Varian Medical Systems Inc
Q3 2017 Earnings Call Transcript

Published: 27 Jul 2017

[Operator:]

Greetings. And welcome to the Varian Medical Systems' Third Quarter Fiscal Year 2017 Earnings Results Conference Call. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Neil Madle. Thank you, sir. You may begin.

[Neil Madle:]

Thank you, operator. Good afternoon, and welcome to Varian Medical Systems' conference call for the third quarter of fiscal year 2017. With me are Dow Wilson, President and CEO; Gary Bischoping, CFO; and Magnus Momsen, our Controller. Dow will review highlights in the quarter in the context of our long-term strategy. Gary will review our financial results. And then we will open the call to Q&A. After Q&A, we'll come back to Dow for a few closing comments. To simplify our discussion, unless otherwise stated, all references to the quarter or year are fiscal quarters and fiscal years. Comparisons are year-over-year. And references to financial results for orders are gross orders. We report non-GAAP earnings to provide comparisons of operational performance, excluding unusual items. Unless otherwise stated, all financial results discussed are non-GAAP and from continuing operations. You can find a reconciliation to the most comparable GAAP measure in our earnings release on our website. Please be advised that this presentation and discussion contains forward-looking statements. Our use of words and phrases such as outlook, believe, expect, anticipate, could, should, will, promising and similar expressions are intended to identify those statements which represent our current judgment on future performance or other future matters. While we believe them to be reasonable based on information currently available to us, these statements are subject to risks and uncertainties that could cause actual results to differ materially. Some of the important risks relating to our business are described in our third quarter earnings release and in our filings with the SEC. We assume no obligation to update or revise the forward-looking statements in this presentation discussion because of new information, future events or otherwise. Before I turn it over to Dow, just a reminder that the replay of this call can be heard on the Varian Investor website at www.varian.com/investor where it will be archived for a year. To hear a telephone replay, please dial 1-877-660-6853 from inside the U.S. or 1-201-612-7415 from outside the U.S., and enter confirmation code 13664498. The telephone replay will be available through 5 p.m. Pacific Time this Friday, July 28. And now, here's Dow.

[Dow R. Wilson:]

Thanks, Neil, and good day, everyone. I want to start by thanking Neil for jumping in for the recently retired Spencer Sias. We'll be replacing Spencer shortly, but thanks, Neil, for leading us through this process this quarter. Before I start, I want to introduce Gary Bischoping, our new Chief Financial Officer. Some of you have already had a chance to meet Gary. He joined us in early May. So he doesn't have a full quarter under his belt yet. But he's already making an impact, and we're delighted to have him on board. Welcome to the first of what I'm sure will be many quarterly earnings calls, Gary. Turning to the quarter, we delivered solid progress towards our long-term aspirational goal to touch 6 million cancer patients each year, more than double where we are today. This is predicated on our focused commitment to develop and deploy industry-leading capabilities in developed and emerging markets, while delivering balanced financial results. In the quarter, we delivered earnings per share of $1.04. Orders for Oncology were up 5% to $708 million in both dollars and in constant currency. Year-to-date, orders were up 6% in dollars and 7% in constant currency. Company-wide revenues were up 3% to $662 million. We received orders across 10 countries for our new Halcyon treatment system, which was introduced during the quarter. And we booked three orders in proton therapy; two orders for single-room systems, one in the U.S. and one in Thailand; and a multi-room project at the Georgia Proton Therapy Center, Atlanta. Turning to our Oncology operations, we had solid contributions from all three of our geographies. In the Americas, orders were up 3% in both dollars and constant currency. Highlights include 3% growth in North America, mainly driven by service and software, where we executed multiple competitive software takeouts, and we gained share. Also in North America, we struck a strategic deal with PetCure to deliver six Halcyon units for a veterinary oncology network. I'll go into more details about Halcyon a little bit later. In Latin America, orders declined due to challenging macro and political environments. Looking at EMEA, gross orders rose 2% in dollars and 5% in constant currency. Growth was particularly strong in India where orders more than doubled. We also had robust order growth in Eastern Europe. During the quarter, we booked a $14 million order with a private European medical center in Russia. In APAC, orders rose by 13% in dollars and in constant currency, with broad-based contributions across the region. In China, we achieved market-leading order growth of more than 30% as our team there continued to do an excellent job establishing Varian as a premier supplier in both the public and private sectors. In the broader APAC region, we also booked multimillion-dollar orders in Vietnam, South Korea, Thailand and the Philippines. In addition, in Australia, we received orders for five TrueBeam systems from GenesisCare, and for two Halcyon systems from the Icon Group. Now let me touch on our new product, Halcyon. As we shared with you during our midyear review in New York, Halcyon received a tremendous reception when we unveiled it at the ASTRO show in Vienna in May. We've designed Halcyon to expand the availability of high-quality cancer care to globally, helping to save the lives of millions more cancer patients. Halcyon is the result of a focused four-year development project to revolutionize clinical workflow by simplifying and enhancing virtually every aspect of image-guided volumetric intensity-modulated radiotherapy. This advanced industry-leading treatment system offers high-quality care, greater ease of use, enhanced patient comfort and lower total cost of ownership. Its smaller footprint means we now have a solution for older cobalt and tomotherapy bunkers, which are too small to accommodate our other linear accelerator products. We believe there are around 2,000 such bunkers as potential opportunities. We launched Halcyon with CE approval, which enabled us to immediately sell in Europe and other key markets. Early interest is high and, during the quarter, we booked several orders from countries where we have approval, including Australia, Belgium, India, Morocco, Romania, Russia, Turkey and the United Kingdom. Just before the close of the third quarter, we received 510(k) approval to market and sell Halcyon in the United States, resulting in several orders in the quarter. Regulatory approvals for China and Japan should follow within the next year. Halcyon is one of the largest new product introductions in our history. Early interest has been strong, and we'll start providing more color on the pacing and impact of the roll-out when we report our fourth quarter results. Also on the new product front, later this year we expect first patient treatments with our HyperArc module for high-definition brain radiosurgery. This upgrade provides ultra-precise doses that cannot be matched by any other system on the market and has the potential to make a meaningful difference in the fight against cancer. Turning to software, we ended the quarter with more than 930 RapidPlan licenses at about 440 customer locations. This knowledge-based treatment planning system is making a major contribution to improving the quality and efficiency of radiotherapy treatment planning globally, while also being accretive to our profitability. Other recent software introductions, such as our InSightive analytics and 360 Oncology systems, continued to gather momentum during the quarter as customers sought to improve workflow in their clinics. As we announced last week, radiation oncology professionals using Varian's Eclipse treatment planning software created the top-scoring head and neck cancer treatment plans at the 2017 International Radiotherapy Plan Competition. The treatment plan competition is part of the Radiation Knowledge initiative, a cloud-based platform for sharing best practices in the medical radiation field. The two highest scoring plans and seven of the top 10 plans at the competition were created using Eclipse and employed Volumetric Arc Therapy to target head and neck cancers. The competition attracted more than 460 dosimetrists from around the world, with the goal of sharing the best planning skills to improve radiotherapy plan quality. Before leaving Oncology Systems, let me call out our service business, which had a 7% increase in global orders in the quarter, supported by an 8% increase in North America. Service continues to be a significant growth driver for our company. Now let me turn to our Particle Therapy business, which delivered $122 million in orders in the quarter, up $71 million, and revenues of $68 million, up $31 million. Among these orders was the Georgia Proton Therapy Center. We delivered the cyclotron to site earlier this month. And the center plans to start treating patients in 2018. We also booked orders during the quarter for two ProBeam Compact systems at the University of Pennsylvania and at Thailand's first proton therapy center in Bangkok. Our proton business continues to gather momentum. There are now five proton therapy centers delivering clinical treatments using our equipment. And we're working on a further 14 projects. A number of these projects are due to begin clinical treatments in the next six months. In addition to the cyclotron installation at Georgia Proton Therapy Center, there were significant milestones at two other projects in June when cyclotrons were delivered to the National Centre for Particle Therapy in Aarhus, Denmark and the Christie Proton Therapy Center in Manchester, England. Now let me turn to guidance for this fiscal year. And as a reminder, this is non-GAAP and from continuing operations point of view. For the fourth quarter, we believe revenues will be flat to down slightly and for earnings per diluted share to be in the range of $1.15 to $1.23. For the second through the fourth quarter, we now expect total company revenues to grow in the range of 2% to 3% and for earnings per share to be in the range of $3.08 to $3.16. Before I turn it over to Gary, I think it's important for me to highlight that this was our first full quarter as a standalone cancer management company, following the successful spinoff of our Imaging Components business in January. Varian is now focused exclusively on expanding our position as the leader in systems and software for the treatment of cancer and other indications. We are increasing our efforts to make the treatment of cancer more effective, affordable and accessible for patients around the world. Now, I'll hand it over to Gary.

[Gary E. Bischoping:]

Thanks, Dow, and hello, everyone. As Dow mentioned, this is my first earnings call for Varian and I'm delighted to be here. I've framed my comments today in the context of our long-term focus to drive balanced financial results including growth, profitability and liquidity. So let me start with growth. We ended the quarter with $3.25 billion in backlog, up 6%, including a 7% increase in Oncology. Backlog adjustments during the quarter were $49 million, bringing net orders for the company to $781 million. Total revenues were up 3% in dollars and 4% in constant currency. Growth in the quarter was impacted by the lumpiness of our revenues in our proton business. Excluding the revenue from the Georgia Proton deal, revenue was down 4%. Oncology revenues totaled $594 million, down 2% in dollars and 1% in constant currency. International revenues, which were 51% of Oncology revenues in the quarter, declined 7%. Oncology revenue growth in the quarter was negatively impacted by increased mix from emerging markets in our backlog. Given emerging markets orders typically take longer to deliver and install, this caused our backlog conversion cycle to lengthen. Year-to-date, Oncology revenues were up 1% in dollars and 2% in constant currency. Our Particle Therapy business posted revenues of $68 million, almost doubling from a year ago, as the Georgia Proton order contributed $46 million in revenue in the quarter. Year-to-date, revenues were up 37% to $130 million. Turning to profitability. Total company gross margin increased 18 basis points to 44.5% and year-to-date margins increased 138 basis points to 44%. The improvement in gross margins for both the quarter and year-to-date was supported by increased mix of services, consistent with our long-term strategy. Oncology Systems gross margin increased by nearly 200 basis points to 48.1% due to higher mix of services revenue as well as ongoing supply chain efficiencies. Year-to-date, Oncology gross margin was up over 200 basis points to 46.4%. Proton Therapy gross margin for the third quarter was 12.7%, or flat. Year-to-date, Proton gross margin was down nearly 400 basis points due to the ongoing impact of the bankruptcy at Scripps and currency headwinds on our two projects in the UK. Selling, general and administrative expenses in the quarter were $117 million, up 2%, driven by investment in new product launches, and flat sequentially, which is 17.6% of revenues. In the quarter, we invested $55 million in R&D or about 8% of revenues. Operating earnings totaled $123 million or 18.5% of revenue, up 3%, driven by improved mix of services as well as supply chain efficiencies. Depreciation and amortization was $14.7 million, and $17.6 million on a GAAP basis. Our effective tax rate was 21.5%, reflecting a revenue mix shift to Europe region where tax rates are relatively low. For the fourth quarter, we believe Varian's tax rate will be about 25%. EPS in the quarter was $1.04, with the Georgia Proton order contributing $0.10 to this. Our diluted share count on the quarter was 92.4 million shares. Year-to-date EPS was $2.51, including the $0.34 impact from the Proton accounts receivable impairment in the first quarter. Turning to the balance sheet and liquidity. We ended the quarter with cash and cash equivalents of $658 million and debt of $364 million. Our increased focus on working capital discipline drove a four-day reduction in DSO year-over-year, supported by a significant decline in DSO in our Oncology business. The reduction in DSO contributed to the $155 million of cash flow from operations we delivered in the quarter, bringing the year-to-date cash flow from operations to $269 million, up $65 million. In addition to R&D, our other investments in the quarter included $47 million to repurchase 500,000 shares of our stock and $8 million in CapEx. As of the end of the quarter, we had 5.5 million shares remaining under our existing repurchase authorization. And now we'd like to turn the call over to questions. Operator?

[Operator:]

Thank you. Our first question comes from Anthony Petrone of Jefferies. Please proceed with your question.

[Dow R. Wilson:]

Hey, Anthony.

[Anthony Petrone:]

Hi. Thanks. How are you, Dow? And welcome, Gary.

[Gary E. Bischoping:]

Thank you.

[Dow R. Wilson:]

Thanks.

[Anthony Petrone:]

Thanks for taking the questions. Let me just start off a couple of revenue questions and Halcyon and then one for Gary specifically on margins. The fiscal fourth quarter guide is a little bit off from where we were expecting. And maybe, Dow, you can walk us through if there's any selling day impacts in there and what the read is for Oncology versus proton specifically in fourth quarter. And then, in terms of Halcyon, are you disclosing the specific order number in the quarters overall? And then maybe how is the funnel shaping up as you look out into the second half of the calendar year?

[Dow R. Wilson:]

Sure. And I'll tell you I'll start with the second one first, how's that? Talk Halcyon here.

[Anthony Petrone:]

Yeah.

[Dow R. Wilson:]

Customers and our field team remain very excited. Response has been terrific. People love the features that we've talked about, the fast installation time, the new collimator, the precision that you can get, the lower operating costs, the lower bunker costs. And, as I mentioned in the script, the access to cobalt vaults and tomotherapy vaults. One of the things that we're seeing is the conversion cost from an old vault to a new vault. The cost of putting a Halcyon unit in is much lower than any other system on the market, and that's having a real impact. We're not disclosing the number on the quarter. We didn't have regulatory approval in the U.S. right to the very end. As I said, we did have orders from 10 countries, including some multi-unit orders. We're very confident about where we are. We feel very optimistic. And we will be disclosing that in Q4 and giving you more kind of unit color Q4. When we did this with TrueBeam, we had global regulatory approval and we were excited that we get to launch it here at ASTRO here in September. So, that'll be its U.S. – Americas launch and get to the global customer as well at ASTRO. But the Halcyon product is going very, very well. You see that a little bit in the order rate. The order rate was very good on the quarter. We're 5% on the quarter with good, strong growth in every one of our regions. And the amazing thing is China did really, really well without Halcyon. So, that'll be in that marketplace probably in about a year's time, as I said on the call. Yeah. In terms of kind of the revenue issues, I'll talk at a high level about these and Gary can jump in. I'd say we're seeing a couple of things. Number one, the emerging market, so this is BRIC plus everybody else, so this is Latin America, Eastern Europe, China, Southeast Asia, that part of our backlog has grown quite substantially. So, year-over-year, we think it is up 300 basis points year-over-year. And this part of the backlog, I'd say it's taken us three to six months more to convert those into sales. So we are seeing a little bit of that. I'd say, coming down the end of the quarter, we had a few slip-outs on some U.S. orders, a combination of some operational challenges, a little construction and installation, nothing that spooks us at all. There might be just a touch of folks kind of waiting to see what's happening with Halcyon in there, but I don't think that's the third in the list of three there. But I'd say those are kind of some of the revenue issues that we've got going on. We did see some of this when we called guidance. So we know we missed our revenue guidance. We thought we could execute through this and between some of the longer emerging market backlog timing, and some of the U.S. pushes to Q4 we had to miss. And we feel very good about where the order rate is landing, continue to feel very positive about the quality of the backlog, still committed to a long-term kind of 5%, 6% growth, and think that that's kind of where it'll land. In fact, we were looking at trailing 12 months – our trailing 12-month order and revenue performance is pretty close. Orders performance is 3.4%, revenue performance 2.7%, 2.8%. So those are tracking. We've got to get our heads around across the emerging market, make sure we got a little better visibility to that. We love the profitability that came in on the quarter, and you see that in guidance as well. So, that part was very strong. And with that, Gary, jump in and...

[Gary E. Bischoping:]

Yeah. Thanks. So the thing I would add, Anthony, to your question on kind of OS and proton, we see Oncology on a revenue basis returning to growth in the fourth quarter, and we do face significant headwinds in the proton business from a year-over-year perspective. I think the other context I would give you with regard to the guidance is that last – so prior year, so Q4 2016, our Oncology sales or revenue growth year-on-year was 6%, and so had a good, solid execution there. So it's up against, I would say, a reasonable compare. And I think it's a pragmatic guidance relative to what we see here.

[Anthony Petrone:]

And just a follow-up, Gary, and I'll let others hop in, just the Oncology gross margin number, a bit of a surprise to the upside this quarter. Maybe just some of the drivers there and your outlook as you look forward for Oncology gross margins and maybe overall gross operating margin goals for the company next several years. Thanks, again.

[Gary E. Bischoping:]

Sure. Thanks, Anthony. We were very happy with the Oncology margin rate and, honestly, the operating execution inside of that business. And given what we saw on the top line, I think we did a good job of managing through and making the right trade-offs associated with where we're investing and how we drove profitability in the quarter. So I think our execution was very good there. As it relates to kind of what happened, the dynamics around it, there's about 0.6% of that 48.1% was driven by an excise tax refund. And so, that certainly was part of that over-delivery. And then the services mix increase was another 100 to 150 basis points of that. And so, you have to kind of carve those two things off. We think we can execute that Oncology gross margin rate in the 44% to 45% range and we think that makes sense relative to being able to then drive our EBIT from 18.5% to, say, 19% to 20% in the near term. So we think good, solid execution in pricing, our ability to get some operating leverage post the Varex spin really make that a realistic number as we think about profitability heading into the fourth quarter.

[Dow R. Wilson:]

Yeah. And our long-term goal remains, over the next three years, can we get us back to 22% return on sales. So, that remains our long-term goal.

[Anthony Petrone:]

Thank you.

[Operator:]

Our next question comes from Amit Hazan of Citi. Please proceed with your question.

[Dow R. Wilson:]

Hi, Amit.

[Amit Hazan:]

Hey. Thanks, guys. And Gary, welcome. Let me maybe just start actually with longer-term fiscal year 2018 thoughts on the top line, just given some of these new mix issues you're talking about. Is the Oncology backlog growth a good way to still think about where fiscal 2018 growth might go for Oncology revenue? Or does this EM mix issue change kind of our thinking about that backlog being a good number to think about for growth in the next year?

[Dow R. Wilson:]

Short version is I think it still remains an outstanding indicator of where we're going to land next year. We do have a little bit of emerging market mix we got to think through and that might mean that the velocity of that portion of the backlog might be a little bit slower. But as an indication of where we're headed, I think it's still an outstanding indicator.

[Gary E. Bischoping:]

Yeah. As Dow stated earlier, our trailing 12 months orders rate relative to our trailing 12 months revenue rate in the Oncology business track pretty much right on top of each other. So you may see some lumpiness in any given quarter, but our ability to execute through that emerging market increased mix, which is a great thing for growth and top line, we'll execute our way through that.

[Amit Hazan:]

Okay. And just to clarify, that push out related to the emerging market mix, you didn't see anything in terms of its units adjusting out of backlog because of that? It's just pure delays in the recognition of revenues of those orders?

[Gary E. Bischoping:]

Yeah. That's correct. And the adjustments we saw in backlog are well within historical norms.

[Amit Hazan:]

Yeah. And then just one question, Gary, just you coming on. Just asking the question about what you've seen so far at the company and in particular what your views are on things like capital allocation going forward? Share repurchases have been, obviously, a key to this company for a while now. How you view that? And generally, just balance sheet risk and taking on, for example, the financed proton deal, do you view these things similar to how they've gone or what's your take on some of that?

[Gary E. Bischoping:]

So, look, I've been really impressed with the board and our operators of this business. I think the board is engaged at the right level and helping us drive strategy forward. And the management team and its ability to execute and take advantage of the pure play cancer treatment platform that we have today is real. And so I'm excited to be part of the team with the fight against cancer and to take advantage of that opportunity I think we have in the marketplace. As it relates to capital allocation, I would tell you that we are going to balance the need for financial flexibility with returning excess cash to shareholders over time. I think that's prudent. And if you think about being in the capital allocation business we are in today and the strategic opportunities we have in front of us, financial flexibility is going to be valuable. And so we'll make sure we keep that balance in place as we move through time.

[Amit Hazan:]

And the proton piece?

[Gary E. Bischoping:]

Oh, yes. Sorry.

[Amit Hazan:]

You financing that deal?

[Gary E. Bischoping:]

Yeah. On the proton side, I come from Dell and they have a capital finance company. I think my view here early days in the proton business is we look very hard at the cash flows of that over a long period of time. It is a long duration business. That asset's going to be in place for a long time. And so you have to think about the risk of that asset over a very long period of time and look at those cash flows. And then we have to score that risk. And I think we do a pretty good job of scoring that risk and evaluating cash flows over time. Will it be lumpy from here to there? Yes, it will. I think it will. But, again, I think we do a nice job of scoring that risk and looking at long-term cash flows to evaluate go or no-go on those business decisions.

[Amit Hazan:]

Okay. Thanks. I'll jump back in queue.

[Operator:]

Our next question comes from Jeff Johnson of Robert W. Baird. Please proceed with your question.

[Jeff D. Johnson:]

Thank you. Good afternoon, guys.

[Dow R. Wilson:]

Hi, Jeff.

[Jeff D. Johnson:]

Hey, Dow and Gary. So, just wondering on, I guess, the proton business to start. One of your single-room European proton competitors recently had to lower their outlook and push out some timing of delivery on some deals in that. Have you guys recently scrubbed your proton backlog or anything from a delivery schedule standpoint we should be thinking about with your proton business?

[Dow R. Wilson:]

Yeah. The short version is we scrub it every day. And there's no change. I mean, these are big projects. You got to stay all over it. I think we've got an exceptional team doing that for us. And there are movements all the time, but we're not seeing anything systematic the way, I believe it was IBA, reported in their last call.

[Jeff D. Johnson:]

Yeah.

[Gary E. Bischoping:]

Sorry. The only thing I would add to that is, we have seen delivering on what we said we're going to do. We've delivered some cyclotrons here recently, as Dow just stated. We're happy with progress at Georgia Proton Therapy Center and our ability to compete in those smaller roll-outs. So I think we're executing well against the backlog we have in place.

[Jeff D. Johnson:]

Yeah. Understood. And Gary, you quantified the Emory or the Georgia Proton at $0.10 in the quarter. Did some of that benefit get caught up in tax rate? I think that's how it flowed through last time with – I'm blanking on the other deal with the one in Baltimore. I just want to make sure I'm not double counting, because your tax rate came in a couple hundred basis points lower than we were expecting. But I think some of that might have been tied to the Emory deal. I just want to make sure I'm understanding your tax rate at 21.5% on the quarter.

[Gary E. Bischoping:]

The tax rate on that is very low. So, that $0.10 is obviously after taxes, and there was an immaterial amount of taxes on that revenue and profitability...

[Jeff D. Johnson:]

If not for Emory, your tax rate, your ETR probably would have been closer to what everyone on the Street was looking for at 23.5% or 23.5%?

[Gary E. Bischoping:]

Correct. That's the correct way to think about it. Yes.

[Jeff D. Johnson:]

Okay. That's helpful. And then, Dow, as I think about your revenue guidance, I know Anthony asked this a little bit. But last quarter, you were guiding to 3% to 5%, now it's to 2% to 3%. You also got a couple hundred basis-point impact here from – benefit from Emory. Currency probably is working in your favor. So is it really just kind of the push out of these emerging market deliveries? Is that really – it just seems like there's a decent sized impact there that changed the guidance once we put Emory and currency in there. So, just wondering if there's anything else impacting timing on deliveries or anything else with revenue.

[Dow R. Wilson:]

Yeah. The good guy was Emory. The actual that we do have a difference on currency. We actually think that's a point to the bad for us, it doesn't. It's not a good guy for us. It's about a point the other way. And then the other two, maybe three that we got that I mentioned briefly on the call is this growth in our emerging market backlog and, as I said, that's about a three- to six-month longer cycle to revenue than, say, our U.S. backlog. Second, we did see in the quarter a little bit of U.S. backlog push out, just call it four, five units, at the end of the quarter. And then, this one is anecdotal and it's tough to quantify, but I do think we have a little bit of folks doing some look-see on Halcyon and what should I think, how did I play this. And the good news is the order rate is chugging along right where we'd like it to be, and we feel good about that. And we feel great about the Halcyon introduction and where it's going. And we might have a little bit of that kind of globally. So, having said that, it didn't pause anything in China for two seconds. They had a banner quarter and we feel really good about our China team and what they're doing. We're seeing success in both the public market and the private market, and just really establishing our leadership position in China.

[Gary E. Bischoping:]

And just to put a finer point on the currency side, currency in the quarter is probably $10 million, $12 million, $15 million of a revenue headwind, given our exposure in the euro, sterling and yen, broadly speaking.

[Jeff D. Johnson:]

Yeah. And I guess my comment, I'm sorry, just to conclude, was the change in currency from maybe last time you updated guidance to this time, I think there's been a positive move since. But I agree, year-over-year in my model it's going to be negative in 4Q as well. So, no, I appreciate that. Thanks, guys.

[Gary E. Bischoping:]

Yes.

[Dow R. Wilson:]

Thanks, Jeff.

[Operator:]

Our next question comes from Brandon Henry of RBC Capital Markets. Please proceed with your question.

[Brandon Henry:]

Yeah. Thanks for taking my question. I just wanted to touch on this lengthening backlog to revenue conversion issue in emerging markets, because I've always thought that EM orders are taking longer to convert to revenue than U.S. orders. So is it just a mix issue in terms of you're seeing a higher EM mix, or are you actually seeing lengthening in the backlog to revenue conversion in emerging markets itself?

[Dow R. Wilson:]

It's pure mix. Yeah, we're not seeing that. As I said, we're seeing about 300 basis point increase year-over-year in our emerging market portion of the backlog. And as that flows through – it's flowing through a little I guess just a bigger mix. We're not seeing any lengthening of the emerging market transition to revenue.

[Brandon Henry:]

Okay. And then can you walk us through how we should be thinking about the ramp for the launch of Halcyon versus the previous TrueBeam launch? Is the TrueBeam a good proxy for Halcyon, kind of why or why not? And then also how do you think the Halcyon launch may impact this backlog to revenue conversion? Might it actually improve that for emerging markets?

[Dow R. Wilson:]

What we like about Halcyon is it's going to improve it operationally. A site still has to be ready. Money's still got to be there. And in some of these emerging markets, that does take a little bit longer. But once the equipment's shipped, its installation today is six to eight weeks, three months sometimes in emerging markets, and we should go to two weeks with Halcyon. So, it's a little bit all over the map in these emerging markets. I'd say, on average, we're going to get a two, three week reduction in installation cycle time. So, that should help a lot. I think in terms of how to think about the overall ramp, we think that this is going to be very significant. TrueBeam was replacing a product line. So it got a lot of price. It got a lot of share. What's interesting about Halcyon is it doesn't just replace a product line. So we're really trying to drive incremental growth with it. We've talked about some of these markets, the cobalt replacement market, the old crusty linac market, whether it's other brands or our own, tomotherapy vaults that we can't fit in. This can go in every one of those. We're seeing a big uptick in the development of emerging market cancer plans. And so governments are getting together. And it's a little bit like the Brazil thing we saw three years ago. And governments are kind of saying, wow, how do we get 5 centers, 4 centers, 10 centers, 50 centers. I'd say we've got conversations like that happening in a number of places. And they love Halcyon because I think the thing that I didn't point out in the call that we should point to is the operator efficiency and the patient creature comforts are outstanding on this product, and the ability to implement it and execute quickly is really good. And then the other factor is these emerging market governments, they're looking at high-throughput cancer centers, and this product is designed with that in mind. The imaging portion alone is four times faster than historical. And you look at the kind of treatment times, we're easily going to be able to meet the kind of volume requirements for patients per day that these markets have. So, Brandon, we will give you a lot more visibility on that next quarter. We feel very good about where we are. The uptick has been nice. We're very optimistic about where things are going. I think TrueBeam as a comparison is a good one. Having said that, it's not perfect because one's a little more – Halcyon isn't replacing TrueBeam. We very much see TrueBeam in our market for people that want the most flexible, the best SBRT product in the world. TrueBeam is it for people that are looking for a little higher-throughput, bread-and-butter go, go, go. Halcyon is the game. We love the new collimator on the product, a much more precise product. And of course, the simplicity is really going to drive it. You asked about the funnel. I'd say the funnel is very robust. We're excited about that both from a market point of view and a share point of view. So I think we're optimistic about the Halcyon funnel.

[Brandon Henry:]

Okay. And just one last question for me. ASTRO has recently released their proposal for episodic or kind of bundled payments. And in that proposal, they talk about eliminating the reimbursement differential for various modalities for radiation oncology. So can you talk about your expectations for the timing of that program to start? And then how are you thinking about a potential similar reimbursement for the different modalities? How will that impact Varian's business, and specifically, proton therapy, which I think has historically had a premium reimbursement? Thanks.

[Dow R. Wilson:]

I think you've seen a month ago, four weeks ago, CMS published their guidelines for this next year. I'd say that had a very little change. So, at least as we see it executing for kind of fiscal year 2018, we don't see much change in the reimbursement scenario. Longer term, I think we've been pretty consistent about this. We think that there will be some bundling options that are put forth. It'll be interesting to see how those go. We have not had any negative feedback from customers in the U.S. as to the reimbursable model they're seeing from CMS here recently. So, at least as it's impacted our comp outlook here and over the next year we don't see much change. As to the long-term, how does value-based pricing impact radiation therapy? I'd just point out that that's how we compete in every other market in the world, and we compete on a very good basis. Radiation therapy remains one of the most cost-effective approaches to cancer care. The economics of radiation therapy are very favorable at that level. It is how we compete outside of the U.S. Change is always the hard part. And when that change comes, I have no doubt there will be some hesitation in the marketplace as people kind of figure out what the new models mean. But I think, in the long-term, it actually is a positive for radiation therapy.

[Brandon Henry:]

Okay. Thank you.

[Dow R. Wilson:]

And oh, by the way, the other factor in there is it will also – the trends to shorter fractionation, SBRT, SRS will continue. And that's a share opportunity for us because we're one of the best in that game.

[Operator:]

Our next question comes from Tycho Peterson of JPMorgan. Please proceed with your question.

[Tycho W. Peterson:]

Hey. Thanks. Maybe first on just the revenue outlook. Dow, I want to make sure you're not factoring any sort of change in sentiment on just the hospital CapEx front. I know on the relative pecking order of issues you called out that that wasn't really listed there, but any sort of change in behavior around ACA?

[Dow R. Wilson:]

None whatsoever. Haven't seen or heard a whisper on that.

[Tycho W. Peterson:]

Okay. And then, on the Halcyon front.

[Dow R. Wilson:]

Other than a lot of noise coming out of Washington. We could talk about that for a long time. But our customers are head down, plowing ahead.

[Tycho W. Peterson:]

Okay. And then, on the Halcyon front, I know it's early days but any preliminary color you can give us on just cobalt swap outs versus older other linacs. And any thoughts on TrueBeam cannibalization at this point?

[Dow R. Wilson:]

I'd say here early on, cobalt may be the couple. I'd say we're still very early. I'd say, when we look at our funnel, there's a whole bunch in the funnel. So we feel very good about that. We also have kind of the interesting thing here is we're working very hard with some international organizations, like the World Health Organization, the UN, the International Atomic Energy Agency. They have historically made recommendations for emerging markets about radiation therapy. Their historical recommendation in these really cost-constrained markets has been for cobalt. Well, there was a news article this last week. As Mosul slipped hands three or four times, there was a cobalt unit that could have been used for evil and fortunately wasn't. Anyway, we are seeing some increased, what should I call it, policy momentum in these organizations to move away from cobalts. And I think Halcyon is enabling that conversation, so we're excited about that. I think, in terms of TrueBeam cannibalization, I alluded to it, I think it's anecdotal at this point. I'd say we haven't – there might be a little bit of it going on out there as customers kind of evaluate, especially while they didn't have regulatory approval. The good news is, in Europe and in the U.S., we move very quickly to regulatory approval. But I think where we are, given the configuration mix in the U.S., we just want to sell more of both. And I think that's – the U.S. impact in the long-term should be negligible. Do we have a little bit of folks hesitating in the short-term? Maybe. Maybe that was a little bit some of our issue here in Q3. But I'm confident that this is really a nice play for us. The other thing that's kind of interesting in the U.S. market is there's a lot of single vault customers out there. And historically, these are older units. We've talked a lot about them on this call before. These are hard to change out because often times they don't have high volumes, call it 25 to 40 patients a day. And swapping out that equipment has meant two or three weeks of de-installation, five or six weeks of new equipment coming in. So a customer is looking at two to three months of transition time. Well, if I'm a private radiation oncologist, my patients have to go somewhere else, and do I get them back? So our customers have been very worried about making that transition. One of the things that Halcyon gives us is a capability for our customers to do that window and they can plan their treatments around it. So, all of a sudden they don't have this decision process to kind of think through oh, no, am I going to lose my patients. We can do it quickly enough that they can get the new equipment in, get re-commissioned, and back to treating patients without having to send their patients elsewhere. So I'd say we haven't seen that yet, so we've got a bunch of that in the funnel. So, that's some of the incremental opportunity that we'll be looking at as we roll forward here.

[Tycho W. Peterson:]

And then was the veterinary one-off? I mean that's not a channel we've thought about for you guys before with PetCure.

[Dow R. Wilson:]

I don't think it's a one-off. I think there's more of it out there. I saw a number, I don't remember it, but there's like 600,000 pets in San Francisco and 60,000 children. And so, one population is growing more than the other. We're excited about this. It's the first six – this isn't going to be what drives our business, but I do think there's some incremental opportunity there. And we're very excited to be partners with PetCure. And it is interesting, the statistics. There's 180 million pets in the U.S., and 12 million diagnosed with cancer, which happens to be almost exactly the same number of patients that are diagnosed with cancer in the U.S.

[Tycho W. Peterson:]

And then you made the comment about commitment to 5% to 6% revenue growth before. Just in light of the commentary you also made on the order book, can you just help us get comfortable with that acceleration? Because that's a level you haven't really grown at on an annual basis since...

[Dow R. Wilson:]

I did say it's aspirational. That's where we want to go. When you look at our 12 months trailing, what was it, Gary, 3.5%, 4%?

[Gary E. Bischoping:]

3%.

[Dow R. Wilson:]

3% 12 months trailing. You look at the last three quarters, a little north of that, we've got new product. So, that's kind of what we're driving to. I think that we've got the usual clouds on the horizon in terms of reimbursement in the U.S. We talked about FXs. We've had other times when we've done really well but had to give a lot of it back in FX. So there's some risk. But, aspirationally, we've got – as we were in New York, we talked about our software opportunity, can we grow that over five years to a $900 million business. We've got good – our portfolio has never been broader, never been deeper. Halcyon opening up some new market that we think is incremental. It's going to take us a while to execute on that, but that's where we're driving to.

[Tycho W. Peterson:]

All right. I'll leave it at that. Thanks.

[Operator:]

Our next question comes from Isaac Ro of Goldman Sachs. Please proceed with your question.

[Joel Kaufman:]

Hi, guys. It's actually Joel in for Isaac.

[Dow R. Wilson:]

Hey, Joel.

[Joel Kaufman:]

Hey. How's it going? Maybe one for Dow. Could we just talk about the additional channel reach you think is necessary to effectively market Halcyon, just given the geographic mix that you're targeting? And then maybe just if you could parse out that operational reach by region?

[Dow R. Wilson:]

I think we're in really good shape. I mean we have over the last three, four years, we've made significant investments in China, in India, in Brazil. We've also invested very heavily in a market development resource and government affairs. A lot of these opportunities are government opportunities. So, as we look at these markets, one of the things we're encouraged by is, at least at this point, I don't think I have to go out and make a big sales investment. I think we've got pretty good coverage. And for where these markets are, we're in pretty good shape.

[Joel Kaufman:]

Great. And then maybe one for Gary. You've had a few months under the hood. And if we think about non-operational items, tax rate, hedging, are there any low-hanging fruit you could identify that you think are ripe for improvement? And then maybe how we should be thinking about the phasing of those initiatives?

[Gary E. Bischoping:]

Yeah. I would tell you that it's working capital is the opportunity. And our ability to – thinking about capitalizing on Halcyon and the working capital benefit of time to value for our customers and our patients as well as in our balance sheet.

[Dow R. Wilson:]

Along with some just good old execution.

[Gary E. Bischoping:]

And that coupled with I think working our way through the right amount of detail and rigor as we think about interacting with our customers day-in and day-out to make it easier for them to take a bill from us and turn that into an actual payment. So it's good old fashioned execution on the working capital line I think is our biggest opportunity after I've been under the hood here for 90 days.

[Joel Kaufman:]

And then maybe just a last one for me from a macro perspective. You made some comments that U.S. CapEx for your customers remains stable. Any color outside of U.S. in terms of CapEx demand?

[Dow R. Wilson:]

I haven't seen any data, so this will be a little bit from the hip. I'd say we haven't seen – maybe a little bit of change in Japan. That market's been tough. And otherwise I'd say kind of Brazil – I don't know if that's a change. It's kind of been that way for the last three or four quarters, so I don't know that Brazil is a change. That market remains tough. But otherwise I'd say pretty stable.

[Joel Kaufman:]

Great. Thanks.

[Operator:]

Our next question comes from Sean Lavin of BTIG. Please proceed with your question.

[Ryan Zimmerman:]

Great. This is actually Ryan Zimmerman on for Sean. Can you hear me okay?

[Dow R. Wilson:]

Hi, Ryan.

[Ryan Zimmerman:]

Great. Just you called out China as an area of growth this quarter, but competitors that we've followed in the space have struggled I think to really gain orders in that market and it's delayed their growth in subsequent quarters. And I'm just curious if you can expand on what you're seeing in China. And you talked about it a little bit, but how sensitive are you to the tender process? And what the opportunity looks like going forward, given how large of an opportunity China could be just from an Oncology standpoint?

[Dow R. Wilson:]

The market remains very good. I like to think of this at a very high level. And when you look at the percent of patients in China that are treated with radiation, it's less than 20%. In U.S. and Western Europe, it's between 50% and 60%. So, that's where I like to start. There's a huge need. And then when you start thinking about it in terms of kind of urban China versus rural China, that's a description of urban China and rural China hasn't even been touched yet. So we are optimistic of our position in all segments. We've worked very hard to kind of get a leading market share in both. We've historically been a leader in the private market and we're working very hard to be a leader in the public market. We're now established leadership in both markets. And we feel very good about that position. So, in terms of the market, I'd say the market and long-term trends are very positive. It is a market that every now and then, what, it was two, two-and-a-half years ago, we had this reform hiccup where they went quiet for a quarter or two while they retooled their purchasing processes due to some anti-kickback issues that they had had in other sectors in healthcare, not in radiation therapy. That impacted everybody, of course. Every now and then when political change happens and chairs rotate, we see a little bit of delay. But I'd say, when you kind of look at trailing 12 months, it's been strong double-digit growth and we feel pretty good about that as being the market. Might we have a quarter or two where things slow down, that could always happen, but our funnel remains very robust in China. We got a very good team over there and feel very good about where the team is, getting deeper and broader and I believe worked hard to establish share leadership in that market, and now have it and are looking to leverage it as that market builds out its cancer capability. And I think, oh by the way, this is worth a reminder. Halcyon is built in China. And we got to get through the regulatory process but we think that also sets us up very nicely for kind of the next inning of this game in that market.

[Ryan Zimmerman:]

Appreciate the color there, Dow. And then just lastly for me and I'll hop back in queue. You had a multi-system order with Georgia Proton Center. And then you had two single-room orders. And just thinking ahead on terms of customer demand for proton, I mean how should we think about the balance between, say, single-room centers versus multi-room centers? And what customers prefer maybe on a broader basis for proton therapy centers would be helpful.

[Dow R. Wilson:]

Yeah. Market is clearly moving down-market. It's interesting. There are some sovereign governments, China, Western Europe. I think they have much more rationalized governmental health systems. And so, they'll do some of these big, large multi-room centers. But I think the U.S. market with maybe this Georgia exception and a few others, it's going to be one and two room treatment centers. Protons remains very interesting clinically. The benefit of the physics behind the proton remain very exciting for our customers and matters. There's some debate about in what percent of cancers does it matter in, but I think it's safe to say that somewhere between 15% and 20% of all cancers can really benefit from proton physics and we're going to see that kind of come into the marketplace. When you look at the financial modeling on these one and two room centers, it's so much easier. It is really difficult to financially pencil out these really, really large centers. And certainly, we've seen that in some of ours and in the broader market as well. So I think the U.S. market is clearly moving to one and two room centers, and we'll see a lot less of that in the future. And so we're excited about these. University of Pennsylvania, the order we booked this last quarter, one of the leaders in the world in proton therapy, to have them kind of give us a vote of confidence is a real boost to our position and talks about the credibility of our single room product. And then, to have this other one in Thailand talks about the scope and scale of Varian, the ability of us to deliver in those markets.

[Ryan Zimmerman:]

Appreciate you taking the question. Thank you.

[Operator:]

Our final question comes from Vijay Kumar of Evercore ISI. Please proceed with your question.

[Vijay Kumar:]

Hey, guys. Thanks for taking my question. A couple of quick questions here. Maybe on this proton therapy, the Georgia, Atlanta orders and revenue rec. I got a bunch of questions from people asking, did you recognize I guess the Atlanta Proton revenues in the Q? I guess the question was, it looks like the installation was completed in July, so was there any criteria in recognizing revenues in June? So there's some confusion. If you can clarify, I think that would be great.

[Gary E. Bischoping:]

Sure. This is Gary. We are on a percent of completion basis accounting for our proton business. And based on the percentage of completion of that project, in the third quarter we booked $46 million in revenue and the associated costs with that.

[Vijay Kumar:]

That's helpful, Gary. And welcome to the earnings call.

[Gary E. Bischoping:]

Thank you.

[Vijay Kumar:]

Just maybe on, I guess, follow up to that question was gross margin strength in the quarter. I know when you do these installations, a lot of the costs are incurred up front. Did these revenues just slow down? Is that possible one as the explanation for this strength in gross margin being in the Q because there were no costs associated with it?

[Gary E. Bischoping:]

No. We recognize the cost and revenue on a percentage completion basis. And so there's the appropriate amount of costs booked relative to the revenue for the percentage completion of that project at that point in time. So, $46 million of revenue did not drop to the bottom line. There was associated cost with that.

[Vijay Kumar:]

I guess maybe continuing on with that, I guess what were the drivers on the gross margin strength? And I apologize if you answered this before. I just hopped on.

[Gary E. Bischoping:]

Sure. In Oncology, I would say there's kind of a couple of things. So we've seen certainly benefits around our supply chain efficiencies. That's certainly a very favorable driver. And we've seen that kind of increase as you look throughout the year. That's been a steady increase in the Oncology business. And I think good, solid pricing discipline has been good. We did in the quarter get an excise tax refund that accounted for about 0.6 percentage points of that increase we saw in Oncology, up to 48.1%. And then we also saw favorability in our services mix as a percent of revenue. And that's about 100 to 150 basis points of that favorability we saw. So we're happy with progress and our ability to manage cost and good pricing discipline in the market as we move through the whole year in the Oncology business.

[Vijay Kumar:]

Got you. Thank you, guys.

[Operator:]

Thanks, gentlemen. We've reached the end of our question-and-answer session. I would like to turn the call back over to Mr. Dow Wilson for closing remarks.

[Dow R. Wilson:]

Yeah. Thanks, operator. I think there's four key takeaways that everybody should think about today. First and foremost, we're the market leader. We now have the strongest portfolio of product offerings in our history, evidenced by our successful launch of Halcyon. This positions us very well as we execute against our long-term aspirational goal to touch 6 million cancer patients each year, more than double where we are today. Second, Varian's focused with our successful spinoff of Varex this year. We're now focused exclusively on extending our position as a leader in systems and software for the treatment of cancer and other indications. Third, we're optimally positioned to grow in both developed and emerging markets, supported by our new product offerings and rapidly growing service and software businesses. And fourth, we have the discipline to drive profitable growth and improve liquidity, both of which strengthen our financial flexibility so that we can continue to invest in growth opportunities. Thanks for joining us today.

[Operator:]

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.