As the distant #3 in the radiation oncology market, Accuray (NASDAQ:ARAY) already has a tough row to hoe and past issues with product reliability and present-day concerns about the cost effectiveness of its systems don't help matters. Even so, it looks like the new CyberKnife M6 and Tomo H products, coupled with operating cost improvements, are giving this company another chance at making a real go of it. The stock's nearly 20% jump since my last update has certainly taken some urgency out of the relative value call, but the pace of order improvements and the extent of skepticism about the company still offer arguments for a long position.
Beating On Multiple Lines
Accuray's fiscal fourth quarter was not anything like an argument that this company is ready to join companies like Novadaq (NASDAQ:NVDQ) and DexCom (NASDAQ:DXCM) in the ranks of growth med-tech. What it was, though, was an argument that management has staunched the bleeding and begun to rebuild credibility as a turnaround story.
Revenue fell 16% from last year, but rose 20% sequentially and came in a couple of million dollars ahead of expectation. Product revenue dropped 37% from last year, but jumped 56% from the prior quarter on a doubling in the number of systems shipped. Service revenue rose 17% from last year and was basically steady with the third quarter.
Margin improvement measures also appear to be holding. Overall GAAP gross margin fell four points (and non-GAAP gross margin fell five points) from last year, but product margins improved significantly on a sequential basis (almost 10 points by GAAP, and seven points non-GAAP), while service margins were down slightly (about one point). Accuray slightly overshot the mark for operating expenses for the quarter, though G&A expenses were down more than 20% and sales and marketing costs fell 10%.
An Encouraging Jump In Orders … But Execution Really Matters
For a company in Accuray's situation, the key metric isn't trailing revenue or operating income, but orders. The extent to which M6 and Tomo H can capture hearts and minds in hospitals and drive better share for Accuray against Varian (NYSE:VAR) and Elekta (OTCPK:EKTAY) is ultimately what makes or breaks this investment.
So on that score, an 11% year-on-year decline in orders doesn't sound great, but a 32% sequential improvement sounds a lot better, as does the 26% outperformance relative to the prior sell-side estimates. With that, the backlog climbed 12% from last year. I think it's also worth noting that the gap between gross and net orders has stayed fairly consistent.
Against that positive order news was another reminder that Accuray hasn't put all of the problems of its past behind it. Because of unacceptable results in durability tests, Accuray has chosen to drop its current multi-leaf collimator (MLC) supplier and find a new vendor. This is likely going to create a delay of at least six months.
On a more positive note, M6 shipments (the equipment which will include the MLC) weren't scheduled until CY 2014 anyway and it's very important for Accuray to get this right and ship good product. As a reminder of why this matters, the additional of the MLC is expected to cut "beam time" by 70% to 90%, giving Accuray's CyberKnife M6 equivalent treatment times to Varian and Elekta, but with superior accuracy.
Reimbursement Largely Neutral, And Again It's About Execution
Reimbursement trends in the radiation oncology space haven't been positive, but again it seems that most of the developments are relatively more favorable for Accuray. Cuts to freestanding clinics will hurt Varian and Elekta more than Accuray, and likewise Accuray continues to benefit from the case mix of its systems (there's more reimbursement pressure in cases/uses where Varian/Elektra are stronger).
While there are some risks to Accuray from the cuts to G codes aimed at improving reimbursement for robotic systems like the CyberKnife (to offset the differences in treatment times), the improved treatment time of the M6 should largely make that a wash. I think it's also worth noting that Blue Cross Blue Shield has recently issued a positive coverage decision on the use of SBRT (again, CyberKnife) in the treatment of prostate cancer, given the strong data that Accuray has produced in this indication.
There's still a lot left to prove, though. While the company has boosted uptime on Tomo from the bad old days of 50% to 99%, Tomo uptake is still slow due in part to a lack of reference sites. Likewise, while M6 traction has been improving, the addition of the MLC will still only make it relevant to about 30% of cases. Although Accuray can more credibly market Tomo H to single-vault centers now that the reliability issue is fixed, the real effort in the coming year(s) will be relying less on three-vault sites and more on two-vault and maybe one-vault sites. With that, it really is important for management to get orders back above $70 million - if they can do that by the end of this calendar year, I think the ultimate credible end market projections will definitely move up.
The Bottom Line
Although bears might point to the company's reduction in revenue guidance (to a midpoint of $335 million from $352 million), I get the sense that nobody really thought the $350 million sell-side number was all that credible. I think that goes a long way toward explaining why the stock was/is so strong on Wednesday despite that revision.
With the stock up 20% since my last bullish call, it's harder to make the case that Accuray is seriously undervalued. What's more, there is still a lot left to prove here. Still, in a med-tech market with few cheap stocks, this name is still worth a look. Although I haven't changed my long-term estimates, the shift in years (making the weak FY 2013 the new starting point) bumps the revenue growth target up to 11%, while I still have the same mid-teens free cash flow margin target.
With the shift out one year, my base-case fair value estimate moves up to $8.25, while my bullish "if everything goes right and they get 20% share" target goes up to $12.50. I would not suggest buying Accuray shares on the basis of that $12.50 number, but I do believe even $8.25 is an argument to buy and I believe Accuray is, for now at least, a company getting stronger and back on a growth trajectory.
Disclosure: I am long ARAY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.