OSI SYSTEMS INC - Quarter Report: 2017 September (Form 10-Q)

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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, 2017

 

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, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer x		Accelerated filer o
Non-accelerated filer o		Smaller reporting company o
(Do not check if a smaller reporting company)
		Emerging growth company o

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

 

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 26, 2017, there were 18,968,450 shares of the registrant’s common stock outstanding.

 

 

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OSI SYSTEMS, INC.

 

INDEX

 

				PAGE
PART I — FINANCIAL INFORMATION				3
	Item 1 —	Financial Statements		3
		Unaudited Condensed Consolidated Balance Sheet at June 30, 2017 and Unaudited Condensed Consolidated Balance Sheet at September 30, 2017		3
		Unaudited Condensed Consolidated Statements of Operations for the three months ended September 30, 2016 and 2017		4
		Unaudited Condensed Consolidated Statements of Comprehensive Income (Loss) for the three months ended September 30, 2016 and 2017		5
		Unaudited Condensed Consolidated Statements of Cash Flows for the three months ended September 30, 2016 and 2017		6
		Notes to Unaudited Condensed Consolidated Financial Statements		7
	Item 2 —	Management’s Discussion and Analysis of Financial Condition and Results of Operations		21
	Item 3 —	Quantitative and Qualitative Disclosures about Market Risk		25
	Item 4 —	Controls and Procedures		26
PART II — OTHER INFORMATION				28
	Item 1 —	Legal Proceedings		28
	Item 1A —	Risk Factors		28
	Item 2 —	Unregistered Sales of Equity Securities and Use of Proceeds		28
	Item 3 —	Defaults Upon Senior Securities		28
	Item 4 —	Mine Safety Disclosures		28
	Item 5 —	Other Information		28
	Item 6 —	Exhibits		28
Signatures				29

 

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PART I —FINANCIAL INFORMATION

 

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

OSI SYSTEMS, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(amounts in thousands, except share amounts)

 

		June 30,			September 30,
		2017			2017
ASSETS
CURRENT ASSETS:
Cash and cash equivalents		$	169,650		$	192,028
Accounts receivable, net		206,526			203,068
Inventories		248,510			271,309
Prepaid expenses and other current assets		28,314			34,425
Total current assets		653,000			700,830
Property and equipment, net		141,539			151,170
Goodwill		242,129			282,656
Intangible assets, net		118,450			145,036
Deferred income taxes		34,897			29,705
Other assets		40,072			42,127
Total assets		$	1,230,087		$	1,351,524
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Bank lines of credit		$	103,000		$	214,000
Current portion of long-term debt		2,396			2,286
Accounts payable		76,121			86,112
Accrued payroll and related expenses		34,621			31,271
Advances from customers		37,934			34,458
Other accrued expenses and current liabilities		92,062			93,224
Total current liabilities		346,134			461,351
Long-term debt		241,750			243,416
Deferred income taxes		20,681			20,323
Other long-term liabilities		52,309			55,054
Total liabilities		660,874			780,144
Commitments and contingencies (Note 9)
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, 18,689,568 shares at June 30, 2017 and 18,958,834 shares at September 30, 2017		222,529			212,931
Retained earnings		363,872			374,029
Accumulated other comprehensive loss		(17,188		)	(15,580		)
Total stockholders’ equity		569,213			571,380
Total liabilities and stockholders’ equity		$	1,230,087		$	1,351,524

 

See accompanying notes to condensed consolidated financial statements.

 

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OSI SYSTEMS, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(amounts in thousands, except per share data)

 

		For the Three Months Ended September 30,
		2016			2017
Net revenues:
Products		$	153,457		$	165,653
Services		67,398			91,480
Total net revenues		220,855			257,133
Cost of goods sold:
Products		113,121			114,180
Services		39,647			51,682
Total cost of goods sold		152,768			165,862
Gross profit		68,087			91,271
Operating expenses:
Selling, general and administrative		43,553			55,647
Research and development		12,478			15,100
Impairment, restructuring and other charges		9,957			1,130
Total operating expenses		65,988			71,877
Income from operations		2,099			19,394
Interest and other expense, net		(1,158		)	(4,249		)
Income before income taxes		941			15,145
Provision for income taxes		264			4,988
Net income		$	677		$	10,157
Earnings per share:
Basic		$	0.04		$	0.54
Diluted		$	0.03		$	0.52
Shares used in per share calculation:
Basic		18,943			18,778
Diluted		19,591			19,591

 

See accompanying notes to condensed consolidated financial statements.

 

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OSI SYSTEMS, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(amounts in thousands)

 

		For the Three Months Ended September 30,
		2016			2017
Net income		$	677		$	10,157
Other comprehensive income (loss):
Foreign currency translation adjustment		(801		)	1,580
Other		79			28
Other comprehensive income (loss)		$	(722	)	$	1,608
Comprehensive income (loss)		$	(45	)	$	11,765

 

See accompanying notes to condensed consolidated financial statements.

 

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OSI SYSTEMS, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(amounts in thousands)

 

		For the Three Months Ended September 30,
		2016			2017
Cash flows from operating activities:
Net income		$	677		$	10,157
Adjustments to reconcile net income to cash flows from operating activities:
Depreciation and amortization		15,426			20,375
Stock based compensation expense		5,830			5,487
Deferred income taxes		98			5,346
Amortization of debt discount and issuance costs		—			2,098
Impairment charges		5,418			—
Other		160			490
Changes in operating assets and liabilities—net of business acquisitions:
Accounts receivable		(11,412		)	16,232
Inventories		10,901			(10,098		)
Prepaid expenses and other current assets		(3,427		)	(8,220		)
Accounts payable		(8,791		)	6,586
Accrued payroll and related expenses		(5,251		)	(5,742		)
Advances from customers		(10,469		)	(3,484		)
Other		(1,018		)	(4,120		)
Net cash provided by (used in) operating activities		(1,858		)	35,107
Cash flows from investing activities:
Acquisition of property and equipment		(2,806		)	(23,719		)
Acquisition of businesses, net of cash acquired		(186,861		)	(83,632		)
Acquisition of intangible and other assets		(1,881		)	(1,179		)
Net cash used in investing activities		(191,548		)	(108,530		)
Cash flows from financing activities:
Net borrowings on bank lines of credit		214,000			111,000
Proceeds from long-term debt		233			118
Payments on long-term debt		(707		)	(670		)
Proceeds from exercise of stock options and employee stock purchase plan		2,099			3,718
Repurchase of common shares		(2,712		)	—
Taxes paid related to net share settlement of equity awards		(290		)	(18,802		)
Net cash provided by financing activities		212,623			95,364
Effect of exchange rate changes on cash		(621		)	437
Net increase in cash and cash equivalents		18,596			22,378
Cash and cash equivalents—beginning of period		104,370			169,650
Cash and cash equivalents—end of period		$	122,966		$	192,028
Supplemental disclosure of cash flow information:
Cash paid, net during the period for:
Interest		$	956		$	2,852
Income taxes		$	6,022		$	4,172

 

See accompanying notes to condensed consolidated financial statements.

 

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OSI SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1. Basis of Presentation

 

Description of Business

 

OSI Systems, Inc., together with our subsidiaries, is a vertically integrated designer and manufacturer of specialized electronic systems and components for critical applications. We sell our products in diversified markets, including homeland security, healthcare, defense and aerospace.

 

We have 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 OEM customers and end users for applications in the defense, aerospace, medical and industrial markets, among others.

 

Through our Security segment, we provide security screening products and related services globally. These products fall into the following categories: baggage and parcel inspection; cargo and vehicle inspection; hold (checked) baggage screening; people screening; radiation detection; and explosive and narcotics trace detection. In addition to these products, we also provide site design, installation, training and technical support services to our customers. We also provide turnkey security screening solutions, which can include the construction, staffing and long-term operation of security screening checkpoints for our customers.

 

Through our Healthcare segment, we design, manufacture, market and service patient monitoring, diagnostic cardiology, and anesthesia delivery and ventilation systems, and related supplies and accessories 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 among other sites.

 

Through our Optoelectronics and Manufacturing segment, we design, manufacture and market optoelectronic components and provide electronics manufacturing services globally for use in a broad range of applications, including aerospace and defense electronics, security and inspection systems, medical imaging and diagnostic products, telecommunications, computer peripherals, industrial automation systems, automotive diagnostic systems, and consumer products. This division provides products and services to OEM customers and end users as well as to our 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 management in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and in conjunction with the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures required for annual financial statements have been condensed or excluded in accordance with SEC rules and regulations applicable to interim unaudited financial statements. Accordingly, the condensed consolidated financial statements do not include all of the information and footnotes required by GAAP for audited financial statements. In the opinion of management, the condensed consolidated financial statements reflect all adjustments of a normal and recurring nature that are considered necessary for a fair presentation of the results for the interim 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, 2017. The results of operations for the three months ended September 30, 2017 are not necessarily indicative of the operating results to be expected for the full 2018 fiscal year or any future periods.

 

Use of Estimates

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of sales and costs of sales during the reporting period. The most significant of these estimates and assumptions for our company relate to contract revenue, profit and loss recognition, fair values of assets acquired and liabilities assumed in business combinations, market values for inventories reported at lower of cost or net realizable value, stock-based employee compensation expense, income taxes, accrued product warranty costs, and the recoverability, useful lives and valuation of

 

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recorded amounts of long lived assets, identifiable intangible assets and goodwill. Changes in estimates are reflected in the periods during which they become known. Actual amounts will likely differ from these estimates and could differ materially.

 

Per Share Computations

 

We compute basic earnings per share by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period. We compute diluted earnings per share by dividing net income available to common stockholders by the sum of the weighted average number of common shares and dilutive potential common shares outstanding during the period. Potential common shares consist of the shares issuable upon the exercise of stock options and restricted stock unit awards under the treasury stock method.  Stock options and stock awards to purchase 0.1 million shares of common stock for each of the three months ended September 30, 2016 and September 30, 2017, respectively,  were excluded from the calculation because to include such options and awards would have been antidilutive.  Prior to our adoption of ASU 2016-09 in the fourth quarter of fiscal 2017, we included tax benefits in assessing whether equity awards were dilutive and in our calculations of weighted average dilutive shares under the treasury stock method. The underlying equity component of the 1.25% convertible senior notes discussed in Note 6 to the condensed consolidated financial statements will have no impact to diluted earnings per share until the average price of our common stock exceeds the conversion price because the principal amount of the Notes is intended to be settled in cash upon conversion.

 

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,
		2016			2017
Net income available to common stockholders		$	677		$	10,157
Weighted average shares outstanding—basic		18,943			18,778
Dilutive effect of equity awards		648			813
Weighted average shares outstanding—diluted		19,591			19,591
Basic earnings per share		$	0.04		$	0.54
Diluted earnings per share		$	0.03		$	0.52

 

Cash Equivalents

 

We consider all highly liquid investments purchased with maturities of three months or less as of the acquisition date to be cash equivalents.

 

Our cash, cash equivalents, and investments totaled $192.0 million at September 30, 2017. Of this amount, approximately 99% was held by our foreign subsidiaries and subject to repatriation tax considerations. These foreign funds were located primarily in Mexico, Malaysia and the United Kingdom, and to a lesser extent in India, Singapore, Germany and China among others. We intend to permanently reinvest a significant portion of our earnings from foreign operations, and we currently do not anticipate that we will need this cash in foreign countries to fund our U.S. operations. In the event that funds from foreign operations are needed to fund operations in the United States and if U.S. taxes have not been previously provided on the related earnings, we would provide for and pay additional U.S. taxes at the time we change our intention with regard to the reinvestment of those earnings.

 

Fair Value of Financial Instruments

 

Our 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 long term debt instruments, are representative of their fair values due to their short term maturities. The carrying values of our 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 available to us.

 

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 for which valuation techniques are unobservable and significant to the fair value measurement. There were no assets where “Level 3” valuation techniques were used. As further discussed in Note 9 to the condensed consolidated financial statements, our contingent payment obligations related to acquisitions are valued using “Level 3” valuation techniques. Such obligations are measured at fair value on a recurring basis.

 

The fair values of the our financial assets and liabilities as of June 30, 2017 and September 30, 2017 are categorized as follows (in thousands):

 

		June 30, 2017												September 30, 2017
		Level 1			Level 2			Level 3			Total			Level 1			Level 2			Level 3			Total
Assets:
Equity securities		$	254		$	—		$	—		$	254		$	231		$	—		$	—		$	231
Insurance company contracts		—			26,940			—			26,940			—			29,183			—			29,183
Interest rate contract		—			20			—			20			—			18			—			18
Total assets		$	254		$	26,960		$	—		$	27,214		$	231		$	29,201		$	—		$	29,432
Liabilities—Contingent payment obligations		$	—		$	—		$	11,840		$	11,840		$	—		$	—		$	13,902		$	13,902

 

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Derivative Instruments and Hedging Activity

 

Our use of derivatives consists of an interest rate swap agreement. 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. 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 (loss) in the consolidated financial statements and are reclassified as net income when the hedge transaction settles.

 

Property and Equipment

 

Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are charged while assets are used in service and are generally computed using the straight-line method over the estimated useful lives of the assets taking into consideration any estimated salvage value. Amortization of leasehold improvements is calculated on the straight-line method over the shorter of the useful life of the asset or the lease term. Leased capital assets are included in property and equipment. Amortization of property and equipment under capital leases is included with depreciation expense. In the event that property and equipment are idle, as a result of excess capacity or the early termination, non-renewal or reduction in scope of a turnkey screening operation, such assets are assessed for impairment on a periodic basis.

 

Goodwill Impairment

 

Goodwill represents the excess purchase price over the estimated fair value of the assets acquired and liabilities assumed in a business combination. Goodwill is allocated to our segments based on the nature of the product line of the acquired business. The carrying value of goodwill is not amortized, but is annually tested for impairment during our second quarter and more frequently if there is an indicator of impairment. We assess qualitative factors of each of our three reporting units to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill.

 

Revenue Recognition

 

Product Sales. We recognize revenue from sales of products upon shipment when title and risk of loss passes and when terms are fixed and collection is probable. In an instance where terms of a product sale include subjective customer acceptance criteria, revenue is deferred until we have achieved the acceptance criteria unless customer acceptance terms are perfunctory or inconsequential.

 

Service Revenue. Revenue from services includes after-market services, installation and implementation of products and turnkey security screening services. Generally, revenue from services is recognized when the services are performed. Revenues from out-of-warranty service maintenance contracts are recognized ratably over the respective terms of such contracts. Deferred revenue for such services arises from payments received from customers for services not yet performed.

 

Multiple-Deliverable Arrangements. We enter into certain agreements with customers for the sale of capital equipment that contain multiple elements that may include civil works to prepare a site for the installation of equipment, manufacture and delivery of equipment,  installation and integration of equipment,  training of customer personnel to operate the equipment and after-market service of the equipment. The duration to fulfill each of these deliverables can range from completion in a short amount of time and entirely within a single reporting period to completion over several reporting periods. The general timing of revenue recognition for

 

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each deliverable may be dependent upon several milestones, including physical delivery of equipment, completion of factory acceptance test, completion of site acceptance test, installation and connectivity of equipment, certification of training of personnel and, in the case of after-market service deliverables, the passage of time (typically evenly over the post-warranty period of the service deliverable).

 

Multiple-deliverable arrangements require that consideration be allocated to each deliverable based on its relative selling price and recognized as revenue when the revenue recognition criteria for each deliverable has been met. The arrangement is separated into more than one unit of accounting if both of the following criteria are met: (i) the delivered item has value to the customer on a stand-alone basis; and (ii) for an arrangement including a general right of return relative to the delivered item, delivery or performance of the undelivered item is considered probable and substantially within our control. If these criteria are not met, the arrangement is accounted for as one unit of accounting and the recognition of revenue is deferred until delivery is complete or is recognized ratably over the contract period as appropriate. If these criteria are met, consideration is allocated at inception of the arrangement to all deliverables on the basis of the relative selling price. We have generally met these criteria for the multiple-deliverable arrangement as all of the deliverables in our arrangements have stand-alone value in that either the customer can resell that item or another vendor sells that item separately. We typically do not offer a general right of return in regards to our multiple-deliverable arrangements.

 

The selling price of each deliverable is determined by establishing vendor-specific objective evidence (“VSOE”), third party evidence (“TPE”) or best estimate of selling price (“BESP”) for each delivered item. Generally, either VSOE or TPE is determinable; however, in the few instances where neither VSOE nor TPE is determinable, we utilize our BESP in order to allocate consideration to those deliverables. BESP for our product deliverables is determined by utilizing a weighted average price approach. BESP for our service deliverables is determined primarily by utilizing a cost-plus margin approach, though in some instances average price per hour is used.

 

We often provide a guarantee to support our performance under multiple-deliverable arrangements.  In the event that customers are permitted to terminate such arrangements, the underlying contract typically requires payment for deliverables and reimbursement of costs incurred through the date of termination.

 

Proportional Performance.  In connection with the agreement with the Servicio de Administración Tributaria (“SAT”) in Mexico, revenue is recognized based upon proportional performance, measured by the actual number of labor hours incurred divided by the total estimated number of labor hours for the project. The impact of changes in the estimated labor hours to service the agreement is reflected in the period during which the change becomes known. In the SAT agreement, customer billings may be submitted for several separate deliverables, including monthly services, activation of services, training of customer personnel and consultation on the design and location of security scanning operations, among others. In the event that payments received from the customer exceed revenue recognition, deferred revenue is recorded.

 

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 recognition. Concurrent with revenue recognition, we accrue reserves for estimated product return and warranty costs. Critical judgments also include estimates of warranty reserves, which are established based on historical experience and knowledge regarding the product under warranty.

 

Recent Accounting Updates Not Yet Adopted

 

In May 2014, the Financial Accounting Standards Board (“FASB”) issued an accounting standards update (“ASU”) amending revenue recognition requirements for multiple deliverable revenue arrangements. This update provides guidance on how revenue is recognized for the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for the goods or services. This determination is made in five steps: (i) identify the contract with the customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) the entity satisfies a performance obligation. The ASU is effective for fiscal years beginning after December 15, 2017 and for interim reporting periods within such fiscal years. Earlier adoption is permitted only for fiscal years beginning after December 15, 2016, including interim reporting periods within such fiscal years. We are in the process of selecting a transition method and our preliminary evaluation of the impact of this ASU indicates that it will not have a material impact on the timing of revenue recognition.

 

In January 2016, FASB issued an ASU which affects the accounting for equity investments, financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. This guidance retains the current accounting for classifying and measuring investments in debt securities and loans, but requires equity investments to be measured at fair value with subsequent changes recognized in net income, except for those accounted for under the equity method or requiring consolidation. The guidance also changes the accounting for investments without a readily determinable fair value and that do not qualify for the practical expedient permitted by the guidance to estimate fair value. A policy election can be made for these investments whereby estimated

 

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fair value may be measured at cost and adjusted in subsequent periods for any impairment or changes in observable prices of identical or similar investments. This ASU is effective for fiscal years beginning after December 15, 2017, including interim reporting periods within such fiscal years. Early application is permitted. We have not yet adopted this ASU and are currently evaluating the impact it may have on our financial condition and results of operations.

 

In February 2016, the FASB issued an ASU which affects the accounting for leases. The guidance requires lessees to recognize assets and liabilities on the balance sheet for the rights and obligations created by all leases with terms of more than 12 months. The amendment also will require qualitative and quantitative disclosures designed to give financial statement users information on the amount, timing, and uncertainty of cash flows arising from leases. This ASU is effective for fiscal years beginning after December 15, 2018, including interim reporting periods within such fiscal years. Early application is permitted. We have not yet adopted this ASU and are currently evaluating the impact it may have on our financial condition and results of operations.

 

In August 2016, the FASB issued an ASU to address the diverse classifications being applied to cash receipts and payments in the reporting entities’ cash flow statement.  This ASU addresses eight specific cash flow issues to reduce diversity in practice. This ASU is effective for fiscal years beginning after December 15, 2017, including interim reporting periods within such fiscal years. We have not yet adopted this ASU and are currently evaluating the impact it may have on our financial condition and results of operations.

 

Adoption of ASU 2015-11

 

Effective July 1, 2017, we adopted ASU 2015-11 “Simplifying the Measurement of Inventory.”  This ASU requires an entity to measure in scope inventory at the lower of cost and net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.  The adoption of this ASU did not have a material impact on our financial condition and results of operations.

 

2.  Business Combinations

 

Under ASU 805, the acquisition method of accounting requires us to record assets acquired and liabilities assumed in an acquisition at their estimated fair values at the date of acquisition. Any excess of the total estimated purchase price of over the estimated fair value of the assets acquired and liabilities assumed should be recorded as goodwill.   Such valuations require management to make significant estimates and assumptions, especially with respect to intangible assets. Significant estimates in valuing certain intangible assets include, but are not limited to, future expected cash flows from acquired customers, acquired technology, trade names, useful lives and discount rates. Management’s estimates of fair value are based upon assumptions believed to be reasonable but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. During the measurement period, which is one year from the acquisition date, we may record adjustments to the assets acquired and liabilities assumed, with the corresponding adjustments to goodwill. Upon the conclusion of the measurement period, any subsequent adjustments are recorded to earnings.

 

Acquisition of Explosive Trace Detection Business

 

On July 7, 2017, we completed the acquisition of the global explosive trace detection business (“ETD”) from Smiths Group plc. We financed the total estimated purchase price of $80.5 million with a combination of cash on hand and borrowings under our existing revolving bank line of credit.

 

Due to the timing and complexity of the transaction, we are in the process of finalizing our valuation of the assets acquired and liabilities assumed. As of September 30, 2017, the final valuation of certain assets and liabilities of ETD are preliminary in nature as they are awaiting the conclusion of the valuation of certain assets by a third party, resolution of accurately carving out certain assets and liabilities from the prior owners of the business and final determination of the working capital adjustment on the purchase price. As a result, the ETD acquisition could necessitate the use of the full one year measurement period to establish the fair values of assets and liabilities as of the acquisition date, including intangible assets, goodwill, accounts receivable, inventory, deferred revenue, property and equipment, contractual obligations, income tax obligations, and certain reserves. Any potential adjustments made could be material in relation to these preliminary values below:

 

Cash and cash equivalents		$	4
Accounts receivable		12,359
Inventories		12,269
Property and equipment		1,594
Intangible assets		30,040
Other long-term assets		303
Accounts payable		(3,070		)
Accrued payroll and related expenses		(2,450		)
Deferred revenues — current		(2,068		)
Accrued warranties		(1,260		)
Other accrued expenses and current liabilities		(1,018		)
Net assets acquired		46,703
Goodwill		33,764
Total consideration		$	80,467

 

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The goodwill is largely attributable to expected growth and the assembled workforce of the ETD business.

 

Intangible assets are recorded at estimated fair value, as determined by management based on available information, which includes a preliminary valuation prepared by an independent third party. The fair value attributed to the intangible assets acquired was based on preliminary estimates, assumptions and other information compiled by management, including independent valuations that utilized established valuation techniques.  The value attributed to goodwill and intangible assets is not deductible for income tax purposes.  The following table summarizes the fair value of acquired identifiable intangible assets as of the acquisition date (amounts in thousands):

 

		Weighted
		Average		Fair
		Lives		Value
Amortizable assets:
Developed technology		10 years		$	13,220
Customer relationships/backlog		7 years		16,420
Total amortizable assets				29,640
Non-amortizable asset — IPR&D				400
Total intangible assets				$	30,040

 

The condensed consolidated statements of operations include $21.7 million of revenue and $4.0 million of pre-tax income from ETD for the  period from July 8, 2017 to September 30, 2017.

 

The following unaudited pro forma results are prepared for comparative purposes only and do not necessarily reflect the results that would have occurred had the acquisition occurred at the beginning of the periods presented or the results which may occur in the future. The following unaudited pro forma results of operations assume the ETD acquisition had occurred on July 1, 2016 (in thousands):

 

		Three Months Ended September 30,
		2016			2017
Revenues		$	236,752		$	257,133
Income from operations		$	4,441		$	19,394

 

Significant pro forma adjustments incorporated into the pro forma results above include the recognition of additional amortization expense related to acquired intangible assets.  In addition, the pro forma results for the three months ended September 30, 2016 were carved out from the operations of the business when it was owned by its former parent.  As a result, these carve-out results have been prepared from the historical accounts of its former parent, and include revenues and expenses specifically identified to ETD, and allocations of certain overhead expenses.

 

Acquisition of American Science and Engineering

 

On September 9, 2016, we acquired by merger 100 percent ownership of American Science and Engineering, Inc. (“AS&E”), a leading provider of detection solutions for advanced cargo, parcel, and personnel inspection.  AS&E’s operations are included in our Security division. We financed the total purchase price of $266 million with a combination of cash on hand and borrowing under our existing revolving bank line of credit, and also issued  restricted stock units (“RSUs”) of the Company to replace RSUs previously issued by AS&E.  Immediately following the close of the acquisition, we used $69 million of AS&E’s existing cash on hand to pay down the revolving bank line of credit.  The valuation of the estimated fair value of the assets acquired and liabilities assumed as a result of this business combination has been finalized, and there were no adjustments to these values during the three months ended September 30, 2017.

 

The  assets acquired and the liabilities assumed by us in the acquisition, reconciled to total purchase consideration are as follows (in thousands):

 

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Current assets		$	138,747
Intangible assets		74,800
Other long term assets		5,538
Current liabilities		(42,111		)
Long-term liabilities		(26,809		)
Net assets acquired		150,165
Goodwill		115,838
Total consideration		$	266,003

 

Other Acquisitions

 

During the three months ended September 30, 2017, the Company (through our Security division) also completed an acquisition of a technology company. The acquisition was financed with cash on hand and determined to be immaterial by management.

 

3. Balance Sheet Details

 

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

 

		June 30,			September 30,
		2017			2017
Accounts receivable		$	216,089		$	213,164
Less allowance for doubtful accounts		(9,563		)	(10,096		)
Total		$	206,526		$	203,068

 

		June 30,			September 30,
		2017			2017
Raw materials		$	129,645		$	134,391
Work-in-process		65,454			67,412
Finished goods		53,411			69,506
Total		$	248,510		$	271,309

 

		Estimated
		Useful		June 30,			September 30,
		Lives		2017			2017
Land		N/A		$	14,212		$	17,129
Buildings, civil works and improvements		5 - 40 years		157,123			174,090
Leasehold improvements		1 - 12 years		9,025			9,412
Equipment and tooling		3 - 10 years		166,991			169,129
Furniture and fixtures		3 - 13 years		3,371			3,411
Computer equipment		3 - 5 years		17,991			18,741
Computer software		3 - 10 years		17,303			17,368
Computer software implementation in process		N/A		2,590			3,090
Construction in process		N/A		1,049			2,534
Total				389,655			414,904
Less accumulated depreciation and amortization				(248,116		)	(263,734		)
Property and equipment, net				$	141,539		$	151,170

 

In September 2017, we purchased the AS&E facility in Billerica, MA for a purchase price of $19.8 million.  Of this amount, $16.9 million was included in Buildings, civil works and improvements and $2.9 million was included in Land above.  Depreciation expense was $13.3 million and $16.2 million for the three months ended September 30, 2016 and 2017, respectively.

 

4. Goodwill and Intangible Assets

 

The changes in the carrying value of goodwill for the three month period ended September 30, 2017 are as follows (in thousands):

 

								Optoelectronics
								and
		Security			Healthcare			Manufacturing
		Division			Division			Division			Consolidated
Balance as of June 30, 2017		$	155,083		$	40,129		$	46,917		$	242,129
Goodwill acquired or adjusted during the period		39,701			—			50			39,751
Foreign currency translation adjustment		152			101			523			776
Balance as of September 30, 2017		$	194,936		$	40,230		$	47,490		$	282,656

 

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Intangible assets consisted of the following (in thousands):

 

				June 30, 2017									September 30, 2017
		Weighted		Gross									Gross
		Average		Carrying			Accumulated			Intangibles			Carrying			Accumulated			Intangibles
		Lives		Value			Amortization			Net			Value			Amortization			Net
Amortizable assets:
Software development costs		9 years		$	26,753		$	(6,291	)	$	20,462		$	26,855		$	(6,905	)	$	19,950
Patents		20 years		8,386			(1,676		)	6,710			8,761			(1,775		)	6,986
Developed technology		10 years		37,446			(5,530		)	31,916			50,766			(6,793		)	43,973
Customer relationships/backlog		7 years		38,289			(7,667		)	30,622			54,868			(9,975		)	44,893
Total amortizable assets				110,874			(21,164		)	89,710			141,250			(25,448		)	115,802
Non-amortizable assets:
Trademarks and trade names				25,540			—			25,540			25,634			—			25,634
IPR&D				3,200			—			3,200			3,600			—			3,600
Total intangible assets				$	139,614		$	(21,164	)	$	118,450		$	170,484		$	(25,448	)	$	145,036

 

Amortization expense related to intangible assets was $2.1 million and $4.2 million for the three months ended September 30, 2016 and 2017, respectively. At September 30, 2017, the estimated future amortization expense was as follows (in thousands):

 

2018 (remaining 9 months)		$	13,839
2019		18,469
2020		16,171
2021		15,360
2022		11,641
2023		10,470
2024 and thereafter, including assets that have not yet begun to be amortized		29,852
Total		$	115,802

 

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 amount computed using the ratio that current revenues for a product bear to the total current and anticipated future revenues for that product. In the event that future revenues are not estimable, such costs are amortized on a straight line basis over the remaining estimated economic life of the product. Amortizable assets that have not yet begun to be amortized are included in 2024 and thereafter in the table above. For the three months ended September 30, 2016 and 2017, we capitalized software development costs in the amount of $1.4 million and $0.1 million, respectively.

 

5. Impairment, Restructuring and Other Charges

 

Impairment

 

During the first quarter of fiscal 2017, we abandoned a product line in our Security division related to a technology we no longer support. As a result, $5.4 million of assets, including the intangible and fixed assets associated with this product line, were fully written off as we determined that these assets have no value and were permanently impaired.

 

Restructuring and Other Charges

 

We endeavor to align our global capacity and infrastructure with demand by our customers as well as fully integrate acquisitions, thereby improving operational efficiency. The significant initiatives undertaken by us are further discussed below and a summary of such activity is included in the succeeding tables.

 

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In conjunction with the acquisition of ETD, beginning in fiscal 2017 we incurred professional fees to complete the acquisition.  Such costs accumulated to $1.7 million through the first quarter of fiscal 2018, of which $0.7 million was incurred during the quarter ended September 30, 2017.

 

The following table summarizes impairment, restructuring and other charges for the periods set forth below (in thousands):

 

		Three Months Ended September 30, 2016
		Security Division			Healthcare Division			Optoelectronics and Manufacturing Division			Corporate			Total
Impairment charges		$	5,332		$	86		$	—		$	—		$	5,418
Acquisition-related costs		725			—			—			3,149			$	3,874
Employee termination costs		150			256			65			—			471
Facility closures/consolidation		176			—			—			—			176
Other charges		7			—			—			11			18
Total expensed		$	6,390		$	342		$	65		$	3,160		$	9,957

 

		Three Months Ended September 30, 2017
		Security Division			Healthcare Division			Optoelectronics and Manufacturing Division			Corporate			Total
Acquisition-related costs		$	—		$	—		$	—		$	820		$	820
Employee termination costs		240			—			—			—			240
Facility closures/consolidation		70			—			—			—			70
Total expensed		$	310		$	—		$	—		$	820		$	1,130

 

The changes in the accrual for restructuring and other charges for the three-month period ended September 30, 2017 were as follows (in thousands):

 

		Acquisition- related Costs			Employee Termination Costs			Facility Closure/ Consolidation Cost			Total
Balance as of June 30, 2017		$	—		$	175		$	291		$	466
Restructuring and other charges		820			240			70			1,130
Payments and other adjustments		(820		)	(263		)	(165		)	(1,248		)
Balance as of September 30, 2017		$	—		$	152		$	196		$	348

 

6. Borrowings

 

Revolving Credit Facility

 

In December 2016, we entered into an amendment to our revolving credit facility, which, among other things, increased the aggregate committed amount available to us from $450 million to $525 million and extended the maturity date to December 2021. The credit facility includes a $300 million sub-limit for letters of credit. Under certain circumstances, we have the ability to increase the facility by the greater of $250 million or such amount as would not cause our secured leverage ratio to exceed a specified level. Borrowings under this facility bear interest at LIBOR plus a margin of 1.25% as of September 30, 2017, but this margin can range from 1.25% to 2.0% based on our consolidated net leverage ratio as defined in the credit facility. Letters of credit reduce the amount available to borrow by their face value. The unused portion of the facility bears a commitment fee of 0.20% as of September 30, 2017, but this fee can range from 0.20% to 0.30% based on our consolidated net leverage ratio as defined in the credit facility.  Due to increased borrowings under this facility as a result of the acquisition of ETD, the borrowing margin is scheduled to increase to 1.50% during the second quarter of fiscal 2018.  Our borrowings under the credit agreement are guaranteed by certain of our U.S. based subsidiaries and are secured by substantially all of our and certain subsidiaries’ assets. The agreement contains various representations and warranties, affirmative, negative and financial covenants and conditions of default customary for financing agreements of this type. As of September 30, 2017, there was $214.0 million of borrowings outstanding under the revolving credit facility and $33.1 million outstanding under the letters of credit sub facility. The amount available to borrow under the credit facility as of September 30, 2017 was $277.9 million. Under the terms of the revolving credit facility, loan amounts may be borrowed, repaid and re-borrowed during the term. Although the principal amount of each revolving loan is due and payable in full on the maturity date, we have the right to repay each revolving loan in whole or in part from time to time without penalty. It is our practice to routinely borrow and repay several times per

 

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year under this revolving facility. Therefore, borrowings under the credit facility are included in current liabilities. As of September 30, 2017, we are in compliance with all covenants under this credit facility.

 

1.25% Convertible Senior Notes Due 2022

 

In February 2017, we issued $287.5 million of 1.25% convertible senior notes due 2022 (the “Notes”) in a private offering. The Notes are governed by an indenture dated February 22, 2017. The maturity for the payment of principal is September 1, 2022. The Notes bear interest at the rate of 1.25% and are payable in cash semiannually in arrears on each March 1 and September 1, commencing on September 1, 2017. The Notes are senior unsecured obligations and rank senior in right of payment to any of our indebtedness that is expressly subordinated in right of payment to the Notes; equal in right of payment to any of our unsecured indebtedness that is not so subordinated; effectively junior in right of payment to any of our secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally junior to all indebtedness and other liabilities (including trade payables) of OSI Systems, Inc. and our subsidiaries, as well as any of the existing and future indebtedness that may be guaranteed by our subsidiaries to the extent of such guarantee (including the guarantees of certain of our subsidiaries under our existing revolving credit facility).

 

The Notes are convertible prior to March 1, 2022 only upon specified events and during specified periods and are, thereafter convertible, at any time, in each case at an initial conversion rate of 9.3056 per $1,000 principal amount of the Notes, which is equal to an initial conversion price of approximately $107.46 per share or a 38.5% premium to our stock price at the time of the issuance. The conversion rate is subject to adjustment upon certain events. Upon conversion, the Notes may be settled, at our election, in shares of our Common Stock, cash or a combination of cash and shares of Common Stock. We have initially elected a combination settlement method to satisfy the conversion obligation, which allows us to settle the principal amount of the Notes in cash and to settle the excess conversion value, if any, in shares, as well as cash in lieu of fractional shares.

 

We may not redeem the Notes prior to March 6, 2020. Thereafter, we may redeem the Notes if the last reported sale price of our Common Stock has been at least 130% of the conversion price then in effect for at least 20 trading days (whether or not consecutive) during any period of 30 consecutive trading days. If we undergo a fundamental change, as defined in the indenture for the Notes, subject to certain conditions, holders of the Notes may require us to repurchase all or part of the Notes for cash at a price equal to 100% of the principal amount of the Notes to be repurchased, plus any accrued and unpaid interest to, but excluding, the fundamental change repurchase date. The occurrence of a fundamental change will also result in the Notes becoming immediately convertible.

 

Pursuant to ASC 470-20, we allocated the $287.5 million gross proceeds of the Notes between liability and equity components. The initial $242.4 million liability component was determined based on the fair value of similar debt instruments excluding the conversion feature for similar terms and priced on the same day the Notes were issued. The initial $45.1 million equity component represents the debt discount and was calculated as the difference between the fair value of the debt and the gross proceeds of the Notes. Issuance costs of $7.7 million were allocated between debt ($6.5 million) and equity ($1.2 million) components with the portion allocated to the debt presented as an offset against long term debt in the consolidated balance sheet and is amortized as interest expense over the life of the Notes using the effective interest method. The total interest expense recognized for three months ended September 30, 2017 was $3.0 million, which consists of $0.9 million of contractual interest expense, $1.8 million of amortization of the debt discount and $0.3 million of amortization of debt issuance costs. As of September 30, 2017, the unamortized debt discount was $40.8 million and is being amortized over the remaining contractual term to maturity of the Notes using an effective interest rate of 4.50%. The unamortized debt issuance cost of $5.8 million as of September 30, 2017 is amortized on a straight-line basis, which approximates the effective interest method, over the life of the Notes. Based on our September 30, 2017 stock price of $91.37 per share, the “if-converted” value of the Notes did not exceed the principal amount.

 

Other Borrowings

 

Several of our foreign subsidiaries maintain bank lines-of-credit, denominated in local currencies and U.S. dollars, primarily for the issuance of letters-of-credit. As of September 30, 2017, $61.1 million was outstanding under these letter-of-credit facilities. As of September 30, 2017, the total amount available under these credit facilities was $13.6 million.

 

In September 2012, we entered into a seven year 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, we 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):

 

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		June 30, 2017			September 30, 2017
1.25% convertible notes due 2022:
Principal amount		$	287,500		$	287,500
Unamortized discount		(42,602		)	(40,799		)
Unamortized debt issuance costs		(6,073		)	(5,779		)
1.25% convertible notes due 2022, net of unamortized discount and debt issuance costs		238,825			240,922
Term loans		3,700			3,304
Other long-term debt		1,621			1,476
		244,146			245,702
Less current portion of long-term debt		(2,396		)	(2,286		)
Long-term portion of debt		$	241,750		$	243,416

 

7. Stockholders’ Equity

 

Stock-based Compensation

 

As of September 30, 2017, we maintained two share based employee compensation plans: the 2012 Incentive Award Plan (“2012 Plan”) and the Amended and Restated 2006 Equity Participation Plan (“2006 Plan”). Upon stockholder approval of the 2012 Plan, we ceased to make grants under the 2006 Plan. In addition, pursuant to the acquisition of AS&E, we assumed two share based employee compensation plans: the AS&E 2005 Equity and Incentive Plan (“2005 AS&E Plan”) and the AS&E 2014 Equity and Incentive Plan (“2014 AS&E Plan”). No new RSU grants will be made under the 2005 AS&E Plan or the 2014 AS&E Plan. The 2012 Plan, the 2006 Plan, the 2005 AS&E Plan and the 2014 AS&E Plan are collectively referred to as the “OSI Plans”.

 

We recorded stock based compensation expense in the consolidated statement of operations as follows (in thousands):

 

		Three Months Ended September 30,
		2016			2017
Cost of goods sold		$	295		$	241
Selling, general and administrative		5,060			5,111
Research and development		55			135
Stock based compensation expense		5,410			5,487

 

As of September 30, 2017, total unrecognized compensation cost related to share based compensation grants were estimated at $0.6 million for stock options and $29.7 million for RSUs under the OSI Plans. We expect to recognize these costs over a weighted average period of 1.9 years with respect to the stock options and 1.8 years for grants of RSUs.

 

The following summarizes stock option activity during the three months ended September 30, 2017:

 

				Weighted Average			Weighted-Average		Aggregate
		Number of		Exercise			Remaining Contractual		Intrinsic Value
		Options		Price			Term		(in thousands)
Outstanding at June 30, 2017		780,671		$	30.00
Granted		6,492		$	79.23
Exercised		(80,101	)	$	21.93
Expired or forfeited		(750	)	$	53.28
Outstanding at September 30, 2017		706,312		$	31.34		3.4 years		$	42,401
Exercisable at September 30, 2017		670,471		$	29.02		3.1 years		$	41,802

 

The following summarizes RSU award activity during the three months ended September 30, 2017:

 

				Weighted-
				Average
		Shares		Fair Value
Nonvested at June 30, 2017		611,687		$	65.85
Granted		320,837		$	72.98
Vested		(372,248	)	$	65.49
Forfeited		(10,051	)	$	67.86
Nonvested at September 30, 2017		550,225		$	70.22

 

As of September 30, 2017, there were approximately 0.7 million shares available for grant under the 2012 Plan.  Under the terms of the 2012 Plan, RSUs and restricted stock granted from the pool of shares available for grant reduce the pool by 1.87 shares for each award granted. RSUs and restricted stock forfeited and returned to the pool of shares available for grant increase the pool by 1.87 shares for each award forfeited.

 

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