Washington, D.C. 20549

 

 

FORM 10-Q

 

ý                                 QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended December 31, 2004

 

or

 

o                                 TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                          to                         

 

Commission File Number 1-7598

 

VARIAN MEDICAL SYSTEMS, INC.

(Exact Name of Registrant as Specified in Its Charter)

 

Delaware		94-2359345
(State or other jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification Number)
3100 Hansen Way, Palo Alto, California		94304-1030
(Address of principal executive offices)		(Zip Code)
(650) 493-4000
(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  ý  No  o

 

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes  ý  No  o

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 133,558,551 shares of Common Stock, par value $1 per share, outstanding as of February 3, 2005.

 

www.varian.com

(NYSE: VAR)

 

 

VARIAN MEDICAL SYSTEMS, INC.

 

FORM 10-Q

 

TABLE OF CONTENTS

 

Part I.	Financial Information
Item 1.	Condensed Consolidated Financial Statements (Unaudited)
	Condensed Consolidated Statements of Earnings
	Condensed Consolidated Balance Sheets
	Condensed Consolidated Statements of Cash Flows
	Notes to the Condensed Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
Part II.	Other Information
Item 1.	Legal Proceedings
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.	Defaults Upon Senior Securities
Item 4.	Submission of Matters to a Vote of Security Holders
Item 5.	Other Information
Item 6.	Exhibits
Signatures
Index to Exhibits

 

2

 

PART I

 

FINANCIAL INFORMATION

 

VARIAN MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS

(Unaudited)

 

		Three Months Ended
(In thousands, except per share amounts)		December 31, 2004			January 2, 2004 (1)
					(As Adjusted)
Revenues:
Product		$	248,171		$	227,808
Service contracts and other		50,785			39,157
Total revenues		298,956			266,965
Cost of revenues:
Product		145,586			134,746
Service contracts and other		28,186			25,510
Total cost of revenues		173,772			160,256
Gross margin		125,184			106,709
Operating expenses:
Research and development		18,368			17,604
Selling, general and administrative		46,190			44,472
Total operating expenses		64,558			62,076
Operating earnings		60,626			44,633
Interest income		1,958			1,648
Interest expense		(1,505		)	(1,215		)
Earnings from operations before taxes		61,079			45,066
Taxes on earnings		20,770			15,780
Net earnings		$	40,309		$	29,286
Net earnings per share:
Basic:		$	0.30		$	0.22
Diluted:		$	0.29		$	0.21
Shares used in the calculation of net earnings per share:
Weighted average shares outstanding - Basic		133,985			136,029
Weighted average shares outstanding - Diluted		139,938			142,121

 

(1) Certain amounts for the three months ended January 2, 2004 have been adjusted to reflect the Company’s change from the last-in, first-out (“LIFO”) method to the first-in, first-out (“FIFO”) method of accounting for inventories as described in Note 3. This change increased basic net earnings per share by $0.01 and had no impact on diluted net earnings per share for the three months ended January 2, 2004.

 

See accompanying notes to the consolidated financial statements.

 

3

 

VARIAN MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

(In thousands, except par values)		December 31, 2004			October 1, 2004 (1)
					(As Adjusted)
Assets
Current assets:
Cash and cash equivalents		$	226,089		$	239,470
Short-term marketable securities		98,539			112,478
Accounts receivable, net		285,064			288,663
Inventories		163,539			144,389
Prepaid expenses and other		41,467			29,454
Deferred tax assets		81,130			81,130
Total current assets		895,828			895,584
Property, plant and equipment, net		91,255			85,377
Long-term marketable securities		39,663			40,970
Goodwill		112,653			112,653
Other assets		53,863			46,056
Total assets		$	1,193,262		$	1,180,640
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable		$	57,966		$	59,639
Accrued expenses		262,087			255,519
Current maturities of long-term debt		5,349			5,250
Product warranty		40,685			40,654
Advance payments from customers		104,548			100,277
Total current liabilities		470,635			461,339
Long-term accrued expenses and other		42,355			41,889
Long-term debt		55,733			53,250
Total liabilities		568,723			556,478
Commitments and contingencies (Note 8)
Stockholders’ equity:
Preferred stock of $1 par value: 1,000 shares authorized; none issued and outstanding		—			—
Common stock of $1 par value: 189,000 shares authorized; 133,543 and 134,045 shares issued and outstanding at December 31, 2004 and at October 1, 2004, respectively		133,543			134,045
Capital in excess of par value		143,721			133,985
Deferred stock compensation		(707		)	(1,110		)
Retained earnings		347,982			357,242
Total stockholders’ equity		624,539			624,162
Total liabilities and stockholders’ equity		$	1,193,262		$	1,180,640

 

(1) Amounts as of October 1, 2004 have been derived from audited financial statements as of that date except that certain amounts have been adjusted to reflect the Company’s change from the LIFO method to the FIFO method of accounting for inventories as described in Note 3.

 

See accompanying notes to the consolidated financial statements.

 

4

 

VARIAN MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

		Three Months Ended
(In thousands)		December 31, 2004			January 2, 2004 (1)
					(As Adjusted)
Cash flows from operating activities:
Net earnings		$	40,309		$	29,286
Adjustments to reconcile net earnings to net cash provided by operating activities:
Tax benefits from employee stock option exercises		9,298			8,590
Depreciation		5,208			5,354
Provision for doubtful accounts receivable		560			297
Loss on disposal of property, plant and equipment		67			109
Amortization of intangibles		1,288			663
Amortization of premium/discount on marketable securities, net		176			410
Amortization of deferred stock compensation		403			263
Deferred taxes		(37		)	3,090
Net change in fair value of derivatives and underlying commitments		(2,710		)	(1,032		)
Income on equity investment in affiliate		(563		)	—
Changes in assets and liabilities:
Accounts receivable		15,944			32,897
Inventories		(19,952		)	(7,217		)
Prepaid expenses and other current assets		926			1,071
Accounts payable		(3,309		)	(1,815		)
Accrued expenses		(9,063		)	(23,805		)
Product warranty		(194		)	1,277
Advance payments from customers		2,885			9,325
Long-term accrued expenses and other liabilities		(332		)	(1,280		)
Net cash provided by operating activities		40,904			57,483
Cash flows from investing activities:
Proceeds from maturities of marketable securities		15,070			11,600
Purchase of businesses, net of cash acquired		—			(34,763		)
Purchases of property, plant and equipment		(8,581		)	(4,009		)
Proceeds from disposal of property, plant and equipment		26			10
Increase in cash surrender value of life insurance		(5,567		)	(4,276		)
Note receivable from affiliate		(750		)	—
Note receivable from other		(875		)	—
Other, net		(806		)	(662		)
Net cash used in investing activities		(1,483		)	(32,100		)
Cash flows from financing activities:
Repurchases of common stock		(60,797		)	(34,929		)
Proceeds from issuance of common stock to employees		11,164			12,875
Repayments of bank borrowings		(16		)	—
Net cash used in financing activities		(49,649		)	(22,054		)
Effects of exchange rate changes on cash and cash equivalents		(3,153		)	(3,186		)
Net increase (decrease) in cash and cash equivalents		(13,381		)	143
Cash and cash equivalents at beginning of period		239,470			210,448
Cash and cash equivalents at end of period		$	226,089		$	210,591

 

(1) Certain amounts for the three months ended January 2, 2004 have been adjusted to reflect the Company’s change from the LIFO method to the FIFO method of accounting for inventories as described in Note 3.

 

See accompanying notes to the consolidated financial statements.

 

5

 

VARIAN MEDICAL SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Description of Business

 

Varian Medical Systems, Inc. and subsidiaries (the “Company” or “VMS”) designs and manufactures advanced equipment and software solutions for treating cancer with radiation, as well as high quality, cost-effective X-ray tubes for original equipment manufacturers, replacement X-ray tubes and flat-panel digital subsystems for imaging in medical, scientific and industrial applications.

 

Fiscal Year

 

The Company’s fiscal year is the 52- or 53-week period ending on the Friday nearest September 30.  Fiscal year 2005 is the 52-week period ending September 30, 2005, and fiscal year 2004 was the 53-week period ended October 1, 2004. The fiscal quarter ended December 31, 2004 was a 13-week period and the fiscal quarter ended January 2, 2004 was a 14-week period.

 

Basis of Presentation

 

The condensed consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the Securities Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. These condensed consolidated financial statements and the accompanying notes are unaudited and should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended October 1, 2004. In the opinion of management, the condensed consolidated financial statements herein include adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the Company’s financial position as of December 31, 2004 and January 2, 2004, results of operations and cash flows for the three months ended December 31, 2004 and January 2, 2004. The results of operations for the three months ended December 31, 2004 are not necessarily indicative of the operating results to be expected for the full fiscal year or any future periods.

 

Stock Split

 

On June 14, 2004, the Company’s Board of Directors declared a two-for-one stock split in the form of a 100% stock dividend. The distribution of the shares was made on July 30, 2004 to stockholders of record as of June 30, 2004. Unless otherwise stated, all references in the financial statements to the number of shares and per share amounts of the Company’s common stock have been retroactively restated to reflect the increased number of shares resulting from the two-for-one stock split.

 

Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

 

Stock-Based Compensation

 

The Company accounts for stock-based employee compensation arrangements under the intrinsic value method of accounting as defined by Accounting Principles Board Opinion No. 25 (“APB 25”), Accounting for Stock Issued to Employees and related interpretations, and complies with the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure.  Under APB 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of the Company’s stock and the exercise price.

 

6

 

The following table illustrates the effect on net earnings and earnings per share if the Company had accounted for the stock-based employee compensation under the fair value method of accounting:

 

		Three Months Ended
(In thousands, except per share amounts)		December 31, 2004			January 2, 2004
					(As Adjusted See Note 3)
Net earnings, as reported		$	40,309		$	29,286
Add: Stock-based employee compensation expense included in reported net earnings under APB No. 25, net of related tax effects		266			171
Deduct: Total stock-based employee compensation determined under fair value based method for all awards, net of related tax effects		(5,560		)	(4,496		)
Pro forma net earnings		$	35,015		$	24,961
Net earnings per share — Basic:
As reported		$	0.30		$	0.22
Pro forma		$	0.26		$	0.18
Net earnings per share — Diluted:
As reported		$	0.29		$	0.21
Pro forma		$	0.25		$	0.18

 

We estimate the fair value of our options using a Black-Scholes option valuation model, which was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option valuation models require the input of assumptions, including the expected stock price volatility. Our options have characteristics significantly different from those of traded options, and changes in the input assumptions can materially affect the fair value estimates. The fair value of options granted and the option component of the employee stock purchase plan shares were estimated at the date of grant using the Black-Scholes option valuation model with the following weighted average assumptions:

 

		Employee Stock Option Plans						Employee Stock Purchase Plan
		December 31, 2004			January 2, 2004			December 31, 2004			January 2, 2004
Expected life (in years)		4			4			0.5			0.5
Risk-free interest rate		3.5		%	3.0		%	2.6		%	1.2		%
Expected volatility		30.5		%	34.2		%	27.2		%	15.7		%
Expected dividend yield		—			—			—			—
Weighted average fair value at grant date		$	11.76		$	10.07		$	12.32		$	8.00

 

No shares were issued from the Employee Stock Purchase Plan during the three months ended December 31, 2004 and January 2, 2004.

 

Recent Accounting Pronouncements

 

In November 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4.  SFAS No. 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning in the Company’s fourth quarter of fiscal year 2005. The Company does not believe the adoption of SFAS No. 151 will have a material effect on its consolidated financial position, results of operations or cash flows.

 

7

 

FASB Staff Position (“FSP”) No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 (“FSP 109-2”), provides guidance under SFAS No. 109, Accounting for Income Taxes, with respect to recording the potential impact of the repatriation provisions of the American Jobs Creation Act of 2004 (the “Jobs Creation Act”) on enterprises’ income tax expense and deferred tax liability.  The Jobs Creation Act was enacted on October 22, 2004.  FSP 109-2 states that an enterprise is allowed time beyond the financial reporting period of enactment to evaluate the effect of the Jobs Creation Act on its plan for reinvestment or repatriation of foreign earnings for purposes of applying SFAS No. 109.  The Company has not yet completed its evaluation on the impact of the repatriation provisions.  Accordingly, as provided for in FSP 109-2, the Company has not adjusted its tax expense or deferred tax liability to reflect the repatriation provisions of the Jobs Creation Act.

 

In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29. SFAS No. 153 addresses the measurement of exchanges of nonmonetary assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged.  SFAS No. 153 is effective for nonmonetary asset exchanges beginning in the Company’s fourth quarter of fiscal year 2005. The Company does not believe the adoption of SFAS No. 153 will have a material effect on its consolidated financial position, results of operations or cash flows.

 

In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment, which replaced SFAS No. 123 and superseded APB 25.  SFAS No. 123R addresses the accounting for share-based payment transactions in which a company receives employee services in exchange for either equity instruments of the company or liabilities that are based on the fair value of the company’s equity instruments or that may be settled by the issuance of such equity instruments. Under SFAS No. 123R, companies will no longer be able to account for share-based compensation transactions using the intrinsic method in accordance with APB 25 but will be required to account for such transactions using a fair-value method and recognize the expense in the consolidated statement of earnings.  SFAS No. 123R is effective beginning in the Company&# 146;s fourth quarter of fiscal year 2005 and allows, but does not require companies to restate the full fiscal year of 2005 to reflect the impact of expensing share-based payments under SFAS No. 123R. The Company has not yet determined which fair-value method and transition provision it will follow. The impact on the Company’s financial statements of applying Black-Scholes option valuation method of accounting for stock options is disclosed in the Stock-Based Compensation section above.

 

2. MARKETABLE SECURITIES

 

The carrying amounts of marketable securities are as follows:

 

(In millions)		December 31, 2004			October 1, 2004
Municipal bonds		$	138.2		$	148.4
Corporate debt securities		—			5.0
		138.2			153.4
Less: Short-term marketable securities		98.5			112.4
Long-term marketable securities		$	39.7		$	41.0

 

3. CHANGE IN METHOD OF ACCOUNTING FOR INVENTORIES

 

Prior to October 2, 2004, the Company accounted for U.S. inventories of Oncology Systems using the LIFO method.  All other inventories were carried at the lower of cost or market (realizable value) using the FIFO or average cost method.  Beginning October 2, 2004, the Company changed its accounting for Oncology Systems’ U.S. inventories from LIFO to FIFO because the Company has experienced relatively stable inventory costs (i.e., little to no inflation) over the last several years; therefore, the use of LIFO to match current costs with current revenues had no significant impact on the Company’s operating results that would have been reported using FIFO.  In addition, the Company believes changing to FIFO would enhance the comparability of its financial statements with those of its industry peers.  In accordance with APB No. 20, Accounting Change, the consolidated financial statements of prior years have been retroactively adjusted to apply the new inventory valuation method and accordingly, retained earnings as of October 1, 2004 has been increased by $10.4 million as a result of adjusting the inventories from their LIFO cost to current FIFO cost, net of the corresponding impact on deferred tax assets.  This accounting change also increased or (decreased) previously reported net earnings by $0.4 million, $(0.5) million and $1.1 million for fiscal years 2004, 2003 and 2002, respectively.

 

8

 

The effects of the accounting change on net earnings and basic net earnings per share as previously reported for the three months ended January 2, 2004 are as follows:

 

(In thousands, except per share amounts)
Net earnings:
As previously reported		$	29,168
Effect of change in accounting for inventories, net of taxes on earnings		118
As adjusted		$	29,286
Basic net earnings per share:
As previously reported		$	0.21
Effect of change in accounting for inventories, net of taxes on earnings		0.01
As adjusted		$	0.22

 

This accounting change did not have any effect on diluted earnings per share as previously reported for the three months ended January 2, 2004.

 

The components of inventories are as follows:

 

(In millions)		December 31, 2004			October 1, 2004			October 1, 2004
					(As Adjusted)			(As Previously Reported)
Raw materials and parts		$	104.2		$	90.6		$	79.8
Work-in-progress		9.1			8.2			7.4
Finished goods		50.2			45.6			40.5
Total Inventories		$	163.5		$	144.4		$	127.7

 

4. GOODWILL AND INTANGIBLE ASSETS

 

Pursuant to SFAS No. 142, Goodwill and Intangible Assets, the Company performs an annual impairment test for goodwill and intangible assts with indefinite lives. The impairment test for goodwill is a two-step process. Step one consists of a comparison of the fair value of a reporting unit with its carrying amount, including the goodwill allocated to each reporting unit. If the carrying amount is in excess of the fair value, step two requires the comparison of the implied fair value of the reporting unit with the carrying amount of the reporting unit’s goodwill. Any excess of the carrying value of the reporting unit’s goodwill over the implied fair value of the reporting unit’s goodwill will be recorded as an impairment loss.

 

The Company performed its annual SFAS No. 142 goodwill impairment assessment for its three reporting units in the fourth quarter of fiscal year 2004 and determined that there was no impairment. However, the Company could be required to record impairment charges in future periods if indicators of potential impairment exist.

 

The impairment test for purchased intangible assets with indefinite useful lives consists of a comparison of fair value to carrying value, with any excess of carrying value over fair value being recorded as an impairment loss. Intangible assets with finite useful lives are amortized over their useful lives, which range from one to twenty years.

 

9

 

The following table reflects the gross carrying amount and accumulated amortization of the Company’s intangible assets included in “Other assets” on the condensed consolidated balance sheets:

 

(In millions)		December 31, 2004			October 1, 2004
Intangible Assets:
Patents, licenses and other		$	13.5		$	13.5
Acquired existing technology		11.5			11.5
Customer contracts and supplier relationship		9.3			9.3
Accumulated amortization		(14.0		)	(12.7		)
Net carrying amount		$	20.3		$	21.6

 

Amortization expense for intangible assets required to be amortized under SFAS No. 142 was $1.3 million and $0.7 million for the three months ended December 31, 2004 and January 2, 2004, respectively.  The Company estimates amortization expense on a straight-line basis for the remaining nine months of fiscal year 2005, fiscal years 2006 through 2009 and thereafter, to be as follows (in millions): $3.8, $5.0, $3.8, $2.4, $1.8, and $3.5.

 

The following table reflects goodwill allocated to the Company’s reportable segments:

 

(In millions)		December 31, 2004			October 1, 2004
Oncology Systems		$	100.0		$	100.0
X-ray Products		0.5			0.5
Other		12.2			12.2
Total		$	112.7		$	112.7

 

5. RELATED PARTY TRANSACTIONS

 

In fiscal years 1999 and 2000, the Company invested a total of $5 million in a three member consortium for a 20% ownership interest in dpiX Holding LLC (“dpiX Holding”), which in turn invested $25 million for an 80.1% ownership interest of dpiX LLC (“dpiX”), a supplier of amorphous silicon based thin-film transistor arrays (“flat panels”) for the Company’s X-ray Products’ digital imaging subsystems and for its Oncology System’s PortalVision imaging systems. The Company had the right to appoint one Manager of the five person Board of Managers and the investment was accounted for under the equity method.  In accordance with the dpiX Holding agreement, net losses were to be allocated to the other two members, in succession, until their capital accounts equaled zero, before being allocated to the Company.  The dpiX Holding agreement also provided that net profits were to be allocated to the other two members, in succession, until their capital accounts equaled the net losses previously allocated, then to the three members in accordance with their ownership interests.

 

In September 2004, the Company acquired from another member in the consortium that member’s 20% ownership interest in dpiX Holding for $1 million.  As a result, the Company has the right to appoint two Managers of the five person Board of Managers and its ownership interest in dpiX Holding increased to 40% with the remaining 60% being held by the other member.  When the Company acquired this additional 20% ownership interest, the capital account of the selling member was zero because it was the first in the consortium to be allocated losses of dpiX Holding.  However, dpiX has been profitable since the Company acquired the additional 20% ownership interest of the member.  As a result, the Company was the first to be allocated net profits to recover previously allocated losses and recorded in the first quarter of fiscal year 2005 income on equity investment in dpiX of $0.6 million, which is included in “Selling, general and administrative” expenses in the condensed consolidated balance sheet.

 

In December 2004 the Company agreed to loan $2 million to dpiX in four separate payments, bearing interest at the rate of prime rate plus 1% per annum.  The principal balance is due and payable to the Company in twelve equal quarterly installments beginning October 2006; interest shall be paid in full according to the same quarterly schedule, but beginning in April 2005; and the entire principal balance, together with accrued and unpaid interest thereon and all other related amounts payable hereunder, being fully due and payable on July 10, 2009.  As of December 31, 2004, the note receivable from dpiX totaled $0.8 million which is included in “Other Assets” in the condensed consolidated balance sheet.

 

10

 

6. PRODUCT WARRANTY

 

The Company provides for estimated future costs of warranty obligations in accordance with FIN 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others that requires an entity to disclose and recognize a liability for the fair value of the obligation it assumes upon issuance of a guarantee.  The Company warrants its products for a specific period of time, generally twelve months, against material defects.  The accrued warranty costs represent the best estimate at the time of sale of the total costs that the Company expects to incur to repair or replace product parts that fail while still under warranty.  The Company accrues for warranty costs in cost of revenues based on historical experience as to product failures as well as current information on repair costs. On a quarterly basis, the Company reviews the accrued warranty costs and updates the historical warranty cost trends.

 

The following table reflects the change in the Company’s product warranty accrual during the three months ended December 31, 2004 and January 2, 2004:

 

		Three Months Ended
(In millions)		December 31, 2004			January 2, 2004
Product warranty accrual, at beginning of period		$	40.7		$	36.1
Charged to cost of revenues		8.2			9.8
Actual product warranty expenditures or reclassifications		(8.2		)	(8.2		)
Product warranty accrual, at end of period		$	40.7		$	37.7

 

7. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

 

The Company has significant international transactions in foreign currencies and addresses certain financial exposures through a controlled program of risk management that includes the use of derivative financial instruments.  The Company sells products throughout the world, often in the currency of the customer’s country, and adheres to a policy of hedging firmly committed foreign currency sales orders. These firmly committed foreign currency sales orders are hedged with forward exchange contracts. The Company enters into foreign currency forward exchange contracts primarily to reduce the effects of fluctuating foreign currency exchange rates. The forward exchange contracts range from one to twelve months in original maturity. At December 31, 2004, the Company did not have any forward exchange contract with an original maturity greater than twelve months.  As international deliveries may extend beyond twelve months, the Company may hedge beyond twelve months in the future.  The Company does not hold derivative instruments for speculative or trading purposes.

 

The Company accounts for its hedges of foreign currency denominated sales orders (firm commitments) as fair value hedges under SFAS No. 149, Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities. For the three months ended December 31, 2004, there were no material gains or losses due to hedge ineffectiveness. At December 31, 2004, the Company had foreign exchange forward contracts to sell and purchase $253.0 million and $8.0 million, respectively, in various foreign currencies. At December 31, 2004, all open forward exchange contracts were deemed effective.

 

The Company also hedges balance sheet exposures monthly from its various foreign subsidiaries and business units. These monthly hedges of foreign-currency-denominated assets and liabilities do not qualify for hedge accounting treatment under SFAS No. 149.  Accordingly, changes in their fair values are recognized in “selling, general and administrative expenses” in the then-current period.  Changes in the values of these hedging instruments are offset by changes in the values of foreign currency denominated assets and liabilities.  Variations from the forecasted foreign currency assets or liabilities, coupled with a significant currency movement, may result in a material gain or loss if the hedges are not effectively offsetting the change in value of the foreign currency asset or liability.  At December 31, 2004, the Company had foreign exchange forward contracts maturing in the second quarter of fiscal year 2005 to sell and purchase $119.0 million and $16.4 million, respectively, to hedge the risks associated with foreign currency denominated assets and liabilities.

 

11

 

8. COMMITMENTS AND CONTINGENCIES

 

Commitments

 

Following a decision by Mitsubishi Electric Co. (“MELCO”) to exit the radiotherapy equipment and service business and its desire to do so in a nondisruptive manner with an established radiotherapy equipment service provider, the Company entered into two separate transactions with MELCO contemporaneously whereby (i) the Company purchased MELCO’s radiotherapy equipment service business (the “Service Business”) to service MELCO’s existing customers and (ii) the Company formed a three-year joint venture (“JVA”) in Japan with MELCO that was effective as of February 3, 2004.

 

On February 2, 2004, the Company’s Japanese subsidiary (“VMS KK”) purchased the Service Business in Japan and certain other Asian and South American countries for 2.0 billion Japanese Yen, or US$19.1 million, plus a contingent “earn out” payable to MELCO at the end of the JVA period.  At the time of the acquisition of the Service Business, the Company and MELCO were unable to agree upon the value of the Service Business.  The Company therefore structured a payment, based on net profits or losses, to be made to or received from MELCO as an “earn out” adjustment to the purchase price to establish and verify the fair value of the Service Business.  This “earn out” payment is equivalent to 100% of the net profits or losses of the Service Business for a three-year period.  As a result of this purchase, VMS KK services and supports the MELCO radiotherapy equipment products in Japan, as well as sells, services and supports the Company’s products.  The Company accounted for the purchase of the Service Business as an acquisition and 100% of the profits and losses from VMS KK are reflected in the Company’s consolidated results.  The Company accounts for the “earn out” payment equivalent to 100% of the net profits or losses of the Service Business during the three-year period as an adjustment to the purchase price of the acquisition at the end of the JVA period in accordance with SFAS No. 141, Business Combinations and EITF No. 95-8, Accounting for Contingent Consideration Paid to the Shareholders of an Acquired Enterprise in a Purchase Business Combination.  For the eleven-month period ended December 31, 2004, net profits for the Service Business totaled approximately $0.7 million.  Assuming no future profits and losses, $0.7 million will be payable to MELCO at the end of the three-year JVA period.

 

In addition to purchasing the Service Business, the Company entered into a distributor arrangement to sell MELCO radiotherapy equipment products through VMS KK for two years to allow customers interested in purchasing MELCO radiotherapy equipment products to purchase such products for a limited period of time.  The Company does not expect that MELCO radiotherapy equipment products sales will be significant.  Pursuant to EITF No. 95-8, the Company accounted for any payment it may pay to MELCO computed on the basis of 50% of the net profits from the sale of MELCO radiotherapy equipment products during the JVA’s first two years as a VMS KK period expense.

 

The joint venture was accomplished through MELCO’s purchase on February 3, 2004, of a 35% ownership interest in VMS KK for 1.4 billion Japanese Yen, or US$13.5 million.  During the three-year JVA period, MELCO is not entitled to any profits or losses generated by VMS KK.  However, MELCO is entitled to elect one of the five members of VMS KK’s Board of Directors.  At the end of the three-year JVA period, MELCO is required to unconditionally sell and the Company is required to unconditionally repurchase MELCO’s 35% ownership interest in VMS KK at the original sale price (1.4 billion Japanese Yen) and there are no settlement alternatives to such a repurchase obligation.  The Company has accounted for MELCO’s 35% ownership interest as a mandatorily redeemable financial instrument, which is included in “Long-term accrued expenses and other” in the condensed consolidated balance sheets.

 

Contingencies

 

The U.S. Environmental Protection Agency or third parties has named the Company as a potentially responsible party under the Comprehensive Environmental Response Compensation and Liability Act of 1980, as amended (“CERCLA”), at eight sites where the Company, as Varian Associates, Inc., is alleged to have shipped manufacturing waste for recycling or disposal.  In addition, the Company is overseeing environmental cleanup projects and as applicable, reimbursing third parties for cleanup activities under the direction of, or in consultation with, federal, state and/or local agencies at certain current VMS or former Varian Associates, Inc. facilities (including facilities disposed of in connection with the Company’s sale of its electron devices business during 1995, and the sale of its thin film systems business during 1997). Under the terms of the agreement governing the distribution (the “spin-offs”) of Varian, Inc. (“VI”) and Varian Semiconductor Equipment Associates, Inc. (“VSEA”), by the Company in 1999, VI and VSEA are each obligated to indemnify the Company for one-third of these environmental cleanup costs (after adjusting for any insurance proceeds realized or tax benefits recognized by the Company). The Company

 

12

 

spent $0.4 million and $0.8 million (net of amounts borne by VI and VSEA) during the three months ended December 31, 2004 and January 2, 2004, respectively, on environmental investigation, cleanup and third party claim costs.

 

For one of these sites and facilities, various uncertainties make it difficult to assess the likelihood and scope of further cleanup activities or to estimate the future costs of such activities (including cleanup costs, reimbursements to third parties, project management costs and legal costs) if undertaken. As of December 31, 2004, the Company nonetheless estimated that the Company’s future exposure (net of VI’s and VSEA’s indemnification obligations) to complete the cleanup projects for these sites ranged in the aggregate from $3.8 million to $7.3 million. The time frame over which the Company expects to complete the cleanup projects varies with each site, ranging up to approximately 30 years as of December 31, 2004. Management believes that no amount in the foregoing range of estimated future costs is more probable of being incurred than any other amount in such range and therefore accrued $3.8 million as of December 31, 2004. The amount accrued has not been discounted to present value due to the uncertainties that make it difficult to develop a best estimate of future costs.

 

As to other sites and facilities, the Company has gained sufficient knowledge based upon formal agreements with other parties defining the Company’s future liabilities or formal cleanup plans for these sites that have either been approved by or completed in accordance with the requirements of the state or federal environmental agency with jurisdiction over the site to better estimate the scope and costs of future cleanup activities. As of December 31, 2004, the Company estimated that the Company’s future exposure (net of VI’s and VSEA’s indemnification obligations) to complete the cleanup projects, including reimbursements to third party’s claims, for these sites and facilities ranged in the aggregate from $13.2 million to $44.9 million. The time frame over which these cleanup projects are expected to be complete varies with each site and facility, ranging up to approximately 30 years as of December 31, 2004. As to each of these sites and facilities, management determined that a particular amount within the range of estimated costs was a better estimate of the future environmental liability than any other amount within the range, and that the amount and timing of these future costs were reliably determinable. The best estimate within the range was $19.4 million at December 31, 2004. The Company accordingly accrued $12.8 million, which represents its best estimate of the future costs of $19.4 million discounted at 4%, net of inflation. This accrual is in addition to the $3.8 million described in the preceding paragraph.

 

The foregoing amounts are only estimates of anticipated future environmental-related costs to cover the known cleanup projects, and the amounts actually spent may be greater or less than such estimates. The aggregate range of cost estimates reflects various uncertainties inherent in many environmental cleanup activities, the large number of sites and facilities involved and the amount of third party claims. The Company believes that most of these cost ranges will narrow as cleanup activities progress. The Company believes that its reserves are adequate, but as the scope of its obligations becomes more clearly defined, these reserves (and the associated indemnification obligations of VI and VSEA) may be modified and related charges/credits against earnings may be made.

 

Although any ultimate liability arising from environmental-related matters described herein could result in significant expenditures that, if aggregated and assumed to occur within a single fiscal year, would be material to the Company’s consolidated financial statements, the likelihood of such occurrence is considered remote. Based on information currently available to management and its best assessment of the ultimate amount and timing of environmental-related events (and assuming VI and VSEA satisfy their indemnification obligations), management believes that the costs of these environmental-related matters are not reasonably likely to have a material adverse effect on the consolidated financial statements of the Company in any fiscal year.

 

The Company evaluates its liability for environmental-related investigation and cleanup costs in light of the liability and financial wherewithal of potentially responsible parties and insurance companies with respect to which the Company believes that it has rights to contribution, indemnity and/or reimbursement (in addition to the obligations of VI and VSEA). Claims for recovery of environmental investigation and cleanup costs already incurred, and to be incurred in the future, have been asserted against various insurance companies and other third parties. The Company receives certain cash payments in the form of settlements and judgments from defendants, its insurers and other third parties from time to time. The Company has also reached an agreement with another insurance company under which the insurance company has agreed to pay a portion of the Company’s past and future environmental-related expenditures, and the Company therefore has a $3.3 million receivable included in “Prepaid expenses and other current assets” and “Other assets” at December 31, 2004. The Company believes that this receivable is recoverable because it is based on a binding, written settlement agreement with a solvent and financially viable insurance company and the insurance company has paid the claims that the Company has made.

 

The Company is also involved in other legal proceedings arising in the ordinary course of its business. While there can be no assurances as to the ultimate outcome of any litigation involving the Company, management does not believe any pending

 

13

 

legal proceeding will result in a judgment or settlement that would have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows.

 

9. RETIREMENT PLANS

 

The Company’s net pension and post-retirement benefit costs were composed of the following:

 

		Defined Benefit Plans						Post-Retirement Benefit Plans
(In thousands)		December 31, 2004			January 2, 2004			December 31, 2004			January 2, 2004
Service cost		$	758		$	757		$	—		$	—
Interest cost		777			649			92			115
Expected return on assets		(732		)	(564		)	—			—
Net amortization and deferral:
Transition amount		60			(3		)	123			123
Prior service cost		33			33			—			—
Recognized actuarial loss (gain)		179			206			(3		)	43
Net pension benefit cost		$	1,075		$	1,078		$	212		$	281

 

The Company made contributions to the defined benefit plans of $1.0 million during the three months ended December 31, 2004. The Company currently expects total contributions for fiscal year 2005 to be approximately $3.6 million.

 

The Company made contributions to the post-retirement benefit plans of $0.2 million during the three months ended December 31, 2004 and expects total contributions for fiscal year 2005 to be approximately $0.6 million.

 

10. STOCKHOLDERS’ EQUITY

 

Stock Repurchase Program

 

On November 19, 2004, the Company announced that its Board of Directors had authorized a repurchase by the Company of up to 6,000,000 shares of its common stock over the period through December 31, 2005 in addition to the 1,460,000 shares of common stock available for repurchase under the previously approved program as of October 1, 2004.  During the three months ended December 31, 2004, the Company paid $60.8 million to repurchase 1,460,000 shares of its common stock.  All shares that have been repurchased have been retired.  As of December 31, 2004, the Company could repurchase up to 6,000,000 shares of its common stock.

 

Comprehensive Earnings

 

Comprehensive earnings for the three months ended December 31, 2004 and January 2, 2004 equaled the reported net earnings.

 

14

 

11. EMPLOYEE STOCK OPTION PLANS

 

Option activity under the Omnibus Stock Plan and the 2000 Stock Option Plan (together, the “Employee Stock Option Plans”) is presented below:

 

				Outstanding Options
(In thousands, except per share amounts)		Shares Available for Grant		Number of Shares		Weighted Average Exercise Price
Balance at September 26, 2003 (12,224 options exercisable at a weighted average exercise price of $11.36)		8,814		16,494		$	14.13
Granted		(3,266	)	3,266		32.90
Cancelled or expired (1)		102		(108	)	25.35
Exercised		—		(3,408	)	11.41
Balance at October 1, 2004 (12,482 options exercisable at a weighted average exercise price of $8.53)		5,650		16,244		$	18.40
Granted		(2,425	)	2,425		39.80
Cancelled or expired		18		(18	)	23.92
Exercised		—		(958	)	11.65
Balance at December 31, 2004		3,243		17,693		$	21.69

 

(1) During the three months ended January 2, 2004, the Company excluded from shares available for grant 6 shares of cancelled or expired options that were granted before the spin-offs of VI and VSEA under the Company’s previous, now inactive, stock option plans.

 

The following tables summarize information concerning options outstanding and exercisable under the Employee Stock Option Plans at December 31, 2004:

 

			Options Outstanding							Options Exercisable
Range of Exercise Prices			Number of Shares Oustanding		Weighted Average Remaining Contractual Life (in years)		Weighted Average Exercise Price			Number of Shares Exercisable		Weighted Average Exercise Price
(Shares in thousands)
$	3.88 – $4.57		220		4.2		$	4.40		220		$	4.40
$	4.58 – $4.62		1,990		4.3		$	4.58		1,990		$	4.58
$	4.63 – $6.65		272		2.8		$	5.53		272		$	5.53
$	6.66 – $13.94		276		4.0		$	8.76		276		$	8.76
$	13.95 – $14.72		4,080		5.9		$	13.95		4,080		$	13.95
$	14.73 – $21.49		2,544		6.9		$	17.93		2,542		$	17.93
$	21.50 – $32.09		2,710		7.9		$	24.41		1,861		$	24.42
$	32.10 – $46.07		5,601		9.3		$	35.90		1,245		$	33.57
Total			17,693		7.1		$	21.69		12,486		$	16.32

 

15

 

12. EARNINGS PER SHARE

 

Basic net earnings per share is computed by dividing net earnings by the weighted average number of shares of common stock outstanding for the period. Diluted net earnings per share is computed by dividing net earnings by the sum of the weighted average number of common shares outstanding and dilutive common shares under the treasury method. The following table sets forth the computation of basic and diluted earnings per share:

 

		Three Months Ended
(In thousands, except per share amounts)		December 31, 2004			January 2, 2004
					(As Adjusted See Note 3)
Numerator:
Net earnings		$	40,309		$	29,286
Denominator:
Basic weighted average shares outstanding		133,985			136,029
Dilutive stock option shares		5,609			5,790
Dilutive restricted performance shares and restricted common stock		344			302
Diluted weighted average shares outstanding		139,938			142,121
Net earnings per Share:
Basic		$	0.30		$	0.22
Diluted		$	0.29		$	0.21

 

The Company excludes options from the computation of diluted weighted average shares outstanding if the exercise price of the options is greater than the average market price of the shares because the inclusion of these options would be antidilutive to earnings per share.  Accordingly, stock options to purchase 248,124 and 3,200 shares at an average exercise price of $42.39 and $33.98 per share, respectively, were excluded from the computation of diluted weighted average shares outstanding during the three months ended December 31, 2004 and January 2, 2004, respectively.

 

13. INDUSTRY SEGMENTS

 

The Company’s operations are grouped into two reportable industry segments: Oncology Systems and X-ray Products. These industry segments were determined based on how management views and evaluates the Company’s operations. The Company’s Ginzton Technology Center (“GTC”), and BrachyTherapy operations are reflected in an “other” category. The Company evaluates its financial performance and allocates its resources primarily based on operating earnings.

 

		Revenues						Operating Earnings
		Three Months Ended						Three Months Ended
(In millions)		December 31, 2004			January 2, 2004			December 31, 2004			January 2, 2004
											(As Adjusted See Note 3)
Oncology Systems		$	242		$	221		$	56		$	46
X-ray Products		44			37			9			7
Other		13			9			3			—
Total industry segments		$	299		$	267		$	68		$	53
Corporate		—			—			(7		)	(8		)
Total company		$	299		$	267		$	61		$	45

 

16

 

14. SUBSEQUENT EVENT

 

On January 17, 2005, the Company announced that it has acquired Sigma Micro Informatique Conseil (“Sigma Micro”), a privately-held company that is the leading supplier of information management software for radiation oncology and medical oncology in cancer clinics and hospitals in France.  Sigma Micro’s products will complement the VARiS Vision™ software for information and image management within integrated treatment networks.  The Company paid approximately $13 million in cash to acquire Sigma Micro, which is based in Toulouse, France.

 

17

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and

Stockholders of Varian Medical Systems, Inc.:

 

We have reviewed the accompanying condensed consolidated balance sheet of Varian Medical Systems, Inc. and its subsidiaries (the “Company”) as of December 31, 2004, and the related condensed consolidated statements of earnings and cash flows for the three-month periods ended December 31, 2004 and January 2, 2004.  These interim financial statements are the responsibility of the Company’s management.

 

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States).  A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters.  It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole.  Accordingly, we do not express such an opinion.

 

Based on our review, we are not aware of any material modifications that should be made to the accompanying condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

 

We previously audited in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of October 1, 2004, and the related consolidated statements of earnings, and of cash flows for the year then ended (not presented herein), and in our report dated November 12, 2004 we expressed an unqualified opinion on those consolidated financial statements.  In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of October 1, 2004, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived.

 

/s/ PRICEWATERHOUSECOOPERS LLP
San Jose, California
January 21, 2005

 

18

 

Item 2.             Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Forward-Looking Statements

 

This Quarterly Report on Form 10-Q contains “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995 which provides a “safe harbor” for statements about future events, products and future financial performance that are based on the beliefs of, estimates made by and information currently available to the management of Varian Medical Systems, Inc. (“we,” “our”, or “the Company”). The outcome of the events described in these forward-looking statements is subject to risks and uncertainties. Actual results and the outcome or timing of certain events may differ significantly from those projected in these forward-looking statements due to the factors listed under “— Factors Affecting Our Business”, and from time to time in our other filings with the Securities and Exchange Commission or SEC. For this purpose, statements concerning industry or market segment outlook; market acceptance of or transition to new products or technology such as intensity modulated radiation therapy, image guided radiation therapy, brachytherapy, software, treatment techniques, and advanced X-ray products; growth drivers; orders, revenues, backlog or earnings growth; future financial results and any statements using the terms “believe,” “expect,” “expectation,” “anticipate,” “can,” “should,” “will,” “would,” “could,” “estimate,” “appear,” “based on,” “may,” “pending,” “intended,” “potential,” “promise,” “predict” and “possible” or similar statements are forward-looking statements that involve risks and uncertainties that could cause our actual results and the outcome and timing of certain events to differ materially from those projected or management’s current expectations.  By making forward-looking statements, we have not assumed any obligation to, and you should not expect us to, update or revise those statements because of new information, future events or otherwise.

 

Overview

 

We finished the first quarter of fiscal year 2005 with higher revenues, increased net orders, stronger margins, healthy earnings and another record quarter-end backlog.  During the first quarter of fiscal year 2005, our net earnings increased by 38%, net earnings per diluted share increased by 38%, overall revenues increased by 12% and overall net orders increased by 8% compared to the first quarter of fiscal year 2004.  At the end of the first quarter of fiscal year 2005, we reported backlog at $1 billion, an increase of 18% from the end of the year-ago quarter.

 

Oncology Systems.  Our largest business segment is Oncology Systems, which produces, sells and services hardware and software products for treating cancer with radiation, including linear accelerators, treatment simulation and verification products, information management and treatment planning software and other sophisticated accessory products and services.  Our products enable radiation oncology departments in hospitals and clinics to perform conventional radiotherapy treatments and offer the advanced treatment processes of intensity modulated radiation therapy, or IMRT, and image guided radiation therapy, or IGRT.

 

We have continued to see growth in the number of clinics that are treating patients with IMRT and IGRT. However, as the leading supplier of IMRT-enabling products and with over 50% of our customer sites worldwide having the products and accessories necessary to perform the most advanced forms of IMRT, we have seen and continue to expect that the rate of revenues growth for IMRT-related equipment will be lower than what we have experienced in the last three years, particularly in the North American market.  IGRT is a new technology driver in radiation therapy and we expect that IGRT will be one of the main contributors to revenues growth in our Oncology Systems business segment in the coming years.  While IGRT is still a nascent technology, we believe we are at the forefront of providing automated and clinically practical products for IGRT treatments.  It is our belief that IGRT should generally follow a similar growth pattern as what we experienced for IMRT.  As in the early days of IMRT, we are seeing a rising percentage of linear accelerators being ordered with IGRT-enabled accessories, though still far below the 90%-95% of linear accelerators that is being ordered with IMRT-enabled products.  At the end of the first quarter of fiscal year 2005, installations of our diagnostic-quality imaging systems for IGRT were either complete or in process at 30 treatment centers around the world.  While the level of orders for our IGRT-enabled products are still small compared to our IMRT-enabled products, we anticipate that, similar to what occurred with IMRT, North American market growth will again accelerate once IGRT is more-widely demonstrated among early adopters.

 

Fundamental market factors for growth in the radiation therapy market continue to be the rising cancer incidence, underserved medical needs outside of the United States, technology advances that are leading to improvements in patient care, patient demand for more advanced and effective treatments (such as IMRT, IGRT and stereotactic cancer treatments), media and marketing promotions as well as educational efforts by hospitals and radiotherapy centers motivated to have the most modern systems to improve clinical outcomes and attract top medical talent.

 

19

 

In the first quarter of fiscal year 2005, we saw a continued slowing in the Oncology Systems North American revenues and net orders growth, which was more than offset by continued strong growth in Oncology Systems international revenues and net orders.  Oncology Systems benefited from a growing international market which contributed 42% of total revenues and 50% of total net orders for the business segment during the quarter principally due to stronger cyclical demand after several years of very slow growth and, to a lesser extent, due to the relatively weak U.S. dollar that effectively made our pricing more competitive with our foreign competitors.  Net orders declined in North America as a result of an apparent contraction in the amount of business available for closure following a strong orders performance in the fourth quarter of fiscal year 2004.  This reflects typical quarterly volatility in a market where growth has slowed over the last two years following several years of heavy investment in advanced technology for IMRT.

 

Our stereotactic cancer treatment and IGRT-enabled products have also positioned us to expand beyond radiation oncology into the estimated $250 million radiosurgery market with a solution built around our Trilogy linear accelerator and on-board imager (“OBI”).  We recently announced the formation of Varian Surgical Sciences as the vehicle for carrying out our initiative to directly address this market.  We expect to offer a clinically effective and more cost-efficient alternative to dedicated radiosurgical devices as well as conventional surgery for the treatment of tumors, vascular malformations and certain functional conditions.

 

Our success in Oncology Systems depends upon our ability to retain leadership in technological innovation, the cost effectiveness of our products, the efficacy of our treatment technology and macroeconomic influences.  Factors affecting the adoption rate of new technologies such as IGRT could include our internal efficiency in design, documentation and testing, deployment and installation and the more-widely demonstrated efficacy of IGRT by early adopters.  They may also include customer training, reimbursement and our ability to educate customers about new technology cost and clinical advantages.  Macroeconomic factors could include hospital financial strength in the United States and governmental healthcare policies outside the United States.

 

X-Ray Products.  Our other significant business segment is X-ray Products, which manufactures and sells (i) X-ray tubes for use in a range of applications including computed tomography, or CT, scanning, radioscopic/fluoroscopic imaging, special procedures, industrial and mammography and (ii) flat panel imaging products (also commonly referred to as flat panel detectors) for digital X-ray image capture, which is an alternative to image intensifier tubes for fluoroscopy or X-ray film for radiography.  We continue to view the fundamental driver for this business to be the on-going success of key OEMs that incorporate our X-ray tube products and flat panel imaging devices into their medical diagnostic and industrial imaging systems. Our flat panel product is being incorporated into next generation imaging equipment, including equipment for IGRT such as OBI.

 

Other.  Through the Ginzton Technology Center, or GTC, we are developing new business areas, including next generation digital X-ray imaging technology and technology for cargo screening.  In addition, we are developing technologies and products that promise to improve disease management by employing targeted energy and molecular agents to enhance the effectiveness and broaden the application of radiation therapy. Our BrachyTherapy operations manufacture, sell and service advanced brachytherapy products, which include treatment planning software, afterloaders and applicators.  Our brachytherapy products are being used for partial breast irradiation.  Significant increase in revenues was due to strong product sales of our GammaMed HDR afterloaders in the first quarter of fiscal year 2005.  The operations of GTC and BrachyTherapy are reported as part of the “Other” category of our industry segments, see Note 13 “Industry Segments” of the Notes to the Condensed Consolidated Financial Statements.

 

This discussion and analysis of our financial condition and results of operations is based upon and should be read in conjunction with the condensed consolidated financial statements and the notes included elsewhere in this report, as well as the information contained under “—Factors Affecting Our Business” and the “Notes to the Consolidated Financial Statements” in our Annual Report on Form 10-K for the fiscal year ended October 1, 2004, and from time to time in our other filings with the SEC.

 

Critical Accounting Estimates

 

The preparation of our financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America, or GAAP, requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses.  These estimates and assumptions are based on historical experience and on various other factors that we believe are reasonable under the circumstances.  We periodically review our accounting policies and estimates and make adjustments when facts and circumstances dictate.  Our critical accounting policies that are

 

20

 

affected by critical accounting estimates include revenue recognition, valuation of allowance for doubtful accounts, valuation of inventory and warranty obligations, assessment of recoverability of goodwill and intangible assets, assessment of environmental remediation liabilities and valuation of taxes on earnings.  Such accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of our Condensed Consolidated Financial Statements, and actual results could differ materially from these estimates.  For a discussion of how these estimates and other factors may affect our business, also see “—Factors Affecting Our Business.”

 

Revenue Recognition

 

We frequently enter into sales arrangements with customers that contain multiple elements or deliverables such as hardware, software and services. Judgments as to the allocation of the proceeds received from an arrangement to the multiple elements of the arrangement, the determination of whether any undelivered elements are essential to the functionality of the delivered elements and the appropriate timing of revenue recognition are critical in respect to these arrangements to ensure compliance with GAAP.  In addition, the amount of product revenues recognized is affected by our judgments as to whether objective and reliable evidence of fair value exists for hardware products and vendor-specific objective evidence of the fair value for software products in arrangements with multiple elements. Changes to the elements in an arrangement and the ability to establish objective and reliable evidence of fair value or vendor-specific objective evidence of the fair value for those elements could affect the timing of revenue recognition.  Revenue recognition also depends on the timing of shipments and is subject to customer acceptance and the readiness of customers’ facilities.  If shipments are not made on scheduled timelines or the products are not accepted by the customer in a timely manner, our reported revenues may differ materially from expectations.

 

Allowance for Doubtful Accounts

 

Credit evaluations are undertaken for all major sale transactions before shipment is authorized. Normal payment terms require payment of a small portion upon signing of the purchase order contract, a significant amount upon transfer of risk of loss and the remaining amount upon completion of the installation.  On a quarterly basis, we evaluate aged items in the accounts receivable aging report and provide an allowance in an amount we deem adequate for doubtful accounts.  If our evaluation of our customers’ financial conditions does not reflect the future ability to collect outstanding receivables, additional provisions may be needed and our future operating results could be negatively impacted.  As of December 31, 2004, our allowance for doubtful accounts represented approximately 1.7% of total accounts receivable.

 

Inventories

 

Our inventories include high technology parts and components that may be specialized in nature or subject to rapid technological obsolescence. We have programs to minimize the required inventories on hand and we regularly review inventory quantities on hand and adjust for excess and obsolete inventory based primarily on historical usage rates and our estimates of product demand and production.  Actual demand may differ from our estimates, in which case we may have understated or overstated the provision required for obsolete and excess inventory, which would have an impact on our operating results.

 

Warranty Obligations

 

We warrant our products for a specific period of time, usually one year, against material defects.  We provide for the estimated future costs of warranty obligations in cost of revenues when the related revenues are recognized.  The accrued warranty costs represent our best estimate at the time of revenues recognized of the total costs that we will incur to repair or replace product parts, which fail while still under warranty.  The amount of accrued estimated warranty costs is primarily based on historical experience as to product failures as well as current information on repair costs.  Actual warranty costs could differ from the estimated amounts. On a quarterly basis, we review the accrued balances of our warranty obligations and update the historical warranty cost trends. If we were required to accrue additional warranty cost in the future, it would negatively affect our operating results.

 

Goodwill and Intangible Assets

 

Goodwill is initially recorded when the purchase price paid for a business acquisition exceeds the estimated fair value of the net identified tangible and intangible assets acquired. The majority of companies we have acquired have not had significant identified tangible assets and, as a result, a significant portion of the purchase price has been typically allocated to intangible assets and goodwill. Our future operating performance will be impacted by the future amortization of these acquired

 

21

 

intangible assets and potential impairment charges related to goodwill if indicators of potential impairment exist. As a result of business acquisitions, the allocation of the purchase price to goodwill and intangible assets could have a significant impact on our future operating results. The allocation of the purchase price of the acquired companies to goodwill and intangible assets requires us to make significant estimates and assumptions, including estimates of future cash flows expected to be generated by the acquired assets and the appropriate discount rate for these cash flows. Should conditions be different from management’s current estimates, material write-downs of intangible assets and/or goodwill may be required, which would adversely affect our operating results.  We will continue to make assessments of impairment on an annual basis in the fourth quarter of our fiscal years or more frequently if indicators of potential impairment arise.  In fiscal year 2004, we performed such evaluation and found no impairment.  As of December 31, 2004, the carrying value of goodwill was $112.7 million.

 

Environmental Matters

 

We are subject to a variety of environmental laws around the world regulating the handling, storage, transport and disposal of hazardous materials that do or may create increased costs for some of our operations.  Environmental remediation liabilities are recorded when environmental assessments and/or remediation efforts are probable, and the costs of these assessments or remediation efforts can be reasonably estimated, in accordance with Statement of Financial Accounting Standards No. 5, Accounting for Contingencies, and the American Institute of Certified Public Accountants, or AICPA, Statement of Position 96-1, Environmental Remediation Liabilities.  The accrued environmental costs represent our best estimate as to the total costs of remediation and the time period over which these costs will be incurred.  On a quarterly basis, we review these accrued balances.  If we were required to accrue additional environmental remediation costs in the future, it would negatively impact our operating results.

 

Taxes on Earnings

 

As a global taxpayer, significant judgments and estimates are required in evaluating our tax positions and determining our provision for taxes on earnings.  The calculation of our tax liabilities involves addressing uncertainties in the application of complex tax regulations.  We recognize liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes and interest may be due.  These liabilities are adjusted in light of changing facts and circumstances, such as the closing of a tax audit.  The provision for taxes on earnings includes the effect of changes to these liabilities that are considered appropriate.

 

In addition, the carrying value of our net deferred tax assets assumes that we will be able to generate sufficient future taxable earnings to fully utilize these deferred tax assets.  Should we conclude it is more likely than not that we will be unable to recover our net deferred tax assets, our tax provision would increase in the period in which we make such a determination.

 

We are subject to taxes on earnings in both the U.S. and numerous foreign jurisdictions.  Earnings derived from our international region are generally taxed at rates lower than U.S. rates.  The ability to maintain our current effective rate is contingent upon existing tax laws in both the U.S. and in the respective countries in which our international subsidiaries are located.  In addition, a decrease in the percentage of our total earnings from our international region, or a change in the mix of international regions among particular tax jurisdictions, could increase our effective tax rate.  Also, our current effective tax rate does not assume U.S. taxes on undistributed profits of certain foreign subsidiaries.  These earnings could become subject to incremental foreign withholding or U.S. federal and state taxes should they either be deemed or actually remitted to the U.S.

 

Results of Operations

 

Fiscal Year

 

Our fiscal year is the 52- or 53-week period ending on the Friday nearest September 30. Fiscal year 2005 is the 52-week period ending September 30, 2005, and fiscal year 2004 was the 53-week period ended October 1, 2004. The fiscal quarter ended December 31, 2004 was a 13-week period and the fiscal quarter ended January 2, 2004 was a 14-week period.

 

On June 14, 2004, our Board of Directors declared a two-for-one stock split in the form of a 100% stock dividend. The distribution of the shares was made on July 30, 2004 to stockholders of record as of June 30, 2004. Unless otherwise stated, all references in the financial statements to the number of shares and per share amounts of our common stock have been retroactively restated to reflect the increased number of shares resulting from the two-for-one stock split.

 

22

---