Varex Imaging Corporation (NASDAQ:VREX) Q3 2022 Results Conference Call August 2, 2022 5:00 PM ET
Company Participants
Christopher Belfiore – Director of Investor Relations
Sunny Sanyal – President and Chief Executive Officer
Shubham Maheshwari – Chief Financial Officer
Conference Call Participants
Larry Solow – CJS Securities
James Sidoti – Sidoiti & Company
Suraj Kalia – Oppenheimer& Co
Operator
Greetings. Welcome to the Varex Third Quarter Fiscal Year 2022 Earnings Call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. [Operator Instructions] Please note this conference is being recorded.
I will now turn the conference over to your host, Chris Belfiore. You may begin.
Christopher Belfiore
Good afternoon, and welcome to Varex Imaging Corporation’s earnings conference call for the third 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 at vareximaging.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 third quarter of fiscal year 2022. In addition, unless otherwise stated, quarterly comparisons are made sequentially from the third quarter of fiscal year 2022 to the second 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
Thank you, Chris, and good afternoon, everyone. I’m happy to report very good results for the third quarter of fiscal 2022. Sales remain very strong reaching $214 million. Our supply chain initiatives began to show results in an otherwise challenging environment and enabled us to realize sales at the high-end of our guidance range. We saw robust demand for our products and continue to be excited about future growth.
Turning to our results, revenue in the third quarter was flat compared to the second quarter and up 2% year-over-year. Revenue in medical declined 2% sequentially, while industrial revenue increased 7%. Non-GAAP gross margin in the quarter was 35%, which was above our expectations. Price actions and productivity gains helped improve gross margins for the quarter.
Adjusted EBITDA was 36 million and non-GAAP EPS was $0.37. Our cash position remains solid at $110 million at the end of the quarter. Our balance was down $5 million sequentially, primarily due to continued investment in inventory to support growth in the current supply chain environment.
Let me give you some high level insights into the current demand environment based on a qualitative assessment of our different modalities and applications during the quarter. Medical segment revenues declined 2% sequentially and was flat year-over-year. Global demand for CT tubes remains robust as OEMs continue to bring new CT models to market to support global demand, particularly in China.
Demand was also strong in our other medical modalities, including fluoroscopy, oncology, radiography, dental and mammography. We remain optimistic about future growth as we continue to work through our supply chain challenges so that we are able to maintain a consistent flow of material.
Revenues in our industrial segment increased 7% sequentially and increased 8% year-over-year. Strong demand for our non-destructive inspection products continued in the quarter, with strength across many different products in our portfolio. We continue to see improvement in demand for high energy sources for security screening.
As we noted last quarter, an increase in tender activity earlier in the year signaled potential for future demand. Some of this activity resulted in sales during the quarter. We continue to see a healthy pipeline in security, especially in our cargo inspection business.
During our first quarter earnings call, we highlighted market growth opportunities in our medical segment. Today, I would like to provide a perspective on our industrial segment and share with you how we see this market segment and our business evolving overtime.
In fiscal 2021, our industrial segment revenues were $174 million or 20% of Varex sales. We estimate the current addressable market for our X-ray imaging components and the industrial segment to be about $1 billion, which we believe can grow at a 5% to 7% CAGR overtime. While the industrial segment has returned to pre-pandemic levels, our revenue growth has been slower than expected due to a slower pace of recovery in the security segment.
Earlier in the year when we had seen increased tender related activity we had anticipated that our orders would pick up later in the year. As expected orders for our linear accelerators which are used in cargo inspection increased in the third quarter.
We continue to see significant potential for our industrial non-destructive inspection portfolio products and believe that this segment can grow at mid to high single-digits over the next several years.
We expect five verticals within the industrial segment to be key to driving our future growth. These verticals are security, energy, food quality, electronics and consumer safety. These are not new markets for Varex, but our approach to them will be different. Historically, our focus across all markets has been to sell X-ray components like tubes and detectors to our customers.
However, as we introduce new technologies like photon counting detectors, image acquisition workflow, software and AI capabilities for automated detection. We intend to provide more integrated system solutions for these in industrial verticals. This approach increases our total addressable market in the industrial segment by nearly $1 billion by fiscal 2027.
Let me share some examples. In the energy verticals specifically in the oil and gas sector, we are offering a full workflow solution for pipeline weld and corrosion inspections. This solution incorporates our hardware components, image acquisition workflow software, as well as automated detection of defects using AI and computer aided detection.
Similarly, on the consumer side, we see a growing use of X-ray and E beam to inspect, sterilized or immediate consumer facing products like medical supplies, packaged foods, grains, as well as fish meat and plant products. This is a growing market and our high power X-ray sources and photon counting detectors can be used to inspect and irradiate, food and other consumer facing products.
We are in the early stages of development and introduction of these solutions to the market. We will share more details as well as customer reactions and feedback when we begin to conduct prototype evaluations.
In summary, in addition to our good results, I’m pleased to be able to say that our customers appreciate our efforts and remain confident in our ability to deliver on our backlog as they continue to place new orders. This was particularly apparent in China where our ability to successfully run operations, despite the COVID lock downs earned us recognition from one of our top customers in China.
Further in July, we attended European Congress of Radiology tradeshow referred to as ECR. This is a large annual event that is attended by global manufacturers who market and sell imaging systems in European markets, as well as radiologists and other imaging professionals from all over Europe.
The event was very well attended by manufacturers. We were happy to see that our recently launched dynamic detector product called Azure was prominently shown incorporated in a system by one of the leading manufacturers in Europe.
We were also happy to use some of our new LUMEN family radiographic detectors also presented by some manufacturers at this show. To-date, we have four OEM customers who are designing our as your Azure dynamic platform into their new systems and 10 others inactive evaluation and planning mode.
In addition, more than 15 OEMs are either already buying our LUMEN family or radiographic detectors from us or plan to do so in 2023. Every customer that I met thanked and appreciated the way our team has been working very closely with them and delivering our products to them despite all the materials shortages.
With that, let me hand over the call to Sam.
Shubham Maheshwari
Thanks Sunny and hello everyone. As a reminder unless otherwise indicated, I will provide sequential comparison of our results for the third quarter of fiscal year 2022 with those of our second quarter of fiscal 2022.
Demand remains robust during the quarter and our supply chain initiatives allowed us to ship more product compared to our expectations. As a result, we posted sales of $214 million, about $10 million above our guidance midpoint.
Non-GAAP gross margin was strong at 35% and withstood the inflationary pressure of rising material costs and logistics, supported by improved pricing and productivity benefits. Non-GAAP EPS was above the top of our guidance at $0.37.
Third quarter revenues were flat compared to the second quarter. Medical revenues were $167 million and industrial revenues were $47 million. Sequentially medical sales decreased 2% and industrial sales increased 7%. Medical revenues were 78% and industrial revenues were 22% of our total revenues for the quarter.
Looking at the revenues by region, Americas decreased 7% sequentially, while EMEA increased 1% and APAC increased 5%. Our local manufacturing and business development initiatives in China are performing well.
Our sales in China are comprised of product manufactured in China for China consumption, as well as exports into China from our other subsidiaries. China was 19% of overall revenue for the quarter, and year-to-date, it is 16%. Currently, our sales in U.S. dollars or roughly 75% of our overall sales, about 15% are in Euros, 7% to 8% are in Chinese Yuan, and the remaining in various other currencies.
Let me now cover our results on a GAAP basis. Third quarter gross margin was 34% 100 basis points higher than the previous quarter. Operating expenses were $50 million, up $6 million and operating income was $23 million down $4 million. Net earnings were $8 million and GAAP EPS was $0.20, based on fully diluted 41 million shares.
Moving on to non-GAAP results for the quarter. Gross margin of 35% was 100 basis points higher than the previous quarter driven by better materials related yields in our Salt Lake City factory.
Overall, we have been successful in mitigating inflation driven downward pressure to the gross margin by price improvements and sales volumes. R&D spending in the third quarter was $20 million, up to $1 million from the prior quarter. It was 9% of revenues within our targeted 8% to 10% range.
SG&A was approximately $27 million $5 million higher than the prior quarter. As a result SG&A was 13% of revenues. Operating expenses are $47 million, or 22% of total revenues, up $6 million from the prior quarter.
The increase in R&D and SG&A and therefore our operating expenses was primarily driven by higher accrual for compensation expectations for the fiscal year associated with the increase in shipments. I want to remind you that in the previous quarter, we recorded a credit associated with our incentive plan.
Operating income was $28 million, down $3 million sequentially due to the increase in operating expenses. Operating margin was 13% of revenue compared to 15% in the previous quarter. Tax expense in the third quarter was $6 million, or 29% of pre-tax income compared to $7 million, or 31% in the previous quarter.
Net earnings were $15 million or $0.37 per diluted share, similar to our performance in the second quarter. Average diluted shares for the quarter on a non-GAAP basis were 40 million. Please note that ASU 2020-06 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 receivables increased by $3 million, and DSO increased two days to 67-days in the quarter due to a higher proportion of product shipments late in the quarter.
Inventory increased $30 million as a result of supply chain related initiatives we highlighted on our last call. We are stocking larger quantities of parts and inventory and also having to pay higher prices for certain inventory items.
Compared to last fiscal year-end inventory is up roughly 33% of which 24% is due to quantity and 9% is due to cost increases. As a result, days of inventory increased 294-days. Accounts payable increased by $4 million as we procured more inventory and these payables was 54-days.
Now moving to debt and cash flow information, cash flow from operations was the use of $3 million in the third quarter, and we ended the quarter with cash, cash equivalents and marketable securities of $110 million on the balance sheet, a decrease of $5 million from the prior quarter. The decrease in cash was primarily due to the growth in working capital.
Gross debt outstanding at the end of the quarter was $451 million and debt net $110 million of cash and marketable securities was $341 million. Adjusted EBITDA for the quarter was $36 million and adjusted EBITDA margin was 17% of sales. Our net debt leverage ratio was 2.4 times at quarter end.
Now, moving on to guidance for the fourth quarter. Demand remains strong and we expect our supply chain initiatives to support higher shipment levels. Revenues are expected between $210 million and $240 million and non-GAAP earnings per diluted share are expected between $0.25 and $0.45.
Our expectations are based on non-GAAP gross margin in a range of 33% to 34%. Non-GAAP operating expenses in a range of $45 million to $46 million, tax rate of about 30% for Q4 and fiscal 2022, non-GAAP diluted share count of about 41 million shares.
With that we will now open the call for your questions.
Sunny Sanyal
Thank you, Sam. Before we turn to Q&A, I just want to add a quick comment. I would like to extend a warm welcome to Katy Bardwell, who we announced today has joined Board of Directors.
Katy is the former senior vice president of Regulatory Affairs and compliance for Steris Corporation, a leading provider of infection prevention and other procedural products and services. She brings our 35-years of audit and accounting experience coupled with an extensive background in the field of quality and regulatory affairs and she will be a tremendous asset to our board.
We look forward to working with you, Kathy. So with that Operator let’s open it up for questions.
Question-and-Answer Session
Operator
[Operator Instructions] Our first question is from Larry Solow with CJS Securities. Please proceed with your questions.
Larry Solow
Just like the first question on the supply chain initiatives. Sunny and Sam, maybe could you or you guys, sounds like you are assuming constraint on the revenue side and it’s seems to be that improving significantly. Are they there still – you know, where we stand today? Are we still more levers you guys to pull there or obviously, you are acquiring a lot of inventory. And that is benefiting you a lot. But other I know, you will qualify more suppliers and even changing some of the cost – excuse me, the actual material suppliers? Most of those issues, are they well on the way they are almost done now? Can you kind of just give us an idea of where we stand on that?
Sunny Sanyal
Yes, hey, Larry, this is Sunny. So we began with several initiatives a while ago, and there are a number of things. First of all, there are two categories you probably talked about situation with semiconductors and then the situation with electromechanical parts and components.
So on the semiconductor side, we are making very good progress on both with dealing with obsolescence and moving our products across to other semiconductors, that is going along well, and we have, you know, we bought purchased a lot of semiconductors as well, to make sure that we have access to them.
Where we have the hotspots where there were critical issues, those have been somewhat mitigated and what we the things that we know of we have done a lot of work against them and that is rolling forward.
There is still some unknowns there. And but those are – I think we are – I wouldn’t say we are out of the woods there, the semiconductor side is still tenuous, but we have at this point, we are seeing better flow of chips.
On the electromechanical side, it continues to be, I call it the newest situation where you, suppliers are, they are late. They are short shipping. That is continuing, and we are continuing with our diversification efforts there. So in summary, Larry, we are not out of the woods yet. But you know, we have done a lot of work and we are seeing some of the results of that worked.
Larry Solow
I appreciate the color and in terms of price increases, I know you guys put price increases, started putting them in, I guess, beginning of the fiscal year or November. And we are sort of anniversary that are coming close to that. And you mentioned, I know, inventory, which is just one component of what you are going to charge, but that is up 9%, like you said at least. So are you getting, I don’t think you are getting price increases quite commensurate with that 9% increase. So is there more to come? Are you still kind of chasing that in on is that still kind of her impacting overall performance?
Shubham Maheshwari
Yes, hi, Larry, this is Sam. We are continuing to increase the prices and as you know in our business, we work with our customers, they are on annual contracts, many of them. And so, as the contract come up for renewal, we are able to increase the prices and then based on the purchase order that have been placed in and after that when the new purchase orders are placed, they are getting placed at higher prices.
So we are definitely making progress on improving the prices. I just want to remind you, Larry that cost of 9% is on the cost basis. And we had announced mid single digit in that range type of price increases. And our goal was to mitigate gross margin impact from inflationary costs.
And so far we have been able to deliver that and it is our plan to keep on delivering on that. So price increases are definitely going through and there is more to go through and more to print on the P&L as a couple more quarters go by.
Larry Solow
Okay. Obviously, need to get your crystal ball out, but it does seem like as we go into next year, or your next fiscal year, likely, I feel like you guys will continue to raise price if you have to, so also to sort of rising costs are good?
Shubham Maheshwari
So of course, we will evaluate the situation as we see how the overall market forces as well, as you know, the inflationary situation is developing. So, yes, we will definitely be looking at it and assessing it on a dynamic basis.
Larry Solow
Okay. And then just the first question on the outlook for Q4, maybe the range has been narrowed slightly, but there is still a pretty wide range. And a lot of uncertainty, nothing’s changed in terms of the environment. Does seem like you guys have a little bit of a better grip on the on the supply chain stuff, which I think also was a big variable. So what was sort of the difference between the low end and the high end? Is it more of a, I think a previous course, was more of a supply issue. Is that still sort of the biggest variable or is there? The demand has a lot of room on the demand side?
Shubham Maheshwari
So as we look at the guidance for Q4, Larry, like Sunny said in the end, in your first question, there is supply chain related uncertainties, there is still trade related delays. So, we have made a lot of progress in supply chain.
And I would like to say that supply in situation seems to be improving. But I don’t think we are at a point where we can say that it is bankable, or it is for it to be baked into our go forward guidance.
So as we look at the situation, we still guide with supply chain uncertainty baked into our guidance. And that is what is forming the guidance range at this point. And so to the extent, there are some hiccups in the receipt of raw material or delays and receiving of raw material, we might be on the lower side of the range. And if we get more material, then we probably would be towards the higher end of the range.
That said, demand is so demand is quite strong, have a backlog went up even further in this last quarter. So the demand is there. It is just we got to get it completed and ship it to the factory.
Larry Solow
Got it. Thanks. I appreciate all the color.
Shubham Maheshwari
Thank you Larry.
Operator
Our next question is from Jim Sidoti with the Sidoiti & Company. Please proceed with your question.
James Sidoti
Hi good afternoon and thanks for taking the question. So just to follow-up on Larry’s question on the price increases, is it fair to say that where you have implemented those increases, it is sticking?
Shubham Maheshwari
Yes, hi Jim its Sam here. Yes they are sticking and we have been able to pass prices to our customers and at this point, customers are also accepting the price increases in the sense everybody understands where the inflation is, and for long-term partnership, they understand and those price increases are sticking.
James Sidoti
And you mentioned that prospects seem to be improvements for the industrial side, I think you called out cargo inspection, our oil and gas pipelines and food inspection. How do you respond to that are you increasing R&D for products related to those markets, are you adding salespeople? What do you do to capitalize on that potential?
Sunny Sanyal
Hey Jim this is Sunny. Industrial has broken out into many verticals, on the security side, we saw tender activity earlier in the year and we are getting orders, we had anticipated that those would turn into some orders for us. And we are starting to see those and that is where we see the pickup on the cargo inspection side.
There we have products that are already in place that are shippable. So really nothing more to be done there other than ongoing R&D, but really the deal there is we just need to ship against those and we are doing that.
In the other areas of the verticals like we talked about food inspection, oil and gas, we have let’s take one of the gas as an example in that segment, we have several products in fact, what I talked about, with the getting closer to the customers with full workflow solutions.
Those are already has – those have been rolled out to our customers are in that sales process of being vetted with our OEM customers. So that is in flight. And we expect that over the next several quarters those will start to convert into some traction with these OEMs.
And then in other areas like food inspection and irradiation, there we have R&D activity and investments that are in flight and will keep you posted on the progress in those areas, but we expect new products to be rolled out in those areas sometime or early to mid next year.
James Sidoti
Okay. And the last one for me, I mean, is there any reason to think that free cash flow should start to improve over the next three or four quarters as the supply chain issues start to subside? Is there anything that would prevent that from happening?
Shubham Maheshwari
Hi, Jim, Sam here. So, in the last couple of quarters as a specific decision of the drove increases in inventory in order to meet our customers demand and inventory has gone up and that is enabling us or putting us in a better position or situation to complete the product and ship it. So as go forward, the rate of inventory increase should slow down. And so, we should be able to generate free cash flow.
At the same time, the priorities for our caches, working capital, capital expenditures for the business followed by wherever we can, we would like to pay down the debt. So, those are the priorities we have sufficient liquidity Jim. We are maintaining $100 million plus cash which is what we have said that we want to keep for operating purposes. And then we also have line of credit, which is completely undrawn.
So I’m quite excited about the growth of our ability to grow because we do have the inventory and as the supply chain situation, like you said, improves a little bit here further or it becomes more bankable or more certain than we should be able to deliver higher sales and deliver more and generate more profits.
James Sidoti
Alright that is it for me. Thank you.
Sunny Sanyal
Thank you.
Shubham Maheshwari
Thanks Jim.
Operator
[Operator Instructions] Our next question is from Suraj Kalia with Oppenheimer& Co. Please proceed with your question.
Unidentified Analyst
I Sunny and Sam, this [Shane Eson] (Ph) for Suraj. Hey, so quick to start status of the OEM partner validation for the carbon nanotubes. Any update?
Sunny Sanyal
Yes, that is proceeding that is continuing on. And so we have got more OEMs engaged in those feasibility assessments. And then for the ones that have, that we had, we have been shipping more tubes to them so that that work is progressing and we are making steady progress.
These types of novel platforms take longer in our development cycle. So this will continue this way. And the OEMs, then take some time to formulate their designs, and then they move forward with their projects. Those are moving forward.
Unidentified Analyst
Got it. Thank you for that. How are you guys seeing the replacement cycle for the tubes in the tech and detectors. Is it slowing given upstream components shortages or being able to maintain steady?
Sunny Sanyal
The replacement cycle is consistent meaning tubes have a finite life. So once you know if a tube lasts a year, they are going to be needs that need to be replaced in the year. For us a replacement tube is no different from a new tube. So it is the same thing. So there is really no difference in our sales cycle or revenue cycle for replacement versus new tubes.
Unidentified Analyst
Okay. How is your roadmap look for getting back, getting to the 40% gross margin? Thank you for taking our questions.
Shubham Maheshwari
Sure thanks Shane. So, we have highlighted that our gross margin for the current business portfolio is around mid-30s. Mid-30 in the gross margin, and right now due to inefficiencies, supply chain related issues, freight etc, running higher, a little bit lower than that.
In terms of our roadmap to get to high 30s or closer to 40%. I think we would need a few new products to be released, which we have been working on particularly platitude nanotubes that you are shamed, and then also photon counting related products. So with those products, and then of course, also software as those products get released and they get adopted. We should see. We should see improvement in our gross margin.
Operator
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
Thank you for your questions and participating in our earnings conference call for the third quarter of fiscal year 2022. The webcast and supplemental slide presentation will be archived on Varex’s website.
A replay of this quarterly conference call will be available through August 16th 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 13731452. Thank you and good bye.
Operator
This concludes today’s conference, and you may disconnect your lines at this time. Thank you for your participation.
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