Saturday, January 26, 2013

Varian Medical Systems Research and Analysis

Varian Medical Systems (NYSE: VAR) offers an attractive long term picture but it also contains some execution risk. In fact, its mix of profit drivers and stock specific risk are so rich and diverse that probably the best way to start looking at it would be via a SWOT analysis. In summary, there are many reasons to like the stock but there are also risks. I think this stock will be great for a large diversified portfolio but less attractive for the kind of focused (20-30 stock) GARP based portfolio that I run. Nevertheless I may take a half position here.

  • Along with Elekta it dominates the radiation oncology market (77% of recent orders). It also has an attractive X-Ray division (16%), of which it has 20-25% market share that can grow over time, and a solid security division (7%), which is involved with things like cargo screening.
  • Current book to bill is 1.1x indicating strong demand even in a slow economy.
  • It is developing a game changing proton therapy treatment which will take a few years to come to fruition.
  • It recently received 510k clearance for its ‘Edge’ radiosurgery suite and will be aggressively marketing it in 2013. This threatens to take share from Accuray Incorporated’s (NASDAQ: ARAY) CyberKnife system, and market awareness of this product may be the reason for Accuray’s poor performance lately. Accuray recently gave a nasty downgrade to sales estimates and it it will face increased competition from VAR's edge in the future. Moreover, if emerging markets are the growth opportunity then it will have to demonstrate a cost effectiveness that small companies are rarely able to achieve with low volume production
  • It is exposed to a sector of the economy least likely to be affected by a slowdown in the BRICs.
  • It has already lost share to surgery in prostate cancer as robotic based surgery becomes more fashionable. Meanwhile the likes of Intuitive Surgical (NASDAQ: ISRG) are aggressively trying to expand the procedures that its systems are popularly used in. Intuitive has achieved a strong position in prostatectomies and growth in colon surgery and hysterectomies but its challenge remains the same. These types of procedures tend to be without significant variance and clinics will find it cost effective to increase volumes by using the da Vinci system. However it is not clear that general surgeons (who perform a much wider range of procedures) will encourage clinics to buy the system.
  • Continual need for innovation creates execution risk, R&D risk and costs EPS.
  • The developed and lucrative US market represents a replacement cycle market for VAR unless it can release a new breakthrough product
  • Emerging markets (where the growth will primarily come from) tends to be lower margin
  • The long term development of proton therapy offers exciting technological  advantages (better targeting, less invasive) and opens up new categories for treatment
  • VAR want to expand radiation therapy in lung cancer and this represents a huge future opportunity in emerging markets. According to VAR, palliative care (with radiation oncology) makes up 80% of lung cancer treatment and only 20% is for curable intent. VAR want to get those figures to 50/50.
  • It has strong emerging market prospects, with notable under provision of linear accelerators (Linacs) in the BRICs. For example the company quotes 2,234 linacs currently in the BRICs but sees the potential for 4,100.
  • Growing software and services sales offer the prospect of margin expansion in future.
  • VAR replaced its partnership with General Electric by signing a partnership with Siemens (NYSE: SI). Siemens is pulling out of radiation oncology but has a 2000 strong installed base with which VAR can now target for replacement. It can also sell its information systems into that installed base as they are now compatible with the Siemens legacy systems. 
  • Austerity measures threaten more severe reimbursement issues for the company, and a large part of its sales are to government bodies
  • Will proton therapy ever be commercially viable? VAR is aiming for solutions in the $25-50 million range but even if they get there, will other less expensive treatments take spending dollars away?
  • Will the loss of the GE deal hurt VAR?
  • Will robotic surgery steal its thunder?
  • Advancements in cancer treatments elsewhere may reduce demand for iits products
The VaR at VAR?

Okay not a technically correct subheading, but you know what I am getting at! There are a lot of opportunities here and I also liked the look of the recent healthcare numbers from GE so don’t be surprised if VAR has some near term upside from clinics being more willing to undergo capital outlays.
On the other hand there are significant risks too. The biggest one probably relates to its plans for proton therapy. Committing huge amounts of investment and giving up EPS is one thing, but VAR is making a bet on being able to make this treatment commercially viable and that it will become a gold standard of cancer treatment. Furthermore, the specter of reimbursement issues always hangs over companies selling expensive capital machinery in the US and longer term threats from the robotic surgery companies like Intuitive also present potential competition.

On balance I think the stock is attractive for long term investors who want a health care stock for the risk end of their portfolio.

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