Varex Imaging Corporation (VREX) Q2 2023 Earnings Report, Transcript and Summary

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. [Operator Instructions]. 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.

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.

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 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 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 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 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 the 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.

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 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 were primarily driven by strengthened CT. Please note there was a minor reallocation of revenue from 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 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 $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.

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

Great. Good afternoon, guys. I guess -- the first question I guess just from a high level. From last quarter, I think you kind of you singled out that the demand environment was softening a little bit. And it sounds like demand remained pretty strong. I know there's always been sort of this impact demand has been impacted or you couldn't serve all demand because of the supply chain issues, but I also felt like last quarter, you spoke to sort of a, supply chain but also caution on OEM partners and more importantly some caution from hospital purchasing. So, I'm just trying to parse out, has that kind of changed? What sort of driving -- what appears to be a better revenue environment, and kind of what we thought it was a couple of quarters back, but then it looks like there was sort of a little bit of a seesaw effect last quarter. If you could maybe just give a little color on that, that'd be great.

Yes. Hi, Larry, this is Sunny.

Hi, Sunny.

First of all, for the quarter, Medical met our expectations and with Industrial that exceeded our expectations. In general, what we saw, and we mentioned this the last quarter that many of our customers were having supply chain issues and that they had with moving through the -- having trouble moving through the factory. So, that gave -- that gave us the reason for some caution saying, okay, when will this clear up and what should we expect then in the subsequent quarters. What we saw in the quarter was our customers started to make progress. And as they made progress, the orders that then they placed with us started to grow. So, that increased our confidence in the second -- for the second half of the year. And secondly, for Industrial, we continue to see strength, ongoing strength. So, that's -- and that has continued on. In terms of the capital environment and that situation, there is still capital prioritization going on. But what we're sensing is that the hospitals are -- have been working hard to improve their financial situation, their profitability. And so, and to the extent that that continues even though they'll still continue on with their prioritization, it should improve, the capital prioritization situation. So, we're feeling better than we were, let's say, in the December, January timeframe.

Okay. And I think you kind of called out sort of low single-digit flat to low single-digit volume growth this year. I think you said last quarter, do you still are you sort of in -- I know you don't really guide the full year, but is that I mean, it feels like you're always at the higher end of that maybe not flat, but maybe more, low single could be 2%, 3% sort of semantics there, but I'm just trying to -- is that, the case that your demand maybe not switch in Q2, but going forward, it feels a little bit better, maybe that's more Industrial driven than Medical.

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 ‘20 -- FY 2023 over the prior year in the range of 3% to 5%.

Okay.

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.

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.

Yes, sure, Larry. A few things to unpack there. If you would remember, we had guided that in Q2 where we just reported results. There is a one-time $2 million --

Right.

Payment related to milestones --

Right.

And successful completion of that for Micro-X. So, that clearly is one-time that goes away in Q3. So, there is that benefit. And then in Q2, we also had like you were saying, we also had R&D material, whenever you're doing more R&D, there's a little bit more R&D material. So, there was a bit higher than expected R&D material spending. So, that also we expect to kind of trend down in this coming quarter, meaning in Q3. So, that's why OpEx is kind of going back into a run rate where I think that is sustainable. I would say that Q2 actuals on the OpEx are not the OpEx that I'm expecting going forward. It was just a one quarter high expenses that we had. Now, coming back to your comment on SG&A, travel has come back in this last quarter, we had full quarter of travel as well as meeting with the customers, the normal things are getting resumed, a few countries opened up for external visitors as well. So, I think SG&A in my mind would continue as it is, but R&D should come.

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

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

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?

So first of all, China has been on the 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%ish type of growth. So, you can kind of plot it in that -- along that trajectory.

All right, great, very helpful. Maybe one on gross margin. I was just wondering, so, some month 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?

Hi, Young, Sam here. Yes, I think in terms of gross margin, a few tailwinds we mentioned Industrial, which is a higher margin business, being a higher portion of sales. So that contributes 30 basis points, 40 basis points, 50 basis points to the overall gross margin number. But then we also benefited from freight. Freight rates have come down both on the ocean as well as air freight. We still need some work to do to move more of the freight from air to ocean. So, that should help. So, I think the freight related benefit, there's more to do there, a little bit more. So, that was that. Foreign exchange dollar, we can -- a little bit here in this last quarter compared to some of the major currencies that we trade in -- that we do business in. Overall, that was a very small effect. So, between all these two or three items, gross margins benefited in Q2. At this point as I look forward, I tend to agree with you that Q1 2023 gross margin are expected to be the low point. And going forward, I'm expecting gross margins to improve further. As some of the price cost drag that the P&L has that we work to balance that. So that should provide some help on gross margin. I'm expecting that freight and supply -- freight environment would continue to remain favorable. And as that happens, that should provide some more benefit to us. So yes, I think Q1 probably is the low point on the gross margin for us.

Excellent. Thank you so much.

Thanks, Young.

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

Hi. Good morning and I'm sorry, good afternoon, and thanks for taking the questions. On the Micro-X, the $2 million payment, so -- I assume that payment was as a result of them hitting some milestones. Can you just talk a little bit about, what the pathway to commercialize that product is?

Yes. Hi, Jim. The two milestones had to do with setting up of our lab here and completing the technology transfer around the bidder, and in building those here successfully by ourselves. So, those were completed and we're satisfied with how that went and so that's one. We are now in the middle of building out, doing what we do next, which is to build up tubes, with them characterizing and doing the necessary performance benchmarking and testing. So, once we have that, Jim, then we go down the path of starting to ship prototypes to our customers. So that is the -- those are steps, those are sort of the bread crumb trails on how we get to commercialization. It will take us the rest of the year to finish up the building of the tubes, testing them and coming up with the spec sheets and the data sheets, but then that would be used to engage the OEMs.

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?

We saw -- we were not affected as much by the COVID shutdowns, because our customers somehow manage 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.

Okay.

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.

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?

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 ship product for them and they're stuck because they're missing another bolt, and our components were stuck in there and their whip. 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.

Okay. Alright. And then the last one on cash, I think you said you have a $122 million, you only show a $104 million on the balance sheet, is the other $20 million or so -- and is that we prepaid and other current assets on?

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.

Okay, all right. Thank you.

Thanks Jim.

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

Hi, it's Shane, on for Suraj, actually. So --

I appreciate it.

Thanks.

No worries.

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?

So, photon counting, I think the two are disconnected in terms of how they may be bought, how they may be purchased. So, let me talk about photon counting, first, and I'll come back to your -- the guts of your question. So, photon counting are detectors are going into industrial applications, and they're fairly broadly dispersed across food inspection, across electronics, battery inspection, a variety of different industrial verticals. There in some cases our industrial tubes are used and some of the cases, our tubes may not be used. There's really no direct connection right now between the detector -- performance of the detector and the performance of the tube. So on the Medical side, our photon counting detectors go into some medical applications that are -- that have those designed in and in some of those cases our tubes are in there. So what depends on how we approach the customer, but inherently there has not been a tight connection between the two. With our customers that, where we are targeting with CT detectors -- sorry the CT detector market, these are -- many of these are our core customers and who have our CT tube. So, there we have the benefit of being an incumbent. So our tubes are already in there. We're going to them with photon counting detector technologies and optimizing our components to work well for them.

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?

Sure. So overall, Shane, in terms of our overall inventory balances, we are targeting inventory to tick down further during the rest of the fiscal year. So, we are planning and working towards bringing inventory amounts down. So, that should be positive from a cash flow generation perspective. And then, in our inventory, there is high price components, and they are rolling through the P&L, and as some of those high price -- high cost components roll through the P&L, we should see a gross margin pickup. But as of now, my estimate is that that would be much more towards the end of this calendar year. So, beginning from January of next year, we should see some gross margin pickup when those components have kind of moved their way across the P&L.

Okay. Thank you. And just last one from our end, and what's the current status of the OEM validation -- evaluation of cold cathode?

Yes. So, those are -- 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.

Thank you.

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.

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

Sure. Look, folks in closing, I'm -- we're very pleased with the second quarter results, and we're encouraged by the demand levels that we're seeing and our growth prospects for the remainder of fiscal 2023. And as always, I'm very proud of the effort of our global employees that they make on a daily basis. Thank you for taking the time to join us today, and thank you for your continued interest in Varex.

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.

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