Description

OSI Systems

“Growth and value investing are joined at the hip” – Warren Buffett

Investment Summary

We recommend a long position in OSI Systems (NASDAQ: OSIS) with the potential for 40%+ gains over the next 12 to 18 months.  The company’s main security division is undergoing a significant transformation in its current business model from the lower-margin selling of equipment to offering higher-margin, turnkey service solutions.  Customers have embraced this initiative wholeheartedly, as evidenced by 250% increase in company’s backlog in just 12 months.   This, combined with an unprecedented pipeline of new products offered in FY2013, will lead to margin expansion on record revenues, supporting our value proposition.

Business Description

OSI Systems is a technology focused engineering and manufacturing company headquartered in Hawthorne, CA with a global presence.  Below are the three divisions through which the company conducts its business:

1. Security Division:

This division participates in the Homeland Security and Aviation markets under the trade name Rapiscan Systems and is the global leader in the space.  Since the 9/11 terrorist attacks, the world has faced persistent threats, especially in the aviation industry, public places, ports, sporting events, large office buildings, hotels, etc.  Rapiscan’s participates in these markets by providing products in the following business areas: 

a. Baggage and Parcel inspection:  The x-ray machines that scan carry-on baggage and laptops fall in this area.  Rapiscan is the market leader with half the US airports.  While these products are generally associated with airports, greater than 75% of company’s products are installed in non-airport locations like office buildings, hotels, sporting events.  Due to lasting threats, the market continues to expand.

b. Check Baggage:  This is the larger equipment employed in the aviation industry that scours for weapons and explosives in the checked baggage.  Rapiscan employs its Multi View X Ray (MVXR) machines with high throughput in non-US airports and commands significant market share.  The US mandates the use of CT technology-based solutions where MVXR is not an option.  The US is a $2+ B market potential and is now at the beginning of a large-scale replacement cycle for the machines installed after the 9/11 terrorist attacks.  Anticipating the arrival of replacement cycle, Rapiscan introduced a new product to address this lucrative market, more of which will be discussed later in “Recent Developments-New Products” section.  

c. Cargo and Vehicle Inspection:  This involves the scanning technologies used at ports, border crossings, and vehicle inspection areas.  With its technology leadership, the company is at the forefront in providing innovative products, such as scanning railway cargo at high speeds up to 45 km/hr etc.  The newly proposed turnkey screening solution, which is discussed in “Recent Developments-Improved Business Model”, is a result of management’s effort to expand business in this category.

d. People Screening:  Walk through metal scanners and body scanners, typically seen at airport checkpoints fall in this category.  Rapiscan is just one of the two companies certified for body scanners.

2. Healthcare Division

This division operates under the Spacelabs brand name, which was acquired from GE.  The company is ranked number one in service for three of past four years by MD Buyline.  The Healthcare division has strong global distribution channels and predominantly operates in the following areas:

a. Patient Monitoring:  Historically, the company has been offering the same platform for several years.  In the summer of 2011, the company introduced a patient monitoring system, XPREZZON, which became an instant hit in the market.  Using this product as a base, the company developed a family of products which will be available over the next two years.  The success of XPREZZON helped the company sign multi-year contracts with Group Purchasing Organizations (GPO).  As an example, OSI signed Healthtrust Purchasing Group (HPG) and MedAssets, which have several thousand members, service a combined 6,000 hospitals and have annually negotiated over $60 B worth of supply contracts.  The potential for the GPOs undertaking distribution of Spacelabs state-of-the-art products is substantial.

b. Anesthesia & Ventilation:  Historically, the company has been selling anesthesia products outside the US, even though the US market is the largest market.  Lately, the company has developed ARKON, a sophisticated anesthesia product and has recently received FDA approval.  This product has limited competition in a large market which we will discuss in “Recent Developments-New Products” section.

c. Diagnostic Cardiology:  For decades, Spacelabs have been selling Holter recorders and ambulatory pressure monitors.  These have the highest margins of all the products offered by OSI and have the largest market share in UK and Germany.  Lately, the company has improved some of the products in this group, which will be marketed in the US shortly. 

With several new offerings from the Healthcare division and an encouraging market response as indicated by the management, we are confident 2013 will be the start of increased top-line and improved margins.

3. Optoelectronics Division

The Optoelectronics (Opto) Division provides key components used in the products of the other two divisions, like X-ray scanners, cargo scanners, anesthesia products, patient monitors etc.  Approximately 20%-25% of Opto revenues are booked internally.  The rest is sold to a diverse set of external customers, including ITT Corp, JDS Uniphase, Smiths Medical, Lockheed Martin, etc. The maximum annual sale to the largest customer is less than 5%.  The R&D expense incurred in this division is funded largely by the customer.  Management considers this division useful in that it helps the other two divisions by being a gateway to the latest scientific developments.  This division requires the least amount of management attention and provides stable EPS and FCF to the company. 

Recent Developments

Improved Business Model in Security Division:

The company hired Alan Edrick in 2006 as the CFO to help integrate 20 odd companies acquired with the emphasis on growing the top-line without much regard to the operations.  It was a story of a typical turn-around implementing cost rationalization programs, restructuring the operations to low-cost geographic locations, all of which contributed to bottom-line improvements.  The restructuring gained further pace during the great recession of 2008-09 as the company reacted to the quickly deteriorating macro dynamics by going into overdrive on its turnaround plan.  While revenues suffered marginally due to external pressures, operating profit increased.  Overall, the operating margin improved from -1% in FY 2007 to 8.5% in FY 2012 and the cash generated was utilized to pay-off company debt.  The stock price responded favorably to the company’s successful turn-around plan.

OSI is an engineering and manufacturing company with special emphasis on its R&D.  Even during the recent right-sizing actions, the technology spend was not curtailed.  The technology focus ensured that the company expanded the breadth of its offerings. This was most notable in the Security Division, propelling Rapiscan in market leadership.  Within the company itself, Rapiscan has increased its revenues by 200% since 2006 and accounts for half of the company’s revenues today.  

Traditionally, Rapiscan’s business operations involved selling equipment and getting additional revenue streams through service, spare parts, and maintenance.  Management, during its recurrent interactions with its customers, observed the following: 

a)      Some customers did not have the technological expertise to operate the sophisticated cargo inspection equipment and would outsource the service contracts, not always to experienced operators.

b)      A segment of prospective or current customers was hesitant to commit up-front capital to purchase security products with ASPs ranging from $1 MM to $5 MM.  However, given an option, these customers were more interested in turnkey service contract engagements.

To serve this segment, management designed a win-win solution:  Instead of selling equipment, company proposed a turnkey screening solutions concept wherein Rapiscan installs the equipment and deploys trained staff.  It then bills the customer on a fee-per-scan or on a fee-per-month.  In this model, the customer will not incur large upfront costs.  Instead, Rapiscan will simply charge an operational fee based on the number of containers scanned or just a monthly fee during the contracted period.  The contract lengths are usually very long and Rapiscan can easily recover the fixed costs.  These contracts can last up to 10 years and can be granted further extensions beyond the initial agreement period.  To date, only two contracts have been awarded globally were RFPs were requested for turnkey screening solutions viz., Puerto Rico Ports Authority and Mexico’s Tax and Custom Authority.  Rapiscan was awarded both these contracts and the company now boasts of succeeding two-for-two on outside bidding.  We believe the new model of offering turnkey services as a solution is a key growth driver and the market has not recognized its strength yet.  Rapiscan’s addressable market has vastly increased and every one of its current customers can be a future target of this offering.  A few noteworthy mentions subsequent to the model change are listed below:

• Backlog at the end of FY 2012 was approximately $1.1 B.  This compares to $300 MM at the end of FY2011, a 250% y-o-y increase.  The Puerto Rican contract is not included due to the way the company records its bookings.  The recently-awarded Mexican contract contributes significantly to this figure and will be delivered over the next six years.  As the company begins booking these revenues in the second half of FY 2013, the operating margins of the Rapiscan division should increase.
• We are encouraged by the capex ramp over the past two quarters as Rapiscan kick-starts the landmark Mexican contract immediately after announcing the award, implying that revenues will increase shortly.
• Mexico has funded the majority of the capex ramp for the $ 900 MM contract through an advance payment of $100 MM, as specified in the latest 10K.  This bolsters our positive view of the strength of Rapiscan branded products and the CFO’s negotiating ability to structure contracts to benefit OSI.
• During the conference calls, management attributed the Mexican win to helping seal the deal for the first contract awarded by Puerto Rico.  As the Rapiscan division continues to build a roster of successful implementations, they can leverage their first-mover advantage to future contract wins.
• The turnkey services typically have a long sales cycle of one year or greater.  Management has alluded to the possibility of winning one or two turnkey contracts every year.  To that end, the company has recently doubled its credit lines a few months ago to $425 MM (+ additional $100MM under certain conditions) as it prepares its balance sheet for future awards. 

Below is quotation by the company’s CEO, Deepak Chopra (no, not THAT Deepak Chopra!) during a recent investor presentation: 

“Results, market share gains with strong top-line momentum; significant margin expansion and EPS growth. January 2012 we’ve announced a $900 million turnkey Security Screening Solution award; this is the largest win in the company history and I think is the largest win in the scanning space of any company. Record Q2 Backlog coupled with recent screening solutions with significantly increases the visibility of the company going forward.”

New Products

OSI Systems has a strong IP portfolio and believes that its technology is the key differentiator that provides a significant competitive advantage.  As mentioned, most of the company’s R&D spend has been invested in new products.  CFO Edrick had this to say in June 2012 at an investor presentation:

“For the current fiscal year, as mentioned earlier, we’ve a very strong backlog, strong earnings and strong cash flow. We have a great pipeline of products.  In fact, in our Healthcare division, we’ve released more new products over the last 18 months than we have over the previous seven years combined.  And this has really generated a lot of momentum for this business both on the top line and the bottom line.”

Recently, company has received multiple FDA 510(k) clearances, i.e. premarket notifications, in its Healthcare division, one of which relates to the ARKON Anesthesia system.  While we do not completely understand the scientific merits of this product, based on our checks, it is believed to be far superior product than what is currently available in the market.  Here is the excerpt about the product from the 2012 Annual Report:

“This is a new high-performance anesthesia delivery system that offers functionality, comfort and control. This anesthesia delivery system can be expanded to enable a wide-angle view of the clinical setting so the clinician can face the patient, as well as other clinical advancements.”

During the product showcase, ARKON was very well received and has a potential to capture its fair share in a $400 MM market.  Also, a month before receiving the clearance, the sales leadership and senior management were revamped, which had a re-energizing impact throughout Spacelabs organization.  Now with the clearance, the product is available for sale starting next quarter, which we believe will improve the company’s top and bottom lines for FY 2013 and beyond. 

In Homeland Security, very few companies provide a product covering such a wide spectrum like Rapiscan does.  In the years following the terrorist attacks on the World Trade Center, airport security was beefed up substantially, with the airports upgrading the checking procedures.  In the US, Rapiscan does not participate in the hold (checked) baggage screening yet because the company’s Real Time Tomography (RTT) products are awaiting clearance.  Now, ten years after the 9/11 attacks, the replacement cycle has hit the market, providing a key-boost to the company’s product line.  Proactively sensing the replacement cycle, Rapiscan incurred substantial R&D expense in creating its hi-tech computed tomography product, the Rapiscan RTT, which has a throughput of 1,800 packages per hour.  The company’s product is more advanced than anything out there in the market.  The product has already received rave reviews and has recently been cleared for European deployment.  The TSA clearance, which we believe is imminent, will set the company up to market the RTT product in the United States as well.  We believe, with almost double the throughput compared to the best available product in the market, Rapiscan RTT is bound to capture a large share of a $ 2 B market.

Valuation

Below, we present the key operating metrics and segment performance since 2006.  Since the 2008-09 economic distress, all three divisions have recovered nicely and FY 2012 is the best year in the company’s history in terms of sales and margins. 

The Security division performed solidly during this period and will continue to do so over the next few years as the company shifts towards services. This will provide new revenue streams that were not previously targeted.  We believe that the release of new products into large and untapped markets will also propel growth in all the three divisions. 

As shown in the Table below, management has been conservative in providing guidance and has consistently exceeded in subsequent reporting periods.

Below is the update during quarterly conference calls for FY 2011 and FY 2012.

We believe FY 2013 will the transformational year with convergence of several game changing catalysts.  Revenues may be lumpy over the next two quarters as Rapiscan ramps up its landmark Mexican operations and introduces the groundbreaking Rapiscan RTT, and Spacelabs releases its new products.   However, as the operations stabilize, which we believe will happen over the course of next few months, operating margins should trend higher towards mid-teens and our estimates for 2014 and 2015 may turn out to be conservative.  Specifically, we believe company expects to see further wins as market embraces its turnkey solutions. 

Due to competitive reasons, OSI management generally evades discussion on operating performance of its turnkey solutions contracts other than to suggest improved margins which will be evident on the future financial statements and the likelihood of operating margins in teens.  A transformational shift in the Rapiscan business from the current 15% of revenues from services to 50%-60% in next three years should alter profitability significantly.  The result of this shift will be recurring revenues, higher margins, and enhanced predictability of underlying business, all of which will warrant higher valuation.

The Healthcare business should see continued growth and improved margins.  In fact, the latest quarter, FY 2012Q4, showed an operating margin of 15% in the division, its highest ever.  As the products introduced in the last year gain traction and the company sells its products in the US, the top and bottom lines will show marked improvement.  Overall, we estimate 12% annual top-line growth and a 13% operating margin for the FY2015 to come up with an FCF estimate of $153 MM.  Assigning a 12x multiple on our FY2015 FCF estimate and netting out the cash build will yield approximately $102 per share, a 40% gain which we believe can be achieved in 12 to 18 months.

Competition

The Healthcare division sells its products internationally and competes on an individual product level.  Several companies listed as competitors include Drager Medical, Maquet, Penlon, Mortara, etc., but they do not provide financials to the public.  We did not look at companies like Philips and GE because they are too large and too well-diversified.

At present, the security division accounts for half OSI and is also its fastest growing division.  Based on our discussion, it is clear that the divergence will continue and therefore, will be more and more value will be assigned based on the performance of this division.  Rapiscan participates in an oligopoly market with competition from L-3 Electronic Systems, Smiths Detection, ASEI, SAFRAN, and Nuctech.  Nuctech is a Chinese Government backed competitor and does not provide its financial statements to the public.  Below, we provide a comparison of OSI and its peers. 

Also, here is a quick comparison of Rapiscan against corresponding divisions at Smiths, SAFRAN, L-3 , and ASEI.

Management believes that the Opto division provides stability to OSI and participates in electronic manufacturing services, optoelectronics services, etc.  This division is the most commodity-like with following competitive drivers:  Proximity to customer location, client relationships, speed of delivery etc. 

With multiple levers discussed throughout the write-up that we believe will be the main drivers for capital appreciation going forward, comps will provide some insight into where companies are trading.  However, we believe OSI’s market valuation will largely depend on the success of the transformational changes in the company’s business model and customer acceptance of a slew of new products than how the company trades today in comparison with listed competitors.   

Risks

• Management execution is the main risk today.  During the execution of the Puerto Rican contract, the company encountered a few setbacks with its first turnkey project due to customer delays in transferring the project site to Rapiscan personnel.  Company has the possession of all the customer sites in Mexico, hence should not encounter this problem.  However, executing any super-large contract may have inherent other risks which we may have not considered.
• Link below presents a recent report on public concerns about exposure to radiation.  We are comfortable with this risk based on further due-diligence about its risks.  http://www.propublica.org/article/u.s.-government-glossed-over-cancer-concerns-as-it-rolled-out-airport-x-ray
• We also worry about management biting off more than it can chew.
•  Management has been opaque about structure of turnkey screening contracts, other than to specify that they are at a lot better operating margins.  Clearly we assume cash flow will be more than adequately cover the capex involved, even though we have no confirmation.  Based on company’s excellent performance since the hire of current CFO, we are willing bet with the management.

Catalyst