VAR: INITIATING COVERAGE OF A UNIQUE GLOBAL ONCOLOGY FRANCHISE
Summary:
We are initiating coverage of Varian Medical Systems (VMS) with an Buy rating. VMS is the leading manufacturer of equipment for treating cancer with radiation and manufactures x-ray tubes for the diagnostic
imaging market. VMS's 1998 revenues were $542 million. Varian's oncology systems encompass linear accelerators that deliver external beam radiation for treating cancer, and a full line of ancillary products and services to enhance therapy as well as manage patient
records and billing.
Highlights:
* Varian Medical Systems is the surviving entity subsequent to the break-up of conglomerate Varian Corporation into its
three component businesses (the others are semi-conductors and instruments). Regular way trading of the new stand alone healthcare business began April 5th.
* Varian Medical Systems (VMS) established the radiation oncology market in 1959, and remains today the global market leader in the $500 million radiation oncology equipment market with over 70% market
share in the United States, and over 50% share worldwide.
* VMS's oncology franchise is built around its Linear Accelerators (LINACS). LINACS are three-ton systems that deliver radiation into the body non-invasively by an external beam. LINACS typically sell for
in excess of $1 million per unit, and require a dedicated facility with eight-foot walls.
* Varian has successfully leveraged its position in radiation oncology to sell through a suite of ancillary hardware, software
and systems based products that provide an integrated approach to cancer treatment. Ancillary product sales have been growing at close to 20%, and consituted approximately 35% of overall sales in 1998. Ancillary products, particularly the software component, carry a higher than corporate average blended gross margin, and so have a
magnified benefit on the bottom line as they continue to expand as a percentage of sales.
* We are projecting 6% top-line growth for VMS in fiscal September 1999 to $576 million and EPS of $1.38 excluding one-time charges. Our 1999 estimates are $618 million and $1.52. Using 11% earnings growth, and our small cap average 40% premium to growth, we are establishing a $23 12-month price target or 15x our forward year estimate. This
represents a 25% increase from current levels, and would put the company in the mid-range in terms of multiple relative to comparable capital equipment companies.
Analysis:
The Global Market Leader in Radiation Oncology
Approximately 1.3 million patients in the US each year are diagnosed with cancer, and 50% of these cancers will be treated with radiation during the course of therapy. Varian established the radiation oncology market in 1959 with the first commercial systems, and remains today the global market leader in the $500 million radiation
oncology equipment market with over 70% market share in the United States, and over 50% share worldwide. Varian's oncology franchise is built around its Linear Accelerators (LINACS). LINACS are three-ton systems that deliver radiation into the body non-invasively by an external beam. LINACS sell for in excess of $1 million per unit, and
require a dedicated facility with eight-foot walls.
Few Competitors. High Barriers To Entry
Manufacturing LINACS requires significant capital investment and manufacturing expertise - it took Varian 15 years to do so profitably. As a result, most of Varian's competitors have exited the business over the last twenty years. Today, there is only one significant competitor to Varian globally in its core business, Siemens, a German
conglomerate that has a broad based business in medical capital equipment. Both GE and Phillips exited the business in the last two years, which has led to a stabilization of the market, particularly in the US. The market for LINACS in the US is mature, and driven by
the replacement cycle (systems can last upwards of 20 years). Varian's international sales in the core LINAC business have been more robust, growing at over 10%, and market expansion overseas continues to
represent a signficicant, potential growth driver going forward.
Leveraging Radiotherapy Equipment to Manage the Patient
In addition to international growth, Varian has also been successful at leveraging its position in radiation oncology to sell through a suite of ancillary hardware, software and systems based products that provide an integrated cancer treatment approach. These products which include enhanced radiation treatment, patient outcomes and
billing management, and servicing of the installed base can add in excess of $500,000 to the base cost of Varian's LINACS. Ancillary product sales have been growing at close to 20%, and consituted approximately 35% of overall sales in 1998. Ancillary products,
particularly the software component, carry a higher than corporate average blended gross margin, and so have a magnified benefit on the bottom line as they continue to expand as a percentage of sales.
Varian also manufactures x-ray tubes (20% of overall sales) as an OEM supplier to the diagnostic imaging. Varian is a market leader, with about 25% share of a $500 million market. X-ray tubes does not generate top line growth, but generates significant cash, and carries above corporate average margins. Varian is attempting to leverage this business through marketing an internally developed digital x-ray technology that is in the early stages of commercialization.
Recommendation
We expect that Varian can grow the top-line in the mid-single digits, with upside potential if the US business remains as strong in 1999, and international growth continues. While Varian is a lean operation, we do anticipate modest operating leverage from being run as a stand-alone, as well as from the product mix continuing to shift
toward software based products. We are projecting 6% top-line growth for VMS in fiscal September 1999 to $576 million and EPS of $1.38
excluding one-time charges. Our 1999 estimates are $618 million and $1.52. Using 11% earnings growth, and our small cap average 40% premium to growth, we are establishing a $23 12-month price target or 15x our forward year estimate. This represents a 25% increase from current levels, and would put the company in the mid-range
in terms of multiple relative to comparable capital equipment companies.
Risks
Choppy Sales and Earnings
Due to the nature of its high-ticket capital equipment business, VMS's results are difficult to project on a quarterly basis. The company has limited visibility on quarterly results until the end of the quarter, when the final installations are made. A shifting of only several units from one quarter to the next can have a material impact on the
quarters results. We have tried to take this into account when setting our expectations, and note that this situation is not unique to VMS, but exists for each of the stand-alone capital equipment companies.
Initial Results Clouded By One-Time Charges
Based on standard accounting rules, Varian Medical Systems as the remaining entity of the just completed triple-spin will be allocated all costs that cannot be directly attributed to the two other companies. This could constitute up to 80% of corporate costs pre-transaction, and could have a significant negative impact on reported results in the fiscal second quarter. These are one-time charges which have yet to be ascertained, and should not impact the
ongoing business of Varian Medical Systems.
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