Accuray Incorporated (NASDAQ:ARAY)
Morgan Stanley Global Healthcare Conference
September 10, 2012 11:10 a.m. ET
Euan Thomson - President & Chief Executive Officer
Steve Beuchaw - Morgan Stanley
Steve Beuchaw - Morgan Stanley
Thank you all for joining us here. I am Steve Beuchaw from the Morgan Stanley medtech team. It’s my pleasure to welcome Accuray this morning. I have Euan Thomson, CEO of the company and Tom Rathjen from Investor Relations. Before we begin though, I do want to point out that all important disclosures including personal holdings disclosures and Morgan Stanley disclosures, appear on the Morgan Stanley public website at morganstanley.com/ researchdisclosures. It’s a riveting read. You should check it out.
Guys, so we had a good conversation last week. We had an opportunity to see the results for the quarter and the outlook for the year. I think the surprise coming out of the quarter of course was the comments around ASTRO. Expectations for ASTRO. I would like to start on innovation. Given how much lately we have all been worried, not specifically with Accuray but with the macro economy and the world of reimbursement. But again, let's start with innovation. So you have been pretty upfront about the importance of the meeting but less clear exactly on what we expect to see there.
So how are you today trying to outline for investors, the importance of ASTRO? What should we be thinking about? A revolutionary patient treatment opportunity, the financial impact. How are you framing it?
It’s a good question. Thanks, Steve. I think we have a little debate internally about how much to sort of discuss at the earnings call about the ASTRO release. And I think when we analyzed it, it has a significant impact on our financial profile as we go into this year that it was right and proper of us to do basically a full disclosure on all the financial impacts. And I will talk through that a little bit.
So on the cost side it’s clear, we have rising R&D costs, we have rising sale and marketing expense. And we wanted to give investors some clarity around the fact that we don’t expect those to stay that high sort of indefinitely. So there is actually an end point and it is this ASTRO. So that mattered to us a lot.
The other thing is that we are seeing some short term impact on revenue in this quarter. Certain customers are aware that something is coming. Very very few customers actually know that details of the technology themselves. But people know that something is brewing and there are certain customers out there who would have been taking installation this quarter. Who were saying to us, it would really be much more comfortable, we know we are going to have this technology for ten years so we will be much more comfortable knowing that we are going to get everything we want from it, and therefore we would like to see what you’re releasing at ASTRO before we take our shipment.
So with the prospect of a -- and it’s not a major impact in terms of the year but in terms of this quarter, some headwinds in terms of getting products, if at all, following by or coupled with the increasing expenses and so on. Then we felt it was best to give just complete clarity over what is going on. You know the good news is that I think as we exited there as we pointed out, we already have solid bookings even without the rollout of these new technologies. We had a third quarter of integration. At the beginning of Q1 last year we had a book to bill ratio that was predictably low as we integrated the two sales forces, down at about 0.7. But after that we rapidly recovered and we have been running sort of a double-digit book to bill ration and averaging the last three quarters at 1.12 and exiting the year at 1.15.
So we have very solid indicators already of future growth in the product revenue line. And it’s not a launch that’s done through an act of desperation. This is a good solid launch that supplements our existing momentum in growing our product revenue line.
Steve Beuchaw - Morgan Stanley
Well, you have introduced quite a few topics there. Let's spend a little bit more time on what's been probably the highest profile topic for investors for the company over the last year, and that’s margins and the evolution of margins. So I think somewhere we are a little bit surprised by the margins in the quarter and we have more spending coming ahead at ASTRO. Can you help people understand though, the trajectory of margins over the course of the year? How the spending that’s happening around ASTRO is somewhat discreet in nature. And then help people think about the longer term trajectory, because you have been very clear about the importance of the  system hurdle. We are still thinking about 10% to 15% margin objective there and we are still thinking about profitability by the end of fiscal ’13. Can you help us walk down that path?
Yeah. The easiest way to answer that is just talking about the individual element and I will give some overall, sort of summary at the end of it. So if you think about the drivers for our profitability, as we entered the year the big question mark was really of the service? And going back beyond that, Accuray had run what I think was an excellent service business with very solid revenue. And if you compare even the topline performance from the service business for the size of our installation versus the other players in the industry, you get a very very positive ratio. So we definitely have always maximized the value of our installed base in terms of service revenue.
But Accuray’s history and TomoTherapy’s history in terms of the service gross margin was very very different. We were driving gross margin on the CyberKnife business somewhere between 35% and 40% and it was steadily improving as well. On the TomoTherapy side it was significantly negative. And putting the two businesses together, sort of Q4 last year, pro forma showed about a minus 2.3% gross margin. Now actually there is no point in growing revenue if you are doing it as a negative margin. So our objective, our number one objective post-integration was to fix the technology issues with the TomoTherapy machine.
And fix the business issues around the service business as a whole. You know no discounting of service contracts, offering a standard industry level price service. Making sure we could keep the machines going in an industry standard way. And really leveling things to get the TomoTherapy system back out in a close level to CyberKnife.
As we existed the year, one of the charts we put up at the earnings call, this is available on our website, shows quite far how we have come in lowering the costs of service of the TomoTherapy machine. And in fact if we look now, the new machines that have rolled out today, TomoTherapy machines that we are rolling out today, and you look at the cost of providing service on a unit by unit basis, it’s actually less than the cost of CyberKnife in 2011 where the margins were separated.
So the potential is there obviously for a higher, as anything service gross margin on TomoTherapy than we were achieving for CyberKnife. So I would characterize this on the service gross margin as being about half way through where we want to get to. If we bring it up to about 20%, we would still like to get the overall service business back up about 35% and close to 40%. For this year we said that we expect the average service gross margin for the year to be somewhere in the 20% to 22% range. I think that’s definitely achievable in light of what we have got to do. And we would expect that to improve.
On the product gross margin side, both products have a good solid gross margin for the industry. CyberKnife was in the high 50s, TomoTherapy was in the low 50s. If you look at it overall, we were around sort of the 55% gross margin for products. So both of those, assuming they are achievable, getting continuous improvement in the service gross margin and getting our -- maintaining product gross margin as we have been, that gives the scope to be profitable organization and after that it comes how profitable.
Now where we are headed for on the OpEx side, we know have this rising operating expenses we go through ASTRO, that I have mentioned. We know that that comes down again. So what we are forecasting for this year is operating expenses by the time we exit the year in Q4, to be down at a level they were at Q1 and Q2 last year. Kind of in the mid-40s in terms of OpEx. And that produces the healthy profile, the profitable profile that we are confident of in in Q4 of this fiscal year, against the quarter that ends in June. So that’s kind of the profile for the year.
Now where we long term I think the operating margin will continue to improve as time goes on and we expect it to be, the operating expenses eventually to be around about 35% of revenue. And the mid-term target is to get at about 40%.
Steve Beuchaw - Morgan Stanley
Is that 10% to 15% objective -- is that too conservative, if the upcoming product launches are as successful as you think they could be?
Yes. And possibly so. I think what we are doing as we go into this year is we are really saying that there are certain unknowns still as go in, not unknowns that we can really have a lot of control over. We, for example, ironically a very successful product launch at ASTRO with all customers demanding new technology and new configurations of that technologies and so on. Those can lead to customer negotiations taking place because obviously nothing we launch and announce should go out the door for nothing. So there will be further negotiations that take place with customers and those could even delay shipments a little bit as well.
I think what we are confident of is at the time we get into Q3 and definitely by Q4, we are kind of back where we would have been in steady state, with the potential for it being enhanced. And we would clearly, we wouldn’t have gone to the trouble of launching new technologies if we didn’t think that it would change the market as a whole. And the feedback we have had from customers so far, you know the words they used on the earnings call, really words that are echoing back from customers was that basically what we will be showing could well change the dynamic of the industry. And be very very impactive in positive way for Accuray.
So really the only uncertainty in my mind at least is the exact -- the way in which precisely we are able to -- the speed at which we are precisely able to ramp our revenue as a result of these launches. Not that I think -- none of us doubt there will be some growth, further growth as a result from this.
Steve Beuchaw - Morgan Stanley
I would like to open it up to the audience, if there are any questions? Could you just wait for the microphone please?
Hi. What matrix should we follow or should the street follow to monitor the launch of these new devices at ASTRO to see if they are going as you expected, better than expected or worse than expected? And then second question is, when customers are currently evaluating CyberKnife and the Tomo device, what is currently a limiting factor for them to buy the device? Is it throughput, is it visual abilities or anything else? Thank you.
Yeah, they’re good questions. Thanks. So I think the metrics of success, they are not instantaneous. I mean instantaneous metric is how much attention does it get, the booth traffic and so on, which are not very helpful necessarily in sense of future indicators of the business as a whole. We would expect two impacts in this fiscal year from the successful launch. One would be an uptick in the book to bill ratio, you know further acceleration and enhancement to the book to bill ratio. That won't necessarily happen in Q2, it’s a little bit early for that.
When you show a technology at ASTRO, the first thing is you have to attract more customers to look at your technologies. But certainly as get to Q3 and Q4, you would hope to start to see some enhanced growth in the book to bill ratio. Revenue is likely to follow the following year and the years thereafter, the 2014. With the natural shipment rates that we have gone, as most people know, it’s a year plus from the time we have taken orders to the time a customer on average will take delivery of it. So this year I think you would hope to see by the end of this year what we expect to see by the end of this year, positive growth in new orders and revenues to follow after that.
The second question was around what factors are people looking at when they choose the technologies today. Sounds correct? Okay. So what's stopping them from purchasing today? Well, I think it’s a different thing for these products. The things we have to count to when it come to the TomoTherapy system are not so much around what it’s known for. I mean it’s known to be a very very good quality intensity motivated radiotherapy machine. It’s known to deliver even in light of other technology developments from some of our competitors. It’s known as the quality of the IMRT that can delivery is really industry leading.
It’s know that you can give image guidance on a daily basis with a TomoTherapy machine. The bigger challenge, in other words the high-end of the market, the most sophisticated form of treatment. I think most people accept the TomoTherapy system really don’t have an edge. I think the challenges we probably have with the TomoTherapy are about that quality comes at a time, an incremental timing cost. So that can be another five minutes or so to get treatment time while you take the images that are used to guide the treatment on a daily basis. That’s primarily where it comes from.
So when you chose whether to have a TomoTherapy machine, you have really got to be choosing a machine that as things stand today, that’s one designed towards the higher end of the radiotherapy market, the quality end of the radiotherapy market where the technical challenges are really greater. So the selling profile today for the TomoTherapy machine is tended to be in the medium to larger sized department where they have enough of that specialist workload and the high end workload to justify it.
So our challenge as an organization is actually to draw attention to the advantages that TomoTherapy system has across the board. And those advantages are real. And even for a treatment as we have seen, like say a breast cancer treatment, the massive, the helical dose delivery offers some significant advantages. You really have a very rudimentary geometric arrangement of treatment field with the C-Arm gantry traditional field. And if you want to treat the breast, which is sort of radiation being [slumped] in across the [checks], where all in you also want to treat sort of nodes that are up in the shoulder, you end up with a traditional C-Arm gantry that is quite a complicated field arrangement. And it can be actually be quite a lengthy treatment to deliver it in its entirety.
So one of our jobs is to point out that by using helical dose delivery and just scrolling down the length of the patient through the auxiliary nodes and then into the breast then passing through the original tumor site, you actually have some very good flexibility to deliver what I believe is a better quality treatment on a routine basis. But I think that -- so that as a company we need to draw people’s attention to that and those issues somewhat go away.
Then we need to demonstrate the value of daily imaging. So if daily imaging is just seen as something that takes longer without the inherent improvement in treatment quality, then it becomes a burden rather than a benefit. Now there are benefits that are real there. Daily positioning is more accurate. In some cases, in United States for example, it’s possible to be reimbursement the daily imaging. And we need to draw people’s attention to those things too.
So that’s a fairly complete overview I think with where we are with the TomoTherapy machine. With CyberKnife it’s always face the challenge and it’s still doubt. But it’s a new treatment philosophy. You know being able to treat essentially a surgical candidates in a non-surgical way. Treating tumors and obliterating tumors with radiation as opposed to needing to cut the patient open to physically remove the tumor, is still somewhat new. And we have had to work over the past ten years or so through every single application, develop clinical data, make sure that there is enough data there to justify reimbursement. To educate the field, educate physicians. And that’s on a worldwide scale.
So those challenges still somewhat exist. Having said that, there is really a huge momentum. Today, [starts] having body radiotherapy is the fastest growing area of radiation oncology. And there is still some major wins to come. Prostate radio surgery, prostate SVRT is still in its infancy. And we are still fighting the residual battles on reimbursement in the United States around prostate radio surgery. So I think, when I look at the challenges we have with selling CyberKnife today, primarily relate to whether people are confident in their clinical program to know that they have enough patients to justify a full time radio surgery unit.
If we are able to convince them of that clinical case, they almost invariably buy a CyberKnife. We really don’t loose on the technical standpoint if we can convince them they have got enough work for a full time machine. It really is about a clinical sell.
Steve Beuchaw - Morgan Stanley
Other questions from the audience?
Thanks. Two quick questions please. First, your competitor Varian it its recent results cited a lot of structural issues in markets and they seem to probably be a bit more negative about both the U.S. and Europe. I appreciate your coming from a smaller base but are you seeing those similar kind of negative market trends? And if so, how are you reacting to them? And then secondarily on reimbursement in the U.S. as you state, do you have any views into what the final versions of the proposed reimbursement, particularly from MPFS, are likely to be in the coming months? Thanks.
Okay. So I am not going to comment on Varian’s announcement (inaudible) but I can give you an overview of the situation as I see it in the U.S. from our standpoint. I think it would be easy for us to claim weakness in the U.S. as a major factor in our overall performance in United States over the past year. And I think that weakness does play a role. So when I look at our performance in the United States selling systems, what we have seen primarily is that we see pockets of activity where we have been very successful and we have seen more generalized areas where we don’t see or we have been successful as we could have been. And that’s what we are addressing specifically now.
So I think, yes, there is certainly still weakness in the United States. Capital is there but actually getting access of that capital is tough. The bar is pretty high. There is uncertainty over healthcare reform. There are other things impacting the market, medical device tax. There are overall uncertainties over the election. So there are multiple factors which certainly make the United States a challenging place to do business. But having said that, I still think, as I indicated, that we have significant scope for improvement in the United States performance. And we have done a lot to address that.
So when we came into this integrated environment, when we acquired TomoTherapy, we had two different strategies we had to address, selling strategies. One was international, where our international sales are organized, new orders are organized around distributors primarily. Few markets we are direct but most we were running distribution channels and TomoTherapy were as well. So we were faced with two products having two independent distributors in the same country. And our distributors lobbied pretty hard for us to amalgamate them, put all the business into one of the two hands and each one had a good reason why it should be them as opposed to the other distributor.
We held back on there on the basis that we felt there was value on having a specialized sales team for each product in those territories, and we felt we would manage it at least in the short term with our sales management personal that we had in place. And that actually proved very successful. So on a worldwide scale, we saw actually a fairly significant increase in the number of TomoTherapy systems that were sold ex U.S. last year. We saw CyberKnife maintain the momentum that we have before. So overall we were actually comfortable and happy and in some ways positively surprised by the success of us selling systems outside of the United States.
In the U.S. we had a slightly different approach. We said that the most important thing was for us to get a single point of contact. We brought all of the sales team from the two companies together. We had a fairly large number of territories and we said this territory manager in each of those territories will be responsible for selling both machines. That led us with a training and education challenge that we had to make sure that they really were educated to the point where they could go into a competitive environment, in a competitive sell against a Varian and actually point out the technical benefits of each machine.
And I think, looking back on it, that strategy was not as successful as our international strategy. So what we did when we restructured the sales force in about April of this year, is we mirrored the structure in the United States that has been successful for us internationally. So we have shrunk down the number of territories. We now have about five territories in the United States and they are still led by a single leader. But within each territory there are people who are responsible for selling one of the two product lines, and that’s their sole responsibility.
So we have more of the profiles that we have internationally inside the United States. People well training, highly motivated to sell each individual product line, and well able to sell from a competitive standpoint. And we have already started to see an improvement in sales activity in the United States. So I think when I look to our overall performance, although, yes, U.S. is weak, because I see certain people in the United States who have maintained sales momentum, I am not pointing to that as the primary thing that we have to address as a company. Which I think is somewhat different from the message you are probably hearing from some of our competitors.
In terms of reimbursement, the primary issue that people are discussing today in our field for reimbursement, is the proposed cuts and intensity modulated radiotherapy, payment rates for free standing centers. And CMS is proposing some significant cuts in those areas. Now from our standpoint again, I can't talk to other companies, we have relatively low, a small amount of business in free standing U.S. market. Primarily because they tend to be smaller by definition and smaller centers and the penetration of either of our two systems hasn’t been high into those free standing markets. Now we want to get to the point where they are, where we do have better penetration in this market. And I think that when I look at the proposed changes in some ways they help us.
Because the TomoTherapy system has the ability to, or has in that inherently images of patients every day, every time they are treated, and that is reimbursable, it’s possible for our customers to make up with the potential decline in IMRT reimbursement by billing for image guidance, daily image guidance. And that makes the TomoTherapy machine more competitive in that environment, probably then it ever has been before.
On the CyberKnife side, in a free standing environment, we are asking people in many cases to switch from IMRT to stereotactic body radiotherapy. Taking prostate cancer as an example, you know in the past when we have discussions with people working in this sort of entrepreneurial free standing environment, they say great, we get the clinical value and the value to the patient to switching from say 40 fraction stand to 4 or fractions, so that when I look at the business case I just get paid more doing IMRT. So if I go down this route my business case is disrupted significantly.
Well, now that argument somewhat goes away. There is a total reimbursement in freestanding environment for CyberKnife treatment, hypofractionated CyberKnife treatment is much closer to the total reimbursement that will be paid for an IMRT treatment. So we think that again will level the playing field more and give us somewhat of a advantage there as well.
So I think the way we view these reimbursement changes, it’s hard to predict whether CMS will follow through with the cut that’s proposed. I think that because we are not penetrated in those markets right now, there is limited downside. If they do follow through, we are seeing potential upside.
Steve Beuchaw - Morgan Stanley
Based on what you have seen from your customer base, let’s say in the last 90 days, what do you think happens if the freestanding center cuts go through and the hospital rates increases go through? How would you expect them to respond in terms of CapEx within the freestanding environment and in the hospital environment given that that hospitals would actually see a benefit over the next, let’s call it 18 months?
I think that has to be a shift in the business. I mean in the United States that has to be shift away from the freestanding environment towards the hospital based treatment practice, specifically for radiation oncology. I think that’s the likely outcome. And it’s the kind of outcome we predict.
Steve Beuchaw - Morgan Stanley
Your gantry based competitors are in the middle of something of a rather public back and forth regarding pricing in the market. You have the fortunate position of not competing with them so directly. But can you comment, specifically on the U.S., about what you are seeing in terms of pricing out there? What's your observation on the market, the lot more competitiveness in the market?
I see that question again. I think that the market dynamic hasn’t changed in as much as the technologies that are not particularly well differentiated from one another. Mainly, obviously those technologies of our competitors. Price does become a huge issue. And it’s natural. Unless they can deliver something which is better, than it becomes a price battle. And the something better tends to change hands on a yearly basis. Somebody comes out with a small amount of (inaudible) with a faster dose rate, takes a little time for the competitors to follow suit. And that can be slight competitive edge. But overall, I think it comes down to ground loyalty and customer established buying patterns. And there not being too much of a price differential between those competitors.
And that dynamic really hasn’t changed on a worldwide scale. For us it’s always been slightly different. It’s always been that we do have differentiated. Well differentiated technologies. We offer something extra. Both of our systems offer better quality and treatments for their respective areas. Different geometry, embedded image guidance for the TomoTherapy system and excellent quality -- and leading quality for intensity modulated radiotherapy. On the CyberKnife side, I mean quite frankly on the CyberKnife we believe you treat patients on the CyberKnife that you just could not treat with any other technology.
So they are very very well differentiated. And that shows itself in our product gross margin and in final analysis. If we look at the product gross margins we have, it demonstrates an environment where we are selling on the technological advantages that we have and not that much on price.
Steve Beuchaw - Morgan Stanley
What are your expectations for the medtech tax? Specifically for Accuray and then broadly speaking, how are you thinking about managing in calendar 2013 the impact of the tax? And what's your sense for how the interpretation and application of the rule might play out over the next six months?
I think we are clearly a small player in the overall industry. I mean the way companies manage the medical device tax we will probably not even be dominated by or controlled by any of the companies in the various oncology stakes. They are just not big enough. I think the diagnostic imaging world and the large players, the medical capital equipments are there in the imaging space, they will be probably set the tone as to how companies manage that medical device tax and whether to pass through to customers or whether they absorb it. But having said that, in the end, companies will be under pressure to maintain the type of margin that they have had and investors will demand whatever happens people recover from it and profits are not compromised.
So my feel is, in the end, however long it takes on that price, the tax will be absorbed in the end by the market as a whole and probably, it’s likely the customer will end up paying. Exactly the speed of transition for that remains to be seen but regardless of what happens we won't be the company to try that. We will observe it carefully and then we will follow the industry suit.
Steve Beuchaw - Morgan Stanley
Well, that brings us to the end of our time. Thank you, gentlemen.