Varex Imaging Corporation (VREX) Earnings Call Transcript & Summary

Greetings, and welcome to the Varex Imaging Corporation First Quarter Fiscal Year 2020 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Howard Goldman, Director of Investor Relations. Please go ahead, sir.

Good afternoon, and welcome to our earnings conference call for the first quarter of fiscal year 2020. With me today are Sunny Sanyal, our President and CEO; and Clarence Verhoef, our CFO. To simplify our discussions, unless otherwise stated, all references to the quarter are comparison for the first quarter of fiscal 2020 versus the first quarter of fiscal 2019. 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 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. Outlook for our net earnings per diluted share is provided on an adjusted basis only. This adjusted financial measure is forward-looking, and we are unable to provide a meaningful or accurate compilation of reconciling items to guidance for GAAP net earnings per diluted share due to the uncertainty of the amount and timing of the unusual items. 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. 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. And now I'll turn the call over to Sunny.

Thank you, Howard. Good afternoon, and welcome. We started off this fiscal year with strong top line performance in the first quarter. However, our profitability was below expectations due to a number of different factors that Clarence and I will review with you. Revenues in the first quarter were up 8% to $200 million from $186 million in the same quarter a year ago. Direct Conversion contributed $5 million in the quarter. On a segment basis, medical revenues increased 8% and industrial revenues increased 6%. Our revenue growth was driven by higher global sales of CT tubes and products for oncology, dental and airport baggage screening applications. Partially offsetting these gains were lower sales of radiographic digital detectors and mammography products. Growth in our Industrial segment in the first quarter was once again led by strong demand for our industrial CT tubes for airport baggage screening applications. To give you some color, according to third-party research, the global market for these airport screening systems is projected to grow at the rate of more than 5% compounded annually over the next 5 years and reach $4.3 billion by 2023. Stringent security regulations and the need for improved throughput has been driving the demand for CT systems for both checked and carry-on baggage screening. Over the coming years, we expect that most airports will replace older systems with more sophisticated next-generation CT systems that offer 3D imaging and automated threat-detection capabilities. In nondestructive testing and inspection, we continue to ship linear accelerators for imaging applications in the aerospace, defense and manufacturing verticals. During the quarter, we also opened a new office in the Houston area to be closer to and better serve customers in the oil and gas vertical. We have several new products for this vertical moving through development phases and expect to talk more about them in the coming quarters. In our Medical segment, we had strong global sales of CT tubes as well as an increase in sales of oncology and dental products. In particular, dental detector revenues increased double digits from the prior year quarter and have grown sequentially over the past 4 quarters. We also announced this afternoon that Varex has renewed its 3-year pricing agreement with Canon Medical Systems for calendar years 2020 through 2022. This agreement extends our multi-decade long relationship with Canon Medical through which we continue to supply our CT tubes and heat exchangers for integration into Canon Medical's CT imaging systems for the global market. We estimate potential product sales during the term of this renewed agreement to be approximately $385 million. In addition, through separate agreements, we also supply Canon Medical with our digital detectors and high-voltage connectors. We're also happy to say that since the beginning of this fiscal year, we have renewed a number of additional multiyear pricing agreements with key customers. To give you a frame of reference, these customers, including Canon, represented more than 50% of our Medical segment revenues in fiscal year 2019. These agreements reinforce the long-term nature of our partnerships with our customers. In China, our local OEM customers continue to make progress in bringing their new CT systems to market, and we expect that our unit volumes will continue to grow this fiscal year. This growth in China, along with rest of world activity, contributed to overall growth in our global CT tube sales during the quarter. As a reminder, most of the CT systems in China are new placements that expand our global installed base of CT tubes. As the installed base grows, we expect to benefit from sales of both the initial CT tubes that are incorporated into the new systems as well as multiple future replacements over the life of the systems. During the first quarter, our Wuxi facility manufactured and shipped its first orders of our new locally made radiographic digital detectors for both local Chinese OEMs and global OEMs at factories in China. We shipped a number of prototypes to existing and prospective customers, and early feedback has been positive. We also recently signed a multiyear contract with the dental OEM customer based in China, and we will be supplying them the detectors from our Wuxi facility. This new customer is just one example of dental OEMs that are launching new systems in China, and we look forward to the prospect of working with more of these potential customers in the future. While we're talking about China, let me give you an update on how the coronavirus outbreak has impacted us. As a point of reference, our facility in Wuxi is located about 450 miles east of Wuhan and about 90 miles west of Shanghai. Like many other manufacturers in China, we have temporarily put a hold on operations at our facility in Wuxi and shifted manufacturing to other locations to cover current demand. While this has certainly been a concerning time, I'm glad to report that as of today none of our employees have contracted the virus. We currently anticipate being able to reopen our factory next week and look forward to resuming production. Somewhat in response to this major health event, we have seen early signs of some increased near-term demand for our CT tubes and radiographic detectors that are incorporated into diagnostic imaging systems used for screening this type of respiratory disease. We will continue to monitor the situation closely. Marketing efforts in our Medical segment are paying off. In December, we attended RSNA, the largest trade show event of the year for the medical imaging industry, where we showcased and discussed several new technologies and innovative products. These included our Z Platform digital detectors, nonglass flexible substrate detectors, photon counting detectors, liquid metal bearing, cardiac and CT tubes and nanotube x-ray tubes. We also exhibited in the new AI Pavilion where our software team demonstrated artificial intelligence capabilities to autonomously detect and discriminate meaningful artifacts and x-ray images for lung screening and liver and dental applications. Overall, RSNA was a busy show for us, and we came away with a good number of meetings scheduled with prospective customers that want to discuss ways our new technologies can be incorporated into their next-generation x-ray imaging systems. We expect these new technologies to be a significant competitive differentiator for us in the future. Before I turn over the call to Clarence, let me provide you with some high-level comments regarding our gross margin, which was lower than expected in the first quarter. Quarterly variation in gross margins is not unusual for us. Our adjusted gross margin rate has ranged from 33% to 38% over the past 8 quarters. This is primarily caused by changes in product mix, volume or productivity and could also be due to timing of customer pricing changes and product cost reduction activities. We are in competitive markets that have varying levels of price erosion, particularly with digital detectors. To offset this, we have ongoing programs to lower our cost structure by optimizing our supply chain, redesigning products for cost effectiveness and improving factory productivity and product yields. A separate and significant opportunity for improvement relates to the previously announced closure of our Santa Clara facility and related transfer of operations to Salt Lake City and other Varex locations. We had expected to be able to stop production in Santa Clara by the end of calendar year 2020. Good progress has been made by the team, and we now expect to pull the closure date in by a full quarter with some ramp down of operations in the fourth quarter of fiscal year 2020. With that, let me hand over the call to Clarence to talk about our financial performance in greater detail.

Thanks, Sunny, and hello, everyone. Let me follow-up on Sunny's comments about the Santa Clara closure. As we get closer to completion of this project, we now have a better view on timing of its financial impact. Previously, we indicated that the net annual benefit from the closure would be in the range of $21 million to $27 million, beginning in the second quarter of fiscal year 2021. We have already received some of that benefit by closing the glass fab portion of the facility in the first half of fiscal year 2019. By now pulling in the closure date for the rest of the facility, we expect to receive a full year of benefit in fiscal year 2021. Last quarter, we indicated that there would be $0.05 to $0.07 of EPS impact in fiscal year 2020 for the overlapping cost of the transition from Santa Clara to Salt Lake City. The pull-in of the closure date allows us to offset these overlapping costs within this fiscal year and helped to maintain our gross margin expectations for the full year. Now turning to the quarter. We had good revenue performance, while both gross and operating margins were weighed down by some onetime events. In particular, we had an additional week in the first quarter. Fiscal year 2020 is a 53-week year for Varex, with the first quarter being 14 weeks instead of 13. This impacted a number of items throughout the P&L in the first quarter. The good news is that in the added week delivered some additional revenues, however, the extra week contained a number of holidays, which had a negative impact on productivity, while we also had higher operating expenses due to the additional week. For the first quarter, revenues were $200 million compared to $186 million in the prior year quarter. Medical revenues for the quarter increased 8% to $156 million, and industrial revenues increased 6% to $45 million. For the first quarter, our gross margin was 31% compared to 32% in the prior year quarter. Medical segment gross margin declined by about 3 points. During the quarter, we had lower productivity in our factories with the added holidays and a physical inventory in the first week of October. Our digital detector margins declined due to additional costs in Europe related to a customs audit, and we increased reserves for warranty and slow-moving inventory. Industrial segment gross margin improved by about 3 points versus the prior year due to a favorable mix of higher-margin products. Overall, our adjusted gross margin was 33% compared to 36% in the prior year quarter. R&D expenses were $22 million in the first quarter, an increase of $3 million from the prior year quarter. R&D expense increased to about 11% of revenues, primarily due to the additional week in the quarter and the inclusion of direct conversion. First quarter SG&A expenses were $35 million and included approximately $5 million of expenses related to acquisition integration, restructuring and other nonoperational costs. SG&A expenses also increased versus the prior year due to the added week in the quarter and higher audit and consulting fees. SG&A expenses for the prior year quarter were $31 million and included approximately $3 million of expenses related to restructuring and other nonoperating costs. Going forward, we will be adopting a change in our reporting of non-GAAP adjustments. For fiscal years 2018 and '19 and the first quarter of fiscal year 2020, we treated the expenses associated with the implementation of Sarbanes-Oxley as a non-GAAP adjustment due to its initial setup after our separation from Varian. Now that SOx implementation and monitoring has transitioned to an ongoing activity, any audit and consulting costs associated with SOx implementation and monitoring will no longer be treated as a non-GAAP adjustment. Depreciation and amortization totaled $9 million for the first quarter compared to $14 million in the prior year. The first quarter of last year included $4 million of accelerated depreciation associated with the restructuring of the detector fab operations. Our operating earnings for the first quarter were $5 million compared to $10 million in the year ago quarter. Our adjusted operating earnings for the first quarter were $15 million compared to $20 million in the year ago quarter. Interest expense in the first quarter was $5 million, which is comparable to the year ago quarter. Tax benefit for the first quarter was near 0 compared to tax expense of $1 million in the prior year quarter. We recorded a net loss of $1 million or $0.03 per diluted share in the first quarter compared to net earnings of $3 million or $0.08 per diluted share in the prior year quarter. Adjusted net earnings for the quarter were $8 million or $0.21 per diluted share compared to $10 million or $0.26 per diluted share in the prior year quarter. Diluted shares outstanding were 39.1 million shares versus 38.3 million shares in the prior year quarter. Looking at our working capital. Accounts receivable decreased by $18 million during the quarter. Days sales outstanding was 55 days compared to 65 days in the prior year quarter. Inventory increased $21 million in the first quarter to $269 million. We ended the first quarter with cash and cash equivalents of $30 million. During the quarter, we reduced debt by $14 million and ended the quarter with total debt outstanding of $381 million. During the first quarter, we completed the implementation of a new accounting standard for leasing. The impact on the P&L was immaterial, but it increased our assets and liabilities by roughly equal amounts of $25 million and $26 million, respectively. We are still completing some of the work related to this new accounting standard, and as a result, we will not file our 10-Q for the first quarter by its deadline tomorrow, but plan on filing it in the near future. Even though the first quarter gross and operating margins were lower than usual, we anticipate that our overall financial performance will be in line with our expectations for the year. Lastly, I would like to announce that after more than 14 years with Varex and Varian, I intend to retire from Varex later this year. I will stay on to assist through the transition to a new CFO. So I look forward to continuing to work with all of you over the next few quarters.

So before we move on to Q&A -- this is Sunny Sanyal, I just want to take a moment to acknowledge the tremendous contributions that Clarence has made to the company. Clarence has been an integral part of our company for many, many years and an inspirational leader through the spinoff from Varian 3 years ago. During his time as a finance leader for Varian and later Varex, the imaging components business grew revenues from under $100 million to over $780 million. And with his help and guidance, we established a global finance team and the corporate infrastructure that will lead us into the future. His in-depth knowledge of the industry and our operations have been a tremendous asset, and we've been very fortunate to have clearance on our management team. With that, let's open up the call for your questions.

[Operator Instructions] Your first question comes from the line of Anthony Petrone with Jefferies.

Clarence, congratulations, and best of luck to you in the future, hope to cross paths again as time goes on. Maybe just to stay on the topic of CEO, just to address just transition expectation for timing on transition and just what the approach is going to be there? And then I'll have a few follow-ups.

Yes, Anthony. So Clarence, as we said, has expressed his intent to retire. So with that, we are just beginning the process. We didn't really start until how we will get going. We expect to do this expeditiously, but Clarence will stay on for a significant portion of the year, and he will assist in transition through that.

Okay. And then maybe just to shift to the numbers for the quarter and just go into adjusted operating margin and guidance and just the bridge. So I understand that some of the costs and nonrecurring and -- allocated to the first quarter. But maybe just as you look out over the next 3 quarters, what -- where is the comfort level and sort of getting back the $0.07 deficit that we've seen here in the first quarter? And specifically, what are the drivers there? Is it mix? Is it the expectation for order flow from whether it be China OEMs or newly signed customers, et cetera? So just a little bit of help in bridging from the first quarter numbers to the guidance for the full year?

Sure. So I'd say this -- I mean, I think you touched on a couple of things, first of all, that you have some onetime events in the quarter, but that also made the margin rates, both operating profit and gross margins be at a lower level than would be for the full year. The key item is actually going to be all around the Santa Clara closure by pulling that in by a quarter, I think that makes a significant benefit because before we had built into the numbers, the overlap cost of ramping up operations in Salt Lake City and a little bit in some other locations and with none of the benefit happening in the fiscal year and really fundamentally not happening till mid-2021. So now as we pull that in, we get a little bit of that benefit or some amount of that benefit in the fourth quarter already and that has a good impact for us. I would say that the other element is, as we've seen the good demand on -- for CT tubes going forward for the year, that helps us a little bit on the product mix side. So I think that's going to be the other element that is going to make a bit of a difference there.

That's helpful. And maybe to shift gears just to the top line outlook and specifics, Sunny, your comments in China. So we've seen so far this earnings season just the mix view as it relates to coronavirus. You mentioned in your prepared comments that potentially, there is some higher-than-expected demand due to coronavirus. Just trying to get a sense of installation cycles, specifically for CT machines in China. Siemens, for instance, sort of announced that it's not necessarily orders, but timing on installations that could be impacted. So just maybe a little bit on CT installation cycles in China? And then I'll have one last follow-up.

Yes. So Anthony, it's -- we don't get good visibility to what it takes for our OEMs from the point where they order our tubes, how long it sits in their facility versus how long it gets -- how long -- what -- how much elapsed time is to install the systems. From our perspective, when our customer places an order, we typically ship x works. So the point where they pick up the tubes is when we consider as having shipped to them. Now that said, these -- the reference I made to slight uptick in demand for the tubes, these are for immediate shipments. I mean the customers are standing on top of us to try to get these tubes from us ASAP. These are over and above what they had ordered. So we're doing our best to get these out to them ASAP and trying to cover as much of that in sort of with urgency. And these systems are -- will get shipped out by our customers ASAP out of their facilities. So that's -- I don't know if that answers your question, but these are -- we expect to fulfill bulk of that extra demand in this current quarter.

Okay. And last one for me, and I'll get back in here is, just in tariffs, there was a deadline that was upcoming in December. Some other capital providers, specifically intuitive, mentioned there was some pull forward of orders ahead of that potential deadline, of course, never happened. But just wondering if there was any sort of tariffs dynamics in the quarter.

No, we did not see any change in our customers' ordering patterns or any other behavior change one way or another due to the tariffs.

Your next question comes from the line of Larry Solow with CGS (sic) [ CJS ] Securities.

Great. Just a couple of questions. Sunny, you mentioned and you had a separate release on the Canon agreement. And you actually mentioned that you've re-upped, it sounds like on greater than 50% of your medical contracts. Can you give us any feel for pricing, volume changes? Are these contracts basically just rolling over at similar levels? Any color there would be great.

Yes. So Larry, a couple of -- first, a backgrounder on the reason for my comment about the other contracts. So first of all, it's great to always see our largest customer, Cannon, continue on this with decades-long relationship with us. So we're excited about this. We're into the second month of the calendar year. And I thought I'd just, as a frame of reference, just give you that example of how we're doing with the rest of our customers, and it's just as a representative. The key point there for us is that these are multiyear agreements. So that means our customers have -- not only have faith in us, but also faith in stability of pricing in the market. You might recall a few years ago when we were seeing huge swings in detector pricing, very few customers would agree to any kind of multiyear pricing agreement with us. But we're happy to say that we're able to get our customers to lock in with 3-year pricing agreements. So we're very happy about that. And then coming to your question about any color on pricing and price erosion, et cetera. Nothing. There's been no real shift in pricing approach or price erosion since our previous conversations that are noteworthy. Tubes' price -- pricing on tubes has continued to be consistent with historical levels. In fact, we get -- in some cases, we were on hold prices. In some cases, we give some nominal adjustments for volumes. And actually, in some other cases, it's performance-driven. We've started looking at performance-based pricing. So I'd say tubes has been fairly consistent. Detectors, fees price erosion. And we've said, historically, we've seen price erosion in single digits, and that has continued. So there's really nothing dramatic that, that's worth mentioning.

Okay. And just trying to follow up just on Anthony's question about the profitability in the quarter. So obviously, it was -- I know you don't guide to the quarter, but it sounds like it was certainly below your numbers on the gross line? And then operating expenses, obviously, were certainly much higher than your guide was for the full year. Is there any -- you said, there was an extra quarter -- excuse me, extra week in the quarter, but that also should obviously benefited revenue. So I'm just trying to bridge the gap a little bit better. And you sort of said, you'll make up for it with a little bit of an earlier closure on the facility, but making up for it. But is there -- are we at a lower -- in other words, was it just - was this an aberration? Or you have to make up for it and then some with other quarters of lower numbers? I'm just trying to get a better grasp to that.

Let me take a shot at that first, Larry, in terms of...

Yes. Just sort of -- in summary, just trying to figure out why you missed, not how you're going to make it up? You've explained how you're going to try and make it up, but you haven't really explained why you missed?

Yes. So I mean the -- adding an extra week is not an insignificant impact on the operating expenses, you're right, and we get a little bit of extra revenue, which is what I mentioned. And we -- and the variable costs are going to be running at the same kinds of levels as the revenue. So that's normal. But the OpEx expenses, there's no offset to that. So there's an incremental $4 million, $5 million, something in that kind of a range of additional operating expenses in the quarter just due to the extra week. And that's basically in R&D and SG&A. And then the -- within the gross margin, you basically have a few of those unusual or onetime kinds of events, not necessarily around -- all around the extra week, but more about relative to the detector business didn't perform quite as well as we wanted it to do in the quarter. And I mentioned customs audit, where we set aside some money for that and set aside some money for warranty and slow-moving inventory. Those are all factors that come into play and are the primary drivers of that. I mean there's -- beyond that, it's kind of business as usual, I would say, in terms of the rest of the moving parts in the quarter.

And then just switching gears a little bit, Sunny mentioned you spoke to some of the closures of the facility in China, and hopefully, that reopen soon, and then also the coronavirus and maybe you'll actually get a little bit of a benefit from some new -- some more diagnostic equipment going towards that. But net-net, are you -- do you think from where you stand today in your guidance is coronavirus have any effect, negative or positive? Or is it right now you're not adjusting for that?

So it's too early to tell one way or another.

Right. I mean just quantitatively more...

Yes, quantitatively, unbalanced. The extra orders of tubes and detectors will be helpful. Those are -- those, we hope, are incremental versus pull-ins. Again, tough to say, but since these are going to the sites that are specifically impacted by the coronavirus, you can hypothesize that these are incremental to the normal plans that any hospitals might have, but that's still TBD. In terms of -- on the cost side, we carry -- we haven't seen any -- there hasn't been a cost impact to us, we -- not yet. We carry inventory for our materials and purchases and the things that we depend on from China. So for the rest of the quarter, and as we get into -- all the way through March, we're working off of our current supply chain. So we haven't felt an impact one way or another. Now if the situation gets worse and beyond the current projections, then I think the entire industry and globally everyone will be impacted and us in a similar way. So -- but that's a wait-and-see situation for us.

I think, Larry, though, what this does is it introduces a little bit more uncertainty in the year. In terms of quarter-to-quarter variation, just like we talked about that we already have quarterly variations, just is more of the same as what that tells me.

Right. Right. Okay. Just last question. Any update on how Direct is performing. I think you sort of scaled back expectations a little bit last quarter from, I think, initially when you acquired it. You mentioned the $5 million this quarter, but perhaps, it's a little of an inflated number. So any update on how that's progressing?

So I would say that -- okay, the $5 million is a nice number for us. And you're right that we had backed off a little bit on the timing of when they -- when some of -- we expect some of their deliveries to happen to their customers. And this isn't about them being -- having challenges with developing product or getting product out the door, but it's more about the new applications that Direct is -- Direct's products, photon counting is going into, take time to get to the market and get -- gone through the market acceptance phases and the development process by their customers. And that's been a little bit where we see their challenge has been a little bit around the timing of when their customers will be ramping up their business. I mean overall, it's still proving out to be a very strong technology that is being well received. We had a ton of traffic at the RSNA trade show around it. There was a lot of interest in the products. So I think it's going to do very well, but it's a question a little bit about near term versus long term.

Great. Okay, excellent. I appreciate it. And Clarence, I second those words. Best of luck to you. I'm sure, we'll still talk for the next couple of quarters or so.

Yes. Thanks, Larry.

Your next question comes from the line of Suraj Kalia with Oppenheimer.

Can you hear me all right?