Earnings Call Transcript - VREX Q2 2023

Operator, Operator

Greetings, and welcome to the Varex Second Quarter Fiscal Year 2023 Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Chris Belfiore, Director of Investor Relations. Thank you, Chris. You may begin.

Christopher Belfiore, Director of Investor Relations

Good afternoon and welcome to Varex Imaging Corporation's earnings conference call for the second quarter of fiscal year 2023. With me today are Sunny Sanyal, our President and CEO; and Sam Maheshwari, our CFO. Please note that the live webcast of this conference call includes a supplemental slide presentation that can be accessed at Varex’s website at vareximaging.com. The website and supplemental slide presentations will be archived on Varex’s website. To simplify our discussion, unless otherwise stated, all references to the quarter are for the second quarter of fiscal year 2023. In addition, unless otherwise stated, quarterly comparisons are made sequentially from the second quarter of fiscal year 2023 to the first quarter of fiscal year 2023. Finally, all references to the year are to the fiscal year and not calendar year, unless otherwise stated. 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 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.

Sunny Sanyal, CEO

Thank you, Chris, and good afternoon, everyone. I'm pleased to report strong second quarter results that exceeded the high-end of our guidance. This was primarily driven by better than expected results in our Industrial segment, while the Medical segment performed in line with our expectations. We're encouraged by the demand levels we're seeing and we anticipate our growth to remain solid in the second half of fiscal 2023. Revenue in the second quarter was up 11% sequentially and 6% year-over-year. Revenue in the Medical segment increased 9% sequentially and 2% year-over-year, while Industrial segment revenue increased 19% sequentially and 22% year-over-year. Non-GAAP gross margin in the second quarter was 33% which was better than our expectations primarily due to a higher proportion of industrial sales. Adjusted EBITDA in the second quarter was $30 million and non-GAAP EPS was $0.26. We ended the second quarter with $122 million of cash, cash equivalents and marketable securities on the balance sheet, up $14 million from the $108 million in the prior quarter. This was primarily due to a $9 million reduction in inventory in the quarter. Let me give you some insights into sales detail by modality in the quarter compared to a five quarter average. Medical segment revenues increased 2% year-over-year and 9% sequentially. Demand for CT tubes was solid in the quarter primarily due to the strength with our Asia-Pacific customers. Fluoroscopy and oncology were down in the quarter. Dental, which can be lumpy from quarter to quarter, was down in Q2 and mammography was flat in the second quarter, while radiography was up. Revenues in our Industrial segment increased 22% year-over-year and 19% sequentially. Demand for industrial products was robust in the quarter and solidly ahead of our expectations. The strength in the quarter was primarily in our nondestructive inspection products across various end markets and service. We also continue to see improvement in the security market, primarily in cargo inspection. As we highlighted last quarter, the technological capabilities of photon counting detectors continues to be a focus for many of our customers. It was a significant topic of our conversations with customers at RSNA in November as well as at the European Congress of Radiology in March. We are excited to announce that we have entered into several projects across our Medical and Industrial businesses to further demonstrate the capabilities of photon counting detectors. In the Medical segment, we continue to make progress with our CT customers for potential integration of photon counting detectors into their systems. In order to accelerate and support these efforts, we have also entered into a publicly funded project led by the Munich Institute of Biomedical Engineering, of the Technical University of Munich. The focus of the project is to develop a technology demonstrator of a photon counting CT system. This project, which will utilize several Varex components in addition to photon counting detectors, will allow Varex to showcase the capabilities enabled by our photon counting detector technology and CT applications, including the use of AI for enhanced imaging. We expect this project will democratize cutting edge CT technology to potentially accelerate the adoption of photon counting detectors in the next generation CT systems. In our Industrial segment, Varex is involved in two collaborative photon counting projects named PARSEC and GRINNER. These projects are sponsored under the Horizon Europe Programme, the EU's key funding programme for research and innovation. The first project, PARSEC, is aimed at addressing the abuse of postal and express courier services by criminals and terrorists. Varex’s role in this project is to help PARSEC enhance the detection of threats and illicit goods in the postal and express courier flows and achieve higher levels of detection performance. Varex will deploy its photon counting technology to assist users in achieving these objectives. The second project, GRINNER, is aimed at addressing issues affecting battery-caused fires in the electrical and electronic equipment waste management chain. These fires can cause significant damage and high costs for waste management companies. Varex’s role in this project is to help develop an AI-powered battery detection system utilizing our photon counting detectors. Across all these three highly innovative projects, we are thankful for the partnerships and associated funding, which help accelerate further development and the use of our technologies in the Medical and Industrial fields. We are encouraged by the demand trends that we are seeing across both segments and expect solid performance to continue in the second half of fiscal 2023. We believe the supply chain situation for our customers is improving and as a result, we expect revenue in fiscal 2023 to grow 3% to 5% over fiscal 2022. With that, let me hand over the call to Sam.

Sam Maheshwari, CFO

Thanks, Sunny, and hello everyone. As a reminder, unless otherwise indicated, I'll provide sequential comparisons of our results for the second quarter of fiscal 2023 with those of our first quarter fiscal 2023. I'm pleased to report solid results for the second quarter compared to our guidance. We exceeded our guidance for revenue gross margin and non-GAAP EPS and generated $27 million of operating cash flow in the quarter. A primary driver of the strong performance was excellent execution in our Industrial segment, which was significantly above recent run rates. As a result, we reported sales of $228 million and non-GAAP gross margin of 33%. The higher gross margin is primarily the result of the larger portion of industrial sales. Non-GAAP EPS was $0.26. Second quarter revenues increased 11% compared to a seasonally low first quarter of fiscal 2023. Revenues increased 6% compared to the second quarter of fiscal 2022. Medical revenues were $174 million and Industrial revenues were $54 million. Medical revenues were 76% and Industrial revenues were 24% of our total revenues for the quarter. Industrial revenues have typically contributed between 20% and 22% of total Varex revenues in the recent past. Looking at revenue by region, Americas increased 2% sequentially, while EMEA increased 7% and APAC increased 23%. The increase in APAC sales was primarily driven by strengthened CT. Please note there was a minor reallocation of revenue from the Americas to APAC in Q1 of fiscal 2023. China continues to perform well for us with sales of 17% of our overall revenue for the quarter. Let me now cover our results on a GAAP basis. Second quarter gross margin was 32%, 100 basis points higher sequentially. Operating expenses were $57 million up $7 million compared to the first quarter of fiscal 2023. And operating income was $16 million up $3 million. Net earnings were $4 million and GAAP EPS was $0.10 based on fully diluted 41 million shares. Moving on to non-GAAP results for the quarter. Gross margin of 33% was up 100 basis points sequentially, driven primarily by the larger proportion of sales in our higher margin Industrial segment, as well as reduced freight expenses. R&D spending in the second quarter was $23 million up $3 million compared to the first quarter due to spending on R&D material and Micro-X related payment. Recall from the guidance we provided last quarter, R&D expense included a $2 million payment for successful completion of Micro-X related technology transfer milestones. Overall, R&D was 10% of revenues at the high end of our targeted 8% to 10% range. SG&A was approximately $29 million, up $1 million compared to the prior quarter. SG&A was 13% of revenues. As a note, compared to the second quarter of fiscal 2022, SG&A was up $6 million. The lower SG&A in Q2 of fiscal 2022 was related to a credit associated with our incentive plan. Operating expenses were $52 million or 23% of revenue. Overall, our operating expenses were higher than our expectations due to higher R&D material spend and SG&A. Operating income was $23 million, up $5 million sequentially. Operating margin was 10% of revenue compared to 9% in the first quarter of fiscal 2020. Tax expense in the second quarter was $4 million or 28% of pre-tax income compared to $2 million or 15% in the first quarter of fiscal 2023. We continue to model approximately a 25% tax rate for the full fiscal year 2023. Net earnings were $11 million or $0.26 per diluted share, up $0.05 sequentially. Average diluted shares for the quarter on a non-GAAP basis were 41 million. Now turning to the balance sheet. Despite a significant increase in sales, accounts receivable increased by $2 million from the prior quarter and DSO decreased 60 days to 64 days. Inventory decreased by $9 million in the second quarter and days of inventory decreased 21 days to 182 days. We are very pleased with our progress reducing inventory, and expect this trend to continue in the second half of fiscal 2023. Accounts payable decreased by $12 million and days payable was 43 days. Now moving to debt and cash flow information. Cash flow from operations was $27 million in the second quarter due primarily to a reduction in inventory. We ended the quarter with cash, cash equivalents and marketable securities of $122 million, an increase of $14 million from the first quarter of fiscal 2023. Gross debt outstanding at the end of the quarter was $449 million and debt net of $122 million of cash and marketable securities was $327 million. Adjusted EBITDA for the quarter was $30 million and adjusted EBITDA margin was 13% of sales. Our net debt leverage ratio was 2.6 times trailing 12 months EBITDA at the quarter end. Now moving on to guidance, due to an improving supply chain situation for our customers, we are now expecting fiscal 2023 sales to be stronger than we anticipated in the last earnings call. We now expect revenue for fiscal 2023 to be up 3% to 5% compared to fiscal 2022. Our expectations for the third quarter of fiscal 2023 are; revenues are expected between $220 million and $240 million, and non-GAAP earnings per diluted share is expected between $0.20 and $0.40. Our expectations are based on non-GAAP gross margin in a range of 32% to 33%. Non-GAAP operating expenses in a range of $47 million to $48 million. Tax rate of about 25% for the third quarter as well as the rest of fiscal 2023, and non-GAAP diluted share count of about 50 million shares. With that, we will now open the call for your questions.

Operator, Operator

Thank you. We will now be conducting a question-and-answer session. Thank you. Our first question is from Larry Solow with CJS Securities. Please proceed with your question.

Larry Solow, Analyst

Good afternoon, everyone. My first question is about the overall demand environment. Last quarter, you mentioned that demand was softening somewhat, but it seems that demand has remained strong. I understand there have been supply chain issues affecting your ability to meet all demand, but last quarter, you also indicated concerns regarding OEM partners and hospital purchasing. I'm trying to understand if this situation has improved. What factors are contributing to what seems to be a better revenue environment compared to a couple of quarters ago? It seemed like there was some fluctuation last quarter, so any additional insights you can provide would be appreciated.

Sunny Sanyal, CEO

Yes, this is Sunny. For the quarter, Medical met our expectations while Industrial exceeded them. Last quarter, we noted that many customers were experiencing supply chain challenges, particularly with factory operations. This led us to approach the situation with caution, questioning when these issues would resolve and what our expectations should be for the coming quarters. However, during this quarter, we observed that our customers began to make progress. As they improved, the orders placed with us started to increase, boosting our confidence for the second half of the year. Additionally, we continue to see ongoing strength in Industrial, which remains consistent. Regarding the capital environment, there is still an emphasis on capital prioritization. However, we are sensing that hospitals are making efforts to enhance their financial health and profitability. If this trend continues, it should positively influence the capital prioritization situation, making us feel more optimistic than we did back in December and January.

Larry Solow, Analyst

Okay. You mentioned expecting low single-digit volume growth this year. Last quarter, it seemed like you were leaning towards the higher end of that range, possibly around 2% or 3%. I'm curious if you believe demand might improve going forward, possibly driven more by Industrial than Medical, even if it doesn't shift in Q2.

Sam Maheshwari, CFO

Hi, Larry. This is Sam. So, yes, in our prepared remarks, we did call out that for the full year, we are now expecting sales growth in FY 2023 over the prior year in the range of 3% to 5%. Previously we had said flat to up, and that's really coming from what, Sunny said that, previously customers were indicating some softness in certain pockets, and as the last few months have progressed, we are seeing less of that, and so we are being more productive here and kind of raising the full year sales number.

Larry Solow, Analyst

Okay. And then just switching gears off. Just on the call side, the little bit of higher expense this quarter, It feels like it seems somewhat temporary as your sort of your guidance for Q3 is kind of back to even below where you originally had guided for this quarter. I think, by a good million dollars. So, was that sort of R&D material spend, was that one-timeish in nature, the higher SG&A, your sales are obviously better than expected too. But just trying to figure out what sort of drove or was that more temporary than permanent, it feels like it? Thanks.

Sam Maheshwari, CFO

Certainly, Larry. There are a few points to discuss. As you may recall, we had indicated that in Q2, which we just reported, there was a one-time payment of $2 million related to milestones for Micro-X. This is a one-time expense that will not carry into Q3. Additionally, in Q2, we had higher-than-anticipated spending on R&D material due to increased R&D activities. We expect this R&D material spending to decrease in the upcoming quarter, meaning in Q3. Therefore, operating expenses will likely return to a more sustainable run rate. I want to clarify that the actual operating expenses for Q2 are not indicative of what I anticipate moving forward; it was primarily a one-time spike due to high expenses. Regarding SG&A, travel resumed in the last quarter, and we had a full quarter of travel and customer meetings as normal activities returned. Some countries opened up for external visitors as well. I anticipate SG&A will remain stable, but R&D expenses should decrease.

Larry Solow, Analyst

Got it. Great. I appreciate all the color. Thanks, Sam.

Operator, Operator

Thank you. Our next question is from Young Li with Jefferies. Please proceed with your question.

Young Li, Analyst

Hi, great. Thanks so much for taking our questions and congrats on a strong quarter. Maybe to start out just on the China business, I was wondering if you can provide a little bit more detail on it. It looks like it's growing 20% plus in the first half of the fiscal year around 17% of rest. I was wondering if you can comment maybe on the growth outlook for China as well. Is it reasonable to assume that China can grow 20% plus for the year?

Sunny Sanyal, CEO

So first of all, China has been on a tear due to first adoption of the systems. And that's why you've seen in the past 20% to 30% growth rates for us. And then we expect the growth rates to settle into the more market growth rates over which is around 10% of China. For the rest of this year, we expect to see the continued trajectory that we've had in the first half, so no, not much of a change expected there, but again, there's always some timing impact. But over time, China's adoption has continued, and our installed base has grown. So for the long haul, we expect a 10% growth. So, you can kind of plot it in that along that trajectory.

Young Li, Analyst

All right, great, very helpful. Maybe one on gross margin. I was just wondering, so, some of macro supply chain issues are improving, you're reducing some of the higher cost inventory, the Industrials business is doing better and the higher margin, should we expect, I guess, the fiscal 1Q's gross margin to be the low watermark for fiscal ‘23 and maybe fiscal ‘24 as well?

Sam Maheshwari, CFO

Hi, Young, it's Sam. Regarding gross margin, we previously mentioned that the Industrial sector, which has higher margins, is making up a larger share of our sales, contributing between 30 to 50 basis points to the overall gross margin. Additionally, we've seen a reduction in freight costs for both ocean and air transport. There is still work to be done in shifting more freight from air to ocean, which should provide further benefits. In the last quarter, foreign exchange had a very minimal impact on us. All these factors contributed positively to gross margins in Q2. Looking ahead, I agree that Q1 2023 will likely be the low point for gross margins, with expectations for further improvement. We are working to balance the price-cost dynamics in our P&L, which should help gross margins as we anticipate a favorable freight and supply chain environment moving forward. So yes, I believe that Q1 will probably represent the low point for our gross margins.

Young Li, Analyst

Excellent. Thank you so much.

Sam Maheshwari, CFO

Thanks, Young.

Operator, Operator

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

Jim Sidoti, Analyst

Hi, good afternoon, and thank you for your questions. Regarding the $2 million payment for Micro-X, I assume that payment was due to them achieving certain milestones. Could you elaborate on the pathway to commercializing that product?

Sunny Sanyal, CEO

Yes. Hi, Jim. The two milestones were related to establishing our lab and completing the technology transfer regarding the bidder, as well as successfully building those here by ourselves. We have completed those and are pleased with the outcome. Currently, we are in the process of building tubes, characterizing them, and performing the necessary performance benchmarking and testing. After we complete that, we will begin shipping prototypes to our customers. These are the steps that lead us towards commercialization. We expect to spend the rest of the year finalizing the building of the tubes, conducting tests, and preparing the specifications and data sheets to engage the OEMs.

Jim Sidoti, Analyst

Okay. And then in China, some of the other device companies that were reported indicated China was particularly slow the first couple months of the quarter because of some of the COVID shutdowns, and then got better in March. Did you see a similar trend?

Sunny Sanyal, CEO

We were not affected as much by the COVID shutdowns, because our customers somehow managed to keep their production environments going and so did we. We worked in the last two years, we came up with very flexible ways of accommodating our workforce, and that helped out. So, that we were fine with that. We didn't sense anything on that front.

Sam Maheshwari, CFO

Yeah. Jim, I would just add that, during the shutdowns we were not that much impacted in China. And so, as a result when things opened up, it's not that we saw a step up or anything like that. China has been strong continuously over a number of quarters here for us, and continued that way. So, we really didn't see much of a difference between January versus March, as far as China is concerned.

Jim Sidoti, Analyst

Okay. And then, the other trend that I've heard on some of the calls, for the quarter is that elective procedure rates seem to be very strong above 2019 levels. Do you think that's what's maybe driving some of the improvement on the hospital side? Do you think that maybe they're a little more likely to make capital purchases, now that they see their procedure rates sort of back up?

Sunny Sanyal, CEO

The sense we're getting from our customers is that the demand environment continues to be strong for them. They were jammed up with their ability to deliver, and so when we shipped products to them and they've also said, as I mentioned in the previous quarter, we were not the reason for their jam ups. So, when we shipped product for them and they're stuck because they're missing another bolt, and our components were stuck in there and their work in progress. So, as that freed up we - they were using up our products. And hence we saw, then our demand strengthen. So overall, we have only heard positive news from our customers about the demand environment.

Jim Sidoti, Analyst

Okay. I understand you mentioned you have $122 million in cash, but only $104 million is reflected on the balance sheet. Can you clarify what happened to the remaining $20 million? Is it related to prepayments and other current assets?

Sam Maheshwari, CFO

No, Jim. So on that one, the difference between the cash that we said and cash reported on balance sheet. You rightly picked up about $20 million or so. They are invested in treasury than others, such securities. And as per GAAP, it is called marketable securities or other security. So, they are elsewhere in the balance sheet. But for all practical purposes, it is cash and it is very low risk cash investments to pick up some yield on the interest income.

Jim Sidoti, Analyst

Okay, all right. Thank you.

Sam Maheshwari, CFO

Thanks, Jim.

Operator, Operator

Thank you. Our next question is from Suraj Kalia with Oppenheimer. Please proceed with your question.

Unidentified Analyst, Analyst

Hi, it's Shane, filling in for Suraj.

Sunny Sanyal, CEO

I appreciate it.

Unidentified Analyst, Analyst

Thanks for taking our questions, and congrats on a strong quarter. So kind of, given that other players also have photon counting detectors, how do you ensure the attach rates of various tubes of various detectors? Is there a mechanism or is it a kind of free for all mix and match?

Sunny Sanyal, CEO

Photon counting and the various ways they are purchased appear to be somewhat disconnected. Let me first discuss photon counting. These detectors are being utilized in industrial applications that span food inspection, electronics, battery inspection, and various other industrial sectors. In some cases, our industrial tubes are employed, while in others, they are not. Currently, there is no direct correlation between the performance of the detectors and the tubes. On the medical side, our photon counting detectors are integrated into certain medical applications, and sometimes our tubes are included. The approach we take with customers varies, but typically, there hasn't been a close link between the two. For our customers who are focused on CT detectors, many are our core clients who already use our CT tubes. This gives us the advantage of being an established provider. We are now approaching them with our photon counting detector technologies while optimizing our components to ensure they function well together.

Unidentified Analyst, Analyst

Okay. Thank you. Turning on a kind of inventory, we saw a down $6 million, I want to say $9 million or $10 million quarter-over-quarter. So kind of how should we expect inventory management for the remainder of the year? And, it's I know you've previously said that there's some higher inventory cost in there, so to speak, from higher component pricing. So, I guess, any gross margin boost as you kind of work through that over the year and if you could quantify that?

Sam Maheshwari, CFO

Overall, we are aiming to reduce our inventory levels further during the remainder of the fiscal year, which should positively impact our cash flow generation. Within our inventory, there are high-priced components that are currently affecting our profit and loss statements. As these high-cost components move through the system, we expect to see an improvement in gross margins. However, I estimate that this will be more noticeable towards the end of this calendar year, with some gross margin improvement anticipated starting in January of next year, once these components have fully processed.

Unidentified Analyst, Analyst

Thank you. And one last question from our end, what is the current status of the OEM evaluation of cold cathode?

Sunny Sanyal, CEO

Yes. So, we've continued to make progress on the technologies and we're continuing to ship the prototypes, the design prototypes, engineering prototypes to our customers. So, that's moving forward with our joint venture, and we are continuing to support them. And at the same time, the technology progress with our Micro-X technology is also moving forward.

Unidentified Analyst, Analyst

Thank you.

Operator, Operator

Thank you. There are no further questions at this time. I would like to turn the floor back over to Chris Belfiore for any closing comments.

Christopher Belfiore, Director of Investor Relations

Great. Thank you for your questions. Sunny, do you have any final comments?

Sunny Sanyal, CEO

Sure. In closing, we are very pleased with the second quarter results and encouraged by the demand levels and our growth prospects for the remainder of fiscal 2023. I am also very proud of the efforts our global employees make on a daily basis. Thank you for joining us today and for your continued interest in Varex.

Christopher Belfiore, Director of Investor Relations

Thank you, Sunny. And thank you all for your questions and participating in our earnings conference call today. The webcast and supplemental slide presentation will be archived on our website. A replay of this quarterly conference will be available through May 16 and can be accessed at www.vareximaging.com/investor-relations. Thank you.

Operator, Operator

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