Varian Medical Systems Inc
Q3 2012 Earnings Call Transcript

Published: 26 Jul 2012

[Operator:]

Good day, ladies and gentlemen, and welcome to the Third Quarter 2012 Varian Medical Systems Incorporated Earnings Conference Call. My name is Ann and I will be your coordinator for today's call. [Operator Instructions] As a reminder this conference is being recorded for replay purposes. [Operator Instructions] I would now like to turn the presentation over to your host for today's call, Mr. Spencer Sias, Vice President of Investor Relations. Please proceed, sir.

[Spencer R. Sias:]

Thank you. Hi, folks, just move your slide to Varian Medical Systems and I apologize for the lateness of getting this call started. We had trouble with our conference operator. But welcome, though, to the Varian Medical Systems Conference Call for the Third Quarter of Fiscal Year 2012. Participating in this call are Tim Guertin, President and CEO; Elisha Finney, CFO; Dow Wilson, Executive Vice President and Chief Operating Officer; and Tai Chen, our Corporate Controller. Tim and Elisha will summarize our results and we'll take your questions following the presentation. To simplify our discussion, unless otherwise stated, all references to the quarter or year are fiscal quarters and fiscal years, the quarterly comparisons are for the third quarter of fiscal 2012 versus the third quarter of fiscal 2011. Please be advised that this presentation and discussion contains forward-looking statements. Our use of words and phrases such as outlook, could, should, believe, think, appear, opportunity, can, expect, potential 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 and discussion because of new information, future events or otherwise. And now, here's Tim.

[Timothy E. Guertin:]

Good afternoon, and welcome. And today, we're reporting results for the third quarter of 2012 with healthy growth in revenue, margins and earnings. Net orders were up slightly in constant currency, but even with the -- excuse me, net orders were up slightly in constant currency, but even with the year-ago period on a dollar basis. To summarize the third quarter results compared to the year-ago quarter, company revenues rose to $705 million, up 9% in dollars and 11% in constant currency. Our gross and operating margins improved even in the face of a weakened euro and net earnings increased 16% to $0.96 per diluted share. Net orders were up in Oncology Systems and were down in our X-ray Products and Security businesses. Our quarter ending backlog rose 16% to more than $2.6 billion with Oncology backlog up 9%. Let me give you more detail about our Oncology Systems Business first. Third quarter revenues for this business were $546 million, up 7% from the year-ago quarter. The gross margin was 44%, up nearly 40 basis points from the year ago quarter and up 2 percentage points from the second quarter. We achieved this improvement while continuing to experience a significant shift to International business, which accounted for 57% of total oncology revenues. Oncology net orders totaled $562 million, up 2% in dollars and 4% in constant currency. Reported net orders were up 4% in North America but down 1% internationally with currency-driven declines in EMEA that offset double-digit growth in Asia. Oncology orders were split 46% in North America and 54% internationally. Our flagship TrueBeam system continues to be ordered and deployed in healthy rates. Since the product launch, we have received 550 orders and some 270 installations are complete or in progress. TrueBeam comprise about 50% of total high-energy machine orders in the quarter. During the quarter, we received several multi-Linac orders including 6 TrueBeams at 2 centers in New York. We also received our first 2 orders as part of a program in the U.K. to stimulate replacement of machines in public hospitals. We were selected to supply a minimum of 10 TrueBeam machines that hospitals can acquire through the National Health Service between April 2012 and March 2013. The first 2 of these have been ordered for our new cancer center in Hereford and to replace a competitor's machine at Clatterbridge, near Liverpool. Service orders and revenues, which represent a long-term annuity for oncology, grew at a faster rate than the overall oncology business. Year-to-date, services achieved double-digit growth and is nearly 35% of Oncology Systems revenues. Shortly after the quarter ended, CMS announced its initial proposals for 2013 reimbursement rates in the U.S. This calls for slight increases in hospital rates, but painful and inappropriate cuts for freestanding clinics. As a consequence, we are working with clinic operators in the industry to oppose these cuts in order to help ensure continued access to cancer care for patients. Freestanding clinics in the U.S. represent about 10% of Varian's global oncology business. With ongoing pressure on reimbursement rates, it's clear to us that the market will place a greater and greater premium on fast, cost-efficient delivery of both radio therapy and radiosurgery without compromising treatment quality. This is a strength for Varian because we offer greater performance and value than any of our competitors. We continue to see promising developments in clinical studies related to the efficacy of modern radiotherapy. I'm pleased to announce today that Varian has become a supporter of a multi- institution, randomized Phase III study comparing surgery and radiosurgery for patients with early-stage, high-risk, operable non-small cell lung cancer. The study will accrue 420 patients across the U.S. over 5 years and evaluate survival at 3 years. It is being conducted by the Alliance for Clinical Trials in Oncology and National Cancer Institute sponsored the cooperative research group. We believe this study is the logical next step towards expanding the use of radiosurgery for the treatment of lung cancer following numerous studies that showed promising results for the treatment of inoperable lung cancer. As we reported in our press release on May 1, doctors at VU Medical Center in Amsterdam published a data showing that radiosurgery can be a viable option for treating potentially operable cases of early-stage lung cancer with outcomes that compare favorably to surgery. We are excited about the results of this study and recommend that you read it in the May issue of the International Journal of Radiation, Oncology, Biology and Physics to fully appreciate the work that is being done in this field. Studies such as these mark the progress that is being made in the fight to control cancer with radiotherapy and radiosurgery and enhance efficiency of these treatment methods. Our X-ray Products business continued to experience challenging conditions in the third quarter, but managed to deliver record margins. Net orders were $120 million, down 1% from the year-ago period and revenues rose 5% to $127 million. Sluggish capital spending on imaging systems around the globe appeared to dampen demand for our components in the quarter. However, we believe our X-ray Products business is doing better than the overall diagnostic imaging industry and that we are growing share. The long-term growth on our X-ray Products business has been driven by our ability to introduce new tubes and panels that enable us to serve more customers and address new market segments. We're currently in the process of introducing multiple new products, which we believe will help us to sustain growth. Looking forward, for example, we are starting to see some new panel business from Siemens for systems that it expressed to sell into emerging markets. Results in our Other category, including the Varian Particle Therapy business and our Security and Inspections Product business were mixed. As you know, results with these businesses can vary substantially from quarter-to-quarter based on the timing of large orders and deliveries. Combined net orders were $7 million down $10 million from the year-ago quarter. Orders for Security were down sharply, revenues rose about 70% to $26 million in the quarter. Deployment of security systems by governments around the world is continuing, and our customers have received orders for systems that incorporate our components. So we can expect to see more orders in this business in a relatively near future. In our Particle Therapy business, we continue to work on the installation of the new system in Scripps in San Diego, and several other customers are in the process of financing and launching their projects. Subsequent to the end of the quarter, we signed an $84 million contract for a new 4-room proton installation at MR University and we will book this order in the backlog when this project is financed. This is a vote of confidence in the future of proton therapy that comes in spite of CMS proposals to cut reimbursement rates for hospital-based Proton Therapy Centers in 2013. The proposed hospital cuts have no direct effect on current Varian projects such as Scripps, Maryland or Emory. These clinics will operate as freestanding centers and negotiate reimbursement rates with their local Medicare providers. I should add, CMS has indicated it is open to modifying its proton reimbursement proposal for hospitals because it has acknowledged that the suggested rates are based on very limited data from only 3 hospitals. And now, let me introduce Elisha Finney to cover the financials.

[Elisha W. Finney:]

Thanks, Tim and hello, everyone. While Tim has already covered net orders, I want to give you a little more detail on the constant currency growth rates. In comparing quarter-over-quarter exchange rate, the U.S. dollar strengthened significantly against European currencies and weakened slightly against the yen. As you know, in the third quarter, the euro weakened by about 10% from the year-ago period. Oncology grew net orders by 2% in dollars or 4% in constant currency. Oncology's European net orders were down 4% in dollars but up 5% in constant currency. And Asian orders were up 12% in dollars and up 11% in constant currency. Third quarter revenues increased 9% to $705 million and 11% in constant currency. Oncology Systems posted a 7% increase with strong growth in international sales. X-ray Products posted a gain of 5% and our Other category doubled with strong growth in the SIP business and with $6 million of proton revenue. Even with the negative quarter-over-quarter currency impact, the gross margin for the company increased by 0.5 points to 43.6%. Oncology Systems gross margin increased by 38 basis points to 34.3% due primarily to strong growth in service and improved installations, warranty and factory cost. X-ray Products gross margin had a new record, climbing 4 points to 45.3% due to favorable product mix as well as improve quality and product costs. The gross margin for the Other business and the total company was negatively impacted by revenue recognized on the Scripps contract, which reduced the company's third quarter gross margin by about 35 basis points. Third quarter SG&A expenses were $105 million or 15% of revenues, and R&D expenses were $49 million or 7% of revenues, both up slightly as a percentage of revenue from the year-ago quarter. Moving on the income statement, third quarter operating earnings totaled $154 million, up 9% to 22% of revenues. Depreciation and amortization totaled $15 million for the quarter. The effective tax rate was 29.3% for the quarter, down about 0.5 points from the year-ago quarter due largely to a geographic shift in earnings towards lower tax jurisdictions. For fiscal year 2012, we now estimate that the tax rate will be about 28%. Fully diluted shares outstanding decreased significantly from the year-ago quarter to $113 million due largely to our ongoing share repurchase program. We repurchased 1.5 million shares in the quarter. Diluted earnings per share rose 16% to $0.96. Turning to the balance sheet, we ended the quarter with cash and cash equivalents of $633 million, debt of $175 million and stockholders equity of $1.5 billion. DSO improved by one day from the year-ago quarter to 80 days. Third quarter cash flow from operations was $143 million, more than net earnings due to noncash items and improvements in working capital. Primary uses of cash included $97 million for stock repurchases. At the end of the quarter, we had approximately 4 million shares remaining under the current repurchase authorization. Now, back to Tim for the outlook.

[Timothy E. Guertin:]

Thanks, Elisha. With tremendous movements in currency exchange rates particularly the substantial weakening of the euro, we're adjusting our outlook for fiscal 2012. Compared with fiscal 2011 totals, we now believe that for fiscal year 2012, revenues could increase by about 8% and net earnings per diluted share from continuing operations could grow by 8% to 9%. Thank you for your attention, and we're now ready for your questions.

[Operator:]

[Operator Instructions] And our first question comes from the line of Steve Beuchaw with Morgan Stanley.

[Steve Beuchaw:]

On freestanding centers, I just want to focus there to help everyone. You mentioned the impact. If we could take it back to 2009, there was a fair amount of understanding about negative commentary from ASTRO on the potential impact of these cuts, which were on the order of what we saw in the proposal for this year for freestanding centers. And there was one survey that suggested quite a few centers would close or potentially restrict treatments for non-CMS patients. So I was wondering, in your dialogue so far with ASTRO and potentially ASRO so far, can you characterize what you're hearing in terms of the message to CMS that they want to deliver about the potential impact of these cuts in an effort to try and turn the tide there?

[Timothy E. Guertin:]

Clearly, ASTRO has been speaking with its members. And nearly 50% of freestanding clinics have indicated that they would either need to shut down or consolidate in some way or restrict Medicare patients. So this is a draconian cut and furthermore it's in error. The formula that was used, they adjusted the hours that they had assigned the radiation therapy, but they did not open up the formula. There were a variety of other errors in the formula itself and when you use correct assumptions for the expenses associated with equipment and time and vault expenses and a variety of other things, you wind up with reimbursement rates similar to what they are today. So for all of those reasons, we think that when that evidence is presented to CMS, which, of course, will happen, by ASTRO and by Association of Freestanding Clinics and by Varian and by others, I think that they'll see that there's enough information that they should rectify this change, that it was a mistake to do this. It's a little different than that we saw in 2009 because in 2009, they made assumptions based upon trigger radiation oncology like we were in imaging business. And so, CMS reversed that because MedPAC encouraged them to do so. In this case, we think we have to open up formulas and reacquaint them with how radiation therapy mathematics actually works in the clinic and change a variety of their assumptions. If they don't do that, then yes, the impact is rather severe and cancer patients will suffer. So we expect that a lot of politicians will get involved and will vent their frustration on this kind of behavior on the part of ASTRO because voters will be affected.

[Steve Beuchaw:]

Tim, that's really helpful. One on gross margins in oncology, Elisha. On the last call, you gave us a sense that you could maintain gross margins in oncology at fiscal '12 level going forward and with the cost-cutting programs that we talked about. It looks like in the fourth quarter gross margin in oncology might be a little wider than the third quarter implied by the outlook, are you still in the view that this fiscal '12 level and maybe 44 is a good level to shoot for, for a sustainable gross margin level for oncology?

[Elisha W. Finney:]

Yes, I think 43 to 44, Steve, is a pretty good level. I need to put the caveat in there that we are just seeing unprecedented swings in currency, which are having a major impact of 50 basis points or so. But when I look at the mix of business, the profiting backlog, the geographic mix, the product mix, from where I sit today, I think that 43 to 44 should be sustainable as we hopefully continue to get some cost reductions going forward. But again, currency, geography can change that pretty significantly in any given quarter compared to another.

[Steve Beuchaw:]

And then just one housekeeping question and then I'll drop. MedTek tax for next year for the fiscal year, somewhere from $10 million to $12 million range, would that be about right?

[Elisha W. Finney:]

Well, if I annualized that, and again we're still trying to understand all of the rules in terms of deferred revenue and how installation, warranty and freight and all of those things are going to be treated. But if I just do a very, very rough calculation, taking U.S. sales of oncology plus aftermarket sales of X-Ray and excluding service and applying the 2.3%, it comes to about an annualized pretax number of $20 million. And then, of course, we were taxed after that.

[Operator:]

And our next question comes from the line of Dalton Chandler with Needham & Company.

[Dalton L. Chandler:]

I just wanted to follow up in the oncology orders. I think you said overall, it was up 4% in constant currency. Press release says North America was up 4%. You also gave us -- Europe up 5% in constant currency, Asia up 11% in constant currency. So what's the number I'm missing that gets the average of all that down to 4%?

[Elisha W. Finney:]

Yes, it's the rest of the world was down in double-digits in constant currency about 15% in dollars and that would include primarily Latin America.

[Dalton L. Chandler:]

You said it was about 15% in constant currency?

[Elisha W. Finney:]

Yes, it's a small part of our business. It ranges from about 5% to 7% of the total Oncology business.

[Dalton L. Chandler:]

Okay. And I guess, just to follow up on that, given where the global economy seems to be today, do you think you for the foreseeable future this sort of the mid-single-digit order rate is where we are or do you think there's a potential rebound sooner?

[Timothy E. Guertin:]

Well, yes, you're asking me the $64 million question. Clearly, the impact on capital markets was slower to hit us than it was some other companies. And about the situation with the euro and the situation with Southern Europe and the confusion in the United States over reimbursement rates in Medicare has started to affect capital equipment and us along with it. And so, if we go forward and the euro stays at 120 or north of that, I think we can find ways to accommodate it. So we'll have to look at that. The good news is, I think it is possible to make this business. I've been saying that my target was to make this a $4 billion business over 3 years. I'm not sure I can do it in 3 years, but I'm pretty sure we could still make it the $4 billion company. China, Southeast Asia, Japan, all still are functioning very well. We were going to have to be cautious because of currency volatility in North America and Europe, especially Southern Europe behavior. The global economy is going to make it a challenge for financing in those locations. And their substantial political uncertainty as well. But we're confident in our technology and our market position. Do I think we can do better? You bet. So we are going to compete aggressively for business. We're going to introduce some new products. We're enhancing our team especially in Asia. I think that in this partnership is going to help us. We're going to use price judiciously as a weapon and we're increasing our presence in a lot of countries. We're going to do what we can to protect reimbursement or we have to do more clinical research. I think we have over ideal ways that we can do this. I don't want to specifically tell you how I think 2013 is going to work out because I want the couple of months to see what the euro does and to see what North America reimbursement trends are and to see whether we can get that reimbursement situation turned around. But hopefully by November, I'll have a much better picture of this. But the list of concerns that you have is the same list of concerns that I have and so all we can do is fight back and we're going to fight back in all the ways that I mentioned.

[Operator:]

And our Next question comes from the line of Jason Wittes with Caris.

[Jason Wittes:]

Just to clarify on the guidance. That's FX, but it also sounds like there's a little bit of concern about the U.S. market and especially that 10% of freestanding clinics. I just want to make sure we -- I also understand.

[Elisha W. Finney:]

Jason, let me kind of give you the guidance block, if you will, from the last quarter when we gave guidance for the fiscal year versus the current guidance for the fiscal year. And the FX impact was significant to say the least. When we gave guidance last quarter, the euro was at about 134. As of yesterday it hit about 120. So 10%, 12% decline in just the last 3 months. So pretty significant. What that meant to our top line is we lost about $20 million just due to the euro exchange rates, and the other $20 million or so is from the fact that we have first thought we would get the Maryland or the Saudi revenue for the proton center both in Q4. I just am not certain that the financing for Maryland is going to be all of the I's dotted, the T's crossed and the contracts signed. And so to be conservative, took it out. It really has no impact on EPS because as you know, the first couple of proton deals are going to be at very, very low margins. So the impact from last guidance to this guidance due to FX alone is $0.05 to $0.06.

[Jason Wittes:]

Okay. So that $0.05 to $0.06 is specifically FX related. And then on the top line, you also have the move out of Saudi and Maryland, just to characterize. Okay. So I guess, it sounds like there's pretty much -- and I don't think this is a big surprise, no leverage on the bottom line to be expected this quarter, except maybe from share buyback -- excuse me, for the year?

[Elisha W. Finney:]

For the year, no. In fact, if you include the proton revenue for the year, the RoS, when you pencil this out, it's going to be around 21%. It was 22.7% in the year-ago period. The impact -- you also, you have to back out proton revenue in the fourth quarter of last year. You remember we started the Scripps project and there was a be catch-up of $33 million. So if I just flip out protons year-over-year, it's more like a 1.5 decline in the EBIT margin. And again, a lot of that is currency-driven.

[Timothy E. Guertin:]

Okay. And I'll just add that we've mentioned in the past that we have significant natural hedging, and we do. But the currency, the amount of business that we're doing in Europe in terms of sales combined with the substantial size of the currency swing is just greater than our natural hedge.

[Elisha W. Finney:]

Yes, Q4 is the biggest impact because we have more revenue in Q4 than any other quarter. And of course, the expenses are a little more linear throughout the year.

[Jason Wittes:]

Okay. And just to backtrack on the reimbursement rates, it sounds like you feel there's a pretty strong case here to be made on reversing those trends, which in terms of at least what they said about their freestanding clinics. I guess in the interim, though, I think have you already seen some holdouts? One, have you already seen some holdouts in terms of order rates from the freestanding clinics? But B, as a backdrop, have they actually been that strong this year anyway and was there much incorporated to your guidance to begin with?

[Timothy E. Guertin:]

It's about 20% of North American business freestanding this year and that includes the third quarter. I don't think -- obviously, this could affect the behavior of freestanding clinics in the fourth quarter. Some of them may adopt a wait and see. We'll have to do it. It's not -- I do think that's necessarily a big swing factor for us in the fourth quarter, but will be a problem in 2013 if it doesn't get turned around. So we have logical and meritorious arguments. To the extent that logical and meritorious arguments will affect the U.S. government agency, I think we will win.

[Jason Wittes:]

And I guess just on the same ...

[Spencer R. Sias:]

Jason, this is Spence. Listen, in the interest of fairness to the other analysts who are covering here, we'll try to circle around back to you if we can [indiscernible].

[Operator:]

And our next question comes from the line of Jeremy Feffer with Cantor Fitzgerald.

[Jeremy Feffer:]

Tim, a couple of quarters ago, you mentioned that as you look at U.S. oncology, you're seeing that market evolving more as a replacement market since you're at pretty high level penetration. So given some of the, I guess, CapEx trends that we've seen, are you seeing any extension or delays in hospitals purchasing new equipment?

[Timothy E. Guertin:]

We have definitely seen some hospitals in -- make some delays. But hospital business seems to be growing in the U.S. and they just got good news, they just got told that their reimbursement is going up. So I would expect hospitals to feel better about the situation right now and act accordingly. Have we seen some hospitals delay decisions? Yes, we have, and I'm hoping that those decision slide no further than the fourth quarter.

[Jeremy Feffer:]

Okay. And just very quickly on x-ray. Where specifically are you seeing most of the weakness or is it pretty global?

[Timothy E. Guertin:]

In X-ray, we're talking about what our customers are seeing. And what they're seeing is a global capital equipment, big systems, scanners and X-ray product, X-ray systems and all these kinds of things. The things we sell tubes and panels for, there's just been a global capital slowdown in this area. So in the first part of the year we saw an inventory adjustment. That's sort of ended. Now what we're just seeing is a slowing, a general slowing of business that's affected our business. At the same time, we think our share is growing in panels and X-ray tubes. We think that we're seeing opportunities that we haven't seen before and we're seeing some customers come to us that we haven't had a chance to talk to before. I mentioned Siemens, for example, as an opportunity that's already starting to have some movement. So for all of those reasons, I think we're strengthening our market position. But in this case, the stronger wind was created by kind of a global slowdown in capital equipment

[Operator:]

Our next question comes from the line of David Roman with Goldman Sachs.

[David H. Roman:]

I was hoping team, Tim, if you could comment a little bit and how you're thinking about capital deployment and the context of what is more difficult operating environment. Your reference obviously, the global CapEx slowdown, as well as some broad-based macroeconomic uncertainty. Obviously, there was accelerated share repurchase programs that you did last year, maybe how you're thinking about cash at this point and can you just remind us what your priorities are?

[Elisha W. Finney:]

Sure. Well, and David, you know we have spent -- in fact, we spent more than the cash generated in the U.S. over the last year and share repurchase and returning capital to shareholders. So we're in the enviable position. We have strong cash flow. We have a very conservative balance sheet. And we spent a lot of time thinking about what's the best way to return that cash to shareholders, whether it's a share repurchase, acquisition, and we can be opportunistic on repurchases based on the stock price. But of course, we're still going to be prudent relative to what's going on in the worldwide economy and what our cash position is and what our debt levels are. So no, this is not giving any guidance or indication as to what our plans are, but I think you should anticipate that we will continue to have a share repurchase program, that we have been buying somewhere between 1 million and 1.5 million shares per quarter on average for the last several quarters. And obviously, it increases our return on equity significantly by having lower cash assets and it's something that we'll continue to do.

[Timothy E. Guertin:]

We have a nice line of credit in the U.S. to hold us up. Of course, a lot of our cash is internationally and that's why we made that move. And I'll just speak to the acquisition point. In my view, we're having a recession in the U.S. And if, let's say, austerity wins out over stimulus in this situation, then we can expect this to go on for a while. I think that is going to create opportunities for us in the acquisition arena, if not, in the early part of 2013, but certainly by the latter part of 2013. I think we will see more acquisition opportunities. When you combine that to the fact that in that -- for some companies, this 2.25% tax burden will be lethal, I think that creates opportunities as well. So, Elisha, spoke to the buyback thing, but I'll just speak to the acquisition things and say, I think opportunities will arrive in 2013 and then our cash position puts us in a position to do both buybacks and some kind of prudent acquisitions where they fit with our business.

[Elisha W. Finney:]

And I just want to finalize by saying, just as a reminder, given that we are borrowing at about a 1% aftertax rate, it is significantly accretive to the spending to even be borrowing at this point and spending all of the cash generated in the U.S. to do the buybacks.

[David H. Roman:]

That makes sense. And then, Tim, maybe a follow up for you and your comments about using price judiciously. I guess what I wanted to extrapolate is, has this market sort of gone from an oligopoly to a duopoly given Siemens' retrenchment here. Could you maybe speak to your view on why price competition would be intensifying here? Is that more a function of geographic mix in the market to which you're selling and those will comprise bigger percentage of the growth rate or is there something that's happening in the competitive set that's driving prices lower?

[Timothy E. Guertin:]

Yes. I think mix, geographic mix will make a difference because in Asia and Latin America, there may be -- in the capital pressures exist around the world. And so people may want to have a business that the competition may be especially fierce and maybe some large tenders for which the competition is exceedingly fierce. So we may see that kind of activity. At the same time, price -- the other effect on price is just simply that I think our major competitor will be trying to get share. And we're going to be trying to get share at the same time. Siemens has exited the market that left a hole. It's not a huge hole, but it's a hole and we're all going to try to fill it and that is going to grade especially in developing markets were Siemens was strong. That's going to create the kind of fierce competition. And I think our competitor has made some predictions about the behavior of markets in 2013, and currency helps them in this current situation. And I think they will try to take advantage of that to strengthen their business. We have, of course, our traditional advantages. Our machines are very fast. We have the highest quality of machines. I think we offer superior value proposition to our customers and we'll take advantage of all of those. But I just -- when you have markets that are not growing as fast as they did, you get -- and you have a small number of competitors, they're going to fight and that's what we're going to see here.

[Operator:]

And our next question comes from the line of Amit Bhalla with Citi.

[Amit Bhalla:]

Tim, you generally in your prepared comments, you go into a lot more detail about what's actually happening in the regions for the Oncology business. So I was hoping you could actually just talk through North America and rest of world specifically with regards to Linac volume price and market share in the past quarter, and how those may have been the same or changed given the growth rates you just talked about in the order book?

[Timothy E. Guertin:]

So you're telling me -- you want to understand North America how pricing volume and everything change in North America?

[Amit Bhalla:]

And share.

[Timothy E. Guertin:]

And share, yes. Okay. well, obviously, since this conversation is a direct channel to my competitors, I'm loathe to discuss volumes except to the extent that we already have by revealing the numbers. I will -- on share, I will tell you, that we study electors' releases as I imagine that you do. As a principal competitor, it's very hard to tell sometimes because we have to extract out their acquisitions. We have to extract out their service business, which is -- require some estimation to do that. We're confident that our market share is about the same as it was a year ago excluding the new Proton acquisition for them. We think our strategy to maintain share or gross share is going to work under these circumstances. But if you ask me to give you Linac numbers this year versus last year and volume and price and all that sort of stuff, I'd rather not get into that level of detail because at this point, as you mentioned -- as was mentioned earlier were down at the competitors and I just have to be more careful about what I say than I have in the past.

[Amit Bhalla:]

Would you be willing to just at least say if Linac volume grew or wad decline or stable, could you at least give a qualitative like that? And that's something you've done in the past.

[Timothy E. Guertin:]

It fluctuates a lot from quarter-to-quarter. So let me think about that question. I don't think I'm willing to answer that at this moment.

[Elisha W. Finney:]

Let me just add, Amit, that service is the biggest growth driver in the third quarter.

[Amit Bhalla:]

Okay. And then just sort of like a follow up. You touched upon like kind of what happened in 2009 after the reimbursement rates came out and, yes, there was a little bit of market stagnation. Can you at least just tell us how July has played out? And if you're seeing any benefit from Siemens overseas?

[Timothy E. Guertin:]

We've seen the Siemens effect. They've helped us on some deals. We're thrilled to have them as a partner in their very helpful. But I think there's some situations where we're going to get business that we would not have been able to get business before. So I can't speak to the Siemens thing. I would prefer not to talk about July now. I think I'll make all of that clear when I make my fourth quarter remarks. But I mean it's obviously, we're all going to be watching the way freestanding clinics behave in the next 3 months, and I'll get back to you with that when I have the discussions. And what I'm hoping for is, what I've said, which is we can turn this reimbursement situation around, then 2013 looks nicer.

[Operator:]

And our next question comes from the line of Jeff Johnson with Robert Baird.

[Jeffrey D. Johnson:]

Tim, I want to start with you. Just, I guess, Elisha gave the number that America was down from 15% constant currency on orders in oncology in the quarter. What's going on there? Is it top comps? Is the market slow, share loss? Just how do you quantify that?

[Timothy E. Guertin:]

There's some -- no, it has to do with some large tenders that are happening in those territories and those tenders just did not happen this quarter. They are happening in the future. We might have originally expected they happen this quarter but are happening later. We're going to have to look at those tenders when they come out and decide how we're going to respond to them. But -- so this is just a lack of business, and it has to do with timing. It's not a lack of interest, it's not a loss of share, it's just share, it's just timing.

[Jeffrey D. Johnson:]

So outside of Brazil, your orders in Australia and some of those other markets and maybe you didn't mention doing okay or ...

[Elisha W. Finney:]

Well, it's such a small market. I believe was down in the quarter, but again just doesn't mean anything in one given quarter. But you are correct, we include Australia and the rest of the world numbers.

[Jeffrey D. Johnson:]

Fair enough. And then, Elisha, did I hear you were right on guidance so it sounds like in the revenue change that you're making the guidance really the only 2 things their FX and proton, there's no operational change outside of proton implied in your revenue guidance?

[Elisha W. Finney:]

Nothing significant. I mean obviously, we would have like to have made of that up in Q4, but where the currency is and even the order rate in Q3 particularly for X-ray, which is a short cycle business. Even though it's going to be tougher to do. But $20 million for proton and $20 million for FX is 95%, 97% of the impact.

[Jeffrey D. Johnson:]

And then last question for me. I'm jumping between call here, so I don't think I'm repeating here. But on the manufacturing cost side, I know you guys have been making some efforts there to take cost out of the process both manufacturing and I guess more assembly than anything. Some of those efforts I think were focused on sourcing from alternate suppliers or maybe even do was suppliers things like that, but you need to be at regulatory approval there. If you do change out a part or something, I mean, are there any efforts that are close to being done at this point? How do think that plays out over the coming quarters?

[Elisha W. Finney:]

We're going -- we'll never be done. This is something we are just going to chip away at dollar by dollar by dollar from now until the end of time, Jeff, and we did made good progress in the quarter. It came a lot from installation. You'll see that we did exceed the state estimates. Some of that was literally getting some acceptance revenue in sooner than we had anticipated, and I think that was the result of getting these installs improved. We have improvements in warranty, we had improvements in purchasing costs in doing some bulk purchasing in factory efficiency, it was just a little bit of gross across the board, but we're not going to take our eye off the ball on this, sort of something that we'll just keep at.

[Jeffrey D. Johnson:]

Still feel comfortable with taking that 15,000 to 20, out for Linac kind of range?

[Elisha W. Finney:]

That's what we're shooting for.

[Operator:]

And our next question comes from the line of Anthony Petrone with Jefferies.

[Anthony Petrone:]

One reimbursement and then one on oncology, one on guidance. For reimbursement, Tim, I know that the stats that have been thrown out there with the IMRT cuts that proposed. You mentioned 50% of the freestanding clinics can potentially go out of business. In your mind, what is the threshold of where the cut would have to settle so that won't be the case? And if it is the case and we're sort of that threshold that's too high, do you see more rapid consolidation of freestanding clinics into hospitals?

[Timothy E. Guertin:]

Under no circumstances should freestanding clinic reimbursement be below hospital reimbursement, and that's what happened. And I think that the idea was that hospitals have all of this overhead and everything. But the fact is that freestanding clinics have a lot of overhead. For example, in staffing issue, usually hospitals have a lot more clinics at a particular location. A freestanding clinic may only have one. So they have extra headcount associated with that. They may have resources that are not shared and the way they are with hospitals. And they may not have the loading that a hospital does because a hospital gets referred from its own institution. So they may have fewer patients per day. So for all of these reasons, I believe freestanding reimbursement should be higher than it is for a hospital, and under no circumstances should it be lower than what a hospital gets. So if you asked me the question where should it settle, I think it should settle above where hospitals are, but the amount above, we're going to have to do mathematically. And we're going to make our recommendations -- we, and other people are going to go back to CMS and were going to tell them. When we do the math, it comes out like this and see what they have to say.

[Anthony Petrone:]

Sure. That's helpful. And then just in terms of consolidation there, do you think some clinics will preemptively look to the consolidator consumed by hospital or is this still going to be wait and see until November?

[Timothy E. Guertin:]

Well, the rules are kind of complicated. If you're a freestanding clinic and you get bought by a hospital but you're not in the physical -- you're not at the physical location of the hospital, then you're still a freestanding clinic. So -- but on the other hand, hospitals might be able to consolidate planning services and do things like that to try and reduce cost. So -- and if some freestandings close, then patients will either not be treated, which is of course, the worst fear, or they're going to have to make trips into hospitals to be treated. That will increase the workload of the hospitals and the hospitals will have to respond by doing something about it. Will they buy used equipment or will they buy new equipment? I really don't know. As you get into this imponderable territory, if you have a train wreck, what will happen in response of the train wreck? But honestly, I just can't bring myself to believe that CMS must stick to this strategy when they understand just how erroneous the math was.

[Anthony Petrone:]

Just on oncology quick ones here. My understanding is that all the information management system you have, is that already fully communicating with the Siemens Linac install base, and can you just provide an update on the approval process for UNIQUE in China?

[Timothy E. Guertin:]

We can communicate good some Siemens equipment. Other than Siemens equipment, we cannot. That is actually one of the things that we're trying to fix with this arrangement with Siemens their providing us with information that we did not have before and we are going to talk at ASTRO. If you come to ASTRO, we'll be able to give you better timing on this and share show you what we've got in accomplishment. Obviously, that was one of the things we hope to accomplish in our relationship with Siemens was to do that. So a bit more formal announcements about what we're able to do there. All we're telling customers is that we went from a situation in which we did not have the cooperation of Siemens in terms of talking to their equipment to a situation in which we do have the cooperation of Siemens to talking to their equipment, and we targeted ASTRO as the time that we would give specific details on that.

[Operator:]

And our next question comes from the line of Junaid Husain with Dougherty & Company.

[Junaid Husain:]

Elisha, on the guidance front, just so this is clear in my head. I know it's hard to figure out the directionality of currency, but does the new guns reflect currency rates where they are today or the does it reflect where you think currency could go by the end of fiscal year?

[Elisha W. Finney:]

No, no. I'm not in the business of predicting it, Junaid. So last quarter, again it was about $1.34 when we gave the guidance. I mean -- we put a range so that I could tolerate a couple of percentage points directional change in either way. But it was just 10% or 12%. We certainly can give guidance expecting that kind of a range. So it's really based on about where we are today at the 120, 121 level that we're looking forward into Q4.

[Junaid Husain:]

And then, Tim, on the proton side, with the proposed lower reimbursement rates for protons, what are conversations been like with the centers that have been contemplating making an investment in proton technology and then what you said has been tougher for them to get financing, you mentioned Maryland.

[Timothy E. Guertin:]

Remember, Maryland, Emory, all of these are freestanding clinics. They negotiate their rates with the local Medicare -- they're considered local and they get a rate assigned to them as a freestanding clinic, a local and they negotiate those rates. For hospitals, the CMS and that with the CMS proposal is about hospitals. They use 3 institutions

[Junaid Husain:]

Got you. And then, Tim, last question for you. I think you mentioned that Latin America has been a tad weak. And you mentioned or you alluded to some government tenders. I believe that government tender is Brazil, and is there anything you can tell us about what's going on with this tender?

[Timothy E. Guertin:]

There is a significant tender coming up in Brazil. I expect it to come out in the fourth quarter and we'll take a look at it at that time. I can't really speculate until I see it, what the response will be. Obviously, it's going to be us versus Elekta. Elekta will be anxious to get it. This is going to be one of those battles that I mentioned earlier in answering questions.

[Junaid Husain:]

And how many linear accelerators?

[Spencer R. Sias:]

This is Spencer. I just want to get everybody in. The answer is something like 80 accelerators, but we want the next person to have a chance to ask a question.

[Operator:]

And our next question comes from the line of Tycho Peterson with JP Morgan.

[Tycho W. Peterson:]

Just first question on numbers for, Elisha. So if we look at this quarter, you'd be by $0.02, you're lowering guidance depending on where consensus comes out by about $0.10 in the fourth quarter. So looks like there's about $0.12 net there. You said currency about $0.06 of that. I'm just trying to reconcile what the rest of that would come from?

[Elisha W. Finney:]

No. As I mentioned, I mean we just, it was timing, it was a good news that we got some revenue and profits sooner than we had expected, which came into Q3 and then there was just timing of expenses, which is always the case. So for the year, the midpoint is coming down by the $0.06 and that is the currency impact that we talked about.

[Tycho W. Peterson:]

And then, Tim, on your strategy for developing markets, I mean you talked about using price judiciously as a weapon. I mean obviously, cutting price in emerging markets to be gain share can be somewhat dangerous. Can you comment a little bit more about where you see TrueBeam going with those customers, when UNIQUE starts to have an impact. I'm just -- I mean, the concern here is that you're going to start cutting very quickly on price and not be able to recover?

[Timothy E. Guertin:]

So I'll begin by reminding everyone that there are a lot of things we're going to do before we resort to price. We want to have superior products. We want to have the best people. We're going to add staffing in locations. We are, so that we have greater presence, we're going to use the Siemens partnership. And so there's a variety of things that were going to do. All I was indicating there is that I expect the -- in a lot of situations, maybe where it used to be, Varian in versus Siemens. Now it's always going to be Varian versus Elekta, and I expect some of those battles to be difficult. Some customers put price high on their list of considerations. The people put pricing low on their list of considerations. Where pricing is not number one on the consideration, I think we have a good chance to be able to hold price or maybe get superior pricing. So far, oncology order pricing is holding and -- but I'm just saying, we're going to have to be in this market under these conditions, I think all of the players are going to be very aggressive about share. We're going to be aggressive about share. But you should not -- when I hear that, when I say that, you should not necessarily read into that the price is the first weapon were going to use.

[Elisha W. Finney:]

And I'll just add to that, that our service business has grown in low-double-digits year-to-date so every socket we capture is very important to on a go-forward basis. I'm walking in that annuity.

[Tycho W. Peterson:]

And then last one, on the position fee schedule, I guess 2 things

[Timothy E. Guertin:]

Well, the hospital formula is quite different than the freestanding formula, and this is one of the points that we made is that they're calculated on different basis. And so, I wouldn't necessarily assume that a formula that was used for freestanding clinics would result in the same changes for a hospital base. In terms of -- what was the first part of your question again?

[Tycho W. Peterson:]

Are you assuming a repeat of the 12 '09 for this current quarter in terms of the freestanding market essentially freezing here until we have resolution over the physician fee schedule?

[Timothy E. Guertin:]

I think that there are some freestanding sites that have enough patients that their confidence will be reasonably high, that they can proceed. And I don't think freestanding clinics really believe, I think that a lot of freestanding people believe that this condition -- that there's not going to be any situation imaginable per hospitals wind up being above the compensation for freestanding clinics. I don't think anybody thinks that situation is going to stand and that at the very, very, very worst, and this would still be wrong, that freestandings would be the same as hospitals and under -- if you do the math under those considerations, I think that a lot of them are still going to think that there's opportunity here. However, caution will be probably more likely in the fourth quarter. We've sort of taken, as we looked at our sales situation, we try to take that into account, but we'll have to see how people behave on the orders front. I think in the end, some -- yes, you should expect some caution on the part of buyers but people are still talking to us, people are still interested. So -- and there's still need for these freestanding clinics.

[Sean D. Lavin:]

And do you think the 6% hospital increase holds or is there a risk that, that gets dialed back?

[Timothy E. Guertin:]

We've done all the -- we do on the average, we calculated, there's 2. I think some of the codes are up in the 5 to 6 category, but we calculated it a 2. We think that's going to hold. We think the mathematics for that is certain. As I said, I think issue is on the freestanding side. There also, I'll just mention, the data that was used was based upon internet data and brochures and things like that. It wasn't based upon a study. And ordinarily, the rules that require that a study be properly conducted. So for all of those reasons, we think that will be reversed. But on the hospital side, I don't see anything that would cause me to think that, that 2% will drop.

[Operator:]

Ladies and gentlemen, with no further questions in the queue, this concludes today's question-and-answer session. I would now like to turn the call back over to Mr. Spencer Sias for closing remarks.

[Spencer R. Sias:]

Thank you. Thank you all for participating. And again we're sorry to get the call started late, but we're glad we got a chance to have all of you and a chance to answer your -- or ask your questions. A 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 call 1 [phone] from inside the U.S. or 1 [phone] from outside the U.S. and answer confirmation code number 56507486. A telephone replay will be available till 5 p.m. this Friday, July 27. Thank you.

[Operator:]

Ladies and gentlemen, we thank you for your participation in today's conference. This concludes today's presentation and you may now disconnect. Have a good day.