Varian Medical Systems Inc
Q3 2009 Earnings Call Transcript

Published: 30 Jul 2009

[Operator:]

Good day, ladies and gentlemen, and welcome to the Third Quarter 2009 Varian Medical Systems Earnings Conference Call. My name is Anita and I'll be your operator for today. At this time all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator's Instructions) As a reminder this conference is being recorded for replay purposes. I would now like to turn the call over to Spencer Sias, Vice President of Investor Relations. Please proceed.

[Spencer R. Sias:]

Thank you. Good afternoon and welcome to Varian Medical Systems conference call for the third quarter of fiscal year 2009. With me are Tim Guertin, President and CEO, Elisha Finney CFO, and Tai Chen, our Corporate Controller. Tim will start this afternoon by summarizing our financial results and operational highlights for the quarter, Elisha will detail the P&L and balance sheet, and Tim will finish the company's outlook for the full fiscal year of 2009. We'll take your questions following the presentation. To typify our discussion, unless otherwise stated, all references to the quarter or year are fiscal quarters and fiscal years, quarterly comparisons are for the third quarter of fiscal year 2009 versus the third quarter of fiscal year 2008. All references to financial performance are for continuing operations and do not include the discontinued operations of the research instrument portions of ACCEL. Please be advised that this presentation and discussion contains predictions and other forward-looking statements. Our use of words and phrases such as expect, believe, could, recurring positions, suggest, hopeful, estimate, and similar expressions, are intended to identify those statements which represent our current judgment on future performance. These statements are subject to risks and uncertainties that could cause actual results to differ materially. Some of the important risks are described in our third-quarter earnings release and in our filings with the SEC. We assume no obligation to update or otherwise revise the forward-looking statements in the presentation and discussion, because of new information or future events, or otherwise. And now here's Tim Guertin.

[Timothy E. Guertin:]

Good afternoon. Today we are reporting third quarter results with solid quarter-over-quarter growth and backlog earnings and margins, but weaker than expected revenues and net orders, particularly in our x-ray products and security and inspection businesses. All of our businesses are feeling the effects of the recession, particularly in the US where proposed healthcare reforms and cuts in reimbursement rates are adding insult to injury. Nevertheless, the quarter was marked by many positive developments that give us confidence that we'll weather the storm and immerge stronger than ever. That, in a nutshell, is what we'll talk about in the call. Compared to the year ago period, our net orders declined by 4% or down 1% on a constant-currency basis. Revenues are flat or up 3% on a constant-currency basis, and our backlog grew 11% to $1.9 billion with normal cancellation rates. We improved our gross margin by more than half a point and increased our operating margin by two points, and our fully diluted EPS from continuing operations grew by a solid 11% to $0.68. Elisha will detail the P&L and balance sheet in a few moments, I'll focus now on market and operational highlights. Oncology Systems third quarter net orders were flat at $459 million with a 9% decline in North America and an 8% gain in international markets. On a constant-currency basis, total Oncology Systems net orders rose 3% with 16% growth in international markets. The North American radiation oncology market is being hit by three strong headwinds. First we have an ongoing research that has shrunk capital equipment budgets, slowed decision making, and made financing for big-ticket purchases more expensive and more time consuming. Second, our customers in freestanding radiotherapy centers are facing proposed reimbursed cuts that are steeper than expected. And third, proposed healthcare reform is adding to uncertainty among many customers who are taking a wait-and-see approach. We saw similar behavior in the last time major reforms were proposed in the early days in the Clinton administration. These current headwinds represent a big challenge to our growth initiatives in North America. We expect uncertainty in North America radiation therapy capital spending to persist until there is greater clarity on healthcare reform and reimbursement rates. We are joining the rest of the radiation and oncology community and actively opposing the cuts for freestanding clinics because we all believe it will reduce patient access to cancer care, particularly in rural areas where these clinics fill a lifesaving need. According to a survey conducted by ASTRO, the industry group for radiation oncology, some of these groups could be forced to close if the proposed cuts are adopted. In addition to letters by clinicians and cancer survivors, Varian employees and friends have sent more than 6,200 letters to their congressional representatives in Washington, voicing these concerns. We are actively engaged in the debate over healthcare reform. We realize and agree that reform is needed, and we believe that reducing government spending at the expense of a treatment that is lifesaving for hundreds of thousands of people around the world is wrong. As a first step towards change we've been advocating and focusing on more cost-efficient and effective cancer-treatment modalities so that we can ensure that all Americans have access to care for this disease. That is why we believe that multipurpose high-speed treatment machines are so advantageous for patients and healthcare providers. With the versatility and speed of our newest clinical products we're making it possible for hospitals and clinics to offer patients the broadest range of cancer treatment options on an outpatient basis in the most cost-efficient manner. Our products and people are making a big difference for many cancer patients and their families. You can see it in the "Dear Cancer" letters that patients, family members, and friends, are writing and posting on our website. For these people we are committed to being a part of the healthcare solution, not just in the US, but around the world. Fortunately we are a global company with 50% of oncology orders year to date coming from international markets. We had excellent orders growth in Asia during the quarter led by China. European net orders were also exceptionally strong in constant currency. We received an order for four clinics with RapidArc in St. Bartholomew's Hospital in London. We're going to be equipping three new cancer centers in Iraq, and filling the tenth order from India for our Novalis Tx unit. All in all, oncology's international market is holding up quite well, even with the relatively strong US dollar and increased pricing competition. We believe we continue to offer the best value proposition for cancer treatment centers around the world. RapidArc continues to offer clinicians unprecedented value, and as of the end of the quarter we had more than 180 RapidArc installations. We set an all-time record for Novalis Tx orders in a single quarter. The oncology service business also grew solidly in the quarter and year to date approached 30% of total oncology orders which provides us with a nice recurring revenue stream to supplement our software and hardware businesses. I want to note here that we acquired the assets of IKOE Medical during the third quarter, to enhance the speed and ease of planning radiotherapy and radiosurgery with our Eclipse treatment planning software. I expect this new technology to contribute to more advances in cancer care as we incorporate it into our treatment planning platform. Before we leave oncology, let me just say that I'm very pleased about the significant margin gains in this business. Product mix and successful cost-control initiatives helped drive oncology's gross margin up almost three percentage points and its operating earnings up by 24%. Let me turn now to X-Ray Products. Third quarter net orders of this business declined by 3% from the year ago quarter. This was much smaller than the 17% decline that we saw in the second quarter of this year when imaging equipment manufacturers began to lower x-ray tube and flat-panel inventories in response to the recession. The relatively modest decline in third-quarter orders suggests that customer-inventory adjustments are abating and that this business could be nearing a return to more normal growth patterns. While the market for new x-ray imaging equipment appears to be weak, the market for replacement tubes and existing equipment should be stable in this environment. In fact, orders for x-ray tubes were up in the quarter while the flat-panel business continued to experience the impact of inventory adjustments, particularly in the product lines for dental and veterinary imaging equipment that have been hit hard by the recession. Looking beyond X-Ray Products third quarter results we had several wins that position this business for future growth. We signed several new supply agreements with major equipment manufacturers in North America, Europe, and Asia, that should result in future orders for our film as radiographic imaging panels. Like oncology, I'm pleased that the X-Ray Products team managed well in a tough climate and with strict attention to cost controls, managed to turn in a 22% return on sales for the quarter. Our other business category including our Security and Inspection Products business, our Varian Particle Therapy business, and our Ginzton Technology Center generated combined net orders of $8 million for the quarter, down by 69% or $18 million, almost exclusively from SIP. The decline in SIP business is largely stemmed from government postponements of several large RFPs until later in calendar year 2009. In addition, cargo screening systems integrators who incorporate our products continue to act cautiously as governments around the world wrestle with spending priorities. I'll finish my comments with the Varian proton therapy business. We are continuing negotiations and are making good progress with several customers both inside and outside the US who are intent on building centers. In fact, we're hopeful of getting our first order for proton therapy system very soon. Now I'll turn it over to Elisha and then come back to you with our outlook for the full fiscal year 2009.

[Elisha W. Finney:]

Thanks, Tim, and hello, everyone. As usual, I will walk you through the income statement attached to the press release, as well as cover a few balance sheet items. The company's third quarter revenues were flat at $510 million in US dollars and up 3% in constant currency. Revenues were weaker than expected, especially in X-Ray Products and SIP. Although Oncology Systems posted an increase of 5%, X-Ray Products posted a 13% decline and the other category declined 36%. X-Ray Products suffered from steeper than expected inventory adjustments among several customers while SIP was impacted by customer-requested delays and delivery. Gross margin for the quarter was 42%, up half a point. Oncology System gross margin was 45%, up three points due to product mix and cost-control initiative. X-Ray Products gross margin fell by three points to 37%, due largely to volume. The gross margin fell in our other category as we booked a $7 million cost based on our revised estimates to complete a proton commissioning project in Europe. Third quarter SG&A expenses were 15% of revenues, a one point improvement from the year-ago quarter, and third quarter R&D expenses were 7% of revenues, about even with the year-ago quarter as we continue to invest in new product development. Moving down the income statement, third-quarter operating earnings increased 11% to $102 million or 20% of revenues. Oncology Systems and X-Ray Products together contributed $132 million in operation earnings while our other businesses in corporate consumed a net $30 million. Depreciation and amortization of intangibles totalled $12 million in the quarter. Net interest expense for the quarter was $300,000, down from $1.3 million in net-interest income in the year-ago period as interest rates on our invested cash remain at near zero. Our effective tax rate was 16.5%, down by one point from the year-ago quarter. For the year we estimate that our tax rate will be near 30% with a rate of approximately 34% in the fourth quarter. Average fully diluted shares outstanding for the quarter were $125 million, down by about 2 million shares from the year-ago period, due primarily to stock repurchases earlier in the fiscal year and a lower stock price. In the interest of conserving cash, until we build cash reserves in the US we again chose not to repurchase shares of stock during the quarter. We reported fully diluted EPS of $0.68 for the quarter, including $0.06 for the share-based compensation expense. Now turning to the balance sheet in cash flow, we ended the quarter with $472 million of cash and cash equivalents, $32 million of total debt, and $1.2 billion of stockholders' equity. DSO was 83 days, up five days from the year-ago period, but an improvement of four days from the second quarter of this fiscal year. We achieved $129 million in cash flows from operations in the quarter primarily from net earnings and strong collections of accounts receivable. Primary uses of cash were $19 million for capital expenditures and $10 million to pay down short-term debt. Now I'll turn it back over to Tim for the outlook.

[Timothy E. Guertin:]

Thanks, Elisha. For the fiscal year we expected net earnings per diluted share from continuing operations could grow to between $2.60 and $2.65, and that revenue from continuing operations could grow by about 4-5%. In keeping with our practice in past on certain markets, we are choosing not to give preliminary guidance on the next fiscal year at this point. We'll talk more about 2010 when we report our results for the fourth quarter. And we will now take your questions.

[Operator:]

(Operator's Instructions) Our first question comes from the line of Amit Hazan.

[Amit Hazan:]

Hi. Good afternoon, guys. I wanted to maybe first focus on some of the new proposed reimbursement rules and just with the comments you made, first ask you if you think that in this specific quarter you already saw any delays in orders that were directly tied to those reimbursement cuts at the freestanding clinic.

[Timothy E. Guertin:]

Yeah. Well the changes of course came out on July 1st which was very close to the end of our quarter. It's possible. Unfortunately it is the nature of our business that we do get a fair number of orders in the last week and so it is possible that we were impacted by it in North America in the last few days of the quarter, but it would be very difficult for me to calibrate for you to what extent we were impacted. Some people were expecting reimbursement issues, so there was probably some of that already built into market behavior, but probably not as much as what we saw when the actual numbers came out on July 1st.

[Amit Hazan:]

Okay. And just trying to get a sense from where you stand on some of those cuts to the freestanding clinics. If we look at the big reduction in the IMRT code in the physician fee schedule, do you think at all it was a result of utilization differences between the freestanding clinic and the hospital? So in other words, if we were to assume that something like 25% of all radiation patients get IMRT, is that the same between freestanding and hospital or were there freestanding clinics treating with a higher utilization rate of IMRT that may have brought on these changes?

[Timothy E. Guertin:]

Well unfortunately of course CMS has not shared with us how they did the math so I have not seen their calculations. We do know that they made an assumption of a very high utilization rate and I think that was the principle factor that changed the number. They used a number that was around 90% and of course freestanding clinics are clinics that are usually in rural areas or distant from population centers, and therefore 90% is a totally unrealistic estimate of utilization. Furthermore, for example if you're running a clinic and you have one machine and it's at 90 or 95% utilization, your waiting times will become very long and so you'll probably want to buy another machine. And when you buy that other machine your utilization instantly drops to 45%. So clearly on its face this is not good. Also ASTRO has done some preliminary looks at utilization rates for freestanding clinics and they're around 50%. So CMS used a number that was recommended for diagnostic radiology, not for radiation therapy. They used a number that was not realistic for freestanding clinics. They did it without any data, and the data that we do have says they should not have done it. So we're hoping that when CMS sees the data from ASTRO and that sort of thing — and they are required by law to use actual data and not indented data so I suspect that when they get around to actually doing the mathematics for the final releases, we'll see something much less Draconian than what we saw in the initial release.

[Amit Hazan:]

Okay. And just one more question for me I guess on fiscal year 10. I recognize you're not giving guidance now, but if we look at the order pattern for you, it's been let's say roughly flat over the last six months and there's usually a very good correlation between the order growth and then the ensuring revenue growth in the following year. And I think first call is right now at about 7% growth for fiscal year 10 and I'm wondering just generally, if I'm correct in assuming there will be that correlation and considering your environment if kind of in terms of orders we should expect things to be exactly kind of like they've been here in the last quarter or two.

[Timothy E. Guertin:]

I can see the worm dangling in front of my face, but I must decline to take it. The fact is we just need to know reimbursements, we need to know recession behavior — there's just a lot of things we need to know before I'm willing to put a fourth quarter and before I'm willing to put a 2010 number in front of you. If I thought there was any way for me to give you an estimate at this time and be trustworthy on it, I would have done it, but I just am too uncomfortable to make that estimate now.

[Amit Hazan:]

Okay. Alright, thanks. I'll get back in queue.

[Operator:]

Our next question comes from the line of Amit Bhalla of Citi. Please proceed.

[Amit Bhalla:]

Hi, good afternoon. I wanted to just continue and ask you a couple more oncology related questions. Maybe you could give us a little bit more detail — in North American, clearly linear accelerator units probably decline, service was still strong, but a little bit more color on how software and brachytherapy therapy performed, and then in addition last quarter you talked a lot about book and ship orders. Clearly it looks like they're probably not coming through, but what's your view there on how you're going to assume book and ship makes up your business going forward?

[Timothy E. Guertin:]

Okay. Let me try to handle that question as best I can. There's a lot of things you have to remember. First, the freestanding segment for us probably represents about 10% of Oncology Systems orders. If you remove service, service is about 30% of the business. If you take the remaining 70% of the business it's about half international and half North America. A minority of that business is freestanding clinics so let's say it's about 10%. So if the reimbursement picture does not improve or does not improve enough that 10% of the business is the portion of the business that will be affected. The rest of the business, the software businesses, the hardware businesses, the service businesses — I think they will do reasonably well in this environment. In this particularly quarter, brachytherapy did quite well. They were strong points for us and the service business did extremely well which is what you would expect. So the biggest issue for us for oncology in this particular quarter has to do with capital equipment, and I mean this is something that all of you folks have been projecting would happen for about a year and we're finally seeing that effect reflected in people's capital budgets. So what we have to do during this period of time is use our brachy-business, a much less expensive item. Use our service business, our software businesses, our proton opportunities, our international opportunities, our security and business and our x-ray flat-panel businesses to try to compensate for what might happen to us in this 10% piece of our market.

[Amit Bhalla:]

Okay. And just my followup would be can you comment on cancelations within the oncology business and quantify the constant-currency order growth rates for the international markets.

[Timothy E. Guertin:]

I'll speak to the cancellation piece and then I'll let Elisha speak to the currencies. The cancellations were normal. The behavior was normal during the quarter so, so far we're not seeing people react by wanting to change business that they've already agreed to. Elisha? Elisha? Yeah. If you look at quarter-over-quarter, Amit, from '08 to '09, the US dollar is 16% stronger today, than it was in the year ago period. So if you look at the international growth rate reported in dollars, it's up 8% for oncology. It would have been up 16% in constant currency, with close to 20% growth in both Europe and the Far East in constant currency. So really strong international market hurt somewhat by the exchange rate.

[Amit Bhalla:]

Okay. Thank you.

[Operator:]

Our next question comes from the line of Tycho Peterson of JP Morgan. Please proceed.

[Tycho Peterson:]

Thanks for taking the question. Maybe just one for Elisha to start with, you mentioned a number of items in the release in terms of driving margins, mix, cost controls, and I guess the tax benefits. Can you just help us gauge the relative contributions of some of those items?

[Elisha W. Finney:]

Sure. Well, the oncology margin up three points in the quarter which was obviously a highlight for us. It came primarily from mix where we continued to see the software, particularly RapidArc, have a very positive impact on the gross margin, and cost controls, which you saw all the way through the P&L. The SG&A, we got a point leverage there and it's all the things you might imagine. We have severely cut back on travel when it's not essential, we've cut back on overtime, we've put a salary freeze in place, we are forcing more vacation — all the things that you would imagine. Reduced hiring and closed some open positions, and fortunately it came through very nicely in the P&L in the quarter and I think that should continue as we go forward and keep these cost-control initiatives in place. The tax rate was a point lower than the year ago period and it was just due to some discrete items in the quarter. If you notice, the third quarter historically has always been the lowest in terms of tax rate and that's because we typically have statutes of limitations expire on opened returns and we also had some favorable settlements of some audits in the quarter as well.

[Tycho Peterson:]

Okay. As we think about some of the cost-control measures, you talked about that as well last quarter, is there any shift in the underlying R&D priority here and maybe just piggybacking off Tim's comments about emphasizing brachium software and some of these other ancillary products a little bit more. Any kind of shift in strategy as we think about the coming year?

[Timothy E. Guertin:]

Well I think a lot of the programs that we had in mind, we probably feel more strongly now than ever that the priorities we set were actually the correct ones. If you looked at us from the outside world, what you'll probably see a year or two from now is that we're making some changes to the products that will make them appealing to more international markets than you might have seen us do three or four years ago, but that is a decision that we made actually before any of this manifested. So I am actually reassured that the priorities that we've set are right. Software is certainly one of our priorities. RapidArc certainly demonstrated to us that, if we didn't know it before, that software is a key ingredient in terms of people doing what they want to do clinically. RapidArc was a wonderful productivity tool for customers and possibly it's going to turn out to be a great clinical boon to patients. So we know that software is important. So I think what Mr. Wilson is doing is investing evermore in the software side of our businesses, but we're keeping our hardware platforms up to date as well and so I think we're doing basically the same things that we ought to do even despite all of these changes in the external market.

[Tycho Peterson:]

Okay. Two other quick ones, in your comments, Tim, you mentioned the credit issues. Again, I think if I go back to it last quarter you had talked about creditworthy customers were getting financing. Has there been a sequential change here or was that just kind of a broader macro comment?

[Elisha W. Finney:]

We had a record quarter for our customer financing team in the third quarter, so they are continuing to go out and secure financing for good credit.

[Tycho Peterson:]

Okay. And then one last one on China, you've mentioned that a couple quarters in a row, how large is that business today?

[Timothy E. Guertin:]

Oh, can you hold on a second? I'm going to try and figure that out. I think it's about a $50 million business.

[Tycho Peterson:]

Okay. That's helpful. Thank you.

[Operator:]

Our next question comes from the line of Jeff Johnson of Robert Baird. Please proceed.

[Jeffrey D. Johnson:]

Thank you, good afternoon. Wondering if I can just first try to dial in on a few of the moving parts on guidance if possible anyway; it looks like revenue guidance coming down by maybe one to three points and by my math and please correct me if I'm wrong here, my math currency from the last time you updated guidance would have provided maybe a one to a two point tailwind, so is the 1-3 point reduction kind of a maybe 2-4 point cut in expectations on actual units and sales there, and the rest currency offsets?

[Elisha W. Finney:]

Well, Jeff, it's really driven by the x-ray business which is more of a short-cycle business which we have just seen a precipitous fall off compared to what our expectations were in the beginning of the year, and also in our Security and Inspection Products. So if you look at oncology, they turned in 5% revenue growth in the quarter which was at the low end of our prior guidance and had we gotten a little more help from currencies that would have been good, but at 140 we'll take that. But it really is the other two businesses where we have just seen bigger than expected falloff. Oncology had a few shipments that were delayed, a couple of international locations — about a handful had some construction delay. That's very meaningful because if you miss an acceptance it's 100% revenue on acceptance in the international locations that can have a big impact in the quarter. So feel like we'll catch those up in Q4 and it's the other two businesses driving the decline.

[Timothy E. Guertin:]

Yeah. And I would just add we're not expecting generous behavior on the part of North American oncology customers in the fourth quarter so we've looked at what's realistic and added it all up and that's how we got to these numbers.

[Jeffrey D. Johnson:]

Okay great, and then on the EPS line a similar question I guess. I'm just looking relative to my model and tell me maybe your expectations were different or maybe I was off in my model, but looks like a lower tax rate this quarter added maybe a nickel in Q4 and a few pennies, so lower tax rate for the year may be $0.07-0.08 of upside relative to what we had been expecting going into the quarter?

[Elisha W. Finney:]

Well I mean of the quarter it was closer to $0.025-0.03 was the impact of the original guidance to the tax rate that we had. So it sounds a little high for the full year, Jeff.

[Jeffrey D. Johnson:]

Okay. I'll check my math, thanks, on that. And then I know quantitatively you don't discuss it, but you can at all qualitatively talk about RapidArc orders in the quarter?

[Timothy E. Guertin:]

RapidArc orders, well I think we've now graduated and so RapidArc orders were down a little bit from the year ago level when we were getting started and it was very exciting. The take rate is very high so that means that people want the product and are accepting it, but as new orders for clinics in North America, which is the strongest take-rate quarter, weren't as strong this quarter as we would've liked — that's where the impact was. We think we still have tremendous room to grow internationally.

[Jeffrey D. Johnson:]

Yeah. And that was going to be my question — is international over the next few quarters still expected to grow pretty nicely and offset just the tough comps in North America, is that how to think about it on (inaudible) quarters?

[Timothy E. Guertin:]

Yeah. We have our fingers crossed and that's what we want to see happen. But it will take a lot of work on our part and we need international markets to behave the way we want them to behave.

[Jeffrey D. Johnson:]

And you do, Tim, come up against a tougher oncology comp in the international markets next quarter, but it sounds like at least at this point a month into that quarter and given the strength of fiscal Q3, still feeling like those markets are holding in pretty well?

[Timothy E. Guertin:]

As you know I don't give guidance on orders, but I will say that international in general still looks healthy, but we're only one month into the quarter, we have two months to go.

[Jeffrey D. Johnson:]

Got it. I just keep trying to dangle that worm that you refer to there (laughter). Last question from me then just on ASTRO coming up about in a month, month and a half, are we going to see anything on motion management there as far as new product launches or what should we think about seeing at ASTRO and then in a couple months at ASTRO?

[Timothy E. Guertin:]

Motion management remains extremely important to us in terms of targeting to moving tumors that remains a significant opportunity for improving cancer care. So we will be showing some of our newest ideas for how that might be done. I can't give you much more detail than that, but that will be an area that we're going to be focused on for the next few years.

[Jeffrey D. Johnson:]

Got it. Thanks all for the comments.

[Operator:]

Our next question comes from the line of Junaid Husain of Soleil Securities.

[Junaid Husain:]

Hi. Good afternoon, guys. Tim or Elisha, for the US oncology business, could you give us a sense for the pacing of the orders, was it particularly well spaced out from month to month, was it light in June but front-end loaded? How did the pacing look?

[Timothy E. Guertin:]

I think it followed our normal pattern which was it's slow,well, slow is not the right word. It's lighter in the first two months of the quarter and heavy in the third month of the quarter and we didn't see it deviate from the normal pattern except for the last week where I think people started to take into account some of the things that have changed in the market.

[Junaid Husain:]

Got it. And could you tell me what percentage of total oncology orders did the freestanding centers represent, and then how does it compare with the last quarter and maybe the year?

[Timothy E. Guertin:]

I don't know what it was specifically for the quarter. If you go back over time, it represents about 10% of total oncology revenue and that's just based upon, as I said, services about 30%, the remaining 70% is split evenly between North America and international, so that's about 35% international. And the ratio is about 10%, 25% for freestanding versus hospital, as a general rule. Now I do believe if you go back over the last nine months, we have seen lighter business in the freestanding than we would ordinarily see. I think free standings have been expecting something and they've been trimming their behavior for the last nine months, but I don't have that calibrated versus the normal 10%. I would say our largest freestanding customers have been very conservative in their order behavior for this year. So it's probably already affected us year to date because I think they were expecting issues, but whether they were expecting issues of this size is another question.

[Junaid Husain:]

When you look at this customer base then, the freestanding guys, if we assume that it represents 10% of the business, I actually thought it represented a lot more of the business of the last quarter —

[Timothy E. Guertin:]

For North America it does. It represents about 30% of the business routinely, but in oncology overall it's about 10%.

[Junaid Husain:]

So then how should we be thinking about that 30% base in the US? Does it completely freeze up or are there still some centers that are (inaudible)?

[Timothy E. Guertin:]

What it does is it moves up the breakeven for a center. So you have to build up your referral base as quickly as possible. So what generally will happen is some center’s ,depending upon what the final numbers turn out to be, and my personal belief is that CMS will not stick with these numbers so you need to take that into account. Of course I have no special insight into CMS, but generally based upon what I know, these numbers don't seem to be the numbers that will persists, but lets' say they do. Let's say they're not good. Well then what will happen is the breakeven will move up from, for example, breakeven right now is probably if you have less than 20 patients a day maybe 16 or 17 and it might move up into the mid-twenties. Under those circumstances you will, if you open a clinic you will only want to open a clinic if you think you can attract that number of patients per day which means you'll want your referral pattern pretty well understood before you begin. You'll want to know where those patients are going to come from, you'll want to establish your center in a location where that volume is possible — so your behavior will be predicated on the mathematics coming through. And you'll want to line up your business with your referring physicians. You'll want to know that your medical oncologists are aligned. So if you look at people like US Oncology where the medical oncologists work for US Oncology and they know their referral patterns, they're likely to put their operations in places where the local market looks very strong. And you're also likely to see an increase in advertising because they'll try to have state of the art. I think the market will likely behave in two different ways depending on what part of the market it is. People who have older machines in freestanding clinics will be more reluctant to buy more machines because they'll want to completely write them off and amortize them. People who want to put a new center in and want to attract patients are likely to buy the most high-end machine they possibly can because they're going to want to promote that to physicians and they're going to want to steal patients, if you will, from facilities that have less advanced equipment and make that their argument. So I think what will happen is it will definitely hurt business in that segment of the market. It won't drop to zero. It'll drop to something less than it has traditionally been, and those people who do buy machines will probably market them more aggressively than we've ever seen them do before.

[Junaid Husain:]

Got you. Tim, thanks, that's actually very helpful. Last couple of questions, just a little bit of housekeeping. I'm just wondering how I should be thinking about sales and marketing expense for the fiscal fourth quarter, especially with the big trade shows coming up.

[Elisha W. Finney:]

Yeah. Well, the ROS margin should go up by about a point, Junaid, so that's maybe one way to look at it, with a significant portion of that coming from gross margin and the rest from SG&A. R&D, we will not get any leverage on most likely.

[Junaid Husain:]

Gotcha. And then last question for you, you've got a nice trove of cash in the bank. I think in the past you've talked about using it strategically as you've told me before, cash is clean. What are your thoughts forecast upon it?

[Elisha W. Finney:]

Well, we ended the quarter with a little bit of US cash. I don't have an exact number. My memory tells me it was somewhere around 20 million or so and cash has continued to grow in the US. So we've always said once we started to get a cash reserve in the US and we weren't borrowing to go out and effect a share repurchase that we would reconsider resuming our share-repurchase program. So that's the plan at this point. We plan to be opportunistic based on the stock price, but of course prudent relative to cash and debt market and interest rates and other uses of cash. But with close to $500 million earning virtually 0% at this point, I think it's a good place for us to put some of the cash going forward.

[Junaid Husain:]

Got it. Thanks so much, guys, that's all I've got.

[Operator:]

Our next question comes from the line of Charley Jones of Barrington Research. Please proceed.

[Charley R. Jones:]

Good afternoon and thanks for taking my questions. I guess the first one is I was curious if freestanding centers have a different book to bill ratio than a typical US hospital, meaning to the clinics tend to order and take possession of the Linac in the same quarter?

[Timothy E. Guertin:]

Oh no. They tend to order them a long time in advance because there's usually a construction project that goes with it So I don't think their behavior's that different from a hospital.

[Charley R. Jones:]

And then are you getting a sense at all in your discussion with hospitals that there's pent-up demand for Linacs that the capital freeze is definitely creating a desire to order systems or buy systems as soon as they do start to get a better feel for whether it's reimbursement or their capital budgets.

[Timothy E. Guertin:]

We definitely know of people who put off ordering because the capital budget for the hospital, it didn't have to do with anything associated with the apartment. The department wanted the machine, was eager to have the machine, was pushing the administration to do it, but the administration was moving slowly. So we saw this pattern in the mid-'90s and I think we'll see it again when the hospital budgets come out. I think we will see kind of a resurgence of orders. The funnel from hospitals looks good, the reimbursement looks good. We just need their general managerial behavior to allow them to start to spend. We even spoke to a hospital recently that, I mean it was making money, it was profitable, and they were still cutting back because they were trying to build up their reserves against possible hardships going forward so they were trying to improve their return on sales in this environment. So we're seeing definite conservative behavior on the part of hospitals when they see the need for that reduced based on the information we're getting from customers. I think you'll see us have a sudden growth spurt on the behavior of hospitals. Also you got to remember that freestanding behavior could change here. Freestanding centers could try to align themselves with hospitals. If a freestanding center decides that it doesn't want to function in this environment anymore with this level of reimbursement or it decides it doesn't want to take Medicare patients or it wants to limit the number of Medicare patients it takes, it will shift those patients to hospitals. And under those environments a lot of these hospitals can't take on the additional patient burden without buying equipment. So there are so many possible ways this could go, it's very difficult for me to predict for you accurately what will happen, which is why I say we're kind of watching this for the next couple of months, we're talking to people, we're trying to understand the behavior. Those hospitals that do have the money and do have nice balance sheets and their P&Ls are in good shape — I mean we had one come in here recently where — I mean they were extremely aggressive in their thinking about their radiation therapy program. They thought it was key to the way they reach out to the community and not just at their main hospital, but at outside facilities as well. So I think radiation therapy remains key to their strategic plans, we're just seeing a general note of caution in everybody's behavior.

[Charley R. Jones:]

So wouldn't it make sense, I mean what did you see coming out of the' 90s then? Wouldn't it make sense to see your book to bill ratio change coming out of the recession that you'll see a lot of hospitals want to take possession of the machines faster so that even though we have lower order rates over the next couple of quarters you'd still see better revenue growth because people want to take possession of the machines faster?

[Timothy E. Guertin:]

That is what happened last time. I mean past events are not a predictor of future whatever — whatever that phrase is, but that is what happened last time when people came out of the recession. Now it didn't happen instantaneously. You have to remember that hospitals have to set budgets, they're on an annual budget cycle, so even if the recession goes away, unemployment drops, and healthcare gets resolved in a way that doesn't make the hospitals feel like they're all going to broke if, if, if — If all of these things work right, hospitals will still take several months to start to show their buying behavior change, but yes, you're absolutely right. There will be a sudden increase.

[Charley R. Jones:]

It sounds like maybe you saw an increasing number of RapidArc orders for existing systems from some of your comments about hospitals wanting seeking throughput. Is that true or are you pretty much just seeing these on new systems still?

[Timothy E. Guertin:]

We are seeing them mostly on new systems. I have to tell you frankly, the upgrade business is one of the businesses that's hurt during the recession. You would think people would spend more money on upgrades, but they don't. They do the opposite. They actually tend to reserve their capital for new things and not for upgrades and I'm not sure I would behave the same way, but that's how they do behave.

[Charley R. Jones:]

It sounds like you've got a European proton therapy deal getting close, is that correct?

[Timothy E. Guertin:]

Did I say that?

[Elisha W. Finney:]

We didn't say where (laughter).

[Charley R. Jones:]

Well that's the other part of the question. I guess, have groups in the US completely backed off or do you think that there's a chance for some US orders maybe this year or next year?

[Timothy E. Guertin:]

US and international interest remains strong and I'm going to have to update you on who goes first when they go first. But these deals, as you might imagine when they're a $60-70 million deal they do take awhile to percolate and sometimes when they happen they happen all of a sudden. So we just have to — what I'm telling you is I'm feeling warmer and fuzzier than I felt for awhile, but as soon as I know something definite or have something definite to report, I will do that.

[Charley R. Jones:]

And last question as I may have missed this, can you discuss what your expectations are for x-ray next quarter? If you already started to see a turnaround? It sounded like you felt like it was — are you already seeing that this quarter?

[Timothy E. Guertin:]

We are having some cautious optimism about x-ray. We had what, 17% orders reduction in the second quarter followed by a 3% in this quarter. That trend is in the right direction. I'm not saying that that line will stay in the same slope into the fourth quarter, but things are definitely getting better. And we have seen several customers for flat panels sign up with us. Now what happens is they agree to go with us, they get some sample flat panels, then they do the R&D to incorporate them in their product and then when their product is ready they place an order on us. So it doesn't turn into orders immediately, but the behavior of certain important customers in key markets gives us reason for optimism. I would say some optimism in quarter four, but a lot of optimism in 2010.

[Charley R. Jones:]

Yeah. So it sounded like at the (inaudible) that you had your largest that had really slowed down their orders for inventory purposes. Are you getting the sense that that customer has worked it down where you're at least seeing orders for the systems that they sell?

[Timothy E. Guertin:]

Some. Definitely that is true for most of them. The dental and veterinary markets I think really were hurt. I think dentists and veterinarians are being more cautious than other segments of the market, but in the human medical market, definite optimism when I talk to Bob Kloogey about that business, he definitely is feeling better.

[Elisha W. Finney:]

We actually had orders increase slightly in the third quarter for the x-ray tube business. So flat panel is where we saw a decline. So that was very good for that particular customer having worked through the inventory.

[Charley R. Jones:]

Great. Thanks for all the questions, appreciate it.

[Operator:]

Our next question comes from the line of Dalton Chandler at Needham & Company. Please proceed.

[Dalton Chandler:]

Hi. Good evening, or at least it's evening here. I was just wondering on the expense side, just a followup there, should we look at this quarter's numbers as a new baseline level or could there be some additional savings coming up?

[Timothy E. Guertin:]

Well obviously we have lots of different alternative things that we could do. What we have done is we have turned the cost-control knobs that are relatively easy to turn. We're going to be watching our markets for the next two quarters and make decisions as to whether or not we have to turn knobs that are more unpleasant to turn. But at this time I'm trying to not do anything I don't have to do because if we see international strength, if we see the flat panel and the proton business and the security business give us some strength — if we see hospital's behavior in North America improve then I don't want to do anything that would weaken our ability to respond to that. So we put a lot of cost controls in place, travel, we reduced our hiring, we've asked people to do what they can in the area of overtime, we've seen people increase their vacation, we've limited salary increases to pretty much flat and we did a very small restructuring in our Salt Lake City because of the 17% order reduction we saw in tubes in the third quarter. Our backlog gives us some visibility so we're able to make these plans more in advance than maybe some companies would, so if we need to do more we will. We certainly haven't done everything that could conceivably be done, but I'm just not a person who wants to behave inappropriately in a time like this.

[Dalton Chandler:]

Okay. And then a followup on the RapidArc and the RapidArc orders. How does your install base that is upgradeable break down between the US and OUS?

[Timothy E. Guertin:]

I think — let me see, we said that number of machines that's upgradeable is about 1,000 as I recall. I would expect that the behavior is about 50-50 for those thousand machines, maybe more. But it's more likely that they will occur then that they will occur internationally. So it's probably more like 70-30 in terms of likely buying behavior for upgrades.

[Dalton Chandler:]

Okay. Thanks a lot.

[Operator:]

That is all of the allotted time we have for question and answer. I would now like to turn the call back over to Mr. Spencer Sias for closing remarks. Please proceed, sir.

[Spencer R. Sias:]

Thank you. Thank you for participating. For listeners who may have come in late, this call has been taped and it will be available for replay on the investors relation page of our website [Author ID1

[Operator:]

Thank you for your participation in today's conference. This concludes the presentation. You may disconnect and have a great day.