OSI SYSTEMS INC - Quarter Report: 2010 December (Form 10-Q)

Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark one)

 

 

For the quarterly period ended December 31, 2010

 

OR

 

 

For the transition period from              to              

 

Commission File Number 0-23125

 

 

OSI SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

 

 

 

12525 Chadron Avenue

Hawthorne, California 90250

(Address of principal executive offices)

 

(310) 978-0516

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No x

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

 

As of January 25, 2011, there were 18,932,010 shares of the registrant’s common stock outstanding.

 

 

Table of Contents

 

OSI SYSTEMS, INC.

INDEX

 

			PAGE
PART I — FINANCIAL INFORMATION			3
	Item 1 —	Condensed Consolidated Financial Statements	3
		Condensed Consolidated Balance Sheets at June 30, 2010 and December 31, 2010	3
		Condensed Consolidated Statements of Operations for the three and six months ended December 31, 2009 and 2010	4
		Condensed Consolidated Statements of Cash Flows for the six months ended December 31, 2009 and 2010	5
		Notes to Condensed Consolidated Financial Statements	6
	Item 2 —	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
	Item 3 —	Quantitative and Qualitative Disclosures about Market Risk	19
	Item 4 —	Controls and Procedures	20
PART II — OTHER INFORMATION			21
	Item 1 —	Legal Proceedings	21
	Item 1A —	Risk Factors	21
	Item 6 —	Exhibits	21
Signatures			22

 

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PART I. FINANCIAL INFORMATION

 

Item 1.                                    Condensed Consolidated Financial Statements

 

OSI SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

 

		June 30,			December 31,
		2010			2010
ASSETS
Current Assets:
Cash and cash equivalents		$	51,989		$	35,323
Accounts receivable		132,728			128,376
Other receivables		2,859			3,126
Inventories		125,930			155,115
Deferred income taxes		17,262			16,620
Prepaid expenses and other current assets		18,433			18,658
Total current assets		349,201			357,218
Property and equipment, net		51,515			51,170
Goodwill		63,941			69,778
Intangible assets, net		31,975			33,110
Other assets		16,482			19,018
Total assets		$	513,114		$	530,294
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities:
Current portion of long-term debt		$	12,743		$	754
Accounts payable		49,673			74,144
Accrued payroll and employee benefits		23,953			17,060
Advances from customers		25,325			24,319
Accrued warranties		10,930			12,069
Deferred revenue		7,698			7,526
Other accrued expenses and current liabilities		14,272			14,234
Total current liabilities		144,594			150,106
Long-term debt		23,366			2,775
Other long-term liabilities		31,444			35,387
Total liabilities		199,404			188,268
Commitment and contingencies (Note 7)
Shareholders’ Equity:
Preferred stock, no par value—authorized, 10,000,000 shares; no shares issued or outstanding		—			—
Common stock, no par value—authorized, 100,000,000 shares; issued and outstanding, 18,326,133 at June 30, 2010 and 18,853,140 shares at December 31, 2010		244,026			254,764
Retained earnings		76,681			89,289
Accumulated other comprehensive loss		(6,997		)	(2,027		)
Total shareholders’ equity		313,710			342,026
Total liabilities and shareholders’ equity		$	513,114		$	530,294

 

See accompanying notes to condensed consolidated financial statements.

 

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OSI SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amount data)

(Unaudited)

 

		For the Three Months Ended December 31,						For the Six Months Ended December 31,
		2009			2010			2009			2010
Revenues		$	150,621		$	169,287		$	284,382		$	297,740
Cost of goods sold		94,256			109,264			183,550			190,819
Gross profit		56,365			60,023			100,832			106,921
Operating expenses:
Selling, general and administrative expenses		34,610			33,958			66,890			65,934
Research and development		10,353			11,842			18,342			21,073
Restructuring and other charges		607			903			607			1,159
Total operating expenses		45,570			46,703			85,839			88,166
Income from operations		10,795			13,320			14,993			18,755
Interest and other expense, net		(784		)	(506		)	(1,389		)	(1,096		)
Income before provision for income taxes		10,011			12,814			13,604			17,659
Provision for income taxes		3,059			3,596			4,142			5,049
Net income		$	6,952		$	9,218		$	9,462		$	12,610
Earnings per share:
Basic		$	0.39		$	0.49		$	0.54		$	0.68
Diluted		$	0.39		$	0.47		$	0.53		$	0.65
Shares used in per share calculation:
Basic		17,643			18,752			17,573			18,592
Diluted		18,014			19,475			17,906			19,289

 

See accompanying notes to condensed consolidated financial statements.

 

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OSI SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(amounts in thousands)

(Unaudited)

 

		For the Six Months Ended December 31
		2009			2010
CASH FLOWS FROM OPERATING ACTIVITIES
Net income		$	9,462		$	12,610
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		8,490			9,206
Stock based compensation expense		2,398			2,752
Recovery of losses on accounts receivable		(521		)	(425		)
Equity in earnings of unconsolidated affiliates		(323		)	(247		)
Deferred income taxes		(1,290		)	815
Other		80			126
Changes in operating assets and liabilities:
Accounts receivable		(5,522		)	6,632
Other receivables		1,986			(88		)
Inventories		19,887			(26,703		)
Prepaid expenses and other current assets		(987		)	(809		)
Accounts payable		(13,429		)	23,102
Accrued payroll and related expenses		(2,146		)	(7,162		)
Advances from customers		9,763			(1,582		)
Accrued warranties		121			1,005
Deferred revenue		(1,203		)	(621		)
Other accrued expenses and current liabilities		(3,378		)	863
Net cash provided by operating activities		23,388			19,474
CASH FLOWS FROM INVESTING ACTIVITIES
Acquisition of property and equipment		(6,926		)	(4,590		)
Acquisition of businesses-net of cash acquired		(3,241		)	(5,248		)
Acquisition of intangible and other assets		(1,106		)	(1,764		)
Net cash used in investing activities		(11,273		)	(11,602		)
CASH FLOWS FROM FINANCING ACTIVITIES
Net repayments of bank lines of credit		(4,000		)	—
Payments on long-term debt		(9,450		)	(32,490		)
Payments of capital lease obligations		(334		)	(169		)
Proceeds from exercise of stock options and employee stock purchase plan		3,423			7,532
Net cash used in financing activities		(10,361		)	(25,127		)
EFFECT OF EXCHANGE RATE CHANGES ON CASH		642			589
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		2,396			(16,666		)
CASH AND CASH EQUIVALENTS - BEGINNING OF PERIOD		25,172			51,989
CASH AND CASH EQUIVALENTS - END OF PERIOD		$	27,568		$	35,323
Supplemental disclosure of cash flow information:
Interest paid		$	1,309		$	796
Income taxes paid		$	4,549		$	3,707

 

See accompanying notes to condensed consolidated financial statements.

 

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OSI SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1. Basis of Presentation

 

Description of Business

 

OSI Systems, Inc., together with its subsidiaries (the “Company”), is a vertically integrated designer and manufacturer of specialized electronic systems and components for critical applications. The Company sells its products in diversified markets, including homeland security, healthcare, defense and aerospace.

 

The Company has three operating divisions: (i) Security, providing security inspection systems and related services; (ii) Healthcare, providing patient monitoring, diagnostic cardiology and anesthesia systems, and related services; and (iii) Optoelectronics and Manufacturing, providing specialized electronic components for the Security and Healthcare divisions as well as for applications in the defense and aerospace markets, among others.

 

Through its Security division, the Company designs, manufactures, markets and services security and inspection systems worldwide, and provides turnkey security screening solutions. The Security division’s products are used to inspect baggage, cargo, vehicles and other objects for weapons, explosives, drugs and other contraband and to screen people. These products and services are also used for the safe, accurate and efficient verification of cargo manifests for the purpose of assessing duties and monitoring the export and import of controlled materials.

 

Through its Healthcare division, the Company designs, manufactures, markets and services patient monitoring, diagnostic cardiology and anesthesia delivery and ventilation systems worldwide primarily under the “Spacelabs” trade name. These products are used by care providers in critical care, emergency and perioperative areas within hospitals as well as physician offices, medical clinics and ambulatory surgery centers.

 

Through its Optoelectronics and Manufacturing division, the Company designs, manufactures and markets optoelectronic devices and provides electronics manufacturing services worldwide for use in a broad range of applications, including aerospace and defense electronics, security and inspection systems, medical imaging and diagnostics, telecommunications, office automation, computer peripherals and industrial automation. This division provides products and services to original equipment manufacturers as well as to the Company’s own Security and Healthcare divisions.

 

Basis of Presentation

 

The condensed consolidated financial statements include the accounts of OSI Systems, Inc. and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. The condensed consolidated financial statements have been prepared by the Company, without audit, pursuant to interim financial reporting guidelines and the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. In the opinion of the Company’s management, all adjustments, consisting of only normal and recurring adjustments, necessary for a fair presentation of the financial position and the results of operations for the periods presented have been included. These condensed consolidated financial statements and the accompanying notes should be read in conjunction with the audited consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2010, filed with the Securities and Exchange Commission on August 27, 2010. The results of operations for the three months and six months ended December 31, 2010, are not necessarily indicative of the operating results to be expected for the full fiscal year or any future periods.

 

Per Share Computations

 

The Company computes basic earnings per share by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period. The Company computes diluted earnings per share by dividing net income available to common shareholders by the sum of the weighted average number of common and dilutive potential common shares outstanding. Potential common shares consist of the shares issuable upon the exercise of stock options or warrants under the treasury stock method. Stock options and warrants to purchase a total of 0.1 million shares of common stock for the six months ended December 31, 2010 were not included in diluted earnings per share calculations because to do so would have been antidilutive, while no options or warrants were excluded from the calculation for the three months ended December 31, 2010. Stock options and warrants

 

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to purchase a total of 1.1 million and 1.2 million shares of common stock for the three months and six months ended December 31, 2009, were not included in diluted earnings per share calculations because to do so would have been antidilutive. The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share amounts):

 

		Three Months Ended December 31,						Six Months Ended December 31,
		2009			2010			2009			2010
Net income available to common shareholders		$	6,952		$	9,218		$	9,462		$	12,610
Weighted average shares outstanding — basic		17,643			18,752			17,573			18,592
Dilutive effect of stock options and warrants		371			723			333			697
Weighted average of shares outstanding — diluted		18,014			19,475			17,906			19,289
Basic earnings per share		$	0.39		$	0.49		$	0.54		$	0.68
Diluted earnings per share		$	0.39		$	0.47		$	0.53		$	0.65

 

Comprehensive Income

 

Comprehensive income is computed as follows (in thousands):

 

		Three Months Ended December 31,						Six Months Ended December 31,
		2009			2010			2009			2010
Net income		$	6,952		$	9,218		$	9,462		$	12,610
Foreign currency translation adjustments		1,371			(1,116		)	(205		)	3,795
Reversal of losses on derivatives and investments		507			1,046			507			1,064
Other		36			(31		)	—			111
Comprehensive income		$	8,866		$	9,117		$	9,764		$	17,580

 

Fair Value of Financial Instruments

 

The Company’s financial instruments consist primarily of cash, marketable securities, accounts receivable, accounts payable and debt instruments. The carrying values of financial instruments, other than debt instruments, are representative of their fair values due to their short-term maturities. The carrying values of the Company’s long-term debt instruments are considered to approximate their fair values because the interest rates of these instruments are variable or comparable to current rates offered to the Company.

 

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  The Company has determined that all of its marketable securities fall into the “Level 1” category, which values assets at the quoted prices in active markets for identical assets; while the Company’s derivative instruments fall into the “Level 2” category, which values assets and liabilities from observable inputs other than quoted market prices. There were no assets or liabilities for which “Level 3” valuation techniques were used and there were no assets and liabilities measured at fair value on a non-recurring basis.

 

The fair values of such assets/ (liabilities) are:

 

		June 30, 2010			December 31, 2010
Level 1		$	5,750		$	7,096
Level 2		(244		)	—
Total		$	5,506		$	7,096

 

Derivative Instruments and Hedging Activity

 

The Company’s use of derivatives consists primarily of foreign exchange contracts and interest rate swap agreements. As of December 31, 2010, the Company had no such derivative contracts outstanding.

 

Business Combinations

 

During the normal course of business the Company makes acquisitions. In the event that an individual acquisition (or an aggregate of acquisitions) is material, appropriate disclosure of such acquisition activity is disclosed.

 

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Recent Accounting Updates Not Yet Adopted

 

In January 2010, the Financial Accounting Standards Board issued an accounting standards update (ASU) improving disclosures surrounding fair market value measurements.  This update requires disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements.  Certain financial assets are measured at fair value on a nonrecurring basis. These assets include equity method investments that are recognized at fair value at the end of the period to the extent that they are deemed to be other-than-temporarily impaired. Non-financial assets such as property plant and equipment, land, goodwill and intangible assets are also subject to nonrecurring fair value measurements if they are deemed to be impaired. The impairment models used for nonfinancial assets depend on the type of asset.  This portion of the ASU is effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. Early application is permitted.  The Company has not yet adopted this update and is currently evaluating the impact it may have on its financial condition and results of operations.

 

2. Balance Sheet Details

 

The following tables provide details of selected balance sheet accounts (in thousands):

 

		June 30, 2010			December 31, 2010
Accounts receivable
Trade receivables		$	138,734		$	133,373
Less: allowance for doubtful accounts		(6,006		)	(4,997		)
Accounts receivable, net		$	132,728		$	128,376

 

		June 30, 2010			December 31, 2010
Inventories, net
Raw materials		$	69,421		$	86,575
Work-in-process		20,847			26,671
Finished goods		35,662			41,869
Total		$	125,930		$	155,115

 

		June 30, 2010			December 31, 2010
Property and equipment
Land		$	5,078		$	5,174
Buildings		8,618			8,761
Leasehold improvements		12,549			12,959
Equipment and tooling		62,861			65,775
Furniture and fixtures		4,753			4,857
Computer equipment		17,738			18,515
Software		13,859			14,369
Total		125,456			130,410
Less: accumulated depreciation and amortization		(73,941		)	(79,240		)
Property and equipment, net		$	51,515		$	51,170

 

3. Goodwill and Intangible Assets

 

The goodwill acquired during the period within the Security, and Optoelectronics and Manufacturing divisions related to acquisitions of businesses that were considered immaterial individually and in the aggregate to the Company. The changes in the carrying value of goodwill for the six month period ended December 31, 2010, are as follows (in thousands):

 

		Security			Healthcare			Optoelectronics and Manufacturing			Consolidated
Balance as of June 30, 2010		$	16,566		$	35,403		$	11,972		$	63,941
Goodwill acquired during the period		3,863			—			1,599			5,462
Foreign currency translation adjustment		283			92			—			375
Balance as of December 31, 2010		$	20,712		$	35,495		$	13,571		$	69,778

 

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Intangible assets consisted of the following (in thousands):

 

				June 30, 2010									December 31, 2010
		Weighted Average Lives		Gross Carrying Value			Accumulated Amortization			Intangibles Net			Gross Carrying Value			Accumulated Amortization			Intangibles Net
Amortizable assets:
Software development costs		5 years		$	11,877		$	3,954		$	7,923		$	12,887		$	4,334		$	8,553
Patents		9 years		1,630			388			1,242			2,161			418			1,743
Core technology		10 years		2,029			1,094			935			2,082			1,227			855
Developed technology		13 years		17,246			8,942			8,304			18,933			9,931			9,002
Customer relationships/ backlog		7 years		10,437			6,132			4,305			10,453			6,796			3,657
Total amortizable assets				43,219			20,510			22,709			46,516			22,706			23,810
Non-amortizable assets:
Trademarks				9,266			—			9,266			9,300			—			9,300
Total intangible assets				$	52,485		$	20,510		$	31,975		$	55,816		$	22,706		$	33,110

 

Amortization expense related to intangibles assets was $2.1 million for each of the six months ended December 31, 2009 and 2010, and $1.1 million for each of the three months ended December 31, 2009 and 2010. At December 31, 2010, the estimated future amortization expense was as follows (in thousands):

 

2011 (remaining 6 months)		$	2,126
2012		4,218
2013		3,926
2014		2,741
2015		1,348
2016		1,467
2017 and thereafter		7,984
Total		$	23,810

 

4. Borrowings

 

On October 15, 2010, the Company entered into a credit agreement with a syndicate of banks for a $250 million revolving credit facility.  This credit agreement replaced the prior agreement described below, which was repaid and terminated simultaneously with the close of the new agreement.  The new facility consists of a $250 million, five-year revolving credit facility, including a $155 million sub-limit for letters of credit.  Borrowings under this facility bear interest, based on the Company’s option, at either (i) London Interbank Offered Rate (LIBOR) plus margins that range from 2.00% to 2.50% or (ii) the sum of margins that range from 1.00% to 1.50% and the higher of (a) the bank’s prime rate, (b) the Fed Funds rate plus 0.5% or (c) LIBOR plus 1.0%.  The margins are determined by the Company’s consolidated leverage ratio.  The Company’s borrowings under the credit agreement are guaranteed by the Company’s domestic subsidiaries and are secured by substantially all of the Company’s and certain subsidiaries’ assets. The agreement contains various representations, warranties, affirmative, negative and financial covenants, and conditions of default customary for financing agreements of this type, including restrictions on the Company’s ability to pay cash dividends. As of December 31, 2010, there was no debt outstanding under the revolving credit facility and $34.0 million was outstanding under the letter-of-credit facility.

 

Prior to the closing of the aforementioned revolving credit facility, the Company maintained a credit agreement with certain lenders allowing for a $74.5 million revolving credit facility (including a $64.5 million sub-limit for letters-of-credit) and an amortizing five-year term loan, which would have matured in July 2012.  Borrowings under the agreement bore interest at either (i) LIBOR plus margins that range from 2.00% to 2.50% or (ii) the sum of margins that range from 1.00% to 1.50% and the higher of (a) the bank’s prime rate or (b) Fed Funds rate plus 0.5%. The rates were determined based on the Company’s consolidated leverage ratio.  The Company’s borrowings under the credit agreement were guaranteed by the Company’s domestic subsidiaries and secured by substantially all of the Company’s and certain subsidiaries’ assets. The agreement contained various representations, warranties, affirmative, negative and financial covenants, and conditions of default customary for financing agreements of this type, including restrictions on the Company’s ability to pay cash dividends.

 

Several of the Company’s foreign subsidiaries maintain bank lines-of-credit, denominated in local currencies, to meet short-term working capital requirements and for the issuance of letters-of-credit. As of December 31, 2010, $13.5 million was outstanding under

 

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these letter-of-credit facilities, while no debt was outstanding. As of December 31, 2010, the total amount available under these credit facilities was $23.4 million, with a total cash borrowing sub-limit of $4.2 million.

 

In fiscal 2005, the Company entered into a bank loan of $5.3 million to fund the acquisition of land and buildings in the U.K. The loan is payable over a 20-year period. The loan bears interest at British pound-based LIBOR plus 1.2%, payable on a quarterly basis. As of December 31, 2010, $3.0 million remained outstanding under this loan at an interest rate of 1.9% per annum.

 

Long-term debt consisted of the following (in thousands):

 

		June 30, 2010			December 31, 2010
Five-year term loan due in fiscal 2013		$	32,281		$	—
Twenty-year term loan due in fiscal 2024		3,015			2,988
Capital leases		711			541
Other		102			—
		36,109			3,529
Less current portion of long-term debt		12,743			754
Long-term portion of debt		$	23,366		$	2,775

 

5. Stock-based Compensation

 

As of December 31, 2010, the Company maintained an equity participation plan and an employee stock purchase plan.

 

The Company recorded stock-based-compensation expense in the condensed consolidated statement of operations as follows (in thousands):

 

		Three Months Ended December 31,						Six Months Ended December 31,
		2009			2010			2009			2010
Cost of goods sold		$	68		$	82		$	140		$	170
Selling, general and administrative		1,147			1,313			2,149			2,469
Research and development		55			59			109			113
Total stock-based compensation expense		$	1,270		$	1,454		$	2,398		$	2,752

 

As of December 31, 2010, total unrecognized compensation cost related to non-vested share-based compensation arrangements granted was approximately $12.0 million. The Company expects to recognize these costs over a weighted-average period of 2.9 years.

 

6. Retirement Benefit Plans

 

The Company sponsors various retirement benefit plans including qualified and nonqualified defined benefit pension plans for its employees. The components of net periodic pension expense are as follows (in thousands):

 

		Three Months Ended December 31,						Six Months Ended December 31,
		2009			2010			2009			2010
Service cost		$	27		$	153		$	34		$	278
Interest cost		45			—			86			—
Amortization of net loss		80			189			152			223
Net periodic pension expense		$	152		$	342		$	272		$	501

 

For the three months ended December 31, 2009 and 2010, the Company made contributions of $0.1 million and $0.9 million, respectively to these defined benefit plans. For the six months ended December 31, 2009 and 2010, the Company made contributions of $0.2 million and $0.9 million, respectively, to these defined benefit plans.

 

In addition, the Company maintains various defined contribution plans. For the three months ended December 31, 2009 and 2010, the Company made contributions of $0.7 million and $1.0 million, respectively, to these defined contribution plans. For the six months ended December 31, 2009 and 2010, the Company made contributions of $1.5 million and $2.4 million, respectively, to these defined contribution plans.

 

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7. Commitments and Contingencies

 

Legal Proceedings

 

The Company is involved in various claims and legal proceedings arising out of the ordinary course of business. In the Company’s opinion after consultation with legal counsel, the ultimate disposition of such proceedings is not likely to have a material adverse effect on its financial position, future results of operations, or cash flows.  The Company has not accrued for loss contingencies relating to such matters because the Company believes that, although unfavorable outcomes in the proceedings may be possible, they are not considered by management to be probable or reasonably estimable. If one or more of these matters are resolved in a manner adverse to the Company, the impact on the Company’s results of operations, financial position and/or liquidity could be material.

 

Contingent Acquisition Obligations

 

Under the terms and conditions of the purchase agreements associated with certain acquisitions, the Company may be obligated to make additional payments based on the achievement by the acquired operations of certain sales and profitability milestones.   Some of the purchase agreements the Company has entered into do not put a cap on the total payments that may be earned, or a deadline for such payments. For acquisitions that occurred prior to fiscal year 2010, which were accounted for under Statement of Financial Accounting Standards 141, “Business Combinations,” the Company accounts for such contingent payments as an addition to the purchase price of the acquired company. For acquisitions accounted for under Accounting Standards Codification 805, “Purchase Price Allocations,” (“ASC 805”), the estimated fair value of these obligations is recorded as a liability in the consolidated balance sheet with subsequent revisions reflected in the consolidated statements of operations. As of June 30, 2010 and December 31, 2010, pursuant to ASC 805, $5.1 million and $9.3 million of contingent payment obligations, respectively, are included in other long-term liabilities in the accompanying condensed consolidated balance sheet.

 

Environmental Contingencies

 

The Company is subject to various environmental laws. The Company’s practice is to ensure that Phase I environmental site assessments are conducted for each of its properties in the United States at which the Company manufactures products in order to identify, as of the date of such report, potential areas of environmental concern related to past and present activities or from nearby operations. In certain cases, the Company has conducted further environmental assessments consisting of soil and groundwater testing and other investigations deemed appropriate by independent environmental consultants.

 

During one investigation, the Company discovered soil and groundwater contamination at its Hawthorne, California facility. The Company filed the requisite reports concerning this problem with the appropriate environmental authorities in fiscal 2001. The Company has not yet received any response to such reports, and no agency action or litigation is presently pending or threatened. The Company’s site was previously used by other companies for semiconductor manufacturing similar to that presently conducted on the site by us, and it is not presently known who is responsible for the contamination or, if required, the remediation. The groundwater contamination is a known regional problem, not limited to the Company’s premises or its immediate surroundings.

 

The Company has also been informed of soil and groundwater evaluation efforts at a facility that its Ferson Technologies subsidiary previously leased in Ocean Springs, Mississippi. Ferson Technologies occupied the facility until October 2003. The Company believes that the owner and previous occupants of the facility have primary responsibility for any remediation that may be required and have an agreement with the facility’s owner under which the owner is responsible for remediation of pre-existing conditions. However, as site evaluation efforts are still in progress, and may be for some time, the Company is unable at this time to ascertain whether Ferson Technologies bears any exposure for remediation costs under applicable environmental regulations.

 

The Company has not accrued for loss contingencies relating to the above environmental matters because it believes that, although unfavorable outcomes may be possible, they are not considered by the Company’s management to be probable and reasonably estimable.  If one or more of these matters are resolved in a manner adverse to the Company, the impact on the Company’s results of operations, financial position and/or liquidity could be material.

 

Product Warranties

 

The Company offers its customers warranties on many of the products that it sells. These warranties typically provide for repairs and maintenance of the products if problems arise during a specified time period after original shipment. Concurrent with the sale of products, the Company records a provision for estimated warranty expenses with a corresponding increase in cost of goods sold. The Company periodically adjusts this provision based on historical and anticipated experience. The Company charges actual expenses of repairs under warranty, including parts and labor, to this provision when incurred.

 

The following table presents changes in warranty provisions (in thousands):

 

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		Three Months Ended December 31,						Six Months Ended December 31,
		2009			2010			2009			2010
Balance at beginning of period		$	9,507		$	11,395		$	10,106		$	10,930
Additions		1,726			1,832			1,997			2,969
Reductions for warranty repair costs		(1,063		)	(1,158		)	(1,933		)	(1,830		)
Balance at end of period		$	10,170		$	12,069		$	10,170		$	12,069

 

8. Income Taxes

 

The provision for income taxes is determined using an effective tax rate that is subject to fluctuations during the year as new information is obtained.  The assumptions used to estimate the annual effective tax rate includes factors such as the mix of pre-tax earnings in the various tax jurisdictions in which the Company operates, valuation allowances against deferred tax assets, increases or decreases in uncertain tax positions, utilization of research and development tax credits, and changes in or the interpretation of tax laws in jurisdictions where the Company conducts business. The Company recognizes deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of its assets and liabilities along with net operating loss and tax credit carryovers. The Company records a valuation allowance against its deferred tax assets to reduce the net carrying value to an amount that it believes is more likely than not to be realized. When the Company establishes or reduces the valuation allowance against its deferred tax assets, the provision for income taxes will increase or decrease, respectively, in the period such determination is made.

 

9. Segment Information

 

The Company operates in three identifiable industry segments: (i) Security, providing security and inspection systems, and turnkey security screening solutions; (ii) Healthcare, providing patient monitoring, diagnostic cardiology and anesthesia systems; and (iii) Optoelectronics and Manufacturing, providing specialized electronic components for affiliated end-products divisions, as well as for applications in the healthcare, defense and aerospace markets, among others. The Company also has a Corporate segment that includes executive compensation and certain other general and administrative expenses. Interest expense and certain expenses related to legal, audit and other professional service fees, are not allocated to industry segments. Both the Security and Healthcare divisions comprise primarily end-product businesses whereas the Optoelectronics and Manufacturing division comprises businesses that primarily supply components and subsystems to original equipment manufacturers, including to the businesses of the Security and Healthcare divisions. All intersegment sales are eliminated in consolidation.

 

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The following table presents segment information (in thousands):

 

		Three Months Ended December 31,						Six Months Ended December 31,
		2009			2010			2009			2010
Revenues — by Segment:
Security division		$	59,092		$	76,703		$	106,427		$	127,800
Healthcare division		57,048			55,799			104,010			101,723
Optoelectronics and Manufacturing division, including intersegment revenues		43,663			47,682			89,454			89,593
Intersegment revenues elimination		(9,182		)	(10,897		)	(15,509		)	(21,376		)
Total		$	150,621		$	169,287		$	284,382		$	297,740
Revenues — by Geography:
North America		$	110,841		$	123,094		$	206,916		$	220,098
Europe		35,545			34,010			66,080			55,074
Asia		13,417			23,079			26,895			43,944
Intersegment revenues elimination		(9,182		)	(10,896		)	(15,509		)	(21,376		)
Total		$	150,621		$	169,287		$	284,382		$	297,740
Operating income (loss) — by Segment:
Security division		$	4,134		$	7,004		$	6,102		$	9,115
Healthcare division		5,808			5,664			7,303			8,262
Optoelectronics and Manufacturing division		3,257			4,270			6,718			7,691
Corporate		(2,689		)	(3,072		)	(5,969		)	(5,248		)
Eliminations (1)		285			(546		)	839			(1,065		)
Total		$	10,795		$	13,320		$	14,993		$	18,755

 

		June 30, 2010			December 31, 2010
Assets — by Segment:
Security division		$	221,019		$	244,919
Healthcare division		138,739			141,432
Optoelectronics and Manufacturing division		85,170			100,318
Corporate		72,731			49,235
Eliminations (1)		(4,545		)	(5,610		)
Total		$	513,114		$	530,294

 

(1)         Eliminations within operating income primarily reflect the change in the elimination of intercompany profit in inventory not-yet-realized; while the eliminations in assets reflect the amount of intercompany profits in inventory as of the balance sheet date. Such intercompany profit will be realized when inventory is shipped to the external customers of the Security and Healthcare divisions.

 

Item 2.                                    Management’s Discussion and Analysis of Financial Condition and Results of Operations

To

Cautionary Statement

 

Certain statements contained in this quarterly report on Form 10-Q that are not related to historical results, including, without limitation, statements regarding our business strategy, objectives and future financial position, are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and involve risks and uncertainties. These forward-looking statements may be identified by the use of forward-looking terms such as “anticipate,” “believe,” “expect,” “may,” “could,” “likely to,” “should,” or “will,” or by discussions of strategy that involve predictions which are based upon a number of future conditions that ultimately may prove to be inaccurate. Statements in this quarterly report on Form 10-Q that are forward-looking are based on current expectations and actual results may differ materially. Forward-looking statements involve numerous risks and uncertainties described in this quarterly report on Form 10-Q, our Annual Report on Form 10-K and other documents previously filed or hereafter filed by us from time to time with the Securities and Exchange Commission. Such factors, of course, do not include all factors that might affect our business and financial condition. Although we believe that the assumptions upon which our forward-looking statements are based are reasonable, such assumptions could prove to

 

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be inaccurate and actual results could differ materially from those expressed in or implied by the forward-looking statements. All forward-looking statements contained in this quarterly report on Form 10-Q are qualified in their entirety by this statement. We undertake no obligation other than as may be required under securities laws to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

 

Critical Accounting Policies and Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions and select accounting policies that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Our critical accounting policies are detailed in our Annual Report on Form 10-K for the year ended June 30, 2010.

 

Recent Accounting Pronouncements

 

We describe recent accounting pronouncements in Item 1 — “Condensed Consolidated Financial Statements — Notes to Condensed Consolidated Financial Statements.”

 

Executive Summary

 

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

 

Security Division. Through our Security division, we design, manufacture, market and service security and inspection systems, and provide turnkey security screening solutions worldwide for sale primarily to U.S. federal, state and local government agencies as well as to foreign customers. These products and services are used to inspect baggage, cargo, vehicles and other objects for weapons, explosives, drugs and other contraband as well as to screen people. Revenues from our Security division accounted for 43% and 37% of our total consolidated revenues for the six months ended December 31, 2010 and 2009, respectively.

 

As a result of the terrorist attacks of September 11, 2001, and subsequent attacks in other locations worldwide, security and inspection products have increasingly been used at a wide range of facilities other than airports, such as border crossings, railway stations, seaports, cruise line terminals, freight forwarding operations, government and military installations and nuclear facilities.

 

Healthcare Division. Through our Healthcare division, we design, manufacture, market and service patient monitoring, diagnostic cardiology and anesthesia systems for sale primarily to hospitals and medical centers. Our products monitor patients in critical, emergency and perioperative care areas of the hospital and provide such information, through wired and wireless networks, to physicians and nurses who may be at the patient’s bedside, in another area of the hospital or even outside the hospital. Revenues from our Healthcare division accounted for 34% and 37% of our total consolidated revenues for the six months ended December 31, 2010 and 2009, respectively.

 

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

 

Optoelectronics and Manufacturing Division. Through our Optoelectronics and Manufacturing division, we design, manufacture and market optoelectronic devices and value-added manufacturing services worldwide for use in a broad range of applications, including aerospace and defense electronics, security and inspection systems, medical imaging and diagnostics, computed tomography, fiber optics, telecommunications, office automation, computer peripherals and industrial automation. We also provide our optoelectronic devices and value-added manufacturing services to our own Security and Healthcare divisions. External revenues from our Optoelectronics and Manufacturing division accounted for 23% and 26% of our total consolidated revenues for the six months ended December 31, 2010 and 2009, respectively.

 

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Results of Operations

 

Three Months Ended December 31, 2010 Compared to Three Months Ended December 31, 2009.

 

Net Revenues

 

The table below and the discussion that follows are based upon the way in which we analyze our business. See Note 9 to the condensed consolidated financial statements for additional information about our business segments.

 

(in millions)		Q2 2010			% of Net Sales			Q2 2011			% of Net Sales			$ Change			% Change
Security division		$	59.1		39	%		$	76.7		45	%		$	17.6		30	%
Healthcare division		57.0			38	%		55.8			33	%		(1.2		)	(2	)%
Optoelectronics and Manufacturing division		43.7			29	%		47.7			28	%		4.0			9	%
Intersegment revenues		(9.2		)	(6	)%		(10.9		)	(6	)%		(1.7		)	18	%
Total revenues		$	150.6		100	%		$	169.3		100	%		$	18.7		12	%

 

Net revenues for the three months ended December 31, 2010, increased $18.7 million, or 12%, to $169.3 million, from $150.6 million for the comparable prior-year period.

 

Revenues for the Security division for the three months ended December 31, 2010, increased $17.6 million, or 30%, to $76.7 million, from $59.1 million for the comparable prior-year period. The increase was attributed to: (i) a $15.9 million, or 35% increase in equipment sales mainly driven by a $12.2 million increase in our baggage and parcel inspection, hold baggage screening and people screening equipment, as well as a $1.9 million increase in cargo and vehicle inspection equipment; and (ii) a $1.7 million or 13% increase in revenue related to contracts to service such equipment. The increase in service revenue was due to the growing installed equipment base, from which we derive service revenues as warranty periods expire.

 

Revenues for the Healthcare division for the three months ended December 31, 2010, decreased $1.2 million, or 2%, to $55.8 million, from $57.0 million for the comparable prior-year period. The decrease was primarily attributable to a $1.1 million decrease in cardiology product revenues.

 

Revenues for the Optoelectronics and Manufacturing division for the three months ended December 31, 2010, increased by $4.0 million, or 9%, to $47.7 million, from $43.7 million for the comparable prior-year period. This increase was primarily the result of a $6.9 million increase in commercial optoelectronics sales due to both a $5.2 million growth in sales to external customers as well as $1.7 million growth in intersegment sales, primarily to our Security division partially offset by expected decreases in contract manufacturing sales of $2.9 million primarily due to the winding down of a defense-industry related contract. Included in this total revenue amount for the three months ended December 31, 2010, the Optoelectronics and Manufacturing division recorded intersegment sales of $10.9 million, compared to $9.2 million in the comparable prior-year period as previously noted. Such intersegment sales are eliminated in consolidation.

 

Gross Profit

 

(in millions)		Q2 2010			% of Net Sales		Q2 2011			% of Net Sales
Gross profit		$	56.4		37.4%		$	60.0		35.4%

 

Gross profit increased $3.6 million, or 6%, to $60.0 million for the three months ended December 31, 2010, from $56.4 million for the comparable prior-year period as a result of a 12% increase in revenue. Such increase was offset by a 2% reduction in our gross margin due primarily to less favorable product mix of sales as sales within our Healthcare division, which historically generates the highest gross margin across the three divisions, declined relative to our Security and Optoelectronics and Manufacturing divisions.

 

Operating Expenses

 

(in millions)		Q2 2010		% of Net Sales		Q2 2011		% of Net Sales		$ Change		% Change
Selling, general and administrative		$34.6		23.0%		$34.0		20.1%		$(0.6	)	(2	)%
Research and development		10.4		6.9%		11.8		7.0%		1.4		13	%
Restructuring and other charges		0.6		0.4%		0.9		0.5%		0.3		50	%
Total operating expenses		$45.6		30.3%		$46.7		27.6%		$1.1		2	%

 

Selling, general and administrative expenses. Selling, general and administrative expenses consist primarily of compensation paid

 

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