New Holdings – Varian and Elekta

Gareth Campbell - Fund Manager

6 August 2020

Radiotherapy is a cancer treatment that uses high doses of radiation to kill cancer cells and shrink tumours.

The most common form of radiotherapy involves using a device called a linear accelerator to deliver x-ray beams from outside the patient’s body. The linear accelerator rotates around a patient and delivers the beam to the specific tumour site. This concentrates the radiation around the tumour while minimising the dose of radiation to healthy tissue surrounding it.

Through multiple generations of new equipment, the accuracy of treatment has improved significantly. As precision of radiation therapy increased and side effects fell the number of indications it could be used in has increased, with leading scientists suggesting 65% of cancer patients should receive some form of radiotherapy.

Why did we invest?

Unfortunately the need for radiotherapy continues to grow every day. According to the WHO the number of diagnosed cancer cases is expected to grow almost 3% per annum for the next decade. This is due to population growth, ageing demographics and increased diagnostics in emerging markets.

We believe the radiotherapy industry will grow around 6% per annum because of increased utilisation of radiotherapy outside of the United States. For example in the UK around 30% of cancer patients receive radiotherapy, less than half what is perceived to be medically optimal. The fastest growth is from emerging markets where we estimate current penetration of radiotherapy at around 15%.

Alongside every equipment sale there is a long term revenue stream of software and services so as the industry grows its installed base, it is also growing a large higher margin recurring revenue stream, improving the margins and return on capital of the industry. Software sales are growing faster than the industry due to investment in artificial intelligence, data analytics and other services to help with treatment planning and accuracy.

The two largest radiotherapy businesses are Varian and Elekta which have over 90% market share of new installations. It’s rare to find an industry with so little uncertainty around its long term growth, with only two main competitors and very high barriers to entry. This gives us very high conviction that Varian and Elekta will benefit from the industry growth and that is why we invested in both businesses.

The coronavirus has caused a reduction in cancer treatment and diagnosis rates. It has also put an unexpected financial burden on hospitals which could impact their ability to buy new equipment. This has had a negative impact on the annual sales and profit of Varian and Elekta causing both businesses to underperform the wider market.

However the long term demand for radiotherapy is unchanged by coronavirus and although hospital budgets are challenged today we think it is unlikely that a global healthcare crisis will result in less investment in healthcare services. For these reasons we think there has been minimal impact to the intrinsic value of both businesses and see the current lower prices as an opportunity to own two excellent businesses with great long term growth potential.

Barriers to entry

Highly specialised and advanced technology is the main barrier to entry. 20 years ago the radiotherapy market was also supplied by Siemens, Phillips, Mitsubishi, Hitachi, Toshiba and General Electric. Today Varian and Elekta have around 90% market share of new installations. Competitors exited the industry as investments in R&D became more challenging and they chose to focus on other areas.

Roughly 50% of revenue is from higher margin services and software. A new competitor would have to invest in years of R&D before launching a product and even if that was successful it would still take at least a further decade to reach the same mix of services and software revenue as Varian and Elekta, limiting the margins and return on capital of new competitors.

Customers are highly risk averse as if new equipment is less effective the patient receives lower quality treatment, which could impact their chance of survival. Malfunctioning equipment could also harm doctors or other patients. For these reasons new innovations in the industry are typically supported by large clinical trials to confirm their benefits.

Varian and Elekta have been investing in AI and data analytics which improve treatment efficacy and workflows. As the largest radiotherapy providers they generate the most clinical data and have the resources to invest in R&D which should increase these barriers to entry over time.

Varian

Varian are the largest radiotherapy business in the world, which gives them an advantage in marketing, distribution and R&D. This means they can maintain higher margins than peers, while still investing 60% more in R&D and new growth opportunities.

Varian have almost 70% market share in the US. With radiotherapy utilisation already at medically optimal levels the market is largely driven by replacement. Varian’s large installed base and strong brand recognition makes it very challenging for competition to take market share.

After a strategic review in 2016 Varian refocused its R&D on software, AI and data analytics to improve the capabilities and efficiency of existing core technology. Varian management have highlighted $1.8 billion of additional revenue if the current installed base paid for all available software upgrades.

Varian have been growing market share as their main competitor Elekta has been focused on the development of a next generation linear accelerator, resulting in delays to upgrades of core products and some poor management execution.

Elekta

Elekta have spent the last two decades developing their Unity product, which is a combination of a linear accelerator and an MR scanner. The powerful magnetic fields used in MR imaging interfere with typical radiotherapy treatments so combining the two technologies has been a huge scientific challenge.

The outcome has created an amazing product which could be revolutionary for patients as it can now accurately locate tumours and deliver precision radiotherapy while in real-time monitoring the tumours movement during treatment.

We believe Unity will help Elekta grow faster as they take market share by expanding the addressable market into new treatment areas which aren’t suitable for traditional radiotherapy. For example Elekta’s management believe Unity could expand the number of patients receiving radiotherapy by 25%.

We also think having the most advanced radiotherapy equipment in the world will help with brand reputation and could enable them to gain market share in customers who previously had no reason to look for a new supplier.

Elekta will soon be launching their first new linear accelerator product upgrade in 6 years. This should make Elekta more competitive in emerging markets and with more price-focused customers, hopefully reducing the market share losses that have impacted the business in recent years.

Elekta now has the most advanced radiotherapy equipment in the world, is launching its first linear accelerator product upgrade since 2013 and is building data on the potential clinical benefits of Unity. Yet the stock currently stands at its lowest relative valuation versus peers in decades so we are very excited to start a new position in Elekta.