On March 12th, Varex Imaging Corporation published financial results for its second fiscal quarter for FY2020 or calendar Q1 2020. These show that overall sales revenue grew during the quarter although underlying profitability deteriorated. The overall sales revenue for calendar Q1 2020 reached $197m, compared with $195.8m during Q1 2019, an increase of approximately 1+% year-on-year. The company has two reportable operating segments, medical and industrial imaging. The sales growth during the first quarter was driven by modest growth from the medical imaging segment, partially offset by a significantly lower sales revenue from the industrial imaging segment.
Medical Imaging Segment
The sales revenue originating from the medical imaging segment reached $155.5m during the first quarter, compared with $148.9m during Q1 2019, an increase of +4.4% year-on-year. This sales growth was driven by a combination of increased sales of CT tubes as well as higher demand for x-ray imaging products that assist with the screening and diagnosis of COVID-19. This was partially offset by lower sales of other medical products related to applications such as dental, oncology and mammography. This was driven by OEM customers slowing their spending and reducing inventory levels in response to the uncertainty created by the Coronavirus pandemic.
US-China trade tariffs
The US-China trade-tariff related actions have a significantly adverse impact on the sales of radiographic digital detectors during FY2019. Detector sales were approximately $20 million lower in China as a direct result of the trade tariffs. Varex subsequently implemented compensating actions in order to mitigate the effects of trade tariffs, including, shifting production to China as well as applying for temporary exclusion from section 301 on components being imported into the U.S. from China. The impact of US-China trade tensions was not a talking point during the Q1 earnings call and no guidance was provided on the impact of US-China tariffs for 2020.
On another tariff-related point, following a customs audit in Germany, the authorities have reclassified detectors being imported into Germany which carried a higher tariff rate that has been previously used by Varex Imaging as well as the wider industry. Varex is accruing for lower profitability although are challenging this within the courts which may result in profit add-back during a later period.
Industrial Imaging Segment
The sales revenue originating from the industrial segment reached $41.6m during the first quarter, compared with $46.9m during Q1 2019, a decrease of -11.3% year-on-year. The contraction during the quarter was driven by a combination of lower oil prices and the widespread economic impact of COVID-19 which led to lower sales of products for cargo screening and non-destructive inspection applications that were partially offset by increased sales of products for the airport security market. The demand for cargo screening products is typically tender driven and funded by governments located in oil-producing regions and hence, lower oil prices tend to have a dampening effect on revenue from this segment. Furthermore, many customers purchasing NDT products are within the oil & gas vertical and spending has contracted sharply in response to the global market price of oil.
Group profitability development
Although revenues were higher for the quarter, overall margins were lower. The gross margin during Q1 2020 was 29%, compared to 33% during Q1 2019. Operating earnings reached $1.4m during the quarter, compared with $14.5m during Q1 2019, a decrease of approximately -90%. This reflects a lower operating margin of -670bps from 7.4% during Q1 2019 to 0.7% during Q1 2020. For the medical segment specifically, gross margin declined by approximately -3%. The decrease in profitability was driven by a combination of factors, including, a substantial shift in product mix, one-time costs as well as negative cost effects due to the Coronavirus pandemic. The shift to a lower margin business mix accounted for approximately -100bps of margin reduction. The one-time costs included approximately $2 million related to the customs audit in Europe and approximately $1 million of accelerated depreciation related to the closure of the Santa Clara facility. In addition, the COVID-19 pandemic has resulted in higher freight costs as well as lower productivity within factor operations due to social distancing measures, resulting in approximately -100bps of margin reduction.
Liquidity and cash preservation measures
To help improve the companies financial condition for the duration of the Coronavirus pandemic, the company initiated a series of cost reduction and cash preservation measures that will continue into the second half of 2020. This includes the following:
- Accelerating the closure date of the Santa Clara facility by a full quarter.
- Within the U.S, reduced labour costs through furloughs and reductions in personnel.
- A reduction in employee remuneration through a combination of two weeks of leave without pay and temporary salary reductions. This is for non-production employees. Remuneration is being reduced by approximately 10% to 30% depending on the job level. This includes a 30% reduction at CEO and board-level.
- Internationally, the company is exploring and implementing salary reductions and reduced work schedules.
- Temporarily suspending the Company’s 401(k) match along with cash components of employee recognition programs.
- Reduction in other discretionary expenses.
In aggregate, it is anticipated that these actions will reduce cost by approximately $15 million to $20 million over the remainder of the fiscal year.
In addition to these measures, during March the company modified the covenants of its credit facility to increase the allowable leverage ratio to 4.25 times adjusted EBITDA. During April, the company borrowed the remaining balance of its credit facility which provided an additional $65 million of cash. The company is also in the process of pursuing other sources of capital, including the US government Main Street Lending Program.
Outlook for the remainder of 2020
Due to the uncertainty associated with the COVID-19 pandemic, Varex has withdrawn its previous guidance for the fiscal year 2020.
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