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Varian Medical Systems (NYSE:VAR)

Q1 2013 Earnings Call

January 23, 2013 5:00 pm ET

Executives

Spencer R. Sias - Vice President of Corporate Communications and Investor Relations

Dow R. Wilson - Chief Executive Officer, President and Director

Elisha W. Finney - Chief Financial Officer and Corporate Executive Vice President of Finance

Analysts

Jeffrey D. Johnson - Robert W. Baird & Co. Incorporated, Research Division

James Terwilliger - The Benchmark Company, LLC, Research Division

Tycho W. Peterson - JP Morgan Chase & Co, Research Division

Amit Bhalla - Citigroup Inc, Research Division

Steve Beuchaw - Morgan Stanley, Research Division

Jeremy Feffer - Cantor Fitzgerald & Co., Research Division

Jonathan J. Palmer - Credit Agricole Securities (NYSE:USA) Inc., Research Division

Jason Wittes - Brean Capital LLC, Research Division

Amit Hazan - SunTrust Robinson Humphrey, Inc., Research Division

David H. Roman - Goldman Sachs Group Inc., Research Division

Anthony Petrone - Jefferies & Company, Inc., Research Division

Operator

Greetings, and welcome to the Varian Medical Systems' First Quarter 2013 Earnings Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Spencer Sias, Vice President of Investor Relations for Varian Medical Systems.

Thank you, Mr. Sias. You may begin.

Spencer R. Sias

Thank you. Good afternoon, and welcome to Varian Medical Systems' conference call for the first quarter of fiscal year 2013. With me are Dow Wilson, President and CEO; Elisha Finney, CFO; and Clarence Verhoef, our Corporate Controller. Dow and Elisha will summarize our results and will take your questions following the presentation.

To simplify our discussion, unless otherwise stated, all references to the quarter or year are fiscal quarters and fiscal year. Quarterly comparisons are for the first quarter of fiscal 2013 versus the first quarter of fiscal 2012. Please be advised that this presentation and discussion contains forward-looking statements or use of words and phrases such as outlook, could, should, believe, can, estimate, will, plan and similar expressions, are intended to identify those statements, which represent our current judgment on future performance or other future matters. While we believe them to be reasonable based on information currently available to us, these statements are subject to risks and uncertainties that could cause actual results to differ materially. Some of the important risks relating to our business are described in our first quarter earnings release and in our filings with the SEC. We assume no obligation to update or revise the forward-looking statements in this presentation and discussion because of new information, future events or otherwise.

And now, here is Dow.

Dow R. Wilson

Good afternoon, and welcome, everyone. I'm pleased to report that our company's first quarter revenues and net earnings grew in line with our expectations for our major businesses and the overall company. We also hit our margin targets, excluding a $4.1 million restructuring charge in the quarter related to an enhanced retirement program. Our operating margin improved versus the year-ago quarter.

Net orders rose robustly in our X-ray Products business but declined in our Oncology business, which experienced weaker orders in Europe and Asia versus very strong year-ago results.

To summarize our results for the quarter, earnings per diluted share increased 9% to $0.86. Revenues rose 8% to $678 million. Net orders were up 21% in X-ray Products and down by 2% in Oncology Systems. Our quarter-ending backlog rose 11% to $2.8 billion. We closed the quarter with $755 million in cash and cash equivalents and $206 million of debt. I will cover the operational highlights for the quarter and let Elisha walk you through the P&L and the balance sheet.

Oncology Systems' first quarter net orders fell 2% to $477 million, with 2% growth in North America that was offset by a 4% decline across markets outside North America. North American orders grew with the help of replacements of competitive software, particularly in the area of treatment planning. We also had strategic wins at several other sites that ordered our TrueBeam system together with our software. Order activity in the U.S. appear to be affected by timing.

Looking at the last 6 months, our North American order growth was 7%, in line with the market growth we have been seeing in this region. The first quarter also may have run into some headwinds from uncertainty in Washington and reimbursement cuts at freestanding clinics.

Additionally, we have seen strong early interest in our newly introduced EDGE radiosurgery system, which received FDA clearance at the end of the quarter. This interest may have caused some customers to extend their purchasing cycle in order to evaluate this exciting new treatment option. I will touch more on EDGE in a few minutes.

Outside of North America, Oncology's overall net orders declined by 4%. This included an 11% decline in EMEA and a 1% decline in Asia that, together, offset a 33% increase in the Rest of the World, including Latin America and Australia.

In Latin America, we booked orders in 5 countries, including the first TrueBeam order in Colombia. In Asia, robust order growth in both China and Japan was offset by sharp declines in several other countries. The sales funnel in Asia continues to look good.

Net orders were down in Northern, Southern and Western Europe, as well as in the Middle East, where government purchase orders were delayed. Orders were up in Africa, where we had a key win in Algeria, and up in Eastern Europe, where we saw significant orders in Russia and Bulgaria. In addition to helping with some international sales during the quarter, the Varian and Siemens strategic partnership went live in North America in October. We believe it contributed to orders during the quarter in Germany as well.

As you know, Brazil is conducting a public tender for the purchase of more than 80 units, and we are competing for this business. To update you on the status of the tender, the Ministry of Health still expects to conduct a reverse auction, and it is continuing to state that it is a "winner take all" proposition for hardware, software and brachytherapy products.

Before leaving Oncology, let me touch on 2 growth drivers for the business. As I mentioned earlier, there is strong customer interest in EDGE, which we launched at ASTRO in November. We hope it becomes a game changer in the fight against lung, liver, pancreatic and other cancers that have been very difficult to treat with traditional technology. Demand for EDGE should be helped by the adoption of the new reimbursement code for thoracic radiosurgery.

Lastly, Oncology's worldwide service organizations continue to drive growth for the segment, with quarter-over-quarter double-digit increases in both orders and revenues. This now represents more than 35% of Oncology's business.

Let me turn now to X-ray Products. This business had a terrific quarter and has started the year on an especially strong note. Good order growth was driven by strong demand for our radiographic panels and high-end CT tubes. Net orders for this business grew 21% during the quarter to $133 million. Revenues grew by 18% to $133 million, and margins for this business were up 1 percentage point over the first quarter of 2012, thanks largely to continued productivity gains.

Demand for our radiographic panels was particularly strong in China, while our newer high-performance CT tubes sold extremely well in Japan as a result of apparent customer share gains in the CT market. The quarter was also helped by the early sales of new products, which included a leading edge 43 x 43 centimeter Cone Beam dynamic panel. In the next few months, we will be launching further new products, including a wireless panel and new dental panels, which would help to continue this momentum. As the panel business expands and trends in digital imaging create new tube opportunities, we remain enthusiastic about our X-ray Products business.

Switching now to the Other category, including the Security and Particle Therapy businesses, we had a quiet quarter in our Security business and no Particle Therapy orders. Net orders for the Other category were $9 million for the quarter versus $12 million in the year-ago quarter. First quarter revenues for the Other category were $21 million compared with $25 million in the year-ago quarter.

Construction work at the Scripps facility in San Diego is nearing conclusion, and commissions at the facility are slated to start treating patients by the end of the fiscal year. Although we did not book any new orders in our Particle Therapy business during the quarter, the pipeline looks good.

Before leaving the Other category, I want to inform you that we have reorganized our Security business to report in to Bob Kluge, who has been managing our successful X-ray Products business. Bob will now oversee our Security business as Senior Vice President of our 2 components businesses. Congratulations to Bob.

Now here's Elisha.

Elisha W. Finney

Thanks, Dow. Congratulations, Bob, and hello, everyone. While Dow has already covered net orders, I want to briefly talk about the constant currency growth rates for the quarter.

In comparing quarter-over-quarter exchange rates, there was a small effect from FX. Worldwide Oncology net orders declined by 2% in dollars and fell by 1% in constant currency. Oncology's North American net orders were up 2% in both dollars and in constant currency. It's -- EMEA net orders fell 11% in dollars and 8% in constant currency, and Asia was down 1% in dollars and up 1% in constant currency. Oncology net orders in the Rest of World region grew by 33% in dollars and 31% in constant currency.

First quarter revenues increased 8% to $678 million, with constant currency growth of 9%. Oncology Systems posted an 8% increase in revenues, and X-ray Products posted a gain of 18%. Revenues from businesses in the Other category declined by $3 million.

Particle Therapy revenues booked on a percentage-of-completion basis was down from the year-ago quarter as expected, reflecting the near completion of our installation at Scripps. As an aside, we expect to book about $20 million in low-margin revenue during the second quarter, related to the Scripps installation and primarily from the commencement of our proton project in Saudi Arabia.

For the year, depending upon the timing of other projects, annual proton revenues could approximate $80 million. The first quarter gross margin for the company was essentially equal to the year-ago period at 42.9%. Oncology Systems' gross margin fell by 1 point, as expected, to 43.9%, due primarily to a product and geographic mix shift.

X-ray Products' gross margin increased more than a point to 41.7%, primarily due to a significant increase in volume and faster growth in our panel products. Panels now represent more than half of the revenue for X-ray Products.

As a reminder, in the second quarter, we will begin to account for the medical excise tax in our gross margin. The total company impact for the balance of the year is expected to be in the range of $8 million to $10 million.

First quarter SG&A expenses were $106 million, or 16% of revenues, up 33 basis points as a percentage of revenue from the year-ago quarter. Included in the SG&A expenses for the first quarter was the $4.1 million restructuring charge. This charge was a bit higher than expected, but it is evidence of the success of the enhanced retirement program. Excluding this charge, SG&A as a percentage of revenue would have improved by about 30 basis points from the year-ago quarter. Before leaving SG&A, I should let you know that during the second quarter, we plan to take an estimated $2.5 million additional restructuring charge to complete the enhanced retirement program.

First quarter R&D expenses were $47 million, or 7% of revenues, equal as a percentage of revenue with the year-ago period. First quarter operating earnings increased 7% to $137 million, or 20% of revenues.

Depreciation and amortization totaled $17 million for the quarter. The effective tax rate was 31% for the quarter, up 1 point from the year-ago period and about 1 point higher than we expected as a result of the geographic mix of profits. As I'm sure you have heard, the R&D tax credit was extended by Congress on January 2. Given this extension, we now believe that the tax rate for this full fiscal year will be about 28.5%. The catch-up of the 2012 R&D tax credit will be reflected in our second fiscal quarter, which should result in a lower tax rate of about 28% for the quarter.

Fully diluted shares outstanding decreased from the year-ago quarter to $111 million, due mainly to our share repurchase program. Diluted earnings per share increased by 9% to $0.86.

Turning to the balance sheet. We ended the quarter with cash and cash equivalent of $755 million, debt of $206 million and stockholder's equity of $1.6 billion. Day sales outstanding increased by 1 day to 87 days, including a 6-day impact from the Particle Therapy business. First quarter cash flow from operations was $72 million, with net earnings partially offset by increases in inventory to support this year's revenue growth. Other primary sources of cash were $59 million from stock option proceeds. Primary uses of cash were $104 million to repurchase 1.5 million shares under our stock repurchase program and $14 million for capital expenditures.

Now I'll turn it back over to Dow for the outlook.

Dow R. Wilson

Thanks, Elisha. We are pleased with our first quarter results in revenues and earnings, which should keep the company on track for hitting its fiscal 2013 growth targets. We remain confident in the fundamental long-term strategy for serving our markets.

For the second quarter of fiscal year 2013, total company revenues could increase by about 5% to 6% over the prior year quarter. With the balance of restructuring charges from the enhanced retirement program, net earnings per diluted share for the second quarter should be in the range of $0.98 to $1.03. For the fiscal year, we continue to believe that total company revenues could increase by about 8% to 9% over the prior fiscal year. Net earnings per diluted share for the fiscal year could be in the range of $4.08 to $4.16.

We're now ready for your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Jeff Johnson of Robert W. Baird.

Jeffrey D. Johnson - Robert W. Baird & Co. Incorporated, Research Division

Question one, Dow, you mentioned timing in your prepared remarks and kind of referenced the last quarter's strength in the U.S. Also, referenced in maybe some delayed interest in EDGE, or maybe some backlog interest in EDGE, given that it didn't get approved till late December. So just trying to figure out, is it -- as you point to timing issues, are you referencing that more as kind of take last quarter's numbers and this quarter's numbers and average them? Or there may have been deferrals this quarter that could come back and help over the coming quarters?

Dow R. Wilson

I think there's a number of things going on here. As we said last quarter, one quarter does not a trend make. So timing is certainly a factor as we look back that way. The reality is, the market's probably not as strong as last quarter and certainly not as weak as this quarter. So we're probably in the kind of mid- to high-single digit growth rates for oncology. We did have, as you know, very robust Q4 and a weak Q1. I think the market is kind of right smack in the middle. We think market fundamentals remain down.

Jeffrey D. Johnson - Robert W. Baird & Co. Incorporated, Research Division

Okay. And I may have misheard there, but it sounds like you may have actually provided a little bit of guidance around orders.

Dow R. Wilson

No, no.

Jeffrey D. Johnson - Robert W. Baird & Co. Incorporated, Research Division

Mid-single digits is kind of what I was hearing there. Mid to upper single digits. But...

Dow R. Wilson

Well, as you look back 6 months, that's kind of what we think the market is doing.

Jeffrey D. Johnson - Robert W. Baird & Co. Incorporated, Research Division

Ah, that was a backward-looking comment. Okay. No, that's fair. And Elisha, one question for you on just tax rate. You, obviously, with the R&D tax credit, can you remind me what was originally embedded in your guidance for this year for expected effective tax rate and maybe what the R&D tax credit is translating to as a sort of EPS tailwind relative to prior guidance?

Elisha W. Finney

Sure, Jeff. And the R&D tax credit is a little less than 1 point impact, if you look at it for the full year. And so, obviously, when we set our original guidance on tax, we're considering lots and lots of different variables that can go into that. What's really driving it more than anything is the geographic mix of earnings, but there's all other sorts of discrete items that go into the rate as well. So that's why we put a range on it. So at this point, what we're saying is that our range, instead of 28% to 29%, we've now come in closer to the 28.5% with that geographic mix of earnings, the negative being offset by the positive somewhat of the R&D tax credit.

Jeffrey D. Johnson - Robert W. Baird & Co. Incorporated, Research Division

All right. That's helpful. Last question, I promise, just on the enhanced retirement program. Dow, can you put any, or Elisha, any numbers around that? What, maybe, percentage headcount reduction now you're thinking you might see, or how that might translate over the next few years from a cost-saving standpoint?

Elisha W. Finney

Sure. It's roughly 80 employees, and that's out of our worldwide number of 6,000. This was a US-based program. And this is the first time the company has done this. We really didn't know what to expect. And I'm happy to say, I think it was widely successful. It was a win-win for employees and for us. And the reason some of this charge is going into Q2 is just given the timing of some retirements. So we couldn't have them all in the first quarter, so there are some that will be completed in the second quarter.

Operator

Our next question is from James Terwilliger of Benchmark.

James Terwilliger - The Benchmark Company, LLC, Research Division

Yes, I had just 2 quick questions. The first one was on the announcement for the TrueBeam in India. And the second, if you could talk about the Indian market and what that product means over there from a competitive standpoint, a pricing standpoint. And the second part of the question would be focused on, I think you had an ASTRO in Japan, and I was wondering if you could provide any color about the ASTRO that took place in Japan as well.

Dow R. Wilson

Relative to India, we have had success with TrueBeam in India. We did get the approval earlier. Was it early in the fourth quarter?

Elisha W. Finney

Yes, CE Mark.

Dow R. Wilson

Yes, yes. Anyway -- so we've been -- there were some local things that we had to go through in the Indian market. Those are now cleared. So we are set to go in the India market. That market is not unlike some other global markets where there's a good piece of the market that's very high end and then a significant piece of the market that's in kind of the performance value segment. TrueBeam will help us in that high-end market. Radiosurgery is a big deal in India. And a few years ago, as an example, we saw very good uptake of our Novalis Tx in that market. So I think this will -- this will help us there. I believe the JASTRO is this next quarter in Japan. So it's coming up on the calendar. So we haven't gone to JASTRO yet.

Operator

Our next question is from Tycho Peterson of JPMorgan.

Tycho W. Peterson - JP Morgan Chase & Co, Research Division

Can you just flush out some of the end market commentary on Europe and Asia in particular? I know you called out some of these in your prepared comments, but where were you surprised by the weakness? And how should we think about trends in the next couple of quarters?

Dow R. Wilson

Sure. I guess -- maybe start with the comments from last quarter. I think, as we went around the horn last quarter, one of the surprises was just how strong Europe was last quarter. So we're very strong in Q4. So we think that timing is probably a good chunk of the main reason of what's going on here. We did see a couple -- a few orders delayed. Northern and Southern Europe were down. Western Europe and the Middle East were flat for us. We had good growth in Eastern Europe and Africa. Anyway, we still believe that the fundamentals in Europe are sound. The last -- if you look back 2 quarters, it's kind of mid-single-digit growth, and that's probably a pretty good indication of what's happening in the market. Our funnel-in forecast looked good there. We believe we're maintaining share, and one of the things we like is a stable foreign exchange environment. So that's kind of the Europe story. In Asia, we had great growth in Japan and China versus very tough comps. In China, we were up 30% on a 40% number from last year. And in Japan, we were up 15% on a 19% number from last year. So we feel very good about Japan and China. The rest of Asia is kind of lumpy. They come and go, and we were, in fact, down 90% in the rest of Asia. We had some orders last year in South Korea, Thailand and Malaysia that were big. And that's kind of the rest of the Asia story. Maybe just to round out the globe here for you, Tycho, in the Rest of the World we were up. We had very good growth, as I mentioned in the script. And Latin America and Rest of the World growth was up 33%.

Tycho W. Peterson - JP Morgan Chase & Co, Research Division

Okay. And then, Elisha, you raised the bottom end of guidance by, I think, $0.02. Is that just the R&D tax credit? Or are there some restructuring benefits from that?

Elisha W. Finney

Well, it's given the results that we had in Q1, where we landed right at the midpoint of the guidance, it's given the little bit lower excise tax, given the constructive pricing ruling that we had recently. That's offset by a little bit higher shares than we had first anticipated, and the higher restructuring charge for the retirement program. And then, yes, the tax is -- the R&D tax is a benefit. So you blend all of that together, and that's how we got to the new range.

Tycho W. Peterson - JP Morgan Chase & Co, Research Division

Okay. And then one last quick one on EDGE. Any update on when we should get the Calypso approval? How we should think about that being ruled out?

Dow R. Wilson

Yes. The Calypso approval, we expect in the -- I believe sometime in the April, May time frame. There's still some uncertainty about it. We have been back to answer questions. And as long as that question set goes around, it could take a while. But the clinical data is complete, and we think we're answering mostly technical questions. So our forecast at this point is kind of the April, May time frame, Tycho.

Operator

Our next question is from Amit Bhalla of Citigroup.

Amit Bhalla - Citigroup Inc, Research Division

Dow, in your "around the horn" comments, I didn't hear a number for how India performed in the quarter. Could you just give us that growth rate? And second, for Elisha on gross margin. The gross margin in the quarter tracked better than your full-year guidance of 42%. So can you just talk to us on how gross margin will play out for the remaining quarters of the year?

Dow R. Wilson

Yes. I'd say, on India, Amit, we -- it's kind of buried in our Europe number. The Middle East, I said, was flat, so -- I don't have India in front of me, but I assume that it's probably in that range.

Elisha W. Finney

So for the gross margin, Amit, we're still at that 42% to 43% for the total company. Oncology landed exactly where we hoped for Q1 and where we thought they would and continue to be in that 43% to 44% range for the full fiscal year. Of course, there is an $8 million to $10 million excise tax. If you were to exclude that, the oncology margin would be, essentially, even with the year-ago period, very close to 44%, but we have to take that into the Oncology margin. X-ray Products is going to be in the low 40s, around 42%. We should see a -- towards the balance of the end of the year, we're going to anticipate significant proton revenue at a very low margin relative to our other businesses. So that has to -- that impacts the total company margin as well. So really, those 2 factors, it's the excise tax and increased proton revenue, which will only be about somewhere around a 12% to 15% gross margin for the deals that we book in Q3 and Q4.

Amit Bhalla - Citigroup Inc, Research Division

Got it. And just a quick follow-up, Dow, on Siemens. It did go live in North America in the quarter. But in your comments, you only highlighted Germany as a potential positive impact. Can you just talk to us about the early thoughts on Siemens in the U.S.?

Dow R. Wilson

Yes. I think -- yes, we did kick it off. It took us till -- we were contractually obligated for our former partner through the end of September. And so that is now off and going. I'd say we've had very good progress. It's really kind of sales teams meeting together at this point. We have sold our few -- our first few CT scanners, CT simulators. So that's good. We -- they are helping us in the U.S. We did see -- we have had other very good contribution from them and other geographies, Northern Africa, Eastern Europe, and even some in Asia. So we are seeing some continued good pick-up outside of the U.S. We're still a little early here in the U.S., but we're -- I guess -- my barometer on these things has always, "How do salespeople react?" And the continued reaction of our salespeople and their salespeople is very positive. So that's, I think, a good barometer of what's to come.

Operator

Our next question comes from Steve Beuchaw of Morgan Stanley.

Steve Beuchaw - Morgan Stanley, Research Division

One question on the software business. Can you give us a sense to where the growth came out for that segment of Oncology in the quarter? Is that still trending in the $100 million to $200 million range, a mid-teens grower? Any updates there?

Dow R. Wilson

I'd say it's broad-based. We have very good customer response to our treatment planning products, probably starts there. Our ARIA product is going through a new product cycle, which is good. Some new features and capability and a lot of creature comfort for usability. So that -- we had a number of competitive takeouts in the quarter. And I'd say, geographically, that business is bigger in the U.S., especially on the oncology information side. But the treatment planning growth has been global, and we are starting to see pickup outside of the U.S. in our software business. Elisha, you want to add anything there?

Elisha W. Finney

No, I think that covered it.

Steve Beuchaw - Morgan Stanley, Research Division

And then, Dow, just going into a little bit more detail on your commentary on a couple of the disruptions in the order funnel in the quarter, whether it's the fiscal cliff or the EDGE launch. Are you seeing signs that give you confidence that any of that disruption on the fiscal cliff is temporary? And then on EDGE, could you spend just a little bit more time talking about the commercial potential and impact of that product over the course of the year?

Dow R. Wilson

Sure. I'd say, in North America, we did have a very strong Q4. Q1 was up 2%. So just to look back on 6 months as a mid-single, a high-single-digit growth market. The hospital market remains okay. And as you know, the freestanding market has been quiet for the last year, and I'd say that market continues to be very, very quiet. The U.S. market is an innovation-driven market. Our share is stable, maybe even to a hair up in the U.S. Fiscal cliff impact, it's not clear. I do think there were some people kind of waiting. No, I don't think it had a big market impact, but the uncertainty around it certainly wasn't a benefit to the market. I think we are continuing to see slowness in the freestanding market. On EDGE, we are seeing strong interest in North America. We are seeing a very good interest from the radiation oncology community, as well as the surgical community. I think it's a game changer in lung cancer. And we're starting to see -- we've talked a little bit about this, but we're starting to see more momentum from folks around liver cancer. That market is mostly outside of the U.S. But even our U.S. customers are getting excited about liver cancer. I think as we said last quarter, the target market for this product -- I think if you add the Gamma Knife and the CyberKnife up, that's about 125 units a year-ish, and that's really where we want to position this product and go after that volume. Customer response to some of the features on the product, especially the 6-degree of freedom couch and the tumor-tracking, multi-leaf collimator have been really outstanding. And from a commercial point of view, we launched at ASTRO, the sales team has been trained. We await FDA approval and -- so we're kind of off and running. We've got to work with customers to get it in their budgets. So I think it's -- I think we'll see some impacts in Q2. It's probably a little bit more of the second half impact for us.

Operator

Our next question is from Jeremy Feffer of Cantor Fitzgerald.

Jeremy Feffer - Cantor Fitzgerald & Co., Research Division

Dow, I want to come back to sort of more bigger picture to the bigger reimbursement environment, and I'm wondering if that's having any impact? I know you've talked about in the past, your expectations of probably mid-single-digit cuts for the next few years, and I'm wondering if you're -- any conversations with customers you're seeing that being a bit of an overhang.

Dow R. Wilson

I would say in the freestanding market for sure. They were down 9% to kind of the final outcome of this last reimbursement decision. So I think the freestanding market is going to remain very quiet. I think this hospital market -- hey, there's always uncertainty around reform and kind of what's happening in Washington, but I don't know that it's, in any material way, different than what we kind of saw last year. So I kind of think the U.S. market is going to be not as strong as last quarter and not as weak as this past quarter. Not as strong as Q4 and not as weak as Q1.

Jeremy Feffer - Cantor Fitzgerald & Co., Research Division

Okay. And then just quickly on gross margin. Elisha, I appreciate your comments there. I'm wondering, as we go forward, how we should think about this -- both the product and geographic mix as it relates to gross margin?

Elisha W. Finney

Well, the biggest driver by far in gross margin is the product mix. So with service and software being our highest margin products, and then accessories and then the hardware. So that can drive the mix pretty significantly. Secondly is the geographic mix. And in emerging markets, it can be 5 points easily lower than what we might see in the U.S. or Japan. So when we're setting -- when we're looking at guidance for quarter in and quarter out, we are looking at estimated -- where are products going to ship and what are the margin on those, and trying to give you our best guesstimate, if you will. And so looking out for the year, again, if we exclude the excise tax, Oncology would be roughly even with the year-ago period.

Operator

Our next question is from Jonathan Palmer of CLSA.

Jonathan J. Palmer - Credit Agricole Securities (USA) Inc., Research Division

Dow, I apologize if I missed it in the prepared remarks, but did you mention when you expect the announcement on the Brazilian tender?

Dow R. Wilson

Yes. Sometime in January or February. Just a little more color on that, February is Mardi Gras, so we don't know if it will be before that or after that. But as we get closer to it, it's probably looking like it might come after. The Ministry is telling us the date's in either January or February. So that's what we know today.

Jonathan J. Palmer - Credit Agricole Securities (USA) Inc., Research Division

That's helpful. And then just in terms of the X-ray business, you've seen 2 very strong quarters of orders there after a more modest prior period. When do we start to see these orders translate into sales?

Elisha W. Finney

Oh, this is a fairly short-cycle business, so you already saw some of the effects in the first quarter where the X-ray sales were up 18% in Q1. The orders were up 21%. So it just tends to be, particularly on the tube side, very short-cycle business with orders and sales typically in the same quarter. Flat panel, we can build a backlog going out 1 to 2 quarters. That's much different than the oncology business.

Jonathan J. Palmer - Credit Agricole Securities (USA) Inc., Research Division

Understood. And then one last one for me. Was there any update on the $80 million per ton order from Emory?

Elisha W. Finney

No. We are waiting until -- Maryland and Emory, we have signed contracts with both, but we will not actually book those deals into backlog until their financing is complete. In the second quarter, it is the Saudi proton project that we expect to commence. And then in the third or fourth quarter, we are assuming that the Maryland financing will be done and that we will be able to book a significant amount of revenue under that project in the second half.

Operator

Our next question is from Jason Wittes of Brean Capital.

Jason Wittes - Brean Capital LLC, Research Division

First, you did mention there perhaps was some slowdown due to fiscal cliff discussions, though it sounded like it was negligible in terms of measurement. But the $1 billion that you did get was -- at least, I think, for Varian, was that the Gamma Knife product reimbursement got cut. I understand they don't sell that many systems into the U.S. at this point, but they do have quite a few -- quite a big install base. Are you hearing from customers that perhaps they are looking to upgrade from a Gamma Knife at this point, now that the reimbursement just isn't quite as attractive as it used to be?

Dow R. Wilson

Our customers were not -- as you stated, our customers are not impacted by the reimbursement cut. One of the things it does is it levels the playing field in stereotactic radiosurgery. So we're excited about that. There's a lot of clinical evidence out there that results from Linac-based SRS and cobalt-based SRS are the same. Also, we think this is the government being responsible with -- a cost comparative effectiveness. So we think EDGE is a game changer in the lung. That's what our customers are looking for as kind of growth into the future. The Gamma Knife, as you know, can't do body radiosurgery. And I think as the big trends move to lung and liver, we're very well positioned.

Jason Wittes - Brean Capital LLC, Research Division

Okay. And Elisha, if I heard you correctly, you've mentioned that you were going to be able to -- I may have heard this incorrectly, but did you say that you were going to be able to book some profits from proton this year, or is that -- or did I mishear you?

Elisha W. Finney

There will be some gross profit at the, again, very low level of 12%, 15%. But on an operating basis, it is still significantly dilutive to the company.

Jason Wittes - Brean Capital LLC, Research Division

But I guess -- my understanding of the accounting was once you kind of had an understanding what the profitability was, you could actually start booking revenues with some profit -- with some gross profit. And it sounds like you're at that point at this point.

Elisha W. Finney

Correct. So Scripps, because it was our first and we couldn't accurately estimate our costs along the way, we deferred any profit until the end of the contract, and there won't be much profit being the very first one. We are now going to revert to a more typical contract accounting on future deals, where we will take a percentage of the revenue and a percentage of the cost. And again, on -- as we've always said, Jason, on the first few of these, is that very, very low gross margin. There was a lot of startup costs built into these first few Cyclotrons. So the hope is that, as we go forward, it will get a little better. But these first few are not going to be high margins.

Operator

Our next question is from Amit Hazan of SunTrust.

Amit Hazan - SunTrust Robinson Humphrey, Inc., Research Division

First question, just on service gross margin. I'm wondering if you can confirm what that was in the quarter. And also, just kind of thinking about the strong growth it's had in recent years, and now that TrueBeam is coming into service, to what extent should that continue to move higher?

Elisha W. Finney

Sure. Well, we don't break it out in that level of granularity, Amit. But I will tell you that the service gross margin continues to be roughly 50%. I mean, it is a very nice product line with a nice recurring revenue stream at high margins. The TrueBeam, yes, as it continues to be a higher take rate, that is a positive on the gross margin. It was offset somewhat by the geographic mix, where it was 3 percentage points higher into international markets as opposed to North America. So you just take all of those things together, it can really drive margin a couple of points in any given quarter.

Dow R. Wilson

And just a comment on TrueBeam. Yes, from a -- it grows our installed base, we get better service contract pricing, that's all favorable. We have, just to update you, 690 orders, plus orders to date. 380 of those are installed or being installed. It did represent about half of our high-energy machines in the first quarter. And we did want to announce today that, in keeping with our practice, we'll stop reporting this number as TrueBeam is now kind of the business and is an established product.

Amit Hazan - SunTrust Robinson Humphrey, Inc., Research Division

All right. And just a quick question on guidance. If I look at kind of the revenues for the second half there, third, a bit back-end loaded compared to maybe looking at the last 2 years. Not much, but just a little bit. I'm just wondering if that's tied to the proton contribution or anything else.

Elisha W. Finney

All right. Yes, it is, where a significant part of the proton revenue will come in the second half. And if you exclude the -- well, it's 1 point or 2 increase in the revenue line for the protons. And for Oncology, when you run your numbers, you'll see that it's relatively low sales growth in the second quarter, and that's really just because that we had a very strong comp in the year-ago quarter. And it's just based on customer expected delivery dates. So you really just look at the year, with Oncology up in the 5%, 6% range and X-ray in the low teens, and the balance of that really being the proton business.

Amit Hazan - SunTrust Robinson Humphrey, Inc., Research Division

Okay. And then finally, kind of just a broader question. We're obviously seeing a lot of rather significant declines in prostate cancer treatments in the new PSA guidelines begin. And I'm wondering if you guys view that as something that, over time, affects your customers from either an ROI standpoint or capacity standpoint, where it could then indirectly impact you over time, or is prostate just too small in the scheme of things to really have that effect?

Dow R. Wilson

A, I do think it is small; B, we have lost some share over the last half a dozen years to robotic prostatectomy. And C, our argument is the best prostate treatment that you can get is with external beam radiation therapy. And we think that some of the new techniques for nerve sparing, our technology with spacers and our Linacs, really present opportunities for us to get toxicity reduction. The results, frankly, are -- we can all do a very good job at treating prostate cancer. And the question is toxicity elimination. There may be -- some of the watchful waiting may have some short-term impact. The patients will eventually come back in if their PSA scores elevate and now they'll come back into the system. But I think at this point, it's really kind of becoming a toxicity argument. And I think we've got some very good things to show the world as we kind of do the clinical work and show the impact of these new capabilities.

Operator

Our next question is from David Roman of Goldman Sachs.

David H. Roman - Goldman Sachs Group Inc., Research Division

Elisha, in your prepared remarks, I know you elaborated a little bit on the call regarding the recognition of the proton revenue from Scripps. I think you said $20 million in the second fiscal quarter is very low margin. Can you maybe just help us think about the longer-term impact of when that term is profitable? And then should we look at Scripps as a good analog for how the profitability of these follow-on projects might be phased in?

Elisha W. Finney

No, I think there was just a lot of learning that went into Scripps. And as they -- as we are booking this, again, Scripps today is at a zero margin, and any profit will not be recorded until we get to the very end of the installation and acceptance. The $20 million of revenue in Q2 is mostly associated with, we will begin the project for our Saudi proton project. And so we will identify components specific to that project, and there will be roughly $15 million or so of revenue that we're anticipating that we can book in the second quarter. As we've said, David, these proton projects in the early years are at very, very low margins. It continues to be dilutive to the total business. We believe in the future of this technology, and we are making an investment to about 5% of our total EBIT dollar. Not going to say exactly when this is going to turn profitable but, suffice it to say, it -- we're at least 18 to 24 months out. But we will start to make progress. And as we get new deals and as we start to book revenue, that dilution number should start trending down. And that is what we're committed to here.

David H. Roman - Goldman Sachs Group Inc., Research Division

Okay, that's helpful. And then obviously, one of your very, very smaller competitors announced fairly disappointing results this quarter. Maybe you could just sort of update us on your latest thoughts about the competitive dynamics, particularly in the U.S.? I mean, is this really turning into a 2-player race? And then I guess you also didn't comment too much on any benefit from the Siemens software partnership, but I think we're now enough time into that where you might be seeing some benefit.

Dow R. Wilson

Maybe just beginning with the last point, the Siemens software, we did introduce to the market, at ASTRO, shipments will happen in our third quarter. So it'll really be, from a kind of P&L point of view, it'll be a second half impact, and we expect it to be small. The overall competitive environment, I think that our Accuray introduced a number of new products at ASTRO, what we kind of hear is they appear to be slipping with those product introductions. It happens to coincide with a very good introduction from us on EDGE, and so I think you got a combination of maybe some execution issues on their side with a really good product introduction on our side. So we're confident that we can make an impact in that market with our new EDGE product.

Operator

And our final question comes from Anthony Petrone of Jefferies.

Anthony Petrone - Jefferies & Company, Inc., Research Division

I'll begin, one, with X-ray, and then a couple on Oncology. Dow, can you walk us through just the tailwind in the X-ray business that you mentioned in your prepared remarks as being driven by CT demand? Just how long will that kind of cycle last? And is there more room for share gains that -- similar to what you witnessed this quarter?

Dow R. Wilson

It's a combination of a couple of things. Our largest customer had a very good quarter. That's Toshiba, in that business, and we believe that they picked up some share gains. Frankly, that's been a long-term trend. When you look at the last 4, 5 years, they have been growing their share. We'd like to hope that our CT tube is part of that, and we can keep growing that. We also had some nice growth from other CT manufacturers. As well, we had introduced a number of products, probably, I'd say, 8 or 9 new products last year. And it takes a while to get those spec'd in. Some of those were panels, some of those were tubes. We started to see some traction at last on those new products, and we had some volume, especially in rad panels, radiographic panels, that drove some growth there, as well as really starting to see some traction from our InfiMed acquisition. So I think it's kind of broad-based, yes, when it happens in the CT business, the pickup is always a little bit faster. But we really like the prospects in this business.

Elisha W. Finney

And to be fair, I think it is over a relatively easy comp in the first half of last year, the X-ray Products business really started to turn around in Q4 of last fiscal year, but they are solidly on track for this year.

Dow R. Wilson

Yes. And let me say that...

Anthony Petrone - Jefferies & Company, Inc., Research Division

Is it fair...

Dow R. Wilson

Yes, let's do that one more time. Sorry. The -- clearly, the trend here is all about digital imaging, and that's really the big driver. That's the macro driver of this business, and that trend is going to -- that's a multi-year trend.

Anthony Petrone - Jefferies & Company, Inc., Research Division

Is it fair to look at the relation from bookings to revenue, on a sequential basis, you had 15% growth in bookings last quarter that resulted in an 18% revenue growth this quarter. And sure, you have to normalize it for the weak quarter. But is the cycle enough to sustain perhaps mid-double-digit revenue growth if we can continue to see bookings to the tune that we saw this quarter, which was 21%?

Elisha W. Finney

Well, yes. I mean, this business tends to be a little more linear than the Oncology business. With that said, the fourth quarter tends to always be the biggest. But as I mentioned earlier, we're expecting low teens sales growth for the X-ray Products segment this year. So it's -- driven largely by the new products that Dow mentioned.

Anthony Petrone - Jefferies & Company, Inc., Research Division

That's helpful. And then on to Oncology. The Siemens relationship will extend to North America this quarter, and it's been in place for little over a year now in Europe. And I'm wondering, in relation to the lumpiness of orders in Europe specifically and how that plays with Siemens, specifically the 20% growth last quarter, and then we've had a decline this quarter, I mean, do you expect similar lumpiness as that relationship extends into North America?

Dow R. Wilson

I guess the short version would be, we always expect lumpiness. I'm not sure how much of it Siemens is a factor in. We have -- as we've kind of said before, we like to look at trends on a little bit longer-term basis. It's pretty tough to get a crystal ball of what's going on by just looking through the lens of a quarter. And I'm not sure that the Siemens relationship helps or hurts that in any one direction. Certainly, at this point, it's too early to tell.

Anthony Petrone - Jefferies & Company, Inc., Research Division

Helpful. And last one for me is, you mentioned Brazil and timing on that. I'm wondering if there's any preliminary thoughts on pricing on that contract? And is it in line with other emerging markets? Is it similar to, perhaps, that gross margin discount that you spoke to, Elisha, when you compare, say, Japan to an emerging market, is that similar in Brazil, or should we expect something different there?

Elisha W. Finney

Let's just say, you're not going to like the growth margin in Brazil. As Dow said, you're going to...

Dow R. Wilson

Groan any way you look at it.

Elisha W. Finney

Yes, you're not going to be happy if we lose, and you might not be happy if we win, given that this is a reverse auction. However, we're looking at this over the lifetime. This is growing and developing a market, looking at it over the life of the equipment, with the service contracts, with the upgrade opportunity that it presents. But it will not be at the Oncology average gross margin, is my expectation.

Anthony Petrone - Jefferies & Company, Inc., Research Division

Is it fair to say the service margin, as well, is much lower, or should we expect a normal service margin should Varian win the contract?

Elisha W. Finney

I'm anticipating it will be lower as well.

Operator

That is all the time we have for questions. I'd like to turn the floor back over to Mr. Sias for any closing remarks.

Spencer R. Sias

Thank you. Thank you, all, for participating. A replay of this call can be heard on the Varian investor website at www.varian.com/investor, where it will be archived for a year. To hear a telephone replay, please dial 1 (877) 660-6853 from inside the U.S., or 1 (201) 612-7415 from outside the U.S. and enter in confirmation code number 406360. The telephone replay will be available through 5 p.m. this Friday, January 25. Thank you.

Dow R. Wilson

Thank you.

Operator

Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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