EKTAY - Accuray Making Progress But Not Enough To Swing Sentiment

• Accuray had a better than expected fiscal fourth quarter, but the business still remains constrained by supply-chain challenges and the lingering impact of the pandemic in China.
• Meaningful technological and product performance improvements are arguably going underappreciated by the market, but the company still must show that it can translate those into sustainable growth and profitability.
• As Accuray expands its Chinese business and leverages technology/product improvements in other markets, revenue growth and profitability should improve, but this is a consummate "show me" story.
• The shares look undervalued below $6 - $7.50, but the company's track record justifies at least some of the skepticism around the name.

When I last wrote about Accuray ( ARAY ) in early February , I said that the challenges the company was facing over the next 12 months from supply-chain issues and ongoing COVID-19 disruptions in China would likely mask any progress at the company. So it has been, as the shares have declined about 25% or so (worse before a recent rally in the shares) and the Street remains largely disinterested in this name.

There is ample cause for skepticism on Accuray; despite several important product/technology advances and progress in the under-penetrated Chinese market, there has been almost no revenue growth over the past decade ($430M versus $409M) and profitability is still inadequate.

On the other hand, those technological and product improvements aren’t trivial, and the radiation oncology market is changing more than some investors may appreciate. The Chinese market should improve as lockdowns ease, and changes to both Accuray’s product line-up and the rad-onc market should drive above-market performance.

All of that said, I completely understand investor skepticism on this name. Although the shares look undervalued (even on low expectations), I will not quibble with investors who want nothing to do with this name, and it’s one that I’d only recommend for more risk-tolerant investors willing to accept the risk that nothing ever really changes here.

Some Momentum In Fiscal Q4, But Still A “Lost Year” In Some Respects

In my view, contextualizing Accuray’s performance over the last year is not a simple process. It’s true that there was limited progress in terms of revenue growth, order growth, and margin performance, but it’s likewise true that there were significant headwinds throughout the year related to COVID-19 and supply-chain disruptions. It wouldn’t be accurate to say that there was no progress, but it also wouldn’t be unfair that this was another year that came up short of the progress that investors expected.

For the fiscal fourth quarter, revenue declined 1%, though that was still about 5% better than expected. Product revenue rose 3% year over year, while service revenue declined 5%; service revenue has always been more volatile here, with the pandemic creating some additional complications.

Gross margin declined 30bp from the year-ago level (to 39.1%), with product gross margin up 360bp to 45.1% and service margin down 480bp to 32.5%. Product gross margin can be quite sensitive to mix in a given quarter, and so too for service margins, so I’d be cautious about reading too much into the result, as management doesn’t provide detail on product revenue mix on a consistent basis.

Adjusted EBITDA declined 22%, while operating income declined 50%, coming in at a margin of just under 2%.

Gross orders declined 22%, while net orders fell 32%. Book-to-bill (on product revenue) was 1.5x on gross orders and about 0.75x on a net order basis. The majority of the gap between net and gross orders was due to age-outs, and these units could still get installed as COVID-19 limitations ease. The company saw only one cancellation in the quarter and that continues an encouraging trend of low cancellation rates. Backlog declined 9% from the year-ago period, but still represents over 10 quarters of product revenue on a trailing average product revenue run-rate over the last four quarters.

Looking at these results, the fourth quarter was better than expected and management’s guidance for FY’23 was within the expected range. There is evidence of momentum in the business tied to new technology offerings (like ClearRT), and underlying demand in China still seems to be solid.

On the other hand, this was supposed to be the year that the company really started delivering on the opportunity in China, and that didn’t happen due to the ongoing disruptions caused by the pandemic. Calling FY’22 a “lost year” may be harsh, but the reality is that the company still hasn’t achieved the hoped-for momentum in the business, nor $100M in quarterly orders on a consistent basis.

What Might The Street Be Missing?

There will be readers who regard any positivity or optimism on Accuray as another repeat of Lucy holding the football for Charlie Brown, but I do believe there are some legitimate positive drivers here that aren’t fully reflected in the share price.

First, the Chinese business is a legitimate opportunity, even with the delays and setbacks seen due to the pandemic. Accuray has around 75% to 85% share of Type A licenses granted in the country (depending on the time period) and China remains a significantly under-penetrated country where radiation oncology systems are concerned. Likewise, while the rollout of China-produced Type B systems has been delayed by the pandemic, that business should see deliveries next year.

Second, the company has continued to make meaningful technological progress with its systems. ClearRT is a significant step forward for imaging and VOLO Ultra delivers meaningful reductions in planning time – both of which are significant “quality of life” selling points with rad-onc centers. Along similar lines, data continue to accumulate supporting the use of the company’s technology in a variety of settings.

While I don’t think you can argue that Accuray’s systems are superior to the Varian systems of Siemens Healthineers ( OTCPK:SMMNY ), the gap has shrunk significantly (especially in planning) and Accuray offers credible competitive systems. Moreover, I think you could make the argument that Accuray’s offerings are much more competitive with Elekta ( OTCPK:EKTAY ), particularly the aging base of GammaKnife installations where I see a meaningful multiyear opportunity for Accuray’s CyberKnife system.

Last and not least is the behavior of the market itself. Between improving technology and changing reimbursement, there is now considerably more support for using higher doses of radiation delivered over fewer sessions (hypofractionation) and Accuray has accumulated good data on the performance of its systems in hypofractionation and ultra-hypofractionation settings (sometimes as few as five treatments). As this approach becomes more mainstream, it could lead rad-onc centers to give more consideration to Accuray systems.

The Outlook

I don’t want to give investors a misleadingly rosy picture – there is a reason that there is skepticism around Accuray, and at least part of that reason is a legacy of inadequate performance and “wait until next year” guidance. Likewise, it’s well worth remembering that Siemens/Varian is the gorilla in the space and that many rad-onc centers stick with Varian systems almost out of reflex – comparatively few radiation oncologists have much experience with Accuray systems and not much reason to advocate strongly to their managements in favor of adding Accuray systems.

While investors may like to believe that technology and system performance win out in the end, that’s not always true in med-tech, as many managers find it easier to just stick with the safe or known options, particularly in the absence of “this changes everything” data or technological advances (and I’d argue that even with the significant improvements at Accuray, they’re not at “this changes everything” levels).

With my model, I’ve taken a more conservative view on FY’24 revenue (and beyond) as I want to see that pick-up in Chinese placements before getting more bullish. I’ve also taken a somewhat more conservative outlook on margins/cash flow, as management seems committed to maintaining R&D investments and the plans for margin improvement sound a bit vague at this point. I’m now looking for revenue of $579M in FY’27 ($594M previously) and an FCF margin of 8% (versus 9.5%), and I am still concerned that my FCF improvement expectations are too bullish.

The Bottom Line

I’ve noted many times in the past across numerous med-tech company articles that the market generally pays up for great margins (a company like Stryker ( SYK ), for instance) or above-average revenue growth (a company like Edwards ( EW )), but companies with neither can languish in a valuation twilight zone. Such is still the case with Accuray; while the market would historically pay something around 1.5x to 2.0x for the expected revenue growth, the lack of profitability and the uncertainty of that revenue growth are both headwinds to valuation.

I do think there’s a case for Accuray as a $6-$7.50 stock on the basis of revenue growth and future cash flow, but that argument is counterbalanced by the reality that Accuray has long struggled to take that next step toward sustainable above-market growth and improving profitability. I do think the situation is better here than it appears at first glance, but this is a story that has already exhausted the patience of many investors and it’s not one that I can advocate for fiercely as a must-own.

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