Varex Imaging Corp (VREX) 2019 Q1 法說會逐字稿

Greetings, and welcome to Varex Imaging Corporation First Quarter Fiscal Year 2019 Earnings Call. (Operator Instructions) As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Howard Goldman, Director of Investor Relations. Please go ahead, sir.

Good afternoon, and welcome to Varex Imaging Corporation's Earnings Conference Call for the first quarter of fiscal year 2019. 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 are fiscal quarters. Quarterly comparisons are for the first quarter of fiscal 2019 versus the first quarter of fiscal 2018, unless stated otherwise. On today's call, we will discuss certain non-GAAP financial measures. These adjusted measures are not presented in accordance with, nor are they a substitute for GAAP financial measures. We provided a reconciliation of each adjusted financial measure to the most directly comparable GAAP financial measure in our earnings press release, which is posted on our website.

Guidance for our net earnings per diluted share is provided on an adjusted basis only. This adjusted financial measure is forward-looking, and we are unable to provide a meaningful or accurate compilation of reconciling items to guidance for GAAP net earnings per diluted share due to the uncertainty of the amount and timing of the unusual items. Please be advised that during this call, we will be making forward-looking statements, which are predictions or projections about future events. These statements are based on current expectations and assumptions, but are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated.

Additional information concerning factors that could cause actual results to materially differ is contained in our SEC filings, including item 1A, risk factors of our annual report on Form 10-K for fiscal year 2018. The information in this discussion speaks as of today's date, and we assume no obligation to update or revise the forward-looking statements in this discussion.

And now I'll turn the call over to Sunny.

Thank you, Howard. Good afternoon, everyone, and welcome to the start of our third year as a public company. Last week, we celebrated our 2-year anniversary and we look forward to many more years of continued innovation, strong customer relationships and growth. We had solid performance in the first quarter of fiscal year 2019. Revenues increased 5% or more than $9 million from the prior year quarter. Medical segment revenues increased 3% and Industrial segment revenues grew 13%. We had a nice improvement in our gross margin rate from the second half of last year, in particular the direct impact from tariffs in the first quarter was lower than we expected. Clarence will have more specifics in a few more minutes.

As you may recall, last year, U.S. tariffs increased by 25% on purchases that we make from suppliers in China for certain components used in our products like printed circuit boards. In addition, on the products we export from the U.S. to China tariffs increased by 25% on digital detectors and by 5% on X-ray tubes.

To help mitigate these increases in tariffs, we previously outlined plans to accelerate the expansion of manufacturing operations in China and Germany. We have made good progress to date and expect production of some product models to start during the second half of this year. Having a number of manufacturing sites around the world gives us the flexibility to be closer to our customers and realign production with local commercial needs.

In our Medical segment we continue to see strong demand for our CT, oncology and mammography imaging products. During the first quarter, shipments of CT tubes to our OEM customers in China continued to gain momentum, and we are on track to ship more than twice as many units as we shipped last year. Some customers are nearing end stages of development, while others are in their regulatory approval process for the new CT systems. We anticipate adding new pricing agreements with some of the smaller OEMs over the coming quarters. In addition to the opportunity for our CT tubes in China, we see our customers continuing to expand their global presence into emerging markets with products in the value segment of the CT market. One of our largest OEM customers recently introduced a CT scanner for emerging markets. We're optimistic about their potential success and other growth opportunities for our products in the value segment of the CT market. Demand for digital detectors also remains solid, but the story is a bit mixed. Sales of our upper tier dynamic detectors improved from the prior year while lower tier radiographic detectors declined due to the impact of tariffs and competitive factors.

We continue to see growth in sales of digital detectors and x-ray tubes for radiation therapy systems. The radiation oncology space is projected to grow at the rate of 5% over the next 5 years, driven by increasing incidences of cancer, the growing elderly population, and technological advances. Both radiation therapy systems incorporate x-ray imaging products that are used for treatment planning and patient positioning. We expect oncology to continue to be a strong contributor to our growths for fiscal year '19 and beyond.

Sales of products for the mammography market grew in the first quarter. We have a broad offering of Imaging Components and software for mammography, and continue to see a strong demand for components, particularly for X-ray tubes.

In our Industrial segment, revenue growth was driven by strong demand for our linear accelerators for nondestructive imaging applications and cargo screening at ports and borders, and industrial X-ray tubes used for security screening, CTs at airports. We expect demand for security tubes in industrial to remain high in the upcoming quarters as airports around the world continue to invest in baggage screening systems using CTs.

Our nondestructive testing business is off to a good start this year. We completed integration of the VMI acquisition that we closed last year, most of which focuses in the refinery segment of the oil and gas market where VMI's proprietary imaging software is used to inspect valves and pipelines. We are encouraged to see several new potential opportunities to combine our digital detectors with VMI's proprietary software for pipeline and refinery inspections. 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. I'd summarize Q1 as a quarter with good top line performance, particularly in the Industrial segment and better than expected gross margins, which were partially offset by higher SG&A expense. Tariffs once again had an impact on our business, but a bit different than we initially expected. Originally, we had expected our OEM customers would ask for price concessions to help offset tariffs that they would pay for the import of digital detectors. Instead, we saw a decline in radiographic detector sales in China during the quarter. Although this lowered revenues, our gross margin rate actually improve due to fewer sales of these lower margin products. Roughly offsetting this gross margin rate gain was a reduction of about 70 basis points due to direct payments of supply chain related tariffs in the U.S. and China.

Our first quarter revenues were up 5% compared to the quarter a year ago which had experienced a slowdown in sales of digital detectors for the 3D dental and oncology markets. Medical segment revenues for the first quarter increased 3% despite the reduction of radiographic detector sales. Industrial segment revenues were up 13% driven by increased demand for CT tubes for airport security and higher linear accelerator shipments for both security and nondestructive testing applications.

Looking ahead, we expect to have some additional variability in quarterly revenues due to various geopolitical issues such as Brexit, U.S. government shutdowns and tariffs. For example, we have seen some delays in receiving export licenses for our linear accelerators which could change the timing of future shipments.

For the first quarter, our gross margin was 32% compared to 35% in the prior year. During the quarter, we completed the closure of the Santa Clara detector fab operations and recorded $4 million of accelerated depreciation as a restructuring charge.

The adjusted gross margin was 36%, which was comparable to the year-ago period. Sequentially, our gross margin rate improved by about 3 points from Q4 of FY '18 due to lower manufacturing variances in Santa Clara, less impact from tariffs and a favorable change in product mix.

R&D expenses were $19 million or 10% of revenues in the quarter compared to $20 million or 11% in the year-ago quarter. First quarter SG&A expenses were $31 million compared to $28 million in the prior year. In the first quarter, we had approximately $1 million of restructuring costs associated with headcount reductions. In addition, we had higher than usual professional accounting fees and incurred additional legal expenses, primarily associated with a patent litigation matter that we had initiated. Depreciation and amortization totaled $14 million for the first quarter compared to $9 million a year earlier. The current quarter included $4 million of accelerated depreciation associated with the restructuring of the detector fab operations. Our operating earnings for the first quarter were $10 million, down from $14 million in the same quarter a year ago. Our operating margin rate was 6% in the first quarter, a decline from 8% in the year-ago quarter, reflecting the restructuring costs.

For the first quarter, our adjusted operating earnings were $20 million compared to $18 million in the prior year. The adjusted operating earnings margin was 11% compared to 10% in the prior year.

Interest expense in the first quarter was $5 million, which was slightly lower than the year-ago quarter. We had other expense of approximately $1 million in the first quarter and the prior year quarter, primarily due to the results from investments in privately held companies. Our effective tax rate before discrete items for the first quarter was 23% compared to 25% in the prior year.

As a reminder, last year, we recorded significant onetime tax adjustments due to U.S. tax reforms. Net earnings for the quarter were $3 million or $0.08 per diluted share compared to $11 million or $0.30 per diluted share in the prior year quarter. Adjusted net earnings for the quarter were $10 million or $0.26 per diluted share compared to $9 million or $0.23 per diluted share in the prior year quarter. Diluted shares outstanding were 38.3 million shares versus 38.2 million shares in the prior year.

Looking at our working capital, accounts receivables decreased by $21 million during the quarter. Day sales outstanding was 65 days compared to 66 days in the prior year. Inventory increased $22 million in the first quarter to $257 million. The increase is primarily due to the transition of supply with the closure of the Santa Clara fab operations and projected demand for the second half of the year.

We ended the first quarter with cash and cash equivalents of $55 million. For the quarter, we had cash flow from operations of approximately $20 million and spent $3 million for property plant and equipment, while reducing debt by $15 million. Our net debt position or total debt less cash was $320 million at the end of the quarter. We are not changing our outlook for fiscal year 2019. As a reminder, the guidance we previously provided was revenues in a range of $755 million to $780 million, including $10 million to $15 million of anticipated impact from currently enacted tariffs, and the adjusted net earnings per diluted share between $1.25 and $1.55.

Now we will open up the call for your questions.

(Operator Instructions) Our first question comes from the line of Anthony Petrone with Jefferies.

I'm going to maybe start on the gross margin side then move into a few just order-related questions, both in medical and industrial. On gross margin, if you look at the trend sort of 4Q to 1Q sequentially, and prior years as sort of being down to the tune of 200 plus basis points higher than that in the prior year. You were up 310 basis points sequentially, and so you walked through some of the drivers there, but Clarence and or Sunny, can you kind of recap how much was mix related? How much was Santa Clara related? And how much of this is sort of sustainable going forward?

Yes, I think, Anthony, it's an interesting one to compare with the Q4 in particular, because I do think that Q4 of FY '18 was a little bit on the light side no doubt, I mean in terms of the high amount of impact that we had from Santa Clara fab operations. And so getting a little bit of that behind us and having that gain from not having as much manufacturing variances in that fab in Q1 is certainly a big factor. The second highest is going to be around the mix in terms of the mix of what we're selling. And it's not insignificant when you have less of those lower margin radiographic detectors coming into play so that's a significant factor as well. Tariffs, I think it's comparable with Q4 so I don't think that as much the swing as more the prior 2 items.

Okay, so is it safe to say that this level that we're seeing here is sort of good proxy for how gross margin trends for the full year?

Well, I mean mix has always a bit of challenge for us, right, in terms of predicting exactly what that mix is going to be. But I think it certainly is heading in the right direction from that perspective. And then at the same time, I do think we have a little bit of an upside that happens with the full exit from Santa Clara fab because we don't have the full impact of that yet hitting us because we still had it running in terms of the cost structure that we had there, and that goes away a fair amount starting in Q2. There is a little bit of time for us to use up the inventory that we had built. As I mentioned that we built up some inventory there. That's at the prior valuations and cost structure, and so it will take us a little bit of time to use that up. So I'm feeling like it's second half of the year kind of time frame when we start to see the favorable impact of the closing of that fab.

That's helpful. And one on China OEM. Is there a way to just -- you sort of mentioned some orders here. What amount of orders, sort of in dollars from China OEM did you have in the queue? And then what is reasonable for the year? You said you expect it to sort of double this year, but is there a way to sort of the frame that in dollars? And then just on industrial, can you just kind of give us a sense of what VMI contributed in the quarter, the acquisition that was announced last quarter? And how much that contributed to growth in industrials?

I'll start with the last one first just because it's, a quick and easy one, which is, overall the VMI business is somewhere in the order of magnitude of $5 million to $7 million kind of business somewhere in that kind of range. So you just do that by a quarter's worth, and it's not a large number in terms of driving the growth. I mean it helps certainly, but it's not that -- not a major factor. I'm not going to go into specific details of orders in China in terms of -- because first of all, we don't really talk about orders unless we have had some very large significant one that we put into the backlog as the pricing agreements that we have. But I would say that 2 things I guess. One is, I touched on that we had a decline in sales of radiographic detectors there, but at the same time, we had nice performance on CT tubes and that puts us on track for the -- for what we had said before of the number of units shipping there doubling.

Our next question comes from line of Larry Solow with CJS Securities.

I mean you guys don't guide to the quarter per se, but could you just give us a little -- just a little bit of flavor? Normally, Q1 is, I believe, seasonally the slowest quarter of the year for you, but look back last year, your Q1 was exceptionally slow as such on the medical side where a lot of orders on the flat panel detectors that were pushed out. So in relation to that, and sort of mid-single-digit growth in the quarter on the medicals overall, and I think 3% of medical, how should we view sort of the rest of the years -- rest of the quarters because your guidance sort of implies, at least on a year-over-year basis some, if you look at the midpoint, some still low to mid-single-digit declines for the rest of the year?

So Larry, I mean, I guess it starts with just kind of -- and you touched on a little bit, which is that we had a soft medical quarter a year ago -- sales in the Medical segment a year ago. And that was driven by 2 segments in particular. The dental space and the oncology space more lighter than usual. I would say that those followed up in the second quarter last year with pretty strong quarter. So I mean, I think I -- from that perspective we actually have a bit of a tough comp going into Q2 for the medical space. And then I mean, overall, you've got the things going on with China, and CT is certainly still going to be a big driver of growth for us as we look for the balance of the year, and that's in the medical space. So I mean, I think that's certainly one of the things that's got a nice uptick. And then, I would say that the business or the amount of business that we see in the oncology and the mammography space is good indicators of kind of the level of demand that we have there. So I'm not sure I fully answered your question, but I think it kind of covers a little bit about the balance of the year for medical.

Okay. And then just on the -- you gave some good color on the gross margin and gross profit outlook. Obviously, when I think the Santa Clara facility, I know, it has been a pretty drag for you guys. So hopefully, as that closes, it sounds like you've already got some improvement this quarter even though the facility was still open, but hopefully, going forward that'll -- you'll be -- reduce even more, which is fine. Just how about on the SG&A side a little bit? I know that's been sort of a thorn on some people's side, just suddenly increased level there, it did seem like it was reduced too much this quarter so -- at least on an absolute basis or as a percentage of revenue. Is that something you still focus on and perhaps an opportunity to materially improve your margin?

Yes, I mean, I'm -- SG&A had a couple of unusuals this quarter. The first being the -- we get -- went through a sizable amount of work to close out last year with the audit and the first time implementation of SOx and there's a fair amount of fees associated with that. So that was an uptick in expense that was just in Q1. The other one that was the -- we had some litigation expense associated with a patent that we are defending, and we are defending our own patents, and that increased some expense as well. So those are -- now that's not a done deal, right. So there's still some additional expense to be had on the litigation side for sure. At the same time, we end up with a higher than usual SG&A as a percentage of revenue, but as I look forward to the year, we have targeted to be around 13%. I still see us having a good shot at getting to that. And it's more about managing the cost structure as well as you get a little bit of revenue growth in there, the math helps you a little bit there.

Okay. Just a question on China, just a quick follow-up. You mentioned, it sounds like, certainly the contracts you already have, customers are advancing and you sort of reaffirmed that expected doubling or more than doubling in unit sales. Just on the follow-up to that, you mentioned you have some smaller OEM customers that -- in the Q that you expect some orders from. Are there -- I would assume it's a pretty big mark opportunity and I believe you have like 5 of the 10 OEMs on the contract already of some sort. Are there larger, maybe not in the near future, but larger contract opportunities as we look out, maybe not in the next 1 to 2 quarters, but over the next 1 to 2 years that you hope to vie for? Or how's that outlook? Or has anything changed on tariffs or spending patterns, or anything in China?

Larry, this is Sunny. Let me take that. Of the 10 OEMs, safe to say, we're playing with everyone. The first 5 that we signed purchase agreements with, they were the largest ones. And what's remaining after that are sort of down the line, smaller OEMs. So if you look at the next 12 to 18 months, I'd say we will end up getting many of those, but they won't be anywhere materially of the size of what we've already closed. They'll be much smaller.

Fair enough. Just go ahead, go ahead, I'm sorry.

Well, Larry, one other comment, I guess, is that from U.S. also about tariff impact. And there is -- what we've seen with the CT tubes, first of all, it's a much smaller tariff rate that's been added on those, and we've not seen any impact on the business there from that perspective. No change in our customers' plans.

Right. So it sounds like that $10 million to $15 million, I know you're not changing that in your guidance, but at least through Q1, the overall impact from tariffs is at least trending towards at least a lower portion of that number if not below it. I know it's only -- early in the year, but is that fair to say?

I guess there's a couple of factors there. One is you got to always remember there's different parts to tariffs. One is, is what we pay and it's in our cost structure, whether we're importing stuff from China or whether we are the importer of record when we ship something into China. And then, the impact on the top line, I still think it's in that range, the 10% to 15%, it's a fair amount of volatility with it because some of it might be still price concession, some of it might be just business that went away. We had kind of similar impact when currency moved 3, 4 years ago, we had similar kinds of things where it was, you had to do price adjustments and the like and so we still have some of that potential as well.

And Larry, second part of your question about is, have we seen any changes in the environment in China. We haven't, and actually it's been the recent announcement by the Chinese -- the purchasing authorities that they're going to buy 3,000, 3,500 CT systems by the end of 2020. That's only reinforced, continuously reinforced, it's an additional data point proving out the market opportunity, and we're not seeing any -- none of our customers are escalating their investments.

Excellent. That's great, I know that the tariffs on the tubes are -- while they were -- a very small minuscule amount and now that's just increased by a little bit, right? So it's mostly on the detector side that you're feeling the impact...

Yes, it was 5% more than what it was before.

Just last housekeeping question. What's the other expense of $1.2 million, what was that? Is that below the line?

So that's in our…

JV?

Yes, the JV that's the detector manufacturer there, dpiX, so.

So that was a bit of a positive for a lot of things for...

Yes, we do have a little bit of variability in that business that just going to go up and up and down at times, just on how their operations are running.

Okay, but does overall directionally that should be a positive contributor, I would say. Right? I mean?

We run it, no it's run to be at a low -- it's a low profit level kind of business and so it's -- most of the positive impact that we get with that is all about the cost structure for what we buy from them. So if they -- as they reduce costs which they are doing -- doing that and they are making good progress in reducing costs, that reduces our cost of goods, it doesn't necessarily hit in that other I&E line.

Our next question comes from the line of John Koller from Oppenheimer.

It's Oppenheimer and Close just to -- for fair advertising. Couple of quick questions. I went through the addendum on the adjustment. And I just wanted to make sure I didn't see it -- did the legal expense and the professional expenses were not part of the adjustment to get to adjusted EPS. Did I read that correct?

Yes, that's right. I did not -- those -- I did not treat those as adjusted items, they are part of our ongoing regular business, I guess. They are not onetime.

Okay, great. Just wanted to make sure. I don't suppose that you want to give any information on the patent litigation? We'll just leave that out there and we'll see it in the Q?

There'll be a little bit more color in the Q as well but nothing more to add at this point in time.

Okay, great. Really quickly then on the manufacturing expansions in China and Germany. I'm going to guess that you're probably some time away from achieving solid efficiency on those? Wonder if you have a time lime or if you think that they're acceptable or if it's just too small at this point?

It's small at this point. We -- the way we're going to roll that out is we'll dribble it out of the product line at a time. So there's really not going to be a material impact in productivity one way or another.

Okay. And I guess those are going to be fairly, maybe in Germany, you can be a little bit more upmarket, but in China, you're probably going to keep those at the mid-to lower technological advancement at this point?

Yes -- so -- we have existing facilities in Germany where it came through our PerkinElmer acquisition. So there's a mix of products. The PerkinElmer products are largely what's made in Germany and in China, it would be again a mix of products both PerkinElmer, the legacy PerkinElmer and Varex products that we sell into China. So it's a mix of products, blend of products.

Okay, great. Then if I could ask on further margin improvement and ability to cut costs. I assume with 1 quarter under your belt, you're still pretty confident that you'll be able to achieve the previously announced targets for cost reductions?

Yes, I don't think anything has changed from that perspective. And I look at things like okay, R&D, we're running around the 10% level which is what we had said we wanted to be at. So -- and I think with the SG&A, it's about in the unusual items or maybe the items that hit us in Q1, not carrying forward so much after that. And then, gross margin, you always got a lot of factors going on. I mean, we talked on those a little bit, relative to the product mix as well as some of our cost-reduction actions that are going on. I don't think that changes anything in terms of outlook.

Okay. And then my last question is really on industrial. It was a sizable improvement in the quarter and I know you've mentioned that you'll see some shifting going forward based on the ability to get linear accelerators out the door. But I'm just curious if you can have -- if you're seeing any traction on the efforts in the assets that you've deployed in industrial beyond what we've seen so far that gives you some confidence, maybe not this year, but maybe in the out years that you're taking appropriate action to really go out and get that market?

Let me just take it, and maybe, Clarence, you can fill in. John, we -- second half of last year, we announced a realignment to focus on industrial and that is having an impact, and we're seeing that in the growth industrial X-ray tubes business, which -- and not the linear accelerator which have the higher energy, the normal energy, kV energy X-ray tubes, that is we have seen pretty good traction there and we expect that'll continue and its investments for the long term. Beyond that, I think we already have a very strong industrial detector business where we expect some additional growth to come from will be through the acquisition of VMI. The VMI brings us some software, proprietary software in the oil and gas vertical. So we're bullish about being able to expand further into oil and gas vertical with our existing products, in our tubes and detectors by packaging them with VMI's offerings because if they've got a good channel and a good market presence in the oil and gas segment.

And I guess one last one, just want to say, congrats on the debt repayment. I know of Q1 is generally pretty soft quarter, especially after this Q4 that you had last fiscal year, but I'm glad to see the focus on debt reduction.

Thank you, John.

Our next session comes from the line of Jim Sidoti with Sidoti & Company.

So you've said over and over there is 2 impacts from tariffs. The tariffs and the concessions you need to make to your customers as a result of the tariffs they're paying and then there's also the tariffs you pay on materials you purchase. That second component, you indicated that was a little bit less this quarter than you thought. Why is that?

I think that it wasn't significantly less but slightly, and I would -- I think it's more volume related than anything in terms of the amount of products that we're either moving cross borders whether it was stuff that we imported and went into our inventory, or whether it was the number of shipments that we did to China.

So essentially the product mix helped you both on gross margin line and with the tariff excess?

Yes, to a certain degree, I think you're right. There is a bit of another hidden benefit, I guess, from product mix that is linked back into the tariffs.

Do have any sense? I mean if things could go the other way for the rest of the year? Or do you think that this is a trend that will continue?

I actually think that Q1 is a pretty good indicator of what the year is looking like in terms of the mix of tariff impact, but we're very early in the year from that perspective and so, it's a little bit difficult to give specifics on the outlier quarters.

Our next question comes from the line of Anthony Petrone with Jefferies.

Just another one to stay on tariffs. Maybe just -- I know that there was a handful of different variables as it relates to tariffs. One was, those related directly to China OEM, your supply materials but also multinational OEMs potentially having to shift their supply chains around. And so, how much -- is all of that kind of factored into the $10 million to $15 million? If it's not, what areas could potentially surprise either to the upside or downside? And again, should we get some favorable announcements come March or April, whatever the case may be, how quickly can you unwind some of the efforts to offset tariffs. Should again we get a favorable announcements that there is a less of a two-way sort of trade war going on between China and the U.S.?

I'll answer the second part first again, which is that if there gets to be resolution and some of these tariffs go away, the obvious one is the part that is setting us on the cost side, okay. So we get that benefit -- that 70 basis points or so that we had of impact in the first quarter, that goes away so we get an uptick there. And then, the more difficult to measure part is what does it mean on the top line stuff. Certainly, with the ones where we've given price concessions. We have structured those in a manner where they are very clearly identifiable and a separate line on the invoice et cetera. So that it's clear that we're doing a price concession because of tariffs. And so that goes away, then we get that benefit back. Now the ones where it's a little more indirect or the business has gone away because somebody doesn't want to pay the tariff, that's still to be determined about how do we get that business back? And I would say that we always have ongoing conversations with these customers. So I think there is a good likelihood that we would get that business back.

Anthony, let me just add to that. This is Sunny. The changes, operational changes, that we made to counteract tariffs were part of our original plan always in our business. We just accelerated them because of the tariffs. So we have to address China 2025. So eventually our Chinese customers and our multinationals want local sourcing in China. So we're not going to -- maybe I misunderstood your question, we're not going to unwind those actions. We just -- we put those in motion, we accelerate those and the costs associated with that are part of our guidance for the year where we will see a benefit, is exactly what Clarence described, the tariffs go away then some material parts of cost will go away, but our investments in China, the capital investments we made, we will just keep those going towards our long-term goals.

That's helpful. And last just follow-up for me would be, again, revisiting VMI, I know it's small, but how much of a gross margin impact does that have in the Q. And are VMI margins on that $5 million to $7 million, are those above corporate average?

I would put the -- I would say their margins are comparable with our business. There's a little bit -- again, they have -- within their own business they have a bit of mix thing going on too. How much of it is their proprietary software that they're selling versus how much is pass through of components versus how much is Varex components being sold. So there -- so it can be any of those 3. And obviously, the more software, the better margin, the more Varex components versus pass through of a third party product would be also higher margin. But overall, what I see in the number is that they're comparable with our -- the rest of our business.

Okay. Then the last one, if I may, just a housekeeping one on -- again on the debt acceleration pay down and just how that flows through with earnings. I mean, how should we think about -- how that plays into the reaffirmed adjusted EPS guidance? How much of that is a benefit? And then any update just on the tax guidance as well would be helpful?

I actually don't think anything changes on either of those. I think at the beginning of the year we had said that interest expense was going to be in the $18 million to $20 million, the debt reduction is in line with what I would say our cash flow generated, which is going towards debt reduction is right in line with what I would expect for the year. So that's -- I don't think anything changes from that perspective. Tax, I said, 23% to 24%, we're 23% this quarter so it feels like it's also still in line.

(Operator Instructions) Our next question comes from the line of Larry Solow with CJS Securities.

A quick follow-up. Just on the R&D side, you guys had pretty nice jump last year. I know you sort of took some of the tax benefit and reinvested in the business, which is I think a great thing and hopefully we'll see some of those benefits probably a couple of years out. But just for the quarter, a little bit of a drop. Is that something that we think will, R&D sort of was toned down a little bit this year, or do you sort of expect to remain at last year's levels or near last year's levels for the full year?

No, last year was around a little -- almost 10.5%, a little bit north of 10.5%. So in this quarter, it was right at 10%. And that's what we're targeting for the year is to be around 10%. And it's -- several factors come into play. One is the timing of prototype materials and the like, we had a pretty good uptick of proto costs for CT tubes last year. I think some of that is behind us now, so I think that's -- that gets normalized a little bit. The other is, there is a little bit of R&D costs associated with the Santa Clara fab in terms of supporting that operation. And so, we take some of that expense out as well. So the combination of those things puts us in that 10% range.

Since there are no further questions left in the queue, I would like to turn the call back over to management for closing remarks.

Thank you for your questions and participating in our earnings conference call for the first quarter of fiscal year 2019. A replay of this conference call will be available from today through February 19 and can be accessed at the company's website or by calling (877) 660-6853 from anywhere in the U.S. or (201) 612-7415 from non-U. S. locations. The replay conference call access code is 13686651. Thank you, and goodbye.

This concludes today's teleconference. You may now disconnect your lines at this time. Thank you for your participation.