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Passport Special Situation Pick: Accuray

PASSPORT CAPITALPassport Special Opportunities Fund is coming off a disappointing fourth quarter – it was down -5.5% net versus 7.3% for the MSCI AC World Index and 11.8% for the S&P 500. Since inception in May 2008, the Fund has compounded at 9.7% net on an annualized basis. Over the same period, the MSCI AC World has compounded at -4.0% and the S&P 500 at -0.4%—Passport Capital has reoriented its outlook and $522.3 million portfolio accordingly (see Passport Capital’s stock picks).

In this article we cover a significant Passport Special Opportunities holding below:

Accuray (NASDAQ: ARAY), also held by Richard Schimel, Phill Gross And Robert Atchinson, and Charles Davidson, is a radiosurgery company with a ~$490 million market capitalization. Radiosurgery uses highly focused radiation therapy to treat cancer, including solid tumors. ARAY’s main product is the CyberKnife, which is the first intelligent robotic radiosurgery system. The CyberKnife system has image-guidance technology and a linear accelerator that is attached on a computer-controlled arm. This system can track and correct for tumor and patient movement real-time and deliver precise doses of radiation to the tumor. A huge benefit is that the procedure does not require anesthesia and can be performed on an outpatient basis. Passport believes Cyberknife is technologically superior to any other competing devices.

Approximately 600 CyberKnife devices have been installed worldwide. To add to its systems, ARAY acquired Tomotherapy last June. At the time, Tomotherapy was the number two player in the radiosurgery field. The $277 million deal should results in pro forma annualized revenue of approximately $400 million and strong bottom line performance if revenue synergies and economies of scale are factored in.

Recently Siemens (NYSE: SI), an electronics and electrical engineering conglomerate, exited the global radiation oncology market. Its products lacked the innovative edge that Varian’s (NYSE: VAR) products have. The result was that SI signed a marketing and distribution agreement with ARAY, under which they are now selling the Cyberknife and Tomotherapy systems. Now that SI is no longer in the linac business, ARAY is well-positioned to grab new orders. We think ARAY will also have an advantage in in retaining the 150-200 annual SI replacement orders given the established sales relationships.

SI’s exit creates a meaningful opportunity for the ARAY and its competitors Elekta (FRA:EJXB) and VAR. SI has a 2,000 unit installed base, representing an estimated $2 to $3 billion opportunity. The market opportunity would comprise new orders and replacement orders. Analysts have estimated that ARAY may be able to capture 10% of the newly freed up linacs. This revenue in addition to increased service revenue could potentially amount to $32 million through the first full year. VAR’s management has remained “cautiously optimistic” about SI conversion opportunities and indicated that the SI service organization would be a nice addition but not necessary to the success of their business.

ARAY did report a strong second quarter. Revenue of $103 million was better-than-expected but down 12% year-over-year. The Company continues to see “a significant sales pipeline” in all geographies. And with SI’s exit from the market, ARAY has already gotten two SI customers to purchase Tomotherapy systems, a positive sign that ARAY is capitalizing on this large opportunity. ARAY reported further good news with a 2.2% increase in backlog bringing the total to $277 million.

Although ARAY has delivered in the past two quarters, the question of how much you pay for a Company with narrow organic growth opportunities and an estimated couple of years before profitability, remains for investors. Cash flow generation would help appease investors, but ARAY is probably still a number of quarters away from turning that number positive.

ARAY and TomoTherapy are leaders in the specialty radiation therapy systems niche. We find the outlook for the radiation oncology market tenuous at best given reimbursement challenges. Additionally integration risks remain between ARAY and TomoTherapy. Shares of ARAY have had a recent surge and progress towards profitability have been made. Valuation is at approximately 1.0x forward sales but unless service margins are improved and additional revenue from the SI exit is successful, we remain cautious on ARAY’s future.

And for those wondering, robotic surgery pioneer, Intuitive Surgical (NASDAQ: ISRG), does not compete directly with ARAY in the radiosurgery/radiation therapy space. ISRG’s focus is on its already commercial da Vinci system. Mako Surgical (NASDAQ: MAKO), does provide robotic systems but its focus is on orthopedic procedures namely for prosthetic implants.

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