Varian Medical Systems, Inc. (VAR) Investor Mid-Year Review Call May 7, 2012 11:30 AM ET Executives Tim Guertin – President and CEO Elisha Finney – CFO Kolleen Kennedy – Corporate SVP and President, Oncology Systems Bob Kluge – SVP and President, X-Ray Products Business Lester Boeh – VP, Emerging Businesses Dow Wilson – EVP and COO Analysts Steve Beuchaw – Morgan Stanley Jeremy Feffer – Cantor Fitzgerald Jeff Johnson – Robert W. Baird Tycho Peterson – JPMorgan Josh Jennings – Cowen Presentation Tim Guertin
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So, I think it’s a good record. What we’re going to try to do for you today is tell you a little bit about our plans so you can at least imagine in your minds what we may be thinking about the next few years.If you look at our order of growth opportunity, we’ve broken it down here into Oncology Systems in blue, X-Ray Products in red, the Proton business in green, and the Security Business in blue. And as you see, we think we have opportunities for growth in all of these businesses. Some of them, of course, will grow faster than others just simply because they have a smaller base to start from. But I think we have good opportunities in all of our businesses. And we think we have substantial growth opportunity in OS that is organic. Almost everything you see here is organic. With that, I’m going to introduce you to Elisha Finney. Elisha, take it away. Elisha Finney Thank you, Tim. And, hi, everyone. It’s really nice to see you. Thanks so much for coming. So given that this is our mid-year review, I’m going to cover the first half financials, and then I’m going to come back and in a little more detail cover some of the specifics of the second quarter. For the first half, the orders for the total company are up 15%. Oncology Systems is up 7%, with North America up 2% and our international markets up 12%. And as of the first half, we are at about 56% is our international business; 44% North America, and 108 TrueBeams booked in the first half. X-Ray products up 2%.We had a tough first quarter where we saw that our Japanese customers were adjusting inventory on tubes and panels, and the first quarter was down 2% in X-ray. The second quarter was up 5%. And we actually saw a pretty strong growth in March which leads us to believe that we are back to our more normalized growth pattern, and would hope that we can get this business back to the double digit level as we move forward now.
We did book two Proton orders in the half, totaling $124 million. We have one for Saudi Arabia, and we also booked a deal in St. Petersburg, Russia.As you can see, revenues were up 10% for total company; Oncology 10%, X-Ray up 3%. And we have booked $23 million of revenue in our Proton business for the first half. And let me just take a minute, we get lots of questions on how we book the revenue in the Proton Business. So, I’ll go ahead and address that here. Because these are – this is our first installation, this is under project accounting, we are – because we have to estimate our remaining cost to complete the project, and this being the first one, that is a fairly difficult path. So, we have taken the conservative position that revenue is going to equal cost until we get towards the very end of the project, and any profit we’ll be taking at that time. As we’ve said, the first two or so of these installations, there is a lot of learning costs that’s still spent into those. It’s just a very high cost of goods sold relative to where we expect to be. So, as we’ve been pretty transparent, there’s not going to be a significant amount of profit on the first couple of these. And so, we just took the more conservative position to wait until we get to the very end. As this business matures and as we get into future installations, it will revert to a more traditional project accounting, where we’ll take a percentage of the revenue – a percentage of the cost as we complete the project over the two to three year period of time. The operating margin for the first half is 20%, which is down three points if you compare that to the year ago period. All of that in the first half declined coming from the gross margin. Gross margin of 42% for the company, again, down three points. Oncology’s margin is off about three points. And we talked pretty extensively on the conference call, and I’ll come back and talk more about margin, but, basically, we had an unprecedented geographic shift to the Emerging Markets where those markets were up about 30% in the second quarter, whereas one of our higher margin countries that buys highly featured products, Japan, was off about 40% as the end of the stimulus program in the year ago period.
I will tell you that Japan has come back and they’re on a more normal pattern now. This was only reflected in the delivery. So, again, that geographic shift had an impact on Oncology’s margin in the half.X-Ray Products had very strong margin performance and is up about 50 basis points in the half. I should say that the Proton business dilutes the gross margin by about one full point for the total company. And, again, that’s going to hold true for the first few of these. We ultimately hope to get the Proton business up to about a 30% gross margin product. And SG&A expenses for the first half were about flat as a percentage of sales, and that’s even with the restructuring charge that we talked about and the dilutive effect from the Calypso acquisition. Operating earnings down 5%. Net earnings down only 1% as that shift to the geographic Emerging Markets causes the gross margin to be lower. We also get a tax benefit as we move to international markets. And so, the tax rate was down three points from the prior year period. Backlog of $2.6 billion is up 18% if you include the Proton business. If you exclude the Proton business, the backlog is still up a very healthy 12%. So, again, that gives us, really looking into the next fiscal year, we can see ourselves returning to low double digit growth. Balance sheet and cash flow. Conservative balance sheet $617 million of cash and equivalents, $32 million short term investments. This is the loan for the APT Scripps project, the Proton project in San Diego. And $162 million of total debt. We have subsequently been paying down that debt and as of the call, I believe the number was around $130 million. The DSO of 83 days was up four days from the prior year period. It’s a little confusing because the Proton business actually impacted DSO by about five days in the second quarter. And that’s because we are booking revenue in advance of when the actual payment terms are due from the customer. And this is under the project accounting method that we talked about. This being our first installation, it is back-end loaded when the payments are actually due from Scripps, and that had an impact on the DSO. If I look back over the last four quarters and just take a simple average, 83 days is the average. So, collections are quite healthy.
Cash flow, $105 million in the second quarter, but year-to-date $159 million. And we did last quarter spend $75 million to repurchase 1.1 million shares.Questions of the day. I guess you guys get the point. It’s margin, margin, margin since the conference call – the questions that Spencer and I have gotten. So I just wanted to take a few of these and address them this morning. Where are they headed? The Oncology margins, I believe, for this year are going to be down by about one point year-over-year. And, again, that’s given this tremendous shift to international and emerging markets. I think going forward we are going to be able to maintain that oncology margin at that level, despite the fact that we are going to continue to see strong growth coming from these emerging markets. Read the rest of this transcript for free on seekingalpha.com