Varex Imaging Corp (VREX) 2019 Q2 法說會逐字稿

Greetings, and welcome to the Varex Imaging Corporation Second 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, Mr. Howard Goldman, Director of Investor Relations. Thank you.

Mr. Goldman, you may now begin.

Good afternoon, and welcome to Varex Imaging Corporation's earnings conference call for the second 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 second quarter of fiscal year 2019 versus the second quarter of fiscal year 2018, unless otherwise stated.

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 that 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 from those anticipated is contained in our SEC filings, including Item 1A - Risk Factors of our quarterly reports for the second quarter of fiscal year 2019 and first quarter of fiscal year 2019 and our annual report on Form 10-K for the fiscal year 2018. The information in this discussion speaks as of today's date, and we assume no obligation to update or revise our forward-looking statements in this discussion.

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

Thank you, Howard. Good afternoon, everyone, and welcome.

I'm pleased to report that as of the mid-year mark, we saw performance that keeps us on track for the year. For the second quarter, revenues were $196 million led by continued strong product sales in industrial markets and gains in certain medical modalities.

Medical segment revenues declined versus a strong Q2 in the prior year. Higher demand for our oncology, mammography and CT products were offset by lower sales in dental, low-end radiographic detectors as well as non-OEM aftermarket X-ray tubes. We had strong demand for mammography components driven by growing use of 3D imaging, and we are seeing increased interest for X-ray tubes in entry-level mammography and CT markets.

In the medical space, end markets continue to be healthy, and the introduction of new technology platforms tends to stimulate adoption of new applications. For our part, we continue to invest in R&D as well as establish partnerships to advance early-stage technology and evaluate acquisitions that will bring new products to our portfolio.

We just completed the acquisition of Direct Conversion which added photon-counting technology. We also recently established a joint venture to develop next-generation X-ray sources using nanotube technology.

Industrial segment revenues increased from the prior year primarily due to higher sales of X-ray tubes and linear accelerators for airport security and nondestructive testing applications. Checked baggage screening systems at airports around the world are in an upgrade cycle that includes CT technologies. Several OEMs in this space are Varex customers, and they are using our X-ray tubes in innovative ways to meet current and future airport security and productivity requirements. These new innovations are intended to allow airports to screen as many as 2,000 pieces of luggage per hour. Our components enable these efforts with superior image quality and faster throughput.

In the second quarter, we released a small footprint linear accelerator with updated electronics and software controls designed for mobile security applications. Shipments of these systems will begin in the third quarter. In addition to being smaller and lighter, this new product also includes technology features that can improve image quality and allow faster scans. We will be working with our customers to find expanded applications of mobile scanners beyond ports and borders to protect key venues in cities globally.

In the quarter, we also saw increased sales of our X-ray tubes used for inspection in laboratories and manufacturing plants. Our components are incorporated into instruments which perform material analysis such as those used for certifying levels of chemical composition to meet quality and regulatory requirements.

We also continue to see demand for high-energy industrial digital detectors. Our large area detectors are used for imaging sizable objects such as aircraft and rocket engine parts, large [telegram ammunition] and automotive components. Our portable high-energy digital detectors are used to image and inspect small and midsize objects during manufacturing of castings, welds, joints, electronic components, et cetera. Both types of detectors have been received well by our customers, and we expect to see demand for these detectors continue to grow as digital imaging applications and manufacturing expand.

Integration of the VMI acquisition, which we completed late last year, is going well. We're combining our digital detectors and software products with VMI's proprietary software for refinery and pipeline inspection. In doing so, we are actively participating in the transition of imaging in the oil and gas industry from X-ray film to digital.

Meanwhile, tariffs continue to impact us, and Clarence will have the specific financial details in a few minutes. Toward mitigating the impact of tariffs, we continue to redirect our supply chain away from China to other countries. We expect that much of this shift will have been completed over the next couple of quarters. We're also continuing to scale up additional manufacturing of our digital detectors at our facility in Germany and expanding our operations in Wuxi to manufacture certain products for sale in China. Even if the current trade war with China is resolved, these actions will benefit our long-term strategy of being closer to our customers.

Next week, Varex will be exhibiting at the China Medical Equipment Fair in Shanghai, one of our industry's largest trade shows in the Asia Pacific region.

In addition to showcasing our latest X-ray imaging technology and products, we will also be launching our new local for local initiative. Among other things, this initiative will highlight investment in our Wuxi facility to service customers in China with local production of digital detectors and certain X-ray tubes.

One of our strategies is to be globally local. In doing so, we want to get as close to our customers as possible by establishing local commercial relationships, delivering local service and support and sourcing from local suppliers as much as possible. Shipments of CT tubes to our OEM customers in China continued during the quarter, and we remain on pace to ship this fiscal year more than twice the number of units we shipped last year. At the same time, as volumes ramp up, we're now seeing a shift in the mix towards lower-priced CT tubes for more basic 16-slice CT systems. As a reminder, China is estimated to need approximately 25,000 new CT systems over the next 10 years as part of government's expansion of health care services. As this plays out, starting in the next 2 to 3 years, the replacement cycle of initially installed CT tubes should begin and will ramp up over time. We estimate the annual market opportunity for replacement CT tubes in China will be approximately $300 million.

I'd like to close with some additional details regarding the Direct Conversion acquisition which we completed at the end of April. Headquartered near Stockholm, Sweden, Direct is a leading manufacturer of linear array digital detectors utilizing photon-counting and charge-integrating technologies. In 2018, Direct had revenues of EUR 16 million that was split evenly between medical and industrial products. Photon counting is exciting because detectors built with this technology can significantly improve image quality while using lower dose and perform more precise material discrimination. The X-ray imaging industry has been working on photon-counting technologies for the past 2 decades and faced several technical challenges. About 2 years ago, Direct solved several of these challenges and successfully commercialized its linear array digital detectors for certain medical and industrial applications. They will also continue to work on applying this technology to additional applications including medical CT detectors.

This acquisition is all about expanding our portfolio with cutting-edge technology that comes with an existing revenue stream and a sizable backlog. Additionally, the wide range of medical and industrial applications for Direct's photon-counting technology are new vertical markets for us that also add new customers. We anticipate this acquisition will expand our addressable market by approximately $200 million over the coming years.

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 usual, I'm going to focus the discussion on our quarterly results while fiscal year-to-date financials can be found in our press release. I'll also provide some details on the addition of the Direct Conversion acquisition to our outlook for the full fiscal year.

I would summarize Q2 as a quarter with good top line performance particularly in the Industrial segment while revenues in the Medical segment continue to be impacted by lower sales due to tariffs. Operating profit was in line with our expectations as we had good expense control that offset some higher-quality costs. As Sunny mentioned, China-related tariffs continue to hurt our business with about $5 million less revenue from radiographic detectors and about $1 million of direct payments for supply chain-related tariffs in the U.S. and China.

Our second quarter revenues were down 3% compared to the quarter a year ago. Medical segment revenues for the second quarter decreased 6% primarily due to the lower sales of radiographic and dental detectors as well as aftermarket X-ray tubes in China. Industrial segment revenues were up 10% driven by increased demand for X-ray tubes for airport security and digital detectors and linear accelerators for nondestructive testing applications.

For the second quarter, our gross margin was 33% compared to 35% in the prior year. The adjusted gross margin was 34% compared to 36% in the prior year. The margin reduction was due to higher cost of quality primarily in our detector business plus increased freight and tariff costs.

R&D expenses were $19 million or less than 10% of revenues in the quarter compared to $22 million or 11% in the year ago quarter.

Second quarter SG&A expenses were $31 million and comparable to the prior year quarter. However, in the second quarter, we had approximately $5 million of additional expenses related to the acquisition of Direct, an asset impairment and other restructuring and litigation costs. While in the prior year quarter, we had approximately $2 million of additional expenses for restructuring and acquisition-related activities.

Depreciation and amortization totaled $8 million for the second quarter compared to $10 million in the prior year quarter. Our operating earnings for the second quarter were $14 million, down from $17 million in the second quarter of the year ago. Our operating margin rate was 7% in the second quarter, a decline from 9% in the year ago quarter.

For the second quarter, our adjusted operating earnings were $23 million compared to $24 million in the prior year. The adjusted operating earnings margin was 12%, the same as in the prior year.

Interest expense in the second quarter was $5 million which was similar to the year ago quarter. In other expense, we had an unfavorable $5 million swing year-over-year. We had an expense of $1 million in the second quarter due to the results from investments in privately held companies and currency adjustments. However, in the prior year quarter, we had a benefit of $4 million. Within this line item are the results from investments in several joint ventures such as the dpiX glass fabrication facility as well as other joint ventures that represent investments in early-stage technologies.

Our effective tax rate before discrete items for the second quarter was 22%, same as in the prior year.

Net earnings for the quarter were $6 million or $0.15 per diluted share compared to $12 million or $0.32 per diluted share in the prior year quarter. Adjusted net earnings for the quarter were $13 million or $0.34 per diluted share compared to $17 million or $0.45 per diluted share in the prior year quarter. Diluted shares outstanding were 38.5 million shares versus 38.4 million shares in the prior year quarter.

Looking at our working capital. Accounts receivable decreased by $9 million during the quarter. Days sales outstanding was 57 days compared to 58 days in the prior year quarter, and inventory increased $4 million in the second quarter to $261 million primarily due to projected demand for the second half of the year.

We ended the second quarter with cash and cash equivalents of $31 million. For the quarter, we had cash flow from operations of approximately $13 million and spent $4 million for property, plant and equipment while reducing debt by $29 million. Our net debt position or total debt less cash was $315 million at the end of the quarter.

Subsequent to the end of the quarter, we closed the acquisition of Direct Conversion. We paid the equivalent of $71 million at time of closing and assumed $3 million of net debt. We utilized $7 million of cash on hand and increased our revolving debt by $64 million.

To give this some context, over the past 4 quarters, we have reduced debt by $73 million so we are reinvesting the free cash of the last year for this acquisition. Five months of Direct's financial results will be included in this fiscal year. We expect this will add approximately $7 million to $8 million of revenue with gross margins above our current level but no impact to adjusted net earnings per share due to their level of R&D spending and the added interest expense.

As a result, we now expect revenues to be in the range of $760 million to $785 million for the fiscal year. We continue to believe that our adjusted gross margins will be in the range of 34% to 35%, that R&D expense will be less than 10% of revenues and SG&A expense will be around 13% of revenues excluding unusual items. We are maintaining our expectations that adjusted net earnings per diluted share will be in the range of $1.25 to $1.55.

We will now open up the call for your questions.

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

Maybe to start off with a couple of questions on guidance, just some of the moving parts there and then just the topics of the day on tariffs as they stand. Just on guidance, can we maybe get a better sense of, one, the base Medical business? We've seen a couple of quarter share impacts, and so you're adding an -- the Direct Conversion transaction at the revenue line. The overall goes up by a bit. Yes, you've seen 2 quarters of impacts in detector plates in Medical. So just maybe a little bit of color on what's going on in the base Medical business that is reflected in the guidance change. And then I'll have a couple of follow-ups.

Sure. Anthony, I guess, I'd start it out by saying when I look at the first half of the year, the Medical business I think is down 1%. So overall, considering the fact that we probably had it in the range of $5 million a quarter for the -- a little bit less than that in the first quarter but roughly in that range for the first 2 quarters. It's still a -- excluding that, it's still got some growth in the medical space. The way I went about this was to say, okay, let's take into account the additional impact of adding in Direct and then look at the -- what do we think the impact of tariffs will be going forward. And that's where we got to the increase that we did in the overall range by bumping it up to the $760 million to $785 million range.

So said another way, should we assume that, that estimated $5 million impact is kind of the quarterly run rate until further notice? Or is that a fair way to think about it?

Well, I would say that it's an impact. So Sunny actually talked a little bit about we're in the process of [ramping] up production in our Wuxi facility and in our German facility as a way to mitigate this, and so we're on the home stretch of that. So once we have that in place, then we start to be able to go back to the market with product in that radiographic detector space. So we -- it's not a "business as usual forever" kind of thing. It feels like "Give us another quarter, and then we'll start to be able to actually mitigate that by having products that are manufactured not subject to tariffs."

All right. And then last one on guidance for me would just be on -- just on the Santa Clara facility, just an update there. I mean is that still on target for having a net benefit to the P&L sort of mid-year and to the back half? Just an update there. And then my final question, I'll just put it out there on tariffs. I mean based on kind of the more recent developments, it's hard to sort of reflect that real time. But maybe just any high-level thoughts if we do get a more hawkish stance from both sides, I'd say. Is there any early thoughts on how that could play out in the business?

All right. Let's set the tariffs one aside for just a second, and let me answer the Santa Clara one first. I would say that the process where we did the closure of the fab operations is behind us and closed out, and yes, I do expect some benefit in the second half of the year. One of the challenges that -- you heard me mention a little bit that we had some higher-quality costs in the second quarter. That's a little bit of carryover from the closure of the fab because we still had some inventory there that has not performed quite as well as we would've liked, I guess. And so -- but that does feel like that's behind us.

The wildcard, I'd say, in gross margins is you've got a fair amount of moving parts always going on, right, whether that's relative to product mix, which I would say that in Q2 was actually a reasonably good product mix quarter, a little bit around price erosion. We continue to have that kind of a challenge. And then our manufacturing performance in the factory, those moving parts come into play when you're looking at the overall gross margin performance. So that's why I'm comfortable with staying at the 34% to 35% although even though I get a little bit of an upside from the closure of the Santa Clara fab operations. Now relative to the tariffs, maybe you want to ask a follow-on before I go to the tariffs?

No. No, that was really helpful.

All right. So maybe -- and I'll probably let Sunny answer a little part of this as well. But my general take, first of all, is that we've had strategy all along to be more global and more local for the customers which actually helps us in dealing with challenges like trade war kinds of generated problems. And so as we continue to expand operations in China or in the Philippines or in some of our European locations, those are ways that we mitigate that. And so that's -- we see a good path forward there. We're already dealing with it very directly with detectors. Detectors right now have a 25% tariff put on them if they are shipped from the U.S. into China. And so accordingly, we saw the reduction in revenues there. But as we transition that, I see some opportunities in the future there. X-ray tubes is a little bit of a different scenario. The exposure is not as high there because it's only a 5% tariff currently. And I think that's -- if you say worst-case scenario, that the challenge that we got to deal with is how do we transition quicker our manufacturing so that it's not subject to tariffs if, worst-case scenario, that rate goes up. Sunny, anything to add?

No. I think Clarence touched on all points. We're -- at this point, we don't know what China's retaliatory tariffs actions will be. To the extent that it touches X-ray tubes, we sell X-ray tubes through 2 channels. One is our OEMs. Those OEMs, they're not going to disappear overnight. Their tubes are engineered into their products so we will -- if tariffs impact those OEM tubes directly, then we will do what we did last year which is go back to the OEMs and get them some kind of an arrangement with them to figure out how to mitigate the impact of tariffs. And what I expect in the short term will be some hit to our gross margin line on those tubes, but we will work those out with our OEM customers.

Then there's the aftermarket tubes which are the much smaller part of our overall business. And there's always a chance that we will see some decline, some waiting. People try to wait it out to either delay the decisions for buying things like that. But at this point, it's speculative. Being engineered into the products of our customers, the cycle time for them to take any action is anywhere between 2 to 3 years, as much as 3 years, I'll say. So we hope that the trade-related issues will get resolved far sooner than then.

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

Just a few thoughts on the tariffs. Just on the $5 million number you called out, how does that relate to the -- is that a price concession going on? I know it's somewhat less last quarter than some -- I don't know whether it be price concessions or less sales. But I know that $5 million number you called out today, was that more price concession -- more or less price concessions or a combination of that and less revenue? Or any color on that?

Sure. The -- it's fundamentally lost business. It's business that -- because I expected when we originally were talking about it that we expected that we would end up with a more -- some mixture thereof and -- but in reality, we've got very little price concessions and mostly that, it was just lost revenue, so less shipments.

So that $5 million, that number was somewhat higher than the Q1 number, right? I don't know if you gave that number.

Yes. It was a little bit lower in Q1. Not [radically], but a little bit lower. Yes.

And what about -- I know the gross margin was sort of in line with your expectations. You [don't guide for the] quarter per se, but -- and then Q1 was perhaps a little bit above. But what sort of just -- and I know it could be dangerous to look at quarters sequentially but just what -- with a little bit of higher revenue base this quarter, it sounds like mix was pretty much -- I don't know if it was an issue but I get the quality, I guess, the quality cost. Is that really the big difference on higher-quality cost even though you actually exited Santa Clara this quarter? Maybe you still have higher cost than you actually did in Q1? Is that fair to say?

Yes. Let me kind of go through that a little bit of detail, okay, Larry, because I think it's worth going through a bit. Because -- I touched on it a little bit with Anthony, but there is the kind of the different elements that go into our gross margin. So product mix being one of them is that, typically, we see a fair amount of variation in product mix. But I would say that the product mix in the quarter was good, just like it was back in Q1. So we continue to have a little higher mix of good-margin products than we did last year. We do have some offset that happens with price erosion where you're just having some price reductions with the high-volume customers, mostly on the detector side, but we had a little bit -- little touch of that on the tube side in the quarter as well.

All in all, those tubes fundamentally offset each other, but the big element that moved the needle in terms of getting a lower gross margin rate in Q2 versus Q1 was the quality cost. That was the biggest factor.

Second biggest factor was higher freight cost. And third is -- well, maybe correspondingly equal is the -- well, the impact of tariffs would have been the same in both quarters. So freight is probably the biggest driver of the second element of it. I was going to say tariffs, but tariffs is more about when you're comparing with prior year.

So you actually saw higher -- sequentially higher freight costs?

We did. I mean some of these are tied to higher volume shipping out the door. But it also was -- just in general, freight costs are more higher.

Right. Right. Okay. And what about -- just on guidance, I know you don't guide quarterly, but a pretty wide range still I think that you started a little bit of a wider range due to a lot of moving parts. We're halfway through the year and maybe you don't want to change guidance, but any thoughts on maybe cadence in Q3, Q4? I think Q3 was not -- it was okay quarter obviously and then Q4, things started to slow down really in the latter part of Q3 and into Q4. So maybe the comps are obviously perhaps getting a little easier as we head out into the last quarter of the year. But any thoughts on that? And what would drive you to the lower end or to the higher end of the range from where you stand today?

Yes. I'm not going to probably answer that last part of that question as far as lower or higher end of the range. But I would tell you this that there is still a fair amount of variation in when we look at what's the balance of the year. There's not a surprising amount of moving parts here. What I just went through on the gross margin line as well as now adding in the impact of Direct which is a new entity that you've got to be a little bit cautious as you look at that and how that gets taken into account in the numbers and their results as well. And then, yes, I mean tariffs by itself is already enough of a moving part in there that I think we have to be cautious, and that's why we still have a fairly broad range.

I would say that when I look at -- compared with a year ago, Q3 was a little light on the revenue side so maybe we have a little bit of an easy comp. But Q3s are typically a bit challenging for us just in that we don't have a big driving factor of somebody's fiscal year-end making it happen and kind of heading into summer season and the like. So it's always a little bit of a wildcard in terms of what the numbers are for Q3. Q4 will be stronger for us just because it's -- we push hard for our fiscal year-end as well as it leads up into people that have calendar year-ends, buying materials in advance for manufacturing and preparation for their year-ends.

Okay. Then just kind of quickies on China, if I may. Just on Sunny's comments, the mix shift or maybe it's not a shift, maybe it's something you expected. But seeing a little bit more lower-priced, it sounds like tubes, is that [unexpected currently] that's hurting you? Will that potentially hurt you guys at all? And then the follow-up is the $300 million sort of replacement market for the tubes that you referred to. Is that a 10-year? Is that sort of like an ultimate or a 10-year target or 5-year, 10-year target? And would you expect yourselves -- and I know there's one other competitor right now who's outsourcing into China. Would it be just you think -- will other guys you think be in that market?

Yes. So let me start with the first one, the mix. So we know that China will buy 25,000 or so over the next 10 years. But in the near term, next couple of years, there's about 3,500-ish CTs that will be purchased. What is -- we assumed in our planning for China that there would be a certain mix of 16-slice, 64-slice high-end CTs. So the mix is not unusual for us. But -- as China starts to buy and the hospitals start to buy CT systems, the mix pattern becomes clear to us. So normally, what happens is you see high-end systems go first and then the low-end systems generally start to trickle down as the rural, small hospitals buy. In a way, this is actually good. But what we're seeing is broad-based volume, so the rural hospitals, the smaller, the lower, also the low-cost 16-slice CT systems are being purchased now.

To me, that's a good sign, an indication that these 3,000 units are going to be bought over the next 2 years. It's front-end loaded versus being back-end loaded. What we like about it ultimately is our goal is get the sockets. We want as many of those CT sockets as possible. And as the replacement market kicks in, the number that I threw out there, approximately $300 million, that's an annual number. We expect that once, let's say fast-forward to 3 years from now, as the number of CT systems in the -- based on the number of the installed CT systems, we're calculating that based on an average life of these tubes that the replacement rate will result in approximately $300 million worth of annual purchases. We expect we'll get our [own fair] share of those tubes with -- it will be shared between us and the majors. The Siemens, Philips, they have their own systems and tubes that they produce. But for the systems certainly that we're penetrating where our tubes are engineered, we expect to get the benefit of those -- that replacement market.

Our next question comes from the line of Mark Strouse of JPMorgan.

Most of our questions are actually have been answered already. But just curious, Sunny, if you can give an update on your top 10 Chinese OEM partners. Any update there since the last call regarding contracts that have been signed or your progress with development cycles, that kind of thing?

Yes. So we are at about 8 contracts signed or 8 customers who have signed purchase agreements for our CT systems. And I kind of remember timing-wise what we said the last time where we were, but we are at about 8 right now with a purchased value of approximately $140 million worth of -- which is the sum total of the pricing agreements. So progress there is very good, which frankly, we're very happy to see a broad-based acceptance of our tubes, and we're making good traction with the OEMs there. And I apologize, I forgot the second part of your question.

Progress.

Progress on the R&D. So look, they're all making -- they're all moving forward. They're all sequentially progressing through their development cycles. It's -- we have not seen any slowdown for any reasons other than normal R&D and clinical trials delays, things that happen or through the process of bringing these kinds of systems to market. So the tariffs haven't played a role in that, neither has anything systemic. So nothing to point to there.

Okay. And then Clarence, in the press release, you kind of mentioned the DC margins or gross margins are higher than the heritage Varex margins. I know it's a relatively small portion of the mix near term. But as that business grows over time, I mean, how should we think about kind of your long-term gross margins? Is there a potential for upside to your -- to the long-term target that you talked about previously if that business can actually grow?

I guess I would describe it as this is one of the elements that helps us achieve that getting back in the range of our goal to be in the 38% to 40% range. And that's -- these are the kinds of things that make a difference. New technologies typically get better gross margins as they mature over the longer period of time. Yes, they come back to more normalized levels, but that's a fair amount of time down the road. And so this is one of those areas where as we continue to invest either through joint ventures, whether it's -- or acquisitions or internally developed technologies, these are all things that are important for us to drive margin accretion at the gross margin line. And I would say that this one is going to be inside the detectors' product portfolio, is where we're going to be counting that and measuring on that internally. And I think that's -- I'm excited about where it will go, but you're -- I think you are right that the size is not big enough yet to move the needle. But they've got a very nice growth trajectory built into their plans, and the fact that they have a very sizable backlog gives me confidence that they will actually execute on that plan.

Our next question comes from the line of Suraj Kalia of Northland Securities.

So Sunny, a lot of the questions have been asked. Let me hone in on Direct Conversion. You guys obviously looked at the landscape and picked Direct Conversion for this hybrid photon-counting technology. I'm curious if there is a pull-through for this technology to your existing DD clients. That would be the first question. The second thing is, and forgive me if you mentioned this on the call, what is Direct's growth rates over last year? I know the $16 million number was given. What do you all expect moving forward?

Yes. So let me start with the first one. So let me just background for why we did this acquisition. Let me take a minute to explain that. So photon counting has been the holy grail of imaging for decades. And the reason for that is you can image -- provide very high resolution, very high-quality images with virtually no noise, so that means you'll need very low dose in order to generate those images. And at the same time, by virtue of the technology, you can do very, very precise material discrimination. So that means you can look at soft tissue, you can look at organs and you can call out the -- very precise the differences between the different soft tissues and so more precise in spotting tumors, et cetera.

That same technology also applies very nicely to industrial imaging and food imaging in the food segment, in oil and gas, a variety of spaces. So that there's -- in terms of its quality, they're second to none [and] the photon counting, it comes out ahead. It had a lot of technological challenges. The materials that are used are -- have been evolving. And the reason we acquired Direct Conversion was that this company has been a leader in commercializing photon-counting detectors. There's -- there are plenty of people researching it, working on it in their R&D bases but actually have commercial products with high $16 million worth of business. We expect about half of that in photon counting, so it gives them a kind of skill, experience, market traction, et cetera.

So as we look at the -- their product portfolio, one of the areas where there will be pull-throughs for us, there are several areas, but one of the areas we expect is in the dental imaging space. There are certain complementary -- by the way, there is no overlap between our detector technologies or detector products. So this is the entirely complementary, complementary technologies, complementary customers, customer base, complementary applications. And so in the dental space, we expect we'll see some pull-throughs. Just like any small companies, Direct has a small channel. We've got a huge footprint so the play for us is to buy, to acquire our way into some of very nice technologies and products that are ready to go and take advantage of our channel and in the future, hopefully, our scale and other benefits that we can bring with our infrastructure. And by the way, we haven't quantified -- we haven't said publicly what those pull-throughs are and what those -- we haven't given much anything about those numbers. Their growth rates -- they are, again, a small company, new products, new technologies. Obviously, we expect to see good growth. Again, we haven't quantified those and disclosed those externally.

One of the key numbers though is $45 million of backlog that they have which is over the next 3, 4 years. So I mean that already gives you a good indication of the opportunity that's there.

Yes. So good opportunity and as we look at their revenue plans, the backlog helps -- gives us the confidence that their -- that they have a book -- nice book of business that they can work through, and it's about execution.

Yes. Sunny, I was really -- the backlog is on a stand-alone de novo basis. I was more curious in terms of the cross-selling where your pull-through of this technology, just to get new customer wins, new sockets or getting some of the -- there, otherwise, you wouldn't have won, but I get your point, and I can appreciate it.

Clarence, maybe you mentioned this, and I was trying to make notes as fast as I can. On a sequential basis, when I look at the gross margins, can you give us the different moving parts? One is the manufacturing delta from Santa Clara. Second is the pricing up and down, how many bps, Direct Conversion and FX exposure. Just kind of help us understand. And as we move into Q3, just kind of walk us through to the extent that you can think about this is moving this direction, this is how we see it playing out. Any color there from a housekeeping perspective would be greatly appreciated. Gentlemen, congrats, and thank you for taking my questions.

Sure. So I'll take a shot at it and do the best I can because that's a fairly complex question in terms of answering detailed movement. Because at the end of the day, we started the year saying we are going to be in the gross margin range of 34% to 35%, and we are still saying we're going to be in the range of 34% to 35%. And at the time when we said that, we already knew what the impact would be from the Santa Clara fab operations that were being closed down where we said a little bit short of about 1 point of gross margin improvement. So we knew that already.

We also then had a pretty good indication or understanding of what our mix of products was at that time. I would say that the mix has pretty well stayed in line with the expectations, maybe a little -- and then at the same -- the other moving part is price erosion which offsets mix in this case. So those are all parts that are, at the end of the day, staying relatively stable to what we expected. I would say that the gross margin impact from Direct is probably not large enough at this point in time to move the needle a lot just because the size and scale of the number is small relative to the overall impact. So I'm not going to give you a specific bps on all of those. I think that's probably a little more challenging than I can do on this call at this point.

(Operator Instructions) Our next question comes from the line of Jim Sidoti of Sidoti & Company.

Can you hear me?

Yes. We got you, Jim.

All right. Great. Just 2 from me. One, did currency have any material impact on the top line or on the gross margin?

No, it did not.

Okay. And two, for Direct, how's the integration going? Have you been able to retain all their salespeople?

I'll take that. We just closed so there hasn't been much time to lapse for us to make much progress with integration. Other than that, let me say there, we still expect their leadership team to stay with us and so their -- and by the way, we've got a good track record of doing that. All the acquisitions we've done, I'm happy to say the entire management team with those acquisitions are with -- still with us, and that's always been the hallmark for how we look at acquisitions. If there isn't a good team, we don't want to do it. In this case, there's a great team. We expect that they will remain with us. We've done the traditional things of giving them offer letters and working through employment agreements with them.

The first steps of integration for us historically always has been on the commercial side. We push to get the sales teams together, we have the product management teams together to discuss product portfolio, figure out what we have to do to take care of customers and that is scheduled within a couple of weeks. And we'll get all our sales teams together and get them to see the -- their technologies, their products. Between signing and closing in that period we have to have hands off. We couldn't get engaged so that -- all that work is beginning now.

So you are planning to -- like your sales guys have a crack at selling these products?

Absolutely. One of the biggest synergies is our channel, and we will - there's 2 parts to it. Direct's products are used in both medical and industrial, and we will make sure that our full-line sales execs have all the Direct products in their portfolio on the medical and industrial side.

At this time, there are no further questions over the audio portion of the conference. I would now like to turn the conference back over to management for closing remarks.

Thank you for your questions and participating in our earnings conference call for the second quarter of fiscal year 2019. A replay of this quarterly conference call will be available from today through May 21 and can be accessed at the company's website or by calling 1 (877) 660-6853 from anywhere in the U.S. or 1 (201) 612-7415 from non-U. S. locations. The replay conference access code is 13690009. Thank you and goodbye.

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