Varex Imaging - Earnings Call - Q2 2025

Executive Summary

• Q2 FY25 delivered a clean beat vs consensus: revenue $213.0M vs $206.8M*, and non-GAAP diluted EPS $0.26 vs $0.14*; gross margin expanded to 36% on volume/mix and productivity gains.
• Management reduced near-term outlook due to China’s 125% retaliatory tariffs; Q3 FY25 guidance: revenue $180–$200M and non-GAAP EPS −$0.05 to $0.10, with gross margin expected at 32–33% and China sales assumption ~$10M.
• Segment performance was balanced: Medical $153.8M (+3% YoY), Industrial $59.1M (+3% YoY); APAC grew +8% YoY on China strength in Q2 before the tariff-induced pause; backlog stood at $316M at quarter end.
• Positive strategic developments: $25M cargo inspection systems orders add to $14M booked last quarter; photon counting progress with leading OEMs; Canon’s Aquilion RISE CT uses Varex tube.
• Capital structure actions: company plans to repay $200M convertible notes at June 2025 maturity; restricted cash of $125M earmarked; net debt leverage ~2.1x TTM adjusted EBITDA.

What Went Well and What Went Wrong

What Went Well

• Margin expansion: non-GAAP gross margin reached 36% (vs 33% YoY) on improved volume, favorable mix, and productivity; CEO: “Higher volumes, improved sales mix and productivity gains drove margin expansion, profitability and cash generation”.
• Balanced segment growth: Medical revenue $153.8M (+3% YoY) and Industrial $59.1M (+3% YoY); modalities including fluoroscopy, oncology, mammography, dental ran above trend; CT stable; industrial demand strong in security screening and aerospace/auto NDT.
• Order wins and product progress: $25M cargo systems orders (in addition to $14M last quarter); photon counting detector integration advancing with multiple OEMs; Canon’s new Aquilion RISE CT features Varex tube.

What Went Wrong

• China tariff shock: 125% tariff on U.S. products led customers to pause deliveries; Q3 impact modeled as ~$20M sales reduction and 150–200 bps GM headwind; EPS effect −$0.15 to −$0.20 in Q3.
• Gross margin tariff sensitivity outside China: inputs sourced globally face tariffs of 10–145%; company is passing tariff dollars to customers but expects 150–200 bps GM impact net of mitigation.
• Radiography softness: radiography was below trend in Q2; APAC strength included China, but China declined 11% sequentially despite +25% YoY, foreshadowing the Q3 pause.

Transcript

Operator (participant)

Welcome to the Varex Q2 fiscal year 2025 call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce you to your host, Chris Belfort, Director of Investor Relations. Thank you, Chris. You may begin.

Chris Belfort (Director of Investor Relations)

Good afternoon and welcome to Varex Imaging Corporation's earnings conference call for the second quarter of fiscal year 2025. With me today are Sunny Sanyal, our President and CEO, and Sam Maheshwari, our CFO. Please note that the live webcast of our conference call includes a supplemental slide presentation that can be accessed at Varex's website at vareximaging.com. The webcast and supplemental slide presentation will be archived on Varex's website. To simplify our discussion, unless otherwise stated, all references to the quarter are for the second quarter of fiscal year 2025. In addition, unless otherwise stated, quarterly comparisons are made year-over-year from the second quarter of fiscal year 2025 to the second quarter of fiscal year 2024. Finally, all references to the year are to the fiscal year and not the calendar year unless otherwise stated.

Please be advised that during this call, we will be making forward-looking statements, which are predictions and projections about future events. These statements are based on current information, expectations, and assumptions that are subject to risk and uncertainty that could cause actual results to differ materially from those anticipated. Risks relating to our business are described in our quarterly earnings release and our filings with the SEC. 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 on Form 10-Q and our annual report on Form 10-K. 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. On today's call, we will discuss certain non-GAAP financial measures.

These non-GAAP measures are not presented in accordance with, nor are they a substitute for GAAP financial measures. We provided a reconciliation of each non-GAAP financial measure to the most directly comparable GAAP financial measure in our earnings press release, which is posted on our website. With that, I will now turn the call over to Sunny.

Sunny Sanyal (President and CEO)

Thank you, Chris. Good afternoon, everyone, and thank you for joining us for our second quarter earnings call. We continue to see strong demand in the second quarter, which resulted in revenue near the high end of our expectations. Both the medical and industrial segment delivered year-over-year revenue growth as we continued to see solid order coverage during the quarter. Gross margin of 36% in the quarter was higher than anticipated. This was primarily the result of improved volume, favorable product sales mix, and productivity gains in both segments. Cash generation was strong, with cash from operations of $17 million in the quarter. This was driven by improved profitability and continued solid working capital management. Turning to the second quarter results, total revenue in both medical and industrial segments were up 3% year-over-year, respectively. Non-GAAP gross margin was 36%, up from 33% in the same quarter last year.

Adjusted EBITDA and non-GAAP EPS in the second quarter were $34.26 compared to $25.16 last year, respectively. We ended the second quarter with $226 million worth of cash, cash equivalents, and marketable securities on the balance sheet, up $13 million compared to fiscal 2024 year-end and up $36 million year-over-year. In addition, we also have $125 million of restricted cash raised from our senior secured debt offering in December. As noted in our press release earlier today, we plan to use this restricted cash and other cash on hand to repay the outstanding principal of our convertible notes upon maturity in June. Let me give you some highlights of sales detail by modality in the quarter compared to a five-quarter average, which we will refer to as the sales trend.

Across both medical tubes and detectors, we continued to see strong demand in the quarter with improved mix, which drove increased profitability. Sales in our medical segment were up in the quarter, led by solid global sales of CT tubes, which were in line with their sales trend. Sales in fluoroscopy, oncology, mammography, and dental modalities were all above their respective sales trends in the quarter. Radiography was below its sales trend in the quarter. Our industrial segment continued to see strong demand. Strength in global security screening drove the sales of cargo inspection components as well as security inspection systems. We continued to see increased demand for checked baggage inspection and cargo screening at airports, as well as non-destructive inspection in verticals such as aerospace and automotive. This demand drove growth in our industrial X-ray tube components product line, which continued to grow.

Now, let me switch gears to talk about how the current tariff environment is impacting Varex. Let me also remind you that it is a very dynamic environment, and our discussion today relates to the current tariff rates. The most pronounced impact of the tariffs for Varex as of today is due to the bilateral tariffs between the U.S. and China. First, on the sales front, we currently expect that the 125% tariff imposed by China on the U.S. products could negatively impact sales by about $20 million in the third quarter. This is primarily due to a pause in purchases by some of our China-based customers.

Our customers typically maintain some level of inventory of our components, and some customers appear to be pushing back deliveries to buy some time to see if there could be an improvement in the tariff rates or if exemptions might become available to them. Separately, we are actively working on implementing a number of options that could reduce the impact for our customers in the near term, including pursuing commonly utilized mitigation practices and localizing more manufacturing activity in the region. Second, on the cost side, raw materials and components sourced from global suppliers can include tariffs ranging from 10%-145%. On an annual basis, materials imported into the U.S. from China represent approximately 3% of total cost of goods sold, and roughly 17% of cost of goods sold is imported from the rest of the world.

Our mitigation actions include passing the tariff charges to our customers, redirecting material purchases to suppliers in lower tariff countries, shifting manufacturing closer to the region of consumption, and localizing supply chain where possible. We expect the impact on our gross margins net of the mitigation efforts to be in the 150-200 basis point range on a go-forward basis. Separately, you may have seen reports that the China Ministry of Commerce recently initiated two investigations of medical products imported into China. One investigation relates to the impact of imports of X-ray tubes on the domestic industry and its competitiveness, and the other investigation relates to alleged sales in China of medical CT X-ray tubes and tube inserts made in the U.S. and India at prices that are less than what they are sold for in the home countries.

We produce X-ray tubes for CTs in the United States, but not in India. We intend to cooperate with the investigation. Moving to some product highlights. In medical, I'm happy to note that our largest customer, Canon Medical Systems, introduced in Japan last month at the International Technical Exhibition of Medical Imaging Trade Show in Yokohama, a very innovative new CT system called Aquilion Rise, which uses a CT tube made by Varex. Aquilion Rise is a whole-body CT scanner and the first of its kind to be able to image a patient in multiple positions, from lying down to sitting to standing vertically, enabling detection of lesions that may not be visible in a lying-down position. This type of operation requires immense mechanical sophistication, and Varex's tubes have demonstrated the ability to perform under high-g forces while rotating at different angles.

We are proud of our partnership with Canon and our continued collaboration on new products. In photon counting, as mentioned previously, we continue to be actively engaged with large imaging OEMs to integrate our photon counting detector technology in their next-generation CT systems. We have two OEMs who are active in their R&D process and others in our pipeline who are evaluating our technology. With photon counting, we have moved past the technology invention part of our development process, and now we are in our typical new platform introduction process with our OEMs, who in turn are in different stages of their new systems development. This week at the Control Trade Show in Stuttgart, Germany, which is one of the largest industrial non-destructive inspection technology conferences in the world, we are prominently showcasing our photon counting technologies for industrial imaging.

A key offering is a product called Thor, which is a linear array detector for high-speed 3D imaging and inspection at the speed of production. This product is also suitable for certain medical imaging applications. I'm happy to say that we are continuing to make forward progress with driving adoption of photon counting and expect it to be a future growth driver for Varex. In our industrial segment, where cargo systems is a key focus, today we announced a new order worth $25 million to provide cargo inspection systems. This order is from an international customer for portal systems that will be used to secure sea and land ports. This order is in addition to the $14 million of orders that we announced last quarter from other international customers. As is typical for these orders, they are expected to be installed over the next 12-18 months.

Two to three years after installing these systems, we expect to see an ongoing service revenue stream from these customers. We are seeing good traction with our offerings and continue to engage with many customers and prospects regarding new systems opportunities. In summary, we're pleased with our solid first-half performance and, with the exception of China, encouraged by the demand trends across our business. While there are headwinds from the current tariff situation, we are partnering with our suppliers and customers to find ways to mitigate the impacts. Considering the mitigation efforts that we have in flight at this point, particularly in China, we're not planning any restructuring in our China business. Also, our customers have not canceled any orders in our $316 million backlog at quarter end. In addition, we remain committed to paying down our convertible debt next month.

We will stay close to the evolving geopolitical situation and adjust our mitigation plans as necessary. We intend to continue to execute on our long-range growth strategies that are based on innovation and cost leadership, and in parallel, continue to invest in our regional manufacturing operations and supply chain capabilities. I'd like to thank all our employees globally for their hard work and commitment in working through this challenging environment. With that, let me hand over the call to Sam.

Sam Maheshwari (CFO)

Thanks, Sunny, and hello, everyone. Turning to the results for the quarter, our revenues in the second quarter were $213 million, above the midpoint of our guidance. Non-GAAP gross margin was 36%, and non-GAAP EPS was 26 cents, both above our expectations. Comparing the second quarter to the same period in fiscal 2024, revenues increased 3%. This increase was driven by a 3% increase in both our medical and industrial segments. Medical revenues were $154 million, and industrial revenues were $59 million. Medical revenues constituted 72% of total, and industrial revenues were 28% of our total revenue for the quarter. Analyzing revenues by region, America saw an increase of 2% compared to the second quarter of fiscal 2024. EMEA revenues were flat, while APAC increased 8% due primarily to increased sales in China. During the quarter, China sales were 15% of total sales.

China sales increased 25% year-over-year and declined 11% compared to the prior quarter. Let me now cover our results on a GAAP basis. Second quarter gross margin was 36%, up approximately 400 basis points year-over-year. Operating expenses were $55 million, a decrease of $3 million compared to the second quarter of fiscal 2024. Operating income was $22 million, an increase of $14 million from Q2 of fiscal 2024. Net earnings were $7 million, and GAAP EPS was $0.07 per share based on fully diluted 51 million shares. Now moving on to the non-GAAP results for the quarter. Gross margin was 36%, an increase of 350 basis points year-over-year, primarily due to increased volume, favorable product sales mix, and productivity gains in both the segments. This was particularly the case in our medical segment, which posted a record gross margin in the quarter.

R&D spending in the second quarter was $22 million, a decrease of approximately $1 million compared to the second quarter of fiscal 2024, and representing 10% of revenues. Of note, R&D in the second quarter of fiscal 2024 included a $1 million milestone payment for the transfer of technology from Micro-X. SG&A expense was $29 million, a decrease of $3 million compared to the second quarter of fiscal 2024, and representing 14% of revenues. The decrease in SG&A was primarily due to a decrease in expenses associated with one of our joint ventures. Consequently, operating expenses totaled $51 million, a decrease of $3 million, and representing 24% of revenues. Operating income was $26 million, an increase of $13 million compared to the previous year, and operating margin was 12% of revenue, up from 6% in the second quarter of fiscal 2024.

Tax expense in the second quarter was $3 million, or 21% of pre-tax income, compared to $2 million, or 19% in the second quarter of fiscal 2024. Net earnings were $12 million, or 26 cents per diluted share, compared to 16 cents in the year-ago quarter. Average diluted shares for the quarter on a non-GAAP basis were 51 million. Now turning to the balance sheet. Accounts receivable increased by $8 million, and day sales outstanding declined by 6 days-62 days in the quarter. The increase in accounts receivable was largely related to the higher sales in the quarter. Inventory increased by $5 million in the second quarter, and days of inventory decreased by 19 days-190 days. The increase in inventory was primarily due to a build-up prior to the tariffs. Accounts payable increased by $5 million, and days payable decreased by 2 days-47 days.

Now moving to debt and cash flow information. Net cash flow from operations was $17 million. We ended the quarter with cash, cash equivalents, and marketable securities of $226 million, up $36 million compared to the second quarter of the prior year, and up $7 million compared to the first quarter of 2025. The $226 million includes $205 million of cash and cash equivalents, and $21 million of marketable securities. In addition to $226 million of cash, we also have $125 million of restricted cash raised through our senior secured add-on debt offering, which is currently held in a restricted account earmarked for paying down our convertible notes. As mentioned previously, we plan to repay the outstanding principal of $200 million of our convertible notes upon maturity in June.

We are pleased to be able to pay off the convertible notes, which will reduce our overall debt burden and simplify our capital structure. Gross debt outstanding at the end of the quarter was $570 million, and debt net of $226 million of cash and marketable securities, and $125 million of restricted cash was $219 million. Adjusted EBITDA for the quarter was $34 million, or 16% of sales. Our trailing 12 months adjusted EBITDA was $103 million, and our net debt leverage ratio was approximately 2.1 times adjusted EBITDA on a trailing 12-month basis. Now moving on to outlook for the third quarter. Under the current tariff environment, we see sales impact of roughly $20 million in China and gross margin impact of 150-200 basis points driven by increase in cost of goods sold, net of price increases to customers.

In total, the lower sales and gross margin impact could result in an approximately 15-20 cents reduction of EPS in the third quarter. With that as a backdrop, our guidance for the third quarter is as follows. Revenues are expected between $180 and $200 million, and we are assuming that sales in China are approximately $10 million for the third quarter. Non-GAAP earnings per diluted share are expected between a 5 cents loss and 10 cents of profit. Our expectations are based on a non-GAAP gross margin of 32%-33%, and these figures include 150 basis points impact from tariff-related costs. Non-GAAP operating expenses are expected approximately $51 million, interest and other expenses on a net basis in a range of $9 million-$10 million, tax rate of about 25% for the third quarter, and non-GAAP diluted share count of about 41 million shares.

With that, we'll now open the call for your questions.

Operator (participant)

Thank you. We will now. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please, while we poll for questions. Thank you. Our first question comes from the line of Young Li with Jefferies. Please proceed.

Young Li (Senior VP and Equity Research Analyst)

All right, great. Thanks so much for taking the question. I guess to start, first on China, it's good to see that despite the really high tariff rates, some customers are still placing orders. I was wondering if you can talk a little bit about the types of orders that are still coming in, and then for the ones that paused purchases, have they given any indication for what they'll need to see before resuming purchasing? Zooming out, any updates on potential stimulus in China as well as medical exemptions?

Sunny Sanyal (President and CEO)

Hey, Young, this is Sunny. Thanks for the question. The first one regarding orders in China, there is not the mix of orders that we have seen continue to be similar to what we have seen in other quarters. The key difference is that for some of the more expensive tubes, particularly the ones that are shipped directly from the U.S., that is where we saw the pause. We have orders. Good news is all the things we said previously, that is the audit was over, and it would start, the buying would begin again. We had also said that destocking was over. Those things pretty much panned out the way we had laid it out. In the first two quarters, we saw upticks in order, and the order intake rate was good.

The pause that I talked about is mainly when a customer, I'll just give an illustrative example. If a customer placed an order for 300 tubes, they said, "Look, here's an order. It's with a firm PO, but in terms of delivery dates, give me the first 100. Hold off on the next 200 until I figure out what's going on." That is sort of the drift of what we meant by the pause. They need those tubes. The X-ray tubes are used for new systems as well as for replacements, so they need them. That is the backdrop here. We make certain products in China as well. Some of our tubes are made in China, and some of our detectors are also made in China. We also sell industrial X-ray tubes and detectors in China.

We continue to see sort of the same profile of orders, but the deliveries were lower, and some of the industrial order volume was slightly lower.

Sam Maheshwari (CFO)

One thing I can add there, Yong, for you is that, as you know, we provide some of our products from Netherlands or Philippines or countries outside of the U.S. Business from those countries into China is continuing as it is. The business from U.S. into China, as Sunny mentioned, is on pause, and the customers are trying to see—they're trying to buy some time here and exhausting their inventory right now because they're hoping maybe there is a trade deal or maybe some other situation changes that makes it a little bit more affordable for them.

At the same time, we are also pursuing a number of strategies, operational strategies, in which we may be able to mitigate the impact of tariff for our customers in China, particularly a number of commonly used operational practices like a bonded warehouse or a free trade zone or stuff like that. We are working on it at a very fast and active pace right now. That is not completed, but we are very hopeful that we are able to complete it by the end of Q3. Right now, we feel that we may be able, either through external environment change on the tariff and trade situation or through our own individual strategies, we may be able to mitigate the impact of tariff for our customers in China.

That is also causing a little bit of a pause for the time being, and we are hopeful of that. Besides that, we are pursuing a few other strategies, and we can talk about it, but that is specifically what is going on in China and related to the pause of buying of our product by our customers in China. Back to you, Sunny.

Sunny Sanyal (President and CEO)

Yeah. Your second question, Yong, was about, have we seen anything more with stimulus, any more demand being driven by stimulus? We have not. Yeah, we have not. At this point, given everything else that is going on, it is very difficult to tease apart what is impacting what. I frankly cannot give you any insight into whether the stimulus is working or not, anything beyond what we have said before, which is we have not seen any direct correlation.

Young Li (Senior VP and Equity Research Analyst)

Okay. Understood. I really appreciate the detailed thoughts. Understanding it's a very dynamic environment. In fact, tariffs might be changing next week on China, so who knows? My follow-up here is just on the $25 million cargo inspection order. It's a pretty big number. Last quarter, I think you had $14 million. I think last quarter, you said the $14 million takes around a year to turn to revenue. This one said 12-18 months. I wanted to get a little bit of understanding about your capacity to deliver, especially if you expect to get more of these types of deals in subsequent quarters. I just wanted to hear your thoughts about the trajectory of these types of orders going forward.

Sunny Sanyal (President and CEO)

Yeah. At this point, first of all, we're really excited that we've been getting good traction. We have been bidding on, since we launched these offerings, we've been actively bidding on tenders. As these start to get into the sales process, we're happy to see that we're able to be successful in these deals. In terms of what it takes to deliver, our lead times, first of all, we have our lead times, so what we need to do to build a product. For us, those lead times are typically 120-180 days. However, these systems typically involve civil works, construction at the local site, depending on the product. If it's a portal, if it's a gantry, then there's construction involved. If it's a mobile, then there's really no construction.

But invariably, when someone sets up this type of scanning, they have to make some changes to roadways and redirect traffic and those kinds of things. A large part of the lead time is due to civil works and construction work. That is the point. Depending on the profile of the projects, if there is less construction and we are adding more portals, then it can go in sooner versus sometimes it can take a little longer. That is why our general statement about 12-18 months. If it is mobile systems, then it is only our lead times, and it is the lead times for what it takes to order the trucks and the equipment. You should expect that the delivery times will be in that range. The order that we received last quarter, we have begun shipping against those. We have got products built.

We shipped some. We're waiting for export licenses for the others. They're all packed, ready to go. From our side, at this point, with the volume of orders we've taken, manufacturing is not a rate-limiting factor. It's mostly everything else around us, from getting the export licenses lined up, getting the construction completed, and then injecting ourselves in that process. By the way, we don't do the construction work. We have local partners that handle all of the civil works.

Young Li (Senior VP and Equity Research Analyst)

Okay. Understood. Thank you so much.

Sunny Sanyal (President and CEO)

Thank you, Young Li.

Operator (participant)

Thank you. Our next question comes from the line of Larry Solow with CJS Securities. Please proceed.

Larry Solow (Managing Director and Equity Analyst)

Great. Good afternoon. I joined the call a little late, so I just want a little clarity on that. So the tariffs, the $20 million in revenue, just to clarify, is not the predominant revenue driver in China tubes? I know there is a little bit of, I guess, a little remaining detectors and some industrial detectors, but I thought when we had the last round of tariffs, you got out of most of the—or yeah, I thought you got out of most of the stuff, excluding the tubes. Is that directionally correct?

Sunny Sanyal (President and CEO)

A majority of our revenue in China is from tubes, and that is really CT tubes.

Larry Solow (Managing Director and Equity Analyst)

Okay. So these customers—go ahead. I'm sorry.

Sunny Sanyal (President and CEO)

No, go ahead, Larry. Go ahead.

Larry Solow (Managing Director and Equity Analyst)

No, I was just going to say, because I thought those tube customers really do not have a—at least in the short term, do not really have a choice. Maybe they do not, and they are just not—they are not always—does not find the ordering from a competitor, but they are just delaying for the inevitable, or they are hoping something will be resolved before they have to buy again. If there is no resolution to the tariffs, let us say, in six months from now or what have you, and nothing has changed, and they need replacement tubes, never mind growth and new machines, which I thought you would get that too. On the replacement side, do not they have to come to you, right? Or is there an opportunity to—can you actually lose share?

Sunny Sanyal (President and CEO)

On the high-end CT tubes, Larry, that is correct. They'll have to come to us, at least in the foreseeable future and the near term. What's happening currently is—I don't know if you missed this part in my script.

Larry Solow (Managing Director and Equity Analyst)

Yeah, I did.

Sunny Sanyal (President and CEO)

The customers, even though they've placed orders, they put a pause because they're trying different things on their end as well. First of all, most of our customers carry a certain amount of inventory. They carry anywhere between 60-90 days' worth of inventory. They can bleed that down for some time while they're biding time to see if they're—they're also lobbying their local governments for exemptions. They're also trying to figure out, working with us to figure out how alternate ways of getting products to them might work. As you know, we're able to make certain tubes in China and get made-in-China designation for them. When we do that, we ship parts. Those parts have lower value, and they come into the country with—even though the tariff rate is the same, the tariff exposure is lower.

Some of the tubes that we do not make there, we are now also accelerating the process of making there. Our customers have many choices. They know that we have given them roadmaps, and they know some of these are coming. On top of that, as they look at the trade discussions that are all the buzz around what might be happening, what could be happening, they are all waiting to see if time is—they feel like time is on their side. They would rather, if they can pause and delay a little bit, they are better off doing that. They are buying what they absolutely need, and that is what they are doing right now. Absolutely need as in if they have depleted their inventory, field inventory, then they need to replenish that. That is what they are doing. If they have inventory, they are just holding off.

Now, we haven't stopped producing since we have frame orders from them. We haven't stopped producing, so we will make those. When they ask for give us shipment dates, we will resume shipments.

Larry Solow (Managing Director and Equity Analyst)

It does not sound like the China revenue is basically essentially going from approximately 15% to about 5%, if everything else was all else equal, plus or minus. It does not feel like that reduction of two-thirds of China revenue sounds like some of it, you think it is temporary, or a lot of it will come back because of several different reasons, right? Whether it be customers are just delaying for eventually, they have to come to you, or some of these mitigation efforts on your behalf, I guess, right?

Sunny Sanyal (President and CEO)

Yeah. That's correct, Larry, in the sense that the Q3 impact, we are viewing it as temporary, and it's clearly temporary. We are continuing on our side a number of initiatives. There can be a number of initiatives on our side, as well as there might be a beneficial macro environment that might happen, which may reduce the burden for the customer. We are clearly expecting this two-thirds loss of revenue in China as temporary. I believe, hopefully, by the time Q4 begins around, we are able to recover this. Clearly, modeling Q3 as the basis for next four quarters, we would—I would think that that would be a mistake at this point.

Larry Solow (Managing Director and Equity Analyst)

Sure. I mean, is there an opportunity without trade resolution that a year from now, this will be an impact, but maybe not? It is certainly not as significant, but do you think it could still be—do you think you could actually mitigate the majority of it?

Sunny Sanyal (President and CEO)

That's the direction we are working towards. That's the direction we are working towards through operational strategies like localizing more, qualifying more local supply chain as well as local manufacturing. On top of that, we are also working on bonded warehouse or free trade zone type of a situation. We are working on all of these. Our focus is to essentially mitigate a lot of this for our China customers. Other than tariff, there is no issue. China was recovering very well for us. You can see in this last quarter, compared to a year ago quarter, China recovered very well for us. The demand was there, is there. It's just that different customers are trying different things to just kind of get away from this, what we are calling a temporary burden.

We are very actively pursuing a few strategies to reduce this burden, mostly based on our own efforts and with the help of our customers working with us.

Larry Solow (Managing Director and Equity Analyst)

Okay. And then just as an aside, there was this—I am sure you guys saw this anti-dumping story in the media a few weeks back related to China and tubes and stuff. That does not seem to have had any impact, or can you comment on that at all?

Sunny Sanyal (President and CEO)

That investigation has not had an impact on our sales side in China. That investigation, there are two parts to it. One is a general industry investigation of competitiveness, market competitiveness of X-ray tubes and how foreign-made, U.S. and India-made tubes by everyone is impacting the local industry. That is one part of the investigation. By the way, this investigation is going to continue somewhere between 12 and 18 months. Initially, they announced 12 months, but it can take 18 months. This will be ongoing. The second one is pricing related, which is the allegation that was made by one of the startup-type companies, that some tubes that are made in India and the United States are being sold at prices—the word dumping implies that it is being sold at prices lower than what they sell for in their home countries. In the home countries.

We do not make tubes in India. We make tubes in the U.S.

Larry Solow (Managing Director and Equity Analyst)

It can't be you.

Sunny Sanyal (President and CEO)

We make CT tubes in the U.S., but the vast majority of our CT OEM customers are outside the U.S. Anyway, we are named in it, so we're collaborating, and we will—I mean, definitely, we will comply.

Larry Solow (Managing Director and Equity Analyst)

Okay. No, that all makes sense. Okay. Last question, I guess. I know a lot's been made on China, but of course, it's only like 15% of your business. I guess when it goes down, just dramatically. How's just overall trends outside of China? OEM trends, I know we're improving. I don't know if you touched on that in the beginning of the call that I missed, but unfortunately, it looks like it's, at least in the short term, going to get overshadowed. The thing is continuing to sort of improve outside of China. Is there any other tariff impact you expect other than this that you talked about?

Sunny Sanyal (President and CEO)

No, in this phase, there's a pause. What we saw in Q2 was that there was broad-based strength, both in medical and industrial. Then we saw many modalities which had been either down or flattished previously: oncology, fluoroscopy. They were recovering. We saw a positive effect. That was driven by demand. Our orders into—look, while the backlog has grown, as you know, it's not necessarily an indicator of strength for us. We look at the order intake rate. Throughout Q1 and Q2, we saw order intake rates going up. Industrial remained strong. It continued to be strong, and we saw a lot of new orders. At this point, it comes down to it's really China for us at this point.

Larry Solow (Managing Director and Equity Analyst)

That's fair. Okay. All right. At least hopefully, we can get some resolution there, and things—sounds like you do have a lot of positives too, so. All right. I'll leave it at that. I appreciate it. Thanks.

Sunny Sanyal (President and CEO)

Thank you.

Thank you, Larry.

Operator (participant)

Thank you. Our next question comes from the line of Suraj Kalia with Oppenheimer. Please proceed.

Seamus Contorno (Analyst)

Hi, Sunny and Sam. This is Seamus on for Suraj. Congrats on a strong quarter.

Sunny Sanyal (President and CEO)

Thank you.

Seamus Contorno (Analyst)

Thanks. I guess to start, obviously, all the focus is on China, and you guys are trying to mitigate supply chains and whatnot. Any updates you can give on the India plant? I guess, is there any chance that you guys could accelerate some spend to kind of get that up and running sooner and kind of utilize that pathway to mitigate some of these tariff impacts?

Sunny Sanyal (President and CEO)

Yes. Our India activities and projects, they are proceeding as per our plan. You are absolutely right, Seamus, that we are looking at that operational flexibility in the factories that we are bringing up there, that we can accelerate some of that to help mitigate some of these tariff-related situations. We are also accelerating qualifying suppliers from India so that can also help us in terms of reducing our cost of procurement as well as localizing more over there. Definitely a tool in the toolkit, so to say here, and puts us in a better place from a regionalization and tariff mitigation perspective.

Seamus Contorno (Analyst)

Got it. Appreciate that. Just kind of piggybacking slightly on a previous question, I guess, can you kind of speak to the current environment you're seeing, like the trends you're starting to see in the sell in April and obviously the beginning of May? I guess kind of putting some things together, you guys noted a 150-200 basis point impact to your gross margin because of tariffs. Are you guys passing on costs to customers due to the increased cost of goods sold? Are you seeing any customer wariness because of that? Are they accepting prices? Just anything you can talk to there would be much appreciated. Thank you for taking our question.

Sunny Sanyal (President and CEO)

Yes. Our plan is to pass along the tariff costs to our customers as tariff charges or price hikes, as any which way you want to—one may say. That is our plan. We have been working on it in terms of figuring all of that out through our ERP system and everything else. We have started to charge our customers already for the tariffs that we are experiencing in the last week or so. Essentially, that is our strategy, to pass tariff dollars to our customers. One thing I would say is that our plan is to not do markups on the tariff. We are basically looking at tariff dollars and then charge it to our customers, charge the customers what we pay in terms of tariffs. We are working with our customers.

With some of our large customers, we are having a back-and-forth type of a discussion as we speak. That is our strategy in terms of passing the tariffs to our customers.

Seamus Contorno (Analyst)

Thank you.

Sunny Sanyal (President and CEO)

Thanks.

Operator (participant)

Thank you. Our next question comes from Jim Sudati with Sudati & Company. Please proceed.

Alex De Souza (Coordinator)

Hey, guys. This is Alex on for Jim. Thanks for taking questions. Yeah, sorry. I don't have Jim in the slide, but.

Yeah.

I know we've covered China and the tariffs fairly well. I just had one quick follow-up on the industrials business. Is there an impact to tariffs that you're anticipating? I know it's smaller than the medical business in China.

Sunny Sanyal (President and CEO)

Yes, there is definitely an impact of tariffs on industrial business also. In the industrial business, we sell industrial detectors, industrial tubes, linear accelerators, and of course, we talked about cargo systems. In all of those products and in their production and raw material sourcing, something or the other that we are buying from vendors outside of the United States. There is an impact of that in terms of cost side of the equation. Our sales of our industrial products into China is very, very small. The China tariffs onto U.S. goods is not at all a major area of discussion for us. On the cost side, product coming in from Germany, Austria, U.K., etc., coming into the U.S. is definitely there, and it increases our costs. There also, our plan is to pass costs related to these tariffs to our customers.

Alex De Souza (Coordinator)

Great. Thank you for the context. Are you hearing anything? You have mentioned some of the local lobbying efforts. Do you think that is more likely to result in exemptions on the medical side or no sort of preferences on either side yet?

Sunny Sanyal (President and CEO)

No, it's to be determined. Our customers in China don't have an indication whether they will get exemptions or not. There have been exemptions given to several different industries and categories of products. Unlike in the U.S., where it's openly announced, I think these are kind of more subtle. At this point in time, the X-ray CT products are not in that list yet. Our customers, they've received exemptions in the past, and they're certainly going to try. They're doing that.

Alex De Souza (Coordinator)

Understood. One more from us. I know you spoke about using cash towards those convertible notes. Could you talk a little bit about how you anticipate annual net interest expense falling out after paying down those notes?

Sunny Sanyal (President and CEO)

Sure. So annual interest expense, once the convertible notes are paid out, they are going to be in the $29 million range, $29 million-$30 million on a go-forward annualized basis interest expense. Our debt would be close to $370 million once we pay down the convertible notes.

Alex De Souza (Coordinator)

Great. Thank you again for taking questions.

Sunny Sanyal (President and CEO)

Thanks, Alex.

Operator (participant)

Thank you. Our next question comes from the line of Anderson and Shuk with B. Riley Securities. Please proceed.

Brandon Carney (Senior Research Associate)

Hi. This is Brandon Carney for Anderson. Thanks for taking our questions. I just wanted to know, if we get any near-term relief on the tariffs, would you expect that to have an immediate impact on your China outlook, or would that take some time to ramp back up?

Sunny Sanyal (President and CEO)

I think we should see if it is near-term, as in gives us enough time in the quarter to get product back to customers, we could see some pretty immediate pull-in, so to say. That is why I made a comment earlier. We have not stopped production. Production is moving on. We are making sure that we are preparing ourselves to be able to pivot. Now, if that happens the last two weeks of the quarter, then we will be out of luck. If it happens, let's say, in the next two weeks, and that still gives us all of June, we will be able to pull some in. We have lost a month, right? That is hard to recover from.

Brandon Carney (Senior Research Associate)

Right. Okay. It sounds to me like just given the assumption that the current levels stay where they're at, the mitigations kind of come into play in the next few quarters, and you expect to ramp up anyway off of that $10 million number. Wondering how the cadence on that's going to be. Is it going to be more towards the back half of the fiscal year, or is it going to be more evenly spaced, the recovery there?

Sunny Sanyal (President and CEO)

Brendon, there are two things. There are two ways to answer your question. One is based on our own efforts in which we are making some operational strategies so that the tariff burden on the customer in China is minimized. If we are successful in terms of executing as per our plan, then we are expecting that to be completed by the end of Q3. Obviously, there are still some steps to do, and not everything can be pinpointed with 100% accuracy in terms of looking into the future here, but there can be some plus-minus in terms of a few weeks on that window. That is what we are working on. If such a thing happens, and provided there is no other impact on the macro side in China or anywhere else, then we should see recovery starting from Q4.

That is one way to look at it. The other way to look at it is that we are not successful, and then we are trying some other strategies. We have a plan A and a plan B. In our plan B, it might take into the following quarter. That way, that strategy may play out in that regard. While we are talking all of the strategies that we are pursuing, the broader world keeps on moving, right, in terms of the macro situation, etc. It is hard to pinpoint, but hopefully, this color gives you an idea about how we are going about it.

Brandon Carney (Senior Research Associate)

All right. That's very helpful. Thanks. Maybe just turning again to the inspection business, it's great to see the $25 million order this quarter. I think you mentioned in the past that you expect that business to be margin accretive once it gets to $10 million-$15 million per quarter. With the $14 million last quarter and the $25 million this quarter, do you have any update on timelines and when you expect to reach that $10-$15 million level?

Sunny Sanyal (President and CEO)

I just want to highlight that those are orders. For example, the $25 million is related to a number of machines or a number of units. These units are going to ship at some sort of a cadence, call it one unit a quarter, two units a quarter. There is also a lead time before we begin to ship them. There is still some time in the sense we may begin to see, say, in the coming quarter, $1 million of revenue from it, and in the following quarter, $2 million or $3 million of revenue from it, even though the backlog would say $25 million and $14 million or so, say, is close to $40 million in backlog. It is going to take its time.

The margin accretiveness of that business comes into play when a sufficient number of machines have shipped, and they have been in the field for 18 months or so, so that they go from warranty into what we call service contract or billable service or time and material service. We are still quite some time away from that side of the business becoming margin accretive. I would say we are at least two years away.

Brandon Carney (Senior Research Associate)

Gotcha. Thanks. That's helpful. Yeah. Thanks for taking our question.

Sunny Sanyal (President and CEO)

Thank you, Brandon.

Brandon Carney (Senior Research Associate)

Thank you.

Operator (participant)

Thank you. Our next question comes from the line of Faruk Prasad with Marshall Wave. Please proceed.

Faruk Prasad (Senior Credit Analyst)

Hey, guys. Thank you for taking my question. Three questions I have. The 150-250 basis points gross margin impact that you talked about, how much of that is from countries excluding China, and how much is China? I'm just trying to figure out if China tariffs go down to 50% next week or something like that, and other countries over time go up to 20%. Does your gross margin impact go up or down?

Sunny Sanyal (President and CEO)

Sure. I do not have that math right away, but you can get to that math. We said that 17% of our cost of goods sold comes from vendors outside of the U.S. ex-China, and 3% of cost of goods comes from vendors in China into the U.S. You can do that math. The second piece, the piece that we did talk about, but mostly in a qualitative manner, is that we are planning to pass the tariff increases that we receive from our vendors in terms of import duties that we pay to the government here to pass it on to the customers. In one way, we are not marking up the tariffs, but we are planning to charge the tariff dollars from our suppliers or from our importation basis over to our customers. Because there is no markup, there is an impact on gross margin.

I know I'm giving you some math, not the 100% math, but this is what we are able to share at this point.

Faruk Prasad (Senior Credit Analyst)

Oh, that's very helpful. That kind of gives me my answer that the ex-China tariffs are more important for your gross margin impact than the China tariffs. The orders that obviously are paused at this moment and on the retaliatory tariffs, assuming that there are some element of retaliatory tariffs that remain, let's just say 50% instead of 125%, how will that be shared between your Chinese customer and you, or should we be thinking about a similar sort of absorption on your end as you are thinking on the U.S. side?

Sunny Sanyal (President and CEO)

From an economic perspective, that obviously reduces the burden on our customers as the tariff rate by China onto the U.S. products reduces. Because this is mostly a theoretical question at this point, we do not have a very specific answer. I would just say broadly that our cadence and our position right now with all of our customers is that we are going to pass the tariffs on to our customers to the best of our ability. Right now, we are targeting to pass near all of the tariffs to our customers. In your question, there will be a point at which it would not make sense for our customers to pay that type of tariff and buy our products. In that situation, sales might get impacted, and we are cognizant of that.

That is why we are trying to localize manufacturing and come up with manufacturing strategies that we significantly, significantly reduce the tariff burden on our customers so that they can pay these tariff dollars to us so that we are unimpacted and the impact on our customers is minuscule or small or something that they can absorb quite easily.

Faruk Prasad (Senior Credit Analyst)

Got it. Okay.

Sunny Sanyal (President and CEO)

That's our thought process, at least at this time. Yeah.

Faruk Prasad (Senior Credit Analyst)

Got it. My last question. You disclose in the 10-Q that the X-ray tube sales into China are roughly 10% of your sales, on which obviously there is that MAVCOM investigation. Is that 10% all of that coming from the U.S.? Is that right?

Sunny Sanyal (President and CEO)

Our sales to China as a company are about 15% to 17%. Tubes are not all tubes and we sell detectors and tubes and a few other industrial products into China. Roughly, what we sell from the U.S. into China and then what we produce in China and other countries in the world into China is 50/50. U.S. into China is 50% of our overall China sales. I would say roughly 40% is made in China and 10% is from Europe or Philippines or whatnot into China.

Faruk Prasad (Senior Credit Analyst)

Got it. Okay.

Sunny Sanyal (President and CEO)

Okay.

Faruk Prasad (Senior Credit Analyst)

This was very helpful. Thank you very much.

Sunny Sanyal (President and CEO)

Thank you.

Just for the top of the hour.

Operator (participant)

Thank you. There are no further questions at this time. I'd like to pass the call back over to Chris for any closing remarks.

Chris Belfort (Director of Investor Relations)

Thank you for your questions and participating in our earnings conference call today. The webcast and supplemental slide presentation will be archived on our website. A replay of the quarterly conference call will be available through May 22 and can be accessed at vareximaging.com/investorrelations. Thank you and goodbye.

Operator (participant)

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