Greetings, and welcome to Varex Imaging Corporation Third Quarter Fiscal Year 2019 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 Howard Goldman, Director of Investor Relations. Thank you, Mr. Goldman. You may begin..

Good afternoon, and welcome to Varex Imaging Corporation's earnings conference call for the third quarter of fiscal year 2019. With me today are Sunny Sanyal, our President and CEO; and Clarence Verhoef, our CFO. To simplify our discussion, unless otherwise stated, all references to the quarter are fiscal quarters.

Quarterly comparisons are for the third quarter of fiscal year 2019 versus the third quarter of fiscal year 2018 unless otherwise stated. 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. Guidance 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 filed in fiscal 2019, and our annual report on Form 10-K for fiscal year 2018.

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, and good afternoon everyone and welcome. Our business had solid gains in revenues in the third quarter and operating earnings were comparable to the prior year. Quarterly revenues increased 3% driven by record level global CT tube sales along with double-digit sales growth in oncology and mammography imaging products.

Revenues in both our Medical and Industrial segments increased to 3% from the prior year quarter. The direct conversion acquisition that we completed during the quarter contributed approximately $2 million of revenues as expected and integration activities are well underway.

Offsetting these gains were significantly lower sales of radiographic digital detectors. Turning now to tariffs. The trade situation between the U.S. and China is very dynamic. The tariff increases that occurred in May did not have any incremental effect on the cost of our products and we're watching closely the news of the past few days.

Please remember that we are affected primarily by tariffs on our products that are shipped to China. The impact from tariffs that we experienced in the third quarter was consistent with the prior quarter and our plans to mitigate the impact of tariffs remain on track. Our CT tube business continued to gain momentum across global markets.

In China, shipments of our OEM customers -- shipments to our OEM customers expanded during the third quarter and we remain on pace to ship more than twice the number of units this year than we shipped last year.

In addition to CT tubes for 16 slight systems that we discussed during our prior call, we also saw demand in China for CT tubes for more advanced systems as well as an increase in demand for our tubes from global OEM customers who are introducing CT systems in emerging markets.

Third quarter growth in our Industrial segment was led by increased sales of our X-ray tubes. In the first nine months of this year, we shipped more tubes for airport security applications than we have ever sold in a full year.

This quarter, we also began shipping the new small footprint, lightweight linear accelerator with fast dose and energy switching capabilities that we discussed last quarter. This product has the potential to expand the use of mobile screening applications at sites beyond ports and border checkpoints and enables quicker scanning.

As an example, our technology can provide imaging systems with capabilities to scan a truck cab in low-dose mode and then instantly ramp up to high-dose mode to scan the trailer. It can also be used to scan train moving up to 30 kilometers per hour.

In our nondestructive inspection business, we're developing imaging solutions for several industry verticals with the current emphasis on the oil and gas space. Recently, our VMI team field tested a recognized portable detector, optimized to detect corrosion in pipelines with promising results.

In the third quarter, we launched three new industrial digital detectors and one detector for 3D dental applications. We're also making progress on our new IGZO detectors which are cost-effective and offer high performance. This technology has potential in multiple medical and industrial applications.

We have a number of key customer projects running with positive feedback based on early demonstrations. Our global detector business continued to be weighed down by the tariff-related loss of radiographic detector sales in China. To counter this, we're in the late stages of setting up production of radiographic detectors in Wuxi.

We expect to launch these products at the end of the calendar year. This is an example of our local-for-local strategy which involves getting as close to our customers as possible by establishing local commercial relationships, delivering local service and support and sourcing from local suppliers.

We believe this strategy will provide us with competitive products that over time will allow us to recapture much of the loss radiographic business in China. As you may recall that at the end of April, we acquired Direct Conversion, a leading developer and manufacturer of linear array detectors based in Stockholm.

Last month, director fund its application innovation center located in the biotech triangle in Munich Germany. This facility will showcase Varex advanced, photon counting X-ray products and provide deeper insight into how this innovative and disruptive imaging technology can benefit health care professionals and patients.

For specifically medical specialists, imaging research experts and representatives from the health care industry will be able to discover how photon counting detectors offer sharper X-ray images at lower dose rates than conventional detectors.

This facility will encompass lab tours, workshops and training as well as ongoing proof-of-concept assessments. On the manufacturing side of our business, we recently announced plans to close our digital detector manufacturing operations in Santa Clara, California.

Completion of these activities will provide significant benefits to our business going forward. I want to thank all employees at these facilities for their hard work, since acquisition and through upcoming transition period and we truly appreciate your efforts.

With that, let me hand over the call to our CFO, Clarence Verhoef to talk about the financial performance in greater detail..

Thanks, Sunny, and hello, everyone. In summary, Q3 was another quarter with good top line performance. Operating profit was in line with the year-ago quarter by restructuring charges and an unusual increase in tax expenses compared to the prior period impacted our earnings in the quarter.

Before I go into the details of the quarterly financials, let me walk you through the math of our restructuring activities. As you may recall, one of the synergies related to our acquisition of the imaging business from PerkinElmer, was the potential for site consolidation.

Last December, we completed the transfer of our glass fabrication production from Santa Clara, to our joint venture dpiX. A few weeks ago, we announced the transfer of the remaining manufacturing operations in Santa Clara to other Varex locations with the majority going to Salt Lake City.

It will take some time to complete the transfer and get customer validation completed, so we expect to cease operations and close our facility by mid 2021. Total overhead cost for the Santa Clara operations were about $36 million per year.

The elimination of these costs will be partially offset by product cost from dpiX and various additions of equipment and support personnel in the other Varex locations. We have estimated that the net annual benefit once the facility is closed should be in the range of $21 million to $27 million.

This will be a critical part of our ongoing cost reduction efforts in the competitive detector market. In the third quarter, we recorded $7 million of restructuring charges bringing the total restructuring charges related to the Santa Clara facility to $23 million, of which less than $3 million was cash based.

We expect to incur another $13 million to $17 million related to closing this facility, of which approximately $9 million will be cash based. Turning to the quarter results.

Medical segment revenues for the third quarter increased 3%, with higher sales of CT, oncology and mammography products that were partially offset by lower sales of radiographic detectors. Industrial segment revenues were also up 3%, mostly driven by increased demand for X-ray tubes for airport security.

For the third quarter, our gross margin was 31% compared to 33% in the prior year. The adjusted gross margin was 34%, compared to 35% in the prior year. The margin reduction was primarily due to higher manufacturing variances. R&D expenses were $21 million and comparable to the prior year quarter.

With the addition of direct conversion R&D increased to – in the current quarter to be more than 10% of revenues. Third quarter, SG&A expenses were $35 million and similar to the prior year quarter. Both periods included additional expenses related to impairments and restructuring related costs with approximately $7 million in each quarter.

Depreciation and amortization totaled $9 million for the third quarter compared to $10 million in the prior year quarter. Including the impact of restructuring costs in both quarters, our operating earnings for the third quarter of fiscal year 2019 were $5 million down from $7 million in the same quarter a year ago.

For the third quarter, our adjusted operating earnings were $19 million, which was comparable to the prior year. Interest expense in the third quarter was $5 million, which was similar to the year-ago quarter. Turning to tax.

In the third quarter of last fiscal year, we had a tax benefit of approximately $1 million due to the implementation of a tax accounting method change. This year, we had tax expense of approximately $1 million, despite having a loss in earnings before tax.

This was due to the nondeductible nature of losses for certain jurisdictions particularly China, where we are seeing both increases in the local payment of tariffs and a ramp-up of operating costs. Based on this, we now expect our effective tax rate for the fiscal year 2019 to be approximately 26%.

Again, including the impact of the restructuring costs, we recorded the net loss of $1 million or $0.04 per diluted share in the third quarter compared to net earnings of $4 million or $0.10 per diluted share in the prior year quarter.

Adjusted net earnings for the quarter were $9 million or $0.24 per diluted share, compared to $13 million or $0.34 per diluted share in the prior year quarter. Diluted shares outstanding were 38.8 million shares versus 38.4 million shares in the prior year quarter.

Looking at our working capital, accounts receivable decreased by $7 million during the quarter. Day sales outstanding were -- was 60 days compared to 62 days in the prior year quarter. Inventory increased $2 million in the third quarter to $263 million, which included $6 million with the addition of direct conversion.

We ended the third quarter with cash and cash equivalents of $29 million. For the quarter, we had cash flow from operations of approximately $15 million and spent $6 million for property plant and equipment. During the quarter, we borrowed $64 million to complete the acquisition of direct conversion.

Even with this, year-to-date our total debt outstanding has only increased $20 million to $410 million. We are not changing our revenue outlook for fiscal year 2019. As a reminder, the guidance we previously provided was revenues in the range of $760 million to $785 million.

We continue to believe that our adjusted gross margins will be in the range of 34% to 35% that R&D expense will be about 10% of revenues and SG&A expense will be around 13.5% of revenues excluding unusual items. We now expect our tax rate to be approximately 26%.

Based on year-to-date results and an anticipated higher effective tax rate, we now expect that adjusted net earnings per diluted share will be in the range of $1.25 to $1.45. We will now open up 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..

Good afternoon.

Clarence, just to summarize on the guidance, so has anything other than the tax rate actually changed? It sounds like the operating expenses numbers, I thought a little bit higher to me than they were, but can you clarify that?.

Sure. Let me go through it again a little bit. So, actually in terms of expectations for gross margins and operating expenses, they are the same as prior. So, no changes from that perspective. So, the fundamental change is really around the tax impact as such.

And how I look at it is that -- when I look at the midpoint of guidance, I took it down by $0.05..

Right..

The guide point down by $0.05, which is exactly tied to the tax changes..

And how about the sort of a pretty wide range for Q4 sort of $0.40 to $0.60, can you maybe discuss some of the factors that would drive it maybe the lower or to the upper end of that pretty wide range for one quarter?.

Yeah. Let me kind of just -- I maybe just clarify for a moment, because we give guidance on an annual basis and that's kind of our what we set that at the beginning of the year and we're not going to make changes unless we take into effect the impact of any known events.

So the known event that happened back a quarter ago was that we acquired direct conversion..

Right..

So we increased the range of the revenue guidance by $5 million at the both the bottom and the top. And so the other impact now that's going on is as we know about the tax change -- the tax rate change. And so that's the only other change. So fundamentally, we're staying with the guidance that we started the year with..

Okay. How about on the gross margin side sort of flat sequential margins a little bit down from Q1. But I know that was a little bit of on dose I think unusually strong.

Did you get any benefit this quarter from the exit of Santa Clara on the fabs -- on the Santa Clara fab, or is that sort of pushed out a little bit on timing?.

Yeah. It's a good question. So let me kind of walk through that a little bit, because yeah, there was an expectation when we had announced the closure of the fab almost a year ago that we would be starting to see a benefit from that by this point in time.

What is kind of becoming more apparent as we're going along is as much of that benefit will not probably happen until the full facility closure. I mean, we have to -- there's some overhead costs that are associated there that don't go away until the facility is fully closed.

So we had a little bit of the stranded overhead as such in my mind is kind of how I think about it that I had planned to have all be gone, but that's still -- some of that's still there. So not as much impact as I would have liked, I would say. I do think that when I look at the R&D line in particular, we do see improvement in the R&D.

And some of that is due to restructurings that happened in association with the announcements of restructurings a year ago. And so we're -- we are seeing a lower R&D rate because of that. And I mean, I think that fundamentally it clarifies or explains the impact on the closure of the fab..

Okay. So the central to $21 million to $27 million which is sort of is that a combination you could sort of combined the two ranges that you had given, it looks like maybe slightly tweaked it, but that's a rounding error.

That -- most of that savings won't really begin until you completely exit, or would you expect some of that a little bit or some I don't know in 2020, or is that all going to be sounds like a fiscal 2021 event? Is that fair to say?.

Yeah. I think realistically the vast majority of it is going to happen when the facility is closed, because you have a lot of costs that are associated with the facility and the building itself and some of the -- and production continues there, right? So it's not that we're ramping down the production.

It's more that we have to transfer that production from one site to another..

But you have transferred the production to the defects on the fab side, right? So you -- but you still like -- is there a sort of double counting there a little bit or double expensing that you have been going on that you won't really get that benefit until it fully closes? Is that what the deal is?.

No. So I'll go in a little bit of detail of the math here a little bit, because we did have overhead reduction in Santa Clara with the closure of the fab and we had reduction of other direct labor costs and the like and material costs as well. That was offset by new costs coming from depicts, basically the material that we buy from the depicts.

It was fundamentally offset there. So it's a relatively a wash from that perspective, but the remaining overhead that we had anticipated to be reduced will not be reduced till later on..

Okay. Okay. And just last question on that. You had -- I think you said in the 8-K it was going to -- you're going to exit at the end of calendar year 2020.

Is that still the right timeline?.

Yes. And so there's a -- some nuances around the wording there because we will be stopping production at that point in time. We will not exit that facility because you have the decommission equipment do some clean up all those kinds of things. So it'll be into the calendar year 2021 till fully out of the facility..

Okay. And then just lastly the direct was that a -- you mentioned $2 million revenues.

Bottom line was that a drag on earnings at all, or is it basically a wash?.

Yes it was a little bit of a drag in the quarter just because they had some R&D expenses that they were incurring. And so I think overall the perception for our outlook for the fiscal year is that it's roughly still a breakeven transaction..

Okay. But maybe 1% or 2% type deal was that – was that model….

Yes, it's exactly it's in that kind of range..

Okay. All right. Great. Thank you very much..

Sure..

Thank you. Our next question is from Anthony Petrone with Jefferies..

Thanks. Maybe just to take up one on direct conversion, I guess $2 million based on the run rate they were doing at the time of the close seems a little bit light.

Is that just timing of when it actually closed? And is that the total acquisition contribution in the quarter, so just to clarify that number?.

Yes. The second part of your question I'm assuming you're asking if there's any other synergies kinds of things where we got some additional add-on bills….

Yes. No I guess VMI, right? So you had VMI which I was -- we were still rolling in...

Yes..

And then direct conversions. So the combination of those what was the total acquisition contribution in the quarter? And then just the $2 million specifically for direct conversion it seemed just a little bit light based on the run rate.

So just -- was that just a timing issue or something else going on there?.

Yes. First of all, let's just remember that it closed at the end of April. So we only had two months for it. And it was just a kind of start-up of the -- of there. We're still comfortable with the $5 million to $8 million that we had said for the revenue for the five months of the year. The VMI is not included in those numbers.

When I talk about -- VMI basically we've already fully integrated and as is kind of rolled into our overall detector business or our overall industrial business so excuse me..

No. That's helpful. Maybe just to shift gears on the two business, specifically and the China OEM order book. So when you look at that number and just given sort of the most recent headlines on tariffs or whether it'd be even currency fluctuations over in China.

I mean, can you give us an update on how many China OEMs the company has orders with the size of the order book? And is there anything incremental based on the last week or so as it relates to trade wars?.

Hey, Anthony this is Sunny. In terms of just the general temperature and how things are going for us with tubes in China. There's frankly there's really no change. The tariff situation since May we've seen no -- the announcements in May did not impact us in any way.

And as far as the tubes business is concerned things are just progressing the way we had anticipated although OEMS are continuing on with their R&D work and the release work. They're still continuing to make progress. We have -- we've had people move one or two steps in their R&D and they're going into.

We see some going into their regulatory planning process. So that's moving forward. And our momentum and shipments of tubes to these customers have continued on. We've said that we were anticipating double the volume we're clearly on track for that.

So I didn't have anything much to add other than to say that, the trade war so far hasn't impacted us, beyond what was already factored in a while back. The most recent discussions, if you look at the list four that went into effect the $300 billion, our products aren't in that list. The specific impact of that list isn't significant for us.

I think what still wait and see is China done with its retaliatory actions, or are there more to come? That's a part we don't know. But so far, since the May release didn't impact us. This current announcement didn't impact us. And frankly, the currency devaluation the impact of that is not known.

But at the same time, I don't expect that the Chinese OEMs, who are in the middle of all of this will – it will matter much them the devaluation was a few percentage points..

Hey, Anthony, let me add one other thing around that. As I do think it's kind of interesting is – is that, when you look at China as a percentage of our business, last year it was 10%. It's probably a point lower right now. And we've got a big shift going on.

So we have significantly lower radiographic detectors being sold to Chinese customers, but it's offset by a significant increase in the amount of CT tubes that are going there. So I mean, it's a – when we look forward and say okay as we ramp up production of radiographic detectors in Wuxi, we've got some opportunity there going forward.

I think that's kind of the key points around that is, is that we have a chance to get that back as time goes on. And then, at the same time, leverage the continuing growth of CT tubes in China..

Maybe just to shift over to – on the industrial side, it was a little light Varex expectation, but the comp was certainly difficult just considering the – the performance last year.

If you go back to last quarter, and the comments here today that the last quarter for instance and earlier this year you had some linear accelerated rate of placements on the security end non-destructive testing was doing well and then CT tubes into airport security checkpoints for check baggage that has been doing well.

So, is there anything to read into the performance in Industrial, and anyone of those areas, or was it just a tough comp? And as you look forward, specifically in airport security can you just give an update on the various different tender processes that are going on for check baggage? Thanks..

Yeah. So let me take a – Anthony, let me take a start at that. By the way Anthony, in your previous question, you asked about how we are doing with – on the contracts to Chinese customers? As we had said that, 8 out of 10 have some form of a contract with us.

It's a three-year purchase agreements and that stayed that way and those – all those customers are still moving forward. So, backlog $140 million or so..

Thanks..

In terms of the Industrial business, so there's – the two parts, as we've mentioned that – tubes for security versus cargo linear accelerators. It's the cargo linear accelerators business that is generally more lumpier. So, we're battling two things, one is a really strong comp for – from last year, and the flattish cargo linear accelerator.

But the tubes – the security side of the business, the batteries of the tubes business continues to be strong continued momentum. The – we don't have good visibility to our OEMs tender activity, but the demand for that is strong. I mean, all I can say is we're seeing very strong demand and the activity is fairly broad-based..

All right. Thanks, again. I'll get back queue..

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

Good afternoon.

Can you hear me?.

Yes, Jim..

Yes, I got you, Jim..

Great. You talk a little bit about some new industrial products released in the quarter.

Can you give us a little more color on what they were?.

Yes, there were -- we talked about two groups of products. One was a new linear accelerator. In the last -- last quarterly call, we announced that we had a new linear accelerator model that we're releasing. And this quarter we actually had the first shipments of that. So we're very excited.

But this product is and if you look at a traditional linear accelerator, it takes up a lot of space. It'd be pretty massive, very heavy, lots of parts and pieces. What we rolled out is a very swell -- small footprint.

You're talking about four feet by four feet type of footprint and stands up tall about six feet tall, occupies very little space, much lighter. So as a result, it can go into a very -- a much smaller vehicle. You don't need a massive tractor trailer to put this thing on.

It can be -- so it can be fashioned into -- it can go into applications that are much more mobile. Typically, for cargo scanning and security inspection need a big setup with -- it's fixed in the ground.

But here, if you can put it on a small truck -- on the back of a small truck, then you can create mobile applications and that's what we're excited about. So it's no more about ports and borders.

And the applications that our OEMs are looking at would be to put them at crossings anywhere on the road you can -- wherever you can drive a truck up to maybe in front of a bridge or before a parking garage or on -- at any venues like ball games et cetera. So these are pretty -- it's a pretty flexible and dynamic up in LINAC.

So we're excited about it. And then others group of products were just new digital detectors. We've -- in order to stay ahead of everyone and the competitors were -- we keep the pressure on-buy a continuous introduction of new models of digital detectors.

So we launched some for general NDT, a high-resolution detectors for NDT and then also a ruggedized detector for oil and gas applications. We're -- as we said in our different verticals of the industrial, we're focusing on a few different verticals, but the focus right now, the current focus is on oil and gas.

And we're launching application -- I mean, products for scanning pipelines and small-large pipelines and oil fields and refineries. And so that -- those were the products..

Okay. And then with regard to the recent news about tariffs, can you just go into a little more detail how the whole process dealing with the OEMs and China works.

I mean, are they sensitive to news like this, or is this something where it takes six to 12 months to sign a deal and the short-term ups and downs really don't have a big effect on the negotiations?.

Yes. So let me start by saying our OEM customers in the medical space particularly don't react quickly to any change, because they've got to go through there -- even China has pretty cumbersome -- very cumbersome regulatory process. In fact, it's much more cumbersome than the U.S.

and they -- it takes them -- it can take as much as 12 months in some cases to get a CT system qualified or through the regulatory process. So they do not react quickly and more so for tubes. Tubes are far more, I'd say ingrained in their system design. And at the same time, the tariff for tubes is not -- it's a small lower amount 5%.

So they have not been sensitive to it at all. And the day-to-day news, we're not seeing our customers reacting at all to those. Where we see some impact is in the low-end radiographic detectors space where the integration is a lot easier. So people -- our clients can swap out these low-end radiographic detectors.

And beginning of the year -- I'm sorry, beginning of this whole tariff trade war situation, which is almost a year ago now. We responded to our customers and entered into commercial agreements with them. Where in some cases they stocked up the tariffs, in some cases we did, in some cases it was 50-50. And then, as time went on.

And there's further escalation and trade war. I think customers start to getting nervous, about well there are other sources available of detectors. So we then decided to back down from just giving full-blown absorbing all the tariffs. And we decided not to.

And that's why we, pulled out a -- we pull back from the low-end, value radiographic digital detector business. Which is a very small part of our overall business, but there it was, basically our call that we don't want lose money on those detectors.

But since this -- that particular space is, is easy to get back into, we're going to double down on this by building these detectors, in China, with local supply chain, with local manufacturing. And at the end of this year, we expect to launch the made-in-China products for China.

And we'll get back in there with -- and win these customers back with margins..

All right, and then, the last one from me, with regards to M&A, you've done a couple of deals now this year, in the past 18 months.

Do you think you have enough on your plate right now? And that you'll take a break from M&A, or do you still continue to look for inorganic opportunities?.

Yeah. So, we have an active pipeline. That said our focus on with the free cash is, to pay down debt. And I think, we've said that, in our conversation that we'd like to pay down the debt over the next 12, 18 months. That said we'll keep an eye out, for small tuck-ins. We may do some small tuck-ins.

But at this point, we want to give that a little bit of breather, on the financials or the financing side. And work on our debt a little bit..

Okay, thank you..

[Operator Instructions] Okay. At this time, there are no further questions. I would like to turn the floor back to Mr. Goldman for closing comments..

Thank you for your questions and participating in our earnings conference call for the third quarter of fiscal year 2019. A replay of this quarterly conference call will be available from today through August 20th. And can be accessed at the company's website or by calling 1-877-660-6853 from anywhere in the U.S. or 1-201-612-7415 from non-U.S.

locations. The replay conference access code is 13692630. Goodbye..

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