Greetings, and welcome to Varex Imaging Corporation Second Quarter Fiscal Year 2019 Earnings Call. 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. I would now like to turn the conference over to your host, Mr. Howard Goldman, Director of Investor Relations. Thank you, Mr. Goldman. You may now begin.

Good afternoon, and welcome to Varex Imaging Corporation's earnings conference call for the second quarter of fiscal year 2019. With me today are Sunny Sanyal, our President and CEO; and Clarence Verhoef, our CFO. To simplify our discussion, unless otherwise stated, all references to the quarter are fiscal quarters. Quarterly comparisons are for the second quarter of fiscal year 2019 versus the second quarter of fiscal year 2018 unless stated otherwise. On today's call, we will discuss certain non-GAAP financial measures. These adjusted measures are not presented in accordance with, nor are they a substitute for GAAP financial measures. We provided a reconciliation of each adjusted financial measure to the most directly comparable GAAP financial measure in our earnings press release, which is posted on our website. Guidance for our net earnings per diluted share is provided on an adjusted basis only. This adjusted financial measure is forward-looking and we are unable to provide a meaningful or accurate compilation of reconciling items to guidance for GAAP net earnings per diluted share, due to the uncertainty of the amount and timing of the unusual items. 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. 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 for the second quarter of fiscal year 2019, and first quarter of fiscal year 2019, and on our annual report on Form 10-K for fiscal year 2018. The information in this discussion speaks as of today's date and we assume no obligation to update or revise our forward-looking statements in this discussion. And now, I'll turn the call over to Sunny.

Thank you, Howard. Good afternoon, everyone and welcome. I'm pleased to report that as of the mid-year mark, we saw performance that keeps us on track for the year. For the second quarter, revenues were $196 million, led by continued strong product sales in industrial markets and gains in certain medical modalities. Medical segment revenues declined versus a strong Q2 in the prior year. Higher demand for our oncology, mammography and CT products were offset by lower sales in dental, low-end radiographic detectors, as well as non-OEM aftermarket X-ray tubes. We had strong demand for mammography components, driven by growing use of 3D imaging and we are seeing increased interest for X-ray tubes in entry level mammography, and CT markets. In the medical space, end markets continue to be healthy and the introduction of new technology platforms tends to stimulate adoption of new applications. For our part, we continue to invest in R&D as well as establish partnerships to advance early stage technology, and evaluate acquisitions that will bring new products to our portfolio. We just completed the acquisition of Direct Conversion, which added photon counting technology. We also recently established a joint venture to develop next generation X-ray sources using nanotube technology. Industrial segment revenues increased from the prior year, primarily due to higher sales of X-ray tubes and linear accelerators for airport security and non-destructive testing applications. Check baggage screening systems at airports around the world are in an upgrade cycle that includes CT technologies. Several OEMs in this space are Varex customers, and they are using our X-ray tubes in innovative ways to meet current and future airport security, and productivity requirements. These new innovations are intended to allow airports to screen as many as 2,000 pieces of luggage per hour. Our components enable these efforts with…

Thanks, Sunny, and hello, everyone. As usual, I'm going to focus the discussion on our quarterly results, while fiscal year-to-date financials can be found in our press release. I'll also provide some details on the addition of the Direct Conversion acquisition to our outlook for the full fiscal year. I would summarize Q2 is a quarter with good top-line performance, particularly in the Industrial segment, while revenues in the Medical segment continued to be impacted by lower sales due to tariffs. Operating profit was in line with our expectations as we had good expense control that offsets some higher quality costs. As Sunny mentioned, China related tariffs continued to hurt our business with about $5 million less revenue from radiographic detectors, and about $1 million of Direct payments for supply chain related tariffs in the US and China. Our second quarter revenues were down 3% compared to the quarter a year ago. Medical segment revenues for the second quarter decreased 6%, primarily due to the lower sales of radiographic and dental detectors, as well as aftermarket X-ray tubes in China. Industrial segment revenues were up 10%, driven by increased demand for X-ray tubes for airport security and digital detectors and linear accelerators for non-destructive testing applications. For the second quarter, our gross margin was 33% compared to 35% in the prior year. The adjusted gross margin was 34% compared to 36% in the prior year. The margin reduction was due to higher cost-to-quality, primarily in our sector business, plus increased freight and tariff costs. R&D expenses were $19 million or less than 10% of revenues in the quarter compared to $22 million or 11% in the year-ago quarter. Second quarter SG&A expenses were $31 million and comparable to the prior year quarter. However, in the second quarter, we had approximately…

Thank you. At this time, we will be conducting the question-and-answer session. [Operator Instructions] Our first question comes from the line of Anthony Petrone of Jefferies. Please proceed with your question.

Thanks. Maybe to start for a couple of questions on guidance, just some of the moving parts there, and then just the topics of the day on tariffs as they stand. Just -- on guidance, could we -- maybe get a better sense of one, the base medical business, we've seen a couple of quarters here impacts. And so you're adding in the Direct Conversion transaction at the revenue line, the overall goes up by a bit. You've seen two quarters of impacts in detector plates in medical, so just maybe a little bit of color on what's going on in the base medical business that is reflected in the guidance change. And then I'll have a couple of follow ups.

Sure. Anthony, I guess I'd started out by saying, when I look at the first half of the year, the medical business I think is down 1%. So overall considering the fact that we probably had in the range of $5 million a quarter for the -- a little bit less than that in the first quarter, but roughly in that range for the first two quarters, it's still a -- excluding that, it's still got some growth in the medical space. The way I went about this was to say, okay, let's take into account the additional impact of adding in Direct and then look at the -- what do we think the impact of tariffs will be going forward. And that's where we got to the increase that we did in the in the overall range by bumping it up to the $760 million to $785 million range.

So said in another way, should we assume that the estimated $5 million impact is kind of the quarterly run rate until further notice or is that a fair way to think about it?

Well, I would say that it's an impact. So Sunny actually talked a little bit about you know, we're in the process of ramping up production in our Wuxi facility and in our German facility as a way to mitigate this. And so we're on the homestretch of that, so once we have that in place, then we start to be able to go back to the market with product in that radiographic detector space. So we -- it's not a business as usual forever kind of thing. It feels like give us another quarter and then we'll start to be able to actually mitigate that by having products that are manufactured not subject to tariffs.

All right. And then last one on guidance for me would just be -- just on the Santa Clara facility, just an update there. I mean is that still on target for having a net benefit to the P&L, short of midyear into the back half, just an update there. And then my final question, I'll just put out there on tariffs. I mean based on kind of the more recent developments, it's hard to sort of reflect that real time, but maybe just any high level thoughts if we do get a more hawkish stance from both sides I'll say, is there any early thoughts on how that could play on the business.

All right. Let's set the tariffs one aside for just a second and let me answer the Santa Clara one first.

Yes.

I would say that the process where we did the closure of the fab operations is behind us and closed out. And yes, I do expect some benefit in the second half of the year. One of the challenges you heard me mention a little bit that we had some higher quality costs in the second quarter. That's a little bit of carryover from the closure of the fab because we still had some inventory there that has not performed quite as well as we would have liked, I guess. And so -- but that does feel like that's behind us. The wildcard I'd say in gross margins is you've got a fair amount of moving parts always going on, right, whether that's relative to product mix, which I would say that in Q2 was actually a reasonably good product mix quarter, a little bit around price erosion, we continue to have that kind of a challenge, and then our manufacturing performance in the factory. Those moving parts come into play when you're looking at the overall gross margin performance. So that's why I'm comfortable with staying at the 34% to 35%. Although -- even though I get a little bit of an upside from the closure of the Santa Clara fab operations. Now, relative to the tariffs, maybe -- well, you want to add some follow up on before I go to the tariffs?

No. That was very helpful. Thanks.

All right. So maybe -- and I'll probably let Sunny answer a little part of this as well. But my general take first of all is that, we've had strategy all along to be more global and more local for the customers, which actually helps us in dealing with challenges like trade war kinds of generated problems. And so as we continue to expand operations in China or in the Philippines or in some of our European locations, those are ways that we mitigate that. And so that's -- we see a good path forward there. We're already dealing with very directly with detectors. Detectors right now has a 25% tariff put on them if they are shipped from the US into China. And so accordingly we saw the reduction in revenues there. But as we transition that, I see some opportunities in the future there. X-ray tubes is a little bit of a different scenario. The exposure is not as high there because it's only a 5% tariff currently. And I think that's if you say worst case scenario, that's the challenge that we've got to deal with is how do we transition quicker our manufacturing, so that it's not subject to tariffs if worst case scenario that rate goes up. Sunny, anything to add?

Yes. I think, that Clarence touched on all points. We're -- at this point, we don't know what China's retaliatory tariffs actions will be to the extent that it touches X-ray tubes. We sale X-ray through two channels. One is our OEMs. Those OEMs, they're not going to disappear overnight. Their tubes are engineered into their products, so we will -- if tariffs impact X-ray -- those OEM tubes directly, then we will do what we did last year, which is go back to the OEMs and get into some kind of an arrangement with them to figure out how to mitigate the impact of tariffs. And what I expect in the short-term will be some hit to our gross margin line on those tubes. But we will work those out with our OEM customers. Then there's the aftermarket tubes, which is a much smaller part of our overall business. And there's always a chance that we will see some decline, some waiting. People try to wait it out, delay the decisions for buying things like that. But at this point, it's speculative. Being engineered into the products of our customers, the cycle time for them to take any action is anywhere between two to three years, as much as three years I'll say. So we hope that the trade related issues will get resolved far sooner than then.

All right. Thanks again.

Our next question comes from the line of Larry Solow of CJS Securities. Please proceed with your question.

Great. Thanks guys. Just a few thoughts on the tariffs. So on the $5 million number that you called out, how does that relate to the -- is that a price concession because I know was somewhat less last quarter, so I don't know whether it would be price concessions or less sales. But I know that $5 million number you called out today, was that more price -- more or less price concessions or a combination of that and less revenue or any color on that?

Sure. Hey, Larry. The -- it's fundamentally lost business. It's business that was -- because I expected when we originally were talking about it that we expected that we would end up with more -- some mixture thereof. But in reality we've got very little price concessions and mostly that it was just lost revenue, so less difference.

So that $5 million, that number was somewhat higher than the Q1 number, right.

Yes. It was a little bit lower in Q1, not radically, but a little bit lower, yes.

And what about -- so I know the gross margin was sort of in line with your expectations. You really got to the quarter per se, but -- and then Q1 was perhaps a little bit above. But what sort of just -- I know, it could be dangerous to look at quarter sequentially, but just what -- with a little bit of higher revenue base this quarter, it sounds like mix was pretty much -- I don't know it was that -- it was an issue, but I get the quality -- I guess the quality cost, is that really the big difference of higher quality cost, even though you actually exited Santa Clara this quarter or maybe still at higher cost than you actually did in Q1, is that fair to say?

Yes. Let me kind of go through that in a little bit of detail, okay, Larry because I do think it's worth going through a bit. Because I touched on a little bit with Anthony, but there's the kind of the different elements that go into our gross margin. So product mix being one of them is the -- typically we see a fair amount of variation in product mix. But I would say that the product mix in the quarter was good, just like it was back in Q1. So we continue to have a little higher mix of good margin products than we did last year. We do have some offset that happens with price erosion where you're just having some price reductions with high volume customers, mostly on the detector side, but we had a little bit -- a little touch of that on the on the tube side in the quarter as well. All-in-all those two fundamentally offset each other. But the big element that move the needle in terms of getting a lower gross margin rate in Q2 versus Q1 was the quality costs. That was the biggest factor. Second biggest factor was higher freight costs. And third is -- well maybe correspondingly equal is the -- well, the impact of tariffs would've been the same both quarters, so freight is probably the biggest driver of the -- the second element of it. I was going to say tariffs, but tariffs is more about when you're comparing with the prior year.

So you actually saw higher -- sequentially higher freight costs.

We did. Yes.

Okay.

I mean some of it is tied to higher volume shipping out the door, but it also was just in general freight costs were higher.

Right. Okay. And what about just on guidance. I know -- again, I know, you don't get quarterly, but a pretty wide range still, I think that the year started a little bit of a wider range due to a lot of moving parts. We're halfway through the year and maybe you don't want to change guidance, but any thoughts on maybe cadence in Q3, Q4, I think Q3 was not -- it was okay quarter, obviously I think Q4 things start to slow in really latter part of Q3 and to Q4, so maybe the comps are obviously perhaps get a little easier as we head out to the last quarter the year. But any thoughts on that and what would drive you to the lower end or to the higher end of the range from where you stand today?

Yes. I'm not going to probably answer that last part of that question as far as lower or higher end of the range. But I would tell you this that there is still a fair amount of variation in when we look at what's the balance of the year. There is not a surprising amount of moving parts here. What I just went through on the gross margin line as well as now adding in the impact of Direct, which is a new entity that you've got to be a little bit cautious as you look at that, and how that gets taken into account in the numbers and their results as well. And then -- yes. I mean tariffs by itself is already enough of a moving part in there that I think we have to be cautious. And that's why we still have a fairly broad range. I would say that when I look at compared with a year ago, Q3 was a little light on the revenue side, so maybe we have a little bit of an easy comp, but Q3s are typically a bit challenging for us. Just in that we don't have a big driving factor of somebody's fiscal year end making it happen, and kind of heading into summer season and the like. So it's always a little bit of a wildcard in terms of what the numbers are for Q3. Q4 will be strong for us just because it's -- we push hard for our fiscal year end as well as it leads up into people that have a calendar year ends buying materials in advance for manufacturing and preparation for their year ends.

Okay. And just a couple of quickies on China if I may. Just on Sunny's comments, the mix shift or maybe it's not a shift; maybe it's something you expected. But I'm seeing a little bit more lower priced, so it sounds like tubes. Is that an expected occurrence and is that hurting you? Will that potentially hurt you guys at all? And then the follow-up is the $300 million sort of replacement market for the tubes that you refer to, is that a 10-year, is that like sort of the ultimate or a 10-year target or five-year, 10-year target? And would you expect yourselves and I know there's one other competitor right now who's outsourcing into China, would it be just you think would other guys you think be in that market? Thanks.

Yes. So let me start to the first one, the mix. So we know that China will buy 25,000 or so over the next 10 years. But in the near-term, next couple of years, there's about 3,500-ish cities that will be purchased. What is -- we assumed in our planning for China that there would be a certain mix of 16-slice, 64-slice high-end CTs. So the mix is not unusual for us. What -- it's, as China starts to buy and the hospitals starts to buy CT systems, the mix pattern becomes clearer to us. So normally what happens is, you see high-end systems go first and then the low-end systems generally start to trickle down as the rural small hospitals buy. In a way this is actually good what we're seeing is broad based buying, so the rural hospital to smaller, to lower, ultra. The low cost 16-slice CT systems are being purchased. Now, to me that's a good sign an indication that those 3,000 units are going to be embark over the next two years. It's front end loaded versus being back end loaded. What we like about it ultimately is our goal is to get the sockets. We want as many of those CT sockets as possible. And as the replacement market kicks in, the number that I threw out there approximately $300 million, that's an annual number. We expect that once -- let's say, fast forward to three years from now, as the number of CT systems in the -- based on the number of installed CT systems, we're calculating that based on an average life of these tubes that the replacement rate will result in approximately $300 million worth of annual purchases. We expect we'll get our unfair share of those tubes with -- it'll be shared between us and the majors, Siemens, Phillips, they have their own systems that tubes that they produce. But for the systems certainly that we're penetrating that where our tubes are engineered, we expect to get the benefit of those -- that replacement market.

Okay, great. Thank you.

Our next question comes from the line of Mark Strouse of JPMorgan. Please proceed with your question.

Yes. Thank you very much for taking our questions. Most of our questions have actually been answered already. But just curious, Sunny if you can give an update on your top 10 Chinese OEM partners, any update there since the last call regarding contracts that have been signed or your progress with development cycles, that kind of thing.

Yes. So we are at about eight contracts signed or eight customers who have signed purchase agreements for our CT systems. And I can't remember timing wise what we said the last time where we were, but we're at about eight right now with purchased value of approximately $140 million worth of which is the price -- the sum total of the pricing agreements. So progress there is very good, which frankly we're very happy to see a broad based acceptance of our tubes, and we're making good traction with the OEMs there and I apologize. I forgot the second part of your question. How the -- progress...

Yes.

...progress on the R&D. Yes. So look, they're all making -- they're all moving forward. They're all sequentially progress -- progressing through their development cycles. It's -- we've not seen any slowdown for any reasons other than normal R&D and clinical trials delays, things that happen through the process of bringing these kinds of systems to market. So the tariffs haven't played a role in that, neither has anything systemic, so nothing to point to there.

Okay. Thank you. And then Clarence, in the press as you kind of mentioned the DC margins are -- gross margins are higher than the heritage gross margins. I know it's a relatively small portion of the mix near-term, but as that business grows over time, I mean how should we think about kind of your long-term gross margins. Is there potential for upside to your -- to the long-term targets that you've talked about previously if that business successfully grow?

I guess I would describe it as this is one of the elements that helps us achieve that getting back in the range of our goal to be in the 38% to 40% range. And that's -- these are the kinds of things that make a difference. New technologies typically get better gross margins. They -- as they mature over the longer period of time, yes, they come back to more normalized levels. But that's a fair amount of time down the road. And so this is one of those areas where as we continue to invest either through joint ventures, whether it's or acquisitions or internally developed technologies, these are all things that are important for us to drive margin accretion at the gross margin line. And I would say, this one is going to be inside the detectors product portfolios where we're going to be counting down that and measuring on that internally. And I think that's I'm excited about where it will go. But you're -- I think you are right that the size is not big enough yet to move the needle. But they've got a very nice growth trajectory built into their plans and the fact that they have a very sizable backlog gives me confidence that they will actually execute on that plan.

Okay, makes sense. Thank you very much.

Sure.

Our next question comes from the line of Suraj Kalia of Northland Securities. Please proceed with your question

Everyone, thanks for taking my questions. So Sunny, and let me -- a lot of the questions have been asked, let me hone in on Direct Conversion. You guys obviously looked at the landscape and picked Direct Conversion with is hybrid photon counting technology. I'm curious if there is a pull through for this technology to your existing DD clients. That would be the first question. The second thing is, and forgive me if you mentioned this on the call. What is Direct's growth rates and -- over last year? I know the $16 million number was given, would you all expect that moving forward?

Yes. So let me start at the first one. So we just background for why we did this acquisition. We take a minute to explain that. So photon counting has been the holy grail of imaging for decades, you know, people. And the reason for that is, you can image -- provide very high resolution, very high quality images with virtually no noise, so that means you need very low dose in order to generate those images. And at the same time, by virtue of the technology, you can do very, very precise material discrimination. So what that means is, you can look at soft tissue, you can look at organs, and you can call out very precisely the differences between the different soft tissues. And so more precise in spotting tumors et cetera. That same technology also applies very nicely to industrial imaging and food -- imaging in the food segment, in oil and gas, so a variety of spaces. So there is -- in terms of image quality, there is second to none and photon counting comes out ahead. It had a lot of technological challenges. The materials that are used are -- have been evolving. And the reason we acquired Direct Conversion was that, this company has been a leader in commercializing photon counting detectors. There's -- there're plenty of people researching it, working on it in their R&D phases. But they actually have commercial products with nice $16 million worth of business, with about half of that in photon counting. So it gives them economies of scale, experience, market traction et cetera. So as we look at their product portfolio, one of the areas where they will be pull throughs for us, and there are several areas, but one of the areas we expect is in the dental imaging space. There are certain complementary -- by the way, there's no overlap between our detector technologies or detector products. So this is entirely complementary, complementary technologies, complementary customers, customer base, complementary applications. And so in the dental space, we expect we'll see some pull throughs. Direct -- as like any small company, Direct has a small channel. We've got a huge footprint. So the play for us is to buy -- to acquire our way into some very nice technologies and products that are ready to go, and take advantage of our channel, and in future hopefully our scale and other benefits that we can bring with our infrastructure. And by the way we haven't quantified though. We haven't said publicly what those pull throughs are and what those. We haven't given much -- anything about those numbers. Their growth rates, they're again a small company, new products, new technologies, obviously though we expect to see good growth. Again we haven't quantified those and disclosed those externally.

Got it.

And maybe one of the key numbers though is $45 million of backlog that they have...

Yes.

...which is over the next three, four years, so I mean that already gives you a good indication of the opportunity that's there.

Yes. So good opportunity. And as we look at their revenue plans, this backlog helps, gives us the confidence of their -- that they have a book -- a nice book of business that they can work through and it's about execution.

Yes. Sunny, I was really -- the backlog is on a standalone de novo basis. I was more curious in terms of the cross-selling there you'll pull through this technology to get new customer wins, new sockets, or getting some of the -- where otherwise you all wouldn't have won. But I get to your point and I can appreciate it.

Sure.

Clarence, and maybe you mentioned this and I was trying to make notes as fast as I can. On a sequential basis when I look at the gross margins, can you give us the different moving parts, one is, the manufacturing delta from Santa Clara; second is, the pricing up and down, how many beeps Direct Conversion and FX exposure, just kind of help us understand. And as we move into Q3, just kind of walk us through to the extent that you can hew to the -- think about this is moving, this direction, this is -- how we see it playing out, any color there from a housekeeping perspective would be greatly appreciated. Gentlemen, congrats and thank you for taking my questions.

Sure. I'll take a shot at it and do the best because that's a fairly complex question in terms of answering detailed movement. Because at the end of the day, we started the year saying we are going to be in the gross margin range of 34% to 35%, and we are still saying we're going to be in the range of 34% to 35%. And at the time when we said that, we already knew what the impact would be from the Santa Clara fab operations that were being closed down where we said, a little bit little bit short of about a point of gross margin improvement. So we knew that already. We also then had a pretty good indication our understanding of what our mix of products was at the time. I would say that the mix is pretty well stayed in line with the expectations, maybe. And then at the same, the other moving part is price erosion, which offsets mix in this case. So those are all parts that are at the end of the day staying relatively stable to what we expected. I would say that the gross margin impact from Direct is probably not large enough at this point in time to move the needle a lot just because the size and scale of the number is small relative to the overall -- over their overall impact. So I'm not going to give you a specific bps on all of those. I think that's probably a little more challenging than I could do on this call at this point.

Thank you.

Sure.

[Operator Instructions] Our next question comes from the line of Jim Sidoti of Sidoti & Company. Please proceed with your question.

Good afternoon. Can you hear me?

Yes.

All right. Great. Just two from me. One, did currency have any material impact on either the top-line or the gross margin?

No, it did not.

Okay. And two, for Direct. How is the integration going? Have you been able to retain all their salespeople?

I'll take that. Hey, we just closed, so there hasn't been much time elapse for us to make much progress integration. Other than let me say, there we fully expect their leadership team to stay with us. And -- so the -- and by the way, we've got a good track record of doing that. All the acquisitions we've done, I'm happy to say the entire management team of those acquisitions are with -- still with us. And that's always been the hallmark for how we look at acquisitions. If there isn't a good team, we don't want to do it. In this case, there's a great team. We expect that they will remain with us. We've done the traditional things of giving them offer letters and working through employment agreements with them. The first steps of integration for us historically always has been on the commercial side. We first to get the sales teams together, get the product management teams together to discuss product portfolio, figure out what we have to do to care our customers. And that's scheduled in a couple of weeks and we'll get all our sales teams together, and get them to see the -- their technologies, their products. Between signing and closing in that period, we had to have hands off. We couldn't get engage, so that's -- all that work is beginning now.

So you are planning to let your sales guys have a crack at selling these products?

Absolutely. One of the biggest synergies is our channel and we will -- there's two parts to it. Direct's products are used in both medical and industrial, and we will make sure that our full line sales execs have all the Direct products in the portfolio and as on the medical and industrial side.

Okay. That was it for me. Thank you.

Thanks, Jim.

Thank you, Jim.

At this time, there are no further questions over the audio portion of the conference. I would now like to turn the conference back over to management for closing remarks.

Thank you for your questions and participating in our earnings conference call for the second quarter of fiscal year 2019. A replay of this quarterly conference call will be available from today through May 21st, and can be accessed at the Company's website or by calling 1-877-660-6853 from anywhere in the US, or 1-201-612-7415 from non-US locations. The replay conference access code is 13690009. Thank you, and goodbye.

This concludes today's conference. Thank you for your participation. You may disconnect your lines at this time.