ARAY - With Chinese Type B Approval In Hand 'Now Or Never' Approaches For Accuray

2023-10-06 00:23:37 ET

Summary

• Accuray's China JV recently received approval to sell its locally-produced Tomo C rad-onc system for China's Type B market - an opportunity that management estimates at $3B over 5 years.
• Management has a good track record in China, but there's a long history here of not delivering on potential growth opportunities and both Varian and Elekta are targeting China.
• China isn't the only driver, as Japan and segments of the U.S. market (including SBRT) could perform better, but execution is paramount.
• If improved revenue growth and margins come through, ARAY shares should outperform.

If you want to take a bearish view of Accuray 's ( ARAY ) corporate history over the last five to 10 years, you could readily say that this has always been a "just wait until…" story. Whether it was significant improvements to product quality/reliability, new software-driven capabilities, growth in the overall stereotactic body radiation therapy (or SBRT) market, corporate partnerships, or country-specific market opportunities (Japan and China), Accuray has forever been on the cusp of better results … but the roughly 2% revenue growth over the past decade has basically tracked (if not modestly lagged) the company's target markets.

The focus now is squarely on the opportunity in China. Accuray has long punched above its weight in China's Type A radiation oncology market, and now that the company's JV partnership with China Isotope & Radiation Corporation (or CIRC) has approval to sell Type B systems in the country, revenue should start to accelerate.

Accuray shares are down another 10% or so since my last update , actually outperforming the broader medical device space and more or less matching the performance of Elekta ( EKTAY ) over that period. While the valuation is not at all demanding, the upside here is gated by actually delivering on the meaningful opportunities in front of the company - a bet that has really never worked for an extended period of time with this name.

Ready To Launch In China

Accuray has been an active player in China's radiation oncology market for many years - winning a majority of Type A licenses (and in some years a very large majority). The Type A market is a relatively limited opportunity, though, and is less than 20% of the overall market opportunity in China.

The bigger market, the Type B market, is where the real opportunity lies. Management has seized the opportunity at $3B over the next five years, and the company's CNNC-Accuray JV (the JV it formed with CIRC) just got approval from the Chinese National Medical Products Administration (or NMPA) to market its Tomo C system for the Type B market. Like the company's similar Radixact system, Tomo C uses helical imaging and radiation delivery that leads to more precise radiation delivery.

While the Type B market is different from the Type A market, Accuray is nevertheless a known player in China (with an installed base of 132 systems at midyear), as is CIRC. The company has also been conducting roadshows across the market to start laying the groundwork for the Tomo C launch. With credible technology, a credible product, an established business, and a well-known local partner (in a market where the government has started actively favoring domestically-produced solutions), I believe the Tomo C can build on Accuray's already-successful legacy in China and deliver better growth.

Other Markets Still A Work In Progress

China is the growth driver for Accuray's foreseeable future, but it's not the only market that matters.

The company saw its U.S. installed base decline in the last quarter and that needs to change. The growing adoption of SBRT and hypofractionation should work in Accuray's favor, but the reality is that radiation oncologists stick with what they know (which is very good for Siemens Healthineers ' ( SMMNY ) Varian business) and Accuray's past issues have cast a long shadow. The company continues to improve its offerings, including the recently approved VitalHold package for breast cancer for Radixact (which, among other things, eliminates the need for positioning tattoos), but execution has to improve. Fortunately, management has said that the company's marketing partnership with GE HealthCare ( GEHC ) has improved the sales funnel, and perhaps that will show in better orders throughout this next fiscal year.

Japan is likewise a significant, and arguably overlooked, market for Accuray. There are a lot of aspects to the Japanese market that should favor Accuray (including an overall lower cost of capex for most of its systems) and here too I want to see better execution. Results weren't spectacular in the last quarter (flat in constant currency), but this market has shown quarter to quarter volatility in the past.

The Outlook

Management's recent presentation at the ASTRO 2023 meeting hit the right notes but didn't really have a lot that was new. Management is targeting high single-digit unit growth across the next three years and 4% to 6% annualized revenue growth. Management is also targeting high single-digit to 10% adjusted EBITDA margins by the end of that period (versus just under 6% in FY'23 on an adjusted basis), and I think that's a reasonable enough target if those revenues come through.

The biggest "but" at this point is whether management can execute on the opportunity. This has been proven difficult in the past, but the size of the opportunity in China makes execution even more important now. I'm guardedly bullish here, but I would also note that Varian and Elekta have likewise made no secret of their ambitions in China and all of these companies are publicly targeting high single-digit revenue growth in a market that's only likely to grow at a low single-digit rate (maybe mid-single-digit at best).

Said differently, they won't all be right and I have the least worries about Varian given its long track record, huge installed base, and strong R&D/product development capabilities. I do think that Elekta is "beatable" - their most recent results were similar on the top line (up 8% cc), but orders were down 7% (with China up double-digits) and I don't see an unbeatable product lineup here. It is worth noting, though, that Elekta is still over three times the size of Accuray and profitable (double-digit EBIT margin in the last quarter).

Based on management's most recent guidance, I've lowered my 2024 revenue estimate from $479M to $468M. That's still above the midpoint of guidance ($460M-$470M), but I understand management wanting to set more conservative assumptions, particularly as a broad anti-corruption investigation in China's healthcare sector (targeting hospital management teams, doctors, and drug and device companies) could lead to delays in orders in the near term.

My long-term assumptions haven't changed meaningfully, though, and I'm still looking for around 5% long-term growth driven by the China Type B opportunity, Japan, and other opportunities like hypofractionation and SBRT in the U.S., as well as increased physician interest from new packages like VitalHold.

On the margin side, FY24 should be modestly better with a more significant ramp in 2025 and 2026 as Chinese orders convert to revenue (and as the company continues to deliver on its backlog and improve manufacturing cost efficiency). Nothing here is all that new and management's guidance is basically consistent with where I was at in my model. To that end, I'm still looking for free cash flow margins in the high single-digits in around five years, and I can see upside into the low double-digits if things go well for the company.

As has been the case for some time, Accuray shares look undervalued on those assumptions, with free cash flow modeling supporting a fair value above $4 and an EV/revenue model based on growth and margins supporting a fair value around $7.

The Bottom Line

There are reasons why Accuray trades where it does - there have been a lot of supposed drivers over the years that have come up short for investors. While I realize this is a negative tone for a stock I otherwise recommend, I think it's important for new readers to understand what they may be getting into here - the potential is legitimate (particularly in China), but executing on these opportunities, particularly on a quarter-in, quarter-out consistent basis, has long been a challenge. If the China Type B opportunity lives up to its potential, though, these shares could start performing again over the next 12-24 months.

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