- Accuray delivered strong product revenue growth and a good rebound in orders to end its fiscal year.
- Gross margins were weaker than expected, but management guidance was consistent with expectations and a growing library of clinical data and the launch of the MLC should support order growth.
- Accuray still looks significantly undervalued on a DCF and EV/revenue basis, but establishing consistent double-digit revenue growth may be the key to generating investor interest.
The good news at Accuray (NASDAQ:ARAY) is that management has established a good track record for doing what they say they are going to do - the service operations are running much better, the multileaf collimator (or MLC) is on track, and the company's efforts to improve its sales strategy appear to be translating into orders. The only "but" is that none of this is all that flashy and the Street has a habit of getting bored with stories like this. I do think there is some upside to orders in CY 2015 if the MLC is released on schedule, but this remains an execution story driven by blocking and tackling and one where the realization of value could still take some time.
An Imperfect Quarter, But Basically Okay
Revenue rose 20% yoy as reported (and 5% qoq), a strong 11% beat relative to expectations, as product revenue jumped 34%/11%. Overseas revenue was particularly strong, rising 28% to 52M for the quarter.
Margins were the imperfect part of the story. Gross margin improved five and a half points from last year, but declined more than three points sequentially and missed the Street average estimate by about two and a half points. Product gross margin rose about eight points yoy (and fell about two points qoq) due in part to production relocation and product mix, while service margins rose about two points yoy (and fell five points sequentially) on higher parts consumption and higher warranty cost. Management made the case that this was a relatively isolated mix of circumstances, but service margins are still something of a sensitive subject with some Accuray investors and analysts.
Operating expenses were also higher than expected, with the overage coming in sales and marketing. This doesn't really concern me all that much (nor does the approximately $2.5 million miss relative to the average of estimates); profitability is a FY2015 expectation and spending to support the sales effort makes sense now.
Accuray disappointed investors with a third quarter order miss, but management said at the time that it saw an improving sales funnel and that it expected orders to improve in the fourth quarter. Management delivered - net orders rose 8% and exceeded expectations by about 10%. Gross orders were up 4%, but a few points are worth remembering. Year-ago gross orders were a tough comp, order age-outs/cancellations seem to have slowed, the MLC is still not commercially available, and the $75M in gross orders is still above that important $70M/quarter level. I'd also note that the backlog rose 15% to $365M.
I'm eager to see what happens next year with orders. The first MLC evaluation unit is in place and management intends to update investors about its commercial launch plans during its FQ2'15 conference call. Is Accuray losing orders to Varian (NYSE:VAR) and Elekta (OTCPK:EKTAY) by not having this available today? Probably. But roughly 10% of installed systems come up for renewal each year, and it's more important to get it right than to get it "right now". What's more, I get the sense that those hospitals that like Accuray's approach are willing to wait.
Another potential positive for orders is the growing library of clinical data and papers supporting Accuray's CyberKnife and Tomo approaches/systems. JP Morgan analyst Tycho Peterson recently highlighted a March Journal of Clinical Oncology paper on a retrospective study of more than 3,000 prostate cancer patients treated by SBRT and IMRT - the mean treatment cost for SBRT (which is the approach that CyberKnife offers) was a third lower than for IMRT. What's more, there have been other recent papers highlighting the efficacy of Accuray systems in hard-to-treat cancer types like brain cancer, lung cancer, and head and neck cancer. Although Varian is starting to devote more attention to the clinical side of things, building this solid foundation of clinical data can only help Accuray when it comes to coaxing potential customers into ordering systems.
The State Of The Market? Not Much Has Changed For Accuray
It seems that worries about reimbursement cuts are now a permanent feature of the radiation oncology landscape. The most recent word on payments doesn't seem to really threaten Accuray. While freestanding centers are seeing more pressure, that's not a strong market for Accuray anyway, so it is more of a risk to Varian and Elekta.
Order trends have been softening at Varian and Elekta has been seeing reimbursement issues for its Gamma Knife line. I don't think either of these issues are particularly relevant to Accuray - the company is small enough that it can still gain share in a tougher capital spending environment and its systems are not vulnerable to reimbursement changes in the same way that Elekta (or Varian) is. Moreover, the steps that Accuray has taken to improve its systems and service are increasing the likelihood that it can penetrate multi-bunker sites as more of a specialty offering for complicated cases.
The Bottom Line
Accuray did what it needed to do in this quarter, though the company really can't see a repeat of the margin issues if it wants a higher multiple in 2015. My DCF-based fair value goes up by about $1, mostly just due to shifting out the FCF-negative FY 2014 and bringing in a new year of positive free cash flow in the out years. On a DCF basis I value the shares at close to $11.25, while I note they trade at a forward EV/revenue of just 1.6x (well below the norms for most med-tech companies). If management can reestablish the company as a double-digit revenue growth story again (which would mean hitting or exceeding the high end of guidance), a rerating and a reevaluation of Accuray as a growth story (as opposed to a turnaround story) could happen in the next year.
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