Varex Imaging Corp Q1 FY2021 Earnings Call

Greetings and welcome to the Earnings Conference Call for the Fiscal Year of 2021. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Howard Goldman, Director of Investor Relations.

Good afternoon and welcome to Varex Imaging Corporation's earnings conference call for the first quarter of fiscal year 2021. With me today are Sunny Sanyal, our President and CEO; and Sam Maheshwari, our CFO. Please note that live of this conference call includes a supplemental slide presentation that can be accessed at Varex's website at investors.vareximaging.com. The webcast and supplemental slide presentation will be archived on Varex's website. To simplify our discussion, unless otherwise stated, all references to the quarter are for the first quarter of fiscal year 2021. In addition, unless otherwise stated, quarterly comparisons are made sequentially from the first quarter of fiscal year 2021 to the fourth quarter of fiscal year 2020 rather than to the same quarter of the prior year. Please be advised that during this call, we will be making forward-looking statements, which are predictions or projections about future events. These statements are based on current expectations and assumptions that are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated. Risks relating to our business are described in our quarterly earnings release and our filings with the SEC. Additional information concerning factors that could cause actual results to materially differ from those anticipated is contained in our SEC filings including item 1A, Risk factors of our quarterly reports on Form 10-Q and our annual report on Form 10-K. The information in this discussion speaks as of today's date and we assume no obligation to update or revise the forward-looking statements in this discussion. On today's call, we will discuss certain non-GAAP financial measures. These non-GAAP measures are not presented in accordance with, nor are they a substitute for, GAAP financial measures. We provided a reconciliation of each non-GAAP financial measure to the most directly comparable GAAP financial measure in our earnings press release, which is posted on our website. And now, I'll turn the call over to Sunny.

Thank you, Howard. Good afternoon, everyone, and welcome. I'm very excited to say that last week was our fourth anniversary as an independent public company. We continue to remain focused on our mission to help improve and save lives throughout the world by making the invisible visible. We are a world leader in X-ray imaging products for our medical and industrial applications and with the help of our 2,000 colleagues, as well as our customers and suppliers, over the last 70 years, we have continued to bring innovative and breakthrough technologies to market. Global OEMs incorporate our mission-critical components into their X-ray imaging systems, and we have continued to strengthen our relationships with them, many of which have spanned more than four decades. Our first quarter results came in towards the higher end of our guidance range. Revenues increased sequentially by 4%, indicating the start of recovery in our business. Global demand for our CT tubes has stayed strong during the last few quarters, and Q1 followed the same trend. Our non-GAAP gross margin increased to 34%. The improvement was due to realization of benefits from previously disclosed cost reductions, as well as a favorable shift in product mix within our medical segment. Non-GAAP operating expenses were down approximately $3 million, reflecting our continued focus on profitability. As a result, our non-GAAP operating margin improved to 8% of revenues. Non-GAAP EPS also came in towards the higher end of our guidance at $0.08 per diluted share. Cash improved to $206 million driven by positive cash flow from operations. Let me give you some high-level insight into how our different modalities performed during the quarter. We previously indicated that our business had stabilized, and this quarter we began to see a recovery. CT has continued to remain strong for a number of quarters, including Q1. Much of our CT business is coming from new system installations, which bodes well for our replacement business in the future. In fluoroscopy and oncology, we saw some improvement, primarily driven by an increase in patient visits for elective procedures. Our other medical modalities remained sequentially flat for the quarter. Industrial is also beginning to see consistent sequential recovery. Cargo and port security, as well as baggage screening business, remained low. However, other non-destructive testing and inspection verticals showed improvement. Let me now give you an update on our progress in China, where we are seeing continued momentum. As a reminder, we estimated that approximately 25,000 new CT systems will be needed in China over a 10-year period. Partially in response to COVID, we believe the Chinese government intends to accelerate the installation of about 10,000 CT systems over the next few years. These systems will be placed in so-called fever clinics and emergency departments at local hospitals, in order to provide dedicated CT scanner rooms for patients with infectious conditions. As a result, we're seeing a significant increase in demand for our tubes for new CT systems in China. For the past few years, we've been working with eight Chinese OEMs and have active pricing agreements with them to incorporate our CT tubes and other components into their new CT systems. On the left panel of this slide, you can see the current plan introduction and rollout of different CT scanner models by various OEMs. As we have said before, these OEMs are making steady progress with their product development, and we are confident that several new CT models, utilizing our components will hit the market over the next couple of years. Now, let me give you some perspectives on how Varex is positioned for growth. Our business has started to exhibit sequential growth that should lead us back to pre-COVID revenue levels of about $200 million per quarter. The pace of recovery will initially be driven by increasing demand for service replacement products, as surgeries and elective procedure volumes increase. Service replacements are typically funded by hospital operating budgets, whereas the purchase of new imaging systems requires capital expenditure budgets. Beyond the initial recovery, we expect that hospitals and medical facilities will begin to commit capital for new imaging systems once utilization levels reach certain thresholds. We also expect that COVID vaccines will play a key role in increasing utilization levels. In our industrial segment, we expect to see continued gradual improvements as the broader economy recovers. The pandemic has revealed substantial vulnerabilities in the preparedness of healthcare systems and associated infrastructure globally. In response, in the midterm, just like we're seeing in China, other governments and medical facilities around the world are likely to increase spending on healthcare. Such spending is likely to occur over many years in numerous areas of healthcare, including modernizing and expanding X-ray imaging capabilities. Over the long term, we expect our new technologies and innovative products to drive growth. These include our photon counting digital detectors and our Nanotube technology, which I will discuss in a moment. Let me give you a summary of what we have achieved as a company since the spin-off from Varian and where we are headed. During our first three years, we focused on standing up a new public company, completing the integration and consolidation of a major acquisition, and expanding our global footprint. We consider Varex 1.0 to be a success. Beginning last year, we entered the second phase, which we call Varex 2.0 and are in the early stages of this transformation. Here we remain focused on three major areas: first, strengthening our balance sheet; second, improving our operating margins; and third, accelerating our growth through innovation. We have already completed the first element of our transformation with the new capital structure that provides increased flexibility with limited financial covenants. Second, we're working to improve the operating structure of the company. Our objective is to improve profitability by expanding our gross margin and reducing our operating expenses. We expect the significant cost reductions that we recently made to largely remain in place even as business recovers. And third, we're focused on releasing new products based on game-changing technologies. We expect that our investments in new and innovative platforms will enable us to release a number of new products over the coming years. While the adoption of new technologies can take several years, the upside is a long, multi-year tale of recurring revenues from products that have been engineered into our customers' X-ray imaging systems. Our new products include the Z Platform family of dynamic digital detectors. These detectors are designed to produce high-quality images at lower doses compared to equivalent amorphous silicon detectors. Since the acquisition of Direct Conversion, we have continued to invest in our photon counting technology. Detectors using photon counting produce high contrast images at low doses and enable very good soft tissue resolution due to their ability to do precise energy discrimination. An exciting application for photon counting technology is CT detectors. We plan to leverage our technology to enter the CT detector market, which is complementary to our CT tube business. At RSNA last year, we introduced our new photon counting CT detector modules. These modules should soon be available for customer evaluation. We believe our entry into the CT detector market has the potential to expand our addressable market by $0.5 billion. While the adoption of this technology may take a few years, we are excited about the opportunity. We continue to work on Nanotube technology with our joint venture, BEC imaging. We are developing a multibeam cold cathode X-ray nanotube. We are pleased with the progress we have made so far and look forward to providing updates on future development. In our industrial segments, we intend to grow by extending our technology into select verticals. We have been focused on our components and subsystems and going forward in certain verticals, we may develop full imaging systems. We are excited about the industrial products we are developing. With that, let me hand over the call to Sam to talk about our financial performance in greater detail.

Thanks, Sunny, and hello, everyone. I wish you all a very happy new year and hope you and your families are keeping safe and healthy. As a reminder, unless otherwise indicated, I will provide sequential comparisons of our results for the first quarter of fiscal year 2021 with those of our fourth quarter of fiscal 2020. As Sunny mentioned, we have begun to see recovery in our business. First quarter revenues were $177 million, an increase of 4% from the fourth quarter of fiscal 2020. Medical segment revenues were $139 million, or 79% of total revenues. Industrial segment revenues were $38 million, or 21% of total revenues. Sequentially, medical sales grew 2% while industrial sales saw robust 11% growth. On a regional basis, first quarter revenue was $62 million in America, $58 million in India, and $57 million in the APAC region. We saw strong growth in China. Let me now cover our result on a GAAP basis. First quarter GAAP gross margin was 32%, a substantial improvement of 570 basis points from the previous quarter. GAAP operating expenses were lower by $7 million compared to the fourth quarter, and loss per share was $0.16 on a fully diluted basis. Let me now cover our results on a non-GAAP basis. Comparable GAAP measures have been included in our earnings release posted on our website. Gross margin was 33.6%, a sequential improvement of 580 basis points from the fourth quarter and significantly ahead of the midpoint of our previously communicated expectations. Please note that we completed the exit from Santa Clara manufacturing operations in Q1 itself ahead of the previously stated schedule. As a result, the Santa Clara closure-related savings were fully reflected in our Q1 non-GAAP results. Just as a reminder, we had previously communicated that we expected to fully realize the savings from the second quarter onwards. Overall, Q1 gross margin when compared to Q4 benefited from progress on our cost reduction efforts, favorable product mix and, to a smaller extent, by higher sales volume. In general, I want to remind you that our gross margin can fluctuate from quarter to quarter due to segment mix between medical and industrial, product mix within each segment, customer concentration, cost performance, and factory utilization levels. One of our fiscal 2021 initiatives is to improve efficiencies in our manufacturing and servicing efforts, where we are targeting a gross margin improvement of 100 basis points by the end of this fiscal year. When revenue volume returns to pre-COVID levels, and we complete our efficiency initiatives, we expect non-GAAP gross margin in the mid-30% level. R&D spending in the first quarter was 9% of revenue as compared to 10% in the prior quarter due to lower spending in R&D materials. Non-GAAP operating expenses are $46 million, down from $48 million in the previous quarter. This $2 million sequential decrease was due to lower R&D expenses as well as fully realizing the benefits from reduction in force that occurred in the previous quarter. Non-GAAP operating earnings were $14 million, as compared to a non-GAAP operating loss of $1 million in the previous quarter. As we outlined in our prior earnings call, our annual cash interest expense is approximately $32 million, or about $8 million per quarter, although the amount actually paid in a quarter can vary. Non-GAAP tax expense in the first quarter was $2 million. The tax rate in Q1 was unusually high at 34% due to Q1 being the transition quarter that we started generating profits from operations as opposed to incurring losses in the prior few quarters. Non-GAAP net earnings were $3 million or $0.08 per diluted share. This compares to a non-GAAP net loss in the fourth quarter of $2 million, or $0.04 per diluted share. Now turning to the balance sheet, accounts receivable decreased by $3 million, inventory decreased by $2 million, and accounts payables also decreased by $5 million during the quarter. Inventory reduction is a priority for us. We have started to make early progress on this initiative and continue to target a $25 million to $30 million inventory reduction by the end of this fiscal year. We tend to achieve this through a combination of completing facility consolidation, implementing lean programs, further streamlining our supply chain, and discontinuing low-velocity products. However, our reduction efforts have been partially offset by the need to bring in higher levels of raw materials to support growth in sales. As a result, in the first quarter, inventory declined by only $2 million from the prior quarter. Now moving to debt and cash flow information, cash flow from operations of $7 million. We ended the quarter with cash of $106 million on the balance sheet, an increase of about $5 million. Gross debt was $514 million, and net of cash was $408 million. Adjusted EBITDA was $22 million in the first quarter, a significant improvement from $4 million in the prior quarter. Now moving to our business outlook for Q2, we expect revenue between $180 million to $200 million, driven by continued recovery in our business, and non-GAAP earnings per diluted share between $0.05 and $0.25. These expectations are based on non-GAAP gross margin between 33% and 35% and non-GAAP operating expenses in the range of $44 million to $45 million. And with that, we will now open up the call for your questions.

At this time, we will be conducting a question-and-answer session. The first question is from Anthony Petrone with Jefferies. Please proceed with your question.

Thanks, Sunny and Sam, and congrats on a good quarter and start to the year. Maybe a couple for Sunny, and then follow-up with a few for Sam. Sunny, maybe just starting with medical, can you give us a sense where you by indications, were you seeing strength I think last quarter mammography was a driver. And was offset maybe perhaps a little bit by dental, maybe just been an update on end indications in medical where you're seeing strength? And then pivoting to China, the rebound there, can you give us a sense of how much of that is driven by CT tubes versus other components? And in particular, are you seeing any recapture on the flat panel detector side?

Yep. Hey, Anthony. So, one thing that's been consistent for the last several quarters has been we've seen strength in CT. So on the medical side, we've continued to see strength in CT, and we've now seen some uptick in a couple of other areas like fluoroscopy and oncology, and these are driven by ongoing increases in patient visits and procedure volumes. For the quarter, particularly, we see that dental was down last quarter and also continued to be slow and soft this quarter, while mammography was soft as well. So the strength this quarter primarily came from recovery in oncology, fluoroscopy, and CT. And regarding your question about China, China for us is a very strong CT market. So that means CT tubes and other components that go with that; as you know, we sell subassemblies in China related to CT. We sell high voltage connectors and there was a general pull-through of components tied to CT. Your question about detectors, we talked about our detector production in Wuxi being up and running. We have begun producing dental detectors and we have seen an uptick from customers in that area. But there are no particular details that I can give at this time about the recovery in dental detectors in China. But in general, the market has been strong in CT, and our strengthened position with our customers and market leadership is helping us there.

In solid form would be on industrial and then 1% on gross margin. On industrial, I think you've referenced Nondestructive Testing being well here. When do you envision you'll see a rebound in airport security and cargo screening? And when do you think those two businesses can get back to their pre-COVID levels? And for Sam on gross margin, how much of the sequential uptake was specific to Santa Clara savings relative to mix? Thanks.

Okay. So, on the industrial side, let me start with the non-security related verticals. The recovery was fairly broad-based with the exception of aerospace, which is still down. However, we have seen beginnings of recovery in most other verticals like food, electronics inspection, battery inspection, automotive, and food inspection. That has been very encouraging. Regarding security, particularly cargo and security inspection, we expect to start seeing some amount of recovery in the second half of the year. You might have noticed that there were some major tender wins by our customers, but those tender wins have not yet translated into specific orders for us due to slow delivery caused by COVID and getting their installations scheduled. Despite that, we are optimistic because there has been orders activity, and sooner or later those will translate into actual shipments for us. We expect to see that in the second half of the year. For airports, we have seen modest upticks in passenger travel-related activity, yielding increased business at airports, primarily tied to our tubes in baggage screening equipment, but nothing yet that I can declare as a strong trend or major contributor. And Anthony, this is Sanyal, I will try to address your question on gross margin. So sequentially from Q4 to Q1, we saw about a 6% improvement; 4% of that is related to what we call the cost bucket, and 1% improvement is due to product mix, and slightly less than 1% is related to uptick in volume. So within that cost bucket, about 3% of that is from our cost reduction efforts, while 2% is from Santa Clara migration and 1% is a number of positions that we eliminated in Q4, which is now fully reflected in Q1 results. So again, 2% Santa Clara, 1% cost reduction outside of Santa Clara, and then we have another 1% driven by productivity improvements and better yields. So that's an overall 4% improvement in cost, with 1% in mix and slightly less than one in the volume area.

That's great. Thank you. I'll get back in queue.

Thank you, Anthony.

Our next question is with Larry Solow with CJS Securities. Please proceed with your question.

Good morning. Excuse me, good afternoon guys, and thanks for taking my questions. The first question is a high-level one. Sunny, maybe for you and maybe you can give Sam. I know you sort of target getting back to pre-COVID levels, which is around $800 million plus or minus. And it does sound like if you take the high-end of your guidance, maybe that's a little bit of an aggressive position, whereas the lower end is more sort of a sequential, not flat number. I'm just trying to decipher, between the low-end and the high-end, do you see that as being the difference between a lot of your markets actually coming back and your mix improving significantly, or are there other variables at play?

Look, I'll ask Sam to provide some additional color. Let me just tie up maybe the latter part of your question to my answer. When we talk about recovering to 2019 levels, we mean getting back to a quarterly running rate of about $195 to $200 million. To get there, we'll need to see two things: ongoing strength in medical and recovery in medical. Fortunately for us, the CT side of our medical business is doing well, and we expect it to continue to do so, which will help to pull the medical aspect harder than it has previously, year-over-year. However, to achieve that $200 million level, we'll also need to see some broader-based recovery in our industrial side.

Okay. To put it another way, it sounds like almost qualitatively not all your markets have fully recovered, and I wouldn't expect them to fully recover in two quarters. To me, it seems that $200 million little hard to predict unless you see broader recovery. Given the context with China now seemingly at a higher level than we were a year ago, could the full recovery exceed 800 right from the start because it does sound like quantitatively you're not there yet?

Yes, so again, what's going well for us is CT. If CT continues to grow well, and if every other area also recovers, then you're talking about a possible scenario, right? At this time, dental is still down. It hasn't recovered yet. We need to see recovery in dental and mammography. Looking at all the medical modalities, they’re firing on all cylinders now, and we're getting uplift from CT, that should position us well.

Go ahead, please.

Also, keep in mind that industrial is still below its historical levels. Therefore, that needs to recover as well, which could also add to growth moving forward.

Right. You guys mentioned as you get back to pre-COVID levels, gross margins could settle in the mid-30s. Could we expect that you set some hurdles to get back to the targeted 38% to 40% gross margins that you claimed post-spin, or is that not realistic after putting an approximate timeline?

Yes. Currently, we have some initiatives going on in manufacturing and servicing areas. Compared to what we just reported, there is also potential upside from volume recovery. So as these initiatives complete and volume returns, I think we're looking at mid-30s type of gross margin. Beyond that range, once these initiatives are completed and the volume is back, we still target the high 30s, around 37% to 38% gross margin; however, to reach that goal, we would need new technologies and products to provide an additional boost. Volume-driven boosts will help as we approach the $200 million quarterly level, but these new products are crucial for that additional growth as well.

Okay, great. One last question is on the China opportunity. Sunny, you mentioned the 25,000 CT machines that will be installed over 10 years, and the 10,000 machines that you expect to be expedited and whether that has continued to sound like if I recall, these tubes are around $40,000. Is that still sort of the average price for the tube? And is it still really you and Philips as the primary suppliers into China today?

So let me address the last part first. Yes, from an OEM standpoint, we’re a market leader. It’s us and primarily Philips in terms of global suppliers. Regarding average pricing, it varies based on a mix of different systems from high-end to lower-end CTs. I can't publicly share exact prices, but the good news is the acceleration of CT purchases is occurring. Our customers are planning for capacity expansion and expect around 10,000 CT systems over the next few years, which has been accelerated. This reflects the realization that healthcare delivery systems need enhancing. The reason for this acceleration is the weaknesses exposed in healthcare delivery systems due to the pandemic. Many governments are looking to invest in healthcare delivery improvements, making this a favorable trend for us, as we expect it will lead to increased demand for medical imaging equipment.

Okay, great. I appreciate that color. Thanks a lot.

Our next question is from Suraj Kalia with Oppenheimer and Company. Please proceed with your question.

Hello, Suraj.

Sure. Good afternoon, Sunny, Sam. Congrats on the quarter. Hello?

Yes, we can hear you.

Okay, perfect. So Sunny, let me start with a very high-level question. And then I'll drill down into two specific and rather technical questions. In listening to your commentary, Sunny, you sound very confident about the outlook, I understand the initiatives that you and Sam are putting in place to drive Varex 2.0. I think the numbers are starting to show results. Your comments about the end markets were somewhat mixed. Maybe I can phrase the question differently: what are your end customers seeing in terms of speeding up the average sales cycle? I'm just trying to see if we can get some leading indicators from you guys regarding what’s happening in the end markets and trying to plan out that scenario?

So, Suraj, first, confidence in outlook comes from a lot of actions that we took last quarter and the previous quarter that are improving our financial performance, which includes a substantial number of cost reduction actions and factory initiatives to enhance productivity efficiency. Many of those actions are already complete, giving us clear line-of-sight to benefiting from those actions. Second, regarding end markets, I would frame it more as general optimism rather than full confidence. The recovery in our volumes in oncology and other modalities signals that patients are returning to hospitals for elective procedures and general surgeries which were halted nine months ago. That indicates a positive trend that healthcare delivery is functioning again despite ongoing COVID challenges. We're also seeing an uptick in customer orders and a positive response in procedure volumes, which contributes to our outlook. However, markets like mammography and dental are still lagging.

Got it. Sunny, this may be getting down into the weeds and I’d be happy to discuss offline. You mentioned your photon counting detector for CT applications. When you launch it eventually with a partner, will the focus be purely on image quality or are there going to be clinical attributes too? Would those be potential reductions, or do you think that will be applied next to the record capital technology?

Let me comment in general about Photon counting and its capabilities. Suraj, to respond to your question on how these capabilities will manifest in the field, still depends largely on how our customers choose to implement it. Photon counting technology provides significant benefits. First, because it counts X-ray photons instead of measuring an intensity signal, these detectors have high signal-to-noise ratios, which leads to superior image quality with lower doses. Second, its ability to perform precise energy discrimination opens avenues for various applications, enhancing performance capabilities. We expect our customers to develop new applications utilizing these inherent benefits. However, I can't share specific timelines for their implementation just yet.

Fair enough. Sunny, one last question, and I’ll hop back in the queue. You have been public for a relatively shorter period, and we look at product life cycles. Can you give us an example of a life cycle model in the past under Varian so we can gauge when to anticipate new technology, i.e., how often we should consider renewal cycles, just in terms of churn and new technology coming in?

Sure. That last question is very good but quite complicated. When we introduce a new platform in the market, such as digital detectors, it typically requires five to seven years in development before it’s available and adopted by OEMs. Following that, it can take an additional two or more years for meaningful revenue generation to take place. However, once established, these new platforms have long revenue streams. Conversely, for products we already have a market presence, bringing new models or iterations takes less time, about 1.5 to three years depending on the customer development cycles. Although new technologies like photon counting take longer due to their novelty and require our customers to build applications around them. Nanotube technology may take more time due to market understanding and acceptance, as it represents a deviation from conventional technologies.

Thank you very much for taking my questions.

Our next question is from Jim Sidoti with Sidoti & Company. Please proceed with your question.

Good afternoon, Sam and Sunny. Can you hear me?

Yes, we can, Jim. How are you?

Yes, Jim.

Great, great. I think you've done a really good job in laying out where you think the business is and how it's going. And the one question I had was it’s about a month now since we've changed administrations. Have you seen any impacts from that and do you expect any policies to be passed at this point with regard to cash, tariffs, and any of those issues?

It's a great question, Jim. Let me pass you back to Sam.

Yeah. So, Jim, so far, we've not seen any significant change, and we will be closely monitoring anything that comes out. From tariffs, we've been working on a local-for-local manufacturing strategy. We have plants and machinery in China along with a facility in Europe and of course, here in Salt Lake City. We’re slowly moving towards a position where we are somewhat insulated from some of these potential impacts, so we feel good about it. But again, we are in a monitoring phase at this time.

Okay, got it. That's it for me. I mean, it's all I had. And I think it's not a matter of if, but rather when these businesses will come back. Some of the measures you've put in place to get through this weak period are starting to pay off and they should pay off even more once the business returns.

That's correct, Jim.

Yes, that's correct, Jim. The only thing I would add is, in the previous two quarters, we indicated that the business had stabilized, and now we are stating that the business is recovering. Looking at the midpoint of our guidance clearly indicates that the business is recovering, and that is what we are seeing based on order patterns and incoming flow.

All right. Well, thank you.

Thanks, Jim.

Ladies and gentlemen, we have reached the end of our question-and-answer session. I would like to turn the call back over to Howard Goldman for closing remarks.

Thank you for your questions and participating in our earnings conference call for the first quarter of fiscal year 2021. The webcast and supplemental slides presentation will be archived on our website. A replay of this quarterly conference call will be available through February 18th, and can be accessed at the Company's website or by calling 877-660-6853 or by dialing 201-612-7415. The replay conference call access code is 13715201. Goodbye.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.