Varex Imaging Corp (VREX) 2017 Q3 法說會逐字稿

Greetings, and welcome to the Varex Imaging Third Quarter Fiscal Year 2017 Earnings Call. (Operator Instructions) As a reminder, this conference is being recorded. It is now pleasure to introduce Howard Goldman, Director of Investor Relations. Thank you. You may begin.

Good afternoon and welcome to our conference call for the third quarter of fiscal year 2017. With me today are Sunny Sanyal, our President and CEO; and Clarence Verhoef, our CFO. To simplify our discussion, unless otherwise stated, all references to the quarter or year are fiscal years and fiscal quarters. Quarterly comparisons are for the third quarter of fiscal year 2007 (sic) [2017] versus the third quarter of fiscal 2016, unless otherwise stated. Year-to-date comparisons are for the first 3 months of fiscal year 2017 -- sorry, first 3 quarters of fiscal '17, versus the 3 quarters of fiscal year 2016 unless otherwise stated. Comparable financial statements for fiscal year 2016 and the first quarter of fiscal year 2017 reflect operating results for the Imaging Components business of Varian Medical Systems prior to our separation, and include estimates of cost allocations for various corporate functions, interest expense and tax expense.

Additionally, third quarter and year-to-date financial statements for fiscal year 2017 reflect 2 months of operating results for the imaging business we acquired from PerkinElmer on May 1 of 2017. In addition, beginning with our financial results for the third quarter of fiscal year 2017, we will supplement our consolidated financial statements prepared in accordance with U.S. generally accepted accounting principles, or GAAP, with the use of adjusted or non-GAAP financial measures of certain elements of financial performance. These adjusted measures are not presented in accordance with, nor are they a substitute for, GAAP financial measures. These adjusted measures include adjusted gross margin, adjusted operating earnings, adjusted operating earnings margin, adjusted net earnings and adjusted net earnings per diluted share. We provided a reconciliation of each adjusted financial measure to the most directly comparable GAAP financial measure used in our earnings press release issued earlier today, which is posted on our website. We are unable to provide without unreasonable effort a reconciliation of adjusted guidance measures to the corresponding GAAP measures on a forward-looking basis due to the potential significant variability and limited visibility of the excluded items discussed.

Please be advised that this discussion contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Our use of words and phrases such as believe, estimate, expect, anticipate, could, will, potential, outlook and similar expressions are intended to identify those statements which represent our current judgment on future performance or other future matters. While we believe them to be reasonable based on information currently available to us, these are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated. Risks relating to our business are described in our third quarter earnings release and in our filings with the SEC. The information in this discussion speaks of -- speaks as of today's date and we assume no obligation to update or revise the forward-looking statements in this discussion because of new information, future events or otherwise. And now I'll turn the call over to Sunny.

Thank you, Howard. Good afternoon, and welcome to our first full quarterly earnings conference call as a public company. This quarter also includes 2 months of results from the recently acquired PerkinElmer imaging business, which naturally makes for a lot of moving pieces. To give you more clarity, starting this quarter, we're including adjusted financial measures with our results, which we believe will provide investors with additional valuable information about the performance of our business.

Let me first start with a summary of our financial results for the third quarter. A little later, Clarence will discuss our results in more detail. Revenues increased 12% to $170 million, including $27 million from the acquired imaging business, and were up 8% for the trailing 4 quarters. For the third quarter, organic revenues declined 5%, but were up 3% for the trailing 4 quarters. In the third and fourth quarters of last year, we saw strong year-over-year revenue growth, as our business started to recover from an earlier downturn. This makes for challenging comps in the second half of this fiscal year.

In our Medical segment, we have seen strong year-to-date growth in the mammography and dental markets and stability in the CT, radiographic and fluoroscopic markets. However, sales of our non-OEM aftermarket X-ray tubes to third-party service organizations declined. We continue to experience good growth in our connect-and-control business for high-voltage connectors and other accessory components.

In the Industrial segment, growth in the security market contributed to increased revenue during the quarter. This sector is comprised of port and border protection as well as airport security, both of which delivered growth during the quarter and year-to-date. We are working with our OEM customers on new development projects to improve throughput and effectiveness of airport screening for carry-on and checked baggage. We expect to see these areas as longer-term opportunities for us.

Net earnings were $11 million or $0.28 per diluted share compared to a net earnings of $18 million or $0.47 per diluted share. Adjusted net earnings were $17 million or $0.44 per diluted share compared to adjusted net earnings of $19 million or $0.49 per diluted share. The reduced profitability was primarily due to lower gross margin.

Now let me shift to operations. Our most significant accomplishment during the quarter was the completion of the acquisition of the PerkinElmer imaging business. This acquisition adds a significant revenue stream, new anchor customers and new technologies and technical expertise, along with a strong brand and expanded footprint in the industrial sector. In a few minutes, Clarence will discuss some financial details and also provide color around revenue and cost synergies.

In the meantime, I'd like to update you on our integration activities. First of all, immediately out of the gates, we integrated that acquired imaging business' sales teams into the Varex organization. We also completed the work to rationalize digital detector offerings and any overlapping R&D projects. For the combined businesses, we have clear product positioning for each modality and the combined sales team is now focused on the full Varex product portfolio. We held corporate level briefings for our newly added customers, including the 2 new anchor customers, GE and Elekta, and introduced them to our business. We also used these meetings to discuss opportunities to supply them with broad range of our X-ray products. The integration teams have already begun comparing best practices in product design, supply chain management and manufacturing, and have identified opportunities for productivity improvements. We have initiated projects to leverage each other's capabilities and assets in the areas of scintillators and glass fabrication, which we believe will generate future cost savings and provide customers with high-performing products.

In summary, the integration efforts are well underway and I'm very happy with our progress. During the quarter, we also completed verification and validation of 4 new detector products for our fluoroscopic and radiographic markets. Customers are currently evaluating prototypes of these digital detectors for an inclusion in the development of their future new systems. Lastly, during the third quarter, we reached a significant milestone with the production of our 100,000th Varex digital detector. As a frame of reference, in 2004, we produced 327 units, and this fiscal year, we are on track to produce over 21,000 units. Including the acquired imaging business, we estimate that Varex has approximately 150,000 digital detectors in service around the world, which is about 1/3 of the detectors in use globally.

Switching over to our X-ray tube products. We continue to innovate in order to bring new X-ray tubes and sources to market, while looking for ways to expand our product offerings. During the third quarter, we launched a new integrated CT solution that combines multiple components. This integrated package incorporates a CT tube, generator, high-voltage connector, heat exchanger and tube control unit. We expect this solution to be attractive to OEMs who are looking to accelerate their time to market with new CT systems. While an average CT tube can sell for $25,000 to $45,000, we are expecting this integrated solution to potentially sell for $80,000 to $100,000. We are initially bringing this integrated solution to new OEMs in emerging markets, particularly China, to help them shorten their time to market for CT imaging systems.

Our strategy is to offer both: Standalone best-of-breed components, as well as integrated suites. Over time, we plan to expand these types of product offerings to a broader range of OEM customers and modalities.

As we have said previously, China is one of the long-term growth drivers for our business. Our revenues there are currently less than 10% of the total company revenues. We have been investing in our development targeted at the Chinese market and we're making excellent progress there. In fact, I'm pleased to announce that we have signed a new pricing agreement with a major OEM in China, for purchases of our CT X-ray tubes. We expect this agreement to generate $70 million to $80 million in revenues over the next 3 years. The Chinese government has made a commitment to expand health care services beyond urban areas, to the rest of this very large country and views CT as one of the imaging modalities of choice, because of its versatility in diagnostics. CT in China is growing at more than 6% a year, compared to global growth of around 4%. Our analysis estimates that China will need approximately 25,000 CT systems over the next 10 years. It also appears that the CT market in China is increasingly favoring local Chinese manufacturers. We believe that our ongoing development projects with local Chinese OEMs will drive significant growth for us over the coming years. In the near term, we expect to see a ramp-up of revenues beginning in fiscal year 2018, as new systems are launched over time.

I'm also very pleased to say that we are continuing to expand our partnerships in the U.S. and in Europe. Earlier this year, GE and their strategic partner, Arineta, introduced CardioGraphe, the world's first dedicated cardiovascular CT system. CardioGraphe incorporates Varex's high-end CT tubes, designed to produce high-quality images of the heart within one heartbeat. We're very excited to have this groundbreaking CT tube inside this advanced cardiovascular CT system. With that, let me hand over the call to our CFO, Clarence Verhoef, to talk about our financial performance in greater detail.

Thanks, Sunny, and hello, everyone. As Howard mentioned in the beginning, in the first half of 2017 as well as 2016, costs associated with the separation from Varian Medical Systems were included in our financial results. In the third quarter of 2017, we had the impact of a major acquisition, as well as acquisition-related costs. Our adjusted financials will exclude the unusual items, such as separation costs, restructuring costs and acquisition-related costs, to provide a clearer representation of our ongoing operations. I will present the quarterly and year-to-date results, both as reported, i.e. GAAP, and as adjusted financials.

Before I go into the details of the financials, let me summarize the P&L for the 2 months of the acquired imaging business that is included in our third quarter results. This acquisition added $27 million of revenue, $9 million of gross margin at 36% and $4 million of operating expenses. We are quickly integrating this acquisition into our business and will not be providing standalone details after the end of fiscal year 2017. Over the coming years, we expect to see annual revenue growth in this acquired business from both market expansion and synergies from cross-selling opportunities. By fiscal year 2021, we expect to reach incremental annual revenues from synergies of approximately $20 million to $30 million. The timing of revenue synergies will depend on a number of factors, including the customer validation process for new imaging components, and multi-year development cycles on customers' new X-ray imaging systems. We expect to realize a number of cost synergies from this acquisition through decreases in SG&A expenses, greater leverage on our manufacturing scale and supply chain cost reductions, as well as rationalization of operations, products and R&D projects. By fiscal year 2021, we anticipate reaching annual cost savings of $15 million to $20 million. In fiscal year 2018, we are targeting approximately $5 million of cost savings.

Now to our P&L. Our third quarter revenues were up 12% to $170 million from $151 million a year ago. Year-to-date revenues were up 8% to $482 million. Medical segment revenues increased 7% in the third quarter to $135 million and included $18 million from the acquired imaging business. For the quarter, the detector growth from the acquired imaging business was partially offset by revenue declines for CT tubes and aftermarket tubes. Year-to-date revenues were up 6% to $392 million. Industrial segment revenues for the third quarter increased 39% to $35 million and included $9 million from the acquired imaging business. Year-to-date revenues were up 17% to $90 million. We continue to see good growth in the security market, which has delivered double-digit growth year-to-date for this group of products.

Our gross margin was $60 million in the third quarter, down from $63 million in the year-ago quarter. Our adjusted gross margin for the third quarter was $64 million compared to $63 million a year ago. As a percent of revenues, the adjusted gross margin was 38% compared to 42% a year ago. In the prior-year period, we had a favorable mix of high-margin product sales and lower than average factory and quality costs. Year-to-date, our gross margin was 36% compared to 40% in the prior year. Our year-to-date adjusted gross margin was 38% compared to 40% in the prior year. The improvements in the third quarter gross margin over the first half of this year is encouraging and we still expect our long-term gross margins to be in the range of 38% to 40%.

Our operating expenses in the third quarter were $44 million, up 27% from the year-ago period. R&D expenses were $18 million or 10.4% of revenues in the quarter, which increased from $14 million or 9.2% of revenues in the year-ago quarter. Year-to-date R&D expenses were 9.4% of revenues compared to 8.8% in the prior year. This increase was a result of higher prototype material cost, primarily for CT X-ray tube development projects, and a higher percentage of R&D spending in the acquired imaging business. We now expect R&D expense to be approximately 9% of revenues for the current fiscal year.

Third quarter SG&A expenses increased to $26 million or 15.5% of revenues from $21 million or 13.6% of revenues in the prior year. The third quarter included $2 million of expenses from the acquired imaging business as well as $4 million of acquisition-related cost. On an apples-to-apples basis, third quarter and year-to-date SG&A expenses were about the same percent of revenues as in the prior year.

During the quarter, we had lower administrative cost offset by higher international sales and marketing expenses. Depreciation and amortization totaled $8 million for the quarter compared to $4 million a year ago. Our operating earnings for the third quarter were $16 million, down from $28 million in the same quarter a year ago. Our operating margin was 9% in the third quarter, a decline from 19% in the year-ago quarter, reflecting the acquisition-related costs, and the decrease in gross margin.

For the third quarter, our adjusted operating earnings were $24 million compared to $30 million in the prior year. The adjusted operating earnings margin was 14% compared to 20% in the prior year. Interest expense in the third quarter was $4 million compared to less than $1 million in the prior year. During the quarter, we had a $2 million gain in our minority investment in dpiX and a $2 million favorable adjustment for currency reevaluation due to a stronger euro.

Net earnings for the third quarter were $11 million or $0.28 per diluted share, compared to net earnings of $18 million or $0.47 per diluted share in the prior year. For the third quarter, adjusted net earnings were $17 million or $0.44 per diluted share compared to $19 million or $0.49 per diluted share in the prior year. Our number of diluted shares outstanding has increased 1% to 38 million shares from 37.7 million shares in the prior year. I would summarize the quarter as mixed. Although we were disappointed with our legacy revenues, we saw growth in Industrial, benefiting from adding the acquisition, saw improved gross margin over the first half of this year and had some favorable items in other income and tax rate.

Now turning to the balance sheet. We ended the third quarter with cash and cash equivalents of $89 million and gross debt of $510 million. During the quarter, in connection with the acquisition, we increased our credit facility to $600 million and borrowed an additional $308 million under this facility to fund the acquisition and credit facility fees and other working capital needs. Separately, we established interest rate swaps that set a fixed rate of 4.2% on approximately $300 million of the outstanding LIBOR-based debt.

Cash flow from operations in the third quarter was $31 million, bringing the total cash flow from operations for the first 9 months of the current year to $64 million. Property, plant and equipment additions were $1 million for the third quarter and $8 million for the year-to-date. Looking at our working capital, our cash receivable increased by $11 million during the quarter, due to the addition of the acquired imaging business, offset by strong collections. Days sales outstanding improved by 4 days during the quarter to 66 days compared to 65 in the year-ago quarter. Inventory increased by $45 million during the quarter due to the addition of the acquired imaging business and ramp-up of inventory in preparation for higher shipments during the fourth quarter.

During the third quarter, current liabilities increased by $12 million due to the addition of the acquired imaging business, partially offset by a reduction in our obligation to Varian.

Now moving on to our outlook for the remainder of this year. For the fourth quarter of fiscal year 2017, we expect revenues to grow by 23% to 26%, including revenues from the acquired imaging business. For fiscal year 2017, we expect that revenues will grow by 12% to 13% over fiscal year 2016, which includes approximately 9% to 10% of additional revenues from the acquired imaging business. Including the operational impact of the acquired imaging business and its related financing, we expect adjusted net earnings for the fourth quarter of fiscal year 2017 to be in a range of $0.50 to $0.54 per diluted share. For fiscal year 2017, we expect adjusted net earnings to be in a range of $1.73 to $1.77 per diluted share. Guides for our net earnings per diluted share is provided on an adjusted basis only. This adjusted financial measure is forward-looking and without unreasonable effort, we are unable to provide a meaningful or accurate compilation of reconciling items to GAAP net earnings per diluted share due to the uncertainty of amounts and timing of unusual items. At this time, we would like to open the call up for your questions.

(Operator Instructions) Our first question comes from Larry Solow with CJS Securities.

Just a few questions. Can you just elaborate a little bit more on the organic declines in Medical in the quarter, looks like it's about 7%, 8%. And if I do the math, it looks like you're predicting or your guidance for Q4, at least on an overall basis, has you returning to organic growth, I think of about 3% to 6%. So I assume Medical is also returning to positive. Can you just clarify those numbers are in the ballpark? And then discuss the declines in the quarter, you called out the non-OEM aftermarket tubes to third-party sales. Is that to hospitals for their replacements? Or if you can help us clarify that one, too, a little more color on that would be great.

Larry, this is Sunny. I'll clarify the last part of the question and then turn it over to Clarence for some further clarification. Most of our business comes from the OEM segment. A very small portion of our tube sales go to third-party sales service organizations or multi-vendor service organizations who service a variety of equipment across many different manufacturers. And we make aftermarket tubes, what we call is aftermarket tubes, for a variety of manufacturers. So those are tubes that we make when we don't have an OEM arrangement with those particular manufacturers. That segment was the one that I was referring to, where we saw a decline. And there, it tends to be -- demand there tends to be volatile, based on any, level of service activity or the amount of tubes that they may have in circulation. So it's largely a drop-in business. We get a call, "Do you have a tube? Can you ship me one right now?" That's how that portion of the business works. So that's where we saw the decline.

Is most of that business -- they are selling their tubes in the aftermarket, though, they are not -- in other words, they're replacement tubes?

These are not our replacement -- these are all aftermarket for third parties, other manufacturers. They're not our replacement tubes, correct. And also, during the year-over-year impact, we had an impact from, if you recall, Toshiba had some adjustments last year. They had a particularly strong quarter last year, as they caught up on some of their inventory adjustments, et cetera. So there was on a corresponding year-over-year basis, we saw some decline there. So those are the 2 reasons for X-ray tubes being down.

So let me add a little bit more to that, I guess. So first of all, I guess, because of the little bit of a tough comp from a quarter ago -- from a year-ago quarter, I think it's always important to look at this business, and I've said this to you multiple times, which is that we look at this business on a longer-term basis. So over the trailing 4 quarters, we're still up 3%. So I think that's a good way to think of it from an organic perspective. I do think your numbers are about right for how you are looking at Q4 and for the year-to-date kind of information, so I think that's accurate. The other piece, I guess, is kind of around the aftermarket business. That's also one of those things where there is a fair amount of aggressiveness, I'd say, by those other manufacturers that are pushing hard in the market to retain their market share. Because that's fundamentally who we are competing with, is we're competing with the original manufacturers of those systems.

So are they actually -- is there price pressure on there, too, then?

Certainly. That's part of how they do it. They do it by a combination of how they set pricing, as well as how they maybe bundle some things together with other products that they have in-hospital and the like.

But this quarter -- obviously, I mean, this quarter obviously caught you by surprise, and it's lumpy, so I guess it's not that easy to predict. But does the quarter itself, is there any -- do you think there's a longer-term increase in competition or something that will -- it just seems like it's a pretty small piece of your business, but is it enough to where there's a big enough change to where it's driving things down more permanently, or permanently impaired or permanently impacted?

I do think, the key point there is you're right, that it's not a large part of our business. But it has been a little bit of drag for us the entire year. We saw a little more of it in Q3, perhaps than in some of the other quarters, but I think that's part of why it's getting discussed a little bit now, as it's a little bit more of a full year kind of impact rather than a single quarter.

So you're still sort of comfortable with your Medical growth, whatever that may be, your long-term -- your 3% targets or whatever, maybe growing to a little bit above that over time?

Yes, let me kind of back up to even maybe more basic than that. The overall guidance for the year is still 3% to 4%. We're just more towards the lower end of the 3% to 4% than the upper end at this point in time. And you are right, I mean, it's driven by 2 parts, always, the Medical and the Industrial, and the Industrial has done very well for us this year. And so that one is up more in the range of 4% to 5% for the year and so that's helping us a lot and then but the Medical is still, longer term, is still at the, we're in a space that's growing in the 3% to 4% kind of range.

Okay, fair enough. And you do assume, you do incorporate some growth -- I know you didn't break out Medical and Industrial for Q4, but you assume, 80% of your revenue being Medical, I guess, you incorporate how -- such a return to growth mode based on your targets, always.

Yes, that's fair to say, yes.

Okay, just switching gears to Perkin and I'll get back in queue. If you could, two-part question, you characterized the cost synergies very well on the long term. Can you just maybe help us sort of bucket what you -- what are sort of the near-term things in that $5 million number, and I assume is that number by the end of '18? Then second question, if you can just on the revenue side, more higher level, it sounds like that takes a little longer, but -- are most of those synergies just from cross-selling?

Yes, so I'll touch on the cost synergy side, and then I'll turn it over to Sunny to talk about where the sales synergies are. Cost synergies, and we're talking very specifically for 2018, we're targeting $5 million of cost savings here, and that's for, not a run rate by the end of the year kind of thing, that's how much the savings would be in the year. And that's -- the starting point there is just leveraging SG&A to begin with. The level of SG&A that we have to have in that business is not near the level of what they had when it was with a bunch of allocated costs when it was part of PerkinElmer. So I think that's the biggest driver of cost reduction to begin with. And then as we start working on looking at the leveraging the scale with the conversations with the suppliers and also just looking at how to be more efficient in the manufacturing processes, those are things that we can see additional benefits as well. More outside of '18 then in '18 for the rest of that stuff. And Sunny, maybe you can touch a little bit on that?

So the revenue synergies, they occur over a longer period of time. The way to think about it is there are 2 parts to it. In the near term, and near term, I characterize it as 2018, 2019 time frame, there are cross-sales opportunities of some of the products that are simpler to integrate. Like for example, in the Industrial segment, to sell industrial tubes to PKI customers who buy their detectors. We expect to see sales synergies from those in the short, near term, where it doesn't involve much integration activity with OEMs. Longer term, sales synergies would come by way of incorporating each others' -- the 2 product portfolios into each others' customer base. So for example, if we were to sell some other products to Elekta or to GE, it would take them some time to integrate it into their systems, and that's why the revenue synergies are over a longer period of time. This point, Clarence's guidance is over a 4-year time frame.

Our next question comes from Paul Coster with JPMorgan.

It's actually Mark Strouse on for Paul. I think we understand the rationale for switching to pro forma EPS guidance. It looks like on the revenue guidance, that pretty much looks unchanged. Are you able to, high level if nothing else, kind of compare the prior GAAP EPS to this new pro forma EPS guidance? Has there been any material change in that number? Maybe compare and contrast to what the pro forma EPS guidance would have been if you would have been issuing that previously.

Yes, so Mark, let me kind of -- I'm glad you asked, because I want to just walk through that a little bit, okay. So last quarter, we still were giving GAAP guidance, and our guidance for the second half of the year was $0.69 to $0.79. The midpoint of that is $0.74. So let's just kind of talk midpoints to keep things a little simpler. To adjust that to non-GAAP or adjusted guidance, there is 2 key things. There's a small amount of adjustments for amortization of intangibles that are in the historical Varex business, and that would add $0.04. And then if you take the, include the impact of adding, the second half of the year of the acquired business, that adds $0.18. You add that $0.22 on top of the $0.74 midpoint and you now have a new midpoint non-GAAP or adjusted midpoint of $0.96. We had $0.44 in Q3, which we just reported, so that leaves $0.52 at the midpoint for Q4. And our range right now, is at $0.50 to $0.54. So basically, I'm saying that the guidance is unchanged. We are still at the same number.

Our next question comes from Bill Kavaler with Seaport Global.

Three questions, all about future business opportunities. Can you talk a little bit about where you see Industrial going and potential growth there. Secondly, China, I know you just said you signed a new contract that should be good for $70 million, $80 million. Is there more that you can do in China? And third, I know that PKI is your last large M&A transaction, but are there others that are bolt-ons that you have been looking at?

Yes, let me talk about Industrial. When we talk about Industrial, which is the non-Medical segment, it has 2 big components to it. One is the industrial, non-destructive testing industrial inspection and the second one is security. So we see growth in both those sectors. Security is driven, we have seen very good uptake in the security segment, largely driven by overhaul of security systems at airports. There is a pretty strong drive to get CT-based systems implemented in airports. There's a EU mandate to get CT systems in place by 2022 and that's driving adoption of CT systems for both hand baggage and checked baggage. And our tubes are incorporated in those technologies across several different manufacturers. So we're going to see ongoing traction there driven by the market needs. Cargo-based security inspection, which is inspection of either pallet-sized cargo or trucks and borders and ports. That remains lumpy, but there is ongoing adoption of X-ray technologies. So we expect over the long term to see growth in that sector, but the timing is always a challenge there and it's driven by tenders globally. So Industrial, we're bullish on Industrial, driven by the adoption of technologies and also driven by security.

China is interesting in that there's, as we said before, we're engaged in product development with almost all the major OEMs that have evolved in China and almost every one of them is working on building CT systems and our CT technologies are being incorporated into their road maps. And what we expect is over the next few years, that progressively, they will bring these CT systems to market. Already a couple of our customers have done that. This new contract that I refer to is with one of those several OEMs, so this is -- we expect more of these, obviously, from the other OEMs. We're very excited to see this, to see this happen, because it's both an affirmation of our, the application of our technologies, our success in those market segments. And we're getting brand recognition in that market. So as these OEMs bring new products to market, CT will be the first one where we expect to see traction, followed by other modalities, such as cardiovascular, mammography, digital radiography is already on its way. So we're bullish on the China market and we feel we're well-positioned there with the ongoing R&D activity, which started, actually, 3 to 4 years ago. And we've made quite a bit of investments there already.

In the last point about PKI as an example of M&A. In our segment, there are lots of small players, a lot of technologies that we could look at. There are very few large companies, and we have looked at, we're always looking and always evaluating opportunities here. At this point, what we would like to do is integrate PKI, do a good job there and pay down a bit of the debt. And then as far as use of our cash and our capital, M&A is a high priority. We know most of the players in this segment. There are deals that can be done, we have evaluated many of them. We just want to get through the PKI acquisition and then reopen our activity there sometime in the near future.

Great, thanks. Speaking of debt, are you comfortable carrying sort of any permanent debt load or would you expect to pay everything down and kind of be debt-free and look to do something further?

No, our debt load right now is a little bit north of 3x EBITDA and we would like to get it down to, let's say, 2x to 2.5x. It doesn't need to be 0 for us to be able to do -- be looking at acquisitions.

Our next question comes from John Koller with Oppenheimer + Close.

So you know my first question is going to be about the quality and the gross margin. so anything you would like to add on that for the F Q3?

So I would say that the gross margin, it's a good news, bad news story. Because the good news is that we saw some improvement from where we were in the first half of the year. The bad news is it's still a little bit lower than what we would like it to be. And there's always -- when you think about gross margin, you always have to think about it in 2 manners. One is the mix of what we're selling, because there is quite a bit variation between higher-end products and the lower-end, lower-margin products, and so that mix will impact us from quarter-to-quarter, and even year-to-year, for that matter. And then as you touched on, I think cost of quality for us is, or yield in our factory and the efficiencies of our factory, are the other factor that comes into play. I would say that our level of performance on cost of quality for this quarter was similar to the prior quarter. We had -- we gained a little bit this quarter because of product mix, more than so much on the cost of quality. So we still have opportunities there. I think we have got dedicated people and dedicated programs focused on improving it, but those take a bit of time to do because it's very -- a lot of reengineering of how we do things.

Okay, great. Getting on to the $70 million to $80 million contract really quick in China. That's over what time period were you -- is it 3 years?

It's over a 3-year time frame. We will start to see it realize in the latter half of 2018. It'll ramp up through 2018 and then it's over a 3-year period.

We are doing some where there's a bit of volume of that, not a large amount, but there are some shipments that happen this quarter, but that's relatively small.

Okay. And then to talk about the Perkin acquisition, you obviously had expectations going in for what you wanted on a return basis. Now that you have it and you're working on it. I'm wondering if you can share your current expectations for returns and whatever metric you want to talk about. And then the discrepancy or differences between then and now. And I'm mostly trying to drive at a return on capital or how you feel spending the money, how you feel that's progressing?

Well, first of all, I think we are still early in the process. I mean we just, we closed it in May and so we've got 2 months of visibility under our belt and I would say that, that's been favorable from what we've seen, pretty well in line with expectations. We talked about that the gross margins of that business were going to be similar to ours and so on. They are at 36%, we're at 38%, so falls in that range. Again, for them, that is also a factor of product mix more than anything. And then the, in terms of returns, when I think about, probably not going to give you specific numbers about expectations for the returns on that yet. And we'll probably go into a little more color as we look at guidance for next year. But I would say that, what I've seen in terms of where we are in terms of profitability of that business, very similar and if not even a little bit higher than our business, somewhat because of the low amount of SG&A that they have, or that we have to add associated with this business. So I think it's, all in all, it's been favorable in terms of our view where it's going. And our first indications of it are nothing but positive.

Let me add to that and say that when we looked at this business, when we're doing the due diligence of that acquisition, our estimates of cost energies and sales synergies have not changed. We didn't -- since they were a competitor of ours, there's only so much we could look in detail, but once we closed the acquisition, we closed all those gaps, and there are no surprises that I can think of at this point that are of any consequence or material. So we're happy about our assessment of the synergies.

Okay, great. And then I know that you, when you do your R&D and your expenditures, you're looking out quite a bit, quite a number of years, you're working on projects that are going to come to fruition in a longer time period. So I know R&D has ticked up a little bit, I'm curious what you think the longer-term trend as a percentage of sales, now that you have Perkin under your belt. Is 9% a realistic number going forward, with some lumpiness based on projects? And then in the future, I'm hearing a lot about projects that I didn't even know you were working on. And maybe some indication of some of the broader, more important products that you have in development, that could be years out, to the extent that you are able to talk about that might be helpful in understanding the R&D spend.

Yes, I'm not sure we're going to go very far along in terms of talking about our longer-term projects, but let me talk about the percent of spending, I guess. I think that is an important topic. So we've been saying that we expect our R&D spending to be 8% to 9%. We're at the higher end of that range this year. I think as revenues grow, that we would continue to stay in that range, 8% to 9%. I will say that we're in the midst of our planning process for next year. So when we give guidance for next year, we'll have a little bit better color around that, so that I can say more definitively what it will be for 2018. I do still think that the long term is in that 8% to 9% range.

Just to give more color what goes into our R&D, there's 2 major cost items, which is labor, FTEs and secondly, materials. Labor is generally constant throughout the year and we predict that and forecast that. Materials can be -- is the part that can be lumpy, depending upon how much we consume any particular quarter, as we're trying to test and accelerate shipments or prototypes, et cetera, to our customers. So that's where you might see some quarter-over-quarter variability in our -- in when we give you color about R&D. And in terms of how we develop products, most of our dollars go into building out platforms for our products and technologies. And then as we acquire OEMs and talk to OEMs, there's some small portion of that, incremental amount, is spent on tailoring it for the specific OEM. And that's the part that depends on the OEM's time frame and can draw out, but it's usually a smaller portion of our platform expenses.

One thing I might add, though, is that what has changed a bit over the last few years is we historically have been an X-ray tube and a detector company. That was where we spent our development dollars. But now we have added the acquisitions over the last few years, software capabilities and connected control capabilities in terms of other accessories components, and that means that we now are spending also time on providing more of the integrated solutions, where we can make sure these things are optimized to work together. So that's a little bit of difference for us in terms of where we have expanded into, and that's a benefit for our customers, by the way, because we can help them by getting, in terms of getting them -- their products to market quicker, as well as more well, efficiently optimized in terms of image quality and image systems performance, by having these products or our components working together better.

Our next question comes from [Oscar Anderson with Boden Home Capital].

Three questions for me. The first one is on the visibility you have on the revenues in Q4. And then the second one on the gross margin guidance, the 38% to 40% in the long term. Does that include Perkin? So do you think the PerkinElmer business will get up to that 38% to 40% range as well? And then the third question is on PerkinElmer's OpEx ratio seems to be like 16% in Q3 here, at least for the 2 months. Like how sustainable is that?

Can you repeat the last part of that? I'm sorry.

On the PerkinElmer OpEx, so the SG&A and R&D ratio to revenues, it was 16% in the quarter, is that sustainable?

Yes, I think -- so I'll work my way from the last to the first, I think, okay. So the OpEx, yes, I think that -- I have to be a little bit cautious, because it's only 2 months of indication. But as I look at forecasts for Q4 as we work on the 2018 planning, I don't see that being significantly different. I think their R&D expenses are a little higher as a percentage of revenues than what we have, because it's near around 10%. But offsetting that is the SG&A is significantly lower. So I think that's a pretty good indication of where it's going. The gross margin longer term of 38% to 40% does include PerkinElmer and so this is where the cost energies are very important for us going forward. That's one of the factors that helps us to get to that higher end of that range. So that's going to continue on. I think that's a good way to look at it, as it's still 38% to 40% as a combined group. And then you had a question about revenue on Q4, maybe give me a little more color what you're looking for?

The visibility on the revenue growth, because it is a bit more ramp up, so in Q3, it was maybe a bit lower than expected. Like how much kind of visibility do you have that you will get back what you lost in Q3?

I'll just kind of walk, as we go into a quarter, we have pretty good visibility, because of forecast from our customers as to what they are planning to manufacture. So there is not a lot variability in there, with the exception of a few things. We'll have some drop-in orders during the quarter, and we will have some portion of aftermarket business that happens during the quarter and we have certain segments that just are more short-term focused, where they don't -- the customers or the OEMs are not necessarily doing as good at long-term planning as some others are. But generally speaking, I'd say we have very good visibility to the quarter and I'm -- I have a lot of confidence in what we have given as the guidance, because otherwise, we wouldn't be doing it. So that 23% to 26% obviously includes a significant uptick, just because of the addition of the PerkinElmer business.

Our next question comes from Larry Solow with CJS Securities.

If I may, just a few follow-ups, but just maybe on that last question. I know you don't guide quarterly or you didn't guide revenue for Q3. But I guess, if we turn the clock back 3 months, and I asked you the question for Q3, would you have had better visibility on what this number was and you may have and just didn't share it with us at that point? Or it looks like the miss this quarter, at least, was from an area where you didn't have a lot of visibility on? Or at least the majority of the miss.

Well, we gave guidance for the full year and you kind of work your way backwards because you know what the first half of the year has been.

Right, so we have second half guidance, essentially, for sales.

Exactly. So I think that's the best way to look at it, is still from that manner. We're in the last quarter of the year, so I think that's why you end up with 1 quarter's worth of guidance.

Right, but my question is, did you sort of -- I'm just trying to assess the visibility question. Were you surprised by this shortfall in this quarter or not so much?

So we knew for the second half of the year that we had a tough comp, right. I mean, we are comparing with the prior year with second half of '16 that had significant growth from the year prior that. So we knew that to begin with, so I mean, I don't think that necessarily this is all that much of a surprise, because we still are looking at things as a second half. Now the real question I think what you're asking is, is there some slippage from Q3 to Q4. A little bit, but not material. I think things went fairly well as expected for the quarter.

Okay. That's fair enough, okay. So in other words, this is not a -- it's a surprise to some, but again, if we add back your Q4 numbers, if we believe that your visibility is fairly good and you come close to Q4, then I think that the Q3 miss looks a lot less than it really -- then it's more of a timing thing?

I'll just reiterate again. We looked at it for the second half of the year, and for the full year, actually, from that perspective.

Yes, Larry, we always -- Q3 tends to, because of summer and holidays in Europe, it tends to start -- we always have some level of things that move around, that was -- and this year was no different.

Got you, that's fair enough. Other few questions. China, that $70 million new contract, is this all incremental? I know you guys had some contributions from China in years past, so that you were looking for a step-up. Is this part of that step-up?

No, Larry, this is part of what we had forecasted and anticipated. We've got expectations of revenue growth in China and our business in China growing. This $70 million to $80 million contract was an affirmation that we're on the right track and we are getting traction and locking those down. And we hope there'll be more of these that we can announce every year.

Fair enough. So I realize it's part of your outlook, but it's still incremental, it's not like it's just replacing another contract or something like that?

Well, no. It's a new agreement, that's true, but it was already built into our plan, there was no -- we've -- this is part of our China strategy.

Fair enough. On the gross margin, just to clarify. The 36% Perkin, was that Perkin on an adjusted basis, so 38% core, or is that -- so the 38% total number, I assume that includes Perkin. The 36% by itself, is that an adjusted Perkin or it's before adjustments?

Yes, it's an adjusted Perkin in that it excludes the amortization of intangibles and one-time purchase accounting charges.

Got you. And are you guys -- I know you gave that 38% to 40% range, do you think we're more closer to the lower end over the next, you know, before you get -- or outside of synergies? I feel like that 38% to 40%, I guess, includes synergies.

Yes, and Larry, we're talking about long-term and I'm going to stay in that level of a range. I'm not sure I can give a, say, longer-term, if it's 38% or whether it's 40%. And I'll give you a little more color on it when we do the guidance for 2018.

Fair enough. Operating margin, I know you guys, you're not going to hit the 16% this year. This quarter you didn't because it looks like there's an aberration in sales declining, but how do you feel about that 16% as a floor and growing from there?

So the year-to-date, I am not sure I know the year-to-date operating margin. I want to say it's somewhere around 16% or somewhere. And I would expect -- it's probably a little bit lower than 16% for year-to-date. But I see us getting in that kind of a range by the -- for the year-to-date. A strong Q4 is going to help us. I mean, this is, when you have higher revenues, I mean, you're just absorbing your operating expenses and you are absorbing your, even some of your manufacturing overhead costs. Those are -- so when you have larger revenue quarters, you end up with better operating margins.

Okay. And then just on -- one more specific question and then a little more general one. Just on the -- I guess, in terms of quality of earnings. If you are non-GAAP-ing the numbers, I would just give you a piece of advice. You probably should take out the currency gain and the gain on the minority interest, because that's really one-time-ish. So I would actually say your EPS on a non-GAAP basis were more like $0.36, and not the $0.44. I just want to make sure there was no tax rate difference on that gain that you had, which would be $0.36, then.

Yes, there is no tax adjustment associated with that. We have defined a policy internally that we're following about what items are included in the adjustments and we're following it.

That's fine. And you did call it out. So I'm not being critical of you, I'm just -- we are able to make the adjustment ourselves, so that's fine. And then the tax rate at 32% is little bit lower, then. Is that just an aberration in the quarter and long-term view is still sort of in that 34%, 35% range?

Tax rates are going to bounce around, but -- so as you go through a year, you're ending up trueing up things on your tax rates based on what you know today and you actually do a little bit of retroactive adjustment, which impacts the current quarter look. I think it's better to look at the tax rate on a year-to-date basis.

Okay, great. And then just last question. Getting just a bunch of inquiries about the transition, or what's remaining of the transition from analog to digital. We initially thought that most of it had already been done, or at least at the high end, and some more low-end stuff outside the U.S. But then there was some talk that there's only been half conversion. Now it seems like maybe that most of what was converted or hasn't been converted at the low end of the market, which won't help too much. If you could clarify that. And then part b of that question is, in the sort of CR, which is, I guess, was it transition in between analog and digital and that conversion from CR to digital, is that almost complete and has that helped you in the last few years, to where that might not help you anymore, that might be a drop-off?

Larry, let me take a stab at that. The conversion is still somewhere around the 50% of the way there. If you -- I'd say -- actually, let me take it back, it varies by type of product lines, so if you say in the U.S., just around 50% or less than that are full digital, okay. Now globally, of course, that number is much smaller, about 20%. So there is still, and this is based on the calculation that there's an install base of about 500,000 units to 600,000 units that need to be converted. So in terms of what's remaining, there's still a substantial chunk of systems that are not digital. And then in terms of modalities that are still converting, radiographic is accelerating and there's -- the largest volume of conversion is happening in the radiographic space and that's still moving very rapidly. And that is mostly the new systems that are being sold, they are increasingly going digital. First in the U.S., because in the U.S. you have reimbursement cuts by -- if you're using film in the U.S. there's 20% reduction by the end of 2017, if you are still using CR, then it will be cut by 7% in 2018 and then an additional 3% by 2023. So you can expect that CR-based systems will get phased out in the U.S. over the next 5 years and it's making good progress in that direction. Globally, that movement is much, much slower. There's still a quite a bit of CR systems and image intensifiers that goes with all the other surgical systems, there's still a very high percentage of that being still shipped as new systems that are analog. So our estimate that this thing is going to have a 10-year run rate to get there globally, we still feel good about that. We are seeing that, we are seeing increased volumes on the radiographic side and of course, you know the volume -- unit volume growth doesn't keep up with the revenue growth, because the price erosion there. But we are seeing the unit volume growth that is giving us the confidence that the analog-to-digital conversion is moving forward.

And the radiographic, is that more of the still X-rays, though, or is that the lower end or is that both?

They're both the high-end X-ray, which is still -- the still-shot images, high-end and low-end, both are converting to digital.

Ladies and gentlemen, we've reached the end of our Q&A session. I would now like to turn the floor back over to Howard Goldman for closing comments.

Thank you for your questions and participating in our earnings conference call. A replay of this quarterly teleconference will be available from August 3 through August 17 and could be accessed at the company's website or by calling (877) 660-6853 from any location in the U.S., or (201) 612-7415 from non-U. S. locations. You will need a pass code for this. It's 13666698. Thank you, and goodbye.

Thank you. Ladies and gentlemen, this concludes today's conference. You may disconnect your lines at this time. Thank you all for your participation.