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In an environment like this, there are two potential paths to take. The first is to take the risk of further broad market declines off the table, either by being net short (though that obviously creates its own category of risk) or by going heavily into cash (ditto).

The second is to lean into the declines — and take on risk. Obviously, individual financial circumstances put constraints on this type of strategy, but in plunging markets on a net basis it’s probably the right play. Market commentators often will recommend steep declines as the time to buy “quality”, but that’s not necessarily correct. If the timing is right, or close, it’s the lowest-quality companies that snap back the quickest. If the timing is wrong, quality doesn’t necessarily help; it’s the quality names that are the last to be sold on the way down.

Indeed, the last three months prove that latter point: the S&P was just 4% off all-time highs as recently as Mar. 29. Just a few weeks ago, utility stocks and the likes of Procter & Gamble (PG) were trading as if the rest of the market was rather quiet. When investors get worried, they sell the bad stuff. When they get panicked, they sell all of it.

As for the argument for being long high-risk rather than low-risk plays, March 2020 is a perfect example. Buying Microsoft (MSFT) was a good trade, but there were 300% and 800% gains to be had on shakier, financially leveraged, companies that saw true panic selling as the novel coronavirus pandemic took hold.

Certainly, forced to choose between more risk and less, for the most part we’ve leaned toward less. In fact, on Thursday, we argued forcefully that investors need to be planning for the worst, in ways that go beyond an equity portfolio. There is a nonzero chance of the next ten years being the ugliest decade of my lifetime (and I’ve got a few of those decades under my belt). We’ve had success in recommending short ideas (most recently Tesla (TSLA)), and in our long ideas have either looked for modest macro exposure and/or cautious entries into those ideas.

But it’s possible that we’re wrong, and that the market is closer to a bottom than we believe. The macro news isn’t all grim, and there’s still some hope on the political and social fronts (right?) Even in a bear market, there’s still some money to be made (Warren Buffett survived the 1970s just fine, thank you). And, to be blunt, we need topics to write about, and they can’t all be short ideas or 3,000-word screeds on how the world is ending.

For all these reasons, the search for long ideas right now should include names that a) have sold off; b) don’t really have the macro exposure to explain that selling pressure; and c) have at least a material chance of snapping back big.

To return to a common theme during this sell-off there are many stocks that won’t be recession victims and have declined — but only to levels where the fundamentals aren’t exactly compelling. Indeed, we’ve spent a few days this week reviewing many of them.1

But here’s one potential opportunity that fits these criteria. We reiterate, however: the point here is to take on risk, not run away from it.

Introducing Accuray

Accuray (ARAY) manufacturers radiosurgery2 and radiation therapy systems worldwide, along with the associated software. The CyberKnife is the company’s radiosurgery platform; the TomoTherapy radiation therapy system is transitioning to the next-gen Radixact system.

Accuray has nearly 1,000 installed systems worldwide, and a roughly equal number of employees. Trailing twelve-month revenue is about $430 million, across diversified geographies. Through the first three quarters of FY22 (ending June), 31% of sales came from the Americas; 29% from EMEA + India; 22% from China; and the remainder from Japan and the rest of the Asia-Pacific region.

ARAY Stock Fits The Profile

In terms of our target stock for this kind of market, ARAY fits well. It’s sold off sharply, declining 63% year-to-date with a notable acceleration of late:

source: finviz.com

In theory, the manufacturer of cancer-fighting machines shouldn’t have much, if any, macro exposure. Yet the stock is down by half since April.

The fiscal Q3 report late that month appears responsible to some degree, certainly: shares sold off 6.3% the following day. But the quarter actually beat estimates and Accuray reiterated full-year guidance; what is going on here seems more market-driven than company-driven.

The sell-off is huge in a historical context. Accuray went public in 2007. Thursday’s close of $1.76 (the stock gained three cents on Friday) was its lowest close ever excluding the three-week stretch (Mar. 13 to Apr. 3) of 2020 in which pandemic fears were at their highest.

And, to be sure, even at the lows there’s plenty of risk involved here.

The Risks First

Price action alone highlights the core risk here. Accuray stock now is down over 90% from its IPO price of $18. There’s a 15-year track record here of disappointment, at least as far as equity investors go.

Indeed, Accuray’s market cap sits at just $181 million; larger rival Varian Medical Systems was acquired last year by Siemens Healthineers (SMMNY) for almost 100x as much ($16.4 billion). Sweden’s Elekta AB (EKTAY) has the leading radiosurgery platform with its Gamma Knife. Accuray hasn’t won, and the nature of these high-tech businesses is that they rarely start winning 15 years after an IPO.

The fundamentals at the moment don’t look great, either, at least on their face. Accuray is guiding for $15-$20 million in Adjusted EBITDA this year. But $10.6 million of that figure comes from the exclusion of stock-based compensation. $8 million-plus in interest expense eats up the rest, and then some. Normalized free cash flow (adjusted for dilution) is in the negative $5 million range this year.

That’s a concern amplified by the balance sheet. Accuray closed Q3 with $182 million in debt, and $84 million net of cash. The net leverage ratio (even with the most generous reading of both Adjusted EBITDA and this year’s guidance) clears 4x.

The combination of low market share and high leverage is obviously a dangerous one. Yet ARAY trades ~16x its guidance for Adjusted EBITDA this year, hardly a multiple that suggests real value.

Improving Competitive Positioning

That said, there is a case that 16x EBITDA (even if most of that EBITDA is stock-based comp) and, perhaps more notably, 0.64x trailing twelve-month revenue both are quite attractive multiples in context.

Accuray is growing, at least on the top line. YTD revenue is up 11% from the same period two years earlier (nearly all of which was pre-pandemic). That’s despite significant headwinds over the last two years, including hospitals with budget priorities elsewhere and sharp declines in cancer screening.

Before the pandemic, Accuray was looking to undertake a turnaround effort. It cut costs while also ramping up R&D spending, which helped back the launch of artificial intelligence technology in the CyberKnife 7. The ability to grow revenue over the last two years suggests the turnaround is bearing at least some fruit; Accuray was able to at least roughly match Elekta’s growth over the same period.

The hope is that Accuray can start taking share from here. One possible catalyst is so-called RO-APM (Radiation Oncology-Alternative Payment Model) reimbursement from the U.S. federal government. RO-APM moves radiation therapy from fee-for-service to a value-based model starting on Jan. 1 (after a series of delays).

This ostensibly should increase demand for more advanced technologies such as radiosurgery, which better fit value-based reimbursement. And there is need for new machines; in a recent presentation Accuray cited an estimate that 40% of the U.S. installed base of radiation therapy machines is over nine years old; essentially at the end of its useful life. That report was actually from 2019, and given pandemic priorities it’s likely the figure now is higher.

Accuray aims to meet that demand with an improved lineup. The Synchrony AI technology can help. ClearRT imaging on the Radixact platform provides better images for technicians, and thus the potential for more effective treatments; it’s already been added to about 50% of orders since launch, per the Q1 call. ClearRT will be added to the CyberKnife platform likely next year.

There is a sense that Accuray finally is a better competitor than it’s been. In a market with relatively few entrants (ViewRay (VRAY) is another, though its sales are barely one-sixth that of Accuray) that can be enough to move the top-line needle.

The same is true of the company’s efforts in China. Accuray has entered a joint venture (JV) with state-owned entity China Isotope and Radiation Corp. For now, CIRC is acting “much like a distributor,” as Accuray put it in the 10-K, selling Accuray machines. Over time, that will transition to the JV manufacturing its own machines for the Chinese Type B (low-end to middle-market) market.

In Type A machines (the higher end of the market), the JV won 85% of the licenses awarded in China’s most recent Five-Year Plan. Accuray sees Type B as a $2.5 billion market opportunity over time; again, Accuray’s TTM sales are just $430 million.

Margin Pressure

Below the top line, Accuray too seems to face challenges. Product gross margins in Q3 looked ugly, dropping 740 bps year-over-year. But per the Q3 call, nearly all of the pressure comes from accounting vagaries related to the JV; that aside, even with cost inflation, product gross margin would have been down marginally y/y (against a +220 bps compare, driven by higher penetration of the CyberKnife).

But service gross margins are getting hit by parts shortages and other factors. Accuray’s guidance for the year was cut after Q2, a reduction which management said on that quarter’s call was driven largely by those shortages and resulting impacts on expedited shipping and other factors.

It’s certainly not good news that EBITDA margins are plunging to an expected ~4% this year from 9%-plus last year. It is, however, understandable news.

So, again, we see a profile here that seems to fit what investors should be looking for in this market, if not precisely today then soon. ARAY stock is down big. Yet this isn’t a growth stock coming back to Earth, or a pandemic winner that needs to adjust its business after reaching peak margins.

The external environment has not been kind to the company. To some extent, that’s interrupted a turnaround that seemed to be showing some green shoots. But the environment may actually be getting better for Accuray as it worsens for so many other companies.

Parts shortages are abating. A recession should moderate some inflationary impacts on costs, while having a minimal impact on demand. Long-term performance has disappointed, and 4% EBITDA margins (with 2%-plus in stock-based comp) are not where they need to be. But there’s a back-of-the-envelope case here for real upside: get revenue above $500 million and EBITDA margins to 8% (below FY21) and at 10x EBITDA, ARAY stock just about doubles.

Investors can poke holes in those somewhat randomly chosen numbers, but the point is that the rewards here are big if the core thesis is correct: that the Accuray turnaround was paused by the pandemic, rather than was ended by it.

And while there are risks, those risks might not be quite what a 4x-plus leverage ratio suggests. Accuray’s 2026 debt converts at $5.86 per share, more than triple the current price; yet those bonds still are priced above 104, yielding just 2.63%. Contrary to popular belief, the bond market isn’t always smarter than the equity market, but debt analysts clearly are arguing that any fears of insolvency are overblown.

Does this story wind up working? It’s truthfully difficult to tell. There are a lot of moving parts here: new ownership at Varian, new reimbursement policies, the crosswinds of a return to normalcy (a return that is much-delayed in the key region of China). It does seem like overall reimbursement rates are declining under RO-APM, which could provide a continued headwind to product sales for Accuray. More simply, the most likely scenario seems to be that Accuray doesn’t get its ship completely righted, if only because it hasn’t been able to do so for the 15 years it’s been a public company.

Those risks in general do seem to be worth taking in the context of a steep sell-off (again, ~50% since April) that doesn’t have a lot of justification. The rewards aren’t guaranteed to come soon, if at all, and in this market there’s no rush to catch a falling knife. But ARAY stock is the kind of stock we should be looking for right about now.

As of this writing, Vince Martin has no positions in any securities mentioned.

Tickers mentioned: ARAY

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