Varex Imaging Corporation — Q2 FY2019 Form 10-Q
Reporting period: Quarter ended March 29, 2019; comparisons are with the quarter ended March 30, 2018. The six-month period covers the first half of fiscal 2019. Varex designs, manufactures, sells and services X-ray imaging components and systems for medical, industrial, security and inspection markets.
Financial performance
| Metric | Q2 FY2019 | Q2 FY2018 | Six months FY2019 | Six months FY2018 |
|---|---|---|---|---|
| Revenue | $195.8m | $201.2m | $381.5m | $377.4m |
| Gross margin | $64.4m; 32.9% | $70.1m; 34.8% | $124.4m; 32.6% | $131.6m; 34.9% |
| Operating earnings | $14.5m | $17.2m | $24.9m | $30.7m |
| Net earnings attributable to Varex | $5.8m; $0.15 diluted EPS | $12.2m; $0.32 diluted EPS | $8.8m; $0.23 diluted EPS | $23.6m; $0.62 diluted EPS |
| Operating cash flow | Not presented separately for the quarter | $32.9m | $45.5m |
Revenue and margins: Q2 revenue fell 2.7%; first-half revenue rose 1.1%. Q2 medical revenue declined 6.1% to $148.9m, while industrial revenue grew 9.8% to $46.9m. For the first half, medical revenue decreased 1.6% to $292.8m and industrial revenue increased 11.3% to $88.7m. Management attributed medical weakness mainly to lower detector and aftermarket X-ray tube sales; industrial growth reflected stronger security and nondestructive-testing demand. Lower medical gross margin—linked to quality costs, freight and tariffs in Q2, and restructuring and quality costs year to date—drove the overall margin decline.
Cash flow and liquidity: First-half operating cash flow was $32.9m, versus $45.5m; capital expenditures were $7.6m, versus $6.9m. Cash and cash equivalents were $31.0m at quarter-end, down from $51.9m at September 28, 2018. Current assets were $437.3m and current liabilities $156.3m. Varex reported $150.0m available under its revolving facility, subject to covenants.
Debt: Gross debt was $353.0m ($346.1m net of deferred loan costs), down from $398.0m gross at fiscal year-end. The debt includes a term facility; no revolver borrowings were outstanding at March 29. Six interest-rate swaps hedged $270.0m of floating-rate debt. The credit agreement matures May 2022 and includes financial and other restrictive covenants.
Material changes and unusual items
- Q2 net earnings attributable to Varex fell to $5.8m from $12.2m. Other expense was $1.3m, compared with $4.1m of other income in the prior-year quarter; management cited lower equity-method investment income as a key driver of higher net interest and other expense.
- First-half net earnings attributable to Varex declined to $8.8m from $23.6m. The prior-year comparison included a one-time tax benefit; first-half FY2019 had a 25.2% effective tax rate versus a 4.8% tax benefit rate in the prior-year period.
- Varex recorded Q2 out-of-period adjustments that reduced pretax income by $1.5m ($1.1m after tax), principally for inventory and deferred financing-cost errors. It also recorded a $0.8m intangible-asset impairment. Management concluded the identified errors were not material to the periods assessed.
- Varex adopted ASC 606 in FY2019. Adoption reduced retained earnings by $3.5m net of tax; the quarter included a $0.6m net-of-tax correction that increased retained earnings. FY2018 comparisons were prepared under the prior revenue standard.
Outlook, management commentary and risks
- No specific consolidated revenue or earnings guidance is provided in the supplied filing text. Management says it considers R&D spending of approximately 8%–10% of annual revenue appropriate over the long term; first-half R&D was 9.9% of revenue.
- Management expects trade tariffs to continue to weigh on the business, including through higher costs, customer price concessions and potential loss or delay of orders. It also notes ongoing detector price erosion and quality-cost pressures.
- On April 29, 2019, after quarter-end, Varex acquired approximately 97.4% of Direct Conversion AB for €62.1m cash, assumed €2.6m of net debt, and agreed to a deferred payment linked to 345,598 Varex shares. The company funded the transaction with $7m of cash and $64m of credit-facility borrowings. Purchase-price allocation was not complete when the filing was prepared.
- Disclosure controls and procedures were deemed ineffective as of March 29, 2019 because of material weaknesses in internal control over financial reporting. Areas included IT access and change controls, revenue and ASC 606 accounting, inventory and cost of revenue, German operations, and the financial close process. Remediation was underway but not yet considered complete.
- Key exposures include customer concentration (Canon Medical Systems represented 17.1% of Q2 revenue and 17.7% for the first half), competition and pricing pressure, tariffs and foreign-exchange movements, quality and product-warranty costs, dependence on limited or sole-source suppliers, floating-rate debt, and unpredictable government-related industrial orders. Varex also disclosed patent-infringement litigation initiated during the fiscal year; management said it knew of no pending litigation expected to have a material adverse effect.
Important facts for investors to verify
- Whether medical sales and gross margins stabilize, particularly given detector quality costs, price erosion and tariff effects.
- Progress and testing evidence for remediation of the disclosed material weaknesses, and whether any further accounting corrections are needed.
- Direct Conversion’s final purchase-price allocation, integration, performance and effect on debt and covenant headroom.
- Operating cash generation, inventory levels, debt repayment capacity and compliance with credit-facility covenants.
- Exposure to Canon and other major OEM customers, supplier continuity—including dpiX—and the financial impact of trade restrictions and litigation.