October 26, 2009 - 9:53pm EST by
2009 2010
Price: 17.72 EPS $0.88 $1.32
Shares Out. (in M): 17 P/E 20.1x 13.4x
Market Cap (in $M): 310 P/FCF 14.2x 10.0x
Net Debt (in $M): 27 EBIT 27 38
TEV ($): 337 TEV/EBIT 12.6x 9.0x

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We are recommending a long position in OSI Systems (OSIS). We believe that value will be achieved from any of the following catalysts; (1) analysts revising upward both revenue and earnings guidance for the year after a number of new contract wins which aren't in managements full year forecast, (2) a sale of any one of the businesses, (3) and a longer term conviction in the relatively new CFO's ability to increase margins at the Company from approximately 4.5% today to up to 10% through identified cost cutting opportunities which improves EPS from $0.88 LTM to over $2 in three years. At $17.72 the company is trading at 13.4x our NTM earnings estimate of $1.32 compared to analysts at $1.20.  We believe this represents a good deal for a business that we believe will grow revenue in the high single digits over the next three years and potentially double operating margins.  Overall, we believe that OSI's security business, which has high barriers to entry and should generate 12%+ top line growth over the next few years could be worth as much as what the entire company trades for today in the market.

The founder and CEO of OSI, Deepak Chopra, is a charismatic guy (salesman) who likes to buy cheap businesses.  OSI is a conglomeration of approximately 25 different acquisitions since the company was founded in 1987. While Deepak has always been interested in revenue growth, he never cared too much about operating margins and earnings. With that said, at the end of 2006, OSI hired Alan Edrick as CFO to improve margins at the business. Alan hit the ground running and has taken a number of steps to improve the overall margins in the different businesses, despite organic revenue declining last year. Alan brought down headcount by close to 15%, consolidated a number of facilities and brought the businesses under the same IT systems. Although Alan has done a good job in managing costs, he still sees a significant number of opportunities at the business to drive higher operating margins (and we agree).  Moreover, we believe that given the revenue decline last year, the market is not fully appreciating the opportunity for margin expansion once revenue picks up. Once we do see a pickup in revenue (which we are expecting this year), we believe that EPS can go from around $1.32 NTM to over $2 in three years. At a 15x multiple, we believe that the longer term value for OSI Systems is at between $30 and $35, or a 70%-98% premium from the current stock price. On a sum of the parts basis, we believe the value is much higher.


OSI Systems was founded in 1987 as a manufacturer of optoelectronic devices and subsystems primarily used in detection, measurement applications and security x-ray systems. The company pursued a vertical integration strategy and made approximately 25 acquisitions over the last two decades, primarily in security inspection and medical monitoring to drive growth and improve profitability. OSI operates as a holding company and has three business segments including security, healthcare and optoelectronics

Segment Overview:

Security (Rapiscan Systems) - 41% of total sales - $241 million

OSI's security business provides inspection systems around the world to screen baggage, cargo, people, vehicles for weapons, explosives and drugs and other contraband.  The majority of sales (70%) come from conventional x-ray inspection systems. Security should continue to be the fastest growing segment for OSI, primarily driven by U.S. government homeland security initiatives and strong international demand.

X-ray machines for baggage and parcel inspection (70% sales) - These are the machines that you see when you go through security at the airport for your carry-on baggage as well as those you don't see for parcel inspection. OSI has about a 50% market share of this business, and is only one of two certified vendors for the TSA (Smiths Detection is the other). The company also sells a large number of machines oversees. This business has extremely high barriers to entry and must be certified by the TSA (which takes years) before being able to sell to airports.  In addition to selling to airports, OSI sells these machines to government facilities, event facilities, army, etc. We expect OSI to maintain its share and possibly grow its share in this market due to "buy America" provisions.

Cargo and Vehicle inspection (20% sales) - Machines that use high energy x-ray or gamma ray technology to inspect cargo and vehicle inspection at airports, border crossings and sea ports. OSI is one of about 5 different providers of this technology. Competitors include Smiths, L-3 Communications, AS&E, SAIC and Nuctech (out of China). Industry representatives expect revenue increases of up to 25% per year over the next few years.

People Screening (10% sales) - Products include walk-through metal detectors for use at security checkpoints and enhanced screeners using backscatter technology to reveal items hiding under clothing that would otherwise not be picked up by a metal detector.


Medical (Spacelabs Healthcare) - 36% of total sales - $214 million

OSI is a vertically integrated global manufacturer of medical systems in primarily three areas including patient monitoring, anesthesia delivery and ventilation and diagnostic cardiology. Around two thirds of medical sales come from North America.

Patient Monitoring (70% sales) - OSI's patient monitoring business has around 10% share of the global patient monitoring market behind Philips and GE in a $2 billion global market. In addition to Philips and GE, the company competes with Draeger/Siemens, Datascope (Mindray), and Welch Allyn. The patient monitors sell mainly into hospitals.

Anesthesia Delivery (10-15% sales) - Designs and manufactures anesthesia delivery systems, anesthesia vapolizers and ventilators. It was acquired by Blease Medical in 2005 and sells mainly into hospital.

Diagnostic Cardiology (10%-15% sales) - Develops holter systems and recorders to monitor the heart.  Business was acquired from Del Mar Reynolds in 2006 to continue its expansion of medical product portfolio to the hospital market and strengthen its presence in Europe, in particular the U.K. and Germany markets.


Optoelectronics - 23% of total sales - $135 million

OSI  provides optoelectronic devices used in a wide variety of applications such as satellites, laser guidance systems, range finders, computer peripherals and other applications that require the conversion of optical signals into electronic signals. Optoelectronic devices and value-added subsystems are used in a wide variety of measurement control, monitoring and industrial applications and are key components in telecommunications technologies. Recently, growth has come from ITT/EDO award for military electronic jammers.


Income Statement and Valuation

We expect OSI to generate approximately $1.32 of EPS in FY 2010 (NTM) and $54 million of EBITDA. This compares to analysts at $1.20 EPS. At the current valuation, OSI is valued at 13.4x NTM EPS and 6.2x EV / EBITDA.  Based on our belief that OSI will grow revenue higher than expected and improve its operating margin by up to 500 basis points through managements cost efficiency plan, we believe that OSI's shares offer a compelling value at the current price.



(FYE June)         2010E          
                  2008 2009 Q1E Q2E Q3E Q4E 2010E 2011E 2012E
    Security     225.8 240.9 61.3 72.4 67.2 70.4 271.4 304.0 334.4
    Medical     256.7 214.3 46.6 54.0 54.4 56.3 211.3 227.2 244.2
    Optoelectronic     140.6 135.2 32.1 32.9 36.5 31.6 133.1 135.1 139.8
Total Revenue     623.1 590.4 140.0 159.4 158.1 158.3 615.8 666.2 718.4
  Cost of Goods Sold     (404.0) (388.9) (94.1) (104.4) (102.0) (102.9) (403.4) (426.4) (452.6)
Gross Profit     219.0 201.5 45.9 55.0 56.1 55.4 212.4 239.8 265.8
GM%           35.2% 34.1% 32.8% 34.5% 35.5% 35.0% 34.5% 36.0% 37.0%
Operating Expenses                      
  SG&A         (150.1) (137.9) (33.5) (34.7) (34.5) (34.5) (137.2) (147.2) (158.0)
  R&D           (45.4) (36.9) (9.4) (9.4) (9.4) (9.4) (37.6) (39.0) (40.0)
Total Operating Expenses   (195.4) (174.8) (42.9) (44.1) (43.9) (43.9) (174.8) (186.2) (198.0)
Operating Income     23.6 26.7 3.1 10.8 12.3 11.5 37.7 53.6 67.8
  Margin         3.8% 4.5% 2.2% 6.8% 7.8% 7.3% 6.1% 8.0% 9.4%
EBITDA         42.9 43.8 7.3 15.0 16.5 15.7 54.5 70.6 84.8
EPS             $0.69 $0.88 $0.09 $0.39 $0.44 $0.41 $1.32 $1.87 $2.35


Catalysts to recognizing upside in the stock:

We believe that there are a number of ways to win from holding this stock. First, OSI has recently received a number of contracts that we believe were not in managements original projections.  These new contracts (specifically on the security side) carry margins higher than the company's security segment operating margin and should provide significant benefit to overall profitability and EPS.  Secondly, we believe that the stock is cheap when looking out longer term.  OSI has struggled earning its cost of capital and has produced margins materially lower than competitors. We believe the new CFO has a plan in place to improve margins and that if executed, would double operating margins and the stock would be worth substantially more than it is today. Lastly, although we don't believe you can own a business based on a sum of the parts analysis since recognizing that value cannot be in your control, the sum of the parts for OSI suggest a value much greater than what the market is currently valuing the company.  We believe that the value of the security business alone is worth almost all of OSI's current enterprise value and that you would be receiving the medical and optoelectronics business ($350 million of revenue) for free at the current price.

Analysts bringing up guidance:

Analyst revenue and EPS numbers are based on the company's guidance from the end of August. We believe that OSI purposely gave a revenue and EPS number that it could easily achieve in the face of a difficult economy.  However since that time, OSI has won a number of lucrative contracts that we don't believe, after speaking with management, were included in its FY 2010 guidance. We believe that management was surprised to win both of these contracts and each one could be material to EPS for the year. Specifically, one contract for $25 million (approx 10% of total security sales) of a proprietary people screening product (Secure 1000) that the company has never sold in the past.  After speaking with management, we believe that this is only the start of awards for the people screening product and that the TSA may award OSI over $100 million in the next five years for this product. We believe that this product alone could account for up to $0.08 in additional earnings for FY 2010. In addition to the order received from the TSA, another order that we don't believe was fully captured in managements original guidance was a recent $17 million order from the Office of Customs and Border Protection. We believe that this order could increase earnings by $0.05 or more for the year.

In addition to the contracts that OSI has already received, we see a significant amount of upside to growth in the security business over the next few years from:

Congress requiring the screening of all cargo carried on passenger airlines in the near term (originally for August 2010)

American Recovery and Reinvestment Act of 2009 - allows for increased funding for a variety of U.S. Department of Homeland Security programs, including its Non-Intrusive Inspection (NII) Systems Program, which supports the deployment of security inspection systems used in the detection and prevention of contraband items such as weapons of mass effect, radioactive materials, narcotics, and currency, from entering or circulating within the United States.

U.S. Customs and Border Protection Container Security Initiative and the Customs-Trade Partnership Against Terrorism requiring other nations to inspect baggage prior to coming to the U.S.

In the medical business, we also see the possibility of an opportunity to beat numbers in 2010 and 2011. Although management has told analysts that it expects to see positive growth Y/Y in medical, most analysts have modeled in negative growth given poor trends in the hospital capex environment. This is mainly because OSI's patient monitoring business has predominantly served the U.S. hospital market (and western Europe). However, going forward, OSI has recently introduced its first low end device targeted at emerging markets.  So far, management is pleased with the reception that it has gotten in the market and expects that it will generate growth for them over the next year and into FY 2011.  We believe that if this transpires, it could prove as a surprise to analysts only focusing on the U.S. hospital market.


Sum of the Parts:

As stated above, we believe that OSI's security business alone may be worth the entire enterprise value of the company. We expect that OSI's security group will generate EBITDA of between $24 million and $28 million in FY 2010 (NTM). We also believe that the security business will grow revenue in the low double digits and has an opportunity to generate higher than 10% operating margins in the next few years. At $28 million of EBITDA and a multiple of 12x (slightly higher than some of its comps trade but lower than the recent deal that GE struck to sell its checked baggage business), OSIs security business would be worth $336 million, or roughly the entire enterprise value of the Company.

Overall, OSI only sells for 0.6x revenue. This is due to a combination of trading at a conglomerate discount and never earnings decent operating margins and return on capital.  We believe that the market is misunderstanding the potential at OSI and that on a sum of the parts basis, OSI is worth substantially more than it is currently trading in the market. This is especially true if the management team executes its plan to improve margins.

We believe that OSI's medical business has a valuable brand and other patient monitoring deals have been struck at over 1x revenue. That would translate into over $200 million for the Company's medical business.  Additionally, OSI's optoelectronics business, although only a GDP grower, is the most profitable part of OSI (from an operating margin basis) and comps such as PerkinElmer trade in the high single digit EBITDA multiple.

On a sum of the parts (as shown below), we believe that OSI could be worth up to $39 per share.



EBITDA   24.0   28.0
Multiple   10.0x   12.0x
Value   240.0   336.0
Revenue   210.0   220.0
Multiple   0.85x   1.25x
Value   178.5   275.0
EBITDA   14.0   16.0
Multiple   6.0x   6.0x
Value   84.0   96.0
Total   502.5   707.0
Net Debt   (27.2)   (27.2)
Market Cap 475.3   679.8
Stock Price $27.16   $38.85


Recent comparables for each business are:

Security - GE selling its checked baggage unit for over 15x EBITDA, and AS&E trading for over 8x EBITDA

Medical - Mindray buying Datascope's patient monitoring business for approximately 1.2x revenue

Optoelectronics - primarily a value EBITDA multiple for a GDP growth business with close to 9% segment operating margins.


Longer term margin opportunity:

OSI Systems LTM operating margins were 4.5%. On first blush, given relatively high quality businesses, these operating margins seem too low when considering the company generates sales of approximately $600 million in revenue.  Since first coming to OSI, Alan recognized the disparity between comps and OSI and is working hard to fix it.  He, along with the rest of management, have outlined a detailed internal plan to bring operating margins up to 10% in three years, with only minimal (5%) revenue growth.  He plans to achieve this by the following:

-Moving medical manufacturing from Seattle to China (currently in the process), expects to generate 300-400 basis points of gross margin improvement

-Efficiency programs around supply chain management

-Further facility consolidation

-Reduction in R&D as a big push in new products roll off over the next two years

-Moving toward less models of each product which creates less one off projects and customization (some of which has been unprofitable)

-Expansion of service revenue with new product sales from the Security segment

-Move in medical R&D staff toward India and China and away from U.S.

We have been impressed thus far with Alan and Deepak's drive to improve margins and shareholder value.  After speaking with competitors, we believe that OSI's operating margins in each of its businesses are substantially lower than comps. Our analysis suggests that margins in well performing medical businesses are approximately 8%, (patient monitoring closer to 6% and the remainder around 12%-14%), security of 10-11%% (x-ray baggage at 10%, cargo inspection at 6% and the new people screener technology at 10%-15%) and optoelectronics at around 8%-10%.  Therefore, we believe that management's internal guidance of bringing the company's margins to 10% in the next three years, while difficult, is possible to achieve. That said, even if OSI can get close to 10%, the stock would be materially higher.  An analysis at different prices is below:


FY 2012 Revenue 718.0 718.0 718.0
EBIT Margins   8.0% 9.0% 10.0%
EBIT   57.4 64.6 71.8
EBITDA   74.4 81.6 88.8
EV / EBITDA   4.5x 4.1x 3.8x
EPS   $2.15 $2.41 $2.68
P/E Multiple   8.3x 7.3x 6.6x



The primary risk in reaching our target would include lower than expected revenue growth from the security business. Although the recent contract wins that we expect to generate sales over a number of years as well as a number of government programs in place over the net two years minimize this risk, if the government significantly reduces spending for security equipment, OSIs security business would be impacted.

Lack of execution by management - part of our longer term thesis requires the management team to execute on promised internal goals to achieve operating margins of 10% in the next three years. Although we believe this is achievable and that a margin anywhere near 10% would generate substantial value from here, lack of management execution will limit the long term upside of this stock


Analysts increasing guidance in the near term. Longer term recognizing that management can double operating margins and improve EPS from $0.88 LTM to over $2 in three years.

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