Greetings and welcome to the Varex Imaging Corporation Third Quarter Fiscal Year 2018 Earnings Call. At this time all participants are in listen only mode. A brief question and answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Howard Goldman, Director of Investor Relations. Thank you, Mr. Goldman. You may begin.

Good afternoon, and welcome to our earnings conference call for the third quarter of fiscal year 2018. With me today are Sunny Sanyal, our President and CEO; and Clarence Verhoef, our CFO. To simplify our discussion, unless otherwise stated, all references to the quarter are fiscal quarters. Quarterly comparisons are for the third quarter of fiscal 2018 versus the third quarter of fiscal 2017, unless stated otherwise. Year-to-date comparisons are for the first 3 quarters of fiscal year 2018 versus the first 3 quarters of fiscal year 2017, unless stated otherwise. On today's call, we will discuss certain non-GAAP financial measures. These adjusted measures are not presented in accordance with, nor are they a substitute for, GAAP financial measures. We've provided a reconciliation of each adjusted financial measure to the most directly comparable GAAP financial measure in our earnings press release, which is posted on our website. 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 can cause actual results to differ materially from those anticipated. Additional information concerning factors that could cause actual results to materially differ is contained in our SEC filings, including Item 1A, Risk Factors of our annual report on Form 10-K for fiscal year 2017, and subsequent quarterly reports on Form 10-Q. 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. And now I'll turn the call over to Sunny.

Thank you, Howard. Good afternoon, everyone. Revenues for the third quarter of fiscal year 2018 were $191 million, up 12% from the prior year. With solid growth across all of our platforms. We had strong performance in our high end radiographic, cargo security, oncology and mammography product lines. And for the trailing 12 months, revenues from our connect and control and software product offerings were up double digits. Our Medical segment grew 6% to $143 million, which was lower than our expectations. During the quarter, we had strong growth from our new high end radiographic digital detector, and saw increased demand for our mammography X-ray tubes. However, late in the quarter, we experienced some unexpected softness in demand. Our initial assessment is that the uncertainty over tariffs caused some of our customers to delay shipments. We also saw lower demands from some of our Japanese customers in the quarter. Industrial segment revenues for the third quarter increased 36% to $48 million. This growth was primarily driven by additional revenues from industrial detectors used in nondestructive testing applications, and higher linear accelerator revenues compared to a light quarter a year ago. Despite apparent tariff related headwinds, China remains a key growth area for our CT business. Our Chinese OEM customers are in different stages of obtaining regulatory approvals and continue to make progress towards their product launches. We saw a nice increase in CT tube shipments to China in Q3, and expect that we will have shipped more than 400 tubes by the end of the fiscal year. We're now seeing that much of the ramp-up of CT tubes for China will happen in fiscal 2019, rather than the second half of fiscal year 2018. When you combine that with the uncertainty associated with tariffs and other factors, we now believe…

Thanks, Sunny. I'm going to focus the discussion on Q3 results, while the year-to-date financials can be found in our press release. I would summarize this Q3 as having good top line growth while our gross margins contracted due to some operational challenges in product mix, which were partially offset by a favorable tax benefit. Our year-to-date operating margins have not met our expectations. We are doing a detailed review of our business and cost structure and are focusing on reducing the cost of goods sold and SG&A expenses as well as prioritizing R&D projects towards those with the highest return on investment. Let me start with an explanation of the restructuring charges and the benefits we will incur going forward. We expect to ramp down the Santa Clara fab operations by the end of the calendar year. Decommission and sell the equipment in the first half of 2019 and book various restructuring costs over that time. The total amount of restructuring charges is expected to be $19 million to $23 million, primarily due to accelerated depreciation and the impairment of assets. Less than a net of $3 million of the charges are cash-based expenses, associated with employee and severance related costs, due to a partial offset by the proceeds from the sale of assets. We recorded $7 million of restructuring charges in the third quarter. As a reminder, in the second quarter, we recorded $2 million of restructuring charges for the closing of our London R&D site, which will be completed by the end of the calendar year. We expect to gain $10 million to $13 million of annual cost savings from the restructurings. The majority of these savings will improve gross margin, and we expect those to take effect in the second quarter of fiscal year 2019. We…

[Operator Instructions] The first question is from Anthony Petrone, Jefferies. Please go ahead sir.

So maybe just jump in right into the tariff impact that you talked about on the call here. And maybe just a little bit on, it seems like there's a timing aspect here just on timing of order flows. I'm just also wondering, as the debate goes on between the two administrations, is there a potential for the OEMs to sort of push back and renegotiate on price in order to absorb the tariffs? And then I have a follow up.

Anthony, this is Sunny. Let me take the first half. Timing. We have normal seasonal fluctuations in our business that's always there. But if I just take the midpoint of where we were before and the midpoint of our current guidance, I'd say about roughly -- of the difference in the revenues there, there are three major factors that impacted our revenues. First one was the delays in China CT; the second one was the late in quarter softness due to tariff concerns; and the third one was some softness by the Japanese customers. The softness of the Japanese customers, I would ascribe to just pure timing. This happens seasonally, they adjust their revenues, look at their needs. That's a normal course of business. The delays due to time, tariffs, that is mostly anecdotal. It's a pause we've seen. We've had lots of discussions with many customers. We're just in the process of -- they're just trying to assess what is going on? And what their strategies will be? So there is really no -- we didn't see any change in demand, we didn't see, we didn't hear anything about changes in plans. It's sort of a pause while they figure out what their strategy is as they're trying to figure out what actions they would take and how they would like for us to react. So there, I think there is a timing issue. We expect that things will settle down for them once they've cleared things up. But we're looking at probably 60 to 90 days of this kind of a modeling around. Although we haven't figured out exactly what their strategies are going to be. On the China delay, it's a -- that's attributed to their normal delays in product development process. We haven't seen any shift…

Okay. So -- and just last one for me just stay on tariffs. The one impact is, again, end products, sold by China OEMs into the U.S. clearly facing an impact, but also there is other materials that are input components from Varex, metals, steels. How does that play in just from a tariffs standpoint? I'll get back in queue.

Sure. Anthony, this is Clarence. So the impact -- direct impact in our gross margin, 20 basis points, which is that tariff on steel and aluminum, that was coming in from various countries. And then there was an additional group of tariffs that were done on July 6, where imports coming in directly from China. And we have some product that we import from China and that has another -- a bit of impact, and that's included in that 20 basis points. I think, the more important part as we go forward is this -- as there's a lot of discussion going on about the next round, and I think that's part of what's causing a little bit of the uncertainty because as you look at the next round, it starts to more be direct impact to us in that -- there will be -- there's a large group of items that have been proposed as tariffs by China in response to U.S. actions. And that group includes some medical components. So some of the components that we would be importing into China would be subject to the tariff. The -- we're still going through a lot of work right now to understand whether our products specifically are applicable there because there's a long list of all these different HTC codes for every part that -- you need to understand if your part is that -- under that code or a different code. The one thing I would say also though, is this, so far, CT tubes are not on that list. So that's -- which is a very significant thing as we talk about where the market is going in terms of what we're developing with the OEMs going forward and the outlook for 2019 when we get to that point is going to -- this so far is not -- has not fallen into that realm of risk.

We have a question from Mr. Larry Solow, CJS Securities. Please go ahead.

Just trying to connect the dots a little bit from a business that supposedly has pretty good annual sort of visibility to how -- you can have to -- sort of, pre-material drop in -- if there's only one quarter left in the year. I get the -- sort of the reasons, but it sounds like that the tariff one, you're -- there's no direct impact on your products or minimal? I guess, some of these OEMs may be are -- have other impacts from other directions, so they are maybe taking a pause. But you sort of mentioned that, that's anecdotal. So I'm just trying to figure out, is this may be -- certainly tariffs are impacting it, but you're cutting as much 5% on one quarter. So that's a much more a material impact. And some of the stuff seems anecdotal, and we know you were trailing significantly on detector piece from early on in the year, and supposedly did this huge bottoms-up analysis and had comfort in your customers reaching that by year-end. So it seems like the tariffs almost is, I hate to say, a convenient excuse, I'm just a little bit confused.

Yes. So Larry, I'll take a shot at that because I think it is -- you touched on a very important part, which is that -- we had a soft first quarter. And then, we had nice recovery in Q2 and good recovery in Q3. I mean, this is not about quarter with a 12% growth. But when we look forward what we didn't see is the ability to catch up what we had missed in the Q1 anymore. And this is -- and I mean, very simplistically, I look at it as is a -- let's just say a $30 million drop in our guidance for the year in terms of -- if I use the midpoints of what we had said before versus now, it's the $30 million. And I can put it into three categories. Third, third, third very simplistically. Third tied very directly with the impact of the tariffs, and what we're just seeing is uncertainty in the market. Third with just the timing of the CT shipments. I mean, that is not business that is gone away in any way, whatsoever. It's just a matter of about the timing. And we were aggressive and optimistic, as that was going to be one of our elements that was going to help us catch up from the Q1. And it just hasn't happened. It's going to happen in 2019. And then the last third, is a little bit of just not having the other offsets. So a little bit of softness with the Japanese OEMs. I don't think that's a large number. And then a little bit of flattening of the dental business and where it's gone and that is not in -- we haven't seen the same growth rate in that business as we have seen in prior years. And that's another item that was going to help us get the little bit of the catch up from Q1. So pretty granular, I mean, I guess, in terms of explaining. But I just wanted you to understand a lot about what happened from Q1 till now.

And then a follow-up. It's just on a -- just to this quarter, in particular. So you actually -- your revenue number actually didn't meet my expectations or slightly less. The mix is a little different, but it's still a little more in the industrial and a little bit less on the Medical side. But just in terms of gross margin, you had this aspiration of hitting 39% in the back half of the year. I mean, you haven't hit that number, I think, since you've gone public, but you sounded pretty confident that you would hit it. The operational challenges that you refer to, what sort of -- is this something that maybe -- it's just part of the business and you can't overcome those? And what -- sort of what caused the impact this quarter? And what gives you confidence that eventually you can get back up to your number. You just had your 5-year planning, I assume your gross margin outlook is probably hasn't changed. So how do you bridge that gap?

Yes. I think, your -- it's a very good question, Larry. Our goal still is to get 38% to 40%. And I do see a path to get there. When I look at this year though, and say, okay, why are we're at 36% when a couple of years ago we were at 40%. And it's a couple of different things. So in the Industrial segment, particularly, in the cargo space, mix of what we sell there actually has a significant impact. So we are at the lower end of the mix range right now in terms of what we're selling, little less of the better margin NDT applications and little more of the cargo security kinds of stuff. So that's part of why industrial margins are down 4 points. And then in addition, I mean, there's been some manufacturing costs in that operation that have been a bit of a disappointment, I would say, and a bit of a surprise by the team there, that are not ongoing kinds of things but they occurred this year. And then, on the Medical side, the bigger factor, I guess, really is this fab that we have in Santa Clara is costing a fair amount of money to us right now. And so we lose a bit of margin just because of that. I mean, when I look forward, and say okay, what's the impact as we do the restructuring and we close down that fab, we're talking about north of a point of margin improvement overall for the company, just with the benefit that we get from closing that fab. So it's one of those actions that will help us get there going forward. I would -- I want to go a little bit deeper here, which is just as I've…

Over the next couple of years or went -- what is that a [indiscernible]...

Yes, I'm not going to give you FY '19 guidance. So, I’m going to ask you to wait a quarter before I get to that point.

We have a question from Mr. John Koller, Oppenheimer & Co. Please go ahead sir.

So a couple of quick questions. If you can help out on the digital detector side. If you can talk about mix, I think, it was sort of alluded to earlier on the dental business, and I'm also curious about radiographic and the lower end of that product line. Where you're seeing pricing and volumes? Just to get a better idea.

Yes. So three things. So let's say, the start of the radiographic. And the radiographic we had favorable mix this time. We resold in our newly introduced high-end radiographic detector did very well. And the margins there are a lot better than the low-end. So we continue to push ourselves in the high-end where there's more value added and more electoral property. And so when we sell more high-end radiographic detectors, we will see a favorable mix there. The dental detectors, the margins there are consistent. There the volumes have been flat for us this year. So that we haven't seen much of a growth, we're expecting a flat year this year. So it hasn't helped in the mix. It hasn't necessarily hurt that much either. The dental margins are good, because these are high-end dental detectors. We sell more, we end up with a better gross margin. So overall, on the detector side, we did well from a mixed perspective this quarter. I think, let me leave you with that.

So and then to get back to R&D and margins and stuff. I guess, I'm struggling here because it seems like you're making some investments for the long-term, and I applaud that and I think that's great. But it also seems, and I know the timing is the timing and you supply OEMs you don't have complete control, but it also seems like cost structure is, kind of, gotten away. And I'm curious the Santa Clara, [indiscernible] silicon, I assume that was somewhat planned from the beginning. And I'm just curious, I mean, what steps do you think you can realistically take to get margins and R&D spend and SG&A expense back in line? I'm not talking about targets to 40%, I'm just talking about stable, for example?

I understand the question, John. And maybe, I'll even go one step further here, and just kind of walk a little bit through our operating profit profile. Because our targeted number there is to be at a 20% operating profit. And right now, I mean, for the year-to-date, we're around between 10% and 11%. We'll probably finish the year at 11% somewhere in that kind of range, which is well south of where we were a few years ago. Yes, we are investing in R&D right now, so we're going to be between 10%, around 10.5% or something in that kind of range on R&D. That's a period of time that you do that as you're ramping up very significant projects like what we're doing with CT tubes for China. That doesn't mean that's -- where it goes long-term, I think we've talked about being in the 8% to 10% range. As we look forward, we will be coming off of the 10.5% that we're at right now and be reducing that somewhat going forward. I think, I talked a little bit about the gross margin profile, that's going to be obviously one of the other factors, but then SG&A is the one where -- this is under our control as well. I mean, I think, how much we invest in R&D is one of items on our -- under our control, and then SG&A as well. So I think that we got a little bit ahead of ourselves when we look at the expectations that we had for revenue, and you end up building some of your spending plans, accordingly. And we're going to make some corrections of that and make some adjustments of that. Now some of this when you start to look at consolidating operations and the like those are opportunities to do that, but we'll look very closely at how much we're spending in consulting services and the like as well. So those are -- I still do believe that we have a formula to get back to the 20% level. Now that one I know I can tell you very definitely it's not going to happen all in FY '19. But it is -- I do have confidence that we will get back to that level and head the direction -- in the opposite direction where it went in the last couple quarters.

The next question is from Francesco Faiella, Sidoti & Company.

Just to go back to the tariff uncertainty. I was wondering if there was more of an impact on stuff that was in the pipeline that's maybe getting delayed to pull the trigger and getting an award or stuff that's you've been awarded. That's going to maybe push back or after some combinations?

No. So just to clarify, there's a direct impact, which is as Clarence mentioned, it's a small amount, it's from our suppliers. The indirect impact is not -- does not relate to us, our importing components or our products into China. It's the impact -- the impact to us is through softness in volume from our OEMs. And it's not clear to us whether that's -- that to me, that's more of a timing problem. So what we have in the pipeline, what our customers have agreed to buy from us. Our expectation is that they will buy, because these are engineered into their products. They are just not -- they don't have the ability to switch this -- switch us out that way. This is more of, they're trying to figure out what their actions are going to be, and whether -- how they're going to manage the routing of their products, production of their products going forward. So it's more of an inventory timing adjustment.

Got you. That's helpful. And then just another quick one. I know acquisitions have always kind of been a strategy for you guys but it seems like maybe there's more focus? And then I'm wondering, if it -- can we think about that as more diversifying into the industrial side? Or do you want to keep -- was just wondering about the general plans, and if anything change there?

Yes. But nothing is changed there, as we've described in the past. Our business has two sets of opportunities. One is consolidation. Consult the competitive consolidation. And second one is adjacencies. There are many components manufacturers or small manufacturers, mostly private companies. Like they claim out in Mavis example that I used. We'll be looking for those. We've been -- we've an active pipeline, we have an active process. The PerkinElmer acquisition was operationally pretty significant for us and consumed all our management bandwidth, but the integration is very quickly getting behind us. And by the end of December, pretty much the bulk of the integration, operational integration will be completed. Just opens us up, both from a management bandwidth perspective as well as on the debt side, I know Clarence would like us to be in the 2 to 2.5x times range, and we're getting there rapidly. So our appetite to do more is increasing.

We have a follow-on question from Mr. Anthony Petrone, Jefferies.

So just a question also on currency kind of dollar's stronger here. Is that compound sort of headwinds for your customers? Obviously, they're forced to convert into dollars from their local currencies in order to purchase tubes and X-ray and detectors and the like. So just wondering how the strength in the dollar plays out as you head into 2019?

My take on that, Anthony, is, is that, it has to do a pretty big move before it becomes a significant event with our customers. And so where we saw that three years ago then it was to a point where it triggered a lot of discussions about pricing. But so far, it has not been a topic of conversation, it has not triggered any conversations. And it just hasn't moved enough to make it an event.

We have a follow-up question from Mr. John Koller of Oppenheimer & Close. Please go ahead.

When you talk about the delays in the CT tubes, and I'm not asking for 2019 guidance, but when this comes back, do you see this as additive? Or replacing business that you would've seen in 2019? In other words, are we talking about pushing the whole chain back? Or do you think you can double up a few winks?

No. We don't think this will push the chain back. This is -- when the customers are -- if you look at the time-to-revenue cycle for us when customers start their engineering development work, they buy a few prototypes. And until they get to the next milestone, they kind of hold off in the -- so as they progress through their development stages, they consume certain amounts of tubes. When they start their clinical trials and pilots then they consume a little bit more. And when they launch, that's when the sharp ramp-up in volume occurs. And it's usually modest in the first year, and then it hits peak within the two to three year timeframe. So with that timeframe in mind, a slight delay in their engineering activities doesn't necessarily imply anything more than the fact that there's a little bit of volume timing, but tied to some -- the smaller -- in early launch type of activities. So we don't think there's a material impact of this in 2019. And nothing moves out, not much moves out either from the back end of 2019 on this. We've seen our customer's plans. We continue to review our customer plans. We don't see any shifts in their major launch dates or their programs. And the customers that we're working with, they have multiple products, many different CT models for different tiers: the high end, mid-tier, low end. So they're juggling many projects at a time.

Okay. And then a comment on the acquisitions. And I mean this in with the utmost respect, I'm not trying to be derogatory in any way, but to some extent you kind of have to earn the ability to go out and spend more money -- shareholder money. As a shareholder, this important. And you have to get the returns up on the existing business, I think, before I feel comfortable that you can go out and continue to do acquisitions. Even if they're sort of tuck-ins. And I'm curious, if you understand what I'm trying to drive at here, and if you see that or if you think that the acquisitions, albeit tuck-ins or whatever are still top of lists of things to do.

So John, let me just pick one small comment to that, and I'll ask Clarence to comment on it. Just the 3 that we've done, their returns on those have exceeded our expectations. So in general, acquisitions, I realize are risky, but we've done really well with Claymount, and PerkinElmer continues to deliver very well both on the -- so in terms of return on investment whether you do it organic versus inorganic in this case all 3 returned superior returns whether you call it or even whether we look at from an organic perspective compared to organic investments as well. With that said, I'll ask Clarence to comment on how we see this use of cash.

Well, and I think I hear what you're saying John, which is somewhat of -- and to me, it's a little of a question about management distraction and management bandwidth. And certainly, acquisitions take a lot of energy and a lot of time. And you -- part of what you're saying and part of what I'm hearing is, look, you got to make sure that your house is in order and everything is working well on your fundamental business before you want to spend management energy and time on doing integration of a large acquisition. At the same time, I think there are opportunities out there, the tuck-in types that are not at the level of big management distraction that actually can deliver very significantly. And we will be looking at those.

Adjusted EBIT coverage, I think, it's what 3.5x on a...

Yes, right now, we're about little bit under 3x, just barely of EBITDA.

So I mean, what level do you think you start to get comfortable that you can go out and spend some money there?

Well, we generate $60 million to $80 million of free cash flow. So I mean, it's on an annual basis. And so -- I mean, tuck-in acquisitions can be done today, I mean from that perspective. It's more about a sizable -- anything of size and substance that would be a -- that's a different discussion.

Gentlemen, there are no further questions at this time. I'd like to turn the floor back over to you for closing comments.

Thank you, everyone, for your questions and participating in our earnings conference call for the third quarter of fiscal year 2018. A replay of this quarterly conference call will be available from today through August 16th and can be accessed at the company's website or by calling 1-877-660-6853 from anywhere in the U.S. or 1-201-612-7415 from non-U.S. locations. The conference call access code is 13681647. Thank you and goodbye.

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