OSI Beats Earnings, But Margin Pressure Lingers From Mexico Contracts

Date of Call: Jan 29, 2026

Financials Results

• Revenue: $464 million, up 11% year-over-year
• EPS: $2.58 per diluted share (non-GAAP adjusted EPS), a Q2 record
• Gross Margin: 33%, down from the same quarter in the prior year
• Operating Margin: 14% (adjusted operating margin), up sequentially from Q1, but down from the prior year’s second quarter

Guidance:

• Raised fiscal 2026 non-GAAP EPS guidance to a range of $10.30-$10.55, representing 10%-13% year-over-year growth.
• Q3 revenue expected to have a headwind of over $50 million from Mexico contracts, with growth in Q4 significantly stronger than Q3.
• Expect substantial cash inflows in the second half from Mexico receivables, leading to strong operating and free cash flow.
• Anticipate operating margin expansion in Q4 and beyond, driven by higher service revenue growth and efficiencies in new manufacturing facilities.

Business Commentary:

Record Revenue and Earnings Growth:

• OSI Systems reported record revenue of $464 million for Q2 fiscal 2026, representing an 11% year-over-year increase.
• The growth was driven by strong performance in their security and optoelectronics divisions, with security revenue up 15% and opto up 12%.

Security Division Performance:

• Security division revenues reached $335 million, a 15% year-over-year increase.
• Growth was driven by higher service revenues, increased revenues from the RF business, and increased aviation product revenues, despite a decrease in large Mexico contracts.

Optoelectronics and Manufacturing Division Growth:

• Optoelectronics and Manufacturing division sales increased 12% year-over-year to $113 million, marking a new Q2 record.
• This growth was attributed to broad demand across a diversified product and customer base, with strong bookings and a solid book-to-bill ratio.

Cash Flow and Financial Positioning:

• The company generated $62 million in operating cash flow for Q2 and expects even stronger cash flow in calendar 2026.
• This was supported by collections from a significant security customer in Mexico and a successful convertible notes transaction that increased liquidity and reduced interest expense.

Guidance and Outlook:

• OSI Systems raised its fiscal 2026 non-GAAP EPS guidance to a range of $10.30-$10.55, reflecting 10%-13% year-over-year growth.
• This increase factors in a challenging comparison from reduced revenues in Mexico contracts but anticipates strong growth in Q4 due to expected backlog conversion and other factors.

Sentiment Analysis:

Overall Tone: Positive

• Management stated: 'We delivered strong second quarter financial results, setting Q2 records across multiple metrics', 'Our security division performed well', 'Opto sales... increased 12% year-over-year to a new Q2 record', 'Overall, we continue to see nice demand across many of our markets, and our backlog remains healthy', 'We are raising our fiscal 2026 guidance for non-GAAP EPS'.

Q&A:

• Question from Jeff Martin (Analyst): Wanted to dive into the orders activity in security comment, softer than expected. The overall backlog was essentially unchanged at $1.8 billion. So is it better to phrase it as the orders were not as strong as you expected rather than soft?
  Response: Expected strong orders were pushed to the right due to the U.S. government shutdown and some international delays, but all opportunities are still in the pipeline with expectations for a strong next six months.

• Question from Jeff Martin (Analyst): Could you expand on the IDIQ contract with Golden Dome? Is it something you could theoretically see orders start to come in in fiscal 2026?
  Response: Dependent on government timing, but management feels good about the foreseeable future for orders, with the company actively pursuing opportunities and having expanded facilities to meet demand.

• Question from Jeff Martin (Analyst): How should we think about interest expense on a quarterly basis going forward?
  Response: Interest expense is expected to decrease from Q2 to Q3 and then be relatively comparable in Q3 and Q4.

• Question from Jeff Martin (Analyst): With quite a bit of excess cash anticipated, what’s the potential for additional share purchases?
  Response: Stock buyback is certainly an option, with the company having a strong balance sheet and having completed a sizable buyback in Q2.

• Question from Josh Nichols (B. Riley Securities): Can you provide more detail about what you’re seeing in terms of the big beautiful bill and RFP timing? Are you seeing some RFPs already in calendar 2026?
  Response: The shutdown moves things to the right, with some money expected in the first six months of the year but most towards the latter part of calendar 2026 and beyond.

• Question from Josh Nichols (B. Riley Securities): Can you elaborate on where we stand in terms of Mexico DSO? Is that gonna continue to be a significant free cash flow driver in the fiscal second half?
  Response: Mexico represents the largest receivable; as it normalizes, it should drive outsized free cash flow conversion and significantly reduce DSO in the latter part of fiscal 2026 and into fiscal 2027.

• Question from Josh Nichols (B. Riley Securities): Any more detail you can provide about the guidance outlook in terms of margin and the growth potential for service revenue relative to hardware?
  Response: Service revenues are expected to grow at a much faster rate than products, with higher margins, leading to room for operating margin expansion, more tilted to Q4.

• Question from Christopher Glynn (Oppenheimer): Could you revisit the tilt to Q4 that you referenced? Should we think about $1 billion revenue in the back half as 45%-55% across the remaining two quarters?
  Response: Q4 revenues and bottom line are expected to be significantly higher than Q3, driven by the U.S. government shutdown and a major Mexico revenue headwind in Q3.

• Question from Christopher Glynn (Oppenheimer): On the expected strong second half bookings, is that essentially a CBP factor?
  Response: Bookings strength is due to a combination of CBP, other government orders, and international orders.

• Question from Christopher Glynn (Oppenheimer): Could you comment on the pipeline for the aviation market, and might there be some announcements in the second half?
  Response: The aviation market remains strong with a strong pipeline, though announcements may not always reach press release level due to order size or timing.

• Question from Mariana Perez Mora (Bank of America): Could you give some color on how large the RF business is today and how we should think about it in 3-5 years?
  Response: The business has substantial growth opportunity over the next few years from the Golden Dome program, with specific details to be provided later as opportunities become clearer.

• Question from Mariana Perez Mora (Bank of America): How do recent GAO reports about CBP lagging in non-intrusive inspection systems affect your orders and market share?
  Response: Despite civil works challenges, OSI Systems is seen as the most efficient supplier to CBP for equipment, with orders expected to continue for border crossings and other areas, potentially speeding up as new systems are deployed.

• Question from Mariana Perez Mora (Bank of America): How is the pipeline for sports events opportunities like the FIFA World Cup and Olympics?
  Response: OSI Systems sees itself as a premier player, feeling very good about recent announcements and upcoming major events in the U.S. and internationally, supported by unmatched technology breadth.

• Question from Rocco (J.P. Morgan): Are there any specific regions or countries leading in international demand for security products?
  Response: Demand is seen across the board, including the U.S. and the Middle East, driven by trade issues encouraging countries to enhance scanning and information sharing.

• Question from Rocco (J.P. Morgan): Does near-term funding have a notable impact on revenue or cash outlook heading into the back half?
  Response: No notable impact, as recent funding issues are related to ICE and other topics, not border security.

• Question from Larry Solow (CJS Securities): On security bookings, was that close to flat, about one?
  Response: Bookings were a bit below 1.0 this quarter.

• Question from Larry Solow (CJS Securities): Does the less than expected orders impact back half sales? Would you have increased guidance if bookings matched expectations?
  Response: It was prudent to maintain revenue guidance given some timing shifts and potential shutdowns, but the company feels very strong about its business.

• Question from Larry Solow (CJS Securities): Is Mexico the substantial driver of margin pressure, given its higher margin revenue?
  Response: Mexico's operational efficiencies from high-volume manufacturing created a margin headwind; this comparison subsides after Q3, with real margin expansion opportunity in Q4 and beyond.

• Question from Larry Solow (CJS Securities): Could you comment on the size of the Golden Dome opportunity over 3-5 years?
  Response: It is a substantial opportunity that will be meaningful to the company, with specifics to be provided later, but the potential is in the hundreds of millions.

• Question from Larry Solow (CJS Securities): What are the drivers for Opto's strong performance, such as book-to-bill?
  Response: Drivers remain a good diverse customer base and demand from existing and new customers moving manufacturing out of China, with strong demand expected to continue.

• Question from Larry Solow (CJS Securities): Could full-year cash flow come close to or exceed net income?
  Response: It is entirely possible if DSOs decrease as expected, leading to strong operating and free cash flow.

Contradiction Point 1

Impact of U.S. Government Shutdown on Orders and Revenue Timing

Contradiction on whether shutdown delays are minor or significantly push orders to the right.

Is "orders were not as strong as expected" a better phrasing than "softer than expected" for the security comment? - Jeff Martin (Analyst)

2026Q2: We expected strong orders, but some got pushed to the right due to the U.S. government shutdown and some international pushouts. - [Alan Edrick](CFO)

What impacts have you observed due to the federal government shutdown? - Jeff Martin (ROTH Capital Partners)

20251031-2026 Q1: The impact has been very limited... Any delays are minor and are not expected to affect the fiscal year 2026 significantly. - [Ajay Mehra](CEO)

Contradiction Point 2

Timing of Funding from the Golden Dome Initiative

Contradiction on when funding is expected to flow, with Q1 suggesting second half of fiscal year and Q2 implying first half.

Can you provide details on the big beautiful bill and RFP timing? Are any RFPs already scheduled for 2026? - Josh Nichols (Analyst, B. Riley Securities)

2026Q2: We expect some money to flow in the first six months of the year... - [Ajay Mehra](CEO)

Have customers received funding from the reconciliation bill, and has the government shutdown impacted this? - Seth Seifman (JPMorgan Chase & Co)

20251031-2026 Q1: Funding is still expected in the second half of the fiscal year, as planned. - [Ajay Mehra](CEO)

Contradiction Point 3

Mexico Revenue Impact on Margins and Timeline

Contradiction on when year-over-year margin headwinds from Mexico subside.

Why are margins below last year's full-year levels despite strong revenue and service revenue growth, particularly in Mexico? - Larry Solow (CJS Securities)

2026Q2: The year-over-year margin headwind from Mexico subsides after Q3, so real margin expansion opportunity is expected in Q4 and beyond. - [Alan Edrick](CFO)

Security margins declined YoY due to mix. When do you expect margins to expand as Mexico revenue stabilizes? - Seth Seifman (JPMorgan Chase & Co)

2026Q1: The final quarter of difficult Mexico comparisons is the upcoming December quarter (included in guidance). Margins should normalize and expansion can be focused on after this, starting in the next calendar year and beyond... - [Alan Edrick](CFO)

Contradiction Point 4

Golden Dome Order Flow Timing

Contradiction on the expected timing for receiving delivery orders under the Golden Dome initiative.

Can you provide details on the IDIQ contract with Golden Dome and whether orders might start in fiscal 2026? - Jeff Martin (Analyst)

2026Q2: We believe delivery orders could be received in the foreseeable future. - [Alan Edrick](CFO)

Were there any unusual factors, beyond product mix, affecting the Security division's gross margin? - Lawrence Solow (CJS Securities, Inc.)

2026Q1: An update on the opportunity is expected in the next 2-3 quarters. - [Ajay Mehra](CEO)

Contradiction Point 5

Revenue and Order Growth Expectations

Guidance and growth expectations for core business ex-Mexico appear inconsistent.

Can you provide more details on the guidance outlook for margins and service revenue growth compared to hardware? - Josh Nichols (Analyst, B. Riley Securities)

2026Q2: We are highly encouraged about margins... This positions us for operating margin expansion... - [Alan Edrick](CFO)

If the ex-Mexico logic is applied to fiscal '26 revenue guidance, would top-line growth be double-digit? - Michael Joshua Nichols (B. Riley Securities, Inc.)

2025Q4: Excluding Mexico, the guidance implies a double-digit growth rate for OSI Systems overall. - [Alan I. Edrick](CFO)