OSI SYSTEMS INC - Quarter Report: 2013 September (Form 10-Q)

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

 

 

For the quarterly period ended September 30, 2013

 

OR

 

 

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, 2013, there were 20,053,538 shares of the Registrant’s common stock par value $0.001 per share outstanding.

 

 

 

OSI SYSTEMS, INC.

 

INDEX

 

		PAGE
PART I —	FINANCIAL INFORMATION	3
Item 1 —	Condensed Consolidated Financial Statements	3
	Condensed Consolidated Balance Sheets at June 30, 2013 and September 30, 2013	3
	Condensed Consolidated Statements of Operations for the three months ended September 30, 2012 and 2013	4
	Condensed Consolidated Statements of Comprehensive Income for the three months ended September 30, 2012 and 2013	5
	Condensed Consolidated Statements of Cash Flows for the three months ended September 30, 2012 and 2013	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2 —	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3 —	Quantitative and Qualitative Disclosures about Market Risk	21
Item 4 —	Controls and Procedures	22
PART II — OTHER INFORMATION		23
Item 1 —	Legal Proceedings	23
Item 1A —	Risk Factors	23
Item 2 —	Unregistered Sales of Equity Securities and Use of Proceeds	23
Item 3 —	Defaults Upon Senior Securities	23
Item 4 —	Mine Safety Disclosures	23
Item 5 —	Other Information	23
Item 6 —	Exhibits	23
Signatures		23

 

 

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,
		2013			2013
ASSETS
Current assets:
Cash and cash equivalents		$	34,697		$	37,186
Accounts receivable, net		206,817			205,283
Inventories		206,213			228,007
Prepaid expenses and other current assets		78,972			77,151
Total current assets		526,699			547,627
Property and equipment, net		249,029			249,406
Goodwill		83,743			91,018
Intangible assets, net		36,603			40,289
Other assets		23,722			24,442
Total assets		$	919,796		$	952,782
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Bank lines of credit		$	59,000		$	79,000
Current portion of long-term debt		1,797			2,956
Accounts payable		97,050			97,334
Accrued payroll and related expenses		28,503			26,432
Advances from customers		37,432			42,979
Accrued warranties		12,890			13,359
Deferred revenue		18,131			15,549
Other accrued expenses and current liabilities		26,610			28,311
Total current liabilities		281,413			305,920
Long-term debt		10,673			12,273
Advances from customers		75,000			68,750
Other long-term liabilities		74,259			81,449
Total liabilities		441,345			468,392
Commitments and contingencies (Note 8)
Stockholders’ equity:
Preferred stock, $0.001 par value, 10,000,000 shares authorized; no shares issued or outstanding		—			—
Common stock, $0.001 par value, 100,000,000 shares authorized; 19,914,089 shares issued and outstanding at June 30, 2013 and 20,053,538 shares at September 30, 2013		285,001			283,146
Retained earnings		199,786			206,180
Accumulated other comprehensive loss		(6,336		)	(4,936		)
Total stockholders’ equity		478,451			484,390
Total liabilities and stockholders’ equity		$	919,796		$	952,782

 

See accompanying notes to condensed consolidated financial statements.

 

3

 

OSI SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(Unaudited)

 

		For the Three Months Ended September 30,
		2012			2013
Net revenues:
Products		$	148,864		$	143,476
Services		32,830			62,798
Total net revenues		181,694			206,274
Cost of goods sold:
Products		98,932			103,593
Services		21,407			34,735
Total cost of goods sold		120,339			138,328
Gross profit		61,355			67,946
Operating expenses:
Selling, general and administrative		39,925			42,214
Research and development		11,316			11,020
Restructuring and other charges		—			4,239
Total operating expenses		51,241			57,473
Income from operations		10,114			10,473
Interest and other expense, net		(1,097		)	(1,470		)
Income before income taxes		9,017			9,003
Provision for income taxes		2,678			2,609
Net income		$	6,339		$	6,394
Net income per share:
Basic		$	0.32		$	0.32
Diluted		$	0.31		$	0.31
Shares used in per share calculation:
Basic		19,906			19,971
Diluted		20,571			20,620

 

See accompanying notes to condensed consolidated financial statements.

 

4

 

OSI SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(amounts in thousands)

(Unaudited)

 

		For the Three Months Ended September 30,
		2012			2013
Net income		$	6,339		$	6,394
Other comprehensive income (loss):
Foreign currency translation adjustment		5,311			1,308
Other		(454		)	92
Other comprehensive income		4,857			1,400
Comprehensive income		$	11,196		$	7,794

 

See accompanying notes to condensed consolidated financial statements.

 

5

 

OSI SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(amounts in thousands)

(Unaudited)

 

		For the Three Months Ended September 30,
		2012			2013
Cash flows from operating activities:
Net income		$	6,339		$	6,394
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		4,907			12,873
Stock based compensation expense		3,533			5,638
Provision for losses on accounts receivable		294			23
Equity in earnings of unconsolidated affiliates		(13		)	(30		)
Deferred income taxes		140			72
Other		1			128
Changes in operating assets and liabilities—net of business acquisitions:
Accounts receivable		11,190			6,305
Inventories		2,286			(16,092		)
Prepaid expenses and other assets		2,318			832
Accounts payable		28,055			(3,151		)
Accrued payroll and related expenses		(4,656		)	(2,308		)
Advances from customers		(8,954		)	(708		)
Accrued warranties		(831		)	77
Deferred revenue		(2,077		)	(3,145		)
Other accrued expenses and liabilities		(155		)	(661		)
Net cash provided by operating activities		42,377			6,247
Cash flows from investing activities:
Acquisition of property and equipment		(62,718		)	(7,971		)
Acquisition of businesses		(1,897		)	(9,302		)
Acquisition of intangible and other assets		(1,416		)	(1,756		)
Net cash used in investing activities		(66,031		)	(19,029		)
Cash flows from financing activities:
Net borrowings on bank lines of credit		—			20,000
Proceeds from long-term debt		11,100			2,769
Payments on long-term debt		(55		)	(805		)
Proceeds from exercise of stock options and employee stock purchase plan		2,951			1,501
Repurchase of common shares		(835		)	(1,514		)
Taxes paid related to net share settlement of equity awards		(8,596		)	(7,481		)
Net cash provided by financing activities		4,565			14,470
Effect of exchange rate changes on cash		1,344			801
Net increase (decrease) in cash and cash equivalents		(17,745		)	2,489
Cash and cash equivalents-beginning of period		91,452			34,697
Cash and cash equivalents-end of period		$	73,707		$	37,186
Supplemental disclosure of cash flow information:
Cash paid, net during the period for:
Interest		$	129		$	1,174
Income taxes		$	1,450		$	4,001

 

See accompanying notes to condensed consolidated financial statements.

 

6

 

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 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 reporting segments: (i) Security, providing security 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 manufacturing clients for applications in the defense, aerospace, medical and industrial markets, among others.

 

Through its Security division, the Company designs, manufactures and markets security inspections systems and security screening, threat detection and non-intrusive inspection products and related services globally. These products fall into the following categories: baggage and parcel inspection systems; cargo and vehicle inspection systems; hold (checked) baggage screening systems; people screening systems and radiation detection systems. In addition to these products, the Company provides site design, installation, training and technical support services to its customers. The Company also provides turnkey security screening solutions, which can include the construction, staffing and long term operation of security screening checkpoints for its customers.

 

Through its Healthcare division, the Company designs, manufactures and markets patient monitoring, diagnostic cardiology and anesthesia delivery and ventilation systems, and related services 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 consumer products. 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, the condensed consolidated financial statements include 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. 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, 2013, filed with the Securities and Exchange Commission on August 16, 2013. The results of operations for the three months ended September 30, 2013 are not necessarily indicative of the operating results to be expected for the full 2014 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 and stock awards or units under the treasury stock method.  There were no stock options or stock awards or units excluded from the calculations for the three months ended September 30, 2012 or September 30, 2013.

 

7

 

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,
		2012			2013
Net income for diluted earnings per share calculation		$	6,339		$	6,394
Weighted average shares for basic earnings per share calculation		19,906			19,971
Dilutive effect of stock awards		665			649
Weighted average shares for diluted earnings per share calculation		20,571			20,620
Basic net income per share		$	0.32		$	0.32
Diluted net income per share		$	0.31		$	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.

 

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. “Level 1” category includes assets and liabilities at the quoted prices in active markets for identical assets and liabilities.  “Level 2” category includes assets and liabilities from observable inputs other than quoted market prices. “Level 3” category includes assets and liabilities whose valuation techniques are unobservable and significant to the fair value measurement.  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 following is a summary of the inputs used in valuing investments carried at fair value (in thousands):

 

		Level 1			Level 2			June 30, 2013			Level 1			Level 2			September 30, 2013
Equity securities		316			—			316			304			—			304
Insurance company contracts		—			13,914			13,914			—			14,978			14,978
Interest rate contract		—			66			66			—			39			39
Total		$	316		$	13,980		$	14,296		$	304		$	15,017		$	15,321

 

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, 2013, the Company had outstanding foreign currency forward contracts of approximately $4.0 million.  The foreign exchange contracts do not meet the criteria as an effective cash flow hedge.  Therefore, the net gain (loss) from these contracts is reported in Interest and other expense, 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.

 

8

 

An 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 income 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 turnkey services agreements is included in revenue from services and 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. On occasion, the Company receives advances from customers that are amortized against future customer payments pursuant to the underlying agreements. Such advances are classified in the condensed consolidated balance sheets as either a current or long term liability dependent upon when the Company estimates the corresponding amortization to occur.

 

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.  During the three months ended September 30, 2013, the Company completed acquisitions that were immaterial both individually and in the aggregate.

 

2. Balance Sheet Details

 

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

 

		June 30, 2013			September 30, 2013
Accounts receivable
Billed receivables		$	179,458		$	164,005
Unbilled receivables		34,636			47,261
Less allowance for doubtful accounts		(7,277		)	(5,983		)
Total		$	206,817		$	205,283

 

Unbilled receivables included earned but unbilled revenue that was billed and collected subsequent to the quarter-end.

 

		June 30, 2013			September 30, 2013
Inventories
Raw materials		$	117,416		$	120,799
Work-in-process		37,337			49,579
Finished goods		51,460			57,629
Total		$	206,213		$	228,007

 

		June 30, 2013			September 30, 2013
Property and equipment, net
Land		$	8,365		$	8,365
Buildings and improvements		102,187			140,650
Leasehold improvements		9,302			9,787
Equipment and tooling		135,437			145,054
Furniture and fixtures		3,551			3,884
Computer equipment		14,309			16,019
Computer software		15,209			15,422
Construction in process		48,713			11,017
Total		337,073			350,198
Less: accumulated depreciation and amortization		(88,044		)	(100,792		)
Property and equipment, net		$	249,029		$	249,406

 

9

 

Construction in process consists primarily of costs related to infrastructure in Mexico that will be depreciated when assets are placed into service.

 

During the three months ended September 30, 2012 and 2013, depreciation expense was approximately $3.7 million and $11.5 million, respectively.

 

3. Goodwill and Intangible Assets

 

The changes in the carrying value of goodwill for the three-month period ended September 30, 2013 are as follows (in thousands):

 

		Security Division			Healthcare Division			Optoelectronics and Manufacturing Division			Consolidated
Balance as of June 30, 2013		$	28,546		$	35,827		$	19,370		$	83,743
Goodwill acquired or adjusted during the period		—			1,018			5,573			6,591
Foreign currency translation adjustment		142			175			367			684
Balance as of September 30, 2013		$	28,688		$	37,020		$	25,310		$	91,018

 

Intangible assets consisted of the following (in thousands):

 

				June 30, 2013									September 30, 2013
		Weighted Average Lives		Gross Carrying Value			Accumulated Amortization			Intangibles Net			Gross Carrying Value			Accumulated Amortization			Intangibles Net
Amortizable assets:
Software development costs		5 years		$	17,350		$	5,396		$	11,954		$	18,590		$	5,913		$	12,677
Patents		13 years		5,400			635			4,765			5,821			668			5,153
Core technology		10 years		2,058			1,728			330			2,161			1,868			293
Developed technology		10 years		20,002			14,620			5,382			15,611			10,643			4,968
Customer relationships/backlog		8 years		9,178			5,624			3,554			11,305			5,985			5,320
Total amortizable assets				53,988			28,003			25,985			53,488			25,077			28,411
Non-amortizable assets:
Trademarks				10,618			—			10,618			11,878			—			11,878
Total intangible assets				$	64,606		$	28,003		$	36,603		$	65,366		$	25,077		$	40,289

 

Amortization expense related to intangibles assets was $1.2 million and $1.4 million for the three months ended September 30, 2012 and 2013, respectively. At September 30, 2013, the estimated future amortization expense was as follows (in thousands):

 

Fiscal Years
2014 (remaining 9 months)		$	2,817
2015		2,554
2016		2,025
2017		1,682
2018		1,573
2019		1,471
2020 and thereafter, including assets that have not yet begun to be amortized		16,289
Total		$	28,411

 

10

 

Software development costs for software products incurred before establishing technological feasibility are charged to operations. Software development costs incurred after establishing technological feasibility are capitalized on a product by product basis until the product is available for general release to customers at which time amortization begins. Annual amortization, charged to cost of goods sold, is the greater of (i) the amount computed using the ratio that current gross revenues for a product bear to the total current and anticipated future gross revenues for that product and (ii) the straight line method over the remaining estimated economic life of the product. Amortizable assets that have not yet begun to be amortized are included in thereafter in the table above. During the three months ended September 30, 2012 and 2013, the Company capitalized software development costs in the amount of $1.5 million and $1.2 million, respectively.

 

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, 2013. 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 and warranties, affirmative and negative and financial covenants, and events of default customary for financing agreements of this type. As of September 30, 2013, there was $79.0 million outstanding under the revolving credit facility and $120.4 million outstanding under the letters-of-credit sub-facility.

 

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, 2013, $5.3 million was outstanding under these letter-of-credit facilities, while no debt was outstanding. As of September 30, 2013, the total amount available under these credit facilities was $40.8 million, with a total cash borrowing sub-limit of $3.2 million.

 

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, which bears interest at LIBOR plus 1.25%, is payable on a monthly basis over seven years.  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.

 

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

 

		June 30, 2013			September 30, 2013
Term loans		$	12,470		$	12,138
Other long-term debt		—			3,091
		12,470			15,229
Less current portion of long-term debt		1,797			2,956
Long-term portion of debt		$	10,673		$	12,273

 

5.  Restructuring and Other Charges

 

The following table summarizes the restructuring and other charges (in thousands):

 

		Security Division			Healthcare Division			Optoelectronics and Manufacturing Division			Corporate		Consolidated
Accrued balance as of June 30, 2013		$	1,043		$	1,639		$	66		—		$	2,748
Expensed during the period:
Facility closure costs related to a facility relocation(1)		—			2,009			—			—		2,009
Employee termination costs related to facility consolidations(2)		—			—			637			—		637
Charges related to contract settlement(3)		1,593			—			—			—		1,593
Total expensed during the period		1,593			2,009			637			—		4,239
Paid during the period		1,378			639			228			—		2,245
Accrued balance as of September 30, 2013		$	1,258		$	3,009		$	475		—		$	4,742

 

(1)         The facility relocation began in fiscal 2013 and was completed during the first quarter of fiscal 2014.

(2)         The facility consolidations began in the first quarter of fiscal 2014 and are expected to be completed during the remainder of the fiscal year.

(3)         This relates to further costs related to a contract settlement with the Transportation Security Administration (TSA) entered into in fiscal 2013, including costs for removal, storage and refurbishing costs for products previously sold to the TSA, and legal costs.

 

11

 

6. Stock-based Compensation

 

As of September 30, 2013, the Company maintained two share-based employee compensation plans (the “OSI Plans”): the 2012 Incentive Award Plan (“2012 Plan”) and the 2006 Equity Participation Plan (“2006 Plan”).

 

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

 

		Three Months Ended September 30,
		2012			2013
Cost of goods sold		$	136		$	269
Selling, general and administrative		3,332			5,303
Research and development		63			66
Stock-based compensation expense before taxes		$	3,531		$	5,638
Less: related income tax benefit		1,335			2,174
Stock-based compensation expense, net of estimated taxes		$	2,196		$	3,464

 

As of September 30, 2013, total unrecognized compensation cost related to share-based compensation grants were estimated at $1.9 million for stock options and $29.9 million for restricted stock and Restricted Stock Units (“RSU”) under the OSI Plans.  The Company expects to recognize these costs over a weighted-average period of 1.8 years with respect to the options and 1.9 years for grants of restricted stock and RSU’s.

 

The following summarizes stock option activity during the three months ended September 30, 2013:

 

		Number of Options		Weighted- Average Exercise Price			Weighted-Average Remaining Contractual Term		Aggregate Intrinsic Value (in thousands)
Outstanding at June 30, 2013		1,019,733		$	26.33
Granted		6,500		$	69.88
Exercised		(1,169	)	$	39.97
Expired or forfeited		(330	)	$	54.50
Outstanding at September 30, 2013		1,024,734		$	26.58		6.4 years		$	48,983
Exercisable at September 30, 2013		826,793		$	20.67		5.9 years		$	43,269

 

A summary of restricted stock and restricted stock unit award activity during the three months ended September 30, 2013 was as follows:

 

		Shares		Weighted- Average Fair Value
Nonvested at June 30, 2013		627,124		$	43.13
Granted		312,398		63.45
Vested		(231,359	)	40.72
Forfeited		(1,429	)	47.94
Nonvested at September 30, 2013		706,734		$	52.95

 

As of September 30, 2013, there were 3,308,870 shares available for grant under the 2012 Plan.  Under the terms of that plan, restricted stock and RSU’s granted from the pool of shares available for grant on or after December 12, 2012 reduce the pool by 1.87 shares for each share granted.  Restricted stock and RSU’s forfeited and returned to the pool of shares available for grant increase the pool by 1.87 shares for each share forfeited.

 

The Company granted 178,500 performance-based awards during the three months ended September 30, 2012 and 160,922 performance-based units during the three months ended September 30, 2013 respectively. These performance-based restricted stock awards and units are contingent on the achievement of certain financial performance metrics. The payout can range from zero to 250% of the original number of shares awarded or units awarded, which are converted into shares of the Company’s common stock.

 

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7. 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,
		2012			2013
Service cost		$	278		$	293
Amortization of prior service cost		230			202
Net periodic pension expense		$	508		$	495

 

For each of the three months ended September 30, 2012 and 2013, the Company made contributions of $0.1 million to these defined benefit plans.

 

In addition, the Company maintains various defined contribution plans. For each of the three months ended September 30, 2012 and 2013, the Company made contributions of $1.0 million to these defined contribution plans.

 

8. Commitments and Contingencies

 

Legal Proceedings

 

The Company is involved in various claims and legal proceedings arising in 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 business, financial condition, 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 business, financial condition, results of operations 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 future payments under arrangements with contingent consideration caps is $52 million as of September 30, 2013. 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, the Company accounts for such contingent payments as an addition to the purchase price of the acquired business. Otherwise, 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 June 30, 2013 and September 30, 2013, $15.4 million and $21.4 million of contingent payment obligations, respectively, 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 amortized.  As of September 30, 2013, $95.8 million of this advance remains outstanding.

 

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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 that the Company believes was the result of unspecified historical releases prior to our occupancy. This site had been used since the mid 1960’s by other companies for semiconductor manufacturing similar to our present operations and was part of a large aircraft manufacturing complex during World War II. It is not presently known when the releases occurred or by whom they were caused. The groundwater contamination is a known regional problem, not limited to our premises or our immediate surroundings. The Company filed the requisite reports concerning this problem with the appropriate environmental authorities in fiscal 2001. We were recently contacted by the local governing agency with a request to provide additional historical information and further characterization of the site. Historical reports and site characterization work plans were completed in fiscal 2013 and further site characterization studies, including soil and groundwater investigations, are scheduled for fiscal 2014. These studies are necessary to determine the extent of the on-site releases and if any remediation of such contamination will be required.

 

The Company has not accrued for loss contingencies relating to the Hawthorne facility or any other 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 environmental matters are resolved in a manner adverse to the Company, the impact on the Company’s business, financial condition, results of operations, financial position and/or liquidity could be material.

 

Indemnifications

 

In the normal course of business, the Company has agreed to indemnify certain parties with respect to certain matters. The Company has agreed to hold certain parties harmless against losses arising from a breach of representations or covenants, or out of intellectual property infringement or other claims made by third parties. These agreements may limit the time within which an indemnification claim can be made and the amount of the claim. In addition, the Company has entered into indemnification agreements with its officers and directors. It is not possible to determine the maximum potential amount under these indemnification agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each particular agreement. The Company has not recorded any liability for costs related to indemnification as of September 30, 2013.

 

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,
		2012			2013
Balance at beginning of period		$	17,562		$	12,890
Additions and adjustments		709			1,254
Reductions for warranty repair costs		(1,352		)	(785		)
Balance at end of period		$	16,919		$	13,359

 

9. 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, changes in or the interpretation of tax laws in jurisdictions where the Company conducts business and certain tax elections. 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.

 

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10. 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-user businesses, while 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, 2013.

 

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

 

		Three Months Ended September 30,
		2012			2013
Revenues — by Segment:
Security division		$	82,916		$	97,153
Healthcare division		51,581			45,787
Optoelectronics and Manufacturing division, including intersegment revenues		57,147			71,311
Intersegment revenues elimination		(9,950		)	(7,977		)
Total		$	181,694		$	206,274

 

		Three Months Ended September 30,
		2012			2013
Operating income (loss) — by Segment:
Security division		$	4,465		$	11,622
Healthcare division		3,881			(1,998		)
Optoelectronics and Manufacturing division		4,833			4,765
Corporate		(3,249		)	(4,045		)
Eliminations(1)		184			129
Total		$	10,114		$	10,473

 

		June 30,  2013			September 30,  2013
Assets — by Segment:
Security division		$	499,539		$	512,063
Healthcare division		190,963			175,757
Optoelectronics and Manufacturing division		158,584			190,861
Corporate		75,496			78,758
Eliminations(1)		(4,786		)	(4,657		)
Total		$	919,796		$	952,782

 

(1)      Eliminations within operating income primarily reflect the change in the elimination of intercompany profit in inventory not-yet-realized. 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

 

In this report, “OSI”, the “Company”, “we”, “us”, “our” and similar terms refer to OSI Systems, Inc. and wholly-owned subsidiaries.

 

This management’s discussion and analysis of financial condition as of September 30, 2013 and results of operations for the three-months ended September 30, 2012 and 2013 should be read in conjunction with management’s discussion and analysis of financial condition and results of operations included in our Annual Report on Form 10-K for the year ended June 30, 2013.

 

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. These forward-looking statements should be considered in light of various important factors, including the following: the impact of global and regional economic and credit market conditions; the potential impact of the recent shutdown of the U.S. federal government and the ongoing debates related to the U.S. budget and debt ceiling; healthcare reform legislation in the United States and its impact on healthcare spending; timing and success of product development and market acceptance of developed products; regulatory approvals, clearances and restrictions; unanticipated manufacturing disruptions; and other risk factors.  Further, 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.

 

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 47% of our total consolidated revenues for the three months ended September 30, 2012 and 2013, 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.

 

Currently, the U.S. federal budget environment is one of continued uncertainty.  Significant uncertainty continues to exist regarding the potential impact of the recent shutdown of the U.S. federal government in October 2013 and the ongoing debates related to the U.S. budget and debt ceiling, which may result in changes to monetary and fiscal policies in the U.S., and sequestration cuts on our fiscal 2014 operations and beyond. Further, while the U.S. federal government continues to discuss various options to address sequestration and the U.S. federal government’s overall fiscal challenges, we cannot predict the outcome of these efforts. We believe that the diversified product portfolio and international customer mix of our Security division position us well to withstand the impact of these uncertainties and even benefit from specific initiatives within the U.S. federal government and other foreign governments.  However, depending on how future sequestration cuts are implemented and how the U.S. federal government manages their fiscal challenges, we believe that these federal actions could have a material, negative impact on our results of operations and cash flows in the future.

 

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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 22% of our total consolidated revenues for the three months ended September 30, 2012 and 2013, 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. In addition, there is continued uncertainty regarding the potential impact of the recent shutdown of the U.S. federal government in October 2013 and the ongoing debates related to the U.S. budget and debt ceiling and the Patient Protection and Affordable Care Act, amended by the Health Care and Education and Reconciliation Act of 2010 (the “Affordable Care Act”), in the U.S., any of which may impact hospital spending, reimbursement and fees which will be levied on certain medical device revenues and adversely affect our business and results of operations.  In addition, hospital capital spending appears to have been impacted by strategic uncertainties surrounding the Affordable Care Act, economic pressures, and negative media reports.  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 than what we have historically experienced, which may negatively impact our sales. Although there are indications that a general economic recovery is underway, we cannot predict when the markets will fully recover or when the uncertainties related to the U.S. federal government will be resolved 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, gaming systems and consumer products. 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% and 31% of our total consolidated revenues for the three months ended September 30, 2012 and 2013, respectively.

 

During the three months ended September 30, 2013, our Optoelectronics and Manufacturing division completed two small acquisitions relating to our contract manufacturing services business and allowed us to expand our customer base and geographic footprint, while leveraging our existing infrastructure.

 

Results of Operations for the Three Months Ended September 30, 2012 (Q1 2013) Compared to Three Months Ended September 30, 2013 (Q1 2014) (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 10 to the condensed consolidated financial statements for additional information about our business segments.

 

		Q1 2013			% of Net Sales		Q1 2014			% of Net Sales		$ Change			% Change
Security division		$	82.9		46	%	$	97.2		47	%	$	14.3		17	%
Healthcare division		51.6			28	%	45.8			22	%	(5.8		)	(11	)%
Optoelectronics and Manufacturing division		57.1			31	%	71.3			35	%	14.2			25	%
Less: inter-division sales		(9.9		)	(5	)%	(8.0		)	(4	)%	1.9			19	%
Total external revenues		$	181.7				$	206.3				$	24.6		14	%

 

Revenues for the Security division for the three months ended September 30, 2013 increased $14.3 million, or 17%, to $97.2 million, from $82.9 million for the comparable prior-year period. The increase was primarily attributable to increases in revenue from our turnkey screening services in Mexico and sales of cargo equipment, which was partially offset by the decrease in equipment revenues associated with the London Olympic Games, which contributed approximately $22.0 million in revenues in the prior year quarter.

 

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Revenues for the Healthcare division for the three months ended September 30, 2013 decreased $5.8 million, or 11%, to $45.8 million, from $51.6 million for the comparable prior-year period. The decrease was primarily attributable to a $4.1 million, or 10%, decrease in patient monitoring revenues and a $1.9 million decrease in anesthesia revenues.  These decreases were prevalent throughout most of our sales channels and geographic markets.

 

Revenues for the Optoelectronics and Manufacturing division for the three months ended September 30, 2013 increased $14.2 million, or 25%, to $71.3 million, from $57.1 million for the comparable prior-year period. Excluding the impact of $5.3 million of revenue attributable to acquired businesses over the past twelve months, the growth was 16%.  This change was primarily attributable to increases in contract manufacturing sales to our customers in the consumer products business, which was partially offset by declines in our core optoelectronics business.

 

Gross Profit

 

		Q1 2013			% of Net Sales		Q1 2014			% of Net Sales
Gross profit		$	61.4		33.8	%	$	67.9		32.9	%

 

Gross profit increased $6.5 million, or 11%, to $67.9 million for the three months ended September 30, 2013, from $61.4 million for the comparable prior-year period and was primarily attributable to a 14% increase in sales.  The gross margin decreased to 32.9% from 33.8% for the comparable prior-year period which was primarily attributable to: i) the impact of reduced revenues in our Healthcare division, which has historically generated the highest gross margin across the three divisions and ii) the impact of increased revenues from our Optoelectronic and Manufacturing division, which has historically generated the lowest gross margins across the three divisions.

 

Operating Expenses

 

		Q1 2013			% of Net Sales		Q1 2014			% of Net Sales		$ Change			% Change
Selling, general and administrative		$	39.9		22.0	%	$	42.2		20.5	%	$	2.3		6	%
Research and development		11.3			6.2	%	11.0			5.3	%	(0.3		)	(3	)%
Restructuring and other charges		—			—		4.2			2.0	%	4.2			—
Total operating expenses		$	51.2		28.2	%	$	57.4		27.8	%	$	6.2		12	%

 

Selling, general and administrative. 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, 2013, SG&A expenses increased by $2.3 million, or 6%, to $42.2 million, from $39.9 million for the comparable prior-year period. This increase was primarily attributable to increasing costs to support our 14% revenue growth.    As a percentage of revenue, SG&A expenses were 20.5% for the three months ended September 30, 2013, compared to 22.0% 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, 2013, such expenses were relatively consistent with the prior year decreasing $0.3 million, to $11.0 million, from $11.3 million.

 

Restructuring and other charges.  We continuously look for opportunities to optimize our infrastructure.  In conjunction with these efforts, during the three months ended September 30, 2013 we incurred restructuring and other charges of $2.0 million in our Healthcare division related to a facility relocation which was concluded in our first quarter of fiscal 2014, and a $0.6 million charge in our Optoelectronics and Manufacturing division, primarily for employee severance related to a facility consolidation planned for completion during our second fiscal quarter of fiscal 2014.  In addition, we incurred a $1.6 million charge in our Security division related to our contract settlement with the Transportation Security Administration. We incurred no restructuring and other charges for the three months ended September 30, 2012.

 

Other Income and Expenses

 

		Q1 2013			% of Net Sales		Q1 2014			% of Net Sales		$ Change			% Change
Interest and other expense, net		$	1.1		0.6	%	$	1.5		0.7	%	$	0.4		36	%

 

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