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Edited Transcript of VAR earnings conference call or presentation 24-Apr-19 8:30pm GMT

Q2 2019 Varian Medical Systems Inc Earnings Call

PALO ALTO May 22, 2019 (Thomson StreetEvents) -- Edited Transcript of Varian Medical Systems Inc earnings conference call or presentation Wednesday, April 24, 2019 at 8:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Dow R. Wilson

Varian Medical Systems, Inc. - President, CEO & Director

* Gary E. Bischoping

Varian Medical Systems, Inc. - Senior VP of Finance & CFO

* J. Michael Bruff

Varian Medical Systems, Inc. - SVP of IR, Corporate Planning and Segment Finance

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Conference Call Participants

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* Amit Hazan

Citigroup Inc, Research Division - Director

* Anthony Charles Petrone

Jefferies LLC, Research Division - Equity Analyst

* Jason M. Bednar

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Associate

* Matthew Charles Taylor

UBS Investment Bank, Research Division - Equity Research Analyst of Medical Supplies & Devices

* Tycho W. Peterson

JP Morgan Chase & Co, Research Division - Senior Analyst

* Vijay Muniyappa Kumar

Evercore ISI Institutional Equities, Research Division - MD

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to Varian's Fiscal Second Quarter 2019 Earnings Conference Call. As a reminder, this conference call is being recorded and a replay could be accessed on the Varian Investor website at www.varian.com/investors.

Now I'll turn the call over to J. Michael Bruff, Senior Vice President of Investor Relations. Please go ahead.

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J. Michael Bruff, Varian Medical Systems, Inc. - SVP of IR, Corporate Planning and Segment Finance [2]

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Thanks, Kevin. Good afternoon, everyone. Joining me today on the call are Varian's President and Chief Executive Officer, Dow Wilson; and Chief Financial Officer, Gary Bischoping. Dow will share his thoughts on our results and long-term strategy, and Gary will cover our operating and financial results in more detail.

On the Varian Investor Relations website, you can find our fiscal second quarter press release and earnings presentation, which are intended to provide additional perspective and details. A webcast of this call and any accompanying non-GAAP reconciliations are available on our website at www.varian.com/investors. Unless otherwise stated, all financial results discussed are non-GAAP. All references to EPS are to net earnings per diluted share. All growth rates are year-over-year, and any references to orders are gross orders. All periods referred to are fiscal periods unless otherwise stated, and all references to trailing 12 months refer to the trailing 12 months ending on the last day of our most recently completed fiscal quarter.

During this call, we will be making forward-looking statements, which are predictions, projections and other statements about future events. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in today's earnings release, this conference call and our SEC filings. We do not undertake any obligation to update any forward-looking statement.

And with all that said, I'll turn it over to Dow.

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Dow R. Wilson, Varian Medical Systems, Inc. - President, CEO & Director [3]

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Thanks, Mike, and good day, everyone. Today, I'll share the key milestones we achieved this past quarter and how they contributed to our long-term strategy. We're pleased to see continued momentum in the first half of 2019 and we're raising our revenue guidance for the fiscal year while continuing to invest in future growth opportunities. First, let me touch on our second quarter results. Total company revenues increased 7% to $779 million. Oncology revenues grew 7%, driven by our integrated platform with best-in-class hardware, software and services. Revenues for our Proton Solutions business were $33 million, up 2%. Operating earnings declined 6% to $119 million or 15.3% of revenues, driven by the impact of tariffs as well as the increased project costs and site delays in our Proton business in the quarter. GAAP earnings per share was $0.96 and non-GAAP earnings per share of $1.05, was down 9%.

Cash flows from operations were negative $13 million, down $79 million due to tax payments and net working capital impacts from revenue growth. Based on the company's strong orders and revenue performance year-to-date and our outlook for the rest of the year, we're raising our fiscal year revenue guidance from 5% to 8% to 6% to 9%.

Now to provide some additional color on the quarter. In terms of our long-term growth and value-creation strategy, we made progress across our 3 growth initiatives: first, strengthening our leadership in radiation therapy. Based on public filings, the radiation therapy market grew 10% on an orders basis over the trailing 12 months ending in December 2018, and we grew our worldwide share during that period.

In our Oncology business, orders grew 15% in the quarter and 13% in the trailing 12 months. This was our fourth quarter in a row of double-digit orders growth and was driven by strong growth in the quarter across all geographies, with strength in hardware, software and services.

Our worldwide net installed base is now 8,292 units, an increase of 338 units or 4%. This continued growth in our installed base drives recurring revenue from software and services. On the hardware side, we made progress with our global rollout of Halcyon and have now taken 238 orders since our May 2017 launch, including 36 orders in the second quarter, double the number of orders from last year.

Since launch, nearly 70% of orders worldwide have been incremental, including greenfield orders, competitive takeouts and orders for systems that require a smaller vault. And our Halcyon systems have now treated over 15,000 patients. Also on the hardware side, we're pleased to announce that for the second year since the radiation therapy category was created, TrueBeam was again selected as category leaded -- as category leader by KLAS, an independent research firm, in its 2019 best-in-class report.

This month, The Lancet published clinical studies of the SABR-COMET randomized Phase II trial for the treatment of oligometastatic cancers. We're happy to report that the study found that SBRT was associated with an improvement in overall survival, achieving median survival of 41 months as compared with 28 months for the control group that was treated using standard of care. Varian is a global leader in SBRT treatments and our platforms are well equipped to care for patients in the protocols outlined in the study.

On the software front, revenues grew 14%, double our hardware growth, driven by customer uptake of our new software features. Additionally, we were honored that for the sixth year in a row, Eclipse was named best-in-class for Oncology treatment planning, receiving the highest average score for overall performance.

Orders for HyperArc, our high-definition radiotherapy solution for SRS, nearly doubled, and orders for Eclipse MCO, our multi-criteria optimization planning software, more than doubled compared with last year. MCO is fast becoming a standard addition to all new treatment planning orders and a significant upgrade opportunity for our installed base. We have now received nearly 1,000 MCO orders at approximately 350 sites and have significant runway remaining with less than 10% penetration among our Eclipse customers.

Given our strong orders performance, we are incurring incremental cost to accelerate our software deployment capabilities to meet demand, which we expect to drive revenue growth in future periods. We expect an incremental $2 million in these costs this year.

Our services revenues grew 1%, including an estimated negative impact of 3 percentage points from FX. This growth was driven by our growing installed base and higher mix of newer machines, which typically have a higher attach rate and contract value.

In our Proton Solutions business, we completed clinical handovers for one room each at the Emory Proton Therapy Center in Georgia, the Christie Hospital in the U.K. and the Danish Centre for Particle Therapy in Aarhus, Denmark. We now have 30 operational rooms at 10 sites, representing an important future recurring revenue stream for our Proton business. In Denmark, we also announced the opening and first-patient treatments at the Danish Center for Particle Therapy, and we achieved an important construction milestone with installation of the gantry for the ProBeam Compact single-room Proton Therapy Center in Singapore. When completed, this project, the first compact proton system in Southeast Asia, will expand access to proton therapy in the region.

Our pipeline in the proton business remains strong, with customer interest driven by our smaller footprint ProBeam 360 and preclinical research we're doing with the FlashForward Consortium. We have been chosen as the preferred vendor at Shandong Cancer Hospital and Institute in China and we're working with the customer to close this deal, which is expected in Q3. And we're optimistic about our prospects for additional deals to close in the second half of this year.

In October, we announced the formation of the FlashForward Consortium to study potentially groundbreaking, ultra-high-dose rate cancer treatments with protons. Earlier this month, at the American Association for Cancer Research meeting, we presented publicly the first preclinical results of our research with the FlashForward Consortium, which showed reduced toxicity in healthy tissues and organs in mice. We're excited about the possible breakthrough in cancer treatment that this research could represent for patients around the world and are encouraged by these initial preclinical results. Based on this progress, we're investing an incremental $5 million this year on our preclinical research with the FlashForward Consortium, the majority of which will occur in the back half of the fiscal year. We incurred approximately $1 million of this spend in the second quarter.

Our second growth initiative is to expand our global footprint. Our global market share growth was driven by continued strong orders performance in our 3 geographies. For EMEA, this was the seventh consecutive quarter of double-digit growth driven by strong performance across the region. An important milestone in EMEA this quarter was the signing of a framework agreement with Tata Trusts to increase patient access to advanced radiation therapy treatments in India. It is estimated that by 2025, there will be 1.8 million new cancer cases diagnosed per year in India. This 3-year agreement, in which Varian has been selected as the preferred supplier, provides for the installation of potentially up to 200 radiation therapy systems across the country. We expect to begin taking orders from this framework agreement beginning in the second half.

In Africa, we announced earlier this month the opening of a new office in South Africa for local sales and service managers to support growth throughout the continent. And in Nigeria, we announced this quarter that we will replace the older systems at a cancer treatment center in Lagos, with 1 Halcyon and 2 VitalBeam radiotherapy systems and we'll deploy a training center to support development of human resource capacity to expand access across West Africa.

In our Asia-Pacific region, we delivered very strong double-digit orders growth in China, Japan and Southeast Asia. In China, our second-largest market, we continue to see strong momentum driven by the demand for SBRT. Our best-in-class product portfolio continues to resonate with the China market, resulting in a leading share position over the trailing 12 months. We also received our first Halcyon orders in China following great reception we had after launching the product at our China Users Meeting earlier this year.

In China, over 4,000 LINACs, more than double the current estimated installed base, are required to meet the current cancer burden in the country. Today, approximately 95% of patients are treated in either tier 3 hospitals or in tier 2 centers located in cities. These facilities cannot meet the demand for cancer care in China and present a barrier to access for patients in rural areas. The Chinese government is driving an initiative to localize cancer treatment, increasing the number of county centers and migrating 70% of patients to these hospitals. This shift presents tremendous opportunity for continued growth in this important market as demand for advanced cancer care in China continues to grow.

Additionally, the Chinese government's announcement of quota increase of radiation therapy licenses demonstrates China's commitment to increasing access to advanced cancer care. We're starting to see some activity in the provinces related to this announcement but haven't booked an order yet related to the quota increase.

Lastly, our third growth initiative is to expand into other addressable markets. This month, Varian went live across Tennessee Oncology network with an implementation of our new patient-reported outcomes and symptoms management platform. We also continue to look at inorganic opportunities to leverage Varian's core strengths to reach more patients and drive long-term growth.

Overall, we're pleased with the progress we made in the second quarter. We remain dedicated to providing customers with the full spectrum of intelligent and advanced tools to help improve patient outcomes and achieve our long-term growth strategy.

With that, I'll turn it over to Gary, who'll provide more context on the second quarter financial results.

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Gary E. Bischoping, Varian Medical Systems, Inc. - Senior VP of Finance & CFO [4]

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Thanks, Dow. As always, I'll consistently frame my comments in the context of our long-term growth and value-creation strategy, which includes balancing growth, profitability and liquidity. So let me start with growth.

Companywide revenues were $779 million in the second quarter, up 7% in dollars and 10% in constant currency. In Oncology, revenues were $747 million, up 7% in dollars and 10% in constant currency driven by growth across hardware, software and services.

Tariffs had a 130 basis point negative impact on the growth rate. On a trailing 12 months basis, revenues grew 11% in dollars and 12% in constant currency. Orders were $766 million, up 15% in dollars and 18% in constant currency. On a trailing 12-month basis, orders grew 13% in dollars and 14% in constant currency. We ended the quarter with $2.9 billion in backlog, up 13%.

Taking a closer look at our Oncology business results. In the Americas, revenues grew 11% with double-digit growth in both North America and Latin America. Orders were $366 million, up 7%. And in North America, orders grew 12% driven by strong execution across our integrated portfolio as well as key wins with Alliance Oncology in Huntsville, Alabama to replace 7 competitor systems and software with Varian solutions; an additional 5-system order from HCA, bringing their total Varian-ordered systems over the past 3 years to over 20 accelerators.

Asia-Pacific revenues grew 7%. Tariffs had a negative impact on the growth rate of 7 percentage points. Orders were $167 million, up 35%. As Dow discussed, we grew strong double digits in China, Japan and Southeast Asia.

In our Europe, Middle East, India and Africa geography, revenues grew 2%. Revenues grew 9% in constant currency as FX had a significant impact this quarter. Orders were $233 million, up 17%, with outstanding performance across the region. This is Europe's -- this is EMEA's seventh consecutive quarter of double-digit orders growth. Our Proton Solutions business posted revenues of $33 million in the quarter, which is up 2%.

Turning to profitability. The company gross margin was relatively flat year-over-year. The gross margin rate was 41.2% of revenue, down 260 basis points. This included negative impacts of 120 basis points from tariffs, 80 basis points from project costs and site delays in our Proton business within the quarter, 30 basis points from FX and 10 basis points from costs related to our software deployment ramp.

Our trailing 12 months gross margin rate was 42.7%, down 60 basis points. This included negative impacts of 70 basis points from tariffs and 20 basis points from project costs and site delays in our Proton business within the quarter.

Oncology gross margin rate was 43.6%, down 210 basis points. This included negative impacts of 130 basis points from tariffs, 40 basis points from FX, 10 basis points from costs related to our software deployment ramp and the remainder from product mix.

Looking at Proton Solutions. Gross margin dollars were negative $4 million, down $5 million driven by $7 million in increased project cost and site delays in the quarter. These items as well as delays in the timing of orders will result in not achieving our aspiration of reaching operating breakeven for the year.

Investments will continue to be a key driver of our long-term growth and value-creation strategy. We invested $59 million in R&D, which is up 1% at 7.6% of revenues.

Likewise, we are continuing to invest in sales and marketing, which grew 10% driven by investments in headcount-supporting sales for recent acquisitions and product management for our treatment planning. We are seeing leverage in the P&L when it comes to general and administrative spend with modest growth of 4% compared with robust orders and revenue growth rates. SG&A expenses were $143 million or 18.3% of revenue, a rate which is flat compared with last year. Company operating earnings were $119 million, down 6% at 15.3% of revenues, down 220 basis points. This included negative impacts of 150 basis points from tariffs, 80 basis points from project costs and site delays in our Proton business within the quarter and 40 basis points from FX. On a trailing 12 months basis, operating earnings increased 6% at a rate of 16.4%, down 60 basis points. This included negative impacts of 80 basis points from tariffs and 20 basis points from project costs and site delays in our Proton business within the quarter.

Turning to tax. Our GAAP effective tax rate for the second quarter was 21.7%, and our non-GAAP effective tax rate was 21.5%. GAAP EPS was $0.96. Our non-GAAP EPS was $1.05, with diluted share count of 91.9 million shares in the quarter.

Turning to the balance sheet and liquidity. We ended the quarter with cash and cash equivalents of $546 million and no debt. Cash flow from operations were negative $13 million, down $79 million due to tax payments and net working capital impacts from revenue growth. Oncology DSO increased from 103 days to 110 days in the quarter driven by strong revenue growth. In addition to R&D, other investments in the quarter included $11 million in CapEx and $51 million to repurchase shares of our stock. As of the end of the quarter, we had 2.9 million shares remaining under our existing share repurchase authorization. I will now turn it back over to Dow.

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Dow R. Wilson, Varian Medical Systems, Inc. - President, CEO & Director [5]

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Thanks, Gary. With respect to our annual guidance, we carefully considered the projected market growth, our recent orders momentum and our mitigation efforts with respect to tariffs, which remain on track. As such, we are raising revenue guidance to $3.09 billion to $3.18 billion, representing growth of 6% to 9%.

Previously, we guided $3.06 billion to $3.15 billion, representing growth of 5% to 8%. And we are reaffirming the following guidance for fiscal year 2019: non-GAAP operating earnings as a percentage of revenues of 17% to 18%; non-GAAP earnings per share of $4.60 to $4.75; cash flows from operations of $460 million to $510 million.

This updated guidance considers the following impacts to operating earnings: an increase of $5 million from the raise in revenue guidance; and a benefit of $5 million from an estimated reduction in gross tariff impact.

Based on strong recent momentum and incremental investment of $5 million in our preclinical research with the FlashForward Consortium, continued investment in software deployment capabilities, which will result in approximately $2 million in incremental costs and the second quarter $7 million increased project costs and site delays in our Proton business. The guidance continues to assume a non-GAAP effective tax rate of 21% to 22%, a weighted average diluted share count of 92 million, currency rates as of the beginning of our third fiscal quarter of 2019 and excludes any future acquisitions. Thank you. And now let's go to Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question today is coming from Amit Hazan from Citi.

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Amit Hazan, Citigroup Inc, Research Division - Director [2]

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Let's just start with the positive and just talk about the order growth you're seeing in the market. And maybe just run through the regions in particular, all of us are probably most interested in the sustainability of that growth. Europe or EMEA stands out as just having been strong for longer than a lot of us expected but also obviously, China with the tender still upcoming there. Just give us a sense of sustainability of what you're seeing in those regions.

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Dow R. Wilson, Varian Medical Systems, Inc. - President, CEO & Director [3]

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Good question. We're continuing to see very strong orders growth across all 3 geographies. As we said, we've got trailing 12 months growth of strong double digit. I'd say it's really driven by execution across the entire portfolio, hardware, software and services. Trailing 12 months orders growth in the Americas, constant currency of 8%, EMEA up 19% and APAC up 21%. So some of that is maybe a little bit above the trend line, I think, for sure. But I'd say from a funnel point of view, Asia looks very strong. In EMEA, we mentioned the Tata momentum, that's an agreement at this point in time. There will be more orders that will be booked against that. We haven't booked many orders against that at this point. We also see big opportunities in Eastern Europe. So I don't know that Europe's going to continue to be double digit, but I think we continue to see strength there.

And then as I mentioned in the remarks, we were double digit in North America. So we're seeing a very strong U.S. market. I know there's always conversation about what reimbursement scenario is coming, but I'd say our U.S. model is really delivering right now. We've got tougher comps in the second half. So we've -- we're looking at that but I'd say the overall market is very, very strong. Gary, did I miss anything there?

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Gary E. Bischoping, Varian Medical Systems, Inc. - Senior VP of Finance & CFO [4]

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No, I think that's right, Dow. I would say that, again, just to reaffirm from a China perspective, these results do not reflect any orders from the quota increase, and so continue to see progress at the provincial level there and we're tightly aligned with kind of the undergoing -- underlying activity that's happening at the provincial level here.

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Dow R. Wilson, Varian Medical Systems, Inc. - President, CEO & Director [5]

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Yes. Maybe the other thing I'd mention is Halcyon just continues to be a big deal here. We had more orders in the quarter in developing markets than we had in developed markets. It continues to be very strong, very pleased with the Halcyon performance.

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Amit Hazan, Citigroup Inc, Research Division - Director [6]

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Okay. And then secondly, to move to the P&L and kind of some of the challenges. I think one thing we'd like to better understand is the gross margin profile from here. Obviously, I'm curious when Halcyon starts to more materially impact that, but also just to understand better, are you thinking about it for this year and next year? That was not a -- it didn't look like a great number to us and I don't know if services is a part of that, that looks like it wasn't growing nearly as fast as it had been in the past, but software looked like it was growing quite fast and that's usually a good guy contributor. So just a little more color on the elements of gross margin and how you're thinking about that for the next 12, 18 months?

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Gary E. Bischoping, Varian Medical Systems, Inc. - Senior VP of Finance & CFO [7]

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Yes. Great, Amit. And thanks for the question. And the gross margin rate, as it relates to the second quarter, there is that Proton kind of site delay as well the project costs. That cost is about -- think about that as kind of 80 basis points in the quarter. And then we'll continue to invest in other elements of the business. But overall, that was a big part of what we saw in the second quarter was that Proton piece and then gross margin rate.

From a services perspective, trailing 12 months growth rate is just fine there. We had a tough compare. Last year, we had a 14% year-on-year growth rate in Q2 in the services side from a revenue perspective. The business is healthy, attach rates are fine, underlying elements of that are moving along just fine. So we're okay there on the services line.

And we had strong growth in orders over the last 12 months. And so we just have to wait, also, for those to anniversary from a warranty perspective and to start to see the growth rate off of those -- that order trajectory you saw over the last 12 months.

As far as going forward goes, I mean from a gross margin rate perspective, as you know we don't guide to that, however, some of what we talked about all throughout the year will start to roll through. One would certainly be our commercial efforts on the tariff mitigation side. That will start to pick up steam in the second half. As you think about that in the second half, it's still more loaded to the second part, so the fourth quarter of the second half. We'll continue -- as you saw, we invested in software deployment teams. So we'll continue to see, we think, nice, strong growth out of the software business, which will be accretive to the gross margin rate in the second half vis-a-vis the first half. And again just to tie it up, that Proton issue that we saw or the challenges we saw with the site delays as well as the overall increase in cost, that we think we have contained to the second quarter. And so that will be accretive in the second half as well. So good underlying dynamics that help us get comfortable with holding on to that range from an earnings per share perspective all while still investing back in the business.

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Dow R. Wilson, Varian Medical Systems, Inc. - President, CEO & Director [8]

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Maybe just to underscore the software point. Our software growth rate is about twice our hardware growth rate and our hardware growth rate is very good. So that's kind of what that investment is laying in for us in the second half. And we should see some -- both some volume and some positive margin mix out of that.

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Operator [9]

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And our next question today is coming from Matt Taylor from UBS.

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Matthew Charles Taylor, UBS Investment Bank, Research Division - Equity Research Analyst of Medical Supplies & Devices [10]

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Just wanted to follow-up on the China quota and the opportunity in India. And specifically what I wanted to understand was you said you were seeing some I guess action in the provinces. When do you think you might start to see some of these orders come through? And at what pace? Can you -- do you have any updated insights there? I'll start with that one.

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Dow R. Wilson, Varian Medical Systems, Inc. - President, CEO & Director [11]

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Yes. yes, Matt, good question. I'd say the activity that we're starting to see, we're seeing some questions, we're seeing the provinces engage. We haven't seen any published tender yet and that -- for me, that would be kind of the #1 signal, when do people start issuing tenders. We do see some initial licenses in the province distributed to hospitals, so now the hospitals kind of got to pull their activity together, issue the tender and get going. I expect that we'll see a little bit of activity in the second half but that most of the real action here is going to be fiscal year '20.

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Matthew Charles Taylor, UBS Investment Bank, Research Division - Equity Research Analyst of Medical Supplies & Devices [12]

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Okay. Great. And I guess same kind of question on the India agreement. Congrats on that. What kind of pacing, if you have any thoughts on the potential 200 orders? Should we expect that they start here in the second half? Do you have any visibility on that?

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Dow R. Wilson, Varian Medical Systems, Inc. - President, CEO & Director [13]

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It's a good question. We have not booked any orders yet from this agreement. We expect the initial orders will be received in the second half of the year. The contract language says up to 200 systems. It's a big market that's way underserved. I talked about -- in India it's 10% to 15% of patients that have access to radiation therapy, whereas in the west, it'd be 50% to 60% get radiation therapy as part of their treatment. The Tata Trust has signed agreements with multiple states throughout India. So we do expect to see orders flowing here in the second half. We're not ready to guide on the amount yet, we want to see some -- kind of want to see the color of the currency as it comes flowing through. But we're very excited about it, that Tata Foundation has been outstanding in this. They're very motivated by bringing cancer care to a population that hasn't had access to cancer treatment in India in, kind of, as I mentioned in the call, in smaller cities and villages. So I expect this will be a multiyear order flow and not a big onetime bolus. And again, just to underscore, that's not in the Q2 performance.

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Operator [14]

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Our next question is coming from Jason Bednar from Robert W. Baird.

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Jason M. Bednar, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Associate [15]

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I wanted to start with -- I just wanted to start with Halcyon. The orders here are a bit better sequentially, up nicely year-over-year. But do you think we're on the cusp of really seeing Halcyon turn a corner? I mean it just seems like a lot of things could be coming together, with China availability starting January, 2.0 having been available for 6 or 12 months here in the U.S. and Europe and 3.0 slated to launch later this year. So just curious if you agree with that assessment or if there's anything else we should be considering with Halcyon?

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Dow R. Wilson, Varian Medical Systems, Inc. - President, CEO & Director [16]

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I would say we love the orders momentum, the socket growth is starting out nicely. Our marketing efforts are working well. The customer endorsements have been outstanding. We have really strong engagement, excellent experience with our customers. I think I said in the call 70% of the Halcyon units, we believe, are incremental. So we're -- so it is hitting. We did launch the product in the beginning of the quarter in China. And we just have a handful of orders in the quarter from China. So we expect -- as you state, we expect that to start hitting, so there should be some good growth coming in China. We have had very good customer reaction in China. Our strategy here is we just want to expand the number of sockets out there. And it really complements our TrueBeam product in the portfolio. We're seeing incremental customers come in with small vaults, resource constrained on the operating side, winning some competitive take-outs and I think we're -- and some cobalt replacements on top of that I think we're very well positioned for continued growth with Halcyon.

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Jason M. Bednar, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Associate [17]

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Okay. And then turning over to revenue and kind of this order-to-revenue conversion maybe. I mean just wondering, you put up some unprecedented growth here just over the past 12 months. I mean when do you expect we'll see -- start to see some of that strong order growth begin translating to an accelerating revenue growth profile? And is it reasonable to think that this will track as typical with Varian and talk about maybe a 12-month lag and we'll start seeing some of that order growth convert to revenue beginning fiscal '20? Or should we have a different lag in mind for some reason?

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Gary E. Bischoping, Varian Medical Systems, Inc. - Senior VP of Finance & CFO [18]

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Yes. No, great question. And what we're seeing here is from an overall trailing 12-month growth rate in Oncology of 13%. And when you take a look at backlog, your backlog grew about the same on a year-over-year basis. So we continue to move product through that, through backlog, and out into revenue at a nice clip. The conversion rate will reflect some of the nuances in the underlying mix of the product in the business. But overall, Jason, when you think about this in the long term, we still see our revenue -- our orders turn into revenue growth and convert. So the trajectory of the orders growth rate continues to accelerate. So you're going to see the revenue growth rate kind of lag a little bit here, and that's what's happening in the business. But overall, we're pleased with how the teams are operating and pushing product out the door and meeting, exceeding customers' needs and demands.

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Operator [19]

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Our next question is coming from Anthony Petrone from Jefferies.

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Anthony Charles Petrone, Jefferies LLC, Research Division - Equity Analyst [20]

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Maybe a couple on China and then one just on the U.S. momentum in Oncology. As far as China, as we look toward really, I guess, quoting now 2020, when you start to see order momentum, clearly there's a larger amount of Type B licenses out there. How do you think the Type B licenses will flow? And what level of sort of chunkiness do you expect once this starts next year? And I'll have a couple of follow-ups.

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Dow R. Wilson, Varian Medical Systems, Inc. - President, CEO & Director [21]

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I think it's going to be small, growing linearly. I mean the one thing about this market is it's one or two at a time. We tend not to see the big like the Tata thing or the Brazil thing we had a few years ago or even Algeria or some of the other countries that we've talked about last 2 or 3 years where we get, call it, 10 to 50 units as part of an order. China is much more linear in the way it's tendered kind of hospital at a time. So I think that's the way it's going to happen. I don't think -- that's the way that market is as well. There are big resource needs. By the way, I think it's one of the things that we're very uniquely positioned to do well. A lot of these are going to be going into smaller cities, more rural orientation, county hospitals. They don't need just the license, they need the people, the training, the education. We have localized the software now. We have significant education resources both on the ground and in flight, so we train everybody locally. We think we're in a very, very good position.

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Gary E. Bischoping, Varian Medical Systems, Inc. - Senior VP of Finance & CFO [22]

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The only thing I would add there, Anthony, is that we've got Halcyon and TrueBeam both in that category now and didn't have that over the last 12 to 24 months as we competed in that marketplace. So we've got, as Dow just -- Dow mentioned, just to put a finer point on it, well positioned to go out there and execute in these rural markets with Halcyon and TrueBeam.

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Anthony Charles Petrone, Jefferies LLC, Research Division - Equity Analyst [23]

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Yes. The follow-up would be just on the tariff side on exemption. Is there any update there on the China side specifically? I know the company filed for some exemptions, maybe just a quick comment on that.

And then the last question would just be on the U.S. reimbursement side. We're in the proposal season here for CMS, are there any thoughts on how this year shakes out?

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Dow R. Wilson, Varian Medical Systems, Inc. - President, CEO & Director [24]

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Yes. I'd say on the tariff side first, I mean we continue to be very engaged both in Washington and in Beijing on the issue. I'd say no major things to report. Maybe the biggest thing to report is that our mitigation activities continue to be very -- to be executed very well by the team. We're executing sustainable actions there. Mitigation efforts are on track. I know that kind of gives us a weird profile for the year. But it's why we kind of feel good about second half is our mitigation activities, as we've kind of said all year, are really implementing in the second half of the year. And Gary, anything else on tariffs?

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Gary E. Bischoping, Varian Medical Systems, Inc. - Senior VP of Finance & CFO [25]

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No. I think directly to your question, the remaining applications we have in the U.S., there's been no update with regard to the parts we're importing there in the couple of applications we have in there, Anthony. And just to reiterate, the ramp in the tariff mitigation is just that, it'll ramp not only into the third quarter but also ramp into the fourth quarter. So as Dow referenced, the profile for the year kind of isn't normally what we would expect.

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Dow R. Wilson, Varian Medical Systems, Inc. - President, CEO & Director [26]

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On the reimbursement side, I'd say it's as opaque as ever, we're waiting for early July proposal from CMS. Clearly, we're hearing the rumor about bundled payments for SBRT. We think that positions our product line very, very well. We are the global leader in stereotactic body radiation therapy with our advanced dose rate, our conformality, our imaging. So I think we're positioned well if that change goes into effect, and we'll kind of keep you updated as we hear more about that.

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Operator [27]

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Our next question is coming from Tycho Peterson from JPMorgan.

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Tycho W. Peterson, JP Morgan Chase & Co, Research Division - Senior Analyst [28]

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Maybe on that last point, Dow, one of the things that you guys have talked about was bundling is you could maybe kind of catalyze some of those customers that don't have SBRT capabilities to upgrade. Can you maybe just talk to how much of your installed base in the U.S. at this point has older systems that potentially would need to upgrade if the bundle goes through and talked about.

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Dow R. Wilson, Varian Medical Systems, Inc. - President, CEO & Director [29]

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I'd say at least 1,000 units. That's kind of my gut reaction. I might need to get our pencil on that a little finer. But I mean our U.S. installed base is 3,500 machines, and we've got a lot of TrueBeam out there. But there's SBRT capabilities on TrueBeam as well as -- I mean it's at least 1,000 units that we have significant opportunity on. But I think it's some of the momentum we're seeing in the U.S. now. I mean you saw the numbers on the quarter, double-digit performance in North America, and I think we're seeing a lot of nice configuration mix out of the U.S. market.

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Tycho W. Peterson, JP Morgan Chase & Co, Research Division - Senior Analyst [30]

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And then can you maybe touch on pricing dynamics? Your biggest competitor called out pricing pressure last quarter after you guys had reported. They've also launched a new value model. As we think about China quota, India orders, EMEA funnel, just curious how you're seeing kind of pricing overall in the market.

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Gary E. Bischoping, Varian Medical Systems, Inc. - Senior VP of Finance & CFO [31]

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I think Elekta is known to compete on price. But Tycho, if you look at the country level for us, pricing dynamics are in check and in order with what we've seen historically so no major changes, kind of puts and takes here and there. But overall, we'll -- we continue to sell value because our customers are really looking for that full solution of hardware, software and services. That differentiated value proposition is enabling us to hold price at the country level, and we feel pretty good about that.

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Tycho W. Peterson, JP Morgan Chase & Co, Research Division - Senior Analyst [32]

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And then, Gary, maybe just one follow-up on cash flow. I know you maintained guidance for the year. Can you maybe just talk to how you get there because it was down again this quarter? So are you assuming NWC kind of reverses? Or what kind of gets you to that full year cash flow based on what we've seen in the last 2 quarters?

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Gary E. Bischoping, Varian Medical Systems, Inc. - Senior VP of Finance & CFO [33]

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Yes. The second quarter is kind of what -- about what we thought in the trajectory of the cash flow for the year. We'll continue to see progress here in the second half with regard to inventory. And as we've talked about, we've talked about billings and inventory for the supply chain. You can see the strong revenue growth here, and so that will work its way through. And on the revenue side, the -- how the revenue flows in the quarter kind of has an impact in the quarter, but you catch that over time. So you'll see us kind of catch this increase in revenue growth with some nice collections in the second half of the year. So I think the teams are out there executing nicely through the supply chain. But yes, to directly answer your question, we see it coming back in net working capital as well as an increase in operating earnings half-over-half as well.

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Operator [34]

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Our next question is coming from Vijay Kumar from Evercore ISI.

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Vijay Muniyappa Kumar, Evercore ISI Institutional Equities, Research Division - MD [35]

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Maybe going back to the margin question, Dow. You gave out a number of moving parts in the Q. I mean it looks like there's incremental cost here, right? You have some benefits from tariffs, but there is more investments in the software piece, in the FlashForward, et cetera. When we think about the $48 million of savings, right, the tariff mitigation efforts, maybe can you talk about the cadence of when those savings are expected to hit? And is that more of Q4 weighted or Q3? And 80 bps impact on this Proton, is that going to come back in the back half?

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Dow R. Wilson, Varian Medical Systems, Inc. - President, CEO & Director [36]

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Maybe let me kind of just start on that Q2 piece. Relative to the margin rate in the Q2, as Gary said in his section, the single biggest piece was proton therapy. And so that was our biggest driver in the first half. Gary, do you want to pick up on the tariff point?

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Gary E. Bischoping, Varian Medical Systems, Inc. - Senior VP of Finance & CFO [37]

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Yes. Vijay, the timing of the tariffs, first of all, it's $42 million in mitigation, right? It was talked about at $60 million down to $42 million. And the timing of the tariff mitigation efforts, as I referenced -- we've been referencing all year, is second half loaded. And even inside of the second half, they'll continue to ramp out of Q3 and into Q4 in terms of higher -- more benefit in the fourth quarter than in the third quarter. So that's how we think about it. Teams are executing well out there in the field. As it relates to the proton, no cost and site delays in the second quarter. We think that's largely contained to the second quarter. I don't see it repeating in the second half, but we won't get that back in the second half, right? So that's part of how we think about the full year guidance is, we don't see us clawing that back in the second half, but it won't repeat in the second half.

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Vijay Muniyappa Kumar, Evercore ISI Institutional Equities, Research Division - MD [38]

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That's helpful, Gary. And just on the guidance as a follow-up. Any -- it looks like FX was worse. Any update on FX? I think the last guidance baked in some modest FX. Maybe it's coming in a little worse. So I guess the underlying growth, a, coming in better? And I think the visibility on that $42 million of savings, the tariff mitigation, maybe can you just talk about the drivers here and your comfort level with that number?

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Gary E. Bischoping, Varian Medical Systems, Inc. - Senior VP of Finance & CFO [39]

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Yes. From a currency impact, no material change from what we guided to originally. If you look at rates kind of from when we guided to the start of the third quarter, there's no material change. There's a year-over-year impact that we called out but nothing really material to note versus guidance.

As it relates to the tariff mitigation efforts, things are on track, and they're moving forward. I would say they're the things we talked about: commercialization, supply chain, our ability to get duties back out as some of those things are coming into the U.S., our ability to reroute how we think about invoicing on the commercial side. G&A productivity, you started to see that in the second quarter, right? G&A was only up 4% year-on-year, so you're starting to see scale out of the G&A line. We think that will continue in the second half. We'll continue to redeploy and rephase some of our R&D investments, nothing against the major programs that are out there.

From a software perspective, we talked about an incremental investment in the software deployment capability, and that's to help to continue to drive that growth rate. You saw in the first half of the year, both in Q1 and Q2, our software revenue growth grew 14% in both quarters. And so we are looking for that investment to continue to help us grow that software business in the second half, which we like from a margin perspective. So all those mitigation efforts are in flight, and the teams are tracking to how we're operating and to deliver this guidance.

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Operator [40]

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Our next question is a follow-up from Anthony Petrone from Jefferies.

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Anthony Charles Petrone, Jefferies LLC, Research Division - Equity Analyst [41]

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Maybe just a follow-up on margin, again, unchanged here this year and obviously there's some headwinds on the Proton side. But just as you look out multiyear, next couple of years, and we start to get perhaps faster acceleration in bookings to revenue, margin benefits potentially from Halcyon and then a mix of software, over time, what are your thoughts on operating margin expansion next couple of years?

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Gary E. Bischoping, Varian Medical Systems, Inc. - Senior VP of Finance & CFO [42]

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Yes. Sure, Anthony. You hit on a lot of them already. We're continuing to march towards our aspiration of north of 20% operating margin. Clearly, the tariffs haven't helped us here. We outlined what that impact is here in fiscal year '19. That being said, the tailwinds that are running for us are software mix. You can see the accelerated growth rates there, twice what we experienced on the hardware side. Proton profitability, while still not back to operating breakeven like we had talked about, but improving on a year-over-year basis. Halcyon mix will certainly help. We're starting to see that now. We saw that in the second quarter, it's becoming visible in the P&L. Continue to work through the upgrade cycles, we've put upgrade teams in place around the globe. They're continuing to execute well. And then we'll continue to work through the tale of the tariff mitigation. So as you think about kind of the next couple of years, that will help us continue to accrete up to that 20 points of operating earnings. Last point I would make is services certainly increasing on the installed base will be a nice tailwind as well.

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Operator [43]

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We've reached the end of our question-and-answer session. I'd like to turn the floor back over to management for any further or closing comments.

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Dow R. Wilson, Varian Medical Systems, Inc. - President, CEO & Director [44]

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Thank you. Per my previous comments, given the momentum in the business, we raised our revenue guidance. And in concert with that revenue raise, we've decided to reinvest in innovation primarily related to the FlashForward Consortium, and we remain on track to achieve our 2019 targets. Looking forward, we'll continue to execute on our growth initiatives and remain committed to investing in innovation and new technologies to drive toward the ultimate victory: a world without the fear of cancer. Thanks for joining us today.

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Operator [45]

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Thank you. That does conclude today's teleconference. You may disconnect your line at this time and have a wonderful day. We thank you for your participation today.