Executive Summary / Key Takeaways

• Varex Imaging, a leader in X-ray imaging components and systems, is strategically positioned across diverse medical and industrial markets, leveraging deep OEM partnerships and a focus on innovation and cost leadership.
• Recent financial performance reflects resilience despite headwinds, with Q2 FY25 revenue near the high end of guidance and Medical segment achieving record gross margins, driven by productivity and favorable mix.
• The company is actively managing significant near-term challenges, including the impact of US-China tariffs (expected $20M sales headwind and 150-200 bps GM pressure in Q3 FY25) and the MOFCOM investigations, while implementing mitigation strategies like manufacturing localization and cost pass-through.
• Key growth drivers are emerging, notably Photon Counting technology (targeting $150M annual revenue by FY29 with accelerated industrial adoption) and the expansion into Industrial Cargo Inspection Systems (securing recent large orders totaling $39M with long-term service revenue potential).
• Varex is poised for significant deleveraging in June 2025 with the planned repayment of its $200M Convertible Notes using restricted cash and cash on hand, aiming for an optimal debt structure of $300M-$350M to enhance financial flexibility for future growth initiatives like M&A.

The Foundation: A Niche Leader In The Imaging Ecosystem

Varex Imaging Corporation stands as a critical, albeit often behind-the-scenes, player in the global imaging ecosystem. Spun off from Varian Medical Systems in 2017, Varex inherited decades of expertise in designing, manufacturing, and servicing X-ray imaging components. The company operates primarily through two segments: Medical and Industrial. Its core business model revolves around supplying sophisticated components – ranging from X-ray tubes and digital detectors to software and high-voltage connectors – predominantly to Original Equipment Manufacturers (OEMs) who integrate these parts into their final imaging systems used in hospitals, clinics, security checkpoints, and industrial inspection sites worldwide.

This OEM-centric model is characterized by deep, long-standing relationships. Varex's products are often custom-built and tightly integrated into customer systems, creating a sticky relationship that makes switching suppliers costly and complex for OEMs. This embeddedness, coupled with the recurring need for replacement components (like CT tubes, which require replacement every 2-6 years, or even more frequently in high-utilization regions like China), forms a significant portion of Varex's stable revenue base. While positioned against much larger, vertically integrated competitors like GE Healthcare (GEHC), Siemens Healthineers (SHLS), and Philips Healthcare (PHG), Varex has carved out a niche as a leading independent supplier, leveraging its specialized expertise and manufacturing scale across a fragmented customer base.

Technological Edge: Fueling Performance And Future Growth

At the heart of Varex's competitive strategy lies its differentiated technology and a commitment to innovation. The company invests significantly in Research and Development, targeting approximately 8% to 10% of annual revenues to stay at the forefront of imaging science.

Varex's core strength lies in its mastery of X-ray tube and detector technology. Its traditional X-ray tubes are designed for durability and performance across various medical modalities (CT, mammography, oncology, etc.) and industrial applications. In detectors, the company has made strategic advancements, notably with the IGZO-based Azure platform. This technology offers high-quality imaging cost-effectively compared to traditional CMOS-based detectors. Varex is actively expanding the Azure portfolio in FY25 to target premium medical applications like surgery and cardiology, aiming to migrate customers from older amorphous silicon products and secure new design wins. In the industrial space, Varex is developing versatile, high-resolution, bendable detectors to accelerate the transition from film to digital in non-destructive testing (NDT), particularly for complex use cases in areas like castings and additive manufacturing. These investments in core platforms like CT, Azure, and industrial detectors are designed to enable expansion into growing application areas and contribute margin-accretive revenue.

Looking ahead, Varex is placing a significant bet on Photon Counting technology. Touted as a key enabler for fast, high-resolution, low radiation dose spectral imaging, this technology is expected to be a new and significant revenue growth driver. Varex is positioning itself as a leading merchant supplier, actively engaging with large OEMs for integration into next-generation CT systems. While medical adoption takes longer (as these are not retrofit systems), Varex anticipates accelerated initial adoption in industrial applications due to the technology's suitability for high-speed 3D imaging. The company has set a clear target: Photon Counting Technologies are expected to contribute approximately $150 million in annual revenue by fiscal 2029. This focus on both enhancing core technologies and developing disruptive platforms like Photon Counting is crucial for Varex to maintain its competitive moat against larger, well-funded rivals and capture future market share.

Beyond detectors, Varex is also exploring Nanotube/cold cathode technology, having completed a technology transfer and begun shipping evaluation kits, engaging with OEMs on early commercialization efforts for this novel approach to X-ray generation.

Navigating Headwinds: Tariffs, Inventory, And China Dynamics

Despite its technological foundation and strategic initiatives, Varex currently faces significant market and geopolitical headwinds that have impacted recent performance and near-term outlook.

A major challenge has been inventory adjustments and destocking by Medical OEM customers outside of China. This phenomenon, which began impacting sales in fiscal year 2024, is expected to subside and be largely behind the company by the second quarter of fiscal year 2025 (calendar Q1 2025), based on improving order intake rates and customer discussions.

The situation in China remains complex. The government's anticorruption campaign and related investigations have led to a notable slowdown in the medical imaging market, impacting Varex's sales in the region. While the company observed modest sequential improvements in sales to China in recent quarters (e.g., $31M in Q4 FY24 vs. $29M in Q3 FY24, and $35M in Q1 FY25), management has cautioned that the business has stabilized at lower levels compared to fiscal year 2023, and they do not expect a meaningful, sustained improvement in the foreseeable future for fiscal year 2025. The anticorruption oversight is expected to continue for at least another two years, potentially leading to slower purchasing processes. While stimulus funds are a potential tailwind, Varex has not yet seen a direct impact on orders and is not factoring significant stimulus benefits into its near-term projections.

Adding to the complexity, the current tariff environment, particularly the bilateral tariffs between the US and China, presents a pronounced impact. As highlighted in the Q2 FY25 earnings call, the 125% tariff imposed by China on US products is expected to negatively impact Q3 FY25 sales by approximately $20 million, primarily due to a pause in purchases of US-made CT tubes by some China-based customers. These customers are delaying deliveries, hoping for tariff relief or exemptions, while drawing down their existing inventory. On the cost side, tariffs on raw materials and components imported into the US (from China and other regions) are expected to result in a 150 to 200 basis point impact on gross margins going forward, net of mitigation efforts.

Varex is actively implementing mitigation strategies to counter these tariff impacts. These include passing along tariff costs to customers (aiming to charge what Varex pays without markup), redirecting material purchases, and accelerating efforts to localize manufacturing and supply chain within China. Management views the Q3 FY25 sales impact as temporary, with potential for recovery starting in Q4 FY25 if mitigation efforts are successful or external conditions change. The India expansion, aimed at global supply, is also seen as a longer-term strategy to enhance resiliency against tariff policy changes.

Operational Performance And Financial Resilience

Despite these headwinds, Varex has demonstrated operational resilience, particularly in its most recent reported quarter.

Gross margin in Q2 FY25 was 36.0% (Non-GAAP), higher than anticipated and a significant improvement from 31.9% in Q2 FY24. This was primarily driven by improved volume, favorable product sales mix, and productivity gains in both segments. The Medical segment, in particular, posted a record gross margin in the quarter. For the first six months of FY25, total revenues were $412.7 million, up 4.2% year-over-year, with gross margin at 35.2% (Non-GAAP), up from 31.0% in the prior year period.

Operating expenses in Q2 FY25 were $54.6 million (GAAP), a decrease from $58.1 million in Q2 FY24, primarily due to lower SG&A. Non-GAAP operating expenses were $51 million, down $3 million year-over-year. R&D spending decreased slightly to $22 million (10.3% of revenue), while SG&A decreased to $29 million (13.6% of revenue).

In Q2 FY25, Varex reported revenues of $213 million, near the high end of its guidance range, representing a 3.2% increase year-over-year. Both the Medical and Industrial segments contributed to this growth, increasing by 3.4% and 3.0% respectively. The Medical segment saw solid global sales of CT tubes and strength across fluoroscopy, oncology, mammography, and dental modalities (above trend), while radiography was below trend. The Industrial segment benefited from strong demand in global security screening, driving sales of cargo inspection components and systems, as well as growth in industrial X-ray tubes and NDT applications. Operating income in Q2 FY25 was $22.1 million (GAAP), a substantial increase from $7.7 million in Q2 FY24. Net income attributable to Varex was $6.9 million ($0.17 per diluted share) in Q2 FY25, up from $1.4 million ($0.03 per diluted share) in Q2 FY24. Non-GAAP net earnings were $0.26 per diluted share in Q2 FY25, compared to $0.16 in the prior year.

Liquidity remains a key focus. Varex ended Q2 FY25 with $226 million in cash, cash equivalents, and marketable securities, up $13 million from the FY24 year-end. Crucially, the company also holds $125 million in restricted cash from the Senior Secured Notes Add On offering in December 2024. This restricted cash, along with other cash on hand, is earmarked for the repayment of the $200 million Convertible Notes maturing in June 2025. This planned repayment will significantly reduce Varex's overall debt burden and simplify its capital structure. Gross debt outstanding was $570 million at the end of Q2 FY25, with a net debt leverage ratio of approximately 2.1 times adjusted EBITDA on a trailing twelve months basis. The company aims for an optimal debt structure between $300 million and $350 million in total debt, which would provide enhanced financial flexibility for future strategic investments, including potential M&A.

Strategic Growth Drivers: Beyond The Core

Beyond its core component business, Varex is actively cultivating new growth avenues, particularly within its Industrial segment.

The expansion into Industrial Cargo Inspection Systems represents a significant strategic move. Leveraging its expertise in high-energy linear accelerators and other core imaging components, Varex is now offering full systems, including portals, gantries, mobile scanners, and car scanners. This market presents a substantial opportunity, estimated at over $1 billion annually with a projected 7% CAGR over the next five years, driven by increasing global security threats and the need for accurate cargo inspection (including for tariff assessment). Varex has recently secured notable orders in this area, including a $25 million order announced in Q2 FY25 and $14 million in orders announced in Q1 FY25. These orders, totaling $39 million, are expected to be installed over the next 12 to 18 months. While the equipment sales initially carry lower margins, the long-term value lies in the ongoing service revenue stream that is expected to commence 2 to 3 years after installation, which management anticipates will be much more margin-accretive. The cargo systems business is expected to become margin accretive overall once it reaches a quarterly run rate of $10 million to $15 million.

Another critical strategic initiative is the India expansion. Varex is building two manufacturing facilities in India, with the first expected to begin production of radiographic components in the second half of fiscal year 2025 and the second in the first half of fiscal year 2026. The strategy is centered on production in India for global consumption, aiming to establish low-cost manufacturing to gain a competitive advantage, particularly in the competitive radiographic and dental markets where Varex has faced pressure from Asia-based competitors. This initiative is also a key part of Varex's broader strategy to enhance local-for-local manufacturing and diversify its supply chain, further mitigating potential tariff impacts and increasing overall operational resiliency. Capital expenditures for FY25 are expected to remain elevated, in the $25 million to $30 million range, largely supporting this India build-out.

Outlook And Risks

Varex's near-term outlook is shaped by the interplay of market recovery outside China, ongoing challenges within China, and the direct impact of tariffs.

For Q3 FY25, Varex has guided for revenues between $180 million and $200 million, reflecting the anticipated ~$20 million headwind from China tariffs, with China sales assumed to be approximately $10 million for the quarter. Non-GAAP earnings per diluted share are expected between a -$0.05 loss and $0.10 profit, impacted by the lower sales volume and an expected 150 basis point reduction in gross margin due to tariff-related costs. Non-GAAP gross margin is guided between 32% and 33%.

Management views the Q3 tariff impact as temporary, with potential for recovery in Q4 FY25 as mitigation efforts take hold. The destocking phenomenon outside China is largely complete, suggesting a potential tailwind for order rates, although the benefit to revenue will phase in over subsequent quarters. The timing of a more significant recovery in China remains uncertain, tied to the pace and impact of stimulus and the evolution of the anticorruption campaign oversight.

Key risks to the investment thesis include:

• Tariff and Trade Policy Uncertainty: The dynamic nature of US-China tariffs and potential retaliatory actions could continue to impact sales, costs, and gross margins beyond current expectations.
• MOFCOM Investigations: The outcome of the investigations into X-ray tube imports and alleged dumping in China could negatively impact Varex's ability to compete in this critical market.
• China Market Recovery: A slower-than-anticipated recovery in China due to prolonged anticorruption impacts or other macroeconomic factors would weigh on overall growth.
• Competitive Intensity: Continued aggressive competition, particularly from Asia-based detector manufacturers and larger, integrated OEMs, could pressure pricing and market share.
• Execution Risk: Successful execution of strategic initiatives like the India build-out, Photon Counting commercialization, and scaling the Cargo Systems business is crucial for future growth.
• Customer Concentration: A significant portion of revenue comes from a limited number of OEM customers, making Varex vulnerable to changes in their purchasing decisions.

Conclusion

Varex Imaging is navigating a complex global landscape marked by both significant challenges and promising opportunities. While near-term performance is expected to be impacted by the direct effects of US-China tariffs and ongoing softness in the China market, the company's recent operational execution, particularly the record Medical gross margin in Q2 FY25, highlights underlying resilience and productivity gains.

The core investment thesis for Varex hinges on its ability to leverage its established OEM relationships and technological expertise to capitalize on emerging growth drivers like Photon Counting and the expansion into Industrial Cargo Systems, while simultaneously enhancing its cost structure through initiatives like the India expansion. The planned repayment of the Convertible Notes in June 2025 represents a critical step towards strengthening the balance sheet and providing the financial flexibility needed to pursue future growth. Investors should closely monitor the effectiveness of Varex's tariff mitigation strategies, the timing and pace of recovery in the China market, and the execution trajectory of its key technology and systems initiatives, as these factors will be pivotal in determining the company's ability to deliver on its long-term growth potential amidst a competitive and dynamic industry backdrop.