In some respects, it is a little surprising that Varian Medical (NYSE: VAR ) is near an all-time high. Revenue and order growth haven't been all that robust lately, rivals like Accuray (NASDAQ: ARAY ) and Elekta appear to have some renewed vitality, and reimbursement in the U.S. is still choppy. Then again, we're talking about a company that has more than 50% global installed share in radiation oncology systems, a long record of 20%-plus returns on invested capital, and a well-deserved reputation as a "fast follower" with good technology, strong service, and demonstrated reliability.
It's hard to call Varian cheap by some metrics, particularly given that competition and a shift toward more OUS business may make it more difficult to produce the same degree of free cash flow leverage as in the past. On the other hand, we're talking about an undisputed leader in its field that, while perhaps not necessarily priced to beat the S&P 500 year in and year out, can nevertheless still produce some decent returns for investors.
Radiation oncology: Replacements here, growth over there
Radiation oncology remains an effective and relatively common tool in treating cancer, with more than 60% of cancer patients getting radiation therapy at some point. That has created an equipment market worth about $4.75 billion a year worldwide. It also is a very concentrated market, with Varian, Elekta, and Accuray accounting for more than 90% of the market.
The U.S. market has grown and matured to a point where it is largely a replacement market. Although hospitals/treatment centers are willing to adopt new technologies, it is unlikely that overall market growth is going to exceed the low-to-mid single digits. Overall market growth may be modest, but it remains an important business to hospitals -- radiation oncology is a consistent, high-margin source of revenue for hospitals and that has led hospitals to prize reliable, versatile systems that maximized throughput.
The market outside the U.S. is quite a bit different. While western Europe is much like the U.S. in terms of being largely a replacement-driven market, countries like China and Brazil represent significant growth opportunities as rising incomes and health care spending bring radiation oncology into the picture as a viable treatment alternative. The overall global growth rate for radiation oncology equipment is in the mid-to-high single digits, but particular markets like China can offer double-digit growth opportunities for many years to come.
Where Varian fits
Varian has built itself into the premier company in the space. Varian is not necessarily first to the market with new technologies, but they are typically a "fast follower" with technologies like the image-guided TrueBeam. Likewise, while Varian's systems are not always the best in all aspects (Accuray's systems generally offer superior accuracy and dose distribution), they often emerge on top when factoring in system reliability and throughput (treatment times and system reliability have been significant challenges for Accuray).
Varian has about 70% of the U.S. installed base, and while Elekta is a stronger rival in Europe, the partnership between Varian and former radiation oncology rival Siemens is leading to share growth in Europe as Varian replaces more former Siemens installations than Elekta. When it comes to the emerging markets, the market is a little more open as neither Varian nor Elekta are really all that far apart on pricing.
There will always be challenges
Varian's status as the big dog in the yard doesn't immunize it from challenges. Elekta has stepped up its game and offers some strong software to augment its systems (useful in planning the radiation treatment). Accuray has also cleaned up its act, with management changing the sales strategy, significantly improving system reliability, and introducing new systems (the CyberKnife M6 and Tomo H) at last year's ASTRO meeting.
It will be some time before Varian needs to worry about Accuray -- Accuray has good technology, but it's not well-suited for "workhorse" status yet, and the majority of radiation centers are one- or two-vault sites. The bigger near-term threat may well be from reimbursement. Although reimbursement changes in 2013 have been generally more favorable than feared, there is ongoing pressure on less complex cases. These make up the majority of Varian's bread-and-butter applications (as opposed to Accuray, which is more oriented toward complex cases), and with more "watchful waiting" in cancers like prostate cancer and new chemotherapies on the market Varian may see some pressure.
The bottom line
All told, though, I believe Varian is well-positioned to continue its run at the top of the sector. The company's systems are flexible and cost-effective, and also generate lucrative service contracts. In addition, proton therapy is an emerging opportunity to augment growth in developed markets like the U.S. and Western Europe. I'm currently projecting long-term revenue and cash flow growth of 5% for Varian, which supports a fair value in the mid-$70s.
Other metrics like EV/EBTIDA and EV/revenue suggest the shares are somewhat undervalued compared to other high-end med-tech companies like Medtronic. There's also a potential M&A angle here, though I'm not sure Siemens, Philips, or General Electric (all of which have tried and failed in radiation oncology) are chomping at the bit to get back in. While the DCF analysis doesn't suggest tremendous undervaluation, it still suggests Varian can generate returns in the same ballpark as the S&P 500 and looks at least like a decent hold for long-term investors.
Medical technology is innovative, but health care's still pricey
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