Varex Imaging, a leading manufacturer of X-ray imaging components, is navigating a complex landscape in China. While the company cites the government's ongoing anti-corruption campaign as the primary culprit for softness in the Chinese market, a deeper dive into the Q1 and Q2 2024 earnings transcripts reveals a potentially more nuanced narrative.

The anti-corruption campaign, focusing on auditing hospital finances, has undoubtedly impacted Varex's sales. The company, positioned upstream in the value chain, experiences the ripple effect of purchase slowdowns from OEM customers who supply hospitals. However, the transcripts also highlight softness in "non-cargo domains" of the industrial segment, particularly semiconductors, automotive, and electronics. This raises a critical question: is the anti-corruption campaign simply a convenient scapegoat for a broader economic downturn affecting multiple industries in China?

The transcripts offer hints of a more widespread economic slowdown. Q1 2024 saw China's revenue contribution drop to 17%, with a 10% year-over-year decline. This decline, while significant, is lower than the 25% to 30% decline initially anticipated. Further, Q2 2024 reveals continued softness in China, leading Varex to revise its full-year revenue guidance towards the lower end of the previously projected 3% to 5% decline. This revised outlook hinges on both the recovery of the Chinese market and a rebound in the industrial segment, suggesting a more intricate interplay of factors beyond just the anti-corruption campaign.

Adding to the intrigue, Varex's Industrial segment revenue actually increased by 10% year-over-year in Q1 2024, despite the mentioned softness in non-cargo domains. This growth, however, was fueled primarily by robust sales of cargo inspection systems, particularly "big linear accelerators or LINACs." Interestingly, these LINACs carry a lower gross margin upon shipment compared to the higher-margin service contracts they subsequently generate. Therefore, the transcript acknowledges a higher proportion of LINAC sales, skewing the Industrial segment's overall gross margin downwards.

Is Varex Playing the Long Game in China?

Here's where the hypothesis emerges: could Varex be strategically prioritizing LINAC sales, even at lower initial margins, to establish a strong foothold in the rapidly growing Chinese security and inspection market? This strategy, while potentially impacting short-term profitability, could position Varex to capitalize on the higher-margin service contracts that follow, ensuring a recurring revenue stream in the future.

This hypothesis gains further traction considering China's ambitious Belt and Road Initiative (BRI), a global infrastructure development strategy that heavily emphasizes trade and transportation security. The BRI's focus on securing trade routes aligns perfectly with the capabilities of Varex's cargo inspection systems, creating a potential demand surge for LINACs and associated services.

Hypothetical Revenue Projection from Cargo Inspection Services

Note: This is a simplified calculation based on assumptions outlined in the article. Actual results may vary.

While this is a simplified calculation, it illustrates the potential long-term benefits of Varex's apparent focus on securing market share in China's security and inspection industry. The anti-corruption campaign, while undoubtedly a factor in the current market dynamics, could be masking a more strategic play by Varex to capitalize on China's long-term growth potential.

It's worth noting that Varex is not alone in facing challenges in China's healthcare market. Several other medical device companies have reported similar slowdowns, highlighting the uncertain landscape. However, Varex's unique position in both the medical and industrial segments, coupled with its innovative photon-counting technology, presents a compelling opportunity to leverage China's broader economic ambitions beyond just healthcare.

China Revenue Contribution and Growth

The chart below shows the revenue contribution from China and its year-over-year growth based on Varex's earnings calls.

"Fun Fact: Varex Imaging was born from a spin-off of Varian Medical Systems in 2017, highlighting its deep roots in X-ray technology."