OSI SYSTEMS INC - Quarter Report: 2012 September (Form 10-Q)

Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

 

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2012

 

OR

 

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from              to             

 

Commission File Number 000-23125

 

 

OSI SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

 

 

 

12525 Chadron Avenue

Hawthorne, California 90250

(Address of principal executive offices) (Zip Code)

 

(310) 978-0516

(Registrant’s telephone number, including area code)

 

N/A

(Former name, former address and former fiscal year, if changed since last report)

 

 

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 x No o

 

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 October 23, 2012, there were 19,990,702 shares of the registrant’s common stock outstanding.

 

 

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OSI SYSTEMS, INC.

 

INDEX

 

		PAGE
PART I —	FINANCIAL INFORMATION	3
Item 1 —	Condensed Consolidated Financial Statements	3
	Condensed Consolidated Balance Sheets at June 30, 2012 and September 30, 2012	3
	Condensed Consolidated Statements of Operations for the three months ended September 30, 2011 and 2012	4
	Condensed Consolidated Statements of Comprehensive Income for the three months ended September 30, 2011 and 2012	5
	Condensed Consolidated Statements of Cash Flows for the three months ended September 30, 2011 and 2012	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2 —	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
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 2 —	Unregistered Sales of Equity Securities and Use of Proceeds	21
Item 3 —	Defaults Upon Senior Securities	21
Item 4 —	Mine Safety Disclosures	21
Item 5 —	Other Information	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)

(Unaudited)

 

		June 30,			September 30,
		2012			2012
ASSETS
Current Assets:
Cash and cash equivalents		$	91,452		$	73,707
Accounts receivable, net of allowance for doubtful accounts of $5,054 and $5,300 as of June 30, 2012 and September 30, 2012, respectively		156,867			146,784
Inventories		195,178			195,388
Deferred income taxes		19,205			19,067
Prepaid expenses and other current assets		20,411			20,181
Total current assets		483,113			455,127
Property and equipment, net		111,664			172,522
Goodwill		82,149			82,435
Intangible assets, net		37,742			38,404
Other assets		35,228			38,237
Total assets		$	749,896		$	786,725
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Current portion of long-term debt		$	215		$	1,677
Accounts payable		56,422			85,325
Accrued payroll and related expenses		24,749			20,199
Advances from customers		22,677			20,733
Accrued warranties		17,562			16,919
Deferred revenue		20,194			17,321
Other accrued expenses and current liabilities		18,830			19,857
Total current liabilities		160,649			182,031
Long-term debt		2,467			12,161
Advances from customers		100,000			93,750
Other long-term liabilities		52,661			56,415
Total liabilities		315,777			344,357
Commitments and contingencies (Note 7)
Stockholders’ Equity:
Preferred stock, $0.001 par value—authorized, 10,000,000 shares; no shares issued or outstanding		—			—
Common stock, $0.001 par value—authorized, 100,000,000 shares; issued and outstanding, 19,821,064 at June 30, 2012 and 19,990,702 shares at September 30, 2012		282,756			279,809
Retained earnings		155,651			161,990
Accumulated other comprehensive income (loss)		(4,288		)	569
Total stockholders’ equity		434,119			442,368
Total liabilities and stockholders’ equity		$	749,896		$	786,725

 

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 data)

(Unaudited)

 

		For the Three Months Ended September 30,
		2011			2012
Net revenues:
Products		$	133,906		$	148,864
Services		27,411			32,830
Total net revenues		161,317			181,694
Cost of goods sold:
Products		89,868			98,932
Services		18,592			21,407
Total cost of goods sold		108,460			120,339
Gross profit		52,857			61,355
Operating expenses:
Selling, general and administrative expenses		34,367			39,925
Research and development		10,880			11,316
Total operating expenses		45,247			51,241
Income from operations		7,610			10,114
Interest and other expense, net		(799		)	(1,097		)
Income before income taxes		6,811			9,017
Provision for income taxes		2,050			2,678
Net income		$	4,761		$	6,339
Net income per share:
Basic		$	0.24		$	0.32
Diluted		$	0.24		$	0.31
Shares used in per share calculation:
Basic		19,576			19,906
Diluted		20,089			20,571

 

See accompanying notes to condensed consolidated financial statements.

 

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OSI SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(amounts in thousands)

(Unaudited)

 

		For the Three Months Ended September 30,
		2011			2012
Net income		$	4,761		$	6,339
Other comprehensive income (loss):
Foreign currency translation adjustment		(3,260		)	5,311
Other		270			(454		)
Other comprehensive income (loss)		(2,990		)	4,857
Comprehensive income		$	1,771		$	11,196

 

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 Three Months Ended September 30,
		2011			2012
Cash flows from operating activities:
Net income		$	4,761		$	6,339
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		4,832			4,907
Stock based compensation expense		1,511			3,533
Provision for losses on accounts receivable		305			294
Equity in earnings of unconsolidated affiliates		(44		)	(13		)
Deferred income taxes		(176		)	140
Other		13			1
Changes in operating assets and liabilities—net of business acquisitions:
Accounts receivable		5,553			11,190
Inventories		(16,579		)	2,286
Prepaid expenses and other current assets		5,691			2,318
Accounts payable		5,163			28,055
Accrued payroll and related expenses		(6,805		)	(4,656		)
Advances from customers		5,421			(8,954		)
Accrued warranties		37			(831		)
Deferred revenue		(2,433		)	(2,077		)
Other accrued expenses and current liabilities		2,744			(155		)
Net cash provided by operating activities		9,994			42,377
Cash flows from investing activities:
Acquisition of property and equipment		(3,148		)	(62,718		)
Acquisition of businesses		(3,189		)	(1,897		)
Acquisition of intangible and other assets		(869		)	(1,416		)
Net cash used in investing activities		(7,206		)	(66,031		)
Cash flows from financing activities:
Proceeds from long-term debt		—			11,100
Payments on long-term debt		(55		)	(55		)
Proceeds from exercise of stock options and employee stock purchase plan		1,109			2,951
Repurchase of common shares		—			(9,431		)
Net cash provided by financing activities		1,054			4,565
Effect of exchange rate changes on cash		(1,098		)	1,344
Net increase (decrease) in cash and cash equivalents		2,744			(17,745		)
Cash and cash equivalents-beginning of period		55,619			91,452
Cash and cash equivalents-end of period		$	58,363		$	73,707
Supplemental disclosure of cash flow information:
Cash paid (refunded), net during the period for:
Interest		$	950		$	129
Income taxes		$	(479	)	$	1,450

 

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, and a provider of security screening services. The Company sells its products and services in diversified markets, including homeland security, healthcare, defense and aerospace.

 

The Company has three operating divisions: (i) Security, providing security and inspection systems, turnkey security screening solutions 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 and electronic manufacturing services for the Security and Healthcare divisions, as well as to external original equipment manufacturer clients for applications in the defense, aerospace, medical and industrial 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. These products are used by care providers in critical care, emergency and perioperative areas within hospitals as well as physicians’ 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 diagnostic products, telecommunications, test and measurement devices, industrial automation systems, automotive diagnostic products and renewable energy technologies. This division provides products and services to original equipment manufacturers and end users 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, 2012, filed with the Securities and Exchange Commission on August 13, 2012. The results of operations for the three months ended September 30, 2012 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 stockholders 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 stockholders 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 to purchase a total of 0.1 million shares of common stock for the three months ended September 30, 2011 were not included in diluted earnings per share calculations because to do so would have been antidilutive, while no such shares were excluded from the calculations for the three months ended September 30, 2012.

 

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The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share amounts):

 

		Three Months Ended September 30,
		2011			2012
Net income for diluted earnings per share calculation		$	4,761		$	6,339
Weighted average shares for basic earnings per share calculation		19,576			19,906
Dilutive effect of stock awards		513			665
Weighted average shares for diluted earnings per share calculation		20,089			20,571
Basic net income per share		$	0.24		$	0.32
Diluted net income per share		$	0.24		$	0.31

 

Cash Equivalents

 

The Company considers all highly liquid investments purchased with maturities of approximately three months or less as of the acquisition date to be cash equivalents.

 

Components of cash and cash equivalents consisted of:

 

		June 30, 2012			September 30, 2012
Cash in bank		$	47,402		$	63,191
Money market		34,063			7,016
Commercial paper		9,987			3,500
Total		$	91,452		$	73,707

 

Fair Value of Financial Instruments

 

The Company’s financial instruments consist primarily of cash, marketable securities, derivative instruments, 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 and liabilities at the quoted prices in active markets for identical assets and liabilities; 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 where “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 the Company’s assets (liabilities) were:

 

		June 30, 2012			September 30, 2012
Level 1		$	10,955		$	12,191
Level 2		13			(24		)
Total		$	10,968		$	12,167

 

Derivative Instruments and Hedging Activity

 

The Company’s use of derivatives consists primarily of foreign exchange contracts and interest rate swap agreements. As of September 30, 2012, the Company had outstanding foreign currency forward contracts of approximately $6.2 million.  The foreign exchange contracts do not meet the criteria as an effective cash flow hedge.  Therefore, the net gain (loss) is reported in Interest expense and other income, net in the condensed consolidated statement of operations.  The interest rate swap agreement was entered into to improve the predictability of cash flows from interest payments related to variable, LIBOR-based debt for the duration of the term loan.

 

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The interest rate swap matures in October 2019.  The interest rate swap is considered an effective cash flow hedge, and, as a result, the net gains or losses on such instrument were reported as a component of other comprehensive income in the condensed consolidated financial statements and are reclassified as net earnings when the hedge transaction settles.

 

Revenue Recognition

 

The Company recognizes revenue from sales of products upon shipment when title and risk of loss passes, and when terms are fixed and collection is probable. Revenue from services includes after-market services, installation and implementation of products, and turnkey security screening services.  The portion of revenue for the sale attributable to installation is deferred and recognized when the installation service is provided. In an instance where terms of sale include subjective customer acceptance criteria, revenue is deferred until the Company has achieved the acceptance criteria. Concurrent with the shipment of the product, the Company accrues estimated product return reserves and warranty expenses. Critical judgments made by management related to revenue recognition include the determination of whether or not customer acceptance criteria are perfunctory or inconsequential. The determination of whether or not customer acceptance terms are perfunctory or inconsequential impacts the amount and timing of revenue recognized. Critical judgments also include estimates of warranty reserves, which are established based on historical experience and knowledge of the product under warranty.

 

Revenue from certain fixed-fee turnkey services agreements is recognized based upon proportional performance, measured by the actual number of hours incurred divided by the total estimated number of hours for the project. The impact of changes in the estimated hours to service the agreement is reflected in the period during which the change becomes known.

 

Revenues from out-of-warranty service maintenance contracts are recognized ratably over the term of such contract. For services not derived from specific maintenance contracts, revenues are recognized as the services are performed. Deferred revenue for such services arises from payments received from customers for services not yet performed.

 

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.

 

2. Balance Sheet Details

 

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

 

		June 30, 2012			September 30, 2012
Inventories, net
Raw materials		$	103,747		$	108,548
Work-in-process		28,096			27,022
Finished goods		63,335			59,818
Total		$	195,178		$	195,388

 

		June 30, 2012			September 30, 2012
Property and equipment, net
Land		$	5,193		$	8,126
Buildings		13,597			24,917
Leasehold improvements		12,385			11,569
Equipment and tooling		74,789			105,103
Furniture and fixtures		3,982			4,119
Computer equipment		13,937			15,316
Computer software		15,245			15,480
Construction in process		52,269			68,523
Total		191,397			253,153
Less: accumulated depreciation and amortization		(79,733		)	(80,631		)
Property and equipment, net		$	111,664		$	172,522

 

Construction in process includes costs primarily related to the construction of equipment and infrastructure associated with a program in Mexico.

 

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3. Goodwill and Intangible Assets

 

The changes in the carrying value of goodwill for the three month period ended September 30, 2012 are as follows (in thousands):

 

		Security Division			Healthcare Division			Optoelectronics and Manufacturing Division			Consolidated
Balance as of June 30, 2012		$	27,583		$	35,887		$	18,679		$	82,149
Goodwill acquired or adjusted during the period		—			—			—			—
Foreign currency translation adjustment		140			149			(3		)	286
Balance as of September 30, 2012		$	27,723		$	36,036		$	18,676		$	82,435

 

Intangible assets consisted of the following (in thousands):

 

				June 30, 2012									September 30, 2012
		Weighted Average Lives		Gross Carrying Value			Accumulated Amortization			Intangibles Net			Gross Carrying Value			Accumulated Amortization			Intangibles Net
Amortizable assets:
Software development costs		5 years		$	15,175		$	4,140		$	11,035		$	16,686		$	4,391		$	12,295
Patents		15 years		4,259			526			3,733			4,497			559			3,938
Core technology		10 years		2,093			1,548			545			2,181			1,667			514
Developed technology		12 years		20,022			12,560			7,462			20,072			13,103			6,969
Customer relationships/backlog		8 years		11,955			7,611			4,344			8,778			4,754			4,024
Total amortizable assets				53,504			26,385			27,119			52,214			24,474			27,740
Non-amortizable assets:
Trademarks				10,623			—			10,623			10,664			—			10,664
Total intangible assets				$	64,127		$	26,385		$	37,742		$	62,878		$	24,474		$	38,404

 

Amortization expense related to intangibles assets was $1.1 million and $1.2 million for the three months ended September 30, 2011 and 2012, respectively. At September 30, 2012, the estimated future amortization expense was as follows (in thousands):

 

2013 (remaining 9 months)		$	3,340
2014		3,835
2015		2,343
2016		2,100
2017		1,742
2018		1,038
2019 and thereafter		13,342
Total		$	27,740

 

4. Borrowings

 

The Company has a $425 million credit agreement maturing November 2016. The credit agreement consists of a $425 million revolving credit facility, including a $375 million sub-limit for letters of credit. The Company has the ability to increase the facility by $100 million under certain circumstances. Borrowings under this facility bear interest at the London Interbank Offered Rate (LIBOR) plus a margin of 1.5% as of September 30, 2012. This margin is determined by the Company’s consolidated leverage ratio and may range from 1.5% to 2.0%. Letters of credit reduce the amount available to borrow by their face value. The unused portion of the facility bears a commitment fee of 0.25%. The Company’s borrowings under the credit agreement are guaranteed by the Company’s U.S. based 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. As of September 30, 2012, there were no borrowings under the revolving credit facility and letters-of-credit outstanding totaled $193.0 million.

 

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 September 30, 2012, $10.7 million was outstanding under these letter-of-credit facilities, while no debt was outstanding. As of September 30, 2012, the total amount available under these credit facilities was $34.1 million, with a total cash borrowing sub-limit of $4.2 million.

 

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In September 2012, the Company entered into a term loan agreement for $11.1 million to fund the acquisition of land and a building in the state of Washington.  The loan is payable over seven years and bears interest at LIBOR plus 1.25%, which is payable on a monthly basis.  Concurrent with entering into the floating rate loan, the Company entered into an interest rate swap agreement that effectively locks the interest rate of the loan to 2.2% per annum for the term of the loan.

 

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 LIBOR plus 1.2%, payable on a quarterly basis. As of September 30, 2012, $2.7 million remained outstanding under this loan at an interest rate of 1.88% per annum.

 

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

 

		June 30, 2012			September 30, 2012
Twenty-year term loan due in 2025		$	2,682		$	2,738
Seven-year term loan due in 2020		—			11,100
		2,682			13,838
Less current portion of long-term debt		215			1,677
Long-term portion of debt		$	2,467		$	12,161

 

5. Stock-based Compensation

 

As of September 30, 2012, 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 September 30,
		2011			2012
Cost of goods sold		$	118		$	136
Selling, general and administrative		1,330			3,332
Research and development		63			63
Stock-based compensation expense before taxes		$	1,511		$	3,531
Less: related income tax benefit		533			1,335
Stock-based compensation expense, net of estimated taxes		$	978		$	2,196

 

The following table summarizes stock-based compensation plan activity during the three months ended September 30, 2012:

 

				Stock Option Activity										Restricted Stock Activity
		Shares Available for Grant		Number of Shares		Weighted Average Exercise Price			Weighted Average Remaining Contractual Term		Aggregate Intrinsic Value (in thousands)			Shares		Weighted Average Grant Date Fair Value
Balance as of June 30, 2012		1,090,876		1,059,397		$	23.01		7.2 years		$	42,729		580,468		$	28.93
Restricted stock shares granted		(234,941	)											234,941		57.63
Restricted stock shares vested														(145,136	)	27.80
Stock options granted		(10,000	)	10,000		61.99
Stock options exercised		116,905	(1)	(108,722	)	14.49
Stock options forfeited and cancelled		1,158		(1,158	)	16.72
Restricted stock shares forfeited and cancelled		3,526												(3,526	)	31.71
Balance as of September 30, 2012		967,524	(2)	959,517		$	24.39		7.2 years		$	51,290		666,747		$	39.28

 

(1)         These shares were returned to the shares available for grant pool as they were shares used for net settlement to cover option cost and tax obligations.

(2)         Of the 967,524 shares available for grant, 525,757 shares may be granted in the form of restricted stock.

 

As of September 30, 2012, total unrecognized compensation cost related to non-vested, share-based compensation arrangements granted was approximately $24.3 million. The Company expects to recognize these costs over a weighted-average period of 2.3 years.

 

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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 September 30,
		2011			2012
Service cost		$	157		$	278
Amortization of prior service cost		112			230
Net periodic pension expense		$	269		$	508

 

For both the three months ended September 30, 2011 and 2012, the Company made contributions of $0.1 million to these defined benefit plans.

 

In addition, the Company maintains various defined contribution plans. For the three months ended September 30, 2011 and 2012, the Company made contributions of $1.1 million and $1.0 million, respectively, to these defined contribution plans.

 

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 or profitability milestones. The maximum amount of such payments under arrangements with contingent consideration caps is $63 million. In addition, one of the purchase agreements the Company entered into requires royalty payments through 2022 based on the license of, or sales of products containing the technology of CXR Limited, a company acquired in 2004.  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 business. For acquisitions accounted for under Accounting Standards Codification 805, “Business Combinations” (“ASC 805”), the estimated fair value of these obligations is recorded as a liability in the condensed consolidated balance sheets with subsequent revisions reflected in the condensed consolidated statements of operations. As of September 30, 2012, pursuant to ASC 805, $20.8 million of contingent payment obligations are included in other long-term liabilities in the accompanying condensed consolidated balance sheets.

 

Advances from Customers

 

The Company receives advances from customers associated with certain projects.  In fiscal 2012, the Company entered into an agreement with the Mexican government to provide a turnkey security screening solution along the country’s borders, and in its ports and airports.  Associated with the agreement, the Company was provided an advance totaling $100 million.  The Company is obligated to provide a guarantee until the advance has been earned.

 

Environmental Contingencies

 

The Company is subject to various environmental laws. The Company’s practice is to conduct appropriate environmental investigations 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.

 

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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 the Company, 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 not accrued for loss contingencies relating to the above environmental matter because it believes that, although an unfavorable outcome may be possible, it is not considered by the Company’s management to be probable and reasonably estimable.  If this matter is 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 experience and anticipated expenses. 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):

 

		Three Months Ended  September 30,
		2011			2012
Balance at beginning of period		$	14,530		$	17,562
Additions		834			632
Reductions for warranty repair costs and adjustments		(926		)	(1,275		)
Balance at end of period		$	14,438		$	16,919

 

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 has determined that it operates in three identifiable industry segments, (a) security and inspection systems (Security division), (b) medical monitoring and anesthesia systems (Healthcare division) and (c) optoelectronic devices and manufacturing (Optoelectronics and Manufacturing division). The Company also has a corporate segment (Corporate) that includes executive compensation and certain other general and administrative expenses; expenses related to stock issuances; and legal and audit and other professional service fees not allocated to product segments. Both the Security and Healthcare divisions comprise primarily end-product businesses whereas the businesses of the Optoelectronics and Manufacturing division primarily supplies components and subsystems to original equipment manufacturers, including to the Security and Healthcare divisions. Sales between divisions are at transfer prices that approximate market values.  All other accounting policies of the segments are the same as described in Note 1, Summary of Significant Accounting Policies of the Form 10-K for the fiscal year ended June 30, 2012.

 

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The following tables present the operations and identifiable assets by industry segment (in thousands):

 

		Three Months Ended September 30,
		2011			2012
Revenues — by Segment:
Security division		$	72,597		$	82,916
Healthcare division		46,520			51,581
Optoelectronics and Manufacturing division, including intersegment revenues		53,091			57,147
Intersegment revenues elimination		(10,891		)	(9,950		)
Total		$	161,317		$	181,694
Revenues — by Geography:
Americas		$	107,822		$	118,480
Europe		35,340			43,818
Asia		29,046			29,346
Intersegment revenues elimination		(10,891		)	(9,950		)
Total		$	161,317		$	181,694

 

		Three Months Ended September 30,
		2011			2012
Operating income (loss) — by Segment:
Security division		$	3,845		$	4,465
Healthcare division		2,398			3,881
Optoelectronics and Manufacturing division		4,938			4,833
Corporate		(3,307		)	(3,249		)
Eliminations (1)		(264		)	184
Total		$	7,610		$	10,114

 

		June 30,  2012			September 30,  2012
Assets — by Segment:
Security division		$	351,668		$	390,621
Healthcare division		162,583			159,658
Optoelectronics and Manufacturing division		132,281			144,515
Corporate		109,405			98,728
Eliminations (1)		(6,041		)	(6,797		)
Total		$	749,896		$	786,725

 

(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.

 

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

 

Forward-Looking Statements

 

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 the Private Securities Litigation Reform Act of 1995, 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 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, 2012.

 

Recent Accounting Pronouncements

 

There are no recent accounting pronouncements that, if implemented, would impact us materially.

 

Executive Summary

 

We are a vertically integrated designer and manufacturer of specialized electronic systems and components for critical applications, and provider of screening services.  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 and market security and inspection systems worldwide for sale primarily to U.S. and foreign government agencies, and provide turnkey security screening solutions. 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 46% and 45% of our total consolidated revenues for the three months ended September 30, 2012 and 2011, 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, sporting venues, government and military installations and nuclear facilities.  We believe that our wide-ranging product portfolio together with our ability to provide turnkey screening solutions position us to competitively pursue security and inspection opportunities as they arise throughout the world.

 

During our third quarter of fiscal 2012, our Security division won a six-year agreement with the Mexican government to provide a turnkey security screening solution along the country’s borders, and in its ports and airports.  We have begun recognizing revenue under this agreement and the results are reported as part of the service revenues.

 

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Healthcare Division. Through our Healthcare division, we design, manufacture, market and service patient monitoring, diagnostic cardiology and anesthesia delivery and ventilation systems worldwide for sale primarily to hospitals and medical centers. Our products monitor patients in critical, emergency and perioperative care areas of the hospital and provide such information, through wired and wireless networks, to physicians and nurses who may be at the patient’s bedside, in another area of the hospital or even outside the hospital.  Revenues from our Healthcare division accounted for 28% and 29% of our total consolidated revenues for the three months ended September 30, 2012 and 2011, 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 anticipated lower sales of patient monitoring, diagnostic cardiology and anesthesia systems products than what we had historically experienced, which negatively impacted our sales. Although there are indications that a recovery is underway, we cannot predict when the markets will fully 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 provide 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, industrial automation, automotive diagnostic systems and renewable energy. 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 26% of our total consolidated revenues for both the three months ended September 30, 2012 and 2011.

 

Results of Operations for the Three Months Ended September 30, 2012 (Q1 2013) Compared to Three Months Ended September 30, 2011 (Q1 2012) (amounts in millions)

 

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.

 

		Q1 2012			% of Net Sales		Q1 2013			% of Net Sales		$ Change			% Change
Security division		$	72.6		45	%	$	82.9		46	%	$	10.3		14	%
Healthcare division		46.5			29	%	51.6			28	%	5.1			11	%
Optoelectronics and Manufacturing division		53.1			33	%	57.1			31	%	4.0			8	%
Intersegment revenues		(10.9		)	(7	)%	(9.9		)	(5	)%	1.0			(9	)%
Total revenues		$	161.3				$	181.7				$	20.4		13	%

 

Revenues for the Security division for the three months ended September 30, 2012 increased $10.3 million, or 14%, to $82.9 million, from $72.6 million for the comparable prior-year period. The increase was attributable to: (i) a $6.4 million or 19% increase in sales of our conventional equipment, primarily in baggage and parcel inspection lines; and (ii) a $4.1 million increase in the sales of radiation and nuclear sensing products.

 

Revenues for the Healthcare division for the three months ended September 30, 2012 increased $5.1 million, or 11%, to $51.6 million, from $46.5 million for the comparable prior-year period. The increase was primarily attributable to a $4.8 million, or 14%, increase in patient monitoring revenues primarily in North America as the economy continued to improve and the market has responded favorably to recently launched new product offerings.

 

Revenues for the Optoelectronics and Manufacturing division for the three months ended September 30, 2012 increased $4.0 million, or 8%, to $57.1 million, from $53.1 million for the comparable prior-year period. This change was driven by strength in our contract manufacturing sales driven by new customers.  The Optoelectronics and Manufacturing division recorded intersegment sales of $9.9 million, compared to $10.9 million in the comparable prior-year period.  Such intersegment sales are eliminated in consolidation.

 

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Gross Profit

 

		Q1 2012			% of Net Sales		Q1 2013			% of Net Sales
Gross profit		$	52.9		32.8	%	$	61.4		33.8	%

 

Gross profit increased $8.5 million, or 16%, to $61.4 million for the three months ended September 30, 2012, from $52.9 million for the comparable prior-year period and was primarily attributable to a 13% increase is sales.  The gross margin increased to 33.8% in the three months ended September 30, 2012, from 32.8% for the comparable prior-year period.  The increase was primarily attributable to the favorable sales mix in our Security division and strong healthcare sales which carry higher gross margins than our other two divisions partially offset by a reduced gross margin in our Optoelectronics and Manufacturing division due to an unfavorable sales mix.

 

Operating Expenses

 

		Q1 2012			% of Net Sales		Q1 2013			% of Net Sales		$ Change			% Change
Selling, general and administrative		$	34.4		21.3	%	$	39.9		22.0	%	$	5.5		16	%
Research and development		10.9			6.8	%	11.3			6.2	%	0.4			4	%
Total operating expenses		$	45.3		28.1	%	$	51.2		28.2	%	$	5.9		13	%

 

Selling, general and administrative expenses. Selling, general and administrative (SG&A) expenses consist primarily of compensation paid to sales, marketing and administrative personnel, professional service fees and marketing expenses. For the three months ended September 30, 2012, SG&A expenses increased by $5.5 million, or 16%, to $39.9 million, from $34.4 million for the comparable prior-year period. This increase was primarily attributable to an increase in costs to support the strong sales growth as well as incremental costs in our Security division in support of our operations related to the aforementioned program in Mexico.  As a percentage of revenue, SG&A expenses were 22.0% for the three months ended September 30, 2012, compared to 21.3% for the comparable prior-year period.

 

Research and development. Research and development (R&D) expenses include research related to new product development and product enhancement expenditures. For the three months ended September 30, 2012, such expenses increased $0.4 million, or 4%, to $11.3 million, from $10.9 million for the comparable prior-year period. As a percentage of revenues, R&D expenses were 6.2% for the three months ended September 30, 2012, compared to 6.8% for the comparable prior-year period. The increase in R&D expenses for the three month period ended September 30, 2012, was primarily attributable to an increase in spending in our Security division in support of new product introductions.

 

Other Income and Expenses

 

		Q1 2012			% of Net Sales		Q1 2013			% of Net Sales		$ Change			% Change
Interest and other expense, net		$	0.8		0.5	%	$	1.1		0.6	%	$	0.3		38	%

 

Interest and other expense, net.  For the three months ended September 30, 2012, interest and other expense, net amounted to $(1.1) million as compared to $(0.8) million in the comparable prior-year period.  The increase was mainly due to higher utilization of the letters-of-credit facility in the three months ended September 30, 2012 compared to the comparable prior-year period.

 

Income taxes.  For the three months ended September 30, 2012, our income tax provision was $2.7 million, compared to $2.0 million for the comparable prior-year period. Our effective tax rate for the three months ended September 30, 2012 was 29.7%, as compared to 30.1% in the comparable prior-year period. Our provision for income taxes is dependent on the mix of income from U.S. and foreign locations due to tax rate differences among countries as well as due to the impact of permanent taxable differences.

 

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