Varex Imaging Corp 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of the financial condition and results should be read together with the unaudited condensed consolidated financial statements and notes thereto that are contained in this Quarterly Report on Form 10-Q as well as our Annual Report on Form 10-K for the fiscal year ended October 1, 2021 and our other filings, including the Current Reports on Form 8-K, that have been filed with the SEC through the date of this report. Forward-Looking Statements This Quarterly Report on Form 10-Q (this “Quarterly Report”) contains “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995, which provides a “safe harbor” for statements about future events, products and future financial performance that are based on the beliefs of, estimates made by, and information currently available to the management of Varex Imaging Corporation (“we,” “our,” “us,” the “Company,” “Varex,” or “Varex Imaging”). Actual results and the outcome or timing of certain events described in these forward-looking statements are subject to risk and uncertainties and may differ significantly from those projected in these forward-looking statements. Important factors that could cause our actual results and financial condition to differ significantly from those projections or expectations include, among other things, the risks described in the Summary of Principal Risk Factors below and further described in the Risk Factors listed in Part II, Item 1A - Risk Factors of this Quarterly Report. Statements concerning: the impact of the ongoing COVID-19 pandemic on the global economy or the Company; supply chain actions; industry or market segment outlook; market acceptance of or transition to new products or technology such as advanced X-ray tube and digital flat panel detector products; growth drivers; future orders, revenues, backlog, earnings or other financial results; and any statements using the terms “believe,” “expect,” “anticipate,” “can,” “should,” “would,” “could,” “estimate,” “may,” “intended,” “potential,” and “possible” or similar statements are forward-looking statements that involve risks and uncertainties that could cause our actual results and the outcome and timing of certain events to differ materially from those projected or management’s current expectations. Any forward-looking statement made in this Quarterly Report (including in any exhibits or documents incorporated by reference) is based only on information currently available to Varex and its management and speaks only as of the date on which it is made. We have not assumed any obligation to, and you should not expect us to, update or revise those statements because of new information, future events or otherwise. Overview Varex Imaging Corporation is a leading innovator, designer and manufacturer of X-ray tubes, digital detectors, linear accelerators and other image software processing solutions, which are critical components in a variety of X-ray based imaging equipment. Our components are used in medical diagnostic imaging, security inspection systems, and industrial quality inspection systems, as well as for analysis and measurement applications in industrial manufacturing applications. Global original equipment manufacturers (“OEMs”) incorporate our X-ray imaging components in their systems to detect, diagnose, protect and inspect. Varex has approximately 2,100 full-time equivalent employees, located at manufacturing and service center sites in North America, Europe, and Asia. Our products are sold in three geographic regions: the Americas, EMEA, and APAC. The Americas includes North America (primarily the United States) and Latin America. EMEA includes Europe, Russia, the Middle East, India and Africa. APAC includes Asia and Australia. Revenues by region are based on the known final destination of products sold. Our success depends, among other things, on our ability to anticipate and respond to changes in our markets, the direction of technological innovation and the demand from our customers. We continually invest in research and development and employ approximately 500 individuals in product development related activities. Our focus on innovation and product performance along with strong and long-term customer relationships allows us to collaborate with our customers to bring industry-leading products to the X-ray imaging market. We continue to work to improve the life and quality of our imaging components and leverage our scale as one of the largest independent X-ray imaging component suppliers to provide cost-effective solutions for our customers. 25 Table of Contents Impact of COVID-19 and the General Economic Environment The unprecedented nature of the COVID-19 pandemic and its effect on the global economy began to significantly disrupt our business in fiscal year 2020 by initially reducing demand for our products followed by strong recovery in demand but increasing variability in supply of raw materials and manufacturing productivity. During fiscal year 2021, demand for many of our products recovered to pre-pandemic levels and business has continued to grow. We believe that demand for our products has increased due to increased investments in healthcare and diagnostics coupled with end-users (such as hospitals) making capital purchases that were previously deferred due to the uncertainty surrounding COVID-19. While we are encouraged by the recovery, we remain cautious as many factors remain unpredictable. We continue to experience logistic, supply chain, and manufacturing challenges that we expect will continue throughout 2022. As economies around the world continue to recover, shortages in raw materials have become more widespread. We continue to experience shortages of certain materials and have used more of our inventory on hand than we have used historically, while also purchasing more materials that are critical to our processes, often at higher costs. Shortages of materials, particularly micro-controller chips and associated electronic components, have caused and may continue to cause, delays in manufacturing products for our customers. In some cases, raw material shortages and delivery delays from our suppliers are communicated to us with very little advanced warning, which has caused operational and customer order fulfillment challenges. Over the past year, our ability to mitigate supply chain challenges was higher than it is currently. For example, during fiscal year 2021, inventory levels decreased due to our strong growth and, despite a concerted effort, it has continued to be difficult to replenish that inventory. While we are dedicating significant resources to manage, mitigate, and resolve these issues, we currently expect supply chain challenges to continue to impact our ability to deliver products to our customers over the next several quarters. Increased freight charges and shipping delays have also become more common during the pandemic and are expected to continue into the foreseeable future. Due to the rising cost environment, in addition to ongoing expense management, we have raised prices on certain products. We expect to make pricing adjustments throughout fiscal year 2022. During the three months ended December 31, 2021, our manufacturing facilities continued to operate without significant disruption due to employee absences, however, with the increasing prevalence of the omicron variant and the general increase in COVID-19 cases in the cities in which our facilities are located, we have experienced an increase in COVID-19 related employee absences that has made it more difficult to manufacture our products. We have been taking significant precautions to maintain employee safety, such as continuing a mask requirement, strongly encouraging vaccination, and asking non-production related employees to work from home when possible. The full extent to which the COVID-19 pandemic and ensuing supply chain challenges have and will directly or indirectly impact us, including our business, financial condition, and results of operations, will depend on future developments that are highly uncertain and cannot be accurately predicted. We will continue to actively monitor the situation and may take further actions that alter our business operations or that we determine are in the best interests of our employees, customers, suppliers, and stockholders. For additional information on risks related to the pandemic and other supply chain risks that could impact our results, see Part I, Item 1A - Risk Factors. Operating Segments and Products We have two reportable operating segments: Medical and Industrial. The segments align our products and service offerings with customer use in medical and industrial markets. Medical In our Medical segment, we design, manufacture, sell and service X-ray imaging components, including X-ray tubes, digital detectors, high voltage connectors, image-processing software and workstations, 3D reconstruction software, computer-aided diagnostic software, collimators, automatic exposure control devices, generators, heat exchangers, ionization chambers and buckys. These components are used in a range of medical imaging applications including CT, mammography, oncology, cardiac, surgery, dental, and other diagnostic radiography uses. Our X-ray imaging components are primarily sold to OEM customers. These OEM customers then design-in our products into their X-ray imaging systems for a variety of medical modalities. A substantial majority of medical X-ray imaging OEMs globally are our customers, and many of these have been our customers for over 25 years. We believe one of the reasons for customer loyalty is that our hardware and software products are tightly integrated with our customers' systems. We work very closely with our customers to create custom built components for their systems based on technology platforms that we have developed. Because our products are often customized for our customers' specific equipment, it can be costly and complex for our customers to switch to another provider. 26 Table of Contents Once our components are designed into our customers' equipment, our customers will typically continue to buy from us for any replacement components and for service and support for that equipment. Some of our products are also included in product registrations for our customers' equipment that require regulatory approval to change. In addition to sales to OEM customers, we sell our products to independent service companies and distributors as well as directly to end-users for replacement purposes. The COVID-19 pandemic had a significant effect on hospitals, clinics and outpatient imaging centers as they encountered declines in elective procedures volume. As a result, they reduced the capital purchases of imaging equipment from OEMs, which led to lower demand for X-ray imaging components for us. Additionally, equipment installations were delayed, due to reduced access to healthcare institutions. Partially offsetting this was an increased demand for imaging equipment used to diagnose respiratory diseases, such as radiographic X-ray imaging systems and CT imaging systems. The Company has experienced growth in demand for its products as health systems globally have continued to address healthcare services gaps. However, the Company is not able to convert all the demand into sales due to on-going supply chain related interruptions and uncertainties, particularly with the availability of micro-controller chips and other electronic components. As a result, uncertainty in overall sales volume is expected to continue into calendar year 2022. In China, the government is broadening the availability of healthcare services. As a result, the number of diagnostic X-ray imaging systems, including CT, has grown significantly. We are developing CT X-ray tubes and related subsystems for Chinese OEMs as they introduce new systems in China. Over the long-term, our objective is to become the partner of choice both for OEMs and in the replacement market as CT systems become more widely adopted throughout the Chinese market. In recent years our business in China has been impacted by the trade war with the United States in three principal ways: (1) imports of raw materials from China to the Unites States have become more expensive, (2) imports of raw materials and sub-assemblies from the Unites States to China have become more expensive, and (3) importing finished U.S. manufactured products into China have become more difficult and expensive. In order to mitigate the impact of tariffs on materials imported from China, we have implemented changes to secure more non-China sources of materials used to manufacture our X-ray imaging products. To help mitigate the impact of tariffs, and to be closer to our global customer base, we continue to expand manufacturing capabilities at our facilities in China, Germany and the Philippines. We have also implemented local sourcing strategies to offer local content. This local-for-local strategy has been well received by both our local customers as well as global OEMs, and acts as a natural hedge against trade wars and other potential supply chain disruptions. Industrial In our Industrial segment, we design, develop, manufacture, sell and service X-ray imaging products for use in a number of markets, including security applications for cargo screening at ports and borders and baggage screening at airports, and nondestructive testing and inspection applications used in a number of other vertical markets. Our industrial products include Linatron® X-ray linear accelerators, X-ray tubes, digital detectors and high voltage connectors. In addition, we license proprietary image-processing and detection software designed to work with other Varex products to provide packaged sub-assembly solutions to our industrial customers. Our Industrial business benefits from the research and development investment and manufacturing economies of scale on the Medical side of our business, as we continue to find new applications for our technology. Along with more favorable pricing dynamics, this allows us to generally achieve higher gross profit for industrial products relative to our Medical business. In addition, our Industrial business benefits from our long-term service agreements for our Linatron® products. The security market primarily consists of cargo security for the screening of trucks, trains, and cargo containers at ports and borders as well as airport security for carry-on baggage, checked baggage and palletized cargo. The end customers for border protection systems are typically government agencies, many of which are in oil-based economies and war zones where there can be significant variation in buying patterns. Non-destructive testing and inspection verticals utilize X-ray imaging to scan items for inspection of manufacturing defects and product integrity in a wide range of industries including the aerospace, automotive, electronics, oil and gas, food packaging, metal castings and 3D printing industries. In addition, new applications for X-ray sources are being developed, such as sterilization of food and its packaging. We provide X-ray sources, digital detectors, high voltage connectors and image processing software to OEM customers, system integrators and manufacturers in a variety of these verticals. We believe that the non-destructive testing market represents a significant growth opportunity for our business, and we are actively pursuing new potential applications for our products. The economic downturn triggered by the COVID-19 pandemic reduced the demand for X-ray imaging equipment utilized in the non-destructive testing market as manufacturers focused on cash preservation and reduced spending for capital equipment. During the three months ended December 31, 2021, we have continued to see improved conditions in this market. 27 Table of Contents Critical Accounting Policies and Estimates The preparation of our condensed consolidated financial statements and related disclosures in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. These estimates and assumptions are based on historical experience and on various other factors that we believe are reasonable under the circumstances. Our critical accounting policies that are affected by accounting estimates require us to use judgments, often as a result of the need to make estimates and assumptions regarding matters that are inherently uncertain, and actual results could differ materially from these estimates. We periodically review our accounting policies, estimates and assumptions and make adjustments when facts and circumstances dictate. Refer to our Annual Report on Form 10-K for the fiscal year ended October 1, 2021 filed with the SEC on November 19, 2021 and Note 1 “Summary of Significant Accounting Policies” of the notes to the condensed consolidated financial statements of this report for further details. Our critical accounting policies that are affected by accounting estimates include valuation of inventories, assessment of recoverability of goodwill and intangible assets, and income taxes. Such accounting policies require us to use judgments, often as a result of the need to make estimates and assumptions regarding matters that are inherently uncertain, and actual results could differ materially from these estimates. There have been no changes to our critical accounting policies, estimates and assumptions or the judgments affecting the application of those estimates and assumptions since the filing of our Annual Report on Form 10-K for year ended October 1, 2021. Fiscal Year The fiscal years of the Company as reported are the 52 or 53-week period ending on the Friday nearest September 30. Fiscal year 2022 is the 52-week period ending September 30, 2022. Fiscal year 2021 was the 52-week period that ended on October 1, 2021. The fiscal quarters ended December 31, 2021 and January 1, 2021 were both 13-week periods. Discussion of Results of Operations for the Three Months Ended December 31, 2021 Compared to the Three Months Ended January 1, 2021 Revenues, net Three Months Ended (In millions) December 31, 2021 January 1, 2021 $ Change % Change Medical $ 155.7 $ 139.2 $ 16.5 11.9 % Industrial 43.1 37.9 5.2 13.7 % Total revenues $ 198.8 $ 177.1 $ 21.7 12.3 % Medical as a percentage of total revenues 78.3 % 78.6 % Industrial as a percentage of total revenues 21.7 % 21.4 % Medical revenues increased $16.5 million primarily due to increased sales of digital detectors for dynamic imaging applications and higher sales of CT X-ray tubes. The increase in medical sales was particularly strong in CT, Oncology, and Dental Modalities. Industrial revenues increased $5.2 million primarily due to increased sales of digital detectors, X-ray tubes, connectors for security and non-destructive inspection applications and service revenues. 28 Table of Contents Gross Profit Three Months Ended (In millions) December 31, 2021 January 1, 2021 $ Change % Change Medical $ 46.0 $ 44.1 $ 1.9 4.3 % Industrial 18.8 13.1 5.7 43.5 % Total gross profit $ 64.8 $ 57.2 $ 7.6 13.3 % Medical gross margin 29.5 % 31.7 % Industrial gross margin 43.6 % 34.6 % Total gross margin 32.6 % 32.3 % The increase in Medical gross profit was primarily due to the increased sales of CT X-ray tubes partially offset by higher inbound freight and material costs. The Industrial segment gross profit increased as a result of increased sales of digital detectors for security and non-destructive inspection applications and service revenues. Operating Expenses Three Months Ended (In millions) December 31, 2021 January 1, 2021 $ Change % Change Research and development $ 17.7 $ 16.7 $ 1.0 6.0 % As a percentage of total revenues 8.9 % 9.4 % Selling, general and administrative $ 33.1 $ 34.4 $ (1.3) (3.8) % As a percentage of total revenues 16.6 % 19.4 % Operating expenses $ 50.8 $ 51.1 $ (0.3) (0.6) % As a percentage of total revenues 25.6 % 28.9 % Research and Development We are committed to investing in the business to support long-term growth and believe long-term research and development expenses of approximately 8% to 10% of annual revenues is the appropriate range that will allow us to innovate and bring new products to market for our global OEM customers. Research and development costs decreased to 8.9% of revenues for the first quarter of 2022 primarily due to increased revenues, cost containment actions and improved material cost management. Selling, General and Administrative Selling, general and administrative expenses for the first quarter of 2022 decreased $1.3 million and decreased to 16.6% of total revenues primarily due to lower external audit, consulting, legal costs, and compensation compared to the prior year quarter. Interest and Other Expense, Net The following table summarizes the Company’s interest and other expense, net: Three Months Ended (In millions) December 31, 2021 January 1, 2021 $ Change Interest expense $ (9.9) $ (10.3) $ 0.4 Other expense, net (0.8) (0.5) (0.3) Interest and other expense, net $ (10.7) $ (10.8) $ 0.1 Interest expense decreased due to the partial redemption of the principal related to our Senior Secured Notes in July 2021. Other expense, net increased due to increased foreign exchange expense during the three months ended December 31, 2021 compared to the three months ended January 1, 2021. These increased expenses were partially offset by our losses in certain investments in privately-held companies being lower for the three months ended December 31, 2021 compared to the three months ended January 1, 2021. 29 Table of Contents Taxes on Income (Loss) For the three months ended December 31, 2021, we recognized income tax expense of $1.7 million on $3.3 million of pre-tax income. We are unable to recognize a tax benefit for pre-tax book losses in certain foreign jurisdictions. For the three months ended January 1, 2021, we recognized income tax expense of $1.6 million on $4.7 million of pre-tax loss. Our tax expense for the three months ended December 31, 2021 increased, primarily due to increased pre-tax income in certain jurisdictions, valuation allowance positions in the Unites States on deferred tax attributes, and losses in certain foreign jurisdictions for which no benefit can be recorded. Liquidity and Capital Resources We assess our liquidity in terms of our ability to generate cash to fund our operations, including working capital and investing activities. We believe that our operating cash flow, cash on our balance sheet and availability under our Asset-Based Loan ("ABL") Facility are sufficient to meet our anticipated operating cash needs for at least the next 12 months and will be sufficient to allow us to continue to invest in our existing businesses, consummate strategic acquisitions and manage our capital structure on a short and long-term basis. The maximum availability under our ABL Facility is $100.0 million; however, the borrowing base under the ABL Facility fluctuates from month-to-month depending on the amount of eligible accounts receivable, inventory, and real estate. As of December 31, 2021 the amount available under our ABL Facility was $67 million, and the ABL Facility remains undrawn. See Part II, Item 1A. “Risk Factors” for a further discussion. At December 31, 2021 we had $433.7 million in Long-term debt, net and $2.8 million of Current maturities of long-term debt, net of discounts and deferred issuance costs of $43.6 million. Cash and Cash Equivalents The following table summarizes our cash and cash equivalents: (In millions) December 31, 2021 October 1, 2021 $ Change Cash and cash equivalents $ 157.8 $ 144.6 $ 13.2 Borrowings The following table summarizes the changes in our debt outstanding: December 31, 2021 October 1, 2021 (In millions, except for percentages) Amount Amount $ Change Current maturities of long-term debt Other debt $ 2.8 $ 2.8 $ — Total current maturities of long-term debt $ 2.8 $ 2.8 $ — Non-current maturities of long-term debt: Convertible Senior Unsecured Notes 200.0 200.0 — Senior Secured Notes 270.0 270.0 — Other debt 7.3 7.8 (0.5) Total non-current maturities of long-term debt: $ 477.3 $ 477.8 $ (0.5) Unamortized issuance costs and debt discounts Unamortized discount - Convertible Notes $ (35.4) $ (37.6) $ 2.2 Unamortized issuance costs - Convertible Notes (3.9) (4.1) 0.2 Unamortized issuance costs - Senior Secured Notes (4.3) (4.4) 0.1 Total $ (43.6) $ (46.1) $ 2.5 Total debt outstanding, net $ 436.5 $ 434.5 $ 2.0 30 Table of Contents Cash Flows Three Months Ended (In millions) December 31, 2021 January 1, 2021 Net cash flow provided by (used in): Operating activities $ 10.8 $ 7.1 Investing activities (2.6) (4.4) Financing activities 5.0 2.2 Effects of exchange rate changes on cash and cash equivalents and restricted cash (0.1) — Net increase in cash and cash equivalents and restricted cash $ 13.1 $ 4.9 Net cash provided by operating activities. Net cash provided by operating activities was $10.8 million and $7.1 million for the three months ended December 31, 2021 and January 1, 2021, respectively. The increase in cash provided by operating activities was primarily due to improved operating performance and strong collections reducing our accounts receivable balance, partially offset by higher inventory purchases, and a decrease in accrued liabilities and other current and long-term liabilities. Net cash used in investing activities. Net cash used in investing activities was $2.6 million and $4.4 million for the three months ended December 31, 2021 and January 1, 2021, respectively. The decrease in cash used in investing activities was primarily due to proceeds received from sales of business and assets during the three months ended December 31, 2021. Net cash provided by financing activities. Net cash provided by financing activities was $5.0 million and $2.2 million for the three months ended December 31, 2021 and January 1, 2021, respectively. The increase in cash provided by financing activities was primarily due to proceeds received from the exercise of stock options. Days Sales Outstanding Trade accounts receivable days sales outstanding (“DSO”) was 58 days at December 31, 2021 and 62 days at October 1, 2021. Our accounts receivable and DSO are impacted by a number of factors, including the timing of product shipments, collections performance, payment terms, the mix of revenues from different regions and the effects of economic instability. Contractual Obligations In October 2013, we entered into an amended agreement with dpiX and other parties that, among other things, provides us with the right to 50% of dpiX’s total manufacturing capacity produced after January 1, 2014. The amended agreement requires us to pay for 50% of the fixed costs (as defined in the amended agreement), as determined at the beginning of each calendar year. As of December 31, 2021, we estimate that we have fixed cost commitments of $13.2 million related to this amended agreement through the remainder of calendar year 2022. The amended agreement will continue unless the ownership structure of dpiX changes (as defined in the amended agreement). In October 2015, pursuant to a Domination and Profit and Loss Transfer Agreement (the “MeVis Agreement”), we committed to pay the noncontrolling shareholders of MeVis an annual recurring net compensation of €0.95 per MeVis share. The annual net payment will continue for the life of the MeVis Agreement, which we anticipate will continue for as long as we remain as the controlling shareholder of MeVis. As of December 31, 2021, noncontrolling shareholders together held approximately 0.5 million shares of MeVis, representing 26.3% of the outstanding shares. During the third quarter of fiscal year 2020, we entered into a purchase agreement with a supplier to acquire certain equipment and intellectual property from the supplier that is utilized to manufacture X-ray cables utilized in our products. As of December 31, 2021, there has been no transfer of control of the underlying equipment. This acquisition is expected to be completed during the 2022 fiscal year and the total consideration to be paid by us for the acquired assets is expected to be ¥1,084.7 million or approximately $9.4 million. 31 Table of Contents Contingencies From time to time, the Company is a party to or otherwise involved in legal proceedings, government inspections, investigations, customs and duty audits, and other claims and contingency matters, both inside and outside the United States, arising in the ordinary course of its business or otherwise. The Company accrues amounts for probable losses, to the extent they can be reasonably estimated, that it believes are adequate to address any liabilities related to legal proceedings and other loss contingencies that the Company believes will result in a probable loss (including, among other things, probable settlement value). A loss or a range of loss is disclosed when it is reasonably possible that a material loss will be incurred and can be estimated or when it is reasonably possible that the amount of a loss, when material, will exceed the recorded provision. The Company did not have any material contingent liabilities as of December 31, 2021 and October 1, 2021. Legal expenses are expensed as incurred. Recent Accounting Standards or Updates Not Yet Effective See Note 1, “Summary of Significant Accounting Policies” of the notes to the accompanying condensed consolidated financial statements for a description of recent accounting standards, including the expected dates of adoption and the estimated effects on our condensed consolidated financial statements. Backlog Backlog is the accumulation of all orders for which revenues have not been recognized and are still considered valid. Backlog also includes a small portion of billed service contracts that are included in deferred revenue. Our estimated total backlog at December 31, 2021 was approximately $289 million. Orders may be revised or canceled, either according to their terms or as customers' needs change. Consequently, it is difficult to predict with certainty the amount of backlog that will result in revenues. We perform a quarterly review to verify that outstanding orders in the backlog remain valid. Aged orders that are not expected to be converted to revenues are deemed dormant and are reflected as a reduction in the backlog amounts in the period identified. In addition to orders for which revenues have not been recognized and are still considered valid, we have pricing agreements with many of our established customers that span multi-year periods. These pricing agreements include volume ranges under which orders are placed.