Accuray's Orders Continue To Stoke Optimism

| About: Accuray Incorporated (ARAY)
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Things are definitely not perfect for Accuray (NASDAQ:ARAY) yet, but the story continues to improve on a quarter by quarter basis. Assuming that the company can successfully convert orders to installations and revenue, the company is gaining share from Varian (NYSE:VAR) and Elekta (OTCPK:EKTAY) and rebuilding credibility that this can once again become a med-tech growth story.

Many things can still go wrong, as the company's order level is still below where it needs to be to be a viable business and the long-term margin structure is a significant unknown. This is also still a volatile stock, as investors have seen these shares trade down recently on worries about reimbursement in the radiation oncology market. These shares are up slightly since my last update, but still up more than 60% from the midyear lows. My base-case scenario estimates see these shares about 20% undervalued today, but total upside in the bullish scenario could still be on the order of 50%.

Revenue Missed Slightly, But It's Not A Revenue Story Today

As much as I cringe when I hear analysts or investors talk about how "earnings don't matter" to a story, the fact is that it's pretty much the truth as it pertains to Accuray today. This is not a revenue or profit growth story today. Instead, it's a story that lives and dies on the company's order trends and whether the company can get to a critical mass that will translate into long-term viability.

Revenue fell 8% this quarter, missing the average sell-side guess by around 4%. Product revenue declined 27%, while service revenue grew 12% and made more than 60% of total revenue. This desert in product revenue was not unexpected and is a part of the company's transition to the next-gen M6 and Tomo H systems.

Profitability is still a work in progress. Gross margin did improve more than a point on an adjusted basis, with ongoing improvements in service margins (which now sit above 30%) and a sequential improvement in product margin. Operating loss declined by a third, as SG&A spending was basically flat. R&D spending declined significantly (down 30% on a GAAP basis), but management's comments on the call suggested that this was largely a timing issue. Keep in mind, though, that Accuray spends about one-quarter to one-third as much money on R&D as Varian and that's not a trivial detail in a technology-driven market.

Orders Ring The Bell Again

In an order-driven story, Accuray delivered what analysts and investors most wanted to see. Orders rose 16% yoy and 3% sequentially, coming in about 10% to 20% above the average estimate. The company's backlog rose to 18% to almost $350 million, or nearly three years of revenue at this quarter's product revenue run-rate.

Just as important, Accuray is gaining share against its large rivals. Varian's fiscal fourth quarter results (reported back in late October) saw gross new orders up 3% (to $841 million), while a revision to its backlog resulted in a reported net order decline of 13%. Elekta reports on a different schedule, but it's midyear report saw orders decline 2% to around $310 million. Some of this share gain can be tied to Accuray's lower exposure to freestanding clinics (Varian's problem) and large emerging market tenders (Elekta recently walked away from business in Brazil over pricing), but progress is progress.

Accuray is still below the significant $70 million/quarter level, but obviously the company is getting closer. Moreover, the company is still just beginning to get real interest in the M6 and Tomo H platforms. Management now believes that the new multileaf collimator (MLC) will be available on a limited basis in June of 2014, but there are still risks to this timeline. Likewise, while limited user experience with the new Tomo system has been showing excellent reliability, it's going to take time to change minds and erase the memories of very poor Tomo reliability in years past.

Feedback Is Positive, But Reimbursement And Technology Are Unknowns

Some of Accuray's recent stock weakness is likely tied to the improvement in the stock's price, but I believe at least some of it can also be tied to ongoing worries about reimbursement. Opinions on reimbursement from the ASTRO 2013 were mixed, which isn't surprising. While reimbursement pressure is a risk for almost every segment of med-tech these days, I would still argue that Accuray's leverage to more complex cases leaves it in a better position than Varian and Elekta. Likewise, data continues to support the potential of Accuray's technology in applications like prostate cancer where alternatives like robot-assisted surgery (offered by Intuitive Surgical (NASDAQ:ISRG)) have come under criticism.

This year's ASTRO 2013 was pretty dead from a new product standpoint, but there was some positive incremental feedback on Accuray. Most interesting (to me, anyway) was word that the M6 is leading to 20% reductions in treatment times even without the MLC. There was also positive anecdotal data on the Tomo H, including the precision and flexibility of the system.

For now, the biggest "to-do" for Accuray is to drive increased interest, acceptance, and orders for its new systems, and then prove to the Street that it can manufacture and market these systems on a profitable basis. From time to time there's more discussion of the emerging technology of proton therapy (which involves private companies like Mevion and ProNova, as well as Varian), but this seems like a technology that's still a long way from primetime - though perhaps not something that Accuray can entirely ignore.

The Bottom Line

Although this quarter saw orders exceed my expectations, I'm not changing my scenarios or fair value all that much. I'm still looking for 11% long-term revenue growth in my base case scenario, as well as mid-teens free cash flow margin. That works out to a fair value of around $8.25, or about 20% to 25% aboveThursday's closing price (though shares were indicated up 10% in premarket trading). Likewise, I still see a long-term bull scenario fair value around $12, but Accuray management still has a great deal left to prove before that scenario can become my base-case.

Accuray is the sort of stock investors have to look at if they want a med-tech bargain these days. Most of the stocks that trade at any meaningful discount to fair value have problems and uncertainties attached to the story. I'm still happy to hold these shares, but readers will have to answer for themselves whether the rewards left on the table are worth the risk of buying in today.

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.