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 our financial condition and results of operations 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 (this "Quarterly Report") as well as our Annual Report on Form 10-K for the fiscal year ended September 29, 2023 ("Annual Report") and our other filings, including the Current Reports on Form 8-K, that have been filed with the Securities and Exchange Commission (" SEC") through the date of this report. In this Quarterly Report, unless otherwise specified or the context otherwise requires, the "Company," "Varex," "we," "us," and "our" refer to Varex Imaging Corporation. Forward-Looking Statements 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. 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 described. Important factors that could cause our actual results and financial condition to differ significantly from those projections or expectations include, among other things, the following: • reduction in or loss of business of one or more of our limited original equipment manufacturing (“OEM”) customers; • loss of business to, and an inability to effectively compete with, competitors; • pricing pressures and other factors that could result in margin erosion and loss of customers; • failure to meet customers’ needs and demands; • global, regional, and country-specific economic instability, shifting political environments, changing tax treatment, reactionary import/export regulatory regimes, and other risks associated with international manufacturing, operations, and sales; • supply chain disruptions resulting in delayed product delivery, and increased costs as a result of reliance on a limited number of suppliers for certain key components; • inability to maintain or defend our intellectual property rights, and high cost of protecting our intellectual property and defending against infringement claims; • disruption of critical information systems or material breaches in the security of our systems; • noncompliance with regulations applicable to marketing, manufacturing, labeling, and distributing our products and delays in obtaining regulatory clearances or approvals; • limitations imposed by operating and financial restrictions of our debt financing agreements could harm our long-term interests, limit our ability to make payments on our debt obligations, and impact our ability to maintain sufficient liquidity and/or to refinance our debt obligations; and • other factors cited in Part I, Item 1A, " Risk Factors " in our Annual Report and in Part II, Item 1A, " Risk Factors " of this Quarterly Report. Statements concerning supply chain and logistics challenges; cost increases and expense management; changes in U.S. and worldwide economic conditions, such as the impact of inflation, and fluctuations in foreign currency exchange rates; geopolitical tensions; industry or market segment outlook; market acceptance of or transition to new products or technologies 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,” “intend,” “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. 28 Table of Contents Overview Varex Imaging Corporation is a leading innovator, designer and manufacturer of X-ray imaging components including X-ray tubes, flat panel and photon counting detectors and accessories, linear accelerators, image software processing solutions, and stand-alone X-ray based systems in select application areas. 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 OEMs incorporate our X-ray imaging components into their systems to detect, diagnose, protect, irradiate, and inspect. Varex has approximately 2,300 full-time equivalent employees, located at engineering, 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, the Middle East, India, and Africa. APAC includes Asia (other than India) 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 350 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. Impact of General Economic Environment While there continues to be some improvement in the general economic environment, we remain cautious as many factors remain dynamic and unpredictable. The uncertain economic environment, supply chain and logistic challenges, and geopolitical tensions have contributed to, and may continue to contribute to, inflation, higher interest rates and capital costs, increased shipping costs, supply shortages, increased costs of labor and materials, exchange rate volatility, and other similar effects. During 2023, we experienced some supply chain, manufacturing, and logistics challenges. Currently, we anticipate such challenges to have less of an impact in fiscal year 2024. Shortages of certain materials 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 have caused operational and customer order fulfillment challenges. In addition, since late 2023 our Medical business has been negatively impacted by the China government initiated anti-corruption measures related to the healthcare industry. We expect these actions to continue into fiscal year 2024, which could impact revenues in our China business. For additional information on risks related to supply chain and logistics challenges, cost increases, changes in U.S. and worldwide economic conditions, geopolitical tensions, and other risks that could impact our results, see Item 1A “ Risk Factors ”. Operating Segments and Products We have two reportable operating segments: Medical and Industrial. The segments align our products and services 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, flat panel and photon counting detectors and accessories, high voltage connectors, image-processing software and workstations, 3D reconstruction software, computer-aided diagnostic software, collimators, automatic exposure control devices, generators, and coolers. These components are used in a range of medical imaging applications including CT, mammography, oncology, cardiac, surgery, dental, fluoroscopy, and other diagnostic radiography uses. Our X-ray imaging components are primarily sold to OEM customers. These OEM customers then design-in our products to 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 35 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. 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. 29 Table of Contents We are one of the largest independent global manufacturers of X-ray imaging components, and each year, we produce over 27,000 X-ray tubes and 20,000 X-ray detectors. We estimate that our world-wide installed base of products includes more than 160,000 X-ray tubes, 170,000 X-ray detectors, 600,000 connect and control components, and 16,500 software instances. Replacement and service of our existing installed base makes up a significant portion of our revenue. Many of our components need to be replaced regularly, depending upon usage and other factors. For example, CT X-ray tubes generally need to be replaced every 2 to 6 years, in comparison to a general radiography tube which can last up to 10 years, depending on utilization. In China, the replacement cycle for CT X-ray tubes currently can be as frequent as every 10 to 20 months due to high utilization of imaging equipment. Other products such as X-ray detectors have a useful life of as much as 7 years or more but can require more frequent service and repairs during their useful life. In addition, our detector customers often elect to upgrade products to newer technology before the end of a current product’s useful life. X-ray imaging software is a relatively small part of our business and includes maintenance revenue for software licenses. 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) importing raw materials from China to the United States has become more expensive, (2) importing raw materials and sub-assemblies from the United States to China has become more expensive, and (3) importing finished United States manufactured products into China has become more difficult and expensive. While the governments of both the United States and China have granted tariff exclusions that temporarily eliminate the additional duties payable for specific commodities, providing partial relief, these exclusions are temporary and/or must be solicited and approved on a shipment-by-shipment basis. There is no guarantee that such exclusions will be granted or extended by either government, and the U.S. tariff exclusions are set to expire on May 31, 2024 unless extended. 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 on materials imported to China, and to be closer to our global customer base, we continue to expand manufacturing capabilities at our facilities in China, Germany, the Netherlands, 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. Our mitigation efforts could prove less effective than anticipated if tensions between China and Taiwan lead to worsening trade relations between China and the United States. 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, baggage screening at airports, and nondestructive testing, irradiation, and inspection applications used in a number of other vertical markets. Our industrial products include Linatron® X-ray linear accelerators, X-ray tubes, flat panel and photon counting detectors, computed radiography scanners, high voltage connectors, and coolers. 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 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 aerospace, automotive, electronics, oil and gas, food packaging, metal castings, and additive manufacturing. 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. 30 Table of Contents Critical Accounting Policies and Estimates The preparation of our unaudited 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 September 29, 2023 filed with the SEC on November 16, 2023 and Note 1, Summary of Significant Accounting Policies, of the Notes to the 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. Except for the changes in certain policies upon adoption of the accounting standard described in Note 1, Summary of Significant Accounting Policies of the Notes to the Condensed Consolidated Financial Statements of this report, there have been no material changes to the Company’s significant accounting policies, compared to the accounting policies described in Note 1, Summary of Significant Accounting Policies , in the Company’s Annual Report on Form 10-K for fiscal year 2023. Fiscal Year The fiscal years of the Company as reported are the 52 or 53-week periods ending on the Friday nearest September 30. Fiscal year 2024 is the 52-week period ending September 27, 2024. Fiscal year 2023 was the 52-week period that ended on September 29, 2023. The fiscal quarters ended December 29, 2023 and December 30, 2022 were both 13-week periods. Discussion of Results of Operations for the Three Months Ended December 29, 2023 Compared to the Three Months Ended December 30, 2022 Revenues, net Three Months Ended (In millions) December 29, 2023 December 30, 2022 $ Change % Change Medical $ 139.9 $ 160.1 $ (20.2) (12.6) % Industrial 50.1 45.5 4.6 10.1 % Total revenues $ 190.0 $ 205.6 $ (15.6) (7.6) % Medical as a percentage of total revenues 73.6 % 77.9 % Industrial as a percentage of total revenues 26.4 % 22.1 % Medical revenues decreased $20.2 million, primarily due to decreased sales of fluoroscopic, dental, and CT, partially offset by increased sales in mammography. Industrial revenues increased $4.6 million, primarily due to increased sales of security inspection products, partially offset by decreased sales of digital detectors. Gross Profit Three Months Ended (In millions) December 29, 2023 December 30, 2022 $ Change % Change Medical $ 38.9 $ 46.3 $ (7.4) (16.0) % Industrial 18.2 17.0 1.2 7.1 % Total gross profit $ 57.1 $ 63.3 $ (6.2) (9.8) % Medical gross margin 27.8 % 28.9 % Industrial gross margin 36.3 % 37.4 % Total gross margin 30.1 % 30.8 % The decrease in Medical segment gross profit was primarily due an unfavorable shift in product sales mix, partially offset by decreased material costs. 31 Table of Contents The Industrial segment gross profit increased primarily due to increased sales in security inspection products, partially offset by an unfavorable shift in product sales mix. Operating Expenses Three Months Ended (In millions) December 29, 2023 December 30, 2022 $ Change % Change Research and development $ 20.5 $ 20.0 $ 0.5 2.5 % As a percentage of total revenues 10.8 % 9.7 % Selling, general, and administrative $ 32.4 $ 30.3 $ 2.1 6.9 % As a percentage of total revenues 17.1 % 14.7 % Operating expenses $ 52.9 $ 50.3 $ 2.6 5.2 % As a percentage of total revenues 27.8 % 24.5 % 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 increased to 10.8% of revenues for the first quarter of fiscal year 2024, primarily due to decreased sales and increased research and development costs. Selling, General, and Administrative Selling, general, and administrative expenses for the first quarter of fiscal year 2024 increased $2.1 million, primarily due to increased fixed cost commitments to a supplier and increased compensation costs. Interest and Other Expense, Net The following table summarizes the Company’s interest and other expense, net: Three Months Ended (In millions) December 29, 2023 December 30, 2022 $ Change Interest income $ 1.9 $ 0.5 $ 1.4 Interest expense (7.3) (7.5) 0.2 Other income (expense), net 0.6 (0.6) 1.2 Interest and other expense, net $ (4.8) $ (7.6) $ 2.8 Interest and other expense, net decreased in the first quarter of fiscal year 2024 compared to the first quarter of 2023. Interest expense decreased due to reduced fees on the ABL Facility and reduced outstanding other debt. Other income (expense), net increased due to a gain on business acquisition, partly offset with losses in certain investments in privately-held companies and equity investments and increased foreign exchange expense. Interest income increased primarily due to an increase in investments made into marketable debt securities. Taxes on (Loss) income For the three months ended December 29, 2023 we recognized income tax benefit of $0.2 million on $0.6 million of pre-tax loss. For the three months ended December 30, 2022 we recognized income tax expense of $2.2 million on $5.4 million of pre-tax income. Our tax expense for the three months ended December 29, 2023 decreased, primarily due to decreased pre-tax income in certain jurisdictions and losses in certain foreign jurisdictions for which no benefit can be recorded. 32 Table of Contents 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, availability under our ABL Facility, and our ability to access the credit and capital markets are sufficient to meet our anticipated operating activities and cash commitments 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-term and long-term basis. We are currently not aware of any trends or demands, commitments, events, or uncertainties that will result in or that are reasonably likely to result in a material change to our liquidity needs during or beyond the next 12 months, except our Convertible Notes that become due in June 2025 that we currently anticipate refinancing using some combination of future borrowings and cash. 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 29, 2023, the amount available under our ABL Facility was $71.9 million, and the ABL Facility remains undrawn. At December 29, 2023 we had total debt of $443.0 million, net of deferred issuance costs of $4.8 million. Cash and Cash Equivalents, Certificates of Deposit, and Marketable Securities The following table summarizes our cash and cash equivalents, certificates of deposit, and marketable securities: (In millions) December 29, 2023 September 29, 2023 $ Change Cash and cash equivalents $ 141.3 $ 152.6 $ (11.3) Certificates of deposit not included in cash and cash equivalents 1.0 1.0 — Marketable securities not included in cash and cash equivalents 52.2 41.3 10.9 Total $ 194.5 $ 194.9 $ (0.4) 33 Table of Contents Borrowings The following table summarizes the changes in our debt outstanding: December 29, 2023 September 29, 2023 (In millions, except for percentages) Amount Amount $ Change Current maturities of long-term debt Other debt $ 1.6 $ 1.5 $ 0.1 Non-current maturities of long-term debt: Convertible Senior Unsecured Notes $ 200.0 $ 200.0 $ — Senior Secured Notes 243.0 243.0 — Other debt 3.2 3.5 (0.3) Total non-current maturities of long-term debt: $ 446.2 $ 446.5 $ (0.3) Unamortized issuance costs Unamortized issuance costs - Convertible Notes $ (2.1) $ (2.5) $ 0.4 Unamortized issuance costs - Senior Secured Notes (2.7) (2.9) 0.2 Total (4.8) (5.4) 0.6 Total debt outstanding, net $ 443.0 $ 442.6 $ 0.4 Cash Flows Three Months Ended (In millions) December 29, 2023 December 30, 2022 Net cash flow (used in) provided by: Operating activities $ 10.3 $ (3.7) Investing activities (19.9) (3.7) Financing activities (1.7) (0.4) Net decrease in cash and cash equivalents and restricted cash $ (11.3) $ (7.8) Net cash provided by (used in) operating activities. Net cash provided by (used in) operating activities was $10.3 million and $(3.7) million for the three months ended December 29, 2023 and December 30, 2022, respectively. The increase in cash provided by operating activities was primarily due to increased collections from accounts receivable and a reduction in cash outflows for inventory and prepaid expenses, partially offset by a decrease in non-cash adjustments to income when compared to the three months ended December 30, 2022. Net cash used in investing activities. Net cash used in investing activities was $19.9 million and $3.7 million for the three months ended December 29, 2023 and December 30, 2022, respectively. The increase in cash used in investing activities was primarily due to increased purchases of marketable debt securities, along with increased purchases of property, plant, and equipment during the three months ended December 29, 2023, partially offset by the settlement of net investment hedges. Net cash used in financing activities. Net cash used in financing activities was $1.7 million and $0.4 million for the three months ended December 29, 2023 and December 30, 2022, respectively. The increase in cash used in financing activities was primarily due to cash payments related to the taxes for net share settlement of equity awards for the three months ended December 30, 2022. Material 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. In January 2024, the Company's fixed cost commitment was determined to be $12.4 million for calendar year 2024. The amended agreement will continue unless the ownership structure of dpiX changes (as defined in the amended agreement). 34 Table of Contents In August 2015, pursuant to a Domination and Profit and Loss Transfer Agreement (the “DPLTA”), we committed to pay the noncontrolling shareholders of MeVis Medical an annual recurring net compensation of €0.95 per MeVis Medical share. The annual net payment will continue for the life of the DPLTA, which we anticipate will continue for as long as we remain as the controlling shareholder of MeVis Medical. As of December 29, 2023, noncontrolling shareholders together held approximately 0.5 million shares of MeVis Medical, representing 26.3% of the outstanding shares. In fiscal year 2022, the Company entered into several agreements with a third-party company, whose stock is publicly traded on a foreign exchange. Under these agreements, the Company will make certain milestone payments of up to $5.0 million upon achievement of specified milestones. During fiscal year 2022, the first of these milestones was achieved and the Company paid $1.0 million to the third-party company. During fiscal year 2023, two more milestones were achieved and the Company paid an additional $2.0 million to the third-party company. No additional milestones were achieved nor were any payments made during the first quarter of fiscal year 2024. Payments made under this agreement are recorded in research and development in the Condensed Consolidated Statements of Operations. As of December 29, 2023, there were two milestones remaining of $1.0 million each under these agreements. The Company enters into purchase agreements with its suppliers in the ordinary course of its business for the purchase of goods and services. Some of these purchase agreements are non-cancellable and thus contractually obligate the Company to future cash payments. As of December 29, 2023, our non-cancellable supplier purchase obligations totaled $8.2 million. Contingencies From time to time, we are 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 our business or otherwise. We accrue amounts for probable losses, to the extent they can be reasonably estimated, that we believe are adequate to address any liabilities related to legal proceedings as well as other loss contingencies that we believe 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. We did not have any material contingent liabilities as of December 29, 2023 and September 29, 2023. Legal expenses are expensed as incurred. Days Sales Outstanding Trade accounts receivable days sales outstanding (“DSO”) was 67 days at December 29, 2023 and 65 days at September 29, 2023. 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. Recent Accounting Standards or Updates Not Yet Effective See Note 1, Summary of Significant Accounting Policies , of the accompanying Notes to the 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 29, 2023 was approximately $299 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.