Varian Medical Systems (VAR) Dow R. Wilson on Q3 2016 Results - Earnings Call Transcript

| About: Varian Medical (VAR)

Varian Medical Systems, Inc. (NYSE:VAR)

Q3 2016 Earnings Call

July 27, 2016 5:00 pm ET

Executives

Spencer R. Sias - VP-Corporate Communications & Investor Relations

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

Elisha W. Finney - Chief Financial Officer & Executive Vice President

Analysts

Anthony Petrone - Jefferies LLC

Leigh Pressman - Citigroup Global Markets, Inc. (Broker)

Brandon Henry - RBC Capital Markets LLC

Jeff D. Johnson - Robert W. Baird & Co., Inc. (Broker)

Stephen C. Beuchaw - Morgan Stanley & Co. LLC

Tycho W. Peterson - JPMorgan Securities LLC

Vijay Kumar - Evercore Group LLC

Jason H. Wittes - Brean Capital LLC

Operator

Greetings, and welcome to the Varian Medical Systems Teleconference. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host Spencer Sias, VP Investor Relations for Varian Medical. Thank you, Mr. Sias. You may now begin.

Spencer R. Sias - VP-Corporate Communications & Investor Relations

Thank you. Good afternoon and welcome to Varian Medical Systems conference call for the third quarter of fiscal year 2016.

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 we'll 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. Quarterly comparisons are for the third quarter of fiscal 2016 versus the third quarter of fiscal 2015. References to financial results for orders are to gross orders, unless otherwise indicated.

This discussion includes some non-GAAP financial measures in order to provide quarter-over-quarter comparisons of operational performance, excluding unusual items. A reconciliation to the most comparable GAAP measure is included in our earnings release, which can be accessed on our website.

Please be advised that this discussion contains forward-looking statements. Our use of words and phrases such as outlook, believe, expect, anticipate, could, will, scheduled, and similar expressions are intended to identify those statements, which represents 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 third 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 - President, Chief Executive Officer & Director

Good afternoon and welcome. Varian is reporting solid results for the third quarter of fiscal year 2016, with strong gross order and revenue growth in our Oncology Systems and Imaging Components business together with substantial improvements in gross and operating margins for both.

In summary, the company is reporting GAAP net earnings of $1.04 per diluted share and $1.22 per diluted share on a non-GAAP basis. Revenues of $789 million, up 1% versus the year-ago quarter, a nearly four point improvement in the company's overall gross margin, and an order for a new multi-room Proton installation in China, our first Proton order there.

Focusing on operational highlights, our Oncology business generated third quarter gross orders of $676 million, up 6% in both dollars and constant currency. Gross orders in the Americas rose by 8% during the quarter, with 15% growth in North America more than offsetting a greater than 40% decline in Latin America.

Year-to-date gross order growth in North America is 8%, driven by a more stable reimbursement environment and in this replacement market, a transition to more advanced clinically efficient systems. Gross orders in APAC increased 19% in dollars and 17% in constant currency during the quarter, driven by robust growth in China and Australia. In EMEA, gross orders declined 3% in dollars and 4% in constant currency, reflecting weakness in Western European markets.

Looking at each of the regions in more detail, our growth in North America was driven by demand for our TrueBeam platform, including Edge radiosurgery systems and our software offerings. Among the highlights for North America were several large multi-system orders from consolidated networks, as well as competitive take-outs. Order activity in Latin America continued to be weak due to macroeconomic factors. During the quarter, we shipped the first units for the large tender conducted by Brazil's Ministry of Health a couple of years ago.

Turning to APAC, the Icon Group placed the largest Varian order ever in Australia for 10 TrueBeam systems, seven of which are going to new sites along with a full complement of our information management and treatment planning software. We had wins for several new accelerator installations in China, where we saw good orders growth. We also saw strong demand for our Edge radiosurgery system in this market where we continue to be the share leader. Elsewhere in APAC, we made good progress in Thailand, Vietnam and Indonesia. Business was stable in Japan where we saw good service growth.

Turning to EMEA, healthy gross order growth in emerging markets including Iran, Russia, Ethiopia, Burkina Faso and Libya was offset by weakness in Western Europe. Our third quarter business in Africa was outstanding, with more than $25 million in gross orders. Among other wins, we saw Ethiopia order its first modern linear accelerators for cancer treatment.

I'm pleased to report that overall unit order volume was up in the quarter and year-to-date, and that average pricing is stable. We're winning with clinically efficient advanced technology that makes quality cancer care affordable and accessible. This was reflected during the quarter in strong orders for our RapidPlan and InSightive Analytics software. We booked our 500th order for RapidPlan, which is a game changer that enables clinics to improve the speed and quality of care for their patients. As of this quarter, treatment plans are now being shared among clinics to our OncoPeer web portal.

As you all know, CMS has announced modest adjustment to reimbursements for 2017 for both hospitals and free standing clinics. We don't expect reimbursement to have a material impact on the radiation oncology markets in the U.S. next year. While we're on the topic of reimbursement, CMS did move forward with policies that will incentivize the adoption of digital x-ray imaging systems in place of film and computed radiography systems. And this should help to support growth in our Imaging Components business.

Speaking of Imaging Components, the business return to growth during the quarter, orders grew by 13% to $138 million and revenues rose by 9% to $147 million. Improvements in margins were driven by productivity gains and a favorable product mix.

Our Tube business saw a good growth in the quarter. We recently celebrated the 40th year of our relationship with Toshiba Medical Systems, and look forward to continuing this relationship when they become part of Canon.

Our recently acquired software and x-ray accessories businesses also helped to drive growth. Touching on the Industrial Imaging business, orders for security products were up in the quarter, but we continue to have a cautious outlook in the face of ongoing customer consolidation. We continue to focus on generating growth in non-destructive testing and inspections.

Let me update you on our progress towards the separation of the Imaging Components business into a new, independent, publicly traded company via a tax-free distribution to Variant stockholders. As you probably saw in the press release issued last week, the name of the new company will be Varex Imaging Corporation. We are now making good progress in the development of detailed plans and activities needed to execute the separation. We are on track to file an initial Form 10 with the SEC in the next several weeks, and we are currently on schedule to complete the separation at the end of the calendar year. We continue to be excited about the prospect of creating two great companies.

Turning now to our Particle Therapy business, we booked an order during the quarter for a multi-room ProBeam installation at the new Hefei Ion Medical Center in China. This is China's first government funded Proton facility. Installation is slated to take place in late 2017, with patient treatments scheduled to begin in late 2018.

Our installation at Cincinnati Children's Hospital is on track, with the first patient treatments scheduled to commence later this summer. We've now successfully commissioned a third room at the Maryland Proton Therapy Center, and installations are underway in Holland, Russia and Saudi Arabia. In total, we have 13 Proton projects generating revenue.

As you probably saw from our 8-K filing with the SEC at the end of June, we sold our $73 million senior loan for the New York Proton Therapy Center to Deutsche Bank, freeing up capital to help finance other Proton projects. The Proton sales funnel continues to look good.

And now, I'll turn it over to Elisha.

Elisha W. Finney - Chief Financial Officer & Executive Vice President

Great. Thanks, Dow, and hello, everyone. Dow has already covered gross orders, so let me start with backlog.

We ended the quarter at $3.3 billion, up 5% from the year-ago period. Backlog adjustments during the quarter totaled $51 million, bringing net orders for the company to $814 million.

Third quarter revenues for the total company were $789 million, up 1% in dollars and even with the year-ago period in constant currency. Year-to-date total company revenues were $2.3 billion, up 1% in dollars and up 3% in constant currency.

Oncology posted a revenue gain of 8% both in dollars and in constant currency, driven by strength in our high-end equipment, as well as our software and service businesses. Imaging Components posted a third quarter revenue gain of 9%, driven by our newly acquired x-ray accessories business, as well as higher Tube sales. Our Particle Therapy business posted third quarter revenues of $37 million, down from the year-ago period when we booked $91 million of revenues, including a substantial amount for the ProBeam installation at the University of Maryland.

Total company gross margin for the quarter was 43.9%, up by nearly four points with significant contributions from both Oncology and Imaging Components. Oncology Systems third quarter gross margin improved by more than four points to 46% with the help of a larger mix of TrueBeam's and software, as well as productivity gains. Imaging Components third quarter gross margin also rose by more than four points to 42.9% due largely to factory productivity gains and favorable product mix.

R&D expenses were $65 million, or 8% of revenue, equal as a percentage of revenue to the year-ago quarter. On a GAAP basis, third quarter SG&A expenses were $151 million, or 19% of revenue. We had about $22 million of unusual expenses in SG&A for items including ongoing patent litigation and the recently announced initiative to separate the Imaging Components business into a new publicly traded company. Excluding these items, SG&A expenses on a non-GAAP basis for the quarter were $129 million, or 16% of revenue.

GAAP operating earnings for the quarter were 16.5% of revenues and 19.5% of revenues on a non-GAAP basis, reflecting our solid gross margin performance in the quarter. Depreciation and amortization totaled $18 million for the quarter.

The effective tax rate was 25.1%, up three points from the year-ago quarter when we benefited from a favorable geographic mix of profits and tax loss carry-forwards associated with the Proton business. We continue to expect that the tax rate will be about 26% to 27% for the year.

Fully diluted shares outstanding were 95.4 million, more than 5 million lower than the year-ago quarter due to our ongoing share repurchase program. Diluted EPS was $1.04 for the quarter on a GAAP basis, and was $1.22 on a non-GAAP basis.

Turning to the balance sheet, we ended the quarter with cash and cash equivalents of $836 million, debt of $701 million, and stockholders' equity of $1.7 billion. DSO at 101 days was up significantly from the year-ago quarter, but improved sequentially from the second quarter.

Third quarter cash flow from operations was $95 million, bringing the total cash flow from operations year-to-date to $204 million. Primary uses of cash were $126 million for the repurchase of 1.5 million shares of stock, $95 million to reduce debt, and $15 million for capital expenditures. At the end of the quarter, we had 4.8 million shares remaining under the existing repurchase authorization that extends through calendar year 2016.

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

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

Thanks, Elisha. Including the results of the third quarter, we believe that total company non-GAAP earnings will be in the range of $4.62 to $4.66 per diluted share for fiscal year 2016. And we continue to believe revenues for fiscal year 2016 will increase by about 3% over fiscal year 2015.

We're now ready for your questions.

Question-and-Answer Session

Operator

Thank you. At this time, we will now be conducting a question-and-answer session. Thank you. And our first question will come from the line of Anthony Petrone with Jefferies. Please proceed with your question.

Anthony Petrone - Jefferies LLC

Oh, great. Thanks and good afternoon. Congratulations on a good quarter.

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

Hey, Anthony.

Anthony Petrone - Jefferies LLC

How are you, Dow? Maybe just start a little bit with just the North American order growth in Oncology there, which reached a multi-quarter high here. Maybe a little bit more in terms of the underlying drivers there. How much was market related, maybe even replacement-cycle related? And how much was it from share gains? And then a follow-up there would be on the product side, how much was driven by VitalBeam, which was a driver last quarter?

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

Yeah. Good questions. I would start by saying our rolling four quarter growth in the Americas has been 7%. So we feel very good about kind of where that is. North America has certainly been the driver. And you're right, North America did hit a high this quarter, but it is kind of a sustained trend that we're seeing, which is good.

We did have a couple multi-system orders including one with HCA. We also had very strong demand, as I mentioned in the call, for software products. And VitalBeam, I think a little more than half of our VitalBeams have been sold in the Americas. So that's – VitalBeam has been part of this story, but I think the overall story, though, is TrueBeam. When you clearly look at what's going on, TrueBeam is what's – it's what's driving both the Americas growth and the global growth, both in orders and revenues. I mean some of – on the revenue side, Elisha will talk about this later, but on the revenue side we had very good TrueBeam mix on the quarter as some of the margin uptick.

But it's – from a kind of a market perspective, the U.S. is a replacement market. That's true. As I said in the call, we are seeing people trade out aggressively to try to get new capability, especially for advanced radiosurgery and body radiosurgery.

I think reimbursement may have been a small factor, certainly not over the last year, but having that be calm in the quarter kind of shored up – shored things up a little bit. I think from a high level that's kind of the story, Anthony.

I think – oh, the other thing I was going to mention is from a market share point of view, we think we've gained a little bit of share. But most of this is market.

Anthony Petrone - Jefferies LLC

No. Very, very helpful, and maybe to shift gears, just to imaging and then one for Elisha. One of the headwinds for that business over the past couple quarters was destocking from several key customers, including Toshiba. I'm just wondering if that has reversed at this point, and specifically, with regards to Toshiba, are they back ordering at this point?

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

I think Toshiba's back a little bit. I wouldn't say they're fully back yet. I mean we had an okay quarter from Toshiba. The Tube business was actually quite strong in the quarter, and some of that was Toshiba, but we also had very good Tube – performance from our other Tube customers on the quarter and it was as much on their backs that we drove this. So I'd say the best Toshiba days, frankly, are still ahead of us. We're not totally out of that headwind yet.

Elisha W. Finney - Chief Financial Officer & Executive Vice President

And the acquisitions helped us also, Anthony.

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

Yeah. Yeah.

Anthony Petrone - Jefferies LLC

Sure. Sure. And then last just quick, I'll hop in queue is, Elisha, Oncology gross margin 46% you called out. That's beyond the normalized 44% level. Is this the new normal or do you expect it to moderate back down to that 44% level over time?

Elisha W. Finney - Chief Financial Officer & Executive Vice President

Well, I would love to say yes, Anthony, but I'm – we just had a really favorable product mix in the quarter. And I just can't count on that every single quarter going forward. What I would say is Oncology has done a fantastic job on pricing, holding stable pricing and on product cost reduction and on productivity gains. And so the hope is, yes, that will last as we move forward, but again product mix drives our margin much more than any other factor. I do think for this fiscal year they should be at the high end of that 43% to 44% range that we've talked about and really helped by this last quarter.

Anthony Petrone - Jefferies LLC

Thank you very much.

Operator

Thank you. And our next question comes from the line of Amit Hazan with Citibank. Please proceed with your question.

Leigh Pressman - Citigroup Global Markets, Inc. (Broker)

Hi, it's Leigh Pressman for Amit. Couple of questions here, I'll start with margins. On the back of the gross margin question, is there anything stronger in gross margin that you would call out as more sustainable in as opposed to good mix in some of the other items you've already called out?

Elisha W. Finney - Chief Financial Officer & Executive Vice President

Well, the product mix drives the margin first and foremost in Oncology, geographic mix secondly. The geographic mix was identical this quarter versus a year ago quarter so that had no impact. I would say the product cost reduction is real and we should continue to have the benefit of that going forward as there's much fewer C-series, our old legacy equipment, and many more TrueBeams at a higher margin. And so, we're starting to see that flow through.

Leigh Pressman - Citigroup Global Markets, Inc. (Broker)

Okay. And then just on operating margin for this year, it looks like there have been two good quarters at or around the 19%. The implication for fourth quarter looks above that too. So is this the range we should be thinking about going forward here? It's a bit above your original guidance. Is this FX-related to some extent or are you seeing sustainability that makes you comfortable we've come off the bottom, and maybe see some further gains heading into 2017?

Elisha W. Finney - Chief Financial Officer & Executive Vice President

Well, I don't want to guide it all into 2017, particularly right at the moment with the spin-off going on. There is a lot of work that we're going to have to do in terms of looking into upright 2017. You are correct, once you run this model through it's going to put us at close to a 19% operating margin for this year, which would be up about half a point versus a year ago period. Again, all businesses have been very focused on head count and on travel and on discretionary spending. And I think you're starting to see this flow through. But most of that improvement for this year is coming through the gross margin.

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

Yeah. And I'd just point out this is consistent with our goal over the next three, four years to get back to that higher return on sales. So it's kind of delivering on the track 50 basis points-ish a year that we were – kind of set as an overarching goal.

Leigh Pressman - Citigroup Global Markets, Inc. (Broker)

Okay, great. And if I could sneak in one more, if I could. Can you talk about maybe the adjustments to backlog this quarter? They were a little bit higher than trend, maybe you can give us some context as to what's going on there?

Elisha W. Finney - Chief Financial Officer & Executive Vice President

Actually the backlog adjustments were lower, I believe, than the prior quarter and were pretty consistent with our average. So the $51 million is really what we would refer to – some cancellations in that number, maybe $20 million of it. The rest is what we call dormancy. When we review the backlog and when we feel like there's no longer a good, hot probability of the machine delivering within two years, we just take it out of our backlog until it fits that criteria. But a $51 million level is very consistent with historically, how it's been.

Leigh Pressman - Citigroup Global Markets, Inc. (Broker)

Okay. And then sorry, one last quick one. If you can maybe give us a sense of why the DSO was up during the quarter?

Elisha W. Finney - Chief Financial Officer & Executive Vice President

Yes. So we had – we've seen this in the last couple of quarters. The good news is Q3, if you look at our cash flow from operations, returned back to a very strong level and was almost equal to net income. So I'm feeling very good that we're back on track in terms of cash flow. What happened is we moved our collections staff earlier in the fiscal year. We did a CRM implementation. I think those things just slowed down collections a little bit in the first half of the year. We've got some catching up to do. But in June and July, our collections have actually been very strong. So I think we're getting back on track.

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

Yeah. And 2Q to Q3 we had 10 days of shipped (23:11) improvement. So it's going in the right direction.

Elisha W. Finney - Chief Financial Officer & Executive Vice President

Yes.

Leigh Pressman - Citigroup Global Markets, Inc. (Broker)

Thanks, guys.

Operator

Thank you. And the next question comes from the line of Brandon Henry with RBC Capital Markets. Please proceed with your question.

Brandon Henry - RBC Capital Markets LLC

Yeah. Thanks for taking my question. First, just on the North American strength in gross orders. Can you just help provide some more details on how much of that performance was from better systems orders versus software and services?

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

I'd – one of the things that we liked about it was that it was broad based. It was both – it was hardware, it was software and it was service. So we saw it in all three categories. There wasn't one – you know as I mentioned from a product mix point of view, that market has largely – it's probably been a 90% TrueBeam market for the last 18 months, two years. And it was at the high end of that. So maybe a little bit of product mix from an orders point of view, but as I said in the call, we had a couple nice, large, strategic deals and we had a number of competitive take-outs in both the hardware and software areas. But it was broad based.

Brandon Henry - RBC Capital Markets LLC

Okay. And did you guys give any growth rates in terms of software as a service this quarter? I might have missed that.

Elisha W. Finney - Chief Financial Officer & Executive Vice President

No, we haven't broken it out.

Brandon Henry - RBC Capital Markets LLC

Okay. All right. And then separate question. Can you provide an update on what portion of Siemens Linacs have been traded out at this point? And how much of the acceleration in the North American Oncology Systems business can be attributed to an acceleration in Siemens' trade outs?

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

You know I think it's a small and maybe even very small factor. It's not coming off the trend line. I think when we first did the relationship with them three years, four years ago there was probably a 2,000-ish unit installed base. And I'd say that's coming out 150-ish a year – or probably coming out. We haven't seen an acceleration or deceleration of that trend. It's been kind of steady, steady, steady as it goes. I mean it is a replacement market, whether it's Siemens or everybody else, and that's what we're seeing.

Brandon Henry - RBC Capital Markets LLC

Okay. And then last question for me just on China. It looks like from the first-half 2016 results from GE and Phillips, it does look like Chinese tender activity and orders are picking up, at least in the diagnostic imaging part of the market. So can you speak to what trends you're seeing in China and if you're seeing a similar pick up in activity in the radiation oncology market in China? Thanks.

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

I think that's very consistent. We had an okay first half, but we had a very good third quarter. Our third quarter was – China was up 13%. We had very strong demand, especially for high-end product, which – our Edge product, as I mentioned on the call, in the script, was very good. One of the things that we really like about the demand that we're seeing is it is almost 90% new vaults (26:33). So obviously, that's going to drive our long-term Service business and software, upgrade opportunities, et cetera, et cetera, et cetera.

So these are new vaults (26:47) going in. They're happening on schedule. We are seeing significant tender activity. We do continue to see some protest of that activity. It doesn't change that much who wins, it just kind of lengthens the process. And there are also, I mean coming back to your previous question, in China there is a large Siemens install base opportunity. That's one of the geographies where they did the best, frankly because of their price position as much as anything else. And so I think over the next couple years, we'll see maybe that install base change out a little more aggressively. So that's going to be one to watch.

The other thing to watch in China, you know we've got this Hefei Proton order, as I mentioned. We see a reasonable funnel of Proton activity in China. So maybe this Hefei order will stimulate some Proton growth in China.

Brandon Henry - RBC Capital Markets LLC

Okay. Thank you.

Operator

Thank you. And our next question comes from the line of Jeff Johnson with Robert W. Baird. Please proceed with your question.

Jeff D. Johnson - Robert W. Baird & Co., Inc. (Broker)

Thank you. Good evening, guys. Can you hear me okay?

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

Hi, Jeff. We can hear loud and clear.

Jeff D. Johnson - Robert W. Baird & Co., Inc. (Broker)

Great, hey, Dow. So one question for you. I don't think anybody has asked on your western European comments at this point. It sounds like you mentioned that being soft this quarter. Last quarter, you guys put up a very strong EMEA number; this quarter the comp was a lot tougher. So have you really seen anything change or is it just comp driven? I know you had some big orders last year in this quarter in EMEA, so just trying to figure out if you're really seeing sequentially change in that market or how you'd describe market trends over in Western Europe right now?

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

You know, we're watching Western Europe and Latin America. Those are the two light spots. Americas, we've talked about that a lot; it continues very strong. China looks good. Japan, flat, which it's been down, so flat's the new good in Japan for us. So that's okay. The two watch areas for us are frankly Western Europe and Latin America. Latin America was down more than 40% this quarter; that's macro economically driven. We do have – in Europe there is a tough comp on the quarter. We had a large order in the U.K. last year. So we've got a little bit of a comp issue going into Q4 as well. But I'd say we're watching Western Europe. It maybe hasn't been as strong as it has been over the last 18 months or so.

Jeff D. Johnson - Robert W. Baird & Co., Inc. (Broker)

Yeah. All right. That's very helpful. And then, Elisha, maybe a few clarifying questions for you. One, I think somebody asked on the software and service side. You said you haven't given that, but could you give that? I think in past quarters you have given those trends; if you could just give us at least qualitatively where software and service was this quarter?

Elisha W. Finney - Chief Financial Officer & Executive Vice President

Yeah. Higher growth rate in software, then equipment, then service.

Jeff D. Johnson - Robert W. Baird & Co., Inc. (Broker)

Okay. Can we be any more specific there, double digits up or single digits? Let me frame it this way: I think you had been double digits for a long while; it slipped over the last couple quarters to upper single digits. Are we seeing any continuation of that trend or...sorry?

Elisha W. Finney - Chief Financial Officer & Executive Vice President

So for year-to-date, let me just say, in constant currency services up in the high-single digits, so 7% to 8%. So, a little off the double-digit but not terribly so. Again, we still feel good. The units volume was up this quarter in orders, which bodes well for the service business going forward. So long-term really not coming off of our expectations for the service business at this point.

Jeff D. Johnson - Robert W. Baird & Co., Inc. (Broker)

All right, that's helpful. And then last two clarifying, just on the EPS guide you took the low end up by a little over a nickel. Is there anything in there other than just operational at this point? A couple companies have been adopting ASU 2016. Anything like that or anything else we should think about that's impacting your guidance other than just pure operational factors?

Elisha W. Finney - Chief Financial Officer & Executive Vice President

It's purely operational, and we just took the midpoint and took it out by the $0.04 beat from the midpoint in Q3 and narrowed the range a little bit, given that we're down to the last quarter. But no, we are not adopting the new tax provision because of the spin. We're going to wait until we get through that.

Jeff D. Johnson - Robert W. Baird & Co., Inc. (Broker)

Okay.

Elisha W. Finney - Chief Financial Officer & Executive Vice President

So nothing in there other than operational.

Jeff D. Johnson - Robert W. Baird & Co., Inc. (Broker)

Makes sense. And last question just on ICB. The orders up 13% and revs up 13% – or 19%, I'm sorry. How much of that was organic and how much was acquisition driven?

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

We're year-over-year with MeVis, so that's in the base now. So Claymount what's different, and it would have been 8% revenue growth.

Jeff D. Johnson - Robert W. Baird & Co., Inc. (Broker)

Okay. So you only have one point of acquisitions?

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

Is that right? Did I get that number right?

Elisha W. Finney - Chief Financial Officer & Executive Vice President

Yeah. That's correct.

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

A little more than a percent.

Jeff D. Johnson - Robert W. Baird & Co., Inc. (Broker)

All right. That's all I've got. Thanks, guys.

Operator

Thank you. And the next question comes from the line of Steve Beuchaw with Morgan Stanley. Please proceed with your question.

Stephen C. Beuchaw - Morgan Stanley & Co. LLC

Hey, Dow.

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

Hi, Steve.

Stephen C. Beuchaw - Morgan Stanley & Co. LLC

When you look across your business and you look at some of the trends in commodity or oil-sensitive countries and you look at the mid-stage funnel, what does it tell you about how things play out? I know we've had a couple of tough quarters here and there for obvious reasons, in places like Latin America. But we've seen commodity prices in a number of spots pick up. Is that a cause for optimism about 2017?

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

You know I'd say – I wish I could look you in the eye and say that about Latin America. I think it's a little broader based than Latin America. And in the Middle East, maybe so. I think it's a good – you know I don't know that we've – it's kind of interesting on this quarter a lot of our Africa volume, and it's actually one of the things we really like, a lot of the Africa volume was in the non-oil-based countries. So it's great to – Ethiopia I mentioned in the call that, that's the first time we've had a Linac order from Ethiopia. And that's the kind of activity we're seeing in those markets. I would say the Middle East has been a little quieter this year, looking back 12 months, because of oil prices. And what are we today? $40, $45 a barrel? You know I think that might be enough to see some of that market come back next year.

Stephen C. Beuchaw - Morgan Stanley & Co. LLC

Got it. And then on the Imaging spin, I wonder how the strategic conversations inside the company have been evolving since the Imaging spin? I mean has that opened any new doors for you in terms of collaborations, partnerships or other strategic activity? Thanks.

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

You know, I mean, we're continuing to look at how we reinforce the strategy of each company as we spin. So we're looking at a broader Oncology front for our – for the remaining company. And looking for a broader components beachhead for our X-ray business. So the good news is it has been pretty active. I think it's accomplishing both strategically and we think long-term from a value point of view what we want to do, and kind of unleashing a lot of energy around those initiatives. Now frankly we're a little bit in head down mode to get the spin done, so that is consuming us pretty hard here for between now and the end of the year. But we're pushing very aggressive as well on kind of the strategy front in both businesses.

Stephen C. Beuchaw - Morgan Stanley & Co. LLC

I appreciate all the color. Thanks much.

Operator

Thank you. And the next question comes from the line of Tycho Peterson with JPMorgan. Please proceed with your question.

Tycho W. Peterson - JPMorgan Securities LLC

Hey. First question, cancellation this quarter; were they about $42 million? And that's a big step down from what you had last quarter. So Elisha, I'm just wondering if you can talk as to what you think is the underlying trend here?

Elisha W. Finney - Chief Financial Officer & Executive Vice President

One of the big differences, Tycho, so it was $51 million in total on backlog adjustments. I believe the actual cancellation was closer to $20 million and the rest was dormancy, where it's just – it's not probable at this point that the machine will ship within the two-year period of time, so we take it out of our backlog. The big difference is we did not have a big FX impact this quarter, and we had a large one in some of the prior quarters, because as you know, our backlog is held at historical rates and so it gets trued-up every quarter based on the FX. And so that was very minimal this quarter.

Tycho W. Peterson - JPMorgan Securities LLC

Okay. That's helpful. And then maybe for Dow, on services, you've been outgrowing the market here for quite some time. Can you maybe just talk about the sustainability of that trend? How long you think you can outgrow the market from a service perspective, and do the attach rates vary meaningfully by geography for you guys on that front?

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

I mean we're very bullish about our Service business still. It's a little bit large number, because it's now a billion dollar business. I think on the quarter in Oncology it was 41%, 42% of the total. And it continued to be a juggernaut for us. I would say that it's one of the things we really like about the new socket growth that we're seeing in Latin America and Asia, in particular. That's going to help drive the growth. The software model going to more – more of a kind of SaaS-based model strengthens that business. And we are seeing lots of positives on the upside.

On the – we are seeing in some markets, some of these emerging markets, we're seeing a little bit of wackiness from third-party competition. I wouldn't say that's the reason for the slowdown, I think the slowdown probably has more to do with large numbers and just kind of where we are but in some of these emerging markets we are seeing some growing presence, especially in the older install base, some third party competition, but I'd say we're still in that high-single-digit range, kind of what we're feeling about the long-term capability of our Service business.

Tycho W. Peterson - JPMorgan Securities LLC

And then, does having stability on the reimbursement front – I mean we got through this Physician Fee cycle relatively unscathed. The first two years of macro will be everybody gets a little bit of a bump. Does that free up the U.S. market a little bit over the next couple years do you think?

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

I think it's too early to tell. But that would be – our gut would be consistent with that. Tycho, I think macro feels a little bit like some of the reimbursement incentives that there were on some of this early IT adoption, three years, four years ago. So I think it's probably a little bit of an upside.

Tycho W. Peterson - JPMorgan Securities LLC

And last one, you made a comment earlier on the China proton funnel. Any sense as to what – how big you think that market could be?

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

Every time I've forecasted this I've been wrong, so I'm not going to take the bait. The good news is these are government customers. So I think we had our first discussion with Hefei 15 months ago, so we went from first conversation to order in 15 months, and for that, for us that's a record in Proton Therapy. When you get in the private market, and where financing instrument is frankly the most difficult part of the transaction. These deals can take a really, really long time. So where it's sovereign finance, it can move pretty fast. We are having – I'd say there are three or four live conversations going on. Will they happen in the next 15 months, 18 months? Maybe. At least we have one now.

Tycho W. Peterson - JPMorgan Securities LLC

Understood. All right. Thank you.

Operator

Thank you. And the next question comes from the line of Vijay Kumar with Evercore ISI. Please proceed with your question.

Vijay Kumar - Evercore Group LLC

Hey, guys, thanks for taking my question. So maybe Dow, a big picture question on – because now we'll have clean numbers in a few months on standalone Oncology. I was just wondering, can you just comment big picture, what's been the installed base over the last three years, right? Has it been flattish, has it been growing in North America? Because I just feel like that's an important question just given your really, really strong showing here in North America. And obviously that has a lot of implications to margin progression.

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

I'd say, starting at a very high level, we have about a 7,500 unit installed base. We have had positive unit growth, a percent or two, of the installed base. One of the things that we like about the O-U.S. growth, as I mentioned about China, is those are all new sockets. And we get some new installed base growth out of it. We did have very – in Q3 we had very good unit growth. So one of the best unit growth quarters we've had in a while. So that's going to help our Service business. So I don't know if I'm answering all your questions, Vijay. Elisha, do you have anything to add?

Elisha W. Finney - Chief Financial Officer & Executive Vice President

Just that the U.S., as we said, Vijay, is largely a replacement market. So the installed base is not necessarily going up, but it is getting higher end equipment that does carry a higher level of service contract.

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

And when we make that trade-out, I'd say our contract capture rate of TrueBeam is 10 points to 15 points higher than our – than the historical product.

Vijay Kumar - Evercore Group LLC

That was very helpful, guys. Maybe just one on software, because – this is the other question we get a lot. What kind of visibility do we have, right, on the software opportunity? Because I know at the Analyst Day, you guys put out the it's a half a billion opportunity, right, because the reason – when I look at your comments on the installed base, right, 1% to 2%, obviously you guys have done better on the share front that's showing up in the North America region from an orders perspective. But how much more software can you keep selling into the install base? Or am I thinking about this the right way? Or because I feel like having some clarity on that has a lot of implications in how people look at the company?

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

I mean there's some really simple math here. We've got an installed base of 7,500 units. We've sold – and we feel really good about it, 500 RapidPlans. We got 7,000 to go. We've got InSightive Analytics, what have we sold, 250, 200-ish? We've got 7,300 to go. So we're in the top half of the first inning, sorry, baseball analogy to my global friends. But we're – the software, it still has very significant upside for us. And what I'm liking is we're getting very good customer response on the software products. A decade ago it was oh, you ship me software and it works, but I don't love it. Now we're getting hey, it does what I like it to do. It's making me more productive in the workplace. I can do better care and take care of patients better. And we've had some external validation out of this with our class – the win we had (43:11) kind of the Gartner of Radiation Oncology, class rated as number one in Treatment Planning and in Oncology information systems, so we like that.

So those were – RapidPlan and InSightive analytics are two examples. We do have – in the 7,500 unit Linac installed base, in that installed base we also have 3,400, 3,500 software installations. So those are opportunities for us to take Rapid – that's the low-hanging fruit of the RapidPlan and InSightive Analytics opportunity. So I think, Vijay, we've still got a lot of opportunity on the software side.

Vijay Kumar - Evercore Group LLC

That was really helpful, Dow. If I may just retort to the baseball analogy, I think in a cricket parlance that would be hitting a six. So congratulations.

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

I think I know what that means, which is a little scary.

Operator

Thank you. And the next question comes from the line of Jason Wittes with Brean Capital. Please proceed with your question.

Jason H. Wittes - Brean Capital LLC

Hi guys, thanks for the questions. Just wanted to get an update. I know that things are still moving, but in terms of the numbers you put out when you first announced the spin-out, you noticed – you mentioned I think – believe $37 million in overhead dyssynergies. Is that still the number that we should be thinking about? And in terms of who absorbs what, is there any update there?

Elisha W. Finney - Chief Financial Officer & Executive Vice President

You know, Jason, at this point it was $20 million of dyssynergies at – that would be at remain co-Varian. And that number has not changed dramatically at this point. So I think it's still a good number to use. And again, with the goal of having that offset within two year, so that we can get back to the same margin point – operating margin point.

Jason H. Wittes - Brean Capital LLC

And I believe that you're going to give – the SpinCo will have cash on hand. I believe that was $50 million, but will that be cash taken from overseas or will that be cash that's been patriated in the U.S.?

Elisha W. Finney - Chief Financial Officer & Executive Vice President

So there – no number has been determined. All we have said is they will not have debt at the time of the spin. And we are working with our advisors on the capital structure at this point, so stay tuned and we'll be talking about how much cash ends up going with SpinCo and how much of that is U.S. versus O-U.S.

Jason H. Wittes - Brean Capital LLC

Okay. And when do you anticipate giving us that update? Will that be when you report the fourth quarter or will that be more towards December?

Elisha W. Finney - Chief Financial Officer & Executive Vice President

It's going to be more towards when we're going on the road show.

Jason H. Wittes - Brean Capital LLC

Okay.

Elisha W. Finney - Chief Financial Officer & Executive Vice President

Closer to the spin date.

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

Yeah.

Jason H. Wittes - Brean Capital LLC

Okay, fair enough. And just on the Proton business, in terms of – you've also put out anticipation of reaching profitability. I assume that still goes, and what kind of revenue run rate do you need for that business to really breakeven and make a profit?

Elisha W. Finney - Chief Financial Officer & Executive Vice President

Yeah. It's a little hard to say, Jason. What we really need is the installs to be completed and the Service business to become material to get a significant pop in the margins. But you know this year it's going to be around $150 million. $200 million – somewhere between $200 million and $225 million it starts looking very different.

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

(46:37)

Elisha W. Finney - Chief Financial Officer & Executive Vice President

We're getting there.

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

As you know, this is going to change with time, because the margin rates on the equipment – today they're high teen, mid-high teens. We hope to get that to the 20 to 30 range with time, but the margin rates on service are pretty good. So as the service contracts start to land, the geography of that profitability becomes a little easier with time. That's probably not next year.

Jason H. Wittes - Brean Capital LLC

Okay. That's helpful, and then the reimbursement was pretty benign, or actually I'd say positive, not benign; more optimistic than that. But in terms of – you did mention that they're going to try to start coaxing the market into being more efficient, I believe that's with MACRA and MIPS. There are centers out there who have adopted it. Have you noticed a change in their behavior in terms of what their – equipment they want, how they're doing they're procedures, things like that? Is there a shift towards more concentrated dosing in those centers, or is it just too early to say?

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

You know I'd say if anything it might be an incentive for people to take our ARIA InSightive analytics and other ARIA features into the market. ARIA is MACRA compliant. One of the things that gets asked is a lot of metrics, a lot of portability; these are some of the things they're looking for and that's part of that product. So short-termish, as we were talking about in one of the other questions; it could be a little bit of upside maybe next year. I would say we haven't really seen a behavior change in terms of peoples' purchasing pattern one way or the other at this point.

Jason H. Wittes - Brean Capital LLC

And also related to that, do you have a sense of how much of the marketplace is actually ready to fully implement MACRA here? It has all of the software in place et cetera?

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

Well, I think the short version is people just got the standard, so zero. You know? And so – we looked at a hard look at it. We know that we've got a few product things to do, but that our product is pretty compliant. We're pretty comfortable with where our product is. It's not going to be like a major rewrite or something that we're going to have to do, but we do have to add a few features. And we're very well-positioned for MACRA implementation. So we like that.

But I would say, if I can come back to the main thrust of the question, I would say we have not seen a purchasing difference with those customers. And with history, if anything, a lot of them tend to be – they want to be clinically advanced, and they want to be very productive, cost efficient. And sometimes it takes a little bit longer to convince them, but once they're convinced they tend to move faster because they've got the clinical data or the productivity data to make their business case.

And they may take a little bit longer to convince them, but once they're convinced they – you know I – one of the examples I've used historically on this is RapidArc with Kaiser. It took us a while to convince them that RapidArc was really clinically advantageous and was going to give them a productivity pop. Once they were convinced, you know Kaiser North outfit every hospital in a year. It was just bang, they really moved. And I think that's typical from what we see from these kind of customers. They might take a little bit longer to convince them, but when they're convinced they go fast.

Jason H. Wittes - Brean Capital LLC

Okay. That's helpful and just a follow-on that. When that happens, which it's going to take some time, I think MACRA itself doesn't really have teeth until the next couple of years. But it does seem like there could be some required upgrades for software that could help you and help I guess your customers as well. But there is an upgrade cycle to be had when this really starts to take over.

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

Absolutely.

Jason H. Wittes - Brean Capital LLC

Is that a fair way to think about it?

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

Yup. Absolutely. And that's the upside opportunity I've been referring to.

Jason H. Wittes - Brean Capital LLC

Yup. Got it. Thank you very much.

Operator

Thank you. And our next question comes from the line of Anthony Petrone with Jefferies. Please proceed with your question.

Anthony Petrone - Jefferies LLC

Oh, good. Thanks, just a couple of follow-ups actually on guidance and Imaging, in particular, and then one on the spin. So for guidance, I guess, the 3% reiteration here, you are baking in quite an acceleration in the fourth quarter. And I'm just wondering how much of that is Oncology-related versus maybe a rebound in Imaging. And then you also spoke quite a bit on Protons, so just trying to get a little bit more color on guidance.

Elisha W. Finney - Chief Financial Officer & Executive Vice President

Sure.

Anthony Petrone - Jefferies LLC

And then I'll have the follow-ups. Thanks.

Elisha W. Finney - Chief Financial Officer & Executive Vice President

So, Anthony, the guidance on Oncology, and I'm assuming you're talking revenue here, should be in the mid-single-digit growth. The Imaging Components business will be in the low-single-digit growth versus the year-ago quarter. And we're going to get $20 million to $25 million or so in additional Proton revenue versus the year-ago period. So a big bump in Proton gets you to around that 7% range in Q4.

Anthony Petrone - Jefferies LLC

No. That's helpful, and then just Imaging Components, again, for the quarter. I know you mentioned in bookings the contribution from – or gross orders rather, from acquisitions. But I'm just wondering what the revenue contribution was in the quarter from Claymount and MeVis.

Elisha W. Finney - Chief Financial Officer & Executive Vice President

About $11 million, I believe, in total.

Anthony Petrone - Jefferies LLC

Helpful. And then last, just on spin. Have you announced if it's a one-for-one share distribution? Or we're still (52:29)

Elisha W. Finney - Chief Financial Officer & Executive Vice President

No, we have not. We're working with JPMorgan on that.

Anthony Petrone - Jefferies LLC

All right. Thanks a lot.

Operator

Thank you. There are no other questions in the queue at this time. I would now like to turn the call back over to management for any closing comments.

Spencer R. Sias - VP-Corporate Communications & Investor Relations

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 201-612-7415 from outside the U.S., and entering confirmation code 13640722. The telephone replay will be available through 5:00 p.m. this Friday, July 29. Thank you, all.

Operator

Thank you. This concludes today's teleconference. You may now disconnect your lines at this time, and we thank all of you for your participation.

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