Varex Imaging Corp Q3 FY2021 Earnings Call

Greetings. Welcome to the Varex Third Quarter Fiscal Year 2021 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I will now turn the call over to your host, Howard Goldman. Please go ahead.

Good afternoon. And welcome to Varex Imaging Corporation’s earnings conference call for the third quarter of fiscal year 2021. With me today are Sunny Sanyal, our President and CEO; Sam Maheshwari, our CFO; and Chris Belfiore, our new Director of Investor Relations. Before turning the call over to Chris, as many of you know, I will soon be retiring from Varex. I want to thank the Varex leadership team for the opportunity to head our Investor Relations mission that began several months prior to our spin-off. It’s been an honor to work with all of you. Chris?

Thank you, Howard. Please note that the live webcast of this conference call includes a supplemental slide presentation that can be accessed from our Varex's website at investors.vareximaging.com. The webcasts 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 third quarter of fiscal year 2021. In addition, unless otherwise stated, quarterly comparisons are made sequentially from the third quarter of fiscal year 2021 to the second quarter of fiscal year 2021 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. I will now turn the call over to Sunny.

Thank you. Good afternoon, everyone. Please join me in welcoming Chris Belfiore to the team and Howard, thank you very much for all your contributions over the last four years. We wish you all the best in your retirement. I’m pleased to report that sales momentum continued in the third quarter of fiscal 2021, with revenues reaching $211 million, driven by strong demand in both medical and industrial segments. Higher sales volume and continued execution on expense management led to margin and profitability expansion in the quarter. We continue to see strong demand for CT tubes globally during the quarter, as well as robust detector sales for both medical and industrial applications. In the third quarter, all medical modalities except dental returned to pre-COVID sales levels or better. Our revenues in the third quarter increased 4% sequentially, driven mainly by gains in the medical segment. Revenues increased 23% year-over-year, by improvement in both medical and industrial segments. Our non-GAAP gross margin increased to 36%, due to higher volume and productivity, partially offset by unfavorable product mix. Our non-GAAP operating margin improved to 14% of revenues. As a result, non-GAAP EPS was $0.40 and exceeded the top end of our guidance range. Let me give you some high-level insight into how different modalities and applications trended during the quarter. Medical segment revenues increased 7% sequentially and 22% year-over-year. The strong trend in CT tubes sales continued during the third quarter, enabling our already large installed base to grow further. Since many of the tubes were for new systems, it bodes well for our future sales related to replacement tubes. In our other medical modalities, oncology, fluoroscopy and mammography posted healthy potential growth and are back to or above pre-COVID levels. We believe growth in medical segments was driven in part by demand that had been deferred over the past year, as well as the expansion of healthcare services in some markets and the adoption of new technologies. Revenues in our industrial segments decreased 6% sequentially and increased 31% year-over-year. We attribute some of the sequential decline in the industrial segment to inter-quarter timing of sales. In Q3 demand for digital detectors for non-destructive inspection increased across several of our industrial verticals, including battery inspection and oil and gas. However, demand for imaging products for security screening at ports and borders, as well as baggage screening at airports continued to be soft. I’d like to take a few minutes to provide an update on China. As we have talked about in the past, China represents a significant growth opportunity for Varex. This has been mainly driven by strong demand for CT systems, increased installations at fever clinics and a focus on making rural health systems more self-reliant, which is expanding the need for CTs in China. This growing installed base of CTs is expected to generate continued demand for replacement tubes. Our strategy in China of establishing relationships with local OEMs drives continued growth momentum. As we have said recently, of the initial 12 CT projects that we have been working on with eight local OEMs, nine projects have been brought to market and three are still in process. In addition to the continued adoption of new CT systems, we expect the previous generation of 16 slice CT systems to be upgraded to 64 and 128 CT systems. This upgrade cycle of the current installed base in China should add another layer to an already strong growth story. These system upgrades are expected to be driven by China’s goal of building a more self-reliant rural healthcare system that can handle advanced diagnostic procedures including cardiac applications. We expect our revenues from China to exceed $100 million by the fiscal year end 2021, which would represent 25% to 30% year-over-year growth for the last two years. While digital detectors had been a significant part of our early growth story in China, year-to-date medical tubes represented over half of the revenues in China. We think this is key to the future growth story of our business in China. The majority of the installations of medical CT tubes is for new systems, which will contribute to future demand for replacement tubes. Outside the CT market, we see other avenues of potential growth in the region. As we have pointed out in the past, our Wuxi facility is capable of manufacturing several thousand detectors per year. The detectors manufactured in the Wuxi plant now span various modalities, including radiographic, dental, oncology and fluoroscopy. This broad set of local offerings, along with strong industrial detector sales, have enabled our detector sales in China to reach levels previously achieved in 2017 and 2018, prior to the onset of the trade war with China and associated tariffs. In addition, our local OEM relationships in China provide a platform to grow into other modalities. We are currently targeting cardiology, dental and radiation therapy. We are very excited about the opportunities that China represents. I look forward to continuing to work with our OEM partners in delivering on the expansion and improvement in the healthcare delivery system for the region. Let me now give you a brief update on product development efforts. First, we recently launched the LUMEN 4336W detector with IP68 rating which allows the detector to be immersed in liquids, which can help with cleaning and disinfection. This detector is part of a new platform, which offers other advanced capabilities, as well as increased durability and ease-of-use for end users. With COVID continuing to be a problem globally, we believe these detectors will be well received by OEMs and healthcare providers. Second, on the Z Platform front for dynamic digital detectors, our first new product is approaching formal product launch, with two more following soon after. All three models are gaining traction with OEMs and they’re covered by a few multiyear customer contracts. Third, in the area of nanotube technology, our joint venture has continued to make progress with product life testing with good results and is now working on customer prototypes. And lastly, during the quarter we completed the acquisition of the outstanding minority stake in Direct Conversion, reflecting our continued belief in the potential for photon counting detector technology. Before I turn over the call to Sam, I just want to spend a minute talking about global supply chain issues that you are all aware of. During the second quarter, we highlighted supply chain constraints largely around freight and logistics. Supply chain challenges became more pronounced in the third quarter and are impacting the availability of some raw materials and semiconductors. We have been able to work through the challenges so far, but we see potential for supply chain constraints and shipping disruptions in Q4 and beyond. Our output may become challenged by the supply chain constraints, and we are working very closely with our current and ultimate suppliers to mitigate potential impacts. With that, let me hand over the call to Sam.

Thanks, Sunny, and hello, everyone. As a reminder, unless otherwise indicated, I’ll provide sequential comparisons of our results for the third quarter of fiscal year 2021 with those of our second quarter of fiscal 2021. Varex continued to deliver strong results in the quarter and we saw solid demand across all modalities. For the quarter, revenue was above the guidance midpoint, and non-GAAP EPS was above the top end of the guidance range. Third quarter revenues were $211 million, an increase of 4% from the second quarter, medical revenues were $167 million and industrial revenues were $44 million. For both Varex in total and the medical segment, this is the highest revenue level in three years. This translated to 9% medical and 21% overall industrial sales. Sequentially, medical sales grew 7%, while industrial sales declined 6%. The decline in industrial sales was due to the timing of shipments, which is more of a quarter-to-quarter aberration. Revenue levels in all three regions remained strong. Americas was down 7% sequentially, while EMEA grew 13% and APAC grew 6%. Let me now cover our results on a GAAP basis. Third quarter gross margin was 35% and up over 300 basis points sequentially from the previous quarter. Operating income increased $10 million compared to the second quarter and operating margin increased 400 basis points sequentially to 12%. Net earnings increased $9 million compared to the previous quarter and earnings per diluted share were $0.29 compared to $0.08 in the second quarter. Moving on to non-GAAP results for the quarter, gross margin was 36%, a sequential improvement of 150 basis points from the second quarter, driven by higher sales volume and improved productivity in manufacturing and service areas, partially offset by unfavorable product mix. Our gross margin has improved sequentially from 28% in the last quarter of fiscal year 2020 to 34% in Q1, 35% in Q2, and now to 36% in Q3. As this year comes to an end, we are achieving the gross margin target that we set earlier in the year. This performance over the last four quarters has been possible due to a continued increase in sales volume, timely completion of cost reduction goals, favorable product mix, and through our initiatives to improve efficiencies in our manufacturing and servicing activities. Despite the ongoing freight and supply chain-related challenges, we are very pleased with our gross margin performance. R&D spending in the third quarter was $19 million or 9% of revenues, which is in the middle of the 8% to 10% range that we target for R&D. R&D was 42% of operating expenses in Q3, as compared to 40% to 41% in Q2, reflecting our continued spending prioritization towards innovation and new product development. SG&A was approximately $27 million in Q3, slightly higher than the prior quarter, but sequentially down 30 basis points as a percentage of sales. Operating expenses were $46 million and sequentially up approximately $1 million due to an increase in R&D. We continue to keep operating expenses in control while successfully meeting increased customer demand, helping improve the quarterly profitability. Overall, our strategy to deliver higher earnings through improved operating leverage is on track and working very well. Operating earnings increased to $30 million or 14% of revenue, compared to $26 million or 13% of revenue in the previous quarter. Tax expense in the third quarter was $6 million, as compared to less than $1 million in the previous quarter. Recall that during Q2, two one-time favorable items in taxes drove a $2 million benefit and resulted in an unusually low tax expense for Q2. Net earnings increased to $16 million or $0.40 per diluted share, compared to $14 million or $0.35 per diluted share in Q2. Despite the higher tax rate in Q3 of 26%, we were able to grow EPS by $0.05 compared to the second quarter. Please note that due to our convertible notes-related bond hedge and recently achieved GAAP income profitability and the associated trading range of our shares, there is a difference between diluted shares for GAAP and non-GAAP purposes. We have provided a reconciliation between the two at the end of our earnings press release. Now turning to the balance sheet, accounts receivables increased by $19 million, partially due to higher sales. As a result, DSO increased by six days to 64 days. Inventory declined $5 million and days inventory declined to 61 days. Accounts payables increased by $14 million, mainly due to an increase in raw material procurement to support higher demand. As a result, days payable increased to 44 days. Now moving to debt and cash flow information, cash flow from operations improved to $22 million. We ended the quarter with cash of $128 million on the balance sheet, an increase of $17 million in the quarter. Gross debt outstanding at the end of the third quarter was $512 million and debt net of cash came down to $384 million, reflecting our priority to continue to deliver on a net debt basis. As we announced in early July, our cash generation enabled us to pay down a portion of our debt. On July 15th, we redeemed $30 million of over $300 million senior secured notes. Due to debt reduction on a go-forward basis, interest expense will be lower by approximately $2.4 million on an annualized basis. Adjusted EBITDA was $39 million in the third quarter, a solid improvement from $33 million in the prior quarter. I’m pleased to note that if you were to analyze our last six months of performance, the net debt leverage ratio at the end of Q3 would be below three times. In summary, our previously stated financial strategy of improving capital leverage and operating leverage is working very well. I want to take a moment to thank our Varex colleagues worldwide for their tremendous efforts in achieving these results. With that, let’s look at our expectations for the fourth quarter. Revenues are expected between $205 million and $225 million, and non-GAAP earnings per diluted share are expected between $0.25 and $0.40. Our expectations are based on non-GAAP gross margin in a range of 35% to 36% and non-GAAP operating expenses in the range of $46 million to $47 million. And with that, we will now open the call for your questions.

Thank you. Your first question comes from Anthony Petrone with Jefferies. Please go ahead.

Thanks and congratulations on a strong quarter. Hope everyone is doing well. Maybe Sunny or Sam, we can start with just sort of the dynamic between the underlying demand and maybe that’s mostly on the CT side in China and just your comments on the supply chain. It seems that while on the one hand, we do have an elevated level of demand that’s perhaps linked to some level of backlog recapture out of the pandemic, there’s still some uncertainties on the supply chain. So maybe a little bit more details on underlying CT tube and component demand? And where do you see the specific bottlenecks in supply chain and how do you think it sort of trends over the next 12 months? Thanks.

Hey, Anthony. This is Sunny. We’re in a strong demand environment, and at this point, we feel good about, as we head into the fourth quarter and looking into next year, we feel good about the demand side. The issues with the supply chain are fairly similar to what you would have been hearing from other companies. There are two categories of supply chain issues: one, where just there’s a shortage of commodities. We have been dealing with it for quite some time. I mean, you sometimes find there is a shortage of copper or aluminum and castings. It’s a daily discussion with suppliers, and we have been doing all the right things, placing appropriate orders and lead times, etc. That’s what we’re battling and we’ve been managing that. But lately, the semiconductor side has also become an issue. The way I would summarize this is that there are supply chain issues that are broader than what we faced maybe a couple of quarters ago with more commodities, materials, and more suppliers becoming delinquent with their shipments. Going into the fourth quarter, we have accounted for that and we have tried to deal with that. So we have visibility to our supplies as we look forward to at least the next quarter. Further out, we sense that the risks are broader than they were a quarter ago. We’re managing our way through it. We’re doing all the things that we can. We are aligning with alternate suppliers and qualifying alternate sources. At this point, given the strength of the demand side, we’re not demand-constrained right now in the near-term, and we will continue to work on the supply chain side.

It’s helpful. And just a couple of follow-ups for Sam, if we can get them in, the adjusted gross margin of 36%, even with the supply chain issues having an impact in the quarter. How much of that benefit was just sales volume-related versus cost savings on Santa Clara? And then the last one for me would be on the R&D side, 9% of the higher sales basis was ahead of the recent trend. I’m just wondering if that is linked to additional tenders or was it a pull-forward on other R&D initiatives? Thanks again.

Yeah. Thanks, Anthony. So taking your first question related to gross margin. Yes, definitely gross margin is benefiting from higher sales volume and it has continued to benefit over the last few quarters as we increase sales every quarter. In terms of cost reduction and the Santa Clara update, we have completed all of that migration of manufacturing from Santa Clara to Salt Lake. That’s fully done at this point and we are benefiting around $14 million to $15 million on an annualized basis. That comes to around $3.5 million a quarter, roughly translating to about 150 basis points. So that is benefiting, and that is flowing through the P&L at this time. Previously, we committed to a 100-basis-point gross margin improvement towards the end of this fiscal year. I would say that we have achieved that a bit sooner. So that was a very big factor in terms of productivity improvements a bit sooner than the initial plan. Overall, there are positive and negative factors, but we are pleased with the gross margin performance. Now, moving on to your next question regarding R&D as a percentage of sales. We target 8% to 10%. We came in right around the middle of that at $19 million. A lot of our R&D is driven by materials-related spending. When the engineers order, when that is delivered, etc., there can be a little bit of fluctuation from quarter to quarter. But, overall, we are investing in R&D, we are investing in delivering innovative products. There is a lot of need by R&D groups for more spending, and we are fully funding R&D. So right now, I think 9% feels good, and we are eager to release new products—there is a lot going on with our teams.

Thank you.

Your next question comes from Larry Solow with CJS Securities.

Good afternoon. Thank you for taking the questions. Howard, best of luck to you, and Chris, welcome aboard. I just wanted to follow up on Anthony’s question regarding the supply chain constraints. In terms of guidance, you mentioned that for Q3 the mix is slightly down. As we consider your guidance for Q4, it appears that achieving high sales levels will be necessary to align Q4 EPS with Q3, primarily due to supply chain and trade concerns. Are there any other issues we should be aware of as we transition from Q3 to Q4? That would be helpful.

Yeah. Let me take this question. Sam here. So, yeah, in terms of Q3, there was a little bit of an unfavorable mix, which is really driven by less industrial sales compared to the prior quarter. Industrial is a higher margin segment for us. This is impacting gross margin a bit, but we expect it to even out. In terms of gross margin, I shared that our gross margins when we get back to pre-COVID levels in terms of revenue of around $205 million to $210 million, we expect gross margin around 35% plus minus 1 percentage point. We are guiding 35 to 36. So we are a little bit higher than what we had set expectations on.

Okay. All right. Fair enough. Just maybe a couple of questions in terms of China, you guys are obviously meeting or exceeding expectations that you’ve spoken about for years. Just trying to figure out if there is any sort of clarity, obviously, in terms of without getting into specifics, you’re doing 100 this year, sounds like more than 50% of that is from tubes. In terms of market share gains or not, I think—and the players who are serving their local OEMs, is it just Varex and Phillips, can you give us any more clarity or other GE, Siemens in there and the mix between you guys and Phillips? I don’t know if you want to speak to that. But are they enjoying the same kind of numbers that you guys are, I mean, how that greater visibility enough. Any color there would be great.

So, Larry, you can frame it. One way to frame it would be that the local OEMs are gaining share in CTs in China, in aggregate. If we take all the local OEMs combined, where they were a few years ago versus where they are today, vis-à-vis local versus global OEMs, the local OEMs have gained share. We have a very large share of those local OEMs consumption of tubes. From our perspective, we’re gaining share in tubes in a very nice way in China, and I feel good about that. So that’s on a very good path, good trend and these are all going into new sockets. So the market share position will keep growing, and we’re bullish about that. On the detector side, I mentioned that I am happy to say that our detectors business has come back to pre-trade war levels, where we were hit by tariffs on both sides and we pulled back. Since then, our actions have allowed us to increase. The growth in detectors in China has been broad-based, not in any one particular modality but across the board. Radiographic continues to be challenged with pricing, but our strength and growth in detectors in China has been across multiple areas. In terms of how we’re doing versus overall market share, I’d say we’re keeping up with market growth rates better.

Okay. And last question maybe Sunny for you. While you took up the platform here. Just remember I look back, I think it was in early 2018, you guys are continuing—you got the reduced tax outlook and you take some of that savings and yet to reinvest in the business, and you did further investment into multiple price points on the CT, and CT machines in China and multiple different new detectors. And you certainly in the last couple of calls been calling out certainly on a qualitative basis, a lot of newer products coming out. And I think if I look back three years ago, you had spoken about, it should be, we should see an acceleration in revenue as we look out sort of three years from now, some of these new products start maturing from prototype to get into commercialization. I realize COVID kind of finds the exact science. But do you still feel that over the next couple of years, we should see this acceleration hopefully in revenue growth that certainly have new product contributions?

Yes. If you recall, we took some of the benefits from reduced tax rates and said we would invest in R&D, putting in additional money to accelerate development on new platforms. What you’re seeing us talk about currently with our new Detector Platform, the LUMEN Platform, the Z Platform, the work we’re doing with photon counting. There have been a number of new products that we pulled earlier to market. We are expecting future growth out of those products, and we think we pulled in the launch of those products by taking those earlier investments. There were also investments that went into supply chain qualification validation to set up our presence in China, and we’re seeing some of that play out in terms of growth. The CT was a growth across multiple tiers; the 16 slices mid-tier high end. And so we invested heavily in the segments that we thought would play out the best in China. I’m happy to say that our assessments and the feedback and input that we got from our local OEMs has served us well, hitting the sweet spot of the market. There has been tremendous growth including 16 slices for mass adoption. As we go forward, we are expecting, in addition to ongoing new socket sales in CT, there is going to be a wave of early 16 slice CT systems getting replaced by 64 and 128 slice CTs, which is more feature-rich. All of that has been enabled by us being in the right place at the right time with the products. Operator? It seems our operator lost her connection. Yeah, hey, our operator lost her connection. She is getting back on. So just hang in there. If there are additional questions, please hold for a second.

Ladies and gentlemen, we do apologize for this technical difficulty. I’ll move onto our next question, which is coming from the line of Suraj Kalia with Oppenheimer. Please proceed with your question.

Good afternoon, Sunny, Sam. Hope you’re well. Congrats on the quarter.

Thank you.

Thank you.

Hey. So, Sunny, a lot of questions have been asked. Maybe if I can just phrase it differently. Sunny the demand, obviously, if there is demand and the supply issues that you talked about. On the demand side, is the pickup, I mean, it just seems like Varex is moving into the next gear? Is the demand pick up more sort of catch up in nature or are you seeing any structural changes that would be more durable, so to speak, and I’m not talking about two quarters, I’m talking more about multiple quarters?

Yeah. So it’s a function of three different vectors. There is a little bit of a catch-up where there was lower sales in some modalities. However, CT demand continues to be strong and it’s not just a catch-up; it is an expansion of healthcare services globally. People are buying CTs at a higher rate than expected. We continually receive strong demand indicators from our customers, who provide us their annual plans and six-month estimates. Continuously, we feel strong about the demand side. The technology side is also driving demand. We’ve launched some new products and often that leads to an uptick in demand. We expect that to continue into next year as well.

I would also like to add that if you remember six to nine months ago we mentioned that our response to the pandemic could lead countries and communities to invest in health care infrastructure and imaging, which would benefit us. This is a broad-based situation affecting multiple regions and modalities. The strength in China is new for us, but we see demand across the board driving healthcare reaction globally, sustaining growth.

And if you take a look at the industrial side, demand has expanded significantly in areas like electronics inspection, battery inspection, and semiconductor inspections. As for security and inspection at airports, demand remains soft, so there is still more potential to tap. In summary, our overall demand profile looks promising.

Got it. Some concerns regarding the Delta variant on the industrial side of the equation?

Not particularly. The reason being is travel is often impacted first during such situations, and the security side of our business has remained slow. We are still waiting for a significant recovery in that area. Demand across industrial sectors has remained strong despite COVID after the initial disruptions, with increased activities. So it would be hard to pinpoint an overwhelming impact from the Delta variant on industrial demand.

Got it. And Sam, final two, I’ll just put both of them together. Sunny at RSNA, are we going to get an update on the core cathode status? And Sam maybe this has already been asked. Please forgive me if this is redundant. The components of the $205 million to $225 million guide, how do you all think through the Medical and Industrial segments?

Regarding the cold cathode technologies, our status is that we are continuing foundational technology development and are past the validation of the meters' strength. We are now into tube development and validating our tests here—more in the new product introduction mode. With RSNA just two months away, you won’t hear anything significantly different, but we’re working on customer prototypes and engaging them.

Suraj, coming back to your question in terms of the industrial and medical breakdown of the guide: Generally, Industrial represents about 21% of our overall revenues for us. I would say that is still our expectation, giving you a normal range of plus-minus 1%. So both medical and industrial are growing, and our guidance reflects that.

Your next question comes from Jim Sidoti with Sidoti & Company. Please go ahead.

Oh! Hi. Good afternoon.

Good afternoon.

Yeah. I’m going to try and ask the question, I think it’s been asked a couple of times and ask it a little bit different. You just had two strong quarters over that $200 million mark. You’re guiding for incurred one over that $200 million mark for the fourth quarter. Is there anything such as supply constraints or any other kind of headwind out there that you’re concerned about that would cause you to dip below that $200 million per quarter mark over the next year or so, or is there anything like that you are aware of?

Let me try to address that, Jim. Good question, thank you. Yes. So, obviously, as sales grow, AR picks up. That’s just normal working capital. There is one large customer of ours that decided for their own balance sheet purposes to pay us a significant amount of cash just one week after the quarter ended. So the AR was a little higher than I would have liked, but it’s just stuff that happens. However, in terms of Q4, we are guiding based on the visibility that we have. There are no significant concerns currently, but as all companies do, we are prepared for any unforeseen events.

All right. That’s it from me.

Thank you.

Thank you. I would like to turn the floor over to Chris for closing remarks.

Thank you for your questions and for participating in our earnings conference call for the third quarter of fiscal year 2021. The webcast and supplemental slide presentation will be archived on Varex's website. A replay of the quarterly conference call will be available through August 17th and can be accessed at the company’s website or by calling 877-660-6853 from anywhere in the United States or 201-612-7415 from non-U.S. locations. The replay conference call access code is 13721643. Thank you and good-bye.

This concludes today’s teleconference. You may disconnect your lines at this time and thank you for your participation.