Varex Imaging Corporation — Q3 FY2019 Form 10-Q
Reporting period: Fiscal third quarter and nine months ended June 28, 2019; comparable periods ended June 29, 2018. Amounts are in U.S. dollars.
Business context
Varex designs, manufactures, sells and services X-ray imaging components and related software for medical, industrial, security and inspection applications. Its reportable segments are Medical and Industrial. The quarter’s results include the Direct Conversion acquisition from April 29, 2019; management said it did not significantly affect results on a pro forma basis.
Financial performance
| Metric | Q3 FY2019 | Q3 FY2018 | Nine months FY2019 | Nine months FY2018 |
|---|---|---|---|---|
| Revenue | $196.7m | $191.2m | $578.2m | $568.6m |
| Gross profit / margin | $60.7m / 30.9% | $63.0m / 32.9% | $185.1m / 32.0% | $194.7m / 34.2% |
| Operating earnings | $4.6m | $7.3m | $29.5m | $38.1m |
| Net earnings attributable to Varex | $(1.4)m | $3.8m | $7.4m | $27.5m |
| Diluted EPS attributable to Varex | $(0.04) | $0.10 | $0.19 | $0.72 |
- Quarterly revenue rose 2.9%. Medical revenue increased 2.8% to $151.6m and Industrial revenue increased 3.0% to $45.1m. For the nine months, revenue rose 1.7%; Industrial grew 8.4% while Medical declined 0.2%.
- Margin pressure was concentrated in Medical: Q3 Medical gross margin was 29.2%, down from 32.0%; Industrial was 36.6%, versus 36.3%. Management cited detector-business restructuring and higher quality costs. Year-to-date gross margin also declined, with higher manufacturing costs weighing on Industrial.
- Q3 interest and other expense, net, was $5.2m versus $4.7m. Nine-month expense was $18.2m versus $12.6m, primarily reflecting lower equity-method investment income. The Q3 tax expense was $0.7m despite a pretax loss; management attributed the unusual effective tax rate to losses in jurisdictions where tax benefits could not be recognized.
Cash flow, balance sheet and liquidity
- Nine-month operating cash flow was $49.0m, down from $66.8m. Investing used $86.4m, including $69.5m net cash paid for Direct Conversion; financing provided $14.7m. Cash and restricted cash ended at $30.0m, compared with $53.4m at the beginning of the period. Balance-sheet cash and equivalents were $28.5m.
- Net debt was $409.6m at June 28, 2019, versus $389.8m at September 28, 2018; gross debt was $416.0m. The company had $84.0m available under its revolving facility, subject to covenants, and reported compliance with debt covenants. The credit facilities mature May 1, 2022.
- Current assets were $441.4m and current liabilities $171.2m. Inventory increased to $263.4m from $235.1m; accounts receivable decreased to $131.1m from $154.0m. DSO improved to 60 days from 68 days.
- Capital expenditures were $13.3m for the nine months, compared with $15.3m. The company also reported $54.1m of investments in privately held companies and $7.4m of remaining 2019 fixed-cost commitments to dpiX.
Material changes, outlook and risks
- Santa Clara facility: Varex announced on July 11, 2019 that it would close the facility as part of integrating the PerkinElmer imaging business. It recorded $7.1m of related Q3 charges—$4.0m of intangible-asset impairment and $3.1m of inventory write-downs—and expects another $13m–$17m of restructuring expense from Q4 FY2019 through FY2021. Operations are expected to cease by the end of 2020, with closure in mid-2021.
- Acquisition: Direct Conversion adds photon-counting detector technology. Consideration was $69.5m cash, net of acquired cash, plus deferred consideration valued at approximately $9.9m; the purchase-price allocation remains preliminary. The acquisition added $46.5m of goodwill.
- Management commentary: Management considers R&D spending of approximately 8%–10% of annual revenue appropriate over the long term; nine-month R&D was 10.1% of revenue. The filing provides no specific revenue or earnings guidance. It states that remaining performance obligations were $281.2m, with a majority expected to be recognized within 12 months.
- Key operating risks: U.S.–China trade tensions and tariffs have hurt detector business in China and may lead to further price concessions or lost business. Varex also cites detector price erosion, customer forecast variability, international exposure, supply-chain concentration, product quality and manufacturing risks, and dependence on a limited number of OEM customers. Canon Medical Systems accounted for 17.1% of Q3 revenue and 17.5% of nine-month revenue.
- Controls and accounting: Management concluded disclosure controls were not effective at quarter-end because material weaknesses in internal control over financial reporting remained. Areas included IT access and change controls, revenue and ASC 606 processes, inventory valuation and counts, German operations, and financial close and reporting. Remediation work is underway, but the weaknesses are not considered resolved until controls operate effectively and are tested. The filing also reports a $1.1m pretax out-of-period adjustment in Q1, principally relating to an inventory overstatement in FY2018; management judged it immaterial.
- Other matters: Varex reported initiating patent-infringement litigation against a third party and said it did not believe pending litigation would materially adversely affect operations or financial position. Product indemnification arrangements can have unlimited potential payments for certain claims, though the company reported no material related costs to date.
Important facts for investors to verify
- Whether gross-margin declines, higher quality costs and detector restructuring costs persist or improve, particularly in Medical.
- Execution, total costs and expected benefits of the Santa Clara closure and Direct Conversion integration.
- Remediation and independent testing of the disclosed material weaknesses, and whether further reporting adjustments arise.
- Cash generation and inventory levels, debt and covenant headroom, and the effect of floating rates beyond the $264.4m of debt notionally covered by interest-rate swaps.
- Customer concentration and the impact of tariffs, China demand, detector pricing and order variability on sales and margins.