Summary of VARIAN MEDICAL SYSTEMS INC

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. ("VMS") and its subsidiaries (collectively "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 or management's current expectations due to the factors cited in this "Management's Discussion and Analysis of Financial Condition and Results of Operations," or MD&A, the Risk Factors listed under Part II, Item 1A of this Quarterly Report on Form 10-Q, and other factors described from time to time in our other filings with the Securities and Exchange Commission, or SEC, or other reasons. For this purpose, statements concerning: industry or market outlook, including growth drivers; our future orders revenues, backlog or earnings growth; future financial results; market acceptance of or transition to new products or technology such as intensity-modulated radiation therapy, or IMRT, image-guided radiation therapy, or IGRT, volumetric modulated arc therapy, or VMAT, brachytherapy, software, treatment techniques, stereotactic radiosurgery, filmless X-rays, security and inspection products, and proton therapy products; any statements using the terms "believe," "expect," "expectation," "anticipate," "can," "should," "will," "would," "could," "estimate," "continue," "grow," "based on," "may," "intended," "potential," "promising," "hope," "optimistic" "on-going," "likely," and "possible" or similar statements are forward-looking statements. 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

In the third quarter of fiscal year 2009, we reported growth in backlog, net earnings and gross margins over the year-ago quarter, but weaker than expected revenues and net orders, particularly in our X-ray Products and Security and Inspection businesses. Excluding the discontinued scientific research instruments business, or Research Instruments, of ACCEL Instruments GmbH, or ACCEL (which subsequently changed its name to Varian Medical Systems Particle Therapy GmbH), net earnings from continuing operations per diluted share was $0.68 in the third quarter of fiscal year 2009 versus $0.61 in the third quarter of fiscal year 2008. Revenues from continuing operations in the third quarter of fiscal year 2009 were about even with revenues from continuing operations in the year-ago quarter. In the third quarter of fiscal year 2009, net orders declined by 4% over the year-ago quarter. Our backlog grew 11% from the end of the year-ago quarter. An improvement in gross margin, together with cost control initiatives, contributed to an almost two percentage point increase in operating margin over the year-ago quarter. We had $472 million of cash and cash equivalents at the end of the third quarter of fiscal year 2009.

In the second quarter of fiscal year 2009, the Company completed the sale of Research Instruments in order to focus that business exclusively on the development of our proton therapy business, now operating as "Varian Particle Therapy." Accordingly, Research Instruments is classified as a discontinued operation for all periods presented and we have segregated the net assets and operating results of Research Instruments from continuing operations in our Condensed Consolidated Balance Sheets and in our Condensed Consolidated Statements of Earnings. Unless otherwise stated, the discussion in this MD&A pertains to our continuing operations. Research Instruments was previously included in the "Other" category.

Oncology Systems. Our largest business segment is Oncology Systems, which designs, manufacturers, sells and services hardware and software products for radiation treatment of cancer with conventional radiation therapy, fixed field IMRT, IGRT, stereotactic radiotherapy and stereotactic radiosurgery, brachytherapy and VMAT, which is a special form of IMRT. Products include linear accelerators, brachytherapy afterloaders, treatment simulation and verification equipment and accessories; as well as information management, treatment planning and image processing software.

In our view, the fundamental market forces that should drive long-term growth in radiation therapy, stereotactic radiosurgery and brachytherapy are the rising cancer incidence; technology advances and product developments that are leading to improvements in patient care; customer demand for more advanced and effective cancer treatments, such as fixed field IMRT, IGRT, stereotactic radiosurgery, brachytherapy and VMAT; competitive conditions among hospitals and clinics to offer such advanced treatments; improvement in cost efficiency in delivering radiation therapy; and underserved medical needs outside of the United States. Our primary goal in the Oncology Systems business is to promote the adoption of more advanced and effective cancer treatments.

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For the third quarter of fiscal year 2009, Oncology Systems experienced the combined effect of a recession that has shrunk capital equipment budgets, slowed decision making and made financing more expensive and time consuming; the added uncertainty created by the prospects of healthcare reform in the United States; and the uncertainty about the proposed reduction in Medicare reimbursement rates for radiotherapy and radiosurgery at freestanding clinics in the United States, which we believe represents approximately 10% of Oncology Systems' business. We expect that uncertainty in North American radiation therapy capital spending will persist until there is greater clarity on healthcare reform and reimbursement rates. North American net orders decreased 9% and Asia and Europe contributed to the 8% growth in international net orders in the third quarter of fiscal year 2009 over the year-ago quarter, while the rest of the world region experienced a decline. The stronger U.S. dollar against foreign currencies compared to the year-ago period negatively impacted international net orders in the third quarter of fiscal year 2009.

In the third quarter of fiscal year 2009, Oncology Systems North American revenues remained relatively flat compared to the year-ago quarter while Oncology Systems international revenues grew by 10%, even though they were negatively affected by the strengthening of the U.S. dollar. A product mix shift toward higher margin software products, together with higher sales volume and cost control initiatives contributed to a 2.8 percentage-point improvement in Oncology Systems gross margin in the third quarter of fiscal year 2009 compared to the year ago period. As of the end of the third quarter of fiscal year 2009, we had more than 180 installations of our RapidArcTM products since we introduced these products in the second quarter of fiscal year 2008.

During the third quarter of fiscal year 2009, we acquired certain assets of IKOEmed LLC and IKOEtech LLC, collectively referred to as "IKOE," which are privately-owned suppliers of software used in the planning of radiotherapy and radiosurgery treatments. The acquired software, which is being incorporated into some of our Oncology Systems products, complements our existing segmentation tools currently used to automate planning for prostate, breast, and lung treatments.

The current worldwide economic downturn is making it more difficult for our customers, our vendors and us to accurately forecast and plan future business activities. We have seen customers' decision-making process further complicated and lengthened as the current worldwide economic downturn causes hospitals, clinics and research institutions to more closely scrutinize and prioritize their capital spending budgets in light of tightened capital budgets, tougher credit requirements and the general constriction in credit availability. We cannot predict the timing or duration of any economic slowdown or the timing or strength of a subsequent economic recovery, in general or specifically in the healthcare industry. If the healthcare market significantly deteriorates due to these macroeconomic effects, our business, financial condition and results of operations will likely be materially and adversely affected. Additionally, other external influences that could adversely impact our Oncology Systems business include the fluctuations in currency exchange rates, healthcare reform and changes in governmental healthcare policy now being considered by Congress or otherwise and changes in Medicare and Medicaid reimbursement rates for radiotherapy, brachytherapy and radiosurgery procedures in the United States.

The strengthening of the U.S. dollar against foreign currencies that we experienced in recent quarters, including the third quarter of fiscal year 2009, has made our pricing less competitive and may result in slower growth in our international orders and revenues. The stronger U.S. dollar compared to prior periods also may negatively affect our revenues and net orders when measured in U.S. dollars. Additionally, we have seen the purchasing cycle lengthen for some customers, which we believe results from a more complex decision-making process associated with larger dollar value transactions for more sophisticated IGRT and surgical equipment and other technical advances. Revenues are also influenced by the timing of product shipments which are tied to planned customer-requested delivery dates. These factors may result in greater fluctuation in our Oncology Systems net orders and revenues.

X-ray Products. Our X-ray Products business segment manufactures and sells:
(i) x-ray tubes for use in a range of applications including computed tomography, or CT, scanning, radiographic or fluoroscopic imaging, mammography, special procedures and industrial applications; and (ii) flat panel digital image detectors for filmless x-ray imaging (commonly referred to as flat panel detectors or digital image detectors), which are an alternative to image intensifier tubes for fluoroscopy and x-ray film and computed radiography, or CR, systems for radiography. We continue to view the long-term fundamental growth driver for this business to be the on-going success of key x-ray imaging original equipment manufacturers, or OEMs, that incorporate our X-ray tube products and flat panel detectors into their medical diagnostic, dental, veterinary and industrial imaging systems.

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X-ray Products revenues decreased in the third quarter of fiscal year 2009 following the inventory adjustments by several imaging equipment manufacturers in the second quarter of fiscal year 2009. A relatively modest decline in net orders in the third quarter of fiscal year 2009 over the third quarter of fiscal year 2008, as compared to the decline in net orders in the second quarter of fiscal year 2009 over the second quarter of fiscal year 2008, suggests that customer inventory adjustments may be abating and that this business segment could be nearing a return to more normal growth patterns. Compared to the year-ago quarter, net orders for x-ray tubes increased in the third quarter of fiscal year 2009 while net orders for our flat panel detectors declined as this product line, particularly in the dental and veterinary markets which have been hit hard in the recession, continued to experience the impact of customer inventory adjustments.

Our success in our X-ray Products business depends upon our ability to anticipate changes in our markets, the direction of technological innovation and the demands of our customers. The general worldwide economic downturn we have seen since 2008 may make it difficult for our OEM customers, our vendors and us to accurately forecast and plan future business activities. If the markets for our customers significantly deteriorate due to these macroeconomic effects, our business and results of operations may be adversely affected. The rising costs of raw materials due to increased worldwide demand which we have seen over the last two years have abated with the recent worldwide economic downturn. Global demand for such commodities has lessened and we have seen decreases in some commodity prices for our materials, which should eventually benefit our product cost structure.

Other. The "Other" category is comprised of SIP, the Varian Particle Therapy business, and the operations of the Ginzton Technology Center, or GTC. (Please refer to Note 15, "Segment Information" to the Condensed Consolidated Financial Statements within this Quarterly Report on Form 10-Q.)

SIP designs, manufactures, sells and services Linatron� x-ray accelerators, imaging processing software and image detection products for security and inspection purposes, such as cargo screening at ports and borders and nondestructive product examination for a variety of applications. SIP also designs, manufactures, sells and services IntellXTM, an imaging product for cargo screening. We generally sell SIP products to OEMs who incorporate our products into their inspection systems, which are then sold to customs and other government agencies, as well as to commercial private parties in the casting, power, aerospace, chemical, petro-chemical and automotive industries for nondestructive product examination purposes.

Use of this technology in security cargo screening and border protection is still in its early stages but we believe growth in the SIP business will be driven by cargo screening and border protection needs, as well as by the needs of customs agencies to verify the contents of shipments for assessing duties and taxes. As a result, this business is heavily influenced by U.S. and foreign governmental policies on national and homeland security, border protection and customs revenue activities; these activities depend upon government budgets and appropriations and are subject to political change. Orders and revenues for our SIP products have been and may continue to be unpredictable as governmental agencies may place large orders with our OEM customers in a short time period and then may not place any orders for a long time period thereafter. However, as budgets are put on hold or reallocated in this recession, customers have postponed their purchasing decisions.

Our Varian Particle Therapy business develops, designs, manufactures and services products and systems for delivering proton therapy, another form of external beam radiation therapy using proton beams for the treatment of cancer. Proton therapy, as a clinical treatment modality, is still not wide-spread and the technology is still developing. We are investing substantial resources to commercialize this advanced proton technology and to build this new business. In the second quarter of fiscal year 2009, we met the Conformit� Europ�enne, or CE, mark requirements, permitting us to market our proton therapy systems within the European Economic Area, or EEA. Also in the same quarter, patient treatments started on our proton therapy system installed at the Rinecker Proton Therapy Center in Munich, Germany. Proton therapy facilities, nevertheless, are large scale construction projects that can take three years or more to complete. With the cost of a multiple-gantry system in excess of $60 million and the total cost for each proton therapy center exceeding $100 million, significant customer investment and perhaps complex project financing will be required. Consequently, the customers' decision-making cycle is very long and orders for proton therapy systems generally involve many contingencies. We will not book orders for proton therapy systems until non-perfunctory contingencies are eliminated under our current practice. We are continuing negotiations and are making progress with several customers both inside and outside the United States. In the short term, we are hopeful of receiving a first order for our proton therapy system, and do not expect to start generating significant proton therapy systems revenues. Given the heavy reliance of customers of this business on credit and large-scale project financing, this business is the most vulnerable to the general worldwide economic downturn and contraction in the credit and public bond markets.

GTC, our scientific research facility, continues to invest in developing technologies that enhance our current businesses or may lead to new business areas, including next generation digital x-ray imaging technology, volumetric and functional imaging, and improved x-ray sources and technology for security and cargo screening applications. In addition, GTC is

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developing technologies and products that are designed to improve disease management by more precise targeting of radiation, as well as by employing targeted energy and molecular agents to enhance the effectiveness and broaden the application of radiation therapy.

In the third quarter of fiscal year 2009, net orders and revenues in the "Other" category decreased 69% and 36%, respectively, over the year-ago quarter due exclusively to declines in SIP net orders and revenues. Government postponements of proposals for port and border security systems and cautious practices among cargo screening systems integrators who incorporate our products contributed to the sharp declines in SIP net orders.

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 Quarterly Report on Form 10-Q, as well as the Consolidated Financial Statements and the Notes to the Consolidated Financial Statements and the related Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended September 26, 2008, or the 2008 Annual Report, as well as the Risk Factors contained in Part II, Item 1A of this Quarterly Report on Form 10-Q, and other information provided 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, 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, estimates and assumptions and make adjustments when facts and circumstances dictate. Our critical accounting policies that are affected by accounting estimates include share-based compensation expense, revenue recognition, valuation of allowance for doubtful accounts, valuation of inventories, assessment of recoverability of goodwill and intangible assets, valuation of warranty obligations, assessment of environmental remediation liabilities, valuation of defined benefit and post-retirement benefit plans, valuation of derivative instruments and taxes on earnings. Such accounting policies require us to use judgments, often as a result of the need to make estimates and assumptions regarding matters that are inherently uncertain; and actual results could differ materially from these estimates. For a discussion of how these estimates and other factors may affect our business, also refer to the Risk Factors listed under Part II, Item 1A of this Quarterly Report on Form 10-Q.

Share-based Compensation Expense

Effective October 1, 2005, we adopted Statement of Financial Accounting Standards, or SFAS, No. 123 (revised 2004), Share-Based Payment, or SFAS 123(R), using the modified prospective transition method. We have valued our share-based payment awards granted beginning in fiscal year 2006 using the Black-Scholes option-pricing model. The determination of fair value of share-based payment awards on the date of grant using the Black-Scholes option-pricing model is affected by VMS's stock price, as well as the input of other subjective assumptions, including the expected term of stock awards and the expected price volatility of VMS stock over the expected term of the awards.

The expected term is based on the observed and expected time to post-vesting exercise and post-vesting cancellations of stock options by our employees. Upon the adoption of SFAS 123(R), we determined the expected term of stock options based on the demographic grouping of employees and retirement eligibility. Upon the adoption of SFAS 123(R), we used a combination of historical and implied volatility, or blended volatility, in deriving the expected volatility assumption. Blended volatility represents the weighted average of implied volatility and historical volatility. Implied volatility was derived based on six-month traded options on VMS common stock. Implied volatility is weighted in the calculation of blended volatility based on the ratio of the six-month term of the exchange-traded options to the expected lives of the employee stock options. Historical volatility represents the remainder of the weighting. Our decision to incorporate implied volatility was based on our assessment that implied volatility of publicly traded options on VMS common stock is reflective of market conditions and is generally reflective of both historical volatility and expectations of how future volatility will differ from historical volatility. In determining the extent of use of implied volatility, we considered: (i) the volume of market activity of traded options; (ii) the ability to reasonably match the input variables of traded options to those of stock options granted by us, including the date of grant; (iii) the similarity of the exercise prices; and (iv) the length of term of traded options. After considering the above factors, we determined that we cannot rely exclusively on implied volatility based on the fact that the term of VMS six-month exchange-traded options is less than one year and that it is different from the expected lives of the stock options we granted. Therefore, we believe a combination of the historical volatility over the expected lives of the stock options granted by us and the implied volatility of six-month exchange-traded options best reflects

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the expected volatility of VMS common stock going forward. The risk-free interest rate assumption is based upon observed interest rates appropriate for the term of our stock options. The dividend yield assumption is based on our history and expectation of dividend payouts. If factors change and we employ different assumptions in future periods, the compensation expense that we record may differ significantly from what we have recorded in the current period. In addition, we are required to estimate the expected forfeiture rate and recognize expense only for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from what we have recorded in the current period.

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 we recognize 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 shipment and is subject to customer acceptance and the readiness of customers' facilities. If shipments are not made on scheduled timelines or if the products are not accepted by the customer in a timely manner, our reported revenues may differ materially from expectations. In addition, revenues related to our highly customized image detection systems are recognized under the percentage-of-completion method. Under the percentage-of-completion method of accounting, sales and gross profit are recognized as work is performed, based on the relationship between actual costs incurred and total estimated costs at the completion of the contract. Because the percentage-of-completion method involves considerable use of estimates in determining revenues, costs and profits and in assigning the dollar amounts to relevant accounting periods, and because the estimates must be periodically reviewed and appropriately adjusted, if our estimates prove to be inaccurate or circumstances change over time, we may be forced to adjust revenues or even record a contract loss in later periods. Also, revenues related our proton therapy commissioning service contract are recognized under the completed contract method. If a loss is expected on a contract under the percentage-of-completion method and completed contract method, the estimated loss would be charged to cost of sales in the period the loss is identified.

Allowance for Doubtful Accounts

We evaluate the creditworthiness of our customers prior to authorizing shipment for all major sale transactions. Our customary payment terms require payment of:
a small portion of the total amount due when the customer signs the purchase order, a significant amount upon transfer of risk of loss to the customer, 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 our future ability to collect outstanding receivables, additional provisions may be needed and our operating results could be affected negatively.

Inventories

Our inventories include high technology parts and components that are highly specialized in nature and that are 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.

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Goodwill and Intangible Assets

Goodwill is initially recorded when the purchase price paid for a business . . .