OSI Systems (OSIS) Sell-Off on Short Report an 'Overreaction' - Drexel Hamilton

(Updated - December 7, 2017 7:35 AM EST)

(updated to expand on analyst comments)

Drexel Hamilton analyst Brian Ruttenbur said yesterday's sell-off in OSI Systems (NASDAQ: OSIS) based on a new short seller report from Muddy Waters was an 'Overreaction'.

Ruttenbur believes the facts in the report are incorrect and is telling clients to take advantage of the weakness.

The analyst highlights four points that directly responds to the key allegations:

1. The report stated they could not reach management of OSIS after multiple tries. I do not know who the researcher attempted to contact, but would recommend contacting the company’s CFO in the future. Most seasoned investors know to contract the CFO, Alan Edrick, for questions about the company’s financials. We believe, as we have been informed, no one from “Muddy Waters Research” attempted to make contact with the CFO at OSIS.

2. Puerto Rico was a negotiated contract that has been in operation for over 5 years. The company is paid on a per container screened basis and we estimate this contract generates between $10M - $12M in revenue annually (probably at the lower end of that range due to the recent hurricane). I have personally visited the company’s Puerto Rico operations with investors on two separate occasions. This turnkey deployment was a first of its kind in the industry and was, in fact, a negotiated deal. The 2% of revenue that was mentioned in the short sellers report for training, appears to be correct (roughly $200,000 annually). This fee does not seem exorbitant given the company is screening at multiple sites within the island and the company has a responsibility to screen all incoming cargo.

3. The estimates by the short seller of the contribution of Mexico appear to be illogical. I have followed the company for over 15 years as a sell side analyst. I estimate Mexico provides roughly $120M per year in revenue and generates profits closer to $30M of EBITDA. This is significantly off from the short seller’s estimate of roughly $100M of EBITDA (again off of $120M of revenue). To be clear, management has not disclosed the specifics of any contract including the Mexico contract. However, given our history, we believe our estimates are much closer to being accurate. We note the Mexico contract is coming to an end and we expect a new contract by mid-January 2018 that will be at a lower revenue run rate (assumed in our estimates). The reason for the lower revenues is the new contract will likely not require significant capital investment (the company invested roughly $200M in equipment to start the Mexico project). The Mexico contract was competitively bid. We followed the process at the time and several companies competed for the business. It was OSI Systems that had the turnkey operating history (no other company had the experience), offered a compelling value proposition of a wide variety of cargo inspection equipment, equipment maintenance, capital investment, and end to end screening that won the bid. The company has been operating successfully in Mexico for 5 years.

4. Albania is a joint venture turnkey operation that was competitively bid three years ago. As we understand the situation, the company’s partner in Albania was/is responsible for significant investment in site preparations. We note that site preparations can cost millions of dollars per location and take significant time to complete (it is sometimes a cumbersome process to prepare a site before large cargo screening equipment can be installed). We estimate OSI Systems generates less than $10M annually from Albania. There is no equity affiliate line related to the Albania joint venture. OSI (per the agreement) recognizes the full revenue and pays its partner in Albania as part of its gross costs in accordance with the agreement (OSI's portion of the profit in Albania flows through to net income).

Further the analyst highlights that during the last 5 years, there have been 3 major dips (2012, 2013, and 2015).
Each time the stock dipped, there was a strong recovery within months.

The analyst reiterated a Buy rating and price target of $105.00

For an analyst ratings summary and ratings history on OSI Systems click here. For more ratings news on OSI Systems click here.

Shares of OSI Systems closed at $59.52 yesterday.

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