Hello, and welcome to the Varex Imaging First Quarter Fiscal Year 2022 Earnings Conference Call and Webcast. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.

It's now my pleasure to turn the call over to Christopher Belfiore, Director of Investor Relations. Please go ahead..

Good afternoon, and welcome to Varex Imaging Corporation's earnings conference call for the first quarter of the 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 slide presentation that can be accessed at Varex website at investors.verximaging.com. The webcast and supplemental slide presentation will be archived on Varex's website.

To simplify our discussion, unless otherwise stated, all references to the quarter are for the first quarter of fiscal year 2022. In addition, unless otherwise stated, quarterly comparisons are made sequentially from the first quarter of fiscal year 2022 to the fourth quarter of fiscal year 2021 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..

Thank you, Chris, and good afternoon, everyone. Demand for our products remained strong in the first quarter but supply chain constraints limited our ability to fulfill orders as planned. As the quarter progressed, the uncertainty in the supply chain increased with challenges becoming progressively worse in the quarter.

Among other issues, we saw abrupt and unexpected delays in delivery of critical electronics components as well as delays in inbound and outbound freight. We estimate that delays in raw material prevented us from shipping more than $20 million of product in the quarter.

As a result, our quarterly revenue was $199 million, which was below our expectations. Revenue in the first quarter decreased 12% sequentially and increased 12% year-over-year. Both Medical and Industrial segments declined sequentially.

Non-GAAP gross margin in the quarter was 34%, which was below our expectations, but reasonable considering the persistent supply chain headwinds that we faced. Non-GAAP operating margin was 11% of revenues and non-GAAP EPS was $0.25. Cash generation continued to be strong in the quarter with cash flow from operations of $11 million.

Our cash balance at the end of the quarter was $158 million, up $13 million sequentially. Let me give you some high-level insight into how the demand environment for our different modalities and applications trended during the quarter.

Since first quarter revenue was severely impacted by supply chain constrained environment, our modality trends are based on qualitative assessments. Medical segment revenues decreased 14% sequentially and increased 12% year-over-year.

We continue to see robust demand globally for CT tubes in the first quarter, including strength in China as well as a recovery in the U.S. market. Demand was strong in our other medical modalities, including fluoroscopy, oncology, radiographic, dental and mammography.

Revenues in our Industrial segment decreased 6% sequentially and increased 14% year-over-year. We continue to see strong demand for products for nondestructive inspection across several of our industrial verticals, including electronics and oil and gas.

We experienced improved demand for imaging products for security screening at ports and borders during the quarter. In the past quarters, we have highlighted various new products and innovation, including photon counting, nanotubes and AI-aided software.

This quarter, I'd like to share with you some additional details on design wins and progress made with these technologies and how they could contribute to our long-term growth strategy. We will be focusing on our Medical segment for today's discussion, and we expect to provide more color on the Industrial segment in the future.

In our tubes business, we began shipping samples of high-performance X-ray tubes for cardiovascular applications in the fourth quarter of fiscal 2021. We are seeing good initial customer interest in this product, and one of them is getting close to a system launch.

In addition, several other customers are evaluating integration and design options for their future systems. These highly innovative, high-performance tubes are significantly lighter than tubes that are used in systems today, and at half the size, take up much smaller footprint.

We expect that these high-performance and compact tubes will give our customers significant systems design flexibility. In addition, these tubes have performance characteristics that can help patient throughput. Our joint venture in Germany continues to make steady progress with Nanotube Technologies.

In the Medical segment, we have signed a prototype development agreement with a customer. In addition, we have shipped the first multimeter prototype to an industrial customer. Additional prototypes are expected to ship this quarter.

In detectors, our Photon counting technology continues to make progress and is currently being utilized in various medical modalities, including dental, breast and skeletal imaging. We now expect to ship CT photon counting modules to customers in the second half of fiscal 2022.

Given that we do not have an offering in the CT detector market today, this would be entirely incremental serviceable addressable market for Varex. Due to its high frame rate per second imaging ability, we are seeing photon counting adoption in in-line industrial inspection systems and dynamic applications with automated detection.

We expect to see some customers launch new systems in 2022, utilizing our photon counting detectors in food inspection and battery inspection. We have had multiple design wins with our Azure, previously Z-Platform dynamic detectors, with mobile CRM and dental customers.

We expect production of these systems and our product shipments to start ramping up in the second half of 2022. Last quarter, we highlighted our AI-aided lung cancer screening software, which continues to gain momentum.

The winning bid for the lung cancer screening program in British Columbia is in the installation phase across six sites, and we expect that implementation of our software will be completed by the end of March.

In addition, we're seeing interest in implementing lung cancer screening programs in other Canadian provinces as well as in the UK and Australia. In Connect and Control, we're excited about several new products.

For example, our smart X-ray tube cooler proactively measures the performance of the cooler, allowing intervention to prevent unscheduled downtime. Similarly, our smart collimator uses proprietary technology that can help limit image retakes, reduces end user cost and improves product life.

Our smart mammography compression panel adapts breast compression to the patient's unique anatomy. Through its proprietary technology, the aim is to improve patient's experience and aid in the health care decision-making process.

We expect these new technologies across the Medical segment to expand our serviceable addressable market, or SAM, of approximately $1 billion in calendar 2026. This expansion is in addition to organic market growth of just under $0.5 billion over the same time frame.

As we look forward to the rest of the fiscal year, we expect supply chain volatility to remain challenging throughout fiscal 2022. We will continue to be vigilant in our efforts to meet customers’ needs while managing the risk in supply chain.

We continue to be encouraged by the level of demand we’re seeing and the effort that our employees are making to weather the supply chain uncertainties. We recently celebrated our five-year anniversary of being Varex Imaging. Over the past five years, we have touched the lives of millions of people around the world, making a difference every day.

I’m proud of our talented global and diverse team. Our investments in innovation have enabled us to expand our market leadership and introduce new technologies, thus allowing our customers to bring innovative imaging solutions to market to help make the world a healthier and safer place. With that, let me hand over the call to Sam..

Thanks, Sunny, and hello, everyone. As a reminder, unless otherwise indicated, I will provide sequential comparison of our results for the first quarter of fiscal year 2022 with those of our fourth quarter of fiscal 2021. Despite high demand, supply chain constraints prevented us from shipping products on time.

As a result, our revenues came in below our guidance. Rising raw material, logistics and expedite costs pressured gross margin. Lower operating expenses provided some offset and helped generate non-GAAP EPS of $0.25. First quarter revenues were $199 million, a decrease of 12% from the fourth quarter.

Medical revenues were $156 million and Industrial revenues were $43 million. Sequentially, medical sales declined 14% and industrial sales declined 6%. Medical revenues were 78% and Industrial revenues were 22% of the overall revenues for the quarter.

Looking at revenue by region, Americas declined 14% sequentially, while EMEA declined 10% and APAC declined 14%, all due to supply chain driven limitations on our shipments. Let me now cover our results on a GAAP basis. First quarter gross margin was 33% in line with the previous quarter, but on a lower revenue base.

Operating income was $14 million, and the tax rate was unusually high at 51%, due to a low base figure of earnings before taxes. This resulted in net earnings of $1 million and GAAP EPS of $0.03. Moving on to non-GAAP results for the quarter.

Gross margin was 34%, which was slightly below our expectations, but reasonable in the face of ongoing supply chain and logistics-related challenges. Freight expenses impacted gross margin by about 30 basis points compared to Q4 2021 and by 100 basis points compared to a year ago quarter.

In addition, we continue to qualify various alternate suppliers. And as a result, R&D resources were diverted towards solving supply chain issues. These activities impacted gross margin for the quarter by 20 basis points.

As we have highlighted since the second quarter of fiscal 2021, challenges in raw material availability, freight and logistics have been a persistent margin headwind. We continue to work through these challenges with current and alternate suppliers to mitigate impact what this has been and continues to be a dynamic environment.

As we noted last quarter, in late October, we rolled out broad-based price increases of mid-single digit percentage or higher. Since many customers are on annual contracts, we expect to realize price increases gradually throughout fiscal 2022.

At this point, majority of our customers whose contracts were up for renewal have accepted price increases, and we continue to work with the remaining customers to incorporate price increases into their contracts. R&D spending in the first quarter was $18 million or 9% of revenues within our 8% to 10% target range.

SG&A was approximately $26 million, down $1 million from the prior quarter. Operating expenses were $44 million, down $1 million from the prior quarter, as explained above. Lower operating expenses helped generate operating earnings of $23 million. Operating margin was 11% of revenue in the quarter. Tax expense in the first quarter was $3 million.

Net earnings were $10 million or $0.25 per diluted share compared to $19 million or $0.45 per diluted share in Q4 2021. Average diluted shares in the quarter were $41 million, in line with the prior quarter.

As we highlighted previously, due to our convertible notes-related bond hedge and the associated trading range of our shares, there is a difference between diluted shares for GAAP and non-GAAP purposes. GAAP share count ignores the bond hedge, while non-GAAP share count includes the economic benefit from this hedge.

We have provided a reconciliation between the two at the end of our earnings press release. The appendix to our slides provides a table showing the effect of this bond hedge on the diluted share count for GAAP and non-GAAP purposes.

Separately, 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 receivable decreased by $28 million, mainly due to lower sales in the quarter. DSO improved to 58 days.

Inventory increased $23 million, primarily due to increase in working process inventory amidst ongoing component shortages as well as premiums being paid to procure raw material. As a result, days of inventory increased to 168 days.

Accounts payable increased by $13 million, partially due to increased purchasing activity, and days payables was 49 days. Now moving to debt and cash flow information. Cash flow from operations was $11 million, and we ended the quarter with cash of $158 million on the balance sheet, an increase of $13 million from the prior quarter.

Gross debt outstanding at the end of the first quarter was $480 million, and debt net of cash declined to $322 million reflecting the continued delevering on a net debt basis. Adjusted EBITDA was $30 million in the first quarter, and adjusted EBITDA margin was 15%.

The combination of profitability and cash generation has helped lower our net debt leverage ratio to 2.3 times at the end of the quarter. We remain focused on meeting the demands of our customers while working to mitigate the challenges presented by a constrained supply chain.

To that end, I would like to thank our Varex colleagues worldwide for their continued efforts in staying on course and achieving these results this quarter. Like last quarter, before providing guidance, I wanted to take a step back and discuss broader revenue and gross margin dynamics. Our Q1 revenue results came in lower than expected.

This was mainly due to supply chain delays. This is the exact opposite of what we experience in the fourth quarter of fiscal 2021. The supply chain environment remains significantly volatile and in the face of strong demand currently remains the governing factor for our sales growth.

Turning to gross margin, as we have noted in the past, our target gross margin is 35% plus or minus 1%.

Although so far, we have been successful in neutralizing cost escalations through customer price increases, we are finding this target is hard to achieve due to inefficiencies caused by manufacturing disruptions, expediting fees, alternate supplier qualification and various other factors.

Given that, for the near-term, we expect gross margin to be slightly below the low end of our targeted gross margin range. With that as a backdrop, here is our guidance for Q2. Revenues are expected between $190 million and $220 million, and non-GAAP earnings per diluted share is expected between $0.15 and $0.40.

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 23% for fiscal 2022, and non-GAAP diluted share count of about 41 million shares. With that, we will now open the call for your questions..

Thank you. [Operator Instructions] Our first question today is coming from Larry Solow from CGS Securities. Your line is now live..

Good afternoon. I guess, just a question on – a few questions, obviously, on the subject of the day of the month, on the supply chain. And Sunny, you mentioned you expect these problems to persist through the year and I think that’s what most companies are saying. And I think you also said that it seems like the problems got worse through the quarter.

So in light of that, and I fully got the guidance range for the upcoming quarter, but the wide range is really depending on the supply chain.

But are we kind of starting from the – below that midpoint? I’m just trying to get a gauge of where you stand there? Because it sounds like demand and you just with back orders alone, you should meet your sales numbers if you had the ability to filtrate and other components weren’t constrained.

So just trying to get a better picture of sort of where we stand today? Are things still deteriorating? Or is it kind of hard to say, and you’re at the mercy of your suppliers and freight and whatnot?.

So let me get started, and then I’ll ask Sam to add more color to it. First of all, the demand for us has been broad-based, and we’ve got a very healthy book of business to that we can deliver against us. The constraint here is being supply chain. And on the supply chain side, there are two types of constraints.

One is what Sam called the disruption in the factory, which is the nuisance type of supply chain situation where we’ve got these rolling shortages, suppliers are delayed by a few days.

Something is supposed to come on Monday, shows up on Thursday, and then you end up with having to scramble to put it together and stuff gets pushed out of the quarter, right? So that’s one type of supply chain. That’s typically in tubes.

The second shortage type of – Larry, so second shortage has been electronics, which is where we’ve had consistent short supply and then delays. And there, we get stops and starts, stops and starts.

As we look forward, what we’re hearing from our suppliers on the – that are – that have had rolling slowness in – mostly in electromechanical parts is, there it’s been had impacts of COVID and a few other things that have disrupted their environment. So we feel like that has the chance of getting better. That seems to be getting better.

We’ve got pockets where there are problems. But the electronics problems are more consistent, and we don’t have visibility for improvement in that part of the supply chain beyond what we can see for the next quarter or so. And so hence, our indication that we expect this to linger on for the rest of this fiscal year..

And Larry, this is Sam. I would like to add here that – what I would like to add here is that sometimes, from the supply chain side and various suppliers, material comes to us. And by the time it comes to us, it takes us time to complete it. And if it comes too late in the quarter, then we are not able to complete it within the quarter.

So there is lumpiness here. And then on electronics, semiconductor chips particularly, that what we use for detectors, they are in short supply. So both of those things are happening.

But going back to your original question, from a guidance perspective, we guide towards the midpoint and we look at the risk and probabilities and then that’s how we guide. So this is what we are seeing right now, and that is what we are guiding as of now..

That’s fair. And what about new orders, it sounds like demand is strong across most of your modalities on both sides. And everything is just getting pushed to the right. Do you feel like eventually, you lose some of these orders? Or is it just that we’re just chasing business for as long as these supply chain issues continue.

And maybe you’re at a sort of your constraint, you can’t maybe do more than $200 million or plus or minus a quarter for quite some time until things get better, right? I mean is that a good way to look at it? And do you feel like losing any share or anything? I suppose, no. But yes..

Larry, everyone in our – others in our space are also having similar problems. So we’re not losing share. But at the same time, we don’t lose these orders. These are designed in products so they just moved to the right, and we just have to manage customers’ expectations. So that, at this point, losing orders is not a concern..

Yes. And Larry, I would like to add that, I don’t think we are seeing rest of the quarters or the business for the rest of the year as hamstrung around $200 million a quarter. That is not the case. I think in the prior quarter, because of Omicron, because of compression, material availability and all of that caused issues.

But there is also reasonable degree of hope out there that sooner or later, these supply chain issues may not be fully resolved, but they begin to improve. And so I would not necessarily suggest that we are indicating that we are stuck around $200 million a quarter..

And you mentioned some – it seems like some more supply issues in – maybe on the tube side. Is there any difference or is it – it sounds like it’s on both medical and industrial, but do you have – is it – obviously, medical is a larger piece of your business.

Do you feel like the disruptions are sort of fairly evenly balanced, you don’t really see a trend between the two different segments? Or is there anything noteworthy there?.

Yes. So I would say that the supply chain issues are a little bit more pronounced in the detector side of the business versus the tubes when you look at it on the product side. But when it comes to Medical versus Industrial segments, I think they are largely similar because demand is strong in both those segments.

It all comes down to what we can finish in terms of product and ship it to our customer..

Got it. Okay. Thanks. I appreciate the color..

Thank you, Larry..

Thank you. Our next question today is coming from Suraj Kalia from Oppenheimer & Company. Your line is now live..

Good afternoon, Sunny, Sam, Chris. Hope everyone is safe and healthy.

Can you hear me all right?.

Yes, we can, Suraj..

Perfect. Sunny, so let me start out with a different version of the supply chain issue question. But you don’t have to ration product delivery given component shortages.

How does the decision matrix look like?.

Yes. So Suraj, great question. Of course, here and there, we do have to do this. Obviously, what we are trying to do, it’s a multidimensional issue and not a straightforward answer. Obviously, everybody wants quite a bit of product, but from our side, we try to make sure no customer is lying down.

So there is a degree of variability, there is a degree of judgment and assessment that our sales leadership makes those decisions. So that’s one.

And then secondly, there are various customers with different degrees of applications in terms of whether it’s medical or industrial, whether it’s a cell phone versus a life-saving machine, there is a degree of assessment that comes in there. And then we also have to look at what is going into the product from a component perspective.

So for example, we may have one component in short supply. But then if we try to work on one set of products, something else may become an issue. So there is a cascading effect of component that’s also thought through. So those are some of the things that come to my mind. And then there are a couple other factors also.

Maybe, Sunny, if you want to add there. But those are the things that come to our mind..

Look, Suraj, these discussions go on daily, weekly with customers, and we try to balance – the number one priority is not letting any customer have a line down. And that’s how we – that’s where we start. And then other factors, as Sam described, goes in and we get that input from our customers on a regular basis..

Got it. Sam, one for you and then one for Sunny, and I’ll pose both of these together. So Sam, one of the tenets of your P&L optimization was eliminating $25 million of inventory. Just given you do have a visibility, if I remember correctly, six to nine months rolling visibility into orders.

So obviously, that helps you all plan your inventory or do inventory management.

Just given everything going on, has anything changed specifically with respect to the $25 million number that you had mentioned earlier? And Sunny, if I quote on a completely different tangent, the multimeter two prototypes being sent in, presumably, this would only be for new sockets, right? And I’d love to – maybe I missed it, what feedback have you all received so far to whichever application or OEM partner you’ll send out your carbon nanotubes.

Gentlemen, thank you for taking my questions..

Sure. So Suraj, I’ll answer your question first. So in terms of inventory, the $25 million reduction, that was our goal for last fiscal year. We achieved that and we were able to make a lot of improvement there in terms of efficiencies and a number of other things.

At this time, what we are doing with raw material procurement is giving out long-lead purchase orders to our suppliers. So as we are getting more and more visibility on the demand side from our customers, we are providing more visibility to our customers.

We are also – areas where the lead times are longer or maybe there is a little bit more volatility from the supplier perspective, we are increasing the stock that we carry. So as a result, you are seeing inventory go up. And then lastly, we are procuring material at higher prices. So cost is definitely beginning to flow through the P&L.

And as a result, inventory values have gone up. And I think inventory will remain high. And at this time, truly, everybody is trying to have more material on hand because the demand and the volume of the demand is quite robust, and there is a lot of visibility on that.

So currently, we would like to have more inventory than less in order to meet our customers’ demand..

And then, Suraj, you asked your question about the nanotubes that we’ve shipped out. We’ve sent out these multimeter tubes, massively multimeter tubes. And we’re getting – the feedback we’re getting is it works as stated.

So customers have given us specs to what they need in terms of energy dose that they need for their imaging application, and it’s working. As we had said earlier in the prior calls that we’re satisfied with the performance levels for the energy and dose levels that we were targeting and have tested, and those are panning out.

So we’re pretty happy with what we’ve done so far..

Thank you. [Operator Instructions] Our next question is coming from Jim Sidoti from Sidoti & Company. Your line is now live..

Hi. Good afternoon and thanks for taking the questions. I think everyone agrees it’s only a matter of time before the supply chain issues get resolved. I don’t think anybody is sure if that’s three, six, nine months from now, but I think everybody thinks it will happen at some point.

So my question is, when you do get back to more of a normal environment, do you think that the price increases that you’re putting in will stick? And is there opportunity for additional cost cutting at that point?.

So let me start. The price increases are – were not intended to be temporary or just temporary pass-throughs. These are increases to the base price. So we – yes, we do expect them to stick. And we will see the realization of that, as Sam said, ramping up through this year and going into next year, we should see the full impact of those price increases.

And then the second – sorry, the second go ahead, Sam..

And the second question in terms of cost cutting, Jim, I can help you with that here. So in terms of – as you look at costs, there are two types of costs that our P&L or our business is experiencing right now.

One is the inflationary cost on the raw material, and we are neutralizing that by passing it on to customers, and we expect that these price increases, like Sunny said, will be longer-term. And so that would definitely neutralize the cost increases.

But there is another set of costs or expenses that is going through our P&L, which is what I call inefficiencies or there is a lot of supply chain chaos, whether it is start and stop in terms of manufacturing lines, or expediting fees or paying the freight for very high or elevated freight expenses.

So I do expect that when the supply chain environment improves and it becomes more orderly and stable, that our inefficiencies would go away, and that would actually create efficiencies or improvements to the P&L. In terms of the raw material cost and inflation, we don’t know right now.

All we can do is monitor it and ensure we are maintaining the profitability for the business by working it out on the pricing side with the customers. So just hopefully, that gives you the color that you’re looking for..

Yes.

Well, I guess what I’m trying to get at is if we look out to fiscal 2023 and beyond, I mean those targets that you put out previously for gross margin, do you think they will be achievable?.

We certainly hope so. Obviously, we need to know supply chain and all of those, but we certainly would target them back in soon as this environment improves. But obviously, we do not know right now when and where we would be achieving those, but that certainly remains the target. Yes..

Thank you..

Thank you. [Operator Instructions] We’ve reached the end of our question-and-answer session. I’d like to turn the floor back over to Chris for any further or closing comments..

Thank you for your questions and participating in our earnings conference call for the first quarter of fiscal year 2022. The webcast and supplemental slide presentation will be archived on Varex’ website.

A replay of this quarterly conference call will be available through February 22 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 13726332. Thank you, and goodbye..

Thank you. That does conclude today’s teleconference and webcast. You may disconnect your line at this time, and have a wonderful day. We thank you for your participation today..