OSI Systems - 10-Q quarterly report FY

 

 

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 þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

As of February 1, 2008, there were 17,663,781 shares of the registrant’s common stock outstanding.

 

 

See accompanying notes to condensed consolidated financial statements.

See accompanying notes to condensed consolidated financial statements.

See accompanying notes to condensed consolidated financial statements.

OSI Systems, Inc. (the Company) is a vertically integrated designer and manufacturer of specialized electronic systems and components for critical applications. The Company sells its products in diversified markets, including homeland security, healthcare, defense and aerospace.

The Company has three operating divisions: (a) Security, providing security inspection systems; (b) Healthcare, providing medical monitoring and anesthesia systems; and (c) Optoelectronics and Manufacturing, providing specialized electronic components for affiliated end-products divisions, as well as for external clients in the defense and aerospace markets, among others.

The Company’s Security division designs, manufactures and markets security and inspection systems worldwide to end users primarily under the “Rapiscan Systems” trade name. Rapiscan Systems products are used for the non-intrusive inspection of baggage, cargo, vehicles and other objects for weapons, explosives, drugs and other contraband and to screen people. These systems are also used for the safe, accurate and efficient verification of cargo manifests for the purpose of assessing duties and monitoring the export and import of controlled materials. Rapiscan Systems products fall into four categories: baggage and parcel inspection, cargo and vehicle inspection, hold (checked) baggage screening and people screening.

The Company’s Healthcare division designs, manufactures and markets patient monitoring, diagnostic cardiology and anesthesia systems worldwide to end users, primarily under the “Spacelabs” trade name. 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. The Company’s Healthcare division also offers centralized cardiac safety core laboratory services in connection with clinical trials by or on behalf of pharmaceutical companies and clinical research organizations.

The Company’s Optoelectronics and Manufacturing division designs, manufactures and markets optoelectronic devices and value-added manufacturing services worldwide for use in a broad range of applications, including aerospace and defense electronics, security and inspection systems, medical imaging and diagnostics, computed tomography, toll and traffic management systems, fiber optics, telecommunications, weapons simulation systems, gaming, office automation, computer peripherals and industrial automation. The Company sells optoelectronic devices primarily under the “OSI Optoelectronics” trade name and performs value-added manufacturing services primarily under the “OSI Electronics” trade name. This division provides products and services to original equipment manufacturers, as well as to the Company’s own Security and Healthcare divisions.

The condensed consolidated financial statements include the accounts of OSI Systems, Inc. and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. The condensed consolidated financial statements have been prepared by the Company, without audit, pursuant to Accounting Principles Board Opinion No. 28, “Interim Financial Reporting” and the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. In the opinion of the Company’s management, all adjustments, consisting of only normal and recurring adjustments, necessary for a fair presentation of the financial position and the results of operations for the periods presented have been included. These condensed consolidated financial statements and the accompanying notes should be read in conjunction with the audited condensed consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2007, filed with the Securities and Exchange Commission on September 13, 2007. The results of operations for the three and six months ended December 31, 2007 are not necessarily indicative of the operating results to be expected for the full fiscal year or any future periods.

In October 2005, Spacelabs Healthcare, Inc., a subsidiary comprising the business operations of the Company’s Healthcare division, completed an initial public offering of approximately 20% of its total issued and outstanding common stock. The Spacelabs Healthcare shares traded under the ticker symbol “SLAB” on the AIM (formerly known as the Alternative Investment Market), a stock market administered by the London Stock Exchange. In the second quarter of fiscal 2007, the Company began repurchasing publicly-traded shares of Spacelabs Healthcare, increasing the Company’s ownership to 84% as of June 30, 2007. By December 31, 2007, the Company increased its ownership in Spacelabs Healthcare to 100% repurchasing all remaining shares of Spacelabs Healthcare. During the six months ended December 31, 2007, the Company spent approximately $15.8 million in cash and issued 240,000 shares of the Company’s common stock in exchange for the remaining outstanding Spacelabs Healthcare shares. At the time of issuance, the 240,000 shares of the Company’s common stock had a fair value of $5.9 million. As of December 31, 2007, $15.1 million of the cash portion of the repurchase remained outstanding and is included in accounts payable in the condensed consolidated financial statements. Effective January 24, 2008, Spacelabs Healthcare shares no longer trade on the AIM.

The Company tests goodwill for impairment in accordance with Statement of Financial Accounting Standards (SFAS) 142, “Goodwill and Other Intangible Assets” (SFAS 142). SFAS 142 requires that goodwill be tested for impairment at the reporting unit level at least annually and more frequently upon the occurrence of certain events. For purposes of SFAS 142, the Company has determined that it has five reporting units, consisting of the Security division, Optoelectronics and Manufacturing division and two reporting units within the Healthcare division. The Company tests goodwill for impairment annually in its second fiscal quarter using a two-step process. First, the Company determines if the carrying amount of any of the reporting units within each of its divisions exceeds its fair value. It uses a discounted cash flows method to make this determination for its Security and Optoelectronics and Manufacturing divisions and it uses a market value method for the reporting units within its Healthcare division (based on the market price of Spacelabs Healthcare common stock on the AIM). If these methods indicate a potential impairment of goodwill associated with any reporting unit, the Company then compares the implied fair value of the goodwill associated with the respective reporting unit to its carrying amount to determine if there is an impairment loss.

In accordance with SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company evaluates long-lived assets, including intangible assets other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. An impairment is considered to exist if the total estimated future cash flows on an undiscounted basis are less than the carrying amount of the assets. If an impairment does exist, the Company measures the impairment loss and records it based on the discounted estimate of future cash flows. In estimating future cash flows, the Company groups assets at the lowest level for which there are identifiable cash flows that are largely independent of cash flows from other asset groups. The Company’s estimate of future cash flows is based upon, among other things, certain assumptions about expected future operating performance, growth rates and other factors.

The Company computes basic earnings per share by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period. The Company computes diluted earnings per share by dividing net income available to common shareholders by the sum of the weighted average number of common and dilutive potential common shares outstanding. Potential common shares consist of the shares issuable upon the exercise of stock options or warrants under the treasury stock method. Stock options and warrants to purchase a total of 0.3 million shares of common stock for the three months and six months ended December 31, 2007, were not included in diluted earnings per share calculations because to do so would have been antidilutive. Stock options and warrants to purchase a total of 1.7 million and 2.0 million shares of common stock for the three months and six months ended December 31, 2006, respectively, were not included in diluted earnings per share calculations because to do so would have been antidilutive. The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share amounts):

Comprehensive income/ (loss) is computed as follows (in thousands):

In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157, “Fair Value Measurements.” This statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. It is effective for fiscal years beginning after November 15, 2007. The Company has not yet determined the impact that this statement will have on its condensed consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities- including an amendment of SFAS No. 115,” (SFAS 159). SFAS 159 allows companies to elect to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been chosen are reported in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company has not yet determined the impact that this statement will have on its condensed consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations,” (SFAS 141(R)). SFAS 141(R) retains the fundamental requirements of the original pronouncement requiring that the purchase method be used for all business combinations. SFAS 141(R) defines the acquirer as the entity that obtains control of one or more businesses in the business combination, establishes the acquisition date as the date that the acquirer achieves control and requires the acquirer to recognize the assets acquired, liabilities assumed and any noncontrolling interest at their fair values as of the acquisition date. In addition, SFAS 141(R) requires expensing of acquisition-related and restructure-related costs, remeasurement of earn out provisions at fair value, measurement of equity securities issued for purchase at the date of close of the transaction and non-expensing of in-process research and development related intangibles. SFAS 141(R) is effective for the Company’s business combinations for which the acquisition date is on or after July 1, 2009. The Company has not yet determined the impact that this statement will have on its condensed consolidated financial statements.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51,” (SFAS 160). SFAS 160 amends ARB 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. It requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the noncontrolling interest. This Statement establishes a single method of accounting for changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation. SFAS No. 160 is effective for the Company’s fiscal year beginning July 1, 2009. The Company has not yet determined the impact that this statement will have on its condensed consolidated financial statements.

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

The changes in the carrying value of goodwill for the six month period ended December 31, 2007, are as follows (in thousands):

Goodwill acquired during the six months ended December 31, 2007, resulted from the repurchase of all outstanding shares of Spacelabs Healthcare stock previously owned by minority shareholders, whereby the entire purchase price in excess of the book value of the minority interest was recorded as goodwill. This is a preliminary purchase price allocation and may be subject to change when final valuations are completed.

Intangible assets consisted of the following (in thousands):

Amortization expense related to intangibles assets was $2.4 million and $1.8 million for the six months ended December 31, 2006 and 2007, respectively. At December 31, 2007, the estimated future amortization expense was as follows (in thousands):

During the quarter ended December 31, 2006, as part of a global review of its operations, the Company assessed the value of certain technologies and product lines. As a result of this assessment, the Company recorded total charges of $31.8 million. These charges consisted of $21.5 million of asset impairment of certain identifiable intangible and fixed assets, and $10.3 of inventory charges, primarily related to finished goods inventory. Of the $21.5 million of impairment charges, $21.3 million was recorded within the Company’s Security division and $0.2 million was recorded within the Optoelectronics and Manufacturing division. Of the $10.3 million of inventory charges, $9.9 million was recorded within the Company’s Security division and $0.4 million was recorded within the Optoelectronics and Manufacturing division. Such inventory charges are reflected in cost of goods sold in the condensed consolidated financial statements. Asset impairments were calculated in accordance with SFAS No. 144 as discussed in Note 1.

During the first half of fiscal 2008, the Company incurred various restructuring and other charges related to consolidating manufacturing processes and facilities of certain businesses, headcount reductions, as well other non-recurring charges. These charges included $1.9 million in the Security division, $0.2 million in the Healthcare division and $0.1 million in the Optoelectronics and manufacturing division. As of December 31, 2007, $1.5 million of restructuring and other charges remained unpaid and is included in accrued expenses and other current liabilities in the condensed consolidated financial statements.

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

On July 27, 2007, the Company entered into a credit agreement with Wachovia Bank allowing for borrowings of up to $89.5 million. The new credit agreement replaced pre-existing agreements with Bank of the West, which were repaid and terminated simultaneously with the close of the agreement with Wachovia Bank. The credit agreement with Wachovia Bank consists of a $44.75 million five-year revolving credit facility, including a $35 million sub-limit for letters-of-credit, and a $44.75 million five-year term loan. Borrowings under this facility bear interest at either (a) the London Interbank Offered Rate plus between 2.00% and 2.50% or (b) the bank’s prime rate plus between 1.00% and 1.50%. The rates are determined based on the Company’s consolidated leverage ratio. As of December 31, 2007, the effective weighted average interest rate under the credit agreement was 7.8%. The Company’s borrowings under the credit agreement are guaranteed by substantially all of the Company’s direct and indirect wholly-owned subsidiaries and are secured by substantially all of the Company’s assets and by the assets of such subsidiaries. The agreement contains various representations, warranties, affirmative, negative and financial covenants, and conditions of default customary for financing agreements of this type. As of December 31, 2007, $43.6 million was outstanding under the term loan, $12.0 million was outstanding under the Company’s revolving credit facility, and $5.5 million was outstanding under the letter-of-credit facility.

Several of the Company’s foreign subsidiaries maintain bank lines-of-credit, denominated in local currencies, to meet short-term working capital requirements and for the issuance of letters-of-credit. As of December 31, 2007, the total amount available under these various credit facilities was $34.4 million with a total cash borrowing sub-limit of $8.6 million, of which $1.5 million was outstanding at December 31, 2007. The weighted average interest rate of these facilities was 6.8% at December 31, 2007.

In December 2004, the Company entered into a bank loan of $5.3 million to fund the acquisition of land and buildings in England. The loan is payable over a 20-year period, with quarterly installments of £34,500 (approximately $69,000 as of December 31, 2007). The loan bears interest at LIBOR plus 1.2%, payable on a quarterly basis. As of December 31, 2007, $4.7 million remained outstanding under this loan.

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

As of December 31, 2007, the Company maintained two significant stock equity participation plans: (a) the 2006 Equity Participation Plan of OSI Systems (OSI Plan), and (b) the 2006 Equity Participation Plan of Rapiscan Systems Holdings. In addition, the Company maintains and administers an employee stock purchase plan.

The Company recorded stock-based-compensation expense in accordance with SFAS No. 123(R) “Share-Based Payment” in the condensed consolidated statement of operations as follows (in thousands):

As of December 31, 2007, total unrecognized compensation cost related to non-vested share-based compensation arrangements granted was approximately $5.4 million. The Company expects to recognize these costs over a weighted-average period of 2.0 years.

The Company sponsors a number of qualified and nonqualified defined benefit pension plans for its employees. The benefits under these plans are based on years of service and an employee’s highest twelve months’ compensation during the last five years of employment. The components of net periodic pension expense are as follows (in thousands):

For the three and six months ended December 31, 2007 and 2006, the Company made contributions of $0.3 million, $0.6 million, $0.4 million and $0.7 million, respectively, to these defined benefit plans.

In addition, the Company sponsors several defined contribution pension plans. For the three and six months ended December 31, 2007 and 2006, the Company made contributions of $0.2 million, $0.7 million, $0.3 million and $0.6 million, respectively, to these defined contribution plans.

In November 2002, L-3 Communications Corporation (L-3) brought suit against the Company seeking a declaratory judgment that L-3 had not breached its obligations to the Company concerning the acquisition of PerkinElmer’s Security Detection Systems Business. The Company asserted counterclaims against L-3 for, among other things, fraud and breach of fiduciary duty. On May 24, 2006, the jury in the case returned a verdict in the Company’s favor and awarded $125 million in damages. The jury found that L-3 had breached its fiduciary duty to the Company and had committed fraud. L-3 has appealed the judgment.

The Company is also involved in various other claims and legal proceedings. In the opinion of the Company’s management, after consultation with legal counsel, the ultimate disposition of such proceedings is unlikely to have a material adverse effect on the Company’s financial statements.

In accordance with SFAS No. 5, “Accounting for Contingencies,” the Company has not accrued for loss contingencies relating to legal proceedings because it believes that, although unfavorable outcomes in the proceedings may be possible, they are not considered by management to be probable or reasonably estimable. If one or more of these matters are resolved in a manner adverse to the Company, the impact on the Company’s results of operations, financial position and/or liquidity could be material.

Under the terms and conditions of the purchase agreements associated with the following acquisitions, the Company may be obligated to make additional payments.

In August 2002, the Company purchased a minority equity interest in CXR Limited. In June 2004, the Company increased its equity interest to approximately 75% and in December 2004, the Company acquired the remaining 25%. As compensation to the selling shareholders for this remaining interest, the Company agreed to make certain royalty payments based on sales of its products through December, 2022. As of December 31, 2007, no royalty payments have been earned.

In January 2004, the Company acquired Advanced Research & Applications Corp. During the seven years following the acquisition, contingent consideration is payable based on its net revenues, provided certain requirements are met. The contingent consideration is capped at $30.0 million. As of December 31, 2007, no contingent consideration has been earned.

In February 2005, the Company completed the acquisition of Blease Medical. During the three years following the acquisition, contingent consideration is payable based on its net revenues, provided certain requirements are met. The contingent consideration is capped at £6.25 million (approximately $12.5 million as of December 31, 2007). As of December 31, 2007, no contingent consideration has been earned.

In July 2005, the Company completed another acquisition that was not material to its overall condensed consolidated financial statements. During the seven years following the acquisition, contingent consideration is payable based on its profits before interest and taxes, provided certain requirements are met. The contingent consideration is capped at $6.0 million. As of December 31, 2007, no contingent consideration has been earned.

In July 2006, the Company completed another acquisition that was not material to its overall condensed consolidated financial statements. During the two years following the acquisition, contingent compensation is payable based upon profitability. Total contingent consideration is capped at $0.6 million. As of December 31, 2007, $0.3 million of contingent consideration has been earned.

The Company is subject to various environmental laws. The Company’s practice is to ensure that Phase I environmental site assessments are conducted for each of its properties in the United States at which the Company manufactures products in order to identify, as of the date of such report, potential sources of contamination of the property. In certain cases, the Company has conducted further environmental assessments consisting of soil and groundwater testing and other investigations deemed appropriate by independent environmental consultants.

During one investigation, the Company discovered soil and groundwater contamination at its Hawthorne, California facility. The Company filed reports concerning this problem with the appropriate environmental authorities in fiscal 2001. The Company has not yet received any response to such reports, and no agency action or litigation is presently pending or threatened. The Company’s site was previously used for semiconductor manufacturing, and it is not presently known who is responsible for the contamination and the remediation. The groundwater contamination is a known regional problem, not limited to the Company’s premises or its immediate surroundings.

The Company has also been informed of soil and groundwater remediation efforts at a facility that its Ferson Technologies, Inc. subsidiary previously leased in Ocean Springs, Mississippi. Ferson Technologies occupied the facility until October 2003. The Company believes that the owner and previous occupants of the facility have primary responsibility for such remediation and have an agreement with the facility’s owner under which the owner is responsible for remediation of pre-existing conditions. However, the Company is unable at this time to ascertain whether Ferson Technologies bears any exposure for remediation costs under applicable environmental regulations.

The Company has not accrued for loss contingencies relating to the above environmental matters because it believes that, although unfavorable outcomes may be possible, they are not considered by the Company’s management to be probable and reasonably estimable. If one or more of these matters are resolved in a manner adverse to the Company, the impact on the Company’s results of operations, financial position and/or liquidity could be material.

The Company offers its customers warranties on many of the products that it sells. These warranties typically provide for repairs and maintenance of the products if problems arise during a specified time period after original shipment. Concurrent with the sale of products, the Company records a provision for estimated warranty expenses with a corresponding increase in cost of goods sold. The Company periodically adjusts this provision based on historical and anticipated experience. The Company charges actual expenses of repairs under warranty, including parts and labor, to this provision when incurred.

The following table presents changes in warranty provisions (in thousands):

On July 1, 2007, the Company adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48). FIN 48 prescribes a two-step process for the financial statement measurement and recognition of a tax position taken or expected to be taken in a tax return. The first step involves the determination of whether it is more likely than not (greater than 50 percent likelihood) that a tax position will be sustained upon examination, based on the technical merits of the position. The second step requires that any tax position that meets the more-likely-than-not recognition threshold be measured and recognized in the financial statements at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. FIN 48 also provides guidance on the accounting for related interest and penalties, financial statement classification and disclosure. The cumulative effect of applying FIN 48 is to be reported as an adjustment to the opening balance of retained earnings in the period of adoption. The cumulative effect of applying FIN 48 to the Company has been recorded as a decrease of $3.3 million to retained earnings, an increase of $2.5 million to deferred tax asset and an increase of $5.8 million to tax liability. In addition, $0.4 million of current tax liability was reclassified to a long-term liability.

As of the July 1, and December 31, 2007, the total amount of gross unrecognized tax benefits was $6.2 million and $6.3 million, respectively. Of this total, $3.7 million represents the amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate. The Company recognizes potential interest and penalties related to income tax matters in income tax expense. As of July 1, and December 31, 2007, the Company has $1.4 million and $1.5 million accrued for the payment of interest and penalties, respectively.

The Company conducts business globally and, as a result, one or more of the Company’s subsidiaries file income tax returns in the U.S. federal jurisdiction and multiple state, local and foreign jurisdictions. The Company is no longer subject to U.S. federal IRS audit for years prior to 2004. With limited exception, the Company’s operations in state and foreign tax jurisdictions are no longer subject to audit by the respective tax authorities for tax years prior to 1998.

The Company operates in three identifiable industry segments: (a) Security, providing security and inspection systems; (b) Healthcare, providing medical monitoring and anesthesia systems; and (c) Optoelectronics and Manufacturing, providing specialized electronic components for affiliated end-products divisions, as well as for applications in the defense and aerospace markets, among others. The Company also has a Corporate segment that includes executive compensation and certain other general and administrative expenses. Interest expense, and certain expenses related to legal, audit and other professional service fees are not allocated to the industry segments. Both the Security and Healthcare divisions comprise primarily end-product businesses whereas the Optoelectronics and Manufacturing division comprises businesses that primarily supply components and subsystems to original equipment manufacturers, including to the businesses of the Security and Healthcare divisions. All intersegment sales are eliminated in consolidation.

The following table presents segment information (in thousands):

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions and select accounting policies that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Our critical accounting policies are detailed in our Annual Report on Form 10-K for the year ended June 30, 2007.

We describe recent accounting pronouncements in Item 1 — “Condensed Consolidated Financial Statements — Notes to Condensed Consolidated Financial Statements.”

We are 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 operating divisions: (a) Security, providing security and inspection systems; (b) Healthcare, providing patient monitoring, diagnostic cardiology and anesthesia systems; and (c) Optoelectronics and Manufacturing, providing specialized electronic components for affiliated end-products divisions, as well as for applications in the defense and aerospace markets, among others.

Security Division. Through our Security division, we design, manufacture and market security and inspection systems worldwide for sale primarily to U.S. federal, state and local government agencies as well as to foreign governments. These products are used to inspect baggage, cargo, vehicles and other objects for weapons, explosives, drugs and other contraband as well as to screen people. Revenues from our Security division accounted for 38% and 34% of our total consolidated revenues for the six months ended December 31, 2007 and 2006, respectively.

Following the September 11, 2001 terrorist attacks, U.S. Government spending for the development and acquisition of security and inspection systems increased in response to the attacks and has continued at high levels during its global war on terrorism. This spending has had a favorable impact on our business. However, future levels of such spending could decrease as a result of changing budgetary priorities or could shift to products that we do not provide. Additionally, competition for contracts with the U.S. Government has become more intense in recent years as new competitors and technologies have entered this market.

Healthcare Division. Through our Healthcare division, we design, manufacture and market patient monitoring, diagnostic cardiology and anesthesia systems for sale primarily to hospitals and medical centers. Our products monitor patients in critical, emergency and perioperative care areas of the hospital and provide such information, through wired and wireless networks, to physicians and nurses who may be at the patient’s bedside, in another area of the hospital or even outside the hospital. Revenues from our Healthcare division accounted for 42% and 44% of our total consolidated revenues for the six months ended December 31, 2007 and 2006, respectively.

The healthcare markets in which we operate are highly competitive. We believe that our customers choose among competing products on the basis of product performance, functionality, value and service. We also believe that price has become an important factor in hospital purchasing decisions because of pressures they are facing to cut costs.

In October 2005, Spacelabs Healthcare, Inc., a subsidiary comprising the business operations of our Healthcare division, completed an initial public offering of approximately 20% of its total issued and outstanding common stock. The Spacelabs Healthcare shares traded under the ticker symbol “SLAB” on the AIM (formerly known as the Alternative Investment Market), a stock market administered by the London Stock Exchange. In the second quarter of fiscal 2007, we began repurchasing publicly-traded shares of Spacelabs Healthcare, increasing our ownership to 84% as of June 30, 2007. By December 31, 2007, we increased our ownership in Spacelabs Healthcare to 100% repurchasing all remaining outstanding shares. During the six months ended December 31, 2007, we spent approximately $15.8 million in cash and issued 240,000 shares of our common stock in exchange for the remaining Spacelabs Healthcare shares. At the time of issuance, the 240,000 shares of our common stock had a fair value of $5.9 million. As of December 31, 2007, $15.1 million of the cash portion of the repurchase remained outstanding and is included in accounts payable in the condensed consolidated financial statements. Effective January 24, 2008, Spacelabs Healthcare shares no longer trade on the AIM.

Optoelectronics and Manufacturing Division. Through our Optoelectronics and Manufacturing division, we design, manufacture and market optoelectronic devices and value-added manufacturing services worldwide for use in a broad range of applications, including aerospace and defense electronics, security and inspection systems, medical imaging and diagnostics, computed tomography, fiber optics, telecommunications, gaming, office automation, computer peripherals and industrial automation. We also provide our optoelectronic devices and value-added manufacturing services to our own Security and Healthcare divisions. Revenues from our Optoelectronics and Manufacturing division accounted for 20% and 22% of our total consolidated revenues for the six months ended December 31, 2007 and 2006, respectively.

Consolidated Results. We reported a consolidated operating profit of $6.1 million for the three months ended December 31, 2007, an improvement from the $31.8 million operating loss reported for the three months ended December 31, 2006. This $37.9 million improvement was largely due to three factors: (i) a $26.7 million, or 19%, growth in revenue; (ii) our recognition, during the second quarter of fiscal 2007, of $31.8 of nonrecurring impairment charges related to various long-lived assets and inventory; and (iii) cost-cutting and facility consolidation initiatives that we began in the second half of fiscal 2007 and that have since resulted in more efficient manufacturing activities and nearly flat operating expenses, even during a period of significant revenue growth. These factors were partially offset by $2.1 million of nonrecurring restructuring costs recognized during the three months ended December 31, 2007, primarily related to further headcount reductions and facility consolidations.

During fiscal 2007, we undertook a review of our global operations as part of our ongoing efforts to integrate recent acquisitions and rationalize our overall cost structure. The review resulted in a plan that led to annualized cost savings of approximately $17 million, including a reduction of approximately 8% of our global workforce and the consolidation of multiple facilities. During the first half of fiscal 2008, we identified additional cost savings opportunities that have been initiated and are expected to benefit future periods.

The table below and the discussion that follows are based upon the way in which we analyze our business. See Note 10 to the condensed consolidated financial statements for additional information about our business segments.

Net revenues for the three months ended December 31, 2007, increased $26.7 million, or 19%, to $164.2 million from $137.5 million for the comparable prior-year period.

Revenues for the Security division for the three months ended December 31, 2007, increased $19.5 million, or 44%, to $63.9 million, from $44.4 million for the comparable prior-year period. The increase was attributable to a $20.1 million, or 271%, increase in sales of cargo and vehicle inspection systems. We believe that this increase in cargo and vehicle inspection system sales reflects greater market acceptance of these products in the early stages of their life cycle.

Revenues for the Healthcare division for the three months ended December 31, 2007, increased $5.2 million, or 8%, to $67.9 million, from $62.7 million for the comparable prior-year period. The increase was primarily attributable to increased patient monitoring equipment sales of $6.0 million, primarily in North America, partially offset by lower anesthesia equipment sales of $0.4 million and lower clinical trial services revenue of $0.4 million.

Revenues for the Optoelectronics and Manufacturing division for the three months ended December 31, 2007, increased $5.0 million, or 13%, to $44.6 million, from $39.6 million for the comparable prior-year period. The change in revenues was attributable to an increase in contract manufacturing sales of $10.4 million, partially offset by a decrease in commercial optoelectronic sales and weapons simulation sales of $3.2 million and $2.7 million, respectively. The increased contract manufacturing business is primarily due to the fulfillment of a significant defense-industry related contract that is expected to continue through the end of the fiscal year and into the first quarter of fiscal 2009. In addition, for the three months ended December 31, 2007, the division recorded intersegment sales of $12.2 million, compared to $9.2 million in the comparable prior-year period. Such sales are eliminated in consolidation.

Gross profit increased $19.7 million, or 50%, to $59.0 million for the three months ended December 31, 2007, from $39.3 million for the comparable prior-year period, as a result of both the 19% increase in total revenues as well as the recording of a $10.3 million inventory impairment charge that reduced gross profit in the second quarter of fiscal 2007. The gross margin increased to 35.9%, from 28.6% over the comparable prior-year period. Excluding the impact of the aforementioned inventory charges, our gross margin in the three months ended December 31, 2007 was essentially flat versus the comparable prior year period. Although we experienced gross margin improvement in our Healthcare division, a change in our overall product mix lead to comparable year over year gross margins. The improvements in gross margins resulted from: (i) growth in the revenues for our Healthcare division, primarily in patient monitoring systems, which generally carry higher gross margins than many of our other products; (ii) cost savings in our Healthcare division from restructuring activities initiated in fiscal 2007; and (iii) gross margin improvement in cargo and vehicle inspection products in our Security division associated with manufacturing efficiencies. Factors that reduced our consolidated gross margins included: (i) lower sales volumes in our commercial optoelectronic products line; (ii) increased contract manufacturing revenues, which tend to carry lower gross margins than our other businesses; and (iii) lower gross margins in our baggage and parcel inspection and people screening systems in our Security division, primarily as a result of changes in product mix.

Selling, general and administrative expenses. Selling, general and administrative (SG&A) expenses consist primarily of compensation paid to sales, marketing and administrative personnel, professional service fees and marketing expenses. For the three months ended December 31, 2007, SG&A expenses increased by $0.7 million, or 2%, to $39.1 million, from $38.4 million for the comparable prior-year period. As a percentage of revenues, SG&A expenses for the three months ended December 31, 2007 decreased to 23.8%, from 27.9% for the comparable prior-year period as we leveraged our fixed cost structure and benefited from cost cutting activities that began in fiscal 2007.

Research and development. Research and development expenses include research related to new product development and product enhancement expenditures. For the three months ended December 31, 2007, such expenses increased $0.5 million, or 4%, to $11.7 million, from $11.2 million for the comparable prior-year period. As a percentage of revenues, research and development expenses were 7.1% for the three months ended December 31, 2007, compared to 8.2% for the comparable prior-year period. The increase in research and development expenses for the three month period ended December 31, 2007 was primarily attributable to increased spending in support of next generation products in our Healthcare division.

Impairment, restructuring, and other charges. Beginning in fiscal 2007, we initiated a series of restructuring activities, which were intended to align our global capacity and infrastructure with demand by our customers and thereby improve our operating efficiencies. During the second quarter ended December 31, 2007, we continued this initiative and realigned our operations to further increase our operating efficiency. As a result, we recorded total impairment, restructuring and other charges of $2.1 million. These charges included $1.8 million in the Security division, $0.2 million charges in our Healthcare division and $0.1 million in our Optoelectronics and Manufacturing division, primarily relating to severance and manufacturing relocation costs.

During the second quarter ended December 31, 2006, as part of a global review of our operations, we assessed the value of certain technologies and product lines. As a result of this assessment, we recorded nonrecurring impairment charges in both operating expenses and cost of goods sold in our condensed consolidated financial statements. In operating expenses, these charges consist of $21.5 million for asset impairment of certain identifiable intangible and fixed assets. Of the $21.5 million of impairment charges of intangible and fixed assets, $21.3 million was recorded within our Security division and $0.2 million was recorded within our Optoelectronics and Manufacturing division. In cost of goods sold, we recorded $10.3 of inventory charges, primarily related to finished goods inventory. Of the $10.3 million of inventory charges, $9.9 million was recorded within our Security division and $0.4 million was recorded within our Optoelectronics and Manufacturing division.

Interest expense. For the three months ended December 31, 2007, we incurred interest expense of $1.3 million, which was consistent with the comparable prior-year period. The interest expense was primarily attributable to ongoing working capital requirements of our operations as well to finance the acquisition of Del Mar Reynolds, a business that we purchased in July 2006. Effective weighted average interest rates during the comparable periods were substantially the same.

Income taxes. For the three months ended December 31, 2007, our income tax expense was $1.7 million, compared to a benefit of $12.1 million for the comparable prior-year period. Our effective tax rate for the three months ended December 31, 2007 was 35.2%, compared to 38.8% in the comparable prior-year period. Our provision for income taxes is dependent on the mix of income from U.S. and foreign locations due to tax rate differences among such countries as well as due to the impact of permanent taxable differences.

The table below and the discussion that follows are based upon the way in which we analyze our business. See Note 9 to the Condensed Consolidated Financial Statements for additional information about our business segments.

Net revenues for the six months ended December 31, 2007, increased $42.2 million, or 17%, to $295.2 million from $253.0 million for the comparable prior-year period.

Revenues for the Security division for the six months ended December 31, 2007, increased $27.3 million, or 32%, to $112.7 million, from $85.4 million for the comparable prior-year period. The increase was attributable to a $28.0 million, or 147%, increase in sales of cargo and vehicle inspection systems. We believe that this increase in cargo and vehicle inspection system sales reflects greater market acceptance of these products in the early stages of their life cycle.

Revenues for the Healthcare division for the six months ended December 31, 2007, increased $13.5 million, or 12%, to $124.5 million, from $111.0 million for the comparable prior-year period. The increase was primarily attributable to: (i) increased patient monitoring equipment sales of $13.3 million, primarily in North America, (ii) increased anesthesia equipment sales of approximately $0.7 million. These increases were partially offset by a reduction in clinical trial services revenue of $1.0 million.

Revenues for the Optoelectronics and Manufacturing division for the six months ended December 31, 2007, increased $7.1 million, or 10%, to $81.0 million, from $73.9 million for the comparable prior-year period. The change in revenues was attributable to an increase in contract manufacturing sales of $12.4 million, partially offset by decreases in commercial optoelectronics sales and weapons simulation sales of $2.9 million and $2.3 million, respectively. The increase in contract manufacturing revenues is primarily due to the fulfillment of a significant defense-industry related contract that is expected to continue through the end of fiscal 2008 and into the first quarter of fiscal 2009. In addition, for the three months ended December 31, 2007, the Optoelectronics and Manufacturing division recorded intersegment sales of $23.0 million, compared to $17.3 million in the comparable prior-year period. Such sales are eliminated in consolidation.

Gross profit increased $25.3 million, or 33%, to $103.1 million for the six months ended December 31, 2007, from $77.8 million for the comparable prior-year period. The increase in gross profit is the result of both the 17% increase in total revenues as well as the recording of $10.3 million inventory impairment charge that reduced gross profit in the first half of fiscal 2007. The gross profit margin increased to 34.9%, from 30.8% over the comparable prior-year period. This increase was attributable to the prior period impact of the inventory charges, which had the effect of reducing our gross margin by 4.1%. Excluding the impact of the aforementioned inventory charges, our gross margin in the six months ended December 31, 2007, was essentially flat versus the comparable prior year period. Although we experienced gross margin improvement in our Healthcare division, a change in our overall product mix lead to comparable year over year gross margins. The factors that generally increased gross margins included: (i) growth in the revenues for our Healthcare division, primarily in patient monitoring systems, which generally carry higher gross margins than many of our other products; (ii) cost savings in our Healthcare division from the restructuring activities initiated in fiscal 2007; and (iii) gross margin improvement in cargo and vehicle inspection products in our Security division associated with manufacturing efficiencies. Factors that reduced our consolidated gross margins included: (i) lower sales volumes in our commercial optoelectronic products line; (ii) increased contract manufacturing revenues, which tend to carry lower gross margins than our other businesses; and (iii) lower gross margins in our baggage and parcel inspection and people screening systems in our Security division primarily as a result of changes in product mix.

Selling, general and administrative expenses. For the six months ended December 31, 2007, SG&A expenses increased by $0.4 million, or 1%, to $75.3 million, from $74.9 million for the comparable prior-year period. As a percentage of revenues, SG&A expenses for the six months ended December 31, 2007 decreased to 25.5%, from 29.6% for the comparable prior-year period as we leveraged our fixed cost structure and benefited from the cost cutting activities that began in fiscal 2007.

Research and development. Research and development expenses include research related to new product development and product enhancement expenditures. For the six months ended December 31, 2007, such expenses decreased $0.6 million, or 3%, to $21.5 million, from $22.1 million for the comparable prior-year period. As a percentage of revenues, research and development expenses were 7.3% for the six months ended December 31, 2007, compared to 8.7% for the comparable prior-year period. The decrease in research and development expenses for the six month period ended December 31, 2007, was primarily attributable to: (i) a decrease in research and development spending within our Security division of $0.9 million and (ii) $0.6 million of costs booked in the six months ended December 31, 2006, for in-process research and development costs incurred by Del Mar Reynolds, a business that we acquired in July of 2006. This decrease was partially offset by an increase of $1.0 million in the six months ended December 31, 2007 in our Healthcare division attributable to increased spending in support of next generation products.

Impairment, restructuring, and other charges. In fiscal 2007, we initiated a series of restructuring activities that were intended to align our global capacity and infrastructure with demand by our customers and thereby improve our operating efficiencies. During the six months ended December 31, 2007, we continued this initiative to further increase our operating efficiency. As a result, we recorded total impairment, restructuring and other charges of $2.2 million. These charges included $1.9 million in the Security division, $0.2 million charges in our Healthcare division and $0.1 million in out Optoelectronics and Manufacturing division, primarily relating to severance and manufacturing relocation costs.

During the six months ended December 31, 2006, as part of a global review of our operations, we assessed the value of certain technologies and product lines. As a result of this assessment, we recorded impairment charges to both operating expenses and to cost of goods sold in our condensed consolidated financial statements. In operating expenses, these charges consist of $21.5 million for asset impairment of certain identifiable intangible and fixed assets. Of the $21.5 million of impairment charges of intangible and fixed assets, $21.3 million was recorded within our Security division and $0.2 million was recorded within our Optoelectronics and Manufacturing division. In cost of goods sold, we recorded $10.3 of inventory charges, primarily related to finished goods inventory. Of the $10.3 million of inventory charges, $9.9 million was recorded within our Security division and $0.4 million was recorded within our Optoelectronics and Manufacturing division.