ARAY - Accuray Stays On Track But Ramping In China Remains A Key Future Driver

2023-04-29 03:01:22 ET

Summary

• Accuray had a respectable fiscal third quarter with better-than-expected revenue driven by another quarter of good system placements, including share gains in the Japanese market.
• Supply chain challenges continue to pressure margins, and orders are still below the $100M threshold that I believe is critical for the share price/valuation.
• Order growth has been frustratingly erratic for years now, but the launch of a locally-produced Type B system for the Chinese market remains a key potential driver.
• I believe Accuray shares remain undervalued, with upside toward the high single-digits if the company continues to execute in Japan and sees a successful Chinese Type B launch.

I’ve often lamented that progress at Accuray ( ARAY ) has been a slow, inconsistent, and frustrating process. While the company is in a better position today than in years past, it often feels like a handful of promising quarters are followed by a painful reset. So far, though, this recent run of better performance has continued and the launch of domestically-produced roughly a year from now remains a key catalyst for the company.

Accuray shares are up about 15% since my last update , outperforming Elekta ( OTCPK:EKTAY ) over that period – I don’t consider Siemens Healthineers ( OTCPK:SMMNY ) (a diversified medical equipment and diagnostics company that owns Varian) or ViewRay ( VRAY ) (which has recently seen serious business pressures) to be great comps at this point. Guidance doesn’t suggest a lot of sequential acceleration at this point, but the trends in product sales and orders are still positive, and the valuation remains undemanding for what is admittedly a very risky stock and a company that still has a lot to prove.

Fiscal Third Quarter Earnings Reflect Progress, But Also Some Ongoing Challenges

Accuray reported 23% revenue growth in the fiscal third quarter (27% in constant currency terms), and that was close to 8% better than expected. Accuray is continuing to benefit from improvements in the supply chain and improvements in site availability, but I do think that progress needs to be seen in the context that on a four-year annualized stack, revenue growth is still only a little more than 4% (roughly in line with the broader radiation oncology space).

Product revenue rose 45% as reported (50% constant currency), and the company saw a 67% year-over-year improvement in shipment volume and a 3% sequential increase (one unit). On a four-year stack, product revenue is up almost 9%, and I find this number to be more encouraging. Revenue in the Americas “more than doubled” according to management, a strong result given the limitations created by staffing challenges, and revenue in Japan was up “almost 150%”.

Service revenue was up 4% as reported and 8% in constant currency.

Margins remain a work in progress, with the company continuing to see challenges from the supply chain. Gross margin fell 340bp year over year and 460bp qoq to 32.8%, and at least some of this would be tied to a mix shift. There’s always quarter-to-quarter variability in the mix of CyberKnife and Radixact systems, and the company continues to see pressures from the supply chain. Product gross margin declined 360bp yoy and 760bp qoq to 30.7%, while service margin declined 70bp yoy and 170bp qoq to 35.1%.

Adjusted EBITDA rose more than 53% year over year and declined about 2% sequentially as the company offset gross margin pressure with better operating efficiency. Operating income reversed a year-ago loss and declined 15% sequentially, with a margin of 1.9% versus 2.4% in the fiscal second quarter.

Orders Likewise Reflect Progress As Well As A Need For Improvement

Accuray reported a 13% year-over-year and 7% quarter-over-quarter decline in constant currency orders, with underlying system volume up 3% yoy (suggesting a mix shift away from CyberKnife to Radixact). Book to bill was still positive at 1.2x.

Net orders improved 26% yoy and 34% qoq, with age-outs still driving most of the difference. It’s worth noting that age-outs are “policy-driven” (orders age out at 30 months) and the company can and does later recoup at least some of these orders – $12 million of revenue this quarter came from systems that had previously aged out of the order book.

Still, backlog declined 13% year over year and about 2% quarter over quarter and I have long maintained that Accuray needs at least $100M in sustained quarterly orders to start getting serious investor attention again. I do believe orders are likely constrained by budgeting and staffing issues (at least in some geographies), and I remain bullish on opportunities for Accuray to gain share in Japan and benefit from locally-produced Type B machines next year in China.

I continue to believe that Japan is an underappreciated opportunity for Accuray and based upon commentary from Siemens and Elekta, and other sources of market information, I believe they are gaining share here. Accuray’s Radixact platform suits the somewhat market-specific needs of the Japanese market, and while stereotactic body radiation therapy (or SBRT) (the type of therapy that CyberKnife primarily addresses) has been slower to catch on in Japan, that’s starting to change.

There are opportunities for Accuray to benefit from increased adoption of SBRT and hypofractionation (treatment using fewer sessions of higher intensity radiation delivery) in the U.S., particularly with Accuray delivering clinical data showing equal or superior outcomes with good safety/tolerability. Likewise, Accuray continues to benefit from improved software and imaging capabilities, as well as an improving reputation where reliability and treatment times are concerned.

Nevertheless, China remains the key to the story here. Locally-produced Type B systems (Accuray has long enjoyed strong share in Type A systems) can unlock hundreds of millions of dollars of addressable revenue, and while Siemens and Elekta are both targeting China as a growth market, Accuray looks well-positioned given its local partnership. That said, this is has been the key driver for Accuray for some time now and delivering on next year’s launch will be critical.

The Outlook

Management modestly lifted its guidance range for the full year and reiterated its adjusted EBITDA guidance. At this point I do think guidance could be a bit conservative for the fourth quarter, but I think that is the right approach for a company that has a shaky track record hitting its goals.

As has long been the case, a key issue here is the likely revenue growth rate. While breakaway success with its Chinese Type B systems could drive double-digit annualized revenue growth (the addressable market is certainly large enough), I’m expecting mid-single-digit revenue growth. That is a serious issue for the stock valuation, as institutional investors don’t usually look to invest in slow-growing small-cap med-tech. The opportunity to do better (and rerate meaningfully higher) is here, but Accuray’s history argues against giving a substantial benefit of the doubt until and unless the Chinese Type B system launch goes well.

I value Accuray on the assumption of a little over 5% long-term annualized revenue growth – a growth rate higher than the underlying market and reflective of opportunities to outperform in Japan and China. Even better growth is possible, but would require success in the Chinese Type B market, further market share gains (and competitive replacements) in Japan, and share gains in the U.S. – I certainly see the first two as possible, while the third is much more of a “I’ll believe it when, and if, I see it” situation.

I believe that Accuray can generate mid-to-high single-digit FCF margins on the revenues I expect, and that supports a double-digit annualized return for the shares from here. I can also argue for a $7 share price based on a 1.75x multiple tied to the company’s revenue growth rate and a double-digit EBITDA multiple within a few years, minus a discount for the fact that slower-growing small-cap med-tech often trades at a discount.

The Bottom Line

I think Accuray has the business pointed in the right direction, but management cannot afford missteps from here. Executing on the opportunities in China and Japan is critical, and I do still see opportunities to win share through marketing and product development execution in North American and Europe. All of that said, while I do still believe the shares are undervalued, these shares are only suitable for investors willing and able to take on high risk.

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