Greetings. Welcome to the Varex Third Quarter Full Year 2023 Earnings Call. [Operator Instructions] Please note this conference is being recorded. I will now turn the conference over to your host, Christopher Belfiore. You may begin.

Good afternoon and welcome to Varex Imaging Corporation’s earnings conference call for the third quarter of fiscal year 2023. With me today are Sunny Sanyal, our President and CEO; and Sam Maheshwari, our CFO. Please note that the live webcast of this conference call includes a supplemental slide presentation that can be accessed at Varex website at vareximaging.com. The webcast and supplemental slide presentation will be archived on Varex’s website. To simplify our discussion, unless otherwise stated, all references to the quarter are for the third quarter of fiscal year 2023. In addition, unless otherwise stated, quarterly comparisons are made sequentially from the third quarter of fiscal year 2023 to the second quarter of fiscal year 2023. Finally, all references to the year are to the fiscal year and not calendar year unless otherwise stated. Please be advised that during this call, we will be making forward-looking statements, which are predictions and 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. Risks relating to our business are described in our quarterly earnings release and our filings with the SEC. 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 on Form 10-Q and our annual report on Form 10-K. The information in this discussion speaks as of today’s date, and we assume no obligation to update or revise the forward-looking statements in this discussion. On today’s call, we will discuss certain non-GAAP financial measures. These non-GAAP measures are not presented in accordance with, nor are they a substitute for GAAP financial measures. We provided a reconciliation of each non-GAAP financial measure to the most directly comparable GAAP financial measures in our earnings press release, which is posted on our website. I will now turn the call over to Sunny.

Thank you, Chris, and good afternoon, everyone. I’m pleased to report another solid quarter for Varex. Revenue of $232 million in the third quarter of fiscal 2023 is a new quarterly record for us. Non-GAAP gross margin of 34% exceeded our expectations and non-GAAP earnings per share of $0.37, was at the high-end of our guidance. These results were helped by continued strength in our industrial business. In addition, we increased cash by $30 million in the quarter, primarily driven by diligent inventory management and increased profitability. Revenue in the third quarter was up 2% sequentially and 8% year-over-year. Revenue in the Medical segment increased 1% sequentially and 5% year-over-year, while Industrial revenue increased 5% sequentially and 20% year-over-year. Non-GAAP gross margin in the third quarter was 34%, which was better than our expectations and up 100 basis points compared to the second quarter. This was primarily due to the higher portion of industrial sales. Adjusted EBITDA in the third quarter was $38 million and non-GAAP EPS was $0.37. We ended the third quarter with $152 million of cash, cash equivalents and marketable securities on the balance sheet, up $30 million from $122 million in the prior quarter. This was primarily due to higher profitability and $13 million reduction in inventory in the quarter. Let me give you some insights into sales detailed by modality in the quarter compared to a 5-quarter average, which we will refer to as sales trend. In our Medical segment, global sales of CT tubes was solid in the quarter and remains above its sales trend. Our fluoroscopy and oncology modalities improved in the quarter, but were flat compared to their respective sales trends. Mammography was solid in the quarter and above its sales trend. Dental which can be lumpy from quarter-to-quarter, remained down in…

Thanks, Sunny, and hello, everyone. As a reminder, unless otherwise indicated, I’ll provide sequential comparisons of our results for the third quarter of fiscal 2023 with those of our second quarter of fiscal 2023. I’m pleased to report another strong quarter. We exceeded the midpoint of guidance for revenue. Gross margin was above the guided range, and non-GAAP EPS was towards the high end of guidance. The primary driver of the strong performance was the continued execution in our Industrial segment. As a result, we reported sales of $232 million and non-GAAP gross margin of 34%. Non-GAAP EPS was $0.37. Further, we generated $38 million of operating cash flow in the quarter, our second highest cash generating quarter as a public company. Third quarter revenues increased 2% compared to the second quarter of fiscal 2023. Revenues increased 8% compared to third quarter of fiscal 2022. Medical revenues were $175 million, and Industrial revenues were $57 million. Due to the ongoing strength of the industrial segment, Industrial revenues climbed to 24% of our total revenues for the quarter. Medical revenues were 76%. Looking at revenue by region. Americas increased 8% sequentially, while EMEA increased 10% and APAC decreased 10%. China was 18% of the overall revenue for the quarter. Let me now cover our results on a GAAP basis. Third quarter gross margin was 33%, 100 basis points higher sequentially. Operating expenses were $52 million, down $5 million compared to the second quarter of fiscal 2023 and operating income was $24 million, up $8 million. Net earnings was $9 million, and GAAP EPS was $0.21 based on fully diluted 50 million shares. Please note that GAAP and non-GAAP EPS for the third quarter reflect the adoption of ASU 2020-06. This involves an add-back of $1.4 million of after-tax interest expense for…

[Operator Instructions] Our first question comes from the line of Suraj Kalia with Oppenheimer & Company. Please proceed with your question.

Hi, Sunny, Sam, can you hear me alright?

Yes, we can, Suraj. How are you?

Doing well. Gentleman, congrats on a really nice quarter. So Sunny or Sam, either one, specifically on medical, Sunny, one of the things that I know you have talked in the past numerous times, and I know, for example, GE is also talking about photon counting detectors as a key thing being viewed. Sunny, if you could, I’d love to understand how should we adjudicate photon counting adoption and competitive dynamics? And maybe if you could give us some real snapshot where worldwide photon counting sales are with Varex fits in that pie?

Sure, Suraj. So photon counting is an emerging technology, and it’s in the process of gaining reputation in the market, and it’s only the last, let’s say, 18 months or so that in the medical field, it has been publicized quite a bit for CT type of applications. So from our perspective, we’re excited about it because we went into photon counting in anticipation of solid capabilities that would bring value in medical CT and now we’re seeing the industry also starting to move in that direction. We are present with photon counting in two markets, industrial and medical. The cycle in Industrial is – has been faster than in medical so far. And so part of our – in industrial this quarter was also driven by use of photon counting detectors in a few applications like food processing, battery inspection, etcetera. So we’re excited to see photon counting get traction. It’s getting traction in industrial faster. We have some OEMs who are engaged in the use of photon counting and medical OEM – medical applications. And more recently, we’ve started gaining a fairly good interest from the market with the use of CT. So that said, this is a novel platform, and we’ve said that our expected contribution to growth in the medical side is still several years away, while the market absorbs these technologies into their newer designs. So that’s where we stand. We’re excited about the technology. It’s moving forward, and we’re glad to see some of the major OEMs also lining up behind it because that’s what that makes the adoption increase.

Yes. And then, Suraj, I’ll add that, as of now, our photon counting and charge integration combined, that business is right now generating about $20 million of sales annualized, and we are seeing growth there. So just wanted to give you that perspective of where we are with this technology as of now revenue-wise.

Perfect. Yes. That is really helpful. Sunny, one more question for you and one for Sam. Sunny, if you could status on cold cathodes case and also MIC China 2025, what are the dynamics there currently to the extent that you can share. And Sam, any updates, and forgive me if I missed this, we have multiple calls going on. Just in terms of inventory management and your gross margin, your pace of growth of GAAP gross margins. How should we think about it as we exit this year and going into, let’s say, first half of ‘24. Gentlemen, thank you for taking my questions. Congrats again.

Okay. So Suraj, for – with respect to cold cathodes, just like I said, with photon counting new technology, it takes time to adopt an adoption curve there is further along than with cold cathode nanotube technologies. Nano tubes are much newer, and the industry is trying to figure out what kinds of applications would be applied to it. So again, our – from our perspective, from a revenue contribution perspective, that’s further out than photon counting, where we are with that technology is the – we’re continuing to make progress on the product development and developing making tubes with that technology. Our technology transfer for Micro-X has gone very well. We are continuing to do with that work, and we’re continuing to evolve that technology. We have continued to make prototypes with our joint venture partner, and now we’re working through some commercial aspects of our relationship. In short, from our perspective, we’re making good progress with the technology. We’re happy with the technology. And we’re seeing now customers starting to get engaged to get their head around how they might think about applications for this technology.

And then coming back to your questions, Suraj, on inventory and gross margin. So in terms of inventories, as you know, we’ve been trying to bring inventories down, and we are very pleased with the progress that we made in this last quarter. We brought inventories down by $13 million, and our focus on that continues. We are expecting inventories to come down further. We are working in that direction. So in the next 3 months and 6 months, we should be bringing inventory further down. we are not guiding by how much the amount – we are not guiding the amount that we are targeting to bring down, but I think we have some room to bring it down further. And then in terms of gross margin, we’ve made good progress in this last quarter. I would say that gross margin has benefited through various initiatives of ours manufacturing efficiencies have come back in. The freight environment has generally been favorable in the last quarter. And as I talked about, price cost drag has been minimized. But there are still – we are still suffering through some continued price cost drag on to the P&L, and we have some high cost components in our inventory, and we are expecting them to fully work their way through the system by December, January time frame. So at that point, I’m thinking of a further pickup of, say, around 100 basis points in gross margin further. So that is how gross margin picture is shaping up, and we remain committed to our target of getting to a non-GAAP gross margin somewhere between 34% and 35%.

Suraj, you also asked about China 2025. I didn’t understand the first word that you said with at MIC, I wasn’t sure of that – what you meant by that. But as far as China 2025 is concerned, we began our journey to address the need requirements for China 2025 a few years ago. And what we were taking two different sites we made in China. In terms of our approach to it, we started with our facility in Wuxi to make products local for local in China, and that has been – we started with tubes, we’ve expanded to detectors, and now we’re making a very large number of tubes and detectors in China. We are – so the couple of things are happening. We’re – our strategy for China 2025 is to get our products registered with – and such that we can get the made in China labeling, which is where we are currently. And we will continue to expand the portfolio of products that – two products that we sell in China to be made that way and have carried that kind of a label. In addition, we’ve been expanding our local commercial relationships in China so that we contract locally with our Wuxi office – our Wuxi facility to handle both shipment of new products, but then also warranty survey support and all the things that you would expect out of a supplier that’s based in China for the Chinese manufacturers. And so our expectations by 2025, a vast majority of the products that we sell in China will be – can be supplied from China. That’s the approach we’re taking. We have validated this approach with our global OEMs and with the local OEMs to see their level of comfort in what we’re doing, and we seem to be in alignment with what they are expecting from us for China 2025.

Thank you.

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

Great, thanks. A couple of follow-ups to Suraj’s questions and a couple of new ones as well. Just on Sunny, you mentioned – or I think Sam might have mentioned on the full-time accounting, it’s about $20 million in sales today. So that’s about 2% of sales. Just trying to get a little of my hands around like you have like a figure of sort of new products or products introduced in the last 3 years and how much they represent of your total sales today. I imagine it’s still under 5%. Is that fair to say?

Larry, this is Sam. In terms of the revenue related to new products, and new products received over the last 3 years from that perspective.

Or whatever that you might have – whatever that – yes, I don’t know how you guys look at that, but I’m just trying to get a sense of products introduced over some newer period, whether that’s 1 year or 3 years, 5 years and sort of how much revenue that’s contributing today and maybe what that could be in 5 years in our [indiscernible].

So Larry, I do not have that number off the top of my head here right now. But I do want to qualitatively say that in our business, once we release the product, it goes through a pretty – fairly long adoption cycle in the sense the product has been released and the customers are trying to make it into their product, and then they release their product. And when that customer’s product picks up volume that is when we see volumes. So it is quite normal and natural in our business that for quite some time and that quite some time could easily be 2 years, 1 to 2 years easily, where the product has been released and it is not generating a significantly high amount of revenues. So from that perspective, for the first 3 years of product release, we may not be seeing a whole lot of revenues, and so we do not track it that way. But we can figure that out for some of the conversation in future. I think in our business, it will make more sense in terms of thinking more from a 5-year horizon perspective. So we can talk about it at some other later call, Larry, I don’t have that right here.

Okay.

Larry, I can give – I’ll give you one frame of reference.

Yes. Go ahead, Sunny.

One frame of reference. You may recall, when we spun off at that time, there were – we had a lot of discussions about China and CT tubes in China and the contribution of revenues from those. It’s been now 6 years. And at that time, those tubes were designed. And recall, we said our OEMs or implementing them, designing them in. We are now 5, 6 years into that journey, and now chatting to you, you see what our China revenues are. that’s sort of you’re going to have as a frame of reference, what happens when we launch products, how long does it take? And once we do, what kind of volume sort of to expect in an active market.

I appreciate the color. Sunny, yes, I appreciate that. While I got you on that. So the 18% that you referenced or Sam referenced is coming from China. Is the vast majority of that today in CT tubes?

It’s in tubes, yes. And majority of tubes is CT tubes for us there.

Right. Okay. Right, okay. But then did I cut you off there, I think you were going to say something else?

No, that’s it.

Okay. And then just a follow-up on the margin question. I guess early in the year, I think you guys sort of cited price-to-cost lag, inflation or, I guess, price-to-cost lag, maybe tie in one of the places you trying to catch up with price raising. But also on supply chain issues I think you sort of said you thought there was like a 400 to 500 basis point tailwind on EBIT – adjusted EBITDA margin. We – how far along are we? You kind of mentioned you have like another 100 bps on gross margin. And if I just look at what you did this quarter versus what you did in Q1, you were sort of 400 bps higher. So does that kind of capture that 400 to 500 bps that you spoke about in Q1? Can we get more as we look out? How should we view that?

Yes, Larry. So 6, 9 months ago, when we talked about it, there were a number of things that were headwinds and slowly, we have been working on it, including freight and manufacturing efficiencies and supply chain-driven issues, etcetera. A lot of them are now back to the precrisis or pre-COVID crisis type of levels. So I would say, at this point, there is still 100 to 200 basis points of improvement possible from where we are here. But I would say more closer to 100, 150 basis points. You might get some noise here and there from quarter-to-quarter and we are working through it. But a lot of these other factors have now actually been recovered or we have already – those are – we are behind it, and that is the cause of the margin improvement.

Fair enough. So you sort of said that 100 bps on gross margin. So it feels like once you hopefully get that sometime maybe by the end of the calendar year, and maybe there is a little bit more on the operating end, but going forward beyond that, it would just have to be new products driving higher prices or operating leverage, I guess, right?

Yes, there will be three things, Larry. One is what you said exactly, sales volume, second will be the other and that will drive the operating leverage. And then the new products will be a major factor in that. And the third element there is the segment mix. as industrial becomes a higher portion of the business, then it has a positive gross margin effect on the overall margin.

Got it. Okay. And let me just squeeze in one more question. Just on the guidance, sort of I get the gross margin maybe come down a little bit because you had a nice quarter of mix this quarter, and I – and usually, Q4 medical is usually stronger seasonally stronger. That’s a little bit lower margin. But so I am just trying to figure out how come – as we look out to Q4, I thought seasonally with medical being stronger and being the majority of revenue. Usually, you have a better Q4 than Q3. Is there any reason why we are kind of at the same guidance range, or is it anything I am missing there?

Yes, sure. So Larry, I will let – me take that question for you. So, if you look at our second half of FY ‘23 versus the first half of FY ‘23, we are up around 7%. If you look at last year second half to first half, we were about 8%. So, I would say if you look at it a little bit broader than the quarter, we are pretty much showing the same pattern. But within the quarter, what can end up happening is $2 million, $3 million, $4 million comes into this quarter versus the next quarter, and so that can give that optics of quarter-to-quarter. But if you look at it, from a half versus half, we are pretty much doing what we said. And then also for the full year, we kind of guided 3% to 5%, and at the midpoint here, we are looking at 4.3% or something for the full year growth. So essentially, from our perspective, we are achieving what we set out to do for FY ‘23. But then a couple of millions here and there between the quarters can have that optics effect.

Got it. Fair enough. I appreciate all the color. Thank you.

Thank you, Larry.

Our next question comes from the line of Young Li with Jefferies. Please proceed with your question.

Alright. Great. Thanks so much for taking our questions. Maybe to start on the industrials performance, good to see the continued growth and margin contribution there. I guess I m wondering if you can maybe talk a little bit about the sustainability of the growth trend, your visibility into the ordering patterns there? And is this sort of are we still in the early innings of a multiyear growth cycle for industrials?

So, industrial has been strong for us, and it has been I think post-COVID, it has come back and been consistently strong, and it has been growing. So, we are very pleased with it. We are also at a point where there are certain segments of the market that are adopting imaging fairly rapidly. And so we continue to be – benefit from that effect. So, look, we are fairly optimistic about continued adoption of technology in industrial, and it seems to be – there are parts of that industry that are tender-driven that can be lumpy. But non-destructive inspection in general industrial areas are fairly – have been fairly steady and strong for us. So, I am optimistic about the long-term prognosis because it’s largely a greenfield market. It’s also – it’s growing faster than medical as well, as we have discussed in the past.

Okay. Very helpful. I guess my follow-up just on China, 18% of rev that implies I guess low single to mid-single digit growth year-over-year, that’s below the historical growth trend. It would be great if you can provide some more color on the growth that you saw this quarter. How did it perform relative to your expectations? And what’s the outlook for growth for China going forward?

Yes, sure, Young. So, China performed as per our expectations. There was neither a positive versus expectations or a negative in this last quarter. And then coming back to your question of year-over-year growth, I would say that the numbers for China are now becoming fairly – are becoming reasonably large for us. So, the law of large numbers as well as – is coming in as well as it’s difficult for a region to continue to grow 15%, 20% ongoing basis, but even smaller percentage is now reasonably large size in terms of the dollar amount. So, you are seeing year-over-year growth kind of moderate, but we are seeing strength in – but in terms of percentages, that strength is moderating, which is natural, and we have talked about this in the past that over time, China growth will fall in – fall back in line with the rest of the world, but there is still some more room to go there in terms of China growing faster than the rest of the world. So, China is – as of now, China is behaving and sales are happening like how we would expect it to do.

Got it. Thank you very much.

Our next question comes from the line of James Sidoti with Sidoti & Company. Please proceed with your question.

Hi. Good afternoon and thanks for taking the questions. Can you talk a little bit about inventory at your medical OEMs. I know at the beginning of the year, you were worried that because they were having supply chain issues that they maybe had an oversupply of your components and might be cutting back. Now, six months to eight months down the road, have those supply chain issues subsided? And where is the inventory of your product at the OEMs?

Hi Jim, this is Sunny. I will generalize. Yes, a couple of quarters ago, there were some acute problems with some of our OEMs with getting their factories to flow because of supply chain issues and they had huge backlogs, and there were some amount of our products that were in inventory. And you may recall, that’s why our first quarter was faced a lot of stress as a result of that. But since then, the flow seems to have improved through the production environments of our customers, and they are not declaring victory yet. There are still supply chain issues spotty and we are seeing those as well, while broad-based supply chain issues have been – have eased. There are still spots where we get – few of our vendors, but there are situations where things get caught up. So, it’s not fully out of the woods yet, but I would say that the overall inventory levels of our product with, I would say, our customers are lower than where they were in, I would say, a couple of quarters ago.

Okay. And then one of the other concerns you had two quarters ago was hospital capital spending, you thought it might slow down because of the economic uncertainty. And again, six months down the road, it seems like the recession may not be as bad as we thought initially. Have you seen pressures there subsided as well? Have you seen hospitals more willing to step up their capital spending?

What we are seeing is that the labor-related costs are easing up. And increasingly, we are hearing hospitals doing better with their use of temporary labor. So, we see that as a positive, that improves profitability. We have also seen some amount of buying – continued buying by hospitals. So, it’s – I would say it’s more positive than it was before. But beyond that, it’s hard for us to speculate what that environment looks like, particularly on a generalized global basis. These things vary by geography.

Okay. Alright. And then I will just sneak in one more on the balance sheet. Prepaid expense and other current assets, that was up about $15 million, $16 million in the quarter. Is that where some of the cash is?

Yes. Jim, I just want to make sure I hear it correctly. Did you say prepaid and other current assets?

Right.

Yes. Some of the cash because it is beyond 90 days is considered other current assets, and that’s where it is, yes.

Okay. Is there any other reason why that was up so much in the quarter, or is that just the basically the cash equivalent.

That is basically the cash equivalents. Now, it might be a few 100K here or there, a nice level change, but most of it is the other – is the cash equivalents.

Okay. Alright. That’s what I felt I just want to make sure. Alright. Thank you.

Thank you.

And our next question comes from the line of Anthony Petrone with Mizuho Securities. Please proceed with your questions.

Thanks for squeezing me in here. On just manufacturing mix, just kind of want to get an update on what amount is actually being produced at Wuxi versus Salt Lake and how that influences margin – overall gross margins. And as we look ahead over the next couple of years, where can that mix trend? And I will have one follow-up question.

So, Anthony, this is Sam. Good to hear your voice. So, in terms of Wuxi production, Wuxi, in the overall scheme of things, even as of now, is a smaller site for us. I would say about closer to 70% of value or revenue volume is done through Salt Lake City and the remaining is done through Germany, Philippines, Netherlands and Wuxi. So, that gives you a little bit of a perspective. I would say it is still on an annualized basis, less than 10% of our overall revenue volume going through Wuxi. So, that gives you a little bit of a perspective there. And then in terms of overall gross margin, it just depends from what type of modality that we are shipping from there, and it can change. So, it is not something which is due to labor difference or anything else. It is – it gets impacted largely depending upon which customer, what modality that we are shipping from Wuxi versus Salt Lake City. So, it’s a little bit of a hard question to answer. It can vary from quarter-to-quarter.

And maybe just an update on the mix between tubes and flat panel detectors, other components, last year, extending maybe even 18 months ago, there was pressure in pricing on flat panel detectors, but CT tubes in particular, were holding price quite well. So, anything of note on the pricing side between tubes and flat panel detectors as we look into the back half of the year, maybe even into 2024. Thanks again for taking the questions.

Yes. So, in general, a few years ago, I would say our business used to be 45% sources, 45% panels and detectors, and 10% would be connect and control or C&C and software. As of now, I would say, we are around 10% C&C and software, but that the 90% split, which used to be equal between sources across industrial and medical segments, used to be 45% and 45%. But now that has moved 50% towards tubes and 40% towards panels, driven by the factor that tubes – the sources side, the medical sources side has grown a bit faster than the panel side. And so that is the overall distribution between panels and X-ray sources and other components of the business. What was the second question, Anthony?

Price.

In terms of pricing, as you know, 18 months ago, 18 or so months ago, we had a broad initiative across the entire customer base for price increases. I would say that we have been successful at that. We have been getting prices. And then it has been somewhat in phases for some time, semiconductors, which largely go into panels. Those prices spiked up. And that enabled us to – that helped us to increase prices on the panel side a bit more. But then on the tubes side, since it’s more of a mechanical and a hardware type of a product, those metals and all those prices – those costs go up. And based on that, we were able to increase prices on sources. I would say, as of now, as I look back at the last 12 months to 18 months of experience, our pricing increases on the sources side has been a bit higher on the panel side.

Thank you very much.

And we have reached the end of the question-and-answer session. And I will turn the call back over to Chris Belfiore for closing remarks.

Thank you. Thank you for your questions. I will now hand the call back to Sunny for some final comments.

Thank you, Chris. In closing, we are very pleased with the solid third quarter results and on track to achieve our target growth rate for the year. And as always, I am very proud of our global team and employees that make a difference on a daily basis. And thank you all for taking the time to join us today and for your continued interest in Varex.

Thank you, Sunny, and thank you all for your questions and participating in our earnings conference call today. The webcast and supplemental slide presentation will be archived on our website. A replay of this quarterly conference call will be available through August 15 and can be accessed on our website, vareximaging.com/investorrelations. Thank you and goodbye.

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