Varex - I Imagine Better Days Ahead For This Spin-Off

| About: Varex Imaging (VREX)

Summary

Varex Imaging has finally been spun-off from Varian Medical.

This pure play on X-ray imaging components is a very interesting business, which has seen some troubles in recent years.

On the back of an anticipated margin recovery, amidst already growing sales, ¨freedom¨ of management and PerkinElmer acquisition, I see better days ahead.

Varex Imaging (VREX) has been spun-off from Varian Medical Systems (VAR). The pure play supplier of X-ray imaging components has quite a substantial market share and decent long term track record, even if recent years have been challenging.

Following the spin-off, the valuation of Varex seems reasonable in relation to the current earnings power. Future earnings can really see a big jump following recent dealmaking and anticipated margin gains. if the ¨freedom¨ given to the new management team can really be the driver behind real margin improvements, I see much better days ahead.

I am therefore anxiously awaiting a much anticipated post spin-off dip in order to pick up a few shares.

Varex, An X-ray Imaging Components Business

Varex designs and produces X-ray imaging components which include tubes and flat panel detectors. Producers of X-ray systems use these components and software to create their end products, with Varex often being a crucial supplier to the functionality of these products.

The global X-ray components business is currently seen at roughly $3.8 billion a year. The medical market is by far the largest segment with roughly $3 billion in sales, complemented by industrial and security applications, a market which is growing by mid single digits.

Within this $3.8 billion market, Varex has real scale as 2016 sales are seen at $620 million, indicating that the company holds a sixth of the total market. Just like the market opportunity, Varex relies largely on the medical market which is responsible for little over 80% of sales. There is still more room to increase sales to existing customers. The company counts 90% of the leading OEMs as its customers, as it has long term relationships with most of these producers. Somewhat troublesome is the fact that Toshiba is the largest customer. This company is responsible for $140 million in revenues as Toshiba has come under a lot of pressure as a result of its adventure in the ¨nuclear¨ market.

Within digital flat panels, Varex holds 33% of the market, and Thales/Trixell holds 29% of the market. In medical tubes the market share stands at a very solid 21%. In the industrial space, Varex is strong in linear accelerators, competing against the likes of Nuctech and Comet.

Ahead of the separation from Varian Medical, Varex has acquired PerkinElmer´s Medical Imaging business. Similar to Varex, the acquired business acts as a supplier of imaging components, in this case digital flat panel X-ray detectors. With the deal, Varex aims to benefit from cross-selling opportunities as well as new technology being obtained, while reducing the reliance on the medical sector.

The $276 million deal which still has to close, adds $140 million in revenues. No other details have been announced other than that the deal is expected to be accretive to earnings.

A Strong Grower, With Some Recent Challenges

Varex has demonstrated on a solid 9% revenue CAGR over the past decade, although sales have been flat to down a bit from 2013 onwards. A strong dollar, and a decision of a large OEM to move production in-house, have been key reasons behind recent disappointments. Fortunately growth has returned in the second half of 2016, and that has continued into the start of the fiscal year 2017.

In 2016, sales came in at $620 million, down from a $685 million peak in 2014. In the peak years of 2013/2014 gross margins came in at 40-41%, accompanied by operating margins of 25%. While gross margins have been constant ever since, operating margins have fallen back towards 18% in 2016, mainly on the back of sales deleveraging. While full year sales were still down 2% in 2016, the worst seems over. Fourth quarter revenues were already up some 7% year-over-year.

Current Valuation

Varian reported its first quarter results for the fiscal year of 2017 last week. It reported that first quarter sales for Varex were up 7% year-over-year, and came in at $152 million. The results perhaps appear better than they really are, as the first quarter of 2016 was particularly soft.

The company guided for 3-4% growth for the year, indicating that sales are seen at roughly $640 million this year, excluding the acquisition of PerkinElmer´s imaging business of course. Management guided for GAAP earnings of $1.20-$1.30 per share in the remaining nine months of the year, based on 38 million shares outstanding and a 35% tax rate.

The question is what the capital structure of Varex looks like exactly. The company made a $200 million payment to its former parent company in connection to the spin-off. It borrowed this money through a combination of a credit facility and term loan which carries a fat 7.5% rate. Previous documents reveal a pro-forma debt load of $203 million and cash holdings of $32 million, yet this does not take into account the acquisition of PerkinElmer´s imaging business.

Using a $640 million revenue estimate, and a 20% margin target, we see operating profits of $128 million. I reduce this number to $120 million on the back of additional costs which result from running the business independently. A 7.5% interest rate on $200 million in debt yields a pre-tax profit number of $105 million.

After applying a 35% tax rate, earnings come in at $68 million, equivalent to $1.80 per share based on 38 million shares outstanding. That more or less corresponds with the company´s guidance for $1.20-$1.30 per share for the remaining three quarters of the year, which annualized comes in at $1.60-$1.75 per share.

Going Forward, PerkinElmer

Once the deal with PerkinElmer closes, pro-forma revenues will jump from $640 to $780 million. If we assume that the acquired activities post similar margins, we might see operating profits of $150 million.

Net debt will increase from $170 million to $450 million. Operating profits come in at $150 million for the pro-forma business, as D&A charges for Varex´s business run at $15 million a year. Including an estimated $5 million depreciation and amortization charges from Perkin´s activities, EBITDA comes in at $170 million, for a 2.6 times leverage ratio which is still very manageable.

A 7% cost of debt on $450 million in net debt yields interest costs of $32 million. After applying a 35% tax rate, earnings might rise to $77 million, equivalent to $2 per share. Trading at $30, that yields a modest 15 times multiple.

The potential is bigger, however: the company anticipates solid growth, but more importantly, unspecified margin gains as well. If the company can grow towards $800 million in sales in 2018 and posts historical high margins of 25%, operating profits might hit $200 million. If interest costs gradually fall to $30 million and very high tax rates fall to 30%, net earnings might improve towards $120 million in a year or two. This would translate into earnings power of more than $3 per share, as a non-demanding multiple could already warrant a +$50 valuation.

Final Thoughts

Varex is inherently an interesting business which has posted solid growth in the long run, and has been challenged in recent years. That said, a low valuation and potential improvements, following the ¨freedom¨ which the new management team has been given, can unleash real potential.

Shares of Varex started trading at $27 per share late in January and have risen towards $30 per share ever since. A ¨typical¨ spin-off company sees its share price often come under pressure, as investors in the parent company are not familiar with the business, or have to sell their ownership stake for compliance reasons. Unfortunately this has not happened with Varex of yet - I would like to have had the opportunity to buy on a dip.

Using the current earnings power of $1.75 per share as a base case, and potential improvements towards $3 per share in the coming two years, I see real potential for the shares to move higher over time. A market multiple on current earnings power justifies the valuation, while improvements in the business can really drive the business to $50 per share in a year or two.

As a result, I am still hopeful to buy shares on dips in the high-twenties in the coming weeks.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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