Varian Medical Systems, Inc. (NYSE:VAR)
Bank of America Merrill Lynch Health Care Conference Call
May 15, 2012 04:00 pm ET
Elisha W. Finney – Corporate Executive Vice President, Finance and Chief Financial Officer
Spencer R. Sias – Vice President, Corporate Communications and Investor Relations
[Call Starts Abruptly]
Analyst at B of A. And here with me from Varian, we have Elisha Finney, the CFO, and Spencer Sias, the Head of Investor Relations. Elisha's is going to go ahead and speak for 15 minutes or so, and then we will open it up for Q&A.
Elisha W. Finney
Thank you, [Lenux]. What we thought we would do is just give a brief summary this afternoon and then make sure we leave time to answer any questions that you might have. I will be making some forward-looking statements. Varian's mission is focusing energy on saving lives. And in all three of our business segments, we focus x-ray energy. In Oncology Systems, we focus our energy on tumors, so that we can kill cancer and cure patients. In the X-ray Products Division, we focus energy on better diagnosis, so that you can be diagnosed earlier.
And then finally, in our Security and Inspection Products business, we are focusing energy on inspecting cargo and having safer borders and ports. The mission or the goal of the company is to save an additional 100,000 life each and every year. We treat about over 2 million patients per year, and we are all at the company very dedicated to reaching this goal.
We have three reportable segments. Last year, we had orders of right at $3 billion. Oncology Systems, just over $2 billion, represents about 75% of the company, X-ray Products $0.5 billion at about 15%, with the remainder coming in our other category, which includes our Security and Inspection Products business, our Proton Therapy business, and our central research facility, which is the Ginzton Technology Center.
Moving into Oncology Systems, which is obviously the largest part of the company, about two-thirds of all patients today receive radiation therapy as part of their course of a cancer treatment. We have been focused on becoming the technology leader and we are today a one stop shop for all radiation therapy needs, including all of the hardware, all of the software, the service, and all of the accessories that go along with that.
The name of the game in radiation therapy is deliver as much dose or radiation as you can to the tumor, so that you can kill the cancer cells, while at the same time minimizing the radiation to healthy tissue, so that you can avoid complication. And we are the technology leader in this. This business is growing. The oncology total business is growing in the high single-digits with mid single-digit growth in the U.S. along with mid-teens growth in the international markets, as well as low-to-mid teens in our service business. And what's driving this growth are several initiatives. Really, there's a three-legged stool to oncology.
The first is driving a replacement market. The second is, moving into emerging markets, where there’s an absolute need for equipment. Third, is the service business, which I'll come back and touch on. And then we just added a fourth leg to this stool with last month announcing a partnership that we have now with Siemens Corporation. The replacement market, we have about 6,800 installed base of machines. And those machines are getting a little long in the tooth, particularly in the U.S. where we have approximately 3,500 machines. And we estimate that the average age today is somewhere over 10 years or older.
And what’s going to drive that replacement cycle is new technology. And this is a picture of our TrueBeam machine that rolled out about two year ago. And again, what we are focused on is giving the best quality treatment at the lowest possible cost for treatment. So this is looking at precision, putting the dose exactly where it needs to be, looking at patient throughput, getting treatment done in as little as 10 to 15 minutes that use to take 30 to 45 minutes, and a lot of work around workflow and usability and making our equipment easy to use.
The equipping of emerging markets I'm going to come back to, we’ll show you a few statistics. But suffice it to say, if we were to bring the international markets not even to the full U.S. standard, we would need 10,000 machines around the globe, so a lot of growth opportunity outside of North America. Our service business is growing in the low to mid teens. As the machines become more complex, it’s more difficult for the hospital to service their won equipment. So we get a higher capture rate of the service contracts.
And as the installed base grows, again, we're getting more service contracts at a very high margin. This is about a 50% margin product line. And we are offering additional services to our customers as well, expanding clinical applications, and this is again being able to provide any and every form of radiation therapy for the patient that walks through the door, whether it's traditional radiation therapy that takes 30 to 40 treatment sessions, or whether it's stereotactic radiosurgery, which can get a treatment done in as little as one to five sessions. We’ve gotten very good at certain cancers on turning them into chronic manageable diseases, but there are unfortunately other cancers where just little progress has been done. We're very focused today on managing motions and not only treating the tumor but treating it real time as it moves. And that’s going to make we think significant progress in lung, liver, and pancreas, which is the next area of real focus for us.
Looking at the world map, cancer is a disease of age with the vast majority of cancer in patients that are 65 years or older. And this shows you the number of radiation therapy machines per million people over 64. And you can see if you look at North America, we're pretty well covered here and again this is largely a replacement market in North America. But if you look at the rest of the world, there is a lot of light green space there and an absolute need for machines outside of North America.
And today about 45% of our total business is in North America, 55% international. And I suspect, in the next five years, it's going to look closure to probably 65%, 35%, 60%, 40% something in that range, as the outside of North America continues to grow significantly faster.
Moving I’ve already talked a good bit about the service business, but let me just add here that it is a very nice recurring revenue stream, a nice annuity to offset, what is otherwise a capital equipment business and today represents about one-third of our total oncology business. Again the expanding installed base and offering more services and having more complex and embedded software means that we're capturing more and more of the service contracts around the globe.
I am going to switch gears just a little bit and talk about our X-ray products and this is where we're a component supplier to the diagnostic imaging industry. We make about 22,000 tubes a year out of our plants in Salt Lake City. And you can see the picture here, the X-ray tubes and flat panel detectors, the tube this is kind of like a pitcher and a catcher. So the tube actually pitches generates the X-ray beam caught by the flat-panel technology it’s converted into light and into a digital image that you can see on a computer real time.
We just if you look down at the bottom right here we just announced last month an acquisition of a workstation company called InfiMed. And between that pitcher and catcher historically these OEM had to do a lot of engineering in the middle of that to make it all work.
With this technology that we bought, this workstation, we now simplify this. We're offering an entire imaging subsystem that we can provide to the OEM manufacturers, make it very simple for them to incorporate this technology and make it easier for them to get faster to market. What’s driving this business is really the fact that hospitals and are moving to filmless imaging, where you don't have to take the film, you don’t have to have it read, you don’t have to store the images, you don’t have as many retakes. So what’s really driving our X-ray product segment today is this move, as we have all done to filmless cameras, the same thing is going on in hospitals to filmless imaging. And we have both the tubes and the panels that can be optimized to work together in that regard.
Switching gears again to our proton therapy business, we purchased a company called ACCEL five years ago back in 2007. ACCEL had built a proton therapy system it was in Munich. I would say that they had very, very good technology but really didn’t have the resources to commercialize this technology. We knew there was some work to be done, a lot of software to be written and so Varian has spent the last five years really, commercializing this technology and getting it ready for prime time.
First I should probably say what is the advantage of proton therapy? Proton therapy is a particle-based radiation treatment, where you have an entrance dose and instead of having an exit dose that the beam stops at the depth of the tumor. So this is very, very important if you are treating a tumor close to a critical structure such as the optic nerve or if you are treating pediatric cancers where the risk of recurrence is over many, many years and you want to be extremely, extremely precise in the treatment.
The downside to proton therapy is that one of these all-in installations is about $200 million. We're working to get that cost down and to move to smaller centers but today these are four- and five-room treatment centers with the Varian equipment being somewhere around $7 million to $8 million or so.
And this is just a depiction of what a proton facility might look like and you have a superconducting cyclotron again it generates the particle-based beam. That beam is then shunted down about the length of a football field through magnets and then it goes into each treatment room. There is a gantry, the patient lies on the couch and then the beam is delivered to each of these four or five rooms as it is needed.
The growth initiatives here and we need to standardize this product. Varian has its first installation underway now at Scripps in San Diego and our goal is we now have to standardize this product. And we have to get the cost down and we have to get the size down and so we are very focused on that. The challenge in the Proton Therapy business is, again these are very large projects. And project financing is tough to come by today when these don't typically cash for somewhere around three years or so.
So we are working through that, our customers are out trying to raise money as we speak. We do have over $200 million of orders in this business that we have booked in the backlog. We have booked our San Diego, we have booked Saudi Arabia, we have a deal in St. Petersburg, Russia. We have also been told we’re the vendor of choice in about four other sites who are out raising money today.
So, I think we turned the corner in the Proton business, we have a product, we have a solution. The customer demand is quite high and again it’s hoping that we can get this business break-even by the end of fiscal year 2014. We have been investing in this business. That's code for dilutive business over the last five years that I'm very excited that I think we are turning the corner in Proton Therapy.
Security and Inspection Products business, the beam that can cure cancer, high-energy x-ray beam, can also look through 17 inches of solid steel and tell you what is on the inside. So we have a small business today, it’s about a $100 million, but we are looking at cargo containers and an entire luggage pallets and things like that to see what's on the inside and obviously, this is to protect our ports and borders.
We have materials discrimination, where we can actually identify anything heavier than lead. So that you know what could be a really bad substance versus fruitcake. And that’s what we are working on as to get better and better at this materials discrimination to help us identify actually what is on the inside of containers.
This is our opportunity over the next five years. We believe that in five years, we will be approaching $5 billion. You kind of see how this lays out. We believe that the big blue bar there, Oncology Systems that we can continue to grow this business in the high single-digits, but all of the growth reasons that I mentioned. One potential upside that I failed to speak about earlier was our collaboration with Siemens that we recently announced.
This is where we have a joint distributor relationship, where we will distribute, Varian will distribute their diagnostic imaging equipment into radiation oncology departments, and Siemens in turn will distribute our equipment. It opens up their entire global footprint and their sales organization. Siemens has been very, very strong in a lot of the emerging markets and in some places that Varian has historically not really had a footprint.
And so, we think this is a good opportunity for going after some of these white spaces. They have an installed base of about 2000 machines. As part of this partnership now, we are going to be having the software connectivity. Historically, the Varian machines and the Siemens software would not talk to each other. So when we went into an all-Siemens department to replace one of their machines with the Varian machine, it became more difficult.
Now, we are getting that interface, so that we will be able to put Varain machines to coexist in departments with Siemens machines, and they can all talk to each other. And then finally, very exciting on future product collaboration and we will be working together as the number one diagnostic imaging company and the number one cancer treatment company and looking at how we might develop products going forward.
The red bar here are X-ray Product segment, we believe can continue to grow. Flat panels is going to grow in the mid-teens, x-ray tubes are little slower than that, but double-digit growth out of our X-ray segment. The Proton Therapy, we believe we will make this a $250 million to $300 million annual business. The goal is that we can get three contracts per year and then with each one of these installations comes about a $5 million annual service contract. So over time, that service business will start to accumulate quite nicely. And then our Security and Inspection Products business, again it’s a very lumpy business, we belie we can grow that on average of about 10% per year.
So I'm just going to leave our investment summary up here on the screen. And then Spencer and I would love to take any questions that you have. Thank you.
Okay, thanks Elisha. I will go ahead and start things off here. I guess no surprise just focusing on margins to begin with, in the Oncology System you saw somewhat weak gross margins last quarter. I believe they were about 42% versus historically in 44% to 45%. And I think you are expecting them to move back closer to the 44% to 45% level in the second half of your fiscal year. Could you maybe just give a little bit of color on what's going to drive that improvement especially since it’s a short period of time?
Elisha W. Finney
Sure. So for the full fiscal year, we expect that the gross margin for Oncology will come down by about a point year-over-year. So really a reset in the oncology margin as most of our growth is coming from the international markets, which historically are lower margin. We saw unprecedented growth in the emerging markets in the second quarter, it’s a lowest margin territory. But the exciting thing is these emerging markets are creating new sockets, a new installed base. And so, even though the gross margin is lower on this capital equipment sale, what it does is gives us a 10 to 15 year service tail that we will be getting on each one of these machines.
So, as a company, we look at it, and we say okay, we can take very high margin business, limit ourselves to the U.S., Japan and Western Europe and grow perhaps in the mid-single digits or we can take lower margin deals in the emerging markets, which are growing very fast and get an additional four to five point growth on the top line and then supplement that with the service over time. So, that's the decision made. We've kind of reset on the Oncology margin because of this international growth.
Going forward, I believe that we will be able to sustain those margin levels because we’ve got some pretty aggressive cost reduction targets underway. And we have quarter-by-quarter plans to get there.
The service business is continuing to grow nicely. And that's a 50% of margin product line and then to be offset somewhat by continued growth in the international markets.
Can you maybe just expand a little bit on the cost reduction initiatives that you’ve mentioned kind of one where you think you can drive out costs or where you can drive that improvement and then I guess just if it is possible to quantify how much cost you could take out and kind of the timelines that you're thinking about?
Elisha W. Finney
Yeah, so we have it’s looking at over the next six to eight quarters, not all of this is going to happen this quarter. Some of it will. And we’re really, this is just back to basics. This is our TrueBeam machine. We just rolled this out two years ago. We have been very focused on getting a great product, getting it distributed, learning how to install it, how to warrant it, how to get any of the bugs if you will out. We've got a fantastic product. It is the undisputed technology leader. Now, we're at the point where we can say, okay, how do we start to cost reduce this product? And so, that's what we're focused on. And this is going to come every $5,000 at a time.
We've got engineering plans. We've got manufacturing plans. We have service plans. So, throughout the oncology organization, this is a huge initiative with different organizations taking a piece of it. We sell about 600 machines a year currently. So, on a machine that cost $1 million, if I just get $10,000 out, $6 million falls to the bottom line. So, we're aiming for much more than that. We know that the emerging markets are going to continue to be the growth area. And so, we are going to be very diligent about getting costs out.
One thing we're going to do is perhaps look at ways we can layer the product to where, if there are certain features that a certain market doesn't need because these people are just starting radiation therapy. If there are certain features that they don't need, we'll take that out of the product, and then they can upgrade over time so that we can get some cost out of COGS that way. So, we're going to be looking across the board at ways to get cost out.
Okay. And just last question around the margin side, you mentioned that it’s worth it to take the hit on the margin and the emerging markets in order to ramp up the installed base on machines and get the service revenues. Are the service revenues in the emerging markets also lower margin than the service revenues in the U.S. as well as the lower margin just on the system?
Elisha W. Finney
It’s primarily on the capital equipment. The service margins will likely be, they're not at the 50% level. But, they are probably close to 40%. And I don't have this country by country. But, it is a little bit lower. But, again, service all falls to the EBIT line because there is no R&D and marketing that's allocated to it.
And I should just say, Varian, we manage the Company at the EBIT margin level, not the gross margin level. And although we may see that the Oncology margins start to stabilize for the next couple of years, I do think we can get some small amount of leverage in the operating margin as we don’t have to grow the corporate cost as quickly as we do the top line.
Great. Any questions from the audience?
Can you expand indications into lung, liver, and pancreas, does that directly lead to incremental purchases, or is it indirectly in terms of the utilization rates of the existing machines goes up so that leads to sale? And then where are you in that process in terms of penetrating these indications?
Spencer R. Sias
We are in early days of getting treatments going for example, stereotactic radiosurgery treatments on lungs. What you're seeing these days are papers coming out showing the tremendous amount of promise and good results in small patient cohorts. This is stimulating more leading centers to equip themselves to be able to offer radiosurgery in addition to radiotherapy. And what this will do ultimately is change the mix of treatments that are occurring in a standard radiation oncology department to include more radiosurgery capabilities.
And so this will drive demand for more advanced treatment capabilities. So, instead of buying a machine that's limited exclusively to radiotherapy, they want one that will do both radiotherapy and radiosurgery. And as people begin to find that they can do an effective job with lungs, we would expect to see them continue to use or to begin to use stereotactic radiosurgery for the treatment of liver mets, perhaps institute broad-scale deployment of hypofractionated treatments for prostate patients and thus cause more of these patients to come into radiation oncology centers. So I think it all builds on itself in that manner.
So I guess just following up on that, how should we think about the catalyst there in terms of driving more growth in lung and liver, is it relates to more data coming out and kind of building better awareness or is it, how should we think about it that catalyst?
Spencer R. Sias
Yeah. As an example, there was a study done by Dr. Timmerman at UT Southwest, who was doing stereotactic radiosurgery on patients who are considered to be inoperable with early stage non-small cell lung cancer. And 70 of those patients, he achieved a 90%, three-year survival rate. And normally, this disease would kill the patient within a year.
And that study in fact, stimulated other studies, and so you are now seeing similar studies, for example, done at VU and Amsterdam by (inaudible) and several other people. And they're sharing these papers at meetings like ASTRO and ESTRO. These are meetings of radiation oncologists. And this stimulates more people to try to use the techniques. And as they do this and they report their findings, then you broader deployment of it.
This is the same way that intensity modulated radiation therapy or IMRT moved into the market. It began really with a study by Memorial Sloan-Kettering, which got very, very good results for prostate cancer. And then this was picked up and applied to a prostate cancer by a broad number of centers and then led to head and neck treatments and other applications of IMRT. So that’s really what it is, it’s the study of the technique, the reporting of it, and then more people moving into it.
Elisha, you’ve spoken in the presentation about the large install base you have and the potential replacement market that you could see over time. Could you talk a little bit about what percentage of your U.S. sales right now are coming from replacements. Have you started to see a meaningful contribution from that? And if not, when would you expect that to start for the year?
Elisha W. Finney
Yeah. So I mean the U.S. is primarily a replacement market. So the U.S. represents about 45% of our total today and 80% to 90% of that is not replacement. And again, if these machines get 10, 12 years old, the technology has evolved tremendously over the last decade with IMRT, IGRT RapidArc, TrueBeam, and it’s technology that’s going to really drive this replacement cycle. So the U.S. has been, we've been flustered, they are dealing with the three R's, the reform, the reimbursement, the recession, and so the U.S. has been a top market for the last four years or so.
If I look back over that period of time U.S. has been relatively flat. So you get quarter-over-quarter variation, but over a four year relatively flat. I think a lot of other companies saw declines and we were able to maintain flat by virtue of rolling out new technology every year, every other year, and that’s what causes the hospitals to say, hey, if I’m going to get referrals, if I’m going to get patients coming in the door that I can advertise my capability, I have to have state-of-the-art technology. I don't yet think because of those three R’s, we’ve really seen the impact yet of the TrueBeam. And I believe as more and more data and studies start coming out that the hope is that will start to drive the replacement cycle in this country.
Can you explain a little bit more and quantify the impact of the Siemens distributions? Why it is necessary? It seems like both of you already have pretty good systems in both sides of the leg?
Spencer R. Sias
Well, the Siemens has obviously, it’s a huge company with tremendous reach. And as big as Varian is, we're quite small by comparison and don’t have the reach, for example, into places like Russia or western part of China. So there is a lot of white space out there for Varian that now becomes addressable through the Siemens sales force. And it allows Siemens to be able to continue offering linear accelerated technology with the bundles that they put together for hospitals, so they can have an imaging and therapy package by combining the technology of both companies. So that should contribute to our growth by having us address that market.
Elisha W. Finney
We are very excited about this collaboration. This is the number one therapy company with the number one diagnostic company marrying up. It makes perfect sense. We greatly expand our global reach, product development. Unfortunately, I think, it got a little overshadowed by the margin issue that we had in the second quarter, but this is a very, very exciting for both Siemens and Varian.
All the big guys have gotten out radiation therapy. Mitsubishi got out, GE got out, now Siemens is getting out. And it's because as an industry, as a market, radiation therapy is relatively small, diagnostic imaging is ten times the size of the radiation therapy market. And so, when you are a big conglomerate all the resources, all the talent, all the R&D everything goes to the bigger market.
Varian and Elekta are really the last two standing and it's because this is our lifeblood, radiation therapy is it. And I think it’s a good collaboration for both parties.
Hi, could you comment on the pricing environment in terms of competitive environment since the Siemens exit, during the last call you referred you had some pricing pressure. So can you comment on to what extent it was already in the numbers in the first quarter or it’s more on a going forward basis that you could more discounts from you?
Spencer R. Sias
The pricing environment has always been pretty aggressive. Elekta has always been quiet aggressive in its pricing. And that’s not going to change. Although we do have some hope that it is more of a duopoly now with the Siemens exit that Elekta will see less of a need to price as aggressively as they have in the past. However, whatever they do we are going to compete for the market pretty aggressively. As Elisha pointed out earlier, we will trade five points of top line growth for a point of margin anytime because the long term prospects for the business and the services that we can sell a much better there.
Another question about your product offering in the emerging markets relative to the western world, are you selling TrueBeams to the same extent in the emerging markets as in the western world or is the product offering very different?
Spencer R. Sias
It depends upon where you are, leading academic centers in China, leading centers in India have ordered TrueBeam. And so, TrueBeam is, there is a market for TrueBeam overseas, but there is also a market for lower-priced models. So, we have a unique accelerator that’s called UNIQUE that does image-guided RapidArc, IMRT and this is priced anywhere from a $1 million to $1.5 million. So it keeps you high throughput, high quality treatment and this machine enjoys some demand in the emerging markets that are looking for lower-priced offerings. But they also want the capability to be able to offer the most advanced forms of treatment. And so, there is a mix there.
Great, thanks very much.
Elisha W. Finney
Spencer R. Sias
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