All right, let's get started with the next session. We're with OSI Systems. I've got Alan Edrick, the CFO. So, Alan, thanks so much for joining us today.
Thank you for having us.
Maybe just to kick it off kind of high level for people in the room that aren't familiar with OSI, could you talk a little bit about what you guys do, the end markets you serve, that sort of thing?
Sure, sure.
OSI Systems, we have three divisions. We have a security division, we have a healthcare division. Kind of what ties it all together is our optoelectronics division. Most of our investors and most people probably follow us for our security division. Our security division is called Rapiscan Systems. It represents over two thirds of our revenues. We are the number one player in security detection and what we do in security. Many people know us for aviation because if you go to airports, we make products for checked baggage, checkpoint, trace detection, body scanners and the like. The bigger part of our business in security and the fastest growing part of our business in security is what we call cargo and solutions for ports and borders and critical infrastructure.
Here in the U.S. at the southern border, the northern border, but internationally as well, we're number one in cargo and solutions by a wide margin. We really are sort of dominating that market, we believe, and it's really where you want to be as well, because it's the fastest growing market. Unlike aviation, which is often a replacement market, for cargo and solutions at ports and borders, we're still in the very early innings of the game. We tend to be the top player in the fastest growing market, which is really a nice place to be. Our recurring revenue is significantly increasing in this area. In our healthcare business, we sell to hospitals, we sell to medium and large hospitals predominantly where we make patient monitors and cardiology products. We have a nice recurring revenue stream there as well.
What ties that together, as I was mentioning, is our optoelectronics business. Unlike security and healthcare, where we sell to the end customers, in opto, we make sensors, detectors, other electronic components for the leading OEMs, the Fortune 500s in a variety of industries: aerospace and defense, industrial, medical, automotive technology. In addition to selling to the third party companies, many of the key components that go into our security products and many of the key components that go into our healthcare products are manufactured by our opto division. Through that vertical integration, we enhance the overall company wide gross margin. We can be faster, more responsive to our customer needs, and solve some of the supply chain challenges that have taken place over the last years.
Yeah.
I guess a quick kind of follow up. You mentioned kind of the penetration opportunity and sort of the ports on the border side relative to the. We spoke about this yesterday. I thought that was sort of interesting anecdotes of, you know, opportunities to still add equipment there.
Yeah, yeah, it really is. You know, so when you think about the ports and the borders, most of the sales that we're making, we're not replacing current equipment that's already there. It's where they haven't been doing scanning ever, really. It's big, big opportunities both here in the United States. We could talk a little bit more later about that opportunity, but internationally as well. You know, we're seeing tremendous opportunities in the Middle East, in Latin America, in Asia, in Europe. It's really a fast expanding market for us.
Yeah, got it.
I guess maybe starting out on the U.S. side with security products. I mean, we started to get some more details of the funding for next year coming out over the last couple days. Can you talk a little bit about that? I mean, obviously border security, big priority for the administration, what you're seeing and sort of when can that translate to growth for you guys?
Yeah, super, super exciting for us, as you mentioned, for border security here with the main agency, it's called CBP, Customs and Border Protection, part of the Department of Homeland Security. You're absolutely right that it's a high priority for the administration, but it's also high priority for Congress. While Republicans and Democrats don't agree on a whole lot of things, one thing that they seem to agree on is the use of what they call NII technology, non intrusive inspection technology at the borders. The budget that they put forth that you see potentially here in the reconciliation bill and budgets going forward is significantly higher than we've ever seen in the past. It's $1.1 billion that they show for NII technology. They also have a couple other categories for biometrics and for other border security that we can also play in.
It appears that there's huge opportunity for us. Our growth over the last couple of years, which has been very robust, has really been driven internationally and we continue to see very strong international growth. Now with the United States funding that you're talking about, that looks to be very, very attractive. Assuming this passes in the next few months, it generally takes a little bit of time to do the RFPs and then issue the awards. That could be something that happens in or around the end of the calendar year.
Yeah, got it.
Trying to put you on the spot. $1.1 billion. Do you know kind of roughly what the run rate has been? How much of an increase is that?
It is significant. In the past, we were expecting around $300 million, so it is almost quadrupling. That is why we are so excited about it. Much, much larger than we even anticipated just six months ago.
Yeah, got it.
Interesting.
More on the international side. Mexico, you guys have had some big contract wins. Those are starting to kind of get a little bit more mature. I guess could you talk a little bit about, as that happens, both the growth profile of that business and also maybe the margins as the mix kind of changes a little bit?
Yeah, so we won a few contracts in Mexico that were quite notable, and we've been delivering on that starting at the end of fiscal 2023. Our fiscal 2024 revenues were very robust. Fiscal 2025 is strong too, but not to the level of fiscal 2024. The nice thing about Mexico, as you mentioned, as it becomes a bit more mature, in fact, during the last quarter, our revenues in Mexico were down 50%, but our overall security revenues were up 10%, which kind of just shows how strong our overall channel is, you know, outside of Mexico. The nice thing about Mexico is as we're delivering these products and we have a much bigger install base after they roll off of warranty, you then start to see the service revenues kick in. Service revenues generally contain a higher margin than the product revenues.
We saw a very notable increase in our service revenues during the March quarter. We expect this to really be our new baseline to continue to grow. Office.
Yeah,
got it.
Apart from Mexico, internationally, are there regions or countries that you see as kind of the biggest opportunities or is it fairly widespread?
It definitely is very widespread, but we see the Middle East being very fertile territory for us. But really on a complete global picture, it seems to be very strong.
Yeah, okay.
I guess just overall, the business, you know, big uptake in kind of product. Product deliveries over the last couple years within security. Can you talk a little bit about the life cycle of those? Like there's a service period after those.
Get delivered and sort of how the.
Business mix overall for security trends from here?
Yes, we've had significant product deliveries over the last few years, really increasing our installed base. The life cycle of most of our products tend to be in that 7-10 year range. What we see is once we sell a product, the service revenue that we get, kind of the aftermarket revenue for that next 7-10 years, roughly approximates, you know, the initial price of the product we sold. If we sold something for $1 million, over the life of that product, we might get $2 million overall. Very nice for us. Important for us to have that large installed base which leads to the strong recurring revenue. That recurring revenue generally is at higher margin than the initial product sale.
Yeah, got it.
I guess another margin opportunity. You guys have talked about some of the new product offerings, turnkey product that you now provide, the software updates. Can you talk about how those are sort of ramping up adoption rates and sort of how accretive that can be for margin?
Yeah. The turnkey or security as a service for us is a great business model that we pioneered. The basic business model that we had always had was we sell the product and then we get that recurring revenue through service, spare parts, and maintenance. A few years back, we sort of challenged ourselves to say, how can we expand those revenues and how can we expand the margins? We said, what if there's a customer set out there that either doesn't have the cash or the capital to buy the equipment up front, or if they do, what if they don't have the operational expertise to run it?
What if we do a full service for them that we call turnkey, where we manufacture the equipment, we place it at the customer site, but we own it, we staff it up with our people, we enter into long term contracts up to 15 years, and then we get this great recurring revenue at higher margin. It's been a real success for us. It's a longer sales cycle, but our pipeline of opportunities in there is good. We've been working on a few deals for quite a long time. It's getting to the point that we think there could be opportunities as we enter fiscal 2026 here. We're June 30, fiscal year. Fiscal 2026 is a few weeks away. That would be hopeful that we'll see further turnkey wins in the next fiscal year.
Yeah, got it.
Could you touch a little bit on?
The airport part of the security business? It's a smaller piece than the border stuff, but just kind of where are we in kind of the airport investment cycle for that? I think it sort of fell after COVID. And now that we're hearing a lot of headlines around, you know, Newark Airport needing to upgrade a lot of systems, like, is there opportunity for that to pick up?
Yeah, there's a big opportunity in airports and aviation. The aviation business is a good business for us. It's growing double digits as well. The U.S. infrastructure is badly in need of investment. When you take a look at checked baggage machines at airports, these machines are sometimes 20 years old, where most of the time it's viewed that the life cycle is about 10 years. Consequently, more service has been needed on these types of machines. Our belief is that there's going to be a big upgrade cycle coming in. In checked baggage, it's been stated publicly, it's probably still a couple of years away from starting and then it'll be about a five year replacement cycle for us. It's all incremental revenue because at the time these things were rolled out 20 years ago, we did not have a checked baggage product.
We then developed the industry's first specifically for security applications and have had great success selling it internationally. We have it in leading airports like Paris and Rome and many locations throughout the world. As we come to the U.S., we'd hope to, as the U.S. starts to have our own roll out of the replacement cycle, we'd expect to get a similar market share. We look at aviation as a big opportunity for us going forward as well.
Yeah, got it.
Can you talk a little bit about the opto business? I mean, interesting mix of end markets there, but we had a little bit of a sort of destocking period, I think with some of your customers. I think we're through the worst of that. Just kind of talk about how that business can grow and what are kind of the biggest drivers.
Yeah, so our opto business, you know, spread throughout a number of industries as we talked about earlier, with no customer concentration, which is great. You know, the destocking, you know, some companies, most customers are now through the destocking. Even during the destocking, our opto business was performing very nice. You know, still had strong revenues and operating margin expansion. If you look at our last quarter, you know, we grew 15% in the opto business. As we look forward into, you know, into fiscal 2026, we see an opportunity for further growth in the business both on the top line and margin expansion. The sales team in opto has done a tremendous job mining new customers and getting additional business out of existing customers.
One of the additional newer opportunities that we see is there are many companies looking to move away from some of their manufacturing partners in China. We do not manufacture in China. Our opto business has a very global footprint. We are in Asia, we are in Indonesia, we are in Malaysia, we are in India, we have Mexico manufacturing, we have U.S., U.K., Canada. We offer a nice footprint for.
Others to move to.
We're seeing a good interest level from a number of companies and moving some of their manufacturing from China to one of our locations.
Got it.
Okay. And then third part of the business in healthcare, you've made some progress. Margins have come back a little bit there, kind of mid single digit compared to, you know, below single digit at one point. We're still not up to where they were, you know, years ago. Just sort of what's the outlook there and what are you guys working on?
Yeah, I'd say the most exciting things for us in our Healthcare division is two things. One, we've been developing a new patient monitoring platform. We've been spending significant research and development dollars on that. We're now getting to the point that we're not far from launching our first phase. We believe that will happen next summer, so about a year from now, which we think can stimulate some significant growth. The second is we brought on a new president at our Spacelabs division February first, so about four months ago, very, very strong individual who led one of our competitors and significantly grew their patient monitoring business. A very sophisticated individual who's going to be upgrading the talent in our organization, upgrading the infrastructure and some of the go to market strategy. Extremely excited about that.
The Healthcare division generates the highest contribution margins of any of our divisions. As we get the top line going, there's a very big pull through to operating margins. As you said, in the past, we've had, you know, mid teens or even high teens operating margins for particular quarters, maybe not always for a full year. If we can get those revenues going with the very, very high contribution margins, we think that's available to us. We think that's more likely to occur as we launch, you know, the new product platform. We'll be continuing to position ourselves for that strength. We'll also be, you know, addressing some costs and the like to hopefully put up even better margins in 2026.
Yeah, got it.
I wanted to ask about cash flow, cash conversion. I think, you know, six months, you know, nine months ago, some concerns because you had sort of lagged a little bit and then that started to recover. So it's quite good. So just thoughts on what drove that and kind of the outlook into next year.
Sure.
We've historically been a very strong generator of cash flow as a company. When we won some big contracts, this is a good thing. We were investing in working capital. We invested in inventory, we invested in receivables. As we were going through some very strong growth. We're now at the level that although we expect to continue to see strong growth, we'll see some normalization of that working capital. The Mexico contracts that you referred to earlier were a big factor in that. In Mexico we still have some, I'll call it outsized receivables. Though we've been collecting a lot of cash. We collected over $100 million from Mexico in the March quarter. We saw our DSOs come down in the December quarter and the March quarter.
As we go into fiscal 2026, we think there's going to be a tremendous conversion of free cash flow. You know, our free cash flow conversion percentage of net income is going to be very, very strong. As we normalize, we should be generating very, very significant free cash flow.
Yeah, got it.
You guys did an acquisition earlier this fiscal year. Is RF-based defense kind of focused product portfolio. Can you talk a little bit about what that business is and sort of how it contributes to the other work that you do?
Yeah, this acquisition has truly been exceptional.
For us so far.
We bought this company in September, a US-based company, and this company had tremendous technology. But being a smaller company, though the sales team was very, very strong, they didn't have the entire reach that our sales team did. When we take their strong technology and we put it into our sales channel in addition to theirs, it's led to some great new bookings. The performance of this business has been strong right out of the gate. We've had good revenues, we've had good operating margins. We expect that to continue. It could be part of the new Golden Dome program as well. A lot of excitement in this business, but a great, great strong technology platform where we sell to many of the same customers both in the U.S. and internationally. It's done very well.
We'll look for acquisitions that continue to do similar type of things for us.
Yeah.
Does that align with kind of the security products business or is it opto? I know there's like a defense aspect in that.
Yeah, there is a defense aspect, but yes, it is part of our Security division because the customers are the same, same customers that we sell to in the Security division. So it's been very, very helpful.
Got it, got it.
Okay. On the cost side, you guys have done a really nice job controlling costs as you grow. SG&A as a percentage of sales has come down as revenue has grown. So I guess could you talk about, is there opportunity for that kind of percentage of sales, SG&A to continue to come down? Does it need to grow at some point? Just kind of. Any thoughts on cost?
Yeah, so we, you know, we're always looking to grow the top line with operating margin expansion, and part of that operating margin expansion comes from leveraging our fixed cost structure. As our revenues have gone up and economies of scale associated with that, our SG&A as a percentage of sales has come down. We're also always looking to challenge ourselves for continuous improvement to see how we can, you know, further optimize, you know, our SG&A or our operating expense. As we go forward, we think we'll continue with that strategy. As we grow the top line, our expectation is to grow our SG&A at a slower rate than we grow our top line. As a percentage of sales, it could come down further and further lead to more operating margin expansion.
Yeah, got it.
Okay. Could you talk a little bit about, you know, the capital deployment strategy, particularly given, as you said, there's a lot of cash coming next year? You know, what are the priorities? Could there be buybacks? Is M & A still a big focus? Any thoughts there?
Yes, yes, all the above. With the strong free cash flow that we expect to generate, our capital allocation is really three things. We can do all three of these things. M&A is in our DNA.
You know, we do.
We like to do acquisitions, but again, as we were talking a little about earlier, we're a very disciplined buyer, but we would like to do some acquisitions complementing that. Stock buyback is a part of our capital allocation as well. Any residual cash we have, we would just use to pay down a revolver to reduce our interest expense.
Yeah, got it. Okay.
Tariffs, I mean, sort of news has died down a little bit. Maybe we're making some progress. Just thoughts on how that potentially could impact your business, those we do end up with tariffs.
Yeah, big picture, we don't think tariffs will be material for us in our security business. Not a big factor in our opto business. Not a big factor either. Although the tariffs that we do absorb in opto, we tend to pass on to the customer almost dollar for dollar. So we would expect very, very little P&L impact from opto. Interestingly, the area that we might have a little bit more exposure in is in our healthcare division. If we're going to have exposure, I'd rather it be in our smallest division where we have about 10% of our revenues because we do source some stuff from China there, but we're actively looking to replace that and have alternatives. Kind of in a nutshell, we don't look at tariffs as anything material for us.
Yeah, got it.
Okay, a couple follow up questions and if anybody has one in the audience, definitely raise your hand. We'll get you in. One of the ones somebody had asked me recently was just on the capacity you guys have. Given that there's a lot of demand, both in the U.S. side and international, do you need to maybe build out any more capacity to support that or do you have spare room left?
Yeah, it's a great question. We do have multiple manufacturing facilities and we've shown in the past that we have the ability to ramp up production and ramp it up fast. You know, we won a big $500 million contract in Mexico following a $200 million contract there as well. Through our manufacturing plants for that part of our business, both in the U.S. and the U.K., we ramped up and delivered everything that we need to deliver. As we continue to grow, we believe we have adequate manufacturing capacity, we can add shifts, we can add more people. We don't believe it requires any significant investment. There might be some modest investments, but nothing significant.
Yeah, got it.
M & A, I mean, we touched on. Still sounds like it's part of the strategy. Can you talk about what the pipeline looks like? Are there a lot of assets coming up for sale and any particular area that would be interesting to add?
Oh, yeah, absolutely. At M & A, we're primarily focused on our security and our opto businesses. For acquisitions, there are a number of companies we're exploring. There's always that delta between what the seller thinks they're worth and what the buyer. Sometimes that takes a little bit.
Of time to.
To narrow that gap. Yes, we're seeing, you know, we're seeing opportunities probably more on the bolt-on size than the sort of the transformational size. You know, similar to the acquisition you mentioned that we did in September, which was, you know, about $100 million deal including earnout, that's kind of more on the bolt-on capacity. Yeah, we are seeing some nice things and we hope to be able to consummate a deal or two in our next fiscal year.
Yeah.
Are there any sort of like adjacent end markets that maybe you would do an acquisition to get into, kind of expand your addressable market, or it would be very much sort of in the wheelhouse of what you're doing already?
Both.
We like to do some things that are right down the middle of the fairway, but we'll also expand a little bit beyond that. The RF acquisition you mentioned is a good example of that. Probably not right down the middle of the fairway, but complements a lot of the stuff that we do and works well with our sales channel. I think we would look at both.
Yeah, yeah, got it.
Can we talk a little bit about market share in the security industry? You guys compete with Leidos, with Smiths. You've gained a lot of share in recent years. Can you talk about kind of what drove that? Do you think there's opportunity to continue the gain?
Yeah, yeah, we think so. I mean, I think we've been the fastest growing security company where I believe we're the largest security detection company.
Now.
You know, all the competitors you mentioned are great companies and we don't take anybody for granted. For us, you know, security is the largest part of our business, so we are highly, highly focused on it. For some of our competitors, it's an important part of their business, but it's not the largest part of their business. I think we think creative, we think out of the box. We don't approach each deal as a cookie cutter. We approach each deal to see what it's going to necessarily take to win. Our goal is to continue to take market share. We already have what we believe to be a very, very strong market share on the ports and borders and critical infrastructure side.
I think there's opportunity to take more market share on the aviation side, particularly as checked baggage replacement cycle starts, where our market share is zero in the U.S. on checked baggage today.
But.
Once that starts, it could be a great opportunity for us.
Yeah, got it.
You guys recently had a CEO change. Can you talk about the new leadership? I do not think there is a big change in the strategy, but just any thoughts on that turnover?
Yeah.
The CEO change was foreshadowed. We had our previous CEO, who's still with us as Executive Chairman, had been in place for quite some time. Earlier in 2024 we announced that he would be retiring. On January first, we named our President of our Security division, so the President of our largest business, as the new CEO. I think what that was a measure of is a vote of continuity. You know, what we're doing is going extremely well. The individual who's led our biggest division has now taken over. The last five and a half months have gone very, very well. Any new leader will bring some new ideas in and, you know, he's continuing to gain his traction, his feet, particularly in the other divisions and getting fully up to speed.
The CEO transition has gone, you know, phenomenally well, backed up by, you know, our former CEO is still the Executive Chairman and, you know, has a nice voice in the company continuing.
Got it.
The last one for me. Again, if anyone in the audience has one, the margins on the aviation part of the business, I guess if that does start to ramp up, is there any reason to expect those would be any different from the port and border stuff? Maybe because it is newer products. Are you not as far down the learning curve or just any kind of mix thing to think about there?
Yeah. The margins vary so much, whether it's between aviation and in cargo and ports and borders, whether it's U.S. or a particular country abroad, you know, there's such a wide variety of margins. As we ramp up our aviation revenues, we don't anticipate it to have any material negative impact on our business. With those economies of scale and the like, you know, we believe it should have a positive impact and help our operating margins because incrementally, it'll add to our overall operating and EBITDA margins.
Yeah, got it.
Okay.
Anything from the audience?
Cool. All right. Yeah, maybe we'll wrap it up there. But, Alan, thanks a lot for joining us.
Thank you very much.
Thanks. Good job.
Thank you.