I feel bad for Accuray (ARAY) management. This team has done a lot of work to improve the company over the years and brought the company to the cusp of a potentially transformative opportunity… only to see COVID-19 slam the brakes on that progress. While delays in converting orders from China into actual placements and revenue are frustrating, I don’t view this as an execution issue, nor do I view this business as lost, just delayed.
How bad things will get over the next quarter or two, and possibly even the next year or two, is a big unknown. While hospitals are continuing to provide radiotherapy to patients, the COVID-19 crisis has brought new procurements and installations to a dead stop and has scrambled the budgets for many centers. The arguments for radiotherapy, and for Accuray’s systems, remain unchanged, though, and I think the worst that will happen is that business, revenue, and profits get “pushed to the right” and delayed. That does reduce the near-term fair value of the shares, but the 40% drop since my last article far exceeds my estimate of that impact.
All Things Considered, A Good Quarter
Not all analysts seem to have tried to incorporate the impact of COVID-19 into their estimates before Accuray reported, so I don’t find comparisons of the company’s performance to those estimates as helpful as they might otherwise be. The company did beat the published average estimate available before the report (by around 2%), and the company’s margins and profits were higher than expected. More importantly, orders were strong.
Revenue declined 4%, missing initial expectations for the quarter by about 4% but beating those more recently-revised estimates. Product revenue declined 2%, as Accuray saw delays and interruptions in bunker modifications and installations. Service revenue was likewise down about 5%, with travel and hospital access restrictions impacting service visits.
Margin performance was mixed, but I’d say not bad overall. Gross margin improved slightly (10bp) as reported, but margin was boosted by a bonus accrual reversal. Product gross margin declined two points and missed initial expectations, but that’s not surprising relative to the shortfall in product revenue. Service margin improved two points as reported and exceeded initial expectations but that was inflated by the bonus accrual adjustment and flat on an adjusted basis.
The bonus accrual also drove upside on operating income and adjusted EBITDA. The latter exceeded initial expectations by $5 million, suggesting some modest upside beyond the $4.5 million bonus item, and likewise for operating income which beat initial expectations by about $6 million. For a quarter in which business conditions changed rapidly and with no real guidance or blueprint to follow, I’d argue Accuray did well managing its expenses.
Net debt did increase, expanding to $101 million (I exclude restricted cash from net debt calculations), but the company doesn’t have any meaningful near-term maturities to worry about. Management did not mention whether or not they’re participating in the Paycheck Protection Program (a federal subsidized loan program).
Surprisingly Strong Orders, Though Delivery/Recognition Timelines, Are Highly Uncertain
I was surprised to see how strongly Accuray’s orders grew this quarter. Gross orders rose 27%, reaching what I believe is the highest-ever quarterly figure. Within that, CyberKnife orders rose 13% yoy and 19% qoq, making up 40% of the order book. Net orders were also strong, rising 28%, with the company seeing $20M of order age-outs and $9M of cancellations.
Orders grew at a double-digit rate in the Americas, Europe, and Asia overall, though orders were down in Japan. The company reported 11 bookings in China, seven of which came through its new JV partner.
Given the challenges created by COVID-19, I view this as a very strong result. I’m not at all surprised to see the drop in Japanese orders, and I’m surprised China held up as well as it did. Management did push back its expected window for converting Chinese Type A license orders to revenue from the fiscal fourth quarter (next quarter) to the first quarter of 2021 (the September 2020 quarter), but that does not surprise me.
While I’ve been critical of this company missing its own timelines in the past, I don’t believe that applies here. Likewise, while I do think management is giving us all their best assessment of the situation, I could see that timeline slipping again by a quarter or two, particularly if there’s a second wave of infection in China.
The key question around Accuray remains basically the same – can the company execute on what looks like an attractive opportunity for radiotherapy in China? Varian (VAR) and Elekta (OTCPK:EKTAY) are targeting the same opportunity, but Accuray has made more efforts to accommodate the market, including the development of the OnRad system and the subsequent development of a “value-priced” Class B system based on the Radixact that will be offered through the JV.
This isn’t to say that opportunities in Japan or the U.S. are insignificant, but I believe Accuray is more of an “is what it is” story in the United States. While the company has made significant product improvements over the years and continues to do so, it takes a long time to change minds in the market and Accuray is still an afterthought for most centers.
I’ve reduced my revenue expectations for fiscal 2020 and 2021, and while I have modeled “catch up” spending in FY’s 2022, 2023, and 2024, Accuray may be challenged to meet that higher level of demand, and it’s possible that some revenue could get pushed out further. Either way, I still think mid-single-digit annualized revenue is attainable, with significantly more growth in China in the coming years.
I’ve tweaked my margin assumptions as well; some deleverage/decremental margin is a risk in FY’20/21, but management is moving aggressively to cut costs and preserve cash, including a temporary reduction in executive salaries, more aggressive working capital management, hiring freezes, and reduced raw material purchases.
The Bottom Line
Between a discounted cash flow approach and a growth-driven EV/revenue approach, I continue to believe that Accuray should trade closer to $6. Clearly, the market doesn’t agree now, and I assume the Street is down on the shares due to the company’s leverage to China and less than ideal liquidity situation. Those are valid concerns, and the risk that COVID-19 disruptions linger is real, but I think the market reaction here has been an overreaction.
Disclosure: I am/we are 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.