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iCAD (NASDAQ:ICAD) announced financial results for the first quarter ending March 31, 2013, on April 30. Results were very strong with revenue at the highest level since Q3 2011 and over 10% better than our estimate. The beat wasn't just confined to the top line as management's continued efforts in limiting operating expense growth and maintaining their very healthy gross margins, despite a bite from the newly enacted medical device tax resulted in operating income about $414,000 better than our estimate. At the risk of being accused of beating a dead horse, we think it's again worth reiterating the commendable job management has done with accelerating growth of the therapy business, decelerating the slide in detection revenue (which actually showed positive growth in the most recent quarter), and maintaining the beefy gross margins all at the same time that they've slashed operating expenses.

All indications point to continued revenue growth, and management again noted on the call that operating expenses should remain at about the current quarterly level. Assuming no deterioration in gross margins -- which we do not anticipate (in fact gross margins should grow over the longer term with increasing sales of higher margin consumables) -- positive operating income and sustainable positive operating cash flow should be right around the corner. As we first noted in our previous update, 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/service-related sales continue to closely track our estimates with the number of console sales (nine) in the quarter actually coming in slightly better than our estimate (eight) and consumables/service-related sales of about $900,000, right in line with our $965,000 estimate. Utilization in both breast IORT and non-melanoma skin cancer continues to accelerate and management remains encouraged by the 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. Use in skin cancer has been a particularly positive boon and, perhaps, somewhat greater than initially anticipated.

Similar to breast, skin use to date has largely been driven by positive patient outcomes (which is not always the facilitator of increased utilization of medical devices) -- an improvement in reimbursement would likely further accelerate adoption and utilization. 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 applications, namely skin and cervical cancers. Cervical cancer is only second behind breast as the most common cancer among women, and pursuit of this area seems a natural addition to ICAD's women's health focus. FDA clearance of a cervical applicator was received in Q1 and is expected to launch in Q2.

Growth in the detection business, which until recently had been hampered by the ever dwindling number of mammography facilities that had yet to switch from film to digital, now finally looks to be turning the corner. Management has done an impressive job of righting this business over the last couple of years when it became evident that the legacy products business may not produce organic growth. New product launches (including PowerLook AMP) and iCAD's recent shift in strategy toward a greater reliance on recurring revenue, services, and a conventional software business model has really begun to pay dividends. New product introductions should follow and ICAD is looking to capitalize on the next generation of image enhancements with the switch from 2D to 3D images and is working on tomosynthesis (3D) products.

The next catalyst in the detection business could come from an agreement with Invivo (part of Philips Healthcare) that ICAD first alluded to on the Q4 call, in which ICAD will develop MRI analysis software that will be incorporated into Invivo's MRI products (new products as well as products already in the field). With a very substantial installed base, and much larger than ICAD's, this provides the company with a greatly expanded footprint and captive customer base in which to sell upgrades and new products to. This partnership also easily facilitates an international presence for ICAD. The initial focus will be MRI products for prostate and breast, but the duo is working on other products and applications as well. The first products related to this agreement are expected to begin rolling out in Q2.

Revenue

Revenue of $7.9 million was up 25% year over year and about 10% better than our $7.2 million estimate.

Cancer Detection: $4.6 million actual (+7% year over year) vs. $4.3 million estimate.

Total product revenue in cancer detection was about $2.7 million, up from about $2.6 million in Q1 2012 and better than our $2.4 million estimate. On the earnings call management noted strong sales to their OEM partners such as GE and Siemens as a contributor to the sales growth. There was also a small ($50,000) revenue contribution from work related to the Invivo service agreement.

Going forward, we think there's a number of near-term catalysts that can facilitate growth of the Detection segment. These include new products such as PowerLook Amp, iCAD's next-generation mammography CAD system that includes highly sought after breast density functionality; CAD for tomosynthesis (3D mammography) and is currently in the planning phase with an initial introduction potentially in 2014; more annual licensing agreements that 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 MRI software development deal with Invivo.

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. 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: $3.3 million (+64% year over year) actual vs. $2.9 million estimate.

Cancer therapy revenue was up 64% year over year and up 6% sequentially -- the sequential increase due to a greater number of Axxent controllers sold in the current quarter, with related consumables/service revenue about flat over the same periods. As we've noted in the past, both controller and consumables sales may be somewhat variable quarter to quarter. iCAD sold nine controllers in the quarter, compared to six in Q1 2012 and eight in Q4 2012. 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 175 in Q1 2013, down from 233 in Q4 2012 but up considerably from 125 sold in Q1 2012. The reason for the sequential decrease is due at least in part to some delay between when a customer purchases a console and when it's put into use (at which point they purchase applicators), as well as bulk applicator purchases which can create some lumpiness quarter to quarter. Importantly, applicator sales are clearly trending upward.

Despite the sequential decrease in applicator sales, in aggregate revenue from the other components of therapy-related consumables and services (X-ray sources, service contracts, etc.) increased on both a sequential and year-over-year basis -- with management noting that the number of minutes purchased under these source agreements having been increasing with increased procedure volume, which directly points to greater utilization. Relative to skin cancer, procedure volumes increased about 50% sequentially and management indicated this rate could accelerate even significantly more going forward based on what they're seeing in terms of demand.

As we noted previously, 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 for treatment delivery.

iCAD, which 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. In April, they announced distribution agreements for parts of China and Russia -- the launch of which is expected to happen following requisite regulatory approvals -- potentially culminated in the next 12 months.

Relative to skin cancer, procedure volumes have similarly been significantly increasing with an estimated 827 procedures performed in 2012, up from 200 in 2011. Q2 volumes were 625, up from 417 in Q4 2012. iCAD will also be aggressive in pushing demand and interest in Axxent for skin cancer. This includes presentations and other awareness-building efforts. In April, a poster presentation of Xoft in skin cancer treatment of 172 patients was made at the American Brachytherapy Society Meeting -- data from this study was also published in the journal Brachytherapy. iCAD also expects to have their cervical applicator, which just received FDA clearance, launched during Q2.

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 (~$275,000) 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

Q1 EPS (excluding non-cash revaluation of warrant liability) of ~($0.11) beat our ($0.14) estimate as a result of the beat on the top line, slightly offset by a marginally narrower (71.2% A vs. 71.8% E) gross margin. EPS was much improved from the ~($0.27), excluding warrant liability revaluation, in Q1 2012. We also note that the GM remains very strong despite about a 160-basis-point bite from the newly enacted medical device tax. ICAD continues to keep a lid on operating expenses, which were just about dead-on with our estimate ($5.98MM A vs. $5.92MM E) even with the beat on revenue. Management reiterated their previous guidance on operating expenses, which is to maintain them at the mid-to-low $6 million range (which, with anticipated revenue growth, should result in nice operating leverage).

Cash

iCAD exited Q1 with $12.7 million in cash and equivalents, down from $13.9 million in Q4 2012. Cash flow from operating activities was an outflow of about $1.2 million, down from about $3.7 million used in Q1 2012. Adjusted EBITDA was approximately $592,000 in the most recent quarter, significantly improved from ($967,000) in Q1 2012. Management noted on the call that they expect to be approximately cash flow break-even in Q2. Given our expectations of significant revenue growth, gross margins maintained at 70%-plus, 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.

Valuation/Recommendation

As there were no material surprises in Q1 or on the conference call, we have made only minor changes to our model following Q1 results. We look for EPS of ($0.23) in 2013, changed from ($0.29) -- almost all of the difference related to the beat in Q1. We continue to 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 analysts' revenue estimates for the years 2013 and 2014, we calculated P/S and EV/S ratios from imaging (HOLX and MRGE) as well as surgical companies (VAR, ARAY and ISR). The five companies currently trade at an average P/S 2013 of 2.1x and P/S 2014 of 1.6x and 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's Double-Digit Growth Looks Sustainable