Accuray Incorporated (NASDAQ:ARAY) F4Q08 Earnings Call August 19, 2008 5:00 PM ET
Tom Rathjen - Vice President of Investor Relations
Euan S. Thomson – President and Chief Executive Officer
Robert McNamara – Chief Financial Officer
Tom Gunderson – Piper Jaffray
Thijs Spoor – JPMorgan
Eric Schneider – UBS
Junaid Husain – Soleil
Peter Bye – Jefferies & Company
Amit Hazan – Oppenheimer
Welcome to Accuray Incorporated’s earnings conference call for the fourth quarter fiscal year 2008 ended June 28, 2008. (Operator Instructions) At this time, I would like to turn the conference over to Tom Rathjen, Vice President of Investor Relations. Please go ahead.
Thank you for joining us today for Accuray's fourth quarter of fiscal year-end 2008 conference call. Joining us this afternoon is Dr. Euan Thomson, Accuray's President and Chief Executive Officer plus Bob McNamara, our Senior Vice President and Chief Financial Officer.
As we did last quarter, we will again be referring to financial data which is found on two slides and a PDF file on the Investor Relations page of the Accuray website at www.accuray.com. Please log on to this site to view this information.
Before we begin, I need to remind you that except for the historical information, the information that follows contains certain forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those projected. Such risks and uncertainties include the matters described in the risk factors section of our report on Form 10-K for 2007 fiscal year as updated from time to time by our quarterly reports on Form 10-Q and other filings with the Securities Exchange Commission including our annual report on Form 10-K for the 2008 fiscal year which will be filed in September of 2008.
And now I would like to turn the call over to our President and Chief Executive Officer, Dr. Euan Thomson.
We’ll start the call with a business overview including an update on clinical data on utilization, reimbursement, and the business environment of the CyberKnife as we look forward into fiscal 2009. Bob McNamara, our Chief Financial Officer, will then provide a detailed report of our financial results for the fiscal fourth quarter and full year 2008. We will then be happy to open the call and take questions.
First let me share some of the financial highlights. Total revenue for the quarter was $50.9 million, a 16% increase over the same period last year. For the full year fiscal 2008, revenue increased 50% to $210.4 million in line with our guidance. Net income for the quarter was $191,000 contributing to our first full year of profitability, with fiscal 2008 net income of $5.4 million or $0.09 per diluted share. Our recurring services revenue grew to $11.8 million in the quarter and $38.8 million for the year. On an annual basis, this represents a 110% increase from the previous year. This growth in recurring services revenue is a very positive result, and services remain a key factor in our future growth profile.
We had an extremely successful quarter with the new orders. In total 28 new contracts are added to backlog in the quarter, representing a total value of $115.5 million. At the end of fiscal 2008, our total backlog was $647 million. New orders contributed $68 million directly to non-contingent backlog, and importantly the proportion of non-contingent backlog increased to 71% of the total or $460 million.
During the quarter, we installed six CyberKnife systems, three in the United States, one in Japan, and two in the rest of Asia, bringing the worldwide installed base to 140.
Before I get into some specific updates for the quarter, I’d like to take a moment to update you on the sales environment for dedicated radiosurgery systems in the United States. I’ll share with you some of the strategic steps we’ve taken to improve the quality of and increase the rate at which we sign new sales contracts. We’ve been very open about the challenges that we’ve encountered in the sales and installation environment as we progressed through fiscal 2008. Specifically, the entrepreneurial freestanding radiation treatment center market was challenged by proposed regulatory changes, the general economy, and the credit environment. These factors combined to place pressure on business plan for these centers, and during the year, we felt the need to reevaluate the timing of their installations, and in some cases, remove their contracts from backlog.
During fiscal 2008, we believe we have made significant progress in actively addressing this situation by refocusing our sales professionals on more established healthcare providers, particularly the hospitals. In parallel, we’ve also carefully examined our backlog each quarter and have removed any contracts that no longer meet our criteria for inclusion. Our sales focus on hospital-based customers. This resulted in a steady enhancement of backlog quality through the year as evidenced by the continued growth of our non-contingent backlog.
As further evidence of the success of our sales team in refocusing their efforts, I can reveal that of the 28 new contracts that we placed into backlog during the fiscal fourth quarter, 24 are associated with hospitals and other high-quality medical institutions, far less affected by the issues associated with more entrepreneurial sites.
In the US, we also have had several strategic successes. I can announce today that we’ve signed a sales contract with Kaiser Foundation Hospitals to provide CyberKnife to their cancer center in South San Francisco. This is a key sale since it is widely known that nonprofit healthcare providers such as Kaiser are motivated by demonstrated clinical value.
I’m also pleased to reveal that during fiscal 2008, we signed agreements with 15 academic centers, 3 in the US and 12 international, and overall our international business continues to be exceptionally strong. Of the 28 new contracts entered into backlog during the quarter, 17 were international contracts. Of particular note, we recently announced the Burdenko Institute of Neurosurgery in Moscow established CyberKnife. During the past year, we also announced the first CyberKnife sales in India, Switzerland, and Canada, further expanding our international reach.
Today, I can also announce that Lospedale San Bartolo in Vicenza will be installing a second CyberKnife system. This is our first confirmed order for a second CyberKnife from a European site, and it is further validation of the growing strength of our clinical program leading to increased demand for treatments. The continued strengthening of our international profile is another key aspect of our future success. As I stated before, international markets are driven very much on clinical validation of new technologies, and our international success is therefore a good indicator of the strengthening of our clinical program. We’ll continue to invest in international business in 2009, specifically we will continue to expand our sales coverage to increase our sales penetration in new market.
In summary, there continues to be a significant in growing sales opportunity for the CyberKnife, and we are encouraged by the robust number of leads we have in our sales pipeline and the clinical knowledge experience and capability of our customer base.
As we have explained in recent conference calls, the sales process of CyberKnife is significantly different to that of traditional radiation therapy equipment. Radiation therapy equipment is most often sold as a replacement to an existing machine that is at the end of its useful life, and in most cases, the budget and space has already been established. Because CyberKnife is still a relatively new technology with new clinical applications, we have little to no replacement business, and often there is no budget or space allocated for dedicated stereotactic body radiosurgery program at our customer sites when we initiate the sales relationship. In addition to being a challenge to completion of sales, this can also add a layer of complexity in converting a sale to an installation.
Following on the recent success of our sales program in the fourth quarter, we plan during fiscal 2009 to expand our resources in the sales support area with a goal accelerating the process turning contracts into installs. This has historically taken longer in the hospital market than in the freestanding market, so we are conscious that as the profile of our customer base changes, we’ll need to work hard on accelerating instillations.
We are currently building a team of dedicated relationship managers who will assist our customers with developing instillation programs following the signing of the CyberKnife contract. The new team will assess and evaluate each customer situation as the contract moves towards installation, addressing and identifying any specific issues that may arise. Our intention is that this initiative will also improve both our visibility and capability in forecasting revenue based on an enhanced customer relationship and better understanding of their individual needs and challenges during the pre-installation process.
I would like to now give you brief update in our treatment planning service business which we announced in the third quarter of fiscal 2008. We now have proof of concept in this service and have had our first plan accepted by our beta partner, Georgetown University Hospital. Our focus at this point has been on ensuring that we can deliver plans of the highest quality.
During fiscal 2009, we’ll begin to focus on growing volume and demand. While we do not expect significant revenue from this service during fiscal 2009, we do expect the service to begin to add to our revenue stream in the mid to long term. Immediate strategic value of the treatment planning service is that it will increase the treatment planning capacity of our customers and therefore increase their patient throughput. This is particularly important at a time when there is a worldwide shortage of medical physics personnel which can cause a a barrier of entry for prospective CyberKnife customers.
The growing strength of our clinical program is reflected by the growing number of CyberKnife publications. In fiscal 2008, there were 76 papers written on various clinical applications of the CyberKnife compared to 42 in fiscal 2007. Overall, there are now close to 300 clinical papers available demonstrating the unique benefits of CyberKnife radiosurgery. We are particularly pleased to report that the clinical study comparing treatment outcomes with surgery versus CyberKnife treatment in early-stage operable lung cancer with its team lead by MD Anderson Cancer Center will begin enrollment this fall.
Also the clinical study of inoperable lung patients was recently published in the July issue of Clinical Lung Cancer by the University of Pittsburgh Medical Center. This significant study further demonstrated the clinical superiority of the CyberKnife in the treatment of lung cancer. This study was conducted on 51 patients with a median followup time of 12 months, and it concludes that the CyberKnife is an effective treatment for patients with medically inoperable recurrent or metastatic lung cancer. The data were compelling. Local control with 85% of stage I non-small-cell lung cancer, 92% for recurrent lung cancer, and 62% for lung metastases. The study goes on to compare these results with conventional radiation therapy which is typically associated with poor local control rates in similar patients. This is clearly a significant publication and further validates CyberKnife’s efficacy in treating lung cancer.
Articles such as the UPMC publication definitely helped to drive clinical utilization and adoption by the medical community, as evidenced by the utilization trends at our installed CyberKnife sites. On this topic, I can announce today that we recently reached a major clinical milestone with more than 50,000 patients now treated on the CyberKnife. During fiscal 2008 alone, approximately 17,000 patients were treated, representing more than one third of the total patients ever treated on the CyberKnife, and the growth area is still extracranial radiosurgery, the field created by the CyberKnife. Approximately 56% of CyberKnife treatments in the United States are now being delivered to extracranial sites.
In March, we announced approximately 90% of worldwide CyberKnife centers outside of Japan were treating lung cancer. CyberKnife is particular promising in the lungs because of the capabilities of our real-time tracking and our synchrony system, which automatically tracks and corrects tumor movement during treatment. During fiscal 2008, worldwide CyberKnife utilization for lung cancer grew by approximately 50% compared to fiscal 2007, and the total number of patients treated surpassed 6000.
We also continue to see significant growth in CyberKnife utilization to treat prostate cancer. Last quarter, I discussed the results of a study published in the International Journal of Radiation Oncology, Biology, and Physics, known as the red journal, that demonstrated that the CyberKnife’s clinical flexibility enabled it to noninvasively deliver complex high-dose brachytherapy-like radiation doses to the prostate without the need for hospitalization and anesthesia. We are also eagerly awaiting the release of long-term clinical studies focused on the treatment of prostate cancer with the CyberKnife. We believe that the publication of these results will be an essential foundation to accelerated acceptance of the CyberKnife as the treatment of choice for prostate cancer.
However, even in the advance of these publications, we are seeing incredible changes in clinical practice. During fiscal 2008, we saw approximately 100% increase in the number of patients treated compared to fiscal 2007. In fact, more than half the patients ever treated for prostate cancer using the CyberKnife were treated in fiscal 2008. This is a remarkable acceptance profile and it reflects increasing confidence in CyberKnife radiosurgery for this application.
Another area where we have observed very strong traction in clinical utilization is treatment of liver cancer. During fiscal 2008, the number liver cancer treatments on the CyberKnife worldwide increased approximately 80%. Liver cancer represents a robust opportunity for growth especially in the Asian market where demographics are weighted towards the high incidence of liver cancer than in other parts of the world. In fact, acceptance of the CyberKnife for treatment of liver cancer already appears to be stronger internationally with international growth being 133% compared to fiscal year 2007. This compared with 52% growth in treatment numbers over the same time period in the US.
Very recently we’ve seen much publicity around the use of the CyberKnife for treatment of pancreatic cancer. Although incidence of pancreatic cancer is fortunately relatively low compared to some of the other applications, we continue to hope that CyberKnife might have an important role to play. Possibly in response to the publicity around this application, we saw significant growth in CyberKnife utilization for pancreatic cancer in Q4. A record number of patients were treated in this quarter, and US numbers increased by approximately 40% as compared to the same time period last year.
Moving on to technological improvement, it’s an important aspect of our business model to support the expansion of the clinical applications of CyberKnife with meaningful hardware and software upgrades. We recently announced that the first patients were treated using the next-generation CyberKnife at the Oklahoma CyberKnife Center Tulsa. This next-generation system features new technologies and system upgrades announced at the 2007 ASTRO annual meeting allowing it to deliver state of the art radiosurgery with significantly reduced treatment planning and delivery times.
In fact, the first patient treatment which was for an intracranial lesion was completed in only 16 minutes, and the next patient treated for non-small-cell lung cancer required only 27 minutes. Both of these times represent significant reductions over previously observed treatment times. This is a significant improvement in patient throughput allowing healthcare providers to increase revenue-generating opportunities and reduce expenses.
One of the customers at the site commented that this new CyberKnife system configuration “allows delivery of radiosurgery almost as fast as radiation therapy treatments.” To put this comment in perspective, although radiation therapy is only an option for a subset CyberKnife patients, typical radiation therapy systems are often quoted as being faster than the CyberKnife system. What is missed in this comparison is that radiation therapy patients are generally required to visit the treatment center up to 40 times. CyberKnife radiosurgery is rarely used for more than 5 treatments in as many days. With individual treatment times close to being comfortable and only 1 to 5 treatment visits for the CyberKnife compared to 40 or so treatments of radiation therapy, there are huge advantages to patients including far less disruption to their daily lives. We will continue to gather data on treatment times as the number of installations of the next-generation CyberKnife increases. This initial data was very encouraging. It’s great news for patients and healthcare providers.
While we hear reports of competitive products having the ability to perform full body radiosurgery, the fact remains that the CyberKnife clearly dominates this space. Once a healthcare center makes a decision to initiate a dedicated full-time radiosurgery practice, CyberKnife Robotic Radiosurgery System is the overwhelming choice. It is still the case that the competition that we see from the providers of so called hybrid systems is not from a technological standpoint; rather, it’s a competition for budget and/or physical space within a hospital. The CyberKnife technologies are developed, and we continue to protect our innovations with robust intellectual property strategy. The CyberKnife and its related software are now protected by 30 issued US patents.
I’d now like to take a few moments to discuss recent updates on the reimbursement environment for treatment with the CyberKnife. CMS has proposed Medicare reimbursement rate charges pertaining to the year 2009. Outpatient technical rates include an average of 6% reduction for robotic radiosurgery, in line with reimbursement changes across the radiosurgery and radiation therapy sectors. Professional fees are projected to change very little, and freestanding center payment rates continue to be priced by the regional carriers as in 2007 and 2008. These changes and adjustments do not seem to have affected our customers’ interest in the CyberKnife.
On the private payer front, we continue to make progress towards widespread support of extracranial radiosurgery. Blue Shield of California recently updated its policy to expand preauthorized coverage for robotic radiosurgery to brain, liver, lung, spine, and prostate cancer, and Blue Cross Blue Shield of Louisiana recently expanded that coverage to include spinal and lung treatments.
During fiscal 2009, we planned to launch an enhanced strategy to engage in discussions with private insurers about the clinical and economic benefits of the CyberKnife. We feel that this initiative is timely as a result of the ever-expanding body of clinical literature on CyberKnife treatments. We hope and believe that this strategy will lead to further acceleration in coverage by insurance plans for the extracranial indications of CyberKnife.
Finally, before I hand over to Bob for financial summary, I’d like to draw your attention to our recent significant breakthrough in Japan. During the fourth quarter of fiscal 2008, we obtained regulatory approval in Japan, known as a Shonin to market the CyberKnife for use in treatment of extracranial tumors. This is a culmination of many years’ work and effectively opens up what is still widely viewed as the largest market outside of the United States. We already have 20 units installed in Japan for treatment of intracranial head and neck tumors, and there is widespread knowledge and experience of CyberKnife technology. We’re currently working with our Japanese distributor to upgrade some of the systems already installed in Japan to support the expanded extracranial use and expect that these upgraded systems will contribute to our increased volumes in that market and serve as the foundation for the launch of our extracranial radiosurgery sales campaign.
To summarize, we believe we are well positioned to increase our leadership position in the expanding radiosurgery market as we continue to build evidence that the CyberKnife is changing the cancer treatment paradigm, and in many cases can replace surgery and/or radiation therapy. During fiscal 2008, we weathered the majority of the effects of a rapid change in US market conditions, while still producing revenue growth of 50%. We feel that our Q4 sales results are extremely encouraging and demonstrate that we have successfully refocused our US sales strategy on hospital customers while the international markets, which have been relatively unaffected by the US’ challenging conditions, have shown excellent sustainable sales growth.
Now, let’s turn the call over to Bob who will review our financial results.
This afternoon, I will review our financial operating results for the fourth quarter and 2008 fiscal year end.
Total revenue for the fiscal fourth quarter was $50.9 million, a 13% sequential decline from Q3 but a 16% increase over fourth quarter of last year. Accuray recorded net income of $191,000 for the quarter and was breakeven on a per diluted share basis, compared to net income of $502,000, or $0.01 per diluted share, in the fourth quarter of last year.
During the fourth quarter, Accuray recorded a non-cash stock-based compensation charge of $4.1 million, or $0.07 per diluted share. It is impotant to keep in mind that these are non-cash charges, approximately 90% of which are the results of stock-based grants during fiscal 2007 and earlier periods.
Total revenue for full fiscal year 2008 was $210.4 million, a 50% increase over fiscal 2007. While we are pleased with this growth, we recognize that this is at the low end of the revenue range we provided at the last earnings call. This illustrates various challenges we face each and every quarter. For example, one CyberKnife that was scheduled to be installed during the quarter had to be delayed when contractors discovered that the soil was not up to specifications and additional concrete needed to be poured. In another case, an international customer pushed out installation by at least 6 months because of permit and personnel issues not foreseen earlier.
Net income for the year 2008 was $5.4 million, or $0.09 per diluted per share. This compares favorably to last year’s loss of $5.6 million, or a loss of $0.18 per diluted share. For the year, Accuray recorded non-cash stock-based compensation charges of $16.9 million, or $0.28 per diluted share.
Taking a closer look at revenue for the fourth quarter, CyberKnife product sales generated $35.6 million. The sequential decrease from the third quarter was primarily due to the significant revenue in the third quarter from the sale of 8 shared ownership programs. Besides, these side issues that I previously discussed also affected the quarter.
Services revenue was $11.8 million, or 23% of total revenue for the quarter, marking a year-over-year increase of 110%. As a reminder, services revenue is primarily associated with long-term maintenance agreements, generally over 4 years with revenue recognized ratably over the respective service period. This important stream of predictable recurring revenue continues to increase as a percentage of total revenue.
Shared ownership contributed $2.2 million for the fourth quarter, a 19% sequential decrease primarily as a result of shared ownership buyouts in previous quarters of 2008. During the fourth quarter, two shared ownership systems were bought out by their respective customers, and one new system was installed, yielding 3 total shared ownership programs installed at the end of the fiscal year. Going forward, we anticipate revenues from our shared ownership arrangement to comprise a small part of our ongoing business; however, it continues to be our policy to encourage CyberKnife ownership with our shared ownership program as a means of transitioning to full purchase ownership. As we’ve said we anticipate eventual buyout of these units before or after installation.
Other revenue for the fiscal fourth quarter was $1.4 million, consisting primarily of upgrade products sold into the Japanese market. Fourth quarter revenue contribution from legacy platinum accounts converted from deferred revenue was $9.8 million. Of this $9.8 million, $6.3 million was from Platinum CyberKnife systems. As you recall, once the sixth and final upgrade has been installed on these contracts, we then ratably recognize the value of that agreement over the remaining life of that contract. Exiting the fourth quarter, all 30 of these legacy platinum systems are installed. We’ve recognized all the revenue on two systems, and we are currently recognizing revenue on 17 systems. Of the remaining 11 systems, most of have less than 2 upgrades to deliver before we begin to recognize that revenue, and we estimate having all platinum-related upgrades delivered by the end of fiscal year 2010.
Accuray’s gross margin improved to 52.8% for the fourth quarter, primarily due to product mix and fewer shared ownership buyouts compared to the previous quarter. Total operating expenses for the fourth quarter were $27.5 million, or 54% of revenue, a year over year improvement of 4%. Our investment in research and development was $8.4 million, or 17% of total revenue, representing our continued focus and investment in this very important area.
During the fourth quarter of fiscal 2008, Accuray booked 28 new contracts into backlog with a value of $115.5 million. Of the new contracts, 17 were from international customers, six of which are within our European operations. The strength of international contracts is evidence of the growing demand for CyberKnife systems outside the US as well as the successful selling effort from our sales team. Of these 28 orders, 24 were operational in nature, which we categorize as hospital based or experienced CyberKnife System users. This reinforces Euan’s point that our sales force is refocused on selling into the more stable hospital based environment.
Moving to installations, six CyberKnife systems were installed during the quarter, three in the US, one in Japan, and two in the rest of Asia. This brings the worldwide CyberKnife installation base to 140. The geographical breakdown at the end of the quarter was as follows: 90 systems in the Americas, 12 systems in Europe, 20 systems in Japan, and 18 systems in the rest of Asia. As we’ve discussed in previous quarters, we recognize revenue upon installation of CyberKnife when Accuray is responsible for doing the install. For those international customers working through distributors who are responsible for installation, Accuray recognizes revenue upon shipment to the end user. With these distributor sales, it is important to keep in mind that there’s often a period of time between shipment and installation of the CyberKnife unit.
During the fourth quarter, we recognized revenue on 12 systems, 3 of which were in Asia, 1 in Europe, and 8 in the US. Of these 8 US revenue systems, 3 were new system installations, 2 were shared ownership buyouts, 1 was a new shared ownership installation, and 2 were the initiation of revenue from legacy platinum accounts.
Moving to backlog, I’d like to draw your attention to the two charts that have been placed on the Investor Relations page of the Accuray website. At the end of the fourth quarter, Accuray’s backlog grew $45 million to $647 million, with $359 million associated with contracts for CyberKnife systems, $255 million associated with long-term service contracts, and $33 million for shared ownership program contracts. As we established last quarter, this chart provides further transparency into our backlog segmentation. As you can see, of the $647 million in total backlog, $460 million, or 71 percent is associated with non-contingent contracts. This reflects a net increase of $74 million, or a 19% increase into the non-contingent category. The remaining 29%, or $187 million of backlog, are contracts which may include standard contingencies such as board approval or certificates of need. Of this contingent segment, more than half represent operational accounts, principally hospital-based customers.
Now, I’d like to call your attention to the second chart shown on our Investor Relations website, again in an effort to provide greater detail on backlog. This bar chart shows non-contingent and contingent backlog trends over the last 8 quarters. A few key points to note: One, total backlog continues to increase annually though with some quarterly fluctuation; two, non-contingent backlog shown in blue increases annually with some quarterly fluctuations and is generally increasing as a percentage of total backlog; and three, contingent backlog shown in red peaked earlier in the year but has decreased the last two quarter and hence has been a small percentage of total backlog. The net result of these trends is that backlog is of a higher quality with a greater degree of certainty of becoming revenue. Our challenge is less with the revenue with the revenue itself, but the timing of that revenue, which depends so much on the customer’s build-out of the facility.
Of the 28 orders that went into backlog for the fourth quarter, 18 of these, or 64%, went directly into non-contingent backlog, which represents $68 million. In addition, approximately $50 million moved from contingent backlog into non-contingent backlog. In total, $118 million flowed into the non-contingent backlog this quarter.
Finally, we did have 8 orders which we adjusted out of contingent backlog, either because we received notification from the customer that the order was cancelled or our confidence level decreased to a level where future revenue recognition is currently in question. Of these 8 orders, all were within the contingent category. The total value of these adjustments was approximately $39 million. Again, all of these adjustments came out of contingent backlog and are reflected in the balance shown on the chart.
Reviewing Accuray’s balance sheet, total cash and investments at the end of June 2008 was $159.5 million. This consists of cash and cash equivalents, short-term investments, and approximately $37.0 million in long-term investments. Deferred revenue was $114.2 million, with $87.5 million in current deferred revenues. Total assets at the end of the quarter were $295 million, and the company continued to have zero debt.
Last August, Accuray’s board of directors approved a stock repurchase plan providing the company with the ability to acquire up to $25 million worth of its common shares in the open market. During the fiscal fourth quarter, we purchased approximately 260,000 shares of Accuray stock for $2.3 million. For the fiscal year ended June 2008, we purchased approximately 2.1 million shares of Accuray stock for $24 million. Hence, we have just over $1 million remaining in the program.
Turning to guidance, based upon projected installations and other anticipated revenue for the upcoming year, we believe that total revenue for fiscal 2009 will be in the range of $230 million to $250 million. While we are offering topline guidance for the fiscal year, the movement of systems from one quarter to the next can have a significant effect on revenue in a particular quarter. We remain dependent upon our customers to build out an appropriate facility to house the CyberKnife and cannot install the system until construction is completed.
With that, I will turn the call back to Euan.
We’ll now open the call for questions.
(Operator Instructions) Our first question comes from the line of Tom Gunderson with Piper Jaffray.
Tom Gunderson – Piper Jaffray
For my two questions, one would be, Euan, six units shipped, we’ve got a tough economy out there, these are profit centers for hospitals. Our eyeball on this would have been that there was somewhere in the neighborhood of 15 or 16 units that were aged long enough that could have been activated. What do you think is going on in the market out there that only six in a quarter are being activated, when the need seems so great?
I think it was 8 units shipped, as I recall, and six completed installation. I think that generally demand is high. The trouble is that we only have relatively small numbers involved right now, and I think what you’re seeing there will still be quarterly fluctuations. The overall trend as we’ve gone through the year is we had to build out the non-contingent element of our backlog. In our original installations at times during the year, we’ve been fairly open about. We certainly had more systems, and because of the environmental changes that took place, we had to remove those from our installation program, but I think we’re coming through that now. We’re seeing some light at the end of the tunnel. It will obviously take a while for those systems that we brought into backlog in Q4 to push their way all the way to revenue, but these quarterly fluctuations will really always be there. They are just dependent on so many factors as Bob indicated, things changing on the permitting line for a particular site, delays in construction, changes in personnel…there’re just so many factors out of our control. What we will be doing, though, as I mentioned in my script is we are definitively investing in this area, both to speed up the installation process and to give ourselves a better handle on exactly when these systems will go in, and the people that I talked about bringing into the Accuray team are really people who will take over after the sale is completed, start to build a relationship not just with the doctor who is interested in buying but with the facilities team at a hospital that is responsible for completing the construction program, and I think in that way, we’ll definitely be able to have better visibility, and I hope and believe that we’ll also be able to decrease the time that our systems sit in non-contingent backlog.
Tom Gunderson – Piper Jaffray
For the second quarter, Japan, can you help us a little bit to understand what the reimbursement picture is there? Traditionally with other medical devices, you get regulatory approval, but then there’s a log of where there is a reimbursement. As you go from intracranial to extracranial, are there any other hoops that you have to jump through to get reimbursement for that?
We have cranial reimbursement already, systems that have been around there for some time. We do have a process to go through now as it relates to extracranial reimbursement. We haven’t started that process off. We’re working with our distributor on that to get things moving along. I think on the good side we do have a very strong clinical knowledge. A lot of the existing uses, in particular the CyberKnife, have been aware that it has been pending, and I think the next phase of that market is ready to get some of the existing sites up and running with extracranial treatment, get some local experience, and then they can help us with the reimbursement enquiries and the reimbursement applications as they come through.
Our next question comes from Tycho Peterson with J.P. Morgan.
Thijs Spoor – JPMorgan
This is Thijs Spoor sitting in for Tycho. Thanks for taking the question. Just a question about the new CyberKnife system that you have coming out. Is that a technical upgrade, is that a software upgrade? Can you give us some color around how that will impact the current customers in backlog or current customers and sort of a margin relation to that, if it’s more of a physical versus software component?
Well, it’s actually a combination of both. These are the upgrades that we talked about and described at the last ASTRO show, which was about 11 or so months ago, I think, or maybe 10 or so months ago. We launched several new upgrades. They were high-output linear accelerator just producing radiation at a faster rate. We had a new variable type collimation system which equaled the IRIS collimator which can actually change the size of the radiation field during the treatment, and also software optimization for planning and optimization for treatment delivery, so the overall package is a combination of hardware and software, and it is those things together, getting one site that had all of these installed together that really only happened during the last quarter. To be honest, we were somewhat surprised ourselves at the combined impact when we looked at those first couple of treatments, and of course, it’s relatively a small number of data points right now. We’re still in the early phases of evaluating what the impact would be across the board, but we were quite frankly amazed that when you combined all of these new upgrades together, we were getting such short treatment times.
Thijs Spoor – JPMorgan
Then just the followup on margins then as it relates to if the new upgraded systems will impact margin also if you have international sales growth through distributors. Do you expect a margin decrease as more sales go through those distributors?
To answer your second question first, we wouldn’t expect a margin decrease as more sales through distributors specifically, although clearly if that takes on a larger percentage of total sales versus direct, then that would impact the gross margin because the gross margin on direct sales is better than the sale through distributors, and then regarding the upgrades, I won’t speak specifically to that, but what I can say is I can speak to next year’s gross margin that we believe will be similar to what it is now in the low 50s.
Some of the technology aspects, we were provider a linear accelerator before, whereas now we’re providing a higher output linear accelerator. We were providing a collimation system; now, we’re providing a variable collimation system, and obviously software, one software version versus another software version has fairly low impact on margin, so I don’t think we’re expecting any significant changes in margin as a result of this upgrade profile.
Our next question comes from Eric Schneider with UBS.
Eric Schneider – UBS
First, thanks for providing a little information on the backlog, particularly the historical split between contingent and non-contingent, which brings my question. On the non-contingent piece, it had been growing sort of the mid-teens rate year over year. The growth in your fourth quarter was stunning compared to that, so do you think that is typical sales, fourth quarter phenomenon, where things are being pulled forward from the first quarter of next fiscal year, so do you expect a drop in that, or is that reflecting some other change dynamic in the market that nobody else is seeing?
I think as we’ve seen historically our fourth quarter is typically our largest quarter in terms of quarters for all the reasons that every sales organization has. As you enter the last quarter where the annual objectives are trying to be met, fourth quarter comes into play more than the other quarters, so to that extent, I think that’s one reason why the actual dollars went up for non-contingent, but the other piece is, focusing again as we talked about a little bit on the call, the quality of the orders that are coming in and the quality of the orders moving more away from the entrepreneurial customer and more to the hospital based customer has clearly affected favorably the non-contingent mix, as well as the international order flow has also favorably affected the non-contingent mix in Q4.
Eric Schneider – UBS
A portion of that non-contingent is the deferred revenue from the legacy contracts. It looks like looking at the balance sheet movements that about $50 million of next year’s expected revenue comes from legacy contracts through. Is that about right?
We currently have within the backlog about $60 million of CyberKnife deferred revenue.
Our next question comes from Junaid Husain with Soleil.
Junaid Husain – Soleil
Relative to the Stark laws, it seems as if the folks at Congress are moving forward with the tightening of the rules relative to the under-arrangements. It would seem at least on first blush that Stark is not outright prohibiting the under-arrangements, but almost evaluating them on a case-by-case basis. Euan, could you very quickly walk us through this very complicated piece of legislation and then talk about what these new rules could potentially mean to your business?
I think we’ve actually touched on that several times over the past year. There’s no doubt it is one of the things we faced very much during the first half of the year. So the changes that are taking place, one relates to under-arrangements which is a freestanding center delivering a treatment on behalf of a hospital and then billing the hospital and the hospital itself then billing for Medicare reimbursement, and CMS continues to tighten up on that. There’s a little bit more information that came out in the inpatient prospective payment schedule, and it does appear that they really are pushing hard on tidying what they consider to be a loophole, but in terms of how that affects our business, I believe we’ve already taken the impact of that over the first part of the year. I think as we see the situation gaining greater clarity, in essence, it’s really helping us because people are then able to structure their business models knowing that rather than sign a contract in the hope that something will happen and everything will work out, and they’ll still be able to persist with the original plan that they had, so I think we’re sorting out through our good customers early on which enables our sales force to either focus on them or not focus on them, and all in all, it just gives much, much greater clarity, so we’re fairly positive at this point, and I think looking at the backlog again, seeing the influx of non-contingent backlog, what that tells you is that we really don’t have a bunch of new contracts that are so heavily weighted towards people sorting out their financing, sorting out their arrangements with hospitals, their joint venture structures, so we’re getting a much cleaner group of contracts all around. That’s really the biggest impact area for us. In terms of Stark and such and ownership, there really hasn’t been an awful lot of change in that. I think it’s always been the case that referring physicians are not really supposed to own the system and benefit from it financially, so that’s an area that doesn’t really change very much, and I think all of our customers always know that that’s the environment that we’re working in.
Junaid Husain – Soleil
And then could you tell us what portion of your backlog, I guess the contingent backlog, is reflective of these entrepreneurial centers?
Sure. Certainly less than half of that contingent is reflective of what we call entrepreneurial.
Junaid Husain – Soleil
So more than half of it is the hospital-based operational.
Our next question comes from Peter Bye with Jefferies & Company.
Peter Bye – Jefferies & Company
Just a couple of questions, and obviously there are questions about orders and units shipped and quality of backlog over the last several quarters. How long does it take once a hospital starts construction to finish the site, and then how many people who placed orders are under construction today?
Let me give you a little bit of view about the time to install and such. We actually think it has expanded over the last year or so, and let me kind of talk about this, and we track this based on the units that have been installed, etc., so if you looked at it, say, in ’06, it was closer to 11 months; in ’07, that extended to about 12 months; and now, it’s actually closer to 18 months, and so while an average can be very dangerous here because every customer is different and it’s bimodal, it’s not trimodal, but we look at the range of right now of being between, in terms of time to install, 15 to 24 months.
Peter Bye – Jefferies & Company
Okay, but do you know sites are under construction today?
We actually don’t disclose that much detail on a public basis.
Our next question comes from Amit Hazan with Oppenheimer.
Amit Hazan – Oppenheimer
I’ll ask both of my questions at once and then take my answers offline just in case we encounter technical difficulties. The first one would be just a very straight forward question, looking historically over the last three years now, you pretty much installed about the same number of units every year, roughly around 30; 32 in ’07, 31 in ’08 net. You’re expecting a huge jump in ’09 to get to your guidance of installations. I recognize you said maybe you think you might be over the hump with some of the economic issues, but in your strongest fiscal quarter, your June quarter, you just put up 6 installations. I’m wondering what gives you the confidence that you can increase your installations beyond what we’ve seen in the last three years. That’s my first question, and my second question is on the new orders, we’re getting to an ASP scores of about $4.1 million for those new orders, so the first question is, why has the ASP gone down so much, and also in addition to that, isn’t that going to negatively impact gross margins as that goes through the P&L?
I’ll answer your second question first. Our ASP is between $3.5 and $4.0 million. It really depends on again whether it’s a direct or whether it is through a distributor, and then your question regarding the growth or acceleration or increase in installations that we’re looking for next year, part of this year, just as we were coming into the fourth quarter, we did run into some issues that we didn’t quite see, and so, had we been able to handle those properly or we’d been able to make those installs, you would’ve seen an increase, first and foremost, and secondly and we touched on this on the call, we really are going after accelerating those installs. We have this non-contingent backlog, and those contracts are good contracts, and we want to make sure we are able to increase the number of installs next year. How do we do that? Well, we focus on it, so we know who those customers. We know where they are in terms of construction, whether it’s pre-construction, during construction, etc. A lot of the issue has to do with the actual build out and whether it’s part of a single CyberKnife unit or part of a larger facility buildup. That is a real challenge for us, but what we want to be able to do is expand our relationships. We have relationships with the clinicians at the hospital. We have relationships with the administrators in the hospital. Where we want to expand this relationship is to the facilities in the hospitals, so that we can in fact accelerate those installations, and that is clearly one of our goals for next year.
We take a followup question comes from Eric Schneider of UBS.
Eric Schneider – UBS
You were talking about the time to install lengthening, and investing and accelerating that. How much is that investment costing? These are additional people that are out in the field trying to push this process through?
I would say yes, but it’s marginal. We have the infrastructure. It’s a matter of reassigning some existing resources. We might bring in some additional resources. While it will be a focus program, it’s not going to be large enough that you’ll really see it negatively affect the financials. In fact, if it’s successful, you’ll see it favorably affecting the financials.
Eric Schneider – UBS
On the clinical side, is there any concern that the traditional radiation treatment market, particularly for prostate, is at risk with the recommendation to actually not screen in older patients though?
No, I don’t think we’re expecting any significant impact in the market from that.
We’ll take a followup from Peter Bye with Jefferies and Company.
Peter Bye – Jefferies & Company
Just to follow up on Eric’s question, you talked about expanding international sales effort too, and given new orders are out-clipping the US orders here, where do you think that sales force should go or will go next year? I think we have you around in the mid 20s right now. I don’t know if that’s right or not, but maybe you can expound on that a little bit.
I’m not sure I understand your question. Are you talking about the…
Peter Bye – Jefferies & Company
Most of our international sales are managed through distributors. Where we focus on those is distributor management, and really if you look at the sales profile, we really have doubled the size of the sales force during ’07 and ’08, and much of that was an investment in international management, so I think we’ve got most of the infrastructure inside where we now need to manage a pretty large distribution network, and we’re really focused on is identifying the correct distributors for us, and that can be somewhat of a challenge. It’s pretty unique technology, capital equipment for a very specific oncology treatment, so we take some time to find those distributors, and it tends to be an ongoing process of interview and review, and that’s really where we’re focusing our efforts. It’s just reaching out into the rest of countries that we’re not covering right now.
And that does conclude our question-and-answer session.
Alright. Q4 fiscal 2008 was a solid quarter for new contracts. As a result of good sales momentum and very encouraging clinical data, we believe we’re well positioned to increase our leadership position in the expanding radiosurgery market. We continue to build evidence that the CyberKnife is changing the cancer treatment paradigm and in many cases to replace surgery and /or radiation therapy. During fiscal 2008, we weathered the majority of the effects of a rapid change in US market conditions, while still producing revenue growth of 50%. Thank you for your time today. We look forward to talking to you on our next call.
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