Could Accuray (ARAY) offer an interesting defensive play? We think so. It’s reasonably priced and offers good longer-term growth prospectives. We also provide a number of full analyst reports in PDF.

Research reports in PDF

• ARAY-Global-Markets-Direct-Sept09
• Jeffries-aray-August25-09
• Jeffries-aray-Sept12-09
• Oppenheimer-aray-Aug31-09

Introduction

We generally tend to like small companies that are best in breed in a growing market. Historically, these have offered the best possible returns, although it invariably is difficult to assess whether the companies in question will be able to dominate their market.

Therefore, it is often wise to build a portfolio of such companies, as even the best products and companies can falter early on (see our Smallcaps Imperative). One of such companies seems to be Accuray Inc. (ARAY).

• Accuray Incorporated (Accuray) is a global leader in the field of robotic radiosurgery. It develops and markets the CyberKnife Robotic Radiosurgery System, designed to treat tumor anywhere in the body with an accuracy of sub-millimeter. The CyberKnife system received FDA approval, CE marking and has been approved for several indications in China, Japan, Korea, Taiwan, and other countries. The company has eight subsidiaries located in Switzerland, France, the UK, Hong Kong, Japan, Spain, India and Singapore. Accuray is headquartered in California, the US.[Global Markets Direct *see link above]

The CyberKnife
It seems that Accuray could be one of these companies that could dominate their market. This is the market for non-invasive surgery. The product they have is the CyberKnife, something you’d expect Robocop to use, but here is some further description of the product:

• By combining a robotic arm with image guidance from X-ray cameras, the CyberKnife System can treat tumours with pinpoint accuracy and therefore with larger doses of radiation and less damage to surrounding tissue. The machine can treat, for example, early-stage lung cancer, spinal tumours and even areas which have already undergone irradiation that would not be treated a second time but where the tumour has returned. Patients with lung cancer who have undergone Cyberknife have a survival rate of around 90 per cent, compared with 30 per cent with conventional treatment. ‘Cyberknife has the potential to replace surgery as the first form of treatment for cancer,’ says Dr Nick Plowman, director of clinical oncology at St Bartholomew’s Hospital. [MailOnline]

What’s also very useful is that by using image guidance technology and computer controlled robotics, the CyberKnife System tracks, detects and rectify tumor and patient movement throughout the treatment.[Global Markets Direct]

• The company provides a one-year warranty on the purchase of the CyberKnife system. Moreover, it also provides a multi year service plan for a fee that is fixed at the time of purchase. The company performs the installation and service of the CyberKnife system in the US and in selected countries outside the US. Also the company, has trained third-party service organizations and its distributors in Korea, Taiwan, Turkey and Italy for the purpose of performing the CyberKnife system installation and service. The company offers various training sessions for its customers and distributors for an additional fee.[Global Markets Direct]

You can find an extensive product description and its modules in the Yearend08 report p7-10.
Metrics

• 56.7M shares outstanding, insiders own 1.1%
• EPS 2010: $0.15 [FinViz]; $0.0-0.14 [Yahoo]
• Cash per share $1.79 [Yahoo]
• Reviewing Accuray’s balance sheet, total cash and investments increased $2 million during the fourth quarter to $159.2 million at the end of June 2009. At the end of the quarter, Accuray’s total assets were $274.4 million and the company continues to have no debt.[CC 26/7/09]
• Our gross profit margin was 46.1% during the fourth quarter, and 49.4% for the full fiscal year 2009. Looking forward, we anticipate gross margins of fiscal 2010 to be similar to the levels achieved in fiscal 2009.[CC 26/7/09]

The Market

• The worldwide installed base is now 176 systems, 36 systems were installed in fiscal 2009 representing a 16% increase over the number of installations completed in the previous year. The geographic breakdown of our worldwide installed base at the end of the quarter was 115 in the Americas, 18 in Europe, 21 in Japan, and 22 in the rest of Asia.[CC 26/7/09]
• The company argues that the US market opportunity consists of some 3,568 units while the estimate the world market opportunity at 7,136 units [see Company fact sheet]

Pricing and sales
The company has done very well over the last five years or so:

• The company’s compounded annual growth rate (CAGR) for revenueswas 81.08% during 2004-2008, increasing from $19.57 million to $210.38 million. This was above the Medical Devices sector average* of 10.2%.[Global Markets Direct Sept 2009p9]
• the premium price point (~$3.3-3.5MM excluding a five year service contract of $495K for years 2-5) [Jeffries & Co. August 5, 2009p3]
• Services revenue was $18.6 million or nearly 1/3 of total revenue for the quarter. Our services revenue is generally derived from long-term maintenance agreements of four or five year terms, and is ratably recognized over the length of the contract providing stability and predictability to our revenue stream as our installed base grows.[CC 27/6/09]

We especially like the latter part, which provide growing and recurrent revenue.

Competition
There are a number of other companies with more or less comparable products, but there seems to be little doubt that the CyberKnife is the market leading product. Competitors include:

• Electra AB
• BrainLAB AG
• Integra Life Sciences Holdings Corporation
• Varian
• Siemens AG
• Tomo Therapy Incorporated
• Intuitive Surgical

Intellectual property
To stay ahead of the competition, Accuray is aggressively pursuing protecting it’s intellectual property:

• We had 13 U.S. patent applications allowed in the fiscal year ended June 30, 2009. As of June 30, 2009, we held 40 U.S. patents, 63 pending U.S. patent applications and are pursuing additional patent applications on additional key inventions to enhance our intellectual property rights. The first of our patents will expire in October 2010 and currently the last of our patents will expire in 2026. As of June 30, 2009, we also held 22 foreign patents, 7 pending published Patent Cooperation Treaty applications and 65 foreign patent applications which correspond to our issued U.S. patents and pending U.S. patent applications. We cannot be sure that any patents will issue from any of our pending patent applications, nor can we assure you that any of our existing patents or any patents that may be granted to us in the future will be commercially useful in protecting our technology. An additional key component of our intellectual property is our proprietary software used in planning and delivering the CyberKnife system’s therapeutic radiation dose.
• In addition to our patents, we also rely upon trade secrets, know-how, trademarks, copyright protection and continuing technological and licensing opportunities to develop and maintain our competitive position. [Year-end report 2008 p14]

Strategy
The best overview comes from the Year-end report 2008 (09/09/09)

• Our goal is to have the CyberKnife system become the standard of care for the treatment of solid tumors, particularly those that are difficult to treat with traditional surgery. We believe our technology can significantly enhance the applications of radiosurgery by increasing the number and type of tumors which can be treated effectively. Key elements of our strategy include the following:
• 1) Increase physician adoption and patient awareness to drive utilization.
• We are continually working to increase adoption and awareness of our CyberKnife system and demonstrate its advantages over traditional treatment methods. We intend to increase the number of worldwide sales and marketing personnel in order to increase sales and drive utilization of the CyberKnife system. In addition, we will continue to hold and sponsor symposia and educational meetings and to support clinical studies in an effort to demonstrate the clinical benefits of the CyberKnife system. Finally, we will continue to assist our customers in increasing patient awareness in their communities by helping them develop marketing and educational campaigns.
• 2) Continue to expand the radiosurgery market.
• While radiosurgery has traditionally been used to treat brain tumors, the CyberKnife system has received FDA clearance for and is increasingly being used to treat tumors anywhere in the body where radiation is indicated. Based on customer data, approximately 58% of patients treated with the CyberKnife system in the United States during the year ended June 30, 2009 were treated for tumors outside of the brain. We are facilitating studies to further demonstrate the CyberKnife system’s efficacy for treating tumors outside of the brain, and we believe these studies will increase overall utilization of the CyberKnife system and continue to expand the number of patients eligible for radiosurgery. In addition, we have developed and are continuing to develop new upgrades to enable the CyberKnife system to be even better suited for treating tumors anywhere in the body where radiation is indicated.
• 3) Continue to innovate through clinical development and collaboration.
• The clinical success of the CyberKnife system is due in large part to the collaborative partnerships we have developed over the last decade with clinicians, researchers and patients. We proactively seek out and rely on constructive feedback from CyberKnife system users to learn what is needed to enhance the technology. Due to this collaborative process, we continually refine and upgrade the CyberKnife system, which ultimately improves our competitive position in the radiosurgery market. Our upgrades are designed to improve the ease of use and accuracy of treatment, decrease the treatment times, and improve the utilization for specific types of tumors. For example, in recent years, we introduced Synchrony, a motion tracking system that is designed to track tumors that move with patient respiration and the Xsight Spine Tracking System, a new target tracking technology, which eliminates the need for surgical implantation of small, inert metal markers, known as fiducials, in the treatment of spinal tumors. In the year ended June 30, 2007, we introduced the Patient Archive and Restore System, the RoboCouch patient positioning system, the Xsight Lung Tracking System, the Xchange robotic collimator changer and the 4D Treatment Optimization and Planning System. In the year ended June 30, 2008, we introduced a higher output linear accelerator, the IRIS Variable Aperture Collimator, MonteCarlo Dose Calculation software, Sequential Optimization treatment planning and a seated RoboCouch, enabling improved patient positioning capabilities. In the year ended June 30, 2009, we introduced the InTempo Adaptive Imaging system, MultiPlan MD Suite, MultiPlan Quick Review, and a Radiosurgery DICOM Interface compatible with the IMPAC MOSAIQ system.
• 4) Leverage our installed base to generate additional recurring revenue.
• We have designed the CyberKnife system so that customers may upgrade their previously purchased systems as we introduce new features. We generate additional revenue by selling multiyear service plans that provide eligibility to receive upgrades, when and if available. These contracts are typically signed prior to the CyberKnife system installation and generate additional revenue throughout the life of the contract. In addition, we sell upgrades to our existing customers who are not covered by service plans or who have exhausted the upgrades deliverable pursuant to their service plans. Finally, we offer the shared ownership program, which enables customers to reduce the upfront investment required for the CyberKnife system in exchange for sharing a significant portion of revenue with us that is derived from each procedure.
• 5) Continue to expand international sales and geographic reach.
• We intend to increase our sales and distribution capabilities outside of the United States to take advantage of the large international opportunity for our products. We currently have regional offices in Paris, France, Hong Kong, China, Tokyo, Japan, Madrid, Spain, New Delhi, India, Singapore, Moscow, Russia, Munich, Germany, London, UK and Istanbul, Turkey and our sales and distribution channels cover more than 80 countries. We intend to increase our international revenue by increasing the number of distributors and direct sales and support personnel in targeted new international markets, and by further penetrating our established international markets.
• 6) Pursue acquisitions, strategic partnerships and joint ventures.
• We intend to actively pursue acquisitions, strategic partnerships and joint ventures that we believe may allow us to complement our growth strategy, increase market share in our current markets and expand into adjacent markets, broaden our technology and intellectual property and strengthen our relationships with our customers.[Yearend08 report p6-7]

Improving the product, helping customers and increasing service, increasing the range of afflictions the CyberKnife can treat and geographical spread are the main planks of strategy.

• The company intends to develop and offer new clinical capabilities enhancing ease of use, reducing treatment times, improving accuracy and improving patient access. Accuray is also facilitating studies to further demonstrate the CyberKnife system’s efficacy for treating tumors outside of the brain. And the company believes that these studies would increase overall utilization of the CyberKnife system and continue to expand the number of patients eligible for radiosurgery. Moreover, the company is continuing to develop new upgrades to enable the CyberKnife system to be better suited for treating tumors where radiation is indicated.[Global Markets Direct Sept 2009p5]

According to Global Markets Direct, the company wants to increase its shared ownership programs:

• The company intends to increase this shared ownership programs and to enable customers to reduce the upfront investment required for the CyberKnife system in exchange for sharing a significant portion of revenue with the company that is derived from each procedure.[Global Markets Direct Sept 2009p6]

This seems to contradict what is actually happening:

• Shared ownership arrangements produced $455,000 of revenue during the fourth quarter, an anticipated decline from $2.2 million during the same period last year, following the buyout and recognition of sales revenue on 12 shared ownership units in fiscal 2008. At the end of the fourth quarter, Accuray had a total of two shared ownership units.[CC 27/6/09]

However, the contradiction is more apparent than real. The shared ownership program is meant to lower the barrier for clients. Once clients step into this program, managing to convert them to outright sales is a benefit. The company also engages in considerable R&D efforts:

• Research and Development expenses totaled $9.2 million, or approximately 16% of total revenue reflecting Accuray’s ongoing commitment to the continued advancement of the CyberKnife’s capabilities as well as clinical studies.[CC 27/6/09]

The strategy is backed by some favourable trends and developments

1) Growing aged population
The incidence in cancer and other desease grows with age.

2) Increasing cancer rates
Unfortunately, cancer rates are still growing even though survival rates have improved for some cancers.

• According to the World Health Organization, or WHO, an estimated 7.9 million people died of cancer in 2007, accounting for 13% of all deaths worldwide. Cancer is the second leading cause of death in the United States, after heart disease. The American Cancer Society, or ACS, estimates that approximately 560,000 Americans will die as a result of cancer in 2009. The ACS also estimates that approximately 1.5 million new cases of cancer will be diagnosed in the United States in 2009, with continued increases in the prevalence of cancer forecasted as the U.S. population ages.[Yearend08 report]

3) Preference for non-invasive treatment
Treatments like chemo and radiation have serious side effects. The CyberKnife offers the following patient benefits:

• Pain free procedure – Non-invasivealternative to surgery
• Minimal recovery time – Outpatient procedure that does not require anesthesia
• Return to normal activities – Outpatient procedure with little or no recovery time typically allows for an immediate return to normal activities
• Minimal risk – Minimal post treatment complications and side effects.[Company fact sheet]

Readers might also want to consult the extensive overview of different forms of treatment provided by the Yearend08 report (p2-4).

4) Favourable ROI for clients
In a note from Jeffries & Co. August 25 of 2009, they argue that hospitals quickly earn a return on the considerable capital outlay for the CyberKnife, which makes it an attractive option for hospital administrators. There seems to be considerable logic in this:

• We believe that the CyberKnife system allows our customers to effectively treat patients who otherwise would not have been treated with radiation or who may not have been good candidates for surgery. Therefore, we believe the treatment of these patients generates additional revenue without affecting our customers’ traditional radiation therapy practices. In addition, because the CyberKnife treatment is a non-invasive, outpatient procedure requiring little or no recovery time, hospitals can treat more patients than through traditional surgery. In traditional surgery, the time a patient must be at the facility for the procedure and the recovery time tend to be measured in days. With the CyberKnife system, the entire procedure is generally completed within 90 minutes, and the patient often leaves the facility very shortly after treatment. Even if the patient receives four to five treatments, the total time the patient is at the hospital or treatment center is still shorter than with traditional surgery. Furthermore, the more time the patient must be at the hospital, the more resources the hospital must dedicate to the patient. The reduction in overall time and resources required for the CyberKnife procedure, when compared to traditional surgery, leads to an increase in the volume of procedures performed and lower per procedure costs for the hospital. The combination of incremental revenue generation and lower per procedure cost makes the CyberKnife system an attractive addition to our customers’ cancer treatment practice.[Yearend08 report p5]

5) Increasing use for other cancers
The company argues that traditional radiosurgery is basically limited to the brain (some 84,000 patients per year). However, the CyberKnife adds treatments at:

• The spine (70,000 patients per year)
• Lungs (380,000 patients per year) In fiscal 09 there was a 45% increase in lung treatments, making lung the fastest growing CyberKnife clinical application [CC 27/6/09]
• Prostrate (136,000 patients per year, and recently  receiving a favourable ruling on patients reimbursment by Medicare in Florida, see CC 27/6/09)
• Liver, head, neck and pancreas (222,000 patients per year) [Company fact sheet]

The company is already embarking on some of these opportunities:

• Over 11,000 lung cancer patients and over 4,000 prostate cancer patients have been treated on the CyberKnife System as of Sept ’09.[Company fact sheet].

6) Other treatments
Besides cancer, the CyberKnife could be used for other treatments

• We have our collaboration with CyberHeart, which is looking at treatment of atrial fibrillation with radiosurgery using the CyberKnife, and that’s interesting. I think outside of that, there’s always work intracranially on sort of psychosurgical disorders and other functional disease, but there are definitely non-cancer applications with the CyberKnife being explored.[CC 26/7/09]

7) Geographical expansion
Currently the company has offices in France, Hong Kong, China, Japan, Spain, Singapore and India, and distribution channels to cover 50 countries, but the company is increasing efforts to establish direct sales forces and distributors abroad, both in existing as well in new markets.

8) New products

• Accuray’s newly approved and launched products provide enough opportunities for the company to improve market share. The company launched the InTempo Adaptive Imaging System that increases its CyberKnife Robotic Radiosurgery System’s ability to continually track and correct for motion of the prostate during treatment on September 19, 2008. Accuray provided a new configuration for its CyberKnife system treatment vault that will allow installation of the System into most existing conventional gantry LINAC vaults. This new layout will allow an accelerated go-live schedule, helping sites to start treating patients within a significantly shorter period of time. On June 19, 2008, Japan’s Ministry of Health, Labor and Welfare (MHLW) granted Shonin approval of its CyberKnife Robotic Radiosurgery System used to treat extracranial tumors. This approval expanded the types of patients that can be treated with the company’s radiosurgery system. As a result of this clearance, the CyberKnife system can be used in Japan for the treatment of tumors, including those in the spine, lung, liver, pancreas and prostate. Furthermore, Accuray announced to provide a treatment planning service to its current and new customers on January 24, 2008. This new service will help its customers control costs and increase their patient throughput, and also help the company to increase its recurring revenue.[Global Markets Direct Sept 2009p10]
• Accuray Incorporated announced today the introduction of the CyberKnife(®) VSI(TM) System, the latest addition to the CyberKnife product family. The new CyberKnife VSI, which stands for versatile, simple and intelligent, is designed to broaden physicians’ range of options from radiosurgery to also include conventionally fractionated Robotic IMRT. This enables them to customize their care around the unique needs of each patient, thereby expanding the population of patients that can benefit from the System’s unparalleled precision. [Company PR]
• As recently announced, the first CyberKnife System configured for an existing radiation therapy vault has now been installed at the CyberKnife center at Chicago at Elmhurst, Memorial Hospital in Elmhurst, Illinois. The ability to install in standard radiation therapy vault is significant since these typically already exist in hospitals. Until now the CyberKnife has required extensive modifications to a standard vault or construction of a new dedicated vault. The treatments delivered by this new configuration almost identical to those of the standard CyberKnife System, but the center gains from a faster and less costly construction program.[CC 26/7/09]

Problems
There are some problems regarding the definition and use of it’s order backlog. The confusing use of definitions is indeed not helpful, and Jeffries could have a point that the changes might make it difficult for the company to hit revenue guidance. We see it as a problem, but also as an opportunity, because the problem is short-term, and it has arguably hit the share price in a significant way.

Another short-term problem is that revenues look to be somwhat inflated because of sales of shared ownership units.

• Upon reviewing the recently issued FY08 10-K, we discovered that ARAY disclosed the revenue associated with the outright sale of 12 shared ownership units for $23.7MM. This implies an ASP of ~$2.0MM per system, while low relative to overall avg. ASP’s, is relatively in-line with our assumption as each shared ownership unit can be purchased in full at a price relative to the age of the system.
• ARAY will not be able to generate another $23.7MM in sales of shared ownership units as there are only three centers left that are utilizing this option. ARAY’s core business is going to have to make up this difference in FY09 and generate an incremental ~10% growth to reach the bottom end of management’s annual top-line guidance, a challenging endeavor in the current macro-economic environment.[Jeffries & Co. Sept 12, 2009]

There are only two shared ownership units left, so these sales gains are essentially a one-off.

What we like

1. Interesting technical situation, see chart above and here
2. Defensive sector usually works well in during sell-off
3. The sector is one we like. Philips turned itself around by embarking on medical technology, for instance
4. Seems to be a world leader with their product
5. Competition is not in same range
6. Significant and growing market opportunity
7. Growing recurring revenues through service contracts growing faster than sales
8. Recurring revenue grows faster than sales
9. The company’s compounded annual growth rate (CAGR) for revenues
   was 81.08% during 2004-2008, increasing from $19.57 million to $210.38
   million. This was above the Medical Devices sector average* of 10.2%.
   [Global Markets Direct Sept 2009p9]