Varex Imaging: Headroom Capped Without Higher Earnings On Capital Employed

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Varex Imaging: Headroom Capped Without Higher Earnings On Capital Employed

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Varex Imaging has high net working capital density and low capital turnover that see it earn sub-par rates on its operating assets.Varex's Q3 FY24 earnings showed extended weakness across all ...

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Pgiam/iStock via Getty Images Varex Imaging - Investment update Following my last publication on Varex Imaging Corporation (NASDAQ:VREX) this time last year the stock is down 40% against a 23% gain in the S&P 500 index. The last 2x VREX analyses I’ve published here on Seeking Alpha share a common theme, namely:  The macroeconomic backdrop in the broad healthcare sector which suggests a wind back in corporate spending and capital investments in the current healthcare cycle. Sales growth is a highlight with the business booking record revenues in Q3 last year. However, balancing this fact, net working capital (\"NWC\") density is high, such that the investment required to produce a dollar of revenues is exquisitely high. Over the last three years, management has had to invest $0.60 to produce $ in incremental revenue. From this, each dollar that has been put to work in VREX’s operations returns $0.93 in sales, pulling to less than 10% profit after tax. Valuations that were unsupportive of additional upsides when indexed against returns on capital employed, reinvestment rates, and a minimum accepted return of 12% as a hurdle rate. The business is earning less than 5% on its operating assets, and despite management’s best efforts to shed capital from the business to improve its fundamental economics, this has not translated to business returns just yet.  Based on the developments that have occurred since the last publication, my views on VREX remain unchanged, even though modelling, forward estimates and implied valuations have changed. Here I will discuss these in brief detail. Net-net, reiterate hold. Figure 1.   TradingView Varex Imaging Q3 FY24 earnings insights VREX Put up $209mm of revenues during Q3, (down 10% YoY) and pulled this to 32% gross margin and 4% operating margin. Due to the continued operating downsides, management now expects $190mm to $210mm in revenues in Q4. It expects to pull this to earnings of $0.15 per share at the upper end of range and looks for operating expenses of $54mm. Figure 2.   Company filings As to the divisional highlights:  The medical segment did $149mm of business, contracting 15% YoY. Part of the reason for the downsize is inventory destocking – trends that have been seen in adjacent sub-industries as customers filled their order books during the supply chain crisis of 2022. Subsequently many stocking inventories and this is impacting the Pace of re-orders and the pass-through purchase orders from its custom base. Management expects these headwinds to adjust by next year. The industrial business was down 6% and did $60mm in revenues – Management said that it incurred an unfavourable product mix during the quarter, but this was offset by income booked from its cargo inspection segment. I would expect these kinds of trends to continue moving forward because the global bias is leaning towards increased global security screening and inspections at cargo terminals.  China continues to be a drag on operating performance, just like it is for many companies with exposure to the country right now. It contributed ~14% to the top line (-400bps YoY) and thus continues to be a meaningful segment – albeit an underperforming one. Management had this to say on the earnings call regarding the outlook on China: In China, we continued to see softness in the third quarter as a result of the ongoing anticorruption actions by the Chinese government. While sales are down year-over-year, in the quarter, we saw modest improvement sequentially. We remain optimistic that the medical imaging market will improve in China and that Varex is well positioned to benefit when growth resumes. Particularly, we continue to see a desire by Chinese medical institutions to upgrade from value, or 16 slice CTs to performance, or 64 and 128 slice CTs. My view of the quarter is that there was nothing remarkable to mention that would suggest an immediate change in the investment debate for VREX. The business continues to contract in terms of sales and operating capital. This is critical because of its business model mainly that it designs manufactures and sells medical imaging components. In other words, its capital produces the profit – and most of this business’s operating assets are tied up in NWC. As such, we need to see either one, or both of these two things in my opinion — 1) sales and operating profit growth as management works through NWC [inventory + receivables/payables], and/or 2) the same financial growth expansion of the NWC base indicating its audible is strong end of long duration. This hasn’t been the case for VREX. Management has ploughed back $32mm back into the business by expanding fixed capital and through general growth in orders/business. However, the market has valued each dollar of this at a -25x multiple — such that every dollar of incremental capital invested has resulted in a $25.50 corresponding reduction in market value. In my opinion investors have got this correct given the fact that VREX earns very little on its operating assets in the first place, and therefore committing more capital to this pool results in an economic failure when investors can earn 10-12% or so annualised simply writing the indexes for less than a basis point. This supports a neutral view. Figure 3.   Company filings VREX stock - Valuations compressed due to economics My view is the company is worth ~$13/share today based on a 1x EV/IC multiple and my updated forward estimates in Appendix 1. Valuation insights  Investors have compressed the multiple on invested capital to 0.8x from a high of 1.7x back in 2021. This is the result of the ongoing economic losses that are produced as a result of the company’s lacklustre business returns. As mentioned, if the minimum accepted return is 10 to 12% (the long-term market averages) then a business earning anything less than this on its own capital post tax produces economic losses for the investor. The opposite is true for earnings above this minimum accepted return. This is why I do not believe we have a statistical discount on our hands. Instead I think investors have valued it correctly – a dollar in the hands of this company is worth less than a dollar in the market.  Figure 4.   Author  Being generous and awarding VREX a 1x EV/IC multiple (which implies it will earn cost of capital returns) we arrive at ~$13/share with little to no compounding capacity under present assumptions (Figure 5). These numbers assume VREX to reinvest ~6-7% of cash earnings each year at a 3.1% marginal rate of return (similar to recent history). Management have not identified any large CapEx of growth investment outlays for the next period, and are focused on strengthening the balance sheet + securing additional business. The issue is, as mentioned, all of this growth is costly for the company and there's no ROI to show for each one of these decisions – capital turnover is <1x, and post-tax margins have halved since FY'21 to 4.5% in the TTM. These economic factors aren't enough to turn the dial to get intelligent investors owning this stock, let alone see it carry higher prices in my view. On the downside, no change in the current 0.8x gets us to ~$8/share in implied value. This supports a hold.  Figure 5.   Author Risks to thesis Downside risks to thesis include 1) negative sales growth over the next three years as this warrants a lower valuation, 2) post tax margins falling below 3% for the same reasons, and 3) the broad set of macroeconomic risks that must be faced into all equity evaluations right now, including the inflation/rates access and geopolitical risks that could be over into stocks. On the upside, sales growth above 10% is a major upside surprise, and if management is able to produce returns on capital above 10% this would change the outlook completely. I give this a less than 25% probability of occurrence. Investors must recognise these risks in full before proceeding further. In short VREX remains a boy in my opinion given the fact it has negligible runway to reinvest its cash earnings to expand its top and bottom lines. All employed in the business is underutilised and isn’t pulling its economic weight, instead, investors have had to endure economic losses of nearly 10% over the last 12 months. Whilst the scope of nabbing up a small position due to the valuation miss pricing on invested, this does not fit with our core investment tenets and therefore must be avoided due to its speculative nature. We prefer owning businesses with low embedded expectations, as is the case here, but with exceptional quality on the other side of the equation, which I believe is not the case here. Net-net, reiterate hold. Appendix 1.    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