Varian Medical Systems Inc. - Shareholder/Analyst Call

| About: Varian Medical (VAR)

Varian Medical Systems, Inc. (NYSE:VAR)

February 09, 2012 7:30 pm ET

Executives

Richard M. Levy - Chairman and Chairman of Executive Committee

Timothy E. Guertin - Chief Executive Officer, President and Executive Director

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

Dow R. Wilson - Chief Operating Officer and Corporate Executive Vice President

Robert H. Kluge - Corporate Senior Vice President and President of X-Ray Products

Richard M. Levy

Good afternoon, ladies and gentlemen. We've reached the 4:30 starting time. The meeting will now be called to order. It's my pleasure to welcome you to the 2012 Annual Meeting of Stockholders of Varian Medical Systems. Quick reminder, this meeting is being webcast, and we'll request that you please turn off your cell phones, which I haven't done yet myself actually.

I'm Dick Levy. I'm Chairman of the Board. Here at the head table with me are Tim Guertin, President and Chief Executive Officer; Elisha Finney, Corporate Senior Vice President of Finance and CFO; Dow Wilson, Executive Vice President and COO; and John Kuo, Corporate Vice President, General Counsel and Secretary. Other directors in attendance, all sitting in front, are Andy Eckert, Dave Illingworth, Mark Laret, Rudi Naumann and Thyagi [Thyagarajan]-- so, Thyagi. Excuse me.

I also want to take a moment to recognize Dave Martin. Dave, raise your hand. Dave is leaving our board. As of this meeting, he's termed out. He's actually been on the Board of Directors of Varian in Varian Associates and Varian Medical Systems going back to 1994, and his term finally expired in 2011. That's a long tenure, but Dave has been a visionary to our board, an ethical compass to the company, a teacher to all of us and a friend to all of us. He served in the old Varian board, and he served during the turbulent period when we split apart the company and became Varian Medical Systems, created a new name, a new charter, a new business strategy, and Dave was there part of that effort. So he's been a great asset to this company and to this board, and we thank him for his service and tell him that we will miss him greatly. David, thank you.

We have other executives in attendance today: Kolleen Kennedy, who is Corporate Senior Vice President, President of Oncology Systems; Tai Chen, Corporate Vice President, Finance, and Controller; Franco Palomba, Corporate Vice President, Finance, and Treasurer; Wendy Scott, Corporate Vice President, Human Resources; George Zdasiuk, Corporate Vice President, Ginzton Technology Center; and a new Vice President, Jennifer Halsey, Senior Vice President of Strategy and Business Development; Lester Boeh, Vice President of Emerging Businesses; Jessica Denecour, Vice President, Corporate Communications -- or Vice President, Chief Information Officer; and Spencer Sias, Vice President, Corporate Communications and Investor Relations, in the back.

I'd also like to recognize Barbara Lange of Orrick, Herrington & Sutcliffe, our outside legal counsel; Greg Vlahos, Tania DeVilliers and Travis Merz of PricewaterhouseCoopers, our independent auditors; and Chris Ecko [ph] of Ecko [ph] Group, representing our inspector of elections. Craig Morrow will be serving as sergeant at arms for today's meeting.

Since I'm advised that we have a quorum, here is how we will conduct the meeting. After we have conducted a formal part of the meeting, I will announce results. After that, the meeting will end, and Tim and Elisha will give a brief overview of our business operations and financial performance this past year. We can then take questions from the floor.

This year, we have 4 proposals to consider. Information regarding each of these proposals is in the proxy statement for this meeting. The first proposal is for the election of 3 directors to serve until the 2015 Annual Meeting of Stockholders. The 3 nomination up for vote are Tim Guertin, Dave Illingworth and Rudi Naumann. The nominations for these directors are now closed. The second proposal is to hold an advisory vote on the compensation of our named executive officers. The third proposal is to approve the amendment and restatement of the Varian 2005 Omnibus Stock Plan. And the fourth proposal is to ratify the selection of PricewaterhouseCoopers LLP as our independent registered public accounting firm for fiscal 2012. The polls are now open for any stockholder who wishes to vote. If you'd like to cast a ballot, submit a proxy or change your vote, please do so at this time. Extra ballots are available, so please raise your hand. You'll be given one. After you have completed your ballot or proxy, you may submit it at the polls in the rear of the room.

If you previously submitted a proxy, your proxy will be voted on in accordance with the instructions that you gave. If you gave no instructions, your proxy will be voted in favor of all the proposals. This does not prevent any stockholder from voting or changing his or her vote at any time up to the moment the poll is closed. However, if you have already submitted a proxy, there is no need to vote again at this meeting unless you need to change your vote. At this time, would anyone who has not already voted and wishes to do so, please turn in your proxy or ballot. The polls are now closed. I would like to call for a preliminary report of the inspector of elections.

The inspector of elections has certified that a quorum of the shares entitled to vote was represented in person or by proxy. The inspector has also certified the preliminary results of the voting, which are as follows. On Proposal 1, all 3 director nominees have been elected as nominated. Congratulations to Tim, David and Rudi. On Proposal 2, the compensation of the Varian Medical Systems named executive officers as described in the proxy statement has been approved. On Proposal 3, the amendment and restatement of the Varian Medical Systems 2005 Omnibus Stock Plan has been approved. And on Proposal 4, the selection of PricewaterhouseCoopers LLP as Varian Medical Systems' independent registered public accounting firm for fiscal 2012 has been ratified.

This concludes the formal part of the agenda. Since there's no further business to come before this meeting, this Annual Meeting of Stockholders stands adjourned. However, I would like to turn the meeting over to Tim Guertin and Elisha Finney, who will provide a general overview of our operations and our financial performance. Tim?

Timothy E. Guertin

Thank you, Dick. So welcome, everybody, and we're going to begin actually by going over the numbers and then I'll be talking about the performance of the business units and the strategy and all of that. So with that, Elisha, try not to tear down the building...

Elisha W. Finney

I'm all wired up here. We'll see if it will work. Thank you, Tim, and hello, everyone. It's nice to see you here again this year. As typical, I'm going to cover the financial results for fiscal year '11, and then I'm going to touch on our first quarter that ended in December and end with the outlook for the balance of the year. But before I get started, I just want to assure you all that just because every single person on the Varian's executive management team is in a black suit today, that the numbers are actually quite good, so we're reporting some good performance for 2011.

Timothy E. Guertin

They don't have red suits.

Elisha W. Finney

Green suits. We will be making some forward-looking statements. Okay, so this is just a snapshot of fiscal year '11. Orders of $2.9 billion were up 15% over the prior year period. You can see sales of $2.6 billion, up 10% operating earnings; meaning, for every dollar of sales, we bring in on a pre-tax basis $0.23 and employees of about 5,700.

Net orders and the -- let me just say net orders for the total company again were up 15%. This does include a Proton Therapy order. We'll come back and talk about that just a little bit. Oncology Systems orders were up 8% to $2.2 billion. North America was up 5%, and the international markets came in strong, up 11% for the year. Europe was particularly strong. And rest of the world, which includes Latin America and Australia, were also very strong. I have to say we are pleased with the performance in Oncology Systems in the year, given that we were operating in a very tough global economic environment, and in the U.S. that there continued to be questions surrounding health care reform and reimbursement changes. X-ray Products grew orders 15% to $483 million with very solid growth in both our flat-panel technology and X-ray tubes, which were both up in the mid-teens. And flat panels has been really a growth driver over the last several years and, today, represents fully 50% of the total X-ray Products segment. And then let me touch on this other category, which had orders of about $200 million for the year, which was up significantly from the prior year, and that was driven by an order for Proton Therapy. This is where we're going to be delivering a system to the Scripps facility in San Diego and booked $88 million in the fourth quarter of the fiscal year.

Revenues, as I said, were up 10% for the total company. Oncology Systems was up 9%, and we had very strong growth in our service business, and we also had that led by the TrueBeam technology that you -- we'll touch on later and that Tim will mention, but we had revenue for 112 systems in the fiscal year for TrueBeam, which is really, really good after an introduction just a couple of years ago.

X-ray Products, up 16%. Again, both tubes and flat panels, with significant growth, that's the biggest part of that coming out of the flat-panel technology. And then again for the Scripps Center, we are recognizing the revenue on what's called a percentage of completion basis, so we had -- we have already begun that project. Installation is ongoing, and we did record $33 million of revenue for that project in the year.

Moving to the profitability for the year. Our operating margin at 23% was even with the year-ago period. If you exclude the protons, which aren't yet dilutive to Varian's overall profitability at this point, it would've been 23.3%, so a little bit of growth year-over-year in the operating margins. Operating earnings, up 10% to $589 million. And with the help of a slightly lower tax rate and lower shares, we had net earnings up 11% for the year.

Let me just move now to the first quarter that just ended in December, and one of the problems with having a near-perfect quarter is you get to compare yourself to that a year later, and that is exactly what happened this quarter. In the year-ago period, we had record margin -- record operating margin, and so it made the comparison difficult. But that said, we came in slightly ahead of our expectations in the quarter, and some revenues and profits were on track and in line with our expectations.

Orders were up 2%. This is the area that was a little surprising to us in the quarter. Oncology was up 6% with all of that growth coming from international markets, where we saw 22% for international. Europe was up 18%, and the Far East was up 27%, so really strong growth outside of the U.S. Where we saw a decline was in the U.S. or in the North American market, where we experienced some order push out. We believe this is just timing and that these orders will, in fact, come in the balance of the year, but we saw a decline in North America in the first quarter.

We also have some surprises in our X-ray Products segment, which you'll see that the orders were down 2%. We had -- this is an inventory adjustment from our -- one of our -- actually, all of our Japanese customers, but one of our largest customers is in Japan, and this was just -- they were, after the tsunami, trying to keep production levels up, and they were just not able to do that, and so our components were on the shelf. And so there's just an inventory correction going on. We'll have a little bit of that in this second quarter that we're currently, and then we should resume to double-digit growth in the second half of this fiscal year.

Revenues -- I should point out that you'll see that there's no proton order in the first quarter, but subsequent to the close of the quarter, we did just book another $77 million Proton Therapy System that's going to be going into Saudi Arabia, so very exciting that we now have 2 orders booked in the backlog for that product. Revenues were up 8%, again, in line with our expectations; 8% for oncology; and 1% in X-ray due to that inventory adjustment.

Profitability in the quarter. In the year-ago period, gross margin had an all-time record, and so this quarter, we did come down by 3 points. Again, we were fully expecting that, and it had an impact on our operating margin, which fell by 3 points to 21%. Operating earnings were down 6%. We had a higher tax rate but lower shares, and so net earnings were down 6% in the quarter as well.

Into the backlog, at $2.5 billion, which is up 14% over the year-ago period. So again, backlog, meaning these are orders that we have booked that will be future revenue -- kind of the revenue in the bank, if you will, and these machines will deliver within the next 24-month period. So looking out, this gives us very good visibility as we're looking out for the balance of this fiscal year by virtue of having these machines in backlog.

A note on the balance sheet. I would continue to characterize our balance sheet as very strong and very conservative. $600 million of cash and equivalents at the end of the first quarter, we have -- the $25 million short-term investment is with the Scripps facility. Varian is actually lending money to the customer, and they have drawn down $25 million under that facility. We had $188 million of debt. You'll note that this is significantly higher than what we would've reported to you in the year-ago period. We drew down under a letter of credit in order that we could facilitate a fairly large share repurchase program for the year.

DSO at 86 days was up 8 days. About 4 days of that is due to protons. Again, it's the project accounting and the fact that we are taking revenue in advance of when the customer payments are actually due to us, and we are seeing some slowdown in collections in Italy and in Spain, as you might imagine. Collections in the U.S. continue to be quite strong. Cash flow from operations was $53 million in the quarter. It was $473 million for the fiscal year. So again, just a very strong cash flow generation, and we expect that we will average over $100 million a quarter for fiscal year '12 as well. We did spend, as I mentioned, a significant part of that cash to repurchase shares. We have 7 million shares remaining in our current authorization.

And just finally, on the outlook for the balance of the year, we believe that revenues will grow for -- at about 10%, and that earnings per share can grow at about 15% for the year, so some pretty significant EPS growth, helped by a slightly lower tax rate, lower shares, but we are getting good solid earnings in the businesses. And you can see in the second quarter, 8% on the top line and 12% to 13% on the bottom line. Thank you, and I'm going to turn it back to Tim.

Timothy E. Guertin

Thanks, Elisha. Let me begin by recognizing someone that Dick didn't mention. That is Bob Kluge. Bob, you want to stand up? Bob is the Head of our X-ray Products business, and he got here early enough to make the meeting, so welcome, Bob. Everybody should go up and shake his hands later, so he feels good that we didn't forget. With that, I'm going to start by discussing the Oncology business unit. As you know, Oncology is our largest business, and it has an extremely important mission, which is to invent devices that can use radiation to treat cancer. And I think mission is very important to this company. We are a company that uses reduces radiation science in the service of saving lives and preventing harm in all of our businesses, and we've been particularly successful in doing that in the Oncology business unit. So let me start with a little movie to talk about that. We need more sound.

[Presentation]

Timothy E. Guertin

Now, this is not working. We're -- we -- he actually has a much higher voice, and he speaks faster than that. Although Elisha says I talk too fast when I do presentation, so maybe I should learn to talk like that. Okay, I'll tell you what we're going to do, we're going to skip that and see if we can fix that by the end, if we can. So with that, one of the areas that's important to us is we've introduced a new product about 2 years ago that's called a TrueBeam. It's been a very successful product introduction for us. We've had 425 orders since the April 2010 launch, 175 installs are complete or underway, and here's a comment by one of our customers in Sweden that they had been forced in the past to introduce shifts to keep up with the patient. They had huge patient demand, but since they introduced TrueBeam, they're able to go back to a normal working day. And it's -- so in Sweden, normal working days are very important, so and as you can imagine around the world, this has been an extremely important effect.

So one of the things that TrueBeam can do extremely well is treat patients with radiosurgery. It is our most advanced radiosurgical machine, and so to give you an example of some research that had taken place on this: lung cancer treatments using radiosurgery; traditionally, lung cancer would be treated with surgery unless the patient was inoperable; what we're looking at now is the possibility of treating operable patients with early stage in lung cancer. So here's a study that was done in the Netherlands, which shows that with 177 patients treated between 2003 and 2010, we got 93% local control rate of the tumors, and that's the equivalent control rates for surgical procedures. But mortality and patients who received the stereotactic radiosurgery was 0 compared to the 2.6% who died when treated surgically within 30 days. So this is the kind of thing that makes me optimistic that this is a procedure that may improve the quality of life for cancer patients, and perhaps even improve survival rates as well.

Looking at Spine, which is another area of importance to us. This is referring to the results of a Phase II study using image-guided stereotactic radiosurgery for spine metastasis. This was done in community hospital settings. 46 patients were treated at 16 institutions, so this is a multi-institution trial. Treatments were delivered less than 2 to 3 millimeters of deviation and the trial was so successful that it's going to proceed with a Phase III study and look at 240 patients. So that's an example of the kind of progress we want to see.

We made an acquisition of Calypso in the fourth quarter of this year -- or I guess, the first quarter. We closed in the first quarter. This little device that you see up there, which is about 7.5 millimeters long is a real-time device. You can implant it in a tumor or other structure and it gives you information at a high rate about exactly where that little beacon is in 3-dimensions, which enables us to stay on targets with 2 moving targets. Otherwise, it would be very difficult to do. It is a small company, less than $15 million in annual revenues, it has about 110 systems installed, but they have treated over 10,000 patients. They have 90 current or pending patents and about 80 employees in -- located up in Seattle. So we're very proud that Calypso has joined the Varian family. To give you an idea about clinically what we think we can do, there's been some studies, a Phase II study on low-risk prostate cancer patients, that's treated 80 patients. They used stereotactic body radiation therapy, so this is 5 fractions instead of the traditional 40 that you would use. They use Varian and Calypso technology. So they had the real-time ability to watch what the prostate was doing. The patients receive 5 treatments each, and they receive significant decreases in toxicity and improve quality of life and great biochemical outcomes.

Their PSA rate fell rapidly over a period of 24 months, So this looks like the kind of thing that we want to be able to do. Very little impact on the patients in terms of installing the device, but a great deal of impact in terms of long-term quality of life.

I'm going to move now to the X-ray business. What you see up here is what's called the M-1500 mammographic tube. It's that anode-grounded tube, so it's based upon our great anode-grounded tube work that Bob and his team started with about 7 or 8 years ago, I think. And it's extremely space-efficient tube, it's high-powered and very small and has very high level of performance.

And combined with that, we have the PaxScan 3024M, a mammographic flat-panel detector, very high resolution, 83 microns, I was sitting over here earlier trying to figure out just exactly how big 83 microns is. It's very small. Recognized for reliable mobile applications, and it uses amorphic silicon. A lot of mammographic panels use a more touchy system for imaging than amorphic silicon, so this is a very reliable panel. It's capable of doing tomosynthesis imaging, and it's one, the edge of the panel can get very close to the patient's skin, so you can get nice chest wall visualization, which is an important requirement for mammographic panel. At the same time looking at mammography inside the oncology business unit, we've introduced this new tabletop that enables women to be treated for breast cancer in the prone position.

Ordinarily, in radiation therapy, traditionally, we would treat patients laying on their back, and this enables the patient to -- for whom this is appropriate to lay on their stomach, that can reduce the dose to the heart, lungs and other healthy tissue. It can reduce tumor motion, and it can increase patient comfort. So to give you an example, there's -- we're doing additional research in this area. Where we have positioned a number of patients in -- at NYU, and 85% of left breast cancer patients are positioned this way and we're seeing a lot less motion in the prone position, which makes targeting easier, and we can keep the lung, excuse me, we can keep the heart out of the field and heart exposure in radiation is one of the effects you want to avoid because heart exposure to radiation over a period of many years can cause heart problems for patients. So this is a nice addition. I'm not saying that everybody in the world is going to get treated this way, but there are a significant number of patients, who look like that they will benefit from this kind of research.

I'm going to switch now to Particle Therapy business. Elisha mentioned a few minutes ago that we got the Saudi order for a Particle Therapy System, $77 million order, we expect to start that installation in 2013 and do treatments in 2014. The Scripps center, we booked an $88 million order for this last year, and we have a $60 million 10-year operations and maintenance agreements. So when I talk about the original price of this deal, you have to recognize that these are worth a lot more when you add in the operations and maintenance agreements.

Treatments are scheduled to begin there in 2013. You can see the Scripps building in the upper right and in the lower left you can see one of our Cyclotrons, a fairly svelte 90 tons. The -- we have a number of pending projects: the University of Maryland, the Emory University, Mestre, near -- which is at the site near Venice, Italy, and possibility of a site in Saint Petersburg, Russia so this business is gaining momentum, very nice to see. We've been investing in this for quite a few years now. So all together, I think we're on the right track in terms of achieving our mission. We say our job is to save another 100,000 years -- 100,100 lives every 5 years. We want to increase the number of people who can survive cancer, and I think we're doing the right thing. This is kind of a Where's Waldo moment because I'm in this picture, but -- so those of you who are in this picture you can look for yourselves at your leisure. But I think we are -- we're doing great things. We're not only making a lot of money. We're accomplishing the mission. Do we -- have we got the mission thing working now? Great, take over.

[Presentation]

Richard M. Levy

Thank you, Tim. Thank you, Elisha. We are now open to questions.

Question-and-Answer Session

Unknown Attendee

Yes. What's your percentage of worldwide sales now as compared to domestic in the United States?

Timothy E. Guertin

I think it's 58%.

Elisha W. Finney

Yes, it's roughly 55%, 45%, international, domestic. It can change in any given quarter, but that's it roughly.

Timothy E. Guertin

Other questions? Yes, sir?

Unknown Attendee

50 years ago, the nuclear engineering at Cal and went up to one of their big machines and was told they would soon be doing proton therapy. How come it's taking so long [indiscernible]?

Timothy E. Guertin

I was doing -- I was at Cal 50 years ago too, and they were actually treating patients. He wouldn't let me do it. It's a fair question, and it's an awfully expensive machine. You remember how big that machine was at Cal?

Unknown Attendee

Bigger than this hotel?

Timothy E. Guertin

Yes, bigger than this hotel. That's the problem. So that's -- svelte 90 -- I'm on the mic, and that svelte 90-ton Cyclotron took a long time to make. That's a superconducting Cyclotron. A lot of technology had to be made, but I -- we're finally, the train is pulling up to the station so I think we made it.

Timothy E. Guertin

That was an interesting question. That was a $100 million machine at Cal. And that's in 1960 dollars. That's a lot of money.

Unknown Attendee

I'm just curious, what are we manufacturing in China?

Timothy E. Guertin

We have a -- Dow, why don't you talk about China?

Dow R. Wilson

[indiscernible]

Timothy E. Guertin

Use a mic too.

Dow R. Wilson

We have a small facility in China, and we make some low-energy -- gradually moving all of our low-energy product line in China. We have really reached the capacity of our Palo Alto facility. In Palo Alto this last year, we probably built 500 plus -- 550 systems in Palo Alto. For those of you who remember the day when we though it that was full, and we're doing a dozen a year, it is -- it has changed quite a bit. We'll probably make 40 to 50 systems in China this year.

Timothy E. Guertin

And we have a very small ability to reload tubes in China as well, but most of China is an educational facility because we have a huge requirement. In China, there are about 1,000 machines, maybe 1,200 machines at this point. They have a need for 4,000 machines, and the only way that's going to happen is we have to train an astonishing number of people on how to use our equipment. And so we're cooperating with the users. We had a meeting earlier today with somebody who wants to work with us on how to do this. And so we have to set up major education facilities, and then they have to be able to use the actual equipment. So we build test levels there, so that people can actually use the equipment and see how it works and learn how to do QA and physics and all of those kinds of things, major undertaking for us.

Richard M. Levy

If there -- one more back here.

Unknown Attendee

I'm Sharon York [ph], came up from Southern California, and I remember last year, you guys had told me that you're selling to City of Hope down there, and I think they're using that device that was invented in 2010 quite successfully. I'm just wondering, is there any way to get a list of facilities that use the new mammography device? Is that anything available?

Timothy E. Guertin

That's an interesting question. That's something we've just introduced, Bob, isn't that right? The mammography tube and panel.

Robert H. Kluge

Yes. That's -- the equipment that was shown there is being incorporated into new equipment of 2 different suppliers that probably wouldn't want me to name them right now. And we also have samples out to several others. My division sells product to big OEM, and so they're very interested in technology, people who want to step ahead a little bit. One of the interesting things about that X-ray tube is its very high output. I mean it's very, very clean beam. Normally an X-ray tube has an awful lot of scattered radiation that has to be dealt in some fashion or another, and it's not useful relative to diagnostic procedures. This X-ray tube has an extremely clean beam, which is very attractive to mammography.

Timothy E. Guertin

That's an interesting idea. We don't usually talk about this, but maybe we should consider it now. Thanks for that suggestion, I'm going to put it in my head, so thank you.

Richard M. Levy

Okay, why don't we adjourn the meeting. We're going to have some refreshments outside, and there's --and we'll all hang around and maybe talk and answer questions that you might have in the reception room, and we hope to see you there. So the meeting is now adjourned. Thank you for attending.

Timothy E. Guertin

Thank you.

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