Varex Imaging(US:VREX)2019-05-08 21:15markdown Part I. Financial Information [Unaudited Financial Statements](index=4&type=section&id=Item%201.%20Unaudited%20Financial%20Statements) Varex Imaging Corporation's unaudited condensed consolidated financial statements are presented, including earnings, balance sheets, cash flows, and equity [Condensed Consolidated Statements of Earnings](index=4&type=section&id=Condensed%20Consolidated%20Statements%20of%20Earnings) Varex reported **$195.8 million** in revenues and **$5.8 million** in net earnings for the three months ended March 29, 2019, a decrease from the prior year Condensed Consolidated Statements of Earnings (Unaudited) | (In millions, except per share amounts) | Three Months Ended March 29, 2019 | Three Months Ended March 30, 2018 | Six Months Ended March 29, 2019 | Six Months Ended March 30, 2018 | |:---|:---:|:---:|:---:|:---:| | **Revenues** | $195.8 | $201.2 | $381.5 | $377.4 | | **Gross margin** | $64.4 | $70.1 | $124.4 | $131.6 | | **Operating earnings** | $14.5 | $17.2 | $24.9 | $30.7 | | **Net earnings attributable to Varex** | $5.8 | $12.2 | $8.8 | $23.6 | | **Diluted EPS attributable to Varex** | $0.15 | $0.32 | $0.23 | $0.62 | [Condensed Consolidated Balance Sheets](index=6&type=section&id=Condensed%20Consolidated%20Balance%20Sheets) Varex reported total assets of **$965.6 million** and total liabilities of **$519.6 million** as of March 29, 2019, with decreased cash and long-term debt Condensed Consolidated Balance Sheet Highlights (Unaudited) | (In millions) | March 29, 2019 | September 28, 2018 | |:---|:---:|:---:| | **Total current assets** | $437.3 | $458.1 | | Cash and cash equivalents | $31.0 | $51.9 | | Inventories, net | $261.2 | $235.1 | | **Total assets** | $965.6 | $987.9 | | **Total current liabilities** | $156.3 | $152.0 | | **Long-term debt** | $316.7 | $364.8 | | **Total liabilities** | $519.6 | $548.5 | | **Total Varex equity** | $433.3 | $426.2 | [Condensed Consolidated Statements of Cash Flows](index=7&type=section&id=Condensed%20Consolidated%20Statements%20of%20Cash%20Flows) Net cash from operations was **$32.9 million** for the six months ended March 29, 2019, decreasing due to lower net earnings and increased inventories Condensed Consolidated Statements of Cash Flows (Unaudited) | (In millions) | Six Months Ended March 29, 2019 | Six Months Ended March 30, 2018 | |:---|:---:|:---:| | **Net cash provided by operating activities** | $32.9 | $45.5 | | **Net cash used in investing activities** | $(7.6) | $(6.9) | | **Net cash used in financing activities** | $(45.6) | $(66.7) | | **Net decrease in cash and cash equivalents** | $(20.9) | $(27.9) | [Notes to the Condensed Consolidated Financial Statements](index=10&type=section&id=Notes%20to%20the%20Condensed%20Consolidated%20Financial%20Statements) Detailed notes explain Varex's accounting policies and financial results, including revenue recognition, segment performance, debt, and the Direct Conversion AB acquisition - The company adopted the new revenue recognition standard ASC 606 on September 29, 2018, using the modified retrospective method, resulting in a net cumulative reduction to retained earnings of **$3.5 million**, net of tax[69](index=69&type=chunk)[106](index=106&type=chunk) - The company has two reportable segments: Medical and Industrial, generating **$292.8 million** and **$88.7 million** in revenue respectively for the six months ended March 29, 2019[32](index=32&type=chunk)[138](index=138&type=chunk) - One customer, Canon Medical Systems Corporation, accounted for **17.7%** of revenues for the six months ended March 29, 2019[42](index=42&type=chunk) - On April 29, 2019, the company acquired approximately **97.4%** of Direct Conversion AB for **€62.1 million**, plus assumed net debt of **€2.6 million**, funded with **$7 million** in cash and **$64 million** of debt[140](index=140&type=chunk)[141](index=141&type=chunk) [Management's Discussion and Analysis of Financial Condition and Results of Operations](index=29&type=section&id=Item%202.%20Management%27s%20Discussion%20and%20Analysis%20of%20Financial%20Condition%20and%20Results%20of%20Operations) Management discusses Varex's financial performance for the three and six months ended March 29, 2019, covering revenue, gross margin, liquidity, and capital resources [Results of Operations](index=31&type=section&id=Results%20of%20Operations) Medical revenues decreased by **$9.6 million** while Industrial revenues grew by **$4.2 million** for the quarter, with overall gross margin percentage declining Revenues by Segment - Three Months Ended | (In millions) | March 29, 2019 | March 30, 2018 | $ Change | % Change | |:---|:---:|:---:|:---:|:---:| | Medical | $148.9 | $158.5 | $(9.6) | (6.1)% | | Industrial | $46.9 | $42.7 | $4.2 | 9.8% | | **Total revenues** | **$195.8** | **$201.2** | **$(5.4)** | **(2.7)%** | Gross Margin by Segment - Three Months Ended | (In millions) | March 29, 2019 | March 30, 2018 | $ Change | % Change | |:---|:---:|:---:|:---:|:---:| | Medical | $46.1 (31.0%) | $53.5 (33.8%) | $(7.4) | (13.8)% | | Industrial | $18.3 (39.0%) | $16.6 (38.9%) | $1.7 | 10.2% | | **Total gross margin** | **$64.4 (32.9%)** | **$70.1 (34.8%)** | **$(5.7)** | **(8.1)%** | - The decrease in medical gross margin percentage was due to higher costs of quality, primarily in the detector business, plus increased freight and tariff costs[165](index=165&type=chunk) - For the six months ended March 29, 2019, Medical revenues decreased by **$4.9 million**, while Industrial revenues increased by **$9.0 million**, resulting in a total revenue increase of **$4.1 million**[175](index=175&type=chunk)[176](index=176&type=chunk) [Liquidity and Capital Resources](index=35&type=section&id=Liquidity%20and%20Capital%20Resources) Varex's liquidity is supported by operating cash flow and a credit facility, with cash at **$31.0 million** and net debt at **$346.1 million** as of March 29, 2019 - The company had **$150.0 million** available for borrowings under its revolving credit facility as of March 29, 2019[188](index=188&type=chunk) Cash Flow Summary - Six Months Ended | (In millions) | March 29, 2019 | March 30, 2018 | |:---|:---:|:---:| | Net cash provided by operating activities | $32.9 | $45.5 | | Net cash used in investing activities | $(7.6) | $(6.9) | | Net cash used in financing activities | $(45.6) | $(66.7) | - The company has a fixed cost commitment of **$14.7 million** for calendar year 2019 with its supplier dpiX, of which **$11.0 million** remained as of March 29, 2019[195](index=195&type=chunk) [Quantitative and Qualitative Disclosures About Market Risk](index=37&type=section&id=Item%203.%20Quantitative%20and%20Qualitative%20Disclosures%20About%20Market%20Risk) Varex is exposed to foreign currency, credit, interest rate, and commodity price risks, managing interest rate risk through swaps hedging **$270.0 million** of debt - The company is exposed to foreign currency risk as a significant portion of customers are outside the U.S. and products are generally priced in U.S. Dollars[202](index=202&type=chunk) - To manage interest rate risk on its floating-rate debt, the company uses interest rate swaps to hedge the LIBOR component on a notional value of **$270.0 million** of its debt[206](index=206&type=chunk) - The company is exposed to commodity price risk from raw materials like tungsten, lead, copper, and molybdenum, but did not have any commodity derivative instruments in place during the quarter[207](index=207&type=chunk)[263](index=263&type=chunk) [Controls and Procedures](index=38&type=section&id=Item%204.%20Controls%20and%20Procedures) Management concluded disclosure controls and procedures were ineffective as of March 29, 2019, due to material weaknesses in internal control over financial reporting - The CEO and CFO concluded that disclosure controls and procedures were not effective as of March 29, 2019, due to material weaknesses in internal control over financial reporting[208](index=208&type=chunk) - Material weaknesses were identified in IT general controls (user access and program change management) and business process controls related to revenue, inventory, German operations, and the financial reporting close process[209](index=209&type=chunk)[212](index=212&type=chunk)[215](index=215&type=chunk) - The company began implementing a remediation plan to address the material weaknesses, which will not be considered remediated until the controls operate effectively for a sufficient period[216](index=216&type=chunk) Part II. Other Information [Legal Proceedings](index=41&type=section&id=Item%201.%20Legal%20Proceedings) Varex is involved in various legal actions, including patent infringement, but management anticipates no material adverse effect on operations or financial position - The company has initiated litigation asserting claims of patent infringement against a third party in the current fiscal year[217](index=217&type=chunk) - Management believes that no currently pending litigation is expected to have a material adverse effect on the company's financial position or operations[217](index=217&type=chunk) [Risk Factors](index=41&type=section&id=Item%201A.%20Risk%20Factors) This section outlines significant risks to Varex's business, including customer dependence, competition, tariffs, new product development, acquisitions, debt, and internal control weaknesses [Business and Market Risks](index=41&type=section&id=Business%20and%20Market%20Risks) Varex faces significant business and market risks, including high dependence on limited OEM customers, intense competition, and negative impacts from U.S. and China tariffs - Varex is dependent on a limited number of OEM customers, with one customer accounting for **18%** of revenue and the ten largest customers accounting for **53%** in the six months ended March 29, 2019[219](index=219&type=chunk) - The company faces intense competition from other manufacturers and from its own OEM customers' in-house manufacturing operations[223](index=223&type=chunk) - Tariffs implemented by the U.S. and retaliatory tariffs by China have increased costs, forced price concessions, and are expected to continue to have a negative effect on the business[226](index=226&type=chunk) [Operational and Strategic Risks](index=43&type=section&id=Operational%20and%20Strategic%20Risks) Operational and strategic risks include new product development, acquisition integration, potential disruptions at the Salt Lake City facility, and managing manufacturing costs - The company's success depends on the continuous development and commercialization of new products, which involves significant investment and risk[229](index=229&type=chunk) - Acquisitions, such as the recent purchase of Direct Conversion AB, present risks including difficult integration, diversion of management attention, and potential failure to realize expected synergies[234](index=234&type=chunk)[235](index=235&type=chunk) - The majority of products are manufactured at the Salt Lake City, Utah facility, making the company vulnerable to disruptions at this single location[247](index=247&type=chunk) [Financial and Economic Risks](index=45&type=section&id=Financial%20and%20Economic%20Risks) Varex faces financial and economic risks from its **$346.1 million** debt, foreign currency exposure from international revenues, and potential impacts from tax law changes - As of March 29, 2019, total debt was approximately **$346.1 million**, with credit facilities containing restrictive covenants that limit activities like incurring future debt and making certain investments[242](index=242&type=chunk)[243](index=243&type=chunk) - Approximately **63%** of revenues were generated from customers outside the U.S. for the three months ended March 29, 2019, exposing the company to risks like currency fluctuations, tariffs, and political instability[249](index=249&type=chunk)[251](index=251&type=chunk) - Changes in tax laws, particularly the U.S. Tax Reform Act of 2017, and shifts in the geographic mix of earnings could significantly impact the company's effective tax rate[253](index=253&type=chunk) [Regulatory and Legal Risks](index=50&type=section&id=Regulatory%20and%20Legal%20Risks) Varex's products are subject to extensive regulation by the FDA and foreign agencies, with non-compliance risking recalls and fines, alongside anti-corruption and healthcare laws - The company's manufacturing operations must comply with the FDA's Quality System Regulations (QSR), with non-compliance potentially leading to enforcement actions, including production shutdowns and fines[272](index=272&type=chunk) - Marketing products internationally requires obtaining and maintaining clearances, such as the CE mark in Europe, with new EU Medical Device Regulations entering into force in 2020 imposing stricter requirements[281](index=281&type=chunk)[283](index=283&type=chunk) - The company is subject to anti-corruption laws like the FCPA and U.K. Bribery Act, as well as anti-kickback and false claims laws, which carry risks of substantial penalties and reputational damage[289](index=289&type=chunk)[292](index=292&type=chunk) [Risks Related to Public Company Status and Separation from Varian](index=49&type=section&id=Risks%20Related%20to%20Public%20Company%20Status%20and%20Separation%20from%20Varian) Varex faces risks from public company compliance, material weaknesses in internal controls, and challenges from its separation from Varian, including financial representativeness and indemnification - Management identified material weaknesses in internal controls related to IT general controls and business processes, which could result in a material misstatement if not remediated[269](index=269&type=chunk) - Historical financial information may not be indicative of future results as a standalone company due to changes in corporate functions, economies of scale, and financing[331](index=331&type=chunk)[332](index=332&type=chunk) - Under the Tax Matters Agreement, Varex could be required to indemnify Varian for material taxes if the spin-off is deemed taxable due to certain actions by Varex, which may discourage a change of control[330](index=330&type=chunk)[337](index=337&type=chunk) [Unregistered Sales of Equity Securities and Use of Proceeds](index=64&type=section&id=Item%202.%20Unregistered%20Sales%20of%20Equity%20Securities%20and%20Use%20of%20Proceeds) As part of the Direct Conversion AB acquisition, Varex will make a deferred payment to former shareholders, comprising cash and unregistered common stock - As part of the Direct Conversion acquisition, a deferred payment equal to the value of **345,598** common shares is due to the former shareholders one year after closing[345](index=345&type=chunk) - The payment will be a mixture of cash and common stock, with any shares issued being unregistered, relying on exemptions under Section 4(a)(2) and Regulation D[345](index=345&type=chunk) [Exhibits](index=65&type=section&id=Item%206.%20Exhibits) This section lists exhibits filed with the Form 10-Q, including the Share Purchase Agreement for Direct Conversions AB, a Credit Agreement amendment, and CEO/CFO certifications - Exhibit **10.1** is the Share Purchase Agreement dated March 21, 2019, for the acquisition of Direct Conversions AB (publ)[350](index=350&type=chunk) - Exhibit **10.2** is Amendment No. 3 to the Credit Agreement, dated March 21, 2019[350](index=350&type=chunk) - Exhibits **31.1**, **31.2**, **32.1**, and **32.2** contain the required CEO and CFO certifications pursuant to the Securities Exchange Act and Sarbanes-Oxley Act[350](index=350&type=chunk)