Varex Imaging (VREX) Q3 2022 Earnings Call Transcript

Varex Imaging (VREX -1.05%)
Q3 2022 Earnings Call
Aug 02, 2022, 5:00 p.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Greetings. Welcome to the Varex third quarter fiscal year 2022 earnings call. [Operator instructions] Please note this conference is being recorded. I will now turn the conference over to your host, Chris Belfiore, you may begin.

Chris Belfiore -- Director of Investor Relations

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 of 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' 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 the same quarter of the prior year. Finally, all references to the year are to the fiscal year and not calendar year, unless otherwise stated. Please be advised that during this call, we will be making forward-looking statements, which are predictions or projections about future events.

These statements are based on current expectations and assumptions that are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated. Risks relating to our business are described in our quarterly earnings release and our filings with the SEC. Additional information concerning factors that could cause actual results to materially differ from those anticipated is contained in our SEC filings, including Item 1A, Risk Factors of our quarterly reports on Form 10-Q and our annual report on Form 10-K. The information in this discussion speaks as of today's date, and we assume no obligation to update or revise the forward-looking statements in this discussion.

On today's call, we will discuss certain non-GAAP financial measures. These non-GAAP measures are not presented in accordance with, nor are they a substitute for GAAP financial measures. We provided a reconciliation of each non-GAAP financial measure to the most directly comparable GAAP financial measure in our earnings press release, which is posted on our website. I will now turn the call over to Sunny.

Sunny Sanyal -- President and Chief Executive Officer

Thank you, Chris, and good afternoon, everyone. I'm happy to report very good results of 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 to 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 our 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're 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 our first-quarter earnings call, we highlighted market growth opportunities in our medical segment. Today, I'd like to provide a perspective on our industrial segment and share with you how we see this market segment and our business evolving over time. 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 in the industrial segment to be about $1 billion, which we believe can grow at a 5% to 7% CAGR over time.

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 of 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 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 vertical, specifically in the oil and gas sector, we are offering a full workflow solution for pipeline weld and corrosion inspection.

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, sterilize, 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 lockdowns earned us a recognition from one of our top customers in China. Further, in July, we attended European Congress of Radiology trade show 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 the 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 see 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 Azure dynamic platform into their new systems and 10 others in active evaluation and planning mode. In addition, more than 15 OEMs are either already buying our LUMEN family of 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 material shortages. With that, let me hand over the call to Sam.

Sam Maheshwari -- Chief Financial Officer

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 remained 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 are 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've 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 $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 were $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 accruals 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 to 194 days. Accounts payable increased by $4 million as we procured more inventory and days payables was 54 days.

Now moving to debt and cash flow information. Cash flow from operations was a 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 of $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 the 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 -- President and Chief Executive Officer

Thank you, Sam. Before we turn to Q&A, I just want to add a quick comment. I'd like to extend a warm welcome to Kathy Bardwell, who we announced today has joined our board of directors. Kathy 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 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.

Questions & Answers:

Operator

At this time, we will be conducting a question-and-answer session. [Operator instructions] Our first question is from Larry Solow with SJS Securities. Please proceed with your question.

Larry Solow -- CJS Securities -- Analyst

Great. Good afternoon. It's CJS. I guess the first question on the supply chain initiatives, it's on you Sam, -- are you guys -- it sounds like you're certainly a bit constrained on the revenue side, and that seems to be that improving significantly.

Are there still -- where we stand today? Are we -- are there still more levers for you guys to pull there? Or obviously, you're acquiring a lot of inventory, and that's benefiting you a lot, but are there other -- I know you were qualifying more suppliers and even changing some of the costs -- excuse me, the actual material supplies. Are most of those initiatives are they well along the way? Are they almost done now? Can you kind of just give us an idea of how -- where we stand on that?

Sunny Sanyal -- President and Chief Executive Officer

Yeah. 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, we talked about situation with semiconductors and then the situation with electromechanical parts and components. So on the semiconductor side, we're making very good progress on both with dealing with obsolescence and moving our products across to other semiconductors. That's going along well.

And we have -- we bought -- purchased a lot of semiconductors as well to make sure that we have access to them. There -- where we had the hot spots 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 indicates them, and that's rolling forward. There's still some unknowns there, but those are -- I think we're -- I wouldn't say we're out of the woods there.

The semiconductor side is still tenuous. But we have, at this point, we're seeing better flow of chips. On the electromechanical side, it continues to be -- I call it the new sense situation where you -- suppliers are -- they're late, they're short shipping, that's continuing. And we're continuing with our diversification efforts there.

So in summary, Larry, we're not out of the woods yet, but we've done a lot of work, and we're seeing some of the results of that work.

Larry Solow -- CJS Securities -- Analyst

I appreciate that 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're sort of anniversarying that or coming close to that. And you mentioned, I know inventory was just one component of what you're getting in the charge, but that's up 9%, like you said, at least.

So are you getting -- I don't think you're getting price increases quite commensurate with that 9% increase. So is there more to come? Or are you still kind of chasing that? Is that still kind of impacting the overall performance?

Sam Maheshwari -- Chief Financial Officer

Yeah. 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 contracts 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 -- right? 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've 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 of more quarters go by.

Larry Solow -- CJS Securities -- Analyst

OK. And then, obviously, to get your crystal ball out and -- 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, right, to offset this sort of rising cost of goods.

Sam Maheshwari -- Chief Financial Officer

So we'll -- of course, we'll evaluate the situation as we see how the overall market forces as well as the inflationary situation is developing. So yes, we will definitely be looking at it and assessing it on a dynamic basis, yeah.

Larry Solow -- CJS Securities -- Analyst

OK. And then just last question on the outlook for Q4. Maybe the range has been narrowed slightly, but it's still a pretty wide range. And I know a lot of uncertainty, nothing has changed in terms of the environment.

It does seem like you guys have a little bit of a better grip on the supply chain stuff, which I think also was a big variable. So what's sort of the difference between the low end and the high end? Is it more of a -- I think in previous quarters, it was more of a supply issue. Is that still sort of the biggest variable? Or is there the demand -- have any -- you still have a lot of room on the demand side? Thanks.

Sam Maheshwari -- Chief Financial Officer

Yeah. So as we look at the guidance for Q4, Larry, like Sunny said in your first question, there is supply chain-related uncertainties. There is still freight-related delays. So we've made a lot of progress in supply chain, and I would like to say that supply chain 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 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's 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 in receiving of raw material, we might be on the lower side of the range.

And if we get more material than we probably would be toward the higher end of the range. That said, demand is -- so demand is quite strong. Our backlog went up even further in this last quarter. So the demand is there, it's just we got to get it completed and ship it through the factory.

Larry Solow -- CJS Securities -- Analyst

Got it. Thanks. I appreciate all the color.

Sam Maheshwari -- Chief Financial Officer

Thank you, Larry.

Operator

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

Jim Sidoti -- Sidoti and Company -- Analyst

Hi. Good afternoon, and thanks for taking the questions. 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's sticking?

Sam Maheshwari -- Chief Financial Officer

Yes. So hi, Jim. 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 sticky.

Jim Sidoti -- Sidoti and Company -- Analyst

And you mentioned that prospects seem to be improving from 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 -- President and Chief Executive Officer

Hey, Jim. This is Sunny. Industrial is broken out into many verticals. On the security side, we are -- we saw tender activity earlier in the year, and we're getting orders -- we had anticipated that those would turn into some orders for us, and we're 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're doing that.

On -- in the other areas of the verticals, like we talked about food inspection, oil, and gas, we have -- let's take oil and gas as an example. In that segment, we have several products. In fact, what I talked about with getting closer to the customers with full workflow solutions. Those are already -- those have been rolled out to our customers, are in that sales process of being embedded with our OEM customers.

So that's 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 we'll keep you posted on the progress in those areas, but we expect new products to be rolled out in those areas sometime early to mid next year.

Jim Sidoti -- Sidoti and Company -- Analyst

OK. And the last one from 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?

Sam Maheshwari -- Chief Financial Officer

Hi, Jim. Sam here. So in the last couple of quarters as a specific decision, we drove increases in inventory in order to meet our customers' demand. And inventory has gone up, and that is enabling us of putting us in a better position, our 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 cash is 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 have -- we are maintaining a $100 million plus cash, which is what we have said that we want to keep for operating purposes. And then we also have a 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, then we should be able to deliver higher sales and deliver more and generate more profits.

Jim Sidoti -- Sidoti and Company -- Analyst

All right. That's it for me. Thank you.

Operator

[Operator instructions] Our next question is from Suraj Kalia with Oppenheimer & Co. Please proceed with your question.

Shaymus Contorno -- Oppenheimer and Company -- Analyst

Hi, Sunny and Sam. This is Shaymus on for Suraj. 

Sunny Sanyal -- President and Chief Executive Officer

Hey, Shaym.

Shaymus Contorno -- Oppenheimer and Company -- Analyst

Hey, so quick to start. The status of the OEM partner validation for the carbon nanotubes, any update?

Sunny Sanyal -- President and Chief Executive Officer

Yeah. That's proceeding. That's continuing on. And so we've got more OEMs engaged in those feasibility assessments.

And then for the ones that we had, we've been shipping more tubes to them. So that work is progressing, and we're making steady progress. These are -- these types of novel platforms take longer in our development cycle. So this will continue this way.

And then the OEMs then take some time to formulate their designs and then they move forward with their projects. Those are moving forward.

Shaymus Contorno -- Oppenheimer and Company -- Analyst

Got it. Thank you for that. And just another one. How are you guys seeing the replacement cycle for the two end detectors.

Is it slowing given upstream component shortages? Or is it able to maintain steady?

Sunny Sanyal -- President and Chief Executive Officer

The replacement cycle is consistent, meaning tubes have a finite life. So once -- if a tube lasts a year, they're going to be -- they need to be replaced in the year. For us, a replacement tube is no different from a new tube, so it's the same thing. So there is really no difference in our sales cycle or revenue cycle for replacement versus new tubes.

Shaymus Contorno -- Oppenheimer and Company -- Analyst

OK. And just last one from me. How is your road map for getting back -- getting to the 40% gross margin work? Thank you for taking our questions.

Sam Maheshwari -- Chief Financial Officer

Sure. Thanks, Shaym. So we highlighted that our gross margin for the current business portfolio is around mid-30s in the gross margin. And right now, due to inefficiency supply chain-related issues, freight, etc., running high, we are a little bit lower than that.

In terms of our road map to get to high 30s or closer to 40%, I think we would need a few new products to be released, which we've been working on, particularly carbon nanotubes, which you asked Shaym, and then also for non-carbon-related products. So with those products and then, of course, also software, as those products get released and they get adopted, 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.

Chris Belfiore -- Director of Investor Relations

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 16 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 goodbye.

Operator

[Operator signoff]

Duration: 0 minutes

Call participants:

Chris Belfiore -- Director of Investor Relations

Sunny Sanyal -- President and Chief Executive Officer

Sam Maheshwari -- Chief Financial Officer

Larry Solow -- CJS Securities -- Analyst

Jim Sidoti -- Sidoti and Company -- Analyst

Shaymus Contorno -- Oppenheimer and Company -- Analyst

More VREX analysis

All earnings call transcripts