VAR - Varian Medical Systems, Inc. at Citi Global Health Care Conference EVENT DATE/TIME: FEBRUARY 28, 2012 / 3:30PM GMT

Transcription

1 THOMSON REUTERS STREETEVENTS EDITED TRANSCRIPT VAR - Varian Medical Systems, Inc. at Citi Global Health Care Conference EVENT DATE/TIME: FEBRUARY 28, 2012 / 3:30PM GMT

2 CORPORATE PARTICIPANTS Elisha Finney Varian Medical Systems, Inc. - SVP and CFO Spencer Sias Varian Medical Systems, Inc. - VP, Corporate Communications and IR CONFERENCE CALL PARTICIPANTS Amit Bhalla Citigroup - Analyst PRESENTATION I'm Amit Bhalla from the medical technology and the life science tool team here at Citi and we're happy to have Varian Medical with us for the next session. To my right is Elisha Finney, Chief Financial Officer and to Elisha's right is Spencer Sias, Vice President of Investor Relations and Corporate Communications. Elisha's going -- actually Spencer's going to take us through a few introductory slides and then we'll have a 20-minute Q&A before the breakout. I'll turn it over to you Spencer to give us an introduction. Thank you. I had 70 slides but I guess I'll just have a few. With the usual forward-looking statement apply here so just for the people who are unfamiliar with Varian. Varian Medical Systems is really a company that specializes in developing products using x-ray technology. We have -- we do it for -- use x-rays for cancer treatment and we sell systems for that.we also sell components for x-ray imaging and we sell to original equipment operators -- I'm sorry original equipment manufacturers. And then we also have a business where we sell x-ray components to systems integrators for cargo screening systems. So the core technology and everything that Varian is doing really is x-ray technology. The biggest business for Varian is our oncology systems business where we're selling radiotherapy equipment, hardware and software and accessories for radiotherapy and radiosurgery and that is a $2.3 billion business as of our last fiscal year, which ended in September. And we sell to the world's hospitals and clinics for radiotherapy and radiosurgery.we have probably a 60% share of the US market and probably 50%, 55% share of the global market for this business. Our second largest business is the x-ray products business. In this business, we're selling x-ray tubes and flat panel detectors to x-ray equipment manufacturers and also to businesses which service x-ray equipment that's in the field for medical diagnostics veterinary, dental, and security applications. And that business is a business that has been growing in the mid teens as a result of a transition in x-ray imaging to filmless x-ray imaging moving away from film, computed radiography and from image intensifiers. Varian really is at the epicenter of a movement there that is probably only about a third of the way through and the business has, therefore, been growing from that perspective. I referenced our security business there.you can see a picture of a truck taken -- using components from x-rays -- from Varian.We sell very powerful x-ray devices to systems integrators who use them to verify cargo manifests or also to determine whether there's something dangerous that's being brought across the border or into a port. And in the lower right there you're seeing a particle therapy cyclotron. This is a new venture for Varian which we hope to build to a $200 million to $300 million business. This is a more precise form of therapy for treating cancer and we can elaborate on that for you in the presentation. Varian's, looking at our last fiscal year, we finished out the year with a total of $2.9 billion in orders and revenues of $2.6 billion and earned $3.44 per share with producing operating earnings of 23% of return on sales. When we've spun out from Varian Associates back in 1999, our operating earnings were only 11% and it was -- so we built it to 23% and our objective is to try to get to 25% and we can talk more about that.we are traded on the New York Stock Exchange under the symbol of VAR. I'll just leave this slide up here as sort of our summary and turn it back to you, Amit, for questions. 1

3 QUESTIONS AND ANSWERS Sure. Thanks, Spencer. I want to start with just a question on the overall environment and visibility that you have into your business. The capital equipment market has been pretty dynamic.we've seen pressure but there's opportunities for the products you sell to still grow in that environment. But I do have a question on what type of visibility you have today in the US market as well as European markets for the oncology business? Sure. In terms of the orders, I guess the best visibility we would have is our sales, final. And this is where the sales people are reporting back on deals that they are working and it's something that we monitor and that we manage very actively on how that funnel is looking, how it's trending. So in terms of perfect visibility, we never know exactly when an order is going to land. I think we have -- being a 55% to 60% of the market share, I think we are aware of just about every deal that is going down for linear accelerators. So we have brought to the table.we have very good visibility on that. In terms of the exact timing, that's where things can fall in or out of a quarter and we never can predict that with accuracy. On the revenue side, the beauty of building a backlog is and our backlog today is up 14% over the year ago quarter is I've got a 12 to 15-month look on average from the time something is booked until the time that it is shipped and becomes revenue. So, very good visibility looking out from the time I book the order until the time we record the revenue. And again very good visibility on our service business, which is about a $650 million business today. That's very repeatable and it's typically under an annual contract where we're just recording the revenue ratably over that period of time. So talk a little bit about -- well is that visibility any different US versus Europe? Europe tends to be more government bid and RFPs. So again very good visibility I'm looking at in the government sector on what deals are being bid. We do participate in the private sector and so there again probably not as great as on the government side, but monitoring the sales funnel in the private sector as well. So how about order cycles though because in an environment where capital equipment dollars are strained, I would think that you have seen -- I think I know you've seen some lengthening order cycles. So where are we on average and is there some stability in the order cycle? I think what we've seen is the process, particularly in the US has just become a little more burdensome in terms of hospitals it used to be if we were to come out with an accessory in the middle of the year, they could go back to administration. They could get the capital budget and they could buy the accessory.today, what we're hearing is that the capital budgets are set and then there's really no work around. So there's a lot of -- there's just more scrutiny on the capital budgets.there's more approval cycles that are required. And I think purchasing outside of those capital budgets has become more difficult.that said, because we are the number one or two profit center in a hospital, because the payback on our equipment is typically in the 18 to 24 month, we're a very high priority in that capital budgeting cycle. So it's not that it's hard to get the dollars, it's just you have to go through the process. And once the dollars are there then they're free to spend. 2

4 Okay. Now, if I -- following you guys for a while, your cancellation rates have been pretty consistent. So you haven't seen any spikes in cancellation rates. But I know in the last quarter you did talk about a few large order push outs. Right. In your hospital segment, right? Correct. So, what struck me about those push outs is typically I expect you to kind of capture those in the next one or two quarters. This time around you said just expected in the next year. So much broader range than I normally think about in capturing order push outs. Is something different in the market today? It sort of goes back to what Elisha touched on earlier is that -- it's taking a little longer for people to get through all the Ts and Cs. And we didn't say next fiscal year, we said this fiscal year. This fiscal year. And so it's an issue really of just people taking longer to go through the stuff. We don't see a fundamental change in the North American market. The customers are still there. They're still talking about buying stuff. And when we look at push outs, it's where -- a push out is defined as a deal that Varian has been picked for but we're still in the process of negotiating the Ts and Cs. So, I think we remain optimistic about the North American market. Okay. 3

5 As probably really sort of a mid single digit grower. When you take a look at the oncology business overall, you're -- we're looking to try to grow this business in the high single digits and there are really three elements to that. There is replacement, which is really the North American market and what drives that is continuing innovations like TrueBeam and RapidArc and repeat iterations of our software.the service now at $650 million annual business sort of in this fiscal year would be our expectation. We think we'll grow in the teens and we will also get growth by penetrating the emerging market. So it's a combination of replacement, service and emerging markets that get you high single digit growth in the oncology business. Okay, got it. And just one other topic I want to touch on in the North American market was what's happening with freestanding clinics and how you're adapting your selling and your targeting of customers based on what's happening in those freestanding clinics. We really don't sell any differently for the hospital market or the freestanding clinics. By freestanding some of these can be what we call a doc in the box where a doctor just goes out on his own and has radiotherapy or someone like a US Oncology which owns nationwide chains of centers. We don't market any differently. Our contracts are no different. We sell them the same equipment. So it's really just a swag in terms of that market used to be we approximate at 30% of our US market. Today, I think it's probably south of 20%, somewhere between 15% and 20%. That market dried up several years ago when there was just a suggested reimbursement rate decline of anywhere from 30% to 40%.That was shocking to that part of the market. The reimbursement never materialized at that level. It was reversed and I think they saw a more normal like 5% reduction. But I think the market never fully recovered from the shock to the system. Hospital reimbursements have been trending up slightly in the 5% range. Freestanding centers have been trending down and I think the goal is to get them more on even footing. Cause what was happening is you had freestanding centers pulling away from the hospitals, taking the profitable parts away and I -- now that trend will reverse and they'll probably re-affiliate -- a lot of these centers will re-affiliate with the hospitals and get the hospital reimbursement rates. Anything else to add? No, I just think the fundamental drivers for growth remain in place and that is that you're going to have more cancer out there that needs to be treated. I mean the number of cancer cases diagnosed annually doubles every 50 years and that's going to happen in the states as well as in the rest of the world. So it almost doesn't matter where you get your treatment, whether it's a hospital or a freestanding clinic, they're going to need to be able to equip to address this need. So we're not as focused on the segmenting the market between clinic and hospital. Reimbursement rates generally don't have as big an impact on our business as I guess people think it does because the time period of ownership is a decade or more and reimbursement rates obviously fluctuate pretty wildly in that. So, the return on investment remains sort of an 18 to 24-month period, so it remains quite profitable to do radiation therapy. And the US is primarily a replacement market.there are 13 machines per million people in this county. If you go to Western Europe, there's 7 or 8. You go to China, it's 0.1. So clearly, we expect that our growth is going to follow where the cancer is and that's going to be outside of North America where we're refocusing and putting a lot of our resources now in emerging markets.we're seeing significant growth in China.That market's growing in excess of 30% a year. Significant growth in India, Eastern Europe, Middle East. So the US will be a replacement market. It looks healthy at the mid-single digit range and we think that's sustainable. But we're going to get higher growth by virtue of following the cancer and where there's not enough equipment, which is primarily in these emerging markets. 4

6 Got it. Do you want to touch on TrueBeam? But just to round out the discussion on freestanding clinics with freestanding clinics becoming a smaller portion of the market, has that capacity been fully absorbed by hospitals? Yes, cause you're not seeing the number of cancer patients go down. So, it's just an issue of where they get treated. And I think as we look at the freestanding clinics' future, we probably should expect more of them to begin affiliating with hospitals. They may -- if they can't make it on their own, they'll affiliate with a nearby hospital as a freestanding clinic or rather as a hospital -- a satellite clinic or they'll sell out to a chain of freestanding clinic operators. And therefore they'll be able to finance new equipment purchases more easily. But we're not going to see a reduction in the number of cancer treatment centers and radiotherapy and radiosurgery centers in the US because of reimbursement. It will just cause a realignment of affiliation. So let's switch over to TrueBeam.That's your newest product line in the linear accelerator side.talk to us just about the traction that is taking place in the US market with TrueBeam? It continues to be the most successful accelerator launch that Varian's had in its history. We ended last quarter with 425 orders since the machine was introduced in the second quarter of So, for our radiation oncology market, that's very, very rapid adoption. And the take rate in the US that is the percentage of high energy machines that are TrueBeam's was approaching 70%. In the last quarter, we saw the machine get traction in international markets. It really became 40% of orders for higher energy machines in Europe. So TrueBeam has captured the imagination of the clinical community for a variety of reasons. One in terms of its ability to deliver dose but I think also its ability to smooth the process of delivering a treatment and potentially lower the cost per treatment for clinics that are looking to get the biggest bang out of the buck or clinics that are frankly overloaded with patients who need to treat more efficiently. Got it. I also want to talk to you about just framing the reimbursement discussion since we get a lot of questions as we start to move into the summer months and the question is always, is there any buzz of any major changes in reimbursements? We haven't heard any. We're in the third year of a four-year plan to reduce freestanding clinics by a cumulative 5%. So if they follow through with their -- what they normally do, the accumulative cut for freestanding clinics would be probably a percent in the quarter and that would equal 5% over a 4-year period. But the expectation for us is that reimbursement rates are going to overall go down because of the government's need to try to control spending a bit more.varian has actually been developing all of its products really around trying to improve the efficiency of treatment. So, our TrueBeam obviously delivered doses more quickly. RapidArc enables you to complete treatments way more quickly. Our software is all set up to streamline the clinical work flow. So what we're doing is countering the expected reduction with more efficient stuff.the last thing I'd say is that TrueBeam is really versatile.tomorrow's clinic can look at not doing just radiotherapy but they can supplement their practice with radiosurgery. And this is going to be very, very important for them. They'll be able to get additional revenue from taking care of more patients, specifically lung cancer patients where we think we can actually make a difference in liver [mets] and cases like that. 5

7 Let's talk about Siemens for a second. That's a consistent question also that we get and I'm sure you get as well. When does that opportunity materialize? Yes, well the opportunity has been materializing over the last several years. That Siemens has technically fallen behind over the last decade. Last year, we replaced 65 Siemens install base machines. Clearly, we are excited about the opportunity of that install base. We believe they have somewhere around 2,000 machines installed, about 500 of those in the US, maybe 600 or 700 in Europe, and the rest spread throughout Asia and rest of world.we intend to go after that install base. It's not something that's going to happen next quarter, but we believe that as a manufacturer has announced that they are exiting the business that it gives us an opportunity to go into that install base of customers and bring them up to a better technical standard of equipment. The near-term opportunity is clearly in backlog and we will not do any order tampering. Siemens can deliver those machines but the question is, are any of the customers going to just decide I'd rather take a different product than deliver on a product where that manufacturer has decided to exit. Siemens right today had a, before they announced, had a roughly 8% market share. So on a go-forward basis, the opportunity is about 8% of the market that is open to the rest of the players in this field. So our cut, do you get a sense that customers who may have committed to a Siemens order are starting to scratch their head? Are they more amenable to talking to you? I certainly would be because when you buy a linear accelerator, it's a platform that's in your clinic for 10 to 15 years. And you're hoping that you're going to see technology come along to supplement or augment its capabilities. If the manufacturer is going to disappear, then that opportunity is lost for you. So, a lot of our equipment when we go into the field actually is upgradable to new capabilities. And so, I would have misgivings if I was -- had just ordered a machine and me thinking that I'm sort of committed to this technology for that long. That said, Siemens has announced they will continue to service their install base. Sure, sure. So if you were just buying on price and price alone, you may take delivery and then just assume they'll service it in the next decade. And it's true. If you take a look at what Siemens often packages linear accelerators with other equipment that the hospital's getting. So the radiation oncology department then would not have as maybe as much of a say in what they were being equipped with by the hospital. 6

8 But Spencer your opinion something that your sales force is telling you that other customers are also echoing that they're starting to --? No, this is going -- I'll say this is my opinion. The sales force, we all sort of think this has got to be what's in people's minds just given how the technology works. So-- So just not yet. Correct. Okay. Got it. Just a few minutes left and I want to touch on the proton business and one additional question after that. But specifically the proton you just had a release on the Russian order. So proton is certainly starting to gain traction. It's not something that's going to contribute to the bottom line for a few years. Correct. But do you get a sense that talking to customers that you're starting to get closer and closer to an inflection point in adoption for proton? Yes, I mean it's been five years since we made a transformational acquisition of ACCEL not in terms of dollars but in terms of technology knowing that we had several years of technical development to really commercialize this product. It's been a tough five years from the dilution standpoint. It's been diluted to the tune of about $0.15. We've been very open about that. But we know that this product has the potential to add to $200 million to $300 million of annual revenue. We have been announced as the preferred supplier in I believe six deals. We have actually only booked into backlog three because we do not book a deal into backlog until any financing or any contingencies are cleared, the biggest of which is financing in today's environment. So, the three that we have booked San Diego, the Script Center; Saudi Arabia; and Russia. And those projects will now be ongoing.we are in the midst of installing in San Diego. It's going quite well.we've also been announced in Mestre, outside of Venice, as the supplier. We're trying to secure financing for that deal, the customer is. And then we've been announced at University of Maryland. We have received a significant down payment. So that project is real that they also are out finalizing on their financing at this point. 7

9 So I do think we're at an inflection point. That is the biggest kind of leverage torque I have in the next two years or so is if we can get this proton business from being dilutive to even neutral in the next year or two. And then longer term the goal is to have it at a 30% growth margin level and about a 15% EBIT margin level. Which isn't counting the service? Correct. Because what comes with -- as an example, what comes with the Script's $88 million order is an additional $60 million agreement for servicing over a 10-year period and service would carry higher margins with it. So as the business evolves or develops, we would expect to see it go into somewhat higher margins than 30%. Got it. And just to round out the discussion, on Friday on the litigation front, we saw that there was a ruling in Pennsylvania on willful infringement of some motion management patents and ultimately there's some royalties that you're now going to have to pay. Can you put some context around what exactly took place in that ruling and what's going to happen to the P&L? Well, first of all we're limited in what we can say because this is ongoing litigation. The validity of the patent still has to be determined and tested in the lower court. And if Varian loses that, Varian will appeal it. In the meantime, customers can continue using their products and that's all we can really say on the litigation. Generally, I will say that this is motion management technology. In the last five years, Varian has brought out a lot of alternative motion management technologies that are quite good. Today, we issued a press release that you may have all seen getting FDA clearance on our Calypso surface transponder.this would be a way to monitor and track motion without using RPM gating.we also have triggered imaging using x-ray. So we can actually monitor motion using x-rays and trigger from there. So, there -- much remains to be determined in terms of the court.that'll be ongoing litigation. In the meantime, customers continue going well and so the royalty discussion isn't really relevant at this point. Okay, great. Well let's stop there and continue the discussion in the breakout session. The breakout session is upstairs one floor up in the Park Avenue Suite Center location. Thanks, Elisha. Thanks, Spencer. 8

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