I. Summary Investment Thesis

OSI Systems, Inc. is a growing company benefitting from multiple tailwinds in the homeland security market but the stock has come under recent pressure due to headline noise around operational mistakes in a politicized business sector.  From FY2010 – 2013, OSIS’ revenue has grown 10% annually while EPS (adjusted) has grown at a 25% annual rate.  OSIS is likely to continue its strong growth trajectory as its core security business expands from a manufacturing and scanning equipment sales model to include a “turnkey “ end-to-end security services product that provides large contracts with higher operating margins than its legacy business (e.g. a $900mm, 6-year contract with Mexico).  OSIS has already made a large investment in its Mexican turnkey business and should soon see the benefits from increased earnings and FCF, and the company is actively pursuing new business that would be incremental to forward estimates.  Furthermore, OSIS’ legacy business should soon benefit from a security scanner upgrade cycle that is likely to be a significant revenue driver.  Given these tailwinds, investors should not let OSIS’ business prospects get drowned out by the noise over curable missteps in dealing with the TSA.  Based on our analysis, it appears that OSIS has limited potential downside to ~$40 and upside of $80 - $100 if the company resolves its current dispute with the TSA and continues to execute on its growth strategy (vs. current price of ~$51).

II. Background

OSI Systems, Inc. is a designer and manufacturer of electronic systems and components for the homeland security, healthcare and defense/industrial markets.  OSI has three business segments, including Security – which includes a legacy inspection equipment business (under the Rapiscan brand) as well as a developing “turnkey” security screenings solution business (e.g. Mexico, where OSIS has contracted to provide complete cargo and vehicle screening services, including personnel, equipment, maintenance and support); Healthcare – which produces patient monitoring and anesthesia systems; and, lastly, the Optoelectronics and Manufacturing segment (“Opto”) – which provides specialized electronic components for the other two divisions as well as external OEM customers in defense, medical and industrial end markets.  In fiscal year 2013 (YE June 2013), Security represented 44% of the $802mm of company revenue while the remainder was split between Healthcare and Opto.  With OSI currently trading at $50.58 (as of 12/19/13), the company is trading with a FY2014E P/E of ~15x - despite significant growth opportunities and a historical forward multiple of closer to 25x - due to overdrawn fears of a possible debarment by the Transportation Security Administration (TSA) and the second headline misstep by management in two years.

Looking back, OSI first drew scrutiny from the TSA in November 2012, when they received a “show cause” letter relating to their backscatter x-ray machines (“naked scanners”) used in airport screening.  In January 2013, OSI announced an agreement with TSA whereby they agreed they were unable to fulfill the terms of the contract at issue and ultimately were forced to remove their machines from airports and reimburse the TSA for associated costs (together, $5mm of revenue was de-booked from backlog and a $3mm one-time charge was taken).  Fast-forward to May 2013 and despite the TSA settlement, OSI next received a Notice of Proposed Debarment (an action which would prevent OSIS from participating in US government contracts) from the Department of Homeland Security in May 2013 in regards to the same issue.  One month later, OSI was ultimately able to reach an Administrative Agreement with the US government which allowed them to continue its current and future business with US agencies without any further penalties.  Between Nov 2012 and June 2013, OSIS stock was highly volatile and traded ~$55-$65 (a ~20–22x forward multiple), before the final settlement with the government reduced the overhang of fear, analysts focused on growth opportunities and the stock traded up to a mid-20’s P/E into the mid-$70’s. 

More recently, on December 6^th 2013, OSIS stock fell 10% on news that the TSA cancelled a $60mm contract only 3 months after awarding it.  OSIS acknowledged this cancellation in a brief 8-K filing.  Two days later, Congressional leaders on the Committee on Homeland Security released a letter sent to the TSA where they reference the cancelled contract, described the use by OSIS of an unapproved part manufactured in China and mention that TSA has moved forward with a recommendation to the Department of the Homeland Security for the debarment of Rapiscan.  On this news, the stock dropped from $65 to as low as $39 (intra-day) before closing at $47 on heavy volume.  OSIS then provided a more informative 8-K update where they explained that the component was vetted by Rapiscan’s internal quality assurance team, but did not meet the TSA’s contractual pre-approval requirement.  Importantly, OSIS says that upon discovering the error, they proactively informed the TSA of the component change as well as the lapse in agreed-to procedure.  Furthermore, we understand that the mid-level employee responsible for making the change without senior management approval or knowledge was fired.  Finally, OSIS CEO Deepak Chopra also described the component as “effectively an x-ray light bulb” that is used by many of OSIS’ competitors.  On this incremental disclosure, the stock traded up slightly to ~$50 and it continues to trade there today.

III. Catalysts

                Despite the noise around the debarment process, OSIS valuation at current levels is a relative bargain (15x 2014E earnings for a company growing EPS at >20% YOY).  Detailed below are several possible scenarios, with base, upside and worst case EPS estimates.  We believe somewhere between the base and upside estimates are likely for 2015, given that the security business is benefitting from two major tailwinds.  Legacy baggage scanners in the US are about to face a new upgrade cycle as they reach the end of their post-2001 10-12 year life.  In addition, changes in European regulations will lead to a new purchase cycle for next generation explosive detection scanners.  In both markets, OSIS’ RTT product line – which is undergoing testing with the TSA in the US and has already been approved in Europe – will likely take significant share of this billion-dollar market over the next few years.  In addition, OSIS’ Turnkey solutions line has 3 wins to date – including Puerto Rico, Mexico and recently Albania – which is strengthening the company’s credibility in a segment with 3x the operating margins of its legacy scanner business and long contract timelines.  OSIS’ inroads in international cargo markets will ideally drive new, chunky contract wins in this space. 

                  Aside from these fundamental positives, the company will nonetheless face scrutiny and volatility until the current TSA mess is resolved.  Using last year’s investigation as a comp, we hope this process will play out over no more than 6 months.  While it’s impossible to predict government decisions, the debarment penalty appears to be utilized in cases of fraud, which don’t match the facts here – in particular the mitigating fact that OSIS brought its recent procedural lapse to the attention of the agency and has since fired the employees responsible.  On top of which, a potential debarment penalty is not in the US government’s interest as it would take away one of the top 2 suppliers of a critical security technology. 

IV. Summary Historical Financials and 2014E

V. FY2015 Scenario Analysis

• Base Case Scenario – TSA Situation resolved with nominal fine
  • Legacy Rapiscan revenue up 5%, but no near-term Turnkey business wins
  • Healthcare segment sees seasonal uplift in Q2 and Q4 and sales return to 2013 level
• Upside Case – TSA Situation resolved with no impact and RTT scanner approved in US
  • Legacy Rapiscan revenue up 15% as OSIS wins back TSA business and begins to fill orders for hold baggage scanners based on the RTT design in the US and EU
    • US hold baggage scanners begins replacement cycle
    • European Civil Aviation Conference (ECAC) EDS Standard 3 requirements will be mandatory at EU airports from September 2014 onwards
  • 1 new Turnkey win with upside
  • Healthcare segment gains significant traction with new Arkon system sales; 10% YOY growth
• Worst Case (including Debarment)
  • Legacy Rapiscan revenue down 20% based on estimate of US-government source revenue
  • No new Turnkey business wins; problems with Mexico and Albania ramp
  • Healthcare segment does not see any uplift; sales flat at reduced level