to do more to contribute. How do you think about the recovery of that business going forward? What are the ways to increase sales, I guess, principally?
Yeah, it's an exciting area for us. Although it only represents 10% of our revenues, it is our highest contribution margin business. As our revenues go up, an awful lot drops through the bottom line. Unfortunately, the inverse can be true too if revenues are going down. As you pointed out, we brought on a new President, a President of this division on February 1, so just about six weeks ago. This individual, we believe to be of a significantly higher caliber than frankly we've ever had in the history of this division, previously ran one of our competitors and tripled the patient monitoring business at one of our competitors under his tenure. Interestingly, he was also at Smiths when they had a medical division that they ultimately sold off as well. Bringing a whole new energy and a whole new way of looking at things.
What we think will really drive this business is a new suite of patient monitoring products that we're going to be bringing out. We have been investing over the last several years significant dollars in R&D to bring out the next generation of patient monitoring systems. It will be a multi-phase approach, but we believe the first phase will be released in the summer of 2026. In the medical device world, that is not too far away now. We are quite excited about that. Before that, we think under the new leadership and the new way of thinking, it can really help stimulate some of the commercial operations and probably get a little bit smarter in the way we run the business to contribute to a better bottom line.
Okay. Okay. No, that's very interesting. When we think about investment across the company, if we were to quantify the investment in kind of new health systems and think about that winding down, I assume, over the next year or so, is that cost that kind of goes away? Are there other investments that'll be needed across the company to kind of fill in that hole?
Yeah, we think we've been doing outside spending on R&D in this division over the last several years. We've got a few more years of that to go. Yes, that won't be a we don't believe that to be a rate that will be there sort of over the long term. As we roll out the products, yes, we think the overall R&D that we're spending will come down.
Okay. When you think about overall investment over the next few years, R&D and CapEx, what's kind of the requirement for the company? I guess specifically, it seems like there is a very meaningful growth opportunity in Ports and Border Security. Are you capacitized to address the demand there?
Yeah. We have a number of plants throughout the world. We believe we have adequate capacity to continue our growth plans. We do not think there is any new plants or major CapEx required in that regard. Our CapEx, we generally say, should be somewhere in that $25-$30 million a year range where it can elevate. This is for a really good thing, if we win new turnkey contracts. We expect to win new turnkey contracts. As we do, there will be an initial upfront capital requirement. The paybacks on those are very strong indeed. We would like to have those happen. On the R&D side, on the security, we will continue to invest in next-generation technologies, which we think has helped us become the market leader. We want to stay the market leader.
We try to grow our R&D investments at a pace that's a little bit slower than our growth in revenues overall. So we get that leverage effect on our operating and our EBITDA margins.
Okay. Okay. Let's talk about cash for a second. The Sedena contract has been a real boon for the top line and driven a lot of growth. But cash conversion during the initial phases of that contract has been fairly low. How do we think about cash conversion, I guess, kind of through cycle for the company and then maybe particularly over the next several quarters, given kind of the low cash conversion we've seen recently?
Yeah. We have had some significant investments in working capital, namely in receivables and inventory associated with the Sedena and a few other contracts. The exciting news is now that we are in 2025, as we look at calendar 2025 and beyond, we think we are going to be generating very, very significant free cash flow. We think we will have a very nice free cash flow to net income conversion. We kind of think that starts now. It is going to be a real positive time for us where we are generating perhaps outsized free cash flow for a while.
Wow. Would that carry through calendar 2025?
We believe so. Yeah.
Okay. As we look out in sort of to a normalized period, how would you think about conversion of net income?
We think 100% conversion is not unrealistic for us. Yeah.
Okay. Okay. We talked about the management change in Healthcare. Also had a management change in the CEO's office recently. A little bit different, though. This is not someone who's new to the company. Ajay Mehra took over, but I think he'd been at the company for over 30 years, so not a totally new face. If you think about any changes that you've observed or expected changes, whether it's in emphasis in capital deployment or strategy or anything like that with the change in leadership?
Yeah. Our longtime CEO, Deepak Chopra, not the spiritual guru, but Deepak Chopra, he remains as our Chairman of the Board and will be instrumentally involved for the foreseeable future. AJ stepping in, having been at the company for about 35 years and leading our Security division to the top position overall, I think was a vote in continuity. The company has been doing real well, and I think it's a continued vote in that. I don't think it's that we'll see a major change in direction, but I think with any new leader, there'll always be some enhanced vision and I think some opportunities to further build upon that and have some new ways of thinking. It's early days.
It's only been about two and a half months, but he's off to a fantastic start and really excited to see what's to come, especially as we start our planning for our new fiscal year here, being a June 30th, which just starts here in a few months.
Yeah. Excellent. I think we're right about at time here, but if I could sneak in a last one, it would just be about capital deployment. With the company, it hasn't generated a lot of cash in recent quarters, but has a very strong balance sheet. There's a lot of cash to be generated over the next several quarters. What are you going to do with it?
Yeah. Yeah. It's a great position to be in with the strong free cash flow that we're going to generate. Really kind of three things we look at for our capital allocation. We don't look at them as mutually exclusive. I think we can do all three of these. M&A has always been in our DNA. We did an acquisition earlier this year. That's off to a fantastic start for us, but we tend to do a couple of acquisitions each year, sometimes smaller bolt-on acquisitions that'll fill a channel need or a technology need or a takeout of competitor, but there could be larger ones as well. We've been active in stock buyback. In our first fiscal quarter, we bought back about $80 million of stock.
Lastly, although our net leverage is not high, it's only 2.1, and we would expect it to continue to go down with our free cash flow. We would pay down any excess cash that we had, just pay down our revolver.
Okay. Okay. With that, I think we'll wrap it up. Alan, thanks so much for being here. Really appreciate it.
Thank you. Appreciate it as well.
Thanks. Thank you. You're a natural people.