Varex Imaging: Record second-quarter sales don’t change economic headwinds or thesis

investment presentation

Varex Imaging Corporation’s Hold rating (NASDAQ: VREX) proved to be a frugal appeal in a June publication. Since then, the stock has fallen sharply and is currently down 17%.Equity benchmarks continue to trade Higher overall, and those names without the business returns to support the case are not currently considered investment grade. This is relevant to VREX, as similar themes plague its investment landscape. The company itself is well positioned and its products are beneficial to the medical imaging industry. Its medical imaging and industrial segments are critical to the industry as a whole.

But there are too many unanswered questions to argue for buying the company right now. This report will explore each of these. Net-net, I reiterate my holding on VREX.

figure 1. VREX collapses from highs, extending long-term trend Downtrend. It is now moving lower below the 50-day line and the 200-day line. No decent bids for over 18 months now.

Revise Key Investment Facts Holding Paper

1. Macroeconomic background

In 2022, cash on hand of U.S. listed companies fell by 11%, the largest year-on-year decline in the past 40 years. Additionally, the S&P 500 cash/asset ratio and cash/equity ratio, which previously hit record highs in 2021, have fallen to their lowest levels since the global financial crisis. Therefore, Goldman Sachs Asset Management (GS) suspects that this decline may slow corporate spending in multiple areas in the coming quarters.

After surging 18% in 2022, U.S. large business investment, measured as capital expenditures and research and development, is expected to slow to 6% this year. Likewise, dividend growth is expected to slow to 5% in FY23, after growing at 9% in FY23. The question is, how long these trends will persist.

In terms of earnings, while corporate earnings have weakened slightly, corporate balance sheets have strengthened. Median leverage (net debt/EBITDA) among S&P 500 non-financial companies as of August 2023 was 1.9x, which puts it in the 95th percentile over the past four years but remains below pre-pandemic levels of about 2.0x level. Goldman Sachs also believes that debt repayments will not pose an immediate threat to many businesses due to prudent decisions made during the “ZIRP” era when interest rates are at historically low levels. For example, the effective interest rate on S&P 500 debt (as shown on the income statement) is only 3.3%, even though the interest rate on the UST 10-year bond is 4% and the starting yield on U.S. investment grade bonds is 5.5%. Additionally, a large portion of the S&P 500’s debt does not mature until after 2030, eliminating interest rate risk for many companies.

As such, it will measure which companies can make the most efficient use of capital in the coming years. A company’s investments must generate cash flow above their costs to be considered viable, and my estimate is that equity returns are likely to mimic these factors in FY25. This discussion is also relevant to the analysis of VREX.

2. FY23 Q3 Insights – Record Revenue, NWC Extremely Intensive

VREX’s quarterly revenue reached a new high in the second quarter, with revenue of US$232, an increase of 2% from the previous quarter and an increase of 8% from the same period last year. Gross margin increased approximately 100 basis points from the previous quarter to 33%, and operating expenses were $52mm. It pulls it to adj. EBITDA was 38mm and earnings per share were $0.37. Management continues to expect full-year sales growth of 3% to 5%. VREX’s current momentum is in line with these expectations. Looking ahead to the fourth quarter, revenue expectations are set at $220 to $240 and earnings per share of $0.20 to $0.40. OCF print was strong for the quarter, totaling 38mm, primarily due to off-balance sheet inventory revisions of 13mm, while VREX had cash on hand of 152mm for the quarter.

The breakdown of revenue by department is as follows (see Figure 2):

1. Medical revenue decreased $175, and operating revenue in the Industrial segment decreased $57. The industrial business grew 20% year-on-year and contributed 24% to revenue. On the other hand, medical revenue contributed 76%, growing about 500 basis points year-on-year.
2. From a regional perspective, VREX’s business in the Americas increased by 8% month-on-month, Europe, the Middle East and Africa increased by 10%, and business in the Asia-Pacific region decreased by 10%. Crucially, China still played a significant role in the record revenue in the second quarter, accounting for 18% of total turnover.

Net working capital (“NWC”) density continues to be a challenge I think VREX faces (discussed in more detail later). In the third quarter, accounts receivable increased by 3mm on top of revenue growth of 8%, despite a 13mm decrease in inventory.Crucially, DSO is stable at 65 days [Figure 3]. On the other hand, inventory days decreased by 8 days to 174 days. But the problem, in my opinion, is that VREX’s cash conversion cycle lasts about 200 days, which is more than half a year to convert every $1 of working capital into cash. NWC’s capital tie for the quarter was approximately $480 (including cash on hand), which was more than double Q2 revenue, which likely took about 200 days on average to convert to cash flow, plus over the past 3 years, each new Project $1 of sales would require a $0.60 increase in NWC to accommodate revenue growth (see: Figure 6) – this is a function of (i) low inventory turns over the past few years (0.5x) and (ii) business economics model (discussed below).

3. Economic benefit analysis

This section discusses a number of key factors. It will examine the company’s economic health and what reinvestment is needed to continue its current growth rate.

As of the third quarter, VREX had $965 of capital at risk, primarily working capital. Much of this is held in inventories in the current account. $965 or $23.90/share generates after-tax income of $1.48/share, a return on investment of 6.2%. We benchmark all companies against a 12% ROIC. So this doesn’t meet the requirements.

The culprit is pretty obvious:

• The after-tax profit margin in the past 2 years was 6-8%;
• The capital turnover rate was <1 times, which was 0.93 times in the previous quarter.

In VREX’s business, you would expect capital turnover >2x, indicating it is creating incremental value. Its products are difficult to differentiate (they are not unique components that VREX sells), so it is forced to adopt a cost leadership strategy by pricing its products below the industry average. The problem is that (i) this further limits after-tax profits, and (ii) its inventory only turns over every 2 years (0.5x inventory turnover). This is consistent with previous economics. Alas, every $1 invested only generated $0.94 in sales and $0.07 in after-tax profits.

In Figure 5, you can see how far VREX’s required capital output at a minimum return on capital of 12% falls short of its performance in NOPAT. Since 2020, a cumulative economic loss of $15.40 per share has been incurred. Not surprisingly, its shares are down $13.60 from their 2021 highs.

The previously mentioned NWC strength is shown in Figure 6. The company’s sales have grown at a geometric rate of 2% for three years, and the average operating profit margin has been stable at 9.2%. But for every $1 of additional sales, $0.60 needs to be invested in NWC, which clearly illustrates where all the profits + cash flow are going. On this basis, it’s no surprise that VAREX’s ROE lags at 5.6%.

Assume it expects to continue growing at the same level in the future. After all, Q3 FY23 revenue hit an all-time high. I retain these assumptions in Figure 7, forecasting the next 12 months. In order to continue to maintain a steady state, I estimate that VAREX requires about $60-75 of net investment (mainly NWC), and about $50-55 of FCF per period. Still, returns on these investments will be below our 12% threshold, and a reinvestment rate of about 10% could mean their intrinsic value averages only about 2.3% (9.2% over the next 12 months).

This assumes sales growth of 2%. At 3%, the reinvestment rate is about 40%, the capital rate remains unchanged, and free cash flow is lower at 51mm. At 4% interest rates, free cash flow is only ~46mm. This clearly shows that growth can damage value if capital productivity falls short of benchmarks. If the ROIC is 15%, using the same specifications as in Figure 6 (2% sales growth, etc.), VREX’s trailing free cash flow could be $125-130 by FY24.

Valuation and conclusion

As things stand, my estimate is that the market is pricing VREX correctly at a compression multiple of 11x forward EBIT and 1.4x book value. It doesn’t achieve high rates of return on the capital it deploys, so VREX doesn’t carry a premium on these assets. It sells for 1.14x EV/IC, which looks expensive even based on 1) the numbers so far, and 2) what VREX’s numbers will look like if it continues to grow at this rate.

Projecting the steady state number out to FY28 and discounting it back to 12% gives you an equity value of $24. While compounding, its stock price is $18.55 per share based on ROI and reinvestment rate multiples. The average price of both is $21 per share, roughly in line with where VREX is selling today. To me, this supports a Neutral rating.

Another extensive analysis of VREX reveals a similar theme: It misses the key benchmark of capitalization margins, meaning there’s no compounding effect on intrinsic value. While the year-to-date sales performance is commendable, it hasn’t translated into shareholder value. This is simply not attractive economics, and the question of opportunity cost immediately arises. Is VREX the best investment right now as the next best alternative? I think absolutely not, and based on the factors listed here, the price looks pretty reasonable at around $18-20. Net net, reiterate hold.