What Accuray (NASDAQ:ARAY) is attempting to do is not easy, and that at least partially explains why the company continues to see lumpy progress on its path toward becoming a fully-fledged growth med-tech. It's hard enough to sell hospital capital equipment with a list price above $4 million, and harder still when competing against such well-established rivals as Varian (NYSE:VAR) and Elekta (OTCPK:EKTAY) (rivals that were able to essentially push Siemens out of the market).
Making matters worse, Accuray's stock has gotten caught up in the same capital flight that has led to other growth med-techs like Novadaq, Heartware, and Insulet seeing share price declines between 15% and 25% over the past three months. The next 18 months are likely to continue to show quarter-to-quarter volatility in certain areas (like orders), but the shares remain too cheap so long as revenue and margins continue to develop favorably.
Good Operating Results In March
Accuray reported 38% revenue growth for the quarter, a solid 18% better than expected on very strong product sales. Product sales jumped 88% this quarter, with service revenue up 10% as well. For this quarter at least, product and service revenue were nearly equal. As of quarter-end, the company's installed base had grown 5% to 730 systems.
Margins also continue to improve to a meaningful extent. Gross margin rose 1,250bp from last year and about 10bp sequentially. This was more than four points better than the sell side expected, with reported product margin improving almost 20 points and service margin improving almost six points. While the company did spend 21% more on sales and marketing, the company more than offset that with a one-third cut in G&A spending (+$2.7 million versus -$5.6 million), leading to an operating loss of just half a million dollars, or about eight million dollars less than expected.
It's Always Something - Net Orders Miss By A Sizable Margin
Showing why Accuray investors can never rest completely easy, the company did post a sizable miss on its net orders this quarter. While management was clear in the prior quarter that orders were going to decline sequentially, the 13% decline in orders led to an $11 million miss ($39 million versus $50 million) versus Street expectations.
This looks bad, and it does bring the company below that $70 million/quarter point that I believe is critical for long-term viability. That said, I don't think this is a development with significant long-term implications. First, orders are lumpy in capital equipment, and Accuray's size leaves it more vulnerable to that lumpiness than Varian or Elekta. Second, the company doesn't have the sizable group purchasing organization (or GPO) exposure that leads to more order visibility and stability - by management's estimation, some 75% of linac orders in the U.S. go through GPOs/GPNs. Third, the company still has yet to launch its multileaf collimator, and the backlog is more than enough to tide the company over through this lumpiness (with more than three quarters' revenue in the book).
Turning back to the GPO issue, Accuray also announced that it had signed a three-year agreement with Novation, a large GPO that includes more than 2,500 member hospitals. While selling through GPOs does usually entail lower prices to the OEM (one of the advantages of GPOs for members is that they aggregate their buying power to get lower prices), it is not as though Accuray wasn't selling systems below list price before this deal.
Progress On Multiple Fronts
I do believe this Novation agreement is a big step in Accuray developing a more sophisticated and competitive sales strategy for the market, but it wasn't the only "detail item" that the company addressed recently.
The company was able to refinance about $70 million of its convertible debt into similar arrangements that give the company the choice of effecting the conversion in stock, cash, or a combination. The net impact was to reduce the potential dilution from 30-35 million to 15-20 million.
Management also reiterated its expectation of launching the multileaf collimator in June. Right now, CyberKnife customers can choose a fixed or iris collimator, but the multileaf collimator will allow the operator to create radiation beams of virtually any shape. As a key feature of the CyberKnife is delivering high doses of radiation at very high precision, this is a significant product enhancement.
Patience Still The Order Of The Day
Accuray still has a lot of work to do. Product margins need to get to (and stay above) 50%, and the company needs to get more efficient about securing and delivering orders (and increasing those orders). The company also has to stay on task with R&D, or risk losing some of its product performance advantages to Varian, Elekta, or smaller up-and-comers.
I am still looking for Accuray to generate low double-digit long-term revenue growth, allowing the company to claim around 15% market share in 2023. I also expect the company to eventually generate FCF margins in the low-to-mid teens. Although it is not impossible to think that Accuray could get acquired before then, I consider the odds to be below-average.
The Bottom Line
Discounting my projected cash flows back to today, I come up with a fair value of around $10 for Accuray. Med-tech investors often like to use EV/forward revenue as a valuation tool, and Accuray looks quite cheap by this metric as well. Established low-growth med-techs frequently get 3x multiples, while growth med-tech stocks often see multiples in the range of 6x to 8x. Accuray presently trades at less than 2x forward revenue, which strikes me as very low, even with the added risk factors of inconsistent performance, net losses, and a very large competitor (Varian).
Accuray is definitely not a widows-and-orphans stock, nor a good pick for investors who can't handle above-average volatility. I continue to believe that Accuray has turned the corner and is on a path towards profitable growth, but as this quarter's net order intake shows, it's not a path without a few potholes left in it.
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.
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