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Executives

Spencer Sias - VP, IR

Tim Guertin - President and CEO

Elisha Finney - CFO

Tai Chen - Corporate Controller

Analysts

Dalton Chandler - Needham & Company

Tycho Peterson - JPMorgan

Amit Hazan - Oppenheimer

Jeff Rhode - Segall Bryant

Amit Bhalla - Citigroup

Varian Medical Systems Inc. (VAR) F1Q09 (Qtr. End 01/02/09) Earnings Call January 29, 2009 5:00 PM ET

Operator

Ladies and gentlemen welcome to the first quarter 2009 Varian Medical Systems Earnings Call. (Operator instructions).

I will now like to turn the presentation over to your host for today's call, Mr. Spencer Sias, Vice President of Investor Relations. Mr. Sias, please proceed.

Spencer Sias

Thank you. Good afternoon and welcome to Varian Medical Systems conference call for the first quarter of fiscal year 2009. With me are Tim Guertin, President and CEO; Elisha Finney, CFO; and Tai Chen, our Corporate Controller.

In this call, we are making PowerPoint slides available through our webcast which you can access on our website at www.varian.com/investor. These slides and a replay of the call will be archived on the website.

Tim will start this afternoon by summarizing our financial results and operational highlights for quarter, Elisha will detail the P&L and the balance sheet and Tim will finish with the company's outlook for the second quarter and full fiscal year 2009. We 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 years, and quarterly comparisons are for the first quarter of fiscal year 2009 versus the first quarter of fiscal year 2008.

All references to financial performance are for continuing operations and do not include the discontinued operations of the research instruments portion of ACCEL. Including this discontinued operation the company's earnings per diluted share for the first quarter is reduced by $0.01 to $0.55.

Please be advised that this presentations and discussions contains predictions and other forward-looking statements. Our use of words and phrases such as expect, believe, could, recurring and similar expressions are intended to identify those statements which represent our current judgment on future performance.

These statements are subject to risks and uncertainties that could cause actual results to differ materially. Some of the important risks 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 Tim.

Tim Guertin

Good afternoon, everybody. Varian Medical Systems grew in the first quarter of fiscal year 2009 with gains in our backlog, net orders, revenues, margins and net earnings. Compared to the year ago period, the backlog rose 14% to $1.9 billion.

Net orders rose 13% to $551 million and revenues increased 13% to $509 million. Both gross and operating margins improved and net earnings per diluted share rose 22% to $0.56 versus $0.46 in the year ago quarter. All of our major business units contributed to this growth.

Oncology Systems first quarter net orders rose 11% to $428 million, with 6% growth in North America and 16% growth in international markets. US dollars, the international growth was due exclusively to the Far East, which more than doubled orders versus the year ago quarter.

Net orders were down slightly in Europe and US dollars but up in the mid-single digit range in local currencies. The growth in the Far East was led by Japan's fiscal year in spending, China, Malaysia, Thailand and Vietnam also contributed to this growth.

RapidArc was a star for the oncology business this quarter. As of the end of the quarter, we had more than 425 RapidArc orders as hospitals and clinics continued to access credit and spend on revenue generating capital equipment that enhances the quality, availability, and affordability of cancer care.

We stepped up RapidArc installations during the quarter and now have customer acceptances on more than 70 systems around the world. After a full year of reporting orders on this new product offering, we will from now on follow our usual practice and report only on installations.

It is clear that our newest products and game changing technology helped to drive the growth in our oncology business in the midst of an otherwise very tough macroeconomic environment. We continue to promote these products and their capabilities during the quarter, and hospitals and clinics followed suit.

Since its introduction, RapidArc has been featured in nearly 100 local, regional and national stories around the world. So this is helping to build patient awareness and demand for this treatment capability.

We added a few sales positions during the quarter to enhance our coverage and support growth in the oncology market. Additionally, we increased our R&D as a percentage of revenues during the quarter.

In short we are striving to generate continued growth in this business by investing more in sales, marketing, and product development. We believe these challenging economic times have created an opportunity for us as to further strengthen our market leadership.

Our X-ray products business turned in great results compared to the year ago quarter with net orders growing 21% to $91 million, and revenues rising 23% to $86 million. Orders of flat panel products for filmless X-ray imaging continued to grow solidly. X-ray tube orders were surprisingly strong during the quarter, but we expect tube orders to return to slower more normal single-digit growth rates for the year.

The growth came from existing customers who added to order volumes for tubes and panels, as well as several new customers who are converting their equipment to filmless imaging capability using our panels. Our new products for radiographic imaging also contributed to the order growth for our flat panel products.

Our other business category, including our SIP, security and inspection products business, our ACCEL proton therapy business and our Ginzton Technology Center generated combined net orders of $33 million for the quarter, up 15% from the year ago period.

Net orders for our security and inspection products rose 15%, driven by volume deployment of inspection systems at ports and borders around the world. The order included a bulk order of units that will be installed in the Middle East.

Higher volume and product mix contributed to the order growth and our newest dual energy scanning products for materials discrimination began to gain traction during the quarter.

So now I will turn it back to Elisha for a review of the numbers and then I'll back to you with our outlook for the second quarter and fiscal year 2009.

Elisha Finney

Thanks Tim and hello everyone. As usual I will walk you through the income statement attached to the press release as well as cover a few balance sheet items. As Tim pointed out the company's first quarter revenues increased 13% to $509 million. Oncology Systems posted an increase of 11%, X-ray products posted a gain of 23%, and the other category gained 17%.

Gross margin for the quarter was 43%, up more than half a point. Oncology Systems gross margin was 44%, up nearly a point primarily due to a significant shift to US sales and a favorable product mix that included RapidArc.

X-ray products gross margin was also up nearly a point to just over 40%, primarily because of higher shipment volumes, a favorable X-ray tube product mix, and lower cost of quality.

First quarter SG&A expenses were 16% of revenues, an improvement of about a quarter of a point due principally to higher revenues. First quarter R&D expenses were 7% of revenues, up by about a point as we stepped up our R&D investments.

Moving down the income statement, first quarter operating earnings increased 13% to $99 million or 19% of revenues.

Oncology systems and X-ray products together contributed a $119 million in operating earnings with our other businesses and corporate consuming a net $20 million.

Depreciation and amortization of intangibles totaled $9 million in the quarter. Net interest income totaled $1.4 million for the quarter, down from the year ago period due to a drop in interest rates as well as higher borrowing in the US.

Our effective tax rate was 30.5%, down significantly from the year ago quarter, because of favorable discreet items. These items included the retroactive reinstatement of the US R&D tax credit and expiration of statute of limitations on some previously filed tax returns. For the year, we continued to estimate that our tax rate will be between 31% and 32% with a rate of about 35% in the second quarter.

Average fully diluted shares outstanding for the quarter were 125 million, down 2.6 million shares due largely to our share repurchase program. We reported fully diluted EPS from continuing operations of $0.56 for the first quarter.

Now turning to the balance sheet, we ended the quarter with $423 million of cash and cash equivalents, $65million of total debt, and $1 billion of stockholders equity. DSO for the quarter was 83 days, an improvement of four days from the year ago period.

We achieved first quarter cash flow from operations of $85 million. Other sources of cash in the quarter included $25 million in short-term borrowings and $4 million from stock option proceeds.

Primary uses of cash were $72 million for the stock repurchase program and about $18 million for capital expenditures. During the quarter we repurchased about 1.5 million shares of stock under our share repurchase authorization.

Now I will turn it back to Tim for the outlook.

Tim Guertin

Thanks, Elisha. Well, despite continuing turbulent financial times we believe that fiscal year 2009 revenues could grow by about 10% to 13% and net earnings per diluted share from continued operations for the fiscal year could grow to between $2.59 and $2.64.

For the second quarter of fiscal year 2009, revenues could grow in the range of 9% to 10% with a slightly faster growth rate in operating earnings.

Including a higher expected tax rate, net earnings per diluted share from continuing operations in the second quarter should be in the range net $0.59 to $0.62.

We remain focused on execution and we are committed to continuing investments in growth through stronger sales and marketing programs as well as productive research and development efforts.

And so I guess we will take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question will come from the line of Dalton Chandler with Needham & Company. Please proceed.

Dalton Chandler - Needham & Company

Hi, good afternoon.

Tim Guertin

Hi, Dalton.

Dalton Chandler - Needham & Company

Elisha I am sorry. If you gave the revenue growth in constant currency, I missed that. Could you tell us what that was?

Elisha Finney

Yes, revenue growth for the total company for the quarter was 13% in US dollars, 15% in constant currency.

Dalton Chandler - Needham & Company

Okay. On the growth rate in new orders for Oncology Systems, you have from time to time talked about the various components of that, like the software component or radiotherapy component. Could you walk through what you saw in the different components for the quarter?

Tim Guertin

I can give you a little color on that. RapidArc and the service businesses I think we're the leaders for us in the first quarter. I think that and they added to -- the RapidArc of course is adding to the average price that we are seeing on deals as a new accessory. New Linac orders were roughly flat with the year ago period.

Dalton Chandler - Needham & Company

Okay. That's helpful. You did mention you are adding sales reps. Could you talk about where you are adding those geographically?

Tim Guertin

It's all over the place. We were adding some in the United States. We were adding some in Europe. So it's in for a variety of indications. Some of is just because as we sell more products to the average customers as they buy more things. We need to have specialists who can talk to them about those particular products. So more people that talk about treatment planning, more people talk about RapidArc, these kinds of things. So I think all together it's about 13 additional sales people.

Dalton Chandler - Needham & Company

Okay. And what does that bring your total sales headcount to now?

Tim Guertin

I don't know. I just went to a meeting where there was a ballroom full of them. So, I'm not sure.

Dalton Chandler - Needham & Company

Okay. And then you know just last...

Tim Guertin

We are north of a 100, but I don’t know what the exact number is.

Dalton Chandler - Needham & Company

Okay. And just you know lastly, last quarter you talked about how financing was definitely still available albeit at usually higher interest rates. Have you seen any change in those trends either in rates or in the amount of time it takes to get a loan underwritten?

Tim Guertin

No, basically the information that we gave you recently still holds true. We are still seeing people to be able to get loans. We are still able to get leases. The rates are about what they were, so nothing has changed recently on that picture. It's kind of reassuring actually.

Dalton Chandler - Needham & Company

Okay. All right, thanks a lot.

Operator

And your next question will come from the line of Tycho Peterson with JPMorgan. Please proceed.

Tycho Peterson - JPMorgan

Hey. Thanks for taking the call.

Tim Guertin

Hi, Tycho.

Tycho Peterson - JPMorgan

Maybe just a question on the international. Tim you talked a little about the opportunity in the Far East and some the strengths you are seeing there. Can you give us an idea I guess of how you are looking at both Europe and Asia over the coming year? And then maybe also just comment on your own China manufacturing?

Tim Guertin

Japan was very strong for us this quarter and I think it was probably the leader around the world in terms of growth rates. So very important and I think Japan is going to be important from here on out.

China, we continue to see, it just looks good for us. It just looks like China is going to work out well. We are continuing to talk to people in China in the leadership who in government positions who are anxious to see radiation therapy grow in China and we are getting to see people there we didn't used to get to see in the past and that's very reassuring. It means that, I don't think they have been meeting with us, if they didn't believe we were important for their future. So I think for China that's a real opportunity.

For Europe, I expect it will be flat to up slightly for the year and the Middle East I think will be good.

Tycho Peterson - JPMorgan

Okay. On RapidArc, can you just give a little bit more color about the order trends you are seeing in terms of, are you seeing repeat orders from some of the early adopters? How do we think about install times at this point as well?

Tim Guertin

I think we probably are seeing some repeat orders from early adopters; I wouldn't know how to give you a percentage of the total deals. What we are seeing is that the early adopters are telling other people how well it works, and that’s what's good news.

So we had at the Morgan conference a few weeks ago we -- and you were there as I recall. We brought in Shawn Zimberg, and he talked about 100 RapidArc patients a day and he talks to people. So people notice this, they listen to this, they realize that they can execute RapidArc, and we get nice letters about it.

So all of these things are the kind of things you want to have happen. And one of the reasons I want to talk about clinical installations now on rather than orders is because I want to reemphasize to everybody that that's where the rubber hits the road. You want to see people install it and you want to see them routinely treat patients because that's what causes it to propagate and what causes orders to grow.

So, I can't really tell you how much is repeat, but I can tell you a lot of it is because people are talking to each other.

Tycho Peterson - JPMorgan

Okay. That's helpful. Then just two quick ones for Elisha. On the buyback, can you just remind us what you have left? And then also the incremental R&D spend you mentioned, just give us a sense as to what that’s going toward if it's a particular area.

Elisha Finney

Well, in terms of the R&D dollars, we’ve historically run about 6% of sales and it was 7% of sales, to put it into context. And in terms of the stock repurchase program, I don't have the exact number; it's several million shares Tycho that are still outstanding under the current authorization.

Tycho Peterson - JPMorgan

Okay. Great. Thank you very much.

Elisha Finney

I think it's around 8 million.

Operator

And your next question will come from the line Amit Hazan with Oppenheimer. Please proceed.

Amit Hazan - Oppenheimer

Thanks. Hi, good afternoon.

Tim Guertin

Amit, how are you?

Amit Hazan - Oppenheimer

Very good. Just a few questions from me. Just asking kind of from the economic side maybe now that you had a little bit more time, I'm wondering your guidance looks very robust which exudes confidence. So, that's a good thing. I'm wondering if you have gone back and talked to some of your customers in your backlog and gotten confidence that those orders are indeed going to come through into delivery over the coming few quarters. Is that a fair comment, or can you comment on that?

Tim Guertin

Yes. I have failed to become depressed in the last 30 days. We have talked to a number of customers who have come in. I asked them how it looks for their institution. And our sales people are just talking to of course a lot more people than I am talking to individually.

So far what people are telling us is very reassuring. They are continuing with their plans. We have very good visibility of course for the next 120 days. And everything looks pretty much the way we expected it to look for the next 120 days. I won't say that nobody pushed out anything because that probably wouldn't be true. Some push outs are always normal for us. What I am telling you is we are not seeing anything out of the ordinary for us.

And nobody has told us that they are changing any of their dates because of macroeconomic conditions. Its other typical kinds of circumstances like construction delays and that sort of stuff. So that's all good news. And of course, for the orders profile, we talked to lots of people. What we are seeing is that we are seeing scrutiny by some institutions on their capital budgets, but radiation therapy is typically remaining in.

In other words, they are cutting back on their capital spending but radiation therapy appears to be one of the items that they want to keep in because it's a revenue generator for them. So I think they want to make solid decisions. They want to make prudent decisions, they want to be careful of their cash and they want to spend it properly, but they haven't cut their capital budgets to zero. They are just eliminating the things that don't add revenue for them or aren't good investments in the short-term and we remain a good investment for the short term.

So nothing, nobody has told me anything that says I want to really love your machine but we are not spending money on anything. Thus I'm not getting that message.

Amit Hazan - Oppenheimer

Okay. That's very helpful. And then Elisha on the gross margin line, the RapidArc, I think it's really the first time that I’ve heard you talk about RapidArc as a contributor to margins maybe even to some extent material enough contributor that you would mention it. I'm wondering if you can help us out a little bit in terms of how much it helped in the quarter and also how to think about margins for the remainder of the fiscal year now that RapidArc installations are more than likely to be increasing every quarter.

Elisha Finney

Right. To put it into context, RapidArc still represented less than 5% of the total oncology sales in the quarter, so it is still very small. With that said, it's a pure software product, so it carries our historical margins in the 80% to 90% range. So it is, in any given quarter it can have an impact, by a much, much bigger degree in the first quarter, was that we had a significant shift to US delivery. It was 60% US sales, 40% international. That was a 14 point swing versus a year ago period, so that was a much-much bigger contributor to the margins.

So for the year, we will see some gross margin improvement and I think that for oncology that will be driven by RapidArc.

Amit Hazan - Oppenheimer

Okay. That's very helpful. And then just on currency, if you can give us the -- in terms of the orders or the international orders, what were they in constant currency and then also, what is the exchange rate that you are now implying in your new guidance?

Elisha Finney

Well, it moved all over the board just today as a matter of fact. But you can assume that at any point when we go out and give guidance and meet that we are looking at rates at that point and building a range around that. So I absolutely agree with Tim that the backlog is holding from what we see. The currency is a more difficult thing for us to estimate, because we’ve just seen extreme volatility, and that's why we’ve got a pretty wide range on the top line growth for the year, really if you take into account the currency volatility.

In terms of orders for the quarter, Q1 oncology orders were 11% in dollars and also 11% in constant currency. And that's because the weak, the yen is very strong and so that helped even as the euro weakened. And then total company orders were up 13% in dollars, and again 13% in constant currency as well.

Amit Hazan - Oppenheimer

Okay, good. I will jump back in queue. Thanks Elisha.

Operator

And your next question will come from the line of Amit Bhalla with Citi. Please proceed.

Amit Bhalla - Citigroup

Good afternoon. Question for you Elisha on the guidance. You beat the quarter by $0.04; you raised the year by a penny. Is there a level of caution that you are taking in the numbers? Maybe you could walk us through what your assumptions are. And the reason I ask is, Tim, you mentioned linacs themselves were flat year-over-year. So is the assumption underlying here is a full year linacs are flat as well?

Elisha Finney

Again, Amit, you know from where we sit today backlog and the customer delivery dates are holding. I think we are obviously cautious around FX rates and what impact that’s going to have on the year and again building a little wider range in there to account for that. As Tim mentioned, we are increasing R&D and significantly interest rates have effectively gone to zero which historically we had been earning around $1.5 million a quarter in interest. So we also are adjusting for that as well.

Amit Bhalla - Citigroup

The question I had on the linacs. What's the underlying assumption for linacs, if they were flat this quarter what's the assumption for the rest of the year?

Tim Guertin

Well, that was an order thing. Our forecast for the year, I don't break it out by individual products. I will sort of give you that retrospectively, but we're still expecting decent orders growth for the year in for the overall oncology business and it would be hard for me to sit here and break that down into the individual components right now.

Amit Bhalla - Citigroup

Okay. Then a question on just the pricing environment. How much pricing power do you have either maybe you could walk through that overseas as well as in the US?

Tim Guertin

Probably have less pricing power than I would like. Our competitors are continuing to drop their prices and which is probably something they feel that they need to do. And so that's a downward pull. And when customers don't have all the money they would like to have, sometimes they order smaller configurations than they would otherwise order. And that means some of our most valuable accessories aren't part of the orders. So, those things would tug us down.

Obviously in the Far East where currencies are doing well that doesn't affect us as much. And in the US we are not seeing that effect so much. We are seeing people they’ll buy up. I think both stereotactic accessories and RapidArc accessories are pulling us up in terms of pricing and so those two effects are probably working against each other. But this is one of the places if you are going to have a tough economic time, this is one of the places where you would expect it to hit. People maybe little more cautious in terms of what they may still order but they may order less and so we will have to watch that.

Amit Bhalla - Citigroup

And is there any other, any comment you could make on how January has progressed thus far. I think I mean given your guidance I think I know the answer but I'm just curious if you could add any color on how January has done?

Tim Guertin

I can’t see it, but Elisha has got a large weapon aimed at me if I answer that question, so I probably will not be able to answer that for you. Sorry.

Amit Bhalla - Citigroup

Okay. Thanks.

Operator

And you have a follow-up question coming from the line of Tyco Peterson with JPMorgan. Please proceed.

Tycho Peterson - JPMorgan

Hey, thanks. I just wanted to probe on the Linac question a little bit further because I think you said in the past about maybe half your RapidArc orders were tied to new linacs. Can you just give us a sense as to whether that's changed and maybe a little bit more clarity on what you are expecting from linacs and now you don't really want to break it out, but are you assuming that linacs orders will grow this year?

Tim Guertin

I don't have the exact ratio of upgrade to orders of RapidArc with new linacs yet I don't have that data at this point. However in the past it has been the vast majority of them with new linacs. So I would expect that overtime the percentage of people who order RapidArc with linacs will rise. But I’d like to get-- I want in the future, I want to get away from talking about RapidArc orders and just talk about RapidArc installs because I think that is the most important thing to focus on. The fact that linacs were flat this quarter is a point on the graph. It's not the graph.

Elisha Finney

And I would just remind you guys that we saw 17% orders growth in the year ago quarter, where most of our orders came in the first half. So tough comp again.

Tim Guertin

It was a tough comp. And linacs were up last year. So it is a tough comp and I'm telling you that it happened, so you know, but I wouldn't draw any conclusions from it.

Tycho Peterson - JPMorgan

Okay. Thanks for your clarification.

Operator

And your next question will come from the line of Jeff Rhode with Segall Bryant. Please proceed.

Jeff Rhode - Segall Bryant

Hi. Thanks for such a good solid quarter. Tim, could you remind us how your customers -- in the past you’ve provided a little bit of breakdown on who uses external financing and things like that.

Tim Guertin

There is a small percentage of customers, would you say, Elisha, that use leasing?

Elisha Finney

Well, yes. Through our leasing program we were going out and facilitating, it is probably somewhere around 15 deals a quarter. But we don't necessarily know if a customer is getting their own financing because in those cases they are just paying us cash.

Tim Guertin

They don't tell us. So we just see the cash. But I'm sure a significant number of them do go out and get financing, especially entrepreneurial sites.

Jeff Rhode - Segall Bryant

And, you want to share that linac graph with us?

Tim Guertin

I'm sorry.

Jeff Rhode - Segall Bryant

Thought we could ask.

Tim Guertin

Okay. No, this isn't -- I don't think this is something we ordinarily track. All we are indicating to you is, we have seen more customers come to us who said, rather than financing this through their normal hospital mechanism, we want to talk to the leasing companies that you have available Varian. And I think that has gone up considerably in recent times. Although, it's still far from the majority of our business in North America.

So, that number has gone up and we been able to get all the people the help that they needed, which is very reassuring. What we are seeing is probably a shift in the way some hospitals are getting their money. And I have had people come in who are interested in using -- I think I've talked about these people before intermediaries, who get financing from other sources and who step in and help customers get through this.

So, these are places where hospitals maybe don't want to spend their own capital budget and would like to see the capital come from some other place and these people step in and help to solve their problem. So we've seen more of that. I wouldn't say that we have seen an astounding amount of that, but we've seen a little bit of it and we expect that number will grow more and more in the future. I have started talking about it qualitatively rather than quantitatively.

Operator

And your next question will come from the line of Amit Bhalla with Citi

Amit Bhalla - Citigroup

Thanks for the follow-up. Elisha, I'm not sure if you have answer this, but in terms of gross margin trend for next quarter and the rest of the year, can you just go over that one more time?

Elisha Finney

Well, as we said for next quarter that the operating earnings would grow slightly faster than the top line growth. So, you can assume that some of that will come from gross margin, some from leveraging SG&A, offset by most likely an increase in R&D as we talked about.

Again, for the year the operating earnings growing faster than the top line and a piece of that coming from gross margin. So, we do expect some improvement in margin for the year. Again, currencies are going to drive this. To be honest, we manage the business at the operating earnings level, because people can compute gross margin slightly differently with where you put continuing engineering as an example. So, we are managing all of the business units on their operating margin percentage.

Amit Bhalla - Citigroup

Yeah. Thanks.

Operator

And there are no further questions at this time. I would now like to turn the call back over to Mr. Spencer Sias.

Spencer Sias

Thank you for participating. For listeners who may have come in late this call has been taped and it will be available for replay on the Investor Relations page of our website at www.varian.com/investor beginning at 4 PM today. You also access a replay via telephone by calling 1-888-286-8010 from inside the US or 1-617-801-6888 from outside the US and enter a confirmation code number 54317886. The telephone replay will be available beginning today at 4 through 5 PM this Friday January 30th. The replay will be archived and available on the company's website for one year. Thank you.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect and have a great day.

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