Earnings Call Transcript - VREX Q2 2022

Operator, Operator

Greetings. Welcome to the Varex Second Quarter Fiscal Year 2022 Earnings Call. At this time, all participants are in a listen-only mode. Please note this conference is being recorded. I will now turn the conference over to your host, Chris Belfiore, Director of Investor Relations. 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 2022. With me today are Sunny Sanyal, our President and CEO; and Sam Maheshwari, our CFO. Please note that the live webcast on this conference call includes a supplemental slide presentation that can be accessed at Varex's website twerximaging.com/news. 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 second quarter of fiscal year 2022. In addition, unless otherwise stated, quarterly comparisons are made sequentially from the second quarter of fiscal year 2022 to the first quarter of fiscal year 2022 rather than to the same quarter of the prior year. 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 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.

Sunny Sanyal, President and CEO

Thank you, Chris, and good afternoon, everyone. We continue to see robust demand for our products in the second quarter of fiscal 2022 and achieved sales of $215 million despite ongoing supply chain constraints. The current operating environment remains challenging with persistent supply constraints, inflationary cost pressure, and continued COVID-related shutdowns outside the U.S. While we continue to work to mitigate these headwinds, they impacted our performance in the second quarter, and we expect this to continue in the third quarter. Despite these headwinds, we remain focused on delivering on our backlog while investing in innovation and being the partner of choice for our customers. Turning to the results; revenue in the second quarter increased 8% sequentially and 6% year-over-year. Revenue in both Medical and Industrial segments increased sequentially. Non-GAAP gross margin in the quarter was 34%, in line with our expectations as price actions helped offset some of the cost increases. Adjusted EBITDA was $38 million and non-GAAP EPS was $0.37. Our cash position remained strong at $115 million at the end of the quarter. Balance was down $43 million sequentially, driven by a redemption of $27 million of our senior secured notes as well as working capital investments. Now based on a qualitative assessment, let me provide some high-level insights into the demand environment for our different modalities and applications during the quarter. Medical segment revenues increased 10% sequentially and 9% year-over-year. We continue to see robust demand globally for CT tubes. Demand was also strong in our other medical modalities, including fluoroscopy, oncology, radiography, dental, and mammography. In addition, all modalities posted improved revenues compared to the prior quarter and a year ago. Revenues in our Industrial segment increased 3% sequentially and decreased 6% year-over-year compared to a very strong quarter in Industrial last year. We continue to see strong demand for products for nondestructive inspection across several of our industrial verticals, including electronics inspection and aerospace applications. Similar to last quarter, we are experiencing improved demand for high energy sources and tubes for security screening. In previous quarters, we had mentioned that we had expected to see future demand as tender activity picked up. In the second quarter, we were pleased to see some of this activity translate into orders for us. In addition, we believe strong backlog at our customers bodes well for future growth in the security business. Last quarter, we provided details on some of our new products in the medical segment. We continue to see good traction with our customers and their response to our new products. In our tubes business, our high-performance X-ray tubes for cardiovascular applications continue to see good initial customer interest. One customer is getting close to a system launch, several others are evaluating integration and design options, and we continue to get positive reactions from additional OEMs. Our joint venture in Germany continues to make steady progress with nanotube technologies. As we noted in the first quarter, we signed a prototype development agreement with a medical customer, and we shipped the first multimeter prototype to an industrial customer. We continue to work closely with this industrial customer as they work on integrating the prototype into their system and also shipped additional prototypes to the customer during the quarter. In detectors, our Photon Counting technology continues to make progress and is currently being utilized or evaluated in a number of medical modalities, including dental, radiography, and mammography. Due to its high frame rate imaging ability, we continue to see Photon Counting adoption in in-line industrial inspection systems with automated detection. We are seeing increased orders from customers in Japan, Europe, and the U.S. for food inspection systems focused on foreign particle detection as well as analysis of food content. Towards the end of this year, we expect to see additional customers launch new systems utilizing our photon counting detectors in food inspection and in battery inspection. We have had multiple design wins with our Z Platform dynamic detectors now called Azure in Mobile C-arm and dental applications. We expect production of these systems and our product shipments to start ramping up in the second half of 2022. In addition, more customers are evaluating our prototypes with positive feedback. Separately, we're seeing good progress with the launch of our LUMEN series RAD detectors. We are excited to see that the LUMEN series is performing well and that several of our existing customers are migrating to this product. We expect to see more competitive wins with the LUMEN series. As we have talked about for several quarters, we continue to see robust demand across the business. Strong order momentum continues adding to an already solid backlog. Our customers' confidence in our ability to work through the current backlog through their issuance of new orders supports our expectations for our continued strong demand environment. Despite current COVID-related shutdowns in China, demand in China remains strong, especially for our CT tubes. Our investment in manufacturing capacity in Wuxi has enabled us to meet our Chinese OEMs' needs for local service and supply, which gives them a competitive advantage. We recently attended a medical imaging exhibition that is part of Japan Radiology Congress. We were happy to see that the conference was well attended by medical imaging OEMs, and we were able to connect live with many of our customers. Japan is a hub for many global medical and industrial imaging OEMs, and our discussions with them confirmed our perspective on the continued strength in CT and imaging systems for surgery. We also saw signs of demand recovery in the high-end cardiovascular systems, which had slowed down during the past two years due to COVID. The results of growing interest and acknowledgment of the potential for photon-counting technologies in medical imaging confirm that our investments in technology are on the right path. As you're all aware, supply chain challenges continue to be a pressure point for Varex and many other companies globally. We continue to operate in a hand-to-mouth environment for certain components like semiconductors and related electronics. This situation is further exacerbated by erratic vendor performance across the supply chain, which we expect will continue into the near future. Let me outline the measures that we are taking to respond to these challenges. First, we have increased inventory levels of key parts and materials. Second, we are redirecting our R&D efforts to redesign certain products and qualify new suppliers. Third, we are sourcing semiconductors from the spot market by paying higher prices. Fourth, we're prepaying certain vendors to improve the likelihood that we receive the material when we need it. Lastly, we moved shipments from ocean to airfreight and are using expedited shipping. These measures helped mitigate some of the supply chain constraints in the second quarter but at the expense of profitability. In summary, as we look forward towards the second half of the fiscal year, we expect supply chain volatility to continue. We're pleased to see robust demand for our products. Pending successful completion of supply chain diversification efforts, which are already underway, we expect fiscal 2022 to be another growth year for Varex.

Sam Maheshwari, CFO

Thanks, Sunny, and hello, everyone. As a reminder, unless otherwise indicated, I'll provide sequential comparison to our results for the second quarter of fiscal 2022 with those of our first quarter of fiscal 2022. Demand remained robust during the quarter, and we were able to mitigate some of the supply chain constraints in the last few weeks of the second quarter. This allowed us to post revenues of $215 million, which was $10 million above the midpoint of our expectations. That said, rising costs of raw material and logistics pressured gross margin offset by volumes being higher than expectations and our pricing initiatives. Non-GAAP EPS was near the top of our guidance at $0.37, which benefited from a credit to SG&A expense. Second quarter revenues increased 8% from the first quarter, helped by improved production towards the end of the quarter. Medical revenues were $170 million and industrial revenues were $44 million. Sequentially, medical sales increased 10% and industrial sales increased 3%. Medical revenues were 79% and industrial revenues were 21% of the overall revenues for the quarter. Looking at revenue by region, Americas increased 13% sequentially. EMEA increased 3% and APAC increased 8%. Overall, China was 15% of the revenue in the quarter. Let me now cover our results on a GAAP basis. First quarter gross margin was 33%, in line with the previous quarter. Operating expenses were $44 million, down $7 million, and operating income was $27 million, up $13 million sequentially. This resulted in net earnings of $8 million and GAAP EPS of $0.18 on fully diluted 42 million shares. Moving on to non-GAAP results for the quarter. Gross margin was 34%, in line with our expectations and similar to last quarter. Price improvement offset by higher costs helped us to maintain our gross margin sequentially. Trade expenses impacted gross margin by about 30 basis points compared to the first quarter and by 100 basis points compared to the year-ago quarter. Compared to pre-COVID levels, freight expenses are impacting gross margin by roughly 150 basis points as of now. Like previous quarters, we continue to qualify various alternate suppliers. And as a result, R&D resources were diverted towards mitigating supply chain issues. These activities impacted gross margin for the quarter by about 30 basis points. As we have stated previously, in late October 2021, we communicated broad-based price increases of mid-single-digit percentage or higher. Since many customers are on an annual contract, we expect to realize price increases gradually throughout fiscal 2022. At this stage, we are seeing traction with this initiative, and we continue to work with the remaining customers as their contracts come up for renewal. I want to reiterate that price improvement initiatives were launched to offset cost inflation and not an initiative to improve profitability. R&D spending in the second quarter was $19 million, up $1 million from the prior quarter. It was 9% of revenues within our 8% to 10% target range. SG&A was approximately $22 million, $4 million lower than the prior quarter. The decrease was related to a credit associated with our incentive plan. As a result, SG&A was 10% of revenues, demonstrating the operating leverage in the P&L. Operating expenses were $41 million or 19% of revenue, down $3 million from the prior quarter, driven mainly by lower SG&A. Operating earnings were $32 million, up $4 million sequentially. Operating margin was 15% of revenue in the quarter compared to 11% in the first quarter. Tax expense in the second quarter was $7 million or 31% of pretax income. Please note that we continue to target about 25% tax rate for the full year. Net earnings were $15 million or $0.37 per diluted share compared to $10 million or $0.25 per diluted share in the first quarter. Average diluted shares in the quarter were $41 million on a non-GAAP basis. We have provided a reconciliation between GAAP and non-GAAP shares at the end of our earnings press release. The appendix to our slides provides a table showing the effect of our bond hedge on the diluted share count for GAAP and non-GAAP purposes at different share prices. Separately, ASU 2020-06, which is related to the accounting for convertible instruments, will become effective for us from Q1 of fiscal year 2023 onwards. Now turning to the balance sheet. Accounts receivable increased by $27 million due to higher sales late in the quarter. Hence, DSO increased to 65 days. Inventory also increased $22 million as a result of our actions to stock larger quantities of parts and materials. This also included having to pay higher prices for semiconductors and prepaying certain vendors to improve the likelihood of receiving the material timely. As a result, days of inventory increased to 170 days. Accounts payable increased by $7 million and days payable was 50 days. Now moving to debt and cash flow information. Cash flow from operations was a reduction of $8 million in the second quarter, and we ended the quarter with cash of $115 million on the balance sheet, a decrease of $43 million from the prior quarter. The decrease in cash was a result of the redemption of $27 million in principal amount of our senior secured notes as well as an increase in inventory and accounts receivable. Gross debt outstanding at the end of the quarter was $452 million and debt net of cash was $337 million. Adjusted EBITDA was $38 million and adjusted EBITDA margin was 18% of sales. The combination of profitability and our solid cash position helped keep our net debt leverage ratio to 2.3x at quarter end. Before providing guidance, I wanted to take a step back and discuss broader revenue dynamics in connection with Sunny's comments earlier. Our Q2 revenue came in above the midpoint of our expectations. This was mainly due to receiving certain raw materials to complete product assembly towards the end of the quarter. This dynamic was the exact opposite of what we experienced in Q1, but somewhat similar to what we experienced in the fourth quarter of fiscal 2021. It illustrates the significant volatility in the current supply chain environment and in the face of strong demand will continue to influence our sales performance in the near future. However, we expect our supply chain diversification initiatives to progress further and reduce this volatility as we move past the third quarter. With that as a backdrop, here is our guidance for Q3. Revenues are expected between $190 million and $220 million and non-GAAP earnings per diluted share are expected between $0.10 and $0.30. Our expectations are based on non-GAAP gross margin in a range of 32% to 34%. Non-GAAP operating expenses in the range of $45 million to $46 million, a tax rate of about 25% for Q3 and fiscal 2022, non-GAAP diluted share count of about 41 million shares. With that, we will now open the call for your questions.

Operator, Operator

At this time, we'll be conducting a question-and-answer session. Our first question is from Larry Solow with CJS Securities. Please proceed with your question.

Larry Solow, Analyst

Great, thanks. It's CJS. Good afternoon, guys. Just on the realization of price increases, Sam, you mentioned sort of those price increases were put in, obviously, more on defense as opposed to offensive just to sort of cover your costs. Just a couple of questions there. So you mentioned most of these are annualized contracts. So I assume we're there kind of calendar '22, so we're not even halfway through the year yet or less than that, obviously. So perhaps you've done some of them, but hopefully, you still have some at least some wind at your back in terms of more price increase or benefit rolling through, but perhaps costs are even higher than you when you first start putting these in. So can you come back to the drawing board and maybe put more in? Or how do you look at that? And I sort of my assumption that you still have a good amount to go. Is that a fair statement?

Sam Maheshwari, CFO

Thanks, Larry. So yes, we communicated to our customers in October and then we started working with them on price increases. So that activity, like you rightly pointed out, began to kick in effectively from January of this year, and it is going on a rolling basis. So we still have more activity ahead of us. And as the contracts come up for renewal, we are able to get those increases. So in a way, as we mentioned that generally, we have these on an annual basis. So for the next round or phase 2 of it, the earliest it would be is October 2022, if we decide to send out the letters and monitor the cost at that time. So we will evaluate the situation at that time. But right now, we are very much into our, call it, phase 1. And we hope inflation subsides, but we don't really have a very good perspective right now. We will just monitor the situation and then act accordingly. But we are very much into the initial phase right now.

Larry Solow, Analyst

Sure. Regarding the impact of the supply chain on revenue, not so much on costs, it appears that the medical segment, which is a larger part of your business, has shown better growth as it recovers from COVID compared to the industrial segment. Is this mainly due to stronger demand, or is the industrial segment also facing significant supply issues?

Sam Maheshwari, CFO

I would characterize that both medical and industrial are kind of experiencing that type of issues; if you would notice, industrial for us is a 20% revenue type of segment. That has been that way for many, many quarters, if not years. And that has continued on. Here and there, Larry, for a given quarter, you might see a spot effect here or there. But other than that, from a thematic perspective, it's still 80-20 or 79%, 21% in terms of revenue split. And that's continuing. You might see plus/minus a percent here or there in terms of proportional revenue for the overall company. So they're both getting impacted similarly, of course, in the industrial business. We also have systems business, particularly on the security side. That business, there's been a lot of tender activity in that business recently. And when I say recently, I would say in the last 6 months, and Sunny mentioned that in his prepared remarks that we are seeing activity there. So we are excited about that piece of the business, finally beginning to come back from the COVID. So on that business, there's been a bit of a delay from COVID to resurgence from COVID, whereas the other business has kind of picked up right after COVID.

Larry Solow, Analyst

Okay, great. And for my last question, I appreciate the update on the R&D side. It sounds like there is good traction with a variety of new products. While it may not be a turning point yet, it seems that many of the larger programs are at least reaching the prototype stage, although there is likely still some time before mass commercialization. Overall, it appears that we are getting closer on several of these programs. Is that accurate?

Sunny Sanyal, President and CEO

The programs are moving forward. So our R&D programs are moving forward. They've continued to be funded. And what's encouraging for us is that on the customer side, there's also engagement and continued activity. A couple of years ago, some of that had slowed down, but we've seen now customers reengaged in earnest.

Sam Maheshwari, CFO

Thanks, Larry.

Operator, Operator

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

Suraj Kalia, Analyst

Good afternoon, Sunny, Sam, can you hear me all right?

Sam Maheshwari, CFO

Yes, we can.

Sunny Sanyal, President and CEO

Yes.

Suraj Kalia, Analyst

Perfect. Gentlemen, congrats on the quarter. Hey, Sunny, many, many calls going on at the same time. So please forgive me if you’ll have already mentioned this. Your core cathode, can you walk us through your regulatory approach? And any specific OEM feedback that could cause – that you’ll have received that might require some tweaking.

Sunny Sanyal, President and CEO

We provide components to our OEMs who integrate these technologies into their systems. Therefore, we do not file 510(k) or seek regulatory approval ourselves; our OEM customers handle that through their established processes and existing predicate devices. This is not something we actively pursue and does not significantly influence how we launch our technology. In terms of feedback, the OEMs are undergoing a process similar to what they use for our other tubes; they alternate between understanding the technology's capabilities and their requirements. The feedback we receive focuses on application-specific needs. The basic technology and multimeter tubes are functioning well, but there might be requests for a specific number of emitters, which is part of an ongoing, dynamic process as our customers design their systems. Currently, we are focused on two things: supporting our customers with their design needs and continuing to market this technology to other OEMs, while exploring applications we believe this technology can effectively serve.

Suraj Kalia, Analyst

Right. And Sunny, forgive, I should have been more specific about your end user regulatory approach. But – would it be an array of devices in terms of different configs on the number of emitters, KvP, so on and so forth across the board? And any update on the cycle testing, where you all are? Or are we pretty much done for the most part and its commercial launch, let’s say, X period down the line?

Sunny Sanyal, President and CEO

We conducted extensive performance characterization early on and shared updates over the last few quarters. We've moved beyond that stage and are pleased with the basic performance and capabilities of the technology. We understand the performance parameters of these tubes regarding dose energy, and there are no new updates to report in that area. Our current focus is on gaining acceptance and adoption of the technology. With a novel technology like this, it requires significant collaboration with customers to encourage adoption. We are currently in this phase, and once we have a few successful examples, we will be in a stronger position to drive demand generation because we can provide concrete case studies.

Suraj Kalia, Analyst

Fair enough. Sam, I have a question for you that I'll come back to later. I know you mentioned the lack of visibility in the current environment, and I appreciate your comments. At what point can you share your thoughts on inventory management, especially regarding LIFO, as gross margins are crucial to your narrative? How are you managing that so LIFO isn’t adversely affected, especially given the cost inflation? I’d appreciate your insights on any changes in your inventory management plans. Thank you, gentlemen, for addressing my questions, and congratulations.

Sam Maheshwari, CFO

Thank you, Suraj. A while back, we focused on improving our production and manufacturing processes to reduce inventory during the COVID phase. Since then, demand has increased significantly, but we've faced supply chain challenges. Currently, we're increasing our stock of raw materials and parts. On average, our inventory has risen, and it may continue to rise slightly. We're implementing several initiatives to ensure we have the necessary materials to meet customer demand. Additionally, we are placing larger, long-lead purchase orders with our suppliers, doubling the typical advance notice from 3 to 4 months. This approach enhances visibility with our suppliers, ensuring a steady supply of materials. However, our factory is currently operating inefficiently due to supply chain issues, which have caused disruptions and material shortages. We're working hard to navigate these challenges and are using our balance sheet effectively to meet customer needs.

Operator, Operator

Suraj, does that answer your question?

Suraj Kalia, Analyst

Yes, thank you.

Operator, Operator

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

Jim Sidoti, Analyst

Good afternoon, and thank you for the questions. The first one is regarding shipments for the three months of the quarter. They were heavily weighted towards the third month due to supply chain issues. Can you elaborate on that?

Sam Maheshwari, CFO

Hi, Jim, this is Sam. Yes, the shipments for the quarter were not linear, and they were tilted towards the third month of the quarter. And as a result, it caused AR to be high on the balance sheet. And yes, so last 2, 3 weeks of the quarter, we were able to get the material, finish it up, finish the product and were able to ship it to our customers. Yes.

Jim Sidoti, Analyst

And I assume there was a lot of overtime during that period. So that impacted the gross margin as well.

Sam Maheshwari, CFO

Yes. And as I was just answering, Suraj, yes. We do have overtime, we do have under time, all of that goes on, we need to have many times, we do both and complete the product. So all those aspects are covered when I say I mean when factories are running inefficiently. So yes.

Jim Sidoti, Analyst

Okay. And then the credit for SG&A, can you just give us a little color on what that was about?

Sam Maheshwari, CFO

Yes. So that credit was related to our incentive plans. And in this quarter, we looked at where the demand is versus where we are able to ship, there is a gap, and we looked at that and we looked at the performance of last year and this year, and we went ahead and adjusted for that and reestimated it, and that's what caused the credit on the P&L.

Jim Sidoti, Analyst

Okay. So we shouldn't expect that to continue in the second half of the year?

Sam Maheshwari, CFO

That is correct, Jim. It would be only for Q2. Outside of that credit, the operating expenses were in line with what we had guided to you and also in line with what Q1 actuals were and also pretty much in line with what we are guiding towards Q3. So the base outside of the credit, operating expenses are running around $45 million or $45 million, $46 million range.

Jim Sidoti, Analyst

Okay. And then Sunny made a comment at the beginning now that despite the supply constraints, he said you expected growth for the year. Is that top line growth or bottom line growth or both.

Sam Maheshwari, CFO

Jim, we are currently only providing guidance for Q3, but we are optimistic about achieving growth in both our top line and bottom line for the full year.

Operator, Operator

Thanks, Jim. We have reached the end of the question-and-answer session. And I will now turn the call over to Chris Belfiore for closing remarks.

Christopher Belfiore, Director of Investor Relations

Thank you for your questions and participating in our earnings conference call for the second quarter of fiscal year '22. The webcast and supplemental slide presentation will be archived on Varex's website. A replay of this quarterly conference call will be available through May 17 and can be accessed at the company's website or by calling (877) 660-6853 from anywhere in the U.S. or (201) 612-7415 from non-U.S. locations. The replay conference call access code is 1372-8899. Thank you, and goodbye.

Operator, Operator

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