I'm here with Alan Edrick at OSI Systems. Thank you for being here with us.
Oh, thank you. Nice to be here.
I like to start these fireside chats usually for the audience that sometimes is an industrial audience. Little bit of a business overview. What do you guys do?
Yeah. Big picture, we have an exciting company. We have three divisions. We have a Security division, we have a Healthcare division, and we have an Optoelectronics division, which sort of ties everything together. Really from a big picture perspective, roughly in rough order of magnitude, you know, about 70% of our business is Security, a little over 20% is Optoelectronics, and a little under 10% is our Healthcare business. We find that most of the investors are primarily interested in our Security business. We believe we're the leading Security detection company in the world, and Security detection means what we're doing is we're doing security in aviation at airports, at ports and borders and critical infrastructure, at sporting events and the like.
Over the time, we've captured significant market share to become what we believe to be the number one player in the world. In our Optoelectronics space, we do sensors, we make sensors, detectors, other electronic components, and we're an OEM supplier, so we supply to the Fortune 500 in industrials, probably many of the companies who are here at this conference, in aerospace and defense, in medical, and a number of other industries. In addition, our Optoelectronics supplies many of the key components that go into our Security products, and many of the key components that go into our Healthcare products. Through that vertical integration, we're able to enhance the margin and control the supply chain, be a little faster and more responsive to our customer needs. Finally, our Healthcare division, the smallest division that we have.
We serve hospitals. We make products in patient monitoring and cardiology, and then we have a lot of recurring revenue through service spare parts and consumables.
You just touched base on that Opto business, and that is the synergies. When did you realize that it was important to have that vertical integration? Have you seen any need to actually expand that vertical integration to actually manage your future and your supply chain?
Yeah. Interestingly, we started out as an optoelectronics company, and we expanded into security, and we expanded into healthcare. Vertical integration has always been ingrained as part of our DNA, and the more stuff that we can bring in-house and capture that margin and control the supply chain, the better for us. What we've been seeing through the course of the years is just that. We have brought more and more in-house. We've seen those intercompany sales expand over the years, and while those revenues are ultimately eliminated in consolidation, the margin remains in-house and helps our earnings per share.
When you think about M&A, how much focus you have into expanding to, like, new opportunities versus actually managing down your supply chain?
Yeah. When we think about M&A, we look at the entire spectrum. You know, we're looking at acquisitions that will fill a need for us, a channel need, a technology need, perhaps take out a competitor. We may look at stuff that will help on the supply chain side as well, but it's usually much more strategic from a business and a financial perspective.
Perfect. Now I'm gonna switch gears to security, mostly about the SEDENA Mexico contracts because h onestly, I don't know, 95% of the conversations I got over the last two years were related to these type of contracts. Right now, like in your top line, most of that risk is gone, and you have been able to fill that risk. How should we think about from a top-line revenue perspective, how much is the Mexico-related services and support revenue that we'll keep seeing?
Yeah. You're absolutely right. We've been getting a lot of questions on Mexico lately. Mexico has been a fantastic opportunity for us. We received three contracts totaling north of $800 million a few years ago. We've been fulfilling those in our fiscal 2024, 2025, this fiscal 2026, continue a little bit into fiscal 2027. As we've had that, a lot of the questions from investors were fantastic winning the orders, but as you convert the backlog to revenue or is your backlog gonna come down? Is your revenues gonna come down? Over the years, we had said, no, you know, we have a tremendous pipeline of opportunities. We've seen just that. You know, our backlog, even as we've converted significant backlog to revenue, our backlog's gone up.
We finished the last quarter at a record backlog, and we've filled that hole, you know, very successfully. Really the exciting thing for us as we move into our fiscal 2027, which is only a month and a half away because we're a June 30th fiscal year, is unlike fiscal 2025 and 2026, where we had very difficult comps and a big hole to fill, which we think we've done, in fiscal 2027, we don't really have any sort of material headwind related to Mexico any longer. While there'll still be a few more product shipments to go there, it does transition primarily to service revenue, and our service revenue is very strong revenue and strong margins. We're excited. It's kind of a much more minimum headwind in fiscal 2027 than we've seen before.
The other piece of those contracts is the receivables, though. It's taking longer to actually be able to build those deliverables and actually collect that money. What is the latest there, and when do you expect to actually recover that money?
First off, we've been dealing with Mexico for a couple decades, we're dealing with the Mexican federal government, in this case, the army and the navy. Over the years, we've had a number of contracts with Mexico. They've paid us every single dollar, every single peso they owed us. Generally speaking, not necessarily on time or when it's due, but we've gotten every amount of money we've had. You know, we finished up our last quarter, the March quarter, with about a $350 million receivable, more or less, from our key customer in Mexico. Subsequent to quarter end, I think we mentioned in our last conference call, we collected about $70+ million. On that, it's come down.
What that means for us, what really, really excites us, you know, for this other $270 million, roughly, is we're gonna have extraordinary, we believe, free cash flow here over the next 12 months. The exact timing of which we don't know. I mean, we believe because, you know, we're owed, you know, right now past due is probably something in the neighborhood of about $170 million, 'cause some of it isn't billed or isn't due yet. This is normal course. This is very, very normal course for our contracts in Mexico, we expect to fully get paid here over the next 12 months, hopefully even sooner.
Once this volatility is out, what is a normalized free cash flow conversion for a business like yours?
You know, over the next year, I think our free cash flow conversions can be nicely north of 100%, you know, absent other things, maybe potentially taking place. What we've seen traditionally in our businesses, our free cash flow conversion is pretty close to 100% of net income. Sometimes a little higher, sometimes a little lower, but our free cash flow conversion is very strong.
You mentioned right before that this is normal business for you to deal with this type of, like, size of contracts, international customers, international governments.
Yes.
How much can you do to prevent this type of volatility from a contractual point of view, and if not, how do you prepare financially to be able to afford these type of opportunities at the end of the day, if they were to come?
Yeah. The good news is we love these contracts in Mexico. If we were offered these contracts 10 more times, we would take them 10 more times. They're great economically. May take us a little bit longer to collect our receivables, but that's built into our overall business model. We have a very strong balance sheet. We have low net debt. We're sitting on a good amount of cash. We have a big credit facility that's untapped for a revolver. We have plenty of capacity in order to take on contracts like this. Now, that being said, we don't often get $800 million in three contracts like that.
If we did, you know, our balance sheet is so strong that we can afford it, and if you look at it from a true economic perspective, it's a fantastic business proposition for us.
Have you seen any competitive advantages just from the willingness of taking that risk versus others or?
Oh, sure. You know, the knowledge we get, the business that we get, the references. You know, when we win business like that, other countries and other potential customers take note of those wins. Some of these wins were expected to be split amongst multiple parties. At the end of the day, we ended up sole sourcing this, and that says a lot about our technology, our service offering, our reputation, our ability to deliver. In fact, we've, you know, we've delivered exceptionally well, we believe.
Perfect. Speaking to international opportunities, we have seen some come from Latin America lately, and Mexico has been super strong. Where else in the world are you seeing most of the incoming opportunities from?
You know, the international opportunities have been strong for us. You know, over the last three, four, five years, the international growth has really driven our overall growth as a company. The funnel remains robust. We really see that in most regions in the world, not just Latin America, but the Middle East has been strong for us. Europe has been strong. Asia has generally been strong. Not China. We don't do a lot in China, but other parts of Asia. It's really kind of the entire world that has been strong, and we see tremendous opportunity going forward as well.
Before we jump into domestic opportunities, you just mentioned the Middle East, and in the first quarter, you started to see some disruption there. How large is that business? How much it represents? How are you thinking about the disruption in the near- term and opportunities as this conflict evolves? I don't know.
Yeah. I mean, the good news for us is we are the largest player in the Middle East for security detection. We're the largest player by far. We do a lot of business in a number of countries there. When the conflict broke out in really the last month of our fiscal third quarter or calendar first quarter, and continues, that has some impact on us. As you can imagine, in a short-term basis, countries aren't necessarily awarding new contracts, it impacts bookings a little bit. The exciting thing for us is both medium and long- term, when these type of conflicts end, it generally means a lot of new business for us. We're quite excited about that. We hope the conflict ends sooner than later.
You know, potential impacts near- term, you know, just could be, you know, continued on the bookings, as well as certain deliveries. Now, we have a lot of ways that we're able to maneuver certain things, but with the Strait of Hormuz closed, certain shipments that may go into the Middle East could be impacted. you know, that was all kinda built into, you know, what we said on our last earnings call.
Perfect. Now moving the focus to the U.S. The one big beautiful bill funded, like, over $1 billion for non-intrusive inspection machines. Because of the shutdown, that money hasn't flown through the system yet. What are your expectations there?
Yeah. This is super exciting for us. You know, this is the type of money that we're seeing from the one big beautiful bill funneling to CBP, Customs and Border Protection, which is part of the Department of Homeland Security, is very, very exciting. You know, we expected very large orders probably starting six months ago. Of course, the government, you know, got shut down in October, and even when the government was reopened, the Department of Homeland Security, by and large, has been closed most of the time until just about a couple of weeks ago. As we look forward, we're extremely excited about our positioning to get significant business.
You mentioned the $1 billion+ for NII, the Non-Intrusive Inspection scanning equipment, which is exactly what we do. In past awards, you know, the most recent past awards for some big IDIQs, we got north of 40% of that business. You know, our hope is that we continue to, you know, maintain a very, very significant share. Our understanding is that we continue to be a preferred supplier for CBP. Our delivery and service was outstanding on these past contracts. We think that, you know, plays a nice role. Our hope is that we're gonna see some significant awards coming from, you know, the one big beautiful bill, as well as some of the leftover money from the past IDIQ contracts.
You mentioned your performance has been outstanding, and this is really interesting to highlight because there are many reports that actually say that in general, there is a lot of these assets and equipment that hasn't been actually installed that everything is lagging where they should be. What makes you unique? Where are you differentiated from a performance point of view? What is your, I don't know, fair share to win from this opportunity considering your unique approach to CBP?
Yeah. You know, on the last big IDIQs, I think there were three parties who received the awards. Again, we got more than 40% of it. While we delivered on time and we were always ready, government wasn't always necessarily ready, some of the sites were delayed. You know, consequently, the program shifted a little bit to the right. Our performance was always spot on. We understand that might not have been the case with some of the other awardees on the contract, and we think that, you know, might position us well on new contracts. You know, what is our right for a fair share to win?
You know, we, of course, you know, think the maximum, but the government, you know, generally does not sole source awards. You know, if we can, you know, keep the same type of, market share percentage or potentially even higher, you know, we would, we'd be very thrilled.
Perfect. When we think about this international growth supporting the backlog, and lately, actually most of the growth, the domestic opportunities, this mix between products and services. What does that to margins? How should we think about, like, margins three, five years from now?
Yeah. Our goal is always to, you know, couple top line growth with operating margin expansion. If you look at what we've done over the past decade, that's generally been our formula. As we look forward, you know, the last couple of years, we've had very, very strong, you know, product revenue growth from a lot of these international sales. When you sell the products, they generally come with a one-year warranty, maybe a little bit longer. As they roll off of warranty, now you get this great recurring service revenue. To your question, our service revenue generally carries more than 10 percentage points higher of margin. We've seen very significant service revenue growth throughout calendar 2025, and we expect to see nice continued service revenue growth going forward.
When you look at that, when you couple, you know, increasing service revenues at higher margin, coupled with economies of scale on higher product sales, our goal is to continue to grow the operating margins, you know, for the foreseeable future.
How is that split today, like the recurring services versus products, and when you target opportunities? What could be your target in the future?
Yeah. You know, today, our recurring revenue is about 30% in the Security division. You know, we see that we could take that to 40% or higher in the future. All that is also, though, dependent upon the level of product sales we have. While we expect to see very significant service revenue growth, there may be very strong product revenue growth sort of simultaneous with that so that percentage mix may take a little bit longer to get to, but overall, it still leads to very significant operating margin expansion. When I say, you know, very significant product revenues, the one big beautiful bill that you just mentioned, as well as some big orders that we've gotten on RF, for Homeland Defense, Golden Dome, if you will, and the like, which is mostly product revenue at the outset. Very exciting times for us.
Before we touch base on RF because I think that's really i nteresting and kind of like new to you. When I think about margins on pricing, is there any difference for like international customers or regions versus domestic? What are the dynamics there?
Yeah. There's no real set way of saying it, you know. Every product might have a different margin depending upon the region, depending upon the customer and the like. It's hard to draw sort of across the board inferences. At times there'll be significant margins, or at times, you know, margins may be a little bit more compressed, you get the much larger recurring revenue for many years. There's not really a great general rule of thumb as related to that.
So now switching to RF. You acquired that business, what, like a year and a half ago. It's performing where like almost like quarterly revenues are matching like the annualized revenues of the business you acquired not so long ago. You just got a, what is like $230+ million contract for Over-the-Horizon sensors. You are selected for the SHIELD Golden Dome contract. How do you think about like opportunities there, and why have you been investing into increased capacity to be able to afford those?
You know, this is a very exciting acquisition that we did about 18 months ago, as you mentioned. This should be sort of a case study in doing acquisitions. It hasn't been a single or a double or a home run. It's been a grand slam so far. The outlook going forward is even stronger than the strong performance that we've shown, you know, to date. The Over-the-Horizon radar technology that we have, the team has an excellent reputation. As we acquired the company, we took these great technologies and products, some of the strong relationships the incumbent management team had.
We supplemented that with our own internal resources, which were a little bit stronger as a larger company in our balance sheet, and it's afforded us the opportunities to bid on bigger projects and to win some of these bigger projects. As you just mentioned, you know, most recently, we were awarded this up to $235 million deal with Homeland Defense. Very exciting for us. We don't believe that's the end. We think there's, you know, much further opportunity there. To your question on expanding capacity, we kinda saw this coming, you know, not necessarily the whole Golden Dome award, but just the expansion of the RF business, say nine months ago. We began to expand capacity.
We brought on new facilities that we began moving into in November of 2025 that will be completed with this year. This expanded our capacity by 3x-4 x , which proved to be very fortuitous as we're getting these larger orders. There may be opportunities to further expand based upon the strong demand that we're seeing out there today.
If I were to think, I'm gonna analyze your first quarter revenues, and you're running at a $150 million revenue line for that business. How much capacity? Like, to what extent you can actually produce with the capacity you just increased?
Yeah. You know, without sort of quantifying that today because we're increasing it today, and we're mostly running on a single shift, but we can move to, you know, two shifts or three shifts. We believe there's adequate capacity to improve, increase our revenues nicely from there, but there may be potential for taking on additional space and building additional capacity too based upon the very exciting level of demand that we're seeing out there.
Perfect. That's a perfect tie to M&A and investments and expansions and capital deployment. How do you think about that as you think about, like, investing into these opportunities you have with your current businesses versus actually going after something like these type of businesses that is something adjacent. I don't know, scope can actually give you bigger opportunities. How do you see that in the pipeline?
The great, really the great answer for us is that both of those things are not necessarily mutually exclusive. We think we can do both. You know, with the strong balance sheet that we have, with the strong free cash flow that we expect to generate, we believe we can invest as much as we need that's appropriate in our business while simultaneously, turbocharging our organic growth with inorganic growth. We think both of those opportunities lie ahead for us.
Okay. Within Security, we haven't talked about airports. You are usually stronger in the cargo market talking about, like, this renewal wave that is about to come in, what? Like, three years from now. You do have better products now. I'm interested about that. How do you think about the opportunities there? Do you think the airports are actually getting the funding to improve all this equipment? What could delay that or not? From a competitive dynamics perspective, a lot is going on, right? Smiths as a standalone business, Leidos merging with Analogic. How do you think about your positioning into these, like, evolving competitive dynamics?
Yeah. The aviation market is exciting to us. We've been growing it at a double-digit mark. It's not as big for us, as you mentioned, as the cargo market for ports and borders where we're, you know, the number one player. In aviation, we are a big player, and the opportunities are exciting. Most of the opportunities that we've been pursuing have been international opportunities, and we've been doing quite well there. As you mentioned, a big replacement cycle is expected to start in a few years here in the United States for checked baggage. We have, you know, probably a 20% or 25% market share on checked baggage outside the United States.
Inside the United States , when these machines were purchased long, long ago, we didn't have a product back then for checked baggage, so we don't have an installed base. Similar to Europe, where we also didn't necessarily have an installed base at the time and have taken a significant market share, we would hope to get, you know, a fair share of the market when this replacement cycle starts in a few years, which is expected to, you know, last for about five years or so, and then the strong recurring revenue of services goes on top of that. We think we're very nicely positioned for aviation. We're improving our products all the time.
You know, we're excited about the aviation market, and we think there might even be some faster growth or opportunities, you know, come a couple of years from now, in that segment of the business.
Perfect. From the competitive dynamics, a re you concerned from a product perspective or pricing power perspective from these businesses actually refocusing on some arena where we see a lot of penetration from the Analogics of the world, international competitors, right?
Yeah. Fundamentally, we don't think the changes that have taken place with one of our competitors in the U.K. being, you know, taken private by a sponsor and the combination, as you mentioned, of Analogic and Leidos. I mean, Leidos had all the products that most of the products that Analogic had on the aviation side, but Analogic has some nice products too. Fundamentally, we don't see it really changing the landscape in any material way, but time will tell. Yeah.
Perfect. Now the other piece, and it's more volatile, is events. How is the opportunity that you have with the World Cup coming? What are the leading, like, orders there? Like, are those already in backlog or last-minute orders? How do we think about the Olympics as well in a couple of years?
Yeah. One of the nice things is we have been the, seems to be the partner of choice for these key events. You know, we've done things in the Super Bowl. We've done many of the Olympics. We've done many of the World Cups. We tend to be well-situated for those. With the upcoming World Cup, in the upcoming Olympics, we like to believe we're well-situated for those as well. The Olympics, Summer Olympics, I'm referring to in 2028. Of course, those decisions, you know, will be made, you know, down the road. They happen to be in, you know, in our hometown of Los Angeles, where we're headquartered, so you know, that's nice for us to see.
Both of these things are very exciting for us, partly from a marketing perspective and partly from a financial perspective as well. The Summer Olympics tend to be much larger type of events, and require much more product services and generate more revenues than a Winter Olympics or a World Cup.
Perfect. Now I'd like to switch gears to Opto. Opto has also been performing, like, really strong. How sustainable is this double-digit growth momentum? What are the arenas that are actually driving this? Like what are the end markets that are driving this?
Yeah. Hats off to our business teams at Opto. They've really done an exceptional job. Double-digit revenue growth in Opto is not characteristic of this division. We've seen just extraordinary demand. You know, we just finished a quarter where despite strong revenue growth, we had a 1.5 book-to-bill ratio, I believe, in Opto. Sitting at a very strong and healthy backlog in the Opto business as well. Typically, we look at this as kind of a mid-single-digit growth business that we look to have some operating margin expansion on top of that. Sometimes we'll try to turbocharge that as well with some M&A. Those are kind of the characteristics of this business. Overall, we've tended to kind of outperform that.
Is there any specific end market that is driving that growth?
Yeah. Our Opto business is extremely well- diversified. There's no end market that we have a high level of concentration in or any customers with a high level of concentration. That being said, aerospace and defense has been very, very strong for us. You know, that's a segment that carries, you know, high margins as well. We're really excited about that part of the business. Frankly, across the board has been generally pretty strong for us.
I could imagine especially defense was already like not related or like tied to China. Have you seen from the other end markets any demand for you guys to help these customers and industries diversify away from China?
Absolutely. You know, that's been a real initiative over the last few years. More and more, multinational companies would prefer to move their supply chain away from China, given some of the challenges there, and I think we've been a beneficiary of that. That trend continues. It's not accelerating, but the trend continues. So much of it has already been done, but more is still taking place.
How much of your products at Opto are like produced in U.S. and North America versus abroad, Asia and other places?
When we look at, where we manufacture for Opto, we do manufacture in the U.S. and the U.K. and Canada, but we also manufacture in a lot of low-cost jurisdictions such as Indonesia, Malaysia, India, Mexico. From a percentage perspective, the majority is produced outside the United States. It's, you know, probably in excess of 2/3 .
Perfect. Last, Healthcare. New management team has been there for a while. That business has been a little bit disappointing in terms of you made like a huge investment into having the right products. Now you have a right team, but like, what is still like lacking an opportunity thing? Is the market ready to actually buy these things? What is delaying the recovery this long?
Yeah, we're excited about the future of healthcare. The new management team, a new President came in just over a year ago, and over the past six months or so, he's really built out the entire management team. It's pretty new. We're absolutely kind of heading in the right direction. I know the numbers may not show that over the past few quarters. Hopefully, they will this quarter and as we move into fiscal 2027. The most exciting thing for us in the Healthcare business is a new patient monitoring platform that we're developing and will be coming out, and it's probably more of a, by the time it has an impact on revenues, will not necessarily be fiscal 2027, but probably more fiscal 2028.
We expect to see the business stabilizing, growing. We're looking at some efficiency improvement initiatives, but we really think we're on the right track. We believe we have the best management team we've ever seen, not just at the President level, but at the operations level and many, many other positions as well. While it has been a little bit underwhelming, you know, over the recent past, it is a very small part of our business, we do believe the future can be bright, and it does have the strongest contribution margins in our entire business. As the top line goes up, the operating margins can go up quite significantly.
Perfect. One question about like that end market. Is this similar like hospitals work like aviation, where you actually have like this replacement cycle for hospitals doing this? What are the macro factors that could determine if that cycle is delayed or not?
This is an essential part of all hospitals, and these products generally are out there for 7- 10 years or so. There's always a replacement cycle. There's of course, new hospital construction and new wings where additional opportunities take place as well, winning some competitive conversions. Yes, it's mostly a replacement cycle business for us on the patient monitoring side. Cardiology a little bit as well. Interestingly, the cardiology part of our business is the highest margin part of our business in healthcare. It's also one of the highest margin businesses in all of OSI Systems. We do have a strong share in places like Germany and the U.K., where we tend to be number one.
We think if we can take that leading market share, bring it here to the United States and other locations, it's a real opportunity for the overall division.
Perfect. I always like to close these conversations with, the two questions. Number one, what excites you the most about the future? On the other side, what keeps you up at night in order to execute this? What is the main problem there?
Yeah. We couldn't be more excited about the future. You know, I think the opportunities that lie ahead of us in our largest division, in particular Security, are outstanding. We've had great growth in our, you know, in our international business for a number of years. We continue to see a very strong and robust pipeline internationally. What we're now seeing in the United States is so exciting. You know, between the One Big Beautiful Bill, between some of the stuff going on with the SHIELD program, as you mentioned, and the Homeland Defense projects that we're getting, we think the U.S. growth can be, you know, outstanding for a number of years. Then you layer on the aviation opportunities that are gonna start to take place coming up as well. You know, very exciting for us.
That coupled with just a continued strong, steady as she comes Optoelectronics business and an improving Healthcare business, I think really lead us to having good top line growth, great earnings power. Our balance sheet is in phenomenal shape. We couldn't be more excited about the future. We're looking forward to our new fiscal year starting in about a month and a half. In terms of what keeps me up at night, probably like many others say, the things within our control we feel really good about. In the world today, there's all sorts of geopolitical changes that sometimes are outside of our control. We respond to that, and we're nimble, we're agile, and I think we've been working through those pretty well.
Amazing. Thank you so much for spending time with us.
Thank you very much.