Varian Medical Systems Inc. reported earnings of $1.22 per share in the third quarter of fiscal 2016, which beat the Zacks Consensus Estimate by a nickel and increased 6.1% on a year-over-year basis. The figure comfortably surpassed management’s guided range of $1.16-$1.20 per share.

The year-over-year growth was primarily driven by strong margin expansion in the quarter. Revenues increased a modest 0.7% to $789.4 million, which also beat the Zacks Consensus Estimate of $785 million.

Varian reported backlog of $3.31 billion at the end of the third quarter, up 5.4% on a year-over-year basis.

Segment Details

Oncology System sales increased 8.3% from the year-ago quarter to $605.2 million, while gross orders increased 6.4% to $675.9 million in the quarter.

Gross orders increased 8% in Americas. Orders in North America grew 15% year over year, which fully offset a decline in Latin America (down 40%). The growth in North America can be attributed to a stable reimbursement market and ongoing transition to more advanced clinically efficient systems.
 

Moreover, strong demand for products like TrueBeam platform, including Edge radiosurgery systems and the company’s software offerings were responsible for the strong top-line growth. Order activity in Latin America continued to remain weak due to macroeconomic factors.

In the EMEA region, gross orders were down 3% (down 4% at cc). Healthy gross order growth in emerging markets including Iran, Russia, Ethiopia, Burkina Faso and Libya was offset by weakness in the Western Europe. In Africa, Varian won gross order worth $25 million.

In the APAC region, gross orders were up 19% (17% at cc) driven by robust growth in China and Australia. Australia-based Icon Group placed an order for 10 additional TrueBeam medical linear accelerators. Icon Group had ordered five systems last year and currently has nine systems installed in its cancer centers throughout the country.

Varian noted that RapidPlan continues to gain traction around the world. The company has already booked 500 orders for the platform. Demand for the InSightive analytics software also remained strong.
 

Imaging Components (comprising X-Ray Products and Security, and Inspection Products) revenues increased 8.9% on a year-over-year basis to $146.7 million. The year-over-year growth was primarily due to strong performance from the tube business and recently acquired software and x-ray accessories businesses.

Imaging Components gross orders increased 13.4% to almost $138 million. Orders for security products were up in the quarter. However, the company continues to have a cautious view on the segment due to ongoing customer consolidation. Varian continues expect growth from non-destructive testing and inspections businesses.

Varian’s plan to separate the Imaging Components business into a new, independent, publicly traded company via a tax-free distribution remains on track. The new company will be known as Varex Imaging Corporation and the whole process is expected to be completed by calendar-year 2016 end.

Other segment (which includes Varian Particle Therapy business and the Ginzton Technology Center) revenues plunged 58.6% to $37.5 million. Notably, the year-ago quarter figure included significant revenues from the company’s proton installation in Maryland.

Gross orders also declined 60.8% to $51.4 million. Varian booked an order for a multi-room ProBeam installation at the new Hefei Ion Medical Center in China. Installation is expected to begin in 2017. In total, the company currently have 13 Proton projects generating revenues.

Operational Details

Gross margin expanded 370 basis points (bps) on a year-over-year basis to 43.9%, primarily due to significant contributions from both the Oncology and Imaging Components businesses.

Oncology gross margin improved more than 400 bps to 46% driven by favorable product mix (higher mix of TrueBeams and software) as well as productivity gains. Imaging Components gross margin also expanded 400 bps to 42.9% due largely to factory productivity gains and favorable product mix.

Research & development expenses (R&D), as percentage of revenues, increased 60 bps to 8.2%, while selling, general and administrative expenses (SG&A) were up 50 bps to 19.1% in the quarter.

As a result, operating margin expanded 80 bps on a year-over-year basis to 19.5%.

Outlook

For fiscal 2016, Varian expects adjusted earnings in the range of $4.62–$4.66 per share, up from earlier given guided range of $4.55–$4.65 per share. Revenues are still expected to increase by 3% in fiscal year 2016.

Our Take

Varian’s oncology business growth prospects remain impressive. The company is addressing both the tier 1 and mid-tier markets through its Edge, Truebeam and VitalBeam products. The company is also winning contracts, not only in the Americas but also in the international markets, which is a huge positive.

We believe China and Africa present significant top-line growth opportunity in the near term. The company is opening up new offices in Africa and the Middle East, which shows that it is aware of the growth opportunities in the region.

Moreover, Varian’s strong product pipeline is a key growth catalyst. The company believes that the Proton system has massive growth opportunities. The recent order win in China is significantly positive in our view.

Nevertheless, increasing local competition is the primary headwind. Moreover, the Imaging Components business spin-off will remain an overhang on the stock, at least in the near term.

Zacks Rank & Key Picks

Currently, Varian carries a Zacks Rank #3 (Hold).

Better-ranked stocks in the medical sector are Abiomed , Masimo Corp (MASI Quick QuoteMASI - Free Report) and Natus Medical . All the three stocks sport a Zacks Rank #1 (Strong Buy).

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