Investment Setup:

Accuray Incorporated (ARAY) is an undervalued and underfollowed healthcare equipment company. In the short term, ARAY is an attractive COVID rebound play as the business stands to meaningfully benefit from the continued improvement in hospital capital budgets over the next 12 months. Over the intermediate and long terms, there are several large growth opportunities and industry tailwinds that the company is well suited to capitalize on. Trading at an 80% discount to peers, this is an attractively valued, “left behind” COVID rebound play with a compelling long-term fundamental outlook that has a high likelihood of a takeout event within the next several years. Recent insider buying further adds to the favorable setup. ARAY is a compelling buy with near term upside of 50%+ and longer term potential upside of 200%+.

Investment Thesis:

1. Turnaround that will be unmasked post-COVID
2. Replacement cycle in existing customers and markets supports high single digit growth
3. Large incremental growth opportunity in China lends significant upside potential

ARAY ($364MM market cap; $416MM EV; $380MM TTM revenue) is a leading-edge radiation oncology company that manufactures, designs and sells the CyberKnife system for stereotactic radiosurgery and the TomoTherapy (now Radixact) system for radiation therapy. Over the past several years, management has set in place the essential components of a turnaround. ARAY has driven innovative technology advancements, added veteran executives, and repositioned the Company’s proprietary technology to compete more effectively in the growing radiation oncology market.  As a result, the Company’s evolving portfolio is in the best competitive position since its 2007 IPO and is poised to capture share.

ARAY’s strong growth outlook is fueled by hospital’s anticipated post-COVID rebound, the CyberKnife & TomoTherapy replacement cycles, and unique access to the China market. The recent launches of CyberKnife and TomoTherapy’s enhanced capabilities should allow ARAY to capitalize on the robust upcoming mature markets replacement cycle which is an $800MM+ opportunity over the next 2-3 years. The China market represents a $2BN+ opportunity over the next 5 years. The smaller China Type A is at least a $200MM opportunity in the next 12-18 months. To best position themselves to win licenses in the far larger China Type B market, ARAY has formed a JV with state owned entity and market leader China Isotope and Radiation Corp (CIRC) which has relationships with over 8K hospitals in China. Additionally, there is a pending change in the US reimbursement model that should drive the industry towards more advanced technologies like those that ARAY offers.

We expect the aforementioned factors to drive strong top line growth over the next several years. Conservatively, we think the Company can grow 8-12% top line with 42-43% gross margins and mid-teen EBITDA margins. Despite the promising future outlook, the stock trades at just 1.1x sales and 10.5x EBITDA – a nearly 80% discount to publicly traded peers. The stock also trades at a steep discount to Siemens’ April 2021 acquisition of ARAY’s largest competitor Varian Medical Systems for 4.2x sales and 19x EBITDA.

The Company is run by a strong management team. In our discussions with management and diligence checks, we have found management to be very credible and capable. While CEO Josh Levine, has been in place since 2012 and returns have been subpar, he is an accomplished healthcare executive. He has sold 2 publicly traded companies while CEO. He sold Mentor to Johnson and Johnson in 2009 for $1.1BN at a 101% premium and 3x sales / 13x EBITDA. He also sold Immucor to TPG Capital in 2011 for $1.6BN at a 36% premium and 5x sales / 11x EBITDA. The Company recently bolstered its executive team with the addition of Suzanne Winter, President and Chief Commercial Officer, who previously ran Medtronic’s diabetes business in the Americas. Additionally, insiders have purchased over $270K shares in recent months.

While COVID has pressured the business and the turnaround took longer than expected, ARAY is emerging from the pandemic a stronger company and is very well positioned with several substantial growth catalysts and is on the cusp of generating much improved fundamental performance. We expect that once they reinstate guidance, possibly next quarter, this will be a consistent beat and raise situation as we think management is very conservative in terms of how they communicate and set expectations with the street. We also think ARAY is a strategic asset and an M&A event would not surprise us over the next couple of years. These factors and others make ARAY an attractive setup and compelling risk / reward profile.

Market Opportunity:

The number of patients receiving radiation therapy is expected to grow 150%+ by 2035 which translates into a significant global shortage of radiotherapy treatment machines. Over the next 15 years, 7.7K new systems will be required to provide adequate patient access to radiation therapy – ~50% increase to the ~14.1K systems currently installed. This represents a ~$50BN+ total market opportunity in replacement and new system sales through 2035.

The market for radiotherapy systems is bifurcated between mature and developing markets. While radiation therapy is generally widely available in mature countries (US, Western Europe and Japan), many developing countries currently do not have a sufficient number of systems to adequately treat their domestic cancer patient populations.

Mature Markets – The opportunity in mature markets are primarily for replacements and upgrades. In mature markets, 80%+ of annual system purchases are replacements. The current worldwide radiation therapy installed base represents a massive replacement opportunity of about $3.5BN annually, which does not include add-ons or updates to existing systems.

ARAY is positioned to capitalize on this replacement opportunity and drive market share gains (particularly from Elekta) with its innovative portfolio and technologies. This includes newer ARAY products such as Synchrony for motion management and real time treatment adaptive capability, ClearRT for diagnostic quality imaging, and the latest generation CyberKnife S7 device.

Specific to the US, the median age of ARAY’s installed base is 8+ years with ~40% being 9 years or older. Replacements tend to happen at ~10 years. ARAY’s installed US replacement opportunity is ~175-180 systems over the next couple of years. At ARAY’s historical 80%+ win / retain rate, this is a $400M+ revenue opportunity. The opportunity in mature markets ex-US is comparable and potentially greater.

ARAY’s installed base has grown at a 5.4% CAGR since 2011. The installed base should grow more quickly over the coming years as older machines are replaced and they execute on their China strategy and place new systems. The growing installed base also provides a steady, recurring revenue stream in the form of service revenue which will increase FCF conversion.

Developing Markets – The opportunity in developing markets is new installments. In the developing markets, ARAY is most focused on China - the largest and most underpenetrated market. Addressing radiotherapy access for patients is an unmet need and a key initiative for the Chinese Ministry of Health (MOH). As highlighted below, there are only 1.4 radiation therapy systems per 1M patients in China which pales in comparison to the 12.4 systems/1M patients in the US and 7.5 in France/Europe. China has laid out aggressive plans to solve this issue in their latest Five Year Plan.

The Chinese market is segmented into Type A and Type B. Generally speaking, the Type A market is the premium segment with systems primarily in academic centers, military hospitals, larger cities, etc. While the Type B market is the economy market with systems primarily located in the smaller provincial markets. Combined, China represents a $2BN+ opportunity for ARAY over the next 5 years.

China’s Type A market is for high end systems and is controlled by the central government. Type A systems comprise roughly 20% of the market. The MOH within the Chinese central government is running the Type A license process. ARAY’s prospective hospital customers were issued 74 out of 90 Type A licenses during the first round representing an 80% win rate. Conversion of this ~$150MM China Type A revenue is expected to continue over the next 12 months.

There are ~95+ Type A licenses left to be granted of the original ~185+ quota. Applications for these licenses have been submitted though the award timing is uncertain (likely within next 12 months). Further, there is a reasonable chance that additional licenses will be awarded in the future. While the 80% win rate may be difficult to maintain, we see no reason why ARAY hospital customers will not win a majority share of new licenses. We think the next tranche of Type A licenses could be a $200MM+ opportunity for ARAY.

The China Type B channel, 80% of the market, represents an exponentially larger and transformative opportunity. The Type B licensing process is overseen at the provincial level. Most small to medium-sized provinces have limited access to radiotherapy and represent the biggest growth channel within the China radiation therapy market. However, the small to medium-sized provinces also represent the most challenging regions for multi-national radiation oncology companies to penetrate.

To best capitalize on this opportunity, ARAY formed a JV with CIRC, a subsidiary of the state owned enterprise China National Nuclear Corp who is the market leader for radio therapy in China. ARAY decided to partner primarily because of CIRC’s 8K+ provincial hospitals relationships and China’s focus on “Made in China.” ARAY’s China strategy is unique and is in stark contrast to their primary competitors, Varian and Elekta, which are pursuing the opportunity independently.

Type B systems will be locally manufactured and China-JV branded. The CEO of the JV is the former general manager of ARAY’s Asia / Pacific region. He also previously ran Siemens’ China operations. We spoke with him and found him to be very impressive. They have already completed construction of their Type B manufacturing facility (outside of Beijing) and now are working on the manufacturing qualification and validation process. They expect to be ready to deliver new JV Type B systems within 15 months. While it is difficult to forecast especially in China, we do think that the timeline could be sooner than expected which should be very positive for the stock. We think ARAY’s differentiated strategy in the Type B market ideally positions them for this $2BN+ opportunity.

Valuation:

ARAY currently trades at 1.1x TTM sales and 10.5x TTM EBTIDA. Despite having a comparable profile, ARAY trades at an 80%+ sales multiple discount and a ~35% EBITDA multiple discount to its primary public competitors. And as noted before, ARAY’s valuation is heavily discounted to Siemens’s acquisition of Varian for 4.2x sales and 19x EBITDA. The discount can largely be attributed to the prolonged turnaround and lackluster results. Additionally, investor sentiment is decidedly negative. COVID hit at an incredibly inopportune time for ARAY as management’s multiyear efforts to improve the business were just beginning to bear fruit. Despite COVID, the thesis and opportunity is unchanged and ARAY's numerous attractive growth drivers should become more evident during normalized periods. The Company should experience improvements over the course of fiscal 2022. We expect the multiple to re-rate higher as the replacement cycle picks up and they continue executing on their growth opportunity in China.

The story is similar when compared to other comparable healthcare companies.

Prior to COVID, management announced long term financial targets at the JP Morgan HC Conference in January 2020 including 8-12% top line CAGR with faster EBITDA and operating profit growth. While COVID pushed these targets out a bit, we still think these are very attainable and have been de-risked with the potential for upside as the new technology roll-outs have been very encouraging and progress in China has been better and faster than expected. Over the next few years we see the top line growing 8-12% with gross margins approaching 42-43% and mid-teens EBITDA margins.

We model fiscal 2022 revenue and EBITDA of $432.6MM and $45.7MM growing to $506.6MM and $79.1MM in fiscal 2024. Applying a 15x EBITDA multiple implies a 12 month price target of $6.65 with a 3 year exit at $12.14. A 2.5x sales multiple implies a 12 month price target of $10.76 with a 3 year exit at $12.92. Assuming comparable multiples to Siemens’ purchase of Varian would imply a 3 year exit at $21.45 on revenue and $15.32 on EBITDA.

We see EBITDA margins converging with peers in the next several years which we believe supports the sales multiple. And in the case of an M&A event, the sales multiple will be very relevant.

Business Summary:

The Company’s industry standard systems are designed to deliver advanced radiation therapy including radiosurgery, stereotactic body radiation therapy (SBRT), intensity modulated radiation therapy (IMRT), image-guided radiation therapy (IGRT) and adaptive radiation therapy tailored (ART) to the specific needs of each patient.

ARAY is a leader and pioneer in hypofractionation therapy with the introduction and advancement of its CyberKnife system in the early 2000s. Hypofractionation affords shorter treatment times (5 treatments with hypo vs. 30+ visits conventional way) and increases the number of patients treated / system. Due to pending changes in reimbursement (discussed later), ARAY’s platforms are well positioned to capitalize on new installments and replacements from the burgeoning need for hypofractionation therapy.

Product sales including equipment and software account for roughly 42% of total. The CyberKnife and TomoTherapy systems are complementary offerings serving largely separate patient populations treated by the same medical specialty, radiation oncology. ARAY’s software solutions enable and enhance precise and efficient radiosurgery and radiotherapy treatment.  The Company also provides services, which include post-contract customer support, installation services, training, and other professional services. Service revenues at 58% of total are highly recurring in nature and are a key driver of FCF generation.  This is a global business with the Americas, APAC and Japan, China, and EMEA representing 27%, 21%, 21% and 31% of sales.

CyberKnife - The CyberKnife is a robotic system designed to deliver radiosurgery treatments to cancer tumors anywhere in the body non-invasively.

• Automatically tracks, detects and corrects for tumor and patient movement in real-time during the procedure, enabling delivery of precise, high dose radiation with sub-millimeter accuracy
• Requires no anesthesia, and treatment sessions are done on an outpatient basis
• While cleared by the FDA to treat tumors anywhere in the body where radiation treatment is indicated, it is primarily used to treat smaller, more discrete tumors such as prostate, lung, brain, spine, liver, pancreas and kidney cancers
• Modular design enables upgrades without a new system purchase
• Strong brand recognition with customers. Doctors often encounter patients that specifically request CyberKnife therapy
• Latest iteration, CyberKnife S7, includes next-gen adaptive radiation technology to enable the motion-synchronized, AI-driven, real-time treatment delivery adaptation

TomoTherapy - The TomoTherapy system is a radiation therapy platform used for larger tumors in a range of cancers. The TomoTherapy systems, including the next-gen Radixact System, are specifically designed for IGRT and IMRT.

• Fully integrated platform for intelligent radiosurgery treatment planning, centralized data management and ultra-precise treatment delivery
• Unique features, combined with daily 3D image guidance, enable physicians to deliver dose distributions which precisely conform to the shape of the patient’s tumor while minimizing dose to normal, healthy tissue, resulting in fewer side effects
• Capable of treating all standard radiation therapy indications including breast, prostate, lung, and head and neck cancers, in addition to complex treatments such as total marrow irradiation
• Possible to treat single or multiple tumors located throughout the body in a single therapy session
• Provides continuous delivery of radiation from 360 degrees around the patient

Recent product innovations are an important aspect of ARAY’s growth strategy. While healthcare systems look to maximize the life of their existing systems especially following COVID, hospitals will be motivated to upgrade systems in order to offer the newest technology for the most advanced patient care such as hypofractionated treatments as the new reimbursement code is enacted and focus is shifted to value based care. Over the past few years, ARAY has focused R&D efforts on new product innovations and capabilities that shorten treatment time and increase treatment efficacy. Our checks suggest these recent product launches will drive new installments, replacements, higher win rates and upgrades.

• Synchrony – AI driven predictive model created for every patient during treatment. Tracks tumor motion and adjusts therapy delivery in real-time. Adapts treatment delivery for tumors that move as a result of bodily processes and patient movement.
• Clear RT – Provides fast, diagnostic quality visualization with largest anatomical field of view. Cutting-edge imaging solution that is basically a CT scanner with a linac attached that can take images across long registration fields.
• VOLO – Facilitates the development of clinically optimal treatment plans up to 90% faster than before and the delivery of the treatment up to an ~50% faster than before, allowing treatments to typically be performed in 15 to 30 minutes.

Evidence of the impact of these new technologies is mounting. In the most recent quarter, 44% of new Radixact orders included Synchrony and 73% of YTD CyberKnife orders consists of their latest generation S7 platform which enables faster, stronger and more accurate hypofractionation therapy. However, we are most excited about ClearRT. We think this is game changing technology and is a differentiator to competitor systems. An industry veteran told us “Just watch what happens with ClearRT.” They only launched ClearRT in the middle of the latest quarter and already received 14 orders (10 upgrades / 4 new systems). The interest in their new products and technologies is a strong signal that demand for next gen hypofractionation therapy is growing and that ARAY has an opportunity to take share from competitors.

From a cost perspective, a CyberKnife system runs $2.8MM - $3.2MM and a Radixact system runs $2MM - $2.25MM. In addition to the capital purchase, customers sign a service agreement which typically costs 5-10% of the purchase price. In recent years, ARAY has focused on becoming more price competitive. Our diligence suggests their pricing is down roughly 30% and is very competitive with other offerings. An important factor is that both CyberKnife and Radixact are modular systems. However, upgrades for their new product launches (Synchrony, ClearRT) are only available for systems that are less than 4 years old.

Competition:

The radiation oncology market is essentially a three-player oligopoly between ARAY, Varian, and Elekta. Varian is the largest player with ~70% market share, followed by Elekta with ~20% market share and ARAY with ~10% market share. ARAY, Varian and Elekta primarily compete on capabilities and cost. ARAY compares favorably on both factors and their recent product launches further augment their market position and value proposition to hospitals. ARAY’s tumor tracking technology, Synchrony, is unmatched and ClearRT leapfrogs Varian’s and Elekta’s existing cone beam technology.

ARAY wins because they are the pioneer of hypo and ultra hypofractionation which enables the highest precision and accuracy radiation treatment. The Company’s unique approach to radiation therapy allows physicians to highly customize treatment programs to best treat cancer patients. ARAY enjoys strong brand recognition from existing and prospective cancer patients which drives the utilization of the CyberKnife and TomoTherapy systems.

Reimbursement:

Another key factor driving the opportunity for ARAY is the pending change in CMS reimbursement. In 2019, CMS decided to implement an alternative payment model for radio therapy called Radiation Oncology Alternative Payment Model (RO-APM). RO-APM was supposed to be fully implemented by January 2021, but, due to COVID, it has been postponed to January 2022.

Historically, radiation therapy has been reimbursed on a fee per service basis. Similar to reimbursement changes for other types of treatments, RO-APM is a value based model where providers get higher reimbursement for providing better and more efficient care. RO-APM lends itself to fewer treatments needed with hypofractionation therapy methods which ARAY is a pioneer and leader.

ARAY believes that the RO-APM program should encourage loyal ARAY centers to look at new features like Synchrony and ClearRT and to move forward with replacements given hypofractionation treatment algorithms provide faster patient throughput and better efficiencies. This scenario could also play out for greenfield opportunities with centers that do not have SBRT technology and are looking to add new systems. Private commercial payers are already moving towards a more value based system, which is benefitting ARAY evidenced by the significant % of new orders including Synchrony and CyberKnife S7 and the initial rollout success with ClearRT.

Financials / Capital Structure:

Over the last five or six years and during the height of the turnaround, the fundamentals have been less than stellar. While top line has been fairly stable, the Company has not generated consistent EBITDA or cash flow. Turnaround expenses and poor execution has weighed on margins.

ARAY has a reasonable balance sheet with $130MM in cash ($4MM restricted) and $183MM of debt. Current gross and net leverage is 4.7x and 1.4x. Leverage should continue to decline as the business recovers from COVID and margins emerge stronger due to cost initiatives instituted during the height of the pandemic (roughly $10MM in opex savings). The business will generate cash which they can use to further delever the balance sheet and / or invest in growth opportunities. The Company recently refinanced its debt facilities. The new bank facilities have a LIBOR spread of L+250-325 compared to L+350-675 on their former facility. Additionally, they announced an exchange and roll of their outstanding convertible out to 2026.

Risk Factors:

There are multiple risk factors to an investment in ARAY:

• Competing against much larger firms in a market where it can be difficult to take market share
• Resurgence of COVID pandemic causes hospital budgets to remain under pressure
• Potential IP issues with China JV strategy
• Entrance of new competitors and technologies
• Business has historically produced subpar, lumpy results