Greetings. Welcome to the Varex Q3 fiscal year 2022 earnings call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. 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 Q3 of fiscal year 2022. 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's website at vareximaging.com/news. 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 Q3 of fiscal year 2022. In addition, unless otherwise stated, quarterly comparisons are made sequentially from the Q3 of fiscal year 2022 to the Q2 of fiscal year 2022, rather than the same quarter of the prior year.
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 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. 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 measure 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 happy to report very good results for the Q3 of fiscal 2022. Sales remained very strong, reaching $214 million. Our supply chain initiatives began to show results in an otherwise challenging environment and enabled us to realize sales at the high end of our guidance range. We saw a robust demand for our products and continue to be excited about future growth. Turning to our results. Revenue in the Q3 was flat compared to the Q2 and up 2% year-over-year. Revenue in medical declined 2% sequentially, while industrial revenue increased 7%. Non-GAAP gross margin in the quarter was 35%, which was above our expectations. Price actions and productivity gains helped improve gross margins for the quarter. Adjusted EBITDA was $36 million, and non-GAAP EPS was $0.37.
Our cash position remained solid at $110 million at the end of the quarter. Our balance was down $5 million sequentially, primarily due to continued investment in inventory to support growth in the current supply chain environment. Let me give you some high-level insights into the current demand environment based on a qualitative assessment of our different modalities and applications during the quarter. Medical segment revenues declined 2% sequentially and was flat year-over-year. Global demand for CT tubes remains robust as OEMs continue to bring new CT models to market to support global demand, particularly in China. Demand was also strong in our other medical modalities, including fluoroscopy, oncology, radiography, dental, and mammography. We remain optimistic about future growth as we continue to work through our supply chain challenges so that we're able to maintain a consistent flow of material.
Revenues in our industrial segment increased 7% sequentially and increased 8% year-over-year. Strong demand for our nondestructive inspection products continued in the quarter with strength across many different products in our portfolio. We continued to see improvement in demand for high energy sources for security screening. As we noted last quarter, an increase in tender activity earlier in the year signaled potential for future demand. Some of this activity resulted in sales during the quarter. We continue to see a healthy pipeline in security, especially in our cargo inspection business. During our Q1 earnings call, we highlighted market growth opportunities in our medical segment. Today, I'd like to provide a perspective on our industrial segment and share with you how we see this market segment and our business evolving over time.
In fiscal 2021, our industrial segment revenues were $174 million or 20% of Varex sales. We estimate the current addressable market for our X-ray imaging components in the industrial segment to be about $1 billion, which we believe can grow at a 5% to 7% CAGR over time. While the industrial segment has returned to pre-pandemic levels, our revenue growth has been slower than expected due to a slower pace of recovery in the security segment. Earlier in the year, when we had seen increased tender-related activity, we had anticipated that our orders would pick up later in the year. As expected, orders for our linear accelerators, which are used in cargo inspection, increased in the Q3 .
We continue to see significant potential for our industrial non-destructive inspection portfolio of products, and believe that this segment can grow at mid- to high-single digits% over the next several years. We expect 5 verticals within the industrial segment to be key to driving our future growth. These verticals are security, energy, food quality, electronics, and consumer safety. These are not new markets for Varex, but our approach to them will be different. Historically, our focus across all markets has been to sell X-ray components, like tubes and detectors to our customers. However, as we introduce new technologies like photon counting detectors, image acquisition workflow software, and AI capabilities for automated detection, we intend to provide more integrated system solutions for these industrial verticals. This approach increases our total addressable market in the industrial segment by nearly $1 billion by fiscal 2027.
Let me share some examples. In the energy vertical, specifically in the oil and gas sector, we are offering a full workflow solution for pipeline weld and corrosion inspection. This solution incorporates our hardware components, image acquisition workflow software, as well as automated detection of defects using AI and computer-aided detection. Similarly, on the consumer side, we see a growing use of X-ray and e-beam to inspect, sterilize or remediate consumer-facing products like medical supplies, packaged foods, grains, as well as fish, meat, and plant products. This is a growing market, and our high-power X-ray sources and photon counting detectors can be used to inspect and irradiate food and other consumer-facing products. We are in the early stages of development and introduction of these solutions to the market. We will share more details as well as customer reactions and feedback when we begin to conduct prototype evaluations.
In summary, in addition to our good results, I'm pleased to be able to say that our customers appreciate our efforts and remain confident in our ability to deliver on our backlog as they continue to place new orders. This was particularly apparent in China, where our ability to successfully run operations despite the COVID lockdowns earned us recognition from one of our top customers in China. Further, in July, we attended European Congress of Radiology trade show, referred to as ECR. This is a large annual event that is attended by global manufacturers who market and sell imaging systems in European markets, as well as radiologists and other imaging professionals from all over Europe. The event was very well attended by manufacturers.
We were happy to see that our recently launched dynamic detector product called Azure was prominently shown incorporated in a system by one of the leading manufacturers in Europe. We were also happy to see some of our new Lumen family of radiographic detectors also presented by some manufacturers at this show. To date, we have 4 OEM customers who are designing our Azure dynamic platform into their new systems, and 10 others in active evaluation and planning mode. In addition, more than 15 OEMs are either already buying our Lumen family of radiographic detectors from us or plan to do so in 2023. Every customer that I met thanked and appreciated the way our team has been working very closely with them and delivering our products to them despite all the material shortages. With that, let me hand over the call to Sam.
Thanks, Sunny, and hello, everyone. As a reminder, unless otherwise indicated, I will provide sequential comparison of our results for the Q3 of fiscal year 2022 with those of our Q2 of fiscal 2022. Demand remained robust during the quarter, and our supply chain initiatives allowed us to ship more product compared to our expectations. As a result, we posted sales of $214 million, about $10 million above our guidance midpoint. Non-GAAP gross margin was strong at 35% and withstood the inflationary pressure of rising material costs and logistics, supported by improved pricing and productivity benefits. Non-GAAP EPS was above the top of our guidance at $0.37. Q3 revenues were flat compared to the Q2 . Medical revenues were $167 million, and industrial revenues were $47 million.
Sequentially, medical sales decreased 2%, and industrial sales increased 7%. Medical revenues were 78%, and industrial revenues were 22% of our total revenues for the quarter. Looking at the revenues by region, Americas decreased 7% sequentially, while EMEA increased 1% and APAC increased 5%. Our local manufacturing and business development initiatives in China are performing well. Our sales in China are comprised of product manufactured in China for China consumption as well as exports into China from our other subsidiaries. China was 19% of overall revenue for the quarter, and year to date, it is 16%. Currently, our sales in US dollars are roughly 75% of our overall sales. About 15% are in euros, 7% to 8% are in Chinese yuan, and the remaining in various other currencies. Let me now cover our results on a GAAP basis.
Q3 gross margin was 34%, 100 basis points higher than the previous quarter. Operating expenses were $50 million, up $6 million, and operating income was $23 million, down $4 million. Net earnings were $8 million, and GAAP EPS was $0.20, based on fully diluted 41 million shares. Moving on to non-GAAP results for the quarter. Gross margin of 35% was 100 basis points higher than the previous quarter, driven by better materials-related yields in our Salt Lake City factory. Overall, we've been successful in mitigating inflation-driven downward pressure to the gross margin by price improvements and sales volumes. R&D spending in the Q3 was $20 million, up $1 million from the prior quarter. It was 9% of revenues within our targeted 8% to 10% range.
SG&A was approximately $27 million, $5 million higher than the prior quarter. As a result, SG&A was 13% of revenues. Operating expenses were $47 million or 22% of total revenues, up $6 million from the prior quarter. The increase in R&D and SG&A, and therefore our operating expenses, was primarily driven by higher accrual for compensation expectations for the fiscal year associated with the increase in shipments. I want to remind you that in the previous quarter, we recorded a credit associated with our incentive plan. Operating income was $28 million, down $3 million sequentially due to the increase in operating expenses. Operating margin was 13% of revenue compared to 15% in the previous quarter.
Tax expense in the Q3 was $6 million or 29% of pre-tax income, compared to $7 million or 31% in the previous quarter. Net earnings were $15 million or $0.37 per diluted share, similar to our performance in the Q2 . Average diluted shares for the quarter on a non-GAAP basis were 40 million. Please note that ASU 2020-06, related to the accounting for convertible instruments, will become effective for us from Q1 of fiscal year 2023 onwards. Now turning to the balance sheet. Accounts receivable increased by $3 million, and DSO increased 2 days to 67 days in the quarter due to a higher proportion of product shipments late in the quarter. Inventory increased $30 million as a result of supply chain related initiatives we highlighted on our last call.
We are stocking larger quantities of parts in inventory and also having to pay higher prices for certain inventory items. Compared to last fiscal year end, inventory is up roughly 33%, of which 24% is due to quantity and 9% is due to cost increases. As a result, days of inventory increased to 194 days. Accounts payable increased by $4 million as we procured more inventory, and days payable was 54 days. Now moving to debt and cash flow information. Cash flow from operations was a use of $3 million in the Q3 , and we ended the quarter with cash equivalents, and marketable securities of $110 million on the balance sheet, a decrease of $5 million from the prior quarter. The decrease in cash was primarily due to the growth in working capital.
Gross debt outstanding at the end of the quarter was $451 million, and debt net of $110 million of cash and marketable securities was $341 million. Adjusted EBITDA for the quarter was $36 million, and adjusted EBITDA margin was 17% of sales. Our net debt leverage ratio was 2.4 x at quarter end. Now moving on to guidance for the Q4 . Demand remains strong and we expect our supply chain initiatives to support higher shipment levels. Revenues are expected between $210 million and $240 million, and non-GAAP earnings per diluted share are expected between $0.25 and $0.45.
Our expectations are based on non-GAAP gross margin in a range of 33% to 34%, non-GAAP operating expenses in a range of $45 million ro $46 million, tax rate of about 30% for Q4 and fiscal 2022, non-GAAP diluted share count of about 41 million shares. With that, we will now open the call for your questions.
Thank you, Sam. Before we turn to Q&A, I just wanna add a quick comment. I'd like to extend a warm welcome to Kathy Bardwell, who we announced today, has joined our board of directors. Kathy is the former Senior Vice President of Regulatory Affairs and Compliance for STERIS Corporation, a leading provider of infection prevention and other procedural products and services. She brings 35 years of audit and accounting experience, coupled with an extensive background in the field of quality and regulatory affairs, and she will be a tremendous asset to our board. We look forward to working with you, Kathy. With that, operator, let's open it up for questions.
At this time, we will be conducting a question and answer session. If you'd like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please while we poll for questions. Our 1st question is from Larry Solow with CJS Securities. Please proceed with your question.
Great. Good afternoon. It's CJS. Just thanks for taking the questions. Just I guess the 1st question on the supply chain initiatives, Sunny or Sam, are you guys. Sounds like you're certainly been constrained on the revenue side, and it seems to be improving significantly. Are there still, you know, where we stand today, are there still more levers for you guys to pull there, you know, or you know, obviously you're acquiring a lot of inventory and that's benefiting you a lot. But are there other, I know you were qualifying more suppliers and even changing some of the costs, excuse me, the actual material supplies. Are most of those initiatives well on the way? Are they almost done now?
Can you kinda just give us an idea of, you know, how where we stand in that?
Hey, Larry. This is Sunny. We began with several initiatives a while ago, and there are a number of things. First of all, there are 2 categories you probably talked about, situation with semiconductors and then the situation with electromechanical parts and components. On the semiconductor side, we're making very good progress on both with dealing with obsolescence and moving our products across to other semiconductors. That's going along well. We have, you know, we bought, purchased a lot of semiconductors as well to make sure that we have access to them. You know, where we had the hotspots, where there were critical issues, those have been somewhat mitigated.
The things that we know of, we have done a lot of work to mitigate them, and that's rolling forward. There's still some unknowns there and, but those are. I wouldn't say we're out of the woods there. The semiconductor side is still tenuous, but we have, at this point, we're seeing better flow of chips. On the electromechanical side, it continues to be, you know, I call it the nuisance situation where, you know, suppliers are, you know, they're late, they're short shipping.
Right.
That's continuing, and we're continuing with our diversification efforts there. In summary, Larry, we're not out of the woods yet , you know, we've done a lot of work, and we're seeing some of the results of that work.
Got it. No, that's no. I appreciate that color. In terms of price increases, I know you guys put price increases or putting them in, I guess, beginning of the fiscal year or November. You know, we're sort of anniversary-ing that or coming close to that. You mentioned, you know, inventory, which is just 1 component of what you're gonna end up charging, but that's up 9%, like you said, at least. Are you getting? I don't think you're getting price increases quite commensurate with that 9% increase. Are there more to come? Are you still kind of, you know, chasing that, you know? Is that still kind of impacting, you know, overall performance?
Hi, Larry. This is Sam. We are continuing to increase the prices and, as you know, in our business, we work with our customers. They are on annual contracts, many of them.
Right.
As the contracts come up for renewal, we are able to increase the prices and then based on the purchase order that have been placed and after that, when the new purchase orders are placed, they are getting placed at higher prices. We are definitely making progress on improving the prices. I just want to remind you, Larry Solow, that cost of 9% is on the cost basis, and.
Right.
We had announced mid-single digit in that range type of price increases, and our goal was to mitigate gross margin impact from inflationary costs. So far, we've been able to deliver that, and it is our plan to keep on delivering on that. Price increases are definitely going through, and there is more to go through and more to print on the P&L as a couple more quarters go by.
Okay. You know, obviously, you don't need to get your crystal ball out and, you know, but does seem like, as we go into next year or your next fiscal year, likely, you know, it feels like you guys will continue to raise price if you have to, right? So to offset this sort of rising costs are good.
We'll evaluate the situation as we see how the overall market forces as well as, you know, the inflationary situation is developing. Yes-
Right.
We will definitely be looking at it and assessing it on a dynamic basis.
Okay. Just last question on the outlook for Q4. Maybe the range has been narrowed just slightly, but it's still a pretty wide range, and I know, you know, a lot of uncertainty, nothing's changed in terms of the environment. It does seem like you guys have a little bit of a better grip on the supply chain stuff, which I think also was a big variable, you know. You know, what's sort of the difference between the low end and the high end? Is it more of a, you know. I think in previous quarters it was more of a supply issue.
Is that still sort of the biggest variable, or is there, you know, the demand have any, you know, you still have a lot of room on the demand side? Thanks.
As we look at the guidance for Q4, you know, Larry, like Sunny said in your first question, there is supply chain related uncertainties. There is still freight related delays. You know, we've made a lot of progress in supply chain, and I would like to say that supply chain situation seems to be improving, but I don't think we are at a point where we can say that it is bankable or it is
Yep.
Fully to be baked into our go forward guidance's. As we look at the situation, we still guide with supply chain uncertainty baked into our guidance, and that's what is forming the guidance range at this point. To the extent there are some hiccups in the receipt of raw material or delays in receiving of raw material, we might be on the lower side of the range. If we get more material, then we probably would be towards the higher end of the range. That said, demand is quite strong. Our backlog went up even further in this last quarter. The demand is there. It's just we got to get it completed and ship it to the factory.
Got it. Thanks. I appreciate all the color.
Thank you, Larry.
Our next question is from Jim Sidoti with Sidoti & Company. Please proceed with your question.
Hi, good afternoon, and thanks for taking the questions. Just to follow up on Larry's question on the price increases, is it fair to say that where you have implemented those increases, it's sticking?
Yes. Hi, Jim, Sam here. Yes, they are sticking, and we have been able to pass prices to our customers. At this point, customers are also accepting the price increases in the sense everybody understands where the inflation is and for long-term partnership, they understand, and those price increases are sticking.
You mentioned that prospects seem to be improving from the industrial side. I think you called out cargo inspection or oil and gas pipelines and food inspection. You know, how do you respond to that? Are you increasing R&D for products related to those markets? Are you adding salespeople? You know, what do you do to capitalize on that potential?
Hey, Jim, it's Sunny. On you know, industrials broken out into many verticals. On the security side, we saw tender activity earlier in the year, and we're getting orders. You know, we had anticipated that those would turn into some orders for us, and we're starting to see those. That is where we see the pickup on the cargo inspection side. There we have products that are already in place that are shippable, so really nothing more to be done there other than you know, ongoing R&D. R eally the deal there is we just need to ship against those, and we're doing that. In the other areas of the verticals, like we talked about food inspection, oil and gas, we have. Let's take oil and gas as an example. In that segment, we have several products.
In fact, what I talked about with getting closer to the customers with full workflow solutions, those have been rolled out to our customers. They're in that sales process of being vetted with our OEM customers, so that's in flight. You know, we expect that over the next several quarters, those will start to convert into some traction with these OEMs. In other areas like food inspection and irradiation, there we have R&D activity and investments that are in flight. You know, we'll keep you posted on the progress in those areas, but we expect new products to be rolled out in those areas sometime early to mid next year.
Okay. The last 1 for me. I mean, is there any reason to think that free cash flow should start to improve over the next 3 or 4 quarters as the supply chain issues start to subside? Is there anything that would prevent that from happening?
Hi, Jim, Sam here. You know, in the last couple of quarters as a specific decision, we drove increases in inventory in order to meet our customers' demand. Inventory has gone up, and that is enabling us or putting us in a better position or situation to complete the product and ship it. As we go forward, the rate of inventory increase should slow down, and so we should be able to generate free cash flow. At the same time, you know, the priorities for our cash is, you know, working capital expenditures for the business, followed by, you know, wherever we can, we would like to pay down the debt. Those are the priorities. We have sufficient liquidity, Jim.
We have, you know, we are maintaining $100 million + cash, which is what we have said that we want to keep on hand for operating purposes. We also have a line of credit, which is completely undrawn. I'm quite excited about the growth of our ability to grow because we do have the inventory. As the supply chain situation, like you said, improves a little bit here, further or it becomes more bankable or more certain, we should be able to deliver higher sales, and deliver more, and generate more profits.
Right. That's it for me. Thank you.
Thank you, Jim.
Thanks, Jim.
As a reminder, if you'd like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. Our next question is from Suraj Kalia with Oppenheimer & Co. Please proceed with your question.
Hi, Sunny and Sam. This is Shane. I'm for Suraj.
Hey, Shane.
Hey. Just quick to start, the status of the OEM partner validation for the carbon nanotubes. Any update?
Yeah, that's proceeding. That's continuing on and we've got more OEMs engaged in those feasibility assessments, and then for the ones that we had, we've been shipping more tubes to them. That work is progressing, and we're making steady progress. You know, these are these types of novel platforms take longer in our development cycle, so this will continue this way. You know, the OEMs then take some time to formulate their designs and then they move forward with their projects. Those are moving forward.
Got it. Thank you for that. Just another 1. How are you guys seeing the replacement cycle for the tubes and detectors? Is it slowing given upstream component shortages or is it being able to maintain steady?
You know, the replacement cycle is consistent, meaning tubes have a finite life. Once you know, if a tube lasts a year, they need to be replaced in a year. For us, a replacement tube is no different from a new tube, so it's the same thing. There is really no difference in our sales cycle or revenue cycle for replacement versus new tubes.
Okay. Just last 1 for me. How's your roadmap look for getting back, getting to the 40% gross margin look? Thank you for taking our questions.
Sure. Thanks, Shane. You know, we highlighted that our gross margin for the current business portfolio is around mid-30's%. Mid-30's% in the gross margin. Right now, due to inefficiency, supply chain related issues, freight, et cetera, running high. We are a little bit you know lower than that. In terms of our roadmap to get to higher 30s% or closer to 40%, I think we would need a few new products to be released, which we've been working on, particularly carbon nanotubes that you asked, Shane, and then also photon counting related products. With those products and then of course also software. As those products get released and they get adopted, we should see improvement in our gross margin.
We have reached the end of the question and answer session, and I'll now turn the call over to Christopher Belfiore for closing remarks.
Thank you for your questions and participating in our earnings conference call for the Q3 of fiscal year 2022. The webcast and supplemental slide presentation will be archived on Varex's website. A replay of this quarterly conference call will be available through August 16th and can be accessed at the company's website or by calling 877-660-6853 from anywhere in the U.S. or 201-612-7415 from non-U.S. locations. The replay conference call access code is 13731452. Thank you and goodbye.
This concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation.