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iCAD (NASDAQ:ICAD) announced financial results for the fourth quarter ending Dec. 31, 2012, on Feb. 20. Results continue to be strong and very much in line with our estimates. While revenue was a hair under our number, net income and EPS (ex non-cash revaluation of warrant liability) beat our estimates as management continued to trim operating expenses more significantly than we anticipated, which is maximizing the amount of revenue flowing to the bottom line. We have consistently overestimated operating expenses the last several quarters, and commend management's success in substantially cutting costs while significantly growing therapy revenue (and recently being able to slow the slide in detection revenue). As we detail below, management's guidance on the conference call relative to maintenance of operating expenses has resulted in a significant (positive) change to our financial model, whereby now we think iCAD can reach sustainable positive cash flow sometime during the current year and generate positive net income and EPS as soon as 2014.

On the operational front, Axxent console and consumables sales remained closely tracking our forecasts. Utilization in both breast IORT and non-melanoma skin cancer continues to accelerate and management remains encouraged by recent trends and market fundamentals, such as greater reimbursement (CMS's Final Rule more than doubled reimbursement for breast IORT) and growing interest in and awareness for use in skin cancer to help catalyze even more robust growth in 2013 and beyond. With the Axxent system barely penetrating just 1% of the U.S. breast IORT market so far, there's potential huge upside for iCAD, particularly when also considering the other ancillary applications such as skin and cervical cancers.

Growth in the detection business remains hampered by the ever dwindling number of mammography facilities that have yet to switch from film to digital, but recent new product launches as well as iCAD's recent shift in strategy toward a greater reliance on recurring revenue, services, and a conventional software business model has begun to pay dividends and helped to stem the slide in sales in this segment. In that vein, on the earnings call management talked about a new software development deal with a "global leader in MRI" that they clearly believe holds great potential and could presumably aid in the turnaround in the detection business. We look forward to hearing more about this -- management noted they expect to be able to talk more about this in the coming months.

Revenue

Revenue of $7.8 million was up 18% year over year and about 2.5% lower than our $8.0 million estimate.

Cancer Detection: $4.7 million actual (-6% year over year) vs. $4.6 million estimate

Total product revenue in cancer detection was about $2.5 million, down from about $3.2 million in Q4 2011 and below our $2.8 million estimate. On the earnings call management again alluded to their OEM partners losing market share, which continues to impact iCAD's detection segment. While the detection segment benefited from new product introductions including PowerLook AMP, which launched in the summer of 2012 and growth in the number of digital products under service agreements, these weren't nearly enough to offset contraction in other areas.

Despite detection revenue's continued slide year over year, revenue from that segment in Q4 was somewhat of a highlight given that it was the highest in all of 2012, increased almost 25% sequentially and was about $100,000 better than our estimate. The year-over-year slide in detection revenue was stemmed to only 6% in the current quarter, far better than the -28%, -19%, and -40% year-over-year drop in each of the first three quarters, respectively, of 2012. This was the result of the services portion of detection posting revenue of $2.2 million, which was up 22% year over year and aided by $400,000 of work related to a project with their new MRI partner.

Going forward we think there's a number of near-term catalysts that can return detection back to positive revenue growth. These include new products such as PowerLook Amp, iCAD's next-generation mammography CAD system (which includes highly sought after breast density functionality); CAD for tomosynthesis (3D mammography), which is currently in the planning phase with an initial introduction potentially in 2014; more annual licensing agreements, which may appeal to a broader customer base; increased service contracts (to iCAD's installed base as well as OEM partners'); partnership deals with OEM's with new products, development projects, and service contracts; and the just-announced software development deal whereby iCAD will develop MRI software, which will be incorporated into their partners' MRI products. And as we've noted in the past, while CT colon CAD revenue has yet to gain much traction in the U.S. as a result of a dearth of reimbursement, management indicated they are seeing some growth internationally and this remains a viable domestic growth opportunity with sufficient reimbursement. The additional data from the ACRIN study that were recently published could be a catalyst to eventually gaining Medicare reimbursement for CT colon CAD.

Cancer Therapy: $3.1 million (+94% year over year) actual vs. $3.5 million estimate

Cancer therapy revenue was up 94% year over year and down 29% sequentially -- the sequential decrease due to a lower number of Axxent controllers sold in the current quarter -- which will almost certainly continue to be somewhat variable quarter to quarter. iCAD sold eight controllers in the quarter, compared to three in Q4 2011 and 12 in Q3 2012. For the full year, 30 controllers were sold compared to just 13 in 2011. The number of balloon applicators (consumables used for breast IORT) sold, which provides some insight into utilization (which will eventually be the long-term driver of Axxent related revenue and overall profit contribution) was 233 in Q4, compared to 103 (+126% year over year) and 190 in Q3 2012 (+23% sequentially). Growth appears to be coming from several fronts, including more favorable reimbursement, greater awareness of the benefits of IORT compared to traditional whole breast radiation therapy, and substantial interest and procedural volume (skin cancer treatment typically requires more than one visit) coming for use in non-melanoma skin cancer. Relative to reimbursement for IORT breast, an additional CPT code (for treatment planning for IORT) became effective in 2012, which has been an apparent catalyst to driving interest in breast IORT. However, we expect an even more substantial catalyst to come from CMS's recent decision to significantly increase reimbursement even more beginning in 2013 (CMS's Final Rule, discussed below) for treatment delivery.

iCAD, who was instrumental in the pursuit of getting higher reimbursement for IORT treatment, notes that they expect to continue to be active in driving more demand for their Axxent system. That will include awareness building efforts, post-marketing studies and continued lobbying for even greater reimbursement for breast IORT and initial reimbursement for skin. The company is also now tapping international markets with a handful of sites in Europe and one in Asia currently using Axxent.

Relative to skin cancer, procedure volumes have similarly been significantly increasing with an estimated 827 procedures performed in 2012, up from 200 in 2011. iCAD will also be aggressive in pushing demand and interest in Axxent for skin cancer and on the call announced they will be launching a major skin study with Axxent which is expected to begin in the coming months and hopes to show superior efficacy and cosmetic results (traditional surgery can cause severe scaring) of eBx compared to traditional surgery. iCAD also expects to have an applicator for the treatment of cervical cancer on the market around the middle of 2013.

As we noted in our last update, utilization remains fairly low. By our estimates each installed console is only being used approximately 3x per month for IORT breast cancer therapy. This procedural volume rate per unit will almost certainly substantially increase as demand for IORT continues to grow and providers look to maximize utilization (in breast as well as skin and other cancers) and speed break even on the cost of the (~$275k) of the console. As the utilization rate grows so will iCAD's revenue growth rate. We model a very incremental step-up in utilization over the next several years, which could actually end up being somewhat conservative. A larger installed base means greater recurring revenue from consumables including balloon catheters and x-ray sources as well as annual service contract revenue, all of which we estimate generate relatively high margins to iCAD compared to that of the consoles.

EPS

Q4 EPS (excluding non-cash revaluation of warrant liability) of ($0.15) beat our ($0.17) estimate as a result of iCAD's very aggressive expense management efforts. Management has been incredibly diligent on cutting costs and leveraging their expense base while growing total revenue. Operating expenses were just $6.4 million in Q4, about 6% less than what we were forecasting and down from $6.7 million in Q4 2011 and $6.5 million in Q3 2012. A further illustration of the company's efficiency efforts is that operating expenses in 2012 were $25.4 million on revenue of $28.3 million compared to operating expenses of $34.6 million on revenue of $28.6 million in 2011. Meanwhile, gross margin ticked up slightly over the same periods, from 69.9% in 2011 to 70.8% in 2012.

Cash

iCAD exited Q4 with $13.9 million in cash and equivalents, up slightly from the $13.8 million at Sept. 30, 2012. Cash flow from operating activities was an inflow of $426,000 in Q4. Excluding changes in working capital, cash flow from operating activities was an outflow of $365,000. Given our expectations of significant revenue growth, gross margins maintained at 70%+, and incrementally increasing operating leverage, we believe that the current cash balance along with cash from operations will be more than sufficient to fund the company for the foreseeable future.

CMS Final Rule More Than Doubles Proposed IORT Reimbursement

In the Final Rule for the Hospital Outpatient Prospective Payment System for 2013, reimbursement for IORT was increased from the previous proposed $496 to $1,006. We expect the recent beneficial changes to reimbursement for IORT to have a positive influence on uptake and interest in the procedure as well as on sales of iCAD's Axxent system and consumables.

As a reminder relative to IORT reimbursement, amounts for 2012 unexpectedly bundled the IORT therapy with the surgery -- this limited the economics for radiation oncologists to use Axxent. After considerable objection from the IORT-participant community, including iCAD, that reimbursement for IORT therapy should be broken out separately given that it is not integral to surgery to remove cancerous tissue, CMS agreed and proposed separate reimbursement of $496 (under APC code 0412, "IMRT Treatment Delivery," the title of which was proposed to change to "Level III Radiation Therapy"). Then after a further public comment period, in November 2012, CMS announced its Final Rule which determined that the IORT procedural codes in question (77424 and 77425) should be mapped to a different APC code (0065, "Level I Stereotactic Radiosurgery, MRgFUS, and MEG) -- which had the effect of increasing IORT reimbursement to $1,006.

Valuation/Recommendation

We have made some material changes to our model following Q4 results and the earnings call. Most of the changes relate to our forecast operating expenses, which, as noted above, we had been consistently estimating too high. Management noted on the call that they estimate operating expenses will remain at roughly $6.5 million per quarter (i.e., approximately the same as 2012) in 2013 -- prior to changes we had modeled 2013 operating expenses to average about $8 million per quarter. We have since trimmed our operating expense estimates for 2013 and beyond, which has had a material positive effect to our estimated net income and EPS. We now look for EPS of ($0.29), compared to ($0.58) prior to the change. We also now model positive net income and EPS in 2014.

We continue to value iCAD based on competitor price/sales (P/S) and enterprise value /sales (EV/S) multiples. Using analyst's revenue estimates for the years 2013 and 2014, we calculated P/S and EV/S ratios from imaging (HOLX, MRGE) as well as surgical (VAR, ARAY, ISR) companies. The five companies currently trade at an average P/S-2013 of 2.1x and P/S-2014 of 1.6x, and an average EV/S-2013 of 2.0x and EV/S-2014 of 1.5x.

Based on the average of the 2013 and 2014 EV/S multiples iCAD is valued at $8.90/share. Based on the average of the 2013 and 2014 P/S multiples iCAD is valued at $7.35/share. We use the average of the two, which values iCAD at approximately $8.25/share. We are maintaining our Outperform rating and recommend accumulating the stock up toward our $8.25/share price target.

Source: iCAD Q4 Results - Revenue Remains Strong, Expense Control Impressive