Accuray Now Solidly On The Right Path

| About: Accuray Incorporated (ARAY)
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After a few quarters of "are they or aren't they?" uncertainty about Accuray's (NASDAQ:ARAY) turnaround, I think this quarter was a significant step forward for the company. Product revenue and orders have both recovered to pre-merger levels and attitudes regarding the systems appear to have turned solidly to the positive. Valuation is becoming a trickier issue now and although the shares are not all that cheap anymore from a cash flow standpoint, the shares could still do well by the looser standards of med-tech investors.

Delivering The Goods In Fiscal Q2

Accuray reported 20% overall growth for the quarter, a nearly 18% beat relative to the average Wall Street guess. The relatively more predictable service revenue component rose about 9% this quarter, while product revenue jumped 36% on better ASPs and strong upgrades.

Margins and profitability continue to be a work in progress, but there has definitely been progress. Gross margin rose over six points from the year-ago level (and beat expectations by about six points) and both components improved. Service margin improved more than 10 points, while product gross margin improved by more than half a point from last year. The company is still reporting an operating loss, but it is below $1 million now and EBITDA improved almost $25 million to just under $7 million.

Orders Are Lumpy, But Getting There

Accuray reported a doubling of gross orders this quarter (to $80 million), while net orders more than tripled the year-ago level. On a less positive note, the net order figure was pretty flat relative to the past two quarters, though management believes that some of the order age-outs that impacted this quarter will re-enter the book over the next year or two.

I have written in the past that $70 million per quarter is an important breakpoint for the company - a level at which I believe the business is viable for the long term. While this quarter saw gross orders get there, it's not going to be sustainable yet. Disruptions from the launch of both a new CyberKnife and Tomo system last year had a significant impact on orders this quarter and management's guidance for net orders for the full year is more on the order of $55 million per quarter. Importantly, the company still has a very significant backlog (over $360 million and up 30% this quarter), and delivering that backlog should be very positive for margins and revenue growth in the coming quarters.

Accuray also continues to see considerably better order growth than its rivals. Varian's (NYSE:VAR) gross orders were up 5%, while Elekta's (OTCPK:EKTAY) were up 10% in the last quarter (reported in December). Certainly, Accuray's tiny market share makes these comparisons of limited value, and Accuray has far less exposure to the emerging markets that are much more significant drivers for Varian and Elekta. Even so, I think Accuray's performance argues that there is a value proposition in its technologies that can lead to good order growth even when overall order growth in developed markets is not that strong.

Execute, Build, Grow

I continue to believe that Accuray has a better mousetrap than both Varian and Elekta when it comes to sterotactic radiosurgery (aka SRS) and sterotactic body radiation therapy (also known as SBRT). As a reminder, CyberKnife uses real-time x-ray images and sophisticated software to guide its robotic arm to deliver a focused high-energy beam of radiation that kills or reduces the tumor while largely sparing healthy tissue. This approach exposes the patient to less radiation than conventional systems and allows for the treatment of complex tumors that are off limits to conventional surgery. Add in the new multi-leaf collimator (that the company still expects to launch this summer) to improve patient throughput, and this is a compelling system for hospitals and centers treating advanced cases.

With the advantages that the CyberKnife system can offer, I believe this system expands the scope of SRS/SBRT treatment - including liver, head and neck, prostate, and pancreatic cancer. That expanded range suggests to me that CyberKnife's addressable market may be close to 800 or 900 systems - or five times the current installed base.

Tomo isn't exactly chopped liver either. The underlying markets for image-guided radiation therapy and intensity-modulated radiation therapy don't have the same growth potential that I see in SRS/SBRT, but they are still growing. As Accuray has developed Tomo systems with better speed (shorter treatment times) and improved treatment planning software, I think this segment can regain some share. While I think these systems are less compelling relative to the systems offered by Varian and Elekta (at least in comparison to what CyberKnife can offer versus its competition), they are compact and centers can re-use older vaults (saving potentially millions in new construction costs).

The key is to keep everything moving forward. This company has shot itself in the foot in the past with poor system reliability and treatment times that weren't as competitive as advertised. With the order book getting pretty large, management needs to deliver these systems on time and with the reliability that customers expect. Early reports are good in that respect, and I think management's decision to delay the launch of the MLC due to quality issues was a strong step in the right direction.

How Much Growth Is Reasonable?

Accuray has historically done pretty well outside of the U.S., but I don't see the company really competing with Varian or Elekta in emerging market tenders. Accuray's systems are typically premium-priced, and that's not going to work when emerging market orders often carry sub-$1 million ASPs (against global averages of more than $2 million). Likewise, I think the company has a ways to go before centers will regard the Tomo line as a potential workhorse system (as opposed to a second or third system after Varian or Elekta). Likewise, I don't ever see CyberKnife becoming a workhorse system - it's a specialized system that does a limited number of things very well.

Although some may be disappointed that this quarter's orders aren't the new baseline, I am not. In fact, I'm increasing my long-term revenue forecast (from about 11.5% to almost 13%) on the basis of the orders the company is seeing and the due diligence calls I've done with centers and hospitals. With mid-teens free cash flow margins that's good for a fair value around $10.50 today.

The Bottom Line

My DCF-based target for Accuray today suggests above-market returns for the stock, but not remarkable undervaluation. Med-tech investors don't often rely on DCF though, favoring instead an EV/revenue approach. By this metric Accuray still has upside. A multiple of 3.0x would actually be pretty low for a company with Accuray's expected revenue growth, though not out of line considering the risks and margins. That sort of multiple leads to a fair value of $14.50 today, and it's not hard to see where a more "med-tech growth-appropriate" multiple of 4x or higher would take the stock.

I do not see Accuray becoming the next Varian or Elekta, but it doesn't have to do that to be a successful company and stock. This call has already worked pretty well for me, and while I'm not as bullish as I once was (due solely to valuation), I don't want to ignore the potential that EV/revenue-based valuation approaches will keep these shares moving higher.

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.