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OSI Stock May Come Unstuck

The scanning-equipment maker should benefit from the coming trends in screening systems.

This column was originally published on RealMoney on Oct. 2 at 10:37 a.m. EDT. It's being republished as a bonus for TheStreet.com readers.

Talk about not getting respect.

OSI Systems

(OSIS) - Get OSI Systems, Inc. Report

showed perfectly decent improvement on both its top and bottom lines for its recently released fourth-quarter report (ended June 30), plus a record backlog, yet its stock remains moribund.

I've been in and out of this stock a couple of times in the past two years, as have insiders, and the insider profile of OSI is not as strong right now as I would like.

Although two insiders have exercised over $400,000 worth of options in recent months and held them, there have also been a couple of sellers this year. However, OSI has stayed on my radar screen since insiders got me in back in 2004, and I still see compelling value in the stock at its current price.

OSI has three divisions. Its Rapiscan security systems division makes a variety of scanners to detect illegal objects on people, in baggage and in shipping containers. Its scanners are well represented in airports and ports around the world.

Its Spacelabs subsidiary makes a complete range of integrated patient monitoring systems for hospitals. It also has an optoelectronics division that accounts for less than a fifth of revenue.

On the plus side, fourth-quarter sales rose 24.7% year over year, and EPS came in at 4 cents vs. a loss of 20 cents last year. Its order backlog is now a record $147 million, with OSI's security division showing particular strength. Sales for the coming year were also guided higher to around $540 million, which would be an increase of nearly 20%.

But this clearly was not enough for investors. Analysts had expected fourth-quarter EPS of 7 cents; 4 cents was considered a miss.

The fact that OSI expects a slight loss in the first quarter also seems to have received more attention than the decent full-year EPS guidance of 35 cents to 45 cents.

Now, it may seem odd for me to assert that OSI is a good buy when it is trading for nearly 50 times expected earnings, but there are several factors that investors need to take into account other than its forward multiple.

I think there is a strong value argument for buying into OSIS now as it trades for 0.7 times trailing sales.

Let's look at it is as the sum of its parts. Its Spacelabs subsidiary, which is listed on London's AIM exchange for speculative stocks under the ticker symbol SLAB, has a market cap of 90.6 million British pounds. OSI owns 80% of it.

Using an exchange rate of $1.90 to the pound produces a dollar value of $138 million, which is 44% of OSI's market cap of $315 million. It accounted for roughly 48% of OSI's revenue in fiscal 2006.

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I would argue that Spacelabs is far from overpriced, trading for 19 times trailing EPS and 1.6 times trailing sales.

For its own fiscal year (also ended June 30), the company's EPS increased 62.5%, to 13 cents, on a 12.7% increase in revenue. A combination of organic growth and more acquisitions is expected to generate another double-digit top-line increase this year.

Such prospects lead Piper Jaffrey analyst Julie Simmonds to view Spacelabs' outlook as "promising." In a recent research note, she concludes, "Spacelabs is undervalued at the current level and there is significant opportunity for investors to make early gains as the company leverages the continuing strength of its brand."

Over the next 12 months, she expects it to trade up over 15%.

What about the Optoelectronics and Rapiscan divisions? Optoelectronics is growing well and is decently profitable. External revenue increased 46% in the fourth quarter and about the same amount for the full fiscal year. Its operating margins in the fourth quarter were 20%. Nothing wrong with that.

This leaves the Rapiscan division as the culprit holding down OSI's share price.

It is the slowest-growing and least profitable unit of OSI. Considering that most investors consider OSI a "security play" after its shares rocketed from $4 to $25 in the months after Sept. 11, this may seem surprising. But with the bulk of the last generation of screening machines already ordered, in place and, frankly, not doing a good enough job, it remains to be seen who the next big winners will be in the sector.

They will need to provide clearly superior products to justify another upgrade by airports, governments and corporations, and OSI is certainly doing its best to make sure it will be one of the winners.

But that is taking a lot of R&D spending, which isn't helping Rapiscan's profit margins in the near term. It's a major reason why the unit booked an operating loss of $600,000 in fiscal 2006, even though sales increased a reasonable 9.6%.

OSI spent $35.9 million on R&D last year, an impressive $2.18 a share. That's quite a chunk of change, given its size. Whether or not investors consider OSI a value now depends on one's opinion of how successful that R&D will be.

I believe it will pay off, and that is why I'm a bull on the stock.

About $19 million of its $35.9 million in R&D spending was on its profitable and growing Spacelab subsidiary. Much of the rest went to systems to screen large cargo, such as shipping containers.

As most everyone (including would-be terrorists) know by now, only about 5% of shipping containers are screened, because examining more would slow commerce to a crawl.

After all its investment, its large-cargo systems are starting to garner orders.

In its fourth-quarter conference call, OSI said that $38 million of the company's $147 million backlog is for such systems, and there have been $25.8 million in orders announced in the two weeks since then. And if politicians ever realize that they can throw an unfunded mandate at (mainly foreign-owned) U.S. port operators to force a larger percentage of containers to be screened, OSI will have more orders than it can handle.

The costs of equipment and procedures to bring inspections up to the 20% mark are still reasonable relative to the money port owners make, and they could in any case pass per-container security surcharges onto their customers to offset the cost.

To the small extent that the price of imported goods may rise as a result of extra security cost, I think consumers would accept it.

Another very promising product that is coming out of OSI's R&D pipeline is its next-generation RTT120 computed tomography system for high-speed hold-baggage screening. It has enough promise that the operators of Manchester Airport in the U.K. preordered $40 million worth of the systems back in May.

If it works as expected, to increase the speed and accuracy of airport screening (still admittedly an "if," given that the system will be ready for market in 2008), the Manchester order should only be the beginning.

It should also be noted that the technology behind the new CT system also has applications in the medical field for OSI's Spacelabs division.

Taking away Spacelabs, the rest of the company is being valued by the market at $177 million. Consider this: In May, OSI won a judgment for $125 million against competitor

L-3 Communications

(LLL) - Get L3 Technologies Inc Report

for L-3's breach of obligations in negotiating the acquisition of certain assets from

PerkinElmer

(PKI) - Get PerkinElmer, Inc. Report

. Of course it could be reversed on appeal, but it seems very odd to me that the market is giving OSI no credit for the initial verdict. The stock has risen less than 50 cents since then.

All this latent value and earnings power makes me view OSI as a stock to own -- and not just as a morbid hedge against a terrorist attack, which would almost certainly cause a huge pop in the stock's price, depending on the type of attack.

I view OSI as a stable firm that is thinking long term, and it should benefit heavily if rational security decisions are made over the next few years.

At the time of publication, Moreland was long OSI, although holdings can change at any time.

Jonathan Moreland is director of research and publisher of the weekly publication InsiderInsights, founder of the Web site InsiderInsights.com and the director of research at Insider Asset Management LLC. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, Moreland appreciates your feedback;

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