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Varian Medical Systems, Inc. (NYSE:VAR)

Investor Mid-Year Review Call

May 7, 2012 11:30 AM ET

Executives

Tim Guertin – President and CEO

Elisha Finney – CFO

Kolleen Kennedy – Corporate SVP and President, Oncology Systems

Bob Kluge – SVP and President, X-Ray Products Business

Lester Boeh – VP, Emerging Businesses

Dow Wilson – EVP and COO

Analysts

Steve Beuchaw – Morgan Stanley

Jeremy Feffer – Cantor Fitzgerald

Jeff Johnson – Robert W. Baird

Tycho Peterson – JPMorgan

Josh Jennings – Cowen

Tim Guertin

Hello. Welcome. I’m Tim Guertin. Welcome to the mid-year review for Varian Medical Systems. I’m going to have a few comments here at the beginning and then you’re going to hear from a series of speakers, and then we will follow it all up with questions at the end.

So, this is the cast of the movie today. Myself, Elisha Finney, who is our CFO; Kolleen Kennedy, who was appointed President of our Oncology Systems Business about six months ago, and Kolleen has been with the company for about 15 years. Bob Kluge, who is our Senior Vice President and President of the X-Ray Products Business; Lester Boeh, who is Head of our Emerging Businesses Business; and, of course, Dow Wilson, who is an Executive VP and COO of the company.

We are, as always, going to be making forward-looking statements. I’ll give you a moment to read this, familiarize yourself because there’ll be a quiz later.

Just to remind you where we come from a little bit. This is six years of earnings growth and you can see from 2006 to 2011 how we progressed. We gave guidance last week of $376 million to $384 million, so you can sort of see where you think this year is going to go.

So, I think it’s a good record. What we’re going to try to do for you today is tell you a little bit about our plans so you can at least imagine in your minds what we may be thinking about the next few years.

If you look at our order of growth opportunity, we’ve broken it down here into Oncology Systems in blue, X-Ray Products in red, the Proton business in green, and the Security Business in blue. And as you see, we think we have opportunities for growth in all of these businesses. Some of them, of course, will grow faster than others just simply because they have a smaller base to start from. But I think we have good opportunities in all of our businesses. And we think we have substantial growth opportunity in OS that is organic. Almost everything you see here is organic.

With that, I’m going to introduce you to Elisha Finney. Elisha, take it away.

Elisha Finney

Thank you, Tim. And, hi, everyone. It’s really nice to see you. Thanks so much for coming. So given that this is our mid-year review, I’m going to cover the first half financials, and then I’m going to come back and in a little more detail cover some of the specifics of the second quarter.

For the first half, the orders for the total company are up 15%. Oncology Systems is up 7%, with North America up 2% and our international markets up 12%. And as of the first half, we are at about 56% is our international business; 44% North America, and 108 TrueBeams booked in the first half. X-Ray products up 2%.We had a tough first quarter where we saw that our Japanese customers were adjusting inventory on tubes and panels, and the first quarter was down 2% in X-ray. The second quarter was up 5%. And we actually saw a pretty strong growth in March which leads us to believe that we are back to our more normalized growth pattern, and would hope that we can get this business back to the double digit level as we move forward now.

We did book two Proton orders in the half, totaling $124 million. We have one for Saudi Arabia, and we also booked a deal in St. Petersburg, Russia.

As you can see, revenues were up 10% for total company; Oncology 10%, X-Ray up 3%. And we have booked $23 million of revenue in our Proton business for the first half.

And let me just take a minute, we get lots of questions on how we book the revenue in the Proton Business. So, I’ll go ahead and address that here. Because these are – this is our first installation, this is under project accounting, we are – because we have to estimate our remaining cost to complete the project, and this being the first one, that is a fairly difficult path. So, we have taken the conservative position that revenue is going to equal cost until we get towards the very end of the project, and any profit we’ll be taking at that time.

As we’ve said, the first two or so of these installations, there is a lot of learning costs that’s still spent into those. It’s just a very high cost of goods sold relative to where we expect to be. So, as we’ve been pretty transparent, there’s not going to be a significant amount of profit on the first couple of these. And so, we just took the more conservative position to wait until we get to the very end.

As this business matures and as we get into future installations, it will revert to a more traditional project accounting, where we’ll take a percentage of the revenue – a percentage of the cost as we complete the project over the two to three year period of time.

The operating margin for the first half is 20%, which is down three points if you compare that to the year ago period. All of that in the first half declined coming from the gross margin. Gross margin of 42% for the company, again, down three points. Oncology’s margin is off about three points. And we talked pretty extensively on the conference call, and I’ll come back and talk more about margin, but, basically, we had an unprecedented geographic shift to the Emerging Markets where those markets were up about 30% in the second quarter, whereas one of our higher margin countries that buys highly featured products, Japan, was off about 40% as the end of the stimulus program in the year ago period.

I will tell you that Japan has come back and they’re on a more normal pattern now. This was only reflected in the delivery. So, again, that geographic shift had an impact on Oncology’s margin in the half.

X-Ray Products had very strong margin performance and is up about 50 basis points in the half. I should say that the Proton business dilutes the gross margin by about one full point for the total company. And, again, that’s going to hold true for the first few of these. We ultimately hope to get the Proton business up to about a 30% gross margin product.

And SG&A expenses for the first half were about flat as a percentage of sales, and that’s even with the restructuring charge that we talked about and the dilutive effect from the Calypso acquisition.

Operating earnings down 5%. Net earnings down only 1% as that shift to the geographic Emerging Markets causes the gross margin to be lower. We also get a tax benefit as we move to international markets. And so, the tax rate was down three points from the prior year period.

Backlog of $2.6 billion is up 18% if you include the Proton business. If you exclude the Proton business, the backlog is still up a very healthy 12%. So, again, that gives us, really looking into the next fiscal year, we can see ourselves returning to low double digit growth.

Balance sheet and cash flow. Conservative balance sheet $617 million of cash and equivalents, $32 million short term investments. This is the loan for the APT Scripps project, the Proton project in San Diego. And $162 million of total debt. We have subsequently been paying down that debt and as of the call, I believe the number was around $130 million.

The DSO of 83 days was up four days from the prior year period. It’s a little confusing because the Proton business actually impacted DSO by about five days in the second quarter. And that’s because we are booking revenue in advance of when the actual payment terms are due from the customer. And this is under the project accounting method that we talked about. This being our first installation, it is back-end loaded when the payments are actually due from Scripps, and that had an impact on the DSO. If I look back over the last four quarters and just take a simple average, 83 days is the average. So, collections are quite healthy.

Cash flow, $105 million in the second quarter, but year-to-date $159 million. And we did last quarter spend $75 million to repurchase 1.1 million shares.

Questions of the day. I guess you guys get the point. It’s margin, margin, margin since the conference call – the questions that Spencer and I have gotten. So I just wanted to take a few of these and address them this morning.

Where are they headed? The Oncology margins, I believe, for this year are going to be down by about one point year-over-year. And, again, that’s given this tremendous shift to international and emerging markets. I think going forward we are going to be able to maintain that oncology margin at that level, despite the fact that we are going to continue to see strong growth coming from these emerging markets.

The way that we’re going to get there is Kolleen has some cost reduction initiatives that are underway. We did not hit our target for the first half, but I am confident in her plans and the fact that we are going to get those cost reductions moving out over the next two to six quarters. And, again, we think for the second half, the Oncology margins are going to start to get closer to the historical rate of about 44% to 45%.

We look at it this way. We’re simply not going to feed the emerging territories that are growing so strongly to a competitor. I could have very high margin business and have a 45% margin, and I could limit that to North America and Japan, and we could be growing Oncology in the mid single digits. We have elected to go after this business. We will take a hit on the gross margins. But by doing so, we’re going to get the long term growth rate up closer to high single digit rates by virtue of going to these international markets.

It’s also important to note that each one of these is a new machine, it’s a new installation. It’s not a replacement, and therefore, it’s going to carry a 10-year on average service tail for each one of these installs that we’re putting in place.

So, we understand we’re taking a bit of a hit on the front end. So we are going into markets that are going to provide tremendous growth opportunities for us and can provide a great service business going forward.

The other thing on margins. I think X-Ray can continue to get some incremental improvement. They’re doing quite well on their margins this year and that’s going to happen by virtue of the flat panels continuing to grow faster than tubes. And then, importantly, the Proton business, which is dilutive today. When we can get the Proton business neutral to positive, that’s going to have a good bit of torque on both gross margin and operating margin.

Why didn’t you see this coming given that you have a backlog? The backlog is literally thousands, and thousands, and thousands of line items. And we do our best to go in and take a look at where we think machines are going to be shipping, to what parts of the world in every single quarter and they’re moving in and out all the time. We begin at the beginning of the year and we have a picture of where the machines are going. The timing for these customers can vary based on getting export license, getting their own construction done, just a whole host of reasons.

We also have to consider what we call book and ship. And those are orders that come in this fiscal year and ship in the same fiscal year, and how that’s going to impact the number.

Through the last 13 years we were able to use some pretty good rules of thumb that worked quite well for us. So we could go region by region and apply some averages on selling price and cost of goods sold, and duties, and FX rates and all those things. And what we found is – so we would look at it by North America, Europe, Asia. Europe within Europe can be extremely different when we’re looking at emerging markets there and the same is true of Asia as opposed to in-total.

We have refined our process. We’re going to get much more granular and looking at this country-by-country and deal-by-deal. Again, that’s what we applied to Q3 and Q4 as we’re looking forward. But machines do change, where they’re going and the timing.

We also have found, and this is actually good news, that these international markets, and particularly the emerging markets, are taking deliveries much sooner than we had first anticipated. And in a lot of cases are taking deliveries sooner than what we see even in North America.

How does Siemens affect the margins? The Siemens deal is a really good deal for us from a margin perspective. I know I mentioned that there were some startup costs that were associated with this contract in the conference call. And I think, unfortunately, there was a little bit of confusion that this over the long term was going to be dilutive to margin.

The startup costs have to do with there is a breakup fee under an existing arrangement we have. There is also – we need to go out and hire some people to represent the Siemens imaging products on a global basis. We have historically only been representing the company in North America. And so, we will be filling out that sales force, and that will obviously have to happen in advance of earning any commissions under this deal.

It is a mirror deal where Siemens will represent Varian and they will be representing our oncology products and we will be representing their diagnostic imaging products. It is structured in a way to where we’re not going to duplicate commissions. So, if Varian has a sales presence, I’m not doubling up here.

This is structured to where this will work particularly when Siemens goes out and helps us in what we refer to as the white space. These are markets where we really don’t even have a presence today. They have a much larger global footprint and they will be able to go out and, again, help us in those markets.

There are instances where we will be replacing existing distributor relationships with Siemens. But, again, this is not additive to paying commission to a Varian sales person and a Siemens sales person. And going forward, we think this will, obviously, create volume for us, and that should be positive to the margins.

Is 50 basis points of ROS leverage still possible? We manage our business at the ROS line, not at the gross margin line. That is important. But what we’re really managing to and compensation is tied to is return on sales. And we do believe going forward that we will still be able to get incremental improvement in that ROS. We’ve gone from 11% at the time of this spend 13 years ago, call it 21% today. And we will get incremental improvement going forward, somewhere between 25 and 50 basis points as we’re moving into next year. Again, the Proton business, a lot of this leverage is going to come from getting our Proton business from dilutive to breakeven.

Which leads me to the last question, the impact of the Proton business today. We are investing. CFO speaks for it is dilutive to the tune of about $0.15.We are building out this business. Long term we expect significant top line growth to come from Proton. We believe we can get the gross margin close to the 30% level. And we’re aiming to get the ROS for this business probably around 15% from where I sit today.

So, stay tuned. It probably won’t turn around until the end of FY’14, but we are building a nice backlog in this business. So, I think we have turned the corner in terms of a chance in getting Protons neutral here in the next couple of years.

And with that, I’m going to turn it over to Kolleen Kennedy. Oh, sorry. Before I do that, Kolleen, you can go ahead and come up. I will just – again, this is just the guidance that was given on the conference call.

Sales growth of about 10%.That does include Proton revenues we’re estimating now for the year of about $60 million, which will be at, effectively, zero margin. So, just take that into account as you do your modeling and EPS growth of 9% to 12%.

Now, I will turn it to Kolleen.

Kolleen Kennedy

Thank you, Elisha. Good afternoon, everyone. I thought I’d start off the Oncology Systems presentation by giving you a little bit of a sneak preview to our Brand Refresh. We’re very excited about this. It’s in the process of being launched out to the oncology community on a global basis. It’s very vibrant, very bright colors and really is quite meaningful in its implication. We’ve got lots of good marketing communications and public relations material in place around our new Brand Refresh.

Our vision is the world without fear of cancer and working closely with our clinical collaborators around the globe. We are hopeful that in the future that the diagnosis of cancer will not inspire fear. It will really mean more that it is a manageable chronic disease. And our mission in Oncology Systems is to innovate, support and simplify cancer-fighting solutions worldwide.

So, we have some really core competencies and characteristics in the Oncology Systems business, a little bit what we call our hallmarks of our organizations. It’s market leadership, it’s financial strength, it’s providing affordable care through product innovations and complete systems integrations, it’s having the strongest customer support services organization around the world in the oncology communities. And it really is focusing on quality and performance in everything that we do.

Taking a look at the mid-year financials, Elisha went over this, I think, in great detail. So I probably won’t dive into it other than to say we had a bit of a slow start in Q1 in Oncology Systems, but we came back strong in Q2 with orders at 9% growth, revenues at 11%, respectively. And then for the half of the year, 7% in orders and 10% in revenue.

Of course, the story is all about margin. We do, in fact, have some territory mix which was discussed, and also, I think, some very aggressive cost reduction programs at the gross margin level, which we feel we’ve got in place now and should start seeing benefit over the next several quarters.

Return on sales, 22% and 23% while being robust; numbers, certainly not where we’ve been in the history of Oncology Systems and certainly not where we’d like to get back to.

So, some of the highlights in the first half. Our international mix continues between 55% and 57%.We certainly expect to see that continue to grow in our overall mix as the business grows over the next few years. Services continues to roll at mid-teens performance. Very, very strong growth there. We got our first TrueBeam orders in Japan. Very excited about that. And we had two systems go live; one in Korea, and one in Thailand. So, continued growth at the very high end into the Asia-Pacific marketplace.

We’re really thrilled to announce the Siemens strategic alliance. I’ll talk a little bit more about that in detail because this really does expand our opportunities around the globe with the Siemens footprint.

And, finally, we launched our customer satisfaction phase, which is our ARIA Oncology Information Systems, Version 11, which provides high tech functionality which is very specific to the US marketplace which will allow all our customers to be able to demonstrate meaningful use for electronic medical record implementation and get that government reimbursement. So, this was really a big win for us in the first half.

A little color on the TrueBeam. We have just under 500 orders now since the product was launched in April 2010.Very excited about that take rate. In North America, it’s about 70% now of all new systems, and globally about 40%. So, we still think we have an awful lot of runway left there in terms of installed base conversions to TrueBeam, as well as new systems. We really only captured about 22% of those conversions of current systems, and we have about 230 installations around the world right now with TrueBeam.

The Siemens strategic alliance, as I mentioned, we are very excited about. It really is a broad global partnership, both in radiation therapy and diagnostic imaging. We believe it will bring another $100 million to $200 million worth of revenue opportunity to us on an annual basis. Broad range there. We’re just now getting our commercialization and marketing aspects into place, as you can imagine. But we’re already seeing strength from customers who are calling us up who are in the process of making decisions, or who thought they had made a decision when this announcement came out, said, “Wow. I really wanted to go with Varian. I was a little worried about the connectivity to my Siemens installs. Let’s talk.” So, we’re already seeing some very, very positive feedback from the community about this alliance.

And the other really key thing about it is it is going to allow us to have collaboration for future product development, leveraging the strength of their diagnostic imaging systems and our radiation therapy delivery systems.

Some immediate benefits, that market I was talking about, that was almost exclusively available to Elekta, but previously, because of their mosaic EMR connectivity, we now have technical teams working diligently to get those interfaces put in place. We think we’ll have those in the next few months. Again, driving some purchasing decisions even now. And also, their footprint and their infrastructure in the emerging markets and in those multi-modality sales, where we really weren’t even invited to the dance previously. We now have very strong organizational representation through this alliance.

In terms of priorities for the (inaudible) the connectivity interfaces, but also ensuring that as Siemens delivers their modulated arc capability, which is their version of volumetric modulation arc therapy, or VMAT, to their community, to their installed base, which they have about 2000 linear accelerators installed around the world right now, making sure that our Eclipse treatment planning system is capable of planning for that capability when they install it on their machines.

As I mentioned, the marketing commercial rollout, we have teams working on that right now. The European Society for Therapeutic Radiology and Oncology meeting, or ESTRO, is this week in Barcelona. Our booths are right across the aisle from each other, and the teams have put together some really exciting marketing communications programs for that particular exhibit.

We’re focusing on possibly leveraging both of our organizations from a component sales perspective, and they have a very strong financing organization that we want to take advantage of, particularly in the emerging markets where some real creativity in terms of financing solutions is needed.

So, if we take a step back for just a moment and look at the oncology market’s trends that we’re observing, they really are informing our roadmap and our vision. Emerging markets growth, that’s what you hear from everyone. And, of course, there is tremendous government focus around the world, in the BRIC countries, in particular, but also a few other countries in Africa. For example, supplemental healthcare spending is certainly a big focus for us as we look at where we’re making our investments as an organization.

The adoption curve for hypofractionated treatments from a stereotactic ablative radiation therapy and stereotactic radio surgery perspective really continues to grow. And this is very attractive to patients because instead of coming in for treatments on a daily basis from a five to seven week perspective, they can come in for one, two, or maybe five treatments total.

So, that sort of hypofractionation trend we continue to see being adopted. And it really is a paradigm shift, particularly when they’re making purchasing decisions for linear accelerators, they want systems that provide the capability to get the patient on and off the table quickly so that they can address their capacity limitations, but also providing the best quality care possible driving those improved patient outcomes.

Increasing regulatory oversight worldwide very, very important for us. Of course, we’re seeing stricter local interpretations of regulations and guidelines. And, of course, services. Having a broad customer support services organization continues to be very important to us, especially as we launch products that have kind of like ET Phone Home capability. Really where it’s self-monitoring and status notification, not only for the customer but also for us.

Global cost reduction efforts. We are truly seeing a mandate by governments as well as healthcare providers to look for clinical efficiencies in healthcare. And we’re seeing all of the oncology disciplines, radiation oncology, medical oncology, and surgical oncology, consolidating to provide a comprehensive cancer solution.

Accessibility to information is a really key trend that we’re seeing around the world, and it’s driving the desire and the need for us to be able to deliver on mobile applications, not only for healthcare providers but also for patients. We’re seeing online health communities popping up all over the place, and social networking is really ensuring that patients are the most educated they can possibly be, and they’re really coming into the clinics asking the physician, “I want to be treated on a TrueBeam machine. I saw this online. This is the best out there. This is the care that I want.” So, we’re making sure, of course, that we have ourselves well-positioned out on the web.

And, finally, the education and knowledge gaps. As we are expanding into these emerging markets, it is very clear to us, and just having recently come back from Brazil, it is very clear that the government and the local oncology community leaders feel the same way. There is the technology aspect of the solution, but there’s also the human capital aspect of the solution. And the successful vendors need to be able to address all aspects of that need around the education and training aspect of it. We provide the best systems. Now we need to partner with local governments, with healthcare providers, professional societies to help drive a partnership solution to ensure that those equipments are being utilized safely and effectively for patient care.

So, radiation therapy today. What you’re looking at here is a map of radiotherapy machines per million people 65 years and older. So, unfortunately, that’s a target of patient drivers out there for cancer care. And what you can see here the red, white and lighter green colors are where they have the least amount of machines per million population over 65, and it could be an accelerator or it could be a cobalt unit. And what I’ve done is simply to highlight in green a little bit of halos those particular geographies where the biggest need is in place. And as Tim has said previously, if you were to increase the availability of care to a westernized standard, we would need 10,000 more linear accelerators around the globe. And you can see those are the territories where those 10,000 linear accelerators would need to go. And we’ll talk a little bit more about some of the investment that we’re making into those emerging territories.

Our growth over the last decade has come from outside North America as the North America market has become more flat. You can see here that our growth, particularly in the last five years, really being driven by EMEA, APAC and LASA, and we continue to focus our efforts in those particular regions.

If we look at BRIC, in particular, a subset of that international growth, you can see we’ve had really nice performance with systems CAGR, product CAGR of about (inaudible) over the last five years, and services CAGR growth at about 29%. So, even though in each of those individual emerging markets it’s been a bit lumpy because of supplemental government spending, overall that growth trajectory has been very solid and we expect that to continue in the future.

So, let’s take a look at each one of those regions in a little bit more detail. Starting with Brazil, we have offices in Sao Paolo with about 60 employees. We, in fact, were the first vendor to install a linear accelerator into Brazil back in 1971 at Hospital Oswaldo Cruz. And we have sales, service, finance, regulatory resources down there, and we are the leader in installed base.

Siemens has just about 90 machines down there as well. And with our strategic alliance, they’re all very excited about that partnership and the opportunity to work more closely together down in Brazil.

We just recently made a commitment to build a complex, and I use the word complex intentionally, down in Brazil because it’s more than just a factory. Of course, it’s going to include manufacturing, but it will also include an education center with a dedicated vault with a live machine because we found that the best way to train people is for them to have hands-on experience with the equipment. So, we’re making that investment into our Brazil complex, which will, in fact, become our hub for all our Latin America and South American operations.

We’re going to be embedding an engineering team for software development and localization and as you grow into these emerging markets, you have to make that commitment because the localization of the GUI, the Graphical User Interface, of your documentation and developing interfaces for local hospital information systems and radiology information systems is so critical to your success in those particular environments.

And the last thing I’ll mention about our investment in Brazil is we have committed to providing several internships every year to President Dilma Rousseff. Our Science Without Borders Program, is one of the programs that is near and dear to her heart. And we believe that is very important for us, again, to focus not only on the technology but also on the human resources piece on the training and education.

So, lots of focus on governmental collaboration in Brazil, as well as strengthening our ties with clinical collaborators such as Sirio-Libanes which recently treated ex-president Lula on a Varian machine, as well as INCA, which is the national cancer institute in Brazil. So, lots of excitement and activity in Brazil.

Looking at Russia. Lots of growth opportunity there as well. A very, very different environment, however. We have an office in Moscow. We continue to expand into that particular space. We’re going to be partnering with local manufacturing entities to get a footprint there. We have an education center, Davidoff Education Center. Again, putting in an engineering team, an embedded engineering team because of the nuances and the very specific needs to the Russian language for our product development.

We’re going to further our investment in terms of logistics network into Russia. And we want to leverage the strong Siemens footprint that already exists there. And, again, this is one of those opportunities where that Siemens alliance will be proved very, very valuable to us.

Working with some very interesting aspects of the government in Russia, the one in particular called Skolkovo, is a large – what they’re trying to do is build up the Russian silicon valley environment where they’ve got a very strong focus on R&D and we’ve been having extensive conversations with them in terms of where we might have an opportunity to partner on some engineering systems.

India. Very large investment that we have in India. Dow and team have been building us up over the last few years. We have offices in Mumbai, and Delhi and Chennai. And we have a significant engineering team in Pune. We’ll continue to grow our operations into India. We launched an education center in Mumbai about a year and a half ago. We’re getting lots of demand from the local community to increase and extend the number of training courses and expand those as well. And we continue to want to expand our footprint there, as well as add some marketing programs specific to the Indian market space.

And, finally, China. You all know we have our headquarters in Beijing. We put in a factory several years ago. We continue to do educational symposiums there as well as live beam training programs as well into the vaults we have. We’ll be developing and putting in place an engineering team there also to support multiple Chinese flavors of language that we need to support.

And, again, Siemens has very, very strong presence in China and we want to leverage that there. This is probably one of those, I wouldn’t call it white space, but certainly know that because the country is so vast and the opportunity is so large that we’re probably not hitting all the opportunity there as strongly as we would like. So, we’ll be leveraging Siemens in China.

We’ll continue to focus on our disease site solutions. It certainly informs our roadmap. We want to be able to provide clinical capabilities across our entire systems, the patient care pathway focusing on lung, prostate, liver, breast and head and neck. And these, are in fact, the sites that are predominant of the prevalence around the globe. We believe if we have the right solutions for these disease sites, we will, in fact, address most of the cancer needs on a global basis.

I’m thrilled to talk a little bit about some new studies that have just recently been published. The first one for Dr. Salesky, et al, here at Memorial Sloan Kettering in New York City, focusing on image-guided radiation therapy for prostate. Historically, obviously MSK is one of the world leaders in the implementation of intensity modulated radiation therapy. And what they’ve done is to really look at the impact of image guidance in prostate. And what they found in looking at about 200 patients is that the long term survival for image guided IMRT delivered prostate care has improved significantly over non-image guided care. And believe it or not, this is the first time that this has actually been demonstrated through a trial and then also published. So, we’re very excited about these results.

They use fiducials in the prostate with our on-board imager KZ imaging solution set. And what it says it implies is that higher level of localization and then conformality of the dose around the prostate volume and avoidance of healthy tissue reduces late effects on the bladder, and also improve that tumor control for the prostate. So, very, very exciting news in the Red Journal.

The second article that came out in Practical Radiation Oncology was from the University of Alabama at Birmingham Physicians, where they were comparing treatment of four brain metastases where they treat it with a single isocenter simultaneously rather than treating a sequence of multiple isocenters for all those metastases.

What’s the big deal, you might ask? The big deal is that if you have to treat them sequentially, the patient is on the table for a significant period of time, sometimes over an hour. And during that timeframe, it’s very hard to keep that patient immobilized. And when you’re treating stereotactic radiosurgery, you want to treat a very high dose to a very small target, and you want to make sure there’s no movement whatsoever because the dose falloff needs to be critical to make sure you’re avoiding surrounding healthy tissues. And what they found with RapidArc is they were able to do that very effectively, and they were able to complete those treatments within a standard treatment time slot of 15 minutes.

So, a huge win for RapidArc Radio surgery and they went so far to even say that they felt this particular approach would eliminate the need for CyberKnife sequential approach and the Gamma Knife sequential approach. So, very exciting news there.

And the final study I’ll reference today was using RapidArc Radio Surgery for central nervous system spine tumors, or CNS. And they were able to treat these patients in under 11 minutes because of the flattening filter-free high intensity mode. So, basically, their dose rate was increased by a factor of three. Only Varian provides this capability with our TrueBeam and TrueBeam STx systems. And, again, from a patient perspective, it really improves the quality of their experience throughout their course of therapy and from a physician perspective, it gives them the conformality they’re looking for, while addressing capacity limitations on the standard treatment machine.

So, changing directions for just a minute. We want to talk about the services businesses. I referenced it a little bit earlier. They are on a trajectory to hit $1 billion worth of revenues over the next several years. A very important part of our business overall and certainly something that we want to drive from a business perspective, but also make sure that we maintain that number one customer satisfaction rating in terms of the service and support that we provide to our customers around the world.

So, I started off by talking about ovarian oncology hallmarks and how important these characteristics were to us. Certainly, these are the core competencies that we don’t’ want to leave. It’s how we run our business. And looking at the strategic initiatives will help us to maintain that market leadership, really focusing on the expansion into emerging markets. Hopefully, I was able to share with you a little bit of our perspective on how we’re going to accomplish that today. Building our services portfolio to hit that $1 billion trajectory, continuing to develop disease site solutions that address the global cancer care need, extending the reach and effectiveness of radiation therapy and radiosurgery with products, and systems and services innovations and, finally, leveraging the power of our new strategic alliance with Siemens, which really will help us move into those markets much more aggressively.

And with that, I’m going to turn it over to Bob Kluge.

Bob Kluge

Thank you. Good afternoon to everyone. I’m going to talk a little bit about our historical growth rate. And we didn’t get off to a real fast start this year. I’ll talk about that, too. But you’ll notice that over a long period of time, in fact, if you go back further than the chart up here, we have grown in double digits. And I’d like to attribute that solely to brilliant management, but that might not be completely accurate.

Actually, the marketplace for X-Ray equipment at the hospital level has probably been growing historically in mid single digits. And it’s really kind of a tough, nasty market. At the hospital level there’s a lot of price competition. And also, you’ve got a lot of new competitors entering the marketplace.

For instance, all the film companies, Carestream, Konica Minolta, Fuji, these guys are all looking at film going away and saying, “What are we going to do to continue the grow of our business?” And what they’re doing is they’re going into equipment.

And they don’t know a heck of a lot about the total equipment equation. What they know about is the part that they’ve specialized in for all these years. And so, they have to go to somebody to buy the components, X-Ray tubes, imaging panels that they don’t have. And we’re the biggest guy on the block, we’re the logical choice. And so, that’s a big trend that’s been working in our favor.

The other big trend that’s been working in our favor is simply given the level of competition, and if you look at one of the big imaging companies, Siemens, Toshiba, whoever, they’ve got a lot of places they have to invest. And they’re buying more and more at a higher level, a component level. They’re outsourcing a little bit, which makes them a little bit more competitive in the marketplace. So, that’s another trend that’s really moving in our direction.

And those two big trends have driven a lot of our growth. We’ve not just sat there looking at this. We planned out how it is we can become the most cost effective, the best logical choice for people in that environment. And I’m going to talk a little bit about that in a couple minutes.

As I’d mentioned, we had an extraordinarily slow start to the year. And the events of last summer in Japan, the tsunami and the rolling blackouts and the like, it’s not that they came as a big surprise to anyone. We’ve been very close to our customers. But our customers were just convinced that they could catch up, work their way through it. We talked to them about backing off orders for tubes and panels after those events occurred. And they felt that they needed those products. They had a full backlog and they were going to work their way through it.

Well, about the time that we started into the first quarter of this fiscal year, it was obvious they weren’t going to work through it. They had excess inventory, just about every one of our big customers. And so, they started rescheduling. Didn’t cancel anything. Their way of doing that is to schedule it out.

And so, what that resulted in was the weakest first quarter that I have seen in a long, long time. And as we got in to really the second half of the second quarter, it seemed like we had worked our way through it and we’re at a more normal kind of circumstance right now. So, I think that is largely behind us.

Our margin performance. Actually, we had a record margin in the second quarter. And there’s a lot of factors go into that. One is that I was mortified by the order rate in Q1, and so I pulled expenses in extremely hard and that helped. But also, we had a lot of cost reduction and quality improvement activity. We work on these things on an ongoing basis, and we just had a lot of it come through for us in the first half of the year. And probably one of the other bigger factors, I’ve talked to this group a few times about the investments that we were making in a new semiconductor fab in Colorado Springs.

I will remind you that we’re partnered with Philip, Siemens and Thales in a fab to make the flat plates that are the largest and most expensive component of a flat panel imager. And the original fab was located in Palo Alto. We decided to build a new one, one that would give us higher quality, be more productive, more cost-effective. And so, we had been working on this for at least a full five years, and we’re just finally through it. We closed the old fab in Palo Alto. And I would say that the benefit that we’re getting from this new dpiX fab maybe exceeds our expectations.

Quality is higher. There were a number of new products that I had put on hold waiting for the new fab to come on line because I needed them for the planned capability in these products. And those are starting to come out, and the cost benefits are just rolling through.

The other fab was so unreliable that I chose to carry a very large supply of inventory so that I could supply my customers in any event. And so, I have like this one year supply of plates, which we probably worked down to eight or nine months, and we continue to work it down. That’s on its way to a more normal business kind of situation. And as we roll that out, we’re going to get the full benefit because the new plates we’re buying are significantly lower cost than the ones I’ve got sitting in inventory.

So, there’s a number of factors, some of which are permanent. Some of the cost reduction things that I put in place we’ll relent on as business starts to grow again. But all-in-all, we had good margin performance and I expect to continue to have good margin performance.

Another big thing that happened was we acquired a work station company. And the logic of that is simple. We are trying very hard to make Varian the easiest choice for our customers to deal with. And when we sell someone a flat panel imager, they get an image comes off this thing and they have to do something with that image. It’s got to go to a workstation. It gets displayed. You can manipulate it. You can analyze it. But you have to do that on the workstation. And one of the big issues that some of our customers have is that the software interfaces can be tricky. If I sell a panel to somebody like Siemens, they have no trouble at all with it. But if I sell it to one of the medium size or small OEMs in China, they have a great deal of trouble with it.

And so, if I sell a complete package, they don’t have to worry about that engineering work. They’re going to get good image quality. I’d go to the RSNA tradeshow and walk around the floor, and I could see all kinds of image quality displayed coming off of my panels. Some made you very proud, and some sort of mortified you. And we think that this will play a very significant role in our business growth going forward.

And then we have a major new product push. I had mentioned that we’d completed this fab in Colorado Springs. And half of our business – the half that’s growing the fastest, panel, we were almost on hold for two or three years. I had to re-engineer every existing product we had to make it fit the new fab.

And then I had to take those products, bring them back, talk to customers, get the customers to sign off on them. You know, we had made changes, small tweaks and changes, to make the performance better. In some cases the customer said, “No, I don’t want that because I’ve already interfaced it. Tell me about it the next time I renew my product line.”

So, this was a big job. And in addition to that, I was waiting for a lot of plates. For instance, I needed the quality coming out of Colorado Springs to do a mammography plate, and I have that now. And so, what happened, we, in effect, (inaudible) our new products, and there’s just a chunk of them coming through. So, over the next couple of years that’s going to be a major driver for us.

I have yet a new slide. Spencer, help me. I’m too modest to bring that up myself.

I’d like to talk a little bit more about the InfiMed product line. If you look on the right hand side you see the display. There’s a computer that’s not shown. And our panel is there. On the left side of the screen, that’s a retrofitted General Electric mobile. There’s thousands of these things out there. It’s one of the biggest install bases anywhere.

And we are now selling a package. This is already – we introduced it to the market. We’ve only had InfiMed for, I don’t know, a little over a month, but this is in the market.

We have our panel fully interfaced to the AMX with their workstation, so that this goes out as a unit. We can sell that to a third party service group or whoever wants to – an in-house service group that wants to upgrade their AMX4 to digital. And it’s a nice neat package. The instructions are all there. You can just simply put it in place and away you go. And we have more of these packages planned. We’ll start out with the radiographic packages, wireless radiographic. But we’ll have a continual flow of easy to implement upgrades on existing products.

This is our new wireless flat panel. We were the very first ones in the market with a wireless panel. And the thing about wireless is is that it’s almost like using a film cassette except you don’t have to process anything. It’s free. You can put it underneath the patient. You can put it into the bucky (ph), you can put it in a wall stand. You’ve got immense versatility. I originally thought that probably the biggest market in radiographic was going to be wired, but it’s proving to be wireless.

The first customer that we work with, Carestream, on this, they have a lot of IP in their own product. So, they’re the only ones handling it. It’s just an immense success for them. And everyone is out there in the market now. You can pick up the ads and you’ll see Fuji and et cetera, et cetera, offering wireless panels. But the truth is, there aren’t that many on the market. And the one that’s out there capturing the lion’s share right now is the one that Carestream is selling. This is like a second generation. We’ve got the radio frequency stuff upgraded. It’ll transmit further, go through walls. The battery management is probably the best we know how to do. We went to experts in the industry. And the panel itself is an upgraded panel with better resolution.

We learned a lot about packaging. This is a very robust product. This product is just on the cusp of coming out. We probably made one rather large engineering lot. Many of the majors and a lot of the minor manufacturers have this product. And the initial feedback is very strong. We’re in the final processes of bringing this thing out, doing our HALT and HASS testing. And it’ll be on the market within a month.

A large area dynamic panel – this is another – it’s going to be a big product for us. I waited for the dpiX fab in order to come out with this because right now the only real competition out there, Thales produces one that I believe Siemens sells, not Phillips. But this product that Thales produces, it’s tiled together, meaning that it’s two separate plates that are almost joined together, both physically and in software; and at a minimum, you’ll use one line of resolution right down the middle if you do that very, very well. It’s expensive to do. And, obviously, there’s some reliability issues any time you do something like that. We chose to wait. We now have it. We have samples all over the place. And initial shipments, again, are occurring in this quarter. There’s a couple thousand of these things sold and we’ll get our share. It’ll take us a while.

Somebody else is already in the market. It’s harder to take market share away from someone. But this is the best panel we know how to build. It’s got cone beam software in it. Very high resolution. Very high quality.

Flat panel tube. You know, plenty of things going on, too, in the market with all the digital applications. If you’ve got an X-Ray machine and you’re using film, there’s a lot of screwing around to move people in and out and probably 15 minutes goes by between your exams and the X-Ray tube has a chance to cool down. Now, we’re selling an awful lot of small X-Ray tubes now because the work flow has speeded up tremendously with digital imaging, and the X-Ray tube can’t take it.

So, this is kind of the answer to that. It’s a very clean beam. It does require a separate generator, an anode grounded generator. So it’ll be a little slower to take off in the market. But there’s a lot of benefits to this product.

And, mammography. We’ve had a dominant position in mammography X-Ray tubes for a long time and there are new procedures that really require monochromatic kind of beam in order to affect what you want. And what that means is you need a much more powerful x-ray tube because the equipment manufacturers are basically throwing most of the beam away.

And so, we came up with this new X-Ray tube. It’s almost a CT tube in capability. And again, this is in both clinicals and engineer evaluation and final product build-out with numerous manufacturers. It will enter our product mix probably next year at some level. The year after at pretty good levels.

A mammography plate. We had waited also for the dpiX fab so that I could get a quality that I needed to use our technology, which is amorphous silicon cesium iodide scintillator and try to give the selenium plates, which really dominate the whole market now, a run for their money.

We’ve made a production run of these. They’re all over the place. I’m not sure exactly who’s going to buy them, but I know we’re going to sell some of these. This is going to be a much more reliable plate. The image quality is about the same as you get on the selenium that’s out there today. But we’re going to have both the cost advantage and a big reliability advantage with this product.

A couple of big high end tubes that we just made. The one on the left, it’s in sales this quarter to our largest customer. It’s a quarter second. What that means, quarter second rotation puts 40 G forces on the internal moving parts of this tube. And there’s like a 14-pound anode in the middle that’s spinning at 6,000 rpm, and then the whole assembly is spinning at 40 Gs. So, it’s kind of a feat to do.

The payoff is that you stop motion in imaging. It’s so fast you stop motion. It gives you a good look at heart valves and things of that nature. And our big customer has been very successful. So, we see this as another product that’s going to be growing this year, next year, the year after.

And probably the biggest install base of CT scanner is using the anode grounded technology is General Electric. They came out with a tube shortly after we started selling to Toshiba that looked suspiciously like ours. And we know how to build these very effectively. And it finally came up on our radar screen where I had enough resources to go after it and we have this product out in clinicals. It’s doing quite well. Probably in a month or two we’ll decide to expand that.

So, a lot of new products. I haven’t really covered them all. But just a lot of new product activity, which is why I’m actually pretty optimistic about the future.

If you look at our base strategy, every one of these new products I just went through with you, there’s some element of technology where I could give my customers some benefit that he doesn’t have if he goes with someone else or if he makes it himself. And so this has always been one of our basic premises to make sure that we have something that we can give the customer that he doesn’t otherwise have.

A value equation. You know, we take cost and quality very, very seriously. If you’re going to sell to these OEMs you’ve got to beat them on cost quality. There’s a whole package. It’s not enough to just save them development cost, time to market. Your factory has to really be good. And we spend a lot of time on this. I would invite anyone who’s in the Salt Lake Area to stop in and visit with me.

Our factory is pretty much controlled by SPC, the Six Sigma processes. We have a Six Sigma group of engineers. If we run into a problem in manufacturing or if we have an area that could use improvement, we’ve got the right technical talent focused on it. From a quality point of view, the same thing. We’re ferociously going after cost and quality all the time.

And the lean manufacturing techniques, for those of you who may not know a lot about it, it’s a very simple concept. Its look at what you’re doing, look at what you could be doing, and figure out how to do it better. And we’ve done this on products. For instance, our biggest selling CT tube used to take us four days to build in processing. It would go on as processing equipment and basically just burn for four days before we took it off.

We now do that in one, and it’s kind of a complex thing. You have to have the data, you have to analyze it, you have to look at things like what if I process it harder as opposed to longer. And then when I do that, how do I make sure that I don’t damage the product and, in fact, get a better product at the other end. So we have a group of people who know how to do this, they focus hard on it and it’s worked very effectively for us.

Worldwide distribution. I mean, something a little different than my colleague Kolleen would mean. I’m not looking at a lot of sales people. For instance, in my China operation, I’ve got inventory to support customers. I’ve got engineering people to support customers. I can do small repairs. We look at what we need in China, for instance, for there’s 15 or 20 kind of emerging manufacturers. And probably five or six of them are going to be around long term, but I don’t know which one, so I’ve got to support them all.

And so, we’re trying to put the infrastructure to give good, on-the-ground engineering support to all of our customers. And that’s fundamentally our strategy. It’s worked for us. And it’s the reason that I think that as we go forward you’re going to see double digit growth reappearing continually.

Thank you.

Lester Boeh

Thanks, Bob, and good afternoon, everybody. I’m Lester Boeh. I’m Vice President for Emerging Businesses at Varian. And today, I’m going to take you through the security and inspection products in particle therapy businesses.

I’ll start with security and inspection. As a lot of you know, very similar to Bob’s business where we’re an OEM supplier wherein we supply key content, the X-Ray source detector software, even some systems design, to the systems integrators around the world – the large companies, the Rapiscan, the Smiths of the world, as well as some of the regional providers.

We also do the same thing in the non-destructive testing space, where we do everything from the component supply up to system support. And this is about an $85 million a year business.

So, what’s going on in the security market? Well, what we’re seeing in the international side is we’re seeing much more broad based deployment, especially in the areas where you would expect to see, mainly Saudi Arabia, Russia, Mexico and even Brazil now, where cross-border trade is increasing rapidly but the necessity to secure that trade is growing just as rapidly.

And so, what happens is this creates some opportunity for us in these large bulk orders. It also creates some challenges in terms of lumpiness in our financials. But, overall, we see it as a positive thing for growing toward the future, as well as growing our service footprint and being able to optimize cost reduction.

In the US (ph) side it’s still the same story. We see very slow adoption, but we did get a large order from Customs and Border Protection last year for five more inspection systems for the northern and southern borders of the US. But, still, the numbers in the US are very small compared to other developing and developed markets.

We are starting to see some acceptance for our new procurement models as governments around the world are seeing challenges on the budgeting side. And these fee for service models have worked well in healthcare. And we’re starting to see some acceptance of adopting a similar procurement model in the security space.

So, what does this look like from a customer perspective? Well, this is just some images from typical border crossings around the world. The US-Mexico border is obviously a very highly crossed border every day. But we’re also seeing growth in central Asia and in the Middle East where we see many, many kilometers of traffic jams every day of trucks with goods waiting to cross borders. And also some growing need to improve or protect a critical infrastructure like this oil refinery in Saudi Arabia. We’re deploying more and more systems for looking at vehicles that are coming in and going out of these facilities on a daily basis.

What’s going on on the technology side? Well, traditionally we provide a high resolution radiograph of a vehicle that’s being inspected. And this is a fairly typical truck. You can see some differences in the gray scale images. But over the last couple of years we’ve provided some enhanced capabilities to make it easier to see threats to look at differences between organic and inorganic and machinery and heavy metals, as well as the density variations for those materials.

But we want to take that to the next step because the key to success in this business is reducing costs. Not only system costs, but also the time overhead for inspecting and getting some level of security about what you’re inspecting.

So, the next step to that is to add a auto threat resolution capability where we take that materials discrimination information, we interrogate it another step and we highlight on the monitor for the user those parts of the container that might represent the largest threat. And so it helps them zero in very quickly on where potential threats might be inside of a container. This also helps on the personnel side because the personnel don’t need as high a level of training in order to be able to identify threats in any given container.

For critical infrastructure protection, the key is speed. It’s mostly small vehicles that are going in and out of these facilities every day. It’s generally several hundred to a couple thousand vehicles going in and out. And so we need something that can inspect these vehicles very quickly.

And so, we developed a high speed scanner. We’ve got about 15 of these installed now with several more on the way. But we can process over 100 vehicles an hour and so we can get very quick look and security about what’s going in any particular vehicle in just a few seconds.

So, the keys to success in this business are going to continue to be auto-threat resolution. So providing that key decision support that the user wants to have in order to be able to resolve threats more quickly. The new procurement models that we’re starting to see acceptance of, even in the US, which is a big change and we think this could really speed adoption. This is working in other countries, and so we think it’s a good model continuing to grow the footprint of this business.

So, I’ll move on to particle therapy. And in the first half, as Elisha mentioned, we did pretty well on the order side. Also the Scripps installation is right on schedule, so we’re very pleased about that result. The Munich site has been very active that treated over 1,000 patients now and they routinely are treating patients in a standard 15-minute time slot or less.

We hit a key milestone in the San Diego project where we extract a beam from the cyclotron that was on schedule, which is a very important fact. The other important fact is we get to bill them for $17.5 million, which makes my day a little bit easier with Elisha.

The installation status for this project, I’ve just got some images here that you can see. It’s about 100,000 square foot building. It’s gorgeous. The facility looks great. And if you’re ever in San Diego, I encourage you to go by and take a look.

In terms of the active Proton projects, we’ve discussed these, but these are the four that are going on now. We also have a cyclotron that’s been operating clinically in Switzerland for about five years. And then on the projects that we have in the pipeline, there are three more in the US and another one in Italy that are in various stages of development. So, the team is going to have a lot to do over the next couple of years.

What does our path to profitability look like? It’s been tremendous fun getting this business up and operational and there are tremendous clinical benefits. But, obviously, we need to turn this into a profitable business and our development plan has us breaking even in this business during FY’14.

But you can see on each one of these projects there’s an installation phase and then we transition to more of an operations and service phase. And as Elisha mentioned earlier on, there’s roughly a ten year service tail with each one of these projects. So, when we have it up and operational, there’s tremendous revenue opportunity for us for many years afterward.

In terms of the market, we’re catching up fast. We were the newest entrant into the market. And if you look at over the past 12 months with the order bookings, you can see we’re a little bit ahead of Hitachi, but we’re leading pretty strongly over IBA. And then the other smaller players really haven’t started generating any serious revenue yet or booking any substantial orders in the last 12 months. So, we’re feeling good about our position and how rapidly we’re catching up.

So, just to remind you about why protons. It gives us the ability to spare critical structures, even when they’re in a very complicated location like here we have a tumor that’s near the spinal cord. It allows you to give a great deal of flexibility in terms of shaping the dose around critical structures, but also keeping the integral dose to a minimum, particularly in pediatric cancers, ocular melanomas. But also in lung and liver we see a lot of hope and promise for this technology. And we’re very excited about what this represents for us for bringing new clinical options to physicians and patients.

So, why are we in this business? Well, our customers have wanted us to be in proton treatment delivery for a very long time and we just had to find the right model that allowed us to do that. The ProBeam system, as part of our proton program, fits very well into our product portfolio for oncology systems with treatment planning, with information systems. And so it becomes another clinical tool that physicians can use to enhance the customization of a treatment to each given patient. Plus, there’s a fairly substantial market. We estimate the total market globally to be about $10 billion.

And with that, I’ll hand it over to Dow for the summary.

Dow Wilson

Just a quick summary and then we’ll open it up for questions. Clearly, the big themes that you’re hearing today start with globalization, something that we’ve been embarking on for the last several years, but clearly see more and more in our business. The numbers that Kolleen talked about the 10,000 unit market opportunity that we see in oncology outside of the US is based on just getting the fusion rate to the standard of Western Europe, not to the US.

So, that would mean a market of about 1,000 units a year for us, which if we just got our kind of 55% to 60% share, that’d be 550 to 600 units for us, that’d be more than the units we have worldwide today. So, the reason that we’re excited about that, the continued strength, that opportunity outside of the US is terrific.

Our business is an innovation-led business. It continues to be so. TrueBeam has driven almost $1.5 billion of revenue for us. And RapidArc another $500 million, $600 million. So, you saw Bob’s exciting lineup in his business. The proton business is working very hard on new products and new capabilities. That’s the big customer driver in our industry.

Affordability is a huge issue, especially in oncology. This is the focus for a number of our product development, and, in fact, as Kolleen mentioned, very much what is behind a lot of the innovation in hypofractionation and a terrific way to offer, not just better care, but more efficient care for our customers.

Quality is a huge deal. It’s how Bob’s getting market share and cost reduction in his business as he focuses on yield. And Kolleen showed you in her business what service means in oncology. But it’s kind of interesting to look at it across the company. This is excluding X-Ray. You could argue that X-Ray is either 100% service business or 0% service business. But excluding X-Ray, if you just look at the combined service revenues of oncology, proton and our security business, we think that we can get that over the next few years well over $1 billion and growing at 12% to 13% rate.

So, a terrific business for us. One where we are seeing margin improvement. We’ve had several years of margin improvement in that business and we see opportunity to grow that through some of the things that Kolleen was talking about with continued technology and focus on capabilities for our customers.

So, investment summary, market and technology leader continues to be the hallmark of the company. Lots of multiple growth platforms. Terrific service operations and margins in that business, $700 million this year, and continued focus on execution and innovation.

And with that, I’ll invite up my colleagues and open it up for questions.

Question-and-Answer Session

Unidentified Participant

Jason (inaudible) from Karas (ph). Just wanted to ask about the Siemens relationship. I know there’s 2,000 machines out there they’re supporting even though they’ve basically exited the business. First off, my understanding was that prior to Siemens officially announcing it, you were still getting about half that Siemens business, the balance going to your competitors.

How did this change the outlook in terms of your being able to grab that additional 2,000? And additionally, you mentioned $100 million to $200 million opportunity. I assume that’s incremental, especially since you’re exiting the GDE business or arrangement.

Elisha Finney

Yes. I think, certainly, I’m not sure that I would feel comfortable that we were getting 50% of the Siemens’ replacement business.

Unidentified Analyst

What would be the number then?

Elisha Finney

Somewhere south of 50%. I do think, however, though, that with the new strategic alliance we have significantly positions us better to increase that take rate when the Siemens machines are pulled out. And keep in mind that Siemens has been a strong contender in the oncology space over the last few years. And it really has been in just the last year or so where they’ve been struggling with their own business when they decided to pull out.

I think the strategic alliance, though, brings all of their strengths aligned with ours, particularly when you’re looking at the connectivity piece which has really been where we suffered in that particular segment of the market because Elekta had their mosaic connectivity and we were not able to provide that. So I think we have some big opportunities there.

Dow Wilson

I’ll just add, Jason. I think that when Siemens machine was coming out that was the last Siemens machine at the site, we probably got a greater share of those. But when there was a Siemens machine left, that meant our information systems couldn’t talk to it.

And if we couldn’t talk to it, that means that it was going to be an Elekta information systems, because there’s only two in the world. And that gave Elekta an edge in those particular situations. Which is why we think it’s probably below 50% but it’s kind of a mixed answer because we probably did better than that when there were no Siemens machines left on site.

Elisha Finney

And just to clarify, GE did not distribute Varian equipment. We distributed their diagnostic imaging. But it was not a mirror partnership like the Siemens partnership.

Dow Wilson

And it was only in the US.

Elisha Finney

Only in the US.

Steve Beuchaw – Morgan Stanley

It’s Steve Beuchaw from Morgan Stanley. For Kolleen, could you go into more detail on the COGS reduction program in Oncology? What sort of operational changes are you making? Are there any structural changes to sourcing or manufacturing? And then, Elisha, on the associated financial impact in the second half of the year, how much of that is tied to the reduction program rather than the timing of potentially higher margin system orders?

Kolleen Kennedy

I’ll go after the COGS reduction one first. I think, certainly, we’ve been looking at expense management as we’ve been watching what’s been happening in terms of territory shift. But with respect to supply chain, we’re going out to all of our vendors very aggressively looking to see if we have some opportunity there. And we’re looking at the supply chain from a global perspective. I think historically we looked at it individually across our different manufacturing facilities. I think we have some additional leverage there.

And then with respect to our big iron products, looking at them from a manufacturing and installation warranty perspective, what’s the further improvements we can make. And, really, we have not begun to see some of the benefits of those programs that will really be playing out over the next few quarters.

Elisha Finney

And then the guidance for the second half it’s really just getting fairly granular in terms of looking at by country where we believe the deliveries are going to go and the product mix and the geographic mix. And some cost reduction is built into that. But, obviously, some of these will take longer to implement than in just a given one or two quarters.

Jeremy Feffer – Cantor Fitzgerald

Jeremy Feffer, Cantor Fitzgerald. Just following up on that last comment. So, you remarked that one of the issues in 2Q was emerging markets taking delivery quicker than expected. Was that a one-quarter thing or is that what you’re factoring into your plan in going forward that there are certain countries that will be a lot quicker than the average?

Elisha Finney

Yes. I think what we saw in the second quarter was just this unprecedented emerging, very, very strong growth. Japan, which typically takes their deliveries in the second quarter, they’re 40% declined. And those two coming together is what caused the decline. We will continue to see emerging market growth. And you saw from Kolleen’s slide, it’s been significant. But that is built into our expectations if you look into the back volume what we see for the balance of the year.

Jeremy Feffer – Cantor Fitzgerald

Okay. And then just very quickly, the same question on the free-standing. Just a general sense of how that market is, has it rebounded at all? Or can we just expect free-standing to just be as it has in recent quarters?

Elisha Finney

Go ahead, Tim.

Tim Guertin

It’s been quiet. And we think it’ll remain quiet. There’s no new news on reimbursement. So that hasn’t changed since we talked last. We have seen some activity at US Oncology and 21st Century. US Oncology, of course, is now owned by McKesson. So, the strength of their balance sheet is a little better.

We are seeing them being a little bit more opportunistic maybe than they’ve been in the past, given the capital structure. But I’d say from an overall market point of view that that market has been quiet. We are seeing continued strength from our hospital customers, both in the hospital and outside of the hospital as they try to get more aggressive and get out in the community and get their referral pattern.

Unidentified Analyst

Thanks. Couple of (inaudible) the $100 million to $200 million target for the alliance, can you give a mix of what is actually in there for radiation and Siemens diagnostic equipment and what’s actually baked in there for a service uptake?

Elisha Finney

I’m trying to understand your question. The $100 million to $200 million you’re asking –

Unidentified Analyst

Your target for Siemens. What is the mix in there of diagnostic equipment, your own equipment, and service uptake?

Elisha Finney

$100 million to $200 million opportunity is really all for therapy equipment. So, it would be revenues to Varian. It’s not diagnostic imaging work at all. We book net commissions on diagnostic imaging, so that equipment revenue does not flow through to Varian but that would flow through to Siemens.

Unidentified Analyst

Sure. And that was not inclusive of any service, if they would be on those incremental systems?

Elisha Finney

Well, they are – on the incremental systems, correct. That would not include any services. And we would be, of course, providing the standard warranty for that. So, that would be a good 12 to 24 months out.

Unidentified Analyst

Sure. And then for Bob on X-Ray. At the yearend Analyst Day I think you were targeting about mid-teens growth for that division. And I think through the first half we had about 3% growth. So, is that still intact for this year? And if it is, sort of how do we get there if you could sort of walk us through those numbers?

Bob Kluge

Well, our third quarter is stronger than Q1 and Q2. And I don’t know that we’re entirely back to where we were. But it’s a little unknowable, but I know the trend is in the right direction. And so, if I look back historically, I’ve had years that were in the 8%, 9% range and I’ve had years that were in the 18% to 20% kind of range.

And last year was a very strong year. That probably picked up a little bit that should have been in this year last year. And I think that as the products start coming out we go into quarter four and into next year, I think we’re going to be back to where we were.

Jeff Johnson – Robert W. Baird

Thanks. Jeff Johnson, Robert W. Baird. So, three quick questions, I guess. Kolleen, just want to push you a little more on the $100 million to $200 million number. I think we’re all trying to feel out. What of that is incremental? What would you have gotten, maybe, without the Siemens relationship? And then how does that compare to the $100 million to $200 million?

Also, Tim, just a question on pricing. Effectively, a duopoly at this point. How do you think about the rational pricing. Do you think your competitor – your major remaining competitor will remain rational on pricing or will be rational on pricing, I guess I should say, going forward?

And then, Dow, just on reimbursement. How important do you think it is for a permanent doc fix versus another one-year patch to get the free-standing centers to maybe free up a bit? Thanks.

Kolleen Kennedy

On the Siemens piece, I think incrementally, historically, if you take a look at the last couple of years, we went anywhere from about $30 million to $60 million worth of Siemens business that was coming in of its own accord. So, if you take a look at $100 million to $200 million on an annual basis, I think the incremental there is probably an opportunity of another $50 million or more from where we were before as a result of the alliance.

Tim Guertin

In terms of pricing, you know my views. My view is rational pricing is better than irrational pricing. And so if you’re down to two competitors, I think – and there’s really three companies left in this business. When you’re down to three companies, I think that there is the possibility for pricing to stabilize. That would be nice to see.

That being said, Elekta is a very aggressive competitor. I think it’s in their genes. So, I’m probably not going to predict any big changes in their behavior going forward. I think they’ll be trying to get Siemens business and we’ll be trying to get Siemens business. And we’ll be facing off as ever before. So I’m not going to predict any reduction in competitive behavior based upon this change even though I’d love to.

Dow Wilson

On the reimbursement front our ongoing forecast is that we’ll see 48% reduction a year. How it plays out is always a big debate. There’s always paranoia over the summer and waiting to see what happens in the fall. I guess from the highest level view we kind of feel like the US market is in a 0% to 5% growth scenario.

And then if we can get 10% to 15% outside of the US, the oncology business, we’ll be in very good shape. So, from a high level, that’s really what we see going on. I do think that a lot of the free-standing market was driven by entrepreneurs while the inpatient hospital-driven customers were kind of content to sit back. And I think that one of the good things that we see going on in the US is especially the strong community and academic hospitals are being more aggressive about trying to get out there in the community and lock in their referral patterns. So, we see them doing more outreach and getting out into the community more.

And so, that that’s a positive thing in the US market. So, we may actually see that kind of free-standing market evolve in a way that’s a little different than we’ve seen it evolve in the past where it was kind of the independent free-standing folks that were really taking it on. And I think we’ve seen that trend, certainly, for the last year.

Tycho Peterson – JPMorgan

Hey. Tycho Peterson, JPMorgan. First one for Elisha. Can you just maybe clarify the gross margin target on Proton, 30%. Is that systems and service? And can you maybe talk to what the service gross margins might look like in Proton once those systems ramp?

Elisha Finney

That was for the equipment. And, again, that won’t be next quarter or even next year. That’s a longer term goal that we are aiming for probably when we get to machine installation in four, five, six and beyond. So, each one of these will carry about a $5 million annual service contract.

Look, I haven’t serviced one yet that we have installed, so I’m a little reluctant to give you an exact number. But we’re aiming that it most likely won’t be at the Oncology service margin, which is at around 50%. I’m hoping we can get it to, say, 40%. And again, as these centers start to accumulate, it’s a big service tail that we can start to generate.

Tycho Peterson – JPMorgan

Okay. And then maybe one for Tim. If we go back a year ago, you had provided a longer term growth target. I think you said around $4 billion in revenues by 2015. Any change in thinking there? And maybe can you also talk about how you’re thinking about M&A?

Tim Guertin

I think that – Kolleen mentioned in her presentation that and I often use this 10,000 figure for where the world should be today. If the average was 40 machines per million people over age 65, the world would need about 21,000 machines. It has about 11,000 machines, so it’s about 10,000 machines short. If you divide that by 15 years and multiply it by 60%, which is the share I would love to get, then you wind up with about 600 machines a year, something like that that we ought to get from that international business.

And then the replacement markets. I don’t want to ignore the replacement markets. If you look at the US market there’s, I think, 3,000 something machines installed that are ours in the United States. And in Europe I’m going to estimate machines that are older. Anyway, you wind up with about 4,000, 4,500 machines. If you divide by 10 years, say those machines came out over 10 years, that would be over 400 machines a year. So it gets you up into the 1,000 machines a year category, whereas, now we’re in the 600 machine category. So, I think there’s substantial organic growth left in Oncology.

If you add in the potential of the Calypso and the Augmentix business for replaceable elements, I think – and by the way, that relates also to liver cancer and lung cancer. Liver and lung are currently indications not prominently used for radiation unless the conditions are inoperable.

So, right now people use RF ablation or chemoembolization for liver. I believe that more and more in the future we can go to radiation. And we’re working with a number of high profile radiation oncologists right now in terms of solving that problem. A big problem in Asia. In China, about 1 million people with lung cancer. Would be really nice to solve that problem.

So, I think as we solve those problems, it increases the market from that 40 machines per million people number that I’ve talked about.

So, for all those reasons, I think that Oncology has big growth. I think that the X-Ray business has got probably, over the next five years, another $250 million to $300 million worth of growth in it. I think the Proton business can grow another $200 million or so over the next few years as (inaudible) out. That’s a business that we decided to get into.

It’s taken us a long time to get it going because, unfortunately, we got into it at the same time that there was a major financial event. But I think as we come out of it we’re going to see that business strengthen. So, I think there’s big potential there.

The security business I’m expecting to grow, but I’m more moderate in my expectations. Before I would have thought maybe $100 million. Now I’m thinking more like $50 million as a reasonable goal for the security business over the next few years.

So, when you add all this up, and you go out five or six years, I’m moving past $4 billion and on my way to $5 billion. So I’m an optimist. Can’t be a CEO without being an optimist. But I see huge opportunity for the company going forward.

Josh Jennings – Cowen

Hi, Josh Jennings from Cowen. First, for Elisha. I was hoping you could give us just a little bit more detail on some of the tailwinds in gross margins, in Oncology specifically, that give you the confidence that you can rebound outside of geographic mix and cost reductions.

And I was hoping specifically some commentary around you’ve had less than half of your total orders of TrueBeam installed. What TrueBeam can actually do for margins going forward? And then also on the service line, you are looking at close to 13% CAGR and with the TrueBeam service contracts coming on board how the gross margin on service can improve?

Elisha Finney

So TrueBeam is accretive margin. So as the installations continue to increase, that should help the gross margin line in Oncology. That said, from the pricing pressure that we’ve seen, particularly in these emerging markets, are for the TrueBeam because these customers want the high end equipment and they just simply don’t have the budget for it.

So, some of the plans that Kolleen mentioned about tiering the product with different features at different price levels, that should help. But that is something that won’t happen immediately. It’ll take us several quarters for that to work through the backlog.

The service business is absolutely accretive to our margins. It’s one of the – and on an ROS basis, it is the highest ROS product line that we report in Oncology. So, it’s at about a 50% margin. Again, it’s one of the reasons we’re simply are not going to feed these gross markets to a competitor on the base machine price when we can lock up the ten year service tail because over time we’re going to make significant margin on that service business.

Josh Jennings – Cowen

Then the second one for Dow. Just with stereotactic radio surgery demand increasing, the number of radiation oncologists practicing SRS and SBRT increasing, I was wondering if you could give us an idea of your mix between TrueBeam and TrueBeam STx. What initial TrueBeam purchasers have done in terms of upgrading to have SRS capabilities? And then, lastly, where you’re at in motion management relative to your competitors?

Dow Wilson

I think on the SRS-SBRT side, we are seeing big uptake. I would say almost all of our customers are doing some level of hypofractionation, some much more than others. From an overall mix standpoint, I would say that the STx line is probably not quite a quarter of the whole mix. But having said that, even on the other 75%, our customers are doing a lot of hypofractionation studies, treatments with our product.

The second part of the question was on motion management. As we’ve said many times, we’ve bet on a number of horses. We have seen terrific uptake and interest in Calypso. So, that part of the strategy is working out very well. We are pursuing a number of regulatory approvals for that product which should expand its use and we can see some growth there. With a little luck we’ll have some announcements yet this year on that.

We have a number of customers doing a frameless fiducial marker based treatments. Lung cancer is getting a lot of play, both on the STx platform and on just regular TrueBeam platform. So, the speed of the machine, the flexibility of the machine, the dose rate, the capabilities that were mentioned from the paper that Kolleen cited in SRS, are truly being worked out. So, we’re very bullish about where that is and continue to see very good growth.

Tim Guertin

So, with that, Spencer has told me that we’re going to stop. So thank you all for joining us today, and have a good afternoon.

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