Varian's Moat May Be Worth Paying For (Podcast)

By Daniel Shvartsman

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Last week, I was on the hot seat pitching Stitch Fix (SFIX) as a long idea. This week, Mike takes his turn. His thesis is on Varian Medical Systems (VAR), which is a more established company by a long shot, but there's an element of paying up for quality here as well. Here's Mike's thesis from our notes, as background to the podcast you can listen to above.

Varian sells machines to doctors so they can zap patients’ cancers with radiation in hopes of killing the cancer.

I think the key thing to understand about this company and its business is that radiation oncology is a complex and highly specialized medical practice with a great risk to the patient. To be successful, a radiation oncologist must continually update their understanding not just of how cancer grows and spreads within a person’s body but also their understanding of how radiation can be targeted at cancer.

Administration of radiation therapy is a highly complex, multi-step process. It requires a multi-person team, all of whom must precisely coordinate their roles. Says Varian:

The process for delivering radiotherapy typically consists of examining the patient, planning the treatment, simulating and verifying the treatment plan, providing quality assurance for the equipment and software, carefully positioning the patient, delivering the treatment, verifying that the treatment was delivered correctly and recording the history and results of the treatment. The team responsible for delivering the radiotherapy treatment generally is comprised of a physician specializing in radiation oncology, a medical physicist or dosimetrist for planning patient treatments, a medical physicist for conducting appropriate quality assurance procedures and a radiation therapist for positioning the patients for treatment and operating the machines.

Meanwhile, the function of radiation as a treatment is quite hazardous. Radiation is a weapon that scrambles DNA and causes cellular death. Here’s Varian’s description:

Radiation damages cellular genetic material (chromosomes), which interrupts cell replication and results in eventual cellular death. Since the need for replication is particularly critical to the survival of a cancer and since normal tissues are better able to repair such damage, radiation tends to disproportionately kill cancer cells. The clinical goal in radiation oncology is to deliver the highest possible radiation dose directly to the tumor to kill the cancerous cells while minimizing radiation exposure to surrounding healthy tissue in order to limit or avoid complications, side effects and secondary effects caused by the treatment.

In my opinion, the complexity and danger inherent to this technology creates a need for consistency, which makes it difficult for users to switch among competitors and creates a high degree of stability in the customer base. These are highly attractive attributes, as they contribute to pricing power (customers would rather pay up than switch) and earnings stability (customers are to some degree trapped within Varian’s system). Meanwhile, there is not a strong concentration of customers, according to Varian, who says that no customer accounts for more than 10% of total revenues.

As a side note, the radiation oncology business is, like many in the U.S. health system, optimized for operational efficiency and throughput. Varian understands this and guides its products toward reduced patient time in system and more services rendered (and billed), which adds to the value of the machines to Varian’s customer base and further boosts pricing power (you’re willing to pay more for a machine that actively helps you generate revenue faster).

Varian seems to be working toward providing an end-to-end solution, but its objective is to provide an open system where Varian devices can mix and match with other systems and technologies.

On top of all this, accelerators for radiation therapy qualify as medical devices and are regulated by the FDA, which creates a strong entry barrier.

In terms of the market, unfortunately for humanity cancer is a growing market. According to Varian,

Worldwide, the number of new cancer cases diagnosed annually is projected to increase from approximately 14 million in 2012 to almost 25 million by 2030 … according to the September 2015 Lancet Oncology report compiled by the Global Task Force on Radiotherapy for Cancer Control.

Varian goes on to say,

According to a peer-reviewed publication in the International Journal of Radiation Oncology Biology and Physics in 2014, radiotherapy is required in more than half of new cancer patients, particularly in low- and middle-income countries, and according to an article published in Seminars in Radiation Oncology in 2017, it is estimated that more than 12,000 additional treatment machines will be required by 2035 in these countries alone.

Varian’s position in the market appears strong.

We are the leading provider of medical linear accelerators and related accessories.

Per Morningstar, more than 50% share globally, more than 70% share in the U.S.

Growth: We grew Oncology Systems orders 17% in EMEA, 9% in APAC and 5% in the Americas

  • 5:00 minute mark - Introduction to Varian Medical Systems and the business case
  • 12:40 - How much does it matter that there are two revenue lines in the income statement? Oncology vs. Proton and Product vs. Service
  • 19:30 - Any reason to think they are transforming more to a service business?
  • 24:30 - Market and customer relationship strategy... moat around business
  • 31:00 - Is a throughput-based model something to be concerned about?
  • 36:00 - Valuation
  • 53:30 - The under the radar aspect of VAR

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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