Accuray Fixing The Margins, But Where's The Growth?

| About: Accuray Incorporated (ARAY)

Med-tech companies don't fix themselves overnight, but Accuray (NASDAQ:ARAY) management deserves real praise for how quickly it has addressed one of the biggest challenges of the TomoTherapy acquisition. That said, the overall system growth for this company is not yet where it needs to be and Accuray remains a "show me" story in small-cap med-tech.

A surprisingly strong fiscal second quarter

Although pro forma revenue did decline 11% this quarter, Accuray beat the average sell-side estimates for the quarter. Although adjusted product revenue fell 23%, service revenue climbed 17% from last year. The decision of Siemens (SI) to exit the linac market already seems to be paying some dividends in terms of incremental equipment placements for Accuray.

Where Accuray really accomplished something was on the gross margin line. Service margins were a huge albatross for TomoTherapy and improving these margins has been a major post-merger focus of the Accuray management. Although overall gross margin did plunge about 15 points compared to last year, service gross margin improved 21 points (to about 13%). Product gross margin slid half a point to just under 56%.

Operating expenses were otherwise basically in-line, but the improved gross margin was not enough to produce an operating profit for the quarter. That said, the per-share loss was better than the average analyst estimate.

Waiting for the transition to growth

While the acquisition of TomoTherapy was, in part, motivated by Accuray's desire to expand its platform into somewhat more conventional products, it came at a cost. TomoTherapy had lousy service margins due in part to reliability and uptime issues with the Hi-Art systems. Accuray is making progress in fixing the service margin structure of the acquired Tomo business, but fixing the reputation/perception of the Hi-Art platform is going to take more time.

For this stock to work, Accuray has to start delivering better growth. To that end, $70 million in orders and a 2% sequential increase in backlog is not so exciting, although the book-to-bill was above 1. This isn't terrible in a hospital environment where capital spending is still tight and reimbursement challenges are very real, but Accuray cannot succeed simply by keeping pace with market-leading Varian (NYSE:VAR).

Although Accuray's CyberKnife system has a lot to offer, the company still has an uphill climb convincing customers to forego systems from entrenched rivals Varian and Elekta. While Accuray is looking to build the credibility of the platform through clinical trials, the risk remains that clinicians will take a wait-and-see attitude - perhaps waiting until they see a Varian system that basically captures the benefits of the current CyberKnife system.

Would anyone target Accuray?

With Siemens out of the linac business (but still involved in radiation oncology on the imaging side), would any other company look to enter this market through an acquisition? Investors have long waited to see General Electric (NYSE:GE) enter the therapeutic healthcare market and Fujifilm has gotten pretty active of late in building up its healthcare business. Still, Accuray would be a challenging buy (the technology is good, but the company will need a big marketing push) and investors shouldn't expect a premium takeover bid.

The Bottom Line

With the recovery in these shares, the stock is not the compelling buy it was just a short while ago. The progress in margins is absolutely welcome, but the fact remains that the next real leg up in this stock probably has to come from some outperformance on the revenue line and management guidance was somewhat conservative in that regard.

A mid-single digit revenue growth rate and steady progress towards profitability and positive free cash flow can support this stock towards a high single-digit price tag. Beyond that, there needs to be real evidence of meaningful placement growth in CyberKnife and Hi-Art to drive a more impressive target.

Disclosure: I am long ARAY.