Small-cap med-tech stories rarely have smooth, parabolic trajectories toward success, and radiotherapy company Accuray (ARAY) is certainly no exception in that regard. While management does deserve praise for the extent to which it has driven better service margins, fiscal Q4's sales shortfall and the company's falling share of new North American placements loom as real concerns. Imminent product introductions give investors a reason to hang on, but sales execution must follow if this stock is going to work.
A Disappointing Q4, but Not a Disaster
Revenue growth (and, by extension, market share) is a big issue with the bears on Accuray, and this quarter doesn't help matters. Revenue dropped 8% on a pro-forma basis, and management also revealed a worrisome 28% fiscal year drop in CyberKnife -- backing up the thesis that not only has Accuray not really benefited from the exit of Siemens (SI) from the market, but that rivals Varian (VAR) and Elekta (EKTAY.PK) continue to stretch their market share lead. On the other hand, a 6% miss is not exactly a reason to freak out.
On a slightly more positive note, Accuray's margins held up relatively better. Gross margin did fall about three points from last year's level, but was pretty close to analyst expectations. Importantly, machine margins are staying above 50%, while the company has improved service margins to almost 20%. Operating expenses were more or less as expected, and the company's miss at the operating line was about four cents -- again, not a disaster.
New Products Have to Work
Small-cap med-techs can occasionally get away with poor near-term performance if it looks as if better results are in sight. That's particularly relevant for Accuray given order trends, guidance, and upcoming product launches.
Accuray will be unveiling two products at ASTRO (in late October) that management describes as "game changing." Details are very scarce (and potential customers who have seen them had to sign NDAs), but I would bet on upgraded/enhanced CyberKnife and Hi-Art systems, as prior management discussions suggested new proton therapies are still a ways away.
On the plus side, management reported a 15% sequential improvement in orders, and it sounds as if these launches are going to be significant material events for the company. On the other hand, guidance for next year is now weighted to the back half and the Street doesn't often like "no jam today, but jam tomorrow" stories.
Management Has to Deliver
Accuray must regain its momentum in the hospital market. Varian and Elekta have significantly shrunk the company's new order market share, and there's only so long that investors will accept the excuse that management had a lot of work to do in repairing the acquired TomoTherapy business. At this point, analysts covering Varian and Elekta barely mention Accuray as a threat anymore, and there is a real risk that Accuray finds itself consigned as a niche player that will struggle to earn enough to fund the R&D it takes to stay in the game.
On the brighter side, I still believe that Accuray has a differentiated product lineup. Varian and Elekta may be closing some of the gap with products like True Beam and Leksell Gamma Knife, respectively, but Accuray is still in the game. What's more, recent reimbursement decisions were relatively favorable to the company.
It's also worth noting that these are not easy times for hospital capital equipment makers. Smaller med-tech names like Mako (MAKO) and Cepheid (CPHD) have seen their own system sale struggles recently, as have larger vendors like Stryker (SYK). Even Varian, the 800-pound gorilla in radiotherapy, has posted some recent disappointments in terms of revenue and order growth.
The Bottom Line
While I have never been wholly bullish on Accuray (I own the stock through its acquisition of TomoTherapy last year), I continue to believe that the Street still undervalues the potential of this company. The trick, as always, with potential is that management has to start delivering if it wants the Street to start believing. While management has indeed done a very good job of repairing Tomo's broken service model, now it's time to gain/regain market share.
I think a fair near-term price target on these shares is in the $7-$9 range. Even at those levels, the stock would trade well below historical norms for a small-cap med-tech.
While double-digit revenue growth and a solid path to positive free cash flow would indeed support a target in the teens, management has to prove that it can walk before it runs. In the meantime, investors should pay attention to the ASTRO meeting and look for customer enthusiasm to show up in the order book over the next couple of quarters.
Disclosure: I am long ARAY.