Q2 2008 Varian, Inc. Earnings Conference Call - Final

OPERATOR: Good day, everyone, and welcome to the Varian, Inc. Q2 earnings conference call. Today's call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Sean Wirtjes. Please go ahead.

SEAN WIRTJES, VP, CONTROLLER, VARIAN, INC.: Good afternoon. Thank you for participating in the webcast to review the financial results of Varian inc. for the second quarter of fiscal year 2008, which ended on March 28. I'm Sear Wirtjes, Vice President and controller, and with me are Garry Rogerson, President and Chief Executive Officer, and Edward McClammy, Senior Vice President and Chief Financial Officer.

Before Garry begins his review, please note that we will be making a number of forward-looking statements this afternoon. Including with respect to orders, revenues, margins, share based compensation expense, affective tax rate, earnings, cash flows, new products, acquisitions, and facility consolidation activities. These forward-looking statements are based on current information and expectations, actual results may differ materially for a variety of reasons, including but not limited to; the risks set forth in today's earnings release, in our last form 10-K, and in our form 10-Q, to be filed with the SEC for the second quarter of our fiscal year 2008. In this presentation we will also be providing certain non-GAAP or adjusted financial information. For reconciliations of that non-GAAP financial information, to the most directly comparable GAAP information, please see the non-GAAP reconciliations provided at the investors page of our website, at www.varianinc.com

I'll now turn the call over to Garry.

GARRY ROGERSON, PRESIDENT, CEO, DIRECTOR, VARIAN, INC.: Good afternoon. This quarter compared to the same quarter a year ago ended with good revenue growth, higher adjusted operating margins, and 13% growth in adjusted diluted earnings per share, despite a high tax rate. Revenues and more importantly adjusted operating margins, were at an all time record in any quarter for the company.

Before discussing the numbers in the press release, it's important to mention order intake was high in the quarter. Order growth was strong in Latin America and Asia Pacific, excluding Korea where pending government elections slowed down the order flow. China and Brazil were standouts in the quarter, with spectacular performance. Eastern Europe including Russia, and also some parts of Western Europe, including the U.K. and Italy continued to do well. After many quarters of strong growth, Germany, France, and Spain saw some slowdown. Vacuum products were particularly strong in Europe. In the U.S. we saw very good growth in analytical products, and positive signs from pharmaceutical and vacuum customers.

We received several large package orders in the quarter, mainly for environmental, food, energy applications, and for general infrastructure buildup. I would be nieve to say there have been no effects from the liquidity issues we hear every day, and there appear to have been some delays in midrange capital expenditures, which was most pronounced in product lines where we have increased pricing. Some companies have also added extra layers of approval for purchases, which delayed a few orders. After saying that, I should reiterate we had a good order quarter compared to the same quarter a year ago. Negatives were easily offset by the diversity of products, applications, and global distribution we have. The look the is again good for all major product lines in the June quarter, typically a difficult quarter for us.

Revenues grew 8% in the quarter, revenues grew in all regions in the world, that is North America, Europe, Asia-Pacific, and Latin America. We saw continued strength in environmental and food applications. We also saw again strong interest in products related to energy applications. Yes, we saw our usual products selling into the traditional gas and petroleum industry. We were seeing more and more inquiries in the new energy applications for biodiesel, ethanol, solar, and most recently nuclear. It is important to note within environmental and energy applications, we're seeing more and more demand for our vacuum products.

For instance in pharmaceutical companies, we're seeing a switch from oil based vacuum pumps in mass spec to dry pumps. This is driven by cost of ownership, and oil with disposal costs. Large vacuum pumps are needed in the manufacturing of solar panels, and more recently we're seeing increased demand for vacuum in processing uranium, for the nuclear energy. To some extent it is these new applications, causing the growth for our vacuum products.

The last few months have been perhaps the most active for new product introductions in the history of the company. In this industry it is new products that drive revenue growth and margin expansion. Our research and development group is second to none. I won't go into detail here, but we'll mention a few of the key products that we recently released. We introduced a new integrated system for both analytical and preparative HPLC. With it we released new 2.3 micron, and 3 micron columns for analytical LC, and a new load and lock system for preparative LC.

We also released a variety of detectors that complement both LC, and LC/MS. Ideal products for pharmaceutical research. We've already taken orders for these systems, and they are shipping. We introduced a new GC, probably the most flexible on the market, with the option of the one, two, or three detectors, ideal for the environmental and energy market, we are taking orders and shipping products.

We also introduced four new information rich detection products in this quarter. A high performance GC/MS with a small footprint, a product that is again ideal for environmental laboratories, where performance and space considerations are important. We are taking orders, and plan to start shipping in this quarter. A new FT-IR product, the highest performance on the market today, and a complement to our NMR, FTMS and recently acquired crystallography line. We now have a full breadth of information rich detection products, we're taking orders now, and the infrared is scheduled to ship, starting this month.

We also released a new hyphenated FTMS product, that combines triple quad and Fourier Transform Mass Spectrometry, with a unique ability to switch GC to LC and vice-versa. This is a specialized products for niche application, especially in environmental research and pharmaceutical research. And we're seeing good interest. New probe technologies for NMR that increased the performance, flexibility, and ease of use of NMR. Again, we are making strides in making NMR a more usable technique, for a wide range of scientists. Although the product is designed to increase ease of use, the technology that went into the design of these probes, is really state of the art.

We're looking for these new products to help accelerate growth, and improve margins. Many components and sub assemblies for these products are coming from low cost suppliers. A key objective of our research and development road map, includes releasing full complements of instruments, consumables, and applications. This is not easy to execute, given the number of R&D groups that are involved in a product. A recent success story is the release of sub-three micron columns for first HPLC applications, which would develop with the new HPLC platform in mind, and all released with a full set of applications.

We've also released a number of GC capillary columns that expand the customer base that we serve, with our gaschromatographs. The newest is our Ulti-Metal version, for high temperature applications. Consumable products contributed strongly to the adjusted operating profit this quarter, due to strong growth in purification, GC columns and both silica based and polymer based solid phase extraction products.

As well as new products we have developed from our own research, we recently completed two acquisitions of small companies, one in flash chromatography and the other in X-ray crystallography. As mentioned at the last earnings call, we've started to take orders and ship flash chromatography consumer board, and plan to start shipping flash chromatography this quarter. The market acceptance of the consumer voice has been good, and the products compliment our preparative LC for pharmaceutical research.

The crystallography product line we have just purchased compliments our NMR, Mass Spec, and infrared products and completes our suite of information rich detection products for the structural elucidation of liquids and solids. We are currently training our sales force in the new products, and are already generating leads across the world, mainly in pharmaceutical research. Being a high end research product line, with a longer sales cycle time, similar to NMR, I would expect growth for this product to be felt early in 2009. With these two acquisitions, our position in drug discovery continues to improve.

We also acquired light scattering detection technology in March, a detect to use to determine size of synthetic macromolecules and large biomolecules. The technology compliments other detector for gel permeation chromatography. We plan to integrate the product into our gel permeation chromatography equipment, and HPLC platforms, and expect to ship and market within the year, to both industrial and life science accounts for polymer and protein research. Acquisitions are key to our continued success, and you should expect us to be in the acquisition mode, buying technologies and products, that are synergistic, fitting with customers we already serve, and sending them down our distribution channel. There are as I have mentioned before, many more possibilities than before.

With our own internal development and acquisitions, we feel good about our ability to get to accelerate growth, and get to our internal revenue goals. Adjusted operating margins as already mentioned, were at a record, mainly due to mix and volume. Strength in consumables and vacuum products contributed to the improvements, as did a better balance between orders and sales. The margin improvement occurred against unprecedented currency movement. Margin should continue to improve as we reduce our lead times and start shipping the expanded array of new products introduced in the last few months. As they ship in numbers, the new products should help improve our margin.

Major sub assemblies of a new HPLC now come from China. And many components of the GC systems come from China, and soon Indonesia. By the end of the year, the majority of GC components, should be manufactured in low cost areas. These are two high volume products that easily lend themselves to manufacturing in low cost areas.

A new FTIR released last month was designed and is now being manufactured in our largest facility in Melbourne, Australia, allowing us to shut down a manufacturing site near Boston. Margins should improve on this product as we ramp up shipments. We also expect significant revenue growth from this product.

The global procurement group we set up a year ago is now paying for its keep. And the gains they now make should flow to the bottom line. Many components for our products in consumables, analytical, and vacuum products are coming from these lower cost areas. This should only increase over the coming quarters. I just mentioned the closure of a Boston facility, the consolidation of our Palo Alto and Walnut Creek facilities in the San Francisco Bay area is going well, and we should start to see some savings in this Q4. The major external headwind to our margin program, is a continuing weakening of the U.S. dollar, which is not we believe significantly affected adjusted EBIT, but has affected adjusted operating margins.

Another factor we need to consider is our recent acquisitions. These nearly always have a dilutive effecting the first six months or so, as they integrate into the network. As you know, we have recently purchased flash chromatography and X-ray crystallography product lines, these will likely dilute us slightly in the first six months, but should then become rapidly accretive. Looking forward at continued investment in R&D, our global distribution, our focus in the three key applications of environmental, energy, and pharmaceutical, our ability to generate cash and deploy it wisely to acquire to grow, and our strong backlog, all combine to put us in a sound position for the future, and to weather downturns in the marketplace.

I should note a few internal execution risks. The consolidation of two of our major factories in California. Successful rollout of the new products we just released, and integration of recent acquisitions. And reducing the lead time of our high-end Magnetic Resonance product. After saying that, we feel comfortable with our guidance for the year, and our ability to strive for our internal stretch goal of $1.2 billion of revenue, and 15.5% adjusted operating margins by 2010.

I'll turn call to Ed for financial details.

ED MCCLAMMY, CFO, SVP, TREASURER, VARIAN, INC.: Thanks Garry. We are pleased with our operating results for Q2, with solid revenue growth and adjusted operating margin expansion compared to the year ago quarter. Our analytical instruments backlog, which has built up over recent quarters, remained high at the end of Q2, as orders during the quarter were strong, and our factories were also focused on executing several new product introductions. Adjusted operating margins benefited from product mix and volume. These benefits were partially offset by high costs in our scientific instruments segment, related to several new product introductions and other initiatives which should benefit margins later in the year. In addition, the weakened U.S. dollar continues to be a headwind for margin improvement, even though we do not believe it has any significant impact on adjusted EBIT growth. The higher than usual adjusted affective tax rate of 36.6% reflects taxes on certain intercompany dividends. The affective tax rate for the full fiscal year is still expected to be approximately 34.5% to 35.5%.

During Q2 we repurchased 1.044 million shares of stock for $56.4 million. During the quarter we completed the January 2007 share repurchase authorization, and the board approved a new $100 million authorization, effective through December 2009. At the end of Q2 we had $79.8 million remaining under this new authorization. The size of the repurchases in Q2 reduced the number of shares used for EPS calculation, but also reduced interest income. Interest income was also lower, because of lower interest rates.

Share based compensation expense for Q2 was $0.07 versus our previous guidance of $0.06. The difference related more to tax effects that to the pretax expense. Share based compensation expense for the full year should be approximately $0.23 per share.

You may have noticed that during Q2 we recorded a $1.9 million after tax charge for impairment of a private company equity investment. This represented a 100% write off of a small equity investment in [Xeral AG], a private Swiss automations company. Unfortunately, the founder recently died, and based on subsequent internal turmoil and events, we believe that there is probably no value remaining in this investment.

Turning to the balance sheet, DSO was 73 days in Q2, compared to 71 days a year ago, and 66 days the prior quarter. This higher than normal DSO was primarily related to the timing of shipments, and not to any significant change in the timeliness of payments. Inventory turns were 3.3 in Q2, compared to 3.5 a year ago, and the prior quarter. This decrease related primarily to an inventory build, to support both the high number of new product introductions, and several manufacturing initiatives across the country. As a result of these higher accounts receivable and inventory levels, free cash flow was only $7 million during the quarter. We expect both the DSO and the inventory turns metrics to improve by the end of the fiscal year, which should result in a significant improvement in cash flow from operations, in the second half of the fiscal year.

Now a few comments looking forward. At this point our outlook for adjusted diluted EPS growth for FY'08 has not changed, and therefor we are still comfortable with the adjusted EPS guidance provided last November. To say it differently, based on the results for the first half, and the demand we currently see, we are just as bullish for the full fiscal year, as we were in November when we established initial guidance for the year.

In summary, the fundamentals of our operations continue to be strong. And our adjusted operating profit came in about as we expected. Most of the ups and downs related to items below adjusted operating profit, such as interest income, share count, effective tax rate, and after tax stock compensation expense. Our diversity and global presence continue to serve us well. We have demonstrated an ability to take advantage of ever changing growth opportunities, whether it be changes in demand by application, or changes in demand by geographic region. We'll now open the call for questions.

OPERATOR: Thank you. (OPERATOR INSTRUCTIONS). We'll go first to Peter Lawson, with Thomas Weisel Partners.

PETER LAWSON, ANALYST, THOMAS WEISEL PARTNERS: Ed, in the vacuum business, what helped margins and then conversely in the instrumentation segment, what instruments hurt the margins for the quarter?

ED MCCLAMMY: On the vacuum side, it had more to do with volume leverage, that business is very sensitive, their margins are very sensitive to the volume. So that was the number 1 driver there. A little bit product mix, but primarily the volume leverage.

In scientific instruments, it didn't have as much to do with that product mix. In fact, as Garry said, product mix actually helped us both in the total company, and also had some positive effect within scientific instruments. The main thing that caused the scientific instruments margins to be down, as I had mentioned in my prepared comments, related to the activities related to all the new product introductions that Gary talked about. R&D expense was somewhat higher. That was all in scientific instruments, to support those new products. And there was also some additional selling and marketing activities, related to those new product introductions. And then the final thing that Garry and I both mentioned that impacted scientific instruments margin, is just the continuing weakening of the dollar, and again we don't think it has any impact on the reported EBIT dollars. But a tail wind to the revenues, and a headwind to the operating margins.

PETER LAWSON: Would you the think you get through the new instrument introduction tail wind, on the scientific instrument segment?

GARRY ROGERSON: On the new products, as I mentioned. I picked on most of them there. So they are beginning to ship, the new LC is shipping, the new GC is shipping. The new infrared is shipping. So those three product lines are shipping, or about to ship. They'll ship this quarter. And we do expect to get margin improvement from those product lines, no question.

PETER LAWSON: And what was the backlog like for the quarter?

GARRY ROGERSON: We don't mention backlog, but we've had a very strong three or four quarters in the company, and backlogs are very sound.

ED MCCLAMMY: I think the main thing that we talked about last quarter, was that for several quarters now, the backlog within analytical instruments that typically ship in a couple of months, has built up, primarily in former quarters because of the strength of the orders. This quarter we thought those might come down noticeably. And they didn't. They came down, but only slightly. And the reasons for that were, one that the orders came in very strong again. And secondly, the factories were very focused on this extremely high number of new product introductions, and that obviously, was some distraction against the day-to-day execution on shipping orders.

GARRY ROGERSON: The factory did amazingly well. We cut into a lot of new products last quarter. And switched out some very big product lines of our own. The GC product line unit wise, has to be the number one product line in the analytical side of the company. LC would not be that far behind unit wise. So they were big cut-ins, and the infrared one, we actually closed the facility in Boston, where we were shipping our infrared from, and started shipping out of our Melbourne facility, a new product. So the factories did very well last quarter, very pleased with the switch of the products.

PETER LAWSON: Okay. And just finally, on the stock options. Were they high this quarter? I missed that. And on the tax rate, as you talked before, just a bouncing around of that number.

ED MCCLAMMY: On the stock option expense, it primarily had to do with getting additional information on what the tax implications were, so revising the tax implications specifically to stock options. And as I said, that we think for the full year that's going to be about $0.23. So that means that, that's another $0.12 spread over the next two quarters.

And then on the tax rate, I'd made a comment that it related primarily to a few just individual events related to dividending money back into the U.S. from a (inaudible) subsidiary. While this quarter is significantly up, we haven't changed the guidance for the full year at all. We still think it's going to be between 34.5 and 35.5. So yes, I think as you're going to start seeing with most companies is that rate is going to bounce around from quarter to quarter.

PETER LAWSON: Thank you so much.

ED MCCLAMMY: Yes.

OPERATOR: We'll go next to Richard Eastman, Robert W. Baird.

RICHARD EASTMAN, ANALYST, ROBERT W. BAIRD: I know from past conference calls you don't section off currency, and the impact it had at the sales line. If I make an assumption on currency that it's around 5%, it could even be a little higher, it just looks like your volume growth is quite weak relative to the way I would think your plan would have laid out for the year. How much of that is due to shipping delays, or could you give-- because it doesn't reconcile real well with your geographic explanation that most things were quite strong?

GARRY ROGERSON: We don't give the currency effect, because we think that calculation isn't that great. Obviously, we hear others saying what they do. You got to remember we have a lot of high end capital equipment here, where there's significant negotiation going on, on pricing. I don't think it relates that well to us.

ED MCCLAMMY: I will say-- we can do the mathematical calculation just like other companies can do. Just to put it in perspective, since there's not that many data points out there, is the mathematical calculation would not show much of a difference for us, than it would have been over the last three or four quarters. But I know there's one data point out there where it shot up pretty significantly. When I do the mathematical calculation for us, it's about the same.

RICHARD EASTMAN: As the industry you mean?

ED MCCLAMMY: No, as it would have been for us. I'm saying, I won't say specifically, Waters threw out a number than was higher than I think they mentioned for the last three or four quarters. If we were putting a number out there for us. It would not have been significantly different from what we would have said the last three or four quarters. I'm not sure why they're saying that higher uptick.

RICHARD EASTMAN: The dollar was weaker in the first quarter sequentially. That's part of what added to it, as well. Can I circle back on the incremental margin within the scientific instruments business? Again, I would think-- how much of a factor did mix play in that incremental margin assumption? Was your -- were your higher margin information rich products-- did they grow at a lesser rate than maybe the analytical instrument piece?

ED MCCLAMMY: Maybe I missed the question. I think both Garry and I said that for overall margins and scientific instruments, we benefited from product mix.

RICHARD EASTMAN: Okay. So just the incremental added costs, absorbed that much and more. Okay.

ED MCCLAMMY: Yes, from the combination of the currency, and again as I've given an example before, we think for every 1% you assume for a currency top line impact, it's about 12 basis points on headwind to margins.

RICHARD EASTMAN: Okay.

ED MCCLAMMY: But no impact to EBIT. And then on top of that there were some pretty significant costs in scientific instruments related to the new product introductions. As you can tell from that list Garry went through, it's certainly more than we've ever mentioned in one call, and probably more than any of our competitors have mentioned in a call. So we have had a lot of new product activity going on.

GARRY ROGERSON: I haven't mentioned all of them.

ED MCCLAMMY: So you can see it's difficult for you to see that in the sales and the SG&A, because there's other things going on. You certainly can see it in the R&D line.

RICHARD EASTMAN: The last question, in terms of the sales numbers here, the sales number-- outside of this couple countries that you had mentioned were soft-- I think you said Spain, what grew in excess of the 8%?

GARRY ROGERSON: I think what we said was that there were a few that were below, which is Germany, France, and Spain, and the rest of the world did quite well.

RICHARD EASTMAN: It did better than that.

GARRY ROGERSON: That's a real generalization.

ED MCCLAMMY: To interrupt there Rick, one thing that is certainly positive, we're very pleased with, is in the last two quarters now we've seen growth again in the U.S., which had been a weak spot force us.

GARRY ROGERSON: Growth in the U.S. analytical and the other key point is that growth was starting to see vacuum in the U.S. Perhaps it's bottomed out. We've always had growth outside the U.S. as product lines have moved out. Manufacturing has moved out. But we appear to be seeing a little bit of growth in vacuum as well.

RICHARD EASTMAN: Okay. All right. Thank you.

GARRY ROGERSON: In analytical, in the U.S. we also got a little bit of growth from our new pharmaceutical sales force we put in place. A lot of our products are directly related to pharmaceutical. Like (inaudible) visible to dissolution, LC we saw a nice pickup in the quarter.

RICHARD EASTMAN: Thank you.

OPERATOR: We'll go next to Derik DeBruin, with UBS.

DERIK DEBRUIN, ANALYST: Hello, good afternoon.

GARRY ROGERSON: Hello, Derek.

DERIK DEBRUIN: Your previous revenue guidance 5% to 7%, all in on the top line, and last call you said, given the currency impacts more toward the higher end of the range. Still comfortable with that?

ED MCCLAMMY: I think I said at the high end or over the top of that range, and we're still comfortable with that. And the inverse is still true as well. We're still comfortable with the range we have for operating margins, but obviously, the up side to that revenue that does come from currency, is going to cause some downward pressure on the margins, within that range.

DERIK DEBRUIN: Okay. I guess when you look at the contribution from acquisitions, since you've had several of them. What do they contribute in Q2 and the first half of '08?

GARRY ROGERSON: As I've said, the flash chromatography was just-- both of them won't contribute for the first few months. It's very, very unusual for an acquisition of the type we make to be accretive in the first few months. because what we're doing, we're doing the training, where we're actually retesting the products, getting their certificates, there's a lot to be done in the type of equipment-- type of technology that we're buying. They're usually not accretive in the first six months or so. In fact I've said, they're likely to be dilutive.

ED MCCLAMMY: And from a revenue perspective, we usually anticipate from the ones we've seen, that there's some disruption during that transition as well. The revenues are usually at best flat, and usually can be even down for a couple of quarters while it's being integrated. But I should say that the guidance that we mention on the revenue is excluding those new acquisitions, so any revenue that we do get would be up side to that.

GARRY ROGERSON: If you think about the crystallography equipment we just bought, and you know that very well, that fits beautifully with our NMR equipment and our infrared, and our FTMS. It's the same customers buying that equipment. So at the moment our people are at this moment are being trained in China, Taiwan, Korea. It will take a little bit of time for them to start building up their prospect lists, and turning those into orders. It's interesting that the prospect lists are already building up. Prospects are popping up all over the place, for that product line which will be obvious, because we're with those customers or similar customers anyway. But it does take a little bit of time to get the whole thing going.

DERIK DEBRUIN: And (inaudible) Correct me if I'm wrong, it's about 15 million in sales.

GARRY ROGERSON: Last year I think it was 15 million, or when we bought it, it was annualizing at 15 million.

ED MCCLAMMY: 15 for the previous 12 months.

DERIK DEBRUIN: And the five to seven excluded in the acquisition. That's fine. And I guess the share count at the end of the quarter was what?

ED MCCLAMMY: Let me see if I've got that here. End of the quarter. I've got the actual share count was 29.5, but then obviously there's been an add on for the typical dilution impact to get to diluted shares.

DERIK DEBRUIN: Right, and Ed, last quarter you had cautioned us, or pointed out to us that the tax rate in this quarter was going to be abnormally higher than the rest of the year. The rest of the other quarters. Is there anything unusual in the tax rate in the coming quarter that we need to worry about?

ED MCCLAMMY: Obviously, if we're going to get within that rate that we talked about for the year, the average will be lower than it was this quarter.

DERIK DEBRUIN: Okay, and I guess when you look at-- do you think about potentially doing an even more accelerated buyback program, given where the stock price is?

ED MCCLAMMY: I think as we've always said, our number one priority for cash, is acquisitions. And as Garry said, there have been more opportunities. So we certainly want to be careful not to extend on the repurchases, to the point we block some of the opportunity that is may be coming along. I think probably the best way to think about it at this point for the remaining authorization, is what we've said before, and until an acquisition comes along, the way I think about it is spreading it over the remaining authorization period. But with that being said, if there's market opportunities, where we feel like the stock has gotten noticeably underpriced, like we did this quarter, we'll get in more actively.

DERIK DEBRUIN: Thank you.

OPERATOR: (OPERATOR INSTRUCTIONS). We'll go next to John Sullivan, with Leerink Swann.

JOHN SULLIVAN, ANALYST, LEERINK SWAN: Good afternoon.

GARRY ROGERSON: Hi, John.

JOHN SULLIVAN: A couple of quick questions. Vacuum technologies -- can your just ballpark the portion of the business that comes out of the life sciences and health care, on the one hand, and comes out of everything else on the other hand?

ED MCCLAMMY: It's not that different than what we've been saying for the total company. It's about 40% life science. And it's a rough number but it's in that ballpark.

GARRY ROGERSON: What's interesting in vacuum at the moment, is this growth of their product lines into these newer technologies into solar, into nuclear energy, into switching out roughing pumps in the pharmaceutical industry because of the oil in them. These are great growth engines for the company. So it's not the typical industrial that you might imagine that we're selling our vacuum into, or where the growth for vacuum are.

ED MCCLAMMY: Another new trend that's using equipment that's not that different from semiconductor manufacturing equipment, is-- Garry mentioned the nano technology. An example is in these nano mirrors, that are used in some of the high definition TVs. It's one of the things that's continued to drive vacuum, if you look at vacuum over a number of years, at a higher rate than-- significantly higher than GDP. There's constantly new applications coming along, and from a manufacturing perspective that's outside of life science, it's places where people are looking to manufacture to tighter tolerances, such as the nano technologies. Where they're looking to manufacture in a more environmentally sensitive way. And in areas where they're looking to minimize the loss of a precious raw material. Over the years, it has pretty consistently been new applications that come along.

JOHN SULLIVAN: I appreciate that. And then can you talk for a second about materials costs and raw materials costs? Are you seeing-- and what are the raw materials that you're most leveraged to in your instrument business? And are your able to control or offset those costs with price increases? Can you just talk about that?

GARRY ROGERSON: I suppose the major raw material costs where we're affected, would probably be in magnet manufacture, and clearly where you're buying copper wire, and things like this, there are increases in costs. But we're always battling that down. And we've better designs and competitive bids for products. That will be the biggest area where there will be a cost increase due to raw materials.

JOHN SULLIVAN: Okay. And would you generally say that you're able to offset increases in materials prices with your own pricing, or how should investors think about that?

GARRY ROGERSON: We're continually (inaudible) from pushing up the pricing on our NMS systems-- that's correct.

JOHN SULLIVAN: I appreciate that.

GARRY ROGERSON: And we are in general -- we're always trying to maximize our pricing in NMR in particular, we are trying to do that.

JOHN SULLIVAN: Okay, and then my last question, you talked about consolidation of some facilities and long term benefits to increase efficiency in this way. The California facilities, what is the timing on consolidation of those?

GARRY ROGERSON: It's a phased timing. But manufacturing should be in, by next year by the end of next quarter, we should be manufacturing most of our NMR products in Walnut Creek. They will have moved to Walnut Creek.

ED MCCLAMMY: The complete consolidation of the two is about a year.

JOHN SULLIVAN: Okay.

GARRY ROGERSON: You'll see savings from that as the year progresses. You're going to see a lot of savings to improve our margins as the year progresses. New product introductions, global procurement, consolidation of factories. And price increasing. Is all contributing to our efforts to improve our margins. And obviously, on the downside, there's what I've talked about before, exchange rate, potentially acquisitions as we do them, can be dilutive, and generally inflationary things, but we believe we can beat that, and we believe we can get north of 15% by 2010.

JOHN SULLIVAN: Appreciate that. And my last question is just-- as far as the backlog of orders remaining strong throughout the quarter, are NMR orders still strong, can you give us any detail on NMR specifically, and customer interest in this high priced item?

GARRY ROGERSON: That midrange area, was the area where if anything we saw some kind of slowdown. Middle of the range from about $150,000 to $300,000 where people were seeming to have more sign-offs put into, and clearing price increases we were putting through. There seemed to be a little bit of a slowdown in that area. NMR as a total business had a very nice quarter, we have to be very careful because it's lumpy. It's a lumpy business, and we got significantly-- significant orders in the quarter for NMR. It had a good quarter for orders. But that midrange-- there was a touch of a slowdown. Now talking about the future and looking forward to this quarter and next, we are reasonably optimistic. I shouldn't say reasonably optimistic, that's being British, we're optimistic.

JOHN SULLIVAN: Thank you so much.

OPERATOR: (OPERATOR INSTRUCTIONS). We'll go next to Jonathan Groberg, with Merrill Lynch.

JONATHAN GROBERG, ANALYST, MERRILL LYNCH: Good afternoon.Thanks for taking the call.

GARRY ROGERSON: Hello, Jonathan.

JONATHAN GROBERG: A few quick questions. Going back to the top line, again a little bit By any measure your use in terms of the FX that you described Garry, and looking at kind of the comps, and the fact that second quarter is typically a little better quarter than the first or third. It seems like revenues were a little weak in the quarter. So I'm just curious. Is there anything-- as you described the fact that orders were strong, you maybe didn't ship quite as much as you wanted? Do you still expect the same seasonality, do you expect Q3 to be weaker or seasonality--

GARRY ROGERSON: As I've said we haven't driven our analytical backlogs down, and they've been building up over the last few quarters. And if I look over the last nine months, there's been quite a significant increase in our backlogs. We really didn't expect them to come down too much in the quarter we just had, because we've been switching over to new product lines. But we would-- we had that behind us for the next quarter as well to start eating into the analytical backlog, does that answer the question?

JONATHAN GROBERG: In the past you've talked about the seasonality in your business. Given some of the things going on internally, Q3 may not be as dry relative to Q2 its been in the past?

ED MCCLAMMY: I think that one thing if you look at the revenues sequentially, we did have the increase from Q1 to Q2. And then I think Garry made a comment that we probably wouldn't have as much of a headwind going into Q3 as we might sometimes have. With some of the demand we're seeing and the backlog that we're taking into the quarter, which we certainly--

JONATHAN GROBERG: I was looking more year-over-year where you had slightly easier comps in the second quarter this year. I think that answers my question. And from just a product standpoint, can you maybe say in the quarter what percent of sales were consumables, and what percent of sales were information rich detection?

GARRY ROGERSON: In consumable we break that out, and it was roughly 33%. It was a really good-- that 33% includes service and parts, and consumables is usually about 15%. It was a very good quarter for our life science based consumables, and our GC columns. So things relating to GC and HPLC the consumables around that were very strong in the quarter. That actually helped our margin.

JONATHAN GROBERG: I would think. On the information rich detection, any of those broad range of products, how those are growing?

GARRY ROGERSON: That kind of had a good quarter. I think everything across the board it was-- there weren't any stars and there weren't any laggers of the serious kind in the quarter.

JONATHAN GROBERG: Okay. Except for maybe the mid range price on the NMR, so my next question is where are you really seeing that, more signatures being required?

GARRY ROGERSON: I noticed that in and as I go around and I get color, and I know you look for color, where I've noticed it is in that area where we noticed the slowdown, which was Germany, France, that area. We notice a little bit more questioning on these high ticket orders. Obviously, in industry and academia, and government, that doesn't occur.

JONATHAN GROBERG: Okay. From a geographic standpoint, more Western Europe, and from industry standpoint was it pharma?

GARRY ROGERSON: Western Europe and the specific companies, as I said. I beg your pardon.

JONATHAN GROBERG: From an industry perspective is it more pharma, or is it even some of the petro-chemical based--

GARRY ROGERSON: It's a more general statement.

JONATHAN GROBERG: Okay.

GARRY ROGERSON: And I really-- at the moment I'm not too concerned about that. Obviously, you're watching it, but I'm not too concerned. It happened in the quarter. I try to give color to the quarter. At the moment I don't see it as a trend.

JONATHAN GROBERG: Speaking of pharma then, a few competitors have talked about weakness there. What are you seeing and are you seeing any changes in procurement? You kind of go straight to the customers, don't use distributors. I'm wondering if you see any change in the way pharma is procuring?

GARRY ROGERSON: I think pharma-- as I said, we put our pharmaceutical sales force together in the U.S. at the beginning of the year. I mentioned to you all, that pharmaceutical is going to be a more interesting area for us, as the year goes on. And as you noticed, we've bought more and more technologies, and we've released more products for pharma and we're starting to see growth in pharma inside the U.S. And has the helped us in the quarter we've just had. But again, I warn you that we're not big enough to really help you understand pharma yet. I think we're getting there. I would listen to others as well as us.

JONATHAN GROBERG: Last question, Garry for you. Why again were the accounts receivable and the inventories so much higher in this quarter?

GARRY ROGERSON: The inventories were much higher because of just this-- we've had an incredible boat load of new instruments released. And when you do that, you build up inventory for those first shipments, or for those first shipments. GC is a mainstay product line to the company. LC is a mainstay product line to the company. Infrared is a reasonable product line for the company. Those three in themselves, meant that we were building up inventory there. At the same time, we are moving our NMR manufacturing from Palo Alto to Walnut Creek. And again, we're building up inventory there. A lot of those products are now coming from the low cost areas. And a lot of tags being put in place, as we go through these transitions.

JONATHAN GROBERG: On the accounts receivable, do you bill when people give orders, is that when you actually send out a bill?

ED MCCLAMMY: You send out the-- we'd love to do that. You send out the invoice when you ship the product. It's related to the-- almost totally to the timing to have shipments. And then coming later in the quarter, being more skewed to the third month, and had no significant impact from any delays in customer payments.

JONATHAN GROBERG: So you'd expect in the third quarter that to shift kind of at the end.

ED MCCLAMMY: I would expect in the second half of the year to see those turn back around. I think the receivables will turn back around quicker than the inventories will.

JONATHAN GROBERG: It's more associated with shipments than customers not paying?

ED MCCLAMMY: Yes.

GARRY ROGERSON: In my whole time in in industry, I haven't seen customers not pay. The only time they don't pay, is if the product doesn't work.

ED MCCLAMMY: Looking at ageings there hasn't been any significance-- any trend of customers whether they're going to pay or not, delaying payments either.

JONATHAN GROBERG: Your still have to ask. There's a lot of things we've never seen before that are occurring in this market.

ED MCCLAMMY: I understand the question, which is why in my script I pointed that out. Because it's one of the things obviously we looked at when we saw the receivables higher as well.

JONATHAN GROBERG: Thanks.

ED MCCLAMMY: Yes.

OPERATOR: And we'll take a follow-up question from Derik De Bruin, with UBS.

DERIK DEBRUIN: Hello. Just discussion all the discussion on the gross margin pressure from the currencies. You do expect to gross margins to be up year-over-year?

ED MCCLAMMY: We haven't given any guidance on gross margins, so we'd rather keep it at this point, on the comment on operating margins.

DERIK DEBRUIN: Okay. But I would argue that it looks like the cost came down in terms of the SG&A cost, came down in the quarter relative to my expectations were. Is that a trend we can see continuing?

ED MCCLAMMY: Probably. I get hesitant to get down to that specific of a level, because a lot can happen.

DERIK DEBRUIN: Basically what you're say is that there's a lot of moving parts, but that you're comfortable with the 13% to 14% range. Biased probably toward the lower end of the range.

ED MCCLAMMY: Correct.

DERIK DEBRUIN: And I guess when you start looking at 2000, you're going forward on the tax rate. Does that start coming down in 2009, 2010?

GARRY ROGERSON: What we said on the tax rate, is that's going to be the toughest for us, and we'll probably start seeing that in the back end of 2009, into 2010. If you remember the presentation we gave at the beginning of the year, that is giving us the least benefit in this three year period. We should get some benefit near the end, but it will give us the least benefit.

DERIK DEBRUIN: All right. Thanks.

OPERATOR: And there are no other questions at this time. I'd like to turn the conference back to Mr. Wirtjes for any closing remarks.

SEAN WIRTJES: That concludes today's webcast. A replay of which will be archived on our website. To access the replay, go to www.varianinc.com, click on the investors link at the top of the right side of the page, and then click on the microphone, and follow the instructions. Thank you very much for joining us today.

OPERATOR: Thank you everyone. That does conclude today's conference. You may now disconnect.

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