Varex: An Overlooked Spin-Off With 25% Upside

About: Varex Imaging Corporation (VREX), Includes: ALOG, AMBD, CMD, DXCM, GMED
by: Tom Yuz

Varian’s spin-off Varex is trading at an EV/EBITDA multiple that is a fourth of the industry average despite its market leading position in medical and industrial markets.

The recent acquisition of PerkinElmer's medical imaging segment offers overlooked opportunities for product cross-selling and manufacturing scale, enabling a potential 30% share price appreciation.

Enhancement in Varex's international operations will fuel greater margin expansion and top-line revenue growth, even as markets remain fixated on domestic production.

Varex Imaging Corporation (NASDAQ: VREX) - Current Price: $34.95 | EBITDA: 121.4M | MV: 1.32B

BUY with Target Price Appreciation: Bear: --2.37%, Base: 25.30%, Bull: 32.0

Investment Thesis & Recommendation

Varian's spin-off Varex has hit the ground running, growing into a leading producer in the world's $26 billion dollar diagnostic imaging market. The multi-layered complexity of digital detector and X-ray tube products has stimulated inefficiencies in market pricing of VREX's assets (EV/EBITDA multiple trading at a fourth of the industry average), while the recent acquisition of PerkinElmer's medical imaging business offers overlooked opportunities for product cross-selling and manufacturing scale. With a price target of $42.09, Varex presents an appealing 25.30% upside even without assuming complete utilization of potential synergies with PerkinElmer's medical imaging segment.

Company Overview

Varex is an international designer and manufacturer of cost-effective diagnostic imaging solutions for original equipment manufacturers (OEMs) in medical (82% of sales) and industrial (18% of sales) segments. 1) The Medical Imaging segment manufactures over 100,000 X-ray tubes for four primary medical diagnostic radiology applications: computed tomography ("CT") scanners, radiographic or fluoroscopic imaging, special procedures, and mammography. OEM customers incorporate VREX products into their medical diagnostic, radiation therapy, dental, and veterinary imaging systems. 2) The Industrial business segment designs, manufactures, sells and services X-ray accelerators, imaging processing software, and image detection products for use in security and industrial inspection applications, such as cargo screening and nondestructive examination in a variety of applications. For instance, OEM customers sell the systems with VREX components to customs and other government agencies for use in ports and borders to screen overland, rail, and sea cargo for contraband, weapons, narcotics and explosives, as well as for manifest verification. Varex also sells its Industrial products to commercial enterprises in the casting, power, aerospace, chemical, petro-chemical and automotive industries for nondestructive product examination purposes, such as industrial inspection and manufacturing quality control.

Industry Overview

1) Medical Imaging: The most immediate market for VREX's technologies is a $3 billion dollar X-Ray radiography market, which is expected to grow at a CAGR of 3% to 2020. In the medical imaging market, flat panel detectors are experiencing rapid growth, driven by a market transition from analog to digital systems due to X-ray dose reductions, lower production costs, increased patient throughput, and U.S.-legislated reimbursement cuts for analog systems. As product cycles shorten, there will be significant replacement opportunity for the 500,000-plus analog units that exist globally. With a fragmented competitive landscape and many OEMs lacking scale, the industry continues to outsource flat panel detector manufacturing to specialists such as VREX while offering substantial potential for consolidation. Moreover, the need for accurate imaging is capable of addressing modalities from magnetic resonance imaging, to medical sonography, to nuclear medicine functional imaging: combining these segments of biological imaging taps into a cumulative $34.43 billion medical imaging market (6% CAGR). Each sophisticated imaging approach sends signals into the body to spatially map out organs. Although these other types of imaging do not require X-ray tubing, they utilize VREX products such as digital detectors (45% of VREX revenues) and connectors + processing workstations (10% of revenues).

2) Industrial and Security Imaging: As disruptive technologies such as 3D printing achieve greater adoption and automation continues to redefine the industrial landscape, in-process inspections using imaging and detection software continue to experience growing demand. The addressable industrial market, currently at $850 million, is expected to more than double to $2 billion dollars by 2025 for a CAGR of 10%. Furthermore, with airport screening and baggage security at the forefront of the public consciousness, security imaging is expected to also grow to $2.5 billion by 2020 in the United States alone. The capital-intensity of manufacturing imaging components will provide sustainable moats to leading manufacturers such as VREX and prevent competitive entry going forward.

Mispricing & Value Drivers

1) The market is discounting the cross-selling capabilities of Varex's acquisition of PerkinElmer's medical imaging business.

On May 1st, 2017, Varex completed the acquisition of PerkinElmer's imaging business for $276 million. The move consolidates two of the three major independent producers in the high-end dynamic detector market. PerkinElmer is head-quartered in Waltham, Mass., with multiple operations across Europe, and specializes in producing high-resolution, digital flat panel CMOS detectors. Currently, PerkinElmer is already projected to add $140 million in annual sales (~51% of purchase price) with end-markets in medical, industrial, and dental imaging. However, VREX's new product portfolio, which blends offerings of x-ray tubes, linear accelerators, and now CMOS-based digital detectors, can achieve rapid margin expansion and top-line revenue growth through successful PerkinElmer-VREX package offerings. For example, if a VREX X-ray tube is sold with each digital detector bought by newly acquired detector customers, sales would rise by an additional $30 (~11% of purchase price) million in annual revenues. With combined production volumes also increasing manufacturing scale and improving direct material costs, PerkinElmer's imaging business serves as a bulwark against margin deterioration and offers return above its purchase price within two years (even without extensive cross selling).

2) Deeper understanding of VREX's product mix reveals robust opportunities for gross margin improvements protected by long-term economic moats and product scale.

X-Ray Tubes: Radiographic X-rays use a small amount of radiation that passes through the body to quickly create a 2D image of a patient's anatomy to assess injury or disease. Computed tomography (CT) combines the power of multiple 2D X-rays with computers to produce 3D, cross-sectional views of the body; the system delivers up to two times improvement in volumetric resolution, detecting smaller lesions in tissues that differ in physical density by 1%. The competitive dynamics of the X-ray tube market are split between higher end CT tubes and lower-end radiographic tubes. Radiographic tubes, which are cheap and easy to manufacture, have experienced a highly competitive market with multiple producers. On the other hand, upper-tier CT imaging components are defined by amplified levels of technological complexity, intellectual property, and engineering that result in higher sales prices and gross margins. Due to manufacturing complexity, there are no independent manufacturers of CT tubes other than Varex, with production limited to OEM's with in-house production capabilities (such as GE, Siemens, Phillips, Toshiba). During the second quarter of 2017, VREX accepted and shipped an order for a package of components for several hundred general radiographic systems. Consequently, the quarter's unfavorable shift to lower-margin components dropped gross margin 2.3% to 37.2%.

However, management has recognized the competitive merits of pursuing higher-end product markets, and a significant portion of revenues going forward will come from the sale of high-end X-ray Tubes used in CT imaging. For instance, VREX recently renewed a 3-year pricing agreement with Toshiba Medical Systems for $345 million dollars' worth of CT Tubes. A separate one-year pricing agreement to supply digital detectors and high-voltage connectors (worth ~$25 million) will further boost revenues while securing higher margins in the future. Of the Top 3 CT Scanners per Providian Medical (GE's BrightSpeed Elite, Philip's Brilliance 16, and Siemens SOMATOM Sensation 10), VREX produces a partner CT tube product for all of them. Even more so, nearly 80% of tubes revenues comes from replacement tubes. CT tubes not only produce the highest product margins, but are also replaced more frequently (every 2-3 years) than radiographic tubes (3-5 years). Based on previous analysis of Varian's medical imaging patent portfolio, VREX owns approximately 220 patents issued in the United States and 108 patents issued throughout the rest of the world and had 129 patent applications on file. By targeting upper-level X-ray tube segments and locking in patent protection, VREX stands to secure long-term organic revenue growth and sustained margin expansion.

Digital Detectors: The second largest chunk of VREX revenues stems from digital detectors, which are also broken down into the lower-end radiographic detectors and the higher-end dynamic detectors. When watching a movie, dynamic detectors can be likened to a five-minute scene while radiographic detectors are single shots. While the highly-competitive market for radiographic detectors has been experiencing price erosion since initial product introductions 10 years ago, dynamic detectors are only beginning to blossom. For U.S users, reimbursements for studies digitized with a radiographic readers will be cut starting in 2018, fueling further adoption of higher-margin digital detectors. Management already produced 22% more detectors in the quarter than one year ago. Continued demand for higher-margin digital detectors will be driven by the growth of the global dental imaging market (7% CAGR) and the growth of mobile C-arm systems for surgical applications (less than 20% of mobile C-arms manufactured by OEMs are shipped as digital systems). As the cost difference between analog image intensifiers and digital detectors continues to diminish, digital detectors will grow to dominate the market in coming years.

3) The market is preoccupied with VREX's domestic operations, even as key opportunities for expansion lay in emerging markets.

VREX's second quarter revenue break-down saw only 33% of revenues stem from sales in the Americas ($51.2 million), while EMEA ($46.9 million) and APAC ($56.7 million) comprised 30% and 37% of sales respectively. While revenues in the Americas and EMEA saw contraction of 6.2% and 0.2% respectively, APAC experienced a notable 17.6% rise in sales (pulling total revenues up 3.3%). Americas revenues declined primarily due to lower sales of x-ray sources and digital detectors. Meanwhile, APAC revenues rose due to higher sales of X-ray tubes, digital detectors, and high voltage connectors, partially due to a large tender-based order shipped during the quarter. In the Q2 2017 earnings call, management noted that, "We're working on a number of new CT tubes and high-voltage connectors for Chinese OEMs who have CT imaging systems in various stages of development and market introduction." It is precisely such distinctions between market development of American and Asian provinces that leads to sharper insight into VREX's future growth trajectory. While management believes that approximately 50% of X-ray imaging systems in the U.S. have already converted to full digital, the world-wide conversion rate toward digital is only at 33%. By 2020, medical imaging is expected to convert from 67% analog to 56% analog, while industrial imaging is expected to convert from 75% analog to 65% analog. Of the 20 new OEM's in China serving as system aggregators (compiling components into a full CT System), VREX has already established 12 new partnerships. As Chinese markets are focused on advanced cardiac CT applications and new CT tubes for mammography, VREX's expansion in international operations will yield incrementally higher margins than domestic operations while delivering more room for future growth (mediating the 2% margin deterioration recently seen in the medical imaging segment).

Valuation & Assumptions

VREX is currently trading at a severe discount to industry peers (DXCM, GMED, ALOG, CMD, ABMD), with an EV/EBITDA of 11.68 compared to an industry median of 18.2. Given the above-mentioned opportunities for modest margin expansion as the gradual integration of the PerkinElmer assets into company operations, the base case undershoots management revenue-growth expectations by 4%, assumes a 2021 EV/EBITDA substantially below the current industry median, and targets 25.3% appreciation.

Given the above sensitivity analysis, multiple expansion toward the industry median serves as a robust confirmation of the discounted cash flow analysis summarized above.


v Third Quarter Reporting of sales combining synergies from the PerkinElmer deal would demonstrate enhancement of revenues from the new product portfolio and increase market awareness of VREX's new top-line revenue composition.

v Future Purchase Orders from APAC Clients would induce greater media attention around VREX's growing dominance in Asia.

Key Risks & Mitigants

v International Customers: More than half of VREX's revenues are generated from customers outside of the United States. Strengthening of the dollar will raise external sourcing costs, increasing customer petitions for discounts, causing delayed purchasing decisions, or increasing reliance on in-house manufacturing. Mitigant: VREX's accretive acquisitions have improved scale and increased cost competitiveness, while complexity of production in higher-end products precludes competitive entry in production.

v Separation Agreement: Per the Separation and Distribution Agreement, VREX will transfer all cash and cash equivalents in excess of $5 million to Varian for 2017. Mitigant: The excess cash payments to complete the transfer is approximately $45.1 million, which will be amply covered by cash currently held on balance sheet of $79.6 million.

Disclosure: I am/we are long VREX. 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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